Harvard Business Case Analysis – Accounting

HBS Case 9-111-114: Bridging the GAAPs" – write up including answers to the case questions on page 6
and supporting analyses.

Dear Students,

A few issues have come up, and to make sure that everyone knows what we
are doing with this case, here is some clarification:

Issue 1: What do we need to do?

From the syllabus: "write up INCLUDING answers to the case questions on page 6 AND supporting
analyses":
Specifically, second paragraph of page 6: " [1] Should HOLT continue
to fully recapitalize all R&D expense, or capitalize only development
expenses, as required by IFRS? [2] Which adjustments would better reflect
economic reality? [3] Would the different treatment affect how HOLT’s
clients viewed Sanofi and Fiat? "
Issue 2: What is the difference between research and development
expenditures in [1]?

R&D are all expenditures associated with coming up with and creating
new products, or coming up with new ideas that simplify things. R&D
group may involve scientists in lab coats at a pharmaceutical company, or
a group of theoretical physicists working on a mathematical formula for a
more efficient car heating system…

Let’s think of a new invention called "Gizmo".
Expenditures on a "Gizmo" stop being research and start being
development when it is almost certain that the "Gizmo" will work.
When the company starts working on "Gizmo", all of the money it
spends goes to an expense until the company is almost sure that
"Gizmo" will work.
When the company determines that it is almost certain that Gizmo will
work, and the company continues spending money to finish
"Gizmo", that newly spent money is capitalized. This may include
final touches, making sure that "Gizmo" will look good and be as
efficient as possible (i.e. more money spent, but not production yet).
Note that the costs that were initially expensed cannot be capitalized.

_
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HOLT Global Adjustments
A corporate performance and valuation advisory service, HOLT had been founded in 1985.1 It was
acquired by Credit Suisse in 2002 and was used both internally at Credit Suisse and by some 750
clients who subscribed directly to its services. HOLT offered clients access to information on more
than 20,000 firms in over 60 countries via its proprietary HOLT® platform. HOLT’s client base
included nearly half the world’s largest money managers, including hedge, mutual, and pension
funds worldwide.2
The value of HOLT’s service came from providing investors with consistent performance metrics
that provided a benchmark for corporate performance across countries and over time. HOLT
converted each company’s income statement and balance sheet into a common performance metric
(CFROI) that captured economic performance after making relevant adjustments to the financial
statements (see Exhibits 1 and 2). Clients used this metric to evaluate their global investment
portfolios and generate investment ideas in new sectors and countries. Equity managers, for example,
used HOLT’s analysis to filter investment ideas and quickly choose investment targets from a broad
universe of global equities, and subsequently to identify short-term tactical moves and long-term
market-driven strategies.
The first step in generating the CFROI metric was to remove differences in accounting treatments
around the world. The HOLT framework was based on the premise that accounting data needed
adjustments for comparability. Because financial statements were presented under various
accounting standards, and subject to managerial discretion, the components of reported income could
vary with prevailing standards and practices. Also, economic conditions and local institutions in each
country often influenced the local standard-setting process.
Adjusting differences in accounting standards across over 60 countries was not a trivial task. The
most common adjustment items were leases, pensions, research and development (R&D) expense,
inflation, and goodwill accounting. In 2010, this process resulted in an aggregate adjustment of $14
trillion USD in the total reported book assets of all companies (see Exhibit 3). In addition, some
countries had special accounting treatments that were idiosyncratic to the region, and these required
special attention. For example, Taiwan’s local GAAP required employee share bonuses to be
considered as a distribution of earnings and not as an expense. Hence, the stock grants to employees
were not considered to be labor costs. Such accounting treatment fostered growth of certain sectors,
such as the semiconductor industry, which often paid more than half of its compensation through
share bonus plans. Investors worried that such accounting treatment distorted the multiples of the
semiconductor companies in Taiwan relative to those in other countries. HOLT adjusted for this
treatment until this rule was revised in 2008.
The regional accounting specialists, who served as the eyes and ears of HOLT, escalated regional
reporting issues and suggested changes to make sure the framework was up to date. Changes that
these specialists suggested were reviewed and approved by the CFROI Framework Committee
(CFC), which was composed of nine senior members, four based in the U.S., three in Europe, and two
in other regional offices. Changes that had a lasting and material impact on financials resulted in a
permanent adjustment to the framework. Structural changes to the framework were implemented
worldwide and communicated to clients. Although not fond of frequent changes to the model, HOLT
1 The name HOLT is derived from the names of its four founders, Robert Hendricks, Eric Olson, Marvin Lipson,
and Rawley
Thomas.
2 According to the company web site (https://www.credit-suisse.com/investment_banking/holt/en).
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clients recognized the value of practical and up-to-date information about regional accounting
differences.
