Development costs capitalization and debt financing

This study investigates debt market effects of research and development (R&D) costs capitalization, using a global sample of public bonds and private syndicated loans issued by public non‐financial firms. Firstly, we show that firms capitalize larger amounts of R&D in a year when they exhibit a propensity for issuing bonds, rather than borrowing funds privately from the syndicated loan market, in the subsequent year. Secondly, we provide evidence that capitalized R&D investments reduce the cost of debt. We infer that debt market participants are able to identify firms’ motives for R&D capitalization, as we find a reduction in the cost of debt only for those firms that do not show indications of employing R&D capitalization for earnings management reasons. Indeed, only for this sub‐sample of firms, the amount of capitalized R&D contributes positively to future earnings. We confirm that R&D capitalization is positively associated with audit fees and thus can be deemed to be a signaling device. Lastly, we find that it is the amount of R&D a firm is expected to capitalize and not the discretionary counterparts, which facilitates a firm's access to public debt markets, reduces bond and syndicated loan prices, and contributes to future benefits.     

Value-relevance of pension transition adjustments and other comprehensive income components in the adoption year of SFAS No. 158

In the present study, we examine the value-relevance of pension transition adjustments and other comprehensive income (OCI) components in the initial adoption year of Statement of Financial Accounting Standard (SFAS) 158—Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans. Using a sample of 697 Standard and Poor (S&P) firms with the fiscal year ending on December 31, 2006, we perform several cross-sectional regression analyses to test the value-relevance of transition adjustments and OCI components in presence of various earnings measures. The results indicate that there is a negative relationship between both the level and change in stock returns and the magnitude of pension transition adjustments. We also find earnings measures and some OCI components are significantly associated with stock returns. When analyzed separately, we find our main results are mostly confined to the sample large S&P 500 firms. We do not find any result for the S&P mid-cap and small-cap firms. The overall results suggest the stock market negatively reacts to the adverse impact of SFAS #158 pension transition adjustments on net worth and future cash flows when the impact is substantial in its magnitude in dollar terms. The study further provides useful insight into the information processing by documenting that the market evaluates accounting information more effectively when such information is recognized in the financial statements rather than disclosed only in the financial footnotes.     

Recognition versus Disclosure of Stock Option Compensation: An Analysis of Judgements and Decisions of Nonprofessional Investors*/CONSTATER OU PRÉSENTER PAR VOIE DE NOTE LA RÉMUNÉRATION SOUS FORME D'OPTIONS D'ACHAT D'ACTIONS: UNE ANALYSE DES JUGEMENTS ET DES DÉCISIONS DES INVESTISSEURS NON PROFESSIONNELS

Given the importance of stock options in the aggregate compensation of chief executive officers and other firm employees in the 1990s and early 2000s, the International Accounting Standards Board issued an International Financial Reporting Standard on stock‐based payments on February 19, 2004, requiring that all share‐based payment transactions be recognized at fair value in entities' financial statements. The Canadian Institute of Chartered Accountants' Accounting Standards Board had already agreed to this principle and amended section 3870 of the CICA Handbook (stock‐based compensation) for financial periods beginning on or after January 1, 2004, making Canada the first major jurisdiction to require all public companies to expense employee stock‐based compensation awards. The revised section eliminated the possibility of disclosing pro forma net income and earnings per share only by way of a note. This research, conducted as a between‐subjects experiment with executive MBA students as nonprofessional investors, examines whether changes in the way stock option compensation is reported (recognition as an expense in the income statement or note disclosure of pro forma net income and earnings per share) affect financial statement users' judgements and investment decisions. Our results indicate that, consistent with the functional fixation hypothesis, the reporting method does indeed significantly influence subjects' judgement of the expected stock price direction, but has no material influence on their investment decisions.     

