General Principles
The three common expense recognition models are as follows: the matching principle, expensing as incurred, and capitalisation with subsequent depreciation or amortisation.
Period costs, expenditures that less directly match revenues, are generally expensed as incurred (i.e., either when the company makes the expenditure in cash or incurs the liability to pay). Costs associated with administrative, managerial, information technology (IT), and research and development activities as well as the maintenance or repair of assets generally fit this model.
Capitalisation versus Expensing
Depreciation and amortisation are non-cash expenses and therefore, apart from their effect on taxable income and taxes payable, they have no impact on the cash flow statement.
Capitalisation of Interest Costs
The treatment of capitalised interest poses certain issues that analysts should consider. First, capitalised interest appears as part of investing cash outflows, whereas expensed interest typically reduces operating cash flow. US GAAP–reporting companies are required to categorise interest in operating cash flow, and IFRS-reporting companies can categorise expensed interest in operating, or financing cash flows. Although the treatment is consistent with accounting standards, an analyst may want to examine the impact on reported cash flows. Second, interest coverage ratios are solvency indicators measuring the extent to which a company’s earnings (or cash flow) in a period covered its interest costs. To provide a true picture of a company’s interest coverage, the entire amount of interest expenditure, both the capitalised portion and the expensed portion, should be used to calculate interest coverage ratios. Additionally, if a company is depreciating interest that it capitalised in a previous period, income should be adjusted to eliminate the effect of that depreciation.
Capitalisation of Internal Development Costs
Implications for Financial Analysis: Expense Recognition
