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New accounting rules forcing companies to capitalize research costs will boost net income and total assets at the time of a business acquisition but then pinch future income, especially for companies in research-intensive sectors, according to a recent study.
The Georgia Tech Financial Analysis Lab studied historical figures for a variety of public companies to see how the numbers might differ if the recently adopted Financial Accounting Standard No. 141R, Business Combinations, had been in place back in 1998. (In reality, FAS 141R maps out a new approach to accounting for business combinations starting in 2009.)
Georgia Tech’s study found research-intensive sectors such as biotech spent the greatest portion of net sales on in-process research and development. Capitalizing that line item at the time of acquiring a business—which forces the company to write down the acquisition cost over a period of years into the future, rather than expensing it immediately—will make a greater dent in earnings.
Typically, companies have been eager to charge off as much of the cost of an acquisition as possible, hoping to avoid future charges to earnings and the negative stigma of goodwill, says Chuck Mulford, director of the Financial Analysis Lab. His study found that the median company expended 1.5 percent of net sales on in-process R&D; the median for companies in the pharmaceuticals or medical sector was a whopping 10.2 percent.
For companies in the computer sector, the median expenditure was 4.1 percent of sales, demonstrating that in-process R&D is an important expense, Mulford says. “Capitalization of in-process R&D will obviously raise earnings in the year it is incurred,” he says. “For many companies, reported losses will become reported profits.”
The significance of in-process R&D—and consequently the significance of the new accounting rules that will change the way it flows through to earnings—is measured as a percentage of sales, total assets, goodwill, and stockholders’ equity, according to Mulford. “We think that reporting companies as well as analysts and investors will find the results to be informative as they begin preparing for the changes,” he says.
Mulford says earnings will not necessarily be lower in future years due to amortization of previously capitalized in-process R&D; the results depend on the amounts of new in-process R&D capitalized and the amortization period for previously capitalized R&D costs.
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