Analysis of the GlaxoSmithKline Finances - Case Study Example

Report on valuation of noncurrent assets Valuation of Noncurrent assets An analysis of the GlaxoSmithKline financial report 0 Introduction Company financial reports are required to provide a “true and fair view” of the financial performance of the company in both the UK GAAP (Generally Accepted Accounting Practice) and in IFRS (International Fair Reporting Standards). This has been reiterated by the UK Financial Reporting Council in June 2011 (FRC, 2011). A key parameter of this true and fair view is the reporting of the value of the company’s assets. A company’s fixed or non-current assets are made up of both tangible or physical assets and intangible assets as shown in the sketch below. The valuation of physical assets such as buildings or machinery is well defined in international accounting practice and does not vary significantly from one industry to another. The value of intangible assets such as Patents, licenses is company or industry specific. In international accounting practice, this valuation is largely left to management judgement. Any change in the basis of valuation has to be disclosed in the annual report. A study in 2010 by the US consulting company Ocean Tomo showed that physical or tangible assets of the S&P 500 companies that contributed to 83% of company book values in 1975 now make up only 20% (OceanTomo, 2010). The predominant share of intangible assets in company book values makes it difficult to compare financial reports across companies, even if the companies are in the same industry. (Chart from Ocean Tomo, 2010) Tony Hadjiloucas of Price Waterhouse Coopers, in a report points out that intangible assets are often the only significant differentiator between companies. They provide barriers to entry, differentiate products and services, provide international recognition and provide a more stable and profitable earnings stream (Hadjiloucas, 2007). The pharmaceutical industry is particularly heavily dependent on intangible assets in their business structure. Their products depend heavily on R&D, they use proprietary manufacturing processes, they create brands for marketing and their market access is governed by the licenses granted by governments. In this report, we examine the composition of non-current assets for GlaxoSmith Kline (GSK), one of the world’s largest pharmaceutical companies and the management practice in valuing these intangible assets in relation to the International Financial reporting Standards. 2. Noncurrent assets in the GSK 2013 Annual Financial Report (a) Noncurrent assets from the GSK Annual report for 2013 (GSK AR 2013) Noncurrent Assets 2013 2012 (In £ million)     Property, plant and equipment 8,872 8,776 Goodwill 4,205 4,359 Other intangible assets 9,283 10,161 Investment in associates 579 560 Other investments 1,202 787 Deferred tax assets 2,084 2,391 Derivative financial instruments 1 54 Other non-current assets 889 682 Total non-current assets 27,115 27,770 Goodwill + Intangible assets (%) 49.7% 52.3% The three principal types of non-current assets owned by GSK are Property, Plant and Equipment Goodwill and Intangible assets Goodwill and Intangible assets make up a significant 49.7 % of the company’s total non-current assets in 2013. (b) Property, Plant and equipment Property, Plant and equipment in the GSK Balance Sheet relates to the land, buildings, plant and equipment used for the manufacture of its products. The value at cost of these noncurrent assets is reported as £ 18,853 million and the value of £ 8,872 million shown in the balance sheet is the value after depreciation (GSK AR 2013, p 69). Depreciation provisions are made depending on the expected life of the assets. These provisions are well accepted in International Financial Accounting rules. The company has made a small provision of £ 58 million for impairment losses on these assets. The impairment provision is based on assessing the assets at fair value less disposal costs or value in use, which is the accepted practice as per the International Accounting Standard -IAS 38. Fair value is the price an arms-length buyer would pay for the asset and value in use is the Net Present Value of future cash flows expected from the asset, discounted at the weighted average cost of capital – 7% (GSK AR 2013, p 158) . The IFRS defines an asset as “a resource controlled by the entity, which is the result of past effort and from which future economic benefits are expected. The item has to have a cost or value that is measurable” (IFRS Workshop, 2012). Property, Plant and equipment meets this definition. (c) Goodwill The GSK balance sheet for 2013 shows Goodwill valued at £ 4,205 million. These intangible assets are as a result acquisitions made by GSK of various companies over the years (GSK AR 2013, p 157). The IFRS 3 recommends that the difference between the price paid for the acquisition of a company and the fair value of its assets be treated as Goodwill in the company’s books (IFRS 3, 2011). GSK has followed this recommendation as illustrated by the treatment of the two major acquisitions made in 2011 and 2012. GSK acquired Human Genome Sciences of US for £ 2,515 million. The acquired company only had £ 31 million in property, plant and equipment and revenues of £ 154 million. GSK has valued the acquisition in its books with £ 1,249 million