4
operating expense, as is the labor cost for an automobile company associated with
producing vehicles.
• Capital expenses are expenses that generate benefits over multiple periods. For
example, the expense associated with building and outfitting a new factory for an
automobile manufacturer is a capital expense, since it will generate several years of
revenues.
• Financial expenses are expenses associated with non-equity capital raised by a firm.
Thus, the interest paid on a bank loan would be a financial expense.
The operating income for a firm, measured correctly, should be equal to its
revenues less its operating expenses. Neither financial nor capital expenses should be
included in the operating expenses in the year that they occur, though capital expenses
may be depreciated or amortized over the period that the firm obtains benefits from the
expenses. The net income of a firm should be its revenues less both its operating and
financial expenses. No capital expenses should be deducted to arrive at net income.
The accounting measures of earnings can be misleading because operating, capital
and financial expenses are sometimes misclassified. We will consider the two most
common misclassifications in this section and how to correct for them. The first is the
inclusion of capital expenses such as R&D in the operating expenses, which skews the
estimation of both operating and net income. The second adjustment is for financial
expenses such as operating leases expenses that are treated as operating expenses. This
affects the measurement of operating income but not net income.
The third factor to consider is the effects of the phenomenon of “managed
earnings” at these firms. Technology firms sometimes use accounting techniques to post
earnings that beat analyst estimates resulting in misleading measures of earnings.
Capital Expenses treated as Operating Expenses
While, in theory, income is not computed after capital expenses, the reality is that
there are a number of capital expenses that are treated as operating expenses. For instance,
a significant shortcoming of accounting statements is the way in which they treat research
and development expenses. Under the rationale that the products of research are too
uncertain and difficult to quantify, accounting standards have generally required that all
5
R&D expenses to be expensed in the period in which they occur. This has several
consequences, but one of the most profound is that the value of the assets created by
research does not show up on the balance sheet as part of the total assets of the firm.
This, in turn, creates ripple effects for the measurement of capital and profitability ratios
for the firm. We will consider how to capitalize R&D expenses in the first part of the
section and extend the argument to other capital expenses in the second part of the
section.
Capitalizing R&D Expenses
Research expenses, notwithstanding the uncertainty about future benefits, should
be capitalized. To capitalize and value research assets, you make an assumption about
how long it takes for research and development to be converted, on average, into
commercial products. This is called the amortizable life of these assets. This life will vary
across firms and reflect the commercial life of the products that emerge from the research.
To illustrate, research and development expenses at a pharmaceutical company should
have fairly long amortizable lives, since the approval process for new drugs is long. In
contrast, research and development expenses at a software firm, where products tend to
emerge from research much more quickly should be amortized over a shorter period.
Once the amortizable life of research and development expenses has been
estimated, the next step is to collect data on R&D expenses over past years ranging back
to the amortizable life of the research asset. Thus, if the research asset has an amortizable
life of 5 years, the R&D expenses in each of the five years prior to the current one have to
be obtained. For simplicity, it can be assumed that the amortization is uniform over time,
which leads to the following estimate of the residual value of research asset today.
∑
0=t
1) (n=t
t
n
t)+(n
D&R =Asset Research theof Value
Thus, in the case of the research asset with a five-year life, you cumulate 1/5 of the R&D
expenses from four years ago, 2/5 of the R & D expenses from three years ago, 3/5 of the
R&D expenses from two years ago, 4/5 of the R&D expenses from last year and this
year’s entire R&D expense to arrive at the value of the research asset. This augments the
value of the assets of the firm, and by extension, the book value of equity.
6
Adjusted Book Value of Equity = Book Value of Equity + Value of the Research Asset
Finally, the operating income is adjusted to reflect the capitalization of R&D
expenses. First, the R&D expenses that were subtracted out to arrive at the operating
income are added back to the operating income, reflecting their re-categorization as capital
expenses. Next, the amortization of the research asset is treated the same way that
depreciation is and netted out to arrive at the adjusted operating income.
Adjusted Operating Income = Operating Income + R & D expenses –
Amortization of Research Asset
The adjusted operating income will generally increase for firms that have R&D expenses
that are growing over time. The net income will also be affected by this adjustment:
Adjusted Net Income = Net Income + R & D expenses – Amortization of Research Asset
While we would normally consider only the after-tax portion of this amount, the fact that
R&D is entirely tax deductible eliminates the need for this adjustment.
