How Does Earnings Management Affect Innovation Strategies of Firms?

Nen-Chen Richard Hwang

Department of Accountancy
California State University San Marcos, U.S.A.
(760) 750-4220
hwang@csusm.edu

Jeng-Ren Chiou
Department of Accountancy
National Cheng Kung University, Taiwan
(886) 6-275-7575 extension 53436
jerryc@mail.ncku.edu.tw

Ming-Hsien Ethan Hsueh*

Department of Accounting
National Changhua University of Education, Taiwan
(886) 4-723-2015 extension 7322
mingsian@gmail.com

Chih-Chieh Hsieh
Department of Accountancy
National Cheng Kung University, Taiwan
(886) 922-139-001
r16004017@mail.ncku.edu.tw  

May 2014

*: Corresponding author

 
 
 How Does Earnings Management Affect Innovation Strategies of Firms?

Abstract

As documented in the literature, firms engaging in more real earnings management have
higher cash flow volatility than those involving less real earnings management. In contrast,
firms taking part of accrual-based earnings management mainly affect their reporting
earnings. However, such activities have little impacts on volatility of firms’ cash flows.
Because firm executives have discretions to decide their innovation strategy by either
developing patents in-house or purchasing patents from a third party and these strategies have
different degree of impacts on firms’ cash flows, we explore whether these is an association
between firms’ innovation strategies and types of earnings management. Then, we investigate
the effect of such association on firm value. The findings reported in this study indicate that
there is a strong association between innovation strategy and types of earnings management
employed by executives. More importantly, this association has significant impacts on firm
value.

Key Words: Innovation, Strategy, Firm Value, Real Earnings Management, Accrual-Based
Earnings Management

1  
 
 Innovation Strategy, Earnings Management, and Firm Value

1. Introduction

Innovation is one of important avenues to fuel a firm’s growth and to maximize

shareholders’ wealth (e.g., Hsu 2009). Engaging in innovations could bring new income

streams, enhance productivity, and improve operational efficiency, thus increasing a firm’s

profit. With enrichment of profitability, innovations could raise the expected returns on stock

and boost the premiums of equity shares (Pakes 1985; Austin 1993; Lev and Sougiannis 1996;

Deng et al. 1999; Chan et al. 2001). When determining how to innovate, executives can

decide to invest in in-house research and development (R&D), acquire patents through the

third parties, or do both. Involving in in-house R&D requires firms to make consistent and

ongoing investments throughout a reasonably long time horizon. By taking this strategy,

management not only has to make commitments to provide resources into projects on a

continual basis but also has to have confidence in their ability to generate sufficient amount

of cash flows regularly to support their R&D activities. Other firms may prefer to acquire

patents from external parties because firms can take advantage of the realized innovations

and quickly bring business interests to the organizations. Since patents are the most actively

traded intangible assets in intellectual property markets (Lev 2001), management does not

need to make long-term financial commitment to technological innovations when

implementing patent purchase strategy. Thus, corporate executives will be less concern about

whether they are able to generate cash flows in a regular basis over time to support R&D

projects. Under this scenario, all management has to do is to secure one-time resource by

issuing equity or debt securities to complete acquisitions when they decide to go for patent

purchased strategy.

There are several characteristics regarding in-house R&D projects (Brown and Petersen

2011). First, it is time consuming and highly uncertain about potential business success of
2  
 
these R&D projects. Second, involving in in-house R&D requires consistent infusions of cash.

Third, investments in R&D projects have limited collateral value. Finally, there are high

termination costs due to infrastructures built for ongoing R&D projects.1 In comparison, it is

relatively fast for corporate executives to acquire patents from active intellectual property

markets. Also, management can determine timing to purchase patents once the amount of

cash for acquisition becomes available. In addition, purchasing patents from the third parties

offer solid, market-based, collateral values because of realizable business interests. Finally, it

is relatively easy for firm management to cease patent acquisitions without worrying about

high termination charges to the organizations driven by the physical infrastructures and

human resources.

As to the potential economic benefits derived from in-house R&D, there is a low

probability of a large-scale adoption by other firms when a firm develops patents. Because of

the proprietary nature of in-house R&D projects, successful innovations only lead to a small

scale of production by the representative firm and the uncertainty of the future productivity

associates with particular R&D projects increases idiosyncratic risk2. In contrast, acquiring

patents from the third parties increases systematic risk3 because desirable patents may not be

available in the market and the acquisition prices of patents are contingent upon the

competition in the market. With an increasing in systematic risk, it leads to a higher beta for

patent acquiring firms. Since beta influences the discount factor, which in turn determine the

net present value of projects, raising beta implies an increase of the required rate of return for

a firm. Applying capital asset pricing model (CAPM) to estimate a firm value, a higher beta

                                                                                                           
1
  The essential element to conduct R&D is physical infrastructure. It consists of instruments and research space
such as laboratories, instruments and computer rooms. Another element of R&D infrastructure is human
resources. For companies engaging in in-house R&D, they also have to continue investing in order to protect
and leverage its intellectual properties.
2
Idiosyncratic risk is the risk specific to an asset or a small group of assets. This type of risk has little or no
correlation with market risk. Therefore, it can be substantially mitigated or eliminated from portfolio by using
adequate diversification. Idiosyncratic risk, by definition, is unpredictable.  
3
  Systematic risk is the risk affects the entire market. This type of risk cannot be mitigated via diversification.
3  
 
insinuates a surge of the required rate of return. Since in-house R&D has little or no impact

on beta (systematic risk), it has limited effect on a firm value. However, acquiring patents

from the intellectual market affects beta. Thus, it affects a firm value.

The extant literature shows that firms have engaged in accrual-based and real earnings

management (e.g., Roychowdhury 2006; Cohen and Zarowin 2010). Both types of earnings

management reduces financial reporting transparency and creates information asymmetry

between corporate executives and market participants. By taking advantage of flexibility in

accrual-based accounting standards, management can successfully manipulate reported

earnings and present a better financial picture to shareholders and other market participants.

When a firm engages in real earnings management, on the other hand, firm executives are

able to boost sales revenue by increasing price discounts, decrease cost of goods sold by

increasing ending inventories, and cutting discretionary expenses to improve the reported

earnings (Cohen and Zarowin 2010). By maneuvering real transactions according to

managerial discretions, reporting transparency decreases. As documented in the literature,

different types of earnings management have distinctive implications to firms’ cash flows.

Managing earnings through accounting accruals has limited impact on the amount and

volatility of a firm’s cash flows. However, manipulating real activities could effectively

reduce the amount of discretionary expenses and raise cash flows on hand. As results from

real earnings management via transactions, volatility of cash flows will increase (Cohen and

Zarowin 2010).

In this study, we postulate that earnings management negatively affects the degree of

innovations. Since types of earnings management have distinctive implications to a firm’s

cash flows, we predict that there is an association between types of earnings management

employed (accrual-based earnings management versus real earnings management) by

corporate executives and a firm’s innovation strategy (in-house R&D versus patent

4  
 
acquisition). Because of different impacts of innovation strategy on a firm’s beta and the

required rate of return, employing innovation strategy would affect a firm value. For the

purpose of examination, we categorize a firm innovation strategy into in-house R&D and

patent acquisitions. To quantify the degree of earnings management, we measure the degree

of accrual-based earnings management using the absolute value of discretionary accruals

estimated by cross-sectional Jones model (Jones, 1991). To derive the level of real earnings

management, we follow Cohen and Zarowin (2010) and gauge the real earnings management

by the decreases in discretionary expenses such as advertising and selling, general, and

administrative (SG&A) expenses. In this study, we use Tobin’q as a proxy for firm value in

order to investigate the effect of the innovation strategy and earnings management.

The period of the study is from 1997 to 2009. We retrieve patent purchasing data of

S&P 500 firms from LexisNexis Academic database and obtain the amount of R&D

expenditures and other financial data from COMPUSTAT database. Several research

hypotheses are examined in this study. First, we investigate the impact of earnings

management on innovation strategy. Then, we explore whether there is an association

between innovation strategy and earnings management. Finally, to understand the effect of

the innovation strategy and earnings management, we conduct several tests to discern their

impacts on firm value. The empirical evidence reported in this study indicates that earnings

management affects a firm’s innovation strategy. The association between earnings

management and cash flows also influences a firm’s innovation strategy. Moreover, firms

acquiring patents from third parties have lower firm value than those choose to pursue

in-house R&D. To be more specific, a firm’s value goes down when the degree of real

earnings management grows and the level of patent purchasing increases.

