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Market Valuation of Intangible Assets

Won W. Choi
DONGGUK UNIVERSITY

Sung S. Kwon
RUTGERS UNIVERSITYCAMDEN

Gerald J. Lobo
SYRACUSE UNIVERSITY

Whether information on intangible assets reported under current financial


reporting requirements conveys information that is relevant to market
participants valuation of firms equity has long been a question of interest
to accounting policymakers and researchers. This study provides empirical
evidence on the relationship between the reported value of intangible
assets, the associated amortization expense, and firms equity market
values. These relationships are examined using a matched pair portfolio
analysis and multiple regression analysis that has been used in prior
research on this topic. The results indicate that the financial market
positively values reported intangible assets. Furthermore, consistent with
theoretical predictions, the markets valuation of a dollar of intangible
assets is lower than its valuation of other reported assets. The results also
indicate that, although the market values amortization expense differently
from other expenses reported in the income statement, it does not negatively
value amortization expense. These results support the current requirement
that intangible assets be reported in firms balance sheets. However,
they do not support the current requirement that intangible assets be
periodically amortized to reflect the assumed decline in their value. J BUSN
RES 2000. 49.3545. 2000 Elsevier Science Inc. All rights reserved

his study examines the relationship between the reported value of intangible assets, the associated amortization expense, and firms equity market values. It is
motivated by the accounting for intangible assets required by
Accounting Principles Board (APB) Opinion No. 17, under
which firms must capitalize the cost of intangible assets and
amortize that cost over a period not to exceed 40 years or
the economic life of the asset, whichever is shorter. These
accounting requirements have long been the subject of controversy. At the core of the controversy is whether the reported
value of intangible assets on the balance sheet reflects the
Address correspondence to Gerald J. Lobo, School of Management, Syracuse
University, 900 S. Crouse Avenue, Syracuse, NY 13244.
Journal of Business Research 49, 3545 (2000)
2000 Elsevier Science Inc. All rights reserved
655 Avenue of the Americas, New York, NY 10010

value of their future economic benefits. A related question is


whether recorded periodic amortization of intangible assets
reflects the decline in their economic value. This research
provides empirical evidence on the extent to which the reported value of intangible assets and its related amortization
expense are reflected in the market value of firms equity.
This evidence is important to users of financial statements for
decision making and to accounting regulators for making
financial reporting policy.
At a more general level, financial statements often have been
criticized for failing to reflect differences in the uncertainty of
future economic benefits and costs associated with different
assets. The balance sheet does not differentially weight assets
that differ in the levels of uncertainty associated with their
related future economic benefits and their related costs. In
addition, the income statement does not differentially weight
different revenue and expense items that have unequal degrees
of uncertainty. Most valuation models, however, indicate that
the value of an asset is inversely related to the uncertainty of
the associated future benefits expected from that asset (Robichek and Myers, 1966; Rubinstein, 1973; Epstein and Turnbull, 1980). This relationship between uncertainty and asset
value is ignored in most balance sheet and income statement
measures and is the primary reason for this criticism of financial statements. It is especially relevant to intangible assets
because of the significantly greater uncertainty associated with
the amount and timing of their future economic benefits.1
Egginton (1990) and Hodgson, Okunev, and Willett (1993)
indicated that flat rate amortization (e.g., straight-line amortization over 40 years) of a particular type of intangible asset
across all firms ignores potentially significant economic differ-

For example, Rabe and Reilly (1996), and Reilly (1996) reported that the
valuation of intangible assets has become an increasingly more integral and
more complex part of the current health care environment and the corporate
bankruptcy and reorganization environment, respectively.

ISSN 0148-2963/00/$see front matter


PII S0148-2963(98)00121-0

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J Busn Res
2000:49:3545

ences, thereby resulting in the periodic decline in the value


of the intangible asset being reported in the income statement
with considerable error. The periodic consumption of an intangible asset depends on the nature of the asset, its economic
life, and the pattern of consumption of its future economic
benefits. Unlike tangible assets, there is considerably greater
uncertainty involved in determining lifetime duration during
which the assets economic benefit will be consumed and
the periodic reduction pattern of the assets service potential,
because it is unclear what the specific benefit is.2 This greater
degree of uncertainty results in a reduction in the accuracy
of the amortization of the intangible asset that is reported in
the income statement.
We provide empirical evidence that is relevant to the controversies and criticisms discussed above. We use a matched
portfolio approach to examine these issues in addition to using
the regression analysis approach that has been employed in
prior research. First, we examine whether firms equity market
values reflect reported values of intangible assets and their
associated amortization expense. To test the balance sheet
(income statement) valuation of intangible assets, we compare
book-to-market (earnings-to-market) values for a portfolio of
firms that have significant and stable amounts of intangible
assets (amortization expense) on their balance sheets (income
statements) to a matched portfolio of control firms that have
no intangible assets (amortization expense). The results of this
analysis provide evidence on the markets perception of the
value-relevance of the reported information on intangible
assets. Second, we examine whether the market valuation of
intangible assets and amortization expense differs from its
valuation of other balance sheet items and income statement
items, respectively. Consistent with the differential uncertainty
explanation, we test the hypothesis that the book-to-market
(earnings-to-market) value ratio of a portfolio of firms that
have significant and stable amounts of intangible assets and
include book values of such assets (amortization expense) on
their balance sheets (income statements) to a matched portfolio of control firms that report no intangible assets (amortization expense). The results of this analysis provide evidence
on the valuation implications of financial statements failure
to reflect differences in the levels of uncertainty across their
different elements. We also conduct tests by using regression
analysis to assess the robustness of our results and to provide
a basis for comparison of our results with those of prior
research.
Our portfolio tests indicate that firms equity market values
reflect reported values of intangible assets. However, no decline in market value is associated with reported amortization
expense. They also indicate that intangible assets and other

An intangible asset, such as goodwill, has no limited term of existence


and is not utilized or consumed in the earnings process. Consequently, its
amortization reduces the reliability of the income statement. (Johnson and
Tearney, 1993).