Adoption of IFRS
Soh’s hedge fund clients had become increasingly interested in the impact of IFRS adoption in
Asia. They wanted to know how HOLT’s services—adjusting financial information to be comparable
across countries—would be affected by IFRS. Many of HOLT’s hedge fund clients were quantitative
traders who scanned thousands of companies, using fundamental factors to find companies that fit
their investment criteria. Clients worried that the changes under IFRS could significantly affect the
efficacy of their investment processes and selection of stocks to buy and sell.
The Asian market reminded Graziano of his experience in 2005, when over 7,000 EU-listed
companies began their first full year of IFRS-compliant financial reporting. He recalled that when the
EU adopted IFRS, many European clients faced the very concern that was now set to repeat itself in
Asia. Since 2005, other countries had adopted IFRS, and IFRS quickly became established as a
globally recognized body of standards.3 At the same time, Graziano was aware that considerable
variation existed in how different jurisdictions applied and enforced the new rules.
Graziano was confident that most changes from IFRS would have little impact on HOLT’s
valuation metrics. HOLT’s methodology to measure companies’ underlying economics was built
under the assumption that the standards used to present financial information should not affect firm
valuation (see Exhibit 13). However, if the new standards provided new information that would
allow HOLT to better reflect economic reality, he was open to changing the current adjustment
process.
Research and Development Expenditures
To illustrate the impact of IFRS adoption, Graziano pointed to a handout from a round-table panel
in which he had recently participated at the Securities and Exchange Commission (SEC) headquarters
in Washington, D.C. One of the interesting points the panel discussed was the requirement under
IFRS IAS 38 to capitalize development expenditure.4 Under IFRS, all research expenditures were
expensed in the period in which they arose, but development expenditures were required to be
capitalized when certain criteria were met. To qualify as capitalized development expenditures under
IFRS, firms were required to demonstrate the intent as well as both the technical and financial
feasibility of the future economic benefits (see “IAS 38 Development Capitalization Criteria” in
Exhibit 4). The company could capitalize the costs once the benefits had achieved technical
feasibility, provided that the company could reliably measure directly attributable costs.
Local accounting standards for accounting for R&D expenditures varied greatly (see Exhibit 4).
For example, countries like Japan and the United States opted for the most conservative approach,
requiring both R&D outlays to be expensed unless R&D was acquired from a third party, whereas in
other countries, such as the U.K., certain portions of R&D could be capitalized under certain
3 As of 2010, 118 jurisdictions required IFRS-based financial reporting for all or certain domestic listed
companies. ( IAS Plus
Information page, http://www.iasplus.com/country/useias,accessed December 2010.)
4 IAS 38: Intangible Assets
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conditions. However, the conditions to meet the capitalization criteria were open to management
interpretation.
HOLT’s approach to adjusting global differences in R&D treatment was to capitalize all R&D
expenditures (see Exhibit 5). The underlying rationale was that all R&D expenditures were, in effect,
building intangible assets off the balance sheet, and simplifying assumptions could be made to
recognize the benefit over the life of an asset, as in capital expenditures made to acquire property,
plants, and equipment. Soh raised the question of whether this approach would be the most
consistent with economic reality.
Drawing the Line Between Research and Development
Graziano reflected on the questions Soh had raised. Soh believed HOLT could utilize the
differentiation between research and development expenditures under IFRS. He pointed out that the
disclosure of R&D under IFRS provided more reliable information about where to draw the line
between an asset and an expense. HOLT’s current treatment capitalized all R&D expenditures,
ignoring the differentiation between research and development.
“Yes, Soh,” Graziano responded, “I agree there might be some lost information by not
differentiating between research and development expenditures, especially when the standards draw
the line for us. Also, the new standards provide clear guidance as to when the research expenditure
meets the threshold to be recognized as an asset. However, keep in mind that HOLT capitalizes R&D
regardless of the accounting rules to better capture the investments in place that generate future cash
flows; fundamentally, we believe R&D expenditure is an investment, not an expense (see Exhibit 6).”
Graziano went on to share his experience during the transition to IFRS in Europe. “I also worry,”
he continued, “that the application of this rule across countries is inconsistent. For example, in 2005,
when Europe adopted IFRS, we anticipated that pharmaceutical companies would experience a large
change on the balance sheet and income statement from the capitalization of development
expenditures (see Exhibit 7). However, on a relative basis, automobile companies were impacted
much more by this rule. This makes me wonder whether capitalized development expenditures
under IFRS are really consistent with economic reality. I have a hard time relying completely on the
potentially inconsistent application of an accounting rule to make investment decisions.”
In practice, the point at which companies met the capitalization criteria for development
expenditures under IFRS varied. Establishing “technical feasibility” for completing a product often
required the input of the product R&D team and engineers.5 For instance, pharmaceutical and biotech
companies could demonstrate commercial feasibility when a product obtained approval of regulatory
agencies. When adopting IFRS in 2005, pharmaceutical companies often announced that they would
capitalize only development expenses for projects for which marketing approval had been filed.6 In
industries that did not require third-party approval of products, such as the automotive industry
development costs were likely to be capitalized earlier. Naturally, “development expense” implied
different things in each industry, even under a harmonized global accounting standard.
