When the Financial Accounting Standard Board (FASB), the non- political body that writes accounting rules, voted unanimously last month to eliminate the practice of treating research and development projects as a cost to be written off as a one time charge, its sought to usher in a new era in technology merger and acquisitions activity. If FASB’s rulings are passed, mergers and acquisitions will loose their immediate appeal as an engine for corporate growth. Each transaction will depress the buyer’s earnings per share figure, negatively effect its stock and furthermore, potentially decrease the valuation placed on acquisition targets.
By calling a halt to R&D write-offs, the accounting body is effectively telling the technology industry that it will no longer be able to treat ‘purchased R&D’ as a cost. Instead it will have to label it as an intangible asset that will have to be amortized over its useful life. FASB’s message, however, goes deeper. The accounting body was warning technology companies that it was time to stop juggling accounting numbers and let investors focus on the fundamentals behind a transaction.
It was not a message that IT vendors wanted to hear. If the new ruling is passed, and there is a strong possibility that it will be set in stone by the end of the year, FASB will call a halt to what has become one of the technology industry’s favorite M&A accounting tactics.
The method of writing-off R&D charges effectively enables an acquirer to write off a large up front charge for so-called acquired research and development at the time of transaction. This avoids any detrimental impact on future earnings growth – Wall Street’s metric for gauging the economic health of a company.
Networking giant Cisco, which has acquired 30 companies in the last six years, has relied heavily on the write-off method of accounting for purchases, as has electronic design automation software house, Cadence. The company took in-process R&D charges of $339m for four acquisitions worth $400m in 1998.
And these companies are not isolated examples. In the last ten years 72% of an entire purchase has been written-off as purchased R&D, according to Barush Lev, an accounting professor at the Stern School of Business in New York, which conducted a study of 400 technology acquisitions in the last decade.
FASB believes both in-process R&D and goodwill can be capitalized and intends to make companies do just that. The accounting board will decree that identifiable intangible assets can be reliably measured and will therefore have to be amortized in a period not to exceed 20 years, except in some cases where there be may justification for writing off the asset over a longer timer period.
Purchased R&D and goodwill, FASB’s other bug bear, go hand in hand because they are the most intangible of intangible assets and therefore the most difficult to quantify and amortize. So the debate continually rages over whether they are assets or costs and whether they can be amortized over a reasonable period or should be written down at all. Goodwill is a very bizarre concept. It basically dictates that if a buyer pays more than the target company’s book value then it must expense that cost over time, says Eric Schoenberg at M&A advisors, BroadView.
The lobby group that will petition FASB to retain R&D write-off accounting practices will argue that accountants cannot apply the same treatment to intangibles as they do tangible assets on the corporate balance sheet. Intangibles cannot be depreciated over a fixed time period in the same way that hard assets can be, they contend. The group will further argue that purchased R&D is a cost not an asset, as only one in every three technology projects ever reach fruition and make it to market as a product. Therefore R&D projects, by and large, produce no return for the purchaser.
I can’t see how you can argue for the end of in-process R&D unless you take the position that M&As are value destroying transactions and a misuse of funds that shouldn’t take place in the first place, says one M&A advisor. FASB’s retort is this: R&D costs must be an asset, the acquirer must have some inclination of which projects will bear fruit otherwise why would it have agreed on the purchase price in the first place?
If R&D write-off accounting is stopped there will be a knock on effect for pooling of interest accounting as companies will no longer be able to attribute intangible assets as purchased R&D but will have to recognize the asset as goodwill. Pooling, a way of combining two companies’ balance sheets in a way, again, that will produce no drag on earnings, is by far the most popular method of accounting for acquisitions. If it is stopped, acquirers will have to attribute larger sums to goodwill and amortize this cost over time and this will depress future earnings. It could, therefore, bring about a subsequent slump in its stock.
FASB intends to limit the use of pooling of interests accounting to mergers in which there is no clear acquirer and there is a mutual sharing of risks and benefits by the combining shareholders in the combined entity. The instances of these criteria being met are so rare that pooling is destined to obsolescence.
Nevertheless, technology companies are putting up a fight. The US accounting rule-making body must give companies a chance to argue against the proposed change. And Cisco, together with Hewlett- Packard and Intel plan to stop the ruling from being passed. The FASB rulings will slow the pace of acquisitions and discourage venture capitalists from investing in start-ups, says Dan Sheinman, VP of legal and government affairs at Cisco, pointing out the broader ramifications the ruling could have.
A principal reason why venture capitalists invest in start-ups is that they are safe in the knowledge that when the company is purchased the VCs will often stand to make a fat profit. If that profit potential is curtailed, then it will become far harder to attract funding for new companies. Earnings sensitive buyers that use a company’s EPS as the test of whether its acquisition strategy makes sense will be totally put off, says Bart Deamer, a Silicon Valley account at McCutchen, Doyle, Brown and Enerson.
That said, there are some within the M&A community that are taking a more optimistic view and argue that the ruling will have only a limited short impact.
Rather than precipitate a meltdown in M&A activity, the FASB proposals will reduce the valuations placed on acquisition targets. It will have a significant impact on the amount of money an acquirer is prepared to pay for a company because the buyer won’t want to see its EPS numbers eroded by huge amortization charges, says Broadview’s Shoenberg. But long term the effect will be negligible, he argues, as EPS figures including amortization charges will no longer hold the same relevance and institutional investors will therefore ignore them. But, with the number of individual investors that may not be so well versed in M&A accounting theory increasing by the day, many technology companies worry that the investor pool will diminish when these investors don’t see immediate quick returns.
The issue of pooling of interest accounting is not a new one. It attracted attention from the Securities and Exchange Commission last year, which wrote to several companies urging them not to overvalue acquired R&D costs. Network Associates, Motorola, PeopleSoft and AOL were all cautioned for abusing the rule and told that a restatement of financial results may be in order if their this was ignored. FASB is now sounding a final warning.
This article is part of ComputerWire’s M&A Impact information service. Some articles from the service are being provided to ComputerGram subscribers for a trial period only. á
