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Should You Expense or Capitalize Your Engineering Costs?

Q: At RealNetworks we always expensed (vs. capitalized) engineering expenses (as does MSFT).  What is your philosophy on this engineering accounting practice.

A: (Brad) Subject to approval by the auditors, I always encourage companies I invest in to expense their engineering costs. 

Regardless of the accounting treatment, I think it’s a bullshit practice to capitalize engineering expenses.  In an early stage company, this simply serves to obfuscate the reality of the P&L by transferring real expenses to an asset on the balance sheet which is subsequently depreciated over a multi-year period of time.  The result – investors and managers have to work harder to understand the P&L and the real economic dynamics of the business.  It gets even worse in a mature company, especially one that is public.

However, our good friends the auditors get in the way on this one and encourage some engineering (and R&D expenses) to be capitalized.  Oh well – we need to follow the rules.  But that doesn’t mean we have to like them.

May 28th, 2008 by     Categories: Financials    
  • Barry Graubart

    Capitalizing engineering costs is a bad idea. In the early days, you should run your business on a cash basis; capitalizing development just encourages you to spend more than you should. I've been in a company where we capitalized development. The worst thing about it was that in the future years, we always had this cost overhang which made it harder to assess the real economics of the business. Whenever possible, expense engineering, don't capitalize.

  • Phil Sugar

    Couldn't agree more!! I've always fought the auditors on this one and won.

    My point is to capitalize something you have to be able to stop the expense and still be able to reap revenue.

    The cost of putting up (not maintaining) a building would be a good example.

    So I ask: Can I fire all of my developers and still run??? Answer no.

    Usually the good push is to tell them we are going to capitalize all of the accounting expense this year. Once we get things set up we can fire all the accountants and reap the benefit…..watch the gears smoke.

    • http://www.feld.com Brad Feld

      Phil – I absolutely love the “fire the accountants” approach. It also works to capitalize legal expenses this way (e.g. you get to fire all the lawyers).

  • http://www.ventureadventure.net Jack Poller

    Speaks Phil: “Usually the good push is to tell them we are going to capitalize all of the accounting expense this year. Once we get things set up we can fire all the accountants and reap the benefit…..watch the gears smoke.”

    This has to be the funniest – and best – comment I've read all year

  • http://www.feld.com Brad Feld

    from an email comment – “In my prior incarnation at Xerox (when its growth was exploding) we expensed all R&D. That depressed current earnings, but when you're growing at 30+% per year and are a patent monopoly, it was another strategy to keep us below Washington's radar. But we always would say, “When Xerox starts capitalizing R&D (which was about 15+% of our top line), you'll know the high growth days are past.” That happened in the late 70s, and Wall Street wasn't fooled. The stock dropped from about 170, eventually to about 5. Same thing applies to ventures. Its an accounting trick that won't fool sophisticated investors.”

  • Phil Sugar

    I really think this is part of the “full employment act” for accountants.

    Lawyers “full employment act” is that they will never read an agreement without making comments. The other side will inevitably comment on the comments, and so on, and so on, making sure that all lawyers stay employed. I am sure this is taught at law school.

    Accountants (and I have an undergrad finance degree with my engineering degree and am occasionally accused of being one which I vehemently deny) want to spend lots, and lots of time counting the beans. The point is nothing amounts to a hill of beans unless you can get somebody to give you beans which has nothing to do with counting them.

    It does not depress current earnings. I reiterate….unless you can fire your best developer and be fine, then you can't tell me its not an expense. When I build a building, my framer, electrician, plumber, dry wall guy, brick layer, carpenter, are all gone….

    Shows a total lack of respect for engineers.

    I have been selling SaaS since 1999….want to know another fight? Installation must be pro-rated over the life of the contract….I give a 90day out (like Cortez burning his ships it motivates the hell out of your staff). I lose money on installation…..but we want to defer that income says Mr. Bean Counter. Why???? “full employment act” its a gift that will keep giving to all accountants for years to come.

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  • http://www.bengelmedia.nl/ marketing bureau

    For me I will, If you will have to capitalized this cost later on the money you’ve spent will return also if you have used your job and work on it. 

  • http://accountingdegreetalk.org/ Rachel Scott

    I think this is the best answer of that question and no doubt it is difficult to get the approval by the auditors.
    http://www.accountingdegreetalk.org/