Laurel Franzen

The Value-relevance of Earnings and Book Value across Profit and Loss Firms: The Case of R&D Spending

We examine the effect of omitting research and development (R&D) expenditures, which is an important value-relevant item embedded in earnings for estimating the Ohlson (1995) valuation model for loss firms. Consistent with the analytical insight, we find that R&D expenditures are positively (negatively) associated with stock prices for loss (profit) firms. For high R&D intensity loss firms, the empirical specification with disaggregated earnings leads to about 45 percent improvement in explanatory power: the adjusted R2 for the disaggregated and bottom-line earnings model are about 32% and 22%, respectively. We find that the coefficient on book value of equity decreases when earnings are disaggregated, which suggests that book value of equity is value-relevant partly due to its correlation with R&D expenditures. In other words, the evidence suggests that book value of equity provides information on expected future earnings rather than abandonment values for loss firms engaged in R&D activity. These findings have implications for empirical research design in studies of value-relevance of accounting information and studies of earnings process.

Managing the Balance Sheet with Leases

We document significantly increased reliance on off-balance-sheet (OBS) lease financing that is inconsistent with economic theory. Specifically, the increase is greatest among non-distressed firms characterized by growth options and high R&D but without obvious tax incentives. We explore alternative incentives and find that (1) OBS leasing enables firms to manage debt covenants limiting debt or capital expenditures, (2) excess OBS leasing is diminished by scrutiny of institutional investors, and (3) firms investigated by the SEC or DOJ for financial misrepresentation exhibit high levels of excess OBS leasing. Overall, we conclude that firms use OBS leases to expand their debt capacity while preserving conservative balance sheets.