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Thursday, February 25, 1999

FOOL ON THE HILL
An Investment Opinion
by Dale Wettlaufer

Financial Karma's Gonna Get You

Attention high-tech investors! Are you ready for the conversion of acquisition-related accounting for R&D intensive companies? Get pumped, baby. That's what appears to be happening with the Financial Accounting Standards Board, which yesterday proposed a new standard that calls for capitalization of acquired R&D rather than its immediate expensing. Yes, that's right, the people that brought you the beloved FASB Statement 125 on gain-on-sale accounting for securitizations of loans, which allows a company to estimate unsure profits and puff up the balance sheet with the resulting "profits and intangible assets" wants to disallow a policy that lets a company immediately expense what are certain to be future expenses, pulling those expenses into the current year and immediately diminish assets and owners' equity.

I can't account for the way FASB works, but I agree with its current thinking on this issue. There are numerous examples of companies that have abused the ability to take an immediate write-off of expenses they will incur in the future. These companies believe that the market will ignore the large one-time expenses because everyone pays attention to "earnings before extraordinary items."

As Alex Schay wrote late last year, "The standard for many years (reinforced by SFAS No. 4) has required that R&D costs acquired in a business combination be treated as if they had been incurred by the acquiring company. That is, they must be expensed as if they were "home grown" at the acquiring company's labs. However, this has created a great incentive for companies that engage in purchase transactions (where goodwill is created) to assign a very high value to acquired R&D -- with very little of the overall purchase price being assigned to goodwill." This allows the immediate expensing of the excess of purchase price over book value, which does not weigh down future earnings per share with amortization of acquisition-related goodwill.

Many executives believe the market will not appreciate the per-share earnings of the company going forward when they include amortization of goodwill. But here's the rub. The market doesn't pay that much if any attention to goodwill amortization expenses anyway. The first reason has to do with the fact that they're non-cash expenses. If it denotes an expense that will not recur, then it has little meaning. But where it does have meaning is where the expense will recur. Some people treat depreciation as an expense that can be ignored because it's a non-cash expense. Do this at your own risk.

Depreciation is a memorandum denoting the consumption of an asset that will most likely need to be replaced. That replacement cost will be paid in cash. In a steady-state situation, depreciation really is a cash expense, because the outflow of cash to replace assets will match pretty closely the non-cash depreciation expense that masks cash inflows. That's why earnings according to Generally Accepted Accounting Principles (GAAP) aren't always screwed up, even though we find very entertaining and productive sport in finding the inadequacies of GAAP.

By writing off acquired R&D expenses all at once, no matter whether you call them that or "goodwill" or some random name like "George," the financial statements of companies engaging in this sort of accounting mis-state the amount of financial resources investors have devoted to the company. If one can't tell how much resources have been invested to create a dollar of earnings, one cannot get a good idea of how much resources it will take in the future to create another dollar of earnings. Without that information, it can be difficult to know the real quality of today's earnings and how much the company can grow in the future. Depriving the market of information makes for an inefficient market. If there were a capital markets karma, every CEO or CFO who enjoys a perpetually overvalued stock in this lifetime would suffer through a few lifetimes of being an executive for a wonderful company whose stock is perpetually and severely undervalued.

Luckily, we don't have to rely on karma to set things straight -- the market is fast-moving wheel of life that takes care of instant karma. The market is made up of dumb players within a smart system. Perpetual overvaluation or undervaluation is rare. The market might be inaccurate in the short term, but over the long term it's pretty accurate at assessing companies' values. Why, for instance, have so many so-called "roll-up" companies fallen apart over the years after experiencing shorter periods of euphoric pricing? If they issue stock to acquire lots of small companies and structure each transaction as a pooling of interests, without any goodwill being marked up on the balance sheet, then their apparent return on capital can be much higher than the actual return on capital as accounted for under purchase transactions. The market knows that no matter what your accounting technique -- pooling or purchase -- there's no difference in the economic substance of the two.

Tomorrow I'll go into why investors should cheer the possibility of a change in accounting rules dealing with acquired R&D.

Discuss this column on the FOTH message board.

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