Em in r&d syazana

EARNINGS MANAGEMENT:
ISSUES IN R&D EXPENDITURE
MANIPULATION
Presenter: Nur Syazana Jalaludin, 2012557973

Slide Content_
 List of Studied Article
 Brief Introduction: R&D as an investment
 Issues & Motivation Discussions
 Mitigation Point
 Summary and Conclusion

Studied Articles_
• Institutional Investors and Earnings
Management:The R&D Expenditures
Manipulation
Iskandar
Rebai, 2010
• The Influence of Institutional Investor on Myopic
R&D Investment Behavior
Brian J.
Bushee, 1998
• Earnings Management by Changing R&D
Expenditure: Evidence on the Role of CEO Stock
Compensation
Frank He,
2003
• Earnings Management:The Effect of Accounting
Flexibility on R&D Investment Choices
SeanWang,
2006
• The Relationship between R&D Spending and the
Earnings Management of Japanese Electronics
Companies
Yoshihiro
Tokuga, 2011

R&D as an Investment_
 Important assets In the industry of high technology and
biotechnology
 To improve future performance and promote growth
opportunities.
 A positive relationship has existed between R&D and
economic growth, future result and business productivity.
 In the market valuation, R&D plays an important role as it
future stock market and profitability.
 it’s a risky investment and a long term commitment with
often failure outcomes.
 R&D investment is a kind of earning management by the
managers.

Issues and Discussions_
1
• Roles of
Institutional
investors
2
• Roles of Stock
CEO
compensation
3
• Accounting
Flexibility

1
• Managerial
Myopia
• Roles of
Institutional
investors
2
• Roles of Stock
CEO
compensation
3
• Accounting
Flexibility

1.0 Managerial Myopia
 Myopic investment behavior
::UNDERINVESTMENT in long term
intangible projects for the purposes of
meeting short-term goals
 It’s a type of EM that most likely to happen
when managers face a trade off between
EARNINGSTARGET and R&D INVESTMENT

1.0 Institutional Investor Roles_
 Institutional investor INCITE
income increasing , which
caused institutional myopia
 Eager to seek IMMEDIATE
return
 Inst. Investor EXACERBERATE
managerial myopia ~
encourage manager to
manipulate earnings by
limiting the R&D spending.

- High Institutional
Ownership
- Large stockholdings
- Sophisticated
institutional investor
- Long term focus
- Low Institutional
Ownership
- Ownership by the
Institution
-Transient ownership
characteristic
- Short term focus
LESSlikelytocuttheR&Dexpenses
MORElikelytocuttheR&Dexpenses

 Recent studies shows that, MAJORITY of inst.
Investor often sees as R&D as an obstacle in
value creation
 Also shown in Japanese firm
 Japanese (3/4) institutional is MORE MYOPIC
than US (1/4)
R & D
institutional investor

Motivation and Incentives_
Factor: ShortTerm focus of Institutional
Investor
 :: R&D cost is reduce to AVOID earnings
disappointment that would trigger
Institutional Investor SELLING, and lead to
MISVALUATION of the firm’s stock price.

Investor
 ::To prevent institutional investor from
LIQUIDATE their position
 by manipulated the short term earnings
 manager FEAR decline in current results
because of the short term goal by investor

Investor
 ::To limit problem ofTAKEOVER -
Institutional investors willing to SELL their
holding after REDUCTION in current earnings
which can lead to DECREASE in stock price.
Institutional sell their stake at low premium,
thus control passes to acquiring firm.

investor
 :: JOB SECURITY - Remuneration LINKED to
achieved result in short term expectation
 Fund managers of institutional investor are
subject to constrains PERFORMANCE
DEMANDED by superiors.To protect job, and
ensure advancement, fund manager are
obliged to encourage manager of firm to
avoid long-term investment.

