Two growing firms are identical except that one firm capitalizes, whereas the other firm expenses costs for long-lived resources over time. For these two firms, which of the following statements is generally true?
I. The expensing firm will show a more volatile pattern of reported income than capitalizing firm.
II. The expensing firm will show a less volatile pattern of return on assets than the capitalizing firm.
III. The expensing firm will show lower cash flows from operations than the capitalizing firm.

A)I only
B)II only
C)I and III only
D)II and III only

Question

Two growing firms are identical except that one firm capitalizes, whereas the other firm expenses costs for long-lived resources over time. For these two firms, which of the following statements is generally true? 
I. The expensing firm will show a more volatile pattern of reported income than capitalizing firm.
II. The expensing firm will show a less volatile pattern of return on assets than the capitalizing firm.
III. The expensing firm will show lower cash flows from operations than the capitalizing firm.

A)I only
B)II only
C)I and III only
D)II and III only

Quizplus · Accepted Answer

I is true because the expensing firm will report higher expenses and lower income in the short term, leading to more fluctuations in reported income. 
III is true because capitalizing on costs will result in lower reported expenses and higher reported operating cash flows in the short term, whereas expensing will result in higher reported expenses and lower reported operating cash flows. 
II is not necessarily true because return on assets depends on both income and assets, and capitalizing may lead to higher reported assets but potentially lower reported income, whereas expensing may lead to lower reported assets but potentially higher reported income.

Two Growing Firms Are Identical Except That One Firm Capitalizes