For Better Earnings, Try Bigger Write-Offs
By GRETCHEN MORGENSON
NEW YORK -- While the stock market ended last week on a high note, pleased with the mix of economic reports, one little-noted piece of data had ominous implications for investors.
Corporate write-offs, as a percentage of the reported earnings per share of the Standard & Poor's 500-stock index, surged in the first quarter to 14 percent. Of the $10.25 a share that the S&P 500 companies reported in earnings for the quarter, write-offs totaled $1.44 a share.
This is more than just a blip. Gabrielle Napolitano, vice president for investment research at Goldman, Sachs, has collected such data for 10 years. She says write-offs have never been higher than they are now.
This is unusual given that we are in an economic boom. Some of the write-offs are a result of mergers, in which companies deduct acquisition charges. The Asian crisis is another factor: 35 percent of the first quarter's write-offs related to commercial banks' loan-loss provisions.
But an alarmingly large chunk of the write-offs -- 15.3 percent -- were nonrecurring charges related to the purchase of so-called in-process research and development. That was up 70 percent over last year.
Why alarming? The rise may indicate that increasing numbers of companies are using an arcane accounting rule to artificially bolster their earnings.
Whenever one company acquires another, some of the assets are of little value to the combined companies. That is especially true for technology or pharmaceutical concerns.
Accounting rules allow the acquiring company to write off immediately against earnings the total value of the in-process R&D that its management considers worthless. It is a nonrecurring charge.
Why should this matter to an investor? Because it affects a company's earnings. Since the one-time charge reduces the value of the acquired assets, it also lowers depreciation expense in future years. And depreciation charges shrink earnings.
So when a company takes a one-time write-off for purchased R&D, future earnings look better than they would have had the company depreciated those assets over time. And if the assets turn out to be not so worthless after all, any income they produce drops straight to the bottom line, unimpeded by depreciation expense.
Howard M. Schilit, president of the Center for Financial Research and Analysis in Rockville, Md., notes that these write-offs not only are much more prevalent today, but that they now amount to big money. "We're seeing a lot of companies that put absurd amounts -- even 95 percent of the purchase price of an acquisition -- into in-process R&D write-offs," he said.
Consider the peculiar case of Applied Materials Inc., a formerly high-flying maker of semiconductor equipment. In the quarter ending in January, it paid $32.2 million to a company in a licensing agreement.
Rather than consider the fee an operating expense, as Schilit said would be typical, Applied Materials called it in-process R&D, even though no acquisition had transpired. That accounting improved the company's operating cash flow by 26 percent.
"Companies do more of these things when their business weakens," Schilit said. "If things are humming, they don't need to reach." The company was closed Friday and did not return a phone message seeking comment.
Indeed, in the same quarter, the company's margins fell significantly. In the April quarter, sales dropped 10 percent.
Sunday, June 7, 1998
Copyright 1998 The New York Times
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