The Effect of R&D Inputs and Outputs on the Relation Between the Uncertainty of Future Operating Performance and R&D Expenditures

Abstract

Consistent with the uncertainty of research and development’s future benefits, prior accounting studies hypothesize and find a positive relation between research and development (R&D) and the variability of future earnings. However, prior research has assumed constant marginal productivity of R&D in the cross-section. We relax this assumption and advance the accounting literature on the informational role of R&D by studying how measures of innovation outputs, namely patent counts and patent citations, which proxy for the economic value of innovation, are related to firms’ future performance. We predict and find that firms’ future operating performance is positively related to the quality of their patents and that this relation is stronger for more productive and innovative firms. We also predict and find that the volatility of future operating performance is negatively related to patent quality and that the relation is stronger for firms with higher R&D expenditures and larger patent portfolios. Overall, firms whose R&D is more productive exhibit higher and less volatile future operating performance. One contribution of our study is that it demonstrates that the relation between R&D expense (i.e., inputs) and future operating performance is better understood by incorporating information about the productivity (i.e., outputs) of a firm’s R&D outlays in the form of patent counts and citations.