Conceptually, how does the accounting for R&D work at FCA and at VW?

Before getting into the accounting issues in the case, work to develop an understanding of the business similarities and differences between FCA and VW. How are the two companies’ business models similar, and how are they different?

Compare FCA’s and VW’s accounting for development costs in 2019:

a) Conceptually, how does the accounting for R&D work at FCA and at VW?

b) How much did each company spend on R&D?

c) What proportion of R&D outlays did each capitalize? (Is this ‘c’ or #3)

Why might FCA and VW use different assumptions to capitalize and amortize their development costs? As an investor how would you interpret the differences? Why?

Would you recommend that the FASB change the reporting of development costs in the U.S. to require (or allow) companies to capitalize some share of development costs? Why or why not? Would your views differ if you were an auto executive or an investor?

Below are additional questions (no downside if not included in the assignment submission) that may be discussed in class. Feel free to add responses to these questions in your assignment – there is no downside in not doing so.

5. Given the amortization expense, what was the average life of the beginning gross carrying value of capitalized development costs?

6. Assume that in 2019 FCA changed its assumptions to match those of VW. How much of its R&D outlays would have been expensed immediately? What would have been its amortization expense (based on the beginning gross carrying value of capitalized development costs)? Are these effects significant?

Requirements:

Financial Accounting V.G. Narayanan and Dennis Campbell, Co-Series Editors + INTERACTIVE ILLUSTRATIONS Assets and Expenses DENNIS CAMPBELL HARVARD BUSINESS SCHOOL 5071 | Published: July 24, 2018

5071 | Core Reading: Assets and Expenses 2 1 Introduction …………………………………………………………………………………………………………………………….3 2 Essential Reading ……………………………………………………………………………………………………………………4 2.1 Current Assets ………………………………………………………………………………………………………………….4 2.1.1 Cash and Cash Equivalents ……………………………………………………………………………………..4 2.1.2 Accounts Receivable ……………………………………………………………………………………………….4 2.1.3 Inventory …………………………………………………………………………………………………………………7 2.1.4 Other …………………………………………………………………………………………………………………… 14 2.2 Long-Lived Assets …………………………………………………………………………………………………………. 14 2.2.1 Long-Lived Fixed Assets………………………………………………………………………………………. 14 2.2.2 Deferred Tax Assets (and Liabilities) …………………………………………………………………….. 22 2.2.3 Investments …………………………………………………………………………………………………………. 22 2.2.4 Goodwill and Other Intangible Assets …………………………………………………………………… 24 2.3 Basis for Recording Assets ……………………………………………………………………………………………. 30 2.3.1 Revaluation …………………………………………………………………………………………………………. 30 2.3.2 Impairment…………………………………………………………………………………………………………… 30 2.3.3 Differences Between FASB and IASB on Recording Basis ……………………………………… 31 2.4 Relationship to Income Statement ………………………………………………………………………………….. 32 2.4.1 Expenditures vs. Expenses …………………………………………………………………………………… 32 2.4.2 Accounts Receivable and Revenues ……………………………………………………………………… 32 2.4.3 Inventory and Cost of Goods Sold ………………………………………………………………………… 32 2.4.4 PP&E and Depreciation ………………………………………………………………………………………… 33 2.4.5 Intangibles and Amortization ………………………………………………………………………………… 33 2.4.6 Other Changes in Asset Values …………………………………………………………………………….. 33 3 Key Terms ……………………………………………………………………………………………………………………………. 34 4 Endnotes……………………………………………………………………………………………………………………………… 36 5 Index …………………………………………………………………………………………………………………………………… 38 This reading contains links to online interactive illustrations, denoted by the icon above. To access these exercises, you will need a broadband internet connection. Verify that your browser meets the minimum technical requirements by visiting http://hbsp.harvard.edu/tech- specs. Dennis Campbell, Dwight P. Robinson, Jr. Professor of Business Administration, Harvard Business School, developed this Core Reading with the assistance of writer Sarah Abbott. Copyright © 2018 Harvard Business School Publishing Corporation. All rights reserved. Table of Contents

5071 | Core Reading: Assets and Expenses 3 sheet. 1 It has been obtained at a measurable cost. 2 It is likely to generate a future benefit, contributing to 3 The entity on whose balance sheet it is recorded controls it. 4 The transaction that has given the entity control over the Assets, composed of liabilities and equity, are recorded on a company’s balance Assets = liabilities + equity If a company has an expenditure (or cash outlay) that does not meet the 1 INTRODUCTION ssets are defined as “probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.”1 To be recorded They present a picture of a company’s financial condition at a specific point in time. There are many types of assets. Land, cash, and investments are examples, but assets can also be intangible, such as an entity’s brand, trademark, and intellectual property. On an entity’s balance sheet, assets are grouped into two broad categories: current assets and long-lived assets. Assets are generally recorded at cost and only when there is reasonable certainty that they will yield a future benefit. To illustrate these concepts, this reading includes selected information from the Coca-Cola Company’s 2014 annual report. statement. definition of an asset, then it will likely be recorded as an expense on the income asset has already occurred. a firm’s cash flow either directly or indirectly. as an asset, an economic resource must have four key characteristics: A

5071 | Core Reading: Assets and Expenses 4 —a current asset customers in the future, An investment constitutes a cash equivalent only if it is high-quality, rather than for investment or other purposes. sequenced from the most liquid 2.1 Current Assets generate a benefit for an entity during either the subsequent year or the normal comprises cash on hand and demand deposits. Cash equivalents include Cash A sale is generally realized when a promise to pay is received in exchange for the are recorded as accounts receivable —when payment is 2 ESSENTIAL READING are , —i.e., the most easily convertible, directly or indirectly, into cash—to the least liquid. 2.1.1 Cash and Cash Equivalents4 Examples of cash equivalents include money market funds, government securities, certificates of deposits (CDs), and investment-grade commercial papers that are readily convertible to known amounts of cash and are subject to an insignificant risk of value change. This asset category is meant to capture cash on hand that is available to fund a firm’s day-to-day operations. However, managers will often shift cash into liquid investments to improve returns while still maintaining liquidity. 2.1.2 Accounts Receivable (i.e., credit sales or sales on account) generally the gross selling price less any discounts or rebates and adjusted by an allowance for doubtful accounts. an It is a A company’s operating cycle is the time between its cash outlay to acquire goods and services and its realization in cash from selling a finished product. receivable are recorded as the amount the company expects to receive from normally expected within the short term or within the operating cycle. Accounts provision of goods or services. Sales to customers in which the company is highly liquid, and short-term (generally maturing in less than three months). highly liquid short-term investments held for short-term cash commitments Under US GAAP, current assets are 2,3,a whichever is longer. specific asset account that is used to offset the balance of that asset account. account related to a The allowance for doubtful accounts is a contra asset, compensated with terms other than cash operating cycle cash and other assets that are reasonably expected to Current assets

5071 | Core Reading: Assets and Expenses 5 The firm may classify outstanding accounts receivables based on To calculate the amount of the allowance for bad debts on the percentage to sales in the current period. historic credit sales that became bad debts and then applying this balance sheet, the firm may also look at the percentage of receivables on Once the firm selects a particular approach, it can calculate the allowance for Beginning allowance + bad debt expense – write-offs = ending allowance used when it is unlikely that all customers will pay their outstanding amounts in full, which often happens when a customer gets into financial difficulty and lacks the means to pay his or her account. In this case, a portion of the accounts Although a firm will likely know the amount of any discounts at the time of the sale, it cannot know the allowance for doubtful accounts in advance, so it will need to reasonably estimate the probable uncollectible amount. Therefore, a firm must establish credit policies to control and assess its accounts receivable accounts, and it must set accounting policies to analyze and determine the appropriate allowance for doubtful accounts. This is generally done by looking at the firm’s historic experience with bad debts. For example: • The resulting amount is charged to expenses in the income statement for that period. • <p2_7> • <p2_8> Using this aging analysis, receivables can be placed into groups (e.g., current; 1–30 days past due; 31–60 days past due) and applies a different allowance percentage to each group of accounts receivables. These adjustments are made to the class of accounts receivable in the aggregate rather than to individual accounts. When the firm determines that a particular customer is not going to pay his or her account, it will remove this account, and the value of that customer’s accounts receivable will be written off, i.e., reduced to $0. For example, credit card companies will write off a customer’s account once the account is 180 days past due. When this happens, no expense is recorded on the income statement. Instead, the allowance is reduced by the amount of the write-off as shown in Exhibit 1.5 The basic equation for the allowance for bad debts reads as follows: doubtful accounts for each accounting period. the balance sheet that historically became bad debts. receivables will become bad debts. the amount of time they have been outstanding. The firm may estimate the allowance by looking at the percentage of

5071 | Core Reading: Assets and Expenses 6 The following excerpt is from the 2014 annual report of the Coca-Cola Company: We record trade accounts receivable at net realizable value. This value includes an appropriate allowance for estimated uncollectible accounts to reflect any loss anticipated on the trade accounts receivable balances and charged to the provision for doubtful accounts. We calculate this allowance based on our history of write-offs, the level of past-due accounts based on the contractual terms of the receivables, and our relationships with, and the economic status of, our bottling partners and customers. We believe our exposure to concentrations of credit risk is limited due to the diverse geographic areas covered by our operations. Activity in the allowance for doubtful accounts was as follows (in millions): Year Ended December 31 * The increase in 2014 was primarily related to concentrate sales receivables from our bottling partner in Venezuela. ** “Other” includes foreign currency translation and the impact of transferring certain assets to assets held for sale. An illustrative example from Coca-Cola’s 2014 annual report is shown in Exhibit 2. EXHIBIT 1 Accounting for Bad Debts EXHIBIT 2 Accounting for Bad Debts at the Coca-Cola Company 2014 2013 2012 Balance at beginning of year $61 $53 $83 Net charges to costs and expenses* $308 $30 $5 Write-offs −$13 −$14 −$19 Other** −$25 −$8 −$16 Balance at end of year $331 $61 $53

5071 | Core Reading: Assets and Expenses 7 sheet primarily at cost. course of business, are in the process of being produced for sale, or are being When inventory is purchased or manufactured, it is recorded on the balance Interactive Illustration 1 offers a visual display of how the allowance for doubtful accounts is calculated. The vertical bars represent debts owed to a company by its customers. These overdue accounts are grouped by how long the debts have been overdue. You can adjust the assumed percentage of uncollectibility of each group using the sliders at the top. The calculated estimate for bad debt is then shown at the bottom as an accounting entry. INTERACTIVE ILLUSTRATION 1 Estimating Bad Debts Scan this QR code, click the image, or use this link to access the interactive illustration: http://bit.ly/hbsp2GgbnxK 2.1.3 Inventory includes . Inventory costs are calculated as “the sum of the applicable expenditures and charges directly or indirectly incurred in bringing an article to its existing condition and location.”7 These costs can include raw oth of which are goods used in the (b raw materials or manufacturing supplies , and (goods in the process of being manufactured) , goods in process for sale) (goods that have been completed and are ready the category of finished goods 6 Inventories generally fall into consumed to produce goods or services for sale. manufacture of goods for sale) items that are being held for sale or use in the ordinary Inventory

