Intangible assets and the book‐to‐market effect

Date01 January 2019
Published date01 January 2019
DOI: 10.1111/eufm.12148
Intangible assets and the book-to-market effect
Hyuna Park
Koppelman School of Business, Brooklyn
College, City University of New York,
2900 Bedford Ave Brooklyn NY 11210,
The book-to-market effect is well known but prior research
does not analyze the impact of goodwill and related
transformations in accounting rules that may bring
significant changes to the effect. This paper analyzes the
impact of SFAS 142, Goodwill and Other Intangible Assets,
issued in 2001. I find that the book-to-market effect is
weaker in the post-SFAS 142 period, especially in firms that
have goodwill, impairment loss, or risk. The book-to-
market effect is stronger for subsamples of firms that do not
have goodwill. These findings are robust to size groups,
different factor models, and test methods.
fair value accounting, goodwill impairment, R&D valuation, value
G12, M41, O3
Finance research has used the ratio of a stock's book value to its market value to explain the cross-
sectional variation in stock returns, reporting evidence on the book-to-market (BM) effect (Asness,
Moskowitz, & Pedersen, 2013; Fama & French, 1992, 1993, 2008, 2012; Lakonishok, Shleifer, &
I would like to thank the anonymous referees, Don Chance, Jay Choi, Byoung-Hyoun Hwang, Daniel Tinkelman, Thomas
Shohfi, Stephan Jank, Hakyin Lee, Sunil Mohanty, George Papaioannou, Yu Ren, Nina Wang, Celim Yildizhan, and the
participants of the Financial Management Association (FMA) 2015 Annual Meeting, the Korea America Finance
Association 2016 Conference, the European Financial Management 2017 Xiamen Symposium, the FMA Applied Finance
Conference 2017, and the Finance Seminar at Hofstra University for helpful comments and suggestions. I am grateful to
SungIn Moon and Minchul Yang for inspiring me to examine the issues in intangibles valuation and goodwill impairment.
A previous version of this paper, Intangible Assets and Value Investing,was a semi-finalist for the Best Paper Award in
Investments at the FMA Annual Meeting in 2015.
Eur Financ Manag. 2019;25:207236. © 2017 John Wiley & Sons, Ltd.
Vishny, 1994; Rosenberg, Reid, & Lanstein, 1985; Zhang, 2005). Since the pioneering work of
Graham and Dodd (1934), value strategies have been popular among practitioners as well.
However, most prior work in the finance literature does not examine the growth in intangible
assets and related transformations in accounting rules that may bring significant changes to the
BM effect. To fill this gap, I analyze the impact of the Statement of Financial Accounting
Standards (SFAS) 142 (Goodwill and Other Intangible Assets), issued by the Financial
Accounting Standards Board (FASB) in 2001. FASB standards are now incorporated in the
FASB's Accounting Standards Codification (ASC) and SFAS 142 can be found under ASC 350-
20-35. However, to be consistent with prior research, I will refer to SFAS 142 instead of ASC
Why is it important to consider intangible-related accounting changes when we analyze the BM
effect? Nakamura (2001, 2003) of the Federal Reserve Bank of Philadelphia estimates that US firms
invest at least $1 trillion in intangibles every year. However, recording intangibles in financial
statements involves many challenges (Damodaran, 2009; Lev, 2001, 2003). The challenges financial
statement preparers face in the valuation of intangibles could affect the quality of the book value data
financial economists use. For example, when researchers at a semiconductor company develop new
technology, the fair value of the internally developed technology is not recorded on the firm's balance
sheet. The main reason is research and development (R&D) expenditures are treated as operating
expenses instead of capital expenses, even though these expenditures create benefits over many years
(Chan, Lakonishok, & Sougiannis, 2001).
Therefore, the book value of the firm is significantly lower than its market value. However, when
the firm is acquired by another company, the market value of the new technology enters the balance
sheet of the acquirer mainly in the form of goodwill. SFAS 141 (Business Combinations, 2001, revised
2007, now ASC 805) defines acquisition goodwill as the excess of the purchase price paid to the target
over the estimated fair market value of the target's identifiable net assets (FASB, 2001b).
I use R&D as an example here, but many other expenses, such as marketing costs to develop brand
names, have the same problem. The categories of intangible assets include: (1) marketing related; (2)
customer related; (3) contract related; (4) technology related; and (5) other unspecified intangible
assets (Castedello & Klingbeil, 2009). Therefore, the book value of intangibles can change
precipitously after the acquisition of a firm. This has been a very controversial issue among preparers
and users of financial statements, as well as regulators (FASB, 1998, 1999, 2001a; Turner, 1999; US
House, 2000; US Senate, 2000). In response, the FASB issued SFAS 142 in 2001, requiring all
goodwill be periodically tested for impairment using fair value estimates.
However, prior research points out that fair value accounting, such as SFAS 142, can be
problematic when actively traded market prices are not available (Ramanna, 2008). Another problem
we should note occurs when market values go back up after impairments by changes in economic
conditions and investor risk aversion. It is a problem because the increase in the fair market value of
intangibles would not be accounted for under US Generally Accepted Accounting Principles (GAAP).
International Financial Reporting Standards (IFRS) allow revaluation to reflect the increase in the
market value of intangibles, but US GAAP does not. Paragraphs 85 and 86 of International Accounting
Standards (IAS) 38 state that revaluation increases and decreases are recognized either in equity or in
profit or loss. Chen, Shroff, and Zhang (2014) identify cases of goodwill impairment that are driven by
Under US GAAP (Generally Accepted Accounting Principles), costs incurred to develop, maintain, or restore intangibles
are generally expensed rather than capitalized. Exceptions include costs associated with computer software and website
development. See US GAAP ASC 350-20-25-3, ASC 730-10-25-1, and ASC 985-20, for details.

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