Capitalised Costs and Their QoE Adjustment
How capitalised costs are treated in Quality of Earnings analysis: identifying over-capitalisation, making QoE adjustments, and the impact on EBITDA.
Capitalised costs are a recurring area of scrutiny in Financial Due Diligence. When a company capitalises costs that should be expensed, it inflates EBITDA artificially — which, when multiplied at the deal multiple, can have a significant valuation impact. FDD analysts need to understand the accounting rules, identify over-capitalisation patterns, and make the appropriate QoE adjustment.
What Does "Capitalising a Cost" Mean?
When a cost is capitalised, it is recorded as an asset on the balance sheet rather than as an expense in the P&L. The asset is then depreciated over its useful economic life, spreading the cost over multiple periods.
Capitalising is appropriate for assets that generate future economic benefits: property, plant, equipment, internally developed software (under certain conditions), and qualifying development costs (IAS 38).
The Problem: Over-Capitalisation
Over-capitalisation occurs when a company capitalises costs that do not meet the accounting criteria for capitalisation — or where management has significant discretion and applies that discretion aggressively to flatter EBITDA.
Common examples:
- Software development: Capitalising costs during the "research phase" (which should always be expensed) rather than only during the "development phase"
- Maintenance vs. enhancement: Capitalising IT maintenance as if it were enhancement
- Staff costs: Capitalising internal staff time on a project beyond what is actually attributable
- Borrowing costs: Capitalising finance costs beyond what accounting standards allow
The FDD Test for Capitalised Costs
Step 1: Identify the Capitalisation Policy
Review the accounting policy note in the statutory accounts. What is the company's stated policy for capitalising software, development costs, or other items?
Step 2: Quantify Annual Capitalisation
Build a schedule showing the amount capitalised each year. A rising trend in capitalisation with no corresponding asset productivity story is a warning sign.
Step 3: Compare to Peer Companies
If peer companies in the same sector expense similar costs, and this company capitalises them, the EBITDA comparison is misleading. A QoE adjustment may be warranted to create a like-for-like basis.
Step 4: Assess the QoE Adjustment
The typical adjustment is to treat the capitalised cost as if it had been expensed:
- EBITDA impact: Reducing EBITDA by the amount capitalised (or the portion deemed over-capitalised)
- Balance sheet impact: Reducing the intangible asset and adjusting net debt (if capitalised costs have been used as collateral)
Practical Example
A software company capitalises €2m per year of development costs. The FDD team determines that €800k of this relates to maintenance (which should be expensed) and €1.2m to genuine new functionality.
The QoE adjustment reduces EBITDA by €800k. At an 8x multiple, this reduces EV by €6.4m.
Why This Matters in TS Interviews
Interviewers ask about capitalised costs because it combines:
- Accounting knowledge (IAS 38, policy application)
- Analytical judgement (what is genuinely capital vs. expense)
- Commercial awareness (impact on deal value)
A candidate who can discuss this fluently demonstrates exactly the depth of thinking TS teams value.
Conclusion
Capitalised costs are a subtle but material QoE risk. Analysts who can identify over-capitalisation patterns, quantify the adjustment and defend it clearly are a genuine asset to any FDD team.
The Transaction Services Interview Programme (€119.99, one-time) covers capitalised costs and all major EBITDA adjustment categories with worked case studies. Get started today.