W. W. Choi et al.

balance sheet elements are not differentially valued. However,


we observe differences in the markets valuation of amortization expense and other income statement items. The results
of the regression analysis are consistent with the portfolio
results. They confirm the evidence of prior research concerning the value-relevance of reported intangible assets and the
price-irrelevance of the related amortization expense. These
results indicate that the market valuation does not reflect
significant differences in uncertainty between intangible assets
and other balance sheet elements. However, it does value
amortization expense related to intangible assets differently
from other income statement elements.
The rest of this article is organized as follows. Section 2
presents the background and identifies the issues addressed
in this article. Section 3 discusses the methodology and the
hypotheses examined. Section 4 describes the data collection
and portfolio formation. Section 5 presents the results of the
empirical analysis, and section 6 contains a summary and
conclusions of the study.

Background
Under APB Opinion No. 17 (American Institute of Certified
Public Accountants, 1970), intangible assets are accounted
for in a manner similar to the accounting required for property,
plant, and equipment. An intangible asset is recorded at historical cost and amortized over the period that the firm expects
to benefit from its use. However, unlike fixed assets, the
uncertainty in the degree and timing of future benefits expected from intangible assets is considerably greater. Because
of the higher levels of uncertainty associated with future benefits to be derived from intangible assets, many practitioners
and academics have suggested that such expenditures should
be written off in the period in which they are incurred. This
suggestion is consistent with valuation models, which indicate
that the value of an asset will approach zero as the level of
uncertainty of its future economic benefits approaches infinity.3 Whether the higher level of uncertainty associated with
the benefits from intangible assets is significant enough to
cause the market to discount those benefits more than it
does for other asset benefit streams is a question that can be
empirically investigated.
The continuing controversy surrounding the accounting
for intangible assets has drawn the attention of academic researchers. Much of the research has focused on issues related
to goodwill accounting, which is the largest intangible asset

3
The notion that the value of an asset will approach zero as the level of
uncertainty of its future economic benefits nears infinity is consistent with
the FASBs definition of an asset as a probable future economic benefit
controlled by an entity as a result of a past transaction or an event under
Statement of Financial Accounting Concepts No. 3. In other words, if the
future realization of the economic benefits resulting from the use of the
intangible asset is not probable, then it should not be classified as an asset.

Market Valuation of Intangible Assets

for most firms.4 Studies by Amir, Harris, and Venuti (1993),


Chauvin and Hirschey (1994), and McCarthy and Schneider
(1995) reported a significant positive relationship between
goodwill and the market value of a firm. Jennings, Robinson,
Thompson, and Duvall (1996) empirically investigated the
relationship between market equity values and purchased goodwill. Consistent with earlier findings, their results indicate that
the market values purchased goodwill as an asset. However,
they find little evidence of a systematic relationship between
goodwill amortization and firms market values.
One explanation for the latter result of Jennings, Robinson,
Thompson, and Duvall (1996) is that goodwill amortization
measures required to be used under generally accepted accounting principles (GAAP) do not correctly reflect the decline
in the economic value of the intangible asset during the period.
This results from the considerable amount of uncertainty associated with estimating the period over which the economic
benefit will be realized and the pattern of reduction of the
assets economic benefit. An alternative way of stating this
is that the high levels of uncertainty associated with future
economic benefits from intangible assets result in amortization
measures that contain large amounts of error. While errors
in measuring amortization expense also will affect the reported
asset value on the balance sheet, the effects of such errors will
not impact balance sheet measures as significantly as they do
income statement measures. There are two reasons for this.
First, the size of the error resulting from incorrectly measuring
amortization expense is relatively smaller for the reported
balance sheet asset than the reported income statement expense.5 Second, to the extent that errors in measuring amortization expense are not highly correlated over time, the cumulative error is likely to be smaller than any single periods error.
Therefore, a cross-sectional regression approach such as that
used by Jennings, Robinson, Thompson, and Duvall (1996)
is likely to show significant relationships between market
values and reported balance sheet goodwill assets but not
between market values and reported income statement goodwill amortization expense.
We test two hypotheses in this study. First, we examine
whether reported amounts for intangible assets and amortization expense are value relevant. If the market value of a firm
reflects reported values for intangible assets and amortization
expense, then we can infer that the market perceives the
information provided by APB No.17 to be value-relevant.
Jennings, Robinson, Thompson, and Duvall (1996) also tested

