How Merger Rules May Nick Earnings; More

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.

Mulford

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.

New Accounting Standard on Insurance Guarantees

The Financial Accounting Standards Board has issued a new accounting standard for insurance companies to clarify some existing accounting issues and expand the disclosures around financial guarantees.

Financial Accounting Standard No. 163, Accounting for Financial Guarantee Insurance Contracts, clarifies how FAS 60, Accounting and Reporting by Insurance Enterprises, applies to financial guarantee insurance contracts issued by insurance enterprises, including the recognition and measurement of premium revenue and claim liabilities. It also requires expanded disclosures about financial guarantee insurance contracts.

FASB Project Manager Mark Trench said in a statement that FAS 163 is intended to end inconsistencies that have made it difficult for investors and users of financial statements to compare insurance companies’ claim liabilities. The standard “is particularly timely in light of recent concerns about the financial health of financial guarantee insurers and will help bring about much-needed transparency and comparability to financial statements,” he said.

FAS 163 requires an insurance enterprise to recognize a claim liability before a default occurs if there’s ample evidence of credit deterioration in an insured financial obligation. It also requires disclosure about the risk-management activities used by an insurance enterprise to evaluate credit deterioration in its insured financial obligations and by the insurance enterprise’s surveillance or watch list. The accounting and disclosure requirements of FAS 163 are intended to elicit more consistent, comparable measurement and recognition of claim liabilities, FASB said.

The standard takes effect for fiscal years beginning after Dec. 15, 2008, while disclosure about enterprise risk management activities are required in the first interim period after the effective date.

SEC Regulations Committee on FAS 141R, FAS 160

The Center for Audit Quality’s SEC Regulations Committee has published the outcomes of recent discussions with SEC staff on how to comply with some narrow provisions of new rules on business combinations and non-controlling interests.

The Regulations Committee meets with the SEC staff periodically to discuss some fine points of complying with SEC rules, including accounting rules written by the Financial Accounting Standards Board. The committee published three discussion documents relating a number of narrow points around FAS 141R, Business Combinations, and FAS 160, Noncontrolling Interests in Consolidated Financial Statements, as well as pro forma management discussion and analysis and transition to new accounting standards for public versus private companies.

On FAS 141R and FAS 160, the committee checked its views with SEC staff on how to treat transaction costs and contingent consideration in a merger or acquisition in a way that complies with Regulation S-X, which governs the form and content of financial statements. The material is not official guidance from the CAQ or SEC but is typically provided as such nonetheless.

The documents also address pro forma financial statement requirements and presentation of research and development expenses in pro forma statements. They also cover how to apply new accounting standards with different provisions for public versus non-public companies in the context of an initial public offering and pro forma management discussion and analysis.

PCAOB Retools to Address Credit Crisis

Audit regulators are tuning into the ongoing credit crisis and changing their regulatory approach accordingly, Mark Olson, chairman of the Public Company Accounting Oversight Board, said recently.

In a speech to the annual meeting of the Association of Audit Committee Members, Olson said that whenever “financial reporting events” arise, such as what the market is currently witnessing, the PCAOB must decide how to make best use of resources to oversee auditors. “The PCAOB is monitoring developments and has made certain adjustments to its programs to assess auditing implications associated with the sub-prime crisis and the credit contraction,” he told the audit committee members.

Olson

Such adjustments include assigning staff to work in standard-setting, risk analysis and inspections, Olson said. “In addition, the Division of Enforcement has a few matters under investigation that touch upon sub-prime and, as is the norm, it is coordinating its efforts” with the Securities and Exchange Commission, he said.

PCAOB spokeswoman Colleen Brennan said after Olson’s speech that he would not elaborate further on the nature of the program or staffing adjustments being made to react to the collapse in credit-based securities, largely driven by worries about failing sub-prime and other residential mortgages.