Measuring Distress Risk: The Effect of R&D Intensity

Abstract

Because of upward trends in research and development activity, accounting measures of financial distress have become less accurate. We document that (1) higher research and development spending increases the likelihood of misclassifying solvent firms, (2) adjusting for conservative accounting of research and development increases the number of correctly identified distressed firms, and (3) adjusted measures of distress alleviate previously documented anomalously low returns of large, high distress risk, low book-to-market firms. The results hold after updating stale parameters and under various tax assumptions. Our evidence raises concerns about interpretation of extant literature that relies on accounting measures of distress. Copyright 2007 by The American Finance Association.

R&D investment and distress risk

“…In Columns (5)-(8) when the adjusted Zscore is used as the dependent variable, R&D variables remain significant though the estimates become smaller. It is consistent with Franzen et al (2007) which show that the adjustments to the Z-score measure for the conservative treatment of R&D reduce the Table 7 The effect of R&D on Z-score. This table reports the estimates from IV-2SLS models.…”

“…Given the conservative accounting treatment of R&D, I follow Franzen et al (2007) to make adjustment to Z-score to reduce the accounting distortion issue. Table 7 shows that R&D has a significant and positive effect on Z-score.…”

“…To avoid accounting distortion, I follow Franzen et al (2007) to adjust for conservative accounting treatment of R&D investment and construct an adjusted ROA. The adjusted ROA for high R&D firms is still significantly lower than that for low R&D firms.…”

“…Opler and Titman (1994) find that highly leveraged firms that engage in R&D suffer the most in economically distressed periods and argue that firms with specialized products are especially vulnerable to financial distress. However, Franzen et al (2007) show that R&D intensive firms are more likely to be falsely classified as financially distressed based on accounting measures of distress risk. To address the accounting distortion issue, I focus on the ex-post measure of distress events and show that firms with higher R&D expenditures are more likely to enter financial distress.…”

Corporate distress and turnaround: integrating the literature and directing future research

“…However, Hotchkiss (1995) offers contradictive results that employ accounting measures, predominantly used in general management research. Although scholars rely on market measures to argue that relative and absolute accounting measures can be subject to managerial manipulation, the counterparty claims market measures are biased by expectations (Eberhart et al 1999;Franzen et al 2007;Furrer et al 2007).…”