Capitalisation of development costs

One thing that irks me about IFRS vs GAAP is the way that software companies can capitalise their development expenses. This can give a very misleading picture of the financial position of a firm, and in extreme cases make the headline profit numbers entirely misleading.

This recently came to my attention while looking at ACS, which isn't even a software company, which managed to make an accounting profit of £2.5m, almost entirely comprised of capitalised development expenses. They had not previously capitalised any development expenses, so had negligible amortization to counterbalance the development costs.

I tihnk the key thing to be careful of is when capitalised development expenses far outweight amortization. In that case the profit will be far higher than cash flow, and the firm may need to borrow or issue shares to survive. On the flipside, if amortization far outweighs capitalised development expenses it may indicate a highly acquisitive company - needing to buy other firms to grow, but with the potential to scale back in a downturn and simply generate large amounts of cash.

Let's look at my 3 firms.

Bond International Software

2008

Profit: £2011m

Capitalised development expense: £2788m

Amortization: £2576m

Free cash flow: £1799m

2007

Profit: £3645k

CDE: £2849k

Amortization: £1883k

Free cash flow: £2679k

Conclusion

Bond largely grows through internal development, so it is reasonable that their profit exceeds free cash flow. Their free cash flow is still very healthy.

At a current market cap of £21m (at 65p) they certainly don't look expensive.

Maxima

2008/2009 (guess)

Profit: £3m

CDE: £400k

Amortization: £4m

Free cash flow: £6600k

2007 / 2008

Profit: £3745k

CDE: £430k

Amortization: £3410

Free cash flow: £6725k

Conclusion

Stonking free cash flow. They grow through acquisition, so you would expect cash flow to exceed profit, but a solid free cash flow is a huge advantage if the market turns against them. Compare their market cap of £21m to their free cash flow of £6m+ - they look very cheap indeed. They do of course have some debt - about £17m worth - so maybe not super cheap, but definitely cheap.

QDG

Free cash flow doesn't look too pretty, but £7m of cash means that at least they can ride out the bad times.