Disappearing Software Research
Accounting gimmicks result in underreported R&D for major software companies
In last month’s report Who Isn’t Expensing Their R&D?, we began our look at how GAAP accounting coupled with non-GAAP adjustments allow companies in research-heavy industries that pursue a growth-through-acquisition strategy to significantly underreport their true development costs. We recommend that readers refer to that report for a detailed discussion of the mechanics of the reporting, but here is a quick explanation of the factors that can lead to underreporting the cost of development:
A company can either develop a new technology in-house or obtain the intellectual property by acquiring another company that incurred all the associated expenses of doing so.
When the acquisition is made, an estimate of the value of the developed technology is split between goodwill and intangible assets. GAAP does not call for the amortization of goodwill so there is no expense related to that spending is ever recorded on the income statement unless the goodwill is deemed to be impaired and is written-off in the future. Even if there is an eventual goodwill write-off at some point, the charge will be lumped into non-GAAP adjustments and never show up in non-GAAP earnings.
While intangibles are amortized over their estimated useful life, virtually all tech companies add back this amortization expense to their non-GAAP earnings. Thus all expense associated with acquiring the R&D is never reflected in non-GAAP earnings-which are nearly universally used by the Street to value companies and assess growth, returns and profitability.
To top it off, stock compensation represents a meaningful part of the compensation for the R&D staff of most tech companies. But again, most tech firms add this expense back to their non-GAAP results.
Two weeks ago, we looked at 19 semiconductor companies whose earnings were impacted to at least some degree by this phenomenon and focused in on several that were particularly exposed. This week, we publish the results of our look at the software space which includes a list of 16 companies with market capitalizations greater than $5 billion whose non-GAAP results we believe are benefitting the most from understated development costs. We then do a deeper dive into 4 whose development costs are particularly low compared to economic reality as well as a look at one in the space whose earnings appear to be high quality from the standpoint of reflecting true development costs.
Let’s get “Behind the Numbers.”