Product market competition, R&D investment choice, and real earnings management

• Published date: 07 August 2017
• DOI: https://doi.org/10.1108/IJAIM-06-2016-0067
• Pages: 296-312
• Date: 07 August 2017
• Author: Hsiao-Fen Hsiao,Szu-Lang Liao,Chi-Wei Su,Hao-Chang Sung

Product market competition, R&D

investment choice, and real

earnings management

Hsiao-Fen Hsiao

Department of Accounting, Ningbo University, Ningbo City, China

Szu-Lang Liao

Department of Money and Banking, National Chengchi University, Taipei, China

Chi-Wei Su

Department of Finance, Ocean University of China, Qingdao, China, and

Hao-Chang Sung

Department of Finance, College of Economics, Jinan University, Guangzhou, China

Abstract

Purpose –Recent studiesin the accountingliterature have investigated the economic consequences of R&D

capitalization. Discretionary R&D capitalization for targetbeating can be characterized as a f‌irm signaling

private information on its future economic benef‌its or as opportunistic earnings management. R&D

capitalization alsohas an impact on a f‌irm’s marginal costs and product market competition.The purpose of

this paper is to address how f‌irms choose R&D levels for thepurpose of meeting or beating their earnings

targetsand how this inf‌luences sequential product market competition.

Design/methodology/approach –The authors study this issue in a stylized game-theoretic model

where R&D choices of a f‌irm are not only strategicallymade but also used to convey proprietary information

to its rival.The model provides a rationale for a f‌irmdistorting its R&D level to earn more prof‌its and meet its

earningstarget.

Findings –The equilibrium result indicates that before the realization of common cost shock,a f‌irm can

inf‌luence the output of its accounting system (i.e. meeting an earnings target) through adjusting its R&D

choices. Thisf‌irm will overinvest in R&D, and this will give an opportunityto create some reserves to be used

later to earna higherprof‌it and reach the earnings target.

Originality/value –This paper contributesto the research on real earnings managementin terms of how

R&D capitalization affects a f‌irm’s R&Dchoices by inf‌luencing the output of its accounting system through

adjustingits R&D choicesand the strategic impact of those choices.

Keywords Earnings target, Oligopoly Competition, One-sided incomplete information,

R&D investment, Real earnings management

Paper type Research paper

1. Introduction

Several studies in the accounting literature examine the consequences of R&D capitalization[1]

(Aboody and Lev, 1998;Oswald and Zarowin, 2007;Seybert, 2010;Dinh et al., 2015a,2015b). As

underinvestment in R&D may not yield much earnings management benef‌itandmaylimita

The authors acknowledge National Social Science Foundation of China under Grant (grant

#15BJY011).

IJAIM

25,3

296

Received21 June 2016

Revised29 September2016

Accepted30 September 2016

InternationalJournal of

Accounting& Information

Management

Vol.25 No. 3, 2017

pp. 296-312

© Emerald Publishing Limited

1834-7649

DOI 10.1108/IJAIM-06-2016-0067

The current issue and full text archive of this journal is available on Emerald Insight at:

www.emeraldinsight.com/1834-7649.htm

f‌irm’s long-term growth and prof‌itability[2], capitalizers may be reluctant to do it (Oswald et al.,

2016).

Hughes and Kao (1991) examine the effects of different rules regarding R&D costs on

oligopoly competition. Hughes and Kao consider incomplete information between f‌irms as

to each f‌irm’s marginal cost. Hughes and Kao argue that capitalization is more informative

than expensing, because it requires estimates of future benef‌its and auditor verif‌ication of

such estimates.

Similar to Hughes and Kao (1991), we examine the informational impact of R&D choice

on a game that two f‌irms play in product market competition. However, the present study

focuses on how R&D capitalization[3]affects a f‌irm’s R&D choice in terms of inf‌luencing the

output of its accounting system (i.e.meeting an earnings target) through adjusting its R&D

choices and the strategic impact of those choices[4]. In a one-sided incomplete information

setting, the rival is uncertain about a f‌irm’s type, which can be either prof‌it-maximizing or

target-meeting. The prof‌it-maximizing type pursues prof‌it maximization in productmarket

competition, while the target-meetingtype attempts to earn more prof‌its, meets the earnings

target and incurs a cost for missing the target[5]. The less informed f‌irm revises its

assessments of the informed f‌irm’s type depending on the informed f‌irm’s R&D investment

level and realization of common cost shock(e.g. raw material price).

This study will investigate how an earnings target can affect the privately informed

f‌irm’s R&D choice, and the impact which this has on Cournot competition in terms of

earning more prof‌its, and more generally, in terms of whether the earnings target is met or

beaten. When the informed f‌irm has diverse purposein its R&D investment, this creates an

additional uncertainty and in turn affects the two f‌irms’decisions in Cournot competition.

We investigate whether the informed f‌irm takes advantage of its rival’s uncertainty

regarding its identity and makes the rival over-invest in R&D, thereby benef‌iting its own

plans to meet its earnings target. We also examine whether the informed f‌irm changes its

R&D choice before the common cost shock (e.g. raw material price) is realized, to exceed

expectation for the purpose of maintaining its rival’s uncertainty about the informed f‌irm’s

type. Such uncertainty is mentioned in the empirical studies conducted byBurgstahler and

Eames (2003) and Yu (2008). They discuss whetheranalysts are able to identify the specif‌ic

f‌irms engaged in earnings manipulations[6] but with diverse results. The present study

further explores thisissue on a rival f‌irm’s decisionsin its real activities.

This study, based on the above scenario, involves a two-stage game. In the f‌irst stage,

two players take an action that bears both strategic and informational effects that will

inf‌luence the decisions in product market competition in the second stage. This class of

games has been studied by researchers in an attempt to explain why theaction choice in the

f‌irst stage may deviate from the choice that maximizes prof‌its directly inf‌luenced by that

choice. The reason is that the choice affects the belief of rivals who will be involved in

product market competitionin the subsequent stage.

Several studies claim that meeting or beating an earnings target induces R&D

underinvestment (i.e. aggressive reporting) (Bushee, 1998;Graham et al.,2005;

Roychowdhury, 2006;Gunny, 2010).However, these studies ignore the sequential impact of

R&D investment. Contrary to such studies, R&D choices for meeting an earnings threshold

in the present study have both strategic and informational impact. For the informational

impact of meeting or beating the earnings target (MBT, hereafter) for an R&D f‌irm,

investing in R&D for meeting or beating earnings targets will convey a positive image of a

f‌irm that cares more about its futureprospects. This is consistent with recent experimental

evidence that f‌irms responsiblefor the external reporting consequences of theirR&D project

are more likely boost their R&D investment (Seybert, 2010). For the competitive impact of

Product

market

competition

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