Speech by SEC Staff:
Making Financial Statements Real:
Recent Problems In the Accounting for Purchased In-Process Research and Development

Remarks of

Lynn E. Turner

Chief Accountant
Office of the Chief Accountant

At the Software and Service Industry Analyst Group

February 10, 1999

The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of Mr. Turner and do not necessarily reflect the views of the Commissioner of other members of the Commission’s staff.

Let me start by thanking the sponsors of this prestigious event. In particular, I would like to thank Rick Sherlund. I have often heard of Ricks’ reputation in the software industry. And during the past year or so, as a CFO, I had the good fortune to work with his firm.

I also have had the good fortune to work closely with the software industry and software companies in the past. This is an industry that in a period of 25 years has rocketed from a new beginning, to having a place in everyone’s life, be it at work with computers, in your home, in your car, in the airplane you might have flown to this conference or in the elevators you will ride to work on January 1st next year.

US capital markets are world renowned for their receptivity to companies with new and unproved ideas. Intriguing possibilities in medicine, computer science, and communications can be realized when risk-taking thinkers connect with risk-taking investors. To pick the next small company that will grow to become an international business empire may take some luck. But an efficient capital market that fosters new technologies and sustains young businesses is not a casino. Over the long term, the willingness of investors to accept risk is directly related to their confidence in the accuracy and completeness of the information they use to weigh alternative investments. That’s why the full disclosure system lies at the foundation of US markets.

Financial statements are a cornerstone of that full disclosure system. Of course, no set of accounting conventions can measure a dynamic business’ financial condition and performance with precision. Even accounting standards are not always perfect! But it is the confidence that accounting rules will be applied consistently, comparably, and transparently -- over time and among different companies -- that allows investors to make sense of financial statements and use those numbers in their investment decision models. Such confidence arises in part from the ability of independent accountants to test the reasonableness of the way management applies the accounting rules.

Investors have good reason to have confidence in the financial reports of US public companies. The vast majority of the business community are working hard and diligently to produce high quality financial statements and disclosure. Most professionals, whether in public accounting or in financial management, are performing their jobs with great integrity and rigor. Of course, we’re alarmed when, as reported by the press in one instance, a company’s capitalization shrinks by $20 billion after correcting half a billion dollars of errors in its financial statements. But those cases receive much public attention precisely because they are the exceptions to the strong record that US companies have for honest and full disclosure.

Those few sensational cases are not the biggest threat to the credibility of financial reporting. In my view, the more serious threat is that erosion of credibility that can occur if investors perceive that companies are routinely playing accounting games. Titles of articles published in the last year suggest that such a crisis of confidence could be building: "Pick a Number, Any Number," "Accounting Abracadabra," "The Auditors Are Always Last to Know," and "Earnings Hocus Pocus, How Companies Come Up With the Numbers They Want." And there is evidence in recent surveys that CFOs themselves are feeling increasing pressure to fudge the numbers -- from within the company, from financial analysts, and from the market which can so furiously punish a missed forecast.

To head off that crisis of confidence, Chairman Levitt highlighted inappropriate earnings management in a speech last September. That speech is available at the SEC’s website, SEC.GOV. Some of the accounting games he criticized were:

• recurring "big bath" restructuring charges,
• "creative" business acquisition accounting,
• miscellaneous "cookie jar" reserves,
• so-called "immaterial," but intentional, errors, and
• manipulative revenue recognition.

And the Chairman set into motion a plan to address these corrosive problems:

• The SEC staff, the AICPA and the FASB are each working to provide additional interpretive accounting guidance or rules to curb those abuses;
• A blue ribbon committee was formed and on February 8 proposed some significant recommendations for strengthening the role and performance of audit committees;
• The Public Oversight Board formed a committee to review the way audits are performed today and assess the impact of recent trends in business and the profession on the effectiveness of the audit; and
• The Divisions of Enforcement and Corporation Finance are increasing their focus on the detection and correction of abusive accounting games.

In recent speeches, which are also available at the SEC web site, I have described these issues and plans in more detail. Also at the web site are samples of letters the Division of Corporation Finance sent last January to a large number of public companies. These letters were the result of users of financial statements highlighting to the staff concerns about whether companies were complying with existing disclosure rules. The letters alerted the companies, prior to their filing 1998 annual reports, of disclosures that are needed to give transparency to charges involving asset impairments, restructuring costs, purchased research and development, and similar items. All of our efforts reflect the Commission’s commitment to help registrants in a proactive and constructive manner, and to enlist standard setters, the accounting profession, business, investors, and even financial analysts in a campaign to improve the transparency and integrity of financial reports.