1
R&Dconv.xls: This spreadsheet allows you to convert R&D expenses from operating
to capital expenses.
Illustration 9.2: Capitalizing R&D expenses: Amgen in March 2001
Amgen is a bio-technology firm. Like most pharmaceutical firms, it has a
substantial amount of R&D expenses and we will attempt to capitalize it in this section.
The first step in this conversion is determining an amortizable life for R & D expenses.
How long will it take, on an expected basis, for research to pay off at Amgen? Given the
length of the approval process for new drugs by the Food and Drugs Administration, we
will assume that this amortizable life is 10 years.
The second step in the analysis is collecting research and development expenses
from prior years, with the number of years of historical data being a function of the
amortizable life. Table 9.2 provides this information for the firm.
1
If only amortization were tax deductible, the tax benefit from R&D expenses would be:
Amortization * tax rate
This extra tax benefit we get from the entire R&D being tax deductible is as follows:
(R&D – Amortization) * tax rate
If we subtract out (R&D – Amortization) (1- tax rate) and add the differential tax benefit which is
computed above, (1- tax rate) drops out of the equation.
7
Table 9.2: Historical R& D Expenses (in millions)
Year R& D Expenses
Current 845.00
-1 822.80
-2 663.30
-3 630.80
-4 528.30
-5 451.70
-6 323.63
-7 255.32
-8 182.30
-9 120.94
-10
[Note that the firm has been in existence for only nine years, and that there is no
information therefore available for year –10.] The current year’s information reflects the
R&D in the last financial year (which was calendar year 2000).
The portion of the expenses in prior years that would have been amortized
already and the amortization this year from each of these expenses is considered. To make
estimation simpler, these expenses are amortized linearly over time; with a 10-year life,
10% is amortized each year. This allows us to estimate the value of the research asset
created at each of these firms and the amortization of R&D expenses in the current year.
The procedure is illustrated in table 9.3:
Table 9.3: Value of Research Asset
Year R&D Expense Unamortized portion
Amortization
this year
Current 845.00 1.00 845.00
-1 822.80 0.90 740.52 $ 82.28
-2 663.30 0.80 530.64 $ 66.33
8
-3 630.80 0.70 441.56 $ 63.08
-4 528.30 0.60 316.98 $ 52.83
-5 451.70 0.50 225.85 $ 45.17
-6 323.63 0.40 129.45 $ 32.36
-7 255.32 0.30 76.60 $ 25.53
-8 182.30 0.20 36.46 $ 18.23
-9 120.94 0.10 12.09 $ 12.09
-10 0.00 0.00 0.00 $ -
[Note that none of the current year’s expenditure has been amortized because it is
assumed to occur at the end of the year but that 50% of the expense from 5 years ago has
been amortized. The sum of the dollar values of unamortized R&D from prior years is
$3.355 billion. This can be viewed as the value of Amgen’s research asset and would be
also added to the book value of equity for computing return on equity and capital
measures. The sum of the amortization in the current year for all prior year expenses is
$397.91 million.
The final step in the process is the adjustment of the operating income to reflect
the capitalization of research and development expenses. We make the adjustment by
adding back R&D expenses to the operating income (to reflect its reclassification as a
capital expense) and subtract out the amortization of the research asset, estimated in the
last step. For Amgen, which reported operating income of $1,549 million in its income
statement for 2000, the adjusted operating earnings would be:
Adjusted Operating Earnings
= Operating Earnings + Current year’s R&D expense – Amortization of Research Asset
= 1,549 + 845 – 398 = $1,996 million
The stated net income of $1,139 million can be adjusted similarly.
Adjusted Net Income
= Net Income + Current year’s R&D expense – Amortization of Research Asset
= 1,139 + 845 – 398 = $1,586 million
9
Both the book value of equity and capital are augmented by the value of the research
asset. Since measures of return on capital and equity are based upon the prior year’s
values, we computed the value of the research asset at the end of 1999, using the same
approach that we used in 2000 and obtained a value of $2,909 million.
