Considering r&d amortization in calculating CFO - CFA lvl 1

A Europe-based telecommunications provider follows International Financial Reporting Standards (IFRS) and capitalizes new product development costs. During 2014, it spent €25 million on new product development and reported an amortization expense related to a prior year’s new product development of €10 million. The company’s cash flow from operations was €290 million.

An analyst is comparing the European company with a US-based telecommunications provider and has decided to adjust its financial statements to US GAAP. Under US GAAP, ignoring tax effects, the cash flow from operations for the European company would be closest to:

  1. €265 million.
  2. €290 million.
  3. €275 million.

A is correct. US GAAP requires that both research and development costs be expensed as incurred. Cash flow from operations would be lower by the amount spent on development: €290 million – €25 million = €265 million. The amortization of previous development costs is a non-cash expense, so it does not affect cash flow.

My question here is since previous year’s development costs under US GAAP would have been expensed off entirely instead of being capitalized, the amortization cost of 10 under IFRS should be deducted from CFO calculated under US GAAP since it shouldnt even exist under US GAAP.

CFO should be 290-10-25 = 255.

Any help would be greatly appreciated!

I recall seeing this somewhere . . . . :wink:

I believe that their answer is wrong; it should be €290 million.

Cash flow is cash flow. There will be differences in Net Income because of the different treatment of R&D, so there will be different adjustments to get from Net Income to CFO, but CFO should be the same: they paid €25 million this year irrespective of what accounting standards they use, and prior years’ cash flows don’t matter irrespective of what accounting standards they use.

In short, their guideline answer is wrong.

Thanks for taking the time to reply!

My thought process is like this (Assuming there is no change to Net Income):
The amortization cost of 10 arising from previous year’s capitalizing of product development costs under US GAAP would never have existed. This should be added back to CFO of 290 under IFRS since to arrive at 290, amortization cost of 10 was added to Net Income.

Let me know your thoughts.

There’s your problem: there has to be a change to Net Income. Under IFRS the €25 million was deducted to arrive at Net Income, while under US GAAP it wasn’t.

Ask yourself this:

  • What cash was paid/received assuming IFRS that wasn’t paid/received assuming US GAAP?
  • What cash was paid/received assuming US GAAP that wasn’t paid/received assuming IFRS?

Note that the curriculum is silent about whether the cash spent for R&D under US GAAP should be classified as CFO or CFI, so that cannot be the point of this question.