By ELIZABETH MACDONALD
Staff Reporter of THE WALL STREET JOURNAL
Investors in stocks of high-tech and pharmaceutical
companies, beware: A study warns that a growing number of
the companies are using an obscure accounting rule that
some critics say can inflate subsequent earnings
The authors of the report say that 3Com, Novell and Exar
have already benefited from the rule. While all three
companies acknowledge using the bookkeeping method, they
say it is mandated by accounting rules, and hasn't
distorted their profits.
Here's how accounting expert Baruch Lev of New York
University says acquisition charges for "in process"
research and development can pump-up subsequent high-tech
earnings. The companies defend their accounting as proper.
Cost of Size ofTime Fiscal FY '96
Acquisitions ChargesPeriod of 1996 Net
Acquisitions Earnings Without
3Com $220.0 $192.9 1/94-10/94 $177.9 $144.8
Novell 529.7 425.9 6/93-6/94 126.0 19.5
Exar 24.1 16.9 5/94-6/94 13.6 10.4
Dollar figures are in millions
*Assumes four-year write-off of R&D costs starting at least
four quarters after acquisition, instead of immediate
The March 1997 study by Baruch Lev, an accounting and
finance professor at New York University, and Zhen Deng, an
NYU graduate student in accounting, found an increasing
number of companies using the 22-year-old rule.
The rule in question lets an acquiring company set a value
for the "in-process" research and development assets at an
acquired company, and immediately write off that amount.
The higher the value, the more acquirers can avoid hits to
future earnings from goodwill. That's because any goodwill
-- the premium of the purchase price over the acquired
company's book value -- is supposed to be deducted from the
acquirer's profits over periods as long as 40 years.
Jack Ciesielski, editor of the Analyst's Accounting
Observer, a Baltimore publication for stock analysts,
warns, "Investors should be careful of subsequent earnings
posted by acquirers using this rule, because they are a bit
Gabrielle Napolitano, a securities analyst who follows
accounting issues at Goldman Sachs, holds a similar
opinion: "Acquiring companies may be assigning too high a
value to this in-process R&D, distorting subsequent
The practice is on the rise. The study says that only three
companies wrote off part of their acquisitions as
"in-process" R&D during the 1980s. But 389 have done so in
the 1990s, a record 156 last year alone. Nearly 40% of the
acquisitions occurred at computer-software and equipment
companies, the rest at pharmaceutical and biotech concerns.
To be sure, companies must take such write-offs to comply
with accounting standards. "The companies are not doing
anything wrong," says Mr. Lev. "But what is wrong is the
accounting system that allows these immediate write-offs."
The authors say investors should watch out for euphemisms
for this acquired R&D, such as "incomplete technology,"
"in-process engineering and development," or "acquired
A computer search by Mr. Lev and Ms. Deng found 392
acquisitions using such a write-off between 1980 to 1996.
The average R&D write-off was a whopping 72% of the entire
purchase price. The size of the write-offs, the authors
say, caused more than 75% of companies in the sample to
post a loss for that quarter.
After that, the authors calculate, the write-offs gave a
temporary 22% kick on average to the acquiring companies'
earnings in the fourth quarter after the acquisitions.
Reason: If they hadn't taken the immediate write-offs for
the R&D, the acquirers would have had to count the R&D
costs as expenses over four years -- which Mr. Lev
estimates is about the average life of R&D software --
which would have reduced their earnings over that period.
"Managers love this write-off because it inflates future
earnings," says Mr. Lev.
Moreover, the authors estimate the write-offs temporarily
overstated the acquiring companies' return on equity by an
average 37% in the year after the write-off. That can put a
smile on the faces of corporate executives, because return
on equity is a yardstick used by compensation committees to
set executive pay, according to William M. Mercer Inc., a
New York compensation consulting firm.
The impact on earnings can be substantial.
In 1994, 3Com, Santa Clara, Calif., wrote off $192.9
million, or 88% of its total $220 million acquisition price
for four companies, including Synernetics and Nice Com. Mr.
Lev estimates that by the fiscal year ended May 1996,
3Com's write-offs had boosted its annual earnings by 23%
over the level that would have been reported if the
acquired R&D had been written off over four years.
Alan Groves, 3Com's corporate controller, said Mr. Lev used
"highly fallacious" assumptions, and that 3Com's accounting
was "conservative." But he wouldn't elaborate.
Another case in point: Novell of Provo, Utah. Between June
1993 and 1994, this maker of network software wrote off as
"in-process" research and development $425.9 million, or
80% of its total $529.7 million price tag for four
acquisitions -- Unix Systems Lab, Serius, Fluent and
Borland International's Quattro Pro, a spreadsheet program.
Novell eventually sold much of Unix's software line and
Mr. Lev says that if Novell had written off the R&D
expenses over four years, its net income would have been
$19.5 million in the year ended October 1996, less than
one-sixth of the $126 million it actually reported.
Novell's director of investor relations, Peter Troop, says,
"Novell accounted for its acquisitions as required by
generally accepted accounting principles."
Exar also wrote off $16.9 million in acquired R&D for two
companies it bought between May 1994 and June 1994. By the
end of the fiscal year ended in March 1996, this Fremont,
Calif., telecommunications company reported $13.6 million
in net income. But Mr. Lev says if it had written the R&D
off over four years, its net would have been $10.4 million.
So the R&D charges boosted net by 31%. Ron Guire, chief
financial officer of Exar, remarks, "It's a nice study for
a college, but in practice I think it's crazy."
Mr. Ciesielski says the sheer size of some of the R&D
write-downs indicates that some acquiring companies are
abusing the rules by including too much goodwill. But most
companies don't release the details of the calculations
they use to arrive at the write-down amounts. Companies
wouldn't have to worry about the size of their goodwill
write-downs if they used "pooling-of-interest" accounting;
but companies that use that method for an acquisition can't
quickly dispose of unwanted assets.
So far, both the Financial Accounting Standards Board, the
chief accounting rulemaking body, and the Securities and
Exchange Commission say they are looking into the
controversy. But little action has been taken to date.
Determining whether R&D write-offs were appropriate in
hindsight is complicated by the fact that, as Bear Stearns
accounting expert Pat McConnell notes, "no reliable data on
R&D cash flows postacquisition exist because such revenue
is typically commingled with a firm's other earnings."
Adds Mr. Ciesielski: "If these write-offs are in fact all
R&D, the companies should be generating phenomenal revenues
and new products -- but are they?"
* * *
BUFFETT AT THE BAT: At the Berkshire Hathaway Inc. annual
meeting Monday, billionaire investor and Salomon Inc.
stockholder Warren Buffett said the "odds are overwhelming"
that he'll convert some of his Salomon preferred-stock
holdings into the common stock of the securities firm this
year, rather than cash out.
In 1995, in what was seen as a no-confidence vote for
Salomon's management, Mr. Buffett chose to take cash for
some of his preferred stock, but, last year, Mr. Buffett
decided to convert a $140 million chunk of preferred into
Salomon common stock. Mr. Buffett can convert his preferred
stock into common shares at $38 apiece, well below
Salomon's current price of $52.625.
When asked about his plans, Mr. Buffett at first hedged a
bit, saying, "We see no reason to swing at the ball when
it's still in the pitcher's glove." Mr. Buffett doesn't
have to decide whether to convert or not this year until
-- Anita Raghavan
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