2
Value of Research Asset
1999
= $2,909 million
Adjusted Book Value of Equity
1999
= Book Value of Equity
1999
+ Value of Research Asset
= 3,024 million + 2,909 million = $5,933 million
Adjusted Book Value of Capital
1999
= Book Value of Capital
1999
+ Value of Research
Asset
= 3,347 million + 2909 million = $6,256 million
The returns on equity and capital are reported with both the unadjusted and adjusted
numbers below:
Unadjusted Adjusted for R&D
Return on Equity
1,139
3,024
= 37.67%
1,586
5,933
= 26.73%
Pre-tax Return on Capital
1,549
3,347
= 46.28%
1,996
6,256
= 31.91%
While the profitability ratios for Amgen remain impressive even after the adjustment,
they decline significantly from the unadjusted numbers. This is likely to happen for most
firms that earn high returns on equity and capital and have substantial R&D expenses.
3
Capitalizing Other Operating Expenses
While R&D expenses are the most prominent example of capital expenses being
treated as operating expenses, there are other operating expenses that arguably should be
treated as capital expenses. Consumer product companies such as Gillette and Coca Cola
could argue that a portion of advertising expenses should be treated as capital expenses,
since they are designed to augment brand name value. For a consulting firm like KPMG,
2
Note that you can arrive at this value using the table above and shifting the amortization numbers by one
row. Thus, $ 822.80 million will become the current year’s R&D, $ 663.3 million will become the R&D
for year –1 and 90% of it will be unamortized and so on.
3
If the return on capital earned by a firm is well below the cost of capital, the adjustment could result in a
higher return.
10
the cost of recruiting and training its employees could be considered a capital expense,
since the consultants who emerge are likely to be the heart of the firm’s assets and
provide benefits over many years. For many new technology firms, including e-tailers
such as Amazon.com, the biggest operating expense item is selling, general and
administrative expenses (SG&A). These firms could argue that a portion of these
expenses should be treated as capital expenses since they are designed to increase brand
name awareness and bring in new presumably long term customers. America Online, for
instance, used this argument to justify capitalizing the expenses associated with the free
trial CDs that it bundled with magazines in the United States.
While this argument has some merit, you should remain wary about using it to
justify capitalizing these expenses. For an operating expense to be capitalized, there
should be substantial evidence that the benefits from the expense accrue over multiple
periods. Does a customer who is enticed to buy from Amazon, based upon an
advertisement or promotion, continue as a customer for the long term? There are some
analysts who claim that this is indeed the case and attribute significant value added to
each new customer.
4
It would be logical, under those circumstances, to capitalize these
expenses using a procedure similar to that used to capitalize R&D expenses.
• Determine the period over which the benefits from the operating expense (such as
SG&A) will flow.
• Estimate the value of the asset (similar to the research asset) created by these
expenses. If the expenses are SG&A expenses, this would be the SG&A asset.
• Adjust the operating income for the expense and the amortization of the created
asset.
Adjusted Operating Income = Operating Income + SG&A expenses for the current period
– Amortization of SG&A Asset
• A similar adjustment has to be made to net income:
4
As an example, Jamie Kiggen, an equity research analyst at Donaldson, Lufkin and Jenrette, valued an
Amazon customer at $2,400 in an equity research report in 1999. This value was based upon the
assumption that the customer would continue to buy from Amazon.com and an expected profit margin
from such sales.
11
Adjusted Net Income = Net Income + SG&A expenses for the current period –
Amortization of SG&A Asset
• Adjust the book value of equity and capital.
Adjusted BV Equity = BV of Equity + Value SG&A Asset
Adjusted BV Capital = BV of Capital + Value SG&A Asset
Illustration 9.3: Should you capitalize SG&A expense? Analyzing Amazon.com and
America Online
Let use consider SG&A expenses at Amazon and America Online. To make a
judgment on whether you should capitalize this expense, you need to get a sense of what
these expenses are and how long the benefits accruing from these expenses last. For
instance, assume that an Amazon promotion (the expense of which would be included in
SG&A) attracts a new customer to the web site and that customers, once they try
Amazon, continue, on average, to be customers for three years. You would then use a
three year amortizable life for SG&A expenses and capitalize them the same way you
capitalized R& D: by collecting historical information on SG&A expenses, amortizing
them each year, estimating the value of the selling asset and then adjusting operating
income and book value of equity.
