When it is determined that costs incurred will benefit future periods, those costs are capitalized or reported as assets. The capitalized costs are then amortized or systematically written off with an expense charge against earnings in the future periods that benefit from these expenditures. In this way, benefits derived in the form of revenues or cost savings are charged with an expense for those costs. This post looks at the cash flow classification of several different kinds of capitalized costs. In particular, my interest is in determining whether these costs are reported as operating activities or investing activities in the statement of cash flows. Enjoy!
In recent years, GAAP have reduced the kinds of costs that firms may capitalize. For example: start-up costs, which consist of costs related to such one-time activities as opening a new facility, introducing a new product or service, commencing activities in a new territory, or pursuing a new class of customer, may no longer be capitalized.
Also, the Securities and Exchange Commission (SEC) has restricted when advertising costs known as direct-response advertising may be capitalized. Direct-response advertising consists of costs incurred to elicit sales to customers who can be shown to have responded specifically to that advertising. Such costs may be capitalized when persuasive historical evidence permits formulation of a reliable estimate of the future revenue that can be obtained from incremental advertising expenditures. The SEC has interpreted capitalization guidelines for such costs in a limited way.
Fact Found: Companies in new, evolving, and unstable industries may not capitalize such costs. This was learned by America Online, Inc., a company that in 1996 was required to take a special $385 million pretax charge to write down direct-response advertising costs that had been capitalized previously.
Yet even with newer limitations, numerous kinds of costs may be, and in some cases must be, capitalized. Some relate to firms across all industries, including, for example, capitalized interest costs, where capitalization is required when certain conditions are met. Others are costs incurred within specific industries, including software development and motion picture development costs.
Although the costs carry different names, many companies in varying industries incur costs related to increasing their customer base. Qwest Corp. describes customer acquisition costs in this way:
Customer Acquisition Costs. We defer the initial direct costs of obtaining a customer to the extent there is sufficient revenue guaranteed under the arrangement to ensure the realizability of the capitalized costs. Deferred customer acquisition costs are amortized over the longer of the contract or the expected life of the customer relationship.
Qwest’s policy describes the nature of these costs well. Customer acquisition costs consist of incremental direct costs incurred in adding new customers. For example: such costs may include direct-response advertising. They also may include commissions paid to sales personnel, similar to the membership-commission advances paid by Pre-Paid Legal. Administrative costs incurred in signing up new customers may be included with customer acquisition costs as well.
Pre-Paid Legal describes its accounting policy for such administrative costs, which it capitalizes, in this way:
Member and Associate Costs. Deferred costs represent the incremental direct and origination costs the Company incurs in enrolling new Members and new associates. . . . Deferred costs for enrolling new members include the cost of the Membership kit and salary and benefit costs for employees who process Membership enrollments. Deferred costs for enrolling new associates include training and success bonuses paid to individuals involved in recruiting the associate and salary and benefit costs of employees who process associate enrollments. Such costs are deferred to the extent of the lesser of actual costs incurred or the amount of the related fee charged for such services.
The company carries these capitalized costs in both the current and noncurrent asset sections of the balance sheet. Classification depends on the amortization period for the capitalized costs, which, in turn, is linked to the term of the related new membership.
Subscriber Acquisition Costs
Pegasus Communications Corp. provides direct broadcast satellite and cable television services. The company refers to the costs incurred in signing up new customers as subscriber acquisition costs and describes its accounting policy for these costs in this way:
These costs consist of the portion of programming costs associated with promotional programming provided to subscribers, equipment related subsidies paid to distributors and applicable costs incurred by us, installation costs and related subsidies paid to dealers, dealer commissions, advertising and marketing costs, and selling costs.
The company expenses these costs. However, it capitalizes certain subscriber acquisition costs that it capitalizes, as described next:
We also have subscription plans for our DIRECTV programming that contain minimum service commitment periods. These plans have early termination fees for subscribers should service be terminated by subscribers before the end of the commitment period. Direct and incremental subscriber acquisition costs associated with these plans is deferred in the aggregate not to exceed the amounts of applicable termination fees. . . . Direct and incremental subscriber acquisition costs consist of equipment costs and related subsidies not capitalized as fixed assets, installation costs and related subsidies, and dealer commissions.
