A company invests Rs 30 crore in developing a new technology platform. Under Ind AS 38, the research phase is expensed. The development phase, if it meets the recognition criteria (technical feasibility, intention to complete, ability to use or sell, probable future economic benefits, adequate resources, reliable measurement), can be capitalised as an intangible asset.
If the Rs 30 crore is expensed entirely, the current year’s P&L absorbs the full cost. Reported EBITDA declines by Rs 30 crore. Reported profit declines by approximately Rs 22 crore after tax.
If Rs 20 crore of the development phase is capitalised, the current year’s P&L absorbs only Rs 10 crore (the research phase). The Rs 20 crore appears on the balance sheet as an intangible asset, amortised over five years at Rs 4 crore per year.
The economic investment is identical: Rs 30 crore spent on technology development. The P&L impact in Year 1 differs by Rs 16 crore after tax. The EBITDA impact differs by Rs 20 crore (because amortisation is below EBITDA).
Why Capitalisation Matters
P&L management
Capitalisation converts a current-period expense into a multi-year amortisation charge. The cost is not eliminated. It is spread. The current period reports higher profit. Future periods absorb the amortisation. For a company whose valuation depends on EBITDA or current-year earnings, the capitalisation decision directly affects the perceived value.
EBITDA inflation
Under most EBITDA definitions, amortisation of capitalised development costs is excluded. A company that capitalises Rs 20 crore of development costs reports EBITDA that is Rs 20 crore higher than a company that expenses the same amount. The economic investment is the same. The metric that investors use to value the company is materially different.
Balance sheet creation
Capitalisation creates an asset on the balance sheet. The asset may or may not have realisable value independent of the company’s ongoing operations. If the technology fails, the market shifts, or the product does not generate the projected benefits, the asset requires impairment. The impairment charge, when it arrives, reverses the capitalisation benefit and more, because it combines the original cost with the additional costs incurred between capitalisation and impairment.
Comparability erosion
Companies in the same industry with different capitalisation policies report different EBITDA, different margins and different ROIC for the same level of investment. The comparison is unreliable unless the analyst adjusts for the capitalisation difference.
The Forensic Assessment
In Northrop Management Private Limited’s forensic and financial reporting work, capitalisation analysis follows four tests.
Test 1: Criteria compliance. Does the capitalised expenditure genuinely meet the Ind AS 38 recognition criteria? Technical feasibility must be demonstrated, not assumed. Intention to complete must be supported by budgeted resources. Probable future economic benefits must be evidenced by market research or customer demand, not by management’s optimism.
Test 2: Boundary between research and development. Where did the company draw the line between research (always expensed) and development (capitalised if criteria are met)? Is the boundary consistent with industry practice? Has it shifted over time?
Test 3: Trend analysis. Is the percentage of total R&D spend that is capitalised stable, increasing or decreasing? An increasing capitalisation rate without a corresponding increase in the proportion of near-market projects suggests that the criteria are being applied more aggressively.
Test 4: Impairment testing. For capitalised assets, is the impairment model realistic? Are the projected cash flows from the capitalised project consistent with actual market performance? A capitalised asset that has not generated the projected revenue should be tested for impairment with assumptions that reflect the actual trajectory, not the original thesis.
Ashish Chaudhary, frames the accounting judgment directly: “Capitalisation can improve current-period earnings while moving the economic cost into future periods. It does not eliminate the cost. It defers it. And the deferral, when it inflates EBITDA, when it flatters the P&L, when it creates a balance sheet asset whose value depends on future performance that has not yet been demonstrated, is one of the most consequential accounting judgments a company makes. The board should understand what is being capitalised, whether the criteria are genuinely met and what the financial statements would look like without the capitalisation.”
Questions for the Boardroom
- What is the total amount of development expenditure capitalised in the current year, and what percentage of total R&D spend does it represent?
- Has the capitalisation rate (percentage of R&D capitalised) increased over the last three years, and if so, why?
- For each capitalised project, does the project’s current performance support the projected economic benefits that justified capitalisation?
- If we expensed all currently capitalised development costs, what would the impact on EBITDA, operating profit and net worth be?
- How does our capitalisation policy and rate compare to industry peers?
Closing Implication
The capitalisation decision is not a technical accounting choice. It is a judgment that determines how much of a company’s investment in its future appears in the current period’s P&L and how much is deferred to future periods through the balance sheet. The judgment is legitimate when the criteria are genuinely met, when the future economic benefits are evidenced, when the asset is tested for impairment and when the board understands the financial statement impact.
The judgment is problematic when it is used to improve current-period earnings by converting costs that should be expensed into assets that will be amortised, creating a balance sheet that overstates the company’s assets and a P&L that understates its costs. The Capitalisation Question forces the board to distinguish between the two by asking: if this expenditure were fully expensed, would the reported performance change in a way that would concern us? If the answer is yes, the capitalisation deserves deeper scrutiny.