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
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1. Introduction
focus on external financial reporting issues major Policy Implications and players NYU Intangibles Center Brookings Institution task force
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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
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0.000
0.005
0.010
0.015
0.020
0.025
R&D/Sale
Economy-Wide Total R&D Expenses Over Total Sales
Economy-Wide Total R&D Expenses Over Total Sales
Year
19 7 19 3 7 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 19 5 8 19 6 8 19 7 8 19 8 8 19 9 9 19 0 9 19 1 9 19 2 9 19 3 9 19 4 9 19 5 9 19 6 9 19 7 9 19 8 9 20 9 0 20 0 0 20 1 02
R&D (In Billions)
100
150
200
250
300
350
50
0
Economy-Wide Aggregate R&D Expenses
Economy-Wide Aggregate R&D Expenses
Year
19 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 2099 2000 2001 02
0
M/B
Economy-Wide Aggregate Market-toBook Ratio
1
2
3
4
Economy-Wide Aggregate Market-to-Book Ratio
Year
19 7 19 3 1974 7 19 5 1976 7 19 7 1978 7 19 9 8 19 0 1981 8 19 2 1983 8 19 4 1985 8 19 6 1987 8 19 8 1989 9 19 0 1991 9 19 2 1993 9 19 4 9 19 5 1996 9 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
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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?
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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?
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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”.
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Brownyn Hall: 1980's - falling valuations, slow management respons
7. New Accounting Rules
Purchase Method for Acquisitions and Goodwill Impairment
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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.
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Example
Cash Short-term investments Accounts receivable Inventories PPE, net Other assets Total Assets Accounts payable Debt Equity Total liabilities and equity Paid for the equity Goodwill Goodwill amortization (30 years) ($ Millions) Market Value 7 7 14 14 15 15 36 41 22 31 5 3 99 111 23 9 67 99 23 10.5 77.5 111 91 13.5 0.45
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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.
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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.
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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.
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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.
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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.
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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.
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8. Summary
Why does it all matter? Even if markets are efficient! Real Consequences Positive vs Normative Research Socially Important Major Policy Implications
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