Internal information quality and patent‐related innovation

• Author: Gregory McPhee,Brent Lao,Kelly Huang
• DOI: http://doi.org/10.1111/jbfa.12439
• Date: 01 March 2020
• Published date: 01 March 2020

DOI: 10.1111/jbfa.12439

Internal information quality and patent-related

innovation

Kelly Huang1Brent Lao2Gregory McPhee3

1Florida International University, 11200 SW 8th

Street, Miami, FL 33199

2Illinois State University, Campus Box5500,

Normal, IL 61790–5500

3Clemson University, 300 Sirrine Hall, Clemson,

SC 29634

Correspondence

KellyHuang, Florida International University,

11200SW 8th Street, Miami, FL 33199.

Email:huangx@fiu.edu

Wethank Ellen Engel, Shawn Huang, Michael

Kirschenheiter,Gilad Livne, Xiumin Martin,

MichalMatejka, Catherine Shakespeare (Editor),

HuaxiangYin, an anonymous reviewer, and par-

ticipantsat University of Illinois at Chicago and

FloridaInternational University workshops, 2016

MASResearch and Case Conference, 2016 Euro-

peanAccounting Association Annual Congress,

2016Conference on Convergence of Financial

andManagerial Accounting Research, 2016

AmericanAccounting Association Annual Confer-

ence,and 2019 Journal of Business Finance and

AccountingCapital Market Conference for their

helpfulcomments.

Abstract

This study investigates how the quality of information available

within a firm affects patent-related innovative activities. Relying on

recent theoretical and empirical research, we use externally observ-

able information attributes to proxy for the quality of internal infor-

mation. Our empirical results indicate that firms with higher inter-

nal information quality generate more patents and patent citations.

Cross-sectional analyses show that this positive effect is greater

when firms are susceptible to greater internal information frictions

due to firm decentralization, short management team tenure, and

long product development cycles. We also document that firms

experience an increase in patents and patent citations following an

improvementof internal information quality proxied by internal con-

trol weakness remediation. Overall,our results suggest that the pos-

itive relation between internal information quality and task perfor-

mance extends to patent-related innovation, a non-routine type of

task that may rely on information originating from sources other

than firms’ formal internal information systems.

KEYWORDS

coordination, internal information quality, patent-related innova-

tion, uncertainty

JEL CODES

M41, D8, O32

1INTRODUCTION

Innovation is a key driver of firm competitive advantage and national economic growth (Porter, 1998; Shumpeter,

1983). Firms engage in innovationto develop new products or internal business processes that range from incremental

improvementsto existing production processes to the creation of novel goods or services through large-scale research

and development(Organization for Economic Co-operation and Development, 2005). Extensive research in economics

and finance has identified how external monitoring, such as institutional ownership and takeover pressure, can alter

managers’ incentivesto innovate (e.g., Aghion, Van Reenen, & Zingales, 2013; Atanassov,2013). In contrast, little atten-

tion has been given to the inner workings of firms that can impact innovation. We propose that the quality of internal

J Bus Fin Acc. 2020;47:489–518. wileyonlinelibrary.com/journal/jbfa c

2020 John Wiley & Sons Ltd 489

490 HUANG ETAL.

information available to managers and employees within firms is an important factor that affects innovationoutputs. 1

We define internal information quality (IIQ) as the extent to which information within the firm is accessible, accurate,

and timely (Demski, 1994; Gallemore & Labro, 2015).

Because innovation is a long-term, complex task with unpredictable outcomes and a high probability of failure, it

poses significant challenges to firms with respect to internal capital allocations and employee coordination (Hoegl,

Weinkauf,& Gemuenden, 2004; Holmstrom, 1989; Seru, 2014). These challenges are likely to be exacerbated by inter-

nal information asymmetries, both vertical and horizontal, among firm managers and employees (Baiman, 1990; Kan-

odia, 1993). For example, vertical information asymmetries between senior managers and project managers reduce

senior managers’ willingness to fund innovation because senior managers are more uncertain about whether project

managers have manipulated project reports for their own benefit (Seru, 2014). Horizontal information asymmetries

among employees across functional areas, such as R&D, marketing,and manufacturing, reduce innovation outputs by

limiting employees’ability to identify team synergies and coordinate their efforts (Bushman, Dai, & Zhang, 2016; Hoegl

etal., 2004; Souder & Moenaert, 1992). Therefore, we predict that high IIQ promotes firm innovation by reducing inter-

nal information asymmetries that impede innovation performance.

Consistent with prior innovation research, we measure the quantity and quality of a firm’s innovation output based

on the number of patents a firm has been awarded and the frequency with which the patents have been cited (e.g.,

Aghion, Bloom, Blundell, Griffith, & Howitt, 2005; He & Tian, 2013). As the most widely used measure of innovation,

patent and patent citations are externally observable outputs that reflect the extent to which a firm develops new

processes and products.2,3 Forexample, Lockheed Martin patented a proprietary method for automatically evaluating

the transition from batch to lean manufacturing techniques (Ivezic & Potok, 1999), and Fordpatented an ornamental

design feature of a car bumper (Gaffka, Strong, Gotschke,& Rogman, 2006).

We rely on prior IIQ-related research to guide our selection of internal information quality proxies. Specifically,

we use the difference of insider trading profitability between top and lower-level managers, management earnings

forecast accuracy,and timeliness of annual earnings announcement to proxy for accessibility, accuracy, and timeliness

of internal information, respectively (Chen, Martin, Wang, Roychowdhury, & Billett, 2018; Gallemore & Labro, 2015).

In addition, we use a composite measure of IIQ that sums the rankings of all three IIQ characteristics.

We use these externally observable IIQ measures for two reasons. One is that prior theoretical research suggests

that there is a high correspondence between the external financial reporting system and the internal management

accounting system that managers utilize when making operating decisions (Hemmer & Labro, 2008; 2019). That is, the

quality of externally reported information can be used to approximate the quality of internal information quality due

to underlying linkages between the two information systems. Forexample, Hunter, Webster,and Wyatt (2012) suggest

that managers can utilize the internal information systems that are used to generate external financial reports when

deciding how much to invest in intangible assets. Another reason is that the positive relationship between the quality

of our observable IIQ measures and the quality of internal management decisions has been empirically supported in

settings such as those related to tax planning and capital investment (Gallemore & Labro, 2015; Goodman, Neamtiu,

Shroff,& White, 2014; Heitzman & Huang, 2019).

Whileprior research has identified a positive relationship between these IIQ measures and managerial decision out-

comes, it remains an open empirical question whether the measures predict patent-related innovation. IIQ measures

may not be correlated with patent production because internal information systems that support external reporting

may havedifferent attributes than internal information systems that support technological development and scientific

1Forease of exposition and in order to remain consistent with prior innovation-related research, we characterize our theoretical construct as being “innova-

tion”and refer to our empirical measures, patents, and patent citations, as “patent-related innovation”.

2TheUnited States Patent and TrademarkOffice specifies that “in the language of the statute, any person who ‘invents or discovers any new and useful process,

machine,manufacture, or composition of matter, or any new and useful improvement thereof,may obtain a patent,’ subject to the conditions and requirements

ofthe law” (https://www.uspto.gov/patent).

3Despitethe broad definition of patents, we acknowledge that not all innovations are patented. For example, firms may choose not to seek patent protection

forstrategic reasons or use trademarks to protect some of their innovations (Hall, Jaffe, & Trajtenberg, 2001a).