5 KPMG, IFRS for Technology Companies: Closing the GAAP?, 2008.
6 Sanofi-Aventis Transition to IFRS Conference Call, April 14, 2005. Jean-Claude Leroy, CFO.
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Sanofi-Aventis and Fiat
Going through his notes from client meetings back when the EU had adopted IFRS, Graziano
found two companies, Sanofi and Fiat, circled. He recalled being puzzled by the adjustment for the
R&D amounts when these two companies had transitioned to IFRS.
Sanofi-Aventis was a multinational pharmaceutical company based in France. The company’s
stock was listed in Paris, EURONEXT, and the NYSE, which made it subject to the financial reporting
regulations of both France and the United States. Sanofi coordinated R&D activities on a worldwide
basis, with more than 20 research centers on three continents. Its annual R&D budget ranked among
the three largest in the global pharmaceutical industry.
Italian car manufacturer Fiat was also recognized for its research and development activities,
especially in powertrain technologies and low-emission gasoline engines. Yet its total R&D budget
did not approach that of Sanofi-Aventis.
Both companies had adopted IFRS in 2005, when France and Italy had mandated reporting under
IFRS. Given that pharmaceutical companies ranked near the top in terms of R&D expenditure and
automakers near the bottom, it was logical to assume that IAS 38 would have a greater impact on
Sanofi than on Fiat. To Graziano’s surprise, however, IAS 38 had a much greater effect on Fiat than
on Sanofi (see Exhibits 8 and 9).
Fiat had reported a €2.24 billion increase in assets related to newly capitalized development costs
under IFRS for the fiscal year ended 2004, which was the first year restated under IFRS (Exhibit 8).
This resulted in a €461 million positive impact on earnings from a reduction in development expenses
(i.e., a €436 million net of amortization). This decline in R&D expenses had a significant effect on
earnings and net assets. During the same year, Sanofi had spent €4 billion, or 15% of sales, on R&D
(compared to Fiat’s €1.8 billion, or 4% of sales). But Sanofi had announced that the new rule requiring
that development expense be capitalized under IFRS would have little effect on its financials (see
Exhibit 9).
Graziano found it hard to believe that the IFRS impact of capitalizing development expenditures
had been greater for Fiat than for Sanofi, whose annual R&D budget ranked among the three largest
in the global pharmaceutical industry. Also, the reporting behavior of the two companies following
the first year of adoption had raised some concerns. For Fiat, reported R&D expenses had declined
notably following the first year of adoption, and continued to fall both in absolute terms and as a
percentage of total sales, whereas Sanofi’s reported R&D expenses had remained fairly stable (see
Exhibit 10).
Graziano was not quite sure what to make of the explanations that the two companies provided.
He worried that the convergence process from IFRS adoption was actually creating global
inconsistencies instead of increasing global comparability, as promised. Graziano illustrated for Soh
how different accounting treatments could alter the relative attractiveness of Sanofi and Fiat. Under
local accounting standards, Fiat appeared to be a more attractive investment based on traditional
multiples (e.g., PE ratios). However, financials reported under IFRS suggested that the two
companies were very comparable. Graziano pointed out that HOLT’s adjustments would identify
Sanofi-Aventis as the better investment regardless of whether the information was presented under
IFRS or local accounting standards (see Exhibits 11 and 12).
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The Decision
Soh knew Graziano’s examples would make a good case for his clients, because under HOLT’s
current approach of capitalizing all R&D expenses, there would be no change with the adoption of
IFRS. But he still wondered in the back of his mind if HOLT should explore the new standards’
distinction between research and development expenses.
Graziano and Soh were left to decide HOLT’s approach to the R&D adjustments. Should HOLT
continue to fully recapitalize all R&D expenses, or capitalize only development expenses, as required
by IFRS? Which adjustments would better reflect economic reality? Would the different treatment
affect how HOLT’s clients viewed Sanofi and Fiat?
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Exhibit 1 Overview of the HOLT Framework
Source: HOLT internal documents.
The HOLT methodology corrects subjectivity by converting income statement and balance sheet
information into a CFROI, or single period operating return measure that approximates a company’s
underlying economics. The CFROI measure is an internal rate of return (IRR) measure that evaluates
economic performance by calculating the return on the expected stream of future gross cash flows.
The resulting returns can be used to assess the firm’s historical ability to create or destroy wealth over
time.
Source: HOLT internal documents.
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Exhibit 2 HOLT’s Adjustment Details
HOLT CFROI® Valuation Framework Adjustments
HOLT Adjustment How Benefit
Asset Write Downs HOLT adds back the value of impaired assets that
are still in use by the company.