5071 | Core Reading: Assets and Expenses 8 to the cost refers “Market” on an ongoing basis lower of cost or market (LCM) periodic method perpetual method the income statement. Activity-based costing (ABC), an even more accurate method for While inventories are recorded at cost initially, they are maintained at the Any decline in inventory value is recorded as a loss or a charge against In the perpetual method, the inventory account is inventory accounting. periodic method, inventory is recorded in a purchases account when it is materials, direct labor, and related overhead costs. They will differ depending on the nature of the company’s business, e.g., manufacturing vs. retail. Various methods can be used for allocating overhead costs to individual inventory items. One approach is to apply a standard overhead rate to each unit of inventory. Another is to allocate overhead based on measures of output volume, such as the machine hours or hours of direct labor required to complete the unit. (including indirect costs) by each type of product. . A market value below the net realizable value less a normal profit margin is a floor value for inventory; a market value above the net realizable value is a ceiling value for inventory. c When inventory is sold, it is recorded as an expense (cost of goods sold) on The timing of this entry, and of the corresponding balance sheet entry, depends on the inventory recordkeeping method the firm employs. A firm can opt to use either the or the of In the Inventory sales are recorded in a separate accounting entry. The b IFRS requires inventories to be measured at either cost and net realizable value, whichever is lower (IAS2-9). c According to Topic 330, Inventory, 330-10-35-2 and 330-10-50, FASB desires a charge separately identified from the consumed inventory costs when there has been a substantial and unusual inventory write-down. IFRS requires the inventory write-down to be recognized as an expense for the period in which it occurred (IAS 2-34). there is a direct adjustment to the income statement through the cost of goods immediately adjusted when inventory is purchased. When inventory is sold, revenue in the entity’s income statement in the accounting period during which value is its selling price less any costs associated with completing and selling it. An item’s net realizable 8,b realizable value reduced by a normal profit margin. reproducing it at a cost equal to or between net realizable value and that net , either by purchasing it in the open market or by of replacing inventory activity costs to products based on cost driver measures that help explain what the product, accumulating the costs per activity, and then allocating those allocating overheads costs, involves identifying activities performed to produce 9 purchased. sold account and to the balance sheet through the inventory account. that decline in value occurs. drives the use of resources

5071 | Core Reading: Assets and Expenses 9 last-in, first-out (LIFO).d first-in, first-out (FIFO), average cost, and are: available for sale. Three more methods calculated using several assumptions about the flow of cost factors. every time the item is moved, inventory items can be fitted with unique barcodes that are scanned LIFO. FIFO. Basic Equation for Accounting for Inventories: Beginning inventories + purchases – ending inventories = cost of goods sold To determine the cost of goods sold, the value or cost of inventory can be purchased during a period is considered as the cost of goods inventory and cost of goods sold accounts are updated at the end of the period to reflect any activity. Recent advances in technology have made inventory management easier. For example, e.g., from the stock room to the sales floor, when shipped to different locations, or when sold. This allows for more accurate tracking. Additionally, wireless networks allow for easier access to inventory data. One method is to record the cost and sales of each inventory item as it is purchased and sold, which makes sense if each inventory item is unique; however, it is not workable if the inventory includes a large number of identical items. It is important to select the method that will most clearly reflect periodic income for a particular firm. • A measure of inventory in which the oldest items are assumed to be transferred into cost of goods sold first. The items remaining in inventory are those purchased most recently, which means that the inventory balance is likely to provide a good measurement of replacement cost. • This cost is divided by the number of units available for sale to determine an average cost per unit. This unit cost is then used to calculate ending inventory and the cost of goods sold. • A measure of inventory in which the most recent additions to inventory are assumed to be transferred into cost of goods sold first. Thus, the oldest inventory items remain in the inventory account. Although LIFO is not permitted under IFRS in d According to FASB, Topic 330, Inventory, 330-10-30-9, in the United States, the cost of inventory may be determined under FIFO, average, or LIFO method. However, under IAS 2-25, the cost of inventories is assigned by using FIFO or weighted average cost formula only. Average cost. The cost of beginning inventory plus inventory

5071 | Core Reading: Assets and Expenses 10 minimize taxable income and reduce ta This makes it popular with firms looking to (as compared to the average cost or FIFO methods), and therefore lower income. xes. For this reason, firms that use LIFO for US tax accounting are also required to use it for financial reporting. Using Interactive Illustration 2, observe how different inventory costing methods affect accounting entries. Begin by clicking on the question marks and choosing a series of sales to customers. Then make a selection between periodic and perpetual, and between FIFO, LIFO, and Average. Click play to see how inventory and cost of goods sold (COGS) would be calculated under those assumptions. Once the animation is over, change the selections at the top to see the immediate effect of the new selections on the calculations. INTERACTIVE ILLUSTRATION 2 Inventory Costing Method Scan this QR code, click the image, or use this link to access the interactive illustration: http://bit.ly/hbsp2LqDdNy some countries, 10 it is permitted—and is commonly used—in the United States. However, in a period with positive inflation, using LIFO will have the impact of higher cost of goods sold

5071 | Core Reading: Assets and Expenses 11 Note: In this example the change in the LIFO reserve for a company using LIFO accounting would equal $31. LIFO COGS ($139) – FIFO COGS ($108) = $31. EXHIBIT 3 Inventory Accounting Units Unit Cost Total Beginning-of-period inventory 4 $15 $60 Purchases: Unit A 1 $20 $20 Unit B 1 $28 $28 Unit C 1 $23 $23 Unit D 1 $24 $24 Unit E 1 $30 $30 $184 Units sold during the period 6 End-of-period inventory 3 Inventory Accounting Method Cost of Goods Sold End-of-period inventory Specific identification: Inspection shows items A, B, and E remain in inventory at period end $107 $78 Last invoice price $94 $90 Simple average $115 $70 FIFO $108 $77 LIFO $139 $45 Because the LIFO method of accounting can result in balance sheet inventory values that do not reflect current market values, the SEC requires firms to disclose in their notes what the value of inventory would have been if they had used the FIFO metho d. The LIFO reserve equals the ending inventory’s FIFO cost less the LIFO cost, but it also equals the cumulative difference between LIFO COGS and FIFO COGS.

5071 | Core Reading: Assets and Expenses 12 for the period LIFO reserve + LIFO reserves for previous periods = the balance sheet LIFO reserve on To better understand how the use of LIFO instead of FIFO affects the calculation of COGS in the presence of increasing raw material prices (acquisition cost), see Interactive Illustration 3. The large display is a graph of the acquisition cost of inventory items. Assume the company purchases items at a rate of 1,000 per month. Using the slider on the right edge of the graph, change the assumption that this cost increases, decreases, or stays the same over the course of a year. Use the slider along the bottom of the graph to change the number of items the company sells over the course of the year. In the output box on the right, observe the impact of the LIFO inventory costing method over the FIFO inventory costing method. In what conditions does LIFO result in higher ending inventory and income? In what conditions does LIFO result in lower ending inventory and income? INTERACTIVE ILLUSTRATION 3 Impact of Inventory Costing Method Scan this QR code, click the image, or use this link to access the interactive illustration: http://bit.ly/hbsp2IT6qfU FIFO COGS – LIFO COGS = LIFO reserve for the period

5071 | Core Reading: Assets and Expenses 13 The following excerpt is from the 2014 annual report of the Coca-Cola Company: Inventories consist primarily of raw materials and packaging (which includes ingredients and supplies) and finished goods (which include concentrates and syrups in our concentrate operations and finished beverages in our finished product operations). Inventories are valued at the lower of cost or market. We determine cost on the basis of the average cost or first-in, first out methods. Inventories consisted of the following (in millions): EXHIBIT 4 Inventory Accounting at the Coca-Cola Company Balance Sheet Year ending December 31 2013 2014 Raw materials and packaging $1,615 $1,692 Finished goods $308 $1,240 Other $351 $345 Total inventories $3,100 $3,277 Income Statement 2013 2014 Cost of goods sold $17,889 $18,421

5071 | Core Reading: Assets and Expenses 14 assets that do not (such as natural resources), and assets subject to depletion assets subject to depreciation goods or services over more than one year or operating cycle. expense is recognized, the asset is reduced by the amount of that expense. Other assets often include prepaid expenses, expenditures made by a firm prior 2.2 Long-Lived Assets The key issues to consider while examining accounting for long-lived fixed periods as operating expenses to best match the benefits that 2.1.4 Other These prepaid These types of assets exemplify the matching convention—because cash is paid before an expense is recognized, an asset is temporarily created. The current portion of an entity’s investments, as described in Section 2.2.2, are also classified as current investment assets. Long-lived assets are assets that are used to generate future benefits for an entity, have a useful life of more than one year, are used in operations, and are not intended for sale in the ordinary course of business. Long-lived fixed assets, investments, and intangibles are among the most common types of long-lived assets. 2.2.1 Long-Lived Fixed Assets In most companies, also known as into one of three categories: They generally fall (such as a truck), such as land). • What costs should be capitalized as assets (i.e., they are added to the balance sheet as assets rather than being expensed)? • • those assets provide? assets are as follows: defined as tangible assets that are used to produce are equipment (PP&E), travel costs. When the and rents, insurance premiums, expenses can include How should asset-related costs be allocated across accounting decline in value over time ( property, plant, and long-lived fixed assets, to being recognized as an expense in the income statement. How should asset-related expenditures made subsequent to acquisition, changes in fair value of assets, and asset sales be properly classified, accounted for, and reported?

5071 | Core Reading: Assets and Expenses 15 this preparation period should be capitalized. straightforward. The costs of manufactured assets include direct materials, cost of the item can be measured reliably.11 PP&E is initially recorded on the balance sheet at cost when it is The allocation of asset-related overhead expenses is not always If funds are borrowed to construct or prepare an asset that requires a period Exhibit 5 shows how Coca-Cola accounts for PP&E. Measurement of Cost PP&E includes land, buildings, and equipment that are used in the ordinary course of business activities, such as computers, machinery, automobiles, tools, and furniture. PP&E may be acquired for cash or in an exchange, or it may be manufactured. The historical cost of purchased assets includes the costs necessarily incurred to bring those assets to the condition and location required for their intended use.12 The cost of PP&E comprises its purchase price (including import duties and nonrefundable purchase taxes after deducting trade discounts and rebates) plus direct set-up costs (delivery, installation, construction, and testing) and any estimated costs needed to retire the asset (such as the cost of dismantling and restoring the site on which the asset is located).13 For example, when constructing a fixed asset in a facility that is operating below capacity, should an overhead allocation be capitalized? If a facility is operating at capacity, utilizing it to manufacture an asset for internal use may decrease the production of items for sale, possibly creating a lost opportunity cost that should be accounted for. If, however, a facility is below capacity and its overhead costs would have been incurred anyway, should those overhead costs be allocated to the cost of manufacturing a fixed asset? 14 The borrowing cost to be capitalized is the interest incurred during the asset’s acquisition period that could have been avoided if the expenditures for the assets had not been made.15 e Under IAS 16-22, IFRS requires any internal profits to be eliminated when calculating the costs of self-constructed assets and of abnormal amounts of wasted material, labor, or other resources incurred in self-constructing an asset to be excluded from the cost of the asset. its intended use, interest cost resulting from the expenditures incurred during time to carry out the preparation activities necessary to bring it to the state of of market value of the asset.e estimated value of that future benefit, and the costs cannot exceed the fair must be directly matched to a future benefit; capitalized costs cannot exceed the direct labor, and related overhead. To capitalize these asset-related costs, they probable that the item’s future economic benefits will flow to the entity and the

5071 | Core Reading: Assets and Expenses 16 allocation of the depreciable cost of the asset over its useful life. asset costs. Many long-lived fixed assets have a limited life. Depreciation is the systematic This depends on the impact the expenditures will have on the asset—will they generate a benefit over more than one year or operating cycle? Maintenance and repair costs that keep the asset in working order should be expensed as incurred, while expenditures that increase the asset’s useful life, efficiency, or productivity should be capitalized. Depreciation The entity can choose the depreciation method based on the pattern in which it expects to consume the asset’s future economic benefits.16 A periodic (at least annual) depreciation charge is recorded in the income statement, and the net value of the assets is reduced by that amount. This net book value appears on the balance sheet as follows: Asset cost − accumulated depreciation = net book value they should be expensed when they are incurred or capitalized and added to the incur subsequent expenditures, which must be analyzed to determine whether Once a fixed asset has been acquired or manufactured, the asset can often

