When a company obtains an asset they have two ways to recognize the expenditure: they can either capitalize the asset or expense it. Both options of recognizing expenditures effect financial statements such as the balance sheet, statement of cash flow, and the income statement. Also, the decision of whether to capitalize or expense will have an impact on key financial ratios, something a candidate in the CFA or CPA program should have a concrete understanding of.
First, companies are only able to capitalize the cost of a resource if it provides the company with a benefit longer than one operating cycle. If a company decides to capitalize an expenditure they will recognize the asset on their balance sheet and record the cost as an investing cash outflow on the statement of cash flows. In each period after the initial purchase, the company will depreciate or amortize the asset over the course of its useful life, assuming the asset can be depreciated or amortized (check out this article to learn all about depreciation/amortization).
Instead of capitalizing an expenditure, a company could expense it. In this situation, no asset is recorded on the balance sheet and the cost is reflected as an operating expense on the statement of cash flows.
In the end, it is up to management to decide whether to capitalize or expense an expenditure as the decision will have different effects on reporting. If it is decided to capitalize, the company will report higher profitability: both ROE and Net Profit Margin will be higher in the first year than if they decided to expense, however capitalizing will result in lower profitability ratios in subsequent years. If management wanted to show a favorable increase in profitability, then they might decide to expense the cost of an asset. This decision this will show lower profitability in the first year, but higher profitability in later years as no portion of the expense will be reported in subsequent years (as the case would be with the depreciation/amortization of a capitalized asset).
Capitalizing an expenditure will result in higher cash flow from operations because the acquisition of property, plant, or equipment, or other long term assets, would be considered cas flow from investing activities. (If you need a refresher on cash flow classification, you might want to read this.) Expensing, however, reduces operating cash flow which is an important factor that analysts look at. Because capitalizing does not lower cash flow from operations, management may try to manipulate cash flow reporting by capitalizing some expenditures that should be expensed.
There are many factors to consider if you are part of the management team of a company deciding whether to expense/capitalize an expenditure, or if you are an analyst looking into a company’s financials. Something that this decision will impact is the amount of taxes a company will owe: a company who expenses an expenditure will end up paying less taxes for the year than a company that capitalizes because they will report more expenses which means lower income.
As an analyst, it is not realistic or feasible to identify each instance involving management’s decision about whether they should capitalize or expense expenditures. However, knowing about and understanding the effects of this decision will be useful if a company expenses a significant item instead of capitalizing it.