Keeping Off the 6 O'Clock News

Cutter Consortium offers tips to make sure IT expenses are capitalized properly.

Arlington, MA  August 5, 2002  While capitalizing IT expenses is legal under current accounting standards, this practice has been improperly used by some corporations to hide failing or failed IT projects. The potential consequences of such actions are not dissimilar to the fate of WorldCom and other corporations of late.

Why would a company choose to capitalize IT expenses? Ram Reddy, a Cutter Consortium senior consultant explained that a major reason is so that IT projects are 'on the same level' as capital expenditures incurred in building manufacturing plants. "The typical manufacturing facility takes a few years to build and commission. Multi-year enterprise applications are similar, in that they take a few years to implement. As we've moved from a manufacturing to a service economy it seems logical to treat IT projects as the 'property, plant, and equipment' of the service economy."

According to Reddy, capitalized expenses are only reflected in the income statement when the IT project is brought online and used to conduct business. With this approach a company could spend millions of dollars on IT projects for a given year  with minimal impact on the income statement for that year.

"An IT project with capitalized expenses is extremely difficult to discontinue if the project is failing or has failed," said Reddy. "Failed IT projects become resource black holes in that additional resources are sucked up trying to revive them. As long as the development work continues on the failed/failing project, expenses associated with it can continue to be capitalized. If the IT project is declared a failure, then the entire accumulated capitalized expenses to date have to be written off."

Reddy continued: "Within the executive ranks, fear of the impact this would have on the income statement and stock price motivates a policy of throwing good money after bad. We continue to spend more money on a failed IT project in the hope that somehow, through a technology silver bullet or supreme project management, the dead IT project can be brought to life."

Given the "virtual" nature of IT projects, it is relatively easy to sweep a failed or failing IT project under the rug. Stakeholders have no constant or visible reminder of the money being spent, as opposed to projects in the "physical world" such as a manufacturing plant that's been under construction for two plus years without being put into production. IT projects are hidden in financial statements, making them invisible to stakeholders, unless they actively seek them out. "Quite simply," says Reddy, "failed IT projects do not have the same attention-grabbing power as an idle manufacturing plant occupying acres of land."

According to the Cutter Consortium, it is up to management to take steps to make sure their company's IT project expenses are above board and being handled properly. Here are some examples:
" Look at the IT projects that have been under development for more than six months. It's likely that a significant number of these projects fall into "failed or failing" IT project category.
" Perform an honest assessment of the project status with key personnel to decide whether the project is going to succeed or fail.
" Given the current market climate, right now is a good time to "come clean" and avoid making the 6 o'clock news by discontinuing failed IT projects and giving them the correct accounting treatment on the income statement.

Said Reddy: "Granted, earnings will take a hit, but at least the company can start with a clean slate. It is time to kill IT projects that continue to be kept alive because of fears of adverse impact on the stock price. This is a great time to defuse another potential accounting land mine."