In-Process Research and Development

In-Process Research and Development:
Takeaways from the Updated
Accounting and Valuation Guide
Justin C. Pogge, CPA/ABV – [email protected]
Research and development (“R&D”) assets are unique in nature
a substantial write-off of purchase price in many transactions,
and are consequently subject to specific accounting and
thereby lowering the value of intangible assets ultimately
valuation guidance, particularly when acquired in a business
recorded and reducing future amortization expense (goodwill
combination. In December 2013, the American Institute of
was amortized at the time). Notably, this practice gained steam
Certified Public Accountants (“AICPA”) finalized the Accounting
after Lotus Development Corp. acquired Samna Corp. in 1990 for
and Valuation Guide, Assets Acquired to Be Used in Research
$65 million and subsequently wrote off over 80% of the purchase
and Development Activities (the “Guide”), concluding a nearly
price. Then, in 1995, International Business Machines Corp.
five-year effort to update the AICPA’s 2001 Practice Aid, Assets
wrote off 57% of its $3.2 billion acquisition of Lotus.2 By the late
Acquired in a Business Combination to Be Used in Research and
1990s, the increase in the number of IPR&D write-offs and their
Development Activities: A Focus on Software, Electronic Devices
percentage of overall purchase price in technology acquisitions
& Pharmaceutical Industries (the “Original Practice Aid”). This
led the Securities and Exchange Commission (“SEC”) to focus on
article discusses the impetus for the development of the Guide,
the valuation and accounting treatment of IPR&D. In response,
with a focus on the significant changes from or additions to the
the AICPA formed the taskforce that developed the Original
Original Practice Aid.
Practice Aid.
Background n n n
The Original Practice Aid was released in 2001, shortly after the
Accounting guidance for specific in-process R&D (“IPR&D”)
projects acquired in business combinations was first established
in Financial Accounting Standards Board (“FASB”) Interpretation
No. 4, Applicability of FASB Statement No. 2 to Business
Combinations Accounted for by the Purchase Method (“FIN 4”),
which stipulated that costs assigned to assets to be used in a
particular R&D project with no alternative future use were to be
expensed on the transaction date.1 Until the 1990s, amounts
issuance of FASB Statement of Financial Accounting Standards
(“SFAS”) No. 141, Business Combinations (“SFAS 141”), and No.
142, Goodwill and Other Intangible Assets (“SFAS 142”). Although
technically non-authoritative, the Original Practice Aid provided
much needed best practices for the valuation and accounting
of IPR&D assets and, perhaps more important, indirectly served
as a general guide for applying the provisions of SFAS 141. As
one of the first documents to formally address many valuation
allocated to IPR&D in business combinations and subsequently
expensed were typically not significant. However, an increase in
technology-based acquisitions during that decade gave rise to
As discussed in this article, FIN 4 was superseded by FASB Statement of Financial
Accounting Standards No. 141R, which was later codified in FASB Accounting Standards
Codification 805, Business Combinations.
2
Michael Schroeder, “High-Technology Firms are Upset over SEC Crackdown on
Write-Offs,” The Wall Street Journal, 1 February 1999.
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nDefensive R&D Assets: IPR&D assets are
topics, including methodologies and even the definition of Fair
Value, the Original Practice Aid became a widely used reference
sometimes acquired solely to prevent others from
owning and continuing to develop the assets.
Assuming the criteria for a separately identifiable
asset in FASB ASC 805 is met, the key distinction
with regard to recognition as an indefinite-lived
intangible asset lies in the stage of development for
the products or activities that are being defended.
If IPR&D is acquired to protect a company’s existing
R&D efforts, the Guide recommends that the Fair
Value of the IPR&D be recorded as an indefinite-lived
intangible asset until the defended R&D project is
completed or abandoned. However, if the IPR&D is
acquired to defend fully developed products, the asset
does not meet the “used in R&D activities” criteria.
for the valuation of intangible assets in general, not just for IPR&D.
Despite the development of the Guide, the Original Practice Aid
continues to remain relevant as it relates to procedures to be
followed by valuation specialists.
However, several developments since its release with regard
to U.S. generally accepted accounting practices (“GAAP”)
necessitated an update. Perhaps most significantly from a valuation
perspective, SFAS No. 157, later codified in FASB Accounting
Standards Codification (“ASC”) 820, Fair Value Measurement
(“FASB ASC 820”), established guidance that defined Fair Value
and detailed a framework for measuring and disclosing Fair Value,
topics for which an entire chapter of the Original Practice Aid
was devoted. Further, from an accounting perspective, SFAS No.
nIdled R&D Assets: Idled assets are similar to
141R, later codified as FASB ASC 805, Business Combinations
defensive assets in that they are not further developed
or used by the acquirer, but differ in that their
dormancy does not contribute to the value of the
acquirer’s other assets. In cases where acquired
IPR&D assets are indefinitely idled, the “used in R&D
activities” criteria are not considered to be met.
However, temporarily idled assets are not considered
abandoned and may meet the criteria for indefinitelived treatment.
