CFA Program Level I for November 2024 !

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K Home & ' Expense Recognition 3 4 7 6

Lessons Table of Contents Confidence Levels Notes Bookmarks Highlights Expense Recognition
u Study Plan

k Lessons

g Flashcards

r Practice EXPENSE RECOGNITION

v Mock Exams
Learning Outcome
j Game Center describe general principles of expense recognition, specific expense recognition applications,
implications of expense recognition choices for financial analysis and contrast costs that are capitalized
e Discussions
versus those that are expensed in the period in which they are incurred
B Search Assume a company purchased inventory for cash and sold the entire inventory in the same period. When
the company paid for the inventory, absent indications to the contrary, it is clear that inventory cost was
incurred and when that inventory is sold, it should be recognized as an expense (cost of goods sold).
Assume also that the company paid all operating and administrative expenses in cash within each
accounting period. In such a simple hypothetical scenario, no issues of expense recognition would arise. In
practice, however, as with revenue recognition, determining when expenses should be recognized can be
somewhat more complex.

General Principles
In general, a company recognizes expenses in the period that it consumes (i.e., uses up) the economic
benefits associated with the expenditure, or loses some previously recognized economic benefit. The three
common expense recognition models are as follows: the matching principle, expensing as incurred, and
capitalization with subsequent depreciation or amortization.

Under matching, a company recognizes expenses (e.g., cost of goods sold) when associated revenues are
recognized, and thus, expenses and revenues are matched. Associated revenues and expenses are those
that result directly and jointly from the same transactions or events. Unlike the simple scenario in which a
company purchases inventory and sells all of the inventory within the same accounting period, in practice, it
is more likely that some of the current period’s sales are made from inventory purchased in a previous
period or previous periods. It is also likely that some of the inventory purchased in the current period will
remain unsold at the end of the current period and so will be sold in a following period. Matching requires
that a company recognizes cost of goods sold in the same period as revenues from the sale of the goods.
Strictly speaking, IFRS do not refer to a “matching principle” but rather to a “matching concept” or to a
process resulting in “matching of costs with revenues.”

Example 2 demonstrate matching applied to inventory and cost of goods sold.

EXAMPLE 2

The Matching of Inventory Costs with Revenues

Kahn Distribution Limited (KDL), a hypothetical company, purchases inventory items for resale. At the
beginning of 20X1, Kahn had no inventory on hand. During 20X1, KDL had the following transactions:

Inventory Purchases

First quarter 2,000 units at USD40 per unit

Second quarter 1,500 units at USD41 per unit
Third quarter 2,200 units at USD43 per unit
Fourth quarter 1,900 units at USD45 per unit
Total 7,600 units at a total cost of USD321,600

KDL sold 5,600 units of inventory during the year at USD50 per unit and received cash. KDL
determines that there were 2,000 remaining units of inventory and specifically identifies that 1,900 were
those purchased in the fourth quarter and 100 were purchased in the third quarter.

1. What are the revenue and expense associated with these transactions during 20X1 based on
specific identification of inventory items as sold or remaining in inventory? (Assume that the
company does not expect any products to be returned.)

Hide Solution

Solution:

The revenue for 20X1 would be USD280,000 (5,600 units × USD50 per unit). Initially, the total
cost of the goods purchased would be recorded as inventory (an asset) in the amount of
USD321,600. During 20X1, the cost of the 5,600 units sold would be expensed (matched
against the revenue) while the cost of the 2,000 remaining unsold units would remain in
inventory as follows:

Cost of Goods Sold

From the first quarter 2,000 units at USD40 per unit = USD80,000
From the second quarter 1,500 units at USD41 per unit = USD61,500
From the third quarter 2,100 units at USD43 per unit = USD90,300
Total cost of goods sold USD231,800

Cost of Goods Remaining in Inventory

From the third quarter 100 units at USD43 per unit = USD4,300
From the fourth quarter 1,900 units at USD45 per unit = USD85,500
Total remaining (or ending) inventory cost USD89,800

To confirm that total costs are accounted for: USD231,800 + USD89,800 = USD321,600. The
cost of the goods sold would be expensed against the revenue of USD280,000 as follows:

Revenue USD280,000
Cost of Goods Sold 231,800
Gross Profit 48,200

An alternative way to think about this is that the company created an asset (inventory) of
USD321,600 as it made its purchases. At the end of the period, the value of the company’s
inventory on hand is USD89,800. Therefore, the amount of the Cost of goods sold expense
recognized for the period should be the difference: USD231,800.

The remaining inventory amount of USD89,800 will be matched against revenue in a future year
when the inventory items are sold.

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. For most companies, payroll expenses are
accounted for this way, excluding employees whose compensation is considered a product cost and
recognized as inventory and later cost of goods sold or items like sales commissions, which are capitalized
and expensed systematically or with sales.

Capitalization versus Expensing

Finally, certain expenditures are capitalized as assets on the balance sheet and typically appear as an
investing cash outflow on the statement of cash flows. After initial recognition, a company expenses the
capitalized amount over the asset’s useful life as depreciation or amortization expense (except assets that
are not depreciated, i.e., land, or amortized, e.g., intangible assets with indefinite lives). This expense
reduces net income on the income statement and reduces the value of the asset on the balance sheet.
Depreciation and amortization 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.