This study makes the following contributions to the literature. First, there is an

increasing trend among academicians to investigate how firms manage reported earnings

5  
 
through manipulations of real activities. By providing empirical evidence to our research

inquires, this study offers additional insights to deepen our understanding on the relation

between innovation strategy and earnings management. Second, firm management has

devoted a great deal of resources to technological innovation by either investing in in-house

R&D or acquiring patents from third parties though intellectual property markets. For firms

committed to in-house R&D, there is little to show to investment community in order to

justify these expenditures until proprietary patents are ready to produce financial interests. To

justify R&D expenditures, our study shows in-house innovation indeed enhances a firm’s

value.

The remainder of this paper is organized as follows. Section 2 provides literature

review and hypotheses development. Section 3 describes data collection and research design.

Section 4 presents the empirical results. Section 5 presents results of several tests conducted

to ensure the robustness of empirical evidence presented in this study. Section 6 concludes

this study by summarizing the research findings, outlining the limitations and offering the

directions for future studies.

2. Literature Review and Hypotheses Development

This section is divided into the following subsections. In Section 2.1, we discuss the

level of earnings management and degree of innovation. In Section 2.2, we investigate the

relation between earnings management, cash flows and innovation strategy. Then, in Section

2.3, we explore the influence of innovation strategy on firm value. Finally, in Section 2.4, we

examine the relation between innovation strategy, earnings management, and firm value.

2.1 Earnings Management and Degree of Innovation

Investors’ adverse selection behavior increases cost of capital for firms seeking external

resources to finance their operational activities. Because of information asymmetry between

6  
 
corporate executives and market participants, market participants tend to believe that

managers will issue equity shares to finance investment projects when share price is

overvalued (Myers and Majluf 1984). Due to this perception, investors are likely to react

negatively when firms announcing their plan to issue additional stock, thus increasing cost of

capital. Along the same line, Hess and Bhagat (1986) and Lim et al. (2008) find that

information asymmetry also raises the cost of capital because investors need to gather

information, understand the managerial intention, evaluate the quality of projects, and then

decide whether to involve with these firms. To alleviate the negative effect on cost of capital

and to improve the firm-level investment, Biddle and Hilary (2006) suggest that the negative

effect of investors’ adverse selection, driven by the information asymmetry between

corporate executives and investors, can be mitigated by enhancing financial reporting quality.

To ease investors’ adverse selection problem, Biddle et al. (2009) point out further that there

is a correlation between financial reporting quality and visibility of valuable investments.

When financial information becomes more transparent, it diminishes the information

asymmetry between corporate executives and market participants, lessens the level of

uncertainty about investment projects, and reduces costs of capital for firms need additional

resources to support their investment activities. If investor adverse selection and information

asymmetry issues cannot be properly taken care of, firms should create an internal capital

market to avoid underinvestment problem (Williamson 1975).

The extant literature documents that earnings management reduces the quality of

financial reporting, decreases the investor’s level of confidence, and decreases investment

efficiency. Therefore, earnings management may lead to shortage of external financial

resources, thus affecting firms to engage in innovations. Furthermore, Brown et al. (2009)

show that the uncertainty and volatility of investment return may limit a firm’ capacity in

seeking for financing alternatives to facilitate R&D activities or patent acquisitions. In case of

7  
 
using equity financing to fund in house R&D activities or patent acquisitions, investors

probably will demand a higher discount rate if investors’ adverse selection prevails. Because

of the uncertain nature of innovation, this issue becomes even more evident. Since

information transparency is key factor to mitigate investors’ adverse selection and

information asymmetry between managers and market participants, earnings management

probably will negatively affect the degree of innovation. Applying these logics, we

hypothesize that:

H1: Earnings management negatively affects the degree of innovation.

2.2 Earnings Management, Cash Flows and Innovation Strategy

Firms engage in accrual-based, as well as real, earnings management (Roychowdhury

2006; Cohen and Zarowin 2010). Management can purposely manage its earnings by taking

advantage of flexibility in accrual-based accounting standards. Executives also can

manipulate earnings through real transactions. There are several reasons for managers to

involve in accrual-based earnings management. For instance, Jones (1991) finds that firms

manage reported earnings in order to benefit from newly-promulgated regulations. Baber et al.

(1991) and Bushee (1998) demonstrate that firms reduce discretionary accruals to meet

earnings benchmarks. Recently, Hwang et al. (2013) study reports that firms manage earnings

by facilitating transactions through related parties to avoid government interventions. As to

manipulate earnings through real transactions, managers have flexibility to boost sales by

increasing price discounts or offering more lenient credit terms to customers, overproduce to

increase ending inventories and decrease cost of goods sold, or cut discretionary spending

such as R&D, advertising, and SG&A expenses (Cohen and Zarowin 2010). Managers also

have incentives to involve in real earnings management. For example, Dechow and Sloan

(1991) show that corporate executives reduce the amount of discretionary expenditures at the

end of their tenure to increase short-term reported profit.

8  
 
 Different type of earnings management has distinct impacts on the amount and the

volatility of cash flows. Managing earnings through accounting accruals has limited impact

on a firm’s cash flows. On the other hand, real earnings management affects the amount, as

well as the degree of volatility, of a firm’s cash flows (Roychowdhury 2006). In addition, the

choice of types of earnings management is driven by other factors. For instance, Cohen and

Zarowin (2010) point out firm executives may prefer to manage earnings through real

activities, instead of using accounting accruals. There are several reasons to support this

viewpoint. First, the realized shortfall between unmanaged earnings and the desired threshold

can exceed the amount by which it is possible to manipulate after the end of the fiscal period.

If reported income falls below a certain threshold and all accrual-based options have been

exhausted, managers are left with no options since real activities cannot be adjusted at or after

the end of the fiscal period. Second issue has to with the nature of accounting accruals. Like

Guay et al. (1996) indicate, manager’s ability to undo the serial correlation in the underlying

earnings process, through the use of discretionary accruals, depends on the flexibility of

accounting standards. This ability is limited by the fact that discretionary accruals eventually

will reverse. Finally, management has incentives to avoid accrual-based earnings

management being detected by auditors after Sabanes-Oxley Act (SOX) because of changes

in regulatory environment (Cohen and Zarowin 2010). However, if management is not

concern about these issues identified above, they may decide to manipulate earnings via real

transactions.

Applying accrual-based and real earnings management into the content of innovation

strategy and considering the amount and volatility of cash flows, firm executives may take

following characteristics into account when deciding how to pursue their innovation strategy

(Brown and Petersen 2011). For firms choose to pursue in-house R&D, they need to produce

a consistent and ongoing cash infusion to the projects. Therefore, management has to

9  
 
understand and be confident about the streams of future cash flows before taking up in-house

R&D strategy. The other factor has to do with a high level of adjustment costs for in-house

R&D activities. When firms abandon projects in late stage of development, it would lead to

large adjustments in the financial statements. These revisions paint an unfavorable financial

picture to the market participants. As result, it makes harder for firms to secure external

financial resources to support other R&D projects. In this case, firms have to focus on cash

flows generated from operations. Under this scenario, management needs to find consistent

and reliable cash flow when deciding to get involved in-house innovations (Brown and

Petersen 2011). In contrast, patent purchasing has different financing need. While in-house

innovation requires consistent cash flows to support this activity, patent acquisitions do not

have such prerequisite. For example, firm management does not have to invest large sum of

capital upfront to hire skilled workers and build R&D facilities when they decide to follow

purchasing patents strategy. Instead, management uses resources to bid and purchase patents

available in the intellectual market. Also, patenting purchasing strategy does not expose firms

to high amount of adjustment costs. Given different needs of cash flows and potential

adjustment costs between in-house R&D and purchase patent strategy, firms in favor of

in-house innovations should have a more steady cash flow compared to those taking up

purchase patent strategy. For these firms, corporate executives may incline to involve in

accrual-based earnings management because such activities have little impact on a firm’s

cash flow. On the other hand, for firms choose to pursue patent purchase strategy, they do not

have strong pressure to maintain a stable stream of cash flow. Therefore, corporate executive

for these companies may incline to involve in real earnings management because the

volatility of a firm’s cash flow may be a major concern for corporate executives. Following

these arguments, we form the following hypothesis:

H2: Firms pursuing in-house innovation strategy are inclined to involve in

accrual-based earnings management; while companies following patent
10  
 
 purchase innovation strategy are more like to engage in real earnings
management

2.3 Effect of Innovation Strategy on Firm Value

Implementing in-house R&D or patent acquisition strategy has different implications to

firm value. As O’Regan and Kling (2011) indicate, firms made significant investments in

in-house innovations tend to outperform their competitors in sales revenue, market share, and

profitability. Moreover, firms implementing in-house R&D have more background

competences and better technological skills (Narula, 2001). Therefore, firms would have less

reliance on external support to commercialize the developed patents. However, the

uncertainty of the future productivity of in-house developed technologies increases

idiosyncratic risk, because of small scale of production and a low probability of a large-scale

adoption after the developed technology introduced in the industry.

