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Fool On The Hill

Monday, March 1, 1999

An Investment Opinion
by Dale Wettlaufer

Financial Karma, Part III

In the last two Fool on the Hill columns (part 1, part 2), I talked about the question of immediately expensing in-process R&D versus capitalizing it and amortizing it over a number of years. I went on to posit that the market discounts free cash flows and not just earnings. Earnings are subject to accounting distortions that take a creditor's view of the enterprise rather than an investor's point of view.

Generally Accepted Accounting Principles (GAAP) are set up in such a way as to make the cost of interest-bearing obligations explicit on the income statement, but GAAP is not consistent in the way it sheds light on the cost of equity. In some situations, deployed equity has a cost that shows up on the income statement, according to GAAP. In others, the cost of equity is not seen. And in some cases, the cost of equity is immediately seen but ignored by investors, as in the current method of writing off acquired R&D. It's not easy to deal with for beginning investors because the logic underlying the different accounting methodologies is not consistent.

To make it consistent, we have to first accept a basic premise -- that all capital has some cost, whether it's equity, debt, or liabilities other than debt. The cost in such a system of thinking could very well be zero, though. In fact, when you look at an insurance underwriter that is able to avoid underwriting losses over 50 years, on average you could say that the cost of the "float" portion of its capital is zero. Deferred tax liabilities with an indefinite maturity are also another example of zero-cost capital. For equity, there is an implicit cost to the firm and its shareholders. It's not stated on the balance sheet, but the cost of equity is the return on equity that investors expect.

The evidence of deployed equity according to GAAP is found in the "equity" portion on the right side of the balance sheet. After all other claims of the enterprise are taken care of, the residual income is divided by equity to arrive at return on equity. Return on total capital looks at after-tax operating income divided by all equity plus debt plus equity equivalents. When you mess with either of these things, you can get a bad idea of how much resources it will take in the future to enhance shareholder value. That's why accounting for R&D-related mergers and acquisitions demands a different accounting treatment than just writing off the acquired R&D.

In a pooling of interests, there is no evidence of equity being deployed even when a company can more than double its shares outstanding. But in a purchase, even when a stock swap is treated as a purchase, goodwill equal to the excess purchase price over appraised net asset value of the acquired company is put on the balance sheet. Then it's amortized over a number of years. As in the cash flow example I gave on Friday, which illustrated the cash resources the firm creates as a return on investment, the market is able to look through these two methods of accounting. It is also able to assess the amount of resources that are put into the firm.

As far as return on capital and cost of capital go, a pooling and a purchase should be no different in economic substance, especially when both are stock-for-stock transactions. For the purpose of conceptualizing the economics of the two cases, assume that you are first selling your stock to raise cash and then using the cash to make the acquisition. In this case, the cash is going to show up on the resulting balance sheet as common stock, par value, and additional paid-in-capital. Return on capital is then measured on the resulting capital and equity bases.

The whole thing gets complicated, however, for R&D-intensive enterprises. Going forward, you're amortizing capitalized R&D and you're not capitalizing the spending that is intended to replace those acquired assets. Therefore, the consumption of the capitalized R&D shows up as an expense in the same period that the spending to replace that R&D shows up as an expense, understating net cash flow available to shareholders.

If the income statement and balance sheet were to truly depict R&D investments that do not have an immediate pay off, all R&D spending would be capitalized and amortized over its estimated useful life. Net income would be immediately higher, of course, but net cash flow available to shareholders (not considering the vital point of what is discretionary capital spending and R&D spending and what is maintenance spending) wouldn't be any different. The depiction of return on capital -- the cash that comes out of the business relative to the resources that go into the business -- would also be the same no matter whether the R&D was acquired or home-grown. Economically, it shouldn't matter how it's acquired.

In summary, mixing a capitalization/amortization expense framework for R&D with a framework in which the maintenance spending is immediately reflected on the income statement is a bad idea from the standpoint of there being hope for the income statement to depict free cash flow. From the standpoint of depicting the resources invested in a company, capitalizing in-process R&D that arises from consolidating two companies is a great idea. It would save a lot of people a lot of time in adjusting GAAP statements to reflect economic reality. It would also wake up people to the fact that if a company wants to write off a huge hunk of deployed capital, its financial statements won't depict the true economics of the business.

The market measures cash flows and return on capital. It does not measure earnings that have been massaged into meaningless Silly Putty, and it does not ignore unrecorded goodwill. Otherwise, fewer roll-up companies would be in the gutter. Only when the reported earnings of a company faithfully reflect the cash flow economics of a business should earnings be taken at face value. You can pretty much forget all the accounting vocabulary above if it gives you a headache. There's not enough space here to really demonstrate it well, either, for the more numerically inclined.

Just remember that it takes money to make money. Masking the amount of money it takes to generate a return by writing it off or by engaging in a pooling transaction that understates the market value that is traded for future earnings doesn't fool the market. For technology executives, don't worry. The market is smart enough to look through the accounting treatment of acquisitions to assess your real cash flow. The market is also smart enough to know if you are underspending if your stated goal is to replace the assets. In all, there is both upside and downside to the Financial Accounting Standards Board's direction on accounting for acquired R&D. And investors are a pretty hardy species. They will adapt and will not be fooled by accounting gimmickry just as they are not lured into believing now that companies that write off all R&D are necessarily more profitable than companies that home-grow their R&D.

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