Capitalizing Research & Development: Signaling or Earnings Management?

This paper analyzes the capitalization of Research & Development (R&D) expenditures under International Financial Reporting Standards (IFRS). Discretionary R&D capitalization can be exercised by managers to signal private information on future economic benefits to the market. It can, however, also serve as opportunistic earnings management. We analyze a unique, hand-collected sample of highly R&D intensive German IFRS firms during 1998–2012. We find that market values are not associated with capitalized R&D for the overall sample, indicating that earnings management may be a concern. We identify firm-years for which R&D capitalization is possibly used for pushing their earnings above a specific threshold (e.g. analysts' forecasted earnings, prior year's earnings). Our results show that both the decision to capitalize and how much to capitalize are strongly associated with benchmark beating. Consistently, we find that market values are negatively associated with capitalized R&D for firms who are likely to use capitalization for benchmark beating (about one third of the overall sample). On the other hand, the market values R&D capitalization positively for well-performing firms, for which capitalizing does not matter to beat an earnings benchmark (about half of the overall sample). This finding is robust to controls for endogeneity, various deflators, and different measures for earnings management.     

The negative impact of R&D capitalization: A value relevance approach

Abstract

Accounting for R&D costs is an open issue. SFAS N°2 mandates that all R&D costs must be immediately expensed. IAS 38 requires capitalization of R&D costs if they meet certain criteria. Recent research papers show the value relevance of capitalized R&D. We test the value relevance of R&D reporting in a sample of 197 French firms between 1993 and 2002. The French context provides an interesting field for R&D value relevance studies because both accounting treatments of R&D costs (expensing and capitalization) are allowed. Unlike previous studies, we find that capitalized R&D is negatively associated with stock prices and returns. This negative coefficient on capitalized R&D implies that investors are concerned with and react negatively to capitalization of R&D. We also find that the firms choosing to capitalize (successful) R&D are smaller, more highly leveraged, less profitable and have less growth opportunities. Taking into account these characteristics, our robustness checks confirm that capitalized R&D is not associated with higher prices and is related to lower returns.     

Accounting Choice and Earnings Quality: The Case of Software Development

In this study I explore how accounting choice affects earnings quality in the software development industry. SFAS No. 86, which requires capitalization of software development costs (SDC), is the only exception in the US to SFAS No. 2, which requires immediate expensing of all research and development (R&D) expenditures. Aboody and Lev (1998) suggest that capitalized SDC are value-relevant. Thus, expensing of these costs might introduce noise into earnings. However, it has been suggested that future benefits associated with SDC are highly uncertain (Software Publishers Association). Consequently, capitalization might introduce noise into earnings by capitalizing unproductive expenditures. Hence, it is not clear how managers' choice between capitalization and expensing will affect earnings quality. I first find that there is a decline in the quality of earnings in the software industry after the adoption of SFAS No. 86, whereas no such decline is observed in other high-tech industries. Second, I find that, within the software industry, the quality of earnings for expensers is greater than for capitalizers. Finally, I find that, among the capitalizers, those with a large increase in software capital have lower earnings quality than others. Overall, the results suggest that capitalization of software costs does not improve earnings quality.     

Does the Capitalization of Development Costs Improve Analyst Forecast Accuracy? Evidence from the UK

It has been documented that investments in Research and Development (R&D) are associated with increased errors and inaccuracy in earnings forecasts made by financial analysts. These deficiencies have been generally attributed to information complexity and the uncertainty of the future benefits of R&D. This paper examines whether the capitalization of development costs can reduce analyst uncertainty about the future economic outcome of R&D investments, provide outsiders with a better matching of future R&D‐related revenues and costs, and therefore promote accuracy in analyst forecasts. UK data is used, because accounting rules in the United Kingdom permitted firms to conditionally capitalize development costs even before the introduction of the International Financial Reporting Standards. The choice to expense R&D rather than conditionally capitalize development costs is found to relate positively to signed analyst forecast errors. This finding is robust to controlling for the influence of other factors that may affect errors, as well as for the influence of R&D investments on forecast errors. The decision to capitalize versus expense is not observed to have a significant influence on analyst forecast revisions. The findings are interpreted as evidence that the choice to capitalize as opposed to expense may help to reduce deficiencies in analyst forecasts; hence, is informative for users of financial statements. Increased informativeness is expected to have repercussions for the effectiveness with which analysts produce earnings forecasts, and, as a result, market efficiency.     

