The Accounting Onion

Failed Convergence of R&D Accounting: Only Politicians and Opportunists Would Have Downplayed the Implications

Unlike BP, which eventually came to admit the actual rate at which oil has been spurting into the Louisiana Gulf, the FASB and IASB continually resist any acknowledgement that the gulf between the two financial reporting regimes will remain vast, even under their best case convergence scenario. That's why the big financial reporting news of the week is the Boards' joint announcement that their latest best case scenario is once again being reluctantly revised downward: 

"The IASB and the FASB today announced their intention to prioritise the major convergence projects to permit a sharper focus on issues and projects that they believe will bring about significant improvement and convergence between IFRSs and US GAAP."

Yes, it is true that a strict reading of the announcement only reveals that the Boards are going to be taking a little more time to finish their grand endeavor. But if an additional six months is all they will require to realize the miracle of Convergence, then why prioritize? Why not just stretch out the existing timetable?

Quite surprisingly, an answer to my questions may be found in another recent document from an unexpected source: the FASB no less. Here is what the FASB stated in its recent financial instruments and hedging exposure draft:

"The FASB's main objective is to develop accounting standards that represent an improvement to U.S. financial reporting. What may be considered an improvement in jurisdictions with less developed financial reporting systems applying International Financial Reporting Standards (IFRS) may not be considered an improvement in the United States." (page 2) 

Is this the first crack in the "convergence is inevitable" façade? Maybe so, but to those of us who have been skeptical about convergence from the outset, the faults in the real convergence foundation made themselves apparent years earlier.

For example, in my previous post I mentioned in passing that convergence of R&D accounting had been attempted in earnest and then dropped like a hot potato. In the remainder of this post, I'm going to delve into that topic more deeply because the abandonment of the R&D convergence project would have been perceived to be a convergence death knell by all but the politicians and opportunists. Moreover, a headlong rush to closure on convergence will undo all the good that was accomplished by the FASB when it steadfastly resisted changes to its R&D standard.

Why SFAS No. 2 Is Right for the US

The differences between SFAS No. 2, Accounting for Research and Development Costs, (ASC 730-10) and the provisions of IAS 38 that deal with R&D arguably constitute the clearest case for why bright line rules may be essential in a particular accounting jurisdiction, even though fuzzy rules are tolerated in another. I'll deal with the fuzzy rules of IAS 38 in a moment, but I'll start with an explanation for why the FASB, in 1974, made a rigid and simple rule the foundation for its first substantive accounting standard.

To set the stage, around the time that SFAS 2 was promulgated there were (very generally) four kinds of R&D-intensive companies: (1 and 2) IBM and AT&T, by dominating computer hardware and telecommunications respectively, were in classes by themselves; (3) there were a few large pharmaceutical companies whose patented drugs made them hugely profitable; and (4) there were numerous smaller technology-driven companies scratching and clawing for capital and market acceptance. For the purpose of evaluating R&D accounting rules, the critical factor was this: the conventional wisdom held that only those smaller companies capable of reporting positive net income in an IPO prospectus would have any chance for a successful stock offering.

In regards to accounting standards, prior to SFAS 2, accounting for R&D was "principles-based." This meant that R&D costs were supposed to be deferred (and matched with future revenue from a project) if the expenditure created a probable future benefit. The costs of unsuccessful projects would have been immediately charged to expense.

That was the way it was supposed to work, but practice turned out to be the polar opposite of theory; virtually everyone did it wrong. Smaller companies seeking a successful IPO would capitalize all R&D expenditures, because that was the only way to report positive net income. For those other R&D intensive companies—like IBM, AT&T and big pharma—being too profitable was generally not in their best interests, in part because 'obscene' profitability would attract the attention of regulators. Thus, the big boys expensed all of their R&D, even though, because of their market power and concentration of intellectual capital, they had many successful projects.

So, the perverse situation that the FASB chose to confront was one where the R&D projects with the highest likelihood of success were being expensed, while the literally go-for-broke ventures would defer their R&D expenditures until their auditors could no longer keep themselves from snorting out loud.

The FASB tried as hard as they could to develop a set of subjective criteria that would permit deferral of some R&D costs, but it ultimately concluded that no set of qualitative or quantitative criteria would result in comparability across companies. Thus was born the rule that all R&D expenditures must go straight to the income statement.

IASC Serves Up R&D Chicken Salad

Four years later, the IASC (predecessor to the IASB) issued IAS 9 (the pertinent portions of which became IAS 38), to provide that research costs should be distinguished from development costs; and that development costs should be capitalized after the issuer met the following criteria:

• Technical feasibility;
• Intention and ability to complete an intangible asset for use or sale;
• Ultimate ability to use or sell the intangible asset;
• Ability to specify how the intangible asset will generate future economic benefits;
• The ability to reliably measure the development costs.

Thus was resurrected the fictions that: (1) management could reliably determine which costs should be deferred, and (2) that deferred development costs provide useful indicators of value. The motive, of course, was to give issuers greater flexibility to manage their earnings.

