The relationship between R&D intensity,conservatism, and management earnings forecast issuance

R&D-intensive firms suffer from high information asymmetry and high proprietary costs and are prone to exhibit bottom-line losses given the unconditional conservative accounting treatment of R&D expenses. We examine how R&D intensity influences the issuance of management earnings forecasts (MEFs) across levels of accounting conservatism, controlling for proprietary costs and other earnings guidance determinants. We provide insights into how managers view the tradeoffs of using MEF disclosures to lower information asymmetry versus the costs of releasing proprietary information to competitors and the loss of reputational capital that could arise from providing inaccurate forecasts. We find that although R&D intensity and conditional conservatism are negatively related to the issuance of MEFs, as shown in prior research, at high levels of research intensity and the accompanying uncertainty about future payoffs, the negative association between conditional conservatism and MEF issuance is mitigated. These findings point to a role for conditional conservatism as a credibility enhancer for managers of R&D intense firms.     

R&D capitalization and audit fees: Evidence from China

Our study investigates the association between capitalized R&D costs and audit fees and whether this association reflects the effect of earnings management. By exploring Chinese listed firms, we find that capitalized R&D costs are positively associated with audit fees, where such positive association holds for both the discretionary and nondiscretionary portions of capitalized R&D costs. Moreover, the positive association between the discretionary portion of capitalized R&D costs and audit fees is more pronounced for firms with stronger incentives to manipulate earnings. Overall, our findings imply that firms' reporting incentives affect how auditors react to clients' accounting choices. This in turn suggests that auditors believe some firms capitalize R&D to manipulate earnings, and the resulting earnings-management concerns lead them to charge higher fees.     

The value relevance of R&D across profit and loss firms

We examine whether the valuation relevance of R&D documented for loss firms extends to profit firms. We use the residual-income valuation model and show that the valuation multiplier on R&D expenditures is likely to be negative (positive) for profit (loss) firms. This occurs because the linear information dynamics assumption of the residual-income model is more appropriate for profit firms than loss firms. Earnings of profit firms are likely to contain information on the future benefits of R&D activity, however, earnings of loss firms do not contain such information. The empirical evidence confirms our predictions for profit and loss firms. An important implication of our findings is that understanding the role of the R&D expense line item in valuation across firms and within firms, across time depends on whether the linear information dynamics assumption of the residual-income model is applicable for the sample of firms under investigation.     

Valuation of Internet Stocks—An IPO Perspective

We empirically investigate valuations of Internet firms at various stages of the initial public offering (IPO) from two perspectives. First, we examine the association between the valuation of Internet IPOs and a set of financial and nonfinancial variables, which prior anecdotal or empirical evidence suggests may serve as value drivers. Second, we document differences in IPO valuations between Internet and non-Internet firms as well as across different stages in the IPO process—i.e., initial prospectus price, final offer price, and first trading day price—within each set of firms. Our primary two conclusions are as follows. First, there are noticeable differences between valuations of Internet and non-Internet firms, especially at the prospectus and final IPO stage. Specifically, the valuation of non-Internet firms generally follows the conventional wisdom regarding valuation: positive earnings and cash flows are priced, while negative earnings and negative cash flows are not. The valuation of Internet firms, however, departs from conventional wisdom, with earnings not being priced, and negative cash flows being priced perhaps because they are viewed as investments. This difference between the two classes of firms may be expected, given the age and unique nature of the Internet industry. Second, there are significant differences between the initial valuation of firms at the prospectus and IPO stage and their valuation by the stock market at the end of the first trading day. For non-Internet firms, the difference is largely ascribed to the relative offering size. For Internet firms, however, the differences are with respect to positive cash flows, sales growth, R&D, and high-risk warnings, in addition to the relative offering size.     

Using real options theory to explain patterns in the valuation of research and development expenditures

Real options theory posits that the value of the firm is a combination of the value generated by the assets in place and the value of the option to invest in the future. It is based on the idea that many decisions are difficult to reverse, and valuing the outcome of these decisions is more complicated than estimating the present value of future cash flows. R&D activities often generate real options due to the nature of these activities, and examining the valuation of R&D expenditures through the lens of real options theory can help explain differing results documented in both the R&D and value relevance of earnings and book value literatures. Numerous studies have documented that the stock market positively values R&D expenditures; however, recent work has raised questions about whether this positive relation occurs across firms reporting both profits and losses. Consistent with real options theory, I find that the negative coefficient on the R&D expenditures of profitable firms documented by prior studies only exists for low growth firms. In addition, for all R&D firms experiencing high sales growth, the market places a lower value on assets in place and a higher value on R&D expenditures.     

Costly trade,managerial myopia,and long-term investment

The costly trade theory predicts that it is much more difficult to exploit long-term private information than short-term. Thus, there is less long-term information impounded in prices. The managerial myopia theory predicts that a variety of short-term pressures, including inadequate information on long-term projects, cause asymmetrically-informed corporate managers to underinvest in long-term projects. The introduction of long-term options called LEAPS provides a natural experiment to jointly test both theories, which are otherwise difficult to test. We conduct an event study around the introduction of LEAPS for a given stock and test whether corporate investment in long-term R&D/sales increases in the years following the introduction. We find that over a two year period of time LEAPS firms increase their R&D/sales between 23% and 28% ($125–$152 million annually) compared to matching non-LEAPS firms. The difference depends on the matching technique used. Two other proxies for long-term investment find similar increases. We find that the increase is positively related to LEAPS volume. We also find that the increase is larger in firms where R&D plays a larger and more strategic role. We test if a firm becomes less likely to beat analyst's quarterly earnings forecasts after LEAPS are introduced and find support for the hypothesis. These results provide both statistically and economically significant support for the costly trade and managerial myopia theories.     

Voluntary disclosure and its impact on share prices: Evidence from the UK biotechnology sector

In the UK, SSAP 13 requires that firms immediately expense most of their R&D expenditures. The reported earnings of high-R&D expenditure firms are therefore likely to convey less value-relevant information to investors than those of less research-intensive firms. Using a sample of firms from the high-R&D UK biotechnology/pharmaceutical sector, we find that earnings announcements have a much lower price impact than drug development announcements. We also find that there are significantly more ‘good news’ voluntary announcements than ‘bad news’ announcements. Furthermore, our findings indicate that these firms are more likely to announce late than early stage developments, and that the pattern of disclosures, and the market’s reaction to them, varies between larger, dominant firms and their smaller counterparts.     

Credit Ratings and Earnings Management around IPOs

This study examines the impact of having a credit rating on earnings management (EM) through accruals and real activities manipulation by initial public offering (IPO) firms. We find that firms going public with a credit rating are less likely to engage in income‐enhancing accrual‐based and real EM in the offering year. The monitoring by a credit rating agency (CRA) and the reduced information asymmetry due to the provision of a credit rating disincentivise rated issuers from managing earnings. We also suggest that the participation of a reputable auditing firm is crucial for CRAs to effectively restrain EM. Moreover, we document that for unrated issuers, at‐issue income‐increasing EM is not linked to future earnings and is negatively related to post‐issue long‐run stock performance. However, for rated issuers, at‐issue income‐increasing EM is positively associated with subsequent accounting performance and is unrelated to long‐run stock performance following the offering. The evidence indicates that managers in unrated firms generally manipulate earnings to mislead investors, while managers in rated firms tend to exercise their accounting and operating discretion for informative purposes.     

