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RD Accounting at Henkel

• Robert Risse
• Internationales Bilanzrecht, Köln 13.06.2008

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Agenda

• Setting the scene basic principles
• Henkel's approach to RD accounting
• Industry examples
• Conclusions

2008 Henkel AG Co. KGaA Global Tax Group (FCS)
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1.1) Reflection of RD in main financial
statements

• PL Research and development expenses
• Balance Sheet Research and development results

Goodwill
Patents, Trademarks Proprietary
Technology Software Customer lists Contracts,
Licenses
Equity
Fixed Assets
Debt
Working Capital
2008 Henkel AG Co. KGaA Global Tax Group (FCS)
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1.2) Accounting for RD

• "Apparent paradox" RD costs are expensed in the
  period incurred, although those costs are
  considered an investment infuture products /
  materials / processes etc. (vs. "matching
  principle")
• IAS 38 provides the relevant framework for RD
  accounting

Intangible assets
Acquired
Internally generated
Separateacquisition
Businesscombination
Other,e.g. patents, software
Other,e.g. patents, software
Goodwill
Goodwill(? IFRS 3)
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1.3) Definitions
RD

• Knowledge-development focus
• May result in a physical asset (e.g. prototype /
  ? secondary aspect)
• The "intangible component" is the primary RD
  feature
• Research Original, planned investigation to gain
  new scientific / technical knowledge and
  understanding
• Development Application of research findings /
  knowledge for new / improved products etc.,
  before commercial production or use

Intangible asset characteristics

• Identifiable resource, non-monetary, without
  physical substance
• Control by the entity due to past events
• Expected future economic benefit

2008 Henkel AG Co. KGaA Global Tax Group (FCS)
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1.4) Recognition criteria for intangible
assets
Intangible asset
Identifiability
Control
Future econ. benefit
- Sales revenues- Cost savings- Other benefits
from use
- Power to obtain future benefits- Restrict
others access to those benefits
- Separable (vs. goodwill)- Arising from legal
rights / contracts
Criteria

• Probability of expected future economic benefit
  according to management best estimate
• Reliable (at) cost measurement for asset
  generation

Challenges

• Unambiguous intangible asset identification
• Probability prediction of future economic benefit
  realisation
• Reliable capture of relevant cost

2008 Henkel AG Co. KGaA Global Tax Group (FCS)
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1.5) RD as a source of intangible assets
generation
Commercialproductionor use
Research phase
Development phase
Customer
No indication of an intangible asset with
expected future economic benefit
Indication of anintangible asset
Recognition criteria for intangible assets 1)
Technical realisation feasibility2) Intention to
complete3) Ability to use / sell4)
Demonstration of future economic benefit5)
Availability of relevant resources6) Reliable
measure of attributable expense
?
No balance sheet recognition! ? RD expense in PL
Mandatory balancesheet recognition!
?
Challenges

• Unambiguous distinction of research vs.
  development phase
• Cumulative proof of all recognition criteria in
  development phase

2008 Henkel AG Co. KGaA Global Tax Group (FCS)
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1.6) Determination of attributable
development expenses

• No ex post recognition of development expenses
  for an intangible asset
• Carry forward of a recognised intangible asset
  either at - cost (less amortisation) or - fair
  value (revaluation less subsequently accumulated
  amortisation or impairment losses)
• Directly attributable costs for intangible assets
  generation relate to materials, services,
  employee benefits, legal registration fees,
  amortisation of patents / licenses
• No (indirect) admin. and overhead expenses,
  inefficiencies or start-up losses or training
  expenditures for staff operating the intangible
  asset

Challenge

• Sufficiently detailed and standardised cost
  center and/or project accounting established

2008 Henkel AG Co. KGaA Global Tax Group (FCS)
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Agenda

• Setting the scene basic principles
• Henkel's approach to RD accounting
• Industry examples
• Conclusions

2008 Henkel AG Co. KGaA Global Tax Group (FCS)
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2.1) Henkel Worldwide

