What Explains the Valuation Difference between Intangible‐intensive Profit and Loss Firms?

Abstract

AbstractPrior research suggests that loss firms are valued based on their abandonment/adaptation option values, while profit firms are valued as going concerns. However, conservative accounting treatment of expensing of R&D leads many R&D‐intensive firms to report losses even though they are not in financial distress. In this paper we investigate the difference in valuation of profit and loss firms that invest in intangibles, either through internal development (R&D) or purchases. The accounting treatment for internally developed intangibles is conservative in that US GAAP requires immediate expensing. Yet, it allows recognition of purchased intangibles. We find that in valuation of firms with high recognized‐intangible assets, book value has more prominence in loss firms than profit firms, while that is not the case for firms with high R&D expenditures. This suggests that their abandonment/adaptation option explains the difference in valuation between profit and loss firms with high recognized‐intangibles, while conservative accounting explains the valuation difference between profit and loss firms with high R&D intensity. This result suggests that recognition of intangibles in financial statements might mitigate the conservative bias in accounting numbers.