Statement of Financial Accounting Standards (SFAS) No. 2 (FASB, 1974, para. 12) mandates that all research and development (R&D) spending be immediately expensed. Lev and Sougiannis (1996, p. 134) indicate that off-balance sheet R&D assets (as a proxy for the future payoffs from R&D spending) provide investors with reliable and relevant information. However, usefulness is a necessary but not a sufficient condition for financial reporting regulation (Lev, 1988, p. 2). Rather, regulators have a mandate to maintain public confidence in the securities markets as a level playing field by mitigating information asymmetry or ex ante inequity (Levitt, 1998, p. 79). In this study, we document the information asymmetry effects associated with off-balance sheet (unrecorded) R&D assets using a market microstructure methodology. Collectively, the evidence suggests that a potential harm (lower market liquidity) is associated with the current accounting treatment of R&D spending.
By requiring that corporate research and development (R&D) spending be immediately expensed, Statement of Financial Accounting Standards (SFAS) No. 2 (FASB, 1974, para. 2) potentially creates a mismatch between costs and subsequent benefits. Potentially, these off-balance sheet (unrecorded) R&D benefits could generate ex ante inequity in the capital markets in the form of an information gap (asymmetry) between informed investors and other investors. The prior literature (e.g., Brennan and Subrahmanyam, 1995, p. 361) indicates that trading by informed investors (i.e., investors with access to private information or the analytical ability to extract private information from publicly available data) can impose “significant liquidity costs on other market participants due to adverse selection.”
The purpose of our paper is to examine the information asymmetry effects associated with off-balance sheet (unrecorded) R&D assets. In particular, our study seeks to examine a potential harm (lower market liquidity) associated with the current accounting treatment for R&D expenditures.1
Lev and Sougiannis (1996, p. 134) indicate that R&D capitalization would provide investors with “statistically reliable and economically relevant information.” However, usefulness is a necessary but not a sufficient condition for financial reporting regulation (Lev, 1988, p. 2). Rather, regulators (such as the Securities and Exchange Commission) have a mandate to maintain public confidence in the securities markets as a level playing field by mitigating information asymmetry or ex ante inequity (Levitt, 1998, p. 79).
As noted by Glosten and Milgrom (1985, pp. 72–74), information asymmetry can lead to adverse economic consequences in the form of higher bid-ask spreads. Higher spreads have been shown empirically to be associated with higher stock returns (which implies a higher cost of capital), a finding consistent with the notion that investors have to be compensated for holding less liquid stocks (Amihud and Mendelson, 1986a and Amihud and Mendelson, 1986b). We utilize the adverse selection component of the spread and the quoted depth as observable proxies for information asymmetry.
In this paper, we utilize intraday stock transactions data to measure the average adverse selection component of the bid-ask spread and the quoted depth during 1995 and 1996 for our sample firms. Our approach is based on theoretical models which indicate that the market maker (dealer) is not in the business of conducting private information search and is therefore at a disadvantage relative to information motivated traders; consequently, faced with the adverse selection risk associated with information asymmetry the market maker's defensive reaction is to increase the adverse selection component of the spread and decrease the quoted depth ( Lee et al., 1993, p. 371).
We perform and report results from three tests. First, we compare the average adverse selection component of the spread (ASCS) and the quoted depth for our sample of R&D-intensive firms with the ASCS and depth for non-R&D-intensive firms. Second, for R&D-intensive firms we examine the association between the ASCS (and depth) and the magnitude of off-balance sheet R&D assets. Finally, we investigate the association between the change in the ASCS (and the change in depth) for these R&D-intensive firms from 1995 to 1996 and the change in the magnitude of unrecorded R&D assets. After controlling for the factors that prior research (e.g., Chung et al., 1995, p. 1031; Stoll, 1978, p. 1170) indicates are associated with the market maker's adverse selection risk, our overall results suggest that: (1) the ASCS is higher for R&D-intensive firms than for non-R&D-intensive firms, (2) the ASCS (and depth) for R&D-intensive firms is significantly associated with the magnitude of off-balance sheet R&D assets, and (3) the change in ASCS is associated with the change in the magnitude of off-balance sheet R&D assets.
The rest of our paper is organized as follows. In Section 2, we review the role of financial reporting regulations in promoting a level playing field (ex ante equity) and prior research on R&D including the value relevance and magnitude of off-balance sheet R&D assets. Section 3 discusses hypotheses, methodology and research design, and Section 4 describes empirical findings. Section 5 presents our concluding remarks.
