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Financial Management: VOLVO Group R&D Analysis

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Using excerpts from Volvo Group's 2009 Financial Statements our analysis focused on assessing costs incurred by the company and the differing treatments available under US GAAP and IFRS. The paper …

Using excerpts from Volvo Group's 2009 Financial Statements our analysis focused on assessing costs incurred by the company and the differing treatments available under US GAAP and IFRS. The paper also includes a comparison between Volvo Group and Navistar from the perspective of a financial analyst.

Contents:
Section 1 - Concepts
Section 2 - Process
Section 3 - Analysis

Published in: Business

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  • 1.  Volvo  Group  –  Research  &  Development  Costs  Case  EMBA  ’13:  203a  Financial  Accounting  for  Management  Presented  by  Team  3Z:  Alexandra  Brooks,  Steve  Chaky,  Ruben  Pedroza,  and  Sharon  Singleton                                     1  
  • 2. Section  1:  Concepts    a.  The  2009  financial  statements  shows  research  and  development  (R&D)  expenses  of  SEK  13,193  (millions  of  Swedish  Krona).  What  types  of  costs  are  likely  included  in  these  amounts?    The  costs  included  in  the  Research  and  Development  expense  line  represent  expenditures  where  the  enterprise  cannot  distinguish  the  research  phase  from  the  development  phase  of  an  internal  project  to  create  an  intangible  asset.      The  expense  line  would  also  include  any  costs  identified  as  those  incurred  during  the  research  phase  in  addition  to  costs  identified  in  the  development  phase,  that  do  not  meet  specific  IAS  38  criteria  to  be  capitalized.      Per  Volvo’s  notes  to  the  consolidated  financial  statements,  examples  of  expenditures  that  would  be  reported  as  an  intangible  asset  include  new  products,  production  systems  and  software.    Per  IAS  38,  examples  of  research  activities  are  activities  aimed  at  obtaining  new  knowledge,  the  search  for,  evaluation  and  final  selection  of,  applications  of  research  findings  or  other  knowledge,  the  search  for  alternatives  for  materials,  devices,  products,  processes,  systems  or  services,  and  the  formulation,  design,  evaluation  and  final  selection  of  possible  alternatives  for  new  or  improved  materials,  devices,  products,  processes,  systems,  or  services.      Per  IAS  38,  some  examples  of  development  activities  are  design,  construction,  testing  of  prototypes  and  models,  a  chosen  alternative  for  new  or  improved  materials,  devices,  products,  processes,  systems  or  services,  or  the  operation  of  a  pilot  plant  that  is  not  of  a  scale  economically  feasible  for  commercially  production.    An  example  of  this  is  that  Volvo  incurs  R&D  costs  related  to  reducing  the  environmental  impact  of  its  products  and  also  on  meeting  future  emissions  and  other  global  regulations  for  its  products.      b)  Volvo  Group  follows  IAS  38-­‐Intangible  Assets,  to  account  for  its  R&D  expenditures.  As  such,  the  company  capitalizes  certain  R&D  costs  and  expenses  others.    What  factors  does  Volvo  Group  consider  as  it  decide  which  R&D  costs  to  capitalize  and  which  to  expense?  Volvo  Group  must  consider  the  following  factors  to  determine  which  costs  to  capitalize  and  which  to  expense:   ○ If  the  expenditure  is  part  of  the  research  phase  of  an  internal  project,  the  expenditure  is  expensed.   ○ If  the  expenditures  for  the  development  of  new  products,  systems,  or  processes  have  a  high  degree  of   certainty  that  they  will  result  in  future  financial  benefits  for  the  company  they  can  be  considered  for   capitalization,  provided  they  meet  other  criteria  listed  IAS  38  under  the  development  phase  item  45  a-­‐f.   ○ If  the  company  is  unable  to  demonstrate  future  economic  benefit  then  the  expenditure  is  expensed.   ○ The  ability  to  determine  the  cost  of  the  asset  reliably,  such  as  distinguishing  it  from  the  cost  of  running  day-­‐to-­‐ day  operations  or  from  the  cost  of  maintenance  and  enhancements  of  the  of  the  enterprise’s  internally   generated  goodwill.   ○ The  ability  to  distinguish  between  the  research  and  development  phase  of  an  internal  project  to  create  an   intangible  asset;  if  unable  to  distinguish,  then  expenditure  is  treated  as  an  expense.   2  
  • 3.  c)  The  R&D  costs  that  Volvo  Group  capitalizes  each  period  (labeled  Product  and  software  development  costs)  are  amortized  in  subsequent  periods,  similar  to  other  capital  assets  such  as  property  and  equipment.  Notes  to  Volvo’s  financial  statements  disclose  that  capitalized  products  and  software  development  costs  are  amortized  over  3  –  8  years.  What  factors  would  the  company  consider  in  determining  the  amortization  period  for  particular  costs?  The  company  would  consider  the  following  factors  in  determining  the  amortization  periods  for  particular  costs:   ○ Determine  the  useful  life  based  on  the  periods  in  which  they  expect  to  receive  future  economic  benefit  from   the  asset  with  consideration  of  technological  obsolescence.       ○ Industry  accepted  periods  for  similar  types  of  intangibles.  d)  Under  U.S.  GAAP,  companies  must  expense  all  R&D  costs,  in  your  opinion,  which  accounting  principle  (IFRS  or  U.S.  GAAP)  provides  financial  statements  that  better  reflect  the  costs  and  benefits  of  periodic  R&D  spending?  As  US  GAAP  assumes  no  benefits  from  R&D,  offering  a  highly  conservative  treatment,  and  ignoring  the  long  run  benefits  of  R&D  spend,  it  be  could  be  argued  that  IFRS  better  reflects  the  benefits  and  costs  of  periodic  R&D  spend.  However,  users  of  IFRS  information  need  to  take  into  account  that  the  intangible  asset  guidelines  (IAS  38)  can  be  extremely  subjective  when  determining  what  part  of  R&D  can  be  considered  development.    Second,  considerable  judgment  is  required  when  determining  the  period  over  which  future  economic  benefit  is  provided  by  the  development.  Third,  it  would  be  arbitrary  to  determine  the  asset  pattern  of  use  since  the  manner  in  which  the  future  benefits  will  be  realized  is  uncertain.      Therefore,  it  is  our  belief  that  GAAP,  with  its  definitive  guidelines  for  R&D  requiring  all  cost  to  be  expensed,  and  a  realistic  outlook  that  the  majority  of  R&D  activities  will  not  offer  future  benefit,  better  reflects  capturing  costs  as  they  are  incurred,  eliminating  some  of  the  arbitrary  and  inconsistent  methods  of  IFRS,  and  providing  a  more  accurate  financial  picture.    Section  2:  Process    e)  Refer  to  footnote  14  where  Volvo  reports  an  intangible  asset  for  “Product  and  software  development.”  Assume  that  the  product  and  software  development  costs  reported  in  footnote  14  are  the  only  R&D  costs  that  Volvo  capitalizes.   I. What  is  the  amount  of  the  capitalized  product  and  software  development  costs,  net  of  accumulated   amortization  at  the  end  of  fiscal  2009?  What  line  item  on  Volvo  Group’s  balance  sheet  reports  this   intangible  asset.    Total  Product  &  Software  Devel  Costs  [$25,148]  -­‐  Total  Accumulated  depreciation  &  amortization  [$13,739]  =  $11,409  The  line  item  under  which  this  intangible  asset  is  reported  on  the  b/s  is:  Assets  >  Intangible  Assets   3  
