Sunday, April 19, 2009

Are accountants learning?

While I have many areas of disagreement with accounting, there are three accounting practices that I have taken particular issue with over time.

1. Not treating employee options as expenses when granted: There should really be no debate about this. Employee options are compensation, and like all other compensation expenses should be recorded at fair value, when granted. The fair value is the option value and not the exercise value.

2. Treating leases (or at least a significant portion of them) as operating expenses: Both FASB and IASB have used the ownership of the asset as the determinant of whether a lease should be treated as an operating or capital lease. As an earlier blog post noted, this allows retailers, restaurants and other big lessees to move most of their debt off the balance sheet.

3. Treating R&D expenses as operating, rather than capital expenses: Using the tenuous argument that the benefits of R&D are too uncertain, accountants have insisted on expensing R&D. In the process, =they misstate earnings at technology and pharmaceutical firms and keep the most valuable assets of these firms off the books.

As recently as three years ago, all three practices were still entrenched in accounting statements and standards. But the times are changing. A couple of years ago, accounting finally came around to the point of view that employee options should be valued and expensed when granted (FASB 123). Now, there is chatter that accounting rules will be changed to force all leases to be treated as debt.

I know that companies will be up in arms over this rule and that analysts will issue scary reports about how making this change will be devastating for compaies. I don't think so, and have written what I hope is a comprehensive paper on what treating leases right (which to me is to treat them as debt) will do to all the numbers that we use in corporate finance and valuation. Since I have been treating all lease commitments as debt, in both my corporate finance and valuation classes, it will not change how I look at companies but it will surely make it easier for me to do so:

All that is left now is for the accounting rule makers to take a look at R&D and exploration costs and the logical fixes to make their treatment consistent with capital expenditures at other firms. I have mixed feelings about this happening. On the one hand, it will be a vindication of much of what I have been arguing for, over the last decade. On the other hand, what will I have left to argue about with my accounting colleagues?


Uiucfinance said...

I have some fear of the R&D capitalization. Just as some financial institutions have been hesitant(a huge understatement) to book losses on nonperforming assets, do we really want to allow this practice to spread across more industries? To me it comes down to trusting the reporting companies, and if they are honest, then yes the above rule will make the reporting better represent economic reality, which should be the ultimate goal of the financial reporting. However this also allows the unethical institutions to abuse the new rules and report earnings further from economic reality. Keeping the rules on this as is may tarnish earnings for the firms, but it seems changing them creates too much conflict of interest. I think we should side with conservatism on this one.

Keep up the great posts! I visit your blog daily.

Aswath Damodaran said...

You are assuming that R&D capitalization will help companies report better profitability. I don't think so. For about 80% of tech companies, the return on equity and capital drop when you capitalize R&D. Forcing these firms to show these investments as assets sets them for the next question, which is how much they add to profits. For many companies, R&D is value destroying.

Walker said...

Professor,I would like to ask your opinion on another accounting effect I just learned from $2.5 billion dollar profit reported of Citi Group in last quarter, that most of the profit came from widening credit spread which reduce market value of debt(or increasing discount rate thus reduce book value of debt,I am not quite sure how accouting rules work here). Should we take caution in similar situations when doing valuation because the profit recorded does not really create value.

Scott said...

Hi Professor, I have two comments on this topic. First, I have to agree with the first post (Uiucfinance) that I like the conservative nature of expensing R&D. I think this approach removes some of the creative accounting that might take place under the capitalization approach (some hybrid of PP&E and Intangibles accounting rules used by management and accountants to manipulate results). It seems that the best outcome of capitalization is more realistic ROIC and ROE performance measures (calculated directly from IS and BS), since valuation is not affected by this approach (expense moved from gross cash flow to gross investment). Second, your comment on R&D as a value destroyer (for many companies) reminds me of Xerox with the GUI interface and the computer mouse. Most likely, the Xerox investment in these two technologies was a value destroyer from Xerox's perspective (invested in a technology but never received the profit rewards from it). But Apple and Microsoft built empires on this very same technology (appropriated the profits). Not to mention all of the accumulated improvements in efficiency/productivity for all companies and individuals using computers. Though I know you were mentioning R&D as value destroying from the perspective of the firm making the research investment, sometimes the contribution to society can still be value enhancing.

Sam NZ said...

Hi Aswath,
Within a DCF framework how material do you think the treatment of R&D is in forming a view on valuation? The key area I can see it impacting is the projections of profitability (i.e the EBITDA or EBIT margin growth rates). Ignoring the tax implications the cash flow statement provides the required insight when dealing with capitalistion. I completely agree with your views on leases and any any other contractual liabilities.
Loving your blog

dharma said...

Professor, in areas of R&D expense for pharma companies, firstly there is no certainity as to the success of a drug discovery process, let alone the next stage of legal hassles to get them approved by regulatory authorities even if a dicovery is indeed made. The same logic applies for exploration cos where the success of oil n gas being discovered is not certain. In the absence of any asset being created that can give the company enduring benefits over a long tenure, how is it prudent for R&D or exploration expenses to be capitalised? Your views on the same would be appreciated.

miszkam said...

Let's not forget that accounting rules allow companies to revalue assets using valuation techniques, after they are recognised. In this case capitalisation would be really usefull, because, with probability rates properly attached, investors would see from the books the way the company values CHANCES for success of it's products/projects from the way the values of intangibles change. Also, if the company is caught at not revaluing assets downwards (known as impairment) when it should really do so the brand image will suffer. Greetings from Russia!