This adjustment restores the original gross investment of
the firm required to generate operating cash flows. This
enables HOLT to measure the economic return on all the
assets of the firm.
Capitalized Operating
Leases
Current year rent expense is capitalized over the
firm’s average asset life and real discount rate. Rent
expense is added back to cash flows, the value of the
capitalized asset is included in HOLT’s total assets
and the value of the capitalized debt is included in
HOLT debt.
The financing decision of how a company attains its
assets is removed. The purchase of an asset, a capital
lease and operating lease are all treated the same within
the CFROI valuation framework.
Capitalized R&D
R&D expense is capitalized over a industry specific
life and inflation adjusted. R&D expense is added
back to cash flows and the capitalized asset is
included in HOLT’s total assets.
R&D expenditures are treated as a longer term
investment as opposed to a periodic expense.
Derivatives (hedging)
Material ineffective hedging gains/losses and
assets/liabilities are removed from cash flows, assets
and debt.
Large non cash hedging gain/losses can have a material
impact on the CFROI calculation. HOLT only includes
effective hedges; this ensures that hedging gain/losses
are offset by underlying operating results within the
business. For example, effective fuel hedging gains
recorded by an Airline company are offset by losses on
the cost of buying fuel and no adjustment is required by
HOLT.
Discontinued Operations
Net discontinued operating asset/liability reported on
a company’s balance sheet is removed from HOLT
total assets.
This ensures that total cash inflows of the firm (which
does not include the discontinued business profits) match
the total assets/liabilities reported by the firm.
FIFO Profits
FIFO inventory is multiplied by the change in PPI to
account for the change in inflation will have on future
cash flows.
Cost of goods sold under the FIFO inventory method can
be distorted because of changes in inflation. HOLTs
adjustment removes the inflation effect from the reported
profits of a firm. Distortions from varying accounting
standards (i.e. LIFO vs FIFO) are also removed.
Financial Subsidiary
HOLT deconsolidates the operations of an industrial
firm’s financing arm, calculates that return on equity
and then embeds the return back into the overall
industrial CFROI.
Industrial companies with financing arms can be
accurately compared to other industrial peers.
Goodwill Remove goodwill from HOLT’s total assets and add
back amortization expense to cash flows.
Goodwill is not an operating asset of the firm…the CFROI
calculation is designed to measure the operating cash
flows against the operating assets of the firm. HOLT’s
Transaction CFROI includes goodwill and can be used to
measure management’s M&A effectiveness.
Gross Plant Add back accumulated depreciation to net plant.
This adjustment holds management accountable for the
full cost of the investment to generate cash flows.
Traditional accounting metrics (RONA) are distorted if a
company intentionally lets its assets age.
Gross Plant Recaptured Recapture gross plant lost under purchase
accounting rules for M&A transactions.
The original gross investment of the combined company is
restored. This enables HOLT to measure the economic
return on all the assets of the firm.
Inflation Adjustment to
Reported Assets
Restate historical assets (gross plant, inventory) to
current dollars by estimating the changes in inflation
over the life of the company’s assets. Total assets are
increased by the inflation charge.
The reported balance sheet is stated in historical dollars
while the income statement is stated in current dollars.
HOLT’s inflation adjustment removes the effect of inflation
to ensure comparisons can be made across time,
industries, and regions.
HOLT’s CFROI® valuation framework provides investors with a benchmark of corporate performance across time,
industries and countries that
is free of accounting distortions. Below are some of the major adjustments made by HOLT to provide an
economic cash return on the total
assets of a firm regardless of how, where or when they were purchased.
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Source: HOLT internal documents.
HOLT Adjustment How Benefit
Investments
Remove the associated income and assets for
material unconsolidated equity method investments
from the CFROI calculation and add it to valuation.
A material equity investment that is unconsolidated does
not disclose critical line items (i.e. depreciation; gross
plant) in order to calculate the CFROI. As such, operating
returns can not be adequately measured. The value of the
investment is added to HOLT’s valuation.
Minority Interest
Add back minority interest expense to cash flows and
determine the FMV of the minority interest claim and
subtract it from valuation.
To determine the common equity value of a firm, HOLT
subtracts the amounts owed to outside owners such as
minority interest owners.
Monetary Holding
Gain/Loss
Net working capital is multiplied by the change in
inflation (CPI) for the year and added to cash flows.
The effect of inflation (loss or gain in purchasing power)
from holding monetary assets is removed.
Non Goodwill Intangibles
Include certain non goodwill intangibles in HOLT’s
total gross investment (examples: FCC licenses,
franchise rights, product rights, and patents).
Intangibles assets deemed critical to operating a business
and deriving cash flows are included in HOLTs gross
investment.
Pensions
Add back pension interest costs and smoothing
adjustments to cash flows. Subtract the value of net
underfunded pensions from valuation.