  • 4. II. Create  a  T-­‐account  for  the  intangible  asset  “Product  and  software  development,”  net  of  accumulated   amortization.  Enter  the  opening  and  closing  balances  for  fiscal  2009.  Show  entries  in  the  T-­‐account  that   record  the  2009  capitalization  (capital  expenditures)  and  amortization.    To  simplify  the  analysis,  group   all  other  account  activity  during  the  year  and  report  the  net  impact  as  one  entry  in  the  T-­‐account.       • T-­‐account:  Please  refer  to  Excel  spreadsheet  at  Appendix  A.   • Modified  Easton  account:  Please  refer  to  Excel  spreadsheet  at  Appendix  A.  f)  Refer  to  Volvo’s  balance  sheet,  footnotes,  and  the  eleven-­‐year  summary.    Assume  that  the  product  and  software  development  costs  reported  in  footnote  14  are  the  only  R&D  costs  that  Volvo  capitalizes.   I. Complete  the  table  below  for  Volvo’s  Product  and  software  development  intangible  asset:     2007   2008   2009  1)  Product  software  development  costs  capitalized  during  year   2,057   2,150   1,858  2)  Total  R&D  expense  on  I/S         11,059   14,348   13,193  3)  Amortization  of  previous  capitalized  costs  (included  in  R&D   2,357   2,864   3,126  expense)  4)  Total  R&D  costs  incurred  during  the  year  =  (1+2-­‐3)         10,759   13,634   11,925     II. Provide  the  journal  entry  that  Volvo  prepares  to  record:  1)  total  2009  R&D  costs  incurred  during  the   year  end  2)  the  amortization  of  previously  capitalized  product  &  software  development  costs.  Consider   your  answer  to  part  a,  above  to  determine  which  accounts  are  affected     • Journal  entries  Volvo  used  to  prepare  the  record:  Refer  to  Excel  spreadsheet  at  Appendix  A.   III. What  proportion  of  Total  R&D  costs  incurred  did  Volvo  Group  capitalize  (as  product  and  software   development  intangible  asset)  in  each  of  the  three  years?         2007   2008   2009  Proportion  of  Total  R&D  costs  incurred  capitalized  by   2,057/10,759   2,150/13,634   1,858/11,925  Volvo  Group  (as  product  and  software  development   =0.194   =  0.158   =  .156  intangible  asset.)   19.4%   15.8%   15.6%        Section  3:  Analysis    g)  Assume  you  work  as  a  financial  analyst  for  Volvo  Group  and  would  like  to  compare  Volvo’s  R&D  expenditures  to  a  U.S.  competitor,  Navistar  International  Corporation.  Navistar  follows  U.S.  GAAP  that  requires  that  all  R&D  costs  be  expensed  in  the  year  they  are  incurred.    You  gather  the  following  information  for  Navistar  for  fiscal  year  end  October  31,  2007  through  2009.   I. Use  the  information  from  Volvo’s  eleven  year  summary  to  complete  the  following  table:  (in  SEK  million)   2007   2008   2009  Net  Sales,  industrial  operations   276,795   294,932   208,487      Total  assets,  from  balance  sheet   321,647   372,419   332,265     4  
  • 5. II. Calculate  the  proportion  of  total  research  and  development  costs  incurred  to  net  sales  from  operations   called,  net  sales  from  manufactured  products,  for  Navistar)  for  both  firms.    How  does  the  proportion   compare  between  the  2  companies?    