Here's an interesting and very relevant DJ article on the issue of expensing R&D in high-tech and biotech companies. I think it lends support to my notion of capitalizing the R&D and then either writing it off or amortizing it depending on whether it is unsuccessful or succesful.
Right now we are likely headed to the worst of all worlds accounting wise - expense it once when you perform the R&D, and amortize it all over again if you then acquire it.
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March 3, 1999
Dow Jones Newswires
TALES OF THE TAPE: Know-How May Find Place On Balance Sheet
By SEAN DAVIS
Dow Jones Newswires
NEW YORK -- Few would argue that in today's economy, knowledge is an asset. But partly because it is difficult to put a value on the know-how embodied in a gene sequence or a software algorithm, U.S. accounting rules require companies to treat spending on research and development as an expense, not a capital investment.
However, a recent decision by the group that sets U.S. accounting standards may portend a broad change in accounting for R&D. That could have a noticeable effect on the reported earnings of companies in knowledge-intensive industries such as software and biotechnology. Short-term earnings would look better, but over the long term, profits would be subdued. Ultimately, this could change the way investors value such businesses.
That would please a few academics and deep thinkers who have argued that spending on R&D is really a capital investment, akin to building a state-of-the-art factory. "The current accounting system either ignores, distorts or has biases with regard to the main drivers of wealth production in a knowledge-based economy," says Steven M. H. Wallman, a Brookings Institute senior fellow and former Securities and Exchange Commission member.
Under traditional accounting, spending on research and development is expensed right away. lowering earnings in the period during which the expense is incurred. This accounting treatment regards R&D as just another cost of doing business, like the rent.
Last week, the Financial Accounting Standards Board, which sets U.S. accounting rules, decided that some categories of research and development should indeed be treated as an asset. But the FASB decision, which is still many months from taking effect, only applies to purchased R&D. The R&D that companies perform on their own behalf would still be considered an expense.
The FASB move comes largely as a response to concerns the expensing of purchased R&D is being abused by companies that write off most of the cost of acquisitions in order to help future earnings.
But the law of unintended consequences could lead to a more sweeping change in how companies account for R&D. "If you say you shouldn't be able to expense purchased R&D because we think you're buying an asset," Wallman says, "then the same rationale should be applied to internal R&D." Bob Willens, an accounting expert at Lehman Brothers Holdings Inc. (LEH), says FASB may have backed itsel& into a corner.
Timothy Lucas, FASB's director of research, says internal R&D isn't part of the current project, and isn't scheduled for consideration. "We might look at that someday," he says.
Higher Short-Term Earnings
If companies treated internal R&D as a capital investment, the effect would be to improve short-term earnings while lowering earnings in future periods. Here's why. Instead of expensing the R&D all at once, the company would amortize - or spread out - the cost over the useful life of the R&D, a period that can vary in length. Additionally, the company would have to take charges in future quarters to pay for the depreciation of the asset over time.
The appeal to accountants of treating internal R&D as an asset is that it results in recording the expense during the same period that it yields revenues. The effect, proponents say, is to give investors a better picture of a company's underlying economic reality.
Changing the way companies account for internal R&D would have a ripple effect, spreading through the various measures investors use to value stocks.
Take the biotech company Amgen Inc. (AMGN). Amgen, based in Thousand Oaks, Calif., spent $663.3 million on research and development in 1998. Had Amgen treated this as a capital investment instead of an expense, it would have had pretax income of $1.89 billion. Based on Amgen's effective tax rate of 29.5%, net income would have been $1.33 billion, or $2.52 a share, 54% greater than the $1.64 a share it actually reported. (Share figures are adjusted for a recent 2-for-1 stock split.)
For the sake of simplicity, these calculations ignore depreciation and amortization of R&D from previous years which, if included, would lower the adjusted earnings somewhat.
One way of looking at this data is to conclude Amgen is undervalued. If the market values Amgen at 39 times earnings, as it did at the close of trading Tuesday, each Amgen share should be worth $98.34, not the $64 at which it actually ended the day.
Another way of looking at the data is to conclude the market already values Amgen as if its R&D spending were going on the balance sheet. Using the adjusted EPS of $2.52 a share and Tuesday's closing share price, Amgen would have a P/E ratio of 25.4 - still high by historical standards, but closer to the current multiple of the Dow Jones Industrial Average (23.7), and less than the current multiple of the Standard & Poor's 500-stock index (32.9).
Valuing R&D An Inexact Science
Valuing R&D before it results in a product is an inexact science. "In order to record something on the books as an asset, you need to be comfortable it's a reliable asset," says Dan Noll, technical manager for accounting standards at the American Institute of Certified Public Accountants. "The issue with R&D is, you never really know if and when it's going to yield benefits." Noll says the AICPA doesn't have a position on whether or not to capitalize R&D.
The reason FASB can justify treating purchased R&D as an asset, say Noll and others, is that it is acquired at arm's length in a negotiated transaction between two companies.
But the Securities and Exchange Commission believes some companies are overestimating the value of purchased R&D in order to improve long-term earnings. Indeed, the perception of such abuse lent momentum to the drive to end the purchased R&D write-off. That weakens the argument that an arm's-length deal makes the value assigned to R&D more reliable.
At the same time, academics are developing techniques for assigning value to R&D and other intangibles. Baruch Lev, a New York University accounting professor and head of a research project on intangibles, says companies should be able to capitalize in-process R&D once it passes feasibility milestones. The R&D for a drug candidate, for example, could go on the balance sheet once the drug advances past human trials, Lev suggests.
Finally, the marketplace may point toward a solution for valuing R&D. In a draft version of a forthcoming paper, Lev and co-author Zhen Deng write that in many recent mergers between technology companies, the R&D in process was the major asset acquired, amounting, on average, to 72% of the purchase price. This points to the emergence of a fast-growing market for R&D, they write.
"The emergence of markets where R&D and other intangibles are traded should be closely watched," Lev and Deng write, "since prices established in these markets may provide guidelines for a change in (accounting practices) for R&D - asset recognition rather than expensing."
-Sean Davis; 201-938-5294; sean.davis@cor.dowjones.com
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