Pantea Alirezazadeh UNIVERSITY OF CONNECTICUT Communicating the Value of Intangibles: The Role of Capitalization and Patent in the Software Industry

Research Objective In the case of R&D assets of software development companies, do firms with large number of filed patents capitalize more of their software development cost? Does filing for patent reduce the information asymmetry between the market and the firm? How both filled patents and capitalized software development cost interact and what would be their mutual effect on information asymmetry?

Outline Intangibles Accounting Rules for Capitalization of R&D Assets Filling for Patent Prior research Hypothesis Data Result

Intangibles Accounting rules define an asset intangible if it owns the following characteristics: Lack of physical substance Non-financial nature Initial useful life extends beyond a single financial reporting period

PatentsTrademarkR&DBrand Computer Software

How it measure Intangibles?  Market Capitalization  Return on Invested Capital  Score Cards  Direct Measure of Intellectual Capital  Brand Valuation

Research and Development The Standard of Financial Accounting Standards(SAFS) No. 2 requires the immediate expensing of all R&D activities. SFAS No. 86 indicate that software capitalization, the only exception in the United States to the full expensing rule of R&D (SFAS No. 2), can be capitalized under certain conditions

SFAS No. 86 Requirements Initiation Stage Technical Feasibility Ready to be Sold Software Sale ExpenseCapitalize Expense

Capitalized Software Development Costs Income Statement Operating Expenses: Depreciation/Amortization R&D Balance Sheet Assets: Property, Plant, Equipment Capitalized Development Cost

Prior Literature: Capitalize or Expense!? Capitalizing software developments costs leads to higher earnings variability which is positively correlated with forecast errors (Shi 2002). Analysts concerned with the size of their earnings forecast errors view capitalization negatively (Aboody and Lev 1998). The greater the uncertainty of future economic benefits from R&D expenditures, the weaker would be the case in favor of capitalization (Kothari and et. al 2002).

Prior Literature: Capitalize or Expense!? Capitalized values of R&D are significantly associated with stock prices. (Lev and Sougiannis 1996) Capitalization-related variables in the financial statement are significantly associated with capital market variables and future earnings. (Aboody and Lev 1998) The expensing of R&D by firms with increasing investment rate in R&D is associated with a decline in the informativeness of reported earnings. (Lev and Zarowin 1999) Capitalization of intangibles is associated with higher analyst following and lower absolute earnings forecast errors. (Matolcsy and Wyatt 2006) Allowing managers to credibly signal their superior information by either capitalizing successful R&D investment or expensing unsuccessful R&D investments reduces information asymmetry. (Ahmed and Falk 2006).

Patents: A Popular Choice of Innovation Proxy Patentable Patentable Subject Matter Industrial Application New Non- Obvious

Prior Literature: Patenting and Market Value Patent citation has a noticeable effect on market value (Hall and et. al. 2005). Patents have a significant impact on firm-level productivity and market value (Bloom and Reenen 2002). There is positive relation between the future operating performance and productivity of a firms’ innovation efforts (Pandit et. al ).

Hypothesis Hypothesis I: The amount of capitalized software development cost is significantly higher for the firms that have filed more patents. Hypothesis II: Filing for patent reduces the information asymmetry. Hypothesis III: The presence of successfully issued patents moderates the signaling power of capitalized software development cost.

VariableDescription CapValue Capitalized software development cost divided by market value MarketValue Market value of the firm three months after the fiscal year DevelopmentIntensity Annual software development costs to sales Profitability Net income plus software amortization minus the annually capitalized software divided by sales. Leverage Long-term debt divided by book value of equity Patent The number of patents applied by the end of the fiscal year Spread Annual average of the logarithm daily relative bid-ask spread, defined as absolute value of the bid-ask spread divided by their average Volatility Logarithm standard deviation of daily stock return Capitalization The amount of capitalized software development cost Patent Dummy 1 if the firm has filed any patent that year and 0 otherwise Turnover Annual average of logarithm trading volume in shares divided by number of shares outstanding Price Annual average of the logarithm of daily stock price Analyst Number of analysts supplying one-year ahead earning forecast

Data COMPUSTAT, CRSP, I/B/E/S SEC Filings, DirectEdgar USPTO, NBER 260 firms for years 2000 to 2008 Computer programming and prepackaged companies: SIC Data Collection: Capitalization of the software development cost and amortization of software asset Financial data Patent Data

Hypothesis I VariableCoefficientt-value LogMarketValue *** LogDevelopmentIntensity *** LogProfitability *** LogLeverage *** LogLagPatent *** ***Denote significance at a probability level below 0.01 **Denote significance at a probability level below 0.1

Heckman Model VariableCoefficientt-value LogMarketValue *** LogDevelopmentIntensity *** LogProfitability *** LogLeverage *** LogLagPatent *** ***Denote significance at a probability level below 0.01 **Denote significance at a probability level below 0.1

Heckman Model(Selection) VariableCoefficient-value LogMarketValue *** LogDevelopmentIntensity ** LogProfitability *** LogLeverage *** LogLagPatent *** LogBeta *** ***Denote significance at a probability level below 0.01 **Denote significance at a probability level below 0.1

Hypothesis II variableCoefficientt-value LogMarketValue *** Volatility *** Turnover *** Price *** Analyst Patent ** ***Denote significance at a probability level below 0.01 **Denote significance at a probability level below 0.1

Hypothesis III VariableCoefficientt-value LogNetIncome PatentDummy LogCapitalization LogCapitalization*PatentDummy

Hypothesis III VariableCoefficientt-Value LogMarketValue *** Volatility *** Turnover *** Price *** Analyst PatentDummy *** Capitalization PatentDummy*Capitalization *** ***Denote significance at a probability level below 0.01

Hypothesis III VariableCoefficientt-Value SharOut *** Analyst *** PatentDummy *** Capitalization PatentDummy*Capitalization ** ***Denote significance at a probability level below 0.01 **Denote significance at a probability level below 0.1

Conclusion Both filing for patent and capitalizing the software development costs both reduce the information asymmetry between firm and the market. Firms that file for more patents have a higher rate of capitalization. Filing for patent reduces the effect of capitalization on information asymmetry.