• Sales 13,074 mill. euros

• 125 countries

• 52,300 employees

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2.2) Three Areas of Competence
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2.3) Overview of our Top Brands
Cosmetics/ Toiletries
Laundry/Home Care
Adhesives Technologies
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2.4) Henkel's perspective on RD
Innovation
IP Generation

• Corporate RD
• Corporate Engineering
• BU Product Development
• BU Process Technology

2008 Henkel AG Co. KGaA Global Tax Group (FCS)
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2.5) Henkel's perspective on RD
Goal Sustainable value creation for Henkel's
customers and shareholders

• We strive forinnovation

• We are customerdriven

• We are committed to shareholder value

2008 Henkel AG Co. KGaA Global Tax Group (FCS)
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2.6) Research Development
Research Development expenditures 2003 - 2007
Figures in mill. euros
400
350
340
324
272
300
257
200
100
2007
2003
2004
2005
2006
2.7
2.6
2.7
2.7
RD ratio
2.7
research expenditures as a proportion of sales
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2.7) Research Development 2007
Research Development expenditures by business
sectors

• 350 mill. euros for Re- search and Development
  (RD) correspond to 2.7percent of sales
• worldwide 2,800 employeesin RD

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27
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46
Adhesives Technologies
Laundry Home Care
Corporate Research
Cosmetics/Toiletries
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2.8) Competence Center Chemistry CCC

• Polymer Chemistry and chemical synthesis
• Physical Chemistry

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2.9) Competence Center EMTech

• Biotechnology
• Microbiology

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2.10) Competence Center Scientific
Computing SC³

• Computer-aided Materials Simulations

Chemoinformatics
Applied Mathematics Statistics
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2.11) Competence Center TechnologyTECC

• Corporate Engineering
• Technology Development

2008 Henkel AG Co. KGaA Global Tax Group (FCS)
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2.12) Challenges for RD accounting at
Henkel

• Highly variable RD portfolio in / for different
  business units
• Diverse research and development project contents
• High interdependencies of project contents
• Broad portfolio of high volume, (rather) low cost
  products,partly short product life cycles (e.g.
  cosmetics, lt 2 years)
• Degree of relevant RD contribution to ultimate
  product successis often hard to determine
  quantitatively in a reliable way,especially at
  an early stage in the development process

• Unambiguous intangible asset identification?
• Transparent future economic benefit
  determination?
• Straightforward distinction of research vs.
  development phase?
• Reliable capture and transparent attributability
  of relevant cost?
• All recognition criteria in development phase
  cumulatively met?

Practical challenges
2008 Henkel AG Co. KGaA Global Tax Group (FCS)
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2.13) Decisions on RD accounting policy
(1/2)

• Tracking of RD costs via projects in SAP (PS) or
  on cost centers
• Separate recognition of divisional and corporate
  RD expenses and local product development
  expenses in Henkel's internal income statement
• Disclosure of RD expenses in Henkel's
  consolidated statement of income (? Annual
  Report)
• No recognition of research expenses as - or
  pertaining to (intangible) assets
• IAS 38 criteria for recognising development
  expenses are currently not all being met

2008 Henkel AG Co. KGaA Global Tax Group (FCS)
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2.14) Decisions on RD accounting policy
(2/2)

• Self-generated software with definite useful live
  is stated at production costs
• Net book value of internally generated intangible
  assets with definite useful live was 100 M at
  31.12.2007(i.e. 2.0 total intangible assets
  book value and 0.8 of total assets in 2007)

2008 Henkel AG Co. KGaA Global Tax Group (FCS)
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2.15) Value based management
implications

• Net income and after tax operating income are
  reduced by expensing RD directly in current
  year, tax deductibility offsets this impact to
  some extent
• Reclassification of RD expenses as capital
  expenditures impacts upon assets, equity,
  operating and net income, profitability measures
  (e.g. return on capital and equity), but no
  effect on (current) free cash flow to the firm
• The impact of RD capitalisation on (expected)
  EBIT growth rates has a strong effect on business
  valuation and on earnings multiples commonly used
  for valuation purposes (e.g. PE ratio,
  Value/EBITDA)

2008 Henkel AG Co. KGaA Global Tax Group (FCS)
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2.16) Consequences regarding Henkel's
application of EVATM

