Introduction to financial accounting

Financial Accounting

For Merck, the company is based in the U.S. And uses the U.S. generally accepted accounting principles (GAAP) to compile its financial statements.

Novartis is based in Switzerland, and it uses international financial reporting standards (IFRS) to prepare its financial statements. It is allowed to use this as foreign firm, even though it has a cross-listing on the New York Stock Exchange, but it files a different form, the 20-C, to recognize that is a foreign entity with foreign accounting practices.

The external auditors for Merck are Price Waterhouse Coopers. They certify that they have followed the standards set by the Public Companies Accounting Oversight Board. They also followed the internal control integrated framework of COSO. The auditor for Novartis is also Price Waterhouse Coopers. They used the criteria of the internal control integrative framework from COSO and the standards of the Public Companies Accounting Oversight Board.

It is interesting to see that both of these auditors are the same company and that they use the same auditing standards. This can be explained with the cross-listing of Novartis. Because Novartis is listing in the U.S., it is subject to U.S. law, including the Sarbanes-Oxley Act. Indeed, the CEO and CFO of Novartis had to sign off on these statements as well, as part of the company's duties under SOX. So while Novartis does not need to use GAAP, it does need to follow the tenets of Sarbanes-Oxley with respect to the use of standards from the PCAOB.

There are several differences in these statements. First, with regards to presentation, the Merck statements use an unusual format for GAAP statements, for example not distinguishing between cost of goods sold and operating expenses. Novartis, using IFRS, has statements with a strange layout. Among the differences are that on the balance sheet the long-term assets are listed above the current. Equity is listed above the liabilities. There actually is not much difference with the income statement.

Overall, these statements are comparable. There are some internal difference, for example in how revenue is recognized. But with regards to presentation, they are actually fairly comparable. The way the balance sheet is rendered is slightly different, but the adjustment is not hard to make. The income statement, for the most part, only has minor cosmetic differences. Thus, on the surface it should not be hard to move between these two statements.

While superficially these statements have a high level of comparability the inputs are different. IFRS and GAAP are not always compatible with respect to how results are tabulated and compiled. Thus, even when they are similar in terms of their presentation, they can be quite different with respect to how those numbers are derived. A serious student wishing to compare these statements would need to delve into the differences between the two accounting systems in order to fully understand the numbers he or she is looking at.

Both firms record their statements in U.S. dollars, which helps for comparability. Presumably Novartis also renders its statements in Swiss francs on its home exchange, and that would be more difficult in terms of comparability.

The difference in profitability between these two companies probably relates more to their operations than to their accounting methodologies. To compare accounting methods would require examining IFRS and GAAP statements for the same company. While Novartis and Merck are in the same industry, they have different products, and these products are often given monopoly protection. Thus, the differences in profitability between major drug companies will relate more to the different products that they have on the market, their cost structures and other internal variables. There might be some influence from accounting methods, but with different companies the operations are where the majority of differences between their profitability levels will lie