Lesson 4 of 9
Capitalise or expense
Research is expensed and bought technology is capitalised, so identical cash produces different profit and returns.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- Research is expensed as incurred under US GAAP, while the same technology bought finished is capitalised and amortised over years.
- Over five years, on identical cash, the expensing company's cumulative profit trails the capitalising company's by exactly the asset still carried on the balance sheet.
- Both routes follow the rules; the distortion is comparing two companies without checking which route each took.
Two companies spend the same cash on the same technology and report different profit. One builds it and, under US GAAP, expenses the research as it goes. The other buys it finished, or capitalises the software costs the rules allow, and amortises them over years.
Same spending, two policies, five years of profit
- Capitalised and amortised
- Expensed immediately
Show the numbers
| Capitalised and amortised | Expensed immediately | |
|---|---|---|
| Year 1 | $180 | $100 |
| Year 2 | $160 | $100 |
| Year 3 | $140 | $100 |
| Year 4 | $120 | $100 |
| Year 5 | $100 | $100 |
What the choice moves
Expensing puts the whole cost in this period's income statement and nothing on the balance sheet, ever. Capitalising puts an asset on the balance sheet and charges it against profit across the years the asset serves. The cash is identical either way, but the cash flow statement classifies it differently: expensed spending sits inside operating cash flow, capitalised spending sits in investing.
Free cash flow is the same either way only if the capitalised spending is counted in capital expenditure. Bought technology usually sits in acquisitions, which most free cash flow figures leave out, so the buyer's free cash flow looks higher.
The boundary is not always between companies. Internal-use software is capitalised in part, from the point the rules set for a project. The same engineer's salary can be an expense one month and an asset the next.
Stock pay sharpens this. It is an expense in profit but a non-cash add-back in cash flow. A company that pays engineers in shares and capitalises their work lowers neither this year's operating profit nor its operating cash flow.
Profit converges, assets do not
By year five, the capitalising company is carrying five overlapping cohorts of amortisation and charges $100 a year, exactly what the expensing company always charged. The two income statements have converged. The balance sheets have not: the capitalising company carries a development asset the expensing company does not, and it will keep carrying one while the spending continues.
Which return you are reading
ValueScreener stores return on capital employed, after tax: the vendor's figure, over total assets less current liabilities, where one is published, and otherwise its own, over equity plus debt less cash. A capitalised development asset sits inside either base.
An expensed one never enters it, in any year. Two companies with the same cash economics and different routes to the same technology are not comparable on return on capital until you have made them comparable yourself.
Do it on a real 10-K
- Open the intangible assets note in Item 8 and find the year's additions to capitalised software or development costs, and the year's amortisation of them.
- Subtract the amortisation from the additions. Add the difference to operating expenses and recompute operating margin: that is the margin under full expensing.
- Repeat for the four prior years. A difference near zero describes a settled policy. One growing faster than revenue describes a policy lifting reported profit.
Check yourself
A company capitalises development spending instead of expensing it. What happens to this year's operating profit and total assets?
- Both fall
- Profit rises and total assets rise
- Neither changes
Show the answer
Answer: B.
The cost is spread over future years instead of charged in full now, so this year's profit is higher and the unamortised balance sits on the balance sheet as an asset.Two companies spend identical cash on the same work for five years, one expensing it and one capitalising and amortising it over five years. By year five, how do their annual profits compare?
- The capitalising company still reports much higher profit
- The two have converged to the same annual charge
- The expensing company now reports a loss
Show the answer
Answer: B.
By year five the capitalising company is amortising five overlapping cohorts, $100 a year, exactly what the expensing company always charged. The balance sheets still differ. The income statements do not.Once the two income statements have converged, which figure still differs?
- Revenue
- Return on capital, because the capitalised asset stays in its denominator
- Cash from financing activities
Show the answer
Answer: B.
The capitalised asset stays inside the capital base a return is divided by, even after the income statements converge. An expensed cost never enters that base, in any year.Sources
- ASC 350-40, Internal-Use Software: costs capitalised once a project passes the point the standard sets.
What this leaves out
- The example assumes flat spending and a five-year straight-line write-off; real amortisation periods differ by asset and by company, and a business whose spending keeps growing never reaches the steady state shown here.
- A capitalised asset later impaired arrives as one late expense, so a clean margin history followed by one large charge can be that.
- This lesson does not say which route is better: under US GAAP most research must be expensed, and capitalisation comes from buying technology or from software rules.
- Nothing here is advice about any security.