The Role of Institutional and Economic Factors in the Strategic Use of Non-GAAP Disclosures to Beat Earnings Benchmarks

Abstract

We use hand-collected data for a sample of large European firms to investigate the influence of countries’ institutional and economic factors on managers’ non-generally accepted accounting principles (GAAP) disclosures. We find that managers are more likely to use non-GAAP measures to meet or beat earnings benchmarks that GAAP earnings would miss in countries with efficient law and enforcement, strong investor protection, developed financial markets, and good communication and dissemination of information. We also find that managers in countries with developed institutional and economic conditions are more likely to adjust non-GAAP earnings for recurring expenses such as R&D, depreciation, and stock-based compensation expenses. Our findings suggest that in environments in which there is more pressure to achieve earnings benchmarks and less opportunity to manipulate GAAP earnings, managers use more non-GAAP earnings disclosures to meet the benchmarks.     

Relative Value Relevance of R&D Reporting: An International Comparison

This study examines the relative value relevance of R&D reporting in France, Germany, the UK and the USA. France and the UK allow conditional capitalization of R&D costs, whereas Germany and the USA (except for the software industry) require the full and immediate expensing of all R&D costs. The relative value relevance of R&D reporting under different R&D accounting standards are compared while controlling for the reporting environment. Test results suggest that the level of R&D reporting has a significant effect on the association of equity price with accounting earnings and book value. The reporting of total R&D costs provides additional information to accounting earnings and book value in Germany and the USA (expensing countries), and the allocation of R&D costs between capitalization and expense further increases the value relevance of R&D reporting in France and the UK (capitalizing countries), including firms in the US software industry.     

Research and Development,Uncertainty, and Analysts’ Forecasts: The Case of IAS 38

This study analyzes the consequences of the capitalization of development expenditures under IAS 38 on analysts’ earnings forecasts. We use unique hand‐collected data in a sample of highly research and development (R&D)‐intensive German‐listed firms over the period 2000–2007. We find that the capitalization of development costs is significantly associated with both higher individual analysts’ forecast errors and forecast dispersion. This suggests that the increasing complexity surrounding the capitalization of development costs negatively impacts forecast accuracy. However, for firms with high underlying environmental uncertainty, forecast errors are negatively associated with capitalized development expenditures. This indicates that the negative impact of increased complexity on forecast accuracy can be outweighed by the information contained in the signals from capitalized development costs when the underlying environmental uncertainty is high. The findings contribute to the ongoing controversial debate on the accounting for self‐generated intangible assets. Our results provide useful insights on the link between capitalization of development costs, environmental uncertainty, and analysts’ forecasts for accounting academics and practitioners alike.     

Analyst Following,Institutional Investors and Pricing of Future Earnings: Evidence from Korea

This paper examines the role of sophisticated investors in pricing future earnings in Korea. Using the future earnings response coefficient (FERC) model, we test the effect of analyst following and institutional ownership on the informativeness of stock returns for future earnings. We find that the informativeness of stock returns for future earnings, measured as the FERC, increases with the analyst following and institutional ownership. We also investigate how the recently introduced Regulation Fair Disclosure in Korea affects the informativeness of stock returns for future earnings and its relation with analyst following and institutional ownership. The results show that the regulation decreases the FERC in general and its relation with analyst following, suggesting that analysts' superior ability is impaired after the regulation.     

Intangible investment in people and productivity

Organizational activity, information and communication technology work, and research and development (R&D) can be classified as work that creates intangible capital. We measure the returns to these three types of labor input by accounting for differences in their productivity compared with other labor inputs using Finnish firm-level data from 1998 to 2008. We apply a novel idea to use hiring as one proxy for productivity and demand shocks. We find that organizational workers increase total factor productivity and improve the profitability of high-productivity firms. R&D workers account for a large share of intangible capital; however, the returns to R&D are low. Investments in organizational competence are more likely to result in more rapid productivity growth. Firms with performance-related pay or domestically owned firms with extensive foreign activities have been among the highest performers with respect to the use of organizational work.     

