The Information Effect of Discretionary R&D Investment on Accounting-based Valuation and Long Term Stock Returns: Signaling vs Managerial Over-optimism

Abstract

This paper aims to investigate the impact of discretionary R&D expenditure (R&D expenditure higher than market expectation) on the value relevance of the accounting information at the earnings announcement date and long-term stock performance after earnings announcement. Qian et al.(2012) argue that the positive discretionary R&D may be due either to signaling motivation or just an inefficient investment made by overconfident and overoptimistic managers. We analyze the information content of discretionary R&D expenditure particularly in high-tech industries where information asymmetry is high to see if it is a manager`s signal or managerial over-optimism in the form of overinvestment in Korean market. In order to do so, we investigate the relationship with market response using two different methods. First, we investigate the association between discretionary R&D and value relevance of accounting information at the time of announcement of annual financial statements. And we find that the firms with positive discretionary R&D decrease (increase) the risk of pricing error (value relevance) by the accounting-based pricing model. Second, we verify whether a difference in discretionary R&D expenditure leads to the difference in long-term abnormal stock returns after the announcement of financial statements. Our analysis indicates that there is a positive and significant association between discretionary R&D and long term abnormal returns in high-tech firms. This result implies that the Korean market construes the positive R&D spending as a signal of investment prospects in high-tech firms. However, further analysis reveals that the signaling effect of discretionary R&D in high-tech firms has diminished as the level of insider ownership increases.