Financial Accounting Standards Board Takes On Write-Offs, Options –

NORWALK, Conn. – Venture capitalists and their portfolio companies might lose several longstanding accounting benefits if the Financial Accounting Standards Board (FASB) passes a few proposals in the works.

The private organization, which makes accounting rules for American companies registered with the Securities and Exchange Commission (SEC) and those that issue audited financial statements, has four specific changes in mind.

The FASB wants to do away with pooling, a form of accounting used in mergers and acquisitions, and leave purchase acquisition as the only acceptable form of accounting for purchases. Under pooling, the two companies combine their balance sheets; under purchase acquisition, however, the buyer must account for the purchased company as an acquisition.

The FASB also wants an acquirer to amortize the research and development activities of a purchased company over time rather than have the in-process research and development (IPR&D) treated as a one-time charge against the acquirer’s earnings.

Meanwhile, the FASB is considering shortening the period over which a company amortizes goodwill – an intangible asset – gained at the time of a purchase. The timeframe would be cut to a maximum of 20 years from its current 40 years.

Finally, the FASB wants companies to treat stock options given to members of a company’s board not as those given to employees but as options given to an outside contractor (story page 40). Under such a rule, companies would have to begin treating as compensation the fair value of the options as they are awarded to directors. FASB also is looking into what accounting rules are triggered when employees’ stock options are re-priced.

Most of the proposed changes, except for those related to stock options, are part of a larger project: standardizing the accounting practices used when businesses combine operations.

Pooling Is Out of FASB Favor

The FASB plans to release a proposal to eliminate pooling in July, at which time the public will have several months to respond before a final decision is made, said FASB Project Manager Kim Petrone. If approved, the new standard likely would take effect in 2000.

The FASB wants to terminate pooling because the agency thinks true “poolings,” or mergers of equals, are rare. Pooling is often the preferred accounting method, but the FASB wants accounting practices to reflect the reality that mergers simply involve one company buying another, Ms. Petrone explained. Further, the United States should conform to the purchase acquisition standards used by most countries in the global economy, Ms. Petrone added.

Wendell Van Auken, a general partner at Mayfield Fund, said eliminating pooling would hamper small- and medium-size companies in joining forces against larger competitors, thereby discouraging roll-ups.

The National Venture Capital Association (NVCA) studied four venture firms – Institutional Venture Partners, New Enterprise Associates, Warburg, Pincus Ventures Inc. and Mayfield Fund – and found that about one-third of their M&A deals used pooling, said Mark Heesen, NVCA director of legislative, regulatory and entrepreneurial affairs.

“VCs are very exercised about it, that’s for sure,” he said of the pooling issue.

Cutting Goodwill Amortization Time

Currently, a company that buys another and uses purchase rules must account for the difference between the hard assets of the acquired company – the equipment and inventory, for example – and the higher price paid for the company. Some of the difference is accounted for as in-process research and development, but most of it is listed as goodwill, a category for intangibles. Currently, companies can take as many as 40 years to amortize the goodwill, avoiding a one-time hit to earnings. The FASB is proposing to cut the maximum amortization period to 20 years, Ms. Petrone said.

Of all the FASB considerations underway, the goodwill issue has the least direct impact on VCs and their portfolio companies.

The FASB had considered proposing 10 years as the maximum amortization period, but critics complained that earnings would be badly hurt by cutting the timeframe to just a decade.

Mr. Van Auken, who views this issue as of secondary importance, proposed a one-time goodwill hit against earnings rather than having a drawn-out process. Mr. Heesen said he would support the one-time goodwill charge.

The FASB is not likely to adopt that approach, preferring a system of amortization over time, Ms. Petrone said.

Unlike amortization, the IPR&D issue would directly affect VCs and their acquired portfolio companies. While an accounting change that puts buyers at a disadvantage likely will not prevent bigger companies from buying smaller ones, a reduced IPR&D write-off could lower the purchase price.

The SEC has stepped up its scrutiny of in-process research and development charges, which in recent years have been used to account for an increasingly large piece of the purchase price when a larger company buys a smaller, younger one with few hard assets, SEC Associate Chief Accountant Ken Marceron told VCJ earlier this year (VCJ, March, page 5).

Figuring IPR&D Fairly

The SEC has been studying IPR&D cases individually out of concern that some buyers may be inappropriately applying the tax write-off for research and development when acquiring a company. But for the FASB, the issue is whether IPR&D should be accounted for as a one-time expense or whether it should be added to the balance sheet as an asset and amortized over time, Ms. Petrone said.

She noted that under current rules a company’s internal research and development are not deducted as one-time charges, which raises the question why R&D from an acquired company should be handled as a one- time write-off.

The FASB has put the in-process research and development issue on a fast track to resolution. Indeed, Ms. Petrone said IPR&D write-offs could be eliminated by the end of the year. A draft outlining a new IPR&D rule could be released as early as June, she said, and the public then will have a few months to submit responses before the FASB develops a final standard.

The agency also is working toward implementing a standard regarding stock options to decide whether directors’ stock options should be treated as an outside contractors’ options. FASB will also decide how re-pricing of employees’ options affect the company’s accounting.

Defining Employees

In late March, the FASB ruled that a company’s board members do not count as employees where stock options are concerned; the FASB is taking public comment on the matter through June and plans to issue a final ruling in September, said Project Manager Bob Traficonti.

The FASB decision was based on an interpretation of the definition of an employee under a 1972 opinion. And, quite simply, directors are not employees under the common-law definition of the word, Mr. Traficonti said.

Mr. Van Auken, however, finds it ironic that the FASB would consider board members akin to outside contractors. “To me, a director is probably one of the most involved and intimate individuals in a company, more intimate than many employees.” He also sees the FASB move as a slide down the slope to treating all employee options like those of an outside contractor. Such a change would affect the earnings statements of companies that distribute options widely, as start-ups often do to attract top-quality employees and managers.

“This is not the camel’s nose under the tent; this is two humps under the tent,” Mr. Heesen warned.