Accounting Ratios

Capitalisation of Expenses

We penalise companies where excessive cost capitalisation inflates near-term profits. While there is some logic to the concept of capitalising costs to develop projects with long lead times, the amount capitalised can be subjective and used to manipulate reported profits. It’s worth bearing in mind that under US GAAP, companies are generally not allowed to capitalise expenses (such as research and development), although they can acquire intangible assets (such as patents and copyrights). Capitalising expenses can lead to companies with identical assets booking different values on these owing to the amount capitalised.

We are particularly concerned when amortisation charges consistently lag costs capitalised, leading to a profit uplift. Our A&G Screen highlights companies where net capitalised expenses (capitalised costs net of amortisation charges) exceed 5% of pretax profits; however, our Master Screen is set to a higher threshold, at 10% of pretax profits. Around 30% of companies capitalise expenses as intangible assets in any given year across a large number of industries. Of these, about 12% (4% of the total sample) report a pretax profit uplift exceeding 10%.

We have written on a number of companies which have reported a profit benefit from capitalising costs such as Technology One (TNE AU), Wisetech (WETC AU) and Techtronic (669 HK).