Accounting for pensions has varied across time and
countries. HOLTs adjustment has consistently held
companies accountable for the underfunded status of
pension plans as debt and only include the operating
costs of pensions in cash flows (removing pension
smoothing adjustments).
Preferred Stock
When the market value of preferred stock is
unavailable, HOLT uses the dividend yield to estimate
the FMV.
To determine the common equity value of a firm, HOLT
subtracts the amounts owed to all outside owners such as
preferred debt.
Special Items
HOLT reviews financial statements for unusual gains
and losses (asset impairments, restructuring charges,
gain/loss on sale of assets, FX charges, derivatives,
taxes, etc) and reverses the effect from cash flows.
HOLT’s treatment of special items ensures the CFROI
can be used as a long term benchmark to assess
corporate performance and provide a starting point to
forecast future returns to determine valuation.
Stock Options
Stock option expense is added back to cash flows
and the value of in-the-money exercisable stock
options (dilution) is included in HOLT debt.
Reported stock option expense is a volatile non cash
estimate of the cost of stock options. HOLT reverses this
charge from cash flows. The CFROI with stock options
expensed can be viewed to estimate the impact on
operating returns. The cost of in-the-money exercisable
stock options is a good estimate of dilution and is included
in HOLT debt.
Taxes HOLT uses the effective tax rate and removes long
term deferred tax liabilities from debt.
Over time the effective and cash tax rate of a firm are
equal to one another. HOLT has found that the effective
tax rate removes unwanted volatility and is a better
indicator of taxes owed on current profits. Long term
deferred tax liabilities are rarely paid down and are
included by exception, not default.
Industry Specific fixes
E&P: Remove differences between full capitalization
and successful efforts drilling costs; Regulated
Utilities: Long term CFROI and Growth rates fade to
lower levels. Insurance, REIT, Financial Models.
Move Forest Land and Landfill assets to non
depreciating assets (similar as land or inventory).
Country Specific Issues
Taiwan: Expensing of Bonus Shares; reversals of tax
credits. Thailand: Deferred taxation; revaluations.
India: Deferred taxation; consolidations; Japan
accelerated depreciation. Brazil: Dual Share class.
Chile, Mexico: hyper inflationary accounting. Korea:
Parent vs Consolidated.
HOLT’s CFROI valuation framework provides investors
with a benchmark of corporate performance across time,
industries and countries that is free of accounting
distortions. Users of the framework have the best
information possible to measure historical operating
returns, gauge the plausibility of future operating returns
and calculate a firm’s valuation.
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Exhibit 3 Impact of HOLT Adjustments on Balance Sheets and Cash Flows
Source: Credit Suisse HOLT online (http://www.credit-suisse.com/HOLTonline).
EBITDA HOLT
Adjustments
HOLT’s Adjusted
Gross Cash Flow
World Index – Reported EBITDA vs HOLT’s Gross Cash Flows (LFY)
R&D, Leases, Pensions,
Inflation, Special Items,
Stock Options
?? HOLT’s A
Flow gre
global ba
?? EBITDA
-8%.
?? HOLT’s
Flow gre
global b
?? EBITDA
-8%.
$-
$1,000,000
$2,000,000
$3,000,000
$4,000,000
$5,000,000
$6,000,000
0
millions
Total Book
Assets
HOLT
Adjustments
HOLT’s Inflation
Adjusted Gross
Investment
World Index – Reported Assets vs HOLT Gross Investment (LFY)
Capitalized R&D
Capitalized Operating
Leases
Pensions
Inflation
Gross Plant
$-
$9,000,000
$18,000,000
$27,000,000
$36,000,000
$45,000,000
$54,000,000
$63,000,000
0
millions
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Exhibit 4 Accounting for R&D Around the World
Country Europe
(post IFRS)
USA UK
(Pre IFRS)
France
(Pre IFRS)
Italy
(Pre IFRS)
Hong Kong
Accounting
Standards
IFRS FASB
Financial
Accounting
ASB
Accounting
Standard
Board
CNC Conseil
National de la
Comptabilité
CNDC
Consiglio
Nazionale
dei Dottori
Hong Kong
Institute of
certified Public
R&D Expensed.
Development
expense can
be
capitalized.
Expensed.
Very limited
development
can be
capitalized.
Expensed.
Developmen
t can be
capitalized.
Expensed. Expensed. Expensed.
Development
may be
capitalized
under certain
circumstances
(HKAS 38).
Source: HOLT internal documents.
Under IFRS, research expenditures are expensed in the period in which they arise, but
development expenditure must be capitalized when certain criteria included in the standard are met.
IAS 38 Development Capitalization Criteria
An intangible asset arising from development (or from the development phase of an internal project) shall be
recognized if and only if, an entity can demonstrate all of the following:
(a) The technical feasibility of completing the intangible asset so that it will be available for use or
sale.
(b) Its intention to complete the intangible asset and use or sell it.