in intangible assets and £ 791 million in goodwill (GSK AR 2012, p 188). GSK acquired the stake held by its partner Shionogi in a Japanese joint venture. This transaction has added £ 1,777 million in intangible assets and a negative goodwill of £ 124 million (GSK AR 2012, p 188) In the year 2013, there is a small decrease in the value of Goodwill, attributed to the change in value of currencies with respect to the reporting currency, the UK Pound (GSK AR 2013, p 69). The assessment of fair value of the acquisition is based on assumptions by the management on sales growth and profits of the acquired company. These assumptions can change when another company enters the market, or if an alternative drug is introduced. Sales and profit projections are also impacted by the general economic conditions in the market and also by governmental action such as price controls or compulsory licensing of the product which is not uncommon in the pharmaceutical industry. Though the valuation and reporting of Goodwill by GSK is entirely in conformity with IFRS, the concern is with the annual report being a true and fair reflection of the company’s book value. In the pharmaceutical industry acquisitions are generally made for obtaining rights to a new drug discovery or for access to a specific market. The value paid for the acquisition would therefore always be several multiples of the fair value of the acquired assets. The average investor would have no way of inferring whether the Goodwill value shown in the annual report is indicative of the true value of the acquired business. If the management has paid too high a price for the acquisition, there would be wrote-offs in future years impacting the earnings of the company. The investor would then have to depend on the reports of independent stock market or industry analysts to make his assessment. The GSK annual report does make the statement that the valuation of Goodwill has “sufficient headroom such that reasonably possible changes to key assumptions are unlikely to result in impairment of related Goodwill” (GSK AR 2013, p 158). (d) Other intangible assets Other intangible assets form the largest single component of noncurrent assets in the GSK balance sheet at a value of £ 9,283 million. The annual report says that these intangible assets include a large number of acquired licences, patents, know-how agreements and marketing rights. The annual report provides a list of the largest individual items which total £ 6,525 million. In addition, GSK assigns a value to its major brands at £2,114 million. The International Accounting Standard IAS 38 defines intangible assets to include “scientific and technical knowledge, design and implementation of new processes or systems, licences, market knowledge and trademarks for future economic benefits” (IAS 38-1, 2010). The GSK definition of intangible assets complies with this definition. The IAS 38 also prescribes certain tests to determine if an intangible asset has been created. The asset should be separable from the entity and be capable of being sold or transferred. The asset should arise from a long term licence or legal contract, whether these are transferable or not The asset should give future economic benefits to the company The company has control over the asset in terms of ensuring that the future economic benefits flow to the company and in restricting others from those benefits. This should flow from legal rights enforceable in a court of law. The IAS 38 prescribes three methods of valuing intangible assets (IAS 38-2, 2012). i. Cost model – where the intangible asset is carried at cost less any amortization applied or impairment losses. ii. Fair value model – the price an arms-length buyer is willing to pay for it iii. Value-in-use model – the money value of the number of units of production or the number of years of service that the intangible asset is expected to give to the company. The valuation method for intangible assets is shown in the chart below. The IAS 36 requires that no asset is carried on a company’s books at a cost higher than the recoverable amount. If the recoverable amount is lower than the carrying cost, an impairment charge must be applied (IAS 36, 2012). The recoverable amount is defined as the higher of the fair value that a buyer is willing to pay or the value-in-use (Ernst & Young, 2008). (Chart from Ernst & Young, 2008) Since it is impossible to determine the price a buyer is willing to pay until the intangible asset is actually put on sale, value-in-use is the most frequently used model for valuation. The value-in-use estimates are based on management judgement and can vary from year to year based on factors such as competition, realizable sales in the market and price projections. (Ernst & Young, 2008). 