What do YAHOO!, AOL and many other companies have in common? A perfectly legal accounting practice that makes earnings look better than they would otherwise.
ACCOUNTING THAT LEAVES INVESTORS IN THE DARK
ÿ
WALL STREET'S love affair with Internet stocks has been predicated on the notion that earnings don't matter. "It's the revenue, stupid," the Internet bulls will tell you. But this earnings season bottom-line results have mattered to a handful of Internet companies such as Amazon.com (AMZN), C|Net (CNWK) and Yahoo! (YHOO), whose stocks soared when the companies reported profits or "narrower than expected losses" that beat analysts' forecasts.
But at least one of those Internet darlings achieved its better than expected earnings using an accounting tactic that many experts say masks the true financial condition of the company. Case in point: The accounting for Yahoo's $49 million acquisition of Cambridge, Mass., software maker Viaweb in June. The deal was done as a stock exchange, but 91% of the purchase price -- $45 million -- was taken as a onetime charge to earnings in what is known as "purchased research and development." In other words, nearly all the purchase price of the acquisition disappeared from the company's books in a single day.
THE ONETIME CHARGE CLUB
ACQUIROR TARGET PRICE PAID R&D WRITEOFF
Compaq Digital Equipment $8.4 billion $3.2 billion
IBM Lotus Development 3.52 billion 1.84 billion
Lucent Technologies Yurie 1.06 billion 620 million
Northern Telecom Broadband Networks 593 million 461 million*
*In Canadian dollars.
Sources: Company reports and Dow Jones News Service.
The beauty of onetime charges -- from the corporate managers' point of view -- is that nobody seems to pay much attention to them. Wall Street focuses on operating earnings. And so it was with Yahoo! when it announced second-quarter earnings July 8 of $8.1 million or 15 cents a share before charges, but a loss of $36 million after charges. Investors paid scant attention, and the shares lost just 1.2% the day after earnings were announced. Yahoo! shares are still up 164% from the beginning of the year (despite a tumble in recent days.)
What's so bad about taking a onetime charge for purchased R&D? Well, if Yahoo! had to amortize the cost of Viaweb over seven years, it would trim 10 cents a share a year from Yahoo! earnings at a time the company is just moving toward profitability. Yahoo! only earned 4 cents a share in all 1997 (discounting the effects of a $21.2 million restructuring charge). In other words, R&D charges help Yahoo! meet analysts' estimates, and propel its share price higher.
"Every single tech company that makes an acquisition tries to write off the kitchen sink," says Cathy Baker, Internet stock analyst for Robertson Stephens funds. "It's financial engineering, and it makes it tougher to get at a company's real economics."
Gary Valenzuela,Yahoo's chief financial officer, counters that he's followed accounting rules to the letter. "We have an acquisition strategy," he says. "The preferred method of accounting for acquisitions is pooling." (That's when the balance sheets of the target and its acquirer are simply added up line by line.) "This deal didn't qualify for it -- so we defaulted to purchase accounting. I think it's a proper way, given current accounting guidelines."
Strictly speaking, Valenzuela is right. A 1975 ruling from the Financial Accounting Standards Board opened the door for companies to establish prices for the R&D acquired in mergers. That much can't be quibbled with. But what has accounting experts and rule makers miffed -- and the thing that should matter to investors -- is that R&D charges are ballooning from 10% of acquisition costs before 1990 to 75% on average in the past six years and sometimes more. And that is distorting the very financial results that investors depend on most -- like earnings and return on investment.
In essence, the accounting practice has the effect of enhancing the financial ratios and other fundamentals that matter most to investors such as return on investment and earnings per share. That in turn helps keep Wall Street excited about a stock. And while companies may tell their stock-option-enriched employees not to become distracted by the stock price, the truth is, when a company uses its stock as currency, every fraction of a point counts. Higher-priced stock allows Yahoo! and other firms with outsized market caps to acquire more companies for fewer shares of stock than they would ever be able to at more down-to-earth valuations.
Here's how purchased R&D can make a company's balance sheet look good. Let's start with ROI. Imagine a company that buys a rival for $50 million, immediately writing off $40 million of the purchase price as in-process research and development. The remaining $10 million of the purchase price represents the hard assets or inventory that the company can't charge off. If it earns $1 million in net income from the acquisition, the return on investment looks like a 10% return. But if you compare it to the full purchase price, $50 million, that return drops to a pitiful 2%, according to Neel Foster, a member of the Financial Accounting Standards Board, who provided the example. "It looks like a reasonable return on investment, but it's not," says Foster.
Now, use the same example to understand the impact on earnings. If our company's acquisition earns income of $5 million in its first year, we can drop that straight to the bottom line if we've expensed the entire purchase price as in-process R&D. That makes investors, managers and analysts happy because the resulting boost to earnings carries no price tag. Had the chief financial officer followed the more conservative accounting practice of amortizing the purchase price over seven years, it would have left the company with less than $1 million in net income.
Yahoo! is certainly not alone. In a study of 722 companies using R&D expensing by Baruch Lev, a New York University Stern School of Business professor, median earnings rose 1.29% in the fourth quarter following the deal, while they would have risen just 0.31% if the companies had to amortize the value of their acquisitions over four years. What's more, Lev says that return on equity is also distorted by the accounting. In his sample, median ROE jumped 4.84%, while the increase would have been just 3.54% if the companies had amortized their purchases rather than expensing them.
That kind of trend has drawn the attention of regulators. Robert Bayless, chief accountant of the Security and Exchange Commission's division of corporation finance, says the SEC is challenging more and more companies about how they are coming up with values for in-process research and development. "With the increasing proportions of in-process research and development being written off, the SEC staff is concerned that some companies may be abusing these rules," says Bayless.
FASB's Foster agrees. "My personal view is that it's being abused,'' he says. "The people who get hurt are less sophisticated investors who aren't told what the real facts are." The issue is being reviewed as part of a broader FASB inquiry into merger accounting.
Do investors care about Yahoo's accounting practices? Obviously not. "No one is valuing Yahoo on this year's or next year's earnings," says Keith Benjamin, an analyst at BancAmerica Robertson Stephens. "Even if they reported a loss and expensed it over the next few years, it wouldn't matter to me. People would look through it."
But unlike Yahoo!, plenty of the companies using R&D writeoffs are valued by investors on earnings. When IBM (IBM) bought Lotus Development in 1995, it expensed more than half the $3.52 billion purchase price or $1.84 billion. Last year, Cisco (CSCO) wrote off $419 million in research and development stemming from three acquisitions totaling $521 million.
These companies aren't doing anything illegal -- they're just following generally accepted accounting procedures. The real problem is with the rules themselves, says Lev. Accountants view research as ephemeral and difficult to value compared to hard assets like buildings and equipment, whose worth can be quickly assessed by auditors. But Lev believes R&D has become much easier to value now that companies routinely put price tags on patents, blueprints and even formulas. "R&D is being treated as a tradable asset," he says. Therefore, Lev reasons, it should be treated as a hard asset -- and amortized like one.
What's more, corporate investment in research is spiking. At $150 billion a year, investment in R&D nearly equals what companies are spending on bricks and mortar. To keep those investments off the balance sheet distorts the value of companies, especially tech companies.
Will it change? FASB is currently revising rules relating to merger accounting, and the SEC is keeping its eyes on that process. But don't expect regulators to shut the door on R&D expensing anytime soon. When it comes to making changes, regulators aren't as fast as the CFOs.
smartmoney.com
|
