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Factors explaining the innefficient valuation of intangibles


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Factors explaining the innefficient valuation of intangibles

  1. 1. Inefficient valuation of intangibles 57 Accounting, Auditing & Accountability Journal Vol. 16 No. 1, 2003 pp. 57-69 # MCB UP Limited 0951-3574 DOI 10.1108/09513570310464282 Received June 2002 Revised July 2002 Accepted November 2002 Factors explaining the inefficient valuation of intangibles Manuel GarcõÂa-Ayuso Department of Accounting, University of Seville, Seville, Spain Keywords Intangible assets, Valuations, Financial analysts, Financial forecasting, Ethics Abstract The inefficient valuation of the intangible determinants of the financial position of business companies may result in significant damages for both firms and their stakeholders. Based on the empirical literature in accounting and finance, this paper suggests possible reasons for the inefficient valuation of intangibles, provides explanations for the existence of biases in analysts' earnings forecasts and proposes alternative ways for the improvement of the resource allocation mechanisms in the capital markets. 1. Introduction In recent years, a number of capital markets-based empirical studies have assessed the extent to which the value relevance[1] of accounting information has changed over time, finding contradictory results. Whereas the pioneering studies documented a decline in the degree of association between stock returns and earnings and between stock prices and both earnings and book values in US capital markets (Collins et al., 1997; Francis and Schipper, 1999; Lev and Zarowin, 1999), recent evidence suggests that empirical results are dependent on the method used (Chang, 1998) and that, once the bias in the coefficient of scale is adjusted for, there is no significant decrease in the value relevance of accounting numbers in time (Brown et al., 1998). Moreover, Ely and Waymire (1998) have shown that the explanatory power of earnings and book values for prices was not significantly different in the USA in the pre- SEC era. This notwithstanding, it seems to be widely accepted nowadays that accounting information is losing relevance, among other reasons, due to the increasing importance of intangibles not recognized as assets under current accounting standards (Wallman, 1995; Lev and Zarowin, 1999). Many consider this as the main force driving the growing difference between the market value of companies and their book value equity (Lev, 2001), as, although intangible investments increase future earnings and cash flows, they are generally expensed, thus understating current earnings and book values. However, it is not reasonable to state that the difference between the market value of the firm and its book value of equity is entirely due to the existence of The Emerald Research Register for this journal is available at The current issue and full text archive of this journal is available at The author gratefully acknowledges the funding provided by the Spanish Association of Accounting and Business Administration to the Carlos Cubillo Chair in Accounting and Auditing, as well as the financial aid of the Spanish Ministry of Education (Project PB98-0415).
  2. 2. AAAJ 16,1 58 intangibles not reflected by the accounting model. First, the book value of equity may be negatively biased not only due to the lack of recognition of intangibles, but also because of the undervaluation of tangible and financial assets. Second, shareholders' equity may not reflect the existence of intangible liabilities that are likely to be discounted in stock prices but not accounted for even under GAAP prudent accounting. Third, stock prices may not always be considered as unbiased estimates of the value of companies. There is an overwhelming amount of empirical research documenting the existence of market anomalies[2] such as the size (Banz, 1981), January (Rozeff and Kinney, 1976), E/P (Basu, 1977) and B/M (Fama and French, 1992) effects, and the underreaction (Ou and Penman, 1998) or overreaction to earnings announcements followed by a post-announcement drift (Bernard and Thomas, 1990)[3]. The significant increase in the stock prices of the so-called new economy firms during the late 1990s and the subsequent burst of the technological bubble have resulted in enormous losses for investors and dramatic job slashes. The question many are posing is whether we could have anticipated the inefficient valuation of these (presumably intangible-intensive) companies and to what extent the damages could have been avoided. In the light of the results reported by recent empirical research in accounting and finance, this paper identifies the causes of the inefficient valuation of intangibles in capital markets, discusses the existence of, and the reasons for, biases in analysts' earnings forecasts, describes some recent efforts undertaken in order to overcome the problems limiting the efficiency of the resource allocation mechanisms in financial markets and suggests ways for the improvement of the resource allocation mechanisms in the capital markets. The next section discusses the problems arising as a result of the inefficient valuation of intangibles in capital markets. Section three delves into the causes of those problems, while section four suggests possible solutions and section five concludes. 