Market Reaction to Proposed Changes in Accounting for Purchased Research and Development in R&D-Intensive Industries

Abstract

Many allege that the accounting profession has failed to adapt to fundamental changes in the business environment because it has not developed timely guidance for reporting intangible assets. Regulatory attention has also focused on the disclosure companies make with respect to intangible assets. Accounting for the value of intangible assets acquired in a merger transaction is a key component of this issue. Specifically, the Securities and Exchange Commission (SEC) alleged that companies routinely overstated the amount allocated to purchased in-process research and development (IPR&D) and stated that the SEC would take steps to enforce generally accepted accounting principles (GAAP) to eliminate abuses of GAAP with respect to IPR&D. Others alleged that the SEC was creating GAAP, that they were unfairly singling out certain industries, and that they were unfairly generalizing abuses made by a few firms to the actions of many firms. In other words, competing hypotheses emerged with the first suggesting that the accounting treatment of IPR&D by companies was improper, while the second suggests that the SEC was establishing new accounting standards without carefully considering the issues. This research examines the stock-price reaction for industry groups that are R&D intensive to proposed changes in accounting for IPR&D. We estimate the shareholder wealth effects associated with a series of events that indicate a potential regulatory change in accounting for IPR&D to infer the capital market's assessment as to whether the problem with IPR&D is inappropriate accounting on the part of companies, or inappropriate policy and enforcement on the part of the SEC and the Financial Accounting Standards Board (FASB). The results show that the stock prices of firms in R&D-intensive industries react negatively, on average, to events that increase the probability of new rules restricting IPR&D charges or that increase the expected degree of SEC scrutiny of these charges. However, the FASB announcement that there would be no immediate changes required in accounting for IPR&D produces a positive market reaction. The results support the theory that investors perceive limitations in reporting IPR&D as detrimental to the evaluation of the present value of R&D intensive firms' future cash flows, indicating that the market is more concerned about increased regulation of IPR&D than about the reliability of accounting estimates. Cross-sectional analysis examines four firm-specific variables: firm size, R&D expenses, recent acquisitions, and industry membership. Results indicate that the predicted reactions are strongest for firms with historically high R&D expenses and specifically those in the software industry. Larger firms and those with experience in acquiring firms with current R&D expense are less negatively affected by a call for the financial community to participate in reducing IPR&D charges. Finally, results indicate that firms having the greatest exposure to regulators' concerns have the most negative valuation impact.