We do believe, on balance, that selling, general and administrative expenses should
continue to be treated as operating expenses and not capitalized for Amazon for two
reasons. First, retail customers are difficult to retain, especially online, and Amazon faces
serious competition not only from B&N.com and Borders.com, but also from traditional
retailers like Walmart, setting up their online operations. Consequently, the customers
that Amazon might attract with its advertising or sales promotions are unlikely to stay
for an extended period just because of the initial inducements. Second, as the company
has become larger, its selling, general and administrative expenses seem increasingly
directed towards generating revenues in current periods rather than future periods to
retain current customers.
In contrast, consider the SG&A expenses at America Online. Especially when the
firm was smaller, these expenses primarily related to the cost of the CDs that AOL would
package with magazines to get readers to try its service. The company’s statistics
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indicated that a customer who tried the service remained a subscriber to it for about 3
years, on average. This makes a case for treating the expense as a capital expense stronger,
with an amortizable life of 3 years.
Illustration 9.4: Capitalizing Recruitment and Training Expenses: Cyber Health
Consulting
Cyber Health Consulting (CHC) is a firm that specializes in offering management
consulting services to health care firms. CHC reported operating income (EBIT) of $51.5
million and net income of $23 million in the most recent year. However, the firm’s
expenses include the cost of recruiting new consultants ($ 5.5 million) and the cost of
training ($8.5 million). A consultant who joins CHC stays with the firm, on average, 4
years.
To capitalize the cost of recruiting and training, we obtained these costs from each
of the prior four years. Table 9.4 reports on these expenses and amortizes each of these
expenses over four years.
Table 9.4: Human Capital Expenses: CHC
Year Training & Recruiting Expenses Unamortized Portion Amortization this year
Current $ 14.00 100% $ 14.00
-1 $ 12.00 75% $ 9.00 $ 3.00
-2 $ 10.40 50% $ 5.20 $ 2.60
-3 $ 9.10 25% $ 2.28 $ 2.28
-4 $ 8.30 - $ 0.00 $ 2.08
Value of Human Capital Asset = $ 30.48 $9.95
The adjustments to operating and net income are as follows:
Adjusted Operating Income = Operating Income + Training and Recruiting expenses –
Amortization of Expense this year = $ 51.5 + $ 14 - $ 9.95 = $ 55.55 million
Net Income = Net Income + + Training and Recruiting expenses – Amortization of
Expense this year = $ 23 million + $ 14 million - $ 9.95 million = $ 27.05 million
As with R&D expenses, the fact that training and recruiting expenses are fully tax
deductible dispenses with the need to consider the tax effect when adjusting net income.
13
Adjustments for Financing Expenses
The second adjustment is for financing expenses that accountants treat as
operating expenses. The most significant example is operating lease expenses, which are
treated as operating expenses, in contrast to capital leases, which are presented as debt.
Converting Operating Leases into Debt
In chapter 3, the basic approach for converting operating leases into debt was
presented. We discount future operating lease commitments back at the firm’s pre-tax
cost of debt. The present value of the operating lease commitments is then added to the
conventional debt of the firm to arrive at the total debt outstanding.
Adjusted Debt = Debt + Present Value of Lease Commitments
Once operating leases are re-categorized as debt, the operating incomes can be
adjusted in two steps. First, the operating lease expense is added back to the operating
income, since it is a financial expense. Next, the depreciation on the leased asset is
subtracted out to arrive at adjusted operating income.
Adjusted Operating Income = Operating Income + Operating Lease Expenses –
Depreciation on leased asset
If you assume that the depreciation on the leased asset approximates the principal
portion of the debt being repaid, the adjusted operating income can be computed by
adding back the imputed interest expense on the debt value of the operating lease expense.
Adjusted Operating Income = Operating Income + (Present Value of Lease
Commitments)*(Pre-tax Interest rate on debt)
Illustration 9.5: Adjusting Operating Income for Operating Leases: The Gap in 2001
As a specialty retailer, the Gap has hundreds of stores that are leased with the
leases being treated as operating leases. For the most recent financial year, the Gap has
operating lease expenses of $705.8 million. Table 9.5 presents the operating lease
commitments for the firm over the next five years and the lump sum of commitments
beyond that point in time.
Table 9.5: The Gap’s Operating Lease Commitments
Year Commitment
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