J Busn Res
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37

this hypothesis by using the regression approach. Second, we


examine whether the market values reported intangible assets
and amortization expenses differently from other components
of the balance sheet and the income statement, respectively.
Evidence of differential valuation will support those who argue
that intangible assets should be treated differently from other
elements of the balance sheet and income statement. Alternatively, if we find no difference in the markets valuation of
these intangible asset measures, then our results will provide
support for the reporting requirements under APB Opinion
No. 17.
We employ two different approaches in this study. In addition to using cross-sectional regressions as in Jennings, Robinson, Thompson, and Duvall (1996) and others to confirm
the validity of our data in relation to these previous studies,
we also use a portfolio approach that is not as sensitive to
the measurement and econometric problems associated with
intangible assets. Additionally, unlike Jennings, Robinson,
Thompson, and Duvall (1996), we do not impose a linear
structure on the cross-sectional market value-intangible asset
relationship. This is important because the market value assigned to intangible assets is likely to differ across firms because of differential amounts of uncertainty associated with
their future economic benefits. We use a control portfolio as
a benchmark to compare the market values associated with
reported intangible assets and amortization expense. We also
use this portfolio approach to test whether the impact of
intangible assets and amortization expense on firms market
values differs from the impact of other line items in the balance
sheet and income statement, respectively.

Methodology and Hypotheses


Market Valuation of Reported Balance
Sheet Items
We form three portfolios to assess the markets valuation
of intangible assets reported in the balance sheet. The first
portfolio, labeled the experimental portfolio comprises firms
with significant amounts of intangible assets that have been
relatively stable over the past three years. This allows us to
focus on the markets valuation of intangible assets that have
been on the firms books for some length of time rather than
on recently acquired intangible assets.6 The second portfolio
comprises the same firms as the experimental portfolio. However, the book value of intangible assets has been subtracted
from each firms balance sheet. We label this the adjusted

McCarthy and Schneider (1995) reported that their research of the COMPUSTAT database identified 1,451 firms reporting goodwill in the aggregate
amount of $158 billion.
5

Consider an intangible asset costing $100, a life of 10 years, and annual


amortization expense of $10. This asset will be reported at $90 on the balance
sheet at the end of year one. If true amortization expense is $11, then the
error in amortization expense expressed as a percentage of the reported
amount is 10%. The true balance sheet amount is $89; therefore, the error
is approximately 1%.

The book value and market value of recently acquired intangible assets are
likely to be closer to one another because the book value will more closely
reflect the price at which the asset was acquired. Consequently, there will
be little impact of accounting methods on the reported book value of the
asset. By restricting the experimental firms to those that have had intangible
assets for a longer period, we are able to focus on how closely the accounting
for these assets corresponds to the markets assessment of their value.

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portfolio. The third portfolio comprises firms that do not


report any intangible assets. We label it the control portfolio.
Firms in the control portfolio are pairwise matched with the
adjusted firms based on three financial statement items: total
assets, book value of equity, and earnings.7 Additionally, firms
in each pair are matched in terms of industry and calendar year.
We compare book-to-market value (BM) ratios of control
and adjusted portfolios to test whether the market positively
values intangible assets. Ceteris paribus, if the market value
assigned to intangible assets is zero, then the BM ratios of the
control and adjusted portfolios will be equal. Alternatively, if
the market places a positive value on intangible assets, then
the BM ratio of the adjusted portfolio will be less than that
of the control portfolio. This is so because the market value
of the adjusted portfolio includes the market value assigned to
intangible assets, whereas its book value excludes the reported
intangible asset value. Consistent with the above reasoning,
we test the following hypothesis (stated in its alternate form):
HB1: The book-to-market value ratio of the adjusted portfolio is less than the book-to-market value ratio of
the control portfolio.
Our second hypothesis examines whether the BM ratio of
intangible assets differs from the BM ratio of tangible assets.
We compare BM ratios between the experimental and control
portfolios to test this hypothesis. If the market values each
dollar of intangible assets and tangible assets equally, then
the experimental and control portfolios will have equal BM
ratios. Alternatively, if the market valuation per dollar of intangible assets is lower than its valuation of tangible assets, then
the BM ratio of the experimental portfolio will exceed that
of the control portfolio. We formalize the above discussion
with the following hypothesis (stated in its alternate form):
HB2: The book-to-market value ratio of the experimental
portfolio is greater than the book-to-market value
ratio of the control portfolio.

Market Valuation of
Reported Income Statement Items
We use an analogous procedure to assess the markets valuation of amortization expense related to intangible assets reported in the income statement. Once again, we form three
portfolios. The first portfolio, labeled the experimental portfolio, comprises firms with significant amounts of amortization
expense that have been relatively stable over the past three
years. The second portfolio, labeled the adjusted portfolio,

These three variables allow us to control for size (by total assets), debt-toequity ratio (by book value of equity and total assets), and return-on-equity
(by earnings and book value of equity). Prior research has shown that these
variables are significant in explaining firms equity market values (e.g., Atiase,
1985; Lang, 1991).

