The impact of intangibles on firms’ financial and market performance: UK evidence

This study provides empirical evidence about the effect of intangible assets on firms’ current and future financial and market performance by utilizing a sample the UK FTSE 150 nonfinancial companies. Generally, the findings of this examination reported a strong evidence on the role of intangibles in boosting firms’ performance. In particular, the results indicate that while goodwill (GW) does have a statistically positive effect on firms’ current and future performance, research and development (R&D) is only associated with firms’ future performance. The results of the current research is consistent with the market-based and resources-based theories which posits that intangible investments are the main driving factors of wealth creation in the long-run; Specifically, R&D operations can create new technologies and products that would enhance firms’ performance and value. In addition, the results reveal that both GW and R&D can explain variations in firms’ financial performance measures suggesting that such investments can enhance firms’ earning leading to capitalization such earnings in the market value. Finally, the results of this research provide practical implication for policy makers and managers.     

Measuring the value of intangibles

We propose a new earnings-based measure for the value of intangibles. To validate this measure, we compare it to commonly used proxies for intangible intensity, such as R&D expenses. While R&D expenses measure the investment in new intangibles, our new measure gauges the productivity of already existing intangibles. We show that our new measure serves as an additional factor to explain firm value, measured either as market capitalization or acquisition prices in M&A transactions. Moreover, it captures the increasing importance of intangibles over time. Finally, we present a specific application of our intangible-intensity measure in the context of capital structure. We find that more intangible-intensive firms have lower leverage.     

Recognized intangibles and the present value of growth options

We investigate the relation of recognized intangibles, defined as acquired intangibles net of goodwill, and the market’s perception of firm growth options (PVGO). We find that: (a) on average recognized intangibles are positively associated with PVGO after controlling for intangible expenditures immediately expensed, firm specific characteristics, industry membership and systematic risk (b) the said relation is highly non-linear (negatively skewed) and more strongly pronounced in companies with lower accumulation of R&D Capital; recognized intangibles are not that significant at higher levels of PVGO and whereas firms have committed to in-house technological development, and (c) while adjusted levels of recognized intangibles increase approximately tenfold over the last 35 years their explanatory power to PVGO over the period generally wanes. Our results are informative for the interpretation of recognized intangibles as a summary balance sheet item and therefore useful to users of financial statements forming investment and credit decisions, to policy makers aiming at stimulating firm growth and to standard setters aiming at improving value relevance.     

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.     

Environmental R&D and the uncertainty of future earnings

This paper examines whether the variability in the future earnings stream generated by the investment in environmentally-related R&D projects is different than that created by the investment in other R&D projects. To carry out this investigation, I decompose total R&D expenditures into two components: those related to R&D projects aimed at reducing the firm’s costs to comply with environmental legislation (i.e., the environmental component), and those related to all other R&D projects, which are focused on increasing the firm’s revenues and/or decreasing its other operating costs (i.e., the residual component). As predicted, I find that the environmental component of R&D expenditures contributes significantly less to the variability of future earnings than the residual component.     

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.     

R&D investments,capital expenditures,and earnings thresholds

Prior studies find that firms cut research and development (R&D) expense in response to earnings considerations. We extend this stream of research by documenting that firms narrowly achieving an earnings threshold also report unusually high capital expenditures. In addition, these firms’ total investments (R&D expense plus capital expenditures) do not vary in response to earnings thresholds, which suggests that, on average, reductions in R&D expense are offset by concurrent increases in capital expenditures. Lastly, our research design allows us to infer that the increased capital expenditures are largely R&D investments that are capitalized instead of non-R&D capital expenditures, suggesting that overall investments in R&D are relatively unchanged.     

Capitalizing R&D expenses versus disclosing intangible information

We study how to improve the value-relevance of financial information for intangible-intensive firms by investigating two alternatives: capitalizing research and development (R&D) expenses and disclosing intangible information. Using patent counts/citations to proxy for intangible intensity, we find that the incremental value-relevance of disclosing patent counts/citations is greater than that of capitalizing R&D expenses for the high-patent group and vice versa for the low- or medium-patent group. Investors favor the disclosure of patent information for firms with more successful innovations. Since disclosing intangible information may lead to appropriation by rivals, we find that, for the high-patent group, the incremental value-relevance of disclosing patent counts/citations is more pronounced for firms in industries with stronger protection of intellectual property. Overall, our results suggest that disclosing R&D outputs can improve the value-relevance of financial statements for firms rich in intangibles and the incremental benefits of such disclosure will be greater in industries with strong protection of intellectual property.     

