Business Analysis and Valuation Using Financial Statements Text and Cases 4th Edition Palepu

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Financial Statements Text and Cases
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Business Analysis and Valuation Using Financial Statements Text and Cases 4th Edition Pal

Chapter 3

Fiat Group’s first time adoption of IFRS

Teaching Note

Version: March 2013

Introduction

This case focuses on the institutional and firm-specific factors that affect the accounting
analysis. The case has two objectives. The first objective is to illustrate that accounting rules
are the result of national accounting objectives and, consequently, have a significant
influence on the usefulness of financial statements to investors. The adjustments that Fiat
made as the result of the company’s switch from Italian GAAP to IFRS clearly reflect that the
primary objective of IFRS is to make financial reports useful for shareholders in making
economic decisions (i.e., contracting and valuation). The new rules, however, also allow
Fiat’s management more accounting discretion (in order to benefit from management’s
firm-specific knowledge and private information). The discussion of Fiat’s switch to IFRS
reporting thus nicely illustrates the trade-off between having rigid accounting rules that may
introduce noise and having flexible accounting rules that may introduce bias into financial
statements. The second objective of the case is to teach students how to identify red flags
for potential misuse of reporting discretion, i.e., assess the probability that Fiat’s
management will abuse the flexibility of IFRS rules to strategically bias the company’s
financial reports. In the end, the case also illustrates that although the adoption of investor-
oriented accounting principles, such as IFRS, potentially improves the usefulness of Fiat’s
financial statements to investors, management’s reporting incentives might conflict with
investors’ reporting demands and, consequently, mitigate the influence of the adoption of
IFRS on accounting quality.
The case starts with the discussion of Fiat’s business environment and key
accounting policies (objective: determining the initial focus of the accounting analysis),
continues with the discussion of Fiat’s accounting changes (objective: understanding the
different natures of Italian and international accounting rules; identifying and evaluating
(differences in) accounting discretion), and ends with the discussion of management’s
reporting incentives (objective: understanding the importance of reporting incentives and
learning to identify red flags).

Questions for students

1. What are Fiat’s key accounting policies? Which of Fiat’s key accounting policies are
affected by the adoption of IFRS?
2. Summarize the differences between Fiat’s key accounting methods under Italian GAAP
and those under IFRS. What characterizes the differences between the two sets of
methods? From the perspective of a minority investor in the company’s shares, which
methods provide better information about the economic performance of Fiat?

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3. Summarize the main factors that affect management’s reporting incentives and strategy
in fiscal year 2005. Which factors might reduce management’s incentive to fully comply
with the IFRSs?

Case analysis

Question 1
Fiat’s primary operational activities are the development, manufacturing and selling of
passenger cars and trucks. The company’s key accounting policies are:
- Accounting for research and development costs. Fiat’s R&D expenditures are
capitalized if (1) they classify as development costs (i.e., relate to a particular
product), (2) can be measured reliably, and (3) will generate future economic
benefits. Fiat’s own estimates of the technical and economic feasibility of newly
developed car models thus determines whether or not such costs are expensed as
incurred or amortized over the models’ estimated lives (i.e., 4-5 years for cars; 8
years for commercial vehicles/trucks).
At the end of 2004, close to 4.0 percent of Fiat’s (IFRS-based) total assets consisted
of capitalized development costs. During 2004, the company’s research and
development expenditures amounted to €1,791 million (3.9 percent of sales), of
which 58 percent was immediately expensed. (The amount of amortized
development costs of 312 million was substantially lower than the amount of newly
capitalized expenditures (€753 million).) The key question is whether Fiat is overly
conservative (or possibly overly aggressive) in immediately expensing 58 percent of
its research and development costs.
- Revenue recognition (and accounting for inventories and property, plant &
equipment). Fiat recognizes revenues when “the risks and rewards of ownership of
the goods are transferred to the customer, the sales price is agreed or determinable
and receipt of payment can be assumed: this corresponds generally to the date
when the vehicles are made available to non-group dealers, or the delivery date in
the case of direct sales.” Hence, Fiat’s revenue recognition policies are relatively
straightforward. One issue may complicate Fiat’s recognition of revenues: the
company sells some of its vehicles in combination with a buy-back option and some
under operating lease agreements. Sales with buy-back commitments are recognized
as operating leases: the difference between carrying value and resale value is
depreciated on a straight line basis; the initial sale price received is recognized as an
advance payment; the difference between the initial sale price and the buy-back
price is recognized as rental revenue on a straight-line basis. The treatment of sales
with buy-back commitments therefore also affects inventories (passenger cars) and
property, plant and equipment (commercial vehicles/trucks).
- Accounting for receivables from financing activities. Fiat provides financing services
to a proportion of its customers. This activity creates long-term receivables on the
company’s balance sheet (amounting to close to 28 percent of total assets at the end
of 2004). With regard to these long-term receivables, important accounting choices
that the company makes are particularly those concerning derecognition of factored
or securitized receivables.
All of these policies were affected by the first-time application of IFRS. Hence, the most
critical changes that Fiat made to its reporting were (1) the capitalization of development

