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example, in the Netherlands goodwill is not amortized against income at all, but is
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written off against shareholders™ equity at the completion of the acquisition. Goodwill
is amortized on a straight-line basis over a maximum of forty years in the U.S., ¬ve years
in Japan, and four years in Germany. In the U.K., goodwill is reported as an asset, but
does not have to be amortized at all if it has not been impaired.
The expected value and economic life of goodwill depend on a number of factors. First,
they depend on the ability of acquiring management to price the intangible assets of the
target appropriately, avoiding overpayment. Second, they depend on acquiring manage-
ment™s ability to integrate the target ¬rm without destroying intangible assets that it pur-
chased, such as superior management, existing customers, or key employees. Finally, the
value and expected life depend on the strategy and strategy implementation capabilities of
the new ¬rm, which can either leverage or destroy the target ¬rm™s intangible assets.2
To illustrate, Cooper Industries, a diversi¬ed company operating in the electrical,
hand-tool, automotive, and energy equipment businesses, acquired Cameron Iron
Works, a manufacturer of oil and gas machinery, for $967 million in 1989.3 Cooper™s
strategy was to acquire manufacturing businesses, strengthen their management, and im-
prove their reporting and control systems. However, several problems arose with this
strategy and its implementation at Cameron. First, Cooper™s expertise was in under-
standing manufacturing. Its management mistakenly believed that this was critical to
Cameron™s success. Only after the acquisition did it learn that service and marketing
were the key performance drivers for Cameron. Second, in implementing the acquisi-
tion, Cooper became preoccupied with control, making it dif¬cult for management at
Cameron to run its business. As a result, Cooper took $440 to $750 million of write-
downs related to the acquisition, and it divested Cameron in 1994.
Given management™s self-interest in communicating to investors that an acquisition
is successful and the challenge in estimating future bene¬ts from outlays for goodwill,
there is a risk that managers making value-decreasing acquisitions will fail to recognize
any deterioration in goodwill values on a timely basis. Equally, for acquisitions that do
create shareholder value, accounting rules for goodwill amortization often do a poor job
of re¬‚ecting merger bene¬ts, since many countries require ¬rms to amortize goodwill
even if the asset has not declined in value.

EXAMPLE: RESEARCH AND DEVELOPMENT OUTLAYS. Research and develop-
ment outlays are intended to create value for the ¬rm in future periods. This suggests that
they should be expensed in the same periods as when the new product revenues they are
expected to generate are recognized. However, research and development (R&D) is a
highly uncertain process. There are typically many failed projects for every successful
one. As a result, accounting rules in most countries require R&D outlays to be expensed
as incurred (see SFAS 2).4
In the U.S., there are several exceptions to the rule requiring expensing of R&D. First,
completed R&D that is purchased from another company is capitalized and amortized
over its useful life (see SFAS 68). Second, software development costs are capitalized
upon completion of a detailed program design plan or working model. Amortization of
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this asset for a particular year is proportional to the project revenues generated during
that year relative to total expected project revenues (see SFAS 86).5
The rules on capitalizing and amortizing outlays for completed R&D and software de-
velopment provide management with opportunity to exercise judgment in ¬nancial re-
porting. Management can potentially use this judgment to match R&D costs with
revenues they generate. Alternatively, it can misuse this judgment to accelerate or defer
earnings, either in their assessments of the types of outlays that satisfy the criteria for
capitalization and amortization against future revenues, or in the estimates of future lives
of any outlays to be amortized.6
The diversity in reporting practice on these issues is likely to raise questions for users
of ¬nancial reports. For example, Microsoft, the most successful software developer in
the world, expenses all software development outlays immediately. In contrast, People-
soft, one of the smaller players in the software industry, capitalizes its development costs
and amortizes them over three years. Is Microsoft being conservative in its reporting? Is
Peoplesoft reporting aggressively? Or do the two ¬rms have very different models of
developing software consistent with their reporting differences?
Analysis is also important for ¬rms whose managers have no opportunity to exercise
judgment in reporting on R&D outlays. For example, ¬rms in the R&D-intensive pharma-
ceutical industry are required to expense all R&D outlays immediately. For these ¬rms,
¬nancial reporting does not help investors discriminate between ¬rms with the most and
the least effective research labs, a critical issue for evaluating the performance of man-
agement and for valuation. As a result, analysts research other sources of information on
¬rms™ research capabilities and successes, such as patent ¬lings and FDA approvals.