W. W. Choi et al.

comprises the same firms as the experimental portfolio; however, the earnings are adjusted to remove the effect of deducting amortization expense related to intangible assets. This
results in the adjusted firms earnings always exceeding the
experimental firms earnings. The third portfolio contains
firms that do not report amortization expense. Firms in this
control portfolio are pairwise matched with the adjusted
firms based on total assets, book value of equity, earnings,
industry, and year.
We compare earnings-to-market value (EM) ratios between
control and adjusted portfolios to examine whether the market
reflects reported amortization expense in its valuation. Ceteris
paribus, if amortization expense has no effect on market value,
them the EM ratios of the control and adjusted portfolios will
be equal. Alternatively, if the market value declines as a result
of the reported amortization expense, then the EM ratio of
the adjusted portfolio will be greater than that of the control
portfolio. This is so because the negative effect of the amortization expense is reflected in the market value of the adjusted
portfolio but not in its earnings. Based upon the above discussion, we test the following hypothesis (stated in its alternate
form):
HI1: The earnings-to-market value ratio of the adjusted
portfolio is greater than the earnings-to-market value
ratio of the control portfolio.
Our second income statement-related hypothesis examines
whether the effect of each dollar of amortization expense on
market value differs from the corresponding effect of other
income statement elements. We compare EM ratios between
experimental and control portfolios to test this hypothesis. If
the market value decrease per dollar of amortization expense
equals the market value decrease per dollar of other income
statement elements, then the experimental and control portfolios will have equal EM ratios. Alternatively, if the reduction
in market value per dollar of amortization expense is less than
it is for other income statement components, then the EM
ratio for the experimental portfolio will be lower than the EM
ratio for the control portfolio. Consistent with this reasoning,
we test the following hypothesis (stated in its alternate form):
HI2: The earnings-to-market value ratio of the experimental portfolio is less than the earnings-to-market value
ratio of the control portfolio.

Data, Sample Selection,


and Portfolio Formation
The test period for our study extends from 1978 to 1994.
Sample firms are selected from among those with available
data in the 1995 COMPUSTAT Industrials Annual file and
the CRSP monthly returns file. We use the following threestep procedure to select firm-year observations for testing our
hypotheses:

Market Valuation of Intangible Assets

1. Selection of firms with significant amounts of intangible


assets (amortization expense) for testing the balance
sheet (income statement) hypotheses. Observations
comprising the experimental portfolios are selected
from among these firms.
2. Selection of firms with no intangible assets (amortization expense). These observations are used to form the
control portfolios.
3. Matching experimental and control observations. These
matched portfolios are used for testing the balance sheet
and income statement hypotheses.
Each of these steps is described in more detail in the remainder of this section.

Portfolio Formation for Balance Sheet Hypotheses


Experimental
firm-year observations are required to satisfy the following
criteria:

SELECTION OF EXPERIMENTAL OBSERVATIONS.

1. The ratio of intangible assets to total assets is greater


than 10%. This criterion ensures that the experimental
observations have significant amounts of intangible
assets. It enhances the power of our tests because we
compare these observations with observations that have
no intangible assets.
2. The ratio of intangible assets to total assets does not
vary by more than 50% over the three-year period ending with the test year. This criterion ensures that the
experimental observations have stable amounts of intangible assets for some length of time prior to the test
year (i.e., the major portion of intangible assets has not
been recently acquired).
3. Data is available on total assets, book value of equity,
and earnings. These variables are used to match experimental observations with control observations. Prior
research indicates that BM ratios (the dependent variable) are related to these three variables. By matching
observations along these three dimensions, we control
for differences in BM ratios that may result from differences in these variables.
4. These observations (for testing the balance sheet
hypotheses) do not overlap with those used for testing
the income statement hypotheses (which are discussed
later). By focusing on observations with significant balance sheet effects but insignificant income statement
effects, differences in BM ratios can more reliably be
attributed to differences in intangible assets reported
on the balance sheet.
These criteria result in a sample of 1,024 firm-year observations over the 17-year period 1978 to 1994. There were 219
different firms represented in the sample.
SELECTION OF CONTROL OBSERVATIONS. Our research design
compares firms with significant and stable amounts of intangi-

J Busn Res
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39

ble assets to matched firms that have no intangible assets.


Control firms are required to:
1. Have no intangible assets and amortization expenses.
2. Have data available on total assets, book value of equity,
and earnings.
These criteria result in 14,683 firm-year observations that
are matched with the experimental observations for testing
both the balance sheet and income statement hypotheses.
MATCHING EXPERIMENTAL WITH CONTROL OBSERVATIONS. Before matching the experimental with the control observations,
we recalculate the total assets, book value of equity, and
earnings of the experimental firms after eliminating intangible
assets and amortization expenses. We reduce the book value
of equity by the amount of intangible assets removed from
the asset side of the balance sheet. Amortization expenses are
added back to earnings. Each adjusted firm-year observation
is then matched with a control firm-year observation by using
the following criteria:

1. The control and adjusted observations are from the


same year.
2. The control and adjusted firms belong to the same onedigit SIC industry.
3. The total assets, book value of equity, and earnings for
the control observation are each within 15% of the
corresponding measures for the adjusted observation.8
These matching criteria result in 83 matched pairs of adjusted and control firms. Panel A of Table 1 summarizes the
sample distribution by year and industry.

Portfolio Formation for


Income Statement Hypotheses
Experimental
observations are required to satisfy the following criteria:

SELECTION OF EXPERIMENTAL OBSERVATIONS.

