Case Solution. Operating Income ($ millions) Adjusted by Expensing of Software Development Costs 1

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1 Case Solution Estimated time to complete this case is 2 hrs Overview The case demonstrates that the financial statement effects of the capitalization versus expensing decision depend on patterns of expenditures. Digital Equipment s expenditures for Software development and R&D for the are listed below. Expenditures ($ millions) Software R&D Total Calculated in Part 1 2 Calculated in Part 5 Note that for (except for a dip in 1991 Software expenditures) software and R&D expenditures rose. From , however, they declined. The effects of the capitalization versus expensing decision are summarized below. Reported income reflects the capitalization of software and the expensing of R&D. Income adjusted by expensing software reflects results of all costs being expensed. Income adjusted by capitalization of R&D reflects results of all costs capitalized. Adjusted by Expensing of Software Development Costs 1 Operating Income ($ millions) (658) (241) (777) 132 Reported (636) (237) (790) 108 Adjusted by Capitalization (506) (400) (1142) (375) of R&D 2 1 Calculated in Part 4 2 Calculated in Part 5 Note that for the period, income with all items capitalized is highest whereas income with all items expensed is lowest. In 1994 and 1995 the situation has reversed with income with all items capitalized the lowest and income with all items expensed the highest. In 1993, (the year expenditures began declining), the results are in transition. Income with all items capitalized is lowest whereas reported income is still higher than income with all items expensed as the shift in rankings depends on whether or not expenditures are higher Solutions Chapter 7 - P. 1

2 or lower than the amortization of previous years costs. The relationship between the patterns of expenditures and the effects on the differences in income are demonstrated in the following graphs. As expenditures rise (decline), capitalization (expensing) results in higher income. R&D and Software Expenditures R&D and Total Software R&D Total Software Operating Income Reported Software Expensed R&D Capitalized Software Expenditure = Amortized expense + in unamortized cost Unamortized Cost $ 0 $ 34 $ 66 $ 90 $110 $112 $134 $138 $125 $101 in Unamort. Cost (13) (24) Amortization expense Software Expenditure Generally, it is approximately one year: 1988 amortization = approximately 1/3 of 1987 expenditure. Similarly 1989 amortization = approximately 1/3 of ( ) expenditures. For , however, the lag appears to be shorter; amortization expense is higher than expected Solutions Chapter 7 - P. 2

3 and in 1995 the lag appears to be longer as amortization expense is lower than the expected 1/3 of expenditures implied by a one-year lag. 3.(a)Research and engineering costs may be difficult to link to specific products while computer software costs can be attributed to specific computers or programs. This distinction may justify the capitalization of the latter but the expensing of the former. (b) The ratio of research and engineering to computer software costs for 1987 was 28.9; for 1992 the ratio was 20.3 ($1754/$86). Had this trend continued, Digital would capitalize and amortize more of its product development costs, increasing its reported profitability and solvency ratios. Both the level and trend would improve as the ratio declines. However, for 1994 and 1995 the trend reversed as the ratio of research and engineering to computer software costs increased to 23.6 and 29.7 respectively. This reversal caused deterioration in profitability and solvency ratios as the next part demonstrates. 4. Adjusted operating income is lower in the years as software development costs (except for 1991) grew. Adjusted ROA & ROE decline as the numerator effect of lower operating income overwhelms the denominator effect of lower assets and equity. However, starting in 1993, software development costs declined. In 1994 they were below amortization expense resulting in higher (adjusted) operating income. For 1995 the effect of the higher income in the numerator combined with the lower assets and equity in the denominator result in a reversal of the trend occurring when software costs were growing. Adjusted ROA and ROE are greater when software costs are declining. Solutions Chapter 7 - P. 3