This model is a form of the matching principle, whereby expenses are recognized on the income statement
over the expected useful life of the investment, so the costs and benefits are “matched.” Example 3
illustrates the impact on the financial statements of capitalizing versus expensing an expenditure.

EXAMPLE 3

General Financial Statement Impact of Capitalizing versus Expensing

Assume two identical (hypothetical) companies, CAP Inc. (CAP) and NOW Inc. (NOW), start with
EUR1,000 cash and EUR1,000 common stock. Each year the companies recognize total revenues of
EUR1,500 cash and make cash expenditures, excluding an equipment purchase, of EUR500. At the
beginning of operations, each company pays EUR900 to purchase equipment. CAP estimates the
equipment will have a useful life of three years and an estimated salvage value of EUR0 at the end of
the three years. NOW estimates a much shorter useful life and expenses the equipment immediately.
The companies have no other assets and make no other asset purchases during the three-year period.
Assume the companies pay no dividends, earn zero interest on cash balances, have a tax rate of 30
percent, and use the same accounting method for financial and tax purposes.

The left side of Exhibit 1 shows CAP’s financial statements—that is, with the expenditure capitalized
and depreciated at EUR300 per year based on the straight-line method of depreciation (EUR900 cost
minus EUR0 salvage value equals EUR900, divided by a three-year life equals EUR300 per year). The
right side of the exhibit shows NOW’s financial statements, with the entire EUR900 expenditure treated
as an expense in the first year. All amounts are in euro.

Exhibit 1: Capitalizing versus Expensing

CAP Inc. NOW Inc.

Capitalize EUR900 as Asset and Depreciate Expense EUR900 Immediately
For Year 1 2 3 For Year 1 2 3

Revenue 1,500 1,500 1,500 Revenue 1,500 1,500 1,500

Cash Expenses 500 500 500 Cash expenses 1,400 500 500
Depreciation 300 300 300 Depreciation 0 0 0
Income before Tax 700 700 700 Income before Tax 100 1,000 1,000
Tax at 30% 210 210 210 Tax at 30% 30 300 300
Net Income 490 490 490 Net Income 70 700 700

Cash from Operations 790 790 790 Cash from Operations 70 700 700
Cash Used in Investing (900) 0 0 Cash Used in Investing 0 0 0
Total Change in Cash (110) 790 790 Total Change in Cash 70 700 700

Time End of End of End of Time End of End of End of

As of 0 Year 1 Year 2 Year 3 Time 0 Year 1 Year 2 Year 3

Cash 1,000 890 1,680 2,470 Cash 1,000 1,070 1,770 2,470
PP&E (net) — 600 300 — PP & E (net) — — — —
Total Assets 1,000 1,490 1,980 2,470 Total Assets 1,000 1,070 1,770 2,470
Retained 0 490 980 1,470 Retained 0 70 770 1,470
Earnings Earnings
Common Stock 1,000 1,000 1,000 1,000 Common 1,000 1,000 1,000 1,000
Stock
Total 1,000 1,490 1,980 2,470 Total 1,000 1,070 1,770 2,470
Shareholders’ Shareholders’
Equity Equity

1. Which company reports higher net income over the three years? Total cash flow? Cash from
operations?

Hide Solution

Solution:

Neither company reports higher total net income or cash flow over the three years. The sum of
net income over the three years is identical (EUR1,470 total) whether the EUR900 is capitalized
or expensed. Also, the sum of the change in cash (EUR1,470 total) is identical under either
scenario. CAP reports higher cash from operations by an amount of EUR900 because, under
the capitalization scenario, the EUR900 purchase is treated as an investing cash flow.

Note: Because the companies use the same accounting method for both financial and taxable
income, absent the assumption of zero interest on cash balances, expensing the EUR900 would
have resulted in higher income and cash flow for NOW because the lower taxes paid in the first
year (EUR30 versus EUR210) would have allowed NOW to earn interest income on the tax
savings.

2. Based on ROE and net profit margin, how does the profitability of the two companies compare?

Hide Solution

Solution:

In general, Ending shareholders’ equity = Beginning shareholders’ equity + Net income + Other
comprehensive income – Dividends + Net capital contributions from shareholders. Because the
companies in this example do not have other comprehensive income, did not pay dividends, and
reported no capital contributions from shareholders, Ending retained earnings = Beginning
retained earnings + Net income, and Ending shareholders’ equity = Beginning shareholders’
equity + Net income.

ROE is calculated as Net income divided by Average shareholders’ equity, and Net profit margin
is calculated as Net income divided by Total revenue. For example, CAP had Year 1 ROE of 39
percent (EUR490/[(EUR1,000 + EUR1,490)/2]), and Year 1 net profit margin of 33 percent
(EUR490/EUR1,500).

CAP Inc. NOW Inc.

Capitalize EUR900 as Asset and Depreciate Expense EUR900 Immediately
For Year 1 2 3 For Year 1 2 3

ROE 39% 28% 22% ROE 7% 49% 33%

Net Profit Margin 33% 33% 33% Net Profit Margin 5% 47% 47%

As shown, compared to expensing, capitalizing results in higher profitability ratios (ROE and net
profit margin) in the first year, and lower profitability ratios in subsequent years. For example,
CAP’s Year 1 ROE of 39 percent was higher than NOW’s Year 1 ROE of 7 percent, but in Years
2 and 3, NOW reports superior profitability.

