US CMA Part 2 · Chapter 2 · Question 14 of 15
During the year Vance Software improperly capitalized $400,000 of routine maintenance costs that should have been expensed. The costs were paid in cash. Ignoring depreciation and taxes, what is the effect on the current year's financial statements?
Test yourself: pick an answer
Reveal answer & explanation
Correct answer: B) Net income and cash flow from operating activities are both overstated
Explanation
Capitalizing the cost removes $400,000 of expense, so net income and total assets are overstated. Because the payment is classified as a capital expenditure, the cash outflow appears in investing activities instead of operating activities, so operating cash flow is overstated by $400,000 and investing cash flow is understated (more negative). Analysts watch for this because it flatters both earnings and operating cash flow.
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