Understand Your Numbers: Treatment of Expenses

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  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. 

Treatment of Expense: 

“Interest and taxes are real expenses. Depreciation is the worst kind of expense: You buy an asset first and then pay a deduction, and you don’t get the tax benefit until you start making money”

-Warren Buffet

Warren Buffet has always been wary of creative accounting tricks employed by management to manipulate earnings. An investor should understand each expense item and question its treatment. In this article, we’ll discuss the treatment of expense items in detail which may change the reported earning numbers.

Stovec Industries Ltd. P&L statement: 

Stovec Industries Ltd. is in business of textile and graphics printing. Let’s have a quick look at Stovec’s expense items.

Cost of Material Consumed / Cost of Goods Sold (COGS): COGS is the raw material expense. COGS doesn’t equal to the actual expense incurred towards purchase of raw material during the year. It only captures the value of raw material which is consumed by the business. Stovec has consumed INR 80.4 cr of raw material during FY2016.

Let’s assume Stovec purchased INR 100 cr of raw material - of which INR 80.4 cr gets consumed during the year. COGS will be INR 80.4 cr. The non-consumed portion - INR 19.6 cr (100 - 80.4) will form part of inventory. This concept of consumption is in alignment with accrual accounting.

Purchases of stock in trade: This expense refers to the purchases of finished goods that the company buys towards conducting its business.

Changes in Inventories of Finished Goods, Work-in-Progress & Stock-in-trade: This expense refers to the change in finished goods in inventory & goods under processing.  

Employee Benefit Expenses: These expenses include wages, pension & retirement related expenses incurred during the year. 

Finance Costs: Finance cost is the interest expense. 

Depreciation & Amortisation: Expenses on plant and machinery is depreciated over a period of time. This expense is capitalised in the form of fixed assets/CWIP and depreciated over a period of machinery life. 

Readers may refer to my post on capitalisation for studying relationship between depreciation & capitalisation concepts. 

The heads under expense section may differ from business to business. However, expenses could be broadly segregated in 3 categories - operating expenses, capital expenses & finance expenses. 

Operating expenses are the expenses which benefit business within the same financial year, eg - employees salary, COGS. Capital expenses include expenses which produce benefits in the long run, eg - depreciation of plant & machinery. Finance expenses include the interest costs. 

Certain businesses classify employees salary / wages as capital expense which seems counter-intuitive. This may be true for consulting, advisory or & IT firms where expenses towards employees’ training produce benefits in the long run. 

CRISIL’s Classification of Expenses: 

CRISIL has three major business segment: Ratings, Research and Advisory.

1. Rating services includes credit ratings for corporates, banks, bank loans, small and medium enterprises (SME), credit analysis services, grading services and global analytical services

2. Research segments includes global research and analytical services, industry reports, customised research assignments , subscription to data services, independent equity research (IER),IPO gradings and training.

3. The Advisory segment comprise of infrastructure advisory, sale of software and annual maintenance contracts.

CRISIL major operating expenses include employee expenses (salaries, wages), establishment expenses (repairs, electricity, communication & insurance etc) and other expenses (printing, recruitment, software etc).     

CRISIL classifies part of Software expenses under operating expenses & part as capital expenses. Typically, management capitalises software costs during the software development stage. The incremental costs need to be reported under operating expense when software is ready for sale / achieved development stage. 

Similarly, CRISIL capitalises part of brand development costs under head ‘Brand’. It classifies  costs under head ‘Business Promotion & Advertisement’ as operating expense. Further study of notes, informs investor that the capitalised portion of software and advertisements are depreciated over 3 and 7 years respectively. An investor should convince herself that software expenses will accrue benefit to business over next 3 years and advertisement expenses over next 7 years. 

If investor is not convinced, she should adjust earnings by treating ‘Brand’ & ‘software’ expense as operating expenses.  

Adjusted Software expenses = (operating software expenses + 'Software' net block at the year end+ 'Software' depreciation for the year) =  INR (43.5 + 1.5+0.7) million = INR 45.7 million

Adjusted advertisement expenses* = INR (19.0 + 0) million = INR 19.0 million

(accumulative depreciation equals the value of advertisement expenses; hence no more expense depreciated in 2015). 

CRISIL capitalises customer relationship costs. Annual report doesn’t explain this cost in detail; this seems to be the costs incurred in developing customer relationship. A conservative investor may treat this as advertisement expense if there is no convincing rationale for its capitalisation. The value of this asset is ~INR 115.3 million (76.0+39.3) as on Dec 31, 2015. 

CRISIL capitalises non-compete fees paid while acquiring other businesses to their exiting promoters can be treated as an operating expense if the fees are not central to the deal. CRISIL non-compete fee is INR 45.4 million which has been classified as capital expense. This is already depreciated fully. 

If a conservative investor decides to re-adjust the earnings by reducing these capitalised costs, CRISIL’s operating expenses will increase by ~INR 117.5 million (1.5+ 0.7 + 115.3). Hence, the earning will reduce from INR 2,851 million to INR 2,733.5 million, reduction of 4% in earnings for the year. 

Concept of Consumption: 

If a machine is purchased at the start of year with useful life less than a year, the cost should go as operating expense item in P&L. As a thumb rule, if the purchased item is consumed within the same year of purchase, cost should be reflected as operating expense item. Alternatively, if purchased item is consumed over multiple years; cost should be reflected in balance sheet as asset (which is then depreciated over useful life of the item). This concept of consumption should be applied irrespective of the nature of item. 

Investor should ask relevant questions to the management if their earning reporting breaches the concept of consumption. Management should provide reasons on why a specific item is being expensed or capitalised.  

Re-classification of Expenses: 

Businesses classify expenses as operating or capital basis the consumption theory. A conservative investor may have to re-classify some of these expense items for better understanding of financial performance of businesses.  

1. Capitalisation of R&D Expenses: R&D, general admin, personnel expenses are typically classified a operating expenses. R&D expenses should be classified as capital expenses. Accountants doesn’t classify R&D expenses as capital expenses since these expenses doesn’t necessarily bring in benefits in the long term. However, R&D expenses are necessary for developing & sustaining competitive advantage over a long period of time. 

Biocon spent ~INR 275 cr in R&D in FY2016. If this amount is depreciated linearly over 5 year period, Biocon earnings will increase by INR (275-55) cr i.e. INR 220 cr. Here, INR 55 cr is assumed to be the annual depreciation.This is an increase of 6% in Biocon FY2016 earnings! 

Snapshot from Biocon Annual Report: 

(Amount in INR million) 

2. Adjusting Financial Expenses: Accountants treat certain expenses like operating lease as operating expense. Operating lease doesn’t transfer the ownership from lessor (actual owner) to lessee (end user). The asset remains in the books of lessor. This improves the return ratios - return on asset and asset turnover. 

Financial lease transfers the ownership of the asset to lessee, bloating lessee's balance sheet. This reduces the return ratios and increases debt on lessee’s books (lease payment comes as debt obligation in balance sheet). The present value of the lease payments are calculated for the value of debt in the balance sheet. 

An investor may treat operating lease similar to finance lease and adjust the earnings by capitalising the leased asset.  

Conclusion: 

Management has multiple tools in its repertoire to manipulate earnings. It's the responsibility of investor to identify these creative accounting gimmicks and re-adjust earnings to produce true picture of business performance.  

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.