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Measuring Distress Risk: The Effect of R&D Intensity

Authors

  • LAUREL A. FRANZEN,

  • KIMBERLY J. RODGERS,

  • TIMOTHY T. SIMIN

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    • Franzen is at the University of Texas at Dallas, Rodgers is at New York University, and Simin is at Pennsylvania State University. The authors are grateful for comments from Edward Altman, Diane Denis, Stacie Laplante, Michael Lemmon, Karl Muller, Micah Officer, and the workshop participants at the University of Texas at Dallas, with special thanks to Robert Stambaugh and an anonymous referee.


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.

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