Expense Recognition Red Flags: Capitalizing vs. Expensing 2.4

>> Hello, I'm Professor Brian Bushee.

Welcome back.

In this video,

we're gonna start to take a look at expense manipulations in which managers

try to play with the timing of expenses in order to manipulate their earnings.

We're gonna take a look at capitalization versus expensing immediately.

These are situations where a company has some kind of big cash cost this period and

they can either expense it all right away or they could capitalize it into an asset

and then amortize the expense over time to try to smooth out the expense.

Let's get started.

Before we get into the capitalization versus expense immediately,

let's do a quick review of expenses.

So expenses are decreases in net income,

not necessarily cash that arise in the process of generating revenues.

We recognize expenses when either the related revenues are recognized,

these are product costs.

Cost that become expenses when we sell the product or service.

So this technically shows up as cost, if its sold on the income statement.

Or they're recognized when incurred, if they're difficult to match with revenues.

These are period costs the selling, general and administrative costs.

So, all the other costs of running a business.

Many expense related manipulations create a huge gap between expenses and

cash flows and we can see part of this on the balance sheet,

because there's gonna be accounts for these capitalized costs.

Basically, storing up these costs until they hit the income statement.

And there's also gonna be reserve accounts,

which we'll talk about next video.

We're gonna take a look at the Statement of Cash Flows where we can see the gap

between net income and cash from operations that's caused by expense

related manipulations and about 35% of SEC

enforcement actions are related to questions around recognition of expenses.

So this is a big deal also.

So we're gonna look at this question of capitalization versus

expensing immediately.

Capitalization means the company creates an asset when the cash is paid and

then amortizes it or expenses it over time.

The alternative is to just recognize an expense when cash is paid and so

this is the choice that companies's managers have to make.

>> My sister once told me that the rules are quite explicit about whether

a company may capitalize a cost or not.

>> Your sister is exactly right, the standard setters have created a lot of

explicit guidance on how expenditures must be treated.

For example, research and development and

advertising has to be expensed immediately, but there's still are a lot

of these expenditures where the rules provide discretion.

For example, whether something is maintenance or

a capital improvement, whether it's a software development cost before or

after something called technological feasibility.

And then companies will occasionally have these customer acquisition costs,

where the guidance is not clear on whether it should be capitalized or

expensed immediately.

So there's still a lot of expenditures where managers have the room to make these

determinations on when you expense something.

Let's look at an example to see how this works.

So let's say, a company spends $120 in 2016 on software development costs and

this is one area where managers have some discretion of whether to capitalize or

expense immediately.

And let's say that costs have a three-year benefit for

generating revenue, so whatever software you're developing

should help you make sales over the next three years.

If the company capitalizes, then in 2016 as they pay 120 cash,

they would create an asset called deferred software development costs.

And then in 2016, 2017 and 2018 at the end of the year,

they would recognize an expense of 40 and reduce the asset by 40.

So they're spreading those costs over three years.

If they expense immediately, then in 2016 as they pay the cash,

they would recognize an expense of 120 and

there would be no expense the next 2 years.

So the more the company capitalizes,

the smaller its expense will be in the first year.

Once you decide to capitalize,

then the question is what do you do with amortization periods?

Now, these should reflect the period over which costs will help generate revenues.

So we saw the example of a three year life where we spread the cost over three years.

If the manager decided to lengthen the period, it would reduce expenses in

the early years, but it would add more years of expense.

So let's say, you decided to do four years instead.

What it does in the first three years is reduce your expense by 10 from

40 down to 30, but then give you an extra expense of 30 in 2019.

Shortening the periods with increase expenses, but

then resolved in fewer years of expense.

So if the company did a two-year life,

then their expenses would be higher in those first two years.

They would have 60 instead of 40, so an extra 20 of expense, but

then there would be no expense after 2017.

So by choosing the amortization period,

the manager can essentially choose how they spread this expense over time and

what the level of their expense would be in the current year.

>> Seriously?

There must be a law that says, how long you can amortize something.

>> If not, you could change the period every year,

depending on whether you wanted higher or lower earnings.

>> No, there is no law that says the exact number of

years that you have to use to amortize a given asset.

Instead, what the rules say is that you should amortized it over its useful life,

which means how long the asset is gonna generate revenue?

So how long, in this case,

these capitalize costs will help you produce revenue?

That is context specific, it differs based on firms, it differs based on assets.

So there can't be a law that centralizes this, but that doesn't mean you could

change your assumptions for the number of periods each and every year.

To change your period, you have to justify to your auditor why circumstances have

changed, which would call for a different useful life and

the auditor will probably let you get away with that once.

But then if you come back the next year and wanna change it again and

then try to change it again and again and again, the auditor will probably say no.