(“FASB ASC 805”) and FASB ASC 350, Intangibles – Goodwill and
Other (“FASB ASC 350”), required the capitalization of intangible
assets acquired in a business combination to be used in R&D
activities, regardless of whether those assets have an alternative
future use. As a result, the practice of writing off large portions
of purchase prices in technology acquisitions was effectively
eliminated. Finally, certain considerations that were not addressed
in the Original Practice Aid have increasingly become areas of
focus in the valuation community, including topics such as the unit
nOutlicensed R&D Assets: Acquirers of IPR&D assets
of account, alternative forms of the income approach, and post-
that outlicense further development only meet the
“used in R&D activities” criteria if they intend to play
an active role in the development of the outlicensed
assets through a collaborative arrangement.
acquisition accounting for IPR&D, among others.
What is IPR&D? n n n
IPR&D assets that are 1) separately identifiable from goodwill
under the guidance of FASB ASC 805 and 2) to be used in R&D
activities are recognized and measured at Fair Value regardless
of whether those assets have an alternative future use, and are
assigned an indefinite useful life until completion or abandonment
of the associated R&D efforts.3 Conversely, acquired intangible
R&D assets that are the result of R&D activities are recorded at
Fair Value on the acquisition date, but are generally assigned a
finite useful life and amortized. The Guide outlines four categories
of intangible assets acquired in a business combination that
could meet the “used in R&D activities” criteria: R&D efforts to
be continued by the acquirer, defensive R&D assets, idled R&D
assets, and outlicensed R&D assets. Acquired IPR&D efforts that
will be continued by the acquirer most clearly meet the “used in
Unit of Account n n n
Once IPR&D assets have been identified, the unit of account that
will be utilized needs to be determined.4 At a high level, assets
that share similar characteristics can be aggregated into a single
unit of account because they are substantially the same. The
Guide suggests that the definition of “identifiable” in the FASB
ASC glossary should be considered when determining the unit of
account, but acknowledges strict adherence to its definition could
limit aggregation and result in a unit of account so specific that
the cost of recognizing and maintaining assets at that level would
exceed the benefits — a result that should be avoided.
R&D activities” criteria, and were discussed at length in the Original
Ultimately, the determination of unit of account is unique to the
Practice Aid. The other concepts are new to the Guide.
facts and circumstances of each acquisition and over simplification
In addition to guidance for the valuation and accounting for IPR&D acquired in a business combination, the Guide also addresses the accounting for IPR&D acquired in an asset
acquisition, which differs from the discussion herein. Given the relative frequency of asset acquisitions versus business combinations, this discussion relates only to IPR&D acquired in
business combinations.
4
The Guide clearly prescribes that tangible and intangible assets used in R&D activities should not be aggregated, nor should indefinite-lived and finite-lived intangible assets.
As such, the discussion in this article relates to the potential aggregation of indefinite-lived, intangible IPR&D assets.
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could result in decreased relevance for the users of financial
ultimate use of the asset. In this scenario, it may be concluded
statements. The Guide offers the following factors to consider
that the use of enabling technology is encompassed within existing
when determining unit of account:
products, IPR&D, and yet-to-be defined technology (i.e., goodwill).
nThe phase of development of the projects
Note that while enabling technology is similar to the concept of
nThe nature of the activities and costs necessary for
further development
core technology outlined in the Original Practice Aid, the Guide
clearly distinguishes between the two and clarifies that enabling
technology is a subset of items formerly viewed as part of core
nThe risk associated with further development
technology. It should therefore be recognized as an asset less
nThe amount and timing of benefits expected to be
frequently than core technology was previously recognized, and
derived in the future from developed assets
nThe expected economic life of the developed asset
(once developed)
the Guide suggests that core technology, as defined in the Original
Practice Aid, is too broad of a concept to meet the recognition
criteria of FASB ASC 805. Core technology also developed over
time as a concept in order to capitalize a portion of technology
nWhether there is intent to manage costs for the developed
that would have been expensed under superseded GAAP literature.
assets separately or on a combined basis in areas such
as strategy, manufacturing, advertising, selling, etc.
Given that all R&D assets are now capitalized in a transaction, the
core technology concept has been abandoned in the Guide.
nWhether the asset (either as an incomplete IPR&D project
or when complete) would be transferred by itself or with
other separately identifiable assets
Technology Migration
600
When analyzing each of these factors, the availability of sufficient
500
inputs for a valuation analysis must be considered. This most often
Revenue (in millions)
relates to the amount and timing of benefits expected to be derived
in the future. While many projects may be easily separated and
identifiable based on the other factors listed above, determining
a value for each project using the income approach becomes
exceedingly difficult if the cash flows from each project are
not considered separately by company management. As such,
400
300
Main Team Members
200
Roles
100
considerable judgment is necessary when determining cost/benefit
of the unit of account, and it should be established early in the
0
valuation process.