Shareholder governance, bondholder governance, and managerial risk-taking

We examine the relation between the overall corporate governance structure and managerial risk-taking behavior. We find that the overall governance structure has a significant impact on how managers make decisions on investment policy: strong bondholder governance motivates more low-risk investments such as capital expenditure and lower high-risk investments such as R&D expenditures, whereas weak shareholder governance (entrenched managers) leads to more R&D expenditures. Moreover, we find that the effects of governance on investment policy differ significantly between speculative and investment-grade firms. For speculative firms, strong bondholder or shareholder governance leads to more capital expenditures and low R&D investments. For investment-grade firms, strong bondholder or shareholder governance leads to low capital expenditures and an insignificant impact on R&D investments. Furthermore, financing and investment covenants exhibit strong binding power to deter risky investments. Finally, a more dependent (or a less independent) board is associated with low capital expenditures and high R&D investments.     

High-Technology Intangibles and Analysts' Forecasts

This study examines the association between firms' intangible assets and properties of the information contained in analysts' earnings forecasts. We hypothesize that analysts will supplement firms' financial information by placing greater relative emphasis on their own private (or idiosyncratic) information when deriving their earnings forecasts for firms with significant intangible assets. Our evidence is consistent with this hypothesis. We find that the consensus in analysts' forecasts, measured as the correlation in analysts' forecast errors, is negatively associated with a firm's level of intangible assets. This result is robust to controlling for analyst uncertainty about a firm's future earnings, which we also find to be higher for firms with high levels of internally generated (and expensed) intangibles. Given that analyst uncertainty increases and analyst consensus decreases with the level of a firm's intangible assets, we also expect and find that the degree to which the mean forecast aggregates private information and is more accurate than an individual analyst's forecast increases with a firm's intangible assets. Finally, additional analysis reveals that lower levels of analyst consensus are associated with high-technology manufacturing companies, and that this association is explained by the relatively high R&D expenditures made by these firms. Overall, our results are consistent with financial analysts augmenting the financial reporting systems of firms with higher levels of intangible assets (in terms of contributing to more accurate earnings expectations), particularly R&D-driven high-tech manufacturers.     

Board reforms and innovation

We study the effect of board reforms on firms' research and development (R&D) investments utilizing a sample of 41 countries. Using a difference-in-differences analysis, we find that firms invest more in R&D following corporate governance reforms. Of these, two legal reforms — having an independent audit committee and board independence — have a greater impact on R&D investment. Additionally, we show that board reforms have a more pronounced effect on R&D investment in hi-tech industries and the health sector.     

Law,Stock Markets,and Innovation

We study a broad sample of firms across 32 countries and find that strong shareholder protections and better access to stock market financing lead to substantially higher long‐run rates of R&D investment, particularly in small firms, but are unimportant for fixed capital investment. Credit market development has a modest impact on fixed investment but no impact on R&D. These findings connect law and stock markets with innovative activities key to economic growth, and show that legal rules and financial developments affecting the availability of external equity financing are particularly important for risky, intangible investments not easily financed with debt.     

Corporate Governance and Its Impact on R&D Investment in Emerging Markets

Corporate R&D activities are inherently risky but also difficult to monitor. Against this background, we examine the impact of ownership concentration and legal shareholder rights protection on corporate R&D investments in emerging markets. Based on a comprehensive sample of publicly listed firms from 24 countries, we find that R&D intensity is lower in firms with (strategic) block ownership, and this effect is more pronounced in countries with stronger shareholder rights protection. This suggests that, similar to the situation in developed economies, dispersed ownership, which allows shareholders to diversify their investment risks, is beneficial for corporate R&D and that this effect is intensified by more developed institutions.     

Investment policy in family controlled firms

We explore the relation between family ownership and corporate investment policy. Our analysis centers on two incentives, risk aversion and extended investment horizons, which potentially influence the level and type of investments that family firms undertake. We find that family firms devote less capital to long-term investments than firms with diffuse ownership structures. When dividing long-term investment into its two components of R&D and capital expenditures, we note that family firms, relative to nonfamily firms, prefer investing in physical assets relative to riskier R&D projects. Additional tests indicate that family firms receive fewer patent citations per dollar of R&D investment relative to nonfamily firms. Overall, all empirical results indicate that family preferences for lower firm risk, across all family sub-types, affects corporate R&D spending and capital expenditures.     