So you get maybe one opportunity to change the amortization period and

the auditor will be okay, but the auditor is there to prevent the company from

changing these periods every single year.

Here are the red flags we're gonna use to look for aggressive capitalization or

amortization behavior.

So look at the ratio of the deferred cost assets to total assets.

So, are these assets getting bigger?

If so, the company's capitalizing more costs.

The ratio of amortization expense to revenue.

Is this ratio getting smaller?

If so, the company's spreading out the amortization over more

periods to reduce the expense.

The average amortization period.

So we can calculate something called months amortization,

which is the average asset balance divided by amortization expense times 12.

So this is similar to the day receivable days inventory ratios that we looked at

earlier, except here we are looking at months.

The gap between net income and cash flow, because these capitalization, amortization

strategies create a bigger gap between net income and cash from operations.

And we can calculate what the company's net income would be,

if they expensed immediately.

So that is gonna be equal to the net income that they report,

which reflects the capitalization, amortization.

We'll add back the amortization expense that removes it from net income.

We'll subtract the cash cost.

Because if the company was expensing immediately, the cash cost would be

the expense for the year and then we have to subtract a tax adjustment.

And the tax adjustment is just the difference between the amortization

expense and the cause cost times whatever the companies tax rate is.

>> Dude, why do you need a tax adjustment?

I like it better when we like ignore taxes.

>> I like ignoring taxes, as well.

But unfortunately, we can't ignore taxes in this situation.

The problem is that net income is an after tax number, but

the amortization expense and the cash costs are pretax.

So we need to include a tax adjustment to figure out what's the tax effect of

changing the expense.

We can include that tax effect with the pretax and the expense.

Add that to net income and we get net income, if we expensed immediately.

Now, let's practice applying these red flags in a case.

The case we're going to look at is Dog Nutrition Associates,

they're a custom dog food provider.

Customers use saliva swabs to collect the dog's DNA and

then they send the results to the company.

The company then, custom crafts the food to the dog's DNA profile and

sends the food to the customers weekly.

The company aggressively markets its product by sending free DNA kits in

the mail to people, regardless of whether they requested them or not.

And the hope is that people will decide to use this free DNA kit and

then become subscribers to the weekly dog food service.

>> My gosh, this company cannot be real.

>> You don't remember their commercials where they would use cute kids to try to

promote their product?

Here, I think I have a clip from one.

>> Is your dog not eating right or not as energetic anymore?

Try our specially formulated dog food, using our free doggie DNA kit.

It will be sent by mail to your home.

Send your dog's DNA sample to the Dog Nutrition Associates or the DNA, so we can

craft the perfect dog food that is both nutritious and delicious for your dog.

All it takes is a lick or a cheek swab.

After you mail the DNA, every week, you will receive a specially made dog

food with an ingredient list on what goes into the food.

It only costs as little as 29.99 a week.

It is the small price to pay for the best nutrients for your dog.

For more information, go to our website dna.aol.com and

keep watching for your kit today.

>> So the company had it's initial Public Offering in 2011 and

had to file 10-K with SEC at that point.

The accounting guidance was not clear about whether the marketing cost for

the DNA kits had to be expensed immediately.

Regular advertising, all the other marketing expenditures did have to be

expensed immediately, but there was no guidance that was specific to DNA kits.

So the company decided to capitalize these as Deferred Subscriber Acquisition costs

and amortize them over the expected period they would generate revenue.

The expected average period was 12 months.

Let's take a look at the spreadsheet where I've summarized the financial statements

for Dog Nutrition Associates.

If you look at their balance sheet, here you can see

the Deferred Subscriber Acquisition costs, which are growing over the two years.

If you look at the income statement, you won't see the amortization of these costs

anywhere, because they're included within costs of revenues.

So the only place that we can find the amount of these costs is on the cash flow

statement.

They report amortization of subscriber acquisition costs, because it's a non

cash expense that has to be added back to net income to get cash from operations.

And what we can also see here is the net income for the company has been growing,

3 million, 7 million.

But if we look at their cash provided by operations,

it actually has dropped between 2011 and 2012.

Now we can take a look at some of these ratios.

So Deferred Subscriber Acquisition cost to total assets has grown from 17% to 21%,

so they're capitalizing cost at a higher rate.

If we look at the expenses as a percent of revenues, it's gone down overall.

And we see the amortization period has dropped slightly,

although that's probably just measurement error as the company grows.

It looks like on average, it's 10 or 11 months,

which is close to the 12 months the company says that it uses.

I showed you before the gap between that income and cash from operations,

it's growing over time and then we can calculate net income if the expense

immediately where we take net income.

We add back the expense.

We subtract the cash payed for Deferred Subscriber Acquisition cost and

where we can find those is on the cash flow statement.

There's a line for Deferred Subscriber Acquisition costs.