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2
3
4
Developed Technology
Enabling Technology and
Technology Migration n n n
5
6
Year
IPR&D
7
8
9
10
Future Technology (Goodwill)
Enabling technology, or shared technology, represents underlying
Enabling technology also must be considered separately from the
technology that has value through its continued use or reuse across
concept of technology migration, which is the process in which
many products or product families, and its potential as a separate
certain elements of technology are used or reused within a product
unit of account should be considered concurrently with the
or product family from one generation to the next (i.e., version two of
determination of the unit of account for IPR&D assets. Specifically,
a software program currently under development may incorporate
the useful life, risk, profitability, and outlicensing capability of
aspects of version one currently on the market). Values of different
enabling technology may differ from the projects that it actually
stages of technology within the technology migration lifecycle are
supports, and it therefore may meet the asset recognition criteria
encompassed in developed technology (current products), the
in FASB ASC 805. In this scenario, such as for a drug delivery
addition of new functionality to current products (IPR&D projects),
mechanism that is used in substantially the same form for drugs
and future technology (goodwill). While enabling technology may
currently on the market and drugs considered IPR&D, a separate
be considered in the same manner, the Guide distinguishes that
unit of account is established for the enabling technology, and it is
enabling technology may or may not be captured in the valuation of
recognized as an asset on the balance sheet (usually with a finite
the different stages presented in the chart above based on the unit
life). However, enabling technology does not always represent a
of account determination previously discussed, while technology
separate unit of account, such as when a drug delivery mechanism
migration will always be captured in the valuation of the different
must be further customized for use in IPR&D products, and the
stages of technology, and therefore would generally not result in
facts and circumstances should be analyzed to determine the
separate recognition of a “technology migration” asset.
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Valuation of IPR&D n n n
Conclusion n n n
FASB ASC 820 stipulates that each of the three standard
The valuation of IPR&D assets acquired in a business combination
approaches to valuation — the cost approach, market approach,
involves many unique theories and concepts, and a thorough
and income approach — should all be considered when
understanding of the business entity being acquired is necessary.
determining the Fair Value of an asset. As it relates to IPR&D,
This article highlights some of the new concepts introduced in
the income approach is the most commonly used methodology.
the Guide that have evolved since the issuance of the Original
Because the cost approach is premised on the determination of
Practice Aid, but the Guide is a comprehensive valuation tool
the amount that would be required to replace the service capacity
that cannot be fully summarized in a brief manner. Further, the
of an asset, its application to IPR&D assets is limited due to the
interrelationship between the Guide and current U.S. GAAP
common expectation that R&D activities will ultimately result in
as outlined in FASB ASC 805, FASB ASC 350, and FASB ASC
profit-generating products (i.e., there is often a disparity between
820 adds additional complexity. Although the Guide is in part a
historical cost expended and Fair Value based on expected future
non-authoritative interpretation of U.S. GAAP, adherence to the
profits). Further, the use of a market approach is usually limited by
methodologies it prescribes is expected by audit firms reviewing
a lack of observable market prices for similar assets.
purchase accounting analyses. Companies that have acquired
The Multiperiod Excess Earnings Method (“MPEEM”) is the income
approach methodology most commonly used when valuing IPR&D
assets, and it is discussed in detail in both the Original Practice
technology-based assets are well served by consulting with
valuation specialists on the details of the Guide in order to meet
their financial reporting requirements.
Aid and the Guide with specific examples given in each. The
Justin C. Pogge, CPA/ABV is a Senior Vice President in the Valuation
MPEEM involves the analysis of prospective financial information
& Financial Opinions Group at SRR. He has extensive experience
(“PFI”) to determine free cash flows and discounting those cash
providing a broad range of business valuation and financial advisory
flows to present value at a rate of return that is commensurate
services to public and private businesses, with an emphasis on
with the risk involved in realizing the cash flows. Since the release
intangible asset valuations for tax and financial reporting purposes,
of the Original Practice Aid, use of the MPEEM has become
and he is well versed in the accounting guidance related to business
widespread, and additional guidance for certain components
combinations. Mr. Pogge can be reached at +1.312.752.3350
of the MPEEM has been published — notably in The Appraisal
or [email protected].
Foundation’s document The Identification of Contributory Assets
and Calculation of Economic Rents.
The Guide, however, is less focused on the MPEEM in its
income approach guidance than the Original Practice Aid. While
acknowledging that the majority of IPR&D valuations will likely
This article is intended for general information purposes only and is not intended to provide,
and should not be used in lieu of, professional advice. The publisher assumes no liability
for readers’ use of the information herein and readers are encouraged to seek professional
assistance with regard to specific matters. Any conclusions or opinions are based on the
specific facts and circumstances of a particular matter and therefore may not apply in all
instances. All opinions expressed in these articles are those of the authors and do not
necessarily reflect the views of Stout Risius Ross, Inc. or Stout Risius Ross Advisors, LLC.
still use the MPEEM, the Guide introduces a variety of income
approach alternatives and stresses that the valuation specialist
should apply the income-based methods or techniques that
most accurately capture the benefit of owning the IPR&D assets,
considering the availability of required inputs. As a result, it is
imperative that valuation specialists are well versed in the following
methodologies and when each may be appropriate to use:
nMPEEM
nRelief from Royalty Method
nDecision Tree Analysis
n“Split” Methods
nMonte Carlo Analysis
nOption Based Methods
nManufacturing Cost Savings
nIncremental Revenue or Profit
n“With and Without” Analysis
nGreenfield Method
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