SEC Challenges "In-Process Research And Develeopment" Writeoffs
[This subject came up in discussing Abraham Briloff's critique of IBM's accounting for its acquisition of Lotus. See:
Message 4079448]
MARKET PLACE
SEC Signals Concern Over Internet
Stock Prices
By SAUL HANSELL -- August 10, 1998
Has the Securities and Exchange Commission begun
voicing subtle warnings about the unusually high
prices
of Internet industry stocks?
Of course, the S.E.C. would never tell investors not to
pay sky-high prices for the stocks of young,
money-losing companies. Nor can it stop companies from
buying each other at equally high prices.
But the agency can send some signals through its
regulation of how those acquisitions are accounted for
on the buyers' financial statements. And at the root of
recent fights the agency has picked with companies that
try to write off most of the price of their
acquisitions up front is a sense that the prices of
technology companies just cannot be reconciled with
conservative accounting.
The most prominent example is America Online Inc.,
which was not able to release its quarterly and
full-year earnings last week because it is still
wrestling with the S.E.C. over the accounting for two
recent acquisitions. The issue is how much of the price
that the online service paid for the acquisitions can
be written off now -- a one-time hit investors tend to
dismiss -- versus how much must be deducted over many
quarters, a weight on profit that more investors would
be likely to heed.
Accounting rules force companies to add up the apparent
value of the assets in companies they acquire -- both
tangible things like real estate and intangibles like
patent rights. If they paid more for the company than
the value of its assets -- and most do -- the excess is
classified as good will, which must be charged against
earnings over a period of 3 to 40 years.
Since many companies do not want that continuing drag
on profits, they look for ways to reduce good will
charges, and technology companies in particular have
latched on to an obscure rule that allows them to write
off immediately the value of continuing research and
development activities in the companies they buy.
(Completed research, on the other hand, is considered
intellectual property that must be accounted for as an
asset on the company's balance sheet.)
Many technology firms now argue that most of the prices
they pay for their acquisitions represent continuing,
or incomplete, research, and thus can be written off as
an expense right away.
Last week, Worldcom Inc. said that it would write off
$6 billion to $7 billion of the $37 billion it had
agreed to pay for the MCI Communications Corporation,
because that was the value of MCI's continuing
research. And other companies, including the Microsoft
Corporation and Cisco Systems Inc., have written off
the bulk of their acquisition costs as in-process
research.
Critics argue that this rule is being abused and that
future earnings at some companies are thus being
overstated.
Both the Financial Accounting Standards Board and the
S.E.C. have started looking more closely at the
research write-offs.
"When a company puts value into the research and
development that should be in good will, it can
drastically affect what earnings they will report to
investors in the future," said Lynn Turner, the
S.E.C.'s chief accountant. He argued that since
technology stocks in particular were trading at very
high multiples to their earnings, even relatively small
accounting changes could have a big impact.
"For a high-tech company trading at 40 times earnings,
a write-off that increases earnings by $20 million a
year can increase the company's market cap by $800
million," he said.
Turner declined to discuss the specifics of America
Online's proposed write-offs. But he did say that often
the question of whether a write-off is fair comes down
to how soon the research will produce a marketable
product and thus contribute to earnings.
"If people ascribe a high value to research that is
early on in its development, the commission staff would
raise questions," he said. "There may be a high degree
of uncertainty about whether it will be completed, and
so it should have a lower value."
In the case of America Online, both of its recent
acquisitions are far from certain moneymakers. In
April, the company paid $29 million for Netchannel, a
company that introduced and then withdrew a service
that connected television sets to the Internet. When
announcing the acquisition, America Online defended it
as a way of hiring Netchannel's management to develop
an entirely new service.
Then in June, America Online spent $287 million for
Mirabilis, a company begun 18 months earlier by four
young Israelis.
Mirabilis is a perfect Rorschach test for how different
investors value Internet companies. To bulls, Mirabilis
has vast potential because it developed a chat service
that has attracted 12 million members who spend hours a
day on line. But skeptics note that Mirabilis has never
generated a dollar in revenue and that America Online's
plans to turn it into an advertising medium are
unproved.
For America Online, this represents another accounting
cloud that darkens what many investors see as one of
the great business growth stories of the decade. The
company was long criticized for its delay in taking
charges for marketing expenses, a move that had the
effect of making the company appear more profitable in
its earlier growing phase.
Last year, it reversed that practice. And indeed the
more recent accounting imbroglios relate to practices
that have the opposite effect -- of taking charges for
expenses faster, depressing near-term earnings but
leaving future earnings free to grow faster. But the
S.E.C. then forced America Online to restate its
earnings -- in part because it had taken $26 million in
expenses too soon.
Now, with its research write-off, America Online says
it is hardly trying to pick yet another fight with
regulators.
"We brought this issue to the attention of the S.E.C.,
and we are confident that it will be worked out," said
Tricia Primrose, a spokeswoman. She said the company
set the value of the research done by Mirabilis and
Netchannel according to calculations of an independent
appraiser and that such write-offs have become standard
in the industry. For example, I.B.M. wrote off as
research $1.8 billion of the $3.4 billion it paid for
Lotus Development in 1995.
The excuse that "everybody is doing it," does not calm
the critics.
"These write-offs should be very minimal, at best,
because when you give management the right to wipe out
future expenses all on one swoop, they tend to abuse
it," said Brad Rexford, an analyst with the Center for
Financial Research and Analysis, a research firm in
Bethesda, Md.
Yet most investors and stock analysts argue that these
fine points of accounting are not related to the
financial health of the companies.
"Good will is noncash and doesn't effect the
cash-generating capacity of a company," said Shaun G.
Andrikopoulos, an analyst with BT Alex. Brown.
If technology companies are forced by the S.E.C. to
reduce their initial write-offs and take more of the
cost of their acquisitions as charges to earnings for
continuing good will, analysts will simply ignore the
reported earnings, Andrikopoulos said. In media
companies, which often have a lot of good will charges,
analysts look more to earnings before income taxes,
depreciation and amortization than to net profit, he
said.
Others worry that tightening rules on research
write-offs will inhibit technology companies from
pursuing acquisitions.
"If the S.E.C. cracks down, it will have an effect on
the whole sector," said Walt Price, who runs a
technology mutual fund for Dresdner RCM Global
Investors. "In the case of Mirabilis, the only way that
acquisition is going to make sense is if you write off
the very large purchase price and then figure out how
to turn it into a business."
Could that be exactly what the S.E.C. has in mind?
Copyright 1998 The New York Times Company |