1
• Roles of
Institutional
investors
2
• Roles of CEO
Stock
compensation
3
• Accounting
Flexibility

2.0. CEO Stock Compensation_
 CEOs are more likely to cut R&D expenditure
to avoid decreases in reported earnings
Let’s cut the
expenses for
R&D so that our
reported earning
looks GREAT!

Avoid earnings decrease that would
lead to
 undervaluation of executive perceived
ability
 decrease compensation

CEO Stock Compensation_
 CEO compensation primarily cash-
dominated, to cut long-term investment
 Cash-based compensation and R&D
reduction is stronger when CEO dominance
firm

Motivate managers to
INCREASE long term
investment
Shift current earnings to
future,
- Can BENEFIT from the
current under-pricing of
firm’s stock
Motivate managers to
CUT long term
investment
Myopic behavior
Reduction in R&D is
more prevalent
LONGTERM
ShortTerm
STOCK-Based
Compensation
CASH-Based
Compensation

Cash-based + Dominance_
 R&D expenditure reductions are more
prevalent when CEO compensation are
primarily CASH dominated.
 CEO DOMINANCE more likely to behave
myopically

Regulates relationship
between CEO and
shareholders
Strong BOD
ENCOURAGECEO to
support long term
investment
R&D reductions
stronger when CEO
serve as the chairman
of the board
(DOMINANCE)
In addition to CASH
based compensation
Myopic behavior
ControlR&D
ReductioninR&D
Independent Board CEO Dominance

Horizon Problems_
 When CEO approach retirement
 With Cash-based compensation
 Tend to cut R&D
 Incentives plane base on earnings (R&D as
expenses) will penalize current CEOs and
reward their successor

Factor: CEO stock compensation
 CEO’s are more likely to cut R&D expenditure
to AVOID decrease in reporting earnings.
 When cash portion of their compensation is
greater than the stock portion
 When the cash portion relative to the stock
portion is increased over period of time

Factor: CEO compensation scheme
 Accounting based - CASH COMPENSATION
motivates under investment in long term
projects, for the purpose of meeting short-
term earnings target

3.0 Accounting Flexibility_
 Because GAAP requires R&D to be fully
EXPENSED, manager can affect
earnings DIRECTLY by changing R&D
expenditure

Accounting Flexibility_
 When expect earnings DECREASES or
LOSSES
 Change discretionary expenses and accruals to
AVOID such decreases and losses
 R&D expenditure is discretionary – manager
could reduce it to meet current earnings.
 Distorted R&D investment behavior are more
likely to take place when executive facing a
face tradeoff between earnings targets and
maintaining R&D investment

Accounting Choice_
 In Japan more than 90% had expensed all of
R&D spending because ofTAX BENEFIT
 Thus they generally use Real Manipulation
 Increase or decrease R&D spending
 Change the content of R&D to gain target result
within short term

Real EM_
 More OPAQUE
 EM more DIFFICULT to detect by
shareholder
 Probability of lawsuit with real earnings is
LESS likely

Accounting Flexibility_
 Firms with GREATER accounting flexibility
exhibit a lower propensity to reduce R&D.
(Less likely to cut R&D)
 Firms with LOW accounting flexibility exhibit
a higher propensity to reduce R&D. (More
likely to cut R&D)

Mitigations Points_
 Presence of long-term institutional investor
mitigates the myopic perspective of
managers who cut R&D to beat
contemporary period benchmark.
 CEO compensation structure mitigates R&D
reduction cost .Structural change from cash-
dominated to stock-dominated can mitigates
CEO’s incentives for reduce R&D

Conclusions_
 Institutional ownership can significantly
influence the investment behavior
 Manager act myopically and reduce R&D
expenses to meet short term expectation
from Investor
 CEO dominance with cash-dominated
compensation, more likely to cut R&D cost

Conclusion_
 Evidence of EM in R&D which can related to
FRAUD intention was not found
 Long term institutional behavior and stock-
dominated compensation can mitigates EM
in R&D

Em in r&d syazana

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