5071 | Core Reading: Assets and Expenses 17 The following excerpt is from the 2014 annual report of the Coca-Cola Company: Property, Plant, and Equipment: Property, plant, and equipment are stated at cost. Repair and maintenance costs that do not improve service potential or extend economic life are expensed as incurred. Depreciation is recorded principally by the straight-line method over the estimated useful lives of our assets, which are reviewed periodically and generally have the following ranges: buildings and improvements: 40 years or less; and machinery, equipment and vehicle fleet: 20 years or less. Land is not depreciated, and construction in progress is not depreciated until ready for service. Depreciation expense, including the depreciation expense of assets under capital lease, totaled $1,716 million, $1,727 million and $1,704 million in 2014, 2013 and 2012, respectively. Note: Table summarizes our property, plant and equipment (in millions). EXHIBIT 5 PP&E Accounting at the Coca-Cola Company Year ended December 31 2013 2014 Land 972 1,011 Buildings and improvements 5,539 5,605 Machinery, equipment, and vehicle fleet 18,225 17,551 Construction in progress 522 865 $25,258 $25,032 Less accumulated depreciation 10,625 10,065 Property, Plant, and Equipment—net $14,633 $14,967 The accumulated depreciation account is a contra asset, which is netted against the asset’s gross carrying amount. Note that there are no cash flows associated with these entries, except for the impact, if any, they have on annual income taxes paid. Depreciation can be calculated as cost − residual value = depreciable cost.

5071 | Core Reading: Assets and Expenses 18 The asset’s residual value is not incorporated depreciation charge. Useful life. Residual value. Cost. plus other applicable costs incurred in readying the asset for its t is also I life. This may be sale value, trade-in value, or scrap proceeds. benefits for the entity. This may be measured in time or in other units across an asset’s useful life. Depreciation expense is constant across straight-line method once the annual depreciation charge is lower depreciable cost is multiplied by a fraction to calculate the annual The key factors in determining depreciation are as follows: • As discussed in Section 2.2.1, • The • The The most common methods in practice include the following: • • straight-line depreciation):  In each year, That depreciation rate is calculated as two times the reciprocal of the asset’s useful life (expressed in years). For example, if the useful life of an asset is five years, the depreciation rate is 2 × 1/5, or 40%. Additionally, some companies  (expressed in years) depreciation charge. That fraction is calculated as the remaining straight-line method. under the double-declining method than it would be under the depreciation is not generally charged However, into this calculation. value is multiplied by a depreciation rate to calculate the annual useful life. years and is equivalent to the asset’s depreciable cost divided by its such as operating hours, miles driven, or units produced. commonly known as the salvage value of an asset. intended use. divided by the sum of the years’ useful life Sum-of-the-years’-digits depreciation. In each year, an asset’s will switch from the double-declining method to the once the net book value equals the residual value. the net book Double-declining balance depreciation. Straight-line depreciation. Depreciable value is allocated equally period over which the asset is expected to generate asset’s net realizable value at the end of its useful this includes the purchase price Depreciation methods must be rational and systematic. Accelerated depreciation. Depreciation charges are front-loaded with lower charges in later years. Two common methods for calculating accelerated depreciation are double-declining balance depreciation and sum-of-the-years’-digits depreciation (as shown in Exhibit 6, with

5071 | Core Reading: Assets and Expenses 19 digits. For example, if the asset’s useful life is five years, the fraction in Year 1 would be 5 / (1 + 2 + 3 + 4 + 5). • Units of production depreciation. The asset’s depreciable value is divided by its estimated life, in terms of output units, to calculate a cost per unit. I n each year, that cost per unit is multiplied by the number of units produced to calculate a depreciation charge. This is also known as activity depreciation.

5071 | Core Reading: Assets and Expenses 20 EXHIBIT 6 Depreciation Accounting Purchase of machinery $22,000 Estimated salvage value $2,000 Depreciable cost $20,000 Useful life 5 years Depreciation Expense Ending Asset Value Straight-Line Method Year 1 $4,000 $18,000 Year 2 $4,000 $14,000 Year 3 $4,000 $10,000 Year 4 $4,000 $6,000 Year 5 $4,000 $2,000 Double-Declining Balance Method (Rate = 40%) Year 1 $8,800 $13,200 Year 2 $5,280 $7,920 Year 3 $3,168 $4,752 Year 4 $1,901 $2,851 Year 5 $851 $2,000 Sum-of-the-Years’-Digits Method (Denominator = 15) Year 1 $6,667 $15,333 Year 2 $5,333 $10,000 Year 3 $4,000 $6,000 Year 4 $2,667 $3,333 Year 5 $1,333 $2,000 Interactive Illustration 4 demonstrates these three common depreciation methods in a side-by-side comparison. Set the initial cost of an asset, in this case a truck, and its estimated residual value. The interactive calculates depreciation

5071 | Core Reading: Assets and Expenses 21 statement. fixed asset is not recoverable and exceeds its fair value.17 changes to depreciation are made on a go-forward basis. An impairment loss occurs when the carrying value (net book value) of the When a fixed asset is sold, a gain or loss on the sale is often recorded. The net expenses and ending book values of a truck over its useful life (five years), using the assumptions for the truck’s initial cost and residual value. INTERACTIVE ILLUSTRATION 4 Depreciation Methods Scan this QR code, click the image, or use this link to access the interactive illustration: http://bit.ly/hbsp2mubrS6 Subsequent Accounting Estimates and Sales Estimates made in calculating depreciation expenses often change over time, e.g. an asset’s useful life may prove to be longer than expected. In such cases, any That is, prior period accounts are not restated to amend past depreciation expense. If it appears that an asset may be impaired, a company must consider whether an impairment loss should be recognized. 18 However, if the entity routinely sells fixed assets in its ordinary activities, the proceeds from the sale are recognized as revenue.19 or loss is reported in income from operations before income taxes in the income of the asset sold is removed from the balance sheet, and any gain depreciation) (capitalized acquisition cost less accumulated book value or carrying cost

5071 | Core Reading: Assets and Expenses 22 development costs are expensed. Any The general rule is that costs associated with discovering and Except for quarries or landfill sites, land is an asset that has an indefinite life and therefore is not depreciated. It should be included on the balance sheet separately at cost, or less than cost if impaired, from depreciable assets even when land and building were acquired together.20 Wasting assets, such as mineral deposits, are used up in the revenue generation process. Exploration costs incurred by companies in the minerals, petroleum, or timber businesses can be expensed as either incurred or capitalized costs. capitalized costs are subject to annual depletion charges. As with depreciation, the purpose of depletion is to spread asset-related costs over the asset’s useful life. 2.2.2 Deferred Tax Assets (and Liabilities) When reporting revenues and expenses for financial and tax purposes, timing differences often exist due to differences in financial accounting (e.g., GAAP or IFRS) and income tax accounting rules. Taxes may be paid before they are recognized in a firm’s income statement, or they may be recognized prior to being paid. These timing differences create a temporary asset or liability known as a deferred tax asset or liability. For example, provisions for bad debts are recognized as expenses for financial reporting purposes but not for tax purposes. As such, when a provision for bad debt is created or added to, a deferred tax asset, equivalent to the tax rate multiplied by the expense, is created. When the bad debt is realized, it is a tax-deductible expense. When the firm realizes a tax benefit, the deferred tax asset is reduced accordingly. Deferred tax assets or liabilities can be recorded as either current or long-term assets or liabilities depending on the expected length of the timing difference. 2.2.3 Investments Investments include the debt and equity securities of another entity reported on a company’s balance sheet as either a current or long-term asset. The accounting method used for investments depends on the purpose of the investment, the degree of influence or control the investor can exert over the investee, and the expected holding period. Debt securities represent a creditor relationship with an entity. These include preferred stock, collateralized mortgage obligations, corporate bonds, developing productive properties are capitalized; all other discovery and Gain or loss on sale = proceeds from sale − net book value of asset sold

5071 | Core Reading: Assets and Expenses 23 commercial paper, and treasury bonds, among others. Debt investments are generally classified as held-to-maturity securities, trading securities, or available-for-sale securities. These types of securities are illustrated in Exhibit 7. A held-to-maturity security is a debt security that the reporting entity intends—and has the ability—to hold to maturity.21 These investments are recorded on the balance sheet at amortized cost, which is the cost of the security adjusted for any purchase discount or premium.22 An entity purchases a trading security with the intent of selling it within hours or days.23 Trading securities are reported on the balance sheet at fair market value. Any changes in its fair market value, referred to as unrealized holding gains and losses, are reported in the income statement.24 Accounting Standards Codification Topic 320 defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”25 Investments held by an entity that have not been classified as either trading securities or held-to-maturity securities are called available-for-sale securities.26 Similar to a trading security, an available-for-sale security is recorded on the balance sheet at fair market value. However, any unrealized holding gains or losses due to changes in its market value are excluded from earnings and are reported in other comprehensive income until realized.27 Equity securities, on the other hand, represent an ownership interest in an entity. Equity investments in which the entity controls less than 20% of the equity are minority passive investments, as the investor entity cannot exert any influence over the investee entity. Minority passive investments with readily determinable fair values are classified as trading securities; otherwise, they may be accounted for at cost but adjusted for any impairments or observable price changes (such as a private company having a new funding round with an observable valuation). Finally, investments in which the entity controls more than 50% of the equity are majority active investments.

5071 | Core Reading: Assets and Expenses 24 2.2.4 Goodwill and Other Intangible Assets Goodwill is created when one entity acquires another and the purchase price EXHIBIT 7 Accounting for Passive Investments Minority active investments are accounted for using the equity method. The investment is recorded at cost and then increases in each accounting period by the entity’s share of the investee’s increase in retained earnings. Majority active investments are accounted for using consolidation accounting, in which the assets, liabilities, revenues, and expenses of the investment are combined with those in the entity’s accounts. The percentage of the investment that is not owned is accounted for via a minority interest account (also known as a noncontrolling interest account). substance. 28, f nonmonetary asset without physical transferabl It is an intangible asset that is not separately At the time of an acquisition, each item on the target’s balance sheet is analyzed and written up or down to market value. The difference between the fair market value of these assets and liabilities f The term “intangibles” is used to refer to intangible assets other than goodwill. e. To calculate goodwill, it is necessary to determine the fair market paid by the acquiring entity exceeds the fair market value of the target entity’s Goodwill value of the target’s assets and liabilities. net identifiable assets.29 names, franchises, and patents. Intangibles include goodwill and intangible assets such as brand An intangible asset is an identifiable,

