Journeys of a Bumbling Investor

What kind of charges should be expensed and what kinds should be capitalized?

To me, a charge can be capitalized only if it satisfies all of the following conditions:

1. the company has a legal right to collect the service paid for in advance
2. the charge is written off during the specified time of service
3. the service paid for is not company-specific, and has value for other companies at the stated capitalized value

The first two conditions are taken from Benjamin Graham’s 1937 edition of The Interpretation of Financial Statements. The 3rd condition is the crucial differentiator that makes sense to me. Companies should not be in the business of smoothening their asset/equity/earnings figures by capitalizing charges – that is the work of the analyst/investor if they choose to do so. Instead, capitalized charges should reflect the true value of the charge that is “left-over”, and by value, I mean market value.

For example, prepaid charges for advertising, and expenses incurred for moving, should not be capitalized. Such items under the assets section distorts the balance sheet because they do not reflect the true value that they can fetch on the market place (e.g. try selling your moving expenses or advertising package to someone). In general though, expensing would be the preferred and more conservative option.

Recently I was looking at John Wiley & Sons (JWA). One of its stated aims is to grow the company by making acquisitions, which it does several times a year. In that situation, revenues, assets, liabilities, equity, etc. will grow as the financials of the acquired company are added onto JWA’s financials. How then do you analyze such a company when its growth is not fueled by its normal operations? (I suppose some can argue that making acquisitions _is_ part of their normal business operations, but let’s not go into that =)

One specific point about JWA is that it funds its acquisitions via bank debt. This additional debt changes the company’s Cost of Capital. One key way to analyze whether such acquisitions are good for the company, is to compare the ROIC with the Cost of Capital, both before and after the acquisition. ROIC is very much like the “interest rate” the company is earning on its invested assets, while the Cost of Capital is the interest rate the company is paying. Naturally then, we would want the ROIC to be as high above the Cost of Capital as possible.