Ch' 7 Aggressive Capitalization

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Ch. 7 - Aggressive Capitalization
Q When should costs be capitalized (versus
expensed)?
A When the expenditure has future economic
benefits.
Matching Principle When reasonable and
practical, expenses should be recognized in the
same period as the revenue it helps to produce.
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What should be capitalized?

• Examples
• Inventory
• Fixed assets (incl. patents, licenses, leases,
  and franchises)
• Organization costs
• Goodwill acquired in merger
• Interest incurred during construction
• Petroleum exploration costs
• Software development costs

3
What should be not be capitalized?

• Examples
• Research and development
• Purchased in-process RD
• Start-up and pre-opening costs
• Advertising (except direct-response)
• Selling expenses

4
Capitalized Interest

• Added to assets cost
• Can't compare to an unlevered firm in same
  industry.
• Analyst should adjust interest expense to lower
  NI, CFO, and interest coverage ratios.
• Also watch for large changes in capitalized
  interest as they may signal changes in capital
  spending.

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Research and Development

• US requires expensing.
• International standards require capitalization
  once the product and market is defined and
  technological feasibility is apparent.
• Reseach shows the benefits of RD last 7-9 years
• Analyst must adjust to achieve comparability.

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Example Microsoft as if it were capitalizing
RD
Assume 3 year amortization period if RD were
capitalized.
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Oil and Gas

• Can use either capitalizing (full cost) or
  expensing (successful efforts)
•  
• Assume
• 1000 cost to drill a hole
• 1 hole producing, 3 dry
• Producing well lasts 4 years and produces net
  revenues of 3,000 per year

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Comparison
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Software Development Cost

• Before technological feasibility, must be
  expensed. After that, can be either capitalized
  or expensed.
• Microsoft expensed before 2000.
• Need to adjust for comparability.
• Lots of judgement involved.

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Example Lucent - as if if were expensing
software costs
From balance sheet
From CF Stmt.
CFO Adjusted
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Detection
Capitalizing normal operating costs.
Changing accounting policies which shift current
expenses to a later period.
Amortizing costs too slowly.
Failing to write down or write-off impaired
assets.
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Detection
Changes in capitalization policies just before
IPOs.
Compare the amortization and depreciation periods
within an industry. A significant difference is a
red flag.