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.
Holding all else constant, capitalising an expenditure enhances current profitability and increases reported cash flow from operations. The profitability-enhancing effect of capitalising continues so long as capital expenditures exceed the depreciation expense. Profitability-enhancing motivations for decisions to capitalise should be considered when analysing performance.
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.
The treatment of capitalised interest raises issues for consideration by an analyst. First, capitalised interest appears as part of investing cash outflows, whereas expensed interest reduces operating or financing cash flow under IFRS and operating cash flow under US GAAP. An analyst may want to examine the impact on reported cash flows of interest expenditures when comparing companies. 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, both the capitalised portion and the expensed portion, should be used in calculating interest coverage ratios.
Capitalisation of Internal Development Costs
Expensing rather than capitalising development costs results in lower net income in the current period. Expensing rather than capitalising will continue to result in lower net income so long as the amount of the current-period development expenses is higher than the amortisation expense that would have resulted from amortising prior periods’ capitalised development costs—the typical situation when a company’s development costs are increasing. On the statement of cash flows, expensing rather than capitalising development costs results in lower net operating cash flows and higher net investing cash flows. This is because the development costs are reflected as operating cash outflows rather than investing cash outflows.
Implications for Financial Analysis: Expense Recognition
Information about a company’s accounting policies and significant estimates are described in the notes to the financial statements and in the management discussion and analysis section of a company’s annual report.