Note also that NOW’s superior growth in net income between Year 1 and Year 2 is not
attributable to superior performance compared to CAP but rather to the accounting decision to
recognize the expense sooner than CAP. In general, all else equal, accounting decisions that
result in recognizing expenses sooner will give the appearance of greater subsequent growth.
Comparison of the growth of the two companies’ net incomes without an awareness of the
difference in accounting methods would be misleading. As a corollary, NOW’s income and
profitability exhibit greater volatility across the three years, not because of more volatile
performance but rather because of the different accounting decision.

3. Why does NOW report change in cash of EUR70 in Year 1, while CAP reports total change in cash
of (EUR110)?

Hide Solution

Solution:

NOW reports an increase in cash of EUR70 in Year 1, while CAP reports a decrease in cash of
EUR110 because NOW’s taxes were EUR180 lower than CAP’s taxes (EUR30 versus
EUR210).

Note that this problem assumes the accounting method used by each company for its tax
purposes is identical to the accounting method used by the company for its financial reporting.
In many countries, companies are allowed to use different depreciation methods for financial
reporting and taxes, which may give rise to deferred taxes.

As shown, discretion regarding whether to expense or capitalize expenditures can impede comparability
across companies. Example 3 assumes the companies purchase a single asset in one year. Because the
sum of net income over the three-year period is identical whether the asset is capitalized or expensed, it
illustrates that although capitalizing results in higher profitability compared with expensing in the first year, it
results in lower profitability in the subsequent years. Conversely, expensing results in lower profitability in the
first year but higher profitability in later years, indicating a favorable trend.

Similarly, shareholders’ equity for a company that capitalizes the expenditure will be higher in the early years
because the initially higher profits result in initially higher retained earnings. Example 3 assumes the
companies purchase a single asset in one year and report identical amounts of total net income over the
three-year period, so shareholders’ equity (and retained earnings) for the firm that expenses will be identical
to shareholders’ equity (and retained earnings) for the capitalizing firm at the end of the three-year period.

Although Example 3 shows companies purchasing an asset only in the first year, if a company continues to
purchase similar or increasing amounts of assets each year, the profitability-enhancing effect of capitalizing
continues if the amount of the expenditures in a period continues to be more than the depreciation expense.
Example 4 illustrates this point.

EXAMPLE 4

Impact of Capitalizing versus Expensing for Ongoing Purchases

A company buys a GBP300 computer in Year 1 and capitalizes the expenditure. The computer has a
useful life of three years and an expected salvage value of GBP0, so the annual depreciation expense
using the straight-line method is GBP100 per year. Compared with expensing the entire GBP300
immediately, the company’s pre-tax profit in Year 1 is GBP200 greater.

1. Assume that the company continues to buy an identical computer each year at the same price. If
the company uses the same accounting treatment for each of the computers, when does the profit-
enhancing effect of capitalizing versus expensing end?

Hide Solution

Solution:

The profit-enhancing effect of capitalizing versus expensing would end in Year 3. In Year 3, the
depreciation expense on each of the three computers bought in Years 1, 2, and 3 would total
GBP300 (GBP100 + GBP100 + GBP100). Therefore, the total depreciation expense for Year 3
will be exactly equal to the capital expenditure in Year 3. The expense in Year 3 would be
GBP300, regardless of whether the company capitalized or expensed the annual computer
purchases.

2. If the company buys another identical computer in Year 4, using the same accounting treatment as
the prior years, what is the effect on Year 4 profits of capitalizing versus expensing these
expenditures?

Hide Solution

Solution:

There is no impact on Year 4 profits. As in the previous year, the depreciation expense on each
of the three computers bought in Years 2, 3, and 4 would total GBP300 (GBP100 + GBP100 +
GBP100). Therefore, the total depreciation expense for Year 4 will be exactly equal to the capital
expenditure in Year 4. Pre-tax profits would be reduced by GBP300, regardless of whether the
company capitalized or expensed the annual computer purchases.

Compared with expensing an expenditure, capitalizing the expenditure typically results in greater amounts
reported as cash from operations. Analysts should be alert to evidence of companies manipulating reported
cash flow from operations by capitalizing expenditures that should be expensed.

In summary, holding all else constant, capitalizing an expenditure enhances current profitability and
increases reported cash flow from operations. The profitability-enhancing effect of capitalizing continues so
long as capital expenditures exceed the depreciation expense. Profitability-enhancing motivations for
decisions to capitalize should be considered when analyzing performance. For example, a company may
choose to capitalize more expenditures (within the allowable bounds of accounting standards) to achieve
earnings targets for a given period. Expensing a cost in the period reduces current period profits but
enhances future profitability and thus enhances the profit trend. Profit trend-enhancing motivations should
also be considered when analyzing performance. If the company is in a reporting environment that requires
identical accounting methods for financial reporting and taxes (unlike the United States, which permits
companies to use depreciation methods for reporting purposes that differ from the depreciation method
required by tax purposes), then expensing will have a more favorable cash flow impact because paying
lower taxes in an earlier period creates an opportunity to earn interest income on the cash saved.

