The choice of accounting methods & its influence

1. The choice of accounting methods & its influence By jenniferkellner

2. R&D effects:U.S. GAAP vs. capitalization • Under U.S. GAAP, expense all R&D in the year in which the firm invests • Otherwise, capitalize R&D expenses, include as assets • Amortize over time • Total expense is equal • The timing is the difference* • Presents the opportunity for earnings management

3. A comparison:Expensed R&D • Revenue is $1.60 for each dollar invested in R&D (continues for 5 subsequent years) • R&D expense equals that which is invested • No amortization, never capitalized • Other expenses are 80% of sales (revenue) • Yields Enterprise Income • Return, last year’s NEA x 10% cost of capital (given) • EPAT – Required Return = REI • NEA remains constant • RNEA = EPAT/NEA

4. A comparison:capitalized R&D • Beg NEA = last year’s Ending NEA • Same relationship between revenue and expenditures (1.6, 5 years) • Amortization expense; over five years & accumulate over times • After 5 years, fully amortized! • REI, RNEA

5. A comparison:RNEA & REI REI is higher in earlier years when capitalizing R&D, reverses later on Expense all now, or spread over time (in the form of amortization) RNEA is also greater in earlier years under capitalization, reversing by 2017 No expense recognized anymore At first, greater income outweighs greater number of assets (under capitalization) Eventually reverses

6. RNEA: 2020 forecasts • Assumption: R&D expenditures go to zero post 2019 • Follow same process • One primary driver  zero R&D expense under GAAP • Why are they different? • REI is much higher b/c EPAT, no expense recognized (alternatively, amortization when capitalized) • Accumulated assets make the required return greater under capitalization, also reducing EPAT • Lower EPAT and higher NEA will cause capitalization to be lower

7. valuation • Valuing both firms should not differ; the same expense is being recognized over the life of the firm • The timing is what causes EPAT, NEA, REI, etc. to be different in different years • The overall amortization expense will equal the total amount expensed immediately under U.S. GAAP • Valuing using data up to 2016 would yield two different values using both methods • Steady-state not reached yet

8. Reduction in R&D expenditures • The firm cuts R&D expenditures by $20 million in 2016, continuing until 2020 (0 expenditures) • Although sales are increasing, RNEA is higher • Why? • The large reduction in R&D expenses outweighs this smaller increase in sales • A one dollar rise in R&D expenditures yields 1.6*(1-.80) or 0.32 cents • One dollar R&D expenditure reduction will increase enterprise income by an entire dollar • Therefore,the reduction carries more weight and RNEA is now higher

9. Depreciation methods:an example • IPO in 2018 • Depreciation: 5 year or 3 year life? • Sales are given • Operational expenses = 70% of sales • Investments • 600 in 2013 • Increases by 100M each year for four years • 1,000 thereafter

10. EPAT & NEA:Forecasts & profitability • NEA is beginning year NEA (or investment) plus current year investment less depreciation • Total depreciation expense accumulates • However, fully depreciated after 3 (5) years • EPAT is higher in 2017 using a 5-year asset life • Depreciation is being "spread" over a greater number of years • Less recognized each period

11. The firm:intrinsic value • Used the FCF model • Discount FCF each period • Total depreciation recognized is the same • Therefore, intrinsic value does not differ • EPAT, NEA, etc. differ

12. consider • Despite having the same value using both methods, founders insist the market will give a higher value if earnings are higher at the time of the IPO: • Higher earnings at the time of the IPOmerely means earnings will be less in other years • Ultimately there is no effect on the final valuation and any higher appearance in earnings now will be offset later on. • Furthermore, it questions the authenticity of the accounting numbers and the ethics of the situation; • Are we trying to portray an accurate image of the firm's financial position, or choose an accounting method that makes it appealing to investors?

13. consider • With stock options vesting in 2022, the CFO wants to focus on profits expected in that year. Which depreciation method should be used? • Since the stock options will vest in 2022, there will no longer be expenses related to these options • This yields higher profits post 2021 • If the CFO wants to focus on profits in 2022, then using a 3-year asset life will depreciate the assets quicker (or in earlier years) allowing profits to be higher in 2022 when it becomes the focus • *However, one should choose the asset life they believe to be the true value, despite how profits may appear

14. Questions?