By mandating that research and development (R&D) spending be expensed immediately, Statement of Financial Accounting Standards (SFAS) No. 2 (FASB [1974]) potentially distorts the income statement in the sense that good news (e.g., an increase in pre-R&D earnings concurrent with a larger increase in R&D spending) could translate into reported bad news (i.e., a decline in reported earnings) and vice versa. In this paper, we focus our analysis on a directed sample of firms for which reported earnings are highly distorted by changes in R&D spending, and rely on intraday trading data and event study tests of both stock returns and trading activity (at the time of quarterly earnings announcements) to examine whether the stock market is fixated on reported earnings or whether it attempts to “look beyond” reported earnings by utilizing the information on R&D spending disclosed as part of the earnings announcement. The results suggest that R&D spending information has an effect on trading activity for all trade sizes and firm information environments, but no price effect for firms with relatively impoverished information environments. The implications of our findings are discussed.
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