1. Intangible Assets, Value Relevance, and Accounting Anomalies Wanncherng Wang Professor of Accounting Department of Business Administration College of Management National Sun Yat-Sen University No. 70, Lienhai Rd., Kaohsiung 80424 Taiwan, R.O.C. Email: wangw@mail.nsysu.edu.twwangw@mail.nsysu.edu.tw Tel: +886-7-525-4511 1

2. Research Background Value drivers of firms—tangibles or intangibles Market valuation vs accounting valuation – Market value and book value; – Accounting and economic earnings have been an unsolved issue in equity valuation. The valuation model--the relationship between earnings, book value and share prices. 2

3. Motivations Information contents of financial statements – Does intangibles estimated from accounting information predict future earnings? Low explanatory power of book value and earnings – Do intangibles thus estimated have explanatory power for market value – Do intangibles thus estimated predict future returns? 3

4. Hypothesis Development 1.Incremental Explanatory Power for Stock Prices and Future Earnings – Recognition of intangibles is inconsistent across firms. Internally developed intangibles are not recognized as assets whereas acquired intangibles, e.g., through a purchase business combination, typically are recognized and amortized against net income over the intangible’s estimated useful life. – Second, changes in intangible values largely are unaccounted for regardless of their magnitude. – Third, expenditures that increase intangible values are expensed in the period incurred rather than capitalized, e.g., advertisement expenditures 4

5. Intangibles and Reported Earnings Simply put, all these accounting treatments can result in firms that invest in intangible development reporting depressed earnings when their intangible values are increasing. Consequently, it seems reasonable to expect that a portion of firm value is missing from book value. In other words, there is a missing part in the link between book value and market value—the intangible asset. 5

6. The Price-Book Relation H1: Intangible assets have incremental explanatory power for the price-book relation. 6

7. Intangibles and Future Earnings The presence of intangible assets represents future excess earnings ability. One can use book value to predict future earnings in the sense that earnings are created from investment. – Therefore, future earnings based on recognized book value will be underestimated when intangible assets are missing from book value. – Inclusion of intangible assets will increase the predictive ability of book value for future earnings. 7

8. Predictive Ability for Future Earnings Therefore, the following hypothesis obtains. H2: Intangible assets have predictive ability for future earnings, incremental to book value and current earnings. 8

9. Stock Prices Incorporate Intangibles? Operating cash flows and current accruals 1.Cash flows are realized in the current period, while accruals represent future-period cash flows – Consequently, the market's valuation of accruals should impound discounts for futurity and risk (Dechow et al. 1996, 26) 9

10. Cash flows vs Accounting Earnings 2.Cash flows are more persistent than accruals. – Future earnings levels are more highly associated with current levels of operating cash flows than with current levels of aggregate (current and noncurrent) accruals. 3.1+2 imply that a dollar of operating cash flows should be valued more than a dollar of current accruals, with a difference in magnitude sufficient to compensate for differences in futurity, risk and persistence. 10

11. Accruals Anomaly Investors seem to fixate on earnings and fail to correctly distinguish between the different levels of persistence of the accrual and cash components of earnings. (Sloan, 1996) Sloan shows that a trading strategy based on accounting accruals can earn abnormal returns and he labels this phenomenon as “the accrual anomaly”. 11

12. Accruals Anomaly The noisy measures hypothesis – The lower persistence of accruals is often attributable to the subjectivity of accrual measures (Richardson et al. 2004, 2005; Hirshleifer et al. 2005). Xie (2001) examines the market pricing of Jones (1991) model estimated abnormal accruals to test whether stock prices rationally reflect the one-year-ahead earnings implications of these accruals. Cheng and Thomas (2006) extend this line of research by employing multiple measures of abnormal accruals to test their relation with both future annual returns and future earnings announcement returns. 12

13. Do the stock market incorporate information regarding future capabilities contained in intangible assets? Intangible assets sustain earnings and growth persistence – one can expect a relationship between intangible assets and earnings. intangible assets also introduce measurement errors into book value and earnings, – obscuring the predictability and raising the uncertainty of future earnings. 13

14. Intangible Anomaly Given the conflicting influences of intangible assets in market valuation, an interesting question is whether and how the share market values intangibles. If share prices are unable to fully reflect the implications of intangibles for firms’ future performance, one can expect a higher-than- normal returns for firms with higher intangibles (CIV). 14

15. Intangible Anomaly In particular, current share prices will underestimate the share values of firms with high CIV, leading to future positive abnormal returns. Therefore, H3: The share market fully reflects the implications of intangibles regarding future earnings. 15

16. Empirical Specifications Value Relevance of Intangible Assets 16 where MV is the total market value of equity, CIV is total calculated intangible value; Alternatively, the regression is also specified in a per- share basis. where PRC is year-end price per share, BPS is book value per share, and CIVPS is CIV per share.

17. Empirical Model where MVE is the market value of equity measured 4 months following the fiscal year-end, BVE is book value of equity, NI is net income before extraordinary, NEG_NI is net income before extraordinary items if net income before extraordinary items 0 otherwise, RND is R&D expenditures, ADVERT is advertising expenditures, CAP_EX is capital expenditures, SALES_GR is annual change in constant-dollar sales, is annual changes in estimated intangibles value and CIV is the estimated year-end intangibles value. 17

18. The Predictive Ability of Intangible Assets for Future Earnings 18 ; where TAC is total accruals, OCF is cash flows from operations, EPS is earnings per share from continuing operations, CIVPS is CIV per share.

