Conservatism and accounting for intangible investments: Does the transitory component of earnings play an informational role in valuation and managerial compensation contract

Two objectives of my research are to investigate the informational role of the transitory component of earnings in the accounting based valuation model and the incentive role of earnings on the managerial compensation contract. It is widely reported that accounting conservatism undervalues assets. The information content of accounting earnings is poor when firms have the large amount of intangible related activities. I focus on a situation where intangibles and innovative activities are critical for business operations. I then address the question of whether the transitory component of earnings signal to the market about firm value and managerial efforts related to intangible-asset-based activities when core earnings cannot play such an informational role.; My analytical results show that when core earnings cannot signal about intangible related activities, the transitory component of earnings should provide information about such activities. The informational role of the transitory component of earnings mitigates effort allocation problems via the market-based compensation and helps to improve firm productivity.; Based on these analytical results I develop four testable hypotheses; (1) the use of market-based compensation is higher for firms with high intensity in intangible assets than those with low intensity, (2) for intangible intensive firms, the overall firm performance is positively associated with the market-based compensation, (3) the ability of the transitory component of earnings to provide information about firms' operating activities is negatively associated with bias in BTM, and (4) the ability of the transitory component of earnings to signal information about the value of unrecorded intangible-related activities is positively associated with the proportion of market-based compensation. I use firm level data from fiscal year 1992 to 2003 and show that my empirical results support all these hypotheses.