Re. In process R&D Write-offs.
A few times I mentioned that IBM's Lotus acquisition has started this trend. It is only partly true.
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February 1, 1999
High-Technology Firms Are Upset
Over SEC Crackdown on Write-Offs
By MICHAEL SCHROEDER
Staff Reporter of THE WALL STREET JOURNAL
WASHINGTON -- High-tech companies are smarting over a new regulatory assault on their number-crunching.
The Securities and Exchange Commission is cracking down on the popular write-offs for "in-process research and development." Regulators, who believe this trendy accounting is being improperly used to manipulate earnings, are trying to stay on top of an acquisition boom in which sheer speculation about a company can affect the buyer's bottom line.
Firms Say SEC Scrutiny of Earnings Goes Too Far
High-technology companies think they have been unfairly singled out and that the SEC has changed how it evaluates R&D expenses. "There's a resounding consensus that the SEC has been unfair," says Mark Nebergall, a vice president for finance and tax policy at the Software & Information Industry Association, which represents some 1,500 firms.
The SEC isn't inclined to sympathize. Agency officials say they are now enforcing more aggressively rules in place since 1975. "As the number of companies claiming larger [in-process R&D] write-offs increased in early 1998, we began to dig deeper into the company's appraisal assumptions," says SEC Chief Accountant Lynn Turner.
At issue is the size of write-offs that companies take for the premiums they pay when acquiring other companies, particularly high-tech concerns.
Goodwill Write-offs
For example, if an acquirer pays more than book value for a company, it must fully account for the excess, or "goodwill." Typically, the difference between book value and purchase price is charged off against earnings over several years. Increasingly, though, buyers of technology companies have capitalized on a rule that lets them take a large one-time write-off for the value of as-yet-undeveloped products they pick up. The buyers thus avoid incurring repeated small charges that can depress earnings for years.
So contentious is the issue that the nation's seven largest auditing firms have asked the Financial Accounting Standards Board to review the practice. Their letters don't advocate a position. But according to industry and government officials, some auditing firms would prefer that the practice be outlawed altogether because valuing R&D is imprecise and open for abuse.
While not commenting on whether the practice should be banned, Bob Herdman, vice chairman of Ernst & Young LLP, said, "It's clear that market participants and other observers don't consider this accounting to be logical. It should be reconsidered."
Auditors have been stung by SEC complaints about their reviews of write-offs. International accounting-standards groups banned R&D write-offs, and U.S. auditors are weighing that option.
Task Force Set Up
"There's definitely support for that approach," said Dan Noll, technical manager of accounting standards at the American Institute of Certified Public Accountants. The group has formed a 20-member task force, including several high-tech companies, to come up with the best ways to value and account for in-process R&D.
Targeted companies are recoiling at the SEC initiative because it has forced earnings restatements. That frequently causes the companies' stock prices to plunge, even though the changes are bookkeeping entries with little to do with operating profits and cash flow.
Envoy Corp. knows. The SEC started asking questions when the health-care transaction-processing firm filed a registration statement for a secondary stock sale last May. When the Nashville, Tenn., company disclosed Aug. 18 that the SEC was reviewing its accounting for three acquisitions, Envoy's stock price that day fell to $26.50 from $36.
Then in November, Envoy announced that it had lowered its previous R&D write-offs to $14.6 million from $68 million, resulting in restatements for 1996, 1997 and the first nine months of 1998. Envoy canceled the stock sale, a spokeswoman said, partly because of its stock-price decline. That also seemed to make Envoy more vulnerable to acquirers. In December, it agreed to be purchased by Quintiles Transnational Corp. in a stock swap valued at about $1.4 billion.
More Art Than Science
Coming up with estimates for "in-process research and development" is more art than science, involving a lot of speculative calculations such as how to estimate future revenue for an unfinished software product. With the high-tech business landscape changing so rapidly, such calculations can be little more than guesses.
As these write-offs grew in recent years -- many represent more than 75% of an acquisition's cost -- the SEC has begun taking a tougher line. In more than a dozen cases, companies have been forced to slash, often by as much as half, write-offs pegged to the R&D valuation, leading to earnings restatements. Also, the reduced R&D value must be deducted from earnings over several years.
"We discovered several flaws in the way some companies were valuing purchased R&D," the SEC's Mr. Turner says. "We found that management typically had made little effort to investigate the R&D project that it later valued so highly."
The SEC put corporate America on notice when it questioned MCI WorldCom Inc.'s plans to write off as much as $7 billion as part of its $37 billion purchase of MCI Communications Corp. last year. Partly to win SEC clearance, MCI WorldCom, Jackson, Miss., lowered the R&D charge to $3.1 billion. A company spokesman said the reduced charge is "consistent with guidance from the SEC."
Early last year, Intellicorp Inc., a business-software concern in Mountain View, Calif., paid $6.6 million for ICS Deloitte Management LLC's interface technology. In the 1998 third quarter, the company took a one-time charge for in-process R&D of $4.8 million, or 73% of the purchase price.
Setting Off Alarms
That set off alarms at the SEC. It started asking questions, which led to the company cutting the write-off to $2.7 million, according to a company filing with the SEC. As a result, Intellicorp restated financials for fiscal 1998, ended June 30. Instead of a one-time $2.5 million loss, the company posted a $698,000 loss. Since June, Intellicorp's stock has slid 65% to about $1.25 a share.
An Intellicorp spokesman said the company negotiated with the SEC for six months. Valuing R&D "is so difficult to get your hands around. There are a lot of gray areas," he said.
Virtually unknown a decade ago, the first significant R&D write-off was in 1990 when Lotus Development Corp. wrote off $53 million of the $65 million purchase price of Atlanta-based Samna Corp. The practice picked up momentum in 1995, when International Business Machines Corp. wrote off 57% of the cost of its $3.2 billion acquisition of Lotus, a software maker.
Mr. Nedergall of the high-tech trade group says accounting professionals took a cue from the SEC's approval of IBM's Lotus write-off as well as IBM's $417 million R&D charge after acquiring Tivoli Systems Inc. in 1996, which was 52% of the acquisition price.
"We're not whining about new rules. We're whining about retroactive application," he said. His group has asked the SEC to apply the standards only to future transactions.
The SEC isn't backing down. In recent weeks, Robert Bayless, chief accountant in the SEC's corporate-finance division, wrote to 150 companies that disclosed plans for asset write-downs, including for R&D. The letter offers guidelines for disclosure and analysis that the SEC expects companies to supply to justify the charges.
--Leslie Shaffer contributed to this article. |