2. The problems The inefficient valuation of intangibles has significant implications for firms and their stakeholders. Among the damages that have been thoroughly discussed in the accounting and financial literature are the following: Stock price volatility arises as a result of the difficulty to accurately estimate the future payoffs and the risk associated with the investment in intangible- intensive companies. The uncertainty regarding the financial position of intangible-intensive companies increases bid-ask spreads (Boone and Raman, 1999) and raises the cost of capital (Botosan, 1997; Sengupta, 1998), resulting also in higher interest rates (Shi, 1999). Information asymmetry increases the opportunities for insider gains (Aboody and Lev, 2000) causing significant losses for small investors[4]. The overstatement of the value of companies in the capital markets results in significant losses for investors when stock prices revert to their fundamental
  3. 3. Inefficient valuation of intangibles 59 values. Conversely, undervaluation reduces the ability of the firm to raise additional capital (Chan et al., 1998; Lev et al., 2000) and increases the risk of hostile takeovers. This is closely related to the dramatic social and economic impact of the enormous job slashes resulting from the initial overvaluation of high-tech companies and the subsequent crash of the stock market. The last few years have witnessed a growing amount of litigation between investors and managers as the former find it difficult to evaluate the firm's performance based on accounting numbers (Lev, 2001). This may be partly due to managers' propensity to manipulate earnings with intangible investments (Bushee, 1998) and to cut down R&D before going public in order to increase earnings and influence investors' expectations (Darrough and Rangan, 2001). Obviously, all these problems are more likely to appear in growing companies undertaking important intangible investments to increase their market share than in mature firms having reached a steady state in which intangible investments are close to the annual depreciation of both their recorded and unrecorded intangible assets. 3. The causes 3.1. Quality of financial information The inefficient valuation of intangibles could stem from the lack of relevant information in the annual reports of business companies. Based on a survey of business-reporting practices by US companies, the FASB's Steering Committee (FASB, 2000) concluded that companies are currently disclosing a large amount of voluntary useful information on their financial position, although there is a ``general lack of meaningful and useful disclosures about intangible assets''. The remainder of this section discusses some possible reasons for the decreasing usefulness that accounting information is experiencing according to both researchers and practitioners. Accounting conservatism limits the recognition of intangible investments as assets in the balance-sheet to those whose cost may be reliably measured, which are separable from the rest of the assets of the firm and yield future benefits that are in control of the company. Therefore, firms investing large amounts in intangibles will report lower book values and will be significantly affected by the immediate recognition of the costs and the delayed recognition of the benefits in accounting earnings, particularly if they are small and have a record of reported losses (Ryan and Zarowin, 2001). In general, managers fail to satisfy the informational needs of the users of corporate financial reports because they do not disclose the information that investors and creditors consider most relevant (PriceWaterhouseCoopers, 2002). This could be due to the existence of benefits for managers, auditors and leading financial analysts from the lack of publicly available information on intangibles (Lev, 2001, p. 87). Corporate financial reports do not provide investors with an accurate view of the value creation process within the firm. Specifically, there is a lack of financial and non-financial information on the firms' value drivers (Amir and
  4. 4. AAAJ 16,1 60 Lev, 1996; Ittner and Larcker, 1998). Also, there appears to be a lack of relevant information on management's prospects for the future financial position of the firm. This view is consistent with the claims of the AICPA (1994) for more forward-looking information in the management report and the suggestion of the former board of the IASB that firms should be encouraged to disclose more narrative information on their intangibles[5]. In sum, there appears to be a growing concern for the lack of usefulness of accounting statements due to the conservatism of accounting regulation and the absence of historical and prospective financial and non-financial information on the intangible determinants of the value of companies. 