5071 | Core Reading: Assets and Expenses 25 more than 10 years.30 has increased or remains the same, goodwill is not adjusted. If the fair value of the reporting unit equal to that decline in value. assets value of Fair market − liabilities value of fair market = assets value of net identifiable net book value or fair done by calculating the fair to determine if its value has been impaired.h This is In 2014, US GAAP accounting rules were amended to simplify goodwill Other Intangibles Purchase price − net book value or fair value of net identifiable assets = goodwill Under FAS 142,g issued in 2001, The amount of impairment loss is the difference between the goodwill and the implied value of the goodwill. The implied value of the goodwill equals the fair value of the reporting unit less the fair value of its net identifiable assets, excluding goodwill.i (In practice the process of estimating the value of goodwill is quite complicated; this description is meant to provide only a simple definition.) Under the new rules, However under IFRS, all companies, including private ones, must use the impairment-only approach to accounting for goodwill.31 Other intangibles are separately transferable “expenditures for special rights, privileges, or competitive advantages which offer the prospect of increased revenues or earnings. They include expenditures for brand names, franchises, patents, and similar items that exist only on paper, but nevertheless can g FAS 142 has since been superseded by ASC 350. h Topic 350-20-35-1, Goodwill shall not be amortized. Instead, goodwill shall be tested for impairment at a level of reporting referred to as a reporting unit. i Topic 350-20-35-2, Impairment is the condition that exists when the carrying amount of goodwill exceeds its implied fair value. opt instead to amortize goodwill on a straight-line basis over a period of no private companies do not have to perform an annual impairment test, but can value, then goodwill is considered impaired and must be reduced by an amount has declined such that the reporting unit’s carrying value exceeds its fair market value of the reporting unit with which the goodwill is associated; if that value goodwill. is the entity’s net book value. The purchase price less the net book value equals ompanies. (i.e., not publicly traded) c accounting for private goodwill should be tested at least once a year

5071 | Core Reading: Assets and Expenses 26 , sheet.35 should be preliminary development stages potential. not to exceed 40 years. difficult Accurately estimating the value and useful life of an intangible asset can be intangible assets with finite lives should be recorded at acquisition cost and then Expenses for developing intangible assets internally are more commonly should be expensed as incurred because whether there will be a future Software development costs. Early-stage costs associated with reasonably be expected to contribute to earnings beyond the current accounting period.”32 . However, the task of valuing the asset is easier if it has been purchased rather than developed internally. Topic 350 stipulates that The straight-line amortization method should be used unless the entity can show that an alternative method is superior. Acquired intangible assets with indefinite lives are not amortized, but instead are subjected to an annual impairment test via a process similar to that described earlier for goodwill.33 A number of expenditure types are recognized as intangible assets: • 34,j However, under IFRS, development costs should be capitalized when the project can be shown to be technically and economically feasible. (i.e., after a working model has been developed or economic feasibility has been established) k Amortization of the asset should begin when development of that asset is complete. j Under IFRS, internally generated intangible assets are expensed during the research phase and capitalized during the development phase when technical feasibility has been established, according to IAS 38-51 to 59. k Under US GAAP, capitalization of cost begins when both of the following occur: (a) The preliminary project stage is completed, and (b) management, with the relevant authority, implicitly or explicitly authorizes and commits to funding a computer software project and the capitalized as an intangible asset and reported on the balance software development costs incurred beyond the However, incurred. internally developed software for internal use should be expensed as helpful information in assessing the company’s future earnings earnings potential, and capitalizing these costs does not provide benefit is likely to be uncertain, costs are often unrelated to any future expensed in the accounting period in which they are incurred rather than amortized over their economic or legal lives, whichever is shorter, for a period • Research and development (R&D) costs. Under US GAAP, R&D costs capitalized on the balance sheet. acquired Accounting Standards Codification (ASC)

5071 | Core Reading: Assets and Expenses 27 Internally developed intangibles that are not being amortized should be • The way in which Coca-Cola accounts for its intangibles is reproduced in Exhibit 8. project will probably be completed and the software will be used to perform the function intended. tested for impairment at least annually and written down in value as required. Patents. If patents are acquired, the purchase price should be capitalized. If a patent is developed internally, only the legal fees and registration costs should be capitalized. All other costs should be expensed as incurred.

5071 | Core Reading: Assets and Expenses 28 EXHIBIT 8 Accounting for Intangibles at the Coca-Cola Company The following excerpt is from the 2014 annual report of the Coca-Cola Company: Goodwill, Trademarks and Other Intangible Assets: We classify intangible assets into three categories: (1 ) intangible assets with definite lives subject to amortization, (2 ) intangible assets with indefinite lives not subject to amortization and (3 ) goodwill. We determine the useful lives of our identifiable intangible assets after considering the specific facts and circumstances related to each intangible asset. Factors we consider when determining useful lives include the contractual term of any agreement related to the asset, the historical performance of the asset, the Company’s long- term strategy for using the asset, any laws or other local regulations which could impact the useful life of the asset, and other economic factors, including competition and specific market conditions. Intangible assets that are deemed to have definite lives are amortized, primarily on a straight-line basis, over their useful lives, generally ranging from 1 to 20 years. When facts and circumstances indicate that the carrying value of definite-lived intangible assets may not be recoverable, management assesses the recoverability of the carrying value by preparing estimates of sales volume and the resulting profit and cash flows. These estimated future cash flows are consistent with those we use in our internal planning. If the sum of the expected future cash flows (undiscounted and without interest charges) is less than the carrying amount, we recognize an impairment loss. The impairment loss recognized is the amount by which the carrying amount of the asset or asset group exceeds the fair value. We use a variety of methodologies to determine the fair value of these assets, including discounted cash flow models, which are consistent with the assumptions we believe hypothetical marketplace participants would use. We test intangible assets determined to have indefinite useful lives, including trademarks, franchise rights, and goodwill, for impairment annually, or more frequently if events or circumstances indicate that assets might be impaired. Our Company performs these annual impairment reviews as of the first day of our third fiscal quarter. We use a variety of methodologies in conducting impairment assessments of indefinite-lived intangible assets, including, but not limited to, discounted cash flow models, which are based on the assumptions we believe hypothetical marketplace participants would use. For indefinite-lived intangible assets, other than goodwill, if the carrying amount exceeds the fair value, an impairment charge is recognized in an amount equal to that excess. The Company has the option to perform a qualitative assessment of indefinite-lived intangible assets, other than goodwill, prior to completing the impairment test described above. The Company must assess whether it is more likely than not that the fair value of the intangible asset is less than its carrying amount. If the Company concludes that this is the case, it must perform the testing described above. Otherwise,

5071 | Core Reading: Assets and Expenses 29 (continued) the Company does not need to perform any further assessment. During 2014, the Company performed qualitative assessments on less than 10 percent of our indefinite-lived intangible assets balance. We perform impairment tests of goodwill at our reporting unit level, which is one level below our operating segments. Our operating segments are primarily based on geographic responsibility, which is consistent with the way management runs our business. Our operating segments are subdivided into smaller geographic regions or territories that we sometimes refer to as “business units.” These business units are also our reporting units. The Bottling Investments operating segment includes all Company-owned or consolidated bottling operations, regardless of geographic location, except for bottling operations managed by CCR, which are included in our North America operating segment. Generally, each Company-owned or consolidated bottling operation within our Bottling Investments operating segment is its own reporting unit. Goodwill is assigned to the reporting unit or units that benefit from the synergies arising from each business combination. The goodwill impairment test consists of a two-step process, if necessary. The first step is to compare the fair value of a reporting unit to its carrying value, including goodwill. We typically use discounted cash flow models to determine the fair value of a reporting unit. The assumptions used in these models are consistent with those we believe hypothetical marketplace participants would use. If the fair value of the reporting unit is less than its carrying value, the second step of the impairment test must be performed in order to determine the amount of impairment loss, if any. The second step compares the implied fair value of the reporting unit’s goodwill with the carrying amount of that goodwill. If the carrying amount of the reporting unit’s goodwill exceeds its implied fair value, an impairment charge is recognized in an amount equal to that excess. The loss recognized cannot exceed the carrying amount of goodwill. The Company has the option to perform a qualitative assessment of goodwill prior to completing the two-step process described above to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount, including goodwill and other intangible assets. If the Company concludes that this is the case, it must perform the two-step process. Otherwise, the Company will forego the two-step process and does not need to perform any further testing. During 2014, the Company performed qualitative assessments on less than 10 percent of our consolidated goodwill balance. Impairment charges related to intangible assets are generally recorded in the line item other operating charges or, to the extent they relate to equity method investees, in the line item equity income (loss)—net in our consolidated statements of income. Note: Depreciation, depletion and amortization are all methods of allocating the cost of an asset over its useful life.

5071 | Core Reading: Assets and Expenses 30 With limited exceptions, and in keeping with SFAC 8,l assets are initially recorded at historical cost and must be reassessed periodically, or at least annually, to determine whether their values need to be reduced. An entity must ask the following questions: Are there assets whose benefit has expired? Are there assets whose future benefits are no longer reasonably certain? Has the estimated future benefit of a particular asset decreased? Should we recognize a particular asset at cost or market value? 2.3.1 Revaluation Revaluation of an asset involves adjusting its book value to reflect its current market value. As a result of this revaluation, the asset’s carrying value may increase or decrease. Although US GAAP does not allow for the upward revaluation of PP&E, it is permitted under IFRS in limited circumstances.m 2.3.2 Impairment An asset must be recorded as an impairment once it becomes known that its value has been impaired. A long-lived asset classified as held for use or held for sale must be tested for impairment by comparing its current carrying value with the estimated future undiscounted cash flows it is expected to generate. If the carrying value is greater than the expected future benefit, the entity must record an impairment charge and write down the carrying value of the asset to its fair value.36 Exhibit 9 shows how Coca-Cola accounts for impairments. l Statement of Financial Accounting Concepts No. 8 September 2010, Conceptual Framework for Financial Reporting. m Under IFRS 16-39, if an asset’s carrying value decreases as a result of a revaluation, the decrease is recognized as a loss in the income statement. However, for an upward revaluation, any gain is not recognized in the income statement but rather in other comprehensive income. 2.3 Basis for Recording Assets

5071 | Core Reading: Assets and Expenses 31 The following excerpt is from the 2014 annual report of the Coca-Cola Company: Certain events or changes in circumstances may indicate that the recoverability of the carrying amount of property, plant and equipment should be assessed, including, among others, a significant decrease in market value, a significant change in the business climate in a particular market, or a current period operating or cash flow loss combined with historical losses or projected future losses. When such events or changes in circumstances are present, we estimate the future cash flows expected to result from the use of the asset or asset group and its eventual disposition. These estimated future cash flows are consistent with those we use in our internal planning. If the sum of the expected future cash flows (undiscounted and without interest charges) is less than the carrying amount, we recognize an impairment loss. The impairment loss recognized is the amount by which the carrying amount exceeds the fair value. We use a variety of methodologies to determine the fair value of property, plant and equipment, including appraisals and discounted cash flow models, which are consistent with the assumptions we believe hypothetical marketplace participants would use. EXHIBIT 9 Impairment Accounting at the Coca-Cola Company 2.3.3 Differences Between FASB and IASB on Recording Basis Although there is significant overlap in the accounting rules for assets under US GAAP and IFRS, there are some noteworthy differences between the two standards. Some of these differences are listed below: • Under US GAAP, upward valuation of PP&E is not allowed; it is allowed under IFRS. • Under US GAAP, companies are allowed to record depreciation for a piece of equipment using component depreciation (i.e., looking at the depreciation rates of different parts), but it is not common to do so. However, component depreciation is required in some instances under IFRS.

