Informational and Managerial Inefficiency and Conservatism for Intangible-Intensive Firms
67 Pages Posted: 8 Aug 2009 Last revised: 17 Jan 2010
Date Written: November 9, 2009
Accounting conservatism is a controversial issue. Immediately expensing R&D and advertising costs distorts accounting information, ignoring the future benefits arising from these expenditures. However, this treatment is often justified because the values of intangible investments are difficult to verify. The motivation of my research is to determine the levels of inefficiency arising from the conservative treatment of intangibles (informational inefficiency) and from managerial resource allocation decisions (management inefficiency). To the end, I analyze the consequences of conservatism on returns on assets (ROA) for intangible-intensive firms. I employ a stochastic frontier estimation technique, which is well-suited to quantify the impact of regulations. I can use this econometric methodology to estimate the shortfalls from the best performing firms by decomposing errors into two parts, a random component and inefficiency. I find that conservatism is associated with shortfalls in ROA (informational inefficiency). This adverse effect is magnified when current earnings are expected to decline. This probably occurs because managers have strong incentives to try to offset some of these expected earnings declines. I also find that for firms in a positive earning region, managers are more likely to reduce R&D spending if they expect current earnings to decline. However, in a negative earning region, managers are less likely to reduce R&D spending even when they expect current earnings to decline. These results are consistent with the notion that the conservative treatment of intangibles encourages myopic managerial decisions about R&D spending, which in-turn increases shortfalls in ROA, and generates managerial inefficiency. Although further analysis is needed, my results also suggest there may be systematic overinvestment in intangible projects. My findings have important implications for regulators because conservative treatment of intangibles creates misalignment of managerial incentives with those of shareholders concerning optimal resource allocation to produce long-term profits.
Keywords: Efficiency Analysis, Resource Allocation, ROA and Conservatism
JEL Classification: M41
Suggested Citation: Suggested Citation