Good disclosure doesn't cure bad accounting—Or does it?: Evaluating the case for SFAS 158

This paper investigates whether the newly required recognition of the funded status of defined benefit (DB) plans under SFAS 158 is incrementally value relevant in its adoption year (2006) relative to the corresponding amounts which were previously disclosed from both equity investor and credit rating perspectives. In equity valuation models, we use a sample of 878 firms (1756 firm years) offering DB plans in 2005 (disclosure year) and 2006 (recognition year), and find no incrementally significant association with market prices of newly recognized amounts under SFAS 158 over the same information that was disclosed pre-SFAS 158. Our credit rating tests, using a sample of 428 DB firms (856 firm years) for 2005 and 2006 also show no differential impact of recognition over disclosure. Overall, we find that equity investors price the SFAS 158-imposed pension differential while credit rating agencies do not, regardless of whether such information is recognized or disclosed in the financial statements. Our results are consistent with efficiency in both equity and credit markets with respect to pension information and suggest that SFAS 158 has not changed the way market participants in aggregate use pension-related financial statement information.     

Firms' Voluntary Recognition of Stock-Based Compensation Expense

We investigate factors associated with firms' decisions in 2002 and early 2003 to recognize stock‐based compensation expense under Statement of Financial Accounting Standards (SFAS) No. 123. We find that the likelihood of SFAS 123 expense recognition is significantly related to the extent of the firm's participation in capital markets, the private incentives of top management and members of the board of directors, the level of information asymmetry, and political costs. Although recognizing firms have significantly smaller SFAS 123 expense, we find no significant incremental relation between recognition likelihood and SFAS 123 expense magnitude after controlling for other factors that we expect explain the recognition decision. We also find positive and significant announcement returns for earlier announcing firms, particularly those stating that increased earnings transparency motivates their decision.     

Accounting for inventory costs and real earnings management behavior

Prior research finds that managers engage in inventory overproduction to inflate current earnings despite the fact that overproduction is associated with significant economic costs. Additionally, Statement of Financial Accounting Standards No. 151 (SFAS 151) limited the fixed costs that can be capitalized to inventory in periods of low production, thereby introducing a penalty for underproduction by requiring firms to expense unallocated overhead in the current period. Because periods of underproduction often follow periods of overproduction, and because SFAS 151's emphasis on the subjective determination of normal capacity can erroneously categorize overproducing firms as underproducers in subsequent years, we posit that SFAS 151 makes overproduction less desirable than before. Therefore, we posit that management's propensity to use overproduction to meet earnings benchmarks should decrease after the adoption of SFAS 151. Consistent with expectations, we find a lower propensity to use overproduction to meet benchmarks following SFAS 151. These results challenge the view that SFAS 151 inadvertently encouraged overproduction.     

Usefulness of comprehensive income reporting in Canada

In January 2005 the Canadian Accounting Standards Board (AcSB) issued three new accounting standards that require Canadian firms to mark-to-market certain financial assets and liabilities and recognize the holding gains and losses related to these items as other comprehensive income or as part of net income. The Board’s objectives for issuing the new standards are (i) to harmonize Canadian GAAP with US and International GAAP, (ii) to enhance the transparency and usefulness of financial statements, and (iii) to keep pace with changes in accounting standards in other countries that are moving towards fair value accounting. This paper investigates empirically whether requiring Canadian companies to report comprehensive income and its components provides the securities market with incremental value-relevant information over the traditional historical-cost earnings approach.Previous empirical studies provide mixed evidence on the value relevance of other comprehensive income and its components. This mixed evidence may be attributed partially to the use of as if methodology to construct an ex-ante measure of other comprehensive income prior to the implementation of SFAS 130, which introduces measurement error. In contrast, this study uses actual data on other comprehensive income for a sample of Canadian firms cross-listed in the US in the period 1998–2003. We find evidence that available-for-sale and cash flow hedges components are significantly associated with price and market returns. We also find that aggregate comprehensive income is more strongly associated (in terms of explanatory power) with both stock price and returns compared to net income. However, we find that net income is a better predictor of future net income relative to comprehensive income. Our findings suggest that mandating all Canadian firms to adopt the new accounting standards is expected to enhance the usefulness of financial statements. Our findings, therefore, should be of interest to Canadian accounting policy makers as they provide ex-ante evidence on the potential usefulness of mandating firms to report comprehensive income and the components of other comprehensive income in their financial statements.     