1. The ratio of amortization expense to sales is greater


than 0.25%. This criterion ensures that the experimental
firms have significant amounts of amortization expense.9
2. The ratio of amortization expense to sales does not vary

We used various ranges (from 5 to 30%) to control for these three variables.
The wider the range, the less the control, while the narrower the range, the
fewer the number of matched observations. Given this trade-off, we chose
15%, because it provided a sufficient number of observations for conducting
our tests. When more than one control firm satisfied these criteria, we ranked
the deviations of total assets, book value of equity, and earnings between
control and adjusted observations, summed the ranks for each firm, and
selected the firm with the lowest total rank.
9

The choice of 0.25% is derived from criterion (1) for selecting experimental observations for the balance sheet tests (intangible assets must comprise
at least 10% of total assets) and the maximum amortization period for intangible assets of 40 years specified in APB No. 17. This cutoff provides a comparable sample size for the income statement tests to that used for the balance
sheet tests.

40

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W. W. Choi et al.

Table 1. Distribution of Sample Observations


Panel A: Sample Observations for Portfolio Tests of Balance Sheet
Hypotheses
Industrya
Year
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
Total

3
2
5
1
1
2
1
1
3
3
2
2
3
1
3
2
5
40

1
1
1
3

1
1

2
3
2
4
18

3
2
1
6

1
2
1
1
1
2
1
9

2
1
2
6

1
1
3

Total
4
3
5
2
1
2
3
1
3
5
10
2
6
4
10
8
14
83

Panel B: Sample Observations for Portfolio Tests of Income Statement


Hypotheses
Industrya
Year
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
Total

2
1
2
1
1

1
1

1
1

1
1
1

1
1
2
1
2
2

2
3
2
3
1
2
2
1

3
4
21

4
3
25

1
2
3
2
2
2
1
2
3
4
3
2
2
32

1
1
1

1
3

1
3
1
1
1
2

12

1
1

Total
4
3
3
2
2
5
7
6
8
4
6
10
6
5
5
14
10
100

One-digit SIC codes: 1; mining, oil and gas, and construction; 2; light manufacturingfood, textile, furniture, printing, and chemical; 3; heavy manufacturing
rubber, glass, metal, electric, and measuring instrument; 4; transportation, communication, and utilities; 5; wholesale and retail trading; 6; financebanking, brokers, insurance, real estate, and investment; 7; personal and business servicehotel, repair, motion
picture, and amusement.

by more than fifty% over the three-year period ending


with the test year. This criterion ensures that the experimental firms have stable amounts of amortization expense for some length of time (i.e., the amortization
expense does not primarily result from recently acquired
intangible assets).

3. Data is available on total assets, book value of equity,


and earnings.
4. These observations (for testing the income statement
hypotheses) do not overlap with those used for testing
the balance sheet hypotheses (which were discussed
earlier). By focusing on observations with significant
income statement effects but insignificant balance sheet
effects, we can more reliably attribute differences in EM
ratios to differences in amortization expenses reported
on the income statement.These criteria result in a sample of 755 firm-year observations over the 17-year test
period. There were 241 different firms represented in
the sample.
The same 14,683
firm-year observations described in the balance sheet control
portfolio selection are used.
SELECTION OF CONTROL OBSERVATIONS.

Matching Experimental
with Control Observations
The same adjustments and matching criteria used for the
balance sheet portfolio are employed. These criteria result in
100 matched pairs of adjusted and control observations. Panel
B of Table 1 summarizes the sample distribution by year and
industry.

Empirical Results
We first present the results of the portfolio analyses. These
results are reported in Tables 2 through 5. We compare mean
(panel A) and median (panel B) values of BM ratios and EM
ratios for the experimental, adjusted, and control portfolios.
Tables 2 and 4 present the analyses for portfolios with matched
observations that are within 15% in terms of the three
control variables (total assets, book value of equity, and earnings. To provide an indication of the sensitivity of our results
to the choice of the 15% matching criterion, we report
corresponding results for observations matched on a 10%
criterion in Tables 3 and 5. The portfolio results are followed
by regression analysis results in Table 6. These results serve
as a basis for comparison with prior research and for comparison with the results of the matched portfolio analysis.

Results of Matched Portfolio Analysis


We first present the results of tests of the balance sheet hypotheses. These are followed by test results for the income statement hypotheses.
TESTS OF BALANCE SHEET HYPOTHESES. Consistent with the
sample selection criteria, the experimental firms exhibit significant amounts of intangible assets as shown in Table 2. The
mean (median) proportion of intangible assets to total assets
is 15.78% (18.32%). The results reported in panel A also
provide evidence on the efficacy of the matching procedure.
There is little difference between mean (and median) values

Market Valuation of Intangible Assets

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41

Table 2. Descriptive Statistics of Variables for Experimental, Adjusted and Control Samples for Tests of Balance Sheet Hypotheses
Panel A: Analysis of Mean Values
Mean Value
Variables
PIA
PAE
TA
BE
EBX
BM

p-Value from Paired t-Test

Experimental
Portfolio

Adjusted
Portfolio

Control
Portfolio

ExperimentalControl pairs

AdjustedControl pairs

0.1578
0.0017
831
396
51.00
0.6295

705
269
52.26
0.4522

695
275
52.07
0.6195

0.0000
0.0000
0.2399
0.3774

0.1406
0.2875
0.4909
0.0000

Panel B: Analysis of Median Values


Median Value
Variables
PIA
PAE
TA
BE
EBX
BM

p-Value from Signed-Ranks Test

Experimental
Portfolio

Adjusted
Portfolio

Control
Portfolio

ExperimentalControl pairs

AdjustedControl pairs

0.1832
0.0000
319
184
17.16
0.5571

225
122
17.16
0.3965

230
114
16.23
0.5589

0.0000
0.0000
0.3816
0.7966

0.1398
0.3013
0.4653
0.0000

83 matched pairs, control variables are within 15%.