On the other hand, obtaining patents from third parties relies on sellers’ willingness to

provide patent-related support after acquisitions. Since technological skills are controlled by

the external parties, patents acquiring firms probably would encounter difficulties to bring

their workforce up to speed after patents acquisitions. Furthermore, desirable patents may not

be available in the market and the acquisition prices are also contingent upon the competition

in the market. Hence, patent acquisition strategy brings high level of systematic risk to firms.

While patent purchasing increases systematic risk, investing in in-house R&D increases

idiosyncratic risk. Applying the capital assets pricing model (CAPM) to the context of

innovation strategy, an increasing in systematic risk leads to a higher beta, thus raising the

required rate of return. As the required rate of return increases, the firm value goes down,

since a higher discount rate has to be used to derive firm value. Therefore, we form the

following hypothesis:

H3: Firms acquiring patents from the third parties have lower firm value than
those choose to pursue in-house R&D.
11  
 
2.4 Association between Innovation Strategy, Earnings Management, and Firm Value

As Cohen and Zarowin (2010) indicate, real earnings management affects the amount

and volatility of cash flows, because management is able to determine the timing and level of

discretionary expenditures. In comparison, accrual-based earnings management has limited

impact on the amount, as well as volatility, of cash flows. As discussed earlier, in-house

R&D requires consistent infusions of resources to support their daily activities. If firms

decide to terminate their in-house R&D projects, there are high adjustment costs to abandon

these activities. On the other hand, firms committing to patent acquisition strategy are not

obligated to provide consistent financial support to innovation. Hence, there is little or no

adjustment cost if firms choose to purchase patents from the third parties.

Considering the nature of strategy of innovation and earnings management, firms

acquiring patents from outsiders are more likely to involve in real earnings management

because they only need to consider when and at what price to acquire patents, without paying

detail attention to volatility of cash flows. On the other hand, firms in favor of in-house R&D

are more likely to engage in accrual-based earnings management since this kind of earnings

management will lead to a lower volatility in cash flows. When firms have more steady

streams of operating cash flows, market participants would perceive these companies to be

less risky than firms with less steady streams of operating cash flows. Because the level risk

will be considered when determining the discount factor, an increase in risk reduces the value

of firm. Specifically, patent acquisition strategy increases systematic risk, increases the

required rate of return, and decreases firm value. Following this logic, we form the

following hypothesis:

H4: Firms engaging in real earnings management and choosing patent

acquisitions strategy would have lower firm value than those involving in
accrual-based earnings management and choosing in-house R&D strategy.

12  
 
3. Data Collection and Research Design

This section describes data and research design. We divide our discussions into the

following subsections: Section 3.1 discusses data collection; Section 3.2 presents the

measurement of accrual-based and real earnings management; Section 3.3 shows the

measurement of the level of in-house R&D and the degree of patent acquisitions; Section 3.4

present the regression models used to test the empirical inquires prescribed in the study.

3.1. Data Collection

We obtain financial data and in-house R&D data from COMPUSTAT. Patent

acquisition data of S&P 500 firms are retrieved from LexisNexis Academic database. The

time period of the study ranges from 1997 to 2009. To identify the data used in the study, we

search the major world publications using the following key words: (1) firm name, (2) patent,

and (3) acquisition and navigating patenting acquisition information in the LexisNexis

Academic database. For patenting acquisition activities, we include the announcement dates

of patent purchasing, the amount paid to acquire patents, number of patents purchased, and

the targeted firm information. Several factors are included in the regression models as control

variables: financial leverage, refocus effect, firm’s profitability, number of outstanding shares,

growth potential, firm size, financial constraints, and year.

3.2. Measuring Accrual-Based and Real Earnings Management

To measure accrual-based earnings management, we follow the literature and estimate the

amount of discretionary accruals (DACC) using the modified Jones model (Jones, 1991;

Dechow et al., 1995; Subramanyam, 1996). To find value for DACC, we first calculate total

accruals for firm i in year t:

TAAi ,t = ONI i ,t − OCFi ,t , (1)

13  
 
 Where

TAAi,t = The absolute value of total accruals for firm i in year t,

ONIi,t = Net income from operations for firm i in year t,
OCFi,t = Operating cash flow for firm i in year t.

Then, we calculate the ratio of the absolute value of total accruals for firm i in year t

(TAAi,t ) and total assets for firm i in year t – 1 (Ai,t-1):

TAAi ,t ⎛ 1 ⎞ ⎛ ΔSalesi ,t − ΔRECi ,t ⎞ ⎛ PPEi ,t ⎞

= α1t ⎜⎜ ⎟ + α 2t ⎜
⎟ ⎜
⎟ + α 3t ⎜
⎟ ⎜ A
⎟ + ε i ,t
⎟
Ai ,t −1 ⎝ Ai ,t −1 ⎠ ⎝ Ai ,t −1 ⎠ ⎝ i ,t −1 ⎠ , (2)

In addition to the above definitions,

ΔSalesi,t = Change in sales revenue for firm i in year t,

ΔRECi,t = Change in accounts receivable for firm i in year t,
PPEi,t = Net property, plant, and equipment for firm i in year t,
ε i,t = Residual term for firm i in year t.

Then we compute the non-DAC (NDACC) using the following equation:

⎛ 1 ⎞ ⎛ ΔSalesi ,t − ΔRECi ,t ⎞ ⎛ PPEi ,t ⎞

NDACCi ,t = α1t ⎜⎜ ⎟ + α 2t ⎜
⎟ ⎜
⎟ + α 3t ⎜
⎟ ⎜ A
⎟
⎟
⎝ Ai ,t −1 ⎠ ⎝ Ai ,t −1 ⎠ ⎝ i ,t −1 ⎠ (3)

Where NDACC present the amount of non-discretionary accruals for firm i in year t.

Finally, we take the value obtained in (2), subtract the value obtained in (3), and derive

the DACC for firm i in year t:

TAAi ,t
DACCi ,t = − NDACCi ,t
Ai ,t −1
(4)

To estimate the degree of real earnings management, we follow Cohen and Zarowin

(2010). Their study measures the real earnings management by the amount of decrease in the

discretionary expenditures including advertising, R&D, and SG&A expenses. The abnormal

14  
 
discretionary expenditures are estimated as the deviations from the following equation. The

ratio between DISX and the amount of assets is labeled as REM_DISX:

!"#$!" ! !"#$!!"!!
= 𝐾! + 𝐾! + 𝜀!" (5)
!""#$"!,!!! !""#$"!,!!! !""#$"!,!!!

Where

DISX i,t = The amount of discretionary expenditures (i.e., the sum of R&D,
advertising, and SG&A expenditures) in year t.
Assetsi,t-1 = Total assets for firm i in year t – 1
Salesi,t-1 = Total sales revenue for firm i in year t-1
ε i,t = Residual term for firm i in year t.

We derive the second measure to capture the degree of real earnings management. Since

the abnormal level of discretionary expenditures is measured as the estimated residual from

the regression, we multiply the residuals by negative one (denoted as REM_DISX) such that

higher values indicate greater amounts of discretionary expenditures cut by firms to increase

reported earnings (Zang 2012). Then, we combine the two real activities manipulation

measures into one proxy by taking their sum and denoted it as REMA (real earnings

management aggregated). In this study, we will report empirical results corresponding the

individual real earnings management proxy, REM_DISX and to the aggregated real earnings

management measure, REMA.

3.3 Measuring In-House R&D and Patent Acquisitions

To measure innovative investment made by firms, we obtain relevant financial data and

in-house patenting data from COMPUSTAT database and treat the “research and

development expenses’’ data as the amount of in-house patenting (XRD). For the patent

purchased from the external entities for S&P 500 firms, we retrieve them the LexisNexis

Academic database. Both in-house patenting and purchased patents cover from 1997 to 2009.

When navigating patenting purchasing data from LexisNexis Academic database, we use the
15  
 
following combination of key words: ’’Firm Name AND Patent AND Acquisition” and then

search it within “major world publications” data file. Our patenting purchasing information

includes the announcement data of patent purchasing, the amount of patent purchasing, the

number of patent purchasing, and the targeted firm financial information.

Four measures are used to capture a firm’s investments in innovation. First, the amount

of patent purchased (PATENT_PURCHASE) represents investments made by the firm to

acquire patents from the third parties. The more committed the firm to the patent acquisition

strategy, the higher the PATENT_PURCHASE value will be. The PATENT_PURCHASE is

measured the amount of resources used to acquire patent each year. Second, the amount of

R&D development expenses (XRD) shows the investments made by the firm to in-house

R&D. The more committed the firm to the in-house innovation strategy, the higher the XRD

value will be. We measure in-house R&D (i.e., XRD) by year. Third, the sum of the amount

of patent purchased and the amount of the research and development expenses

(PATENT_PURCHASE+XRD) reflect the total investments made by the firm to innovation.