5071 | Core Reading: Assets and Expenses 32 2.4 Relationship to Income Statement • US GAAP allows for LIFO accounting for inventory. LIFO is prohibited under IFRS. Development costs for intangibles are expensed as incurred under US GAAP except in specific instances (e.g., certain software costs). Under IFRS, they are capitalized as soon as a project is determined to be technically and economically feasible.37 2.4.1 Expenditures vs. Expenses Expenses are outflows of economic resources to pay for the consumption of goods or services for the purpose of generating revenue. They are incurred when a product or service generates revenues, without regard to when that product or service was purchased. An expenditure, on the other hand, is an outlay of cash, but if it is not used to generate revenue for the entity in the accounting period in which it is made, it is neither recorded as an expense nor reported in the income statement. (Instead this timing difference between the expenditure being made and the expense being recognized is accounted for as a prepaid asset and reported on the balance sheet. For example, prepaid rent is an asset created when rent is paid in advance.) 2.4.2 Accounts Receivable and Revenues Revenues are income that a company receives from its normal business activities. They usually create an asset or decrease a liability. If a sale is made for cash, cash on the balance sheet will increase. If a sale is made on credit (with a promise of payment in the future), accounts receivable will increase. If a company received cash before the sale took place, an unearned revenue liability is created. Upon the sale, this liability would decrease. 2.4.3 Inventory and Cost of Goods Sold The purchase of an inventory item is an expenditure—an outlay of cash—but it is neither recognized as an expense in the accounting records nor reported on the income statement of an entity. Instead, the inventory is recorded in an inventory account and reported on the entity’s balance sheet as an asset. Once that inventory is sold, the asset is removed from the balance sheet and an expense, in the form of cost of goods sold, is recognized.

5071 | Core Reading: Assets and Expenses 33 2.4.4 PP&E and Depreciation Because a long-lived fixed asset is expected to generate benefits over its useful life that cover multiple accounting periods, its cost should be spread over its useful life in the appropriate accounting period. For this reason, when a long- lived asset is purchased, no immediate expense is recorded in the income statement. Instead the annual consumed or expired cost of that asset is reflected in the annual depreciation charge. 2.4.5 Intangibles and Amortization Any decrease in the value of intangible assets is reflected in the income statement. This may occur systematically via an annual amortization charge or as needed via an impairment charge. 2.4.6 Other Changes in Asset Values Other changes in asset values that are recorded on the income statement include unrealized gains or losses on trading securities, changes in the provision for bad debts (which are added to the allowance for doubtful accounts), gains and losses on the sale or disposal of PP&E, write-downs of inventory, and write-downs of long-lived fixed assets.

5071 | Core Reading: Assets and Expenses 34 3 KEY TERMS assets Resources that are owned and that provide a future economic benefit. accounts receivable An asset that represents money owed to a company by its customers for goods or services, for which payment is normally expected either in the short term or within the operating cycle. activity-based costing (ABC) A method for allocating direct, indirect, and overhead costs to specific production activities. allowance for doubtful accounts A contra asset account, often computed as a percentage of sales, from which the bad debts expense is subtracted. available-for-sale security An investment whose timeframe falls between held-to-maturity securities and trading securities; that is, it is not intended to be sold within hours or days of purchase, nor is it intended to be held to maturity. bad debt An account receivable that is not expected to be collected. cash An account on the balance sheet that comprises cash on hand and demand deposits. contra asset An account that adjusts the net value of an asset on the balance sheet and chart of accounts. Assets typically have credit balances, while contra asset accounts typically have debit balances. current assets Cash and other assets that are reasonably expected to generate a benefit for an entity during either the subsequent year or the normal operating cycle (whichever is longer). debt investments Debt securities, such as preferred stock, collateralized mortgage obligations, corporate bonds, commercial paper, and treasury bonds, that represent a creditor relationship with an entity. deferred tax asset or liability A temporary asset or liability that is created when there is a difference in timing between when taxes are paid and when they are recognized in a firm’s income. depreciation The systematic allocation of an asset’s depreciable cost, which reflects the decrease in value over its useful life. equity investments Equity securities that represent an ownership interest in an entity.

5071 | Core Reading: Assets and Expenses 35 first-in, first-out (FIFO) A measure of inventory in which the oldest items in inventory are assumed to be transferred into cost of goods sold first. The items remaining in inventory are those purchased most recently, which means that the inventory balance is likely to provide a good measurement of replacement cost. goodwill A nontransferrable intangible asset that is created when one entity acquires another and the purchase price paid by the acquiring entity exceeds the fair market value of the target entity’s net identifiable assets. held-to-maturity security A debt security that the reporting entity intends (and has the ability) to hold to maturity. inventory Assets that are held for sale or use in the ordinary course of business, in the process of either being produced for sale or being consumed to produce goods or services for sale. last-in, last-out (LIFO) A measure of inventory in which the most recent additions to inventory are assumed to be transferred into cost of goods sold first. Thus, the oldest inventory items remain in the inventory account. lower of cost or market (LCM) The reported value of an asset equal to the smaller of two possible values: (a) the cost to create the asset, or (b) the cost to purchase it. net realizable value The selling price of an item less any costs associated with completing and selling it. periodic method An inventory recordkeeping method by which the inventory purchased is recorded in a purchases account and inventory sales are recorded via a separate accounting entry. The inventory and cost of goods sold accounts are updated at the end of the period for activity during the period. perpetual method An inventory recordkeeping method by which the inventory account is immediately adjusted when inventory is purchased. When inventory is sold, there is a direct adjustment to the income statement through the cost of goods sold account and to the balance sheet through the inventory account. property, plant, and equipment (PP&E) Tangible assets that are used to produce goods or services over more than one year or operating cycle. trading security An investment intended to be sold within hours or days of purchase. wasting assets Assets, such as natural resources, that are depleted in the revenue generation process.

5071 | Core Reading: Assets and Expenses 36 4 ENDNOTES 1 Financial Accounting Standards Board, Statement of Financial Accounting Concepts No. 6 (2008): CON 6-1, http://www.fasb.org/cs/BlobServer?blobcol=urldata&blobtable=MungoBlobs&blobkey= id&blobwhere=1175820901044&blobheader=application%2Fpdf, accessed January 24, 2018. 2 Financial Accounting Standards Board, Accounting Standards Update: Balance Sheet (Topic 210), January 2017, ASC 210-10-20: Glossary, Current Assets, https://asc.fasb.org/imageRoot/94/108336194.pdf, accessed January 24, 2018; European Commission, International Accounting Standard 1: Presentation of Financial Statements, February 18, 2011, IAS 1-66, http://ec.europa.eu/internal_market/accounting/docs/consolidated/ias1_en.pdf, accessed January 24, 2018. 3 Financial Accounting Standards Board, Accounting Standards Update: Balance Sheet (Topic 210), January 2017, ASC 210-10-20: Glossary, Operating Cycle, https://asc.fasb.org/imageRoot/94/108336194.pdf, accessed January 24, 2018; European Commission, International Accounting Standard 1: Presentation of Financial Statements, February 18, 2011, IAS 1-68, http://ec.europa.eu/internal_market/accounting/docs/consolidated/ias1_en.pdf, accessed January 24, 2018. 4 Financial Accounting Standards Board, Accounting Standards Update: Cash and Cash Equivalents, (Topic 305), January 2013, ASC 305-10-20: Glossary, Cash and Cash Equivalents; European Commission, International Accounting Standard 7: Statement of Cash Flows, March 24, 2010, http://ec.europa.eu/internal_market/accounting/docs/consolidated/ias7_en.pdf, IAS 7-6/7, accessed January 24, 2018. 5 Financial Accounting Standards Board, Accounting Standards Update: Receivables (Topic 310), July 2010, ASC 310-35-41. 6 Financial Accounting Standards Board, Accounting Standards Update: Inventory (Topic 330), July 2015, ASC 330-10-20: Glossary, Inventory; European Commission, International Accounting Standard 2: Inventories, September 16, 2009, http://ec.europa.eu/internal_market/accounting/docs/consolidated/ias2_en.pdf, IAS 2-6, accessed January 24, 2018. 7 Financial Accounting Standards Board, Accounting Standards Update: Inventory (Topic 330), July 2015, ASC 330-10-30-1. 8 Financial Accounting Standards Board, Accounting Standards Update: Inventory (Topic 330), July 2015, ASC 330-10-20: Glossary, Market. 9 Financial Accounting Standards Board, Accounting Standards Update: Inventory (Topic 330), July 2015, ASC 330-10-20: Glossary, Net Realizable Value. 10 European Commission, International Accounting Standard 2: Inventories, September 16, 2009, http://ec.europa.eu/internal_market/accounting/docs/consolidated/ias2_en.pdf, IAS 2-25, accessed January 24, 2018. 11 European Commission, International Accounting Standard 16: Property, Plant and Equipment, September 16, 2009, http://ec.europa.eu/internal_market/accounting/docs/consolidated/ias16_en.pdf, IAS 16-7, accessed January 24, 2018. 12 Financial Accounting Standards Board, Accounting Standards Update: Property, Plant, and Equipment (Topic 360), April 2014, ASC 360-10-30-1, https://asc.fasb.org/imageRoot/76/51742576.pdf, accessed January 24, 2018. 13 European Commission, International Accounting Standard 16: Property, Plant and Equipment, September 16, 2009, http://ec.europa.eu/internal_market/accounting/docs/consolidated/ias16_en.pdf, IAS 16-16, accessed January 24, 2018.

5071 | Core Reading: Assets and Expenses 37 14 Financial Accounting Standards Board, Accounting Standards Update: Interest (Topic 835), 835-20- 05-01. 15 Financial Accounting Standards Board, Accounting Standards Update: Interest (Topic 835), 835-20- 30-2. 16 Financial Accounting Standards Board, Accounting Standards Update: Property, Plant, and Equipment (Topic 360), April 2014, ASC 360-10-35-4; European Commission, International Accounting Standard 16: Property, Plant and Equipment, September 16, 2009, http://ec.europa.eu/internal_market/accounting/docs/consolidated/ias16_en.pdf, IAS 16-60, accessed January 24, 2018. 17 Financial Accounting Standards Board, Accounting Standards Update: Property, Plant, and Equipment (Topic 360), April 2014, ASC 360-10-20: Glossary, Impairment; European Commission, International Accounting Standard 36: Impairment of Assets, March 24, 2010, http://ec.europa.eu/internal_market/accounting/docs/consolidated/ias36_en.pdf, IAS 36-8, accessed January 24, 2018. 18 Financial Accounting Standards Board, Accounting Standards Update: Property, Plant, and Equipment (Topic 360), April 2014, ASC 360-10-45-5; European Commission, International Accounting Standard 36: Impairment of Assets, March 24, 2010, http://ec.europa.eu/internal_market/accounting/docs/consolidated/ias36_en.pdf, IAS 36-68, accessed January 24, 2018. 19 European Commission, International Accounting Standard 36: Impairment of Assets, March 24, 2010, http://ec.europa.eu/internal_market/accounting/docs/consolidated/ias36_en.pdf, IAS 36-68A, accessed January 24, 2018. 20 European Commission, International Accounting Standard 16: Property, Plant and Equipment, September 16, 2009, http://ec.europa.eu/internal_market/accounting/docs/consolidated/ias16_en.pdf, IAS 16-58, accessed January 24, 2018. 21 Financial Accounting Standards Board, Accounting Standards Update: Investments—Debt and Equity (Topic 320), ASC 320-10-25-1(c). 22 Financial Accounting Standards Board, Accounting Standards Update: Investments—Debt and Equity (Topic 320), ASC 320-35-1(c). 23 Financial Accounting Standards Board, Accounting Standards Update: Investments—Debt and Equity (Topic 320), ASC 320-25-1(a). 24 Financial Accounting Standards Board, Accounting Standards Update: Investments—Debt and Equity (Topic 320), ASC 320-35-1(a). 25 Financial Accounting Standards Board, Accounting Standards Update: Investments—Debt and Equity (Topic 320): Glossary, Fair Value. 26 Financial Accounting Standards Board, Accounting Standards Update: Investments—Debt and Equity (Topic 320), ASC 320-25-1(b). 27 Financial Accounting Standards Board, Accounting Standards Update: Investments—Debt and Equity (Topic 320), ASC 320-35-1(b). 28 Financial Accounting Standards Board, Accounting Standards Update: Intangibles—Goodwill and Other (Topic 350), January 2017, ASC 350-10-20: Glossary, Intangibles; European Commission, International Accounting Standard 38: Intangible Assets, March 24, 2010, http://ec.europa.eu/internal_market/accounting/docs/consolidated/ias38_en.pdf, IAS 38-8, accessed January 24, 2018. 29 Financial Accounting Standards Board, Accounting Standards Update: Business Combinations (Topic 805), January 2017, ASC 805-30-1, https://asc.fasb.org/imageRoot/94/108336194.pdf: accessed January 24, 2018.