Variable definitions: PIA, proportion of reported intangible assets (IA) to total assets (TA); PAE, proportion of amortization expense (AE) to sales; TA, total assets; BE, book value
of common equity; EBX, earnings before extraordinary items; BM, book-to-market value ratio BE/market value of common equity.

of total assets, book value of equity, and earnings across the


adjusted and control portfolios. This suggests that it is unlikely
that observed differences in BM ratios result from differences
in these control variables. We compare BM ratios for the
adjusted and control portfolios to test hypothesis HB1. Both
the mean and median BM ratios for the adjusted firms are
less than their corresponding values for the control firms.
The parametric paired t-test and the nonparametric Wilcoxon
matched-pairs signed-ranks test indicate that the differences
in BM ratios are significant at the 0.01 level. These results
indicate that the market positively values intangible assets.
To test the second balance sheet hypothesis, we compare
BM ratios between the experimental and control firms. Consistent with the hypothesis, both the mean and median BM
ratios for the experimental portfolio are greater than their
corresponding values for the control portfolio. However, the
differences are not statistically significant. Based on these results, we are unable to reject the null hypothesis that the
market differentially values intangible and tangible assets.
To examine the sensitivity of these results to the matching
criterion of 15% that was used for the control variables, we
repeat the tests by using portfolios that are matched using
a 10% criterion. This stricter criterion enables us to better
match the experimental, adjusted, and control portfolios;
however, it results in a smaller number of matched pairs.
Thus, while the power of our tests increases because of the
better matching, it is reduced by the smaller number of available observations. The results reported in Table 3 are consis-

tent with those reported in Table 2. They suggest that the


earlier conclusions are relatively insensitive to our choice of
matching criteria.
Sample statistics
for testing the two income statement hypotheses are reported
in Table 4. Consistent with the selection criteria, the experimental firms exhibit significant amounts of amortization expense. The adjusted and control portfolios appear well
matched in terms of the control variables. Parametric and
nonparametric tests indicate that there are insignificant differences in total assets, book value of equity, and earnings across
these portfolios. Therefore, it is unlikely that observed differences in EM ratios across these portfolios are attributable to
differences in these control variables.
Hypothesis HI1 indicates that the adjusted portfolio will
have a larger EM ratio than the EM ratio for the control
portfolio. The results reported in panel B show that neither
the mean nor the median EM ratio for the adjusted firms is
greater than its corresponding value for the control firms.
Based on this result, we are unable to reject the hypothesis
that reported amortization expense related to intangible assets
is reflected in firms equity market values. We compare EM
ratios for the experimental and control portfolios to test the
second income statement hypothesis. As predicted, the mean
and median EM ratios for the experimental portfolio are each
significantly lower than their corresponding values for the
control firms. Based on these results, we conclude that the
TESTS OF INCOME STATEMENT HYPOTHESES.

42

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W. W. Choi et al.

Table 3. Descriptive Statistics of Variables for Experimental, Adjusted and Control Samples for the Tests of Balance Sheet Hypotheses
Panel A: Analysis of Mean Values
Mean Value
Variables
PIA
PAE
TA
BE
EBX
BM

p-Value from Paired t-Test

Experimental
Portfolio

Adjusted
Portfolio

Control
Portfolio

ExperimentalControl pairs

AdjustedControl pairs

0.1478
0.0018
640
310
39.43
0.6947

543
214
40.62
0.5031

542
216
40.24
0.6610

0.0000
0.0000
0.0420
0.3176

0.9399
0.9212
0.9139
0.0046

Panel B: Analysis of Median Values


Median Value
Variables
PIA
PAE
TA
BE
EBX
BM

p-Value from Signed-Ranks Test

Experimental
Portfolio

Adjusted
Portfolio

Control
Portfolio

ExperimentalControl Pairs

AdjustedControl Pairs

0.1373
0.0000
289
153
16.06
0.5894

247
86
16.06
0.4456

248
81
15.96
0.6224

0.0000
0.0000
0.0510
0.6893

0.8123
0.8838
0.8694
0.0059

32 matched pairs, control variables are within 10%.


Variable definitions: PIA, proportion of reported intangible assets (IA) to total assets (TA); PAE, proportion of amortization expense (AE) to sales; TA, total assets; BE, book value
of common equity; EBX, earnings before extraordinary items; BM, book-to-market value ratio BE/market value of common equity.