• Uncertainty regarding actual marketability of
  products, resulting from clearly identifiable
  development project contributions, is the main
  aspect to opt against capitalisation of
  development expenses
• Given the relatively stable amount of RD spend,
  in line with Henkel's peer group companies, a
  (partial) reclassification of RD expenses could
  potentially lead to higher accuracy regarding
  theapplication of the theoretical concept
• However, with respect to the magnitude of
  Henkel's RD spend in relation to total assets,
  no fundamentally different presentation of
  company performance to potential and current
  investors expected
• On the down side, capitalisation of development
  expenses would require enhanced administrative
  effort, e.g. monitoring and evaluation of
  development project results on an ongoing basis

2008 Henkel AG Co. KGaA Global Tax Group (FCS)
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Agenda

• Setting the scene basic principles
• Henkel's approach to RD accounting
• Industry examples
• Conclusions

2008 Henkel AG Co. KGaA Global Tax Group (FCS)
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3.1) RD accounting in the automobile
industry
Example BMW move from HGB to IAS in 2000
2008 Henkel AG Co. KGaA Global Tax Group (FCS)
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3.2) Characteristic features of BMW's RD

• Clear separation of research vs. development
  process
• "Engineering-type" development, allowing for
  stringent step-wise planning
• Reduced (limited) uncertainty, due to thorough
  experience from similar "predecessor series"
• Focused development contents / objects

2008 Henkel AG Co. KGaA Global Tax Group (FCS)
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3.3) Equity and PL impact for BMW (HGB ?
IAS, 31.12.2000)
of HGBequity
M
Equity
Recognition of development costs
2054
41.9
of HGB result ofordinarybusinessactivity
Change inM
PL
Recognition of development costs
236
14.2
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3.4) Impact on BMW's financial key figures
and ratios (31.12.2000)
Change (M, points)
HGB
IAS
Equity (M)
4.896
9.272
4.376
Equity ratio ()
13.7
18.9
5.2
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3.5) Other practical examples

• Bayer Health CareDa eigene Entwicklungsprojekte
  häufig behördlichen Genehmigungsver-fahren und
  anderen Unwägbarkeiten unterliegen, sind die
  Bedingungen füreine Aktivierung der vor der
  Genehmigung entstandenen Kosten in derRegel
  nicht erfüllt. (Source Bayer AG,
  Geschäftsbericht 2007, FE Quote 11.5 / 1700
  M)
• BeiersdorfCheck of development projects for
  recognition as self-generated intangible assets
  according to IAS 38. If criteria are not met,
  expensing in current period.(Reference
  Beiersdorf AG, Geschäftsbericht 2007, FE Quote
  2.3 / 127 M)
• Unilever"Expenditure on research and market
  support, such as advertising, is chargedto the
  income statement when incurred." (Source
  Unilever, Annual Report 2007, RD ratio 2.2 /
  868 M)
• Procter Gamble"Research and development costs
  are charged to expense as incurred." (Source
  PG, Annual Report 2007, RD ratio 2.8 / 2112
  M)

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Agenda

• Setting the scene basic principles
• Henkel's approach to RD accounting
• Industry examples
• Conclusions

2008 Henkel AG Co. KGaA Global Tax Group (FCS)
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4.1) Status of and outlook on RD
accounting at Henkel

• For the time being, no change of RD accounting
  policy intended
• No obvious immediate advantages discernable for
  Henkel's shareholders nor stakeholders, resulting
  from a potential(partial) reclassification of
  development expenses
• Administrative effort to track, identify and
  evaluate development expenses in line with IAS 38
  should not be underestimated
• Harmonisation of international accounting
  standards and HGB regulations (eg. BilMoG) is
  advantageous, allowing for a true andfair
  representation of company performance to enable
  and facilitate investors' decisions in capital
  markets

2008 Henkel AG Co. KGaA Global Tax Group (FCS)
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4.2) Last not least

• Thank you for your attention on a Friday
  afternoon!

2008 Henkel AG Co. KGaA Global Tax Group (FCS)
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