Income Conservatism in the U.S. Technology Sector

Abstract

SYNOPSIS I investigate the extent and nature of income conservatism in the financial statement numbers of firms in the U.S. technology sector. Technology firms are predicted to have greater income conservatism than other U.S. firms because they are subject to both higher shareholder litigation risk and conservative accounting standards such as SFAS 2. In the absence of a generally accepted measure of conservatism, I examine several proxies, including loss incidence and accounting rates of return, operating cash flow and nonoperating accrual levels, and regression coefficients from the earnings-return model in Basu (1997). Relative to other companies, technology firms' earnings are characterized by higher (and intertemporally increasing) levels of both conditional and unconditional conservatism. These differences are both statistically and economically significant. Further analysis suggests that technology firms' higher conservatism results primarily from lower operating cash flows due to R&D expensing and more income-decreasing accounting accruals linked to litigation risk. The results of this study are potentially useful to financial analysts, researchers, regulators, managers, and other users of financial statements. Data Availability: Data are available from public sources.

Strategic Conservative Earnings Management of Technology Firms: Evidence from the IPO Market

“…This hypothesis is consistent withChandra (2004), which documents the accounting conservatism of US technology firms.3 Ball and Shivakumar (2006) andArmstrong (2009) are a few exceptions, and they find that IPOs prospectus financials are associated with more conservative accruals.…”

Do Political Connections Affect the Conservative Financial Reporting of Family Firms?

“…Furthermore, Khan and Watts [66] found that conservative financial reporting is positively related to investment uncertainty; therefore, we included the length of the investment cycle (LINC) in the model. A shigh technology firms face greater risks of shareholder litigation and greater discretionary expenditures affected by accounting standards, such as the recognition of research and development (R&D) costs and potential loss of patent litigation [74,75], such firms can use conservative accounting to reduce anticipated litigation costs from shareholders; thus, we included an indicator variable to control for firms facing high litigation risks (LIT). Finally, we controlled for yearly and industry sector fixed effects, which both account for the systematic time period and controls for any omitted industry factor.…”

Scale effects of R&D as reflected in earnings and returns

“…We do, however, also include book-to-market ratio as a control variable, as Fama and French (1995) suggest that book-to-market ratio is negatively related to future earnings. Chandra et al (2004) characterize the accounting treatment of R&D expenditures as conservative, because all R&D is immediately expensed, whereas benefits are realized later. Hence we adjust earnings for expensing of R&D consistent with LS (1996) to eliminate the impact of conservative reporting.…”