Terry Smith: Capitalisation of Interest payments
Posted: May 21st, 2019, 12:08 pm
Hi Folks,
I've started reading Terry Smith's book "Accounting for Growth" the one-time controversial book which exposes the kinds of creative company accounting which he observed in his career as an analyst. A few chapters in, Terry discusses the concept of "Capitalisation of Costs", in other words, how to turn an expense into an asset.
Terry focuses on the Capitalisation of interest, presumably because this was a commonly employed corporate technique back in the 90s. He briefly uses the example of how a builder will borrow money to build a house, and will incorporate the interest charges into his final selling price if possible, and in that form it's easy to see how what were costs then become part of the overall value of the asset produced. He then illustrates that in the corporate world this practice has the effect of boosting reported profits, since the payments won't be deducted, and even more alarmingly will boost the "Interest Cover" (EBIT/interest payable) ratio which is frequently used by analysts to assess the risks in owning a company which carries net debt.
Whilst I, from my very limited recent experiences from reading company Financial Statements, have seen R&D costs being capitalised (i.e. not expensed), with the justification that the costs are used to produce useful future assets (e.g. software programs), I have don't to date seen any examples of the capitalisation of interest payable. I did very briefly word search (i.e. "capitalisation", "interest" etc.) within a very small selection of company reports which I have to hand (e.g. Marshalls Plc MSLH, Alliance Pharma APH), and I did not see any evidence of the capitalisation of interest being used by any of the companies.
So I was wondering, does Capitalisation of Interest payments still occur in UK-domiciled companies, or has it been outlawed?
thanks Matt
I've started reading Terry Smith's book "Accounting for Growth" the one-time controversial book which exposes the kinds of creative company accounting which he observed in his career as an analyst. A few chapters in, Terry discusses the concept of "Capitalisation of Costs", in other words, how to turn an expense into an asset.
Terry focuses on the Capitalisation of interest, presumably because this was a commonly employed corporate technique back in the 90s. He briefly uses the example of how a builder will borrow money to build a house, and will incorporate the interest charges into his final selling price if possible, and in that form it's easy to see how what were costs then become part of the overall value of the asset produced. He then illustrates that in the corporate world this practice has the effect of boosting reported profits, since the payments won't be deducted, and even more alarmingly will boost the "Interest Cover" (EBIT/interest payable) ratio which is frequently used by analysts to assess the risks in owning a company which carries net debt.
Whilst I, from my very limited recent experiences from reading company Financial Statements, have seen R&D costs being capitalised (i.e. not expensed), with the justification that the costs are used to produce useful future assets (e.g. software programs), I have don't to date seen any examples of the capitalisation of interest payable. I did very briefly word search (i.e. "capitalisation", "interest" etc.) within a very small selection of company reports which I have to hand (e.g. Marshalls Plc MSLH, Alliance Pharma APH), and I did not see any evidence of the capitalisation of interest being used by any of the companies.
So I was wondering, does Capitalisation of Interest payments still occur in UK-domiciled companies, or has it been outlawed?
thanks Matt