NAVISTAR   2007   2008   2009  A-­‐  Total  R&D  costs   375   384   433      B-­‐  Net  Sales,  industrial  operations   11910   14399   11300  Proportion  of  total  research  and  development  costs  incurred   3.15%   2.67%   3.83%  to  net  sales  from  operations  (called,  net  sales  from      manufactured  products,  for  Navistar)  for  both  firms  A  /  B  *  100  =  %  VOLVO              A-­‐  Total  R&D  costs   10,759   13,634   11,925      B-­‐  Net  Sales,  industrial  operations   276,795   294,932   208,487  Proportion  of  total  research  and  development  costs  incurred   3.9%   4.6%   5.7%  to  net  sales  from  operations  (called,  net  sales  from  manufactured  products,  for  Navistar)  for  both  firms  A  /  B  *  100  =  %  Volvo  appears  to  be  increasing  its  R&D  spend  in  proportion  to  net  sales  over  three  consecutive  years;  at  approximately  1%/year.  Navistar  has  itself  increased  its  spending  similarly  over  time,  but  at  about  0.5%/year.    We  see  that  although  the  two  companies  are  different  sizes  and  their  respective  net  sales  are  very  different,  the  amount  of  capital  spent  on  R&D  is  comparable.      Finally,  we  noted  that  although  there  was  a  drop  in  sales  in  2009,  Navistar  continue  to  increase  spending  (1.1%  year  to  year)  while  Volvo  decreased  spending  on  R&D  (5.7%  year  to  year).    Because  of  the  large  drop  in  sales  in  2009,  30%  for  Volvo  and  3%  for  Navistar,  the  proportion  of  capital  spent  on  R&D  was  higher  for  Volvo.  h)    Assume  you  work  as  a  financial  analyst  for  Navistar.    Your  firm  is  considering  the  f/s  implications  of  adopting  IFRS  including  IAS  38.    As  such,  you  decide  to  prepare  pro  forma  information  for  Navistar  assuming  the  company  had  adopted  IAS  38  at  the  start  of  fiscal  2007.    Refer  to  financial  statement  information  for  Navistar,  in  part  g,  above.  …/…   I. What  would  Navistar  have  reported  as  Operating  Income  before  tax  in  fiscal  2007,  2008,  and  2009   under  IFRS?  Is  the  difference  significant?  N.B.  To  see  the  detailed  calculations  for  h-­‐i  and  -­‐ii  please  refer  to  the  Excel  spreadsheet  presented  at  Appendix  A.  The  Operating  Income  before  tax  under  IFRS,  reported  in  US  $  millions  would  be:  2007=$40,    2008  =  $278  2009=$431.98  Yes,  these  differences  are  significant,  as  they  increased  operating  income  by  the  following  amounts  in  US  $  millions:   5  
  • 6. $113,  $87,  and  $73  for  the  years  2007,  2008,  and  2009  respectively,  which  makes  Navistar  look  significantly  more  profitable.         II. What  amount  for  “Capitalized  product  development  costs,  net”  would  Navistar  have  reported  on  its   b/s  at  the  end  of  each  of  the  3  years  under  IFRS?  Calculate  the  relative  size  of  the  intangible  asset  each   year  compared  to  total  assets.  How  does  this  compare  to  the  relative  size  for  Volvo  Group?  …/…  In   your  opinion,  is  this  a  significant  asset  on  Navistar’s  b/s?  The  amounts  of  “Capitalized  product  development  costs,  net”  Navistar  would  have  reported  under  IFRS  in  US  $  millions  on  its  balance  sheet  at  the  end  of  each  of  the  three  years  are  $113,  $200,  and  $273  for  year  end  2007,  2008,  and  2009  respectively.    The  relative  size  of  the  intangible  asset  each  year  compared  to  total  assets  for  Navistar  is  0.97%,  1.89%,  and  2.65%  for  the  years  2007,  2008,  and  2009  respectively.      The  relative  size  of  the  intangible  each  year  compared  to  total  assets  for  Volvo  is  approximately  3%  per  year.    In  our  opinion,  the  “capitalized  product  development  costs”  are  not  significant  since  they  represent  3%  or  less  of  Navistar’s  total  assets.    Navistar’s  relative  size  of  intangibles  each  year  compared  to  total  assets  seems  to  be  in  line  with  the  industry,  as  compared  to  its  competitor,  Volvo.   III. How  would  cash  be  affected  for  fiscal  2009  had  Navistar  followed  IFRS?    