NEED A FINANCIAL ANALYSIS THAT WILL STAND UP TO SCRUTINY? GET THE POWER OF DUFF & PHELPS.

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1 NEED A FINANCIAL ANALYSIS THAT WILL STAND UP TO SCRUTINY? GET THE POWER OF DUFF & PHELPS. From intellectual property valuation and management to transfer pricing and dispute consulting, Duff & Phelps provides trusted analysis and insight on critical issues. With more than 700 of the best minds working together across North America, Europe and Asia, the depth and breadth of our industry and technical expertise is unsurpassed. Get the strength of one of the world s leading independent financial advisory firms. > Financial Reporting Valuation > Tax Valuation & Consulting > Real Estate & Fixed Asset Services > Investment Banking > Transaction Advisory Services > Dispute Consulting & Forensic Advisory Services duffandphelps.com Investment banking services are provided by Duff & Phelps Securities, LLC, an NASD registered broker-dealer.

2 Hans le Grand, Henk Oosterhout and Gary Roland Duff & Phelps Valuation Research and development: accounting and valuation Accounting for the fair value of acquired in-process research and development (IPR&D) has had a volatile past. Current accounting projects, as well as ongoing debates regarding fair value accounting, continue to contribute to uncertainty on this critical issue. However, the valuation of IPR&D is and will continue to be a common thread for all accounting treatment. In 1998 IPR&D charges resulting from purchase price allocations exceeded $20 billion, resulting in two Wall Street Journal articles addressing this phenomenon. The Securities and Exchange Commission s heightened scrutiny resulted in a sharp decline to $5.9 billion in As part of its increased focus on IPR&D, the Securities and Exchange Commission requested that the American Institute of Certified Public Accountants prepare a practice aid, which was published in 2001 and set out guidelines for the valuation of IPR&D. This chapter discusses the present situation and recent developments in the accounting and valuation of IPR&D. (Note that references to IPR&D are specific to accounting for this activity, as opposed to R&D activities which refers to research activities in general.) Background R&D activities are directed to the development of knowledge. They may lead to new products, improved production or logistic processes and cost reductions, all of which add value to a company. R&D value is also recognised by the stock market. High market-to-book multiples, especially in R&D-intensive industries, as well as positive stock market reactions to announcements of increased R&D investments, suggest that the stock market places significant value on R&D. Furthermore, the value of R&D is more often part of day-to-day management. Increasingly, especially for R&D-intensive companies, management needs a proper assessment of individual R&D projects as well as an analysis of the possible acquisition of other R&D-intensive companies. The trends in increased R&D value, along with the need to manage and measure this value, are reflected in accounting regulations, as there is an emphasis on recognising the value of R&D in accounting policy. Although this recognition is beyond doubt, the issue of how to account for it remains the subject of debate. This is evidenced by the convergence between various accounting standards: the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board have committed to the convergence of US and international accounting standards. There are two main issues with respect to R&D in current accounting regulations US Generally Accepted Accounting Principles (GAAP) and the International Financial Reporting Standards (IFRS). The first issue is whether to expense or capitalise R&D expenditures, and the second is how to reach consistency between in-house R&D projects and IPR&D that is obtained through an acquisition. Expense or capitalise? Under the various accounting regulations, costs can be treated by either expensing or capitalising. To transfer from the former to the latter, the following steps occur: Costs are separated from operating expenses and shown as capital expenditures (similar to the treatment of fixed assets); After-tax development capital expenses are aggregated over time to create assets (known as technology in the case of R&D costs); and Like most tangible fixed assets, technology will lose value over its lifetime and hence will have to be amortised or regularly tested for impairment. The decision of whether to expense or capitalise is generally prescribed by regulations. US GAAP The main standards related to R&D activities are as follows: FASB Statement of Financial Accounting Standards No 2 Accounting for Research and Development Costs, which defines R&D and sets out broad guidelines on the activities that constitute R&D activities; and FASB Interpretation No 4 Applicability of FASB Building and enforcing intellectual property value

