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For software companies, all software development costs incurred prior to technological feasibility are expensed as R&D.  Once technological feasibility is reached, software development costs are capitalized up to the point of product completion and release.  At this point, amortization of capitalized costs begins.

Determining technological feasibility and the timing of software development completion entails management judgment and creating flexibility in capitalization policies.  Given this flexibility, it can be difficult to compare financial results across firms in the software industry.  The purpose of this study is to survey policies for software development capitalization during 2009.  The results are then compared with a similar study conducted in 2006.

Overall 71% of the software companies in the sample expensed all software costs incurred.  Of the remaining 29% of companies that capitalized costs, the average percentage of software costs incurred that were capitalized was 15%.  These results are in line with the 2006 study where 70.5% of the sample companies expensed all software costs incurred.  However, in that earlier study, the companies that capitalized software costs had an average rate of capitalization of 20%.


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In this research report we look at triggering events for goodwill impairment charges and examine the factors underlying the impairment charges taken by firms during the 2008 – 2009 recession. Firms in our sample who took goodwill impairment charges did so for 67% of their pre-charge goodwill balance. There were many firms, however, who evaluated a goodwill impairment triggering event and determined that a goodwill impairment charge was not necessary. There were no differences noted in the impairment triggers between firms who recorded an impairment charge and firms who did not. Triggering events do not determine when a goodwill impairment charge is needed, rather the fair value of the reporting unit and the carrying value of its net assets, including goodwill, are the real determinants.

Many would consider a decline in market equity prices to be a goodwill impairment triggering event. We found several firms who, in the absence of other deteriorating fundamentals, did not consider a market price decline to be a goodwill triggering event. Given the improvements noted in equity prices generally since March 2009, it would appear that these firms may have been right. A price decline in the absence of other developing problems may not be in and of itself a valid goodwill impairment triggering event.

This research report was adapted from “Goodwill, Triggering Events and Impairment Accounting,” by Eugene Comiskey and Charles Mulford, which appeared in Managerial Finance, Volume 36, Issue 9.


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Quarter 2, 2010
Free Cash Margin Index:
Recession Lows

2.43% (Mar. 2001)

Current

5.97% (Jun. 2010)

Recent High

6.69% (Mar. 2010)

For the twelve months ended June 2010, median free cash margin for the 3,807 non-financial firms in our survey declined to 5.97% from 6.69% for the twelve months ended March 2010. Even as free cash margin declined, however, firm fundamentals continued to improve. Revenues increased for the second consecutive reporting period and were accompanied by an improvement in gross margin and a reduction in spending on SG&A. Receivable days and inventory days remained relatively flat, though companies took longer to pay vendors, using increased payables days to boost cash flow. Capital spending measured as a percent of revenue continued to bounce near recent lows. Overall, our data give no obvious signs that companies are beginning to embrace growth. They are shunning new investments in inventory and capital equipment and sheltering resources as protection against uncertainty.

In our sample during the current reporting period, four industry sectors reported improved free cash margin from the same period in 2009, and five sectors saw free cash margin decline. Eleven sectors saw their free cash margin remain relatively stable. Individual companies with interesting free cash margin trends that are examined in this report are Wal-Mart (WMT), Ruddick Corp. (RDK), Lear Corp. (LEA), Ciena Corp. (Ciena), Hertz (HTZ) and Landstar Systems (LSTR).


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As part of its revenue recognition project, the FASB is currently evaluating proposed changes to the manner in which companies account for, and currently capitalize, direct-response advertising costs. Our study examines the potential effects of such proposed changes on total assets, shareholders’ equity, financial leverage and pre-tax income. We include a total of 25 companies in our sample and use information provided in their 2008 and 2009 Form 10-K annual filings to the SEC.

Amortization periods for capitalized direct-response advertising costs are typically less than twelve months. As such, the effects of capitalization relative to the direct expensing of direct-response advertising costs are, for most firms, not that significant. We find that as a result of capitalization, companies hold on average 2.26% of total assets and 3.17% of shareholders’ equity in the form of capitalized direct-response advertising costs. Though the effects for some firms exceed 20% and 28%, respectively. As to the effects on pre-tax income, depending on amounts capitalized relative to amounts amortized, some firms would see declines in pre-tax income of 30% or more. However, the effects for most firms are limited, with the average firm seeing a decrease of 3.53%. Investors and accounting regulators will want to take note of these findings.


