Im currently reading through "Financial Statements" by Chris Higson and im having some issues understanding the implications of expensing intangibles:
Quick summary, there are 2 companies, Pow! spends $5million developing a tv program which will make $2million each yr for the next 5 yrs.
Zap! hires a company to come up with the tv show, and then takes out the licience for 5yrs.
-ttp://i.imgur.com/KKyUJnC.jpg place an h instead of the -
"In this example the investment in the new format was a one-ff. In steady state, if both companies continued to develop or licence a similar format every year then income would be the same under either treatment. Pow! would spend $5 million on developing a new format each year while Zap would have 5 licences running at any point, requiring $5 million of amortization each year. So earning may equalize in steady state.
But the balance sheet of the company that expenses intangibles remain incomplete, overstating return on capital. Anyhow, although companies that invest in intangibles tend to continue to do so, they also tend to grow, if only as a result of inflation. As a result, expensing tend to understate income because the dollar value of the amortization of earlier investments lags behind the dollar value of this year's expenditure."
Questions:
Specifically its the last part im having issues with. How does expensing underestimate income?? Income is fixed at $2 million each year. Regading the following statement "... the amortisation of earlier investments lags behind the dollar value of this years expenditure", is that not also the case for ZAP as well though?
Im also unsure how he manages to get the Return on Capital percentages. I thought ROC =(net income)/(Debt + equity)
Thanks very much for your help
Quick summary, there are 2 companies, Pow! spends $5million developing a tv program which will make $2million each yr for the next 5 yrs.
Zap! hires a company to come up with the tv show, and then takes out the licience for 5yrs.
-ttp://i.imgur.com/KKyUJnC.jpg place an h instead of the -
"In this example the investment in the new format was a one-ff. In steady state, if both companies continued to develop or licence a similar format every year then income would be the same under either treatment. Pow! would spend $5 million on developing a new format each year while Zap would have 5 licences running at any point, requiring $5 million of amortization each year. So earning may equalize in steady state.
But the balance sheet of the company that expenses intangibles remain incomplete, overstating return on capital. Anyhow, although companies that invest in intangibles tend to continue to do so, they also tend to grow, if only as a result of inflation. As a result, expensing tend to understate income because the dollar value of the amortization of earlier investments lags behind the dollar value of this year's expenditure."
Questions:
Specifically its the last part im having issues with. How does expensing underestimate income?? Income is fixed at $2 million each year. Regading the following statement "... the amortisation of earlier investments lags behind the dollar value of this years expenditure", is that not also the case for ZAP as well though?
Im also unsure how he manages to get the Return on Capital percentages. I thought ROC =(net income)/(Debt + equity)
Thanks very much for your help