Study: R&D Rule Threatens Future Earnings

In the year of an acquisition, however, it should boost net income and help some companies swing reported losses into a profit.

Starting next year, companies that acquire incomplete research-and-development projects in a merger will have to capitalize — and eventually amortize — the assets, rather than follow the current practice of expensing the items.

The change, mandated by the newly-revised FAS No. 141(r), Business Combinations, will likely boost company earnings in the year of the acquisition and, in some cases, help companies swing reported losses into a profit, a new study finds.

But there’s a tradeoff. The current-year FAS 141(r) boost will be followed by a longer-term hit to earnings, says the report. The study, released last week by the Georgia Institute of Technology’s Financial Analysis Lab, examines the effects of the new rule on more than 900 deals that took place during 2003-2005 and involved the acquisition of in-process R&D.

If FAS 141(r) had been in place during that period, the acquiring company’s income, total assets, and stockholders’ equity would have increased in 2006—a benefit of removing the expense from the income statement and putting it on the balance sheet as a long-term asset.

But future income would have been dragged down in the years following an acquisition, since companies amortize completed R&D projects over the useful life of the asset. “FAS 141(r) puts earnings at risk into the future,” says accounting professor Charles Mulford, director of the Georgia Tech Lab, who co-authored the study with graduate student Ling Yang.

Most finance executives won’t like the inherent tradeoff of FAS 141(r). The rule “shifts an expense from the time of acquisition — when everybody is expecting non-reoccurring charges, and hope springs eternal about what the future will bring — to a time when a company has to fess up about an asset not having value,” Mulford told CFO.com.

That true-up period happens slowly, as capitalized in-process R&D assets are completed and then amortized. Finance chiefs prefer the current rule, which forces them to take a big, one-time charge upfront, according to Mulford. In general, executives believe that explaining a one-time, acquisition-related earnings charge to investors and analysts is easier than defending continuing charges to future earnings.

To understand how significant in-process R&D is to the study group, the researchers examined 923 merger deals involving in-process R&D that took place between 1998 and 2006. Then they narrowed the time frame to three years to observe what effect FAS 141(r) would have on pretax income during a three-year capitalization period and beyond.

During the eight-year period, in-process R&D represented, on average, 1.47 percent of net sales for the total sample. The authors say that while the number is not “particularly noteworthy,” it does represent the percentage boost to pretax net margin if the acquiring company had been required to apply FAS 141(r) and capitalize the expense.

Regarding other metrics, in-process R&D represents, on average, 7 percent of goodwill, 0.9 percent of total assets, and 1.7 percent of total equity for each deal. The study also notes that the percentages shift dramatically depending on the industry considered. For example, in the pharmaceutical and medicine sector, in-process R&D represents 35 percent of goodwill, 10 percent of net sales, 3.2 percent of total assets, and nearly 5 percent of total equity.

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