To find the value for the PATENT_PURCHASE+XRD, we sum the amount patent purchased

from the third parties and the amount of the research and development expenses. Finally, the

ratio between the amount of patent purchased and the amount of research and development

expenses (PATENT_PURCHASE/XRD) illustrate the proportion of innovations to purchase

patents and in-house R&D. The more committed the firm to the patent acquisition strategy,

the higher the PATENT_PURCHASE/XRD value will be. The value of

PATENT_PURCHASE/XRD is the ratio between PATENT_PURCHASE and XRD.

3.4 Regression Models

To test H1, we develop to following regression model by follow Brown et al. (2009)

study:

16  
 
 𝑃𝑎𝑡𝑒𝑛𝑡!,! = 𝛽! + 𝛽! 𝑃𝑎𝑡𝑒𝑛𝑡!,  !!! + 𝛽! 𝐸𝑀!,! + 𝛽! 𝑀𝑎𝑟𝑘𝑒𝑡𝐵𝑜𝑜𝑘!,  ! + 𝛽! 𝑆𝑔𝑤𝑡ℎ!,  ! +
𝛽! 𝐶𝑎𝑠ℎ𝐹𝑙𝑜𝑤!,  ! + 𝛽! 𝐶𝑎𝑠ℎ𝐹𝑙𝑜𝑤!,  !!! + 𝛽! 𝑆𝑡𝑘𝐼𝑠𝑠𝑢𝑒𝑠!,  ! + 𝛽! 𝑆𝑡𝑘𝐼𝑠𝑠𝑢𝑒𝑠!,  !!! +
𝛽! 𝐷𝑏𝑡𝐼𝑠𝑠𝑢𝑒𝑠!,  ! + 𝛽!" 𝐷𝑏𝑡𝐼𝑠𝑠𝑢𝑒𝑠!,  !!! + 𝑌𝑒𝑎𝑟 + 𝜖!,! (6)

The dependent variable, Patent, in Model (6) represents one of four measures of

in-house R&D investment and investments on purchasing patents (i.e.,

PATENT_PURCHASE, XRD, PATENT_PURCHASE+XRD, PATENT_PURCHASE/XRD.)

There are two types of earnings managements, accrual earnings managements (ABEM) and

real earnings managements (REM). The degree of ABEM is estimated using the modified

Jones model. The degree of REM is estimated by decreases in discretionary expenses

including advertising, R&D, and SG&A expenses, REM_DISX according to Cohen and

Zarowin (2010) and REMA by following Zang (2012). MarketBook is market-to-book ratio.

Sgwth is the percentage of the growth in sales revenue. CashFlow equals sum of cash and

short-term investments divided by total assets. StkIssues equals the net cash raised from stock

issued divided by the amount of total assets. DbtIssues is a ratio of net new long-term debt

issued and the amount of total assets. Finally, Year is a dummy variable and used to control

fixed effect of year.

To test H2, we divide our observations into two groups: ABEM and REM. To examine

H2, we separate our samples into the four groups: (1) firms with high degree of accrual-based

earnings management (high-ABEM) and high level of real earnings management (high-REM);

(2) firms with high degree of accrual-based earnings management (high-ABEM) and low

level of real earnings management (low-REM); (3) firms with low degree of accrual-based

earnings management (low-ABEM) and high level of real earnings management (high-REM);

(4) firms with low degree of accrual-based earnings management (low-ABEM) and low level

of real earnings management (low-REM). Following Cohen and Zarowin (2010), our

conjecture is that firms involving in high level of real earnings management tend to

17  
 
experience high volatility in cash flows. Since firms need to provide consistent cash flows to

support in-house R&D activities, firms in high real earnings management would be in favor

of patent acquisitions from third parties; because cash flows consistency is not a prerequisite

to buy patents from third parties. Moreover, following Biddle and Hilary’s (2006) argument,

firms having high level of accrual earnings management tend to experience the

underinvestment problem because (1) information asymmetry between corporate executives

and market participants, and (2) investors are also concern about moral hazard problems of

firm management. Therefore, firms have to generate consistent internal cash flows to support

in-house innovations. Because firms in the high accrual earnings management are more likely

to have steady cash flows, management would be in favor of engaging in in-house R&D

strategy. Hence, we employ the following model to test H3:

𝑃𝑎𝑡𝑒𝑛𝑡!,! =
𝛽! + 𝛽! 𝑃𝑎𝑡𝑒𝑛𝑡!,  !!! + 𝛽! 𝐴𝐸𝑀!,! + 𝛽! 𝑅𝐸𝑀!,! +
𝛽! 𝐴𝐸𝑀×𝑅𝐸𝑀!,! +𝛽! 𝑀𝑎𝑟𝑘𝑒𝑡𝐵𝑜𝑜𝑘!,  ! + 𝛽! 𝑆𝑔𝑤𝑡ℎ!,  ! + 𝛽! 𝐶𝑎𝑠ℎ𝐹𝑙𝑜𝑤!,  ! +
𝛽! 𝐶𝑎𝑠ℎ𝐹𝑙𝑜𝑤!,  !!! + 𝛽! 𝑆𝑡𝑘𝐼𝑠𝑠𝑢𝑒𝑠!,  ! + 𝛽!" 𝑆𝑡𝑘𝐼𝑠𝑠𝑢𝑒𝑠!,  !!! + 𝛽!! 𝐷𝑏𝑡𝐼𝑠𝑠𝑢𝑒𝑠!,  ! +
𝛽!" 𝐷𝑏𝑡𝐼𝑠𝑠𝑢𝑒𝑠!,  !!! + 𝑌𝑒𝑎𝑟 + +𝜖!,! (7)

Definitions of variables in the equation (7) are the same as those described above for

equation (6). Furthermore, H3 examines whether patent purchasing reduces firm value

because of high systematic risk of patent purchasing. To test H3, we develop the following

regression model:

𝑇𝑜𝑏𝑖𝑛′𝑞!,  ! =
𝛽! + 𝛽! 𝑃𝑎𝑡𝑒𝑛𝑡!,  ! + 𝛽! 𝐹𝑖𝑟𝑚  𝑆𝑖𝑧𝑒!,  ! + 𝛽! 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒!,  ! + 𝛽! 𝐿𝑖𝑞𝑢𝑖𝑑𝑖𝑡𝑦!,  ! +
𝛽! 𝑃𝑟𝑜𝑓𝑖𝑡𝑎𝑏𝑖𝑙𝑖𝑡𝑦!,  ! + 𝑌𝑒𝑎𝑟 + 𝜖!,! (8)

To obtain a value for Tobin’s q, we sum the market value of equity shares and book

value of total liabilities and divide it by the book value of total assets. Same as equations (6)

and (7), Patent represents one of the types of patent investments (PATENT_PURCHASE,
18  
 
XRD, PATENT_PURCHASE+XRD, PATENT_PURCHASE/XRD.) FirmSize is the value of

natural logarithm of total assets. Leverage is the ratio of total liabilities to total assets.

Liquidity is gauged by the sum the amount of cash on hand and the amount of short term

investment and then divided it by the amount of total assets. Profitability is the ratio between

EBITDA and the amount of total assets. Finally, we include Year as a dummy variable to

control for year fixed effect. In the regression model, we include Industry in the regression

model to control for industry fixed effect. Finally, ε represents an error term derived from the

regression model.

H4 investigates whether there is an association between earnings management,

innovation strategy, and firm value. To test this hypothesis, we use the following regression

model:

𝑇𝑜𝑏𝑖𝑛𝑄!,  ! = 𝛽! + 𝛽! 𝑃𝑎𝑡𝑒𝑛𝑡!,  ! + 𝛽! 𝑃𝑎𝑡𝑒𝑛𝑡×𝐴𝐸𝑀!,  ! + 𝛽! 𝑃𝑎𝑡𝑒𝑛𝑡×𝑅𝐸𝑀!,  ! +

𝛽! 𝐴𝐸𝑀!,! + 𝛽! 𝑅𝐸𝑀!,! + 𝛽! 𝐹𝑖𝑟𝑚  𝑆𝑖𝑧𝑒!,  ! + 𝛽! 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒!,  ! + 𝛽! 𝐿𝑖𝑞𝑢𝑖𝑑𝑖𝑡𝑦!,  ! +
𝛽! 𝑃𝑟𝑜𝑓𝑖𝑡𝑎𝑏𝑖𝑙𝑖𝑡𝑦!,  ! + 𝑌𝑒𝑎𝑟 + 𝜖!,! (9)

Definitions of variables in regression models (6), (7), (8) and (9) are illustrated in

Figure 1.

[Please Insert Figure 1 Here]

4. Empirical Results

This section is divided into three subsections. In Section 4.1, we present descriptive

statistics. Section 4.2 presents the results of univariate analysis. In Section 4.3, we discuss the

empirical results of multivariate analysis to test our research inquires.

