SEC forces AOL to reduce purchased in-process R&D writeoffs - NYTimes
MARKET PLACE
"S.E.C. Crackdown on Technology
Write-Offs"
By SAUL HANSELL -- September 29, 1998
It is upgrade time at America Online.
Never mind the noise about its new 4.0 browser software
version. The Securities and Exchange Commission has
ordered the online service, and the rest of the
technology industry, to improve the way they account
for mergers and acquisitions.
The issue is how technology companies have seized on a
footnote in the accounting rules related to research
expenses to write off most of the purchase price of
companies as soon as they acquire them. This prevents a
continuing drag on profits that would result from
writing off the purchase price over several years.
The S.E.C.'s move comes as it is cracking down on a
number of accounting practices it finds abusive. In
comments at New York University, Arthur Levit Jr., the
chairman of the commission, said his staff would
immediately increase its scrutiny of companies that use
certain aggressive accounting techniques to inflate
their quarterly earnings.
In choosing to make an example of
America Online, the biggest Internet
company, the commission took the
extreme step of blocking it from
publishing its fiscal fourth-quarter
earnings for nearly two months.
America Online finally reached an
agreement with the S.E.C. and published
its earnings Monday. It wrote off $70.5
million related to research at two
companies it acquired, representing 22
percent of the $316 million it had paid for them.
Previously the company had said it planned to write off
a vast majority of the purchase price, though it gave
no specific figures.
Separately, Lynn Turner, the S.E.C.'s chief accountant,
called on the accounting industry to tighten its rules
related to writing off the cost of research. In a
letter to the American Institute of Certified Public
Accountants, he said that a study by the SEC had found
"significant problems in the recognition and valuation"
of the research write-offs.
The letter outlined a proposed standard for such
write-offs that is much stricter than accountants have
been using. And the commission threatened to make
companies take the embarrassing step of restating their
published earnings reports in cases where it deems
their research write-offs to be "materially
misleading."
Analysts said that the change could inhibit
acquisitions, especially by smaller technology
companies.
"It has more significance for other companies besides
AOL," said Keith Benjamin, an analyst at BancAmerica
Robertson Stephens. "You will see more young Internet
companies forced to take lower write-offs." America
Online is less affected, he said, because it has become
big enough to absorb the additional charges.
At issue is how companies account for the value of
"in-process research and development" -- research that
has yet to be turned into a marketable product -- at
companies they buy. In an acquisition, companies
estimate the value of all of the assets they are
buying, both tangible ones like buildings and
intangible assets like brand names and customer lists.
If the purchase price is higher than the value of all
of these assets -- and it usually is -- the remainder
is added to a catch-all item known as good will.
Companies are forced to write off the value of all of
these assets over a period of from 3-40 years,
depending on the useful life of the asset. The one
exception is in-process research, which is written off
immediately.
Since technology companies are especially interested in
showing investors accelerating earnings growth, many
have started attributing the bulk of their acquisition
costs to in-process research.
The S.E.C. letter listed a number of what it described
as "abuses" in this practice. In one case, for example,
a company that the commission did not name wrote off
nearly all the purchase price of an acquisition as
in-process research, even though the target company had
not spent a significant amount money on research or
development.
"If a company didn't spend significant amounts on R&D,
it would raise questions in my mind," said Baruch Lev,
a professor of accounting at New York University. He
conducted a study of 400 acquisitions, mostly of
technology companies, and found that the buyers wrote
off 75 percent of the purchase price as in-process
research.
America Online said that it would not be deterred from
buying more companies because of the change in rules.
"When we look at acquisitions we will look for those
that have the right strategic value and the right
economic value," said J. Michael Kelly, the company's
chief financial officer.
Because the allowed write-off was less than analysts
had expected, America Online posted an unexpected
profit for its fourth quarter. It earned $7.1 million,
or 3 cents a fully diluted share. That compares with a
loss of $11.8 million, or 6 cents a fully diluted
share, a year earlier.
America Online said it would write off the rest of the
cost of its acquisitions over 5-10 years. That will
mean a deduction of between $25 million and $50 million
a year from its reported profits. The company told
analysts Monday that its core business continued to do
better than expected and that as a result, it predicted
it would meet their previous earnings estimates.
Shares of America Online increased $2.375 each Monday,
to $117.125.
Jonathan Cohen, an analyst with Merrill Lynch, said
that the market was not concerned with the deductions
from profits.
"Reported earnings is one small piece of a larger
picture at technology companies that includes revenue
growth, market position, audience size and brand
equity," he said.
Yet even if investors are ignoring the good will
charges now, Jack Ciesielski, a money manager and the
publisher of the Analyst's Accounting Observer, argues
that it provides a useful reminder of how much
companies are spending on acquisitions, especially if
the good times end.
"If there is a big blob of good will and they aren't
earning a return on it, investors can see it and start
asking questions," Ciesielski said. "If you have an
immediate write off, the trail is destroyed."
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