A company spends $500,000 on a cost that it capitalizes as an asset, whereas an otherwise identical competitor expenses an equivalent cost immediately. In the year of the expenditure, relative to the competitor, the capitalizing company will most likely report:
- ANo effect on net income, higher total assets, and lower return on assets
- BHigher net income, higher total assets, and typically higher return on assets in that year
- CLower net income, lower total assets, and higher return on assets
- DHigher net income, lower total assets, and lower return on assets
Show answer & explanationAnswer & explanation
Correct answer: B. Higher net income, higher total assets, and typically higher return on assets in that year
Capitalizing defers the cost, recognizing only a fraction as depreciation in year one rather than the full expense; this results in higher net income and higher total assets than expensing. Because net income typically rises proportionally more than assets in the first year, ROA is typically higher for the capitalizing firm in that period (though ROA will be lower than the expensing firm's in later years).
Why the other options are wrong
- A. Incorrect — capitalizing does increase net income in the year of expenditure since only depreciation, not the full cost, is expensed.
- C. Incorrect — capitalizing raises, not lowers, net income and total assets in year one.
- D. Incorrect — capitalizing increases total assets, it does not decrease them.
Capitalizing vs. Expensing Costs
Capitalizing a cost spreads the expense over future periods via depreciation, whereas expensing recognizes the full cost immediately, affecting net income, total assets, and related ratios differently in the year of expenditure.
- Capitalizing: higher net income and total assets in year one
- Expensing: lower net income and total assets immediately, but higher expense volatility avoided later
- Capitalizing generally produces higher ROA/ROE and smoother earnings in early years, reversing over the asset's life
Memory trick: Capitalize now, depreciate later — assets and earnings both look bigger today