In contrast with these relatively simple examples, it is generally neither possible nor desirable to identify
individual instances involving discretion about whether to capitalize or expense expenditures. An analyst
can, however, typically identify significant items of expenditure treated differently across companies. The
items of expenditure giving rise to the most relevant differences across companies will vary by industry. This
cross-industry variation is apparent in the following discussion of the capitalization of expenditures.

Capitalization versus Expensing

1. All else equal, in the fiscal year when long-lived equipment is purchased:

A. depreciation expense increases.

B. cash from operations decreases.
C. net income is reduced by the amount of the purchase.

Hide Solution

Solution:

A is correct. In the fiscal year when long-lived equipment is purchased, the assets on the balance
sheet increase and depreciation expense on the income statement increases because of the new
long-lived asset.

2. Companies X and Z have the same beginning-of-the-year book value of equity and the same tax rate.
The companies have identical transactions throughout the year and report all transactions similarly
except for one. Both companies acquire a GBP300,000 printer with a three-year useful life and a
salvage value of GBP0 on 1 January of the new year. Company X capitalizes the printer and
depreciates it on a straight-line basis, and Company Z expenses the printer. The year-end information
in Exhibit 2 is gathered for Company X.

Exhibit 2: Company X Year-End Information

Company X as of 31 December

Ending Shareholders’ Equity GBP10,000,000

Tax Rate 25%
Dividends GBP0.00
Net Income GBP750,000

Based on the information in Exhibit 2, Company Z’s return on equity using year-end equity will be
closest to:

A. 5.4 percent.
B. 6.1 percent.
C. 7.5 percent.

Hide Solution

Solution:

B is correct. Company Z’s return on equity based on year-end equity value will be 6.1 percent.
Company Z will have an additional GBP200,000 of expenses compared with Company X.
Company Z expensed the printer for GBP300,000 rather than capitalizing the printer and having a
depreciation expense of GBP100,000 like Company X. Company Z’s net income and
shareholders’ equity will be GBP150,000 lower (= GBP200,000 × 0.75) than that of Company X.

( Shareholders' Equity )
Net income
ROE =

= GBP600,00/GBP9,850,000

= 0.61 = 6.1%.

The following information relates to questions 3-6.

Melanie Hart, CFA, is a transportation analyst. Hart has been asked to write a research report on Altai
Mountain Rail Company (AMRC). Like other companies in the railroad industry, AMRC’s operations
are capital intensive, with significant investments in such long-lived tangible assets as property, plant,
and equipment. In November 2008, AMRC’s board of directors hired a new team to manage the
company. In reviewing the company’s 2009 annual report, Hart is concerned about some of the
accounting choices that the new management has made. These choices differ from those of the
previous management and from common industry practice. Hart has highlighted the following
statements from the company’s annual report:

Statement 1 “In 2009, AMRC spent significant amounts on track replacement and similar
improvements. AMRC expensed rather than capitalized a significant proportion of these
expenditures.”

Statement 2 “AMRC uses the straight-line method of depreciation for both financial and tax reporting
purposes to account for plant and equipment.”

Statement 3 “In 2009, AMRC recognized an impairment loss of EUR50 million on a fleet of
locomotives. The impairment loss was reported as ‘other income’ in the income
statement and reduced the carrying amount of the assets on the balance sheet.”

Exhibit 3 and 4 contain AMRC’s 2009 consolidated income statement and balance sheet. AMRC
prepares its financial statements in accordance with International Financial Reporting Standards.

Exhibit 3: Consolidated Statement of Income

2009 2008
For the Years Ended 31 December Euro Millions Revenues (%) Euro Millions Revenues (%)

Operating revenues 2,600 100.0 2,300 100.0

Operating expenses
Depreciation (200) (7.7) (190) (8.3)
Other operating expense (1,590) (61.1) (1,515) (65.9)
Total operating expenses (1,790) (68.8) (1,705) (74.2)
Operating income 810 31.2 595 25.8
Other income (50) (1.9) — 0.0
Interest expense (73) (2.8) (69) (3.0)
Income before taxes 687 26.5 526 22.8
Income taxes (272) (10.5) (198) (8.6)
Net income 415 16 328 14.2

Exhibit 4: Consolidated Balance Sheet

As of 31 December 2009 2008

Assets Euro Millions Assets (%) Euro Millions Assets (%)

Current assets 500 9.4 450 8.5

Property and equipment:
Land 700 13.1 700 13.2
Plant and equipment 6,000 112.1 5,800 109.4
Total property and equipment 6,700 125.2 6,500 122.6
Accumulated depreciation (1,850) (34.6) (1,650) (31.1)
Net property and equipment 4,850 90.6 4,850 91.5
Total assets 5,350 100.0 5,300 100.0

Liabilities and Shareholders’ Equity

Current liabilities 480 9.0 430 8.1

Long-term debt 1,030 19.3 1,080 20.4
Other long-term provisions and liabilities 1,240 23.1 1,440 27.2
Total liabilities 2,750 51.4 2,950 55.7
Shareholders’ equity
Common stock and paid-in-surplus 760 14.2 760 14.3
Retained earnings 1,888 35.5 1,600 30.2
Other comprehensive losses (48) (0.9) (10) (0.2)
Total shareholders’ equity 2,600 48.6 2,350 44.3
Total liabilities & shareholders’ equity 5,350 100.0 5,300 100.0

3. With respect to Statement 1, which of the following is the most likely effect of management’s decision
to expense rather than capitalize these expenditures?

