The immediate expensing of R&D expenditures is often justified by the conservatism principle. However, no accounting procedure consistently applied can be conservative throughout the firm's life. We ask the following questions: (a) When is the expensing of R&D conservative and when is it aggressive, relative to R&D capitalization? and (b) What are the capital market implications of these reporting biases? To address these questions we construct a model of profitability biases (differences between reported profitability under R&D expensing and capitalization) and show that the key drivers of the reporting biases are the differences between R&D growth and earnings growth (momentum), and between R&D growth and return on equity (ROE). Companies with a high R&D growth rate relative to their profitability (typically early cycle companies) report conservatively, while firms with a low R&D growth rate (mature companies) tend to report aggressively under current GAAP. Our empirical analysis, covering the period 1972-2003, generally supports the analytical predictions.In the valuation analysis we find evidence consistent with investor fixation on the reported profitability measures: we detect undervaluation of conservatively reporting firms and overvaluation of aggressively reporting firms. These misvaluations appear to be corrected when the reporting biases reverse from conservative to aggressive and vice versa.-1- R&D Reporting Biases and Their Consequences IntroductionThe immediate expensing of practically all internally-generated intangible investments in the U.S., a questionable procedure given the substantial future benefits of many such investments, is often justified by the conservatism principle. 1Conservative accounting procedures, goes the argument, counter managers' prevalent optimism, 2 and are appropriate given the generally high level of uncertainty associated with the outcome of intangible investments. We address these two questions in the current study. We focus on three widely-used indicators of performance-the return on equity (ROE), return on assets (ROA), and earnings growth (momentum)-and derive the general conditions under which R&D expensing (the 1 The only exception in the U.S. to intangibles' expensing is the capitalization of some software development costs, required by SFAS 86. For an empirical examination of software capitalizations, see Aboody and Lev (1998). For a discussion of the evidence concerning R&D benefits, see Lev (1999). 2 "Thus if the animal spirits are dimmed and the spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die." (Keynes, 1936, pp. 161-162).3 Kothari et al. (2002) report that the earnings volatility associated with R&D is three times larger than that associated with tangible investment in property, plant and equipment.-2-current GAAP procedure) will result in overstated or understated values of these indicators, relative to capitalized R&D. We then examine the validity of these general cons...

The immediate expensing of R&D expenditures is often justified by the conservatism principle. However, no accounting procedure consistently applied can be conservative throughout the firm's life. We ask the following questions: (a) When is the expensing of R&D conservative and when is it aggressive, relative to R&D capitalization? and (b) What are the capital market implications of these reporting biases? To address these questions we construct a model of profitability biases (differences between reported profitability under R&D expensing and capitalization) and show that the key drivers of the reporting biases are the differences between R&D growth and earnings growth (momentum), and between R&D growth and return on equity (ROE). Companies with a high R&D growth rate relative to their profitability (typically early cycle companies) report conservatively, while firms with a low R&D growth rate (mature companies) tend to report aggressively under current GAAP. Our empirical analysis, covering the period 1972-2003, generally supports the analytical predictions.In the valuation analysis we find evidence consistent with investor fixation on the reported profitability measures: we detect undervaluation of conservatively reporting firms and overvaluation of aggressively reporting firms. These misvaluations appear to be corrected when the reporting biases reverse from conservative to aggressive and vice versa.-1- R&D Reporting Biases and Their Consequences IntroductionThe immediate expensing of practically all internally-generated intangible investments in the U.S., a questionable procedure given the substantial future benefits of many such investments, is often justified by the conservatism principle. 1Conservative accounting procedures, goes the argument, counter managers' prevalent optimism, 2 and are appropriate given the generally high level of uncertainty associated with the outcome of intangible investments. We address these two questions in the current study. We focus on three widely-used indicators of performance-the return on equity (ROE), return on assets (ROA), and earnings growth (momentum)-and derive the general conditions under which R&D expensing (the 1 The only exception in the U.S. to intangibles' expensing is the capitalization of some software development costs, required by SFAS 86. For an empirical examination of software capitalizations, see Aboody and Lev (1998). For a discussion of the evidence concerning R&D benefits, see Lev (1999). 2 "Thus if the animal spirits are dimmed and the spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die." (Keynes, 1936, pp. 161-162).3 Kothari et al. (2002) report that the earnings volatility associated with R&D is three times larger than that associated with tangible investment in property, plant and equipment.-2-current GAAP procedure) will result in overstated or understated values of these indicators, relative to capitalized R&D. We then examine the validity of these general cons...

Backdating stock options, a practice that retroactively adjusts stock option grant dates to lower the exercise price, has raised governance, legal, accounting, tax, and auditing concerns. The practice of backdating options generally is believed to be a result of both ineffective corporate governance and management opportunism. Both of these factors have been linked to a higher level of discretionary accruals adjustments. This study examines the accruals-based earnings management patterns for a group of firms that were implicated by the Securities and Exchange Commission (SEC) for backdating stock options with a matched control group of nonimplicated firms for a time period surrounding the enactment of the Sarbanes-Oxley Act (SOX) of 2002. Both the univariate and multivariate analyses show that in the pre-SOX years, the sample of implicated firms managed abnormal accruals at a significantly greater level than the matched group of nonimplicated firms. The differential pattern of accruals management across these two groups becomes insignificant in the post-SOX period. Our result also suggests that the effect of SOX on mitigating the level of accruals management is substantially greater for the implicated companies than for the nonimplicated companies. The difference in the effect of SOX on the two groups of firms persists even after controlling for the differences in their governance and internal control effectiveness. We, therefore, suggest that SOX had effects on management’s reporting choices beyond those resulting from improvements in governance and internal control over financial reporting.

Purpose The purpose of this paper is to investigate the association between bargain purchase gains (BPGs) booked by the acquirer and smoothing of acquirers’ earning performance across time. Design/methodology/approach The authors use a sample of 122 bargain purchase acquisitions in non-financial industries from 2009 to 2012 and a pair-match control group of 122 goodwill acquisitions. Findings The authors find that BPGs, and in particular, the Level-3 fair value estimates of intangible assets acquired, have consistently been used to smooth earnings but that such smoothing activities are not associated with long-term market returns. Originality/value This study is the first one to investigate bargain purchase acquisitions in a broad range of non-financial industries and suggests that managers are using the valuation of intangibles to avoid unfavorable earnings even though these valuations are not credible to investors.

We examine differences in stock price, option volatility, and litigation reactions to restatement announcements that are associated with a material weakness (MW) disclosure. Contrasted with restatements that are not associated with any MW disclosure, our analyses reveal that firms that announce both a restatement and an associated MW experience significantly more negative market returns, greater implied volatility, and higher likelihood of class action lawsuits. Separating the restatements into timely reporters, where the MW precedes the restatement, and non‐timely reporters, where the MW is concurrent with or follows the restatement, we find that timely reporters experience more negative returns at the time of the restatement, relative to non‐timely reporters, suggesting that investors perceive the early MW disclosure to signal more pervasive control‐related problems. Interestingly, we find that timely and non‐timely reporters are equally likely to be sued, consistent with the argument that wrongdoing (through either a timely or non‐timely MW disclosure) provides stronger grounds for establishing scienter. However, timely reporters appear to secure more favorable litigation outcomes: they face higher likelihood of lawsuit dismissals and pay much lower settlements, compared to non‐timely reporters. Overall, our evidence provides new insights into how market participants incorporate information about internal control weaknesses into their perceptions regarding the economic implications of financial restatements, and financial reporting quality.