Good investment choices are the result of careful examination of all available information relating to the investment under consideration. For many investors, the primary source of information about their common stock investments comes from the company's audited financial statements. Having a thorough understanding of the way information is presented in the financial statements may impact an investor's decisions.
In-process research and development expenses are a very specific component of the income statement, but having an understanding of these items and the accounting that surrounds them can help investors uncover investment opportunities (or a lack thereof) in a newly acquired company. (See also: Find Investment Quality in the Income Statement.)
Getting to Know the Basics
When one company acquires another, the purchase price is often an amount that is greater than the book value of the acquired company. In accounting terminology, the premium paid over book value is called goodwill, which is treated as an asset on the balance sheet of the acquiring company. Recall that an asset is a resource of economic value that a corporation owns or controls with the expectation that it will provide future benefit. Goodwill resulting from an acquisition is expected to provide a future economic benefit to the acquiring company. (See also: Reading the Balance Sheet and Can You Count on Goodwill?)
When an acquisition is completed, the acquiring company must identify and allocate goodwill to the acquired assets. If an acquired company is conducting research and development on a new product, but that product is not yet being sold, Generally Accepted Accounting Principles (GAAP) require that any premium in the purchase price over book value attributed to that product be expensed. This scenario is referred to as in-process research and development.
For example, suppose that International Blowfish acquires Fugu Inc. for $1.5 million. Fugu is developing a product that is slated to become its major asset. Blowfish determines that $900,000 of the purchase price should be allocated to the product. This amount is considered in-process research and development because the product is not yet ready for sale as of the closing date of the acquisition. The product may be only weeks away from being introduced to the market, but GAAP requires Blowfish to expense the $900,000 rather than record it as goodwill. (See also: The Basics of Mergers And Acquisitions.)
Paying top dollar for another company only to turn around and expense a large portion of the acquisition price may cause investors to wonder whether it was worth making the acquisition. In the above example, it really doesn't seem to be logical, especially because the product was almost ready to be introduced to the market.
However, although the requirement to expense in-process research and development costs appears unreasonable, it is actually consistent with the treatment of similar costs incurred by a company seeking to internally develop new products. GAAP requires that all research and development costs be expensed. One may argue that this violates the matching principle of accounting, which requires that costs be recognized in the same period as the revenues they create, but research and development costs are expensed because the future economic benefit generated by the resulting product can be highly uncertain.
Implications for Investors
Investors who know and understand the rules relating to in-process research and development expenses have the opportunity to make more informed investment choices. If an investor believes that current earnings have been temporarily impaired as a result of the application of the accounting requirements, and that there will be significant future economic benefit as a result of the research and development secured in an acquisition, then they may be able to profit from the information if other investors have overlooked this possibility in their valuations of the company. Conversely, if an investor believes that the current valuation of a company reflects the expectation of future economic benefits that may result from an acquisition, but understands that the acquisition resulted in an in-process research and development expense, then they may conclude that a future benefit is highly uncertain as reflected in the accounting treatment of the transaction. This may lead the investor to determine that the stock is overvalued.
Additionally, it may be useful for investors to consider the judgment applied by management in the application of the rules regarding allocation of goodwill. Because the application of this accounting principle can be somewhat subjective, investors should be aware that management may have the opportunity to use this principle to manipulate earnings. If management overallocates expense to in-process research and development, it can understate earnings in the current reporting period to the benefit of future earnings. (See also: Cooking the Books 101.)
Investors should determine whether the company has hired an outside consultant to examine the facts and allocate goodwill. Hiring an independent consultant or accountant could indicate that management is making an effort to get it right by receiving objective assessments.
In-process research and development is a complicated accounting concept that deserves a high level of scrutiny from investors and other users of financial statements. The accounting principle is not necessarily bad, it is simply the accounting profession's best attempt to provide accurate financial information about complex business transactions. Investors who have a thorough understanding of the principle and know its limitations have the opportunity to make more informed investment decisions.