(c) Its ability to use or sell the intangible asset.
(d) How the intangible asset will generate probable future economic benefits. Among other things, the entity
can
demonstrate the existence of a market for the output of the intangible asset or the intangible asset itself
or, if it is
to be used internally, the usefulness of the intangible asset.
(e) The availability of adequate technical, financial and other resources to complete the development and to
use
or sell the intangible asset.
Source: IFRS IAS 38.
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Exhibit 5 HOLT’s Approach: R&D Adjustments
?? Both research expenses and development expenditures are capitalized.
?? Capitalized R&D amortized over fixed lives by industry: Pharmaceuticals: 11 years; Chemicals: 7
years; Computer Hardware: 6 years; Electronic Equipment: 5 years; Software: 4 years
?? HOLT’s capitalized R&D equals the sum of all R&D expenditures over an assigned life (inflationadjusted
to current dollars).
– The assumption is that cash to fund research and development represents an investment
intended to generate cash flows in future years. By investing in R&D, a company is
building an intangible asset off the balance sheet.
– The approach provides a consistent method to capitalize R&D expenditures for all
companies across the globe. Without capitalization, it is very difficult to compare firms
across industries and regions.
Source: HOLT internal documents. Useful life based on Lev, B., and T. Sougiannis, 1996, The capitalization,
amortization and
value-relevance of R&D, Journal of Accounting and Economics 21, 107-138.
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Exhibit 6 Aggregate Impact of the HOLT R&D Adjustment
In 2009, HOLT added approximately $303 million of R&D expense back to its reported
income statement. Also, $2 trillion was added to reported book assets as a result of the
recapitalization.
Source: HOLT ValueSearch®: Firm sample includes firms in USA and Europe with greater than $1billion in
market
capitalization. Includes all firms from Pharmaceutical, Health Care, Technology, Capital Goods, Autos, Media
and
Consumer Goods industry. Capitalized R&D is a HOLT-specific calculation.
Company Ticker Industry Country Market Cap
Reported
R&D
Expense
R&D % of
Sales
HOLT
Capitalized
R&D
PFIZER INC PFE Pharmaceuticals, Biotechnology & Life USA $135,280 $7,822 11% $124,040
SANOFI-AVENTIS SASY Pharmaceuticals, Biotechnology & Life FRA $89,580 $6,555 16% $75,548
MERCK & CO MRK Pharmaceuticals, Biotechnology & Life USA $108,740 $5,613 12% $74,642
JOHNSON & JOHNSON JNJ Pharmaceuticals, Biotechnology & Life USA $175,390 $6,986 11% $69,391
ROCHE HOLDING ROG Pharmaceuticals, Biotechnology & Life CHE $126,520 $9,123 19% $66,376
GLAXOSMITHKLINE PLC GSK Pharmaceuticals, Biotechnology & Life GBR $101,510 $5,839 13% $58,788
NOVARTIS AG NOVN Pharmaceuticals, Biotechnology & Life CHE $129,090 $7,287 16% $56,462
BAYER AG BAYGn Pharmaceuticals, Biotechnology & Life DEU $65,390 $3,940 9% $52,236
ASTRAZENECA PLC AZN Pharmaceuticals, Biotechnology & Life GBR $70,940 $4,241 13% $46,288
NOKIA CORPORATION NOK1V Technology Hardware & Equipment FIN $37,550 $7,130 12% $38,912
LILLY (ELI) & CO LLY Pharmaceuticals, Biotechnology & Life USA $38,240 $4,417 20% $37,071
FORD MOTOR CO F Automobiles & Components USA $55,980 $4,900 5% $36,501
BRISTOL-MYERS SQUIBB BMY Pharmaceuticals, Biotechnology & Life USA $44,400 $3,677 18% $35,877
ABBOTT LABORATORIES ABT Pharmaceuticals, Biotechnology & Life USA $73,270 $2,914 9% $33,352
EADS NV EAD Capital Goods NLD $19,220 $4,053 7% $30,681
MICROSOFT CORP MSFT Software & Services USA $221,220 $7,874 13% $30,540
SIEMENS AG SIEGn Capital Goods DEU $106,960 $5,595 5% $26,793
AMGEN INC AMGN Pharmaceuticals, Biotechnology & Life USA $52,360 $2,858 20% $26,733
BOEING CO BA Capital Goods USA $46,640 $6,506 10% $26,200
PORSCHE AUTOMOBIL PSHG_p Automobiles & Components DEU $11,970 $2,575 2% $24,764
VOLKSWAGEN AG VOWG Automobiles & Components DEU $68,780 $5,514 4% $24,302
INTL BUSINESS MACHINES CIBM Software & Services USA $180,200 $5,476 6% $23,839
CISCO SYSTEMS INC CSCO Technology Hardware & Equipment USA $110,890 $4,823 12% $23,667
DAIMLER AG DAI Automobiles & Components DEU $73,710 $4,155 4% $22,982
INTEL CORP INTC Semiconductors & Semiconductor Equip USA $117,850 $5,338 15% $22,163
$303,282 5% $2,021,89USA and EUR Aggregate and Medians 3
Purchased by Aaron Lau ([email protected]) on November 29, 2012
111-114 Bridging the GAAPs
14
Exhibit 7 R&D Exposure by Country and Industry
Source: Credit Suisse HOLT online (http://www.credit-suisse.com/HOLTonline).
