Introduction
Understanding the financial health of a company is critical for investors and stakeholders. A key aspect of financial analysis involves evaluating a company's tangible and intangible assets, as well as its cash flows.
We will analyze the differences between tangible and intangible assets, the implications of capitalizing vs. expensing intangible assets. We will also discuss the impact of product life cycles on cash flows.
Tangible and Intangible Assets
Tangible assets are things you can touch, having physical substance. In contrast, intangible assets do not have physical substance and include items such as patents, brand value, trademarks, copyrights, licenses, goodwill, customer lists, and franchise rights, among others.
Capitalizing vs. Expensing Intangible Assets
Internally developed intangible assets are typically expensed, as opposed to property, plant, and equipment (PPE), which is capitalized and recorded on the balance sheet. The rationale for this treatment is that the future economic value of intangible assets is considered more subjective and not reliably measurable. However, under GAAP, certain expenditures, such as software development, can be capitalized and included on the balance sheet.
Market Value vs. Book Value
Often, companies have a much larger market value of total assets compared to their book value of total assets. One significant reason for this discrepancy is that companies often possess numerous intangible assets that do not appear on their balance sheet due to US GAAP rules as issued by the Financial Accounting Standards Board (FASB) and the Governmental Accounting Standards Board (GASB). The market value of a company will reflect the value of its intangible assets, whereas the book value will not.
Capitalizing Investments in Intangible Assets (software development)
The accounting rules for capitalizing software development costs depend on the current phase of the software research and development process. Costs are expensed during the initial research/preliminary development phase. Once the development has reached the subjective phase where completion of the software is likely, the company may begin to capitalize the software development costs. After the costs are capitalized, they are expensed over the subjective useful life of the software. The rules are slightly more lenient for software developed for internal use than for software developed to be sold to external customers.
However, a study by Mulford and Roberts (2006) found that 71% of US software firms choose not to capitalize any of their software development costs. This could be interpreted as these companies believing that all their costs occur before they reach a point where they believe the completion of their software is likely.
The IFRS encourages capitalization of development costs more broadly. However, a study by Mazzi, Slack, Tsalavoutas, and Tsoligkas (2019) found that over 60% of companies studied did not choose to capitalize development costs.
In my opinion, this research implies that companies are allowed to use their discretion and judgement to determine if they should capitalize or expense software development costs. This likely stems from the subjective determination of when the software can be considered likely to reach completion, as well as companies weighing the pros and cons of capitalizing versus expensing; but that is just my guess as I have not personally looked into this issue at any depth.
Amortization and Depreciation Explained
Both amortization and depreciation are accounting methods used to allocate the cost of an asset over its useful life. While depreciation is applied to tangible assets, amortization is used for intangible assets.
Depreciation
For example, if your company purchases a computer server for $50,000 with a useful life of 5 years and a salvage value of $0 after five years, the initial cash payment of $50,000 would be deducted from the balance sheet's cash account, and $50,000 would be added to the property, plant, and equipment (PPE) account. At the end of each year, the company would allocate $10,000 (i.e., $50,000 / 5) to the balance sheet's accumulated depreciation contra asset account and deduct the $10,000 depreciation expense from the retained earnings account. Additionally, the company would record the $10,000 depreciation expense annually on the income statement. After five years, when the server is disposed of, the $50,000 is removed from the PPE account, and the $50,000 is removed from the accumulated depreciation account.
Amortization
Amortization functions similarly, but it applies to intangible assets such as capitalized software development costs. These costs are added to the balance sheet in a dedicated account, and the accumulated amortization account is used instead of the accumulated depreciation account. Finally, with amortization the asset is assumed to have zero salvage value.
Implications of Useful Life Estimation on Comparable Valuations
When conducting financial statement analysis and comparing two companies, it is crucial to take into account management's assumptions about the capitalization and amortization of software development costs.
Consider two companies that develop internal use software, with one company estimating a useful life of 5 years for their software and the other company estimating 2 years. This difference in useful life estimation will result in significantly different annual amortization expenses, affecting net income. To compare these companies more accurately, you may create a pro forma software development capitalization by recasting one of the companies' annual capitalized software development expenses using the other company's useful life estimate. This adjustment can help to better understand the relative performance between the two companies. However, it is essential to ensure that the revised useful life estimation is reasonable before making such a change.
Important Aspects of Intangible Assets
- Technology companies often have valuable intangible assets.
- In general, investments in intangible assets are expensed under GAAP. However, GAAP does allow software development expenses to be capitalized.
- We saw above that if and how a company chooses to capitalize software development costs is often subjective and can vary widely. When performing financial statement analysis of similar companies (or companies with competing product lines), it may be necessary to make pro forma statements that recast how a company amortized their capitalized software development costs to be able to compare one company to another.
- When a company acquires another company, the intangible assets of the acquired company do get recorded on the balance sheet of the purchasing company.
Conclusion
Assessing a company's financial health involves a comprehensive understanding of tangible and intangible assets. By evaluating intangible assets, such as software development costs, and their treatment in financial statements, we can gain valuable insights into a company's financial position and make more accurate comparisons between companies.