A. 2009 net profit margin is higher than if the expenditures had been capitalized.
B. 2009 total asset turnover is lower than if the expenditures had been capitalized.
C. Future profit growth will be higher than if the expenditures had been capitalized.

Hide Solution

Solution:

C is correct. Expensing rather than capitalizing an investment in long-term assets will result in
higher expenses and lower net income and net profit margin in the current year. Future years’
incomes will not include depreciation expense related to these expenditures. Consequently, year-
to-year growth in profitability will be higher. If the expenses had been capitalized, the carrying
amount of the assets would have been higher and the 2009 total asset turnover would have been
lower.

4. With respect to Statement 2, what would be the most likely effect in 2010 if AMRC were to switch to
an accelerated depreciation method for both financial and tax reporting?

A. Net profit margin would increase.

B. Total asset turnover would decrease.
C. Cash flow from operating activities would increase.

Hide Solution

Solution:

C is correct. In 2010, switching to an accelerated depreciation method would increase depreciation

expense and decrease income before taxes, taxes payable, and net income. Cash flow from
operating activities would increase because of the resulting tax savings.

5. With respect to Statement 3, what is the most likely effect of the impairment loss?

A. Net income in years prior to 2009 was likely understated.

B. Net profit margins in years after 2009 will likely exceed the 2009 net profit margin.
C. Cash flow from operating activities in 2009 was likely lower due to the impairment loss.

Hide Solution

Solution:

B is correct. 2009 net income and net profit margin are lower because of the impairment loss.
Consequently, net profit margins in subsequent years are likely to be higher. An impairment loss
suggests that insufficient depreciation expense was recognized in prior years, and net income was
overstated in prior years. The impairment loss is a non-cash item and will not affect operating cash
flows.

6. Based on Exhibit 1 and 2, the best estimate of the average remaining useful life of the company’s
plant and equipment at the end of 2009 is:

A. 20.75 years.
B. 24.25 years.
C. 30.00 years.

Hide Solution

Solution:

A is correct. The estimated average remaining useful life is 20.75 years.

Estimate of remaining useful life = Net plant and equipment ÷ Annual depreciation expense

Net plant and equipment = Gross P & E – Accumulated depreciation

= €6000 – €1850 = €4150

Estimate of remaining useful life = Net P & E ÷ Depreciation expense

= €4150 ÷ €200 = 20.75

Capitalization of Interest Costs

Companies generally must capitalize interest costs associated with acquiring or constructing an asset that
requires a long period of time to get ready for its intended use

As a consequence of this accounting treatment, a company’s interest costs for a period can appear either on
the balance sheet (to the extent they are capitalized) or on the income statement (to the extent they are
expensed).

If the interest expenditure is incurred in connection with constructing an asset for the company’s own use,
the capitalized interest appears on the balance sheet as a part of the relevant long-lived asset. The
capitalized interest is expensed over time as the property is depreciated—and is thus part of depreciation
expense rather than interest expense. If the interest expenditure is incurred in connection with constructing
an asset to sell, for example, by a real estate construction company, the capitalized interest appears on the
company’s balance sheet as part of inventory. The capitalized interest is then expensed as part of the cost of
 sales when the asset is sold.

The treatment of capitalized interest poses certain issues that analysts should consider. First, capitalized
interest appears as part of investing cash outflows, whereas expensed interest typically reduces operating
cash flow. US GAAP–reporting companies are required to categorize interest in operating cash flow, and
IFRS-reporting companies can categorize interest in operating, investing, 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 capitalized portion and the
expensed portion, should be used to calculate interest coverage ratios. Additionally, if a company is
depreciating interest that it capitalized in a previous period, income should be adjusted to eliminate the effect
of that depreciation. Example 5 illustrates the calculations.

EXAMPLE 5

Effect of Capitalized Interest Costs on Coverage Ratios and Cash Flow

Melco Resorts & Entertainment Limited (NASDAQ: MLCO), a Hong Kong SAR–based casino company,
which is listed on the NASDAQ stock exchange and prepares financial reports under US GAAP,
disclosed the following information in one of the footnotes to its 2017 financial statements: “Interest and
amortization of deferred financing costs associated with major development and construction projects is
capitalized and included in the cost of the project. . . . Total interest expenses incurred amounted to
$267,065, $252,600, and $253,168, of which $37,483, $29,033, and $134,838 were capitalized during
the years ended December 31, 2017, 2016, and 2015, respectively. Amortization of deferred financing
costs of $26,182, $48,345, and $38,511, net of amortization capitalized of nil, nil, and $5,458, were
recorded during the years ended December 31, 2017, 2016, and 2015, respectively” (Form 20-F filed
12 April 2018). Cash payments for deferred financing costs were reported in cash flows from financing
activities.

Exhibit 5: Melco Resorts and Entertainment Limited Selected Data,

as Reported (US dollar thousands)

2017 2016 2015

EBIT (from income statement) 544,865 298,663 58,553

Interest expense (from income statement) 229,582 223,567 118,330
Capitalized interest (from footnote) 37,483 29,033 134,838
Amortization of deferred financing costs (from footnote) 26,182 48,345 38,511

Net cash provided by operating activities 1,162,500 1,158,128 522,026

Net cash from (used) in investing activities (410,226) 280,604 (469,656)
Net cash from (used) in financing activities (1,046,041) (1,339,717) (29,688)
Notes: EBIT represents “Income (Loss) Before Income Tax” plus “Interest expenses, net of capitalized interest” from the income
statement.

