The Accounting Profession Vs. The Sec: When Is A Loan Not A Loan?

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The proposed public offering of Hadron Inc. (see story) is not the only research and development limited partnership awaiting a decision from the Securities and Exchange Commission. According to one estimate, at the end of 1981 some 15 registrations were pending in SEC files, one saddled with an unusually long comment letter as if in warning of things to come. And, indeed, the SEC is determined that specific guidance be provided in the accounting standards for R&D partnership reporting on balance sheets and income statements.

For public or about-to-go-public corporations, an important consideration of R&D partnership funding has been the off-the-sheets method most accountants use. Current standards are vague enough to allow partnership arrangements to be described in footnotes as a contingent liability, and do not require them to be expensed on profit statements. Alerted to the public interest by last year's big Wall Street packages -- Trilogy's $50-million public funding and Storage Technology's $90-million private placement -- the SEC would like to see less casual disclosure. Since SEC staff members feel that in R&D partnerships, it's likely the sponsor will buy out investor interests, they view the technique as a financing device and want it booked as a loan. They would have it set up as a liability, with expenses recorded on the P&L as incurred and with provisions for accruing interest at arbitrarily determined "venture capital rates." And the SEC's arbitrary determination of venture capital rates tends to be toward the maximum end.

Practitioners in the field respond that because of the large risks involved, partnership investment is anything but a loan. The expected high rate of return is certainly not in line with traditional lending fees, they argue, and since there's no obligation-to buy the technology, why should the deal be expensed?

Former SEC branch chief Grover Wickersham, now in private practice in Los Angeles, is one of the securities lawyers to have had an R&D partnership cleared by the SEC. Nonetheless he worries that the agency's position "may inhibit public companies from using partnerships to expand their R&D budgets, because of the very negative short-term impact on earnings." Moreover, he asks, what happens if the project is unsuccessful and the partners are given nothing? With the loan obligation ended, suddenly a "huge slug of phantom income hits the financial statement." Hopeful that the SEC will back away from its hard-line position, he adds, "There's not another corporate function more important than research and development." His opinion is backed up by the experience of Coopers & Lybrand partner Nicholas Moore, who notes that many of his big public clients have been making inquiries about R&D partnerships. "The principal thing retarding them," says Moore, "is the uncertainty of the accounting treatment."

But not all observers feel the SEC is overly concerned. Technology Funding's Charles Kokesh admits that there is are too many accounting procedures being employed. "I've seen a study showing 10 annual reports using eight different methods," Kokesh notes.

The accounting profession likely will come up with an accommodation. A member of the advisory group to the Financial Accounting Standards Board says the FASB will consider the presence or absence of certain factors in determining whether a partnership arrangement should be put on the books. Among them (1) Do the limited partners bear the risk of the research project's not being successfully completed? (2) If the project is completed, does the partnership bear the risk of the technology not being acquired by the corporation? (3) Does the partnership have legal or practical restraints on its ability to place the project elsewhere if the sponsor doesn't exercise its option? And (4) Is there an independent general partner entirely separate from the sponsor company? Whether such criteria will satisfy the SEC will be known shortly, as the FASB's position is due to be released this spring. Says Howard Hodges, Jr., an SEC chief accountant, "The SEC will take steps unless the FASB comes up with something. We hope to cooperate with them." Hodges anticipates that there will be changes as well, in the way the agreements themselves are phrased in regard to risk to the limited partners, specifically proving that indeed the partners are at a risk. If there aren't, he predicts, off-the-balance-sheet accounting "will disappear."