Saturday, November 1

Should Advertising Expenses be capitalised while valuing companies?

While evaluating differences between accounting line items for Accounting and Valuation purposes, we do come across some Expenses which are treated as Operating Expenses from an Accounting perspective though they are often treated as Capital Expenses for Valuation purposes.

Research & Development Expense (R&D) Expense is a common example where it is treated as Operating Expenses under most Accounting Rules (some rules allow Development Expenses to be capitalised with a lot of conditions attached to them), but for valuation purposes they are treated as Capital Expenses because the benefits of R&D are usually derived over a longer period of time.

But what about Advertisement Expenses?
Companies usually spend a lot of money acquiring customers by spending huge amount of money on Advertisement. Consumer Goods companies such as Unilever, Procter & Gamble (P&G) and beverage companies such as Coke and PepsiCo are known to be heavy spenders on advertisement to get customers.

The key part to evaluate whether advertisement expenses should be capitalised or not is to understand whether these companies are able to get customers who will become loyal to the company and will stick to the brand for a longer period of time. More importantly, it is important to evaluate whether the loyalty of the customers is attributed to the advertisement spend by the company. For example, Apple might have created a huge loyal customer base for itself in the mobile and tablet space, but the customer loyalty is attributed largely to the product itself rather than the advertisement that Apple might spend on the products.

Analysts need to be conscious while capitalising such expenses though. According to Aswath Damodaran, "For an operating expense to be capitalised, there should be substantial evidence that the benefits from the expense  accrue over multiple periods."

If you are satisfied about the long term benefits derived from the customer base acquired on account of advertising, the Advertisement Expenses may be added back to the Operating Income and the amortised portion of advertisement should be reduced accordingly.

Recently, there has been a huge spurt in online e-commerce space (also known as e-marketplace) with companies like www.Amazon.com, E-Bay.com, Flipkart.com, Alibaba.com, snapdeal.com fighting for market share in countries like India and China apart from more developed markets. Though they spend huge amount of money on advertisement, the advertisement spend may not be treated as Capital Expenses for valuation purposes. The reason for this is that the customers do not have any brand loyalty towards any specific e-marketplace. They would surf all websites to find the best price (and product options) and would buy from whichever site they want. In such cases, these companies cannot claim to gain customer loyalty for a loner period of time to be able to capitalise Advertisement spend.



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