The valuation of intangibles involves various assumptions and managerial estimates. Prior studies show that managers exploit their discretion to delay the recognition of intangible impairments. In this paper, I focus on the role of auditors who can reduce the managerial discretion in the valuation of intangibles by conducting stricter procedures. Also, I extend my analyses into the governance role of auditors in intangible investments.
I use PCAOB (Public Company Accounting Oversight Board) inspections to answer my research question. The PCAOB conducts periodic inspections of audit engagements to detect deficiencies in procedures performed by auditors. From the PCAOB's inspection reports, I identify audit deficiencies that indicate insufficient audit procedures about management's valuation assertions of intangibles on financial statements. I posit that auditors subsequently scrutinize the valuation of intangibles by implementing more audit procedures to remediate their deficiencies, leading their clients to recognize more impairments of intangibles.
I find that the clients of deficient auditors recognize more intangible impairments, reflecting increased auditor scrutiny of the valuation of intangibles in subsequent audits. Also, I find that the remediation of deficiencies strengthens the association between economic signals for impairment losses and impairments recognized by the clients of deficient auditors, suggesting that PCAOB inspections contribute to mitigating the untimely recognition of intangible impairments.
The academic studies and anecdotal cases show the frequent and increasing use of M&A deals for innovation. However, significant agency costs exist in these deals due to managers' empire building incentives and optimistic bias. Such investment decisions distort resource allocation for innovation because resources could have been better invested in alternative projects for innovation.
Next, I find that the clients of deficient auditors subsequently reduce their reliance on external innovation strategies (M&A deals) relative to internal innovation strategies (in-house R&D). This is because the decrease in managerial discretion primarily affects external innovation strategies in which companies recognize intangible assets that are subject to valuation and impairment tests. In contrast, audit deficiencies regarding the valuation of intangibles have almost no effect on internal innovation strategies because most internally developed intangibles are expensed immediately under U.S. GAAP.
This paper makes several practical and academic contributions. First, this paper shows the role of auditors when companies increasingly rely on external resources for innovation. The remediation of audit deficiencies regarding the valuation of intangibles creates an incentive to curb excessive reliance on external innovation strategies. Second, the finding that PCAOB inspections mitigate the untimely recognition of intangible impairments in the post-SFAS 142 period provides policy implications for accounting standard setters. Lastly, the effects of audit deficiencies on clients' corporate innovation are arguably unintended consequences of PCAOB inspections. An empirical examination of unintended regulatory outcomes is important because regulators rarely have internal systems to monitor these consequences.