1. Calculate and interpret Melco’s interest coverage ratio with and without capitalized interest.

Hide Solution

Solution:

Interest coverage ratios with and without capitalized interest were as follows:

For 2017

2.37 (USD544,865 ÷ USD229,582) without adjusting for capitalized interest; and

2.14 [(USD544,865 + USD26,182) ÷ (USD229,582 + USD37,483)], including an

adjustment to EBIT for depreciation of previously capitalized interest and an adjustment
to interest expense for the amount of interest capitalized in 2017.

For 2016

1.34 (USD298,663÷ USD223,567) without adjusting for capitalized interest; and

1.37 [(USD298,663 + USD48,345) ÷ (USD223,567 + USD29,033)], including an

adjustment to EBIT for depreciation of previously capitalized interest and an adjustment
to interest expense for the amount of interest capitalized in 2016.

For 2015

0.49 (USD58,533÷ USD118,330) without adjusting for capitalized interest; and

0.38 [(USD58,533 + USD38,511) ÷ (USD118,330+ USD134,838)], including an

adjustment to EBIT for depreciation of previously capitalized interest and an adjustment
to interest expense for the amount of interest capitalized in 2015.

These calculations indicate that Melco’s interest coverage improved in 2017 compared with the
previous two years. In both 2017 and 2015, the coverage ratio was lower when adjusted for
capitalized interest.

2. Calculate Melco’s percentage change in operating cash flow from 2016 to 2017. Assuming the
financial reporting does not affect reporting for income taxes, what were the effects of capitalized
interest on operating and investing cash flows?

Hide Solution

Solution:

If the interest had been expensed rather than capitalized, operating cash flows would have been
lower in all three years. On an adjusted basis, but not an unadjusted basis, the company’s
operating cash flow declined in 2017 compared with 2016. On an unadjusted basis, for 2017
compared with 2016, Melco’s operating cash flow increased by 0.4 percent in 2017
[(USD1,162,500 ÷ USD1,158,128) – 1]. Including adjustments to expense all interest costs,
Melco’s operating cash flow also decreased by 0.4 percent in 2017 {[USD1,162,500 –
USD37,483) ÷ (USD1,158,128 – USD29,033)] – 1}.

If the interest had been expensed rather than capitalized, financing cash flows would have been
higher in all three years.

The treatment of capitalized interest raises issues for consideration by an analyst. First, capitalized 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 capitalized portion and the expensed portion, should be used in calculating interest
coverage ratios.

Generally, including capitalized interest in the calculation of interest coverage ratios provides a better
assessment of a company’s solvency. In assigning credit ratings, rating agencies include capitalized interest
in coverage ratios. For example, Standard & Poor’s calculates the EBIT interest coverage ratio as EBIT
divided by gross interest (defined as interest prior to deductions for capitalized interest or interest income).

Maintaining a minimum interest coverage ratio is a financial covenant often included in lending agreements
(e.g., bank loans and bond indentures). The definition of the coverage ratio can be found in the company’s
credit agreement. The definition is relevant because treatment of capitalized interest in calculating coverage
ratios would affect an assessment of how close a company’s actual ratios are to the levels specified by its
financial covenants and thus the probability of breaching those covenants.

Capitalization of Internal Development Costs

Accounting standards require companies to capitalize software development costs after a product’s
feasibility is established. Despite this requirement, judgment in determining feasibility means that companies’
capitalization practices may differ. For example, as illustrated in Exhibit 6, Microsoft judges product feasibility
to be established very shortly before manufacturing begins and, therefore, effectively expenses—rather than
capitalizes—research and development costs.

Exhibit 6: Disclosure on Software Development Costs

Excerpt from Management’s Discussion and Analysis (MD&A) of Microsoft Corporation, Application of
Critical Accounting Policies, Research and Development Costs:

Costs incurred internally in researching and developing a computer software product are charged to
expense until technological feasibility has been established for the product. Once technological
feasibility is established, all software costs are capitalized until the product is available for general
release to customers. Judgment is required in determining when technological feasibility of a product is
established. We have determined that technological feasibility for our software products is reached after
all high-risk development issues have been resolved through coding and testing. Generally, this occurs
shortly before the products are released to production. The amortization of these costs is included in
cost of revenue over the estimated life of the products.

Source: Microsoft Corporation, 2017 Annual Report on Form 10-K, p. 45.

Expensing rather than capitalizing development costs results in lower net income in the current period.
Expensing rather than capitalizing will continue to result in lower net income so long as the amount of the
current-period development expenses is higher than the amortization expense that would have resulted from
amortizing prior periods’ capitalized development costs—the typical situation when a company’s
development costs are increasing. On the statement of cash flows, expensing rather than capitalizing
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.

In comparing the financial performance of a company that expenses most or all software development costs,
such as Microsoft, with another company that capitalizes software development costs, adjustments can be
made to make the two comparable. For the company that capitalizes software development costs, an
analyst can adjust (1) the income statement to include software development costs as an expense and to
exclude amortization of prior years’ software development costs; (2) the balance sheet to exclude capitalized
software (decrease assets and equity); and (3) the statement of cash flows to decrease operating cash flows
and decrease cash used in investing by the amount of the current period development costs. Any ratios that
include income, long-lived assets, or cash flow from operations—such as return on equity—also will be
affected.