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expenditures, (2) the delayed recognition of sales with buy-back commitments, and (3) the
re-recognition of previously derecognized “sold” receivables.

Question 2
The following discussion describes many of the accounting changes—also less critical
changes—that Fiat implemented as a result of its first time adoption of IFRS. To speed up
the discussion, the instructor could choose to focus on the changes in critical accounting
policies only. Three accounting changes are related to Fiat’s critical accounting policies: the
change to capitalization of development expenditures, the change in (de)recognition of
“sold” receivables, and the change in the recognition of margins on sales with buy-back
commitments (see also question 1).

The accounting changes that Fiat made illustrate the influence of national objectives
of accounting regulation on accounting practices. Like in many other Continental European
countries, pre-IFRS financial reporting practices in Italy were influenced by government
through the commercial code, which set out the laws that governed accounting. Reporting
practices were also strongly influenced by tax rules: some expenses must be recognized in
the financial statements in order to be tax deductible. As a consequence, Italian accounting
rules typically focused on assuring the reliability (verifiability) of recognized income
components.
Fiat’s switch to IFRS-based reporting allows students to benchmark Fiat’s accounting
practices under Italian GAAP (focusing on verifiability) with those under IFRS (focusing on
relevance but, of course, not ignoring verifiability). The key takeaway from such an analysis
would be that changing from Italian GAAP-based reporting to IFRS-based reporting typically
improves the usefulness of financial reports for the purpose of making economic decisions
(such as investment decisions). This is because IFRS is to a greater extent designed to make
financial statements “decision useful” than Italian GAAP. A side-effect of the change from
Italian GAAP to IFRS is, however, that management’s reporting discretion increases. This is
because management can best decide which accounting methods and estimates are most
appropriate given the economics of their firm and, consequently, improve the informative
value of financial reports.
One way to discuss this question is to shortly summarize one change and randomly
call upon one student to reflect on whether and why the change “improves” Fiat’s financial
reports (from the perspective of an investor). A second student could then be called upon to
identify the areas where management’s discretion increases under IFRS. The discussion
could conclude by asking the class whether and how the accounting analysis should address
the identified area(s) of discretion.
A possibly more appealing strategy to discuss Fiat’s accounting changes is to first let
students identify the common characteristics of Fiat’s most critical changes. The main
differences between Italian GAAP and IFRS relate to the following two questions:
- Who owns the assets?
- How should the firm adjust the carrying value of assets and liabilities to changes in
the fair value of the asset?
Fiat’s accounting changes can be used to illustrate how Italian GAAP and IFRS provide
different answers to these questions. Italian GAAP tends to avoid the recognition of difficult-
to-verify fair value changes in accounting profits (especially when such changes are
positive). In addition, the Italian accounting rules tend to link asset recognition decisions to

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