3.2. Market imperfections Inefficient valuations may also be the consequence of the inexistence of markets for intangibles and the imperfections in capital markets. Since there are no markets for intangibles, their value may not be assessed on the basis of a consensus as is the case with commodities or other tangible and financial assets. Moreover, there are no widely accepted valuation models for intangible assets such as those developed for stocks, bonds or options. Market imperfections giving rise to information asymmetry allow insider gains and have negative economic consequences for smaller investors and stakeholders that do not have the capability to influence management's decisions because of their small share in the capital of the firm, due to the incomplete nature of the contracts upon which corporate governance mechanisms are based or because of their small bargaining power. The audit function fails to guarantee the necessary transparency in financial markets and to ensure the disclosure of all the information that is relevant to understand the financial position of the firm. Furthermore, there are problems affecting the timeliness in the announcement of the relevant events and the financial information required by stakeholders. The lack of international harmonization of accounting standards and financial markets' regulatory frameworks is also seen by many as the cause of inefficiencies in the resource allocation mechanisms. In sum, market imperfections may result in inefficiencies that are likely to cause greater damage to smaller stakeholders and may only be corrected if financial markets' regulations are improved and international harmonization is achieved. 3.3. Limited capability of financial analysts?[6] Financial analysts are sophisticated users of accounting information. The strong competition in the financial markets forces them to exploit all available knowledge to provide their customers with the most efficient financial advising services. In order to survive in their competitive environment, analysts need to have not only the ability to access all value-relevant information in a timely fashion, but also the capability to understand and exploit its content. Their capability to predict future earnings accurately has
  5. 5. Inefficient valuation of intangibles 61 been extensively documented in the accounting literature (Brown and Rozeff, 1978; Affleck-Graves et al., 1990; Richardson et al., 1999). In fact most contemporary research studies use analysts' forecasts as a surrogate for the market's expectations (Liu and Thomas, 2000). Credibility is another fundamental requisite for financial services companies in markets nowadays and, consequently, significant or systematic errors in buy or sell recommendations are likely to undermine the confidence of their customers and, eventually, result in the loss of a significant part of their revenues. The results of Mikhail et al. (1999) show that analyst turnover is greater, the lower their forecast accuracy. However, there may be significant differences across analysts in the ability to access relevant and timely information, as well as in their capability to extract all its value-relevant content to make accurate predictions. Differences in the ability of market participants to exploit the information content of the earnings numbers disclosed by companies may explain the existence of over- and under-reaction to earnings announcements followed by a subsequent drift in stock prices. If a small subset of market participants are able to exploit all the value-relevant information conveyed by the earnings figure disclosed at a given moment, but the rest of the investors fail to fully understand the impact of current information on the present value of the future cash flows of the firm, there will be an initial stock price reaction that does not completely reflect all value-relevant information. Once the leading investors have adjusted their expectations and reacted accordingly, the rest of the market participants will slowly move in the direction signalled by the leading steers and, consequently, prices will show a drift towards the intrinsic value of the stock. Analysts' earnings forecasts have become widely used by investors as a basis for the design of their portfolios and investment strategies. Biases in earnings forecasts may result in an inefficient valuation of companies. There are in the empirical literature a large number of studies documenting the existence of a systematic positive difference between analysts' earnings forecasts and the actual earnings numbers[7], which appears to be greater for smaller companies, is not dependent on the data sources used by the researcher, and is also present in the case of long horizon growth forecasts (LaPorta, 1996). Cognitive biases and analysts' incentives are the two main economic determinants of forecast biases that have been analyzed by empirical studies. The potential sources of cognitive biases are related to the anomalous behaviour of stock markets. DeBondt and Thaler (1985) spawned a stream of research based on the hypothesis that analysts systematically overreact to the information (either good or bad) conveyed in earnings. Although the evidence on overreaction to good news in earnings appears to be consistent, Easterwood and Nutt (1999) have shown that analysts underreact to bad news. However, Abarbanell and Lehavy (2000a) have concluded that biases in earnings forecasts may not be explained by cognitive biases.