These costs are amortized over a 12-month period and are carried on the balance sheet as current assets.
Policy Acquisition Costs
Customer acquisition costs typically are capitalized in the insurance industry, where they are referred to as policy acquisition costs. Miix Group, Inc., which provides professional liability insurance products to the medical profession, describes its accounting method for policy acquisition costs in this way:
Deferred Policy Acquisition Costs. Policy acquisition costs (primarily commissions and premium tax expenses), that vary with and are directly related to the production of business, are capitalized and amortized over the effective period of the related policies.
Miix Group does not classify its balance sheet into current and noncurrent asset sections. The company simply reports assets in a single section of its balance sheet. Accordingly, deferred policy acquisition costs are not separated from current assets, such as cash or accounts receivable, or noncurrent assets, such as goodwill or property, plant, and equipment. Nonetheless, given that their amortization period generally extends beyond one year, they should be considered to be long-lived in nature.
Aetna, Inc., a health-insurance provider, expenses acquisition costs related to its prepaid health and health indemnity contracts. The company does, however, capitalize acquisition costs related to its long-term care policies. Those costs are carried in other long-term assets on the company’s balance sheet.
The primary line of business of CPI Corp. is to operate portrait studios within Sears, Roebuck & Co. retail stores. Certain of the costs incurred by the company in marketing its services to consumers are capitalized as direct-response advertising. The policy is described in this way:
The Company expenses costs involved in advertising the first time the advertising takes place, except for direct-response advertising, which is capitalized and amortized over its expected period of future benefits.
Direct-response advertising consists of direct mail advertisements, which include coupons for the Company’s products, and of certain broadcast costs. The capitalized costs of the advertising are amortized over the expected period of future benefits following the delivery of the direct mail in which it appears. Total advertising reported as a capitalized cost for direct-response advertising and classified with other assets for 2001 and 2000 was $1.3 million and $1.2 million, respectively. The capitalized direct-response advertising costs of CPI Corp. are carried with other assets, a noncurrent asset, on the company’s balance sheet. Direct-response advertising is very important to companies in the direct-to-consumer catalog sales business.
Consider this disclosure made by Lillian Vernon Corp:
Catalog costs are deferred and amortized over the estimated productive life of the catalog, generally three months. Such deferred costs are considered direct-response advertising. . . and are reflected as long-term assets in the accompanying balance sheets.
Lillian Vernon, which uses catalogs to market miscellaneous merchandise, including gift, household, kitchen, and gardening products, incurs direct-response advertising costs when it mails catalogs to consumers. Although the company notes that a three-month amortization period is used for such costs, capitalized catalog costs are reported as a noncurrent asset on its balance sheet. In its membership shopping and time-share sales programs, Cendant Corp. also incurs advertising costs that are considered to be direct-response advertising. As described in the next note, however, the company generally expenses such costs as incurred:
Advertising costs, including direct response advertising related to membership and timeshare sales programs, are generally expensed in the period incurred.
Cash Flow Classification of Customer Acquisition Costs
The discussion in the previous section reveals that customer acquisition costs include a wide range of expenditures carrying different names. Depending on the company and the industry, such titles as customer acquisition costs, subscriber acquisition costs, policy acquisition costs, and directresponse advertising are used. The costs are all designed to add to a company’s customer base.
Among the many companies surveyed, capitalization of customer acquisition costs was common but not universal. There was, however, no consistency in the balance sheet treatment of assets resulting from cost capitalized. Some companies reported them as current assets and others as noncurrent assets. Companies that did not classify their balance sheets simply reported unamortized customer acquisition costs among their listed assets. Although differences were noted in the balance sheet treatment of capitalized customer acquisition costs, there was little disagreement in the cash flow treatment of these costs. Regardless of the balance sheet classification employed, capitalized customer acquisition costs were reported as an operating use of cash. On this item I found consistent treatment.