Table 4. Descriptive Statistics of Variables for Experimental, Adjusted and Control Samples for Tests of Income Statement Hypotheses
Panel A: Analysis of Mean Values
Mean Value
Variables
PIA
PAE
TA
BE
EBX
EM

p-Value from Paired t-Test

Experimental
Portfolio

Adjusted
Portfolio

Control
Portfolio

ExperimentalControl pairs

AdjustedControl pairs

0.0641
0.0066
1547
609
73.48
0.0733

1467
529
80.59
0.0806

1462
530
79.08
0.0870

0.0000
0.0000
0.0008
0.0364

0.2680
0.5213
0.3227
0.8019

Panel B: Analysis of Median Values


Median Value
Variables
PIA
PAE
TA
BE
EBX
EM

p-Value from Signed-Ranks Test

Experimental
Portfolio

Adjusted
Portfolio

Control
Portfolio

ExperimentalControl pairs

AdjustedControl Pairs

0.0562
0.0043
446
212
25.13
0.0713

399
175
28.66
0.0762

397
172
26.42
0.0776

0.0000
0.0000
0.0000
0.0032

0.4159
0.6695
0.3194
0.8377

100 matched pairs, control variables are within 15%.


Variable definitions: PIA, proportion of reported intangible assets (IA) to total assets (TA); PAE, proportion of amortization expense (AE) to sales; TA, total assets; BE, book value
of common equity; EBX, earnings before extraordinary items; EM, earnings-to-market value ratio EBX/market value of common equity.

Market Valuation of Intangible Assets

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43

Table 5. Descriptive Statistics of Variables for Experimental, Adjusted and Control Samples for the Tests of Income Statement Hypotheses
Panel A: Analysis of Mean Values
Mean Value
Variables
PIA
PAE
TA
BE
EBX
EM

p-Value from Paired t-Test

Experimental
Portfolio

Adjusted
Portfolio

Control
Portfolio

ExperimentalControl pairs

AdjustedControl pairs

0.0928
0.0067
2253
911
117.55
0.0723

2119
776
126.52
0.0783

2165
805
126.45
0.0984

0.0007
0.0000
0.0998
0.0145

0.5464
0.4218
0.9686
0.9559

Panel B: Analysis of Median Values


Median Value
Variables
PIA
PAE
TA
BE
EBX
EM

p-Value from Signed-Ranks Test

Experimental
Portfolio

Adjusted
Portfolio

Control
Portfolio

ExperimentalControl Pairs

AdjustedControl Pairs

0.0597
0.0049
554
303
35.29
0.0744

522
184
38.11
0.0801

487
176
37.45
0.0776

0.0002
0.0000
0.0001
0.0214

0.5130
0.6368
0.8489
0.2070

30 matched pairs, control variables are within 10%.


Variable definitions: PIA, proportion of reported intangible assets (IA) to total assets (TA); PAE, proportion of amortization expense (AE) to sales; TA, total assets; BE, book value
of common equity; EBX, earnings before extraordinary items; EM, book-to-market value ratio EBX/market value of common equity.

market differentially values amortization expense and other


income statement items.
Table 5 reports results for matched portfolios based on the
stricter matching criterion of 10%. The results are consistent
with the results reported in Table 4. They indicate that, while
the market differentially values amortization expense and
other income statement items, we are unable to detect the
hypothesized negative effect of amortization expense.

Results of Regression Analyses


We first estimate the market value associated with reported
intangible assets. We then examine the impact of reported
amortization expense on firms market values.
TESTS OF BALANCE SHEET HYPOTHESES. We estimate the following regression model to estimate the relation between reported intangible assets and market value [Eq. (1)]:

MVit 0 1ABPIit 2PPEit

(1)

3IAit 4LIABit et
where MV market value of common equity measured at
the fiscal year end, ABPI book value of total assets minus
property, plant, and equipment and intangible assets, PPE
book value of property, plant, and equipment, IA book
value of intangible assets, and LIAB book value of sum of
liabilities plus book value of preferred stock.
Each of the above variables is scaled by the beginning-ofyear book value of total assets to reduce potential problems

resulting from heteroskedasticity. Model 1 is estimated using


1,024 firm-year observations with available data over the period of study.
The results of estimating model 1 are reported in panel A
of Table 6. They indicate that there is a strong relation between
market values of equity and reported book values of assets
and liabilities, which explain more than 50% of the variation
in market values. The coefficients on the asset variables, 1,
2, and 3, are all significantly greater than zero while the
coefficient on the liabilities variable is significantly negative.
The significant positive value for 3 is consistent with the
market positively valuing intangible assets. This result is consistent with Jennings, Robinson, Thompson, and Duvall
(1996) and McCarthy and Schneider (1995). Consistent with
our hypothesis, our results also show that the coefficient on
IA is less than the coefficients on PPE and ABPI. That 3 is
less than 2 and 1 suggests that the market views the future
benefits associated with IA to be more uncertain than the
future benefits associated with PPE or ABPI. This result differs
from Jennings, Robinson, Thompson, and Duvall (1996) and
McCarthy and Schneider (1995) who report higher valuations
for IA than for PPE and ABPI. One explanation for this difference is that, unlike those studies, our sample is structured to
include firms that have stable intangible assets.10

10

We also estimated model (1) on a year-by-year basis. Inferences from these


estimations are qualitatively similar to those reported in this section.

44

J Busn Res
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W. W. Choi et al.

