Deferred Revenue Expenditure

In last few years many Indian companies had adjusted their accumulated
deferred revenue expenditure against the security premium
account(SPA). Such write offs have helped the companies to escape the
reduction in profits due to amortization. In my analysis I try to
account for such things but I felt a need to have a broader discussion
on this subject. So here is the complete story. Do post your views and
comments.

Around 2001-03 the companies started the restructuring binge. The auto
companies were leading the pack. Here are some new items.

http://www.blonnet.com/iw/2003/02/09/stories/2003020900270700.htm
Tata Engineering set off Rs 1,180 crore against the share premium
account in 2001-02, Ashok Leyland is in the process of writing off Rs
160 crore the same way while Tata Steel had planned to set off a huge
Rs 1,550 crore now.

M&M wrote off around 500 Crs. from SPA.

While I understand that there is nothing wrong in deferring the
genuine product development expenditure which is going to pay off in
later years, I have 2 serious objections.

1. I'm skeptical about the type of expenditure being charged into
Deferred Revenue account. I read a document on guidelines for
accounting for such costs.
Monograph on Accounting for Research and Development Cost
http://www.aicmas.com/rd.doc

Page 13 of this document sets out what can be termed as a Research and
Development cost. It further adds "The amount of the research and
development costs described above should be charged as an expense of
the period in which they are incurred except to the extent that
development costs are deferred in accordance with the following
paragraph" In page 14 it describes what can be deferred.

The essence of this document is that you can defer the costs only when
you can reasonably expect the costs to be recovered from future
revenues. However the trend I noticed in Indian companies is to treat
it as "when you can dream the costs to be recovered from future
revenues". All the new product developments are straight away being
deferred regardless of their commercial viability. You can see this by
looking at low R&D expenses of Indian Companies because they never
account for it in the year such costs are incurred but defer it for
later periods.

2. The second and most significant objection to this related to
avoiding amortization of such costs. You say that I've spent 100 crs.
this year on R&D and I'll recover that in future revenues and hence
you don't treat 100 crs. as expenditure but defer it. Next year you
write of 100 crs from balance sheet. Let's assume our R&D pays off and
you make 30 Crs. per year for next 10 years. As you have already
written off the costs you would report 30 Cr p.a. profit. Had you not
done, and amortized the costs over 10 years, your profits would have
been 20 crs. p.a.
And what if the product fails. If you write off your mistakes will
never be visible in the income statements and quarterly results. After
all in a world blinded by Q on Q growth who has the patience to read
balance sheets!!

The guidelines clearly say "If development costs of a project are
deferred, they should be allocated on a systematic basis to future
accounting period by reference either to the sale of use of the
product or process or to the time period over which the product or
process is expected to be sold or used"

It is clear that any such write offs will give incorrect picture of
the future earnings. Now coming back to Indian companies, I'm
surprised that the managements have lauded their decisions to resort
to such "deceptive" tricks.

An excerpt from Tata Motors report
`Telco has recently written off assets and expenses to the tune of Rs
1,180 crore from its balance sheet against its securities premium
account (SPA), thereby eroding its reserves by 40 per cent and net
worth by 36 per cent. The company has written off deferred revenue
expenses on account of product development and employee separation of
Rs 933 crore, accounting for the bulk of the write-off. The write-off
due to the fall in the value of investments and fixed assets is Rs 32
crore and Rs 215 crore respectively.
According to Mr Kadle: "The rightsizing of the balancesheet will give
a true reflection of the company in the future years. This is not the
end of the restructuring process. We are looking at further cost
reduction and the requirements of working capital." `
Other companies are no different in their description of "financial
restructuring"

As an analyst I don't care what the managements say but any deviation
from standard accounting practices makes my life difficult. I'm unable
to delegate my analysis process to my analytical models and I'm forced
to do a case by case analysis. The legalese used in notes to accounts
makes it even more difficult to understand what's happening.

let's take an example. Tata Motors had spent around 1400 Crs. on
development of Indica. Out of that they deferred 1000 Crs. and then
wrote it off by charging it to SPA. Now I should amortize it over a
period same as expected life time of the product. I'll to make a
guess here and take a random 10 year period. You would notice that the
write off has significant impact of jacking up profits. More than this
it gives very incorrect picture of the Return on Net Worth(RONW). The
numerator(Profit) is jacked up as there is no ammortization. The
denominator is braught down because the net worth is brought down by
write off. The results are obvious. In case of Tata Motors the RONW is
24.2% for FY03-04 and 30.16% for FY04-05. No auto company in the world
generates such returns on networth(GM -15.56%, Toyota 12.94%, Ford
13.49%, Daimler Chrysler 6.59%). If you adjust the book value and
account for amortization the RONW comes to more reasonable figures 15%
and 20% for last 2 years. Looking at the results of Tata Motors for
last 15 years you would realize that the CAGR of its book value(even
after adding back the 1180 crs) is ONLY 6.83%. Taking dividends into
account the returns come to 12.38% p.a. This shows to what extent the
write offs skew the real picture. (For detailed calculations refer to
the following file)
http://in.groups.yahoo.com/group/lawarrenbuffet/files/A%20School/tataMotors-Writeoff.xls

Some people go even farther to skew the reality using prism of their
wishful thinking and their ignorance of valuation concepts. If a
company has average RONW of r and has dividend retention ratio b then
the expected growth rate would be r*b. With the jacked up RONW of 30%
in case of Tata Motors and taking average retention ratio of 55% you
can get a Expected long term growth rate of 16.5%. The they calculate
FY07 EPS and multiply it with P/E based on 16.5% long term growth
rate. If you do this you can stretch the valuations like rubber band.
I see renowned analysts applying such faulty logic every day.

To summarize, analysts should make the adjustments for such write offs
because if you don't, you would end up with grossly incorrect picture
of company's profitability.

Posted: Nov 20, 2005
http://in.groups.yahoo.com/group/lawarrenbuffet/message/1672