3. Valuation of intangible assets provides opportunity for earnings management One reason for concern about the valuation of intangible assets in a company’s financial reports is the opportunity that it provides for “earnings management”. A study by Richard Andrews of the Hull University Business School in 2012 shows that companies periodically indulge in the accounting practices termed “income smoothing and big bathing” in their financial reports. “Income smoothing”, as the name suggests, is the process where managements advance or defer asset write-down to avoid fluctuations in reported profits. “Big bathing” is writing off large blocks of assets using the opportunity of an acquisition/ divestiture or restructuring in the company to clean the books. The study shows that an astounding 93% of the 57 firms examined in the study have indulged in this practice between 2005 and 2007 (Andrews, 2012). Kevin Amor and Alan Warner say in their book “Uncovering Creative Accounting”, managers control the data in companies and have the power and opportunity to manipulate the financial numbers to meet the needs of company management rather than provide objective numbers for the shareholders. This practice referred to as “earnings smoothing” is commonplace and usually acceptable as long as it is not part of an intention to deceive over the long term (Amor and Warner, 2003, p3). The large value of intangible assets in GSK’s books made up of patents, brand names and marketing rights provides opportunities for the company to over or understate impairment to smooth earnings. The company makes periodic divestitures of brands and manufacturing facilities where big bathing of assets is possible. There is no evidence of GSK having attempted earnings management in either of the 2012 or 2013 Annual Reports. However, the annual bonus component of the remuneration of members of the Board of Directors is linked 75% to the Group operating profit and 25% to the Group profit before interest and tax (GSK AR 2013, p 98). If, in a particular year, the group operating profits show a dip which members of the board persuade themselves to be a temporary problem, there would be a strong temptation to use income smoothing. 4. Conclusion The analysis of GlaxoSmithKline’s financial report for 2013 shows that 49.7% of the company’s book value is made up of Goodwill and other intangible assets. Major additions to Goodwill and Intangible assets take place when the company acquires other companies to expand its product line or to enter a new market or in one case to buy-out a Joint Venture. The valuation of these intangible assets is primarily by management judgement. The International Accounting rules only provide broad guidelines. The valuation of these intangible assets provides opportunities to the company for earnings management while remaining within the guidelines of accounting rules. The fact that a part of the remuneration of senior executives is linked to company profitability offers strong temptation for earnings management. There is, of course, no evidence of any earnings management in the two annual reports analysed and GSK has a strong reputation in the financial markets for good governance practices. 5. References: 1. Amor, K. and Warner, A., 2003. Uncovering Creative Accounting, Prentice Hall, 2003. 2. Andrews, R., 2012. Fair Value, earnings management and asset impairment: The impact of a change in regulatory environment, Procedia Economics and Finance, 2(2012), 16-25. Available at : http://www.sciencedirect.com/science/article/pii/S2212567112000603 (Accessed 29 Oct 2014). 3. Ernst & Young, 2008. Impairment Accounting – the basics of IAS 36 Impairment of assets, 2008 IFRS Standards update, 2008. Available at: http://ey.mobi/Publication/vwLUAssets/ Impairment_accounting_the_basics_of_IAS_36_Impairment_of_Assets/$FILE/Impairment_accounting_IAS_36.pdf (Accessed 29 Oct 2014 at www.ey.com). 4. FRC, 2011. Effective Company Stewardship, Next Steps, Financial Reporting Council, Jan 2011. Available at : https://www.frc.org.uk/Our-Work/Publications/FRC-Board/Effective-Company-Stewardship-Enhancing-Corporate-File.pdf (Accessed 29 Oct 2014). 5. GSK AR 2012. GlaxoSmithKline Annual Report, 2012. Available at: http://www.gsk.com/en-gb/investors/corporate-reporting/corporate-reporting-archive/2012/annual-report-2012/ (Accessed 29 Oct 2014). 6. GSK AR 2013. GlaxoSmithKline Annual Report, 2013. Available at: http://www.gsk.com/ media/325156/annual-report-2013.pdf (Accessed 29 Oct 2014). 7. IAS 36, 2012. “Impairment of Assets”, 1 January 2012. Available at: http://www.ifrs.org/ IFRSs/IFRS-technical-summaries/Documents/IAS36-English.pdf (Accessed 29 Oct 2014). 8. IAS 38 -1, 2010. International Accounting Standard 38 – Intangible Assets, 24 March 2010. Available at : http://ec.europa.eu/internal_market/accounting/docs/consolidated/ias38_en.pdf (Accessed 29 Oct 2014). 9. IAS 38-2, (2012). IAS 38 Technical Summary, 1 Jan 2012. Available at: http://www.ifrs.org/ IFRSs/IFRS-technical-summaries/Documents/IAS38-English.pdf (Accessed 29 Oct 2014). 10. IFRS 3, 2012. International Financial Reporting Standards 3 – Business Combinations, 1 Jan 2012. Available at: http://www.ifrs.org/ IFRSs/Documents/English%20Web%20summaries/ IFRS%203.pdf (Accessed 29 Oct 2014). 11. IFRS Workshop, (2012). Classification of Assets, International Financial Reporting Standards Workshop, 30 April – 4 May 2012. Available at: http://www.ifrs.org/ Use around .../ 1.%20Classification%20of%20assets.pptx. (Accessed 29 Oct 2014). 12. Hadjiloucas, T., 2007. The increasing importance of intangibles in industry, Price Waterhouse Coopers, October 2007. Available at: http://www.pwc.com.cy/en_CY/cy/ publications/ (Accessed on 29 Oct 2014). 13. Ocean Tomo, 2011. Ocean Tomo’s annual study of Intangible Assets Market Value – 2010, Ocean Tomo Media Room, 4 April 2011. Available at: http://www.oceantomo.com/ media/ newsreleases/intangible_asset_market_value-2010. (Accessed 29 Oct 2014). Read More