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Accounting Estimates: Recognizing Expenses

In the last article, we discussed revenue recognition, and its implication on financial statement analysis. We will follow up that discussion by going over the other half of the income statement: expenses. We will go over what the accounting standards are and what discretion management has, and how they could use these ambiguities.

As with revenue, managing expenses will impact income statement ratios. All the ratios we went over in the last article will be affected by how expenses are recognized. Specifically, these are profitability ratios, efficiency ratios and valuation multiples. You should understand how management estimates expenses, and whether they are different from industry norms before using these ratios for financial analysis.

A simplified income statement looks like this:

Revenue $100
Cost of Sales (COGS, Cost of Services) ($40)
Gross Profit $60
Other Operating Expenses (D&A, SG&A, R&D) ($20)
Operating Profit $40
Interest Expense ($10)
Tax Expense ($10)
Net Income $20

Changes to any of these expenses will flow through the rest of the income statement, and the balance sheet through retained earnings.

Recognizing Expenses

Capitalize or Expense

Generally, when a company incurs cost, it can choose to expense or capitalize the cost. Capitalizing should only be done if the benefit generated from the cost will last more than a year, an example could be Amazon buying a new distribution center. Capitalizing costs bypass the income statement and increases assets (debit PPE, credit cash), while expensing costs recognizes costs on the income statement of the period in which it was incurred. Capitalized costs are then allocated to the income statement over the economic life of the asset through depreciation. Essentially, you are trading one big expense for multiple smaller expenses.

There may be an incentive for management to capitalize costs, as (1) management bonuses are usually tied to some sort of return measure (ROE is common) and (2) management bonuses are composed of stock options, which is in part tied to financial performance.

Cost of Goods Sold

Cost of goods sold is almost always the second line on the income statement. A change to COGS will affect the rest of the income statement (GP, EBITDA, EBIT and net income). On some income statements, it may be bundled within cost of sales, which is a sum of COGS and cost of service. If it is bundled, breaking it into its components can be useful.

Cost of goods sold is the direct cost associated with the revenue for that period. For traditional industries such as manufacturing, it is the cost of the products – materials, workers, supervisors, utilities, depreciation on the equipment used to make the products etc. Period costs such as admin, marketing, and research are not considered to be a part of COGS. When the goods are manufactured or bought, the costs will be held in inventory until the goods are sold.

Inventory is recorded in the balance sheet at cost. When they are sold, the costs associated with the sale are estimated by First In First Out, Average Cost, or Last In First Out (only under US GAAP). The choice of method impacts both inventory (and therefore ratios such as inventory turnover), and COGS (and therefore ratios such as gross margin). The methods are relatively simple to understand:

  • FIFO: inventory first acquired or made is sold first
  • AC: inventory is sold at average cost
  • LIFO: inventory last acquired or made is sold first

If we consider a normal, inflationary environment, using FIFO will result in the lowest COGS, but highest ending inventory balance. Using LIFO will result in the opposite: highest COGS and lowest inventory. Companies should use the method that best match their business – grocery stores should use FIFO.

Inventory is also subjected to write-downs, at Lower Of Cost Or Market (LOCOM). If the market value (net realizable value) of inventory is lower than its book value, inventory is written down and the expense is recorded as COGS in the income statement. The write-down can be reversed. An example of inventory write-down would be Samsung writing down a significant portion of its inventory when it had to recall its explosive phones.

Depreciation and Amortization

Depreciation and amortization are non-cash items recorded in the other operating expense portion of the income statement. A change in D&A will not affect EBITDA, but will affect EBIT and net income (EPS). Depreciation is added back into the operating cash flow and will not affect free cash flow or the cash balance, other than the tax shield it provides.

Depreciation refers to the transfer of capitalized assets into the income statement as expenses, representing the use of assets such as buildings and equipment. It should be recognized as equitably as possible through their economic lives. The economic life is the period of time in which the asset can generate economic benefit (not the physical life of the asset). Calculating depreciation requires significant amounts of estimation, namely the economic life, the residual value, and the depreciation method.

Depreciation Methods

Depreciation can be accounted for by three different methods: straight-line, double declining balance, and units of production. The method used to depreciate an asset should best match how the asset is used. For example, a piece of equipment used for manufacturing might be depreciated by the units of production, if the economic life is dependent on how often the equipment is used.

  • Straight-line: depreciate evenly over the life of the asset
    • Depreciation expense = (book value – residual value)/(economic life)
  • Double declining balance: accelerated depreciation, higher in the early years of the asset
    • Depreciation expense = [(book value)/(economic life)]*2
  • Units of production: depreciate based on units produced by asset
    • Depreciation expense = [(book value – residual value)/(total units)] * units produced

The straight-line method is the simplest method, and the double declining balance method is the most conservative method.

Asset Impairments

Impairment expense is a non-cash, non-operating item on the income statement that comes after operating profit. Depending on the context, it can be treated as a one-time expense. If it is non-recurring, it may be appropriate for the analyst to adjust earnings by the amount of impairment. Like depreciation, impairments are added back into the cash flow and will not affect cash. Impairments can be insufficient or aggressive, and is often used after a switch in management.

Plant, property and equipment (PPE), like inventory, is reported at their net book values (book value – accumulated depreciation). If the value decreases due to a permanent impairment, the company must recognize the impairment. Some reasons for impairments are changes in technology, economy, or regulations. The impairment is equal to the net book value minus the recoverable amount (higher of fair value less cost of sale, or value in use). Reversals of impairments are also possible.

Finance 101APV Method: Adjusted Present Value Analysis · Introduction to Capital Structure · Value Capture Model · Understanding Porter’s Five Forces · Modern Portfolio Theory and the Capital Allocation Line · M&A Deal Case Study · Introduction to Enterprise Value and Valuation · Option Contracts and Put Call Parity · Fama French and Multi Factor Models · Capital Budgeting Methods · Understanding the Yield Curve · Bond Valuation and Arbitrage · CAPM – Capital Asset Pricing Model · Inflation and Interest · Annuities and Perpetuities · Net Present Value ·
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