This afternoon, I want to focus on only one part of that campaign that may be of particular interest to many in this audience. Over the past year, I’ve received letters and read many press reports that expressed skepticism about whether purchased in-process research and development is being accounted for consistently by public companies. Under APB Opinion No. 16, as you know, the total cost to acquire a business must be allocated to its individual assets and liabilities based on their fair values. While all the other assets acquired in a business combination are capitalized, the amount allocated to purchased R&D must be written off immediately, pursuant to FASB Interpretation No. 4, unless it has a use other than in that R&D project. Although this accounting requirement has remained unchanged since 1975, we’ve found that amounts written off as purchased R&D have escalated rapidly in the last few years.

Researchers at New York University’s Stern School of Business ¹ found no more than three business combinations where purchased R&D was written off during the 1980’s. But in only the first seven months of 1996, the researchers identified 147 such instances. Their data indicated that the proportion of purchased R&D to total business purchase price had grown significantly. By 1998, the valuations had reached a magnitude and frequency that defied belief. Some have estimated that, in 1998 alone, perhaps more than $16 billion of value was attributed to purchased R&D and written off.

Some in the financial community believe that unreasonably large write-offs of purchased R&D are being used to hype the company’s stock price. Amounts paid in the business combination are written off immediately as purchased R&D when they should have been allocated to other, capitalized assets. The excessive up-front write-off avoids future amortization and depreciation expense. The misleading result in periods immediately after the acquisition are higher earnings, higher earnings per share, higher return on assets, and higher return on equity. At the same time, since management claimed to have valued the purchased R&D based on the future cash flows to be derived from it, exaggeration of that value implies to investors significant, auditor-certified profits after the projects were completed.

The SEC staff began to probe the reasons for increased R&D valuations in the Spring of 1998. Prior to that time, on occasion we challenged particular appraisal assumptions, but ultimately we often relied substantially on the expertise of management and its advisors concerning this item.

However, it is useful to look at financial transactions, such as an acquisition, from a business perspective. This also is true for acquisitions of technology driven companies. For example, what is the purpose for the acquisition? To gain access to new market channels or particular customers, an engineering work force, additional products that can be produced with existing capacity, a quicker time to market through buying the target’s products or products under development, or perhaps merging two businesses and gaining certain synergies by elimination of duplicate capacity and costs.

To fully understand the underlying economics of a transaction, and management’s perspective on it, it is useful to consider information such as the presentations made by a target and management to the Board of Directors. This provides a clearer perspective of what the buyer and seller considered to be the key drivers of the transaction, including the assets being acquired. Offering memorandums, due diligence information, and business plans also are useful in providing clarity to what the target company is selling and the buyer acquiring.

This is why in 1998, the staff began to dig deeper as increasingly larger writeoffs occurred. We examined material presented to the Board of Directors about the purchase. We studied descriptions of the individual R&D projects and the engineer’s technology road maps. We evaluated the nature of the work completed at the acquisition date, and the nature of the work that remained to be done by the purchaser. As a result, we recognized at least three recurring flaws in the way some companies, particularly computer-related companies, were approaching the valuation of purchased R&D under the existing fair value rules.

First, some companies were not rigorously isolating the R&D project from all other valuable assets acquired in the transaction. Many appraisals were premised on the view that, since continuous upgrading is necessary to meet competition, any existing product has little value while its upgrade in process is the source of substantially all value. That view misallocates the purchase price and causes other assets to be undervalued, such as the existing commercialized core technology and know-how, the value of the right to upgrade and embellish that core technology, and the value of the customer relationships and goodwill that would give sales momentum to the next generation product.

Second, the appraisals often reflected little or no analysis of the project’s stage of development or the complexity and uniqueness of the seller’s achievements at the acquisition date relative to the complexity and uniqueness of efforts which the purchaser must undertake to complete it. The methods used implied little difference in value between a project still in the conceptual stage and one approaching completion and commercialization. They recognized little difference in value between a project where the seller had mastered the trickiest elements and one where the most difficult work remained to be done.