3 Valuation Duff & Phelps Statement No 2 to Business Combinations Accounted for by the Purchase Method, which states the IPR&D is reported as an asset if an alternative future use exists for that asset or immediately charged to income. In practice, this means that under US GAAP R&D costs, independent of the state of completion or the likelihood of commercialisation, should be expensed. By contrast, acquired R&D is either expensed as IPR&D or capitalised if it has alternative future uses. IFRS Compared to US GAAP, the IFRS are considerably different in making a distinction between research costs and development costs for the purposes of in-house developed R&D. According to International Accounting Standard (IAS) 38.7: research is original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding; and development is the application of research findings or other knowledge to a plan or design for the production of new or substantially improved materials, devices, products, processes, systems or services before the commencement of commercial production or use. The differences between the treatment of research costs and development costs are also stated in IAS 38 Intangible Assets. IAS states that no intangible asset arising from research should be recognised. In this sense, the treatment of research under the IFRS is similar to that under the US GAAP. However, according to IAS and 38.51, development should be recognised as an intangible asset under the following conditions: the intent and probability of completion and commercialisation; the likelihood of future generation of benefits; and the ability to measure accurately the expenditures attributable to them. Internally generated brands, mastheads, publishing titles and customer lists should not be recognised as intangible assets. In-house R&D versus acquired R&D The difference in accounting treatment of the expense in the development of an asset is paralleled by the accounting treatment after an acquisition of a target with IPR&D. US GAAP and the IFRS are similar in that they require an estimation for the fair value of the IPR&D in the context of a purchase price allocation. The total purchase price is allocated based on the fair value of the respective assets acquired. The present value of the cash flows attributed to IPR&D provides a basis for the fair value of the IPR&D. The subsequent treatment of this fair value is different under US GAAP and the IFRS. Under US GAAP, the fair value attributed to IPR&D is expensed immediately, whereas under the IFRS the fair value remains on the balance sheet as an IPR&D intangible. Subsequently, the IPR&D intangible is tested for impairment on an annual basis until the project is completed and commercialised. At that time, the company reclasses the asset into an amortisable asset and begins its periodic amortisation. Impairment testing is then performed upon trigger events rather than on an annual basis. Should the IPR&D intangible fail in its development efforts, the carrying value of the asset is then expensed. It is important to realise that under US GAAP the treatment of acquired IPR&D is consistent with the treatment of in-house developed R&D: IPR&D never appears on the balance sheet. On the other hand, the IFRS is fully consistent only with respect to development, as it always appears on the balance sheet either as the historical cost to the company to realise the asset or at its fair value when acquired. With respect to research, the IFRS is less consistent; if developed in-house, the research costs are expensed, while research obtained as a result of the acquisition of an R&D project remains on the balance sheet unless there is no development component to it. In addition to the fact that both accounting systems are consistent with regard to in-house and acquired development costs, there is one other important parallel: they both recognise the importance of proper valuation of IPR&D in the context of acquisitions. In fact, they do not diverge in their prescription on how to carry out this valuation. IPR&D valuation in an accounting context It is clear that R&D projects can significantly add to the value of a company. This is covered extensively in academic literature (see, for example, A Cazavan-Jeny and T Jeanjean, Value Relevance of R&D Reporting: A Signalling Interpretation, working paper by ESSEC; B Lev and T Sougiannis, Journal of Accounting and Economics 21, 107 to 138, and LKC Chan, J Lakonishok and T Sougiannis, Journal of Finance 56, 2431 to 2456). The valuation of R&D is important and necessary in various circumstances. In R&Dintensive companies R&D is a significant contributor to a company s competitive edge. Just as investments in fixed assets are crucial for asset-intensive companies, managing R&D is critical for R&D-intensive companies. Therefore, when accounting for the value of R&D projects a high level 60 Building and enforcing intellectual property value 2007

4 Duff & Phelps Valuation of accuracy and consistency is needed. Similarly, if the target of an acquisition has significant technological knowhow, valuing the IPR&D in place is crucial. Therefore, the question arises as to the proper approach to valuing IPR&D for financial reporting purposes. The practice aid issued by the American Institute of Certified Public Accountants details the preferred approach: the multi-period excess earnings method. Real options methodologies are mentioned as a supplemental approach. Furthermore, alternative generally accepted valuation techniques (eg, the cost and market approaches) are discussed (see Choose wisely: how IP value depends on R&D strategy for the merits of these alternative approaches). Multi-period excess earnings method This is the most common approach used in the valuation of IPR&D for accounting purposes. As acquired IPR&D is currently expensed under US GAAP, this approach places a significant emphasis on identifying the incremental benefits of IPR&D so as to exclude from its value all other amortisable assets. This is a critical aspect of financial reporting, which results in some striking differences from the typical net present value analyses and funding prioritisation of the project. Issues that must be considered when valuing IPR&D in the context of accounting include the following: Not all research projects are categorised as IPR&D. Specific characteristics and attributes must be present in order to qualify as IPR&D under the accounting rules. Projections must be evaluated from the perspective of market participants that is, the company s intended use of the project s outcome may not reflect general expectations, in which case the projections may need to be revised. Furthermore, specific company synergies must be excluded in the analysis. All non-ipr&d activities must be removed from the projections (eg, maintenance, consulting, service and other ancillary revenues and costs). Projections are to be adjusted to remove the cash flows attributable to other amortisable intangible assets that are used in R&D activities (eg, patents, software copyrights, developed product technology). These cash flows are extracted from the projections through an allocation of income or, for non-income generating assets (eg, fixed assets), a contributory asset or rental charge is applied. Both traditional net present value analyses and accounting IPR&D valuations also make adjustments to the cash flows to reflect the investment in or usage of working capital and fixed assets. Developed product technology relates to the functionality of prior versions or releases of the product (technology migration) that is incorporated in an IPR&D project. IPR&D projections are to be limited solely to the incremental functionality resulting from the research. Base technology reflects the existence of underlying technology that has value through its continued use or re-use in many products or many generations of a single product. The incremental benefit resulting from the IPR&D project must be isolated. Having isolated the direct economic benefit from other amortisable assets, the analysis turns to the determination of the appropriate discount rate. It is common to segregate the technological risk from the commercial risk. This approach considers each project s unique stage of completion and staged probability of success. Consideration should be given to the following factors in assessing the risk and appropriate discount rate to apply to a project: the industry segment and rate of technological or competitive change; the nature of the product, service or process to be developed; the length of time needed to complete the project; the company s history in bringing products to commercial success; and the competitive position of the IPR&D project (eg, whether the product will be the first to market or a follow-on product). A further distortion between the fair value of IPR&D in the accounting context and typical net present value analyses is the requirement to include the related income tax benefits resulting from the amortisation of the asset acquired for income tax purposes, whether real or hypothetical. In summary, the use of the multi-period excess earnings method in accounting may result in significantly different values from those expected under a traditional net present value analysis. If the trend towards fair value accounting continues on its current course, companies (and their IP personnel in particular) may be faced with increased involvement in the preparation of IPR&D values and the challenges of applying complex accounting guidance in the valuation. Convergence on the horizon The globalisation of companies has created the need for more consistent accounting treatment of IPR&D in business combinations. Recognising this need, the FASB Building and enforcing intellectual property value

