The introduction of International Financial Regulatory Standards (IFRS) in January is the big bang for accountancy. Public companies in the European Union will switch to new international rules that enable more precise cross-border comparison.
But the rules will affect different industries in different ways. In the case of drugs and technology companies, the expensing of share options issued to staff and the capitalization of development are likely to be the biggest changes. The problem is that while the new rules on options are welcome and bring clarity to a murky area, the rules on development could make a muddle of an area that is currently relatively clear.
Option expensing will certainly affect the financial statements of tech and pharma companies – both of which have been heavy users of options. If IFRS had been in force last year for example, German enterprise resource software company SAP’s earnings would have been reduced by 11% and mobile phone maker Nokia’s by 7%.
Drugs companies would have been less hard hit as they have issued fewer options than tech companies. But the average hit to their earnings would still have been of the order of 5%.
There is no question that granting options is a real cost to shareholders. Expensing these grants is a welcome step towards more transparent company accounts. But as this information is readily available – most of the big European companies have US stock listings and therefore disclose the effects of options expensing in submissions to the SEC – it is probably well discounted. And the effects are likely to shrink in the future. After all, just the threat of options expensing has reduced options grants in several US technology companies such as Microsoft.
A greater and more unpredictable change comes from new rules for research and development. Unfortunately, leaving everything the way it was would have been better. The treatment of R&D is something of a bête noire for both tech and pharma companies. Many gripe about the current system, under which it is treated as a cost and expensed. Surely it would be better, one argument goes, to treat R&D like any other investment and capitalize it. The problem, of course, is that it is difficult to separate useful R&D from wasteful R&D.
The new standards have stepped into this minefield in an attempt to find a workable compromise. The result, unfortunately, might simply bring confusion.
Under the new rules, research is still regarded as a cost. But development must be capitalized when, in the company’s judgement, it reaches a point where it is likely to generate economic value. The value is then amortized over the life of the asset.
There are two problems with this. It is rather arbitrary to say that research is a cost whereas development is an investment. And allowing companies to choose when to capitalize development is problematic because the point at which a project becomes marketable is hard to determine precisely.
Consider the impact on the software and drugs industries. It can take years of investment before the final version of a software program is produced. But only investment made after the company recognizes that the program is a viable asset can be capitalized. And this is likely to be only a fraction of the total development costs.
The question is even more complicated for the drugs industry. It takes well over a decade to develop a new drug, and the vast majority of candidates never make it to market. The successful candidates obviously have value, but how much and when it can be recognized is hard to pin down. And as a portfolio approach is not allowed, coming up with a correct estimate is even harder.
Companies might be willing to live with the complexity. After all, the capitalization of development costs should enable them to increase their earnings. But will the change really help investors? The market already seems to make an allowance for R&D. The biotech sector as a whole trades at about 35 times next year’s earnings – more than twice as high as the much more profitable big pharma universe.
More complications
The new rule will actually require them investors to do a lot more work, picking out the costs companies had capitalized on dud projects. It’s not clear they will be any better off. Possibly the reverse. So the biggest, and most reputable, companies are avoiding the issue altogether. Swiss-based Roche and Novartis, already apply IFRS. They take the easy way out and do not capitalize any development expenses on drugs they develop. But things aren’t as easy as they seem. The new rules mandate companies to capitalize the estimated value of projects or compounds acquired from other companies. This leads to a curious discrepancy: drugs developed in house probably won’t be capitalized, while drugs in-licensed from other companies will be. This will make balance sheets much harder to decipher.
The adjustments required could be significant. Bristol-Myers, for instance, spent $2 billion acquiring the rights to cancer drug Erbitux. And more and more companies are seeking to buy drugs from biotech companies to bolster their pipelines.
Of course, it won’t matter if companies disclose all the information that is needed to adjust earnings back to the pre-IFRS system. But it adds to the complexity. And not all of them might do this.
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