The Investment Opportunity Set and Capitalization versus Expensing Methods of Accounting Choice

This paper examines the effects of the investment opportunity set (IOS) on management's decision to capitalize or expense significant costs in two diverse settings: (1) in accounting for exploration and development (E&D) costs by firms in the oil-and-gas industry, and (2) in accounting for research and development (R&D) costs by firms (across industries) prior to 1974. We argue that the relation between the IOS and the decision to capitalize versus to expense is based upon managerial incentives to reduce the variance of accounting earnings. High-growth firms are more likely to have more variable earnings, which therefore creates greater incentives to reduce earnings variability. Because the capitalization method generally results in a lower variance of reported earnings than does the expensing method, high-growth firms are more likely to select capitalization. Our results show that, after controlling for firm size and for the indirect effects of the IOS mediated by debt contracts, high-growth firms (firms with fewer assets-in-place) are more likely than low-growth firms to select the capitalization method of accounting for E&D and R&D expenses.
JEL classification: M41; G31     

Development costs capitalization and debt financing

This study investigates debt market effects of research and development (R&D) costs capitalization, using a global sample of public bonds and private syndicated loans issued by public non‐financial firms. Firstly, we show that firms capitalize larger amounts of R&D in a year when they exhibit a propensity for issuing bonds, rather than borrowing funds privately from the syndicated loan market, in the subsequent year. Secondly, we provide evidence that capitalized R&D investments reduce the cost of debt. We infer that debt market participants are able to identify firms’ motives for R&D capitalization, as we find a reduction in the cost of debt only for those firms that do not show indications of employing R&D capitalization for earnings management reasons. Indeed, only for this sub‐sample of firms, the amount of capitalized R&D contributes positively to future earnings. We confirm that R&D capitalization is positively associated with audit fees and thus can be deemed to be a signaling device. Lastly, we find that it is the amount of R&D a firm is expected to capitalize and not the discretionary counterparts, which facilitates a firm's access to public debt markets, reduces bond and syndicated loan prices, and contributes to future benefits.     

Capitalization of R&D costs and earnings management: Evidence from Italian listed companies

The capitalization of research and development (R&D) costs is a controversial accounting issue because of the contention that such capitalization is motivated by incentives to manipulate earnings. Based on a sample of Italian listed companies, this study examines whether companies' decisions to capitalize R&D costs are affected by earnings-management motivations. Italy provides a natural context for testing our hypothesized relationships because Italian GAAP allows for the capitalization of R&D costs. Using a Tobit regression model to test our hypotheses, we show that companies tend to use cost capitalization for earnings-smoothing purposes. The hypothesis that firms capitalize R&D costs to reduce the risk of violating debt covenants is not supported.     

Accounting choice and future performance: The case of R&D accounting in France

We examine whether managers’ decisions to capitalize or expense R&D expenditures convey information about the future performance of the firm. Focusing on a French setting where managers can choose to capitalize R&D expenditures under certain circumstances, we find that, after controlling for industry effects, firms that capitalize R&D expenditures spend less on R&D, have more volatile R&D efforts, and are smaller and more leveraged than firms that expense R&D expenditures. We also find that capitalizers capitalize R&D outlays when they need to meet or beat thresholds. Finally, we show that the decision to capitalize R&D is generally associated with a negative or neutral impact on future performance, even after controlling for self-selection. Our results also show that when firms both capitalize and expense R&D expenditures, the expensed portion exhibits a stronger (and negative) relationship with future performance. Market-based tests corroborate these findings. While we cannot unambiguously establish whether our findings imply that management uses R&D capitalization to manage earnings or because it is unable to estimate the earning power of R&D projects, our results suggest that management is unable to truthfully convey information about future performance through its decision to capitalize R&D. Our findings, based on real data as opposed to simulated data, therefore contrast with previous supportive evidence in favor of capitalization in the literature.     

The effect of management incentives and cross-listing status on the accounting treatment of R&D spending

This paper investigates the effect of management incentives and cross-listing status on the accounting treatment of research and development (R&D) spending for a sample of Canadian hi-tech and biopharmaceutical firms. U.S. GAAP adopts an immediate expensing rule for all R&D spending except for software development costs for which technological feasibility has been established. Contrary to the U.S., Canadian and international standard setters recommend capitalization if development costs meet certain criteria. Because those criteria are largely based on management judgment, capitalization of R&D spending is an accounting choice that can be used for income manipulation or signaling.Using a logit model, we examine how the decision to capitalize R&D spending is influenced by the cross-listing status and several other key firm characteristics that are well documented in the accounting literature. We find that the probability of capitalizing R&D spending increases for cross-listed and non-cross-listed firms in the software industry. The probability of capitalizing R&D spending also increases for firms that are more leveraged, more mature, and have higher level of cash flows from operations. However, the probability of capitalizing R&D spending decreases for larger corporations, firms with more concentrated ownership and highly profitable firms. Overall our results indicate a preference for Canadian firms in the software industry to emulate U.S. accounting practices for R&D spending. They also suggest that firms use the decision to capitalize or expense R&D spending as an earning management tool to either meet debt covenants or to smooth income.     

Earnings management and firm financial motives: A financial investigation of UK listed firms

This study focuses on the investigation of motives for and characteristics of UK firms that engage in earnings management activities. It concentrates particularly on the provision of voluntary accounting disclosures, the violation of debt covenants, management compensation, and on the equity and debt capital needs of firms and their relation with the use of earnings management. The study examines also the earnings management inclination of firms that seek to meet or exceed financial analysts' forecasts. The findings generally indicate that firms with low profitability and high leverage measures are likely to use earnings management. Also, firms that are in equity and debt capital need and are close to debt covenant violation also appear to be inclined to employ earnings management practices. Likewise, firms tend to use earnings management to improve their financial numbers and subsequently reinforce their compensation and meet and/or exceed financial analysts' earnings forecasts. In contrast, