Nothing attracts investors more than a company’s future earnings potential. But predicting growth isn’t a foolproof science.
“Investors look at historical financial statements and calculate earnings before interest, taxes, depreciation and amortization (EBITDA). That’s easy to do, but doesn’t provide the entire picture, and certain expenses associated with internal capital projects and leases might not be apparent,” says Tom Vande Berg, a partner with Crowe Horwath LLP in the Transaction Services Group.
Smart Business spoke with Vande Berg about these hidden expenses and how they can affect growth potential.
Why are capital leases an area of concern?
If a lease is capitalized, the associated expense is recognized on the income statement as depreciation and interest rather than rent. Therefore, EBITDA would not include an expense for the lease even though the company has ongoing monthly payments. If a similar piece of equipment were treated as an operating lease, it would incur a profit and loss expense.
When are leases capitalized?
The Financial Accounting Standards Board Accounting Standards Codification (FASB ASC) Topic 840 states that leases must be capitalized if they meet one of four criteria:
- Ownership automatically transfers to the lessee at the end of the lease term.
- The lease includes a bargain purchase option.
- The term of the lease is 75 percent or more of the asset’s useful life.
- Present value of minimum lease payments is 90 percent or more of the fair value of the asset.
Companies might have several pieces of similar machinery or equipment for which some leases are considered capital and others are categorized as operating.
What are other examples of hidden expenses?
- Nonlevel rent — If a company has periods of free rent or rent escalations, its rent expense might not equal its cash rent payments. For example, a company could have a 10-year operating lease that increases annually by 3 percent. An investor analyzing rent expense after year five of the lease would see an expense less than actual future cash expenditures.
- Machinery constructed in-house — In these cases, labor and overhead is typically capitalized in relation to the project. If the capitalized labor and overhead relate to salaried employees, the costs should be considered ongoing expenses in an EBITDA calculation.
- Capitalized repairs and maintenance — Companies without a formal capitalization policy might improperly capitalize normal repair and maintenance into fixed assets. These expenditures should be included as part of the normal operating expenditures.
- Capitalized internal-use software — Costs incurred creating new computer software for internal use can be divided into two stages: preliminary project phase and development phase. All costs of the preliminary project phase should be expensed. Development stage activities can be capitalized, but if capitalized payroll and related costs are for salaried employees who would be paid regardless of the current project, the costs should be considered ongoing expenses.
- Capitalized software to be leased or sold — According to FASB ASC 985-20, internal costs in creating computer software are expensed until feasibility is established. Then, the costs of coding, testing and other activities associated with producing product masters are capitalized, which may include allocated indirect costs. As a result, certain ongoing operating expenses such as payroll and rent may be capitalized and excluded from the initial calculation of EBITDA.
So an investor just looking at EBITDA would only be getting part of the picture?
While the EBITDA calculation is a valuable tool for analyzing future earning potential, it might not reflect all recurring expenses. Investors also must consider what expenses are lurking below the surface, as capitalized or lease costs could significantly affect future cash flow.
Tom Vande Berg is a partner in the Transaction Services Group at Crowe Horwath LLP. Reach him at (214) 777-5253 or firstname.lastname@example.org.
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