EXAMPLE 6

Software Development Costs

You are working on a project involving the analysis of JHH Software, a (hypothetical) software
development company that established technical feasibility for its first product in 2017. Part of your
analysis involves computing certain market-based ratios, which you will use to compare JHH to another
company that expenses all of its software development expenditures. Relevant data and excerpts from
the company’s annual report are included in Exhibit 7.

Exhibit 7: JHH SOFTWARE (US dollar thousands, except per share

amounts)

Consolidated Statement of Earnings—Abbreviated

For Year Ended 31 December: 2018 2017 2016

Total revenue USD91,424 USD91,134 USD96,293

Total operating expenses 78,107 78,908 85,624
Operating income 13,317 12,226 10,669
Provision for income taxes 3,825 4,232 3,172
Net income USD9,492 USD7,994 USD7,479
Earnings per share (EPS) USD1.40 USD0.82 USD0.68
Footnote disclosure of accounting policy for software development:
Expenses that are related to the conceptual formulation and design of software products are
expensed to research and development as incurred. The company capitalises expenses that are
incurred to produce the finished product after technological feasibility has been established.

Statement of Cash Flows—Abbreviated

For Year Ended 31 December: 2018 2017 2016

Net cash provided by operating activities USD15,007 USD14,874 USD15,266

Net cash used in investing activities* (11,549) (4,423) (5,346)
Net cash used in financing activities (8,003) (7,936) (7,157)
Net change in cash and cash equivalents (USD4,545) USD2,515 USD2,763

*Includes software development expenses of and includes (USD6,000) (USD4,000) (USD2,000)

capital expenditures of (USD2,000) (USD1,600) (USD1,200)
Footnote disclosure of accounting policy for software development:
Expenses that are related to the conceptual formulation and design of software products are
expensed to research and development as incurred. The company capitalises expenses that are
incurred to produce the finished product after technological feasibility has been established.

Additional Information:
For Year Ended 31 December: 2018 2017 2016

Market value of outstanding debt 0 0 0

Amortization of capitalized software development expenses (USD2,000) (USD667) 0
Depreciation expense (USD2,200) (USD1,440) (USD1,320)

Market price per share of common stock USD42 USD26 USD17

Shares of common stock outstanding (thousands) 6,780 9,765 10,999
Footnote disclosure of accounting policy for software development:
Expenses that are related to the conceptual formulation and design of software products are
expensed to research and development as incurred. The company capitalises expenses that are
incurred to produce the finished product after technological feasibility has been established.

1. Compute the following ratios for JHH based on the reported financial statements for fiscal year
ended 31 December 2018, with no adjustments. Next, determine the approximate impact on these
ratios if the company had expensed rather than capitalized its investments in software. (Assume the
financial reporting does not affect reporting for income taxes. There would be no change in the
effective tax rate.)

A. P/E: Price/Earnings per share

B. P/CFO: Price/Operating cash flow per share
C. EV/EBITDA: Enterprise value/EBITDA, where enterprise value is defined as the total market
value of all sources of a company’s financing, including equity and debt, and EBITDA is earnings
before interest, taxes, depreciation, and amortization.

Hide Solution

Solution:

(US dollars are in thousands, except per share amounts.) JHH’s 2019 ratios are presented in
the following table:

Ratios As reported As adjusted

A P/E ratio 30.0 42.9
B P/CFO 19.0 31.6
C EV/EBITDA 16.3 24.7

A. Based on the information as reported, the P/E ratio was 30.0 (USD42 ÷ USD1.40). Based
on EPS adjusted to expense software development costs, the P/E ratio was 42.9 (USD42
÷ USD0.98).

Price: Assuming that the market value of the company’s equity is based on its
fundamentals, the price per share is USD42, regardless of a difference in accounting.

EPS: As reported, EPS was USD1.40. Adjusted EPS was USD0.98. Expensing software
development costs would have reduced JHH’s 2018 operating income by USD6,000, but
the company would have reported no amortization of prior years’ software costs, which
would have increased operating income by USD2,000. The net change of USD4,000
would have reduced operating income from the reported USD13,317 to USD9,317. The
effective tax rate for 2018 (USD3,825 ÷ USD13,317) is 28.72%, and using this effective
tax rate would give an adjusted net income of USD6,641 [USD9,317 × (1 – 0.2872)],
compared to USD9,492 before the adjustment. The EPS would therefore be reduced from
the reported USD1.40 to USD0.98 (adjusted net income of USD6,641 divided by 6,780
shares).
B. Based on information as reported, the P/CFO was 19.0 (USD42 ÷ USD2.21). Based on
CFO adjusted to expense software development costs, the P/CFO was 31.6 (USD42 ÷
USD1.33).

Price: Assuming that the market value of the company’s equity is based on its
fundamentals, the price per share is USD42, regardless of a difference in accounting.

CFO per share, as reported, was USD2.21 (total operating cash flows USD15,007 ÷ 6,780
shares).

