Capitalizing Other Operating Expenses

While R&D represents the most prominent example of capital expenses being treated as operating expenses, there are other operating expense items in conventional accounting that arguably should be treated as capital expenses. Consumer product companies such as Proctor & Gamble and Coca Cola could argue that a portion of their advertising expenses should be treated as capital expenses, since they are designed to augment brand name value. For a consulting firm, the cost of recruiting and training its employees could be considered a capital expense, since the consultants who emerge from the training are likely to be the firm's biggest assets and generate benefits over many years. For many young technology firm, the biggest operating expense item is selling, general and administrative expenses (SG&A). These firms could argue that a portion of these expenses should be treated as capital expenses since they are designed to increase brand name awareness and bring in new long term customers. AOL, for instance, used this argument to justify capitalizing the expenses associated with the free trial CDs that it bundled with magazines in the United States during the late 1990s.

While this argument has some merit, we should remain wary about using it too loosely. For an operating expense to be capitalized there should be substantial evidence that the benefits from the expense accrue over multiple periods. Does a customer who is enticed to buy from an online retailer like Amazon, based upon an advertisement or promotion, continue as a customer for the long term? There are some analysts who claim that this is indeed the case and attribute significant value added to each new customer.16 It would be logical, under those circumstances, to capitalize these expenses using a procedure similar to that used to capitalize R&D expenses.

1. Determine the period over which the benefits from the operating expense (such as SG&A) will flow.
2. Estimate the value of the asset (similar to the research asset) created by these expenses. If the expenses are SG&A expenses, this would be the SG&A asset.
3. Adjust the operating and net income for the expense and the amortization of the created asset.

To adjust the book value of equity and capital, we would estimate the value of the asset that emerges from treating SG&A expenses as capital expenses.

The net effect of this adjustment will be an increase in both income and capital invested, leading to mixed effects on the computed returns. We should hasten to note that the recent push in accounting to reflect the fair value of intangible assets, such as brand name, can actually lead to poorer estimates of return on capital, because they try to estimate the market or fair value of these assets, rather than the capital invested in these assets. Thus, a firm that creates a valuable brand name with relatively small investments in advertising will not be given the high returns that it deserves since the brand name value on the balance sheet, measured right, will reflect the market value of the brand rather than the capital invested in it. In general, fair value accounting threatens to wreak havoc with return computations because it replaces capital invested numbers with estimated value numbers.

16 As an example, Jamie Kiggen, an equity research analyst at Donaldson, Lufkin and Jenrette, valued an Amazon customer at $2,400 in an equity research report in 1999. This value was based upon the assumption that the customer would continue to buy from Amazon.com and expected profit margins from such sales.

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