Are You Comparing Apple With Apple?

Foreword from ShareInvestor

This article “Are You Comparing Apple With Apple?” by Teh Hooi Ling was first published in The Business Times on 11 December 2004 and is reproduced in this blog in its entirety.

Whether a company capitalises or expenses an item can make a big difference to its balance sheet, income and cash flow statements, and its accounting ratios

This week, education group Auston said that its profits were overstated because it had capitalised instead of expensed up-front fees payment to certain universities.

This is the second franchise company whose accounting practices were called into question. Today, we’ll discuss the impact of capitalising versus expensing on a company’s balance sheet, income and cash flow statements, and its accounting ratios. We’ll also try to compare the accounting policies of a few Singapore companies with franchises. 

 What They Did

Auston said that under its accounting policies, student enrolment charges paid to certain universities should be expensed. However, if the payments relate to up-front fees for collaborations with the universities or academic co-operation fees, then they could be capitalized.

It was found some of the enrolment charges were recorded as collaboration or cooperation fees, and were thus capitalised instead of expensed.

Incidentally, Auston changed the estimate useful of its furniture and fittings from five years to 10 years last year. That change resulted in a rise of $43,000 in its 2003 net profit.

When an item is expensed, it means that the item is deducted against the revenues of a company in its profit and loss statement. So the company’s net profit will be reduced by that amount.

However, if it is capitalised, it is recorded as an asset. The company’s profit and loss account will not be hit immediately. The asset will then be amortised over its useful life, say, five years. In other words, the sum spent on acquiring the ‘asset’ will be split up and deducted from the company’s profits over five years.

Under the generally accepted accounting principles, the costs associated with the acquisition of long-lived assets which will yield future economic benefits can be capitalised. Or, they can be expensed at the discretion of the management.

In Auston’s case, the company has decided that ‘development costs incurred in developing new courses and the accompanying manuals and other projects are capitalised so long as it can reasonably be expected to be recovered from related future revenues’.

Such expenditure is amortised over the periods expected to benefit from it, commencing with the period in which related revenues are first generated.

As for Breadtalk, the company has decided to capitalise cost relating to trademarks and amortise them over five years. And cost relating to master franchise fees paid are capitalised and amortised on a straight-line basis (or equally) over the franchise period.

Osim, however, did not disclose if it capitalises any of its costs associated with the development of its products or franchise. From its balance sheet, there is no item in the assets segment to suggest it capitalises some of its costs. Unless, of course, it lump them into other categories of assets. 

 The Impact

 Management discretion can result in smoothing or manipulation of reported income, cash flows and other measures of financial performance. Moreover, unlike some accounting choices whose effects reverse or ‘even out’ over time, effects of the decision to capitalise or expense may never reverse.

The decision to capitalise or expense an item will have the biggest impact on the financial numbers of a company in its early stages of growth.

Companies that capitalise costs and depreciate them over time show smoother patterns of reported earnings, while those that expense costs as incurred have greater volatility in reported earnings.

But as the company matures and grows bigger, that volatility declines.

For two similar growing companies, the one that decides to expense all its costs will report lower profitability, both in absolute terms and relative to its assets and sales.

In later years, as the companies mature and growth subsides, return on sales remains lower for the expensing companies. But because their asset base is smaller as a result of not carrying the costs as part of assets, their return on asset and return on equity will exceed those that capitalise costs.

The decision to capitalise or expense an item also has implications on the company’s reported cash flow statements.

Cash expenditures for capitalised assets are included in investing cash flows and never flow through cash from operations. Meanwhile, companies that expense the outlays include them in the cash flows generated or used in operations. In other words, a company that expenses its development costs will report lower cash flows from operations compared with one that capitalised its costs.

And since expensing companies report lower assets and equity balances, their debt-to-equity and debt to assets ratios will appear worse than companies that capitalise the same costs.

Now let’s work through an example.

Company A and B are in exactly the same business and in the same stage of growth. But A is more conservative and decides to expense all its development costs for its products. B, however, has decided to capitalise them and amortise them over five years.

Let’s say both companies have an asset base of $1,000. Both are developing a new product for the future and that costs them $100. By the end of the year, both companies rake in $300 of revenues.

Assume that the other operating costs amount to $150. For company A, since it has decided to expense its development costs, its reported profits will be $50 only ($300-$150-$100).

For company B, only one-fifth of development costs will be charged to its profit and loss account this year. So it will report a higher profit of $130 ($300-$150-$20).

At the end of the year, company A’s return on asset will work out to 5 per cent ($50/$1,000). Company B’s ROA, meanwhile, will be 12 per cent. That’s $130 divided by $1,080. The remaining development costs not expensed will be recorded as profits.

 Big Difference

 As you can see, the difference can be quite significant. The discrepancy can be even bigger if the two companies adopt different revenue recognition policies.

So the next time you compare two similar companies, make sure that they have the same accounting policies. If not, do the adjustment yourself so that you are comparing apple with apple.