I have written an article about Frontier Developments for SharePad, and I highlighted the company’s somewhat questionable accounting:
I thought I would add some further comments here.
The accounting issue relates to the capitalisation of development costs. Companies are permitted to capitalise certain costs onto the balance sheet and avoid expensing them immediately to earnings. Those capitalised costs are subsequently expensed against earnings through an amortisation charge, which typically spreads the cost over several years.
With Frontier, I maintain that its amortisation period is too long and as such flatters near-term earnings. Sales of computer games are generated mostly within the first few months after launch, and so the associated development costs should be expensed in a similar manner.
Let’s compare Frontier to two other games developers, Team 17 and Codemasters .
The capitalisation policy for Frontier:
Development costs are amortised on a straight-line basis generally over 3-5 years, but could be over 6 or 8 or maybe 10.
Contrast that policy with Team 17:
Development costs are amortised over two years on an 85% reducing-balance basis. So 85% of the costs are expensed in year 1, then the rest is expensed in year 2. Note the text: “ The amortisation is also heavily weighted towards the first year to reflect the sales curve of titles”.
Contrast now with Codemasters:
Development costs are amortised over one year, with 65% expensed in month 1 and the rest expensed over months 2-12. Note the text: “ The directors consider that it is appropriate for the amortisation period to be based upon the expected revenue profile .”
Let’s now look at the accounting effect of these policies for the three shares.
For the last two years, total cash development costs came to £26.0m while the associated amortisation charge was £13.3m. Amortisation therefore reflected 51% of the cash costs.
Next, Team 17:
For the last two years, total cash development costs came to £7.1m while the associated amortisation charge was £7.4m. Amortisation therefore reflected 104% of the cash costs.
For the last two years, total cash development costs came to £46.7m while the associated amortisation charge was £44.7m. Amortisation therefore reflected 96% of the cash costs.
The amortisation policies of Team 17 and Codemasters appear far more prudent to me, and results in development costs being largely matched by the associated amortisation charge — and therefore earnings not becoming too distorted.
The amortisation policy applied by Frontier results in only half of the development costs being expensed to earnings for a particular year, thereby exaggerating near-term earnings.
So… what makes Frontier’s games so different that the development costs can be amortised over several years on a straight-line basis…
…when other companies amortise over no more than two years, with most of the cost recognised earlier rather than later?
From this three-company sample, I have to question Frontier’s amortisation policy and its reported earnings.