4 4. As reported (all data in $ millions): Research & eng. costs Operating income Total assets Equity $7,173 5,728 $1,010 1,612 8,407 6,294 $1,306 1,635 10,112 7,510 $1,525 1,336 10,668 8,036 $1, ,655 8,182 $1, ,875 7,624 $1,754 (636) 11,284 4,931 $1,530 (237) 10,950 4,885 $1,301 (790) 10,580 3,280 $1, ,947 3,528 ROA ROE 20.7% 26.8% 17.7% 23.7% 12.9% 17.2% 5.0% 6.9% 4.3% 6.5% (5.5%) (10.1%) (2.1%) (4.8%) (7.3%) (19.4%) 1.1% 3.2% Operating income 1 Total assets 2 Equity 2 Adjusted to expense computer software costs (all data in $ millions): $7,173 5,728 $1,578 8,373 6,260 $1,603 10,046 7,444 $1,312 10,578 7,946 $543 11,545 8,072 $509 11,763 7,512 $(658) 11,150 4,797 $(241) 10,812 4,757 $(777) 10,455 3,155 $132 9,846 3,427 ROA ROE 20.3% 26.3% 17.4% 23.4% 12.7% 17.1% 4.9% 6.8% 4.4% 6.5% (5.7%) (10.7%) (2.2%) (5.0%) (7.3%) (19.6%) 1.3% 4.0% 1 Decrease reported operating income by change in unamortized cost calculated in Part 1. 2 Decrease assets and equity by unamortized cost. Solutions Chapter 7 - P. 4

5 5 Adjusted to capitalize and amortize research and engineering costs as well as software development costs (all data in $ millions): Oper. income (reported) Adjustments to oper. income: Capitalization of research & engineering costs 1 Amortization of capital. costs 2 Net effect of capitalization Oper. income (adjusted) (Years) $1,612 1,009 (721) $ 288 1,900 $1,635 1,294 (847) $447 2,082 $1,336 1,498 (1,039) $459 1,795 $ 563 1,577 (1,267) $ $ 511 1,605 (1,456) $ $ (636) 1,690 (1,560) $ 130 (506) $ (237) 1,461 (1,624) $(163) (400) $ (790) 1,233 (1,585) $(352) (1,142) $ (1,464) $(483) (375) Increase in assets & equity 3 Total assets (adjusted) Equity (adjusted) $1,502 8,675 7,230 $1,791 10,198 8,085 $2,238 12,350 9,748 $2,697 13,365 10,733 $3,007 14,662 11,189 $3,156 15,031 10,780 $3,286 14,570 8,217 $3,123 14,073 8,008 $2,777 13,357 6,057 $2,295 12,242 5,823 ROA ROE 20.1% 24.8% 18.5% 23.4% 14.0% 17.5% 6.2% 8.0% 4.4% 6.0% (3.4%) (5.3%) (2.8%) (4.9%) (8.3%) (16.3%) (2.9%) (6.3%) 1 Research and engineering costs less amortization of computer software costs. 2 One-third of sum of capitalized costs over previous three years 3 Increase equals capitalized costs less amortization. 1992, for example, equals 1992 costs plus 2/3 x 1991 costs plus 1/3 x 1990 costs.; i. e = [ (2x1605/3) + (1577/3)]. {Note that research and engineering costs for are found in Exhibit 7C-1. } Solutions Chapter 7 - P. 5

6 Note that adjusted operating income is higher as growing research costs exceed their amortization until From 1993 the situation reverses and adjusted income is lower. The effect of capitalization on ROA and ROE varies; in some years the numerator effect is more powerful but in others the denominator effect dominates. 6 The capitalization of research or software costs increases cash from operations (and increases cash outflow for investment). In part 4 the effect of expensing software costs would be minimal as CFO would be reduced by $73, $55, and $35 million respectively. The effect of capitalizing engineering costs in part 5 however, is highly significant due to their large size. CFO would increase by more than 30 fold in 1993 and increase by approximately three fold in 1994 and 1995 as CFO would increase by $1,461, $1,240, and $981 million respectively. Solutions Chapter 7 - P. 6

