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Review of Quantitative Finance and Accounting

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01.04.2016 | Original Research

Capitalizing R&D expenses versus disclosing intangible information

verfasst von: Mustafa Ciftci, Nan Zhou

Erschienen in: Review of Quantitative Finance and Accounting | Ausgabe 3/2016

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Abstract

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.

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This is part of the Norwalk Agreement. On Sept. 18, 2002, in Norwalk, Connecticut, FASB and IASB met and issued a Memorandum of Understanding, outlining plans to converge US GAAP and IFRS into one set of high quality and compatible standards.

Completing the February 2006 Memorandum of Understanding: A progress report and timetable for completion (FASB, September 2008). http://www.fasb.org/intl/MOU_09-11-08.pdf.

http://www.ifrs.org/Current-Projects/IASB-Projects/Intangible-Assets/Summaries/Pages/IASB-December-2007.aspx.

http://www.ifrs.org/Current-Projects/IASB-Projects/Intangible-Assets/Pages/Intangible-Assets.aspx#.

http://www.iasplus.com/en/projects/research/intangible-assets.

AIMR rankings are based on the annual survey of financial analysts’ rankings of US firms’ disclosure activities by the Association for Investment Management and Research (AIMR). AIMR has changed its name to CFA institute.

Issued in 1998 and revised in 2004, IAS 38 has been further amended in 2008, 2009, and 2013, according to the history of IAS 38 at http://www.iasplus.com/en-us/standards/ias/ias38.

Our results are very similar, if we use R-squared rather than adjusted R-squared in all our analyses.

We measure intangibles using the NBER (National Bureau of Economic Research) Patent Data described in Hall et al. (2001).

The result based on patent counts is qualitatively similar.

The NBER Patent Data is compiled based on filings to the United States Patent and Trademark Office (USPTO). While patent information is available from USPTO, it is very difficult for individual investors to analyze such information due to the lack of technical expertise. On the contrary, institutional investors can generate such information not disclosed the financial statements by either conducting research in house or purchasing research reports from financial analysts. Therefore, the disadvantage of individual investors may be reduced if firms are required to disclose patent related information.

Amir and Lev (1996) use same approach for nonfinancial assets such as population growth and market penetration ratios are value-relevant for wireless communication. They show that these assets have incremental value-relevance beyond earnings and book values and argue that these assets complement accounting information in the financial statements.

The recent patent auction by the bankrupt telecommunication firm Nortel illustrates the magnitude of those unreported intangibles in the financial statements. On July 1, 2011, Nortel sold some 6,000 patents and patent applications for $4.5 billion to a coalition of companies comprised of Apple, EMC, Ericsson, Microsoft, RIM, and Sony (http://www.reuters.com/article/2011/07/01/us-nortel-idUSTRE7600PF20110701).

The survey scores are obtained from Table 1 of Cohen et al. (2000) which use ISIC to classify the industries. We convert ISIC to SIC using the mapping in Appendix A of Erkens (2011). We restrict this section of analyses to manufacturing firms, because the survey scores in Cohen et al. (2000) are available only for manufacturing industries.

The debate between disclosure versus recognition has also been studied in other accounting settings, such as pension accounting (Gopalakrishnan 1994) and stock option accounting (Cheng and Smith 2013).

SFAS No. 86 requires capitalization of software development costs after reaching technical feasibility. It is the only exception to immediate expensing of R&D in the US We do not restrict our study to the software industry for two reasons. First, while capitalization of software development costs is required, some firms never capitalize these costs (Mohd 2005). Consequently, there is a wide variation in the software industry about capitalization decisions and rates. Second, if we only use the software industry in our analyses, the results may not be generalizable to other industries as there is a wide industry variation in the number of years that R&D generates future benefits (Lev and Sougiannis 1996). .

Reproduced as Exhibit 6.3 on page 133 of Mard et al. (2002).

Available at http://www.nber.org/patents.

We obtain very similar results, when we winsorize the extreme observations at the top and bottom 1.5 percentage of earnings-to-price ratio and book value-to-market value ratio.

Comparable to that for the low-, medium-, and high group of patent counts (citations), the number of observations for the no-patent subgroups is 10,373 (10,709) for analyses based on patent counts (citations).

The result based on patent counts is qualitatively similar.

Collins et al. (1997, p. 59) measure R&D intangible intensity based on SIC codes. Any firm in one of the following SIC codes is considered intangible-intensive: 282 plastics and synthetic materials; 283 drugs; 357 computer and office equipment; 367 electronics components and accessories; 48 communications; 73 business services; 87 engineering, accounting, R&D and management related services. When we separate firms into the intangible-intensive group and the non-intangible-intensive group based on the Collins et al. measure, we also find that there is no difference in value-relevance between the two groups.

Assuming that the research asset has a five-year life, we cumulate 1/5 of the R&D expenses from four years ago, 2/5 of the R & D expenses from three years ago, 3/5 of the R&D expenses from two years ago, 4/5 of the R&D expenses from last year, and this year’s entire R&D expense to arrive at the capitalized research asset.

In our paper, we capitalize R&D using a hypothetical 20 % amortization rate which has been used by many studies in the literature (e.g., Chan et al. 2001; Ciftci et al. 2011). Since some software firms may have capitalized part of their software development costs under SFAS No. 86, including software firms may cause double capitalization for these firms. To avoid potential double capitalization, we replicate Table 4 by excluding the software industry (4-digit SIC = 7370–7374). Since the results without the software industry are similar to those reported in Table 4, we conclude that our inferences are not affected by the capitalization issue in the software industry.

Note that the Vuong test is also used by Chambers et al. (2003; Table 2, p. 90) to compare the R-squared from R&D capitalization with the R-squared from R&D expensing.

By replacing unadjusted EPS and BVPS with adjusted EPS and BVPS (adjusted for capitalizing R&D expenses), we have the following Eq. (6).

${\text{PRC}}_{\text{it}} = {\text{ a}}_{0} + {\text{ a}}_{ 1} {\text{EPSAJ}}_{\text{it}} + {\text{ a}}_{ 2} {\text{BVPSAJ}}_{\text{it}} + {\text{ a}}_{ 3} {\text{LP }}\left( {\text{LC}} \right)_{\text{it}} + {\text{ IND }} + \,\upvarepsilon_{\text{it}} \quad (6)$

The results based on Eq. (6) are very similar to those Table 6 results based on Eq. (5) with unadjusted EPS and BVPS.

In Table 8, we study the incremental value-relevance from the disclosure regime to the joint capitalization- and disclosure regime. As a robustness check, we consider an alternative path. We examine the incremental value-relevance from the capitalization regime to the joint capitalization- and disclosure regime, and find that such incremental value-relevance pertaining to disclosure is economically significant for the high-patent group but not for the low- and medium-patent group. Our results suggest that disclosing patent information improves value-relevance for firms rich in intangibles but does not make a difference for firms with fewer patents. These findings are consistent with those reported in Table 8.

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Titel: Capitalizing R&D expenses versus disclosing intangible information
verfasst von: Mustafa Ciftci
Nan Zhou
Publikationsdatum: 01.04.2016
Verlag: Springer US
Erschienen in: Review of Quantitative Finance and Accounting / Ausgabe 3/2016
Print ISSN: 0924-865X
Elektronische ISSN: 1573-7179
DOI: https://doi.org/10.1007/s11156-014-0482-0

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