R&D & Intangibles
San Francisco Academy
Thursday, February 19, 2004
Professor Paul Zarowin, PhD
New York University
Stern School of Business
KMEC 10-90
44 West 4th Street
New York, NY 10012
Tel (212) 998-0015 / Fax (212) 995-4004
pzarowin@stern.nyu.edu
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Presentation Outline
1. Introduction
2. The problem/issue
3. How we got here: FASB and
barriers to change
4. Capital market consequences
5. Solutions
6. Management accounting issues
7. New Accounting Rules
8. Summary
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1. Introduction

focus on external financial reporting issues

major Policy Implications and players

NYU Intangibles Center

Brookings Institution task force
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2. The Problem/Issue
Growth in R&D
BAD Accounting
Paucity of R&D disclosures
hinders evaluation
SUMMARY: Bad Accounting and Insufficient Disclosure,
when good accounting and more disclosure are needed
most
4
19
7
19 3
7
19 4
7
19 5
7
19 6
7
19 7
7
19 8
7
19 9
8
19 0
8
19 1
8
19 2
8
19 3
8
19 4
8
19 5
8
19 6
8
19 7
8
19 8
8
19 9
9
19 0
9
19 1
9
19 2
9
19 3
9
19 4
9
19 5
9
19 6
9
19 7
9
19 8
9
20 9
0
20 0
0
20 1
02
Economy-Wide Total R&D Expenses Over Total Sales
R&D/Sale
0.025
0.020
0.015
0.010
Economy-Wide Total R&D Expenses
Over Total Sales
0.005
0.000
Year
19
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
2099
2000
2001
02
Economy-Wide Aggregate R&D Expenses
R&D (In Billions)
350
300
250
200
150
100
Economy-Wide Aggregate R&D
Expenses
50
0
Year
19
7
19 3
1974
7
19 5
1976
7
19 7
1978
7
19 9
8
19 0
1981
8
19 2
1983
8
19 4
1985
8
19 6
1987
8
19 8
1989
9
19 0
1991
9
19 2
1993
9
19 4
9
19 5
1996
9
19 7
1998
9
20 9
2000
0
20 1
02
Economy-Wide Aggregate Market-to-Book Ratio
M/B
4
3
2
Economy-Wide Aggregate Market-toBook Ratio
1
0
Year
3.How we got here-standard
setting/barriers to change
A. Standard setters’ motivation/rationale behind the current
rules (full expensing) - SFAS #2, 1974
lack of (Value) Relevance to investors Lack of Reliability (Objectivity) -
B. Barriers to changing status quo
firms and auditors
regulators
investors/analysts
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4. Capital Market Consequences of the
Problem
1. Declining usefulness (timeliness, value relevance) of accounting
data 2. Market inefficiency 3. Increased cost of capital 4. Increased analysts’ effort 5. Insider trading gains 6. Earnings management (EM) Key Q: Why do firms accept the status quo?
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5. Solutions - what to do?!
1. “Partial equilibrium”“Home-made” capitalization
2. “General equilibrium” Financial Reporting
Legal Environment
R&D markets In-Process R&D and Targeted Stocks Software capitalization
- Key Q: How generalizable to other types of R&D?
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6. Management accounting/internal
control issues

nascent area

major problems

Michael Jensen’s 1993 AFA Presidential address:

1980's: poor internal controls, wasteful R&D expenditures
The Economist (1990): in the 1980's
“American industry went on and R&D spending spree,
with few big successes to show for it”.

Brownyn Hall: 1980's - falling valuations, slow management respons
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7. New Accounting Rules
Purchase Method for Acquisitions and
Goodwill Impairment
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Accounting Rules - Acquisitions
Pooling of interest versus purchase.
The purchase method led to
“Goodwill”, which had to be
amortized over a period not to
exceed 40 years.
Companies tried avoiding the purchase method
because future earnings were negatively
impacted.
The new accounting rules eliminated pooling
and required purchase for all acquisitions.
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Example
Cash
Short-term investments
Accounts receivable
Inventories
PPE, net
Other assets
Total Assets
($ Millions) Market Value
7
7
14
14
15
15
36
41
22
31
5
3
99
111
Accounts payable
Debt
Equity
Total liabilities and equity
Paid for the equity
23
9
67
99
23
10.5
77.5
111
91
Goodwill
13.5
Goodwill amortization (30 years)
0.45
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New Accounting Rules
Upon acquisition, break the excess of
acquisition price over fair market value of
assets purchased into specifically-identifiable
intangible assets.
The remainder is “goodwill”.
Goodwill is not to be amortized, but
has to be tested for impairment in
value.
– Test annually and whenever
conditions may warrant.
– Write down goodwill if impaired.
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Amortization and Impairment
Assess whether intangible assets have finite
or indefinite lives.
Finite-life intangible assets should be
amortized, typically on a straight-line
basis.
Other intangible assets are subject to (at
least) annual impairment testing:
If impaired, asset write-down is required
with a negative effect on income in the
same period.
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Impairment Test
Intangible assets subject to amortization should be
reviewed according to SFAS No. 121, i.e., if the
carrying amount exceeds fair value and is not
recoverable, write the asset down.
Undiscounted cash flows are less than carrying
amount.
Goodwill: Compare the fair value of the reporting unit to
its carrying amount (including goodwill). If carrying
amount is higher, goodwill is likely to have impaired.
Fair value is the amount that can be obtained in a sale
of the reporting unit. Best evidence is market prices.
Otherwise, use comparables, present value techniques.
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Impairment Amount
Allocate the fair value (as determined before) to
tangible and intangible assets of the unit,
excluding goodwill.
The excess of the fair value of the reporting unit
over the amount assigned to its individual
assets and liabilities is the implied fair value of
goodwill.
Goodwill should be written down to the implied
fair value or zero, whichever is greater.
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Example- Wellman (WLM)
The company manufactures and markets polyester
products and PET resins. It also recycles PET plastics.
In the first quarter of 2002, the company adopted SFAS
No. 142. The adoption resulted in a charge against
income of $197 million!
The earnings from continuing operations were $5.6
million, on sales of $239.4 million.
Stockholders equity declined from $612.7 at the
beginning of the quarter to $397.0 at the end.
Goodwill declined from $230.5 million to $33.3 million at
the end of the quarter.
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Example- Wellman (WLM)
The company used the two-step process; first testing for impairment
in its reporting units, and then reducing the goodwill to its implied
value in the Fibers and Recycled Products Group, which
accounted for about 48% of quarterly revenues.
The fair value was based on the present value of estimated future
discounted cash flows.
The entire goodwill related to this segment was written off.
Goodwill in the other segment was left intact, with no amortization
charge.
Goodwill amortization in Q1/01 was $2.1 million.
Other assets which were intended to be sold were written down to fair
value less than cost of disposal (another charge of $19 million to
earnings), consistent with SFAS No. 144.
Net Earnings from continuing operations in the second quarter of
2002 were $12.8 million.
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8. Summary
Why does it all matter?
Even if markets are efficient!
Real Consequences
Positive vs Normative Research
Socially Important
Major Policy Implications
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