How Companies Misuse Capitalizing of Expenses

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Jae Jun

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What You Will Learn

• How companies use capitalizing of expenses to cheat in accounting
• 4 easy ways expenses can be capitalized and red flags on agressive capitalizing of expenses

Aggressive and Conservative Accounting Series

For previous articles in the series, click on the links below.

• Aggressive and Conservative Accounting Policies
• How to Detect Aggressive Revenue Recognition Policy
• FIFO LIFO Inventory Valuation Methods
• Straight Line and Accelerated Depreciation Methods
• Aggressive Accounting: Reserves, Allowances, Contingent Liabilities
• How Companies Misuse Capitalizing of Expenses

Introduction to Capitalizing of Expenses

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Capitalizing of Expenses and how it works

Capitalizing of expenses | Flickr: Phillie Casablanca

Companies expense costs related to the business which offsets revenue, but there are instances where companies will record costs as an asset on the balance sheet. This is what you call “capitalizing” or capitalizing of expenses. Note that this is completely different to capitalization/capital structure, which is how a firm finances its overall operations and growth by using different sources of funds.

To start, you need to group assets into two categories.

1. assets that are expected to produce a future benefit such as inventory, equipment and property
2. assets that are expected to be exchanged for another asset such as cash, receivables and investments

As an example for no.1, assume that a company has spent $10,000 for a two year insurance policy. At the time of the purchase, the entire amount represents a future benefit and would therefore be an asset. After one year passes the insurance policy would only have one year of insurance asset ($5,000) on the balance sheet with the other half ($5,000) now being classified as an expense.

By the end of the second year, the asset line will be zero and the expense line will show another $5,000 for the final year expense.

What you see is that if a company capitalizes an expense, the cash outflow is immediate but rather than offsetting the revenue immediately, only a partial amount is offset with the remaining being depreciated or amortized.

4 Ways in which Expenses can be Capitalized

Here are four ways to distinguish expenses from capital expenditures. In reality though, it can be difficult to distinguish between the two. (wikipedia)

1. Costs that produce a benefit that will last substantially beyond the end of the taxable year.
2. New assets that have a useful life substantially beyond one year.
3. Improvements that prolong the life of the property,restore property to a “like-new” condition, or add value to the property.
4. Adaptations that permit the property to be used for a new or different purpose.

There is a lot of gray in accounting and it is up to you as an investor to determine whether the capitalized costs are reasonable.

Can Marketing Costs be Capitalized?

Marketing expenses are normal operating expenses that produce short term benefits. Unless the company can produce evidence that a specific advertising will create long term benefits, assume that all marketing costs should be expensed instead of capitalized.

Marketing, advertising, solicitation costs are all the same thing. Don’t be fooled by the language that companies use in order to hide aggressive accounting.

3 Warnings Signs of Aggressively Capitalizing Expenses

1. Sudden improvements in profit margins with a large jump in certain assets
2. Big unexpected drops in FCF and cash flow from operations
3. Unexpected increases in capex that do not match company guidance and market conditions

Inappropriate Capitalizing of Expenses

Additional items you should watch for.

• Watch for changes in accounting policy as this is a big red flag. An accounting change is not growth. It will not recur.
• Watch for strange new asset line items on the balance sheet. If a new asset account suddenly appears and is growing rapidly, you have some information to dig up related to what this new asset is for.
• Capitalizing too much. Make sure the company does not capitalize more than it needs to. E.g. you wouldn’t want to see a company capitalized 100% of its R&D cost.
• Be wary of software development costs being capitalized. Early stage research and development should be expensed while later stage developments can be capitalized. Best to make sure it is in line with industry standards.
• Watch for different capitalization policies in the same industry.
• Watch for accelerated software capitalization. An accelerating rate of software capitalization is often a red flag that earnings benefited from keeping more costs on the balance sheet.

Companies are allowed to use capitalizing of expenses but the decision comes down to what expenses should be capitalized. Most will remain within the boundary legitimacy while others will walk an aggressive tight line that leads to creative accounting and earnings manipulation.