Nearly a decade has passed since IBM purchased Lotus Development Corp. and attracted widespread attention to the potentially large write-offs that were possible on financial statements for purchased in-process research and development.

The scrutiny of IPR&D increased, as did the criticism that many corporations were managing their earnings with excessive IPR&D write-offs. As a result, the Financial Accounting Standards Board, in conjunction with the American Institute of CPAs, formed an IPR&D task force and issued new guidelines in 2001 to govern the practice.

After a few years of relative calm, IPR&D is about to take center stage once again.

As part of FASB's Business Combination Project, a significantly different accounting treatment for IPR&D is being proposed. In fact, many analysts believe that the changes related to IPR&D will be the most significant of all the changes proposed by FASB in its Business Combination Project. A number of analysts also believe that corporate earnings and merger and acquisition activity in general are likely to be affected considerably by the adoption of the new rules.

Old rules lead to aggressive write-offs

Many companies embark on long-term R&D projects to develop products that they hope will eventually be accepted in the marketplace. Pharmaceutical companies, for example, typically spend at least 15 percent to 20 percent of their annual revenue on R&D programs. Software companies also spend a significant portion of their revenues on product development.

Under generally accepted accounting principles in the U.S., these R&D costs are expensed if the product has not reached the point of technological feasibility, and if it has no alternative future use. Considerable judgment is required to decide if technological feasibility has been reached. In many cases, technological feasibility is assumed to exist once a significant milestone has occurred (such as beta testing for new software, or Food and Drug Administration approval for a new drug).

Alternative future use involves the portability of the technology to another use other than the one that was originally intended. For example, if a subset of code being developed for a word processing package can be used in its current state as part of a spreadsheet application, then that technology has an alternative future use.

In the case of mergers and acquisitions, current GAAP business combination rules require purchased R&D to be treated essentially the same as internal R&D programs. For example, assume that Company A purchases Company B for $100 million. At the closing date of the transaction, Company B has one software project that has not reached technological feasibility. Therefore, this would qualify the project as IPR&D.

Under purchase accounting, the fair value of the project would be written off by the acquiring company as of the valuation date. (It is important to note that only the fair value of the R&D should be written off, rather than the total expenses incurred on the project to date. The fair value is typically determined through a form of the income approach called the excess earnings approach.)

In the era before SFAS 141 and 142 (FASB's new rules regarding business combinations and intangible assets, respectively), when goodwill was able to be amortized, many chief financial officers favored high IPR&D write-offs because they lowered the goodwill amortization going forward, and therefore increased earnings per share. In addition, the lower asset base resulting from the write-off led to higher profitability ratios, such as return on assets and return on equity.

Though these write-offs were commonplace prior to the mid-1990s, IPR&D received few headlines. However, that all changed when IBM purchased Lotus in 1995 for approximately $3.2 billion, and took an immediate write-off of $1.8 billion for IPR&D - more than 50 percent of the purchase price.

By the mid-to-late-1990s, as merger and acquisition activity began to heat up, it was not uncommon for technology companies to allocate more than 75 percent of an acquisition's total purchase price to IPR&D. In the midst of increased earnings expectations, companies were becoming much more aggressive in terms of IPR&D write-offs.

As one would expect, these increased write-offs began to generate an increasing amount of attention.

FASB's new solution

In early 1999, FASB announced that it would initiate an IPR&D project that would eliminate the write-offs altogether. The project was eventually postponed, partially as a result of corporate outcry. However, many companies employed more conservative assumptions in the valuation of IPR&D to avoid Securities and Exchange Commission scrutiny.

While it's taken several years, FASB has recently put additional thought into the accounting treatment of IPR&D. Although new rules have not been finalized, the current FASB proposal is that the fair value of the purchased IPR&D should be reflected on the balance sheet and assigned an indefinite life until the R&D efforts are completed or abandoned.

Therefore, if one company acquires another that is working on a project that qualifies as IPR&D, the fair value of the IPR&D would be carried on the books and tested for impairment according to SFAS 142 until project completion. Once it is completed, the acquirer would determine the remaining useful life to the asset, and the fair value of the IPR&D would be amortized as an intangible asset, subject to impairment testing under SFAS 144.

The implications of these changes for financial analysis will be significant, because they will affect the balance sheet and the income statement. Many analysts are expected to treat this amortization as a production cost, which would reduce earnings. Some in the high-tech world speculate that M&A activity will increase prior to the adoption of the new rules, as companies try to avoid the additional IPR&D burden that will be placed on earnings.

In any event, the new FASB rules will put to rest the question of how to address IPR&D following an acquisition. Some people may not like the new rules, but that is how the game most likely will be played in the future.

Todd Patrick is a director in the CBiz Valuation Group.

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