4.1 Descriptive Statistics

Table 1 presents the descriptive statistics for the dependent, test, and control variables.

The mean (median) value of patent measured by PATENT_PURCHASE, XRD,

19  
 
PATENT_PURCHASE+XRD and PATENT_PURCHASE/XRD respectively is 0.000 (0.000),

0.029 (0.000), 0.029 (0.000), and 0.001 (0.000). These results indicate that firms tend to

invest in R&D to innovate their technology. The mean (median) value of absolute value of

discretion accruals, estimated by Jones model (|𝐽𝑂𝑁𝐸𝑆|), Modified Jones Model

(|MODIFIEDJONES|), Performance Matched Jones Model (|KOTHARIJONES|), are 0.133

(0.083), 0.134 (0.084), and 0.192 (0.122), respectively. These statistics show that firms

engage in accrual-based earnings management. The mean (median) value of real earnings

managements, REM_DISX is 0.000 (0.072) and 0.007 (0.058), estimated by following

approaches adopted by Cohen and Zarowin (2010). Since REM_DISX is measured by

decreases in discretionary expenses including advertising, R&D, and SG&A expenses, these

results illustrated that firms do involve in real earnings management. As to the aggregate

measure of total real earnings management (i.e., REMA), the mean (median) value of REMA

is -0.007 (0.065). Since we multiply the residuals by negative one (denoted as REM_DISX),

the higher values of REMA, the greater amounts of discretionary expenditures cut by firms to

increase reported earnings. With a negative median value of REMA, the result appears to

point out firms may cut discretionary expenditures in advertising, R&D, and SG&A expenses

to raise their reported earnings.

[Please Insert Table 1 Here]

4.2 Univariate Analysis

As stated in H1, earnings management affects the degree of innovations. Referring to

Table 2, the degree of innovations is measured by PATENT_PURCHASE, XRD,

PATENT_PURCHASE+XRD, PATENT_PURCHASE/XRD. As to the earnings management,

ABEM, REM_DISX, and REMA represent, accrual-based earnings management, real earnings,

and real earnings management aggregated measure, respectively. Since information

transparency is key factor to mitigate investors’ adverse selection and information asymmetry
20  
 
between managers and market participants, we predict that earnings management will affect

investment efficiency.

As shown in Table 2, accrual-based earnings management, real earnings, and real

earnings management aggregated are presented in Panel A, B, and C, respectively. Referring

to Panel A, results of t-test between high versus low accrual-based earnings management. As

expected, firms with high accrual-based earnings management are less likely to involve in

patent purchasing than firms with lower accrual-based earnings management. The means of

PATENT_PURCHASE of two categories are 0.191 and 0.179, respectively. The difference in

mean is statistically significant at the 1% level. This finding supports our argument that firms

engaging in accrual-based earnings management may have high degree of information

asymmetry between corporate executives and market participants. Combining information

asymmetry and moral hazard problem of firm management, it would reduce the level of

patent purchasing activities. In this case, firms have to go for in-house patenting strategy to

keep up with innovation. The other finding relates to in-house patenting is that firms with

high accrual-based earnings management tend to have higher in-house patenting than firms

with low accrual-based earnings management as well. This difference in mean is also

statistically significant at the 1% level. Since implementing in-house patenting strategy

requires consistent financing resources to support innovation activities internally

(Roychowdhury 2006, Brown and Petersen 2011), firms with higher accrual earnings

management are more likely to involve in in-house patenting by holding the level of real

earnings management constant.

Panel B and Panel C of Table 2 show the results of t-tests between high versus low real

earnings management by measuring the earnings management activities using REM_DISX

and REMA, respectively. Referring to Panel B of Table 2, the means of XRD are 22.134 and

12.657 for firms in the low and high real earnings management categories, respectively.

21  
 
Similarly, in Panel C of Table 2, the results show that means of XRD are 23.172 and 12.851

for firms in the low and high real earnings management categories, respectively. These

results support the notion that firms having high real earnings management are likely to

invest less on in-house patenting than those firms having low real earnings management.

These findings provide preliminary evidence that firms with higher real earnings

management tend to experience high volatility in cash flows. In this case, firms may have

difficulties in maintaining in-house patenting because of consistent cash infusions to

innovation. Therefore, these firms are more likely to purchase patents from outside parties as

long as they find suitable patents and sufficient cash on hand to facilitate acquisitions.

[Please Insert Table 2 Here]

4.3 Multivariate Analysis

First, we examine whether earnings management reduces patent investment. As

predicted in H1, earnings management will negatively affect a firm’s innovation in

developing patents because such activities decrease the degree of reporting transparency.

Referring to the regression model (6), the dependent variable, Patent, is gauged by one of one

of four measures; PATENT_PURCHASE, XRD, PATENT_PURCHASE+XRD, and

PATENT_PURCHASE/XRD. The results from our analyses are presented in Table 3. As

shown in Panels A, B, and C of Table 3, the effect of earnings management using the

accrual-based earnings management, REM_DISX (real earnings management) and REMA

(real earnings management), respectively. There are two major observations can be made

from this analysis. One is that Panel A of Table 3 shows that coefficients on accrual earnings

management measured by |JONES| are positive when Patent is measured by

PATENT_PURCHASE, XRD and PATENT_PURCHASE+XRD. These results indicate that

accrual-based earnings management does not impair the consistency of cash flows.

22  
 
Therefore, firms were able to keep investing in innovation. The other observation is that the

coefficients on real earnings management are negative when Patent is measured by

PATENT_PURCHASE, XRD and PATENT_PURCHASE+XRD. These results indicate that

engaging in real earnings management raises the cash flow volatility. Thus, it reduces the

level of innovation. Albeit our findings do not provide strong support H1 regarding the effect

of reporting transparency on patent investments, these results support H2 according to our

argument built based on cash flow volatility theory. That is, cash flow volatility could be one

of key factors when firms decide whether to engage in patent development as part of their

innovation strategy.

[Please Insert Table 3 Here]

As stated in H2, at a given-level of accrual-based earnings management, firms in favor

of purchasing patents from third party have higher degree of real earnings management than

those choose to pursue in-house patenting strategy. Referring to Panels A and B of Table 4,

the results indicate that the coefficients on real earnings management (REM_DISX and REMA)

are significantly negative when the patent investments are measured by XRD (Panel A:

t-value of REM_DISX = -0.207 and p-value = 0.00; Panel B: t-value of REMA = -0.163 and

p-value = 0.00) and PATENT_PURCHASE+XRD (Panel A: t-value of REM_DISX = -0.207l

and p-value = 0.00; Panel B: t-value of REMA = -0.163 and p-value = 0.00). These results

indicate that firms with high real earnings management prefer investing patent purchasing

activities instead of in-house patenting activities. Thus, H2 is supported. These results appear

to indicate that investors’ concerns over information asymmetry and volatility of firms’ cash

flows have negative influence on patent investments. Albeit it is not statistically significant,

Panel A of Table 4 shows that the coefficients of REAL_JONESDISX are negative when XRD

and PATENT_PURCHASE+XRD are used to capture firms’ patent investment. These results

23  
 
indicate that when firms engage in accrual earnings management and real earnings

management simultaneously. Under this scenario, the effect of accrual-based earnings

management and real earnings management on firm’s preference toward patent investment

may offset each other.

[Please Insert Table 4 Here]

Extant literature indicates that firms with significant in-house patenting investment

outperform other firms in terms of sales revenue, market share, and profitability (e.g.,

O’Regan and Kling 2011). Moreover, firms involving in in-house patenting tend to have

higher level of background competences and marginal competences than firms do not involve

in in-house patenting (Narula, 2001). Following these arguments, H3 states that firms choose

to acquire patents from third parties have lower firm value than firms decide to develop

patents in-house. Referring to Table 5, when firms taking in-house patenting strategy, it has

significant and positive impact on firm value, measured by Tobin’s q (XRD: t-value = 2.041

and p-value = 0.00; PATENT_PURCHASE+XRD: t-value = 2.043 and p-value = 0.00). On

the other hand, when firms going for patents purchasing strategy, its influence on firm value

is positive but statistically insignificant (PATENT_PURCHASE: t-value = 2.681 and p-value

= 0.41; PATENT_PURCHASE/XRD: t-value = 0.117 and p-value = 0.44). Overall, these

results support O’Regan and Kling’s (2011) argument that in-house patenting strategy tends

to create greater positive value for the firms than patent purchasing strategy. Thus, H3 is

supported.

[Please Insert Table 5 Here]

As stated in H4, firms with high real earnings management and high level of patent

purchasing have lowest firm value among all groups at a given-level of accrual-based

24  
 
earnings management. Referring to Table 6, several observations can be made according to

the empirical evidence. Frist, implementing in-house patenting strategy improves firm value

(XRD: t-value = 2.524 and p-value = 0.00; PATENT_PURCHASE+XRD: t-value = 2.517 and

p-value = 0.00). Second, real earnings management can be detrimental to firm value.

