Our cost capitalisation model is designed to identify companies where amortisation charges lag costs capitalised, leading to a profit uplift. The model is triggered if the profit uplift exceeds 15% of pre-tax profit and the company operates in a sector known to capitalise costs. About 2% of companies globally trigger the full model (and are flagged as red) although a further 5% report a profit uplift but do not operate in the shortlisted sectors (flagged as yellow). Both outcomes should be investigated.
Accounting for development costs
Under both IFRS and US GAAP, all research costs should be expensed as incurred[1]. However, IFRS allows development costs to be capitalised as an intangible asset under limited circumstances. Development is defined as the application of research findings for the design or production of new or substantially improved materials, devices, products, processes, systems or services, before the start of commercial production or use. It does not include the maintenance or enhancement of ongoing operations. IFRS allows the capitalisation of development costs only if a company can demonstrate all the following[2]:
Technical feasibility of completing the intangible asset so that it will be available for use or sale;
- its intention and ability to complete the intangible asset and use or sell it;
- probable future economic benefits from sale or use of the intangible asset; and
- its ability to measure reliably the expenditure attributable to the intangible asset during its development.
The focus is on feasibility and intention. The standard provides some examples of development costs which can be capitalised:
- Design, construction and testing of pre‑production or pre‑use prototypes and models;
- design of tools, jigs, moulds and dies involving new technology;
- design, construction and operation of a pilot plant that is not of a scale economically feasible for commercial production; and
- design, construction and testing of a chosen alternative for new or improved materials, devices, products, processes, systems or services.
Capitalised development costs are recorded as intangible assets which should be amortised over their useful lives, normally on a straight-line basis. The standard notes that given the history of rapid changes in technology, computer software and many other areas, intangible assets will often have short useful lives. Amortisation only begins when the asset is available for use.
In contrast to IFRS, in general, under US GAAP, internally generated development costs are expensed as incurred, although there are some exceptions for certain computer software and advertising-related costs[3]. Therefore, development cost capitalisation is rare for companies reporting under US GAAP.
In our view, the capitalisation of development expenditure under IFRS is an accounting weak spot given subjective assumptions used to decide (i) which costs to capitalise, (ii) when amortisation should commence and (iii) the period over which costs are amortised. As a result, there is significant variation between companies, and sometimes countries, in the level of costs capitalised and amortisation rates. This subjectivity is a concern given the large potential impact on earnings. We are most concerned with companies that make sudden changes to the amounts capitalised or the underlying assumptions, including increasing the level of capitalisation or extending the amortisation period.
Coat Capitalisation Model
Our model is triggered if a company operates in a sector known for capitalising costs and where the profit benefit (the difference between the amortisation charge and the amount capitalised) exceeds 15% of pre-tax profit…
Relevant sectors: Our past research has shown that 70% of companies identified as inflating profits from capitalising costs were in just 10% of sectors. These six sectors included autos, software, auto components, pharmaceuticals, semi-conductors and machinery.
Calculating profit uplift: Disclosure on cost capitalisation tends to be patchy, especially in China where the information is hard to extract from financial statements[4]. As such, our model uses two methods to estimate the profit benefit for each company:
- Cash flow method (default): Payments for intangible assets as reported in the cash flow, minus intangible amortisation charges. The model defaults to this method when data is available and the balance sheet method when not…
- Balance sheet method: The year-on-year change in net book value of intangible assets (excluding goodwill). This is a way to estimate net payments for intangibles from the balance sheet since the increase represents the amount invested less the amortisation charge.
If a company triggers the above criteria, the Cost Capitalisation Model will flag red. However, if a company outside of the sector short-list reports more than 15% profit uplift, the model will flag yellow.
Incidence rate
In general, about 2% of all companies trigger our model (i.e., flag red). Our past research[5] suggests that approximately half of these are actually experiencing a profit uplift from cost capitalisation. The remainder will have falsely triggered the model for a number of reasons. For example, intangible assets might arise from acquisitions, be purchased from third parties, include mining rights, video content rights, pharmaceutical licences or concession assets. A further 5% of all companies will see a material profit benefit but are not from the sector short-list (i.e., flag yellow). The likelihood that they are reporting a profit uplift from capitalising costs is substantially lower. However, both outcomes should be investigated.
For additional reading, see our reports on Technology One (TNE AU), Wisetech (WTC AU) and Techtronic (669 HK).
[1] IFRS defines research as original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding. See IAS 38, para 54, and KPMG Insights, 3 May 2021
[2] IAS 38, para 57
[3] See KPMG: Handbook: IFRS compared to US GAAP, Nov 2023
[4] Information relating to the payment for intangible assets is bundled with capex within the cash flow statement; the information needs to be extracted from the note relating to intangible assets.
[5] GMT Research: COST CAPITALISATION: Lax rules tempting Asian companies, 23 Feb 2024