5071 | Core Reading: Assets and Expenses 38 30 Financial Accounting Standards Board, Accounting Standards Update: Intangibles—Goodwill and Other (Topic 350), January 2017, ASC 350-20-15-4 and ASC 350-20-65-2, Transition Guidance. 31 European Financial Reporting Advisory Group, Should Goodwill Still Not Be Amortised? Accounting and Disclosure For Goodwill,” 2014, http://old.efrag.org/files/Goodwill%20Impairment%20and%20Amortisation/140725_Should_good will_still_not_be_amortised_Research_Group_paper.pdf, accessed January 24, 2018. 32 David F. Hawkins, “Intangible Assets Other Than Goodwill: Accounting and Analysis,” HBS No. 194- 077 (Boston: Harvard Business School, 2011). 33 Financial Accounting Standards Board, Accounting Standards Update: Intangibles—Goodwill and Other (Topic 350), January 2017, ASC 350-30-35-1. 34 Financial Accounting Standards Board, Accounting Standards Update: Intangibles—Goodwill and Other (Topic 350), January 2017, ASC 350-30-25-3. 35 Financial Accounting Standards Board, Accounting Standards Update: Intangibles—Goodwill and Other (Topic 350), January 2017, ASC 350-40-25-12. 36 Financial Accounting Standards Board, Accounting Standards Update: Property, Plant, and Equipment (Topic 360), April 2014, ASC 360-10-35-16 and 360-10-35-17; European Commission, International Accounting Standard 36: Impairment of Assets, March 24, 2010, http://ec.europa.eu/internal_market/accounting/docs/consolidated/ias36_en.pdf, IAS 36-8 and IAS 36-58-64, accessed January 24, 2018. 37 European Commission, International Accounting Standard 38: Intangible Assets, March 24, 2010, http://ec.europa.eu/internal_market/accounting/docs/consolidated/ias38_en.pdf, IAS 38-54 through 38-59, accessed January 24, 2018. 5 INDEX accelerated depreciation, 18 Accounting Standards Codification (ASC), 21, 24 accounts receivable, aging analysis of, 5 accounts receivable, credit and accounting policies for, 5 accounts receivable, definition of, 4, 32 accounts receivable, income statements recording, 30 accounts receivable, recording of, 4 acquired intangible assets, 24 activity-based costing (ABC), 8, 32 activity depreciation, 19 aging analysis, 5 allowance for doubtful accounts, accounting for, 5, 6 allowance for doubtful accounts, calculation for each accounting period, 5 allowance for doubtful accounts, Coca- Cola’s accounting for, 6 allowance for doubtful accounts, credit and accounting policies for, 5 allowance for doubtful accounts, definition of, 4, 32 allowance for doubtful accounts, Interactive Illustration on calculating, 7 assets, current, 4 assets, definition of, 3, 32

5071 | Core Reading: Assets and Expenses 2 assets, four key characteristics of, 3 assets, as impairments, 28 assets, long-lived, 14 assets, other items included in, 14 assets, recording of, 3, 28 assets, revaluation of, 28 assets, types of, 3 assets, US GAAP and IFRS differences in recording, 29 available-for-sale securities, 22, 22, 32 average cost, definition of, 9 average cost, Interactive Illustration on, 10 bad debts, accounting for, 5, 6 bad debts, allowance on balance sheet for, 5 bad debts, Coca-Cola’s accounting for, 6 bad debts, as deferred tax asset, 14 bad debts, definition of, 5, 32 bad debts, Interactive Illustration on estimating, 7 balance sheets, assets recorded on, 3 balance sheets, bad debt allowances on, 5 balance sheets, inventory recorded on, 7 balance sheets, land on, 21 cash, definition of, 4, 32 cash equivalents, 4 cash on hand, 4 Coca-Cola, bad debts accounting by, 6 Coca-Cola, goodwill accounting by, 27 Coca-Cola, impairments accounting by, 29 Coca-Cola, intangible assets accounting by, 26 Coca-Cola, inventory accounting by, 13 Coca-Cola, property, plant, and equipment (PP&E) accounting by, 17 contra asset, accumulated depreciation account as, 17 contra asset, definition of, 4, 32 cost measurement, in property, plant, and equipment (PP&E), 15, 18 cost of goods sold (COGS), costing methods and, 10, 11 cost of goods sold (COGS), on income statements, 30 cost of goods sold (COGS), Interactive Illustration on LIFO and FIFO on, 12 current assets, definition of, 4, 32 current assets, types of, 3 debt investments, 21, 32 deferred tax asset or liability, definition of, 14, 32 deferred tax asset or liability, recording of, 14 depletion charges, 21 depreciation, changes made on a go forward basis, 20 depreciation, common methods used in, 18, 19 depreciation, definition of,16, 32 depreciation, Interactive Illustrations on methods of, 20 depreciation, key factors in determining, 18 depreciation, long-lived fixed assets and, 14, 16, 31 depreciation, net book value of, 16 depreciation, US GAAP and IFRS differences in recording, 29 double-declining balance depreciation, 18, 19, 20 equity, assets composed of liabilities and, 3 equity investments, 22, 32 exploration costs, 21 fair market value, goodwill and, 23 fair market value, trading securities and, 21 first-in first-out (FIFO), definition of, 9, 33 first-in first-out (FIFO), Interactive Illustrations on, 10, 12 goodwill, Coca-Cola’s accounting for, 27 goodwill, definition of, 23, 33 goodwill, periodic testing of, 23 held-to-maturity securities, 21, 22, 33 IFRS, assets recording under, 29

5071 | Core Reading: Assets and Expenses 3 IFRS, deferred tax asset or liability under, 13 IFRS, last-in last-out (LIFO) under, 9 IFRS, revaluation under, 28 impairments, assets as, 28, 31 impairments, Coca-Cola’s accounting for, 29 income statements, accounts receivable and revenue on, 30 income statements, expenditures vs. expenses on, 30 income statements, intangibles and amortization on, 31 income statements, inventory and costs of goods sold on, 30 income statements, PP&E and depreciation on, 31 intangible assets, acquired, 24 intangible assets, changes in on income statements, 31 intangible assets, Coca-Cola’s accounting for, 26 intangible assets, development costs of, 25, 30 intangible assets, types of, 23, 24 inventory, accounting for, 7 inventory, categories of, 7 inventory, Coca-Cola’s accounting for, 13 inventory, definition of, 7, 33 inventory, on income statements, 30 inventory, Interactive Illustration on impact of costing methods on, 12 inventory, Interactive Illustration on different costing methods in, 10 inventory, overhead cost allocation methods in, 8 investments, accounting for, 22 investments, items included in, 21 land, accounting for, 21 last-in last-out (LIFO), definition of, 9, 33 last-in last-out (LIFO), Interactive Illustrations on, 10, 12 last-in last-out (LIFO), US GAAP and IFRS differences in recording, 29 liabilities, assets composed of equity and, 3 long-lived assets, definition of, 14 long-lived assets, types of, 14 long-lived fixed assets, categories of, 14 long-lived fixed assets, Coca-Cola’s accounting for, 17 long-lived fixed assets, definition of, 14 long-lived fixed assets, depreciation of, 16 long-lived fixed assets, income statements recording, 31 long-lived fixed assets, key issues in accounting for, 15 long-lived fixed assets, measurement of cost for, 15 lower of cost or market (LCM), 8, 33 majority active investments, 22 minority active investments, 22 net realizable value, 8, 33 noncontrolling interest account, 22 overhead cost allocation, in inventory, 8 overhead cost allocation, in property, plant, and equipment (PP&E), 15 patents, 25 periodic method, definition of, 8, 33 periodic method, Interactive Illustration on, 10 perpetual method, definition of, 8, 33 perpetual method, Interactive Illustration on, 10 prepaid expenses, 14, 30 property, plant, and equipment (PP&E), categories of, 14 property, plant, and equipment (PP&E), accounting of, 17 property, plant, and equipment (PP&E), definition of, 14, 33 property, plant, and equipment (PP&E), depreciation of, 16 property, plant, and equipment (PP&E), on income statements, 31 property, plant, and equipment (PP&E), key issues in accounting for, 15 property, plant, and equipment (PP&E), measurement of cost for, 15

5071 | Core Reading: Assets and Expenses 4 property, plant, and equipment (PP&E), US GAAP and IFRS differences in, 29 research and development costs (R&D) costs, 24 residual price, in depreciation, 18 revaluation, 28 software development costs, 25 straight-line depreciation, acquired intangible assets, 24 straight-line depreciation, definition of, 18, 19, 20 straight-line depreciation, goodwill under, 24 sum-of-the-years’-digits depreciation, 18, 19, 20 taxation, deferred asset or liability in, 13 trading securities, 21, 22, 33 units of production depreciation, 18 unrealized holding gains and losses, 21, 22 useful life, in depreciation, 18 US GAAP, assets recording under, 29 US GAAP, deferred tax asset or liability under, 13 US GAAP, goodwill under, 24 US GAAP, revaluation under, 28 wasting assets, 21, 33 write-offs of bad debts, accounting for, 5, 6 write-offs of bad debts, Coca-Cola’s example of, 6

9 – 121 – 018 R E V : A U G U S T 2 , 20 21 P A U L M . H EA LY M ARS H AL H E R RM AN N Capitalizing Development Costs at Fiat Chrysler Automobiles and Volkswagen In 2019, automobile companies throughout the world spent $103 billion on research1 and development (R&D), making the industry the third largest spender behind only the pharmaceuticals/biotech, and technology hardware/equipment industries.2 For U.S. auto companies, U.S. Generally Accepted Accounting Standards (GAAP) required that all R&D spending be reported as an expense when incurred. However, standards set by the International Accounting Standards Board (IASB), which governed financial reporting for many non-U.S. auto makers, considered certain development costs as intangible assets to be amortized over their useful lives.a The application of these standards led to variation in reporting assumptions used by auto makers to capitalize and amortize development costs. To examine the impact of this reporting standard, we consider R&D in the auto industry, and the financial reporting practices of Fiat Chrysler Automobile and Volkswagen, both headquartered in Europe, and which used international financial reporting standards (IFRS). Research and Development in the Auto Industry Several factors drove the high R&D spending of auto makers. The technological sophistication of the automobile had increased since the late 1990s as on-board electronics, computer systems, sensors, and software facilitated on-board entertainment systems, and improved energy efficiency and safety. A 2018 report on the industry in the U.S.3 observed that: A new smart phone contains one microprocessor, while a new car or truck contains about 60. These microprocessors manage 100 or more sensors located throughout the vehicle, connected by as much as a mile of wiring. Just as important, a microprocessor in a smart phone is expected to last about three years, while autos are expected to last 12 years or more. a In practice, the terms R&D spending, R&D outlays, R&D expenditures, and R&D costs are used interchangeably to refer to the amount a company spends during a period on research and development activities. R&D expense is the amount it reports in its income statement as the expense for the period. Professor Paul M. Healy and Teaching Fellow Marshal Herrmann prepared this case. This case was developed from published sources. Funding for the development of this case was provided by Harvard Business School and not by the company. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management. Copyright © 2020, 2021 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545- 7685, write Harvard Business School Publishing, Boston, MA 02163, or go to www.hbsp.harvard.edu. This publication may not be digitized, photocopied, or otherwise reproduced, posted, or transmitted, without the permission of Harvard Business School.