7 3.{M} (i) Payable Problems - Ch. 7 Debt ($000s) Rate (%) ($000s) Development loan $ 6, % $ 660 Mortgage debt 10, Debentures 40, ,000 Payable $5,560 (ii) Capitalized Debt ($000s) Rate (%) ($000s) Development loan 1 $ 6, % $ 660 Debentures 2 4, Capitalized $1,060 1 Development loan assumed to be related to the office building. 2 Mortgage debt is assumed to be related to specific projects and the problem does not state that it is related to the office building; the remaining balance is assumed to be financed by debentures. (iii) expense = payable - capitalized interest $5,560,000 - $ 1,060,000 = $4,500,000 B. The coverage ratio should be based on interest payable, not on interest expense. The capitalization of interest is an accounting requirement and does not affect the leverage of the firm. coverage should be computed as: (Pretax income + interest expense) / (interest payable) C. Capitalization of interest reduces the comparability of the interest coverage ratio, CFO, and profitability ratios. Capitalization of interest improves all of these indicators for affected firms. Among the factors that affect capitalization are: Solutions Chapter 7 - P. 7

8 1. The availability of internally generated funds limits the firm's ability to capitalize interest; it can be capitalized only on external borrowings. Thus, a firm with excess cash and/or a lower debt/equity ratio will be able to capitalize less interest than a firm that must borrow, even if they are otherwise identical. 2. Firms with lower borrowing costs will be able to capitalize less interest than (riskier) firms that must pay higher interest rates. 3. Capitalized interest becomes part of the carrying amount of the asset and is amortized (depreciated) over time. Different firms may use different depreciation methods (accelerated versus straight-line) and lives (short or longer) for similar assets. Firms that use accelerated methods and shorter lives will report lower profitability (and interest coverage) in the years following the construction of the asset. Amortization does not, however, affect cash from operations as it is a noncash expense. The computation of ratios and other performance measures should, therefore, be based on data that excludes the effect of capitalized interest. Such measures will reflect the actual leverage and cost of capital of the firm and will not be affected by the differences discussed above. Solutions Chapter 7 - P. 8

9 6.{M}A. (i) The deferral of development costs increased pretax income by $4,710,000 in 1991 as these costs would otherwise have been included in operating expense. (ii) The deferral of development costs increased cash from operations by $4,710,000. Cash outflows for investment were increased by the same amount. Net cash flow was unchanged. (iii) When the project becomes operational, the deferred costs will increase the depreciation or amortization of the investment in the project. If the commercial viability of the project becomes doubtful, the remaining, unamortized deferred costs will be written off and will reduce income in the year of the writeoff. (iv) Future year cash flows will not be affected by the cost deferral. If the project is successful, depreciation will be a noncash expense; if the project is noncommercial, there will be a noncash writeoff. Thus, the decision to capitalize development costs shifts the expenditures from operating to investment cash flows; that shift will never be reversed. B. (i) The initial effect of the cost deferral is an increase in net income and, therefore, equity. The debt-to-equity ratio declines (improves). The decline will be reversed gradually by amortization of the deferred costs and immediately if they are written off. Thus, the debt-to-equity ratio was reduced in 1991 but will, in future years, approach the ratio based on immediate expensing of the development costs. (ii) Return on assets increased in 1991 because of the cost deferral. Both profits and assets were increased by the same amount; the effect on profits had a greater effect on the ratio. However, the cost deferral will tend to reduce the future trend of ROA. The higher asset level will reduce the ROA produced by any level of income. In addition, future amortization or writeoff of the deferred costs will reduce both income and assets, tending to depress ROA. The deferral of development costs, therefore, improved both ratios for 1991 at the expense of future ratios. Solutions Chapter 7 - P. 9

Review for the June 2008 Level 1 CFA Exam Study Session 9 Tuesday, February 26, 2008 Assets and Liabilities

Review for the June 2008 Level 1 CFA Exam Study Session 9 Tuesday, February 26, 2008 Assets and Liabilities Kris Clark 404.413.7208 or kjclark@gsu.edu Reading 35: Analysis of Inventories LOS 35a: Compute