CFO per share, as adjusted, was USD1.33. The company’s USD6,000 expenditure on
software development costs was reported as a cash outflow from investing activities, so
expensing those costs would reduce cash from operating activities by USD6,000, from the
reported USD15,007 to USD9,007. Dividing adjusted total operating cash flow of
USD9,007 by 6,780 shares results in cash flow per share of USD1.33.
C. Based on information as reported, the EV/EBITDA was 16.3 (USD284,760 ÷ USD17,517).
Based on EBITDA adjusted to expense software development costs, the EV/EBITDA was
24.7 (USD284,760 ÷ USD11,517).

Enterprise Value: Enterprise value is the sum of the market value of the company’s equity
and debt. JHH has no debt, and therefore the enterprise value is equal to the market
value of its equity. The market value of its equity is USD284,760 (USD42 per share ×
6,780 shares).

EBITDA, as reported, was USD17,517 (earnings before interest and taxes of USD13,317
plus USD2,200 depreciation plus USD2,000 amortization).

EBITDA, adjusted for expensing software development costs by the inclusion of

USD6,000 development expense and the exclusion of USD2,000 amortization of prior
expense, would be USD11,517 (earnings before interest and taxes of USD9,317 plus
USD2,200 depreciation plus USD0 amortization).

2. Interpret the changes in the ratios.

Hide Solution

Solution:

Expensing software development costs would decrease historical profits, operating cash flow,
and EBITDA, and would thus increase all market multiples. So JHH’s stock would appear to be
more expensive if it expensed rather than capitalized the software development costs.

If the unadjusted market-based ratios were used in the comparison of JHH to its competitor that
expenses all software development expenditures, then JHH might appear to be under-priced
when the difference is solely related to accounting factors. JHH’s adjusted market-based ratios
provide a better basis for comparison.

For the company in Example 6, current period software development expenditures exceed the amortization
of prior periods’ capitalized software development expenditures. As a result, expensing rather than
capitalizing software development costs would have the effect of lowering income. If, however, software
development expenditures slowed such that current expenditures were lower than the amortization of prior
periods’ capitalized software development expenditures, then expensing software development costs would
have the effect of increasing income relative to capitalizing it.

This section illustrated how decisions about capitalizing versus expensing affect financial statements and
ratios. Earlier expensing lowers current profits but enhances trends, whereas capitalizing now and
expensing later enhances current profits. Having described the accounting for acquisition of long-lived
assets, we now turn to the topic of measuring long-lived assets in subsequent periods.

Implications for Financial Analysts: Expense Recognition

As with revenue recognition policies, a company’s choice of expense recognition can be characterized by its
relative conservatism. A policy that results in recognition of expenses later rather than sooner is considered
less conservative. In addition, many items of expense require the company to make estimates that can
significantly affect net income. Analysis of a company’s financial statements, and particularly comparison of
one company’s financial statements with those of another, requires an understanding of differences in these
estimates and their potential impact.

If, for example, a company shows a significant year-to-year change in its estimates of uncollectible accounts
as a percentage of sales, warranty expenses as a percentage of sales, or estimated useful lives of assets,
the analyst should seek to understand the underlying reasons. Do the changes reflect a change in business
operations (e.g., lower estimated warranty expenses reflecting recent experience of fewer warranty claims
because of improved product quality)? Or are the changes seemingly unrelated to changes in business
operations and thus possibly a signal that a company is manipulating estimates to achieve a particular effect
on its reported net income?

As another example, if two companies in the same industry have dramatically different estimates for
uncollectible accounts as a percentage of their sales, warranty expenses as a percentage of sales, or
estimated useful lives as a percentage of assets, it is important to understand the underlying reasons. Are
the differences consistent with differences in the two companies’ business operations (e.g., lower
uncollectible accounts for one company reflecting a different, more creditworthy customer base or possibly
stricter credit policies)? Another difference consistent with differences in business operations would be a
difference in estimated useful lives of assets if one of the companies employs newer equipment. Or, Rate Your Confidence
alternatively, are the differences seemingly inconsistent with differences in the two companies’ business
operations, possibly signaling that a company is manipulating estimates? High

Information about a company’s accounting policies and significant estimates are described in the notes to Medium

the financial statements and in the management discussion and analysis section of a company’s annual
Low
report.

When possible, the monetary effect of differences in expense recognition policies and estimates can Continue (
facilitate more meaningful comparisons with a single company’s historical performance or across a number
of companies. An analyst can use the monetary effect to adjust the reported expenses so that they are on a Category
comparable basis. Analyzing Income Statements

Even when the monetary effects of differences in policies and estimates cannot be calculated, it is generally r Related Questions:
possible to characterize the relative conservatism of the policies and estimates and, therefore, to Practice questions related to
qualitatively assess how such differences might affect reported expenses and thus financial ratios. this topic

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Discussion

In example 6, while calculating P/CFO after adjustment, wouldn't CFO be calculated for tax adjustments too (i.e. 15007-6000+3825-2675.84, where 2675.84 being the new tax
VS
after reduced net income)?

Created 6 days ago by VISHAL SINGH CHAUHAN 1 reply | Last Activity: 2 days ago
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some mistakes in exhibits

DH

Created 7 days ago by DUYU HUANG 0 replies | Last Activity: 7 days ago
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If interest is expensed rather than capitalized, the CFO will be lower. Is that correct
KB

Created 22 days ago by Kezya Benita Herman 1 reply | Last Activity: 10 days ago
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