Inflating Earnings By Capitalizing Expenses

In real life, expenses are pretty straightforward. Anything which constitutes an outflow of money to pay for a product or service is deemed as an expense. For accounting students, an expense is recorded when an asset is used up and a liability recorded. Simple, right?

However, there are instances when you struggle to answer this question: Should a cost be expensed or capitalized?

Our accounting rules stipulate that any benefits have to be matched with an expense on the balance sheet. We classify business costs such as salaries, utilities, rental, purchase of consumables, etc, automatically under expenses as they are deemed to produce short-term benefits.

However, costs such as a new machinery or factory are often capitalized, that is their values are recorded as assets that slowly decline in value over time, because they produce long-term benefits.

Now, here comes the juicy part which every CFOs love. A company fixated on creative accounting rather than creating value can tweak expenses to inflate earnings, so much that investors are tricked into believing this once-in-a-lifetime investment and part with their hard-earned money.

To illustrate, assume this site (jeflin.net) is going to be listed soon. To improve my meager earnings, how about capitalizing $1000 of advertising and marketing costs into the equation, and then spreading out the expense over several years, rather than marking it as a $1000 expense straightaway.

The advertising campaigns will build awareness and give me traffic and subscribers, so there are certainly long-term benefits involved. For investors who know no better, they may think I am doing pretty well, on the basis of my earnings report. However, there is no telling if the supposed benefits will materialize at all.

Why take the risks to invest when we cannot ascertain whether the “asset” (expense) can generate long term economic benefits or not? As investors, if we want to preserve our portfolio, it is our job to spot the red flags as the management will not look out for us.

Hence, I believe it is always worthwhile to spend time examining the footnotes of annual reports. If you see an expense which is capitalized, be critical and ask whether it is justified.

A factory may be useful for 50 years and a truck can serve you for 10 years but office furniture, subscribers, or software are virtually worthless and if a company capitalize these expenses as assets, then it is best to take your money elsewhere.

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