Intangible Assets, Information Complexity, and Analysts' Earnings Forecasts

Abstract:   We examine the relation between analysts' earnings forecasts and firms' intangible assets, including technology‐based intangibles, brand names, and recognized intangibles. We predict that high information complexity of intangible assets increases the difficulty for analysts to assimilate information and increases analysts' forecast error of intangibles‐intensive firms. We find a positive association between analysts' forecast error and the firm's intangible intensity that deviates from the industry norm. We also find that analysts' forecast errors are greater for firms with diverse and innovative technologies. In contrast, analysts' forecast errors are smaller for biotech/pharmaceutical and medical equipment firms that are subject to intangibles‐related regulation.     

The effect of R&D on future returns and earnings forecasts

Prior studies attribute the future excess returns of research and development activity (R&D) firms to either compensation for increased risk or to mispricing. We suggest a third explanation and show that neither the level of R&D investment nor the change in R&D investment explains future returns. Rather, the positive future returns that prior studies attribute to R&D investment are actually due to the component of the R&D firm??s realized return that is unrelated to R&D investment but present in R&D firms. Our results suggest that the excess returns of R&D firms are part of the larger value/growth anomaly. In addition, we show that while future earnings are positively associated with current R&D, errors in earnings expectations by investors and analysts are not related to R&D investment.     

R&D sensitivity to asset sale proceeds: New evidence on financing constraints and intangible investment

We examine the intersection between corporate divestitures of tangible assets and investment in intangible capital (R&D) to provide new tests for the impact financing constraints have on real activity. A positive R&D sensitivity to asset sale proceeds indicates binding financing constraints since cash inflows from tangible asset sales are negatively correlated with productivity shocks and not otherwise connected to intangible investment via non-financial channels. Using a variety of estimation approaches, we document a strong, positive link between cash inflows from fixed asset sales and corporate R&D investment, but only among firms most likely facing binding financing constraints. These results offer robust evidence that financing frictions impact the increasingly important yet understudied intangible corporate investments that drive innovative activity, and they highlight a previously unexplored but potentially valuable use of proceeds from fixed asset divestitures.     

The effect of capital market pressures on the association between R&;D spending and CEO option compensation

We examine the effect of capital market pressures for meeting earnings benchmarks on the relationship between R&D spending and CEO option compensation. We consider a particular scenario when firms face small earnings declines but could opportunistically reduce R&D spending to increase reported earnings. We find that firms with income reporting concerns punish their CEOs with lower option compensation when R&D spending increases but reported earnings decreases. Further, for firms with income reporting concerns, we find that the penalty for increasing R&D is greater when the firms frequently miss quarterly earnings benchmarks in the year. Overall, our findings suggest that the adverse consequence on CEO options encourages short-run compensation-motivated actions to eliminate or postpone R&D projects with positive net present values.     

Firm strategy and market reaction to earnings

We examine whether a firm's strategy affects the information content of the firm's earnings announcement. A cost leadership strategy is characterized by low sales margins coupled with large sales volumes, economies of scale and major investments in plant and physical assets, whereas a differentiation strategy involves high sales margins achieved through product quality and branding realized by investments in intangibles such as R&D and advertising. These characteristics of the strategies result in differential impact on investor reactions to new information that is revealed about firms. Our results show that firms pursuing a cost leadership strategy have earnings announcements that are more commonly interpreted and result in a greater change in the average belief about stock price. On the other hand, earnings announcements of firms pursuing a differentiation strategy result in more heterogeneous interpretation accompanied by a smaller change in the average belief about stock price. This paper advances our understanding of the cross-sectional variation in the market's reaction to earnings announcements. In addition, the paper demonstrates a predictable instance of divergence in the price reaction and trading volume reaction to an earnings announcement.     

Legal shareholder protection and corporate R&D investment

This paper investigates the effects of shareholder protection law on corporate R&D investment. I find that the institutional protection of shareholder benefits reduces both underinvestment and overinvestment in R&D projects. Legal shareholder rights significantly increase R&D investment for firms that may underinvest, but reduce R&D for firms that may overinvest. Shareholder protection further enhances the growth of firms in R&D intensive industries, and promotes the economic growth of innovative countries. The results consistently show that enforcing stronger legal shareholder protection can help firms achieve an overall more efficient capital allocation to productive R&D investment.