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Market Underestimation of the Implications of R&D Increases for Future Earnings: The US Evidence

Authors

  • Ashiq Ali,

    1. The first and third authors are from The University of Texas at Dallas. The second author is from Binghamton University, State University of New York. They gratefully acknowledge the comments of Peter Pope and Andy Stark (editors), an anonymous referee, Jim Ohlson, Paul Zarowin, and seminar participants at the 2011 JBFA Conference and at the American Accounting Association's Financial Accounting and Reporting Section Conference.
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  • Mustafa Ciftci,

    1. The first and third authors are from The University of Texas at Dallas. The second author is from Binghamton University, State University of New York. They gratefully acknowledge the comments of Peter Pope and Andy Stark (editors), an anonymous referee, Jim Ohlson, Paul Zarowin, and seminar participants at the 2011 JBFA Conference and at the American Accounting Association's Financial Accounting and Reporting Section Conference.
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  • William M. Cready

    Corresponding author
    1. The first and third authors are from The University of Texas at Dallas. The second author is from Binghamton University, State University of New York. They gratefully acknowledge the comments of Peter Pope and Andy Stark (editors), an anonymous referee, Jim Ohlson, Paul Zarowin, and seminar participants at the 2011 JBFA Conference and at the American Accounting Association's Financial Accounting and Reporting Section Conference.
    Search for more papers by this author

Ashiq Ali, 800 West Campbell Road, SM41, Richardson, TX 75080-3021, USA. e-mail: ashiq.ali@utdallas.edu

Abstract

Abstract:  This study shows that future abnormal returns to R&D increases are concentrated around subsequent earnings announcements. It further shows that market expectations, implied from stock prices, underestimate the future earnings benefits of increase in R&D. Finally, it documents that in their forecasts of future earnings, security analysts also underestimate the effect of increase in R&D spending. These results suggest that future abnormal returns following R&D increases are at least in part due to the market's underestimation of the earnings benefits of R&D increases. The finding in this study contributes to the longstanding debate in accounting on whether the US GAAP requirement to expense R&D costs when incurred causes investors to underestimate the benefits of R&D.

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