Fiat Chrysler Automobiles 121-018 Capitalizing Development Costs at Fiat Chrysler Automobiles and Volkswagen R&D in the industry had improved efficiency and reduced fuel consumption and emissions. Innovations had included lighter vehicles, with better aerodynamics, less drag and resistance, engine stop-start (which turned off the engine and fuel flow automatically when the vehicle stopped and re- started it when the driver disengaged the brake), as well as high-efficiency alternators and smart charging technology to reduce fuel consumption. R&D on powertrain technologies had improved fuel economy and emission levels of small and medium gasoline engines, and led to inventions of hybrid and battery propulsion cars, and natural gas engines. Many of these changes were reinforced by increasingly stringent government regulations on fuel economy, emissions, and safety. These regulations had stimulated innovations within the auto industry and led to collaborations with other industries, such as electronics, materials, and aerospace. In addition, traditional automakers were facing competition from new entrants, such as Telsa Motors and Google’s Waymo, that were designing and building new electric and driverless vehicles. And in emerging economies, such as China and India, local companies, such as Geely, Changan Automobile Group, Dongfeng Motor,4 Mahindra & Mahindra, and Tata Motors,5 were becoming increasingly competitive. Industry observers concluded that the costs of funding these innovations had increased economies of scale in the industry: In earlier times economies of scale were linked to individual models, and production of some 250,000 units per year could be enough for that model to break even for a producer. Today, however, economies of scale in the industry are rather linked to the underlying platforms and shared modules and components. This creates opportunities for firms to find ways to spread costs across models.6 Funding R&D spending in 2019 was further exacerbated by stagnant global auto sales and excess capacity. In 2019, unit sales of autos declined by 10% in China, 13% in India, and by 2% in the U.S. and Japan. See Exhibit 1 for global auto sales and sales by region from 2015 to 2019. Fiat Chrysler Automobiles N.V. was created in October 2014 through the combination of Fiat, the largest Italian car maker, and Chrysler, the third largest U.S. auto manufacturer. By acquiring the troubled Chrysler, which went through Chapter 11 bankruptcy reorganization in 2009 and was rescued by the U.S. government,7 Fiat sought to compete more effectively with rivals like Toyota and Volkswagen. It anticipated that by “developing common vehicle platforms and powertrains,” the merger would “accelerate the time-to-market for many of our new vehicle launches and result in cost savings.”8 The new merged company, Fiat Chrysler Automobiles NV (FCA), largest automaker.9 FCA was incorporated in the Netherlands, tax domiciled in the UK, and listed on the New York Stock Exchange and the Milan Borsa Italiana.10 Its corporate headquarters were in Amsterdam, its financial headquarters in London, and its mass-market auto brands operated through two subsidiaries, FCA Italy (previously Fiat Group Automobiles SpA) in Turin, and FCA U.S. (previously Chrysler Group LLC) in Auburn Hills, Michigan. FCA positioned the Chrysler brand as its main North American line to compete with Ford, Chevrolet, Toyota and Volkswagen, and used the Dodge brand to focus on performance-based vehicles. Jeep was positioned globally, with models introduced in new markets, such as Asia. Finally, 2 became the world’s seventh

By 2029, VW projected that its lineup would EBIT margins improved. Yet Volkswagen remained profitable for most of the period 2015 to 2019. Its sales grew steadily, and emissions diesel-powered vehicles. In 2015, VW faced a major scandal over its strategy of promoting and selling fuel-efficient, low- with leading market shares in Europe, North America and China In 2019, VW was the largest automaker in the world emissions. R&D was focused on two areas: reducing vehicle energy demand, and lowering fuel consumption and In 2019, FCA had 46 R&D centers located throughout the world, with around 18,000 employees. Its able to reduce its debt. Since the 2014 merger, FCA’s gross and EBIT margins had improved, a market share of 5.1%. 2019, the company was the world’s eighth largest auto maker with VW’s cars fell well-short of these and the company had been It announced plans to spend €33 billion through year, and 8.2% of the company’s total workforce.15 In 2019, VW’s research departments employed 54,947 people, an increase of 5.8% over the prior Capitalizing Development Costs at Fiat Chrysler Automobiles and Volkswagen 121-018 Fiat was the company’s main brand outside North America, Alfa Romeo was positioned as its premium brand to compete with Mercedes-Benz, BMW, and Audi, and the Maserati brand competed in the luxury market. FCA’s strongest markets were North America, Italy, and Brazil (where the Fiat Strada, Mobi, and Toro models were among the top ten selling cars).11 But its sales throughout the remainder of Western Europe and China lagged the market leaders. See Exhibit 2 for auto sales for FCA by geographic segment. In See Exhibit 3 for a list of the world’s 15 largest auto makers and their market shares. However, sales had remained relatively flat. See Exhibit 4 for a summary of FCA’s financial performance from 2015 to 2019. Research to reduce energy demand included work to cut vehicle weight, aerodynamic drag, tire rolling resistance, brake drag torque, driveline parasitic losses, heating and air conditioning, and electrical loads. Fuel consumption and emissions reduction activities covered powertrain technologies, such as engines, transmissions and drivelines, hybrid and electric propulsion and alternative fuels. FCA had also intended to devote additional R&D resources for developing automated driving and connectivity technologies. In October 2019, FCA announced its intention to merge with PSA, the French auto maker. If completed, the new company would become the world’s fourth largest auto company. Volkswagen Founded in 1937 and headquartered in Wolfsburg, Germany, Volkswagen (VW) designed, manufactured, and distributed vehicles under its own name as well as the SEAT, Audi, Skoda, Porsche, Bentley, Lamborghini and Bugatti brands. Exhibit 3), (see Exhibit 2). (see The U.S. Environmental Protection Agency found that software had intentionally been included in many VW and Audi cars sold in the U.S. to detect emissions testing and modify performance to meet regulatory standards. However, standards in regular driving conditions. VW acknowledged the cheating, which affected 482,000 cars sold in the U.S. and around 11 million cars globally,12 and set up recall and buyback programs to correct the problem or buy back affected vehicles. In January 2017, the company pleaded guilty to criminal charges in the U.S. and was fined $2.8 billion.13 By mid-2020, the scandal had reportedly cost VW $34.7 billion in fines, penalties, financial settlements and buyback costs,14 and additional government and civil actions were ongoing in the U.S. and Europe. See Exhibit 5 for VW’s financial information during this period. 3 electric – as many as three million electric vehicles per year. anticipating that, by 2025, 25% of its new vehicles would be 2024 to develop new electric vehicles,16

developer could demonstrate all of the following: , spending for the development phase of a project created an intangible asset if the include 75 battery-powered electric vehicles and roughly 60 hybrid models. (a) Technical feasibility of completing the intangible assets so it will be available for sale or use. (b) Its intention to complete the intangible asset and use or sell it. (c) Its ability to use or sell the intangible asset. the intangible asset itself or, if it is to be used internally, the usefulness of the intangible asset. the entity can demonstrate the existence of a market for the output of the intangible asset or (d) How the intangible asset will generate probable future economic benefits. Among other things, development and to use or sell the intangible asset. (e) The availability of adequate technical, financial and other resources to complete the development. (f) Its ability to reliably measure the expenditure attributable to the intangible asset during its 121-018 Capitalizing Development Costs at Fiat Chrysler Automobiles and Volkswagen To accomplish this and other research goals, the company had entered into a series of alliances. A partnership with Ford Motor Company was created to develop vans and mid-sized pickups and an autonomous driving system. A strategic partnership with Northvolt AB had been created to build a lithium battery factory in Salzgitter, and an alliance with Microsoft had been formed to work on connectivity. Accounting for R&D at FCA and VW Regulators in the Netherlands and Germany, where FCA and VW were headquartered, required public companies to prepare their financial statements using International Financial Reporting Standards (IFRS) set by the International Accounting Standards Board (IASB). See Exhibit 6 for an overview of accounting standard setting and standard setters. Under IFRS (IAS 38), research spending was always expensed when incurred. These included spending to create new knowledge, and to search for, design, formulate or review alternatives. But, the IASB concluded Instead of being expensed when incurred, development spending that satisfied these conditions was capitalized, that is reported as an intangible asset, and amortized over the asset’s useful life once it became available for use. Activities in the development phase included the design, construction and testing of proto-types; tools, moulds and dies involving new technology; the design and construction of a pilot plant that was not at a scale that made it economically feasible for commercial production; and the design, construction, and testing of a specific new improved material, product, process or service. In contrast, under U.S. accounting standards, known as generally accepted accounting principles (US GAAP) and formulated by the Financial Accounting Standards Board (FASB), all research and development spending was required to be expensed as incurred (Financial Accounting Standard No. 2). b b One exception to this requirement was for software development costs. Under FASB Accounting Standards Codification (ASC) Topic 985, Software, these costs could be capitalized and amortized over their useful life. 4

outlays and amortized them over their expected lives. both FCA and VW capitalized a portion of their development Capitalizing Development Costs at Fiat Chrysler Automobiles and Volkswagen 121-018 As a result of applying this standard, Exhibits 7 and 8 report information on the research and development costs during the period 2015 to 2019 for FCA and VW. 5

121-018 Capitalizing Development Costs at Fiat Chrysler Automobiles and Volkswagen Exhibit 1 Number of vehicles sold (000) by geographic region from 2015 to 2019 Source: Best-selling-cars.com, https://www.best-selling-cars.com/international/2019-full-year-international-worldwide-car- sales/, retrieved June 4, 2020. Exhibit 2 Number of vehicles shipped by geographic regions for FCA and VW in 2018 and 2019 FCAa VWb 2019 2018 2019 2018 North America 2,427 2,460 565 574 Western Europe 778 865 1,496 1,469 China 92 163 3,163 3,110 Brazil 497 434 392 336 Central & Eastern Europe na na 279 268 Source: Statista, https://www.statista.com/statistics/475673/vehicle-sales-of-fca-in-leading-countries/, retrieved June 4, 2020, VW web-site, https://www.best-selling-cars.com/brands/2019-full-year-globale-volkswagen-sales- worldwide/, retrieved June 4, 2020 6

Capitalizing Development Costs at Fiat Chrysler Automobiles and Volkswagen 121-018 Exhibit 3 Largest automobile manufacturers by number of vehicles sold in 2018 Rank Company Country No of vehicles sold (000) Market share 1 Volkswagen Group Germany 10,457 11.8% 2 Renault Nissan Alliance Japan/France 9,828 11.1% 3 Toyota Japan 9,536 10.7% 4 General Motors U.S. 8,690 9.8% 5 Hyundai-Kia South Korea 7,327 8.2% 6 Ford U.S. 5,318 6.0% 7 Honda Japan 4,859 5.5% 8 FCA Italy/U.S. 4,538 5.1% 9 Groupe PSA France 3,496 3.9% 10 Suzuki Japan 2,717 3.1% 11 Mercedes Daimler Germany 2,552 2.9% 12 BMW Germany 2,502 2.8% 13 Geely Group China 2,247 2.5% 14 Mazda Japan 1,557 1.8% 15 Changan China 1,185 1.3% Source: Focus2move, https://www.focus2move.com/world-car-group-ranking-2018/, retrieved June 4, 2020 7

121-018 -8- Exhibit 4 Fiat Chrysler Automobiles, summary income statements and balance sheets for fiscal years ending December 31, 2016 to 2019 (€millions) 2019 2018 2017 2016 Income statement data Revenues 108,187 110,412 105,730 105,798 Cost of revenues 93,164 95,011 89,710 90,927 Gross profit 15,023 15,401 16,020 14,871 Research & development expense 3,612 3,051 2,903 2,930 Other operating expenses 6,594 7,421 7,187 7,443 Operating profit before tax 4,817 4,929 5,930 4,498 Net income 6,630 3,632 3,510 1,814 Balance sheet data Current assets 34,932 38,292 36,274 39,722 Property, plant and equipment 28,608 26,307 29,014 30,431 Capitalized development expenditures, net 10,507 9,825 9,697 9,359 Other noncurrent assets 23,997 22,452 21,314 24,831 Assets 98,044 96,876 96,299 104,343 Current liabilities 43,354 46,474 47,269 49,469 Noncurrent liabilities 26,015 25,496 28,043 35,521 Equity 28,675 24,903 20,987 19,353 Total Liabilities & Equity 98,044 96,873 96,299 104,343 Number of vehicles sold (000) 4,272 4,655 4,423 4,482 Source: Fiat Annual Report 2019 For the exclusive use of N. AlGhaith, 2021.