Don't Tell Anyone, but R&D Convergence Was a Complete Failure

Soon after the Boards inked their agreement to pursue convergence in 2002, they divided the work into two piles: high-priority projects for which they believed convergence could be achieved in relatively short order; and everything else. R&D was put in the first pile, apparently because the differences between US GAAP and IFRS were seen as particularly straightforward and tractable. 

Right. After about four years of back-and-forth wrangling from polar opposite points of view, the following statement was buried deep in the bowels of the FASB's website (it's long gone of course, and for all I know the only version that exists is the one I salted away for a moment such as this):

"…The Boards noted that elimination of the differences between IFRSs and US GAAP could involve consideration of fundamental issues and that those issues were part of a longer-term research project on intangibles being led by the Australian Accounting Standards Board. Nonetheless, the Boards agreed that they should explore possibilities to eliminate some IFRSs/US GAAP differences in the short-term. They instructed the staff (a) to consider the criteria for capitalisation of costs under SFAS 86 … to see if they could be used to make the criteria for internally-generated intangible assets in IAS 38 more operational and (b) to consider whether there are any aspects of US GAAP that could be moved closer to IAS 38, e.g. the requirements related to initial recognition of intangible assets acquired in transactions other than a business combination."

In other words, the FASB ran up against a brick wall erected by chicken salad chefs from Australia and who knows where else. While the R&D accounting project may have been formally suspended, it was effectively sentenced to die from inattention—and to be buried in an unmarked grave.

Depending on one's point of view, one may regard SFAS 2 as either a rules-based standard or a principles-based standard (the principal being that deferred costs per se should not be put on the balance sheet as assets). But however one views the quality of SFAS 2, the FASB clearly saw, to its significant credit, that the IASB's hazy, lazy criteria for capitalization would be a step backwards from what the FASB struggled to achieve in its earliest days; and the FASB would only accept a converged solution that constituted an improvement.

It could have even been the case that the FASB actually accepted at face value the propaganda from the opportunists that convergence was supposed to enhance comparability, and so they resisted change when comparability would, in their judgment, not be enhanced. I readily grant that I may be asking for too much, but the IASB's obstinate adherence to an R&D treatment that defeats comparability should have raised huge red flags for the FASB. If R&D accounting, which was seen as both important and low hanging fruit, could not be converged, then there might be little reason to expect that US investors would be best served by efforts to converge US GAAP and IFRS.

But now that we are supposedly on the cusp of convergence, whither R&D accounting? This crazy race to deliver something, anything, to the SEC by 2011 would completely undo the FASB's principled stance in opposition to the IASB's approach to accounting for R&D. What was formerly a high priority topic has been studiously ignored for years; for acting in any other way is to openly recognize what a charade the convergence dance has become, especially as we must endure in its final throes.

I wish I could be as sanguine as Shankar Venkataraman of Georgia Tech, who made this comment after the FASB acknowledged in their financial instruments ED that what is good for the goose may not always be good for the gander:

"This should be music to your ears, Tom. Of course, you recognize that the FASB cannot be as blunt as you are. Nonetheless, this seems to be a HUGE departure from the idea in the not-so-distant past that convergence was inevitable, no?"

Perhaps that lone acknowledgement may have signaled some shift in outlook, but there is still a long way to go before I'll concede that the FASB and I might be finally singing the same tune on convergence. I will say, however, that I never felt I was merely a member of a vocal minority (so sayeth the convergence opportunists). To the contrary, I firmly believe that the vast majority of stakeholders in the U.S. capital markets feel as I do; I'm just a lot noisier than most.

EITF 07-1: Can a Good Accounting Rule Drive Out a Bad One?

It seems that business practice tends toward greater exploitation of opportunities for collaboration over time.  On a personal note, it has been said that people don't choose to become professors because they are smart, but because they couldn't play nicely (i.e., collaborate) with other children. 

My own neuroses aside, the first standard on the accounting for collaborative arrangements, APB 18, was the subject of one of my earlier rants--I mean posts.  EITF 07-1, Accounting for Collaborative Arrangements Related to the Development and Commercialization of Intellectual Property, is a recent and interesting sequel to APB 18. 

Setting the Stage for Evaluating EITF 07-1 

At the risk of appearing to re-invent the wheel, I'll start with a broad look at collaboration itself. It seems that there are two kinds:  (1) financial arrangements to provide capital (i.e., wealth or risk transfer), and (2) operational arrangements to use capital effectively (i.e., wealth creation).  There is no dearth of detailed accounting rules governing financial collaborations, with the multi-tentacled 'Liabilities and Equity' project being just the latest example.  However, operational collaborations have not received near the same attention, despite their prominence and importance to investors.