  6. 6. AAAJ 16,1 62 Inefficient forecasts could be due to the intense competition between and within firms that forces analysts to strive for their customers' capital to the detriment of the rigour in their methods. As shown by Welch (2000), the recommendations issued by the leading analysts are immediately followed by the rest (presumably less capable), thus resulting in poorer aggregate information. Moreover, Cooper et al. (2001) have found that the forecasts of the leading analysts have a greater impact on stock prices. Taken together, the findings of these studies suggest that competition among analysts results in herding behaviour that significantly affects stock prices. Related to this are the time constraints facing financial analysts, which may lead them to prefer technical analysis or cheap fundamental analysis, i.e. stock screening (Penman, 2001) instead of a deep fundamental analysis using valuation techniques that assess the intrinsic value of companies based on estimates of future payoffs and risk. Although contrary investment strategies aimed at exploiting market inefficiencies may yield positive abnormal returns, they may also result in significant losses if the analyst fails to accurately estimate the future payoffs and the risk associated with the investment and other analysts are able to draw more efficient estimates of the intrinsic value of the stock. Functional fixation is another possible source of inefficient earnings estimates and firm valuations. Analysts may not be able to incorporate information on intangibles as inputs in their decision processes if the dominant culture in their investment firms suggests it is not acceptable. Moreover, analysts may not consider the information voluntarily disclosed by managers as reliable. Finally, they may fear that investors will not consider information on intangibles as a consistent basis to sustain their investment decision (Johanson, 2002). Despite the substantial amount of evidence of systematic biases in analysts' forecasts, the results of recent studies suggest that the magnitude of the bias is decreasing in time (Brown, 1997, 1998)[8]. In fact, Richardson et al. (1999) have found that the optimism in earnings forecasts has recently turned into pessimism. Three reasons may explain this change in the pattern documented by previous studies: analysts are learning from past errors and face negative consequences when their forecast accuracy is systematically low (Mikhail et al., 1997); their incentives have changed and, the quality of the data used by empirical studies of analysts' forecasts has improved significantly in the last few years (Abarbanell and Lehavy, 2000b); the observed biases could be the consequence of earnings management practices intended to report earnings numbers that slightly beat analysts' forecasts[9]. Amir et al. (1999) have documented that, on average, the information provided by financial analysts to investors represents a modest contribution beyond that conveyed by financial statements (12 per cent in adjusted R2 terms), suggesting that analysts mainly react to the observed changes in stock prices rather than cause them. However, they conclude that the use of the information provided by analysts in their forecasts mitigates the decrease in the value relevance of financial statements. The contribution of financial
  7. 7. Inefficient valuation of intangibles 63 analysts appears to be greater in high-tech industries and, particularly, for companies with large investments in R&D. Taken together, their results suggest that financial analysts are capable of understanding the value implications of intangibles and provide forecasts and recommendations that are useful to investors. 3.4. Ethics We have recently witnessed lamentable events in the capital markets that have caused huge economic losses to investors and have undermined the confidence of investors in the financial markets. They have all been the consequence of the unethical behaviour of managers, auditors and financial analysts. Inefficient valuations may be caused by misleading management practices such as the disclosure of false information in conference calls or the manipulation of accounting numbers. Darrough and Rangan (2001) have shown that managers tend to reduce their R&D investments to increase earnings in the year of the initial public offering to improve investors' expectations and Bushee (1998) has also found evidence that firms may manage their earnings using R&D[10]. The main role of auditors is to reduce the information asymmetry between investors and managers. Audit firms providing consulting services to their clients may be tempted to hide their qualifications as long as it maintains and increases their customer portfolio. Based on the resulting unreliable information, investors are likely to overestimate the value of firms and, subsequently, incur losses when the private information becomes public and stock prices are adjusted downwards. Investors may also suffer damages if analysts' behaviour is not ethical. Biased forecasts will lead investors to allocate resources to overvalued assets whose price will eventually revert to their fundamental value (Lee et al., 1999). Besides cognitive limitations, earnings forecast optimism may be driven by the incentives of financial analysts. An optimistic bias in earnings forecasts issued by sell-side financial analysts is likely to result in an increase in the compensation they receive for their services in equity issues, mergers and acquisitions (Lin and McNichols, 1998). On the other hand, analysts working for investment banks appear to be more likely to issue optimistic forecasts in the case of companies to which the bank provides financial services (Michaely and Womack, 1999). However, it could also be the case that firms choose the provider of financial services whose analysts issue the most optimistic earnings forecasts, in the belief that the amount of capital raised in the public offerings would be greater. Optimistic forecasts may also be a way to improve analysts' access to corporate information. For issuing positively biased earnings estimates is likely to improve the relationships between the analyst and the firm's management, allowing the first to access relevant information that could be particularly beneficial in the case of significant information asymmetries.