121-018 -9- Exhibit 5 Volkswagen, summary income statements and balance sheets for fiscal years ending December 31, 2015 to 2019 (€millions) 2019 2018 2017 2016 Income Statement Revenues 212,473 201,067 196,949 186,016 Cost of revenues1 157,278 158,361 158,863 158,968 Gross profit 55,195 42,706 38,086 27,048 Research & development expense 13,199 12,116 11,614 11,509 Other operating expenses 28,248 19,463 15,326 10,871 Operating profit before tax 13,748 11,127 11,146 4,668 Net income 11,027 9,926 8,099 3,591 Balance sheet Current assets 93,081 91,371 80,210 81,083 Property, plant and equipment 65,043 54,619 52,503 51,415 Capitalized development expenditures, net 23,988 22,426 20,972 19,573 Other noncurrent assets 64,704 66,108 67,436 68,014 Assets 246,816 234,524 221,121 220,085 Current liabilities 63,220 67,982 69,711 80,973 Noncurrent liabilities 90,822 77,692 69,805 69,982 Equity 92,774 88,850 81,605 69,130 Total Liabilities & Equity 246,816 234,524 221,121 220,085 Number of vehicles sold (000) 10,956 10,900 10,777 10,391 Source: Volkswagen Annual Report 2016, 2017, 2018, 2019 1. Volkswagen includes its Research & Development expense as part of Cost of revenues. For comparative purposes, the case authors have presented it separately in similar layout and presentation as FCA. For the exclusive use of N. AlGhaith, 2021.

121-018 Capitalizing Development Costs at Fiat Chrysler Automobiles and Volkswagen Exhibit 6 Overview of accounting standard setting To increase the reliability and comparability of financial reports, countries regulated the accounting methods that public companies could use to record their business transactions. Outside the U.S., standards were specified by country regulators and standard-setting bodies. However, over time, many had decided to adopt International Financial Reporting Standards (IFRS), set by the International Accounting Standards Board (IASB). The IASB was an independent board of 16 members with standard setting, auditing, company preparer, investor, and academic backgrounds, who represented countries that had agreed to adopt its standards. It was funded by public authorities (such as China’s Ministry of Finance and the U.S. Federal Reserve System), accounting firms, and publication sales. In 2019, 144 countries required all or most domestic public companies to use IFRS Standards. Notable exceptions, included China, Japan, India, and the U.S. Chinese companies listed on local exchanges reported using standards that “substantially converged with IFRS Standards”, although Chinese companies listed on the Hong Kong stock exchange were required to report under IFRS standards. Japanese listed companies were permitted to use IFRS, US standards, or Japanese national standards, and Indian standards were “based on and substantially converged with IFRS Standards.” In the United States, standard setting was performed by the Financial Accounting Standards Board (FASB), an independent standard-setting body delegated responsibility for setting accounting standards by the Securities and Exchange Commission (SEC). The accounting standards formulated by the FASB were known as generally accepted accounting principles (US GAAP). The FASB was an independent board of seven full-time members with auditing, company preparer, investor, and academic backgrounds. It was funded through fees on publicly-traded companies and from sales of FASB publications. Both the FASB and the IASB followed a similar deliberation process for setting standards. Reporting issues to be reviewed were typically raised by stakeholder recommendations and concerns. These issues were then analyzed by research staff and aired at one or more public meetings. A proposed standard, issued in the form of an Exposure Draft, was released and stakeholder input solicited. After considering this feedback, a final standard was issued. Although IFRS Standards and US GAAP were both accrual-based, with similar purposes and outcomes, there were differences in their approaches. IFRS Standards were more principles-based (more flexible and broader), whereas US GAAP was more rules-based (involving more complex standards and narrower interpretations). However, since 2002, the two rule-making bodies had worked together in an effort to harmonize the two sets of standards, by developing standards jointly and eliminating narrow differences where possible. Source: International Financial Reporting Standards (IFRS) set by the International Accounting Standards Board (IASB). 10

121-018 -11- Exhibit 7 Gross and net carrying values of capitalized development costs and R&D expenses at Fiat Chrysler Automobiles for fiscal years Source: Fiat Annual Report 2019 For the exclusive use of N. AlGhaith, 2021. ending December 31, 2016 to 2019 (€millions) 2019 2018 2017 2016 Capitalized development costs gross carrying value At January 1 20,228 19,899 18,739 15,749 Additions 2,889 2,235 2,586 2,558 Other (divestitures, translation differences) (191) (1,906) (1,426) 432 At December 31 22,926 20,228 19,899 18,739 Accumulated amortization At January 1 10,403 10,202 9,380 7,610 Amortization 1,358 1,456 1,424 1,492 Impairment losses and write-offs 949 147 110 121 Other (divestitures, translation differences) (291) (1,402) (712) 157 At December 31 12,419 10,403 10,202 9,380 Net carrying amount, December 31 10,507 9,825 9,697 9,359 Research and development expense R&D expenditures expensed 1,305 1,448 1,369 1,317 Amortization of capitalized dev. expenditures 1,358 1,456 1,424 1,492 Impairment and write-off of capitalized dev. expenditures 949 147 110 121 Total 3,612 3,051 2,903 2,930

121-018 -12- Exhibit 8 Gross and net carrying values of capitalized development costs and R&D expenses at Volkswagen for fiscal years ending December Source: Volkswagen Annual Report 2016, 2017, 2018, 2019 For the exclusive use of N. AlGhaith, 2021. 31, 2016 to 2019 (€millions) 2019 2018 2017 2016 Capitalized development costs gross carrying value At January 1 39,235 36,067 34,651 30,462 Additions 5,171 5,234 5,260 5,750 Other (divestitures, translation differences) (1,323) (2,066) (3,844) (1,561) At December 31 43,083 39,235 36,067 34,651 Accumulated amortization At January 1 16,810 15,094 15,079 13,005 Amortization 4,049 3,665 3,345 3,278 Impairment losses and write-offs (384) 2 389 308 Other (divestitures, translation differences) (1,377) (1,951) (3,719) (1,512) At December 31 19,098 16,810 15,094 15,079 Net carrying amount, December 31 23,985 22,425 20,973 19,572 Research and development expense R&D expenditures expensed 9,534 8,449 7,880 7,923 Amortization of capitalized dev. expenditures 4,049 3,665 3,345 3,278 Impairment and write-off of capitalized dev. expenditures (384) 2 389 308 Total 13,199 12,116 11,614 11,509

Capitalizing Development Costs at Fiat Chrysler Automobiles and Volkswagen 121-018 Endnotes 1 Statista, Total global research and development spending on automotive from 2017 to 2019, https://www.statista.com/statistics/1102932/global-research-and-development-spending-automotive/, retrieved June 4, 2020. 2 American Automotive Policy Council, State of the U.S. Automotive Industry, August 2018, retrieved May 30, 2020, http://www.americanautocouncil.org/sites/aapc2016/files/2018%20Economic%20Contribution%20Report.pdf. 3 Ibid. 4 Willy Shih, Don’t Underestimate Chinese Automakers, July 25, 2018, Forbes, retrieved June 3, 2020, https://www.forbes.com/sites/willyshih/2018/07/25/dont-underestimate-chinese-auto-makers/#2adb8e66ec96 5 Auto Punditz, Report Card – 2019 Car Sales in India, retrieved June 3, 2020, http://www.autopunditz.com/news/report- card-2019-car-sales-india/. 6 David Bailey, Alex de Ruyter, Jonthan Michie, and Peter Tyler, Global Restructuring and the auto Industry, Cambridge Journal of Regions, Economy and Society, November 2010, retrieved June 3, 2020, https://academic.oup.com/cjres/article/3/3/311/497525. 7 Jim Rutenberg and Bill Vlasic, Chrysler Files to Seek Bankruptcy Protection, April 30, 2009, The New York Times, https://www.nytimes.com/2009/05/01/business/01auto.html, retrieved May 26, 2020. Chris Isidore, Chrysler Won’t Repay Bailout Money, May 9, 2009, CNN, https://money.cnn.com/2009/05/05/news/companies/chrysler_loans/, retrieved May 26, 2020. 8 SEC, Form F-1 Registration Statement, Fiat Chrysler Automobiles, 2014, retrieved June 3, 2020, https://www.sec.gov/Archives/edgar/data/1605484/000119312514369330/d755216df1.htm#rom755216_9 9 Ibid. 10 Reuters, Fiat says Merger into Dutch-registered FCA Effective October 12, October 7, 2014, https://www.reuters.com/article/us-fiat-spa-chrysler/fiat-says-merger-into-dutch-registered-fca-effective-october-12- idUSKCN0HW0CZ20141007, retrieved May 26, 2020. Tim Worstall, Tax Competition Does Work; Fiat Chrysler to be Based in the UK, Forber, May 10, 2014, https://www.forbes.com/sites/timworstall/2014/05/10/tax-competition-does-work-fiat- chrysler-to-be-based-in-the-uk/#2731a0392652, retrieved May 26, 2020. 11 Global Fleet, Brazil’s 2017 Top 10 Selling Cars, Jan. 15, 2018, https://www.globalfleet.com/en/manufacturers/latin- america/article/brazils-2017-top-10-sold-cars?a=DBL10&t%5B0%5D=Brazil&curl=1, retrieved June 3, 2020. 12 Volkswagen Emissions Scandal Timeline, The Guardian, https://www.theguardian.com/business/2015/dec/10/volkswagen-emissions-scandal-timeline-events, retrieved June 4, 2020. 13 Hiroki Tabuchi and Jack Ewing, Wolkswagen to Pay $14.7 billion to Settle Diesel Claims in U.S., New York Times, June 27, 2016,. https://www.nytimes.com/2016/06/28/business/volkswagen-settlement-diesel- scandal.html?action=click&contentCollection=Business&region=Footer&module=WhatsNext&version=WhatsNext&contentID =WhatsNext&moduleDetail=undefined&pgtype=Multimedia, retrieved June 4, 2020. 14 Volkswagen says scandal has cost it 31.3 billion euros, Reuters, March 17, 2020, https://www.reuters.com/article/us- volkswagen-results-diesel/volkswagen-says-diesel-scandal-has-cost-it-31-3-billion-euros-idUSKBN2141JB, retrieved June 4, 2020. 15 Volkswagen 2019 annual report. 16 Sean Szymkowski, Volkswagen shovels $66 billion at electric cars, digital tech, Road Show, Nov. 15, 2019, https://www.cnet.com/roadshow/news/volkswagen-electric-cars-technology-investment/, retrieved June 4, 2020. 13

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