September 01, 2014

Research and development (“R&D”) assets are unique in nature and are consequently subject to specific accounting and valuation guidance, particularly when acquired in a business combination. In December 2013, the American Institute of Certified Public Accountants (“AICPA”) finalized the Accounting and Valuation Guide, Assets Acquired to Be Used in Research and Development Activities (the “Guide”), concluding a nearly five-year effort to update the AICPA’s 2001 Practice Aid, Assets Acquired in a Business Combination to Be Used in Research and Development Activities: A Focus on Software, Electronic Devices & Pharmaceutical Industries (the “Original Practice Aid”). This article discusses the impetus for the development of the Guide, with a focus on the significant changes from or additions to the Original Practice Aid.

Background

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 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 a substantial write-off of purchase price in many transactions, thereby lowering the value of intangible assets ultimately recorded and reducing future amortization expense (goodwill was amortized at the time). Notably, this practice gained steam after Lotus Development Corp. acquired Samna Corp. in 1990 for $65 million and subsequently wrote off over 80% of the purchase price. Then, in 1995, International Business Machines Corp. wrote off 57% of its $3.2 billion acquisition of Lotus.2 By the late 1990s, the increase in the number of IPR&D write-offs and their percentage of overall purchase price in technology acquisitions led the Securities and Exchange Commission (“SEC”) to focus on the valuation and accounting treatment of IPR&D. In response, the AICPA formed the taskforce that developed the Original Practice Aid.

The Original Practice Aid was released in 2001, shortly after the 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 topics, including methodologies and even the definition of Fair Value, the Original Practice Aid became a widely used reference 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. 141R, later codified as FASB ASC 805, Business Combinations (“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 of account, alternative forms of the income approach, and post-acquisition accounting for IPR&D, among others.

What is IPR&D?

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 R&D activities” criteria, and were discussed at length in the Original Practice Aid. The other concepts are new to the Guide.

  • Defensive R&D Assets: IPR&D assets are 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.
  • Idled R&D Assets: Idled assets are similar to 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 indefinite-lived treatment.
  • Outlicensed R&D Assets: Acquirers of IPR&D assets 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.

Unit of Account

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.

Ultimately, the determination of unit of account is unique to the facts and circumstances of each acquisition and over simplification could result in decreased relevance for the users of financial statements. The Guide offers the following factors to consider when determining unit of account:

  • The phase of development of the projects
  • The nature of the activities and costs necessary for further development
  • The risk associated with further development
  • The amount and timing of benefits expected to be derived in the future from developed assets
  • The expected economic life of the developed asset (once developed)
  • Whether there is intent to manage costs for the developed assets separately or on a combined basis in areas such as strategy, manufacturing, advertising, selling, etc.
  • Whether the asset (either as an incomplete IPR&D project or when complete) would be transferred by itself or with other separately identifiable assets

When analyzing each of these factors, the availability of sufficient inputs for a valuation analysis must be considered. This most often 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, considerable judgment is necessary when determining cost/benefit of the unit of account, and it should be established early in the valuation process.

Enabling Technology and Technology Migration

Enabling technology, or shared technology, represents underlying technology that has value through its continued use or reuse across many products or product families, and its potential as a separate unit of account should be considered concurrently with the determination of the unit of account for IPR&D assets. Specifically, the useful life, risk, profitability, and outlicensing capability of enabling technology may differ from the projects that it actually supports, and it therefore may meet the asset recognition criteria in FASB ASC 805. In this scenario, such as for a drug delivery mechanism that is used in substantially the same form for drugs currently on the market and drugs considered IPR&D, a separate unit of account is established for the enabling technology, and it is recognized as an asset on the balance sheet (usually with a finite life). However, enabling technology does not always represent a separate unit of account, such as when a drug delivery mechanism must be further customized for use in IPR&D products, and the facts and circumstances should be analyzed to determine the ultimate use of the asset. In this scenario, it may be concluded that the use of enabling technology is encompassed within existing products, IPR&D, and yet-to-be defined technology (i.e., goodwill).

Note that while enabling technology is similar to the concept of 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 technology. It should therefore be recognized as an asset less frequently than core technology was previously recognized, and 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 that would have been expensed under superseded GAAP literature. Given that all R&D assets are now capitalized in a transaction, the core technology concept has been abandoned in the Guide.

IPRD1

Enabling technology also must be considered separately from the concept of technology migration, which is the process in which certain elements of technology are used or reused within a product or product family from one generation to the next (i.e., version two of a software program currently under development may incorporate aspects of version one currently on the market). Values of different stages of technology within the technology migration lifecycle are encompassed in developed technology (current products), the addition of new functionality to current products (IPR&D projects), and future technology (goodwill). While enabling technology may be considered in the same manner, the Guide distinguishes that enabling technology may or may not be captured in the valuation of the different stages presented in the chart above based on the unit of account determination previously discussed, while technology migration will always be captured in the valuation of the different stages of technology, and therefore would generally not result in separate recognition of a “technology migration” asset.

Valuation of IPR&D

FASB ASC 820 stipulates that each of the three standard approaches to valuation — the cost approach, market approach, and income approach — should all be considered when determining the Fair Value of an asset. As it relates to IPR&D, the income approach is the most commonly used methodology. Because the cost approach is premised on the determination of the amount that would be required to replace the service capacity of an asset, its application to IPR&D assets is limited due to the common expectation that R&D activities will ultimately result in profit-generating products (i.e., there is often a disparity between historical cost expended and Fair Value based on expected future profits). Further, the use of a market approach is usually limited by a lack of observable market prices for similar assets.

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 Aid and the Guide with specific examples given in each. The MPEEM involves the analysis of prospective financial information (“PFI”) to determine free cash flows and discounting those cash flows to present value at a rate of return that is commensurate with the risk involved in realizing the cash flows. Since the release of the Original Practice Aid, use of the MPEEM has become widespread, and additional guidance for certain components of the MPEEM has been published — notably in The Appraisal 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 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:

  • MPEEM
  • Relief from Royalty Method
  • Decision Tree Analysis
  • “Split” Methods
  • Monte Carlo Analysis
  • Option Based Methods
  • Manufacturing Cost Savings
  • Incremental Revenue or Profit
  • “With and Without” Analysis
  • Greenfield Method

Conclusion

The valuation of IPR&D assets acquired in a business combination involves many unique theories and concepts, and a thorough understanding of the business entity being acquired is necessary. This article highlights some of the new concepts introduced in the Guide that have evolved since the issuance of the Original Practice Aid, but the Guide is a comprehensive valuation tool that cannot be fully summarized in a brief manner. Further, the interrelationship between the Guide and current U.S. GAAP as outlined in FASB ASC 805, FASB ASC 350, and FASB ASC 820 adds additional complexity. Although the Guide is in part a non-authoritative interpretation of U.S. GAAP, adherence to the methodologies it prescribes is expected by audit firms reviewing purchase accounting analyses. Companies that have acquired 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.