Financial Education

Cash is the most basic example of an asset. Clearly it is a resource that will lead to future benefit for the enterprise. When a company spends its cash, it must determine whether the cash expenditure simply covered a current period operating cost or whether it purchased an asset that will be used to operate in future periods.

Operating costs are recorded as an expense on the income statement. For example, the payment of rent of $10,000 for the current period is an expense. This reduces assets (cash) by the amount spent and owners� equity (retained earnings). The next picture graphically illustrates the $10,000 expenditure.

Payment of Cash for an Operating Expense

Asset purchases are “capitalized” and recorded as an asset on the balance sheet. Only later (as the asset is used up) will the cost of the asset be transferred to the income statement as an expense. For example, buying inventory that will be sold in a future period would reduce the cash asset and increase the inventory asset. The next picture depicts using cash to acquire another asset (for example, inventory) that becomes a resource for future use.

Payment of Cash to Acquire Another Asset

The primary criteria for capitalizing rather than expensing an expenditure is whether it is expected to provide some future benefit (i.e. cash collection when the inventory is sold.) Since the classification requires some judgment, it is possible for management to make an honest mistake or to unscrupulously misclassify an expense as an asset. Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, Second Edition recommends that investors compare asset growth (particularly “other assets”) to sales growth as a means of identifying possible overcapitalization problems.

For more information, see all articles on: Accounting, Adjusting Reported Financial Statements, Financial Statement Analysis, Fundamental Analysis, Ratio Analysis

See also:

Accounting for Long-Term Intangible Assets: Capitalization vs. Expensing

Value Weighted Index

Debt to Equity

Economic Value Added (EVA)

Price Multiples