Long Lived Assets are assets that are expected to provide economic benefits over a future period of time, usually more than 1 year (also known as long-term assets). They can be Tangible, intangible or financial assets, I am not planning to explain these categories in details since I am addressing the method to treat them during the financial analysis (we might get into them with more details in some future posts). As most of accountants know, the 2 main issues when you are accounting for long lived assets are determining the cost at acquisition and allocating the cost to be expensed during the life of the long lived asset. During my work there was another issue I faced which was when to use the cost model and when to use the revaluation model, derecogintion of assets is another major issue for me personally.
When capitalizing an asset the amount of assets on the balance sheet increases and the amount of investing cash outflow also increases!. After that the company starts depreciating the capitalized asset(after determining its useful life, salvage value and depreciation method of course) the expense will reduce net income and the asset’s value on the balance sheet, they(the expenses) will have no impact on the cashflow statement other than their impact on the taxable income.
On the other hand, an asset that is expensed will have no impact on the assets’ section on the balance sheet, it will only reduce the net income in the period it is expensed and will have an impact on the operating cashflow in that period, no effect will be registered in the subsequent periods !.
From what I have explained earlier its obvious that capitalizing will result in higher profitability in the first year and lower profitability ratios in the subsequent years, however! expensing will result in lower profitability in the first year and higher profitability in the coming years which will show a positive trend.
It is quite important for analysts to understand the effects of capitalising or expensing on cashflow statements, as we all know cashflow from operating activities are important in valuation models so it’s common that companies try to capitalize assets that should be expensed in order to increase their operating cashflows in cases where they should actually be expensed.
CAPITALISATION OF INTEREST COSTS
According to the International Accounting Standards(IAS), any interest costs associated directly to the construction of an asset that needs a long period for its intended use should be capitalised (IAS 23 Borrowing Costs), however some companies do expense those costs.
Let’s say the interest incurred is for a construction for the company’s asset to use, that interest will be reflected on the balance sheet as part of long lived assets, it will be expensed over time with the depreciation expense, however if the company was a real estate company, the capitalised interest will be expensed whenever the company makes a sale through cost of goods sold.
when making a financial analysis we should be aware that capitalised interest will appear as investing cash outflow whereas expensed interest will reduce the operating cashflow, so an analyst should be able to distinguish between those effects and adjust them if he is faced with similar firms that treated their assets differently. Another thing to keep in mind is that if a company is depreciating an interest that has been capitalised in previous periods, income should be adjusted to eliminate the effect of that depreciation.
One last thing to say about interest costs is when using solvency ratios, the analyst should use capitalised interest and expensed interest to calculate interest coverage ratios in order to come up with accurate conclusions.
This is a little part to give some insights about how to distinguish between “capitalised” and “expensed” fixed assets during your financial analysis. This topic can’t be narrowed and explained in details in one article so we will come to it again with more details on specific points.