Accounting for Intangibles: Does Method of Accounting Matter?

V. Brooks PooleJ. Shaw

University of MississippiFebruary 9, 2008

Motivation

• To contribute to the conflicting literature on the understanding of the market’s reaction to differences in reporting intangible-related transactions

• Companies are investing heavily in intangible assets; the ratio of tangible to intangible assets has changed from 30:70 to 63:37 from 1929 to 1990 (Canibano, et. al., 2000)

Motivation

• IASB hopes to create a framework that will establish international agreement on how to account for intangibles.

• In the US, internally generated intangibles are expensed while those acquire externally are capitalized because internally generated intangibles are difficult to value (Radebaugh, et. al., 2006)

Motivation

• To determine whether international consensus on how to account for intangible-related transactions is necessary

• To determine if mandatory disclosure of accounting treatment is more appropriate than specific accounting rules

Prior Research

• Disclosed intangibles, while consistently undervalued relative to tangible assets, are valued positively (Choi et. al., 2000)

• The market values R&D, goodwill, and brands regardless whether they are treated as assets or expenses (Lev, 1999)

• Australian and UK F/S are more informative about intangibles than US F/S (Goodwin, 2003; Abrahams and Sidhu, 1998; Alford, et al., 1993)

Prior Research

• British companies that disclose internally generated brand names by capitalizing them reap positive benefits (Mather and Peasnell, 1991)

• Even though internally-generated intangibles are difficult to value, they are valuable and should be disclosed in F/S (Amir and Lev, 1996)

Prior Research

• US F/S have substantially less value than they could because internally generated intangibles go unreported (Wyatt, 2005)

• Limiting managements’ choices to record intangibles as assets tends to reduce the quality of the B/S. Accounting method of intangible-related transactions does affect users of F/S (Luft and Shields, 2001)

Research Questions

• Is the market efficient in understanding that two transactions are identical in nature even though they are accounted for differently to adhere to particular reporting requirements?

• Does size of an intangible-related transaction affect investors’ perceptions of its benefit on future earnings?

Research Questions

• Is a large or small intangible-related expenditure perceived more favorably by investors when it is accounted for in a particular manner—capitalized or expensed?

Underlying Theory

• Efficient Market Hypothesis– All publicly available information is quickly

incorporated into stock share prices.– The prices of traded assets reflect all known

information about the company and what investors project for the company’s future (Fama, 1970 & 1991; Lev, 1999).

– If true, method of accounting for intangibles is irrelevant as long as full disclosure of accounting treatment is disclosed.

Hypothesis 1

Ceteris paribus, the market’s reaction to two identical intangible-related transactions will differ as accounting treatment of such transaction differs, given the accounting treatment of such transaction is fully disclosed

Underlying Theory

• Size– Small expenditures will be perceived by

investors in the same manner as no expenditure would be perceived.

– A reasonable investor will not be influenced in investment decisions by a fluctuation in net income less than or equal to 5% (Vorhies, 2005).

Underlying Theory

• Size– Jordan and Clark (2004) find that when

defining materiality for capitalizing interest, 4 to 5 percent or less of operating income is considered immaterial and does not affect stakeholders’ analyses of financial statements

Hypothesis 2

Ceteris paribus, the market’s reaction to two identical intangible-related transactions will differ as size of the expenditure differs, given the amount of such transaction is fully disclosed.

Hypothesis 3

Ceteris paribus, the market’s reaction to two identical intangible-related transactions accounted for differently will differ as size of the expenditure differs, given the accounting treatment and size of such transaction is fully disclosed.

Research Design

• 2X2 Behavioral Experiment• Subjects

– 104 upper-level and masters-level business students

– Students who have completed financial accounting courses are able to acquire and use financial information in a similar manner to nonprofessional investors (Elliot et. al., 2007)

Research Design

• Instrument– 4 versions– Narrative describing the intangible-related

activities of an automobile company– Financial statements – 2 questions asking subjects to determine the

benefit of the intangible expenditures– 2 demographic questions

Research Design

• Development costs is the intangible manipulated since convergence of US GAAP and IFRS remains unresolved

• Manipulation– US company expenses development costs– UK company capitalizes development costs– Within each company the amount of the

expenditure is varied from an small to large amount

Data Analysis

• Pilot test• Factorial ANOVA

– Purpose: to determine if a relationship between independent variable(s) and dependent variable exists

– Are accounting treatment, size, and/or the interaction of accounting treatment and size significant indicators of subjects’ responses

Data Analysis

• Independent variables– Accounting Treatment

• Coded 1 for IFRS treatment (capitalize)• Coded 2 for GAAP treatment (expense)

– Size• Coded 1 for a material expenditure• Coded 2 for an immaterial expenditure

• Dependent Variable– Investor’s Perceived Benefit of an Intangible

Expenditure (Q1 and Q2 of the instrument)

Results

• Demographics: Neither gender nor level of education of subjects is significantly related to the DV when entered into the ANOVA model alone or in conjunction with the IVs; therefore they are excluded from the ANOVA models.