19. The Mishkin Tests—Rational Pricing of Intangibles 19, and where t is time index, TAC is accruals component, OCF is operating cash flows, and CIV is intangibles.

20. Trading Returns to Zero Net Investment Based on Intangible Assets 20

21. The empirical results Sample Selection and Descriptive Statistics – The study sample includes all firms listed on TSE and OTC (Taiwan) and covers the period of years 1989-2009. All financial and market data are from Taiwan Economic Journal. 21

22. Descriptive Statistics 22 Table 1. Descriptive Statistics Panel A. Basic Statistics (N = 10,873) VariableMeanStd Dev 5th Pctl25th Pctl 50th Pctl 75th Pctl 95th Pctl MinMax AR10.1170.685-0.510-0.1880.0000.2531.113-2.43428.598 AR0.1250.702-0.518-0.1880.0000.2591.188-2.43428.598 PRC29.32436.9874.11010.35019.10035.35083.5000.330645.000 BPS15.7647.2166.75012.05014.50017.95028.0300.050102.180 CIVPS4.27819.249-11.182-3.6321.3387.93326.829-130.809354.721 TAC-0.0200.119-0.185-0.076-0.0250.0270.164-0.8660.953 OCF0.0660.116-0.0890.0120.0610.1230.247-1.0340.891 BTM0.9610.8930.2220.4460.7351.1902.3810.01125.000 EP-0.0230.437-0.3610.0000.0420.0800.136-16.04214.400 AR is abnormal returns estimated following Fama and French (1993); AR1 = one-year-ahead AR; PRC is price close per share; BPS = book value per share; BPS = book value per share; CIVPS = calculated intangible value per share; TAC = total accounting accruals; OCF = operating cash flows; BTM = book- to-market; EP = earnings-to-price.

23. Descriptive Statistics 23 Panel B. Correlation Coefficients. Pearson Correlation Coefficients (above diagonal) and Spearman Correlation Coefficients (below diagonal), N = 10873 Prob > |r| under H0: Rho=0 AR1ARPRCBPSCIVPSTACOCFBTMEP AR11.00-0.04 -0.02 0.030.10-0.01 <.0001 0.110.100.080.00<.00010.32 AR-0.041.000.290.09-0.010.180.06-0.240.11 <.0001 0.56<.0001 PRC0.000.371.000.660.460.220.29-0.390.12 0.67<.0001 BPS0.020.170.691.000.470.25 -0.250.23 0.01<.0001 CIVPS0.040.050.450.511.000.100.23-0.180.10 <.0001 TAC0.010.200.31 0.181.00-0.59-0.230.25 0.54<.0001 OCF0.100.150.320.300.32-0.501.00-0.130.10 <.0001 BTM0.01-0.40-0.90-0.38-0.30-0.25 1.00-0.47 0.27<.0001 EP0.140.260.340.510.420.320.36-0.181.00 <.0001

24. Value Relevance of Intangible Assets regarding Equity Valuation 24 Table 2. Regression Results. (M1), where MV is total market value of equity, CIV is total calculated intangible value; (M2), where PRC is year-end price per share, BPS is book value per share, and CIVPS is CIV per share. (M1)(M2) Indep. VariableCoef. INTERCEPT-2359228.00 *** -937928.00 *** -23.34 *** -18.14 *** EQTY2.19 *** 1.76 *** CIV0.67 *** BPS3.36 *** 2.94 *** CIVPS0.33 *** ADJ. R 2 0.760.810.430.45 N10,999

25. 25 Table 3. Equity value and intangibles here MVE is the market value of equity, BVE is the book value of equity, NI is net income before extraordinary items, NEG_NI is negative earnings, RND is R&D expenditures, ADVERT is advertising expenses, CAPEX is capital expenditures, measured by cash outflows for fixed assets, SALE_GROW is sale growth, is changes in unrecognized intangibles assets, CIV is intangible assets as measure by calculated intangible value. VariableParameter Estimate Standard Error t ValuePr > |t| INTERCEPT0.950.0243.41<.0001 NI/BVE3.100.1225<.0001 NEG_NI/BVE-3.290.13-25.65<.0001 RND/BVE5.990.2128.76<.0001 ADVERT/BVE1.380.1112.8<.0001 CAPEX/BVE-2.790.15-18.49<.0001 SALE_GROW/BE0.00 0.90.3705 CIV/BVE0.020.011.930.0537 CIV/BVE0.030.013.89<.0001 N9740 Adj. R 2 0.51

26. Does Estimated Intangible Assets Predict Future Earnings 26 Table 4. Earnings, accruals, operating cash flows and future earnings. M1: ; M2: where TAC is total accruals, OCF is cash flows from operations, EPS is earnings per share from continuing operations, CIVPS is CIV per share. (N = 8,443) M1M2 Coef.StddevP-valueCoef.StddevP-value INTERCEPT0.230.03<.00010.210.03<.0001 TAC12.520.60<.00011.050.600.08 OCF13.810.61<.00011.740.600.00 EPS-0.150.130.22360.060.160.70 EPS(t+1)0.640.04<.0001 CIVPS0.070.01<.00010.020.00<.0001 Adj R 2 0.470.54 N8,473

27. The Accrual Anomaly and the Intangibles Anomaly 27

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