Intangible Assets and Equity Valuation in the Pre-SEC Era

Abstract

Some have recently called for expanded reporting of intangible asset values asserting that their limited recognition under U.S. GAAP has eroded the usefulness of financial statements. In response to this interest, accounting researchers have sought to provide empirical evidence on the role of intangibles in equity valuation. Aboody and Lev [1998] document that the software development cost assets which some firms elect to capitalize under SFAS 86 are positively related to share prices. Extending this research to other intangibles is difficult since U.S. GAAP takes a conservative view towards recognition of such assets. Consequently, other studies have examined off-balance sheet measures of intangible asset values (see Lev and Sougiannis [1996], Barth, et al. [1998], and Ittner and Larcker [1998]) or data from other countries where firms face less restrictive reporting rules (see Barth and Clinch [1998]). We contribute to this literature by investigating the role of intangibles in equity valuation under a reporting regime where managers are allowed virtually unrestricted discretion to capitalize intangible assets. Our sample consists of firms with common equity traded on the New York Stock Exchange (NYSE) in the 1920's. These firms operated in a reporting environment which permitted managers broad discretion to initially capitalize intangibles, determine subsequent amortization and revaluation policies, and structure supplementary disclosures (if any). Consequently, pre-SEC industrials firms reported a broad range of intangibles with material carrying amounts on their balance sheets. We investigate the value-relevance of intangible assets using valuation models where intangibles play two possible roles in equity valuation. The first is a direct role where intangibles can map positively into share price and the second is an interactive role where the level of intangibles conditions investor evaluation of reported earnings. If investors perceive capitalized intangibles to be legitimate assets, their carrying values will be positively related to share price. Alternatively, if investors view the capitalization of intangibles as a means for managers to overstate reported earnings, then the coefficient mapping earnings into price will decline as the level of capitalized intangibles increases. The results from our primary tests indicate no significant positive relation between capitalized intangibles and share prices. We do find evidence that the coefficient relating earnings to share price decreases with the level of capitalized intangibles, consistent with a perception by investors that managers may overstate earnings by capitalizing intangibles. We also document that separate reporting for intangible assets strengthens the relation between price and summary balance sheet measures. Book value is not significantly related to share price but the coefficient mapping tangible book value into share price is positive and highly significant when intangibles are disaggregated from book value. Finally, earnings are a highly significant determinant of equity price suggesting that, at least for our sample, investors may identify the existence of economically relevant intangibles on the basis of reported earnings rather than carrying values for intangibles reported in the balance sheet.