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Operating expenses vs capital expenses12/26/2023 ![]() ![]() (Excerpts from Financial Intelligence, Chapter 1: You Can’t Always Trust the Numbers)Īn example of the artful work of finance – and another one that played a huge role in recent financial scandals – is determining whether a given cost is a capital expenditure or an operating expense… You can see the temptation here. To Wall Street, it appeared that WorldCom was suddenly generating profits in a down industry – and no one caught on until later, when the whole house of cards collapsed. Bingo: these expenses disappeared off the income statement, and profits rose by billions of dollars. That was the logic pursued by CFO Scott Sullivan who began “capitalizing” his company’s line costs in the late 1990’s. Line costs were normally treated as ordinary operating expenses, but they argued (albeit incorrectly) that some of them were actually investments in new markets and wouldn’t start paying off for years. These were fees paid to local phone companies to use their phone lines. Take WorldCom, a large portion of this big telecom company’s expenses consisted of operating expenses called line costs. ![]() Taking a big item off the income statement and putting it on the balance sheet, so that only the depreciation shows up as a charge against profits, can have the effect of increasing profits considerably. Most companies follow a rule that any purchase over a certain dollar amount counts as a capital expenditure, while anything less is an operating expense. There is not an objective distinction between expensed costs and capitalized costs each company determines for itself which costs should be capitalized vs. Capitalizing indicates that the cost has been determined to be a capital expenditure and is accounted for on the balance sheet as an asset, with only the depreciation showing up on the income statement. Expensing a cost indicates it is included on the income statement and subtracted from revenue to determine profit. capitalizing refers to how a cost is treated on the financial statements. ![]()
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