Post of the Day
May 7, 1998

From our AOL
Cisco Systems Board


Subject: Clarification for R&D Controversy !!!!!!
Author: Gurekaiola

People, Do not get caught on terminology disputes!!

In technology industry acquisitions, the acquirer pays a premium for the time (precious time!) that it would take it to develop the acquiree's technology in-house. We all agree with this, and whether a the acquirer accounts for the acquisition by a purchase, by a pooling of interests, or by acquiring "In-process R&D" (as I will explain, yet another accounting gimmick), HAS NO IMPACT WHATSOEVER ON FREE CASH FLOW!!!!!!!! (Do not forget that the charges arising form acquisition accounting are all non-cash items!!) The choice of accouting method, however, indeed has an impact on Earnings, but as we all also agree, investors care about Free Cash Flows, not about Earnings. Let me explain...
  Thus, it is all a matter of market psychology, because even though the impacts on earnings of any of the previous accounting methods may be different, the impact on Free Cash Flows are finally the same!!!
Acquisition of "In-Process R&D" is just an accounting gimmick. Traditionally there have been two methods of accounting for acquisitions: 1) Purchase accouting; and 2) Pooling of interests.

All acquiring companies prefer to use the pooling method because the purchase method creates the so-called "goodwill." Goodwill is the difference between the price paid and the fair value of the target's assets. Goodwill is treated as an intangible asset and has to be amortized over a maximum period of 40 years, thus taking a dent on earnings for a long period of time. Not surprisingly, companies try to avoid purchase accounting at at all costs, so much so that many companies drop imminent deals because they did not qualify for the pooling of interests, that does not have a negative impact earnings. Unfortunately, in order to qualify for a pooling, the companies involved have to satisfy about 10 arbitrary criteria, some of which refer to past actions. In other words, because of some past actions of either party, the transaction would never qualify as a pooling.

Lately, however, many technology companies do not qualify for a pooling have found a way to get around such messy and absurd accounting standards. How? Basically, instead of creating goodwill, they take a one-time charge against earnings (also known as "In-Process Acquired R&D"). Why? Concious of the fact that financial markets are far from perfect, acquisition-intensive companies such as Cisco know that analysts will probably ignore recent one-time non-cash charges on earnings for acquiring companies, and will probably not ignore the permanent dent that the amortizations of goodwill accumulated over many years will have on net earnings.

Thus, it is all a matter of market psychology, because even though the impacts on earnings of any of the previous accounting methods may be different, the impact on Free Cash Flows are finally the same!!! Let me explain: when you account for an acquisition using "In-process R&D", you are treating the acquisition as an expense (that, like any expense, is a one-time charge). When you do so with purchase accounting, you are treating the acquisition as an investment (that, like any invesment on assets, has to be amortized). If you define Free Cash Flow as Net earnings + Depr. & Amort. - Change in WC - Investments, at the bottomline, it does not matter whether you charge say $100 M to earnings in the form of an expense, or whether you leave earnings intact and charge $100 M to Free Cash flow in the form of an investement.

Roman Zurutuza

zurutuza@aol.com


Go To Cisco Systems Board

The Post of the Day may be edited for readability or length, but never for content. The opinions expressed in the Posts are those of their authors, and not necessarily The Motley Fool. We make no claim or warranty as to the veracity or accuracy of any post, and present this feature only as an example of what may be found on our message boards. Don't take the Post of the Day, or anything else here, as gospel and, as our seventh grade English teacher, Mrs. Peacock, used to say, do your own homework, and avoid run-on sentences.