Modeling college major choices using elicited measures of expectations and counterfactuals

The choice of a college major plays a critical role in determining the future earnings of college graduates. Students make their college major decisions in part due to the future earnings streams associated with the different majors. We survey students about what their expected earnings would be both in the major they have chosen and in counterfactual majors. We also elicit students’ subjective assessments of their abilities in chosen and counterfactual majors. We estimate a model of college major choice that incorporates these subjective expectations and assessments. We show that both expected earnings and students’ abilities in the different majors are important determinants of a student’s choice of a college major. We also consider how differences in students’ forecasts about what the average Duke student would earn in different majors versus what they expect they would earn both influence one’s choice of a college major. In particular, our estimates suggest that 7.8% of students would switch majors if they had the same expectations about the average returns to different majors and differed only in their perceived comparative advantages across these majors.     

Do Investors Pay Sufficient Attention to Banks’ Unrealized Gains and Losses on Available-for-sale Securities?

Abstract

Unrealized gains and losses on available-for-sale securities (AFSGL) are included in Other Comprehensive Income (OCI) and directly affect shareholders’ equity but are not included in earnings. We investigate whether unrealized AFSGL help predict future earnings and whether analysts and investors incorporate the information conveyed by unrealized AFSGL in a timely manner. We conduct our investigation on a sample of banks because unrealized AFSGL are material in the banking industry. First, we show that unrealized AFSGL are material and help in predicting next period realized AFSGL and future earnings change. Second, we document that financial analysts are slow to react to unrealized AFSGL and update their forecasts after AFSGL are realized in earnings. Third, we find that investors are also slow to react to unrealized AFSGL and do so only after AFSGL are included (realized) in earnings and after financial analysts update their forecasts. We document an annual difference of 5% in future abnormal returns between banks in the top and bottom quintiles of past unrealized AFSGL. A zero-cost trading strategy that relies on public information about unrealized AFSGL generates a sizeable monthly alpha that ranges between 1.8% and 1.9%.     

R&D Cuts and Subsequent Reversals: Meeting or Beating Quarterly Analyst Forecasts

Abstract

Among firms that meet or beat earnings expectations, we find that cuts to R&D spending are more prevalent in Q4 relative to other interim quarters. This is consistent with the relative costs of real-activities management (accruals-based earnings management) decreasing (increasing) in Q4 due to the annual audit. More importantly, we find that the subsequent reversal of such R&D cuts is more prevalent and economically more significant following Q4 cuts relative to the reversals that follow cuts in other interim quarters. Our findings suggest that examination at the quarterly level (rather than annual level) lends new insights into the current debate regarding the prevalence of potentially value-destroying R&D cuts that managers make. Indeed, our findings suggest that some cuts may merely be temporary deferrals of R&D outlays.     

公司战略与研发支出会计政策选择

利用2009—2015年中国A股非金融上市公司数据考察公司战略对研发活动中会计政策选择盈余管理的影响。研究发现：相比于采取防御型战略的上市公司,采取进攻型战略的上市公司更可能利用研发支出资本化进行盈余操纵。进一步的研究表明,在企业融资需求高、融资难度大时,激进的进攻型战略更可能导致上市公司利用会计政策进行盈余管理。在采用多种方式测试结果稳健性后,结论仍然成立。     

The R&D knowledge base in city-agglomerations and knowledge searching in product innovative SMEs

ABSTRACT

This paper looks at the relation between the R&D knowledge base of city-agglomerations and knowledge sourcing in product innovative small and medium-sized enterprises (SMEs). The small open Belgian economy is used as a test case. The characteristics of the city-agglomeration’s R&D knowledge are posited to be instrumental for SMEs’ reliance on particular sources of information for innovation. The R&D knowledge base is studied as a multidimensional concept consisting of R&D capacity, R&D specialization and R&D diversification. A representative sample of product innovative SMEs drawn from two waves of the Community Innovation Survey between 2008 and 2012 reveals that a strong R&D capacity at city-agglomeration level favours private external information sources for innovation, but has no influence on the likelihood to rely on public sources for innovation. Accordance between specialization of the private R&D knowledge base and the SME’s activities positively influences the use of clients as information sources for innovation, whereas under these circumstances supplier responsiveness turns out to be less frequently solicited for. A more diversified private R&D environment reduces the reliance on universities and public research organizations as information sources for innovation. A public R&D knowledge base specialized in natural sciences or engineering favours information sources from universities.     

