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October 25 2007
Good investment choices are the result of careful examination of all available
information relating to the investment under consideration. For many investors,
the primary source of information about their common stock investments comes
from the company's audited financial statements. Having a thorough
understanding of the way information is presented in the financial statements
may impact an investor's decisions. In-process research and development
expenses are a very specific component of the income statement, but having an
understanding of these items and the accounting that surrounds them can help
investors uncover investment opportunities (or a lack thereof) in a newly
acquired company. (To learn more, read Find Investment Quality In The Income
Statement.)
Getting To Know The Basics
When one company acquires another, the purchase price is often an amount that
is greater than the book value of the acquired company. In accounting
terminology, the premium paid over book value is called goodwill, which is
treated as an asset on the balance sheet of the acquiring company. Recall that
an asset is a resource of economic value that a corporation owns or controls
with the expectation that it will provide future benefit. Goodwill resulting
from an acquisition is expected to provide a future economic benefit to the
acquiring company. (To learn more, please see Reading The Balance Sheet and Can
You Count On Goodwill?)
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When an acquisition is completed, the acquiring company must identify and
allocate goodwill to the acquired assets. If an acquired company is conducting
research and development on a new product, but that product is not yet being
sold, Generally Accepted Accounting Principles (GAAP) require that any premium
in the purchase price over book value attributed to that product be expensed.
This scenario is referred to as in-process research and development.
For example, suppose that International Blowfish acquires Fugu Inc. for $1.5
million. Fugu is developing a product that is slated to become its major asset.
Blowfish determines that $900,000 of the purchase price should be allocated to
the product. This amount is considered in-process research and development
because the product is not yet ready for sale as of the closing date of the
acquisition. The product may be only weeks away from being introduced to the
market, but GAAP requires Blowfish to expense the $900,000 rather than record
it as goodwill. (To learn more, read The Basics Of Mergers And Acquisitions.)
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The Logic
Paying top dollar for another company only to turn around and expense a large
portion of the acquisition price may cause investors to wonder whether it was
worth making the acquisition. In the above example, it really doesn't seem to
be logical, especially because the product was almost ready to be introduced to
the market.
However, although the requirement to expense in-process research and
development costs appears unreasonable, it is actually consistent with the
treatment of similar costs incurred by a company seeking to internally develop
new products. GAAP requires that all research and development costs be
expensed. One may argue that this violates the matching principle of
accounting, which requires that costs be recognized in the same period as the
revenues they create, but research and development costs are expensed because
the future economic benefit generated by the resulting product can be highly
uncertain.
Implications for Investors
Investors who know and understand the rules relating to in-process research and
development expenses have the opportunity to make more informed investment
choices. If an investor believes that current earnings have been temporarily
impaired as a result of the application of the accounting requirements, and
that there will be significant future economic benefit as a result of the
research and development secured in an acquisition, then the investor may be
able to profit from the information if other investors have overlooked this
possibility in their valuations of the company. Conversely, if an investor
believes that the current valuation of a company reflects the expectation of
future economic benefits that may result from an acquisition, but the investor
understands that the acquisition resulted in an in-process research and
development expense, then the investor may conclude that a future benefit is
highly uncertain as reflected in the accounting treatment of the transaction.
This may lead the investor to determine that the stock is overvalued.
Additionally, it may be useful for investors to consider the judgment applied
by management in the application of the rules regarding allocation of goodwill.
Because the application of this accounting principle can be somewhat
subjective, investors should be aware that management may have the opportunity
to use this principle to manipulate earnings. If management over-allocates
expense to in-process research and development, it can understate earnings in
the current reporting period to the benefit of future earnings. (To learn more
about earnings manipulation, please see Cooking The Books 101.)
Investors should determine whether the company has hired an outside consultant
to examine the facts and allocate goodwill. Hiring an independent consultant/
accountant could indicate that management is making an effort to get it right
by receiving objective assessments.
Conclusion
In-process research and development is a complicated accounting concept that
deserves a high level of scrutiny from investors and other users of financial
statements. The accounting principle is not necessarily bad, it is simply the
accounting profession's best attempt to provide accurate financial information
about complex business transactions. Investors who have a thorough
understanding of the principle and know its limitations have the opportunity to
make more informed investment decisions.
by Jerry Sais Jr. & Melissa W. Sais
Jerry D. Sais Jr., CPA, CFA, AIFA, is a registered investment advisor and chief
investment officer of REDW Stanley Financial Advisors, LLC, in Albuquerque,
N.M. Melissa W. Sais is an Albuquerque-based writer and editor.