  8. 8. AAAJ 16,1 64 4. Possible solutions Changes in the regulation are needed in order to improve the market imperfections that result in economic damages for firms and their stakeholders. It is necessary to promote efforts aimed at suppressing the arbitrage opportunities that arise from the differences in the market regulations across countries. The coordination and integration of financial markets will surely have positive consequences in this respect. But, most important, the current accounting model must be improved, issuing new standards to ensure the disclosure of a greater amount of higher quality information on the intangible determinants of the value of companies. It is also necessary to encourage voluntary disclosures including forward-looking information by management. Managers must use a language that financial analysts and investors are able to understand. They have to provide explanations of the value creation process in the firm and make clear links between intangible investments and future value creation. This will increase the transparency and reduce the asymmetry limiting the efficiency of capital markets. The conservative perspective on the recognition of intangible investments in the balance-sheet adopted by the IASB in IAS 38 (IASC, 1998) will have to be revised in the future because of the new developments in the accounting standard-setting process in the USA. The FASB has decided to allow the no amortization of goodwill and prescribe the disclosure of more information on R&D investments in SFAS 141 and 142. As a result, fair valuation of tangible and intangible assets becomes a fundamental tool for managers to provide stakeholders with relevant information on the financial position of the firm. The elaboration and implementation of codes of good governance are a necessary step towards enhancing the credibility of that information. Codes of ethics in audit and investment firms are also necessary to ensure that audit reports and analysts' recommendations are considered by investors as reliable inputs for their investment decision processes. But that is not enough. Regulatory bodies must enforce controls to ensure that all market participants respect their provisions and should impose severe sanctions on those who violate them and cause damage to the system. However, we must always be aware that managers, auditors and analysts may have no incentives to trigger changes in the current state of things[11]. 5. Concluding remarks The inefficient valuation of intangibles has significant negative economic and social consequences in our economies. High growth rates in GDPs, low interest rates and excessively optimistic expectations on the potential for future wealth creation of the so-called new economy businesses have resulted in the overvaluation of a number of intangible-intensive firms in the capital markets. Inefficient valuations may be the consequence of low quality financial information, market imperfections, the insufficient capability of managers, auditors and analysts or their unethical behaviour.