5 Valuation Duff & Phelps and the International Accounting Standards Board have committed to the convergence of US and international accounting standards. Proposed changes to the FASB Statement of Financial Accounting Standards No 141 include the capitalisation of IPR&D after an acquisition rather than expensing it, thus (at least in part) aligning the accounting treatment with its counterpart IFRS 3. The proposed standard would require reporting entities to capitalise and test acquired IPR&D for impairment as an indefinite lived asset. If the project fails, the reporting entity would expense the carrying amount of the IPR&D; if development is successful, it would be capitalised and amortised over its remaining useful life. Convergence in accounting will certainly help to enhance market efficiencies and the allocation of capital in the global capital markets. However, such changes to the regulation would result in an inconsistency in US GAAP, expensing current R&D costs versus capitalising acquired IPR&D, which could lead to further discussion on the expensing requirement of current R&D costs. The need for convergence stimulates debate on the question of how to account for IPR&D, a debate which extends into academia. Academic literature supports the argument that accounting for R&D needs special care; no capitalisation generally leads to an undervaluation of the company, while if R&D is overcapitalised, it may lead to overvaluation (see B Lev, B Sarath and T Sougiannis, R&D Reporting Biases and Their Consequences, Contemporary Accounting Research, Winter 2005, 977 to1026). Hence, although capital markets do value R&D projects, they can be put off due to accounting policies. Conclusion As the economy continues to be increasingly R&D intensive, IPR&D performance and management have become a critical component of company reporting. Consequently, the manner in which IPR&D should be reported is heavily debated. A key issue in IPR&D reporting is the choice between expensing and capitalising. US GAAP favours the former, while the IFRS prescribe the latter, although with respect to development costs only. Another issue is the consistency between the treatment of acquired R&D versus in-house developed R&D. In this respect, although US GAAP are at present more consistent than the IFRS, due to pressure for convergence with the IFRS in order to increase transparency this consistency may be endangered as long as the capitalisation of in-house R&D does not appear on the US agenda as well. At present, fair value estimation of IPR&D is particularly important in the treatment of acquired IPR&D. US GAAP and the IFRS both prescribe a purchase price allocation process to estimate the value of various intangibles, of which IPR&D is often one of the most prominent. The current trend towards fair value reporting could have a profound impact on how these assets are reflected on the balance sheet in the future. Hans joined Duff & Phelps in January 2006 and is part of the financial reporting valuation practice. In addition to his work for clients, he aims to further the firm s leadership in the valuation field by means of research and publications. Hans is an expert on shareholder value management. He holds a PhD in physics and an MDiv, and has published material in the fields of physics, divinity and finance. Hans le Grand Director, Amsterdam Tel hans.legrand@duffandphelps.com Duff & Phelps BV The Netherlands Henk set up and heads the Dutch office of Duff & Phelps. He has a PhD in corporate finance and worked at the JL Kellogg Graduate School of Management at Northwestern University, Chicago and Tilburg University in the Netherlands from 1990 to 1996 before joining the valuation industry. Henk has been involved in valuation engagements covering a wide variety of industries, with a particular focus on purchase price allocations and impairment testing. Henk Oosterhout Managing Director, Amsterdam Tel henk.oosterhout@ duffandphelps.com Duff & Phelps BV The Netherlands Gary is a director in the financial reporting valuation practice of Duff & Phelps. He has 22 years of valuation experience, with a particular focus on purchase price allocations and impairment testing. Gary has an MBA in finance and is a chartered financial analyst and a certified public accountant. Gary Roland Director, Philadelphia Tel gary.roland@duffandphelps.com Duff & Phelps LLC United States 62 Building and enforcing intellectual property value 2007