However, such effect is not observed when firms involving in accrual-based earnings

management. Finally, interaction between innovation strategy and earnings management

approach does not have significant impact on firm value. Overall, H4 is partially supported.

[Please Insert Table 6 Here]

5. Robustness Tests

To ensure the robustness of the empirical evidence reported in the study, split the

accrual earnings management measured by cross-sectional Jones model (Jones, 1991) into

two categories: (1) upward earnings management (|UPJONES|) and (2) downward earnings

management |DOWNJONES|. Then, we replace |JONES| by these two accrual-based earnings

management and re-run all regression analyses. These examinations are important, because it

allows us to discern whether the direction of accrual-based earnings management affects

firm’s patent investment decision making and firm value. For simplicity, we do not tabulate

the results of these tests in the paper.

First, we reexamine the effect of accrual earnings management on firm’s patent

investment. The result is consistent with the main analysis by indicating that there is a

positive association between accrual earnings management and patent investment. In other

words, the accrual-based earnings management would increase patent investments;

particularly for firms with in-house patenting. Since accrual earnings management will not

reduce the consistency of cash flow, firms will be able to maintain the level of investments in

developing patents. Moreover, the results from this analysis further confirm cash flow

25  
 
volatility theory. That is, cash flow volatility probably is the main concern for the managers

when deciding investments in innovations.

Then, we further examine whether firms with high real earnings management prefer to

patent purchasing when the level of accrual earnings management has reached a certain level.

Our analysis finds that there are significant negative association between real earnings

managements and patent investment at given level of accrual earnings management when

separating earnings management into upward (|UPJONES|) and downward earnings

management |DOWNJONES| categories. As Cohen and Zarowin (2010) stated, firms will

experience highly volatile cash flows after they conduct real earnings management. In this

case, they will not be able to support in-house patenting because such activities require

consistent financial resources, so they do not have terminate projects by making major

adjustments to the reported earnings.

In addition, we use |UPJONES| and |DOWNJONES| to examine whether firms with

high real earnings management prefer patent purchasing and thus have lower firm value at

given level of accrual earnings management. The results shows that the coefficients on XRD

X DISX, (PATENT_PURCHASE+XRD) X DISX and (PATENT_PURCHASE/XRD) X DISX

are negative. These results further confirm our prediction that firms with high real earnings

management and high level of patent purchase have lowest firm after separating the

observations into upward and downward accrual earnings management.

To investigate whether firm earnings management and patent investment affect firm

value, either short-term or long-term, we calculate three different Tobin’s q into three time

periods (i.e., one year, two years and three years) and then reexamine H3. Results of these

analyses indicate that patent investments have positive influences on short-term, as well as

long-term, firm value regardless types of patent investments. Finally, we examine H4 using

three spectrums of Tobin’s q. The results from these analyses are consistent with the main

26  
 
results reported in the study. That is there is a negative association between firms with high

real earnings management and high level of patent purchase and firm value. Overall, firms

involve in high real earnings management and engage in patent purchasing have lowest firm

value.

6. Conclusions, Limitations, and Directions for Future Research

This paper investigates whether a firm with high real earnings management and high

level of patent purchase has lowest firm value. Since high accounting information quality

reduces adverse selection and moral hazard problem, and hence increases firms’ investment

efficiency Biddle and Hilary (2006). Previous literatures only focus on how financing

resources affect in-house patenting activities. Contrast to in-house patenting investments,

patent purchasing has different financing need. In-house patenting activity needs consistent

cash flow to support it, but patent purchasing doesn’t need consistent cash flow to support it.

Moreover, Paster and Veronesi (2009) argue that new technologies bring high

uncertainty of future productivity and come up with observed stock price patterns. When

firms develop new technologies, the uncertainty of the future productivity increases

idiosyncratic risk, because small scale of production and a low probability of a large-scale

adoption. This argument indicates that developing in-house patenting increases idiosyncratic

risk and patent purchasing increases systematic risk. According to CAPM model, increasing

systematic risk brings high beta and thus increases required return. We infer that patent

purchasing decreases firm value. We also examine the relationship between firm’s patenting

decision and its firm value. And we have the same predict result consistent with previous

literature’s argument.

The main findings support our hypothesis that earnings management would decreases

patent investment. These results also consist with Biddle and Hilary’s (2006) argument that

accounting information quality can improve firm-level investment, since high accounting
27  
 
information quality reduces adverse selection and moral hazard problem. Our findings

support Cohen and Zarowin (2010) that real earnings management will impact cash flow,

since it will directly affect expenditures or investment strategies of firms and (Brown and

Petersen, 2011) that firms with high real earnings management would conduct more patent

purchasing activities, because of high volatility of cash flow resulted from real earnings

management and the need of cash holding buffers for in-house patenting. In the end of our

paper, we find out that no matter which kind of earnings management a firm conducts,

earnings management increases information asymmetry between investors and managers.

Although conducting innovation activities represents growth potential of firms, it represents

the uncertainty of future cash flow as well. In other words, firms with high innovation

activities have high information asymmetry between investors and managers. Managing

earnings just represents that firms with high innovation activities have high information

asymmetry. And the firm value is impaired due to information asymmetry created by

earnings management, despite the patent investment is positive to firm value.

This study makes two major contributions to the literature. First, we provide further

evidence to indicate that how real earnings management and accrual earnings management

affect patent investments. Previous literatures either examine the relationship between accrual

earnings management and in-house patenting or examine the relation between real earnings

management and in-house patenting. However, these two earnings management methods

have different impacts on cash flow volatility and also these two patenting investment have

different cash flow needs (consistently invest or one-time invest). Therefore, we provide

further evidence to explain earnings management strategies and patent investment strategies.

Second, we provide further evidence to explain how these two patent investment strategies

affect firm value.

28  
 
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 Table1 Descriptive Statistics

VARIABLES MEAN MEDIAN Q1 Q3 STD N

PATENT_PURCHASE 0.000 0.000 0.000 0.000 0.004 67,381

XRD 0.029 0.000 0.000 0.010 0.076 67,381
PATENT_PURCHASE+XRD 0.029 0.000 0.000 0.010 0.076 67,381
PATENT_PURCHASE/XRD 0.001 0.000 0.000 0.000 0.105 67,381
ABS_DA_CROSS_JONES 0.133 0.083 0.036 0.181 0.138 27,920
ABS_DA_CROSS_MODIFIED_JONES 0.134 0.084 0.036 0.182 0.138 27,558
ABS_KOTHARI_JONES 0.192 0.122 0.047 0.265 0.200 27,716
|DOWNJONES| 0.144 0.093 0.040 0.199 0.143 15,368
|UPJONES| 0.121 0.072 0.032 0.157 0.130 12,552
REM_DISX1 0.000 0.072 -0.149 0.239 0.337 25,985
REM_CFO1 0.000 -0.038 -0.103 0.064 0.189 28,946
REM_PROD1 0.000 0.010 -0.137 0.116 0.267 27,397
RM1 -0.019 0.065 -0.285 0.322 0.533 24,360
RM2 0.007 0.058 -0.144 0.203 0.313 25,694
TOBINSQ 5.892 1.573 1.139 2.540 135.536 28,800
ROA -0.072 0.024 -0.134 0.072 0.254 29,419
ROE -0.072 0.024 -0.134 0.072 0.254 29,419
MARKETBOOK 3.041 1.994 1.204 3.502 203.216 28,831
SGWTH 0.103 0.057 -0.008 0.192 0.215 29,333
CASHFLOW 0.050 0.091 -0.006 0.168 0.228 29,263
LAG1_CASHFLOW -0.389 0.095 0.003 0.181 20.886 28,076
STKISSUES 0.960 0.141 0.053 0.428 7.591 28,707
LAG1_STKISSUES 34.831 0.150 0.055 0.487 2,181.740 27,636
DBTISSUES 0.008 0.000 -0.013 0.015 0.123 29,291
LAG1_DBTISSUES 1.855 0.000 -0.012 0.027 292.955 28,076
LOG_AT 4.864 4.854 3.334 6.521 2.299 33,624
LEVERAGE 0.159 0.074 0.000 0.276 0.193 29,323
LIQUIDITY 0.549 0.509 0.273 0.743 0.445 28,947
PROFITABILITY -0.072 0.024 -0.134 0.072 0.254 29,419

 
31  
 
 Table 2 Univariate Test: Effect of Earnings Management on Innovation Strategy  
Panel A: High Accrual versus Low Accrual

Low Accrual
High Accrual Earnings
Earnings
Variables Management DIFF.
Management
MEAN N MEAN N