Mean Scores for the DVs

Manipulation Q1 Q2

Capitalize/Material n=28

7.714 7.000

Capitalize/Immaterial n=24

6.166 5.000

Expense/Material n=24

7.333 6.167

Expense/Immaterial n=28

7.535 6.465

ANOVA Results

DV:Q1;Adj R2=0.13 DV:Q2;Adj R2=0.13

SS F-stat SS F-stat

Model 36.568 6.177*** 54.462 7.618***

Method 6.309 3.197* 2.572 1.079

Size 11.693 5.925** 18.726 7.858***

Interact. 19.788 10.03*** 34.111 14.31***

***p-value<0.01;**p-value<0.05;*p-value<0.10

ANOVA

• Accounting Treatment is statistically significant at the p<0.10 level when Q1 is treated as the DV

• Size is statistically significant at the p<0.05 level when Q1 is treated as the DV and at the p<0.01 level when Q2 is treated as the DV

• The interaction of accounting treatment and size is statistically significant at the p<0.01 level when Q1 or Q2 is treated as the DV

Interpretation of ANOVA Results

• Method of Accounting is statistically significant when Q1 is the DV.

• Investors will not perceive the benefit of 2 identical intangible-related expenditures the same if they are accounted for differently.

• Thus, H1 is not rejected.

Interpretation of ANOVA Results

• Size is statistically significant in each ANOVA model.

• As size of intangible-related expenditures varies, investors’ expected benefit from the expenditure varies.

• Thus, H2 is not rejected.

Interpretation of ANOVA Results

• The interaction of method and size is statistically significant in each ANOVA model.

• Neither method of accounting nor size alone reveals how investors perceive an intangible-related expenditure.

• It is the interaction term that is most meaningful.

Interpretation of Method*Size

• Perceived benefit depends on the combination of accounting method and size of the expenditure.

• H3 is not rejected.

• Pairwise comparisons reveal where differences among groups exist.

Pairwise Comparisons

• Simple t-tests reveal differences in these four groups:– IFRS treatment of a large expenditure– IFRS treatment of a small expenditure– GAAP treatment of a large expenditure– GAAP treatment of a small expenditure

Pairwise Comparisons

Group Difference;Q1=DV Difference;Q2=DV

1 vs. 4 0.1786 0.5357

1 vs. 3 0.3810 0.8333

1 vs. 2 1.5476* 2.0000*

4 vs. 3 0.2024 0.2976

4 vs. 2 1.3690* 1.4643

3 vs. 2 1.1667* 1.1667*

*p-value<0.05

Pairwise Comparisons

• A large expenditure accounted for as an asset is perceived more beneficial than a small expenditure accounted for as an asset.

• An expenditure accounted for as an expense is not perceived differently based on size; the perceived benefit of a large vs. small expense does not differ.

Interpretation

• A large expense is perceived no more beneficial than a small expense.

• Had the expenditure been capitalized, the large expenditure would have been perceived more beneficial than the small expenditure.

Interpretation

• No difference is perception is found between a large expense vs. a large asset

• Small expenses are perceived more beneficial relative to small assets. (Investors perceive a small asset as insignificant relative to other assets or total assets of a company perhaps.)

• While expenditures are identical in nature, their perceived benefits differ as size and accounting treatment differs.

Relevance of Findings

• IASB and FASB should resume convergence efforts

• International investors are valuing identical transactions differently

• Investors do not perceive the future benefits of identical (large or small) expenditures that are accounted for differently in the same manner

• To make international companies’ F/S comparable, consensus is needed

Limitations

• Different markets have different levels of efficiency. IASB must consider this when developing international consensus of standards

• Subjects– All US citizens and part of the US market– Upper-level undergraduate and masters-level

students; not investors

Future Research Ideas

• Use subjects from different markets• Determine empirically through an archival study

if expenditures related to development costs do have potential future value and should therefore be capitalized or if their benefits are exhausted upon incurrence and should therefore be expensed

• Test whether the deductibility for tax purposes of expensed intangibles influences how companies account for intangibles.

Questions/Comments