To capitalize or to expense

2. Example of asset capitalization concept

Let’s look at a simple example to better understand how capitalizing or expensing a cost affects the balance sheet and income statement. Fictitious Entity is a public company that manufactures and sells high-tech medical equipment. As of December 31, 20X1, the company had the following balance sheet (simplified):

Fictitious Company
Simplified Balance Sheet
December 31, 20X1

Assets

$10,000

Liabilities

$4,000

   

Shareholders’ Equity

$6,000

Total Assets

$10,000

Total Liabilities & Shareholders’ Equity

$10,000

During 20X2, Fictitious Entity recognized $3,000 in revenues and $2,000 in expenses. Also, at the end of the year, the company incurred $500 in machinery repair and maintenance costs. Should the company capitalize or expense $500? To see the accounting treatment of the repair and maintenance costs, refer to the following guide on accounting for repair and maintenance costs.

To analyze the effects of capitalizing or expensing a cost, let’s look at the resulting financial statements for 20X2 in both cases (i.e., assume all transactions were in cash):

 

Capitalize

Expense

Difference

Balance Sheet

     

Assets

$11,000

$10,500

$500

Liabilities

4,000

4,000

0

Shareholders’ Equity

7,000

6,500

500

       

Income Statement

     

Revenues

$3,000

$3,000

0

Expenses

2,000

2,500

(500)

Net income

1,000

500

500

If the company expenses $500 of repairs and maintenance costs (i.e., minor repairs), it will recognize more expenses and as the result its net income will be lower (by $500). Also, in this case the total assets and shareholders’ equity will be lower.

If the company capitalizes $500 of repairs and maintenance costs (i.e., major repairs), no expense will be recognized in 20X2 (because repair and maintenance costs were incurred at the end of the year) and the net income will be $500 higher. This added cost of $500 will however be recognized in future periods as depreciation expense. Most probably this amount of $500 will be spread over multiple years and thus, the $500 will increase depreciation expense (reduce net income) in multiple future periods.

If Fictitious Entity is a high-growth company with few assets in place, it might have an incentive to capitalize the repair and maintenance cost to reduce the variability (“inconsistency”) in its accounting earnings (i.e., smooth income). Also, the existence of accounting-based debt covenants (e.g., such ratios as: long-term debt and equity to long-term debt, reported earnings to interest expense, net tangible assets to long-term debt) and management compensation contracts (e.g., CEO bonus based on reported earnings) might provide an incentive to reduce the earnings variability. The reduction in earnings variability can have other potential benefits for the company including a lower cost of capital, reduced political costs, analysts following, investor confidence, stock price increase, etc.

One of the fraud cases involving capitalization of ordinary expenses is WorldCom scandal. For instance, in 2001 WorldCom recognized $3.1 billion in long-distance charges as a capital expenditure (asset) while the $3.1 billion should have been booked as an operating expense. If the company had recognized the $3.1 billion as an operating expense, the company would have been at a loss in 2001. By capitalizing the cost, the company was able to “smooth” its earnings.

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