The expense side: capitalised costs, reserves and big baths
WorldCom later said it had moved 3 billion dollars of operating costs into capital accounts, and it had reported a profit. See which figures it fooled, which it couldn't, and how analysts check costs, reserves and estimates.
FinanceReading the accounts like an analystAbout 8 min: 8 readingUpdated
General education, not financial advice.
- Explain when a cost may be capitalised and what capitalising does to profit, operating cash flow and free cash flow
- Recognise cookie-jar reserves, big baths and estimate changes in the accounts
- Judge how much of a year's profit comes from accounting choices on the cost side
Builds toward: Judge a company. Read a company's accounts, apply Graham's tests, and make a rough valuation.
Reading the accounts like an analyst: lesson 9 of 10
- Reading the accounts like an analyst
- The three statements and how they link 10 min
- Common-size statements and trends 9 min
- Profitability ratios: margins, ROA and ROE 9 min
- Efficiency ratios and the cash conversion cycle 9 min
- DuPont analysis: where ROE comes from 10 min
- Reading the cash flow statement like an analyst 9 min
- Profit against cash: accruals and earnings quality 11 min
- When is a sale a sale? Revenue timing and channel stuffing 10 min
- The expense side: capitalised costs, reserves and big baths 8 min
- The Beneish M-score: a screen for manipulation, and its limits 10 min
Pairs with any financial statement analysis text (the chapter on earnings quality: expenses, reserves and estimates)
Mission
From: a portfolio manager whose fund holds WorldCom bonds Due: this week; it is March 2002, and WorldCom has just filed its 2001 annual report
Telecoms is in a slump, but WorldCom still reported 1.5 billion dollars of profit for 2001 and strong operating cash flow. Before we decide whether to keep the bonds, tell me whether the profit and the cash look believable, and what you'd check. Half a page.
The documents (WorldCom, Inc., Form 10-K for 2001, filed 13 March 2002; millions of dollars):
| 1999 | 2000 | 2001 | |
|---|---|---|---|
| Revenues | 35,908 | 39,090 | 35,179 |
| Line costs | 14,739 | 15,462 | 14,739 |
| Line costs, % of revenues | 41.0% | 39.6% | 41.9% |
| Depreciation and amortisation | 4,354 | 4,878 | 5,880 |
| Income before taxes (1) | 7,164 | 7,568 | 2,393 |
| Net income | 4,013 | 4,153 | 1,501 |
| Operating cash flow | 11,005 | 7,666 | 7,994 |
| Capital expenditures | 8,716 | 11,484 | 7,886 |
(1) Before minority interests and the cumulative effect of an accounting change.
"Line costs" are what WorldCom paid other telephone companies to carry its customers' calls and data on their networks.
What it is
The toolkit for this job.
Capitalise or expense? A cost is capitalised (put on the balance sheet as an asset, then depreciated) only if it creates a future economic benefit the company controls, such as a new building or network equipment. Costs of running the business this period (wages, rent, fees paid to others to carry traffic) are expenses.
What capitalising does. Moving a cost from expenses to assets:
- raises this year's profit by the full amount (less a little depreciation);
- raises operating cash flow, because the cash now leaves through investing as capital expenditure;
- leaves free cash flow (operating cash flow − capex) unchanged.
So the one cash measure it can't fool is free cash flow, together with capex trends.
Reserves ("cookie jars"). Companies set up provisions for future costs: returns, restructuring, litigation. Setting them too high in a bad year and releasing them into profit later smooths or inflates results. In a 1998 speech, "The Numbers Game", the then SEC chairman Arthur Levitt named "cookie jar reserves" and "big bath" charges among the practices that blur a company's true performance.
Big bath. Taking unusually large charges in one year (often a new management's first) makes that year look worse and later years better, as over-provided costs reverse.
Estimate changes. Lengthening the useful lives of assets, or changing provisions for bad debts or warranties, can be entirely proper, but it moves profit without any change in the business. Companies must disclose the effect of a material change in estimate.
Before you start
You've met these habits before. Write down your first three checks on WorldCom's figures before you open the model answer.
Why it matters
On the cost side, manipulation hides in judgements: what is an asset, how big a provision should be, how long equipment lasts. Each looks technical. Together they can turn a loss into a profit, and the operating cash flow that analysts trust to confirm earnings can move with it. An analyst who knows which measures each trick can and can't move knows where to look.
Worked example
An imaginary company, Corran, has revenue of 1,000, operating costs of 900 and capex of 100, so profit (ignoring depreciation and tax) is 100, operating cash flow 100 and free cash flow 0. It decides to treat 80 of its operating costs as capital spending:
| Honest | Capitalised | |
|---|---|---|
| Profit | 100 | 180 |
| Operating cash flow | 100 | 180 |
| Capex | (100) | (180) |
| Free cash flow | 0 | 0 |
Profit and operating cash flow both jump 80%. Free cash flow doesn't move.
Common mistake
Using operating cash flow to confirm earnings and stopping there. When costs are capitalised, both rise together and confirm each other. Check free cash flow, capex against depreciation and against the business's growth, and the cost lines as a share of revenue against the industry's trend.
Key terms
- capitalise
- record a cost as an asset and spread it over future years as depreciation
- cookie-jar reserve
- a provision set too high in one period and released into profit later
- big bath
- taking unusually large charges in one period, which flatters later periods
- change in accounting estimate
- a revision to a judgement such as an asset's useful life; it affects the current and future periods
- line costs
- fees a telecoms company pays other carriers to use their networks
Practise the key terms
Tap a card to turn it over. 5 cards.
| Front | Back |
|---|---|
| capitalise | record a cost as an asset and spread it over future years as depreciation |
| cookie-jar reserve | a provision set too high in one period and released into profit later |
| big bath | taking unusually large charges in one period, which flatters later periods |
| change in accounting estimate | a revision to a judgement such as an asset's useful life; it affects the current and future periods |
| line costs | fees a telecoms company pays other carriers to use their networks |
Task
Write the half-page note to the portfolio manager:
- what the figures show about profit, operating cash flow and free cash flow over the three years;
- which figures could and couldn't be flattered by the way costs are treated;
- whether the 2001 profit looks believable, how confident you are, and what you would check next.
Model answer
Show the model answer
The figures. Income before taxes fell from 20.0% of revenue (1999) to 19.4% (2000) and 6.8% (2001). Free cash flow: 1999 11,005 − 8,716 = 2,289; 2000 7,666 − 11,484 = −3,818; 2001 7,994 − 7,886 = 108.
WorldCom: the profit rests on cost treatment I can't yet confirm · Source: Form 10-K for 2001
The reported profit and operating cash flow look healthier than the free cash flow, which was almost nil in 2001. Revenue fell 10%, yet line costs held at about 42% of revenue and capital spending stayed high at 7.9 billion, 22% of revenue and well above depreciation of 5.9 billion, while revenue was shrinking; I'd want to see whether rivals were investing at anything like that rate. Operating cash flow (8.0 billion) is above net income, which would normally reassure; but if any operating costs were treated as capital spending, profit and operating cash flow would both be overstated by the same amount and free cash flow would be the only measure left unchanged.
Confidence: this is a pattern to investigate, not evidence of wrongdoing. What I'd check next: the composition of 2001 capital spending in the notes and in management's statements; line costs per unit of traffic against rivals' disclosures; the accounting policy for capitalising network costs; and quarterly trends in capex and line costs.
What happened. On 25 June 2002 WorldCom announced that an internal audit had found $3.055 billion of "transfers from line cost expenses to capital accounts" in 2001 (and $797 million in the first quarter of 2002) that were not in accordance with GAAP, and that without them it would have reported a net loss (Form 8-K, 26 June 2002). The SEC charged the company with fraud the next day. Without the transfers, 2001 line costs would have been 17,794, or 50.6% of revenue, and income before taxes about −660; operating cash flow would have been about 4,940 and capex about 4,830, with free cash flow unchanged at 108.
How the expert gets there. They know which measures capitalising moves (profit, operating cash flow, capex) and which it can't (free cash flow), so they put free cash flow and capex against the industry trend first. They notice a cost ratio that held steady when everything around it was falling, and a capex level out of line with the business. They stop short of accusing, and name the checks that would settle it.
What a reviewer would flag:
- "Operating cash flow confirms the profit": not when costs may have been capitalised.
- Comparing 2001 with 2000 only, instead of looking at the three-year trend.
- Calling it fraud in March 2002: the evidence then justified questions, not conclusions.
Practice
Transfer: a margin rise. Meta Platforms' operating income rose from 69.4 billion dollars in 2024 to 83.3 billion in 2025, up 20% (Form 10-K for 2025, filed 29 January 2026). Read the 10-K. In three sentences: how much of the rise came from the business, and what would change your mind?
A model answer
Most of it came from the business, but about a fifth came from a change in estimate. With effect from 1 January 2025 Meta extended the estimated useful lives of most servers and network assets to 5.5 years, which the 10-K says cut 2025 depreciation by $2.92 billion: about 21% of the 13.9 billion rise in operating income. The change is a proper, disclosed estimate, but it flatters the comparison with 2024 and will keep lowering depreciation on the affected assets until it reverses towards the end of their longer lives (the total depreciated doesn't change). What would change my mind: evidence that servers in fact last 5.5 years in use, or a later shortening of lives that reverses the effect.
How the expert gets there: when margins rise in a capital-heavy business, they read the estimates note before the MD&A's explanation.
What a reviewer would flag: treating a disclosed estimate change as manipulation; ignoring it because it's legal.
In short
- Capitalise only costs that create a future benefit; running costs are expenses.
- Capitalising raises profit and operating cash flow together; free cash flow doesn't move.
- Cookie-jar reserves and big baths shift profit between years.
- Estimate changes are legal but can move profit a lot: find them in the notes and size them.
- Investigate patterns; don't accuse on a ratio.
Check yourself
Answer in your head first, then open the answer. Nothing is saved.
A company capitalises 50 of costs it should have expensed. What happens to profit, operating cash flow and free cash flow?
Show answer
Profit and operating cash flow both rise by about 50; free cash flow is unchanged.
What is a "big bath", and why does it flatter later years?
Show answer
Taking unusually large charges in one year; costs over-provided then reverse, or are already written off, so later profit is higher.
A company extends the useful life of its equipment from four years to six. What happens to profit, and is it wrong?
Show answer
Depreciation falls and profit rises; it's proper if the equipment really lasts longer and the effect is disclosed.
Further reading
- WorldCom, Inc., Form 10-K for 2001 (filed 13 March 2002) and Form 8-K filed 26 June 2002 (SEC EDGAR).
- US Securities and Exchange Commission, Litigation Release No. 17588, "SEC Charges WorldCom with $3.8 Billion Fraud" (27 June 2002).
- Arthur Levitt, "The Numbers Game", speech at the NYU Center for Law and Business, 28 September 1998 (sec.gov).
- Meta Platforms, Inc., Form 10-K for 2025, note 1 (change in accounting estimate).
- On this site: Reading the cash flow statement like an analyst.
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