Accounting, Valuation

On Expensing and Capitalization

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.



One thought on “On Expensing and Capitalization

  1. Great Article. Graham is considered the first proponent of Value Investing, and I am a great fan of Benjamin Graham myself, I follow most of his rules, I started a site on value investing. The site mainly screens out Low PE, Low PB, High Divident Yeild. Low PB+ High Div etc.. for the India markets. I really appreciate the effort you have put in your blog. Best Wishes.

    Posted by Equity School | September 18, 2009, 1:42 am

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