PATENT_PURCHASE 0.191 13,955 0.179 13,965 0.012***

XRD 13.479 13,955 17.983 13,965 -4.504***

PATENT_PURCHASE+XRD 13.670 13,955 18.162 13,965 -4.492***

PATENT_PURCHASE/XRD 0.002 13,955 0.001 13,965 0.001***

Panel B: High Real Earnings Management versus Low Real Earnings Management
(Measured by REM_DISX)

Low Real Earnings High Real Earnings

Variables Management Management DIFF.
MEAN N MEAN N

PATENT_PURCHASE 0.233 12,988 0.148 12,997 0.085***

XRD 22.134 12,988 12.657 12,997 9.477***

PATENT_PURCHASE+XRD 22.367 12,988 12.805 12,997 9.562***

PATENT_PURCHASE/XRD 0.001 12,988 0.002 12,997 -0.001***

Panel C: High Real Earnings Management versus Low Real Earnings Management
(Measured by REMA)

Low Real Earnings High Real Earnings

Variables Management Management DIFF.
MEAN N MEAN N

PATENT_PURCHASE 0.349 12,843 0.036 12,851 0.313***

XRD 23.172 12,843 11.912 12,851 11.260***

PATENT_PURCHASE+XRD 23.521 12,843 11.948 12,851 11.573***

PATENT_PURCHASE/XRD 0.003 12,843 0.001 12,851 0.003***

a. The definitions of all variables are presented in Figure 1.

b. ***, **, * indicates significance at the 1%, 5%, and 10% level, respectively.  
   
32  
 
 Table 3: Earnings Management Approaches and Innovation Strategy
Panel A: Accrual-Based Earnings Management and Innovation Strategy on Patents

PATENT_ PATENT_
PATENT_
VARIABLES XRD PURCHASE PURCHASE
PURCHASE
+XRD /XRD
LAG1_PATENT_PURCHASE 0.081***
(0.00)
LAG1_XRD 0.001***
(0.00)
LAG1_PATENT_PURCHASE+XRD 0.001***
(0.00)
LAG_PATENT_PURCHASE/XRD 0.054***
(0.00)
|JONES| 0.000 0.216*** 0.216*** -0.004
(0.80) (0.00) (0.00) (0.62)
MARKETBOOK 0.000 0.000 0.000 0.000
(0.91) (0.34) (0.34) (0.88)
SGWTH 0.000 -0.024*** -0.024*** 0.001
(0.59) (0.00) (0.00) (0.79)
CASHFLOW 0.000 0.025*** 0.025*** 0.004
(0.46) (0.00) (0.00) (0.44)
LAG1_CASHFLOW 0.000 0.000 0.000 0.000
(0.99) (0.26) (0.26) (0.98)
STKISSUES 0.000 0.000*** 0.000*** 0.000
(0.95) (0.00) (0.00) (0.99)
LAG1_STKISSUES 0.000 0.000*** 0.000*** 0.000
(1.00) (0.00) (0.00) (0.95)
DBTISSUES 0.000 -0.014*** -0.013*** 0.003
(0.26) (0.01) (0.01) (0.72)
LAG1_DBTISSUES 0.000 0.000*** 0.000*** 0.000
(0.99) (0.01) (0.01) (0.95)
INTERCEPT 0.000 0.034*** 0.034*** 0.003
(0.33) (0.00) (0.00) (0.47)
N 24955 24955 24955 24955
R² 0.010 0.085 0.084 0.004
a. The definitions of all variables are presented in Figure 1.
b. ***, **, * indicates significance at the 1%, 5%, and 10% level, respectively.

33  
 
 Panel B: Real Earnings Management on Patent Investment Strategies
(Real Earnings Management Measured by REM_DISX)

PATENT_ PATENT_
PATENT_
VARIABLES XRD PURCHASE PURCHASE
PURCHASE
+XRD /XRD
LAG1_PATENT_PURCHASE 0.081***
(0.00)
LAG1_XRD 0.000***
(0.00)
LAG1_PATENT_PURCHASE+XRD 0.000***
(0.00)
LAG_PATENT_PURCHASE/XRD 0.054***
(0.00)
REM_DISX 0.000 -0.217*** -0.217*** 0.001
(0.84) (0.00) (0.00) (0.68)
MARKETBOOK 0.000 0.000 0.000 0.000
(0.89) (0.28) (0.28) (0.83)
SGWTH 0.000 -0.068*** -0.067*** 0.001
(0.63) (0.00) (0.00) (0.78)
CASHFLOW 0.000 0.058*** 0.058*** 0.004
(0.46) (0.00) (0.00) (0.44)
LAG1_CASHFLOW 0.000 0.000 0.000 0.000
(0.99) (0.22) (0.24) (0.98)
STKISSUES 0.000 0.001*** 0.001*** 0.000
(0.95) (0.00) (0.00) (0.99)
LAG1_STKISSUES 0.000 0.000 0.000 0.000
(1.00) (0.20) (0.21) (0.95)
DBTISSUES 0.000 0.000 0.001 0.003
(0.26) (0.92) (0.88) (0.72)
LAG1_DBTISSUES 0.000 0.000 0.000 0.000
(0.99) (0.36) (0.38) (0.95)
INTERCEPT 0.000 0.066*** 0.075*** 0.003
(0.13) (0.00) (0.00) (0.53)
N 23794 23794 23794 23794
R² 0.010 0.433 0.430 0.004
a. The definitions of all variables are presented in Figure 1.
b. ***, **, * indicates significance at the 1%, 5%, and 10% level, respectively.

34  
 
 Panel C: Panel B: Real Earnings Management on Patent Investment Strategies
(Real Earnings Management Measured by REMA)

PATENT_ PATENT_
PATENT_
VARIABLES XRD PURCHASE PURCHASE
PURCHASE
+XRD /XRD
LAG1_PATENT_PURCHASE 0.081***
(0.00)
LAG1_XRD 0.000***
(0.01)
LAG1_PATENT_PURCHASE+XR
0.000***
D
(0.01)
LAG_PATENT_PURCHASE/XRD 0.054***
(0.00)
REMA 0.000 -0.164*** -0.164*** 0.000
(0.53) (0.00) (0.00) (0.89)
MARKETBOOK 0.000 0.000 0.000 0.000
(0.89) (0.46) (0.45) (0.84)
SGWTH 0.000 -0.044*** -0.044*** 0.001
(0.65) (0.00) (0.00) (0.81)
CASHFLOW 0.000 -0.040*** -0.040*** 0.004
(0.58) (0.00) (0.00) (0.40)
LAG1_CASHFLOW 0.000 0.000*** 0.000*** 0.000
(0.99) (0.00) (0.00) (0.99)
STKISSUES 0.000 0.000*** 0.000*** 0.000
(0.93) (0.01) (0.01) (1.00)
LAG1_STKISSUES 0.000 0.000*** 0.000*** 0.000
(0.99) (0.00) (0.00) (0.95)
DBTISSUES 0.000 -0.001 0.000 0.003
(0.25) (0.91) (0.98) (0.71)
LAG1_DBTISSUES 0.000 0.000** 0.000** 0.000
(0.98) (0.03) (0.03) (0.95)
INTERCEPT 0.000 0.071*** 0.071*** 0.003
(0.12) (0.00) (0.00) (0.54)
N 23617 23617 23617 23617
R² 0.010 0.210 0.209 0.004
a. The definitions of all variables are presented in Figure 1.
b. ***, **, * indicates significance at the 1%, 5%, and 10% level, respectively.

35  
 
 Table 4: Joint Effect of Accrual Earnings Management and Real Earnings Management on
Innovation Investment Strategies  

Panel A: Real Earnings Management Measured by Discretionary Expenses (REM_DISX)

PATENT_ PATENT_
PATENT_
VARIABLES XRD PURCHASE PURCHASE
PURCHASE
+XRD /XRD
LAG1_PATENT_PURCHASE 0.081***
(0.00)
LAG1_XRD 0.000***
(0.00)
LAG1_PATENT_PURCHASE +XRD 0.000***
(0.00)
LAG_PATENT_PURCHASE/XRD 0.054***
(0.00)
|JONES| 0.000 0.098*** 0.099*** -0.004
(1.00) (0.00) (0.00) (0.61)
REM_DISX1 0.000 -0.207*** -0.207*** 0.002
(0.81) (0.00) (0.00) (0.71)
REAL_JONESXDISX 0.000 -0.006 -0.006 -0.004
(0.84) (0.55) (0.57) (0.83)
MARKETBOOK 0.000 0.000 0.000 0.000
(0.88) (0.85) (0.84) (0.84)
SGWTH 0.000 -0.070*** -0.070*** 0.001
(0.47) (0.00) (0.00) (0.78)
CASHFLOW 0.000 0.063*** 0.064*** 0.004
(0.40) (0.00) (0.00) (0.46)
LAG1_CASHFLOW 0.000 0.000 0.000 0.000
(1.00) (0.30) (0.31) (0.98)
STKISSUES 0.000 0.001*** 0.001*** 0.000
(0.95) (0.00) (0.00) (0.99)
LAG1_STKISSUES 0.000 0.000 0.000 0.000
(0.96) (0.26) (0.26) (0.95)
DBTISSUES 0.001 0.000 0.001 0.003
(0.22) (0.96) (0.88) (0.72)
LAG1_DBTISSUES 0.000 0.000 0.000 0.000
(0.95) (0.43) (0.42) (0.95)
INTERCEPT 0.000 0.052*** 0.053*** 0.003
(0.24) (0.00) (0.00) (0.47)
N 23058 23058 23058 23058
R² 0.010 0.446 0.444 0.004
a. The definitions of all variables are presented in Appendix A.
b. ***, **, * indicates significance at the 1%, 5%, and 10% level, respectively.
   