  9. 9. Inefficient valuation of intangibles 65 In recent years, some studies conducted by academics, professional organizations and standard-setting bodies have suggested that the quality (usefulness) of accounting information is decreasing and that the users of financial statements need more forward-looking financial and non-financial information, particularly on the intangible determinants of the value of companies. To avoid the inefficient valuation of intangibles in capital markets standard- setting bodies must improve current accounting regulation so as to ensure the full disclosure of relevant information on intangibles, increase the transparency and reduce the asymmetry limiting the efficiency of capital markets. Moreover, managers should provide more narrative information using a language that stakeholders and analysts are able to understand, that is, providing a clear picture of the value creation process within the firm and explanations of the contribution of intangible investments. Guidelines for the measurement and voluntary disclosure of relevant information on the intangible determinants of the value of companies may be useful in this regard[12]. Although published empirical literature suggests that analysts' forecasts are systematically biased, recent studies lead us to believe that forecast errors are not caused by cognitive biases and that analysts actually provide investors with relevant information beyond that contained in financial statements, particularly in the case of intangible-intensive companies. Two consequences may be drawn from these findings: first, analysts seem to be able to obtain information on intangibles from sources other than the financial statements; second, the inefficient valuation of intangibles may not be explained by the lack of ability of analysts to understand the contribution of intangibles to the value creation process within the firm. Rather, research points to the unethical behaviour of market participants as the most suitable source of inefficiencies. Because of the lack of publicly available information on intangibles, the unethical behaviour of managers, auditors and financial analysts has resulted in an overvaluation of intangible- intensive companies followed by a subsequent correction in their stock prices that caused significant losses for uninformed investors. Managers, auditors and analysts must now undertake efforts aimed at improving their credibility in the eyes of investors. Codes of good governance and codes of ethics in audit and financial firms are not sufficient. Market regulatory frameworks and accounting standards must be improved to ensure the efficient functioning of capital markets and guarantee that any conduct causing damage to the financial system is identified and punished. I agree with Steven Wallman (1995) that we cannot have financial reporting and disclosure constraints that slow the pace of progress in capital markets, decrease the rate of reduction in the cost of capital, or limit innovation. The next step collectively is ours. Notes 1. In general, an item in the financial statements is considered as relevant if it has the ability to make a difference to decisions of financial statement users (Barth, 2000). More
  10. 10. AAAJ 16,1 66 specifically, an accounting number is value-relevant if it conveys information that has the power to modify investors' expectations on the future payoffs or the risk associated with a given resource allocation. In an efficient market all value-relevant information would be immediately and completely reflected in stock prices. 2. Kothari (2001) provides an extensive review of the empirical accounting literature and its implications for the efficient markets hypothesis. 3. See Fama (1998) for a thorough discussion and a critical interpretation of the empirical evidence on market anomalies. 4. Barth et al. (1999) have found that analyst coverage is directly associated with the existence of intangibles in the firm, as analysts try to exploit the greater information asymmetries existing for these companies. 5. Although not mentioned, the underlying reason is that voluntary disclosures are expected to reduce asymmetries, forecasts errors and bid-ask spreads by helping stakeholders understand the contribution of intangible investments to the value creation process in the firm. 6. The discussion presented in this section is mainly based on the results of empirical studies of analysts' earnings forecasts. Case studies based on interviews are only marginally considered here as they are the focus of Holland (2002). 7. See Kothari (2001) and Brown (1993, 1997) for a thorough discussion of the accuracy of analysts' earnings forecasts and their possible explanations. 8. Brown (1998) reports that the mean bias has decreased from 2.6 cents per share in 1993 to 0.39 cents in 1997. 9. Bartov et al. (2002) have found that companies beating or meeting analysts' forecasts experience higher subsequent stock returns. 10. Ely and Waymire (1999) concluded that as early as 1927 (in the pre-SEC era) investors perceived that managers overstated earnings through earnings capitalization. 11. See Lev (2001) for an interesting discussion of the politics of intangibles disclosures. 12. See and References Abarbanell, J. and Lehavy, R. (2000a), ``Biased forecasts or biased earnings? The role of earnings management in explaining apparent optimism and inefficiency in analysts' earnings forecasts'', working paper, University of North Carolina, Chapel Hill, NC. Abarbanell, J. and Lehavy, R. (2000b), ``Differences in commercial database reported earnings: implications for inferences in research on analysts' forecast rationality, earnings management and earnings response coefficients'', working paper, University of North Carolina, Chapel Hill, NC. Aboody, D. and Lev, B. (2000), ``Information asymmetry, R&D and insider gains'', Journal of Finance, Vol. 55, pp. 2747-66. Affleck-Graves, J., Davis, R. and Mendenhall, R. (1990), ``Forecasts of earnings per share: possible sources of analyst superiority and bias'', Contemporary Accounting Research, Vol. 6, pp. 501-17. AICPA (1994), Improving Business Reporting: A Customer Focus, Report of the Special Committee on Financial Reporting, American Institute of Certified Public Accountants, Jersey City, NJ. Amir, E. and Lev, B. (1996), ``Value relevance of non-financial information: the wireless communications industry'', Journal of Accounting and Economics, Vol. 22, pp. 3-30.
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