As EITF 07-1 is about operational collaboration (my term, not theirs), let's go deeper into that concept; it seems that there are two ways to operate a business: with and without collaboration.  Here's a list, including annotations of related accounting rules, to illustrate what I mean:

• Operating modes not involving collaboration
  • Develop a product, purchase equipment and inventory, pay salaries and overhead, sell finished goods. (All of the rules you were introduced to in Accounting 101)
  • Acquire a controlling interest in another company that will take over, or complement, one or more business functions. (FAS 94, FAS 141, FAS 142, FIN 46(R))
• Operating collaboratively
  • Acquire a stake in another company that is less than controlling, but large enough to be able to influence its operations in ways that can benefit your own. (APB 18)
  • Acquire a stake in a joint venture (JV) that will do part of the work.  No investor in the JV can act without the permission of the other venturers. (The AICPA has impaled JVs with APB 18.)
  • Retain an agent, compensated with commissions, to help you sell or buy inventory. (EITF 99-19 provides guidance to determine whether you should accounting for a transaction as an agent or as a principal.)
  • Contract with another company to divide up the work. (EITF 07-1)

EITF 07-1,considers four related issues:

1. What constitutes a collaborative arrangement for the purpose of the new rule about to be created?  This is a fence-building exercise for the purpose of preventing encroachment on the scope of other standards and practices--mainly APB 18.  It would not be necessary to do so if the FASB were to take instead a way overdue fresh look at collaborative arrangements.  But, for the purpose of this post, the following example of a collaborative arrangement will suffice:
   
   Company A, having secured patents for a new product, collaborates with Company B, which has a manufacturing facility and an established distribution channel.  The companies have entered into an agreement whereby A will perform the development activities and B will perform the commercialization activities.  All revenues and costs would be split equally.
2. Reporting costs incurred and revenues generated by the collaborators from transactions with third parties.  This is the issue (hereinafter, Issue 2) that I will focus on.


3. Reporting revenues and expenses generated by a collaborator from transactions with other collaborators.  This is an important issue, but not as important as Issue 2 in terms of examining how EITF 07-1 affects the tenor of the accounting for collaborative arrangements.


4. Disclosure. 

The EITF's tentative consensus on Issue 2 is that, unless one party is acting as an agent for the other (see EITF 99-19), each party records its share of expenses and revenues separately on their income statement. 

Get to the Point!

The tentative consensus on Issue 2 makes sense.  That means they contradict the nonsensical presentation provisions of APB 18.  Under APB 18, each collaborating party would report its share of revenues and expenses net, and not gross as would be required by EITF 07-1.  In other words, the legal form of the collaboration (whether or not the collaboration is housed in its own legal entity), and not its commercial substance, will dictate presentation.  This is especially curious since the stated reason for the EITF taking up the issue was to achieve greater uniformity. 

Finally, take note that EITF 07-1 has not yet been ratified by the FASB.  I wonder if they have considered the implications of the issue on APB 18 as I have.  If so, do they care?

EITF 07-03: Which Part of 'Nonrefundable' Doesn't EITF Understand?

EITF Consensus 07-03, Accounting for Nonrefundable Advance Payments for Goods or Services to Be Used in Future Research and Development Activities, is very straightforward and basic; so much so that it might require less than one class period of Accounting 101 to discuss thoroughly. 

Here is a typical fact pattern: Entity A outsources R&D activities to Entity B, who requires a nonrefundable advance payment.  Should Entity A capitalize or expense the advance payment?  Proponents of the asset/liability view (i.e., expense measurement based only on changes in assets and liabilities) would support immediate expensing; proponents of the competing revenue/expense view (i.e., 'matching') would capitalize the expenditure and subsequently transfer it to expense as services are performed. 

The SEC and FASB have stated they are committed to the asset/liability approach to accounting standard setting, at minimum implying strong resistance to creation of new categories of deferred costs. The policy was officially established in 2003, as the SEC fulfilled its responsibilities under the Sarbanes-Oxley Act to report on the possibility of implementing principles-based accounting in the U.S. In its report, the SEC took the position that the revenue/expense view would be inappropriate in an objectives-oriented regime, and further stated that the FASB should maintain the asset/liability view in continuing its move to an objectives-oriented setting regime.  The FASB published a response, which agreed with the SEC study on this point. 

In a nutshell, matching had been dead for over a decade, and the SEC's SOX report should have been the last nail in the coffin.  Or so it seemed, as the EITF reached a consensus that nonrefundable advance payments for future R&D activities should be initially capitalized and subsequently transferred to expense as the goods are delivered, or services performed.  As justification, the EITF claims, without citing a source, that customers who agree to nonrefundable advance payments nonetheless have a legal right to receive a refund in the event of nonperformance.  Huh?  Are they saying that 'nonrefundable' means 'refundable'!  You say refundable, I say nonrefundable; let's call the whole thing off. 

One can only guess what forces were at play on the EITF (my money is on drug companies) as Issue 07-03 was deliberated.  As if it weren't obvious enough that the fix was in, a telltale sign is provided by the statement that the Consensus may not be applied by analogy to facts and circumstances outside of its narrow scope. 

PS - For those of you numerologist/accountants out there, you may be interested to note that my birthday is July 3rd.  Some dark force surely decreed that I should write about EITF 07-03.