R&D Expense % of Sales
0%
1%
2%
3%
4%
5%
6%
7%
USA DEU FRA GBR Rest of
EUROPE
ITA
R&D Expense % of Sales
0%
2%
4%
6%
8%
10%
12%
Semiconductors &
Semiconductor
Equipment
Pharmaceuticals,
Biotechnology &
Life Sciences
Software &
Services
Technology
Hardware &
Equipment
Health Care
Equipment &
Services
Automobiles &
Components
Capital Goods
Telecommunication
Services
Purchased by Aaron Lau ([email protected]) on November 29, 2012
Bridging the GAAPs 111-114
15
Exhibit 8 Financial Impact of IFRS on Fiat’s R&D Expenses
Development costs
Under Italian GAAP, applied R&D costs could alternatively be capitalized or charged to
operations when incurred. Fiat Group had mainly expensed R&D costs when they were incurred. IAS
38: Intangible Assets required that research costs be expensed, whereas development costs that met
the criteria for capitalization must be capitalized and then amortized from the start of production
over the economic life of the related products.
Under IFRS, the group had capitalized development costs in the Fiat Auto, Ferrari-Maserati,
Agricultural and Construction Equipment, Commercial Vehicle, and Components sectors, using the
retrospective approach in compliance with IFRS 1.
The positive impact of €1.876 billion on the opening IFRS stockholders’ equity on January 1, 2004
corresponded to the cumulative amount of qualifying development expenditures incurred in prior
years by the group, or the net of accumulated amortization. Consistently, intangible assets showed an
increase of €2.09 billion and €2.499 billion on January 1, 2004 and December 31, 2004, respectively.
The 2004 net result was positively impacted by €436 million in the year, reflecting the combined effect
of the capitalization of development costs incurred in the period that had been expensed under
Italian GAAP, and the amortization of the amount that had been capitalized in the opening IFRS
balance sheet on January 1, 2004. R&D costs accounted for this positive impact.
Purchased by Aaron Lau ([email protected]) on November 29, 2012
111-114 Bridging the GAAPs
16
Exhibit 8 (continued)
Source: Fiat Group 2005 Annual Report. Reconciliation to IFRS.
Capitalized D
Purchased by Aaron Lau ([email protected]) on November 29, 2012
Bridging the GAAPs 111-114
17
Exhibit 9 Financial Impact of IFRS on Sanofi’s R&D Expenses
2004 IFRS adjusted income statement, adjustments for R&D
Under IAS 38, research expenditures must be expensed as incurred, and capitalization of
development cost is mandatory when six criteria defined in the standard have been met and
demonstrated.
• In-house R&D
o The six criteria are not met until an application for marketing approval has been filed.
?? In-house development costs can be only be capitalized in two cases: if
development has incurred certain chemical development costs, and if
material.
• Acquired R&D
o The six criteria are always considered to be satisfied and payments must be
capitalized in the following cases:
?? R&D is capitalized in the period in which payment is made ( + €13 million in
2004).
?? R&D is amortized from the date on which marketing approval is obtained (+
€4 million in 2004).
?? Require and an annual impairment test until marketing approval is obtained.
2004 IFRS adjusted pro forma income statements
in millions of euros 2004 French GAAP 2004 IFRS
Sales and other revenues 25,418 26,308
Cost of sales -6,042 -6,918
GROSS PROFIT 19,376 19,390
Research and development -3,961 -3,964
Selling and general expenses -7,678 -7,888
Other current operating income 524 314
Other current operating expenses -98 -98
Amortization of intangibles – -114
OPERATING INCOME – CURRENT 8,163 7,640
Restructuring -140
Other operating income and expenses 181
OPERATING INCOME 8,163 7,681
Intangibles (amortization and impairment) -110
Financial expenses/income -599 -639
INCOME BEFORE TAX, SHARE OF PROFIT/LOSS FROM
ASSOCIATES AND DISCONTINUED OPERATIONS
7,454 6,942
Exceptional income and expenses 29
Income tax expenses -2,355 -2,146
Income tax rate 31.6% 30.9%
Share of profit/loss of associates 176 534
Goodwill amortization -9
NET INCOME BEFORE MINORITY INTEREST 5,295 5,330
Minority interest -48 -305
NET INCOME 5,247 5,025
Number of shares 1,347,480,482 1,333,367,525
EARNINGS PER SHARE 3.89 3.77
Source: Sanofi-Aventis Transition to IFRS Conference Call. April 14, 2005. Jean-Claude Leroy, CFO.