How to improve IFRS for intangible assets? A milestone approach

This study focuses on the decreasing relevance of financial information associated with current financial reporting standards for intangible assets. We summarize and compare three approaches to improving financial reporting standards for internally generated intangibles—the recognition approach, the fair value approach and the disclosure approach, among which we focus on the recognition approach. We investigate the impact of current International Accounting Standard 38 on the R&D capitalization policies of the high-tech industry, particularly among medical device firms in China. We conclude that the current recognition criteria are so stringent that they disincentivize firms from capitalizing their R&D investments. A large variation exists in capitalization timing within the medical device industry. Accordingly, we propose the milestone approach to revising financial reporting standards for intangible assets. We suggest that determining the capitalization criteria for intangibles based on the R&D cycle and capitalization timing should be moved forward.     

What Explains the Valuation Difference between Intangible‐intensive Profit and Loss Firms?

Prior research suggests that loss firms are valued based on their abandonment/adaptation option values, while profit firms are valued as going concerns. However, conservative accounting treatment of expensing of R&D leads many R&D‐intensive firms to report losses even though they are not in financial distress. In this paper we investigate the difference in valuation of profit and loss firms that invest in intangibles, either through internal development (R&D) or purchases. The accounting treatment for internally developed intangibles is conservative in that US GAAP requires immediate expensing. Yet, it allows recognition of purchased intangibles. We find that in valuation of firms with high recognized‐intangible assets, book value has more prominence in loss firms than profit firms, while that is not the case for firms with high R&D expenditures. This suggests that their abandonment/adaptation option explains the difference in valuation between profit and loss firms with high recognized‐intangibles, while conservative accounting explains the valuation difference between profit and loss firms with high R&D intensity. This result suggests that recognition of intangibles in financial statements might mitigate the conservative bias in accounting numbers.     

Expensing stock-based payments: A material concern?

Using SFAS 123 disclosures, Botosan and Plumlee [Botosan, C., & Plumlee, M. (2001). Stock option expense: The sword of Damocles Revealed. Accounting Horizons, 15, 311-327] find that if stock-based compensation were to be expensed rather than not recognised on the face of financial statements, the impact on key measures used to assess the performance of the fastest growing US firms would be material. Street and Cereola [Street, D. L., & Cereola, S. (2004). Stock option compensation: impact of expense recognition on performance indicators of non-domestic companies listed in the U.S. Journal of International Accounting, Auditing and Taxation, 13, 21-37] subsequently also use SFAS 123 disclosures to determine that the average impact of expensing stock-based compensation on diluted EPS for non-US domiciled firms listed on US exchanges will be material and approximately 40%. In this paper, we examine whether these findings apply across international borders to firms that are required from 2005 to adopt IFRS 2 Share-Based Payment to expense stock-based payments, and across a broad range of industries and firms’ growth phases. Based on Australian Stock Exchange-listed firms’ 2002 stock-based compensation disclosures of the value of options granted to directors and the top 5 executives, the expensing of options will have a significant negative effect on approximately 20% of our sample firms’ financial performance ratios. It appears that the materiality of the impact is neither industry specific nor restricted to high growth firms. As the IFRS 2 expensing requirement extends to stock-based compensation issued to all employees, our findings are conservative estimates of the impact. The findings suggest that a stock-based compensation accounting policy change will affect recognised financial numbers and could have consequential ramifications for contractual specifications and valuations of firms across a range of industries and growth phases. Our sample of Australian firms provides an interesting context for the study, since these firms have neither traditionally expensed nor necessarily disclosed stock-based payments but from 2005, all stock-exchange listed Australian firms will be at the forefront of IFRS 2 adoption.     

Information content of mandatory quarterly foreign sales data of U.S. multinational companies under SFAS 131

This paper investigates the information content of mandatorily disclosed quarterly foreign sales data of U.S. multinational companies under SFAS No. 131. We examine two types of companies. Predisclosing companies had voluntarily disclosed quarterly foreign sales data prior to implementation of SFAS No. 131. Non-predisclosing companies had not voluntarily disclosed quarterly foreign sales data prior to implementation of SFAS No. 131. We analyze the behavior of stock prices surrounding the filing date of the 10Q using short-window event study methodology and the market model for the initial years after enacting SFAS No. 131. We discover that the quarterly foreign sales data has information content to investors for both predisclosing firms and non-predisclosing firms except for 1 year. The data has no information content for non-predisclosing companies during the first year of implementation of SFAS No. 131. Except for the first year of implementation of SFAS No. 131, we find no difference in the information content of this data between predisclosing and non-predisclosing companies.     