36  
 
 Panel B: Real Earnings Management Measured by Aggregated Measurement (REMA)

PATENT_ PATENT_
PATENT_
VARIABLES XRD PURCHASE PURCHASE
PURCHASE
+XRD /XRD
LAG1_PATENT_PURCHASE 0.081***
(0.00)
LAG1_XRD 0.000***
(0.01)
LAG1_PATENT_PURCHASE+XR
0.000***
D
(0.01)
LAG_PATENT_PURCHASE/XRD 0.054***
(0.00)
ABS_DA_CROSS_JONES 0.000 0.146*** 0.146*** -0.004
(0.93) (0.00) (0.00) (0.59)
REMA 0.000 -0.163*** -0.163*** 0.000
(0.61) (0.00) (0.00) (0.99)
REAL_JONESXDISX 0.000 0.075*** 0.075*** 0.001
(0.83) (0.00) (0.00) (0.97)
MARKETBOOK 0.000 0.000 0.000 0.000
(0.88) (0.25) (0.24) (0.85)
SGWTH 0.000 -0.047*** -0.047*** 0.001
(0.48) (0.00) (0.00) (0.80)
CASHFLOW 0.000 -0.027*** -0.026*** 0.004
(0.50) (0.00) (0.00) (0.45)
LAG1_CASHFLOW 0.000 0.000*** 0.000*** 0.000
(0.98) (0.00) (0.00) (0.98)
STKISSUES 0.000 0.000* 0.000* 0.000
(0.94) (0.06) (0.06) (0.99)
LAG1_STKISSUES 0.000 0.000*** 0.000*** 0.000
(0.95) (0.00) (0.00) (0.95)
DBTISSUES 0.001 -0.001 0.000 0.003
(0.22) (0.88) (0.96) (0.71)
LAG1_DBTISSUES 0.000 0.000** 0.000** 0.000
(0.94) (0.03) (0.03) (0.95)
INTERCEPT 0.000 0.051*** 0.051*** 0.003
(0.23) (0.00) (0.00) (0.46)
N 22928 22928 22928 22928
R² 0.010 0.241 0.240 0.004
a. The definitions of all variables are presented in Appendix A.
b. ***, **, * indicates significance at the 1%, 5%, and 10% level, respectively.

 
   
37  
 
 Table 5: Effect of Innovation Investment Strategies on Firm Value

VARIABLES Firm value measured by Tobin’s q  

PATENT_PURCHASE 2.681
(0.41)
XRD 2.041***
(0.00)
PATENT_PURCHASE+XRD 2.043***
(0.00)
PATENT_PURCHASE/XRD 0.117
(0.44)
LOG_AT -0.227*** -0.257*** -0.221*** -0.227***
(0.00) (0.00) (0.00) (0.00)
LEVERAGE -0.051 0.050 0.064 -0.051
(0.71) (0.72) (0.65) (0.71)
LIQUIDITY 0.621*** 0.590*** 0.454*** 0.621***
(0.00) (0.00) (0.00) (0.00)
PROFITABILITY -2.819*** -2.748*** -2.528*** -2.819***
(0.00) (0.00) (0.00) (0.00)
INTERCEPT 2.706*** 2.633*** 2.633*** 2.706***
(0.00) (0.00) (0.00) (0.00)
N 26615 26615 26615 26615
R² 0.077 0.079 0.079 0.077
a. The definitions of all variables are presented in Appendix A.
b. ***, **, * indicates significance at the 1%, 5%, and 10% level, respectively.

 
   

38  
 
 Table 6: Effect of Real Earnings Management, Accrual Earnings Management, and
Innovation Investment Strategies on Firm Value

VARIABLES Firm value measured by Tobin’s q

PATENT_PURCHASE 2.865
(0.54)
PATENT_PURCHASE x DISX -3.270
(0.88)
PATENT_PURCHASE x JONES -1.785
(0.94)
XRD 2.524***
(0.00)
XRD x DISX 1.743***
(0.01)
XRD x JONES 1.264
(0.39)
PATENT_PURCHASE+XRD 2.517***
(0.00)
(PATENT_PURCHASE+XRD) x DISX 1.732
(0.00) ***
(PATENT_PURCHASE+XRD) x JONES 1.260
(0.39)
PATENT_PURCHASE/XRD 0.055
(0.94)
(PATENT_PURCHASE/XRD) x DISX -0.231
(0.95)
(PATENT_PURCHASE/XRD) x JONES 1.497
(0.66)
DISX -0.314*** -0.165 -0.164 -0.425***
(0.00) (0.17) (0.18) (0.00)
|JONES| 1.083*** 0.785*** 0.785*** 1.025***
(0.00) (0.00) (0.00) (0.00)
LOG_AT -0.207*** -0.207*** -0.208*** -0.208
(0.00) (0.00) (0.00) (0.00)
LEVERAGE 0.046 0.170 0.168 0.258
(0.76) (0.25) (0.25) (0.20)
LIQUIDITY 0.542*** 0.460*** 0.460*** 0.654***
(0.00) (0.00) (0.00) (0.00)
PROFITABILITY -2.489*** -2.313*** -2.313*** -1.981***
(0.00) (0.00) (0.00) (0.00)
INTERCEPT 2.421*** 2.353*** 2.354*** 2.340***
(0.00) (0.00) (0.00) (0.00)
N 23889 23889 23889 14289
R² 0.076 0.078 0.078 0.077
a. The definitions of all variables are presented in Appendix A.
b. ***, **, * indicates significance at the 1%, 5%, and 10% level, respectively.

39  
 
 Figure 1: Variable Definition

Variables Definition

PATENT_PURCHASE The amount of patent purchasing

XRD The amount of research and development expenses

The sum of the amount of patent purchasing and the amount of

PATENT_PURCHASE+XRD
research and development expenses

The ratio of the amount of patent purchasing to the amount of

PATENT_PURCHASE/XRD
research and development expenses

Absolute value of discretionary accrual from Jones model

|JONES|
(1991)

Absolute value of discretionary accrual from modified Jones

|MODIFIED JONES|
model (1991)

Absolute value of discretionary accrual from Kothari, Leone,

|KOTHARI JONES|
and Wesley’s Performance matching Jones model (2005)

Where DISX are discretionary expenses during the year, and

REM_DISX are calculated by the sum of advertising expenses, R&D
expenses and SG&A.

The abnormal cash from operations are estimated as the

REM_CFO deviations from the predicted values from above industry-year
regression.

Where PROD are production costs, calculated by the sum of

REM_PROD
costs of goods sold and change in inventory during the year.

Multiply abnormal cash flows from operations and abnormal

REMA discretionary expenses by negative one and then aggregate
them into one measure.

The ratio of market value of equity plus book value of total

TOBINSQ
liabilities to book value of total assets.

ROA Return on total assets by controlling profitability.

ROE Return on total equity by controlling profitability.

MARKETBOOK Market-to-Book ratio

Sales growth ratio. The ratio of change in net sales to lagged net
SGWTH
sales.

40  
 
 Gross cash flow in period t divided by the book value of total
assets at the beginning of period t, where gross cash flow is
CASHFLOW defined as (after-tax) income before extraordinary items plus
depreciation and amortization plus research and development
expense.

Net cash rose from stock issues in period t, where net cash from
STKISSUES stock issues is equal to the sale of common and preferred stock
minus the purchase of common and preferred stock.

Net new long-term debt issued in period t divided by the book

value of total assets at the beginning of period t, where net new
DBTISSES
long-term debt is equal to long-term debt issued minus
long-term debt reduction.

The log of total assets. Controlling Size effect. (Biddle, Hilary,

LOG_AT
and Verdi, 2009)

Total debt in period t divided by the book value of total assets

LEVERAGE
at the beginning of period t.

Cash and short term investment in period t divided by the book

LIQUIDITY
value of total assets at the beginning of period t.

EBITDA in period t divided by the book value of total assets at

PROFITABILITY
the beginning of period t.

41