Table 6. Results of Regression Analysis


Panel A: Tests of Balance Sheet Hypotheses
Model: MVit b0 b1ABPIit b2PPEit b3IAit b4LIABit et
Coefficient

Estimate

White t

Prob |t|

0
1
2
3
4

1.5629
3.9520
4.5911
3.3326
2.7492

8.6924
12.5049
11.7155
4.2168
9.4544

0.0001
0.0001
0.0001
0.0001
0.0001

Adjusted R2
F-value
N

0.5131
270.25
1024

Panel B: Tests of Income Statement Hypotheses


Model: RETit c0 c1EBDAit c2DEPRit c3AMORit
c4MRETt et
Coefficient

Estimate

White t

Prob |t|

c0
c1
c2
c3
c4

0.0729
1.3053
0.9098
0.8651
0.7176

2.5806
7.4767
2.7507
0.9048
8.5458

0.0100
0.0001
0.0060
0.6342
0.0001

Adjusted R2
F-value
N

0.2438
58.63
755

Variable definitions: RET, annual stock return; EBDA, earnings before extraordinary
items plus depreciation and amortization expenses; DEPR, depreciation expenses of
property, plant, and equipment; AMOR, amortization expenses of intangible assets;
MRET, equally weighted market return adjusted for dividends payout (EBDA, DEPR,
and AMOR are deflated by beginning market value of comon equity.)

We estimate the
following regression model to estimate the relation between
reported amortization expense and market value [Eq. (2)]:

TESTS OF INCOME STATEMENT HYPOTHESES.

RETit 0 1EBDAit 2DEPRit

(2)

3AMORit 4MRETt et
where RET annual stock return over the fiscal year, EBDA
earnings before extraordinary items plus depreciation and
amortization expense, DEPR depreciation expense on property, plant, and equipment, AMOR amortization expense
on intangible assets, and MRET equally weighted market
return adjusted for dividend payout.
EBDA, DEPR, and AMOR are deflated by beginning of year
market value of common equity. Model 2 is estimated using
755 firm-year observations with available data over the period
of study.
The results of estimating model 2 are reported in panel B
of Table 6. They indicate that the income statement variables,
EBDA is significantly positively related to firm return and
DEPR is significantly negatively related to firm return. These
results are consistent with theoretical predictions. The market
positively values EBDA and negatively values DEPR. The re-

sults also indicate that the coefficient on amortization expense,


3, is not significantly related to firm return. This result is
consistent with Jennings, Robinson, Thompson, and Duvall
(1996), who also find that amortization expense is not significantly valued by the market. A probable explanation for this
result is that the measure of amortization expense used in
financial reports measures the decline in the value of intangible
assets with considerable error. The economic value of intangible assets may decline for some firms but increase for others.
However, APB Opinion No. 17 requires that intangible assets
be amortized regardless of whether their economic value increases or decreases with the passage of time. This treatment
could result in significant measurement error, which may
explain the insignificant relation between amortization expense and firm returns observed for our sample firms.

Summary and Conclusions


Financial reporting of intangible assets has long been a source
of controversy. Whether reporting of intangible assets and
their related amortization expense provides information that
is relevant to market participants valuation of firms equity
has been a question of continuing debate among accounting
policymakers and academics. This study provides empirical
evidence on the major issues of that debate.
The empirical results based on portfolio analyses indicate
that the financial market positively values reported intangible
assets on the balance sheet but insignificantly regards their
amortization expenses on the income statement. The markets
valuation of a dollar of intangible assets is, however, not
significantly different from its valuation of other reported balance sheet elements. Therefore, the portfolio tests fail to distinguish intangibles from other balance sheet assets according
to the degree and timing of uncertainty in the realization of
future benefits. Our results also suggest that, although the
market does not significantly value amortization expense, it
differentially values amortization expense related to intangible
assets and other income statement elements. These results are
further supported by regression analyses, which indicate that
there is a positive relation between the book value of intangible
assets and the market value of common equity. Moreover,
consistent with the uncertainty hypothesis, the markets valuation of a dollar of intangible assets is lower than its valuation
of other reported balance sheet items. With regards to the
income statement hypotheses, the regression analyses show
that amortization expense is not significantly related to annual
stock returns. These findings are consistent with those of the
portfolio analyses. They suggest that either the market does
not view intangible assets as wasting assets or that recorded
amortization expense reflects the decline in value of the intangible asset with considerable error.
The results of our study have several important implications. First, that intangible assets are positively valued by the
financial market supports the current GAAP requirement that

Market Valuation of Intangible Assets

these assets be reported on firms balance sheets rather than


being immediately expensed. Second, that amortization expense is not significantly related to stock returns does not
support the current GAAP requirement that reported income
be reduced by the periodic amortization of intangible assets.
The results of this study suggest that the current GAAP requirement of periodic amortization of intangible assets be seriously
questioned. One suggestion is that amortization expense be
based on assessed uncertainty in the degree and timing of
future benefits expected from each intangible asset. Finally,
that the market value per dollar of intangible assets is less
than the market value per dollar of tangible assets, and that
the market value associated with each dollar of amortization
expense is lower than the market value associated with each
dollar of other income statement items, is consistent with
relatively greater levels of uncertainty related to intangible
assets and amortization expense. These results support the
criticism of financial statements failure to reflect differential
levels of uncertainty across their different elements. They suggest that accounting reports would be more informative to
decision makers if they include information on differences in
uncertainty related to future economic benefits (costs) across
their different elements.
We thank John Wild, Douglas Schneider, and the anonymous reviewer for
valuable comments. Won Choi acknowledges financial support from Dongguk
University, Sung Kwon from the School of Business at Rutgers University,
and Gerald Lobo from the George E. Bennett Research Center and the Office
of the Vice President of Research and Computing at Syracuse University.

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