Acquired in-process research and development (IPR&D) is an intriguing aspect of mergers and acquisitions, particularly within industries heavily reliant on innovation and technological advancements. But what exactly is it considered as from a financial reporting perspective?
Demystifying Acquired IPR&D
Essentially, acquired IPR&D refers to the unfinished research and development (R&D) projects of a company that is acquired through a merger or acquisition. This can include a wide range of assets, such as:
- Patents pending: These are inventions in the process of being patented but have not yet received official recognition.
- Prototypes: Early models or samples of a product under development that demonstrate its intended function.
- Research data: Collected information and analysis from ongoing research efforts.
- Software under development: Code and related materials for software programs still in progress.
Accounting for Acquired IPR&D
Prior to 2001, acquired IPR&D was often capitalized on a company’s balance sheet as an intangible asset. This meant its value was recognized over time, similar to property, plant, and equipment. However, the Financial Accounting Standards Board (FASB) introduced new guidance in Statement No. 141, later superseded by Accounting Standards Codification (ASC) 350, which significantly changed the accounting treatment.
Under the current guidance, acquired IPR&D is generally expensed immediately as incurred in the acquisition. This means that the entire cost of the unfinished R&D projects is recognized as an expense on the income statement in the period the acquisition occurs.
Reasons for Expensing Acquired IPR&D
There are several reasons why FASB moved towards immediate expensing:
- Uncertainty: The future benefits of unfinished R&D are inherently uncertain. It’s difficult to predict whether the projects will be successful or commercially viable.
- Measurement Challenges: Assigning a reliable fair value to acquired IPR&D can be extremely complex and subjective.
Impact on Financial Statements
The expensing of acquired IPR&D can have a significant impact on a company’s financial statements:
- Lower Net Income: Recognizing the full cost as an expense reduces net income in the acquisition period.
- Increased Volatility: Large acquisitions involving substantial IPR&D can create significant fluctuations in earnings.
- Focus on Future R&D: Since acquired IPR&D is expensed, companies might prioritize investing in their own internal R&D efforts for future growth.
The Importance of Due Diligence
Given the accounting treatment and the inherent uncertainties surrounding IPR&D, conducting thorough due diligence during the acquisition process is crucial. This includes:
- Assessing the status of R&D projects: Understanding the progress, risks, and potential of each project.
- Valuing IPR&D: Engaging valuation specialists to help determine a fair price.
- Negotiating the purchase price: Considering the impact of expensing IPR&D on the overall deal value.
Conclusion
Acquired IPR&D is an important consideration in mergers and acquisitions, especially in R&D-intensive industries. Understanding its accounting treatment and the implications for financial reporting is essential for both acquirers and the companies being acquired. While the immediate expensing requirement aims to improve transparency, it also emphasizes the need for careful due diligence and valuation to ensure fair deal terms and informed investment decisions.