The Influences of Financial Statement Recognition and Analyst Coverage on the Market's Valuation of R&D Capital

Abstract

Statement of Financial Accounting Standards No. 141 (SFAS No. 141)'s requirement that an acquirer in a business combination estimate the fair value of the target's separately identifiable assets and liabilities (including research and development capital) provides a rare occasion where estimated fair values of U.S. firms' research and development (R&D) capital based on private information about their R&D activities are publicly disclosed. The degree to which equity values impound the estimated fair values of R&D depends upon the extent to which the private information implicit in the R&D estimates is reflected in investor expectations. Financial statement recognition of R&D capital and analyst activities have been cited as alternative mechanisms by which private information about firms' R&D activities can be revealed to investors. I investigate the degree to which both mechanisms lead to the public revelation of the private information implicit in the R&D fair value estimates by examining whether financial statement recognition of R&D assets by the target prior to the merger announcement and/or analyst coverage of a target prior to the merger announcement influence the degree to which the target's pre-merger announcement equity value reflects the acquirer's subsequently disclosed estimate of the fair value of the target's R&D capital. I find that the degree to which a target's pre-merger announcement equity value reflects the estimated fair value of its R&D capital is increasing in the amount of R&D-related intangibles captured in the target's pre-merger announcement balance sheets and in the number of analysts covering the target prior to the merger announcement. This evidence is consistent with the notion that both financial statement recognition and analysts' private information search activities lead to the revelation of private information about the value of R&D assets that investors incorporate into equity values. I further find that the positive relation between analyst following and the market's valuation of R&D capital is strongest for the portion of the estimated fair value of R&D capital that is unrecognized by the target prior to the merger announcement. This finding is consistent with analysts filling in the information gap left by the lack of financial statement recognition. The results of this study confirm the theorized roles of financial statement recognition and analyst activities in aiding the market's valuation of intangible assets.

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