March 1999 Issue


figures SEC Chair Arthur Levitt and Chief Accountant Lynn Turner are concerned that corporate earnings are being managed in part by classifying a significant portion of the price of an acquired entity as in-process research and development (IPR&D), which is immediately written off in a business combination and accounted for as a purchase.

Accounting Requirements. The allocation of the cost of a purchased business or group of assets can have a significant effect on the company's current and future results. The first step in the allocation process is a "rigorous analysis" of all purchased tangible and intangible assets (including rights to existing products, underlying technology, patents, copyrights, brand names, customer lists, marketing channels, engineering workforce, and IPR&D). The fair value of each asset must be estimated, and the total purchase price is allocated based on the relative fair values of the individual assets.

Costs allocated to purchased assets are usually capitalized. IPR&D is an exception. FASB Interpretation No. 4, Applicability of FASB Statement No. 2 to Business Combinations Accounted for by the Purchase Method , distinguishes between "assets resulting from research and development activities" and "assets to be used in research and
development activities." The amount of the purchase price allocated to "assets to be used in research and development activities" is to be expensed as IPR&D, unless such assets have an alternative future use.

SEC Concerns. The SEC is concerned that purchase price allocations have overstated the amount of IPR&D so that a significant portion of the purchase price could be expensed, rather than capitalized.

According to the SEC's chief accountant, "unreasonable valuations of IPR&D appear to be caused frequently by management's treatment of attributes of capitalized assets as if they were attributes of IPR&D. A common practice problem is the bifurcation of purchased rights to technology into two categories: the immediate value of any presently completed product, and the future value of the right to enhance or embellish that product. The latter right was deemed to be IPR&D because that right will be used in research and development." The SEC staff believes that the value of the right to enhance or embellish an existing product, or an existing technology that has alternative future uses, is not separable from the value of ownership of the intellectual rights to the technology. Therefore, if the technology meets the criteria for capitalization, the fair value includes the value of the right to enhance or embellish the technology.

The SEC also has questioned purchased price allocations based on appraisals that use an income approach involving forecasted cash flows between IPR&D and other assets, when such forecasts include overly optimistic assumptions (e.g., earnings growth, timing, and size of anticipated cost savings) in estimating future cash flows.

Disclosures. At a recent AICPA conference, the SEC staff advised public companies to include "substantial disclosures" regarding IPR&D in the financial statement footnotes as well as Management's Discussion and Analysis of Financial Condition and Results of Operations.

Additional information is available in an October 9, 1998, letter from the SEC Chief Accountant to the AICPA, reproduced on the AICPA website, *

Source: Deloitte & Touche Review, December 21, 1998

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