High technology firms have found a new trick which lets them manipulate their reported earnings figures, a recent study alleges. And the number of companies using the technique is growing. The 22 year old dodge applies to the already complex area of acquisition accounting where the assets of a company being purchased are brought onto […]
High technology firms have found a new trick which lets them manipulate their reported earnings figures, a recent study alleges. And the number of companies using the technique is growing. The 22 year old dodge applies to the already complex area of acquisition accounting where the assets of a company being purchased are brought onto the balance sheet of the new parent company.
By Alex Sloley
Using the dodge, the acquirer can take an early reduction in profits which it blames on the acquisition, while the earnings of future periods can be left free of charges. In this way, companies can produce the kind of incremental earnings growth that the market likes to see. The study, produced in March this year by two accounting academics at New York University, Baruch Lev and Zhen Deng, names 3Com Corp, Novell Inc and Exar Corp as companies known to have used the technique, but the companies insist the practice is mandatory and hasn’t distorted their earnings. According to American accounting standards, a purchaser is required to assign a fair value to all of the assets acquired when a new subsidiary is bought. What high tech companies are allegedly doing is assigning extremely high values to what they call in-process research and development, implying that a large proportion of the value of the acquired company lies in the as yet unfinished development work it has underway. Having recognized the value of this intangible asset for a split second, the equivalent amount is immediately written off as a one time charge following the acquisition.
In this way, acquisitive companies can artificially reduce the amount of purchased goodwill generated in an acquisition (goodwill is the difference between the fair value of the assets acquired and the price paid). This purchased goodwill has to be amortized by writing it off against profits in subsequent periods. In essence there is nothing wrong with the accounting standard which promotes this practice. Companies can and should assign an estimated value to the different assets and liabilities they acquire. Unfortunately, the accounting standard involved does not give detailed guidance on how in-process research and development should be valued and as usual, companies are using the loop hole instead of observing the spirit of the rules. At present, the US authorities have no plans to address this problem directly but the Accounting Standards Board does plan to review the whole area of acquisition accounting in the near future.