Study: R&D Rule Threatens Future Earnings

In the year of an acquisition, however, it should boost net income and help some companies swing reported losses into a profit.
Marie LeoneMay 20, 2008

Starting next year, companies that acquire incomplete research-and-development projects in a merger will have to capitalize — and eventually amortize — the assets, rather than follow the current practice of expensing the items.

The change, mandated by the newly-revised FAS No. 141(r), Business Combinations, will likely boost company earnings in the year of the acquisition and, in some cases, help companies swing reported losses into a profit, a new study finds.

But there’s a tradeoff. The current-year FAS 141(r) boost will be followed by a longer-term hit to earnings, says the report. The study, released last week by the Georgia Institute of Technology’s Financial Analysis Lab, examines the effects of the new rule on more than 900 deals that took place during 2003-2005 and involved the acquisition of in-process R&D.

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If FAS 141(r) had been in place during that period, the acquiring company’s income, total assets, and stockholders’ equity would have increased in 2006—a benefit of removing the expense from the income statement and putting it on the balance sheet as a long-term asset.

But future income would have been dragged down in the years following an acquisition, since companies amortize completed R&D projects over the useful life of the asset. “FAS 141(r) puts earnings at risk into the future,” says accounting professor Charles Mulford, director of the Georgia Tech Lab, who co-authored the study with graduate student Ling Yang.

Most finance executives won’t like the inherent tradeoff of FAS 141(r). The rule “shifts an expense from the time of acquisition — when everybody is expecting non-reoccurring charges, and hope springs eternal about what the future will bring — to a time when a company has to fess up about an asset not having value,” Mulford told CFO.com.

That true-up period happens slowly, as capitalized in-process R&D assets are completed and then amortized. Finance chiefs prefer the current rule, which forces them to take a big, one-time charge upfront, according to Mulford. In general, executives believe that explaining a one-time, acquisition-related earnings charge to investors and analysts is easier than defending continuing charges to future earnings.

To understand how significant in-process R&D is to the study group, the researchers examined 923 merger deals involving in-process R&D that took place between 1998 and 2006. Then they narrowed the time frame to three years to observe what effect FAS 141(r) would have on pretax income during a three-year capitalization period and beyond.

During the eight-year period, in-process R&D represented, on average, 1.47 percent of net sales for the total sample. The authors say that while the number is not “particularly noteworthy,” it does represent the percentage boost to pretax net margin if the acquiring company had been required to apply FAS 141(r) and capitalize the expense.

Regarding other metrics, in-process R&D represents, on average, 7 percent of goodwill, 0.9 percent of total assets, and 1.7 percent of total equity for each deal. The study also notes that the percentages shift dramatically depending on the industry considered. For example, in the pharmaceutical and medicine sector, in-process R&D represents 35 percent of goodwill, 10 percent of net sales, 3.2 percent of total assets, and nearly 5 percent of total equity.

Meanwhile, the computer and electronic-products industries are closer to the study average, with in-process R&D accounting for 10 percent of goodwill, 1.4 percent of net sales, 1 percent of total assets, and 2 percent of total equity. (See Chart 1)

The study also revealed to what extent FAS 141(r) may affect future earnings. The longer the amortization period, the lower the recorded expense. So “the trick is choosing the optimal amortization period,” says Mulford. In the case of software, the company may decide the amortization period is only five years because that coincides with a typical copyright. For a new drug, the amortization schedule may run as long as its 20-year patent life.

Using financial results for 2003 through 2005, and assuming a three-year capitalization period in which in-process R&D is completed in 2005, the Georgia Tech researchers applied the new rule and recorded its impact on 2006 financials. Pretax income would, on average, drop by 1.1 percent for the year, assuming a 5-year amortization schedule, and decrease by 0.24 percent based on a 20-year amortization schedule, according to the study. (See Chart 2)

The pharmaceuticals sector and the computers and electronic products industries would be hit the hardest, enduring pretax income decreases of 4.2 percent and 0.91 percent for a 5-year and 20-year schedule respectively.

But the picture is much brighter for companies that acquired a significant amount of in-process R&D during 2006. Witness Abbott Laboratories, which reaped the most dramatic advantage of the group — an 85 percent increase in 2006 pretax income based on a 5-year amortization period, and an 87 percent increase over 20 years.

To be sure, Abbott’s 2006 pretax income would have jumped from $2.3 billion to $4.2 billion based on $2 billion worth of in-process R&D capitalized that year, and $400 million worth of cumulative in-process R&D from 2003 through 2005.

Meanwhile, Edward Lifesciences would have taken a hit to earnings if FAS 141(r) was in effect. Edward acquired no in-process R&D in 2006, and only $108 million worth of the assets during the three-year period. As a result, its 2006 reported pre-tax income would have dropped from $172 million to $151 million based on a 5-year amortization schedule, and to $167 million over a 20-year schedule — a decrease of 12.5 percent and 3.1 percent, respectively.

While companies that have the ability and cash to acquire in-process R&D annually will enjoy improved earnings in the current year, the FAS 141(r) boost will eventually be overtaken by amortization losses, once the buying binge stops. In the end, FAS 141(r) is a rule about transparency. “If a company just paid good money for an asset, why not show it as an asset on your balance sheet?” asserts Mulford?

Chart 1: What Would 2006 Financial Results Have Looked Like If FAS 141(r) Was in Effect?
The study measured the average percentage change to key balance sheet and income statement metrics. IPR&D/Goodwill IPR&D/Net Sales IPR&D/Total Assets IPR&D/Total Equity All industries 7.44% 1.47% 0.91% 1.66% Pharma/medicine 34.56% 10.16% 3.17% 4.86% Computers/electronic products 10.20% 1.42% 1.03% 1.95% Medical equipment and supplies manufacturing 14.61% 2.82% 1.92% 4.29% Software 10.85% 2.40% 1.34% 2.21% Computer systems design and related services 6.97% 4.13% 0.87% 1.50% Source: “COMPUSTAT North America; Georgia Tech Financial Analysis Lab calculations.
Chart 2: Income Hit: What If FAS 141(r) Was in Effect in 2006?
The study examined the average percentage change in reported pretax income for in-process R&D over two amortization periods. Industry Revised pretax income: 5-year amortization Revised pretax income: 10-year amortization All – 1.12% – 0.24% Pharma/medicine – 4.18% – 091% Computers/electronic products – 4.18% – 0.91% Medical equipment and supplies manufacturing – 1.12% – 0.23% Software – 0.40% 1.76%* Computer systems design and related services – 0.39% – 0.08% * Only positive swing noted in the table.
Source: “COMPUSTAT North America; Georgia Tech Financial Analysis Lab calculations.