Development Costs: Expensing vs. Capitalising

Development costs refer to costs a company incurs when it is developing a product of service. There are two principal ways of dealing with this cost; to expense it or to capitalise it. Expensing and Capitalising are two methods of treating for development costs within a company's accounts, and whilst both are perfectly valid, they can lead to interpretation issues within a company's results.

There are numerous reasons for why you may wish to choose one of these treatments over the other. One main reason why you capitalise development costs into an asset is because you believe it will have economic value in future periods. For example, you may spend £500,000 on developing a new product with an associated patent and believe that this represents long-term economic value. You may typically call a development cost an expense if the economic value does not extend into the future. However, there are other reasons and these will become clearer later.

Expensing vs. Capitalising

The method of each treatment is relatively simple. Assume that you represent a company and wish to spend £200,000 on new solar panel technology.

You may choose to expense that development cost. The impact of expensing a development cost is that the operating profit on an income statement declines. Therefore, if you were on track to make £1,000,000 in operating profit this year before the £200,000 development cost, that would decline to £800,000. That decline means that as a company you would pay a lower amount in income tax. Since it is expensed, the company's cash flows from operations declines. However, given that it impacts the operating profit, swings in development spend can make profitability more volatile.

However, you may choose to capitalise that development cost. By doing so you are saying that the development cost is worthy of a longer-term value, as you are turning it into an asset on the balance sheet. By doing so, the operating profit for the period is unaffected so profits are higher than if the expensed route is used. Since an asset is being created on the balance sheet, total assets rise which gives a higher net asset value (usually intangibles; which are often best stripped out). The amount paid in income tax is also relatively higher compared to expensing. Cash flows from operations are also higher vs. expensing, with the capitalised costs shown under the cash flows from investing activities section. However, since an asset has been created it needs to be depreciated or amortised over time, hence creating a future cost, but one that is much smoother. For information on Depreciation and Amortisation, click here.

Which treatment is better?

It very much depends. One reason why capitalising development spend may be disliked is that it does not always smooth expenditure over time (through depreciation and amortisation). Since an asset has been created, we are saying that this spend has created a valuable asset. If we spend £200,000 on new solar panel technology and capitalise it all, then we are assigning £200,000 to the balance sheet under the asset section.

But what if it turns out that the new solar panel technology is worthless? What happens is that the company must take on an impairment charge where the value of the asset is written down. See here for more information on impairments. This can actually cause larger fluctuations in group profitability.

Below is an example. Newmark Security capitalised a quantity of development costs relating to technology useful for cash-in-transit boxes where, if someone tries to break into the box, an adhesive is released. The box is useful on paper banknotes. However, with the Bank of England set to move over to 'plastic' banknotes, the value of that development spend has to be written off, causing an impairment charge upon profits.

The preferable way from an investor's perspective is to fully expense the development cost in each period. After all, cash flows are more important than profits. If each year for 5 years a company generated profits of £1m but capitalised development costs each year of £2m, then clearly the company should not be valued at a high multiple of profits. It does not generate cash! Free cash flow is therefore a very important figure.

However, some level of capitalisation can be acceptable, and that is more the case when the development costs are not intrinsic to the business. If a company has, for one year only, to spend £1m in development costs then it is not ridiculous to see that capitalised and depreciated over time. However, if the company has to commit to a high level of development spend every year due to competition or other reasons, then it makes sense that it should be expensed and profits reduced accordingly. That is where software companies come into play.

Software Companies: A Special Case?

Software companies are often referred to as a special case. That's because these companies tend to need to keep on innovating to ensure they have the best technology on the market. Due to this, development spend tends to be high and the issue of expensing vs. capitalising costs becomes a contentious issue, which many investors simply gloss over.

To keep it short, if a company is a software company, it is usually better to factor the entirety of a proportion of development spend out of profitability
Here are two useful examples of software and technology companies capitalising development costs.
The first is Lombard Risk Management (LSE:LRM), a company which develops software for the financial services industry. It's a software stock that trades on a forward PE ratio of just 6.4 for 2016 with a forecast rapidly growing earnings profile. Cheap, right?
Wrong. That valuation is being attributed by the market as it capitalises development spend, which is a core part of their business. In reality all investors should treat it as if it were expensed to get a clearer value of cash generation, which is what ultimately matters. A quick glance at the company's balance sheet shows that the £1.822m in operating cash generation is overshadowed by £2m in capitalised development spend, hence the profits are not a useful gauge of value in this instance and are heavily flattered. The company actually lost money over the period despite high headline profits.
The big question is whether enough investors actually pay attention to capitalising development costs for it to matter...
The second company, which is Proactis Holdings (LSE:PHD), would suggest otherwise as the share price is up from 20p last year to over 80p this year. Once again though it's the same problem in that the profit figures do not account for development spending, which is a real cost and therefore should really be expensed given how it's a software company. Therefore, despite the company reporting EBITDA of £2m, it's the cash flows that matter.
Once again it's the same point. The company generated £1.69m from operations and had earnings before interest, tax and D&A of £2m, yet its cash generation against those figures is weak. In fact, net cash from operations minus capitalised development spend was just short of £500k. That is about a quarter of the reported EBITDA. This is not a company that should therefore be valued at a simple multiple of earnings as the cash it generates (again, this is what matters) is flattered by capitalising development costs over expensing them. Yet it is on a 2016 forward PE of  over 12 as broker forecasts will also no doubt be assuming capitalised development spend.
In reality do investors care in most cases? In the long-run investors do care as companies that cannot generate cash tend to lose the interest of the investment community over time. In the short-term, those with inflated profits due to capitalised development spend can perform well. To be safe, it is always worth checking out the operating cash flow - investing cash flow for software companies to check for capitalisation of development costs so that you can alter your valuations accordingly. Also check the company's balance sheets and either heavily discount or remove the 'intangible assets' from asset value calculations as they could be inflated as a result of capitalisation.