On Capitalizing Expenses

Expenses are costs to the company and as such they are typically recorded as a charge against revenues or sometimes surplus. But in some cases, expenses are capitalized. That is, the costs incurred are not charged against revenue or surplus, but instead built into the balance sheet as assets.

Sounds backwards? But there are valid and legal reasons for this. Imagine that you build a factory, that costs $1M to build over two years. Some expenses incurred can be capitalized because the factory you built is now an asset that is worth something if sold in the market. That's what capitalize means -- to convert into capital.

The problem starts when one needs to decide how much of the total cost should be capitalized. If the factory when ready is worth in the market $2M, then an argument can be made that $2M is what should be capitalized when the factory is ready. But if out of your building cost of $1M, some $300,000 went into buying new equipment that was stolen during construction, then an informed buyer of your factory wouldn't need to repay you that much, since he could rebuild the factory himself for only $700,000. So an argument could be made that the asset is worth only $700,000.

Moreover, if this factory is used to build sprockets that can be sold for $15 each and it can build them for $5, at the rate of 10,000 per year, then one could use the $10 spread, times the volume built to value this factory as one would value a bond or a dividend-paying stock. For the sake of the exercise, with a 9% discount rate and depreciating the factory over a period of 20 years, the fair value of this factory would be $912,854. Such projections can be misleading and are not proper accounting methods, but it illustrates how widely one can value assets.

So, what's the fair value of this hypothetical factory? In my mind, I would treat the monthly expenses for the two years it takes to build it as just that, expenses. The income statements and the balance sheet should both reflect the costs incurred. After all, it's hard to value a partially-built factory and if bad times happen and the company needs to raise cash, it will find itself in a precarious position and unable to sell the factory for what it has paid thus far. After construction, I'd call an appraiser and have the market value of the factory be reflected on my balance sheet.

Of course, this is being very conservative and is very lumpy, especially at the end. Most companies don't do it this way, but instead capitalize some or all expenses as they are incurred.

But an investor should be on the look out for abuses. AOL, during the dot-com boom, once capitalized advertising expenses, as they argued that the money used would soon be reflected in the form of new customers and increased revenues. Another company capitalized its Christmas party, under the excuse that it would reap the benefits of increased morale.

In another post, I will discuss a likely undervalued company that has many capitalized assets that need some intricate adjusting.

No comments:

Post a Comment