After the initial feasibility studies, all software development costs can be capitalized under US GAAP. Ultrasoft and Littlesoft are rival firms which are similar in size and scope of operations. Ultrasoft has decided not to capitalize but expense software development costs in Year
1. Littlesoft, on the other hand, has decided to capitalize a similar amount of development costs, to be amortized over 5 years. Which of the following is/are true over the next 5 years?
I. Littlesoft will show higher equity than Ultrasoft
II. The difference in Littlesoft's assets and Ultrasoft's assets will be lower in Year 3 than in Year 2.
III. The total tax deductions due to the development costs are equal for the two firms.
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A. B. C. D.Explanation
When Littlesoft capitalizes the expenses, its assets increase, net of depreciation and tax expenses. Hence, it shows higher assets than Ultrasoft (but this difference reduces steadily to zero over the period over which the expense is amortized). This difference also translates into an equal difference between the retained earnings as well as equity (Recall assets = liabilities + equity). Thus, over the next 5 years, Littlesoft will show higher equity than Ultrasoft. The difference will reduce to zero by the end of the period over which the capitalized expense is amortized. Over 5 years, the total tax deductions taken by the two firms are equal to the initial expense. Hence, the taxes paid are equal; the difference is that Ultrasoft delays the payment of taxes by expensing. Lesson: Expensing delays tax payments, capitalizing hastens them.