Expense Recognition for an Information Service Provider Thomson Corporation, based in Canada, is one of the world’s leading information services providers. The software industry is an interesting sector to examine because it allows considerable discretion with

Question

Expense Recognition for an Information Service Provider

Thomson Corporation, based in Canada, is one of the world’s leading information services providers. The software industry is an interesting sector to examine because it allows considerable discretion with respect to capitalization decisions. Software providers are allowed to capitalize costs associated with software development and then amortize these costs over a period in which the product is expected to be sold. Thomson’s income statement for the year ended 31 December 2006, along with selected notes related to its treatment of software development costs, is presented below.

Note 1: Summary of Significant Accounting Policies: Computer Software

Capitalized Software for Internal Use

Certain costs incurred in connection with the development of software to be used internally are capitalized once a project has progressed beyond a conceptual, preliminary stage to that of application development. Costs which qualify for capitalization include both internal and external costs, but are limited to those that are directly related to the specific project. The capitalized amounts, net of accumulated amortization, are included in “Computer software, net” in the consolidated balance sheet. These costs are amortized over their expected useful lives, which range from three to ten years. The amortization expense is included in “Depreciation” in the consolidated statement of earnings.

Capitalized Software to Be Marketed

In connection with the development of software that is intended to be marketed to customers, certain costs are capitalized once technological feasibility of the product is established and a market for the product has been identified. The capitalized amounts, net of accumulated amortization, are also included in “Computer software, net” in the consolidated balance sheet. The capitalized amounts are amortized over the expected period of benefit, not to exceed three years, and this amortization expense is included in “Cost of sales, selling, marketing, general and administrative expenses” in the consolidated statement of earnings.

Note 12: Computer Software

Computer software consists of the following:

The amortization charge for internal use computer software in 2006 was $241 million (2005, $224 million) and is included in “Depreciation” in the consolidated statement of earnings. The amortization charge for software intended to be marketed was $25 million (2005, $21 million) and is included in “Cost of sales, selling, marketing, general and administrative expenses” in the consolidated statement of earnings.

Based on the information given, address the following problems:

1. Contrast Thomson’s recognition of software related costs in 2006 with the actual cash spent acquiring and developing the software.
2. Estimate Thomson’s 2006 operating profit and earnings from continuing operations assuming Thomson expensed all software related costs when the related cash flows occurred.
3. Contrast the implications for the cash fl ow statement from expensing software development costs rather than capitalizing and amortizing them.
4. Many analysts use EV/EBITDA (enterprise value divided by earnings before interest, taxes, depreciation and amortization) as a valuation measure for software companies. Enterprise value is simply the sum of the market capitalization and the book value of outstanding debt. Critique the use of this measure when software related costs are being capitalized.

Accepted Answer

Solution to 1. The total balance for capitalized computer software increased from $568 in 2005 to $647 in 2006, a total of $79. This is the amount by which computer software costs exceeded the amount recognized as an expense on the income statement.

Solution to 2. Operating profit would have been $1,258 - 79 = $1,179. The effective tax rate for 2006 is 11.5% [= 119 ÷ (1,258 + 1 - 221)]. Net income would be reduced by $79 adjusted for tax, or $79(1 - 0.115) $70, so the adjusted earnings from continuing operations is $919 - 70 = 849. Earnings from continuing operations were effectively overstated by 8.2 percent ( = 70 ÷ 849) relative to cash costs.

Solution to 3. Software development costs would typically be expensed as part of research and development, or in Thomson’s case as part of cost of sales. With such treatment, software development costs affect (reduce) cash flow from operating activities. By contrast, capitalized software costs are amortized to expense over time. The initial expenditure is recorded as a cash flow from investing activities. Amortization of the capitalized amount is added back to net income when calculating cash flow from operating activities. In effect, capitalizing software costs reclassifies them from an operating cash flow to an investing cash flow, and then allocates that amount to amortization expense over time.

Solution to 4. EBITDA ignores the costs related to software development by adding amortization back to operating income. Unless either the initial capitalized amount or the subsequent amortization is deducted, investors are effectively ignoring a software company’s software development costs altogether in evaluating the company. Because software companies must develop software in order to stay in business, valuing the companies on the basis of EBITDA potentially ignores a critical component of expense, akin to ignoring a retailer’s inventory costs. In the case of Thomson, the amortization of software to be marketed is included in SG&A expenses, so it is captured in the computation of EBITDA. However, most of Thomson’s software costs related to software to be marketed and was not included in SG&A. Thus, using EBITDA in this case would result in ignoring most software costs.

Thomson Corporation: Consolidated Statement of Earnings (US$ millions except per-common-share amounts)
	Year ended 31 December
	2006	2005
Revenues	6,641	6,173
Cost of sales, selling, marketing, general and administrative expenses	(4,702)	(4,351)
Depreciation (Notes 11 and 12)	(439)	(414)
Amortization (Note 13)	$\underline{(242)}$	$\underline{ (236)}$
Operating profit	1,258	1,172
Net other income (expense) (Note 4)	1	(28)
Net interest expense and other financing costs (Note 5)	(221)	(221)
Income taxes (Note 6)	$\underline{(119)}$	$\underline{ (261)}$
Earnings from continuing operations	919	662
Earnings from discontinued operations, net of tax (Note 7)	$\underline{201}$	$\underline{ 272}$
Net earnings	1,120	934
Dividends declared on preference shares (Note 16)	$\underline{(5)}$	$\underline{(4)}$
Earnings attributable to common shares	1,115	930
Earnings per Common Share (Note 8)
Basic and diluted earnings per common share:
From continuing operations	$1.41	$1.00
From discontinued operations	$\underline{0.32}$	$\underline{0.42}$
Basic and diluted earnings per common share	$1.73	$1.42

As of 31 December 2006	Cost	Accumulated Amortization	Net Computer Software
Capitalized software for internal use	1,791	(1,228)	563
Capitalized software to be marketed	$\underline{212}$	$\underline{ (128)}$	$\underline{84}$
	2,003	(1,356)	647
Capitalized software for internal use	1,608	(1,085)	523
Capitalized software to be marketed	$\underline{143}$	$\underline{(98)}$	$\underline{45}$
	1,751	(1,183)	568

Question 17.4: Expense Recognition for an Information Service Provider Thom...

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