Purchased by Aaron Lau ([email protected]) on November 29, 2012
111-114 Bridging the GAAPs
18
Exhibit 10 R&D Trends for FIAT and Sanofi
Source: Credit Suisse HOLT online (http://www.credit-suisse.com/HOLTonline).
Fiat
Accounting Standards Followed Local Local Local Local Local IFRS IFRS IFRS IFRS IFRS IFRS
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2008
R&D Expense (as reported) € 1,406 € 1,725 € 1,817 € 1,748 € 1,724 € 1,350 € 1,364 € 785 € 809 € 753 € 646
Sales € 48,404 € 57,603 € 57,575 € 55,427 € 48,346 € 45,637 € 46,544 € 51,832 € 58,529 € 59,380 € 50,102
R&D % of Sales 3% 3% 3% 3% 4% 3% 3% 2% 1% 1% 1%
Capitalized R&D (as reported under IFRS) € 2,239 € 2,603 € 2,776 € 2,962 € 3,329 € 3,593
Purchased by Aaron Lau ([email protected]) on November 29, 2012
Bridging the GAAPs 111-114
19
Exhibit 11 Financial Impact of Different Approaches
Under local GAAP
(FYE 2004, EUR millions)
Fiat
(Italian GAAP)
Sanofi-Aventis
(French GAAP)
Operating income before R&D 2,451 12,124
Less R&D expenses (1,810) (3,961)
Operating income 641 8,163
HOLT adjusted operating income 2,451 12,124
Shares outstanding 979 1,343
Share price 15 82
P/E ratio 22.1 13.5
HOLT adjusted PE 6.0 9.1
Under IFRS
(FYE 2004, EUR millions)
Fiat
(IFRS)
Sanofi-Aventis
(IFRS)
Operating income before R&D 2,451 12,124
Less R&D expenses (1,350) (3,964)
Operating income 1,101 8,160
HOLT adjusted operating income 2,451 12,124
Shares outstanding 979 1,343
Share price 15 82
P/E ratio 13.3 13.5
HOLT adjusted PE 6.0 9.1
Source: Financial statement filings of Sanofi-Aventis and Fiat and author’s calculations.
Purchased by Aaron Lau ([email protected]) on November 29, 2012
111-114 Bridging the GAAPs
20
Exhibit 12 Impact of Different Approaches on Asset Turnover
Under local GAAP Fiat Sanofi-Aventis
(FYE 2004, EUR millions) (Italian GAAP) (French GAAP)
Sales 45,637 25,418
Research and development expenditures 9,816 47,560
Reported capitalized R&D 0 0
HOLT capitalized R&D 9,816 47,560
Sales/capitalized R&D – –
Sales/HOLT capitalized R&D 4.65 0.53
Under IFRS Fiat Sanofi-Aventis
(FYE 2004, EUR millions) (IFRS) (IFRS)
Sales 45,637 25,418
Research and development expenditures 9,816 47,560
Reported capitalized R&D 2,239 52
HOLT capitalized R&D 9,816 47,560
Sales/capitalized R&D 20.38 488.81
Sales/HOLT capitalized R&D 4.65 0.53
Source: Financial statement filings of Sanofi-Aventis and Fiat and author’s calculations.
Purchased by Aaron Lau ([email protected]) on November 29, 2012
Bridging the GAAPs 111-114
21
Exhibit 13 HOLT Relative Wealth Chart for Sanofi-Aventis and Fiat
HOLT’s relative wealth charts provide a quick snapshot of a firm’s CFROI level, asset growth, and
shareholder returns. Fundamental investors use the relative wealth chart to quickly track historical
returns with the CFROI measure and scan across companies on a global basis to rank companies for
buy or sell consideration.
There are multiple levels to consider to evaluate the fundamental value of an equity.
The top panel illustrates the return history of each company, namely the CFROI and its cost of
capital. The green dot represents the market expectations for CFROIs over the next five years implied
from the current stock price (€50.30/share). HOLT constructs its own warranted price of €94.32 based
on a scenario of flat CFROI levels and 3% growth per year.7 This implies that the current price of
Sanofi is traded at a large discount (88%) relative to its fundamentals.
The middle panel shows the long-term growth potential of each company reflected in the
reinvestment behavior of its assets. The purple bars show the comparable reinvestment rates relative
to the way it could grow given its level of cash flows.
The bottom panel represents the company’s total shareholder returns relative to the S&P 500 index
returns. The two panels show that Sanofi has generated substantial shareholder returns by growing
at a rate above operating returns and reinvestment over the past five years.
Source: Credit Suisse HOLT online (http://www.credit-suisse.com/HOLTonline).
7 The average CFROI level is 6% and average growth rate is 2.5% for all companies on a global basis.

 

 

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