Capitalization of expenses: how it works and why it matters 📈
If you are involved in technology companies, you probably have already heard of the concept of ‘capitalization’ of costs related to investments in technology - or the so-called IP (intellectual property).
This process is basically an accounting principle in which an expenditure gets incorporated as an asset - an Intangible Assset, more specifically - instead of being recognized as an expense in the Income Statement.
Intangibles assets recognition and treatment are governed by IAS 38 - a principle that allows you to capitalize costs (instead of recognizing them as an expense line in your profit and loss statement) when there is an investment being made in the development of a proprietary technology that will be able to realize a gain in the future (sale).
Let’s first understand what makes an asset under accounting principles. There are 3 key driving principles that must be met for any asset classification:
Identifiability: separate with legal rights
Control: power to obtain benefits from the asset
Future economic benefits: revenues or reduced future costs
Now, how can you confirm that your expenses on building the technology or IP will ultimately result in the creation of future benefits? And also, what would be those expenses? Another test that needs to be done is to determine if the expense meets the definition of an intangible asset (identifiable non-monetary asset without physical substance) that:
Provides probable economic benefits will flow to the asset
Costs can be reliably measured
Usually, tech companies use the expenses related to the salaries of the tech and product teams as the main investments on the intangible assets that are being created by the company.
The best way to support your capitalization policy is by keeping a timesheet for these teams, with the tasks and work developed by them segregated by research, development, and testing of the technology. You can then use this as an estimated percentage of the time to apply as the capitalization portion of the payroll.
This is beneficial because several tech companies end up having an ‘empty’ balance sheet - by not requiring any traditional ‘hard assets’ to be acquired (other than computers and peripherals) - you are able to show clearly in you b/s the estimated amount (on a cost value basis) for the investment you’ve been making into your tech development.
It can be seen as negative as a few players may claim that instead of expensing the amount you’re trying to ‘hide’ the real expenses of running your business. This is a well-adopted and received accounting policy trying to catch up with the new era of businesses that are so different from the traditional businesses of retail, manufacturing, and sales that the accounting principles were built upon.
🎧 Podcast recommendations
▶️ The CFO Playbook: Top Automation Lessons from Finance Leaders: Main takeaway from several interviews with CFOs and Finance leaders across different industries: there’s no way you can scale a finance department without technology. Good practical tips.
▶️ This week in Startups: Twitter new CRO, Mr. Beast record-breaking Squid Game + Haus Helena Price Hambrecht: Great podcast updating on the latest hot news in the tech world: Jack Dorsey stepping down as Twitter CEO and Haus tremendous success in the alcohol D2C market. I’m a fan of the brand since the early days.
This is Open Books - a weekly newsletter carefully curated by me, Leticia Souza. Every week I’ll be compiling relevant topics around finance and financial strategy - from choosing your first accounting system to how to successfully close a fundraising round to your business.
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See you all next week 👋🏼
Leticia
Important lessons, especially as most companies are becoming increasingly IP based.