Investment vs. Expense – Understand the Difference

[Guest post by Sanjay Anandaram, entrepreneur turned investor.] In the tough economic times such as the one we’re currently facing, the pervasive and prudent mantra is to conserve cash, hunker…

[Guest post by Sanjay Anandaram, entrepreneur turned investor.]

In the tough economic times such as the one we’re currently facing, the pervasive and prudent mantra is to conserve cash, hunker down, reduce expenses and somehow survive till better times arrive. But then what expenses should one cut? Where should the costs be reduced? Should investments be stopped?

I’ve received mails from entrepreneurs asking the above questions. In order to answer these questions, it is important to understand the differences between the terms. Semantics aside, understanding of the terms will also help decide where to save and where not to. Lets take a simple example.

Your company decides to participate in a day long event for which 500 samples of your product are procured for Rs 5L. However, only 400 samples were handed out, since only 400 customers showed up, leaving 100 samples that could be used for another event next month. The costs incurred by your company is therefore Rs 5L while Rs 4L were the expenses for the event and the 100 unused samples worth Rs 1L are assets. Expenses therefore mean a cost that has been incurred while undertaking revenue generating activities. A cost may or may not be an expense, for example, in the case of land that your company acquires since the land does not get used up and depreciated. Computers purchased by your company will initially be recorded as assets on the balance sheet while their costs each year become depreciation expenses in the profit & loss statement as they get used in generating revenues.

Should technology costs be treated as an asset (capitalized) or should they be expenses as costs are incurred? Investments and assets are those costs that are expected to result in revenues over a future time period. This depends on the nature of the company’s business and how critical the technology development is for future revenues. For a software company building software IP, the technology can be largely capitalized. Sales costs for example are generally treated as expenses since the revenue impact is felt within the financial year.
However, marketing costs are more difficult to segregate between an investment and an expense. Again, the nature of the business plays a role. For example, if the company is in the business of developing and creating brands, then a significant portion of marketing costs can be treated as investments while for other companies, they can be treated as expenses since results may be expected within the year. In a management consulting company, the biggest cost is the people cost. However, their intellectual property (patents, knowhow, processes) are their assets and management needs to decide how much they’ll invest in growing their IP based on their assessment of its revenue generating ability over a period of time.

So in these troubled times, what should a startup do? Since the first goal is to conserve cash it is important to only incur those costs that can be expensed against revenues. If there are existing assets, it is time to dust those assets and make those assets sweat to generate revenues. Many companies talk of their people being their greatest assets, so it should not be a surprise if making these assets work harder, longer and smarter to generate more revenues is one way of making “assets sweat!” In spite of their best efforts, if there’s no visibility of revenues in the foreseeable future companies shed their assets. Shedding assets could mean selling physical assets (buildings and land) to generate cash or letting go of people assets as companies cannot afford to keep incurring costs if these cannot be expensed against revenues.

As is obvious, serious consideration and judgement is required in reaching conclusions about whether to look at costs as investments or expenses and in estimating how and when revenues can be realized. Misrepresentation or erroneous classification can lead to inaccurate financial statements and to other very serious problems as the recent Satyam case has highlighted.

What do you think?

[The article first appeared in FE. Reproduced with author’s permission.]

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