Accounting choice and future performance: The case of R&D accounting in France

We examine whether managers’ decisions to capitalize or expense R&D expenditures convey information about the future performance of the firm. Focusing on a French setting where managers can choose to capitalize R&D expenditures under certain circumstances, we find that, after controlling for industry effects, firms that capitalize R&D expenditures spend less on R&D, have more volatile R&D efforts, and are smaller and more leveraged than firms that expense R&D expenditures. We also find that capitalizers capitalize R&D outlays when they need to meet or beat thresholds. Finally, we show that the decision to capitalize R&D is generally associated with a negative or neutral impact on future performance, even after controlling for self-selection. Our results also show that when firms both capitalize and expense R&D expenditures, the expensed portion exhibits a stronger (and negative) relationship with future performance. Market-based tests corroborate these findings. While we cannot unambiguously establish whether our findings imply that management uses R&D capitalization to manage earnings or because it is unable to estimate the earning power of R&D projects, our results suggest that management is unable to truthfully convey information about future performance through its decision to capitalize R&D. Our findings, based on real data as opposed to simulated data, therefore contrast with previous supportive evidence in favor of capitalization in the literature.     

The incidence of earnings management on information asymmetry in an uncertain environment: Some Canadian evidence

In this study, we investigate the association between earnings management and information asymmetry considering environmental uncertainty. Results show that a complex and dynamic environment weakens the relationship between discretionary accruals and information asymmetry measured as share price volatility and bid-ask spread. More specifically, the positive relationship between earnings management and information asymmetry is weakened for diversified firms, those intensively investing in R&D, and those facing high sales volatility. This highlights the difficulty for investors to assess earnings management in an uncertain environment. Finally, in such a context, discretionary accruals are more likely to be detected by investors for firms cross-listed on a U.S. stock exchange, a more liquid and transparent stock market compared with the Canadian stock market.     

Conservatism, Growth and the Role of Accounting Numbers in the Fundamental Analysis Process

I evaluate the effects of conservative accounting for research and development (R&D) and past growth in R&D on: (1) the relation between aggregate earnings (deflated by price) and contemporaneous stock return, and (2) the association between estimates of value derived from the residual income valuation model (i.e., RIV estimates) and equity market value. I show that the conservative treatment of R&D affects the earnings/return relation only for firms that experience high growth in R&D during the return interval of interest. I also demonstrate that the effect of conservative accounting for R&D on the association between RIV estimates and equity market values is increasing in past growth in R&D.This revised version was published online in August 2005 with a corrected cover date.     

Boards,takeover protection,and real earnings management

We investigate the effect of board governance and takeover protection on real earnings management. Four types of real earnings management are considered: sales manipulation, overproduction, the abnormal reduction of research and development (R&D) expenses, and the abnormal reduction of other discretionary expenditures. Using panel data from US public firms in the post-Sarbanes–Oxley Act period, we find that the level of real earnings management (sales manipulation, abnormal declines in R&D expenses, and other discretionary expenses) increases with better board governance and decreases with higher takeover protection. These two governance factors generally have no significant effect on overproduction. We further find that firms substitute accrual-based earnings management with sales manipulation and abnormal cuts in discretionary expenses, and the substitution effect is more pronounced in firms with stronger board governance. Overall, our findings indicate that the level of real earnings management is higher when a firm is faced with tough board monitoring, and that takeover protection may reduce managerial incentives for real earnings management.     

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.     

The size,concentration and evolution of corporate R&D spending in U.S. firms from 1976 to 2010: Evidence and implications

The use of research and development (R&D) spending as an empirical proxy for managerial discretion, information asymmetry and growth opportunities, is pervasive in empirical corporate finance research. Underlying this is the implicit assumption that firms choose levels of R&D to maximize value, given firm and industry characteristics. An alternative framework views the level of R&D spending as subject to idiosyncratic behavior as managers myopically manipulate R&D expenditures to meet short-term earnings goals. Using aggregate firm and industry level data, we find evidence consistent with the view that R&D is determined by firm and industry characteristics. Time invariant firm and industry fixed effects explain most of the cross-sectional variation in observed R&D spending, while time-varying factors like size, profitability, or market-to-book explain little of the cross-sectional variation. We find that R&D spending continues to grow faster than advertising and capital expenditures. We also find no evidence of managerial myopia as corporate aggregate R&D expenditures are growing faster than aggregate profitability and the number of firms that undertake R&D has increased over the period from 1976 to 2010.     

