The Value-relevance of Earnings and Book Value across Profit and Loss Firms: The Case of R&D Spending

Abstract

We examine the effect of omitting research and development (R&D) expenditures, which is an important value-relevant item embedded in earnings for estimating the Ohlson (1995) valuation model for loss firms. Consistent with the analytical insight, we find that R&D expenditures are positively (negatively) associated with stock prices for loss (profit) firms. For high R&D intensity loss firms, the empirical specification with disaggregated earnings leads to about 45 percent improvement in explanatory power: the adjusted R2 for the disaggregated and bottom-line earnings model are about 32% and 22%, respectively. We find that the coefficient on book value of equity decreases when earnings are disaggregated, which suggests that book value of equity is value-relevant partly due to its correlation with R&D expenditures. In other words, the evidence suggests that book value of equity provides information on expected future earnings rather than abandonment values for loss firms engaged in R&D activity. These findings have implications for empirical research design in studies of value-relevance of accounting information and studies of earnings process.