Capitalised Costs: a Worked Example

The accounting idea is sound. Spending that will earn over several years should be matched against those years, so a machine or a finished product design is held as an asset and written down over its life. The trouble for a lender lies in where the write-down goes. Depreciation and amortisation sit below EBITDA, so capitalised spending does not reach the figure most covenants and leverage multiples are built on. It appears once, on the balance sheet and in the investing section of the cash flow statement, and the earnings measure carries on without it.

The usual candidates are the directly attributable costs of building or installing an asset, development spending, and in some cases borrowing costs during construction, which is capitalised interest. Repairs and everyday running costs are not candidates, and that boundary is one a lender watches.

The frameworks differ, and the difference matters for comparison. Under IAS 38 (NZ IAS 38 and AASB 138 locally), research is expensed and development spending must be capitalised once six conditions are met, including technical feasibility and probable future benefit. Management's judgement lies in deciding when those conditions are met. Under FRS 102, the framework most UK mid-market groups use, capitalising qualifying development spending is a choice of accounting policy, applied consistently. A UK group that expenses and another that capitalises can therefore report different EBITDA from the same activity. FRS 102 also makes capitalising borrowing costs a policy choice. Accounts prepared for tax or other special purposes may differ again.

A maker of water-quality sensors, constructed for this page like every figure in it, reports three years of rising EBITDA. Net debt at the end of year 3 is US$28.0m. The figures are in US$m.

Reported EBITDA is up 15% over two years. Before capitalising it is down 23%, on revenue up 10%, and the amount capitalised has multiplied 3.8 times. The cash flow statement shows the same thing from a different angle: a business reporting US$6.6m of operating cash flow has US$2.8m left once it has paid for the work that keeps its products current. Which leverage figure is right depends on the facts. If the sensors in development are new lines with orders behind them, some of that spending is real investment and 5.19 times is harsh. If most of it maintains products already on sale, it is closer to an operating cost and 3.04 times flatters. The figures are the example's, and neither multiple is offered as a level to aim for.

Capital expenditure is the cash paid for long-lived assets. Capitalisation is the accounting decision that places the spending there. A machine bought outright is capex with no room for argument; the questions arise with internal wages, development and refits, where a change of policy can move a cost from one side of the line to the other. In Issue 07, US$4.1m of store refits are capitalised after earlier years expensed the same work as repairs.

An add-back raises EBITDA by adjustment after the accounts are drawn up, and it is visible in the covenant calculation. Capitalising a cost raises EBITDA before anyone adjusts anything, so it arrives inside the reported figure. That makes it harder to see, and it is why quality of earnings work begins with accounting policies. The related measure is maintenance capex: capitalised spending that merely keeps the business where it is should be read as a cost of staying in business.

DEFINED IN ONE PARAGRAPH → · QUALITY OF EARNINGS → · MAINTENANCE CAPEX →

A lender reads the accounting policy note, the intangible assets or fixed assets note, and the movement in the capitalised balance over several years, and then asks what the spending bought. Three signals tend to change the view: a policy that has changed, a capitalised amount growing faster than revenue, and a balance that keeps climbing while the products it relates to do not appear. Rising capitalised costs with falling operating margins before capitalisation are the combination that deserves the longest conversation.

The answer usually shows up in the document. A lender may define EBITDA to deduct capitalised development spending, cap capital expenditure, or fix accounting policies at signing so that a later change cannot improve the covenant. The asset itself is often deducted when working out tangible net worth, since capitalised development may be worth little on enforcement. And cash cover measured after all capital spending, in the cash flow analysis, cannot be changed by where the cost is reported.

DEBT TO EBITDA → · CASH FLOW ANALYSIS →