Would  the  cash  flow   statement  be  different?    Assume  that  the  tax  treatment  of  R&D  expenditures  is  not  related  to  the   accounting  treatment.  Cash  is  not  impacted  based  on  the  method  of  IFRS  as  compared  to  GAAP,  since  the  cash  expenditure  occurred  either  way.    Under  GAAP,  the  $130mil  expenditure  for  R&D  is  reflected  on  the  SCF  as  a  reduction  to  cash  flows  from  operating  activities.    Under  IFRS,  the  statement  of  cash  flows  is  impacted,  as  the  Operating  Income  line  for  2009  is  higher  than  GAAP  operating  income  by  $73mil.    The  SCF  is  also  impacted  by  the  amortization  expense  (that  is  added  back  to  operating  income)  that  will  be  increased  under  IFRS  by  the  2009  amount  of  $57mil.    Both  of  these  line  increases  will  cause  an  increase  to  the  Cash  flow  from  Operating  activity  line  on  the  SCF  by  a  total  of  $130mil  ($73+$57mil).    The  statement  of  cash  flows  for  Navistar  in  2009  is  also  impacted  by  an  increase  of  cash  outflow  of  $130mil  in  Other  Long  Term  assets  (which  represents  the  portion  of  cash  outflow  related  to  the  intangible  asset  expenditures  in  2009)  under  IFRS  as  compared  to  GAAP.    This  will  increase  the  Cash  outflow  from  investing  activities  line  on  the  SCF  by  $130mil.    i)    What  line  item  would  the  parent  company  Ford,  whose  accounting  method  is  GAAP,  record  the  Volvo  R&D  expenditures  on  in  the  Ford  consolidated  financials,  and  does  Ford  disclose  any  information  about  how  it  determines  the  Volvo  R&D  amounts  that  should  be  expensed?  We  think  this  question  is  worth  asking,  since  the  treatment  of  R&D  expenditures  differs  significantly  between  IFRS  and  GAAP,  and  because  a  user  of  financial  statement  information  should  have  awareness  about  how  these  differences  may  impact  results  reported  on  consolidated  financials.    We  researched  the  following  sections  in  Ford’s  consolidated  10-­‐k  for  the  year  ending  2009:       ○ Note  2:  Summary  of  Accounting  Policies  -­‐  Selected  Other  Costs:  Research  and  development  was  identified  as   being  reported  as  part  of  the  Automotive  Cost  of  Sales.    There  was  no  reference  to  the  IFRS  accounting   method  used  by  Ford’s  subsidiaries  and  how  this  information  was  added  to  the  consolidated  financials  as   6  
  • 7. Automotive  Cost  of  Sales.       ○ Item  1:  Business-­‐  Engineering,  Research  and  Development:  This  section  provided  more  information  about  the   types  of  R&D  the  company  performs,  such  as  to  improve  the  performance,  safety,  customer  satisfaction  of   products  and  to  development  new  products.    It  indicates  that  the  company  has  large  R&D  centers,  one  of   which  is  where  Volvo  is  located,  but  it  makes  no  mention  of  how  accounting  method  differences  are  handled   by  the  parent  company.   ○ Note  16:  Goodwill  and  other  Net  Intangible  Assets:  We  read  through  this  section  to  determine  if  any   additional  information  might  be  provided  about  the  company’s  treatment  of  its  subsidiaries’  IFRS  accounting   method  to  GAAP.    This  section  only  stated  the  types  of  intangibles  Ford  has,  but  it  did  not  provide  information   about  their  treatment  of  accounting  method  differences.  Based  on  these  findings,  our  conclusion  is  that  the  way  differences  of  accounting  methods  are  handled  are  not  something  that  is  provided  in  a  consolidated  financial  statement,  or  the  differences  of  the  accounting  methods  may  result  in  amounts  that  are  immaterial  to  require  a  specific  footnote  to  the  financials.   ###   7