Third, some appraisals computed an "investment value" for the R&D project, rather than its "fair value." Of course, no value should be assigned to purchased R&D that will not be used or sold by the purchasing company. But R&D to be used by the purchaser must be valued at its expected exchange price between a willing buyer and seller. Fair value is intrinsic to the R&D project itself, rather than dependent on the particular resources and plans of the purchaser. We sometimes found that management’s cash flow projections improperly bestowed on the R&D project the value of the unique competitive advantages inherent in the purchaser’s own management team, engineering staff, production techniques, sales and distribution systems, and customer relationships. In any case, in some cases the amount assigned to the R&D project was rarely tested realistically against the purchaser’s ability to undertake the R&D project independently, that is, the classic make or buy decision rather than acquiring the seller’s project in-process.

A fourth concern was raised when the staff would challenge a company’s valuation of IPR&D, and the CFO would say that he or she had relied on the independent auditor to come up with the numbers. This gives rise to a serious question as to whether the auditors were in fact independent with respect to the services provided to their clients. I must note, however, that four of the Big Five firms have indicated they are no longer providing IPR&D valuation services to their clients who are public companies. I commend them for this action. I also should note the staff has asked the Independence Standards Board to address this issue.

When the staff stepped back in 1998 and looked at the particular cases where we had dug the deepest into the support for the appraisal, we were struck most profoundly by the fact that many of the valuations of purchased R&D simply were not grounded in basic business sense. This is what has concerned us the most. In case after case, the staff has found that management’s considerations in negotiating the acquisition failed to support, and sometimes directly contradicted, its assertions in the financial statements that the R&D project was the most valuable acquired asset. Presentations made by the target companies and members of management to the Boards of Directors were inconsistent with assumptions used to value the IPR&D. In some acquisitions, management had made little effort to investigate the R&D project that it later valued so highly. Although it had allocated a large portion of the purchase price to purchased R&D, management acknowledged in some cases that the price it would have been willing to pay would not have varied significantly had the seller not initiated the R&D project at all. There appeared to be a complete disconnect between management’s business judgments and the appraisals it was tendering to the independent accountant in support of the accounting. It is that disconnect between the reality and the accounting, between common business sense and the elaborately prepared appraisals, that has caught the attention of the SEC staff.

I want to emphasize that we aren’t changing the accounting rules. We aren’t forcing any particular appraisal methodology on public companies. And we certainly aren’t specifying some predetermined percentage of the purchase price to be written off or "safe harbored." We’re trying to achieve compliance with GAAP.

We’ll leave the accounting rules to the Financial Accounting Standards Board, which may consider a change from the current requirement to expense purchased R&D. And we’ll leave the appraisal methodology and related matters to the AICPA Committee that was established recently to develop best practice guidance in this area. This guidance is currently expected by the end of the second quarter of 1999. It is also worth noting that the seven largest public accounting firms have asked the FASB to put a project on its agenda on accounting for IPR&D, and to provide timely guidance.

The thrust of the staff’s review efforts is more fundamental. We are requesting corrections to valuations of purchased R&D when the amounts assigned are disconnected from reality. We are challenging the incredible valuations that cast doubt on the general credibility of financial reporting by companies that develop, use or sell technologically sophisticated products or services. We are pressing for common sense and realistic valuations that comply with GAAP, taking into account the unique factors of each R&D project and enabling investors to distinguish one deal from another.

And we are continuing to press registrants for disclosures that explain the value and risks of the purchased R&D and enable investors to hold management accountable for that expenditure. Why is the company paying dozens of multiples of the cost incurred by the seller to date for a project whose technological feasibility remains in doubt? If the value assigned is strongly influenced by the purchaser’s ability to complete the project within a particular time-frame, what will the impact be if the project is delayed? How have periods subsequent to the acquisition been affected by completion of the project and introduction of the technology?

We hope that auditors, investors, and registrants, including high technology companies, will support our efforts to reign in abuses and bring greater transparency to these issues. Abusive accounting for purchased R&D could poison the well from which companies draw their financial sustenance. Complete disclosure and consistent accounting nurture investor confidence and risk tolerance. Capital markets properly cultivated and protected will continue to propel the good ideas of these companies into commercial reality. Through the continued team efforts of financial management, auditors and audit committees, high quality financial statements will continue to provide relevant and accurate information that investors need to make informed decisions.

Thank you.

¹The Valuation of Acquired R&D by Zhen Deng and Baruch Lev. April 1998.

http://www.sec.gov/news/speech/speecharchive/1999/spch251.htm