EXAMPLE: ADVERTISING OUTLAYS. Advertising outlays create an even greater
challenge for ¬nancial reporting than R&D. As discussed in Chapter 4, companies such
as Coca-Cola have been able to create long-term sustainable economic rents from adver-
tising their products. However, it is often unclear what link, if any, exists between adver-
tising outlays in a period and future revenues.
To illustrate the dif¬culty in linking a ¬rm™s advertising program to long-term reve-
nues, consider Microsoft™s $220 million campaign to launch Windows 95. The role of
this campaign in the success of the new product is dif¬cult to estimate. Because of the
company™s dominant position in its market, there was widespread public interest in the
product well before the ¬rst paid advertisement for Windows appeared on August 24,
1995. The Wall Street Journal estimated that 3,000 headlines, 6,852 stories, and over 3
million words had been dedicated to Windows 95 during the period July 1 to August 24,
1995. In addition, during the launch week, Microsoft engaged in a series of publicity
stunts to promote the new product. A 600-foot Windows 95 banner was hung from the
CN Tower in Toronto, the Empire State Building was lit in the colors of the Windows 95
logo, and the company paid The London Times to distribute an entire day™s run of 1.5
million copies free. What was the role of these promotions relative to the $220 million
advertising campaign in making the product a market success?
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As shown by the Windows 95 example, the long-term effectiveness of a ¬rm™s ad-
vertising is typically dif¬cult to assess because so many other factors aside from the
company™s advertising strategy are likely to in¬‚uence its campaign effectiveness. Inter-
vening factors include the ¬rm™s own pricing and promotion decisions, the price, promo-
tion, and advertising responses of competitors, the market position of the ¬rm relative to
its competitors, and the stage of the product market (growing, mature, or declining).
Given the dif¬culty in quantifying these effects and isolating any cause-and-effect rela-
tion between advertising outlays and future revenues, accounting standards typically
require advertising expenditures to be expensed as incurred.
However, for several industries it is possible to link some forms of marketing outlays
and future revenues. For example, life insurance companies pay commissions to com-
pensate sales representatives for signing up new policyholders. The bene¬ts of these
contracts can be short-term (for property-casualty insurers) or long-term (for life insur-
ers). As a result, SFAS 60 and SFAS 120 require insurers to capitalize these outlays and
to expense them over the life of the contract.
Direct response advertising costs are another type of advertising outlay where it may
be possible to establish a link between outlays and future revenues. Credit card compa-
nies, telephone companies, Internet service providers, satellite television providers,
magazine publishers, and membership service companies spend heavily on direct re-
sponse advertising to attract new members. Many of these ¬rms can document the sign-
up rates from their programs, as well as the rates of membership renewal. Indeed, many
of these ¬rms use market research to target customers that are most likely to sign up and
subsequently renew their memberships. Consequently, accounting standards (see State-
ment of Practice 93-7) permit ¬rms to capitalize these types of costs provided they can
document that (a) customers have responded directly to the advertising campaign, and
(b) future bene¬ts from the expenditures are reasonably certain. The ¬rst requirement
can be satis¬ed by use of coded order forms, coupons, or response cards. The second can
be satis¬ed by reference to historical data on membership renewals. Of course, there are
always risks that future renewals will not follow historical patterns, perhaps due to in-
creased competition or to customer disappointments over service.


Key Analysis Questions
The above discussion indicates that management sometimes has an opportunity to
use judgment to expense resources that provide value over multiple periods. In addi-
tion, accounting standards for reporting on some of these resources require all ¬rms
to immediately expense outlays. This makes it more dif¬cult for analysts to distin-
guish ¬rms that are able to create multi-period bene¬ts from these outlays from ¬rms
that are not. As a result, the following questions are likely to be useful for analysts:
• What assumptions are made by management to amortize resources with
multi-period benefits? Are these assumptions consistent with the firm™s busi-
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ness strategy? How do they compare to assumptions made by other firms in
the industry? If there are significant differences, what factors can explain
these differences?
• Has the firm changed its amortization assumptions over time? What factors
explain these decisions? For example, is it following a different business or
operating model?
• Is there evidence that management has consistently over- or underamortized
long-lived assets? Such evidence includes systematic reporting of gains (or
losses) on asset sales, or persistent asset write-downs.
• What is the value and reliability of benefits expected from capitalized current
period outlays? These are affected by the firm™s position in its product market
and the sustainability of that position. For example, if the firm records signif-
icant goodwill as a result of an acquisition, is there an economic basis for this
asset, or did the acquirer overpay for the target?
• If accounting standards require outlays for intangible resources to be ex-
pensed as incurred, analysts may want to discount the effect of these expens-
es on earnings, particularly for firms that appear to be capable of creating
long-term value from these outlays. This requires an analysis of the expected
benefits and associated risks from these outlays. Does the firm have a track
record of creating new products through its R&D labs, or brand names
through its marketing campaigns?



