Earnings Pressure and Strategic Patent Sales: A Troubling Paradox

We’ve all heard the stories – corporations engaging in accounting shenanigans to meet Wall Street’s relentless earnings expectations. But in our recent study, we uncover a subtle yet insidious way firms can boost their reported bottom line: selling off their patent portfolios at the 11th hour.

The Accounting Loophole Incentivizing Patent Sales

Our investigation begins with a puzzling observation about the accounting rules for intangible assets like patents. Under U.S. GAAP (Generally Accepted Accounting Principles), companies must immediately expense all the costs incurred to internally develop new inventions and patent them. That means significant R&D outlays – salaries for scientists, lab equipment, etc. – reduce earnings the moment they’re incurred rather than being capitalized as an asset.

Contrast that with the treatment of patents acquired from another firm. In those cases, the purchaser records the patent on its balance sheet at the price paid and then gradually expenses it over its remaining useful life. This asymmetry between the “make vs. buy” accounting treatment creates a powerful incentive to sell internally-developed patents.

Why? Because for internally-developed patents, the entire proceeds from any sale get recognized as a one-time gain, boosting earnings in the period of the transaction. This could be a tempting lever to pull for managers staring down the barrel of missing earnings expectations. However, these strategic patent sales could come at the expense of divesting valuable intellectual property.

Tracking the Patent Sale Trail

To investigate this phenomenon, we constructed a novel database tracking patent reassignments for all U.S. public firms. Using the USPTO assignment records, we identified instances of corporations selling one or more of their patents between 1985 and 2021.

The initial pattern we uncovered was striking – firms consistently sold more patents in the final month of their fiscal year compared to any other month. On average, patent sales jumped 9.6% in that last month, equivalent to over 600 additional transactions across our sample.

But to establish this as an earnings management tactic, our analyses went deeper. We ran several tests identifying situations where managers are likely more motivated to find an extra penny or two of EPS (earnings per share).

Three distinct findings emerged:

• Meeting Analyst Expectations: In years where a firm just met consensus earnings forecasts by a cent or less, we saw a significantly higher magnitude of last-minute patent sales (13-15% more) compared to other years.
• Beating by a Penny: Tellingly, we found a sharp discontinuity in patent sales right around the breakeven point relative to analyst estimates. Firms that beat expectations by a penny had drastically higher patent sales than those missing by a penny – but only in the last fiscal month.
• Executive Compensation Incentives: The end-of-year patent sale boost was most pronounced (17% higher) at firms where stock and options made up a bigger chunk of C-suite pay packages. Equity-linked compensation is known to incentivize earnings management since execs’ payouts depend on the stock price.

In combination, these tests painted a vivid picture – managers appear to be keep a reserve of “saleable” patents on hand in case they need a last-minute earnings boost. But the costs of this strategy became apparent when we looked at who was buying all these 11th-hour patent packages.

Fueling the “Patent Troll” Phenomenon

In our sample, a disproportionate number of patents sold in the final fiscal month end up in the hands of NPEs (non-practicing entities) – firms derided as “patent trolls” who don’t make any products but specialize in acquiring patents to assert against operating companies through litigation.

On average, patents sold in the last month of a company’s fiscal year were:

• 33% more likely to be litigated overall.
• 79% more likely to be deployed in a lawsuit by a patent troll.

NPEs seemed to be acting as ready buyers for these hasty year-end patent sales, which potentially are sold at fire-sale prices. However, because pricing data is not publicly available, we are unable to confirm that empirically.

We also examined the liquidity role of patent trolls by exploiting the staggered rollout of anti-troll laws across 34 U.S. states between 2013-2017. These statutes made it riskier for trolls to bring lawsuits within a state’s borders. Accordingly, after a state implemented such a law, we found a 6.9% drop in the volume of last-minute patent sales by firms headquartered there. NPEs appeared to pull back as buyers once the regulatory environment turned against them.

The Unintended Consequences of Shortsighted Incentives

Our findings expose a troubling paradox at the heart of financial reporting incentives for U.S. corporations. On one hand, managers are pressured by capital market participants to “make their numbers”. Missing EPS estimates by just a penny can reduce a firm’s stock price.

Myopic earnings incentives create a powerful temptation to pull levers like strategically selling off patents, even if it means forfeiting valuable intellectual property. Prior studies have documented other “real earnings management” moves like cutting R&D or overproducing inventory to massage short-term profits. But we’re the first to highlight patent sales as another mechanism.

The potential costs of strategic patent sales can include more than just the foregone revenues and profits from commercializing a divested patent in-house. By dumping these patents at fire-sale prices, firms are fueling the very patent troll ecosystem they publicly decry.

The Obama administration estimated that defendants in NPE litigation incurred $29 billion in direct costs in 2011, a 400% increase from 2005 levels. And that doesn’t even count the harder-to-quantify opportunity costs – management hours eaten up by frivolous lawsuits rather than deployed toward productive innovation.

Collectively, our results add to the tradeoffs policy makers and board members should consider when setting accounting policies and compensation practices.

Implications for Policymakers, Investors and Managers

We see several key implications from our work:

• Accounting Policymakers: The divergent treatment of internally-developed vs. externally-acquired IP under GAAP creates a skewed incentive to part with homegrown patents. Policymakers at the FASB can consider this asymmetry as part of any project on accounting for intangibles.
• Securities Regulators: If a firm has an unusual spike in patent sales or transfers right before year-end, that could raise red flags about potential earnings management. SEC reviewers may want to scrutinize the motives and economics behind such transactions.
• Investors: Excessive fixation on quarterly EPS and punishing small misses is part of what induces firms to engage in value-destructive moves. Taking a longer-term view of corporate performance may mitigate some of these pressures.
• Boards and Compensation Committees: Our results underscore how equity-heavy pay packages can tempt managers to juice short-term earnings potentially at the expense of a firm’s intellectual property portfolio. A more balanced mix of incentives that rewards sustainable innovation could help.

Looking ahead, we hope our work spurs deeper exploration of how capital market pressure warps strategic decision-making within innovative firms.

 

Jinhwan Kim is an associate professor at the Stanford Graduate School of Business. Professor Kim’s research focuses on the economic consequences of corporate disclosure. His research investigates how traditional and non-traditional forms of corporate disclosure affect capital market and real outcomes. His research has been published in top journals in accounting and finance such as the Journal of Accounting and Economics, Journal of Accounting Research, and the Review of Financial Studies. He holds BS and MS degrees from Columbia University and a PhD from MIT Sloan School of Management.

 

Kristen Valentine is an associate professor of accounting at the University of Georgia. Her primary research area explores how accounting and disclosure influence innovation. She also examines the factors that influence managers’ voluntary disclosure choices, disclosure regulation, and real earnings management. She has publications in the Journal of Accounting and Economics, Journal of Accounting Research, The Accounting Review, Contemporary Accounting Research, Review of Accounting Studies, and the American Business Law Journal. She earned her PhD at the University of Texas at Austin.