The Impact of Mandatory IFRS Adoption on Equity Valuation of Accounting Numbers for Security Investors in the EU

Motivated by the European Union (EU) decision to mandate application of the International Financial Reporting Standards (IFRS) to the consolidated financial statements of all EU listed firms (Regulation (EC) 1606/2002), starting in December 2005, we compare the value relevance of accounting information in 14 European countries in the year prior to and the year of the mandatory adoption of the IFRS. We focus on three accounting information items for which measurements under IFRS are likely to differ considerably from measurements under domestic accounting practices across the EU countries prior to the introduction of the international standards: goodwill, research and development expenses (R&D), and asset revaluation. These three items, selected on an a priori basis, have been shown in previous research to differ in the effect of uncertainty on their future benefits. We use valuation models that include these three variables and in addition the book value of equity and earnings. Overall, our study suggests that the adoption of the IFRS has increased the value relevance of the three accounting numbers for investors in equity securities in the EU. Association tests support our two hypotheses: (1) in the year prior to the mandatory adoption of the IFRS, the incremental value relevance to investors of the three domestic GAAP-based accounting items was greater in countries where the respective domestic standards were more compatible with the IFRS; and (2) the higher the deviation of the three domestic GAAP-based accounting items from their corresponding IFRS values, the greater the incremental value relevance to investors from the switch to IFRS. These associations prevail when considering cross-country differences in the institutional environments, which tend to provide complementary effects.     

Impact of R&D and Technology Diffusion on Productivity Growth: Empirical Evidence for 10 OECD Countries

This paper examines the empirical evidence on the impact of performed R&D and of R&D embodied in intermediate and capital goods on productivity performance in 10 major OECD countries over the last two decades. To quantify intersectoral and international technology flows, industry-level embodied R&D variables were constructed from an input–output (IO) R&D embodiment model. The productivity variables used are discrete Divisia growth indexes of total factor productivity (TFP), which were estimated from an IO growth accounting model. The results from pooled regressions indicate that the rates of return of the R&D variables were positively significant and increasing in the 1980s. In particular, embodied R&D is an important source for TFP growth in services, indicating very high social returns of the flows of capital-embodied technology into this sector. Moreover, the information and communi-cation technology (ICT) cluster of industries played a major role in the generation and cquisition of new technologies at the international level.     

An approach to the R&D value based upon real option method

This paper aims to build up feasible models based upon the real option method (ROM) to assess R&D. In this paper we built eight models integrating with three conditions to assimilate the real situation an R&D project may encounter. We utilized both numerical and statistical illustration based upon an empirical case to exhibit the correctness of our models. We diverged our discussion into either expense or capital viewpoint to react with current accounting debate. The results shed us the light: our models in both expense and capital viewpoint can correctly asses R&D; the selected conditions play essential roles to influence the correctness of our models.     

The U-shaped effect of R&D intensity on employee downsizing: evidence from Spanish manufacturing firms (1994–2010)

Abstract

This study explores an empirically untested issue: the relationship between the level of a firm’s R&D intensity and employee downsizing. Basing our conceptual development on the Resource-Based View of the firm, we argue that a linear relationship is a poor approximation of the proposed relationship. Instead, we find theoretical insights supporting the logic that employee downsizing decreases as firms shift from low to moderate levels of R&D intensity but increases as firms change from moderate to high levels. This prediction suggests that a U-shaped link is a better representation of the way in which a firm’s R&D intensity can affect downsizing. This hypothesis is tested and confirmed using a sample of Spanish manufacturing firms during the 1994–2010 period. We also propose a novel empirical tool (i.e. dynamic probit models) that is especially useful for addressing the potential endogeneity and simultaneity problem in studying this relationship. Implications for future research and practice are presented along with the conclusions of our findings.     

Dissemination of Accruals Information,Role of Semi‐Annual Reporting,and Analysts' Earnings Forecasts: Evidence from Japan

Our study investigates the effects of dissemination of accounting accruals information on stock prices using Japanese annual reports as our sample. We conduct month‐by‐month detailed analyses of price adjustment behavior with a particular focus on revisions of analysts' earnings forecasts and changes in trading volume around the period of upcoming semi‐annual reports. We find that analysts' forecasts are often revised around this time, and analysts use this as auxiliary information. In addition, an accompanying re‐adjustment of abnormal returns and an increase in trading volume are observed. Our findings demonstrate that informational uncertainty initially triggered by the announcement of annual reports decreases as semi‐annual reports are disclosed and analysts change their earnings forecasts, and confirms the importance of semi‐annual reporting.