Transition Period of Mandated Accounting Changes — Timing of Adoption and Economic Consequences: The Case of SEAS No. 13

This study examines the economics of the timing of adoption of SFAS No. 13, Accounting for Leases by Lessees . We analyzed actual debt contracts of the affected firms to determine whether they were based on GAAP or Non-GAAP accounting rules. We also examined what actions were taken by management to alleviate the negative effects of complying with SFAS No. 13 . The results indicate that late adopters had a higher percentage of debt convenants based on GAAP measures, and that the late adopters would have experienced significant increases in closeness to default had they adopted SFAS No. 13 early. The results also indicate that by choosing late adoption, the firms were able to reduce the expected negative effects of the new accounting standard on financial statements.     

The relation between R&;D intensity and future market returns: does expensing versus capitalization matter?

The Australian accounting environment provides an ideal setting for examining the impact of different accounting treatments of firms’ R&D activities on their subsequent returns. Unlike US firms, which can only expense R&D, Australian GAAP permits firms to either expense or capitalize their R&D expenditure. We examine separately the market impact of the R&D intensity of all R&D active firms, ‘capitalizers’ and ‘expensers’. Our results suggest that firms with higher R&D intensity perform better, regardless of the accounting method used, consistent with the resource-based view of the firm. We also find some evidence that firms which expense R&D outperform those which capitalize R&D after controlling for R&D intensity.

The effect of management incentives and cross-listing status on the accounting treatment of R&D spending

This paper investigates the effect of management incentives and cross-listing status on the accounting treatment of research and development (R&D) spending for a sample of Canadian hi-tech and biopharmaceutical firms. U.S. GAAP adopts an immediate expensing rule for all R&D spending except for software development costs for which technological feasibility has been established. Contrary to the U.S., Canadian and international standard setters recommend capitalization if development costs meet certain criteria. Because those criteria are largely based on management judgment, capitalization of R&D spending is an accounting choice that can be used for income manipulation or signaling.Using a logit model, we examine how the decision to capitalize R&D spending is influenced by the cross-listing status and several other key firm characteristics that are well documented in the accounting literature. We find that the probability of capitalizing R&D spending increases for cross-listed and non-cross-listed firms in the software industry. The probability of capitalizing R&D spending also increases for firms that are more leveraged, more mature, and have higher level of cash flows from operations. However, the probability of capitalizing R&D spending decreases for larger corporations, firms with more concentrated ownership and highly profitable firms. Overall our results indicate a preference for Canadian firms in the software industry to emulate U.S. accounting practices for R&D spending. They also suggest that firms use the decision to capitalize or expense R&D spending as an earning management tool to either meet debt covenants or to smooth income.     

What is the After‐Tax Price of R&D? An Interstate Comparison*

As of 2005, 31 US states offered corporate income tax credits on research and development (R&D) expenses in order to encourage more in‐state innovation activities. Empirical questions about the efficacy of such tax breaks at the state level persist, in part because the complexity of the tax laws means that simple credit‐rate comparisons across states do not fully capture the differential variation in effective after‐tax price incentives firms face in choosing where to locate R&D activities. We are unaware of any research analysing and comparing the effective prices of R&D faced by firms, across all US states and utilising micro‐level data. Using data extracted from detailed reading of individual firms' 10‐K and S‐1 filings and of state‐level tax credit rules, we estimate the effective after‐tax price of basic and qualified research expenditure each firm would have faced in each of the 50 states had they been located there. Our methodology simulates the effective tax price of each firm's marginal dollar of research expenditure, assuming the firm chose to move all of its R&D operations to each of the 49 other states. Through Monte Carlo techniques, we consider the sensitivity of our interstate comparative results to several modelling assumptions. We find significant variation in after‐tax R&D prices across states with quite different R&D tax laws. Prices range from $0.176 to $0.520 on a marginal dollar of R&D in Virginia and Washington State, respectively. We also find that the interstate variability is generally more important – indeed, much wider than we had anticipated before investigating state‐by‐state regulations – than the inter‐firm variability within states.     

