Capitalization

[Nicolas.joun]

Company X paid $4 million to acquire a franchise at thc beginning of 2000 that was expensed in 2000. If Company X had elected to capitalize the franchise as an intangible asset and amortize the cost of the franchise over eight years, what effect would this decision have on Company’s X 2000 cash flow from operations and 2001 debt-to-assets-ratio?
A. Both would be higher with capitalization.
B. Both would be lower with capitalization.
C. One would be higher and one would be lower with capitalization.
Answer is C.
I believe it’s answer A - if the asset was capitalized in year 2000 then year 2000 Debt-to-asset ratio would be lower.
However Debt-to-Asset ratio in 2001 is higher. with accumulated depreciation asset would decline and the ratio is higher.
thoughts??

 

[lawnm0wer]

To clarify, operating cash flow would definitely be higher because the “expense” is not being amorized over eight years instead of being taken all in 2000.
As far as your point about accumulated depreciation, I think it’s incorrect for a couple of reasons. First, the question doesn’t outline the depreciation method, so why not absolutely relevant, I would take that as a clue that you may be overthinking the problem. Secondly, even if we assume accumulated depreciation is on the books, reducing the asset’s carrying value, the debt-to-asset ratio is still lower than compared to the option of expensing the asset.
It seems like you’re trying to compare the debt-to-asset ratio from 2000 to 2001 when the question is asking you to compare debt-to-assets using two different methods of accounting for the asset.

 

[Nicolas.joun]

True ! well reasonned.
exactly was comparing 2000 to 2001.

 

[S2000magician]

Try some numbers (assuming 2001 net income is $2 million without the purchase, and all liabilities are debt). Without the purchase:

• 2000 Assets: $20 million
• 2000 Liabilities: $12 million
• 2000 Equity: $8 million
• 2001 Assets: $22 million
• 2001 Liabilities: $12 million
• 2001 Equity: $10 million

Expensing the purchase:

• 2000 Assets: $16 million
• 2000 Liabilities: $12 million
• 2000 Equity: $4 million
• 2001 Assets: $18 million
• 2001 Liabilities: $12 million
• 2001 Equity: $6 million
• 2001 debt-to-assets: 0.6667

Capitalizing the purchase:

• 2000 Assets: $20 million
• 2000 Liabilities: $12 million
• 2000 Equity: $8 million
• 2001 Assets: $21.5 million
• 2001 Liabilities: $12 million
• 2001 Equity: $9.5 million
• 2001 debt-to-assets: 0.5581

 

[Nicolas.joun]

exactly ! looks way better with numbers
thanks for elaborating. Appreciate it

 

[achokshi]

S2000magician wrote:
Try some numbers (assuming 2001 net income is $2 million without the purchase, and all liabilities are debt). Without the purchase:

• 2000 Assets: $20 million
• 2000 Liabilities: $12 million
• 2000 Equity: $8 million
• 2001 Assets: $22 million
• 2001 Liabilities: $12 million
• 2001 Equity: $10 million

Expensing the purchase:

• 2000 Assets: $16 million
• 2000 Liabilities: $12 million
• 2000 Equity: $4 million
• 2001 Assets: $18 million
• 2001 Liabilities: $12 million
• 2001 Equity: $6 million
• 2001 debt-to-assets: 0.6667

Capitalizing the purchase:

• 2000 Assets: $20 million
• 2000 Liabilities: $12 million
• 2000 Equity: $4 million
• 2001 Assets: $21.5 million
• 2001 Liabilities: $12 million
• 2001 Equity: $9.5 million
• 2001 debt-to-assets: 0.5581

A = 20 mill
L = 12
E = 4
A does not = L + E here? Why not?

 

[S2000magician]

achokshi wrote:

S2000magician wrote:Try some numbers (assuming 2001 net income is $2 million without the purchase, and all liabilities are debt). Without the purchase:

• 2000 Assets: $20 million
• 2000 Liabilities: $12 million
• 2000 Equity: $8 million
• 2001 Assets: $22 million
• 2001 Liabilities: $12 million
• 2001 Equity: $10 million

Expensing the purchase:

• 2000 Assets: $16 million
• 2000 Liabilities: $12 million
• 2000 Equity: $4 million
• 2001 Assets: $18 million
• 2001 Liabilities: $12 million
• 2001 Equity: $6 million
• 2001 debt-to-assets: 0.6667

Capitalizing the purchase:

• 2000 Assets: $20 million
• 2000 Liabilities: $12 million
• 2000 Equity: $4 million
• 2001 Assets: $21.5 million
• 2001 Liabilities: $12 million
• 2001 Equity: $9.5 million
• 2001 debt-to-assets: 0.5581

A = 20 mill
L = 12
E = 4
A does not = L + E here? Why not?

Typo. Good eye. Fixed.