Saturday, October 1, 2016

Understand Your Numbers: Capitalisation Study

Accounting has evolved significantly over last few decades. A maze of new financial terminologies were devised along the way - ROE, ROCE, ROIC, ROA etc. It’s difficult for an investor from non-finance background to understand many of these terminologies. I’ll share my thoughts about some of these concepts as part of ‘Understand Your Numbers’ series. This series is an attempt to structure my thoughts as well as help investors understand the nuances of financial concepts. 

Capitalisation

Capitalisation is an innocuous way for businesses to manipulate Profit & Loss (P&L) and Balance Sheet statements. These manipulations may be allowed as per accounting guidelines but it is important for an investor to be aware of its effects on the profitability numbers. To grasp the concept of capitalisation, we need to first refer to the concept of depreciation.

Depreciation is reduction in value of an asset over period of time. This reduction reduces the value of asset in the balance sheet and transfers this decrease as expense in the P&L. 

Capitalisation is reverse of depreciation. Capitalisation allows companies to transfer expenses from P&L to balance sheet as asset. Depreciation then moves this asset from balance sheet to P&L as expense over a period of time. Standard accounting methods allow capitalisation / depreciation of variety of costs or expenses.

Capitalisation of expenses:

Capitalisation principle is based on accrual used accounting. Under the accrual basis of accounting, expenses are matched with the related revenues & are reported when the expense occurs, not when the cash is paid. 

A construction company may take substantial amount of time to complete a project. The expenses towards this project may be capitalised (i.e. transferred to balance sheet as asset instead of P&L as expense) since the project is not yet ready for revenue generation activity. These expenses go to Capital Work in Progress (CWIP) which is eventually transferred to fixed asset & depreciated over a period of time. 

A look at the DLF balance sheet of FY2016 shows CWIP of INR 399 cr, which refers to projects under work that are yet to start generating revenue.  



The capitalisation of expenses can be initiated by company when:

a) It incurs expenditure for the asset
b) Incurs borrowing cost (if company raised debt for asset creation) 
c) Undertakes activities necessary to prepare the asset. 

Capitalisation should be ceased when the activities necessary to prepare the asset for its intended use are complete.

It’s easier to identify physical assets and judge their completion status, however complication increases when the company is in services industry ex - IT. 

Let’s take an example of an IT company which is developing a software. Software will take ’t’ time to be ready for sale to clients. The major expenses will be borne by the company during development stage of the software while the cashflows will kick in after the software is ready for sale to the clients. IT company can capitalise the expenses during the development stage. 

A quick reference to Intellect Design annual report (AR) suggests that company capitalises R&D expenses and part of financial lease expenses. The Capital Work in Progress (CWIP) of ~INR 12.3 cr is the expenditure towards R&D which gets reflected under assets in balance sheet. 

Notes from Intellect Design Arena AR:  






Persistent Systems capitalises the expenses under software development and construction of building. Company is capitalising its expenses towards Solar Power Systems and R&D. Company segregates its software development expenses under head ‘intangible assets under development’ and physical infrastructure expenses under CWIP in balance sheet. Company ceased capitalisation of expenses of Goa and Nagpur buildings which seem to be ready for intended use.  

Notes from Persistent Systems AR:   




Management may over or under capitalise assets to suit their specific objectives. Over-capitalisation  reduces expenses, increasing the profitability of company & vice-versa. It is important for an investor to understand the way company capitalises its various expenses. Equally important is to know when does company initiate and cease capitalisation of expenses. 

Capitalisation of borrowing costs: 

Capitalisation of borrowing costs is another creative accounting tool employed by companies to reduce their interest expenses. Accounting principles allow companies to capitalise their interest expenses for borrowings raised for capital asset creation. These expenses are moved to CWIP instead of interest expense section in P&L statement.  

Polyplex Corporation’s debt is INR 1,294 cr at consolidated level with interest expense of only INR 48 cr. The interest rate turns out to be 3.7%! 

The expected interest out go at prevailing interest rate of ~12% is INR 177 cr. Polyplex seems to be capitalising INR 129 cr (INR 177 cr - INR 48 cr) of interest expense.   


Polyplex Corporation’s net profit was INR 29 cr. Company would have shown losses if interest expenses were not capitalised!  



This is a significantly large number and further probe is needed to understand the exact borrowing mix of the company. Polyplex has foreign subsidiaries & has raised debt in foreign currency. Polyplex’s FY2016 AR shows foreign currency borrowing of INR 800 cr ~ 62% of overall borrowing.   



Cost of borrowing in foreign currency is low - let’s assume it to be 5% for Polyplex. The weighted average cost of borrowing will be 6.5%. Company seems to be capitalising around 3% of the borrowing rate.   

Conclusion: 

Management may follow aggressive expense capitalisation to show strong profitability numbers. It may also help them to achieve specific debt covenants ratios. An investor, however, needs to understand the actual expenses for objectively analysing a business.  

Addendum (12 Oct 2016):

I gave reference of DLF in the article while discussing CWIP. Mr. GVSB Reddy (Twitter handle @reddygvsb) explained to me that real estate companies take the under-construction / development costs to inventory. CWIP includes assets for intended use or assets for lease / rentals. I agree with his views. DLF's CWIP of INR 399 cr includes assets which are for its own use or are being developed for lease / rental purposes. 

Disclaimer:

All data has been taken from public sources. I don't have any financial interest in the companies discussed in this article. I may or may not invest in these companies or any of their affiliates in future. An investor should do her own analysis before making an investment decision. The views expressed are personal and doesn't represent that of my employer’s.

This article is just a collection of my thoughts. 

I am not registered with SEBI under SEBI (Research Analysts) Regulations, 2014. As per the clarifications provided by SEBI: “Any person who makes recommendation or offers an opinion concerning securities or public offers only through public media is not required to obtain registration as research analyst under RA Regulations.

Please refer to 'Disclaimer' page for further details. 

9 comments:

  1. Don't RE companies take the under-construction / development costs to inventory (unless intended for rental of owned bldgs)?

    ReplyDelete
    Replies
    1. Hi Reddy,

      Yes, your understanding is right.

      Regards

      Delete
  2. Very good article it's simple and thoughtful

    ReplyDelete
    Replies
    1. Thanks Shree Hari! Appreciate your kind words.

      Delete
  3. Great vikrant.The way you explain is simply superb.

    ReplyDelete
    Replies
    1. AKJ,

      Thanks for your kind words.

      Regards

      Delete
    2. AKJ,

      Thanks for your kind words.

      Regards

      Delete
  4. Great vikrant.The way you explain is simply superb.

    ReplyDelete
  5. Thanks for sharing this useful information. I can also suggest secure data room that I had experience with.

    ReplyDelete