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R&D & Intangibles

San Francisco AcademyThursday, February 19, 2004

Professor Paul Zarowin, PhD

New York UniversityStern School of Business

KMEC 10-9044 West 4th Street

New York, NY 10012Tel (212) 998-0015 / Fax (212) 995-4004

pzarowin@stern.nyu.edu

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Presentation Outline

1. Introduction2. The problem/issue3. How we got here: FASB and

barriers to change4. Capital market consequences5. Solutions6. Management accounting issues7. New Accounting Rules8. 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 AccountingPaucity of R&D disclosureshinders evaluation

SUMMARY: Bad Accounting and Insufficient Disclosure, when good accounting and more disclosure are needed most

Economy-Wide Total R&D Expenses Over Total Sales

Economy-Wide Total R&D Expenses Over Total Sales

0.000

0.005

0.010

0.015

0.020

0.025

Year

R&D/Sale

Economy-Wide Aggregate R&D Expenses

Economy-Wide Aggregate R&D Expenses

050

100150

200250

300350

Year

R&D (In Billions)

Economy-Wide Aggregate Market-to-Book Ratio

Economy-Wide Aggregate Market-to-Book Ratio

0

1

2

3

4

Year

M/B

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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”.

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

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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

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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