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Quarter 1, 2010
Free Cash Margin Index:
Recession Lows

2.43%, 4.12% (Mar. 2001, Dec. 2008)

Current

6.69% (Mar. 2010)

Last Expansion High

5.14% (Jun. 2004)

For the twelve months ending with the first quarter 2010, overall free cash margin for all non-financial firms surveyed continued its climb, reaching a new high point of 6.69%, the highest we have seen the measure since we began tracking it in March 2000.  Although the increase in free cash margin has slowed of late, the metric still increased during the latest reporting period.  Captial expenditures as a % of revenue remained essentially flat from the fourth quarter 2009, which was a large driver behind the previous increases in free cash margin.  An increase in operating cushion, or operating profit before depreciation and amortization, pushed free cash margin higher in the first quarter, driven by an increase in gross margin and a reduction in SG&A as a percent of revenue.  This is a testament to managers'ability to control costs.  We will continue to monitor the process in future reports to see if companies can maintain the current high level of free cash margin, especially as they ramp up capital spending with an improving economy.

During the current reporting period, six industry secotrs reported improved free cash margin from the same period in 2009, while only one sector saw free cash margin decline.  Thirteen sectors saw their free cash margin remain relatively stable.  Individual companies with interesting free cash margin trends that are examined in this report are Intel Corp (INTC), Advanced Micro Devices (AMD), Sirius XM Radio Inc. (SIRI), AT&T Inc. (T), and Verizon Communications Inc. (VZ).


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Quarter 4, 2009
Free Cash Margin Index:
Recession Lows

2.43%, 3.96% (Mar. 2001, Dec. 2008)

Current

6.56% (Dec. 2009)

Last Expansion High

5.14% (Jun. 2004)

Despite declining revenues, free cash margin improved during the four quarters ended December 2009 to 6.56%, the highest recorded reading since we began collecting data in March 2000.  That measure is up from 5.36% for the four quarters ending September 2009.  Driving the increase in free cash margin were improvements in gross margin and a reduction in capital expenditures as a percent of revenue, offset by an increase in cash cycle, caused by an increase in inventories and receivables.  Companies have now reduced capital spending each quarter since March 2008.  For the four quarters ending December 2009, capital spending as a percent of revenue stood at a recession low of 2.82%, down 3.02% in the period ended September 2009.  Our expectation is that as the economy grows, it will be necessary for companies to once again begin increasing their fixed asset base, which could weigh significantly on free cash margin.

Fourteen industry sectors reported improved free cash margin from the same period in 2008, while no sectors saw free cash margin decline.  Six sectors saw their free cash margin remain relatively stable.  Individual companies examined in this report are XTO Energy (XTO), Target Corp. (TGT), Research in Motion (RIMM), Lions Gate Entertainment (LGF), Alkermes Inc. (ALKS), and Tele Norte Leste Participaco (TNE).


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The FASB is currently evaluating proposed changes to the manner in which insurance companies account for, and currently capitalize, the costs of selling and initiating insurance contracts. Our study examines the potential effects of such proposed changes on total assets, shareholders’ equity, financial leverage and pre-tax income. We include a total of 28 companies with market caps in excess of $3 billion in our sample and use information provided in their 2008 and 2007 10-K annual filings to the SEC.

We find that as a result of capitalization, companies hold on average 4.41% of total assets and 32.65% of shareholders’ equity in the form of deferred acquisition costs. If the firms in our sample were forced to write-off their deferred acquisition costs, the accompanying reduction in shareholders’ equity would increase their average ratio of liabilities to shareholders’ equity, a common balance sheet measure of financial leverage, from 9.88 to 63.91. Such an increase in leverage could potentially hurt their credit ratings and put pressure on the firms to raise equity. We also find that pre-tax income would be impacted by the proposed changes. Depending on amounts capitalized relative to amounts amortized, some firms would see declines in pre-tax income of 20% or more, while others would see similar increases. Investors and accounting regulators, including the FASB and the IASB, will want to take note of these findings.


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Cash Flow Trends and Their Fundamental Drivers:Comprehensive Review (Quarter 1, 2012)

FREE CASH MARGIN INDEX: