02.7 · Deeper cuts I: assets & expenses¶

Why this matters: two companies with identical cash flows can report very different profits, depending on how they cost inventory, depreciate plant, test for impairment, treat development spending, account for leases and book grants. None of these choices changes the cash; all of them change when profit shows up. If you can't see the choices, you will mistake accounting timing for business performance.

Learning objectives — after this lesson you can:

Compute cost of goods sold and closing inventory under FIFO and weighted average (and LIFO, for US comparisons), and explain why Ind AS does not allow LIFO.
Calculate depreciation under straight-line and written-down-value methods, read Schedule II useful lives, estimate a company's implied asset life and age from its statements, and quantify the profit effect of a useful-life change.
Run a simple Ind AS 36 impairment test (value in use vs carrying amount) and show how sensitive it is to the discount rate.
Decide whether a cost should be capitalised or expensed (development, software, borrowing costs, pre-operative costs), and trace the effect through all three statements, including the shift from CFO to CFI.
Build a lease liability and right-of-use schedule under Ind AS 116 and restate EBITDA to a pre-Ind AS 116 basis.
Explain grant accounting under Ind AS 20, and demonstrate that each of these choices moves profit between periods without changing total cash.

Prerequisites: 02.3 The income statement, 02.4 The balance sheet, 02.5 The cash-flow statement, 02.6 How the three statements link · Time: ~150 min

1. The one idea: cash is spent once; accounting decides when it becomes expense¶

Every rupee a company spends ends up as an expense eventually, apart from land and anything it sells on. The accounting question is when. There are only two routes:

Expense it now. The cost hits the P&L in the period it is incurred.
Capitalise it. The cost goes onto the balance sheet as an asset: a resource the company controls and expects to produce future economic benefits. The asset is then turned into expense over time through depreciation (for tangible assets), amortisation (for intangibles and right-of-use assets) or impairment (a one-off write-down when the asset turns out to be worth less than its book value).

flowchart LR
  C[Cash spent] --> D{Expected future benefit<br/>that meets the<br/>recognition criteria?}
  D -- No --> E[Expense in P&L now<br/>cash outflow in CFO]
  D -- Yes --> A[Asset on balance sheet<br/>cash outflow usually in CFI]
  A --> DA[Depreciation / amortisation<br/>P&L over useful life]
  A --> IM[Impairment<br/>P&L when value falls]
  A --> S[Sale / scrap<br/>gain or loss]

Two facts follow, and they drive the rest of this lesson.

The timing identity. Over the full life of an asset, ignoring tax and residual value,

\[\sum_{t} \text{expense}_t \;=\; \sum_{t} \text{cash spent}_t .\]

Choices about lives, methods, capitalisation and impairment change the path of expense, not the total. A policy that raises profit today lowers it later. In a growing company "later" keeps getting pushed back, which is why aggressive policies can flatter profit for years.

The cash-flow classification shift. Expensed spending sits in cash flow from operations (CFO). Capitalised spending usually sits in cash flow from investing (CFI). So capitalising a cost raises reported profit and reported CFO in the same year, even though the bank balance is identical. This is how WorldCom famously turned ordinary line costs into "capital expenditure"; forensic detail is in 09.4 Cash-flow games. The lesson for now: free cash flow (CFO − capex) is immune to this trick; CFO alone is not.

Lever	What management chooses	Profit now	Profit later	Cash
Inventory cost formula	FIFO vs weighted average	Higher with FIFO when input prices rise	Reverses when prices fall	Same (tax aside)
Useful life / residual value	Longer life, higher residual	Higher	Lower	Same
Depreciation method	Straight-line vs WDV	Higher with SLM in early years	Lower	Same
Impairment	Timing and size of write-downs	Lower in the "big bath" year	Higher afterwards	Same
Capitalise vs expense	Development, software, interest, pre-operative	Higher if capitalised	Lower (amortisation)	Same; CFO higher
Leases (Ind AS 116)	Not a choice, but it reshuffles lines	EBITDA higher; PAT slightly lower early	PAT higher late	Same; CFO higher
Grants	Net against asset vs deferred income	Same PAT; EBITDA differs	Same	Same

We now take each lever in turn.

2. Inventory: what it costs, and which cost you sell¶

2.1 What goes into inventory cost¶

Inventory is goods held for sale, work in progress, and raw materials and stores to be used in production. Ind AS 2 (Inventories) says inventory is carried at cost, which includes:

purchase costs: price, import duties, non-refundable taxes and freight, less trade discounts. Recoverable GST input credit is not part of cost, because the government refunds it through the input-credit mechanism;
conversion costs: direct labour plus a systematic allocation of production overheads, both variable (power, consumables) and fixed (factory depreciation, supervisors' salaries);
other costs incurred to bring the inventory to its present location and condition.

Excluded, and expensed immediately: abnormal wastage, storage (unless it is part of production, as with maturing whisky or cheese), administrative overheads, and selling costs.

One rule matters a lot for analysts. Fixed production overheads are allocated on the basis of normal capacity. If a plant runs below normal capacity, the fixed overhead per unit is not inflated to absorb the shortfall. The unabsorbed overhead is expensed in the period. Kaveri's Hosur motors plant ran at 48% utilisation in FY25 and 57% in FY26. A plant that runs well below normal capacity throws unabsorbed fixed cost straight into the P&L, and that cost falls away as utilisation climbs. It is one mechanical source of the operating leverage you will quantify in 04.2 Margins & cost structure.

2.2 Cost formulas: which unit did you sell?¶

When identical items are bought at different prices, the company needs a rule to decide which cost goes to cost of goods sold (COGS) and which stays in closing inventory. Ind AS 2 allows:

Specific identification, for items that are not interchangeable (a custom industrial pump built to order).
FIFO (first-in, first-out). The oldest costs go to COGS first, so closing inventory carries the most recent prices.
Weighted average cost (WAC). Every unit carries the average cost of the pool, recomputed periodically or after each purchase ("moving average").

LIFO (last-in, first-out), where the newest costs go to COGS first, is not permitted under Ind AS 2 or IAS 2. The IASB removed it in the 2003 revision of IAS 2 (KPMG, Inventory accounting: IFRS vs US GAAP, 2026; IFRS Community on cost formulas). US GAAP still allows it, which matters when you compare with US peers (02.9).

A company must use the same formula for all inventories of a similar nature and use. Changing formula is a change in accounting policy under Ind AS 8. It must be justified, applied retrospectively and disclosed.

Worked example 1 — copper for a motor maker, in a rising market¶

A fictional motor maker, Bhavani Motors, uses copper winding wire. Copper prices rise through the year. Quantities are in tonnes (t) and prices in ₹ lakh per tonne (1 crore = 100 lakh).

Lot	Tonnes	Price (₹ lakh/t)	Cost (₹ lakh)
Opening inventory	100	8.0	800
Q1 purchase	150	8.4	1,260
Q2 purchase	150	8.8	1,320
Q3 purchase	150	9.2	1,380
Q4 purchase	150	9.6	1,440
Available	700		6,200 (= ₹62.0 Cr)

It consumes 600 t, so 100 t remain at year-end. To isolate the effect, treat copper as the only cost and assume the motors sold bring in revenue of ₹70.0 Cr.

FIFO: the 100 t left are the latest lot, 100 × 9.6 = 960 lakh = ₹9.6 Cr. COGS = 62.0 − 9.6 = ₹52.4 Cr.
Weighted average (periodic): average cost = 6,200 / 700 = ₹8.857 lakh/t. Closing = 100 × 8.857 = ₹8.86 Cr. COGS = 62.0 − 8.86 = ₹53.1 Cr.
LIFO (US GAAP only): the 100 t left are "the oldest", 100 × 8.0 = ₹8.0 Cr. COGS = 62.0 − 8.0 = ₹54.0 Cr.

₹ Cr	FIFO	Weighted avg.	LIFO (US only)
Revenue	70.0	70.0	70.0
COGS	(52.4)	(53.1)	(54.0)
Gross profit	17.6	16.9	16.0
Gross margin	25.1%	24.1%	22.9%
Tax at 25.17% on this gross profit	4.4	4.2	4.0
Closing inventory on balance sheet	9.6	8.9	8.0
Cash paid to suppliers in the year	54.0	54.0	54.0

What to notice:

Cash is identical: ₹54.0 Cr of purchases in every column. Only the split between COGS and closing inventory changes.
In a rising market FIFO reports the highest profit. Part of its gross profit (₹1.6 Cr more than LIFO) is really an inventory holding gain: copper bought cheap early was "sold" at prices set when copper was dear. Replacing the 600 t at the year-end price would cost 600 × 9.6 = ₹57.6 Cr, more than any of the COGS figures. FIFO profit is partly unrepeatable if prices stop rising.
LIFO COGS here equals the year's purchases (₹54.0 Cr) because quantities were stable. That is why LIFO is said to match "current costs" against current revenue, and why US companies like it for tax: lower profit means lower tax when prices rise.
When prices fall all of this reverses. FIFO then pushes old, expensive costs into COGS and margins look worse than the business is.

Analyst's takeaway. For commodity-heavy manufacturers (copper and steel for pump makers, crude for refiners, cotton for spinners), part of the gross-margin swing in any quarter is inventory timing, not pricing power. Management calls it "inventory gains/losses" on the concall. Strip it out before extrapolating.

2.3 Why LIFO is banned under Ind AS / IFRS¶

The IASB's objections, in plain terms:

The balance sheet becomes fiction. Under LIFO, inventory can sit at costs that are decades old. A US company that has used LIFO since the 1970s may carry steel at 1970s prices.
LIFO liquidation profits. If a LIFO company runs inventory down, very old, cheap layers flow into COGS and profit jumps for no economic reason. Management can time purchases to manage this.
It is not a faithful model of physical flow for almost any business (nobody sells the freshest milk first).

The US kept LIFO largely because of the LIFO conformity rule: a US company that uses LIFO for tax must also use it in its financial statements. 02.9 shows how to convert a US LIFO company to FIFO using its disclosed LIFO reserve.

2.4 Lower of cost and net realisable value¶

Inventory is carried at the lower of cost and net realisable value (NRV). NRV is the estimated selling price less the costs to complete and sell. If finished pumps can only be sold at a loss, they are written down to NRV and the write-down is an expense.

Two details:

Raw materials are not written down just because their market price fell, as long as the finished products they go into are still expected to sell at or above cost.
Reversals are allowed under Ind AS 2 (up to original cost) when circumstances improve. US GAAP forbids reversal of inventory write-downs.

In the notes you will see "provision for slow-moving / obsolete inventory". A shrinking provision while inventory days rise is a yellow flag: management may be releasing provisions to protect margins. See 09.3 Expense & asset red flags.

3. Depreciation: allocating cost, not measuring value¶

3.1 What depreciation is (and is not)¶

Depreciation is the systematic allocation of the depreciable amount of a tangible asset (cost − residual value) over its useful life. It is not an estimate of how much the asset's market value fell. A 10-year-old CNC machine can be worth more than its book value, or nothing at all.

The main methods under Ind AS 16 (Property, Plant and Equipment):

Straight-line method (SLM): equal charge each year, \(\;D = \dfrac{\text{Cost} - \text{Residual}}{\text{Life}}\). This is by far the most common in Indian consolidated accounts.
Written-down value (WDV) (declining balance): a fixed percentage of the opening book value each year. That gives high charges early and low charges later. The rate that takes cost down to residual value \(R\) in \(n\) years is \(\;r = 1 - (R/\text{Cost})^{1/n}\).
Units of production: charge proportional to use (machine hours, tonnes mined). Used in mining and oil & gas.

Two further rules:

Component accounting. If a significant part of an asset has a different life from the rest (a furnace's refractory lining, an aircraft's engines), that part is depreciated separately. Schedule II made this mandatory in India from 1-Apr-2015 (Schedule II text, ca2013.com).
Land is not depreciated, because its life is treated as indefinite. Kaveri's gross block includes land, so you must strip it out when you compute implied lives.

3.2 Schedule II: India's reference lives¶

Schedule II of the Companies Act, 2013 sets out indicative useful lives (Part C) and a residual-value norm of not more than 5% of original cost. A company may use a different life or residual value, but must disclose that and justify it with technical advice (Schedule II, Part A; as of Sep-2026).

Asset class (Schedule II, Part C)	Indicative useful life
Factory buildings	30 years
Buildings other than factory (RCC frame)	60 years
Plant & machinery — general	15 years
Continuous process plant	25 years
Electrical installations	10 years
Furniture & fittings (general)	10 years
Motor cars (not in hire business)	8 years
Office equipment	5 years
Computers — end-user devices	3 years
Computers — servers & networks	6 years

Schedule II also provides extra-shift depreciation: for assets not marked "no extra shift depreciation", the charge goes up by 50% for periods of double-shift working and 100% for triple-shift.

Income-tax depreciation is a separate system of block-wise WDV rates. The gap between book and tax depreciation is what creates the deferred tax liability you will meet in 02.8.

Worked example 2 — Kaveri's Hosur plant¶

Kaveri commissioned its Hosur motors plant at end-FY24 at a cost of about ₹190 Cr. For illustration, treat all of it as general plant & machinery with a 5% residual value (₹9.5 Cr).

Policy	Annual charge (₹ Cr)	Arithmetic
SLM, 15 years (Schedule II)	12.03	(190 − 9.5) / 15
SLM, 20 years (technical estimate)	9.03	(190 − 9.5) / 20
WDV at 18.1% (reaches 5% in 15 yrs) — year 1	34.40	190 × 18.1%; rate = 1 − 0.05^(1/15)
WDV — year 2	28.17	(190 − 34.4) × 18.1%
WDV — year 3	23.07	127.43 × 18.1%

Choosing 20 years instead of 15 raises PBT by ₹3.0 Cr a year. Choosing WDV over SLM cuts year-1 PBT by ₹22.4 Cr. On a company whose FY26 PBT was ₹121.0 Cr, that is a big number. Total depreciation over the plant's life is ₹180.5 Cr under every policy.

A change of estimate mid-life. Suppose Kaveri uses 15 years, and after two years (net book value 190 − 2 × 12.03 = ₹165.93 Cr) decides, with an engineer's report, that the plant will last 20 years in total. A change in useful life is a change in accounting estimate under Ind AS 8. It is applied prospectively: the remaining depreciable amount is spread over the new remaining life, and prior years are not restated.

Old path: (165.93 − 9.5) / 13 remaining years = ₹12.03 Cr a year.
New path: (165.93 − 9.5) / 18 remaining years = ₹8.69 Cr a year.
PBT uplift = ₹3.34 Cr a year, which is 2.8% of FY26 PBT. After tax at 25.17% that is ₹2.50 Cr, or about ₹0.42 of EPS on 6.00 Cr shares, against FY26 basic EPS of ₹15.1.

No cash moved and the plant is the same plant. Nearly 3% of "earnings growth" came from a spreadsheet.

3.3 Reading a company's depreciation from the outside¶

You rarely know each asset's life, but three ratios tell you a lot. Here they are on Kaveri FY26, with numbers from the reference page.

Land was ₹22.0 Cr at FY20 and a parcel with book value ₹4.0 Cr was sold in FY25, so land ≈ ₹18.0 Cr (assuming no other land transactions). Depreciable gross block = 830.0 − 18.0 = ₹812.0 Cr.

Ratio	Formula	Kaveri FY26	Reading
Implied average useful life	Depreciable gross block / PP&E depreciation	812.0 / 39.6 = 20.5 yrs	Longer than the 15-year Schedule II norm for plant, but the block also contains buildings (30 years), so plausible
Average age of assets	Accumulated depreciation / depreciation	334.7 / 39.6 = 8.5 yrs	The asset base is roughly 40% through its life
Net block / gross block	Net block / gross block	495.3 / 830.0 = 59.7%	The same idea: how much life is left
Depreciation rate	Depreciation / average gross block	39.6 / 805.0 = 4.9%	Track the trend; a falling rate with no change in mix suggests lives were lengthened

A second check is the step-up after commissioning. PP&E depreciation jumped from ₹25.8 Cr (FY24) to ₹37.0 Cr (FY25), +₹11.2 Cr, the year after Hosur (~₹190 Cr) moved from CWIP to gross block. If Hosur alone explained the whole step-up, the implied life would be 190 × 0.95 / 11.2 ≈ 16 years, consistent with plant & machinery lives. (FY25's own additions also add a little, so this is approximate.) The statements tie out: FY24 gross block 518.0 + capex 148.0 + CWIP released 68.0 = 734.0; FY26 accumulated depreciation 295.1 + 39.6 = 334.7.

Trader's lens

Think of depreciation policy as the choice of theta decay schedule on a premium you have already paid. The capex cheque is the premium: sunk and fixed. Straight-line is linear decay, WDV is front-loaded decay, and a useful-life extension is simply re-marking the time to expiry. Over the full round trip the total decay equals the premium, whatever the schedule. Only the quarterly P&L path changes, so judge the policy, not the smoothness of the path it produces.

3.4 Changing useful lives: a lever that moves billions¶

Extending useful lives is legal, often defensible, and powerful. Real examples from US filings:

Alphabet (2023). After a January 2023 review, Alphabet extended the estimated useful life of its servers (from four to six years) and certain network equipment (from five to six years). It expected this to cut 2023 depreciation by ≈USD 3.4 bn (Alphabet, Q1-2023 reporting note filed with the SEC).
Amazon (2024, then back in 2025). Amazon lengthened server lives from five to six years from 1-Jan-2024, which lowered 2024 D&A by ≈USD 3.2 bn. From 1-Jan-2025 it shortened the life of a subset of servers and networking equipment from six to five years, citing the faster pace of AI-related technology change. The 2025 effect was ≈USD 1.4 bn of extra D&A (Amazon Form 10-K for FY2025, SEC).

Neither company did anything improper. The changes were disclosed and justified. The lesson is that a single estimate can swing operating income by billions, and a reversal can hurt as much. In India, look for the phrase "change in accounting estimate" in the PP&E note and the significant accounting policies. Also watch any company whose depreciation rate (depreciation / average gross block) drifts down while its asset mix is unchanged.

4. Impairment: when the asset is worth less than the books say¶

4.1 The test¶

Depreciation spreads cost over time. Impairment is the one-off write-down when an asset's carrying amount exceeds what it can recover. Under Ind AS 36 (Impairment of Assets):

Recoverable amount = the higher of
fair value less costs of disposal (FVLCD), what a buyer would pay, net of selling costs; and
value in use (VIU), the present value of the cash flows the asset will generate if kept, using a pre-tax discount rate and cash flows that exclude financing and tax.
If carrying amount > recoverable amount, the difference is an impairment loss in the P&L.
Most assets don't generate cash on their own, so the test is run on a cash-generating unit (CGU): the smallest group of assets that produces largely independent cash inflows (a plant, a brand's business, a retail region).

When to test:

For PP&E and finite-life intangibles, only when there is an indicator: a market decline, adverse change in technology or regulation, rising interest rates, physical damage, underperformance against budget, or the company's market capitalisation falling below its book value.
For goodwill, indefinite-life intangibles and intangibles not yet in use, every year, indicator or not.

Allocating the loss: first to goodwill in the CGU, then pro rata to the other assets, though no asset is written below the highest of its FVLCD, VIU or zero.

Reversals: allowed for assets other than goodwill, up to what the carrying amount would have been without the impairment. Goodwill impairment is never reversed. US GAAP forbids all reversals (02.9).

Worked example 3 — a snacks brand that disappointed¶

Fictional Tungabhadra Foods bought a regional snacks business. The CGU now carries:

Carrying amount of the CGU	₹ Cr
Goodwill	80.0
Brand (intangible)	40.0
PP&E	180.0
Working capital	50.0
Total	350.0

Sales have missed the acquisition plan. Management's cash-flow forecast for the CGU for the next five years is ₹30, 32, 33, 34 and 35 Cr, growing 4% a year thereafter. The pre-tax discount rate is 13%. A broker indicates the business could be sold for about ₹290 Cr net of costs (FVLCD).

Value in use:

\[\text{VIU} = \sum_{t=1}^{5} \frac{CF_t}{1.13^t} + \frac{1}{1.13^5}\cdot\frac{35 \times 1.04}{0.13 - 0.04}\]

PV of years 1–5: 26.55 + 25.06 + 22.87 + 20.85 + 19.00 = ₹114.3 Cr
Terminal value at year 5: 36.4 / 0.09 = ₹404.4 Cr, whose PV is 404.4 / 1.8424 = ₹219.5 Cr
VIU = ₹333.8 Cr. Recoverable amount = max(290.0, 333.8) = ₹333.8 Cr.
Impairment = 350.0 − 333.8 = ₹16.2 Cr, charged entirely to goodwill (80.0 → 63.8).

Now the uncomfortable part, the sensitivity:

Pre-tax discount rate	VIU (₹ Cr)	Impairment (₹ Cr)
12%	375.4	0.0
13%	333.8	16.2
14%	300.6	49.4

The break-even rate is about 12.6%. At 13% the terminal value is 66% of VIU. Whether the company reports a ₹16 Cr hit, a ₹49 Cr hit or nothing turns on a one-point change in a rate that management picks. That is why Ind AS 36 requires disclosure of key assumptions (discount rate, growth rate, forecast period) and of how much headroom exists before an impairment.

Trader's lens

An impairment test is a mark-to-model where the seller supplies the model. Management chooses the cash flows, the growth rate and the discount rate, then marks its own book. You would never accept a counterparty's mark on an illiquid option without checking the vol surface they used. Treat goodwill the same way: take the disclosed discount rate and terminal growth, compare them with your own WACC (06.2) and with what the market cap implies, and ask how much headroom is left.

4.2 How impairments get timed¶

The standard is principles-based and the inputs are judgements, so the timing of impairments is partly discretionary:

The big bath. A new CEO writes everything down in year one. The loss gets blamed on the predecessor, and future depreciation and amortisation fall, so later profits look better. Watch for large impairments in the first year of a new management team.
The lagging confession. Management avoids impairing an acquisition that has plainly failed, because that would be admitting a mistake. The market often prices it in long before the accounts do. A market cap persistently below book value, with no impairment, is worth a question.
"Exceptional items" that recur. Impairments are usually shown as exceptional items. A company with "one-off" write-downs every other year has a capital-allocation problem, not bad luck (04.7).

Impairment has no cash effect. The cash was lost when the company overpaid for the asset. The impairment is the accounts catching up, which is why analysts usually add it back to measure current operating performance but never forget it when judging management's capital allocation (05.5).

5. Capitalise or expense?¶

5.1 The general test¶

A cost can be capitalised only if it creates an asset. The resource must be controlled by the company, future economic benefits must be probable, and the cost must be reliably measurable. Ind AS 16 adds that PP&E cost includes the purchase price and directly attributable costs to bring the asset to working condition: site preparation, delivery, installation, professional fees, testing. It excludes general overheads, administration, and the costs of opening a new facility, introducing a new product, advertising, or relocating and training staff. Those are expensed.

A small but important rule: since the 2022 amendment to Ind AS 16, sale proceeds of items produced while testing a plant (for example, the first batch of pumps from a new line) go to the P&L with their related cost. They no longer reduce the asset's cost.

5.2 Research and development (Ind AS 38)¶

Ind AS 38 (Intangible Assets) splits internal projects into two phases:

Research (original investigation for new knowledge) is always expensed.
Development (applying knowledge to a plan or design for new or substantially improved products or processes) is capitalised if, and only if, the company can demonstrate all six:
1. technical feasibility of completing the asset;
2. intention to complete it and use or sell it;
3. ability to use or sell it;
4. how it will generate probable future economic benefits (a market for the output, or usefulness if used internally);
5. adequate technical, financial and other resources to complete it;
6. ability to measure the development spending reliably.

Capitalised development appears as "intangible assets" and, while incomplete, as intangible assets under development. Since 2021 Schedule III requires an ageing schedule for these, like the one for CWIP. It is amortised over the product's useful life once available for use, and tested for impairment annually until then.

Judgement enters at the boundary: when does research become development, and when is feasibility "demonstrated"? Two pharma companies with identical labs can report very different profits depending on where they draw the line.

Worked example 4 — capitalising development in a growing company¶

Fictional Nandi Diagnostics spends on development: ₹20 Cr in year 1, rising by ₹4 Cr a year to ₹40 Cr in year 6, then flat at ₹40 Cr. Compare (A) expensing everything with (B) capitalising everything and amortising each year's spend straight-line over 5 years, starting the year after it is incurred.

Year	Spend (₹ Cr)	Amortisation under (B)	PBT uplift of (B) over (A) = spend − amortisation	Capitalised asset at year-end
1	20	0.0	20.0	20.0
2	24	4.0	20.0	40.0
3	28	8.8	19.2	59.2
4	32	14.4	17.6	76.8
5	36	20.8	15.2	92.0
6	40	28.0	12.0	104.0
7	40	32.0	8.0	112.0
8	40	35.2	4.8	116.8
9	40	37.6	2.4	119.2
10	40	39.2	0.8	120.0
11 onward	40	40.0	0.0	120.0

What to notice:

While spending grows, capitalising flatters profit every single year. The uplift only fades once spending levels off, and never turns negative here, because spending never falls.
The capitalised asset (₹120 Cr) is exactly the cumulative profit pulled forward. Sum the uplift column: 120.0. The balance sheet is storing expenses that have not yet hit the P&L.
If spending ever falls (the pipeline dries up), amortisation of past spending exceeds current spending and profit under (B) drops below (A). The capitalising company then reports a margin squeeze that is purely accounting.
Cash is identical, but under (B) the ₹40 Cr a year shows up in CFI, so CFO is ₹40 Cr higher. EBITDA is higher too, because amortisation sits below EBITDA.

For valuation, many analysts (following Damodaran) capitalise R&D for every company, including the ones that expense it, so that ROIC is measured on the true invested capital. That adjustment is in 04.3.

5.3 Software and the cloud¶

Purchased software licences and the directly attributable cost of implementing them (an ERP rollout) are capitalised as intangibles.
Internally developed software follows the research/development split above.
Cloud (SaaS) arrangements usually give the customer a service, not an asset it controls. Configuration and customisation costs are then generally expensed, as the IFRS Interpretations Committee concluded in an April 2021 agenda decision. Indian practice under Ind AS follows the same logic. A company still capitalising large "software" balances for what is really a subscription deserves a closer look.

5.4 Borrowing costs (Ind AS 23)¶

If a company borrows to build a qualifying asset (one that necessarily takes a substantial period to get ready: a plant, a power project, a real-estate development held as inventory), the interest during construction is capitalised into the asset's cost instead of being expensed. Capitalisation starts when spending, borrowing and construction activity are all under way. It is suspended during long idle periods and stops when the asset is substantially ready.

Mini-example. A company builds a ₹200 Cr plant over two years, funded partly by a ₹150 Cr specific loan at 9%. Interest = 13.5 a year, ₹27.0 Cr over two years, all capitalised. The plant goes on the books at ₹227 Cr. Once operating, it depreciates at 227 × 0.95 / 15 instead of 200 × 0.95 / 15, which is ₹1.71 Cr a year more, for 15 years.

During construction, suppose EBIT is ₹40 Cr and other interest ₹5 Cr:

Interest coverage with capitalisation: 40 / 5 = 8.0×.
Coverage on total interest incurred: 40 / (5 + 13.5) = 2.2×.

The second number is the one a lender cares about. Two checks:

the finance-cost note usually discloses "borrowing costs capitalised" (compare it with the P&L finance cost);
the cash-flow statement shows interest paid, which includes capitalised interest, against the P&L's finance cost, which excludes it.

A persistent gap is a sign of long construction periods, or worse, of "never-ending CWIP" (09.3).

Kaveri's reference statements expense all finance costs (a simplification of the course's data generator). A real company building Hosur with a term loan in FY23–FY24 would have capitalised the construction-period interest into CWIP.

5.5 A quick reference: capitalise or expense?¶

Cost	Usual treatment (Ind AS)	Where it goes
New machine, freight, installation, testing	Capitalise	PP&E; CFI
Routine repairs and maintenance	Expense	Other expenses; CFO
Major overhaul that extends life (e.g., relining a furnace)	Capitalise as a component	PP&E; CFI
Research	Expense	P&L; CFO
Development meeting all six criteria	Capitalise	Intangibles / IAUD; CFI
Advertising, brand building, training, start-up / pre-opening costs	Expense	P&L; CFO
Interest on loans funding a qualifying asset during construction	Capitalise	CWIP / PP&E; interest paid often shown in CFF
SaaS configuration (no control of software)	Usually expense	P&L; CFO
Internally generated brands, customer lists, goodwill	Never capitalise	—

The last row explains why balance sheets miss the most valuable assets of consumer companies (02.4).

6. Leases under Ind AS 116¶

6.1 What changed on 1-Apr-2019¶

Before FY20, Indian companies split leases in two. Finance leases (which transfer substantially all risks and rewards) were on balance sheet. Operating leases (most property, retail stores, many aircraft) were off balance sheet, and the rent simply ran through "other expenses".

Ind AS 116 (Leases), effective for periods beginning 1-Apr-2019, removed that split for lessees. With narrow exemptions for short-term leases (12 months or less) and low-value assets, every lease now brings onto the balance sheet:

a lease liability: the present value of the fixed lease payments over the lease term (including renewal options the lessee is reasonably certain to exercise), discounted at the rate implicit in the lease or, usually, the lessee's incremental borrowing rate;
a right-of-use (ROU) asset: initially the same amount, adjusted for prepaid rent, initial direct costs and restoration obligations.

In the P&L the rent line disappears for these leases. It is replaced by:

depreciation of the ROU asset (usually straight-line), and
interest on the lease liability, which is high early and falls as the liability is paid down.

Variable payments that don't depend on an index or rate, such as revenue-share rents in malls, stay outside the liability and remain in operating expenses.

In the cash-flow statement, the principal portion of lease payments moves to financing (CFF). The interest portion goes to CFF or CFO depending on the company's interest-paid policy. Kaveri shows total lease payments (₹5.9 Cr in FY26) in CFF.

Worked example 5 — one store lease, start to finish¶

A fictional QSR chain signs a 10-year store lease at ₹10 Cr a year, paid at each year-end, with an incremental borrowing rate of 9%.

\[\text{Lease liability}_0 = 10 \times \frac{1 - 1.09^{-10}}{0.09} = ₹64.18 \text{ Cr} = \text{ROU asset}_0\]

ROU depreciation = 64.18 / 10 = ₹6.42 Cr a year. Interest = 9% × opening liability.

Year	Interest	ROU depreciation	Total P&L charge	Old-style rent	Closing liability
1	5.78	6.42	12.19	10.00	59.95
2	5.40	6.42	11.81	10.00	55.35
3	4.98	6.42	11.40	10.00	50.33
4	4.53	6.42	10.95	10.00	44.86
5	4.04	6.42	10.45	10.00	38.90
6	3.50	6.42	9.92	10.00	32.40
7	2.92	6.42	9.33	10.00	25.31
8	2.28	6.42	8.70	10.00	17.59
9	1.58	6.42	8.00	10.00	9.17
10	0.83	6.42	7.24	10.00	0.00
Total	35.82	64.18	100.00	100.00

What changes for this single lease:

EBITDA rises by ₹10 Cr every year, because rent was an operating expense and neither depreciation nor interest sits above EBITDA.
EBIT rises by the interest amount (₹5.78 Cr in year 1).
PBT falls in years 1–5 (charge above ₹10 Cr) and rises in years 6–10. Total P&L cost over the life is identical: ₹100 Cr.
Net debt rises by the lease liability (₹64.18 Cr on day one) if you include leases, and CFO rises because the payments move to CFF.
For a portfolio of staggered leases, the front-loading partly averages out. For a fast-growing chain full of young leases, reported PAT is structurally a little lower than under the old rules.

6.2 The real thing: Jubilant FoodWorks, Q1 FY20¶

Jubilant FoodWorks (Domino's franchisee in India) adopted Ind AS 116 from 1-Apr-2019 using the modified retrospective approach, which does not restate comparatives. Helpfully, it also published Q1 FY20 on the old basis. Standalone, ₹ Cr (converted from ₹ million):

Q1 FY20, standalone	With Ind AS 116	Without Ind AS 116
Revenue from operations	940.1	940.1
Rent expense	21.0	92.1
EBITDA	219.1	147.2
EBITDA margin	23.3%	15.7%
Depreciation	80.8	37.8
Interest cost	39.5	0.3
PBT	114.1	124.4
PAT	74.8	81.5

Source: Jubilant FoodWorks Q1 FY20 earnings presentation, July 2019.

Nothing changed in the pizza business that quarter. But EBITDA rose 49% and the margin jumped ~760 bps, while PAT fell 8% because of front-loaded interest on a young lease book. Every retailer, QSR chain, airline and multiplex saw some version of this. Anyone screening on "EBITDA growth FY20 vs FY19" found a lot of false positives. Airlines, with large fleets on operating leases, saw some of the biggest balance-sheet effects.

6.3 Undoing Ind AS 116 on Kaveri¶

Kaveri is not lease-heavy, but the mechanics are the same. FY26:

Reported EBITDA ₹181.9 Cr (13.8% margin). Lease payments ₹5.9 Cr.
EBITDA on a pre-Ind AS 116 basis ("EBITDA after rent") ≈ 181.9 − 5.9 = ₹176.0 Cr (13.4%).
P&L lease charges = ROU amortisation 4.7 + lease interest 1.4 = ₹6.1 Cr, slightly more than the ₹5.9 Cr of cash. That is the front-loading from worked example 5.
CFO after lease payments = 65.1 − 5.9 = ₹59.2 Cr. For a consistent FCF figure, deduct lease payments, since they are as unavoidable as rent ever was.

6.4 Rules for leases in analysis¶

Be consistent between numerator and denominator. If EBITDA includes the lease add-back (post-Ind AS 116), EV must include lease liabilities. Kaveri's reference EV/EBITDA does exactly this, and its equity bridge subtracts lease liabilities of ₹18.2 Cr (kaveri-valuation). If you use EBITDA after rent, exclude lease liabilities from EV. Mixing the two understates the multiple. More in 01.2 and 06.5.
Compare across the FY20 break with care. Ten-year Screener series mix old and new bases. Restate either the old years or the new ones.
Compare with US peers with care. Under US GAAP (ASC 842), operating leases go on the balance sheet but the P&L still shows a single straight-line lease cost in operating expenses, so US EBITDA is not boosted (02.9).
Leverage ratios: net debt / EBITDA with leases in both, or in neither (04.5).

7. Government grants (Ind AS 20)¶

Governments give companies capital subsidies for plants in backward regions, interest subventions, export incentives, and, since 2020, Production-Linked Incentives (PLI). Ind AS 20 says a grant is recognised only when there is reasonable assurance that the company will comply with the conditions and that the grant will be received. It is then recognised in P&L systematically over the periods in which the related costs are expensed.

Grants related to income (a PLI payment linked to incremental sales, an interest subvention) are shown as income ("other operating revenue" or "other income") or deducted from the related expense. Presentation varies across Indian companies, so read the note before comparing margins.
Grants related to assets (a capital subsidy on a plant) can be presented either
as deferred income, released to P&L over the asset's life, or
by deducting the grant from the asset's carrying amount, so depreciation is lower.

The second option, and the option to record non-monetary grants (such as land given free) at a nominal amount, were brought into Ind AS 20 by an amendment notified in September 2018, effective from 1-Apr-2018 (PwC ReportingInBrief on the Ind AS 20 amendments).

Worked example 6 — same subsidy, two presentations¶

A plant costs ₹100 Cr and attracts a capital subsidy of ₹20 Cr. It has a 10-year life with nil residual and generates EBITDA of ₹25 Cr a year before any grant accounting. Revenue is ₹150 Cr.

Year 1, ₹ Cr	Deferred-income method	Net-off method
Gross block	100.0	80.0
Deferred grant income (liability)	20.0	–
EBITDA (grant release counted as operating income)	27.0	25.0
Depreciation	(10.0)	(8.0)
EBIT	17.0	17.0
EBIT / opening gross asset	17.0%	21.3%
Revenue / gross block	1.5×	1.9×

PAT and cash are identical. EBITDA, the asset base, asset turnover and a naive ROCE are not. When you compare a subsidised plant with an unsubsidised peer, put both on the same basis. And remember that a subsidy is a gift of cash that won't recur on the next plant, which matters for estimating incremental returns on new capacity. A tax holiday is not an Ind AS 20 grant. It shows up as a low effective tax rate, which also lapses.

8. Putting it together: the profit-shifting map¶

Every lever in this lesson obeys the timing identity from §1. A summary you can keep beside you when reading notes:

Lever	Where to look in the annual report	What moves	The analyst's check
Inventory formula, NRV	Accounting policies; inventory note	Gross margin; inventory days	Commodity price trend vs gross margin; provision for obsolescence vs inventory growth
Useful lives, residual values	PP&E policy; "change in estimate" disclosures	Depreciation; EBIT	Depreciation / average gross block trend; implied life; average age
Impairment	Goodwill & intangibles note; exceptional items	EBIT (one-off); future D&A	Discount rate and growth used vs your WACC; headroom; market cap vs book
Development capitalised	Intangibles note; IAUD ageing	EBITDA, EBIT, CFO	Capitalised / total R&D ratio trend; amortisation vs spend
Borrowing costs capitalised	Finance-cost note; CWIP note	Finance cost; interest coverage	Interest paid (CFS) vs finance cost (P&L); CWIP ageing
Leases	Leases note; ROU and lease-liability schedules	EBITDA, EBIT, net debt, CFO	Restate to a single basis; consistent EV and EBITDA
Grants	Government-grant policy; other operating revenue note	EBITDA, asset base	Recurring or not; gross vs net presentation

India notes

Schedule II (Companies Act, 2013) gives the reference lives and the ≤5% residual norm. Deviations need disclosed technical justification. Component accounting has been mandatory since 1-Apr-2015. Extra-shift depreciation (+50% / +100%) applies to eligible assets (Schedule II).
Book vs tax depreciation. Income-tax depreciation uses block-wise WDV rates. It is usually faster than Schedule II SLM early on, which builds the deferred tax liability (Kaveri's DTL grows every year; see 02.8). From 1-Apr-2026 the Income-tax Act, 2025 replaced the 1961 Act, and section numbers changed. Check the current depreciation rules rather than old section references.
Schedule III ageing tables (added by the 2021 amendment) for CWIP and intangible assets under development show how long projects have been stuck. They are the fastest way to spot "never-ending CWIP".
The FY20 Ind AS 116 break runs through every Indian time series for retailers, QSR, airlines, hospitals, multiplexes and logistics companies. Screener and other aggregators generally don't restate.
PLI incentives are grants related to income. Where they sit (revenue, other income, cost reduction) varies, and they are time-bound, so model their expiry.
Ind AS transition (FY16–FY17). Many companies elected fair value as deemed cost for land and some PP&E at transition. That raised equity (and depressed ROE) with no change in the business. Check the Ind AS 101 reconciliation in the first Ind AS annual report.

Common mistakes

Treating a margin jump in a commodity upcycle as pricing power when part of it is FIFO inventory gains.
Comparing EBITDA across the FY20 Ind AS 116 break, or comparing an Indian retailer's EBITDA with a US retailer's without adjusting for leases.
Putting lease liabilities in EV but using "EBITDA after rent", or the reverse.
Reading CFO growth as better business when capitalised development or interest has simply moved outflows into CFI. Use FCF.
Assuming depreciation equals maintenance capex. In an inflationary, growing company, historical-cost depreciation understates the cost of replacing assets (04.4).
Treating impairments as "non-cash, ignore". They are non-cash now. The cash was destroyed earlier, and the impairment is evidence about capital allocation.
Forgetting that land in gross block is not depreciated when computing implied useful lives.
Missing a useful-life change because it is applied prospectively with no restatement. Read the PP&E policy every year and compare it with last year's.

Key terms¶

Term	Meaning
Capitalise	Record a cost as an asset on the balance sheet rather than as an expense, then expense it over time
FIFO / weighted average / LIFO	Cost formulas deciding which purchase costs go to COGS; LIFO is not permitted under Ind AS/IFRS
Net realisable value (NRV)	Estimated selling price less costs to complete and sell; inventory is carried at the lower of cost and NRV
Normal capacity	The production level expected on average; fixed overhead is absorbed into inventory on this basis, and the unabsorbed part is expensed
Depreciable amount	Cost minus residual value
Useful life	The period over which an asset is expected to be used; Schedule II gives indicative lives
SLM / WDV	Straight-line (equal charge) vs written-down value (fixed percentage of opening book value) depreciation
Component accounting	Depreciating significant parts of an asset separately over their own lives
Change in accounting estimate	A revision (e.g., useful life) applied prospectively without restating prior years (Ind AS 8)
Impairment	Write-down when carrying amount exceeds recoverable amount (Ind AS 36)
Recoverable amount	Higher of fair value less costs of disposal and value in use
Value in use (VIU)	PV of future pre-tax cash flows from an asset or CGU, at a pre-tax discount rate
Cash-generating unit (CGU)	Smallest group of assets generating largely independent cash inflows
Development costs	Spending on applying research to new products or processes; capitalised only if the six Ind AS 38 criteria are met
Qualifying asset	An asset that takes a substantial period to get ready; borrowing costs on it are capitalised (Ind AS 23)
Right-of-use (ROU) asset	Lessee's asset representing the right to use a leased item (Ind AS 116)
Lease liability	PV of future fixed lease payments, discounted at the implicit rate or incremental borrowing rate
Government grant	Assistance from government in return for compliance with conditions (Ind AS 20); related to assets or to income
Timing identity	Over an asset's life, total expense equals total cash spent; accounting choices only move the timing

Check your understanding¶

1. A pump maker's gross margin rose 180 bps in a year when copper prices rose 20%, while its selling prices rose only 4%. It uses FIFO. Give an accounting explanation for part of the margin rise and say what you'd expect if copper prices fall next year.

Answer

Under FIFO in a rising market, COGS carries older, cheaper copper while revenue reflects current prices, so part of the margin is an inventory holding gain (worked example 1: FIFO gross profit ₹1.6 Cr above LIFO on the same cash). It is not pricing power. If copper falls, FIFO pushes the older, expensive layers into COGS and the margin will fall more than the economics warrant, until the costly inventory is used up. Ask management on the concall for the inventory gain or loss, and compare gross margin with the copper price lagged by roughly one inventory cycle (Kaveri's inventory days are about 80).

2. Kaveri's FY26 PP&E depreciation was ₹39.6 Cr, gross block ₹830.0 Cr (including ≈₹18 Cr of land) and accumulated depreciation ₹334.7 Cr. Compute the implied average useful life and average age. If next year depreciation is ₹38.0 Cr despite ₹48 Cr of capex, what would you check?

Answer

Implied life = (830.0 − 18.0) / 39.6 = 20.5 years. Average age = 334.7 / 39.6 = 8.5 years. Depreciation falling while gross block grows would mean the depreciation rate (depreciation / average gross block) dropped sharply from 4.9%. Check:

the PP&E accounting policy and notes for a change in useful lives or residual values (applied prospectively, so there is no restatement);
whether large assets became fully depreciated (possible, but you can test it with the gross block ageing);
whether capex went into CWIP rather than gross block.

3. In worked example 3, management switches the pre-tax discount rate from 13% to 12%, citing "lower interest rates". What happens to the impairment, and what would you check?

Answer

VIU rises from ₹333.8 Cr to ₹375.4 Cr, above the ₹350 Cr carrying amount, so the ₹16.2 Cr impairment disappears. The break-even rate is ~12.6%. Check:

whether the rate is consistent with the company's own cost of capital and with market rates (was there really a 100 bp fall?);
whether cash-flow forecasts were also changed;
the headroom disclosure;
whether the market cap implies a much lower value for the business than VIU does.

A cut in the discount rate in the very year an impairment would otherwise be needed is a yellow flag.

4. A company capitalises ₹60 Cr of development spending this year and amortises ₹35 Cr from past years. Its reported CFO is ₹300 Cr. What would CFO, EBITDA and PBT be if it expensed all development?

Answer

CFO: the ₹60 Cr would move from CFI into CFO, so CFO = 300 − 60 = ₹240 Cr. FCF is unchanged.
EBITDA: falls by ₹60 Cr (amortisation sits below EBITDA; the full spend would now be an operating expense).
PBT: falls by 60 − 35 = ₹25 Cr (expense ₹60 Cr instead of amortisation ₹35 Cr).

Tax effects aside, cash is identical.

5. A 10-year lease has annual payments of ₹10 Cr in arrears and an incremental borrowing rate of 9%. What are the initial lease liability, the year-1 P&L charge and the year-1 EBITDA effect versus the old rent accounting?

Answer

Liability = 10 × (1 − 1.09⁻¹⁰) / 0.09 = ₹64.18 Cr (= ROU asset).
Year-1 charge = depreciation 6.42 + interest 5.78 = ₹12.19 Cr, versus ₹10 Cr of rent before, so PBT is lower by ₹2.19 Cr.
EBITDA is ₹10 Cr higher, since no part of the charge is above EBITDA.
Over 10 years the total charge is exactly ₹100 Cr.

6. During construction, a company's EBIT is ₹40 Cr, its P&L finance cost ₹5 Cr, and the cash-flow statement shows interest paid of ₹18.5 Cr. What is going on, and which interest-coverage ratio would you use?

Answer

The ₹13.5 Cr gap is most likely interest capitalised into CWIP under Ind AS 23 (qualifying asset under construction). Reported coverage (40 / 5 = 8.0×) flatters debt-service capacity. A lender or equity analyst should use coverage on interest incurred: 40 / 18.5 ≈ 2.2×. Confirm with the "borrowing costs capitalised" disclosure and the CWIP ageing schedule.

7. Two identical plants cost ₹100 Cr each; one got a ₹20 Cr capital subsidy and nets it off, the other got nothing. Both report EBIT of ₹17 Cr. Which has the better economics, and how would a naive ROCE comparison mislead?

Answer

The subsidised plant earns ₹17 Cr on ₹80 Cr of shareholders' money, so economically it is better for this plant. But the subsidy is a one-off gift. A naive "ROCE" of 21.3% (17/80) on the subsidised plant versus 17.0% on the other overstates the operating superiority. EBIT is actually the same, and the next plant probably won't get a subsidy. To judge the business's ability to earn on new capital, compare on gross cost (17%) and treat the subsidy separately as a non-recurring benefit.

8. True or false, with a one-line reason: "Over the full life of an asset, a longer useful-life assumption increases total profit."

Answer

False. The timing identity: total depreciation over the asset's life equals cost minus residual value whatever the assumed life. A longer life raises profit in early years and lowers it later (or shows up as a loss on disposal if the asset is scrapped before the assumed life ends).

Go deeper¶

Schedule II, Companies Act, 2013 (ca2013.com): the full list of useful lives and the Part A rules, worth reading once in full.
Ind AS 2, 16, 20, 23, 36, 38 and 116: the standards themselves, free on the MCA website and ICAI's Ind AS pages; the "Illustrative Examples" appendices are excellent.
Howard Schilit, Jeremy Perler & Yoni Engelhart, Financial Shenanigans (4th ed., 2018): chapters on shifting current expenses to later periods and on capitalisation tricks.
Aswath Damodaran, "Research and Development Expenses: Implications for Profitability Measurement and Valuation" (NYU Stern working paper): why and how to capitalise R&D for every company.
IASB, IFRS 16 Leases — Effects Analysis (January 2016): the standard-setter's own estimate of how lease capitalisation changes EBITDA, leverage and ratios across industries.

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