Challenge Two: The Timing and Amount
of Payment for Resources Is Uncertain
Some transactions require ¬rms to make long-term commitments for resources that have
no long-term bene¬ts to the ¬rm. For example, many ¬rms offer pension and other post-
retirement bene¬ts to their employees. Firms also incur long-term obligations to pay for
the cleanup of environmental hazards for which they are responsible. These obligations
represent expenses, since they provide no future bene¬t to the ¬rm. Any bene¬ts have
already been realized in either the current period or prior periods. However, they are
challenging to record, since the timing and amount of the obligations is frequently
uncertain.
How should these types of commitments be recorded? Should an expense be esti-
mated for the expected obligation or for the present value of the expected obligation? If
so, how should errors in management™s forecasts of these obligations and interest rates
be re¬‚ected? Alternatively, should recording the expense be delayed until the timing and
amount of the obligation can be determined more accurately?
To illustrate the challenges associated with recording expenses for long-term obliga-
tions with no future bene¬ts, we discuss the accounting for pension and post-retirement
bene¬ts and environmental obligations.
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EXAMPLE: PENSIONS AND OTHER POST-RETIREMENT BENEFITS. Many ¬rms
offer employees a pension plan and other forms of post-retirement bene¬ts. Typically,
employees are entitled to receive some form of bene¬t after working for a ¬rm for a min-
imum period. Thereafter, the magnitude of the bene¬ts typically increases for each year
the employee works.
As discussed in Chapter 5, companies are required to estimate liabilities for the ex-
pected future obligations under pension and post-retirement plans. This is a signi¬cant
challenge for recording the liability associated with de¬ned bene¬t plans, where an em-
ployer guarantees certain future levels of bene¬ts for employees.7 For these types of
plans, managers have to forecast current employees™ future working lives with the ¬rm,
their life expectancies, retirement ages, and the expected cost of the future bene¬ts.
These data are used to estimate the present value of the expected future bene¬ts for all
current employees. This value is amortized as a bene¬t expense by using a straight-line
method over the employees™ expected working lives with the ¬rm. In addition, the ben-
e¬t expense re¬‚ects increases in the value of the obligation as employees get closer to
receiving bene¬ts (an interest effect) and decreases as any assets invested by the com-
pany to fund the bene¬t plan increase in value. Expenses are also adjusted as manage-
ment revises its forecasts of future plan commitments. Of course, under this approach,
management has considerable judgment in estimating the annual bene¬t cost.
Estimating the cost of obligations provided under such plans is challenging for man-
agement. However, it does ensure that the risks associated with the plans, such as uncer-
tainty over employee turnover, medical cost in¬‚ation, and employee life expectancy, are
re¬‚ected in the ¬nancial statements. It is likely to be important for management and for
external users of ¬nancial statements to understand the implications of these risks and
the value of the bene¬ts provided to employees.

EXAMPLE: ENVIRONMENTAL COSTS. As discussed in Chapter 5, the Comprehen-
sive Environmental Response, Compensation, and Liability Act (CERCLA) empowers
the federal government to make those responsible for the improper disposal of hazard-
ous waste at the nation™s worst hazardous waste sites bear the cost of cleanup. The chal-
lenges in measuring environmental liabilities, namely the dif¬culties in estimating the
cost of the cleanup and in assessing how the cleanup cost will be shared by the parties
associated with the site, also make it challenging to record an expense. How should the
expense be recorded? For example, should it be recorded as a one-time charge at the
same time as the liability is recorded, or should it be spread out over the cleanup period?
Should it be shown as an extraordinary item, as a non-operating item, or as a part of nor-
mal operations?
As noted in Chapter 5, a liability must be recorded when much of the uncertainty over
the cost of cleanup and the ¬rm™s responsibility have been resolved (see SFAS 5 and
Statement of Position 96-1). The Statement of Position also requires ¬rms to recognize
the full cost of cleanup as an operating expense when the liability is recorded. Cleanup
costs cannot be considered extraordinary or included in the “other income and expense”
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