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Growth Investing

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Growth Investing
R&D & Intangibles

San Francisco Academy

Thursday, February 19, 2004









Professor Paul Zarowin, PhD



New York University

Stern School of Business

KMEC 10-90

44 West 4th Street

New York, NY 10012

Tel (212) 998-0015 / Fax (212) 995-4004

pzarowin@stern.nyu.edu

1

Presentation Outline



1. Introduction

2. The problem/issue

3. How we got here: FASB and

barriers to change

4. Capital market consequences

5. Solutions

6. Management accounting issues

7. New Accounting Rules

8. Summary

2

1. Introduction





 focus on external financial reporting issues



 major Policy Implications and players



 NYU Intangibles Center



 Brookings Institution task force



3

2. The Problem/Issue

Growth in R&D

BAD Accounting

Paucity of R&D disclosures

hinders evaluation









SUMMARY: Bad Accounting and Insufficient Disclosure,

when good accounting and more disclosure are needed

most

4

0.000

0.005

0.010

0.015

0.020

0.025

19

7

19 3

7 R&D/Sale

19 4

7

19 5

7

19 6

7

19 7

7

19 8

7

19 9

8

19 0

8

19 1

8

19 2

8

19 3

8

19 4

8

Over Total Sales

19 5

8

19 6

8

19 7

8

19 8

8









Year

19 9

9

19 0

9

19 1

9

19 2

9

Economy-Wide Total R&D Expenses









19 3

9

19 4

9

19 5

9

19 6

9

19 7

9

19 8

9

Economy-Wide Total R&D Expenses Over Total Sales









20 9

0

20 0

0

20 1

02

R&D (In Billions)



19









100

150

200

250

300

350









0

50

1973

1974

1975

1976

1977

1978



Expenses

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988







Year

Economy-Wide Aggregate R&D









1989

1990

1991

1992

1993

Economy-Wide Aggregate R&D Expenses









1994

1995

1996

1997

1998

2099

2000

2001

02

0

1

2

3

4

19

7



M/B

19 3

1974

7

19 5

1976

7

19 7

1978

7

19 9

8

19 0

1981

8



Book Ratio

19 2

1983

8

19 4

1985

8

19 6

1987

8

19 8









Year

1989

9

19 0

1991

9

19 2

Economy-Wide Aggregate Market-to-









1993

9

19 4

9

19 5

1996

9

Economy-Wide Aggregate Market-to-Book Ratio









19 7

1998

9

20 9

2000

0

20 1

02

3.How we got here-standard

setting/barriers to change



A. Standard setters’ motivation/rationale behind the current

rules (full expensing) - SFAS #2, 1974



lack of (Value) Relevance to investors -



Lack of Reliability (Objectivity) -





B. Barriers to changing status quo

firms and auditors



regulators



investors/analysts





8

4. Capital Market Consequences of the

Problem

1. Declining usefulness (timeliness, value relevance) of accounting

data -



2. Market inefficiency -



3. Increased cost of capital -



4. Increased analysts’ effort -



5. Insider trading gains -



6. Earnings management (EM) -

Key Q: Why do firms accept the status quo?

9

5. Solutions - what to do?!

1. “Partial equilibrium”-

“Home-made” capitalization





2. “General equilibrium” -

Financial Reporting



Legal Environment



R&D markets -

In-Process R&D and Targeted Stocks -



Software capitalization

- Key Q: How generalizable to other types of R&D?

10

6. Management accounting/internal

control issues

 nascent area



 major problems





 Michael Jensen’s 1993 AFA Presidential address:



 1980's: poor internal controls, wasteful R&D expenditures



The Economist (1990): in the 1980's



“American industry went on and R&D spending spree,

with few big successes to show for it”.



 Brownyn Hall: 1980's - falling valuations, slow management respons

11

7. New Accounting Rules









Purchase Method for Acquisitions and

Goodwill Impairment









12

Accounting Rules - Acquisitions



Pooling of interest versus purchase.

The purchase method led to

“Goodwill”, which had to be

amortized over a period not to

exceed 40 years.

Companies tried avoiding the purchase method

because future earnings were negatively

impacted.

The new accounting rules eliminated pooling

and required purchase for all acquisitions.



13

Example

($ Millions) Market Value

Cash 7 7

Short-term investments 14 14

Accounts receivable 15 15

Inventories 36 41

PPE, net 22 31

Other assets 5 3

Total Assets 99 111



Accounts payable 23 23

Debt 9 10.5

Equity 67 77.5

Total liabilities and equity 99 111



Paid for the equity 91



Goodwill 13.5



14

Goodwill amortization (30 years) 0.45

New Accounting Rules



Upon acquisition, break the excess of

acquisition price over fair market value of

assets purchased into specifically-identifiable

intangible assets.

The remainder is “goodwill”.

Goodwill is not to be amortized, but

has to be tested for impairment in

value.

– Test annually and whenever

conditions may warrant.

– Write down goodwill if impaired.

15

Amortization and Impairment

Assess whether intangible assets have finite

or indefinite lives.

Finite-life intangible assets should be

amortized, typically on a straight-line

basis.

Other intangible assets are subject to (at

least) annual impairment testing:

If impaired, asset write-down is required

with a negative effect on income in the

same period.

16

Impairment Test



Intangible assets subject to amortization should be

reviewed according to SFAS No. 121, i.e., if the

carrying amount exceeds fair value and is not

recoverable, write the asset down.

Undiscounted cash flows are less than carrying

amount.

Goodwill: Compare the fair value of the reporting unit to

its carrying amount (including goodwill). If carrying

amount is higher, goodwill is likely to have impaired.

Fair value is the amount that can be obtained in a sale

of the reporting unit. Best evidence is market prices.

Otherwise, use comparables, present value techniques.



17

Impairment Amount



Allocate the fair value (as determined before) to

tangible and intangible assets of the unit,

excluding goodwill.

The excess of the fair value of the reporting unit

over the amount assigned to its individual

assets and liabilities is the implied fair value of

goodwill.

Goodwill should be written down to the implied

fair value or zero, whichever is greater.





18

Example- Wellman (WLM)



The company manufactures and markets polyester

products and PET resins. It also recycles PET plastics.

In the first quarter of 2002, the company adopted SFAS

No. 142. The adoption resulted in a charge against

income of $197 million!

The earnings from continuing operations were $5.6

million, on sales of $239.4 million.

Stockholders equity declined from $612.7 at the

beginning of the quarter to $397.0 at the end.

Goodwill declined from $230.5 million to $33.3 million at

the end of the quarter.



19

Example- Wellman (WLM)

The company used the two-step process; first testing for impairment

in its reporting units, and then reducing the goodwill to its implied

value in the Fibers and Recycled Products Group, which

accounted for about 48% of quarterly revenues.

The fair value was based on the present value of estimated future

discounted cash flows.

The entire goodwill related to this segment was written off.

Goodwill in the other segment was left intact, with no amortization

charge.

Goodwill amortization in Q1/01 was $2.1 million.

Other assets which were intended to be sold were written down to fair

value less than cost of disposal (another charge of $19 million to

earnings), consistent with SFAS No. 144.

Net Earnings from continuing operations in the second quarter of

2002 were $12.8 million.



20

8. Summary



Why does it all matter?



Even if markets are efficient!



Real Consequences



Positive vs Normative Research



Socially Important



Major Policy Implications



21


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