Here's the amount of cash they're spending, we can add those.

Well, actually, subtract those in this equation to the tax adjustment and

we can see that if they expense immediately that have net income that was

negative and declining overtime.

Analysts and investors were disappointed by mixed results in 2012, whereas revenue

was up 350%, net income was flat and cash from operations was negative as we saw.

At the start of FY2013, the company changed its amortization policy based on

changes in subscriber experience data.

It turned out customers were maintaining food subscriptions longer than expected.

And so now,

they would amortize Deferred Subscriber Acquisition costs over 24 months.

Let's take a look at how that would affect their results in 2013.

I have added the 2013 results to the spreadsheet.

We can see that the Deferred Subscriber Acquisition costs asset continues to grow.

We can also see that revenues have grown substantially, huge increase in 2013.

We see that net income is also up substantially from 7 to 30 million.

We see the big increase in subscriber acquisition cost expense that

is being advertised and a huge increase in the amount of cash costs

spent to send out these DNA kits and the cash operations is negative and declining.

So let's take a look at the ratios.

Now the Deferred Subscriber Acquisitions cost asset is 40% of total assets,

so they're capitalizing an enormous amount of these costs.

The expense has dropped from 14 to 11% of revenue.

And if we do the month's amortization, we can see the evidence that they

length of amortization period has gone from 10 to 18 months.

If we look at the gap between the incoming cash flow as we saw, it's widening and

then what would their net income look like if they expensed immediately?

Well, we add back the amortization, subtract out the cost that they're

spending during the year on these DNA kits, adjust for taxes and

they have a huge loss.

So by capitalizing and

amortizing, the company is showing steadily increasing net income.

If they're expensing immediately, they'd show a steadily decreasing net loss.

Analysts and

investors were starting to notice what we were noticing in the ratios and

they started to criticize the company's capitalization policy during 2014 So,

the company decided to switch to expensing immediately in the middle of the year.

Basically, they caved into the demands of these analysts and investors and

they wrote off all of their Deferred Subscriber Acquisition costs in 2014.

>> Why would the company cave into the demands of these nefarious analysts?

>> Excellent question.

So when a company is growing rapidly, it's better off capitalizing and

amortizing and that's because the expense from the cash outlays is much greater

than what the expense would be if you capitalize it and

smooth it over time with the amortizing.

But when a company's growth slows down, the situation actually reverses.

The amortization expense, which represents the past cash outlays can get bigger

than what the expense would be if you just did it based on current cash outlays and

that's a situation the company's gotten into.

It's realized that it's growth has slowed and

it's gonna be stuck now with these huge amortization expenses going forward.

So, it takes advantage of the controversy to write off this asset.

The asset disappears, which means it no longer has to worry about those

amortization expenses off into the future.

Instead, it will just expense immediately when it spends cash.

And in doing so, actually have higher earnings than if they capitalized and

amortized into the future.

So if we bring up the spreadsheet one more time,

I've added 2014 column to the spreadsheet and

what we can see is the Deferred Subscriber Acquisition cost asset goes away.

So at the end of 2014 at zero, they've written it off,

they've gotten rid of all those deferred costs.

If we look at the income statement, we see the revenues are still growing.

They have a $500 million net loss, but that's because they wrote off that

entire deferred subscriber acquisition cost asset at once and

it was $385 million when they decided to write it off.

So that's $385 million of future expenses that they will no longer have to

recognize, because they put it all in this period.

In on the cash flow statement, you could see it's added back as a non-cash expense.

There was a little bit of amortization and Deferred Subscriber Acquisition cash cost

reported, that's from the part of the year before they change their policy.

After they change their policy, you no longer going to see these two line items,

because all the expense is gonna be cash just be included in net income and

cash from operations.

And hey, notice cash from operations has turned around and become positive.

If we look at the ratios, the ratios don't make any sense anymore,

because they've changed their policy.

Now we can't compare the ratios across time anymore,

because it's a different accounting regime.

But what we can see is if they expensed immediately,

they still would have had a drop in net income, because they are still growing and

they still have these huge costs of sending out the DNA kit.

Now for those of you that have been googling Dog Nutrition Associates

to sign up for their service, this is a made up company, but

it is based on a real company, which I'm not gonna tell you who it is.

But the only way the real company got out of this mess was they,

basically, used their inflated stock price to make a big acquisition, get

into a different business and then they were able to carry on from this point.

That wraps our look at capitalizing versus expensing immediately.

It's a very easy way that managers can play with the timing of their expenses to

smooth out their earnings, but it's also a way that's a little bit easy to spot.

What were gonna take a look at in the next video are some expense

manipulations that are more difficult to find,

because they involve reserve accounts that are buried deep into the footnotes.

I'll see you then.

>> See you next video.

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