A Comparative Analysis of Real and Accrual Earnings Management around Initial Public Offerings under Different Regulatory Environments

While earnings management around IPOs has been researched in a number of settings, there has been a relative absence of work that analyses the impact of the regulatory environment on such activities. We find that the regulatory environment does impact the real and accrual earnings management activities of IPO firms. Our results show that IPO firms listing on the lightly regulated UK Alternative Investment Market (AIM) have higher (lower) levels of accrual‐based and sales‐based (discretionary expenses‐based) earnings management around the IPO than firms listing on the more heavily regulated Main market in the UK.     

IPO Underpricing, Firm Quality, and Analyst Forecasts

We find that IPO underpricing is positively related to post-IPO growth in sales and EBITDA, but is not significantly related to growth in earnings. Our evidence suggests that accrual reversals or earnings management may cause this inconsistency. We interpret the growth rates of sales and EBITDA as measures of firm quality, and conclude that our evidence supports the notion that IPO firms with greater underpricing are of better quality. Our tests on analysts' earnings forecast errors show that analysts are less positively biased in their earnings forecasts for IPO firms that have greater underpricing.     

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.     

Investment efficiency: Dual-class vs. Single-class firms

This study examines the effects of a dual-class structure on investment efficiency. Agency theory suggests that a dual-class structure exacerbates agency problems, leading to under- or overinvestment, but another view posits that the dual-class structure insulates managers from the pressure of the marketplace or activist investors seeking short-term profits. We find that dual-class firms invest more efficiently than single-class peers. This effect is more pronounced among firms with less transparent investments such as R&D. Our findings are robust to a propensity score matching approach and a setting where single-class firms recapitalize with dual-class shares. Furthermore, we find that among firms most at risk of overinvestment, dual-class firms have higher future accounting profitability and less volatile future returns.     

Growth opportunities,short-term market pressure,and dual-class share structure

We test the hypothesis that dual-class shares can help managers focus on the implementation of long-term projects while avoiding short-term market pressure. Consistent with this idea, we find that dual-class firms face lower short-term market pressure (fewer transient or short-term institutional holdings, a lower probability of being taken over, and lower analyst coverage) than propensity-matched single-class firms. Dual-class firms also tend to have more growth opportunities (higher sales growth and R&D intensity). The dual-class share structure increases the market valuation of high growth firms, in contrast to the finding in the literature that dual-class firms trade at lower valuations. To address endogeneity concerns, we evaluate a sample of dual-class share unifications and find that growth opportunities decline while short-term market pressure increases after share unifications.     

Regulations,earnings management,and post-IPO performance: The Chinese evidence

In this study, we examine whether government regulatory initiatives in China involving IPO by SOEs may have contributed to opportunistic behaviors by the issuer. We focus on two sets of IPO regulations issued between January 1, 1996 and February 11, 1999: pricing regulations, which stipulate that IPO prices be a function of accounting performance, and penalty regulations, which penalize IPO firms for overly optimistic forecasts. We find that IPO firms that report better pricing-period accounting performance have larger declines in post-IPO profitability, lower first-day stock returns and worse long-run post-IPO stock performance. Furthermore, IPO firms that make overoptimistic forecasts also have lower first-day returns and worse post-IPO stock performance. Using non-core earnings as the proxy for earnings management, we document some evidence that IPO firms that report higher pricing-period accounting performance have engaged in more income-increasing earnings management. Hence, pricing regulations may have induced IPO firms to inflate pricing-period earnings and affect the post-IPO performance negatively. On the other hand, penalty regulations have deterred IPO firms from making overoptimistic earnings forecast and therefore have a positive impact on the behavior of IPO firms.