INTERNATIONAL DIFFERENCES IN RESEARCH AND DEVELOPMENT REPORTING PRACTICES: A FRENCH AND CANADIAN COMPARISON

This paper compares the research and development (R&D) disclosure practices in France and Canada, as evidenced in the annual reports of 76 French and 110 Canadian listed companies. It finds that Canadian high-tech companies (hardware, software, and biotechnology) disclose significantly more information on their R&D activities than their French counterparts. It also finds a strong link between R&D intensity and R&D disclosure among Canadian high-tech companies. Canadian companies overall are also found to be more likely to use non-financial disclosure as a means to resolve any R&D information asymmetry, while French firms disclose more traditional financial and accounting information. Canadian companies are also more willing than French firms to provide information concerning their future R&D expenditures. These results are consistent with inherent cultural and capital market differences between France and Canada. In contrast, the study does not find any significant difference in R&D expenditure capitalization policies between French and Canadian firms.     

Disclosure versus recognition: Evidence from lobbying behavior in response to SFAS No. 158

This study examines the lobbying behavior of firms following the release of the SFAS No. 158 exposure draft. SFAS No. 158 requires the recognition of previously disclosed net pension and postretirement benefit obligations on the balance sheet. The study documents that firms that lobbied against the pronouncement had large, underfunded plans and the decision to lobby was related to the magnitude of the SFAS No. 158 balance sheet adjustment. The findings have important implications for the recognition versus disclosure debate because they document management’s reaction to the relocation of information disclosed in the financial statement footnotes to its recognition on the balance sheet.     

The impact of SFAS No. 123(R) on financial statement conservatism

SFAS No. 123(R) requires firms to recognize the fair value of stock options as compensation expense over the vesting period of the options. Thus, SFAS No. 123(R) leads to an overall increase in financial statement conservatism. However, it is not known whether SFAS No. 123(R) increases conditional and/or unconditional conservatism. Because the different forms of conservatism have different implications for the quality of earnings, I investigate which types of conservatism are impacted by SFAS No. 123(R) to gain insight into the ramifications of the Standard. I find that SFAS No. 123(R) leads to an increase in both unconditional and conditional conservatism. I additionally find that the Standard causes an increased negative relation between contemporaneous economic gains and income. These findings hold outside of the sample period and under a non-priced based model of conservatism.     

The value-relevance of R&D and advertising expenditures: Evidence from Korea

This study examines the value-relevance of R&D and advertising expenditures of Korean firms, using a regression model based on the Ohlson [Contemp. Account. Res. (1995) 661] equity-valuation framework. Results indicate that R&D expenditures are positively associated with stock price, suggesting that capitalizing R&D expenditures is appropriate. The association is stronger for the portion of R&D expenditures that is capitalized, rather than expensed, suggesting that investors agree with management that the capitalized expenditures represent greater future economic benefits. Investors also appear to interpret fully expensed R&D expenditures as positive net present-value investments, however, suggesting that these expenditure should also be capitalized. Additional results indicate that advertising expenditures are negatively associated with stock price, and the magnitude of this negative association is similar to the association between other expenses and stock price. These findings suggest that investors believe the economic benefits of advertising expenditures expire in the current period, similar to other expenses.     

Do analysts follow emerging economy firms with higher intangible assets? Empirical evidence from Egypt

This paper tests whether analyst coverage and effort are related to the level of intangible assets reported by Egyptian listed firms. Intangible assets represent increasingly important investments for many firms, but most of these assets are not capitalized under prevailing accounting standards. Analysts reduce the information asymmetry by examining both financial reports and other information. Many Egyptian firms today seek access to foreign capital. I hypothesize that the larger the potential intangible assets of firms the more analysts will cover these firms and pursue private information about these firms. Sample consists of 435 firm-year observations over the period 1999–2007, and intangible assets are measured using eight different firm- and industry-level proxies. Consistent with prior research, results suggest that coverage is significantly associated with firm R&D, industry advertising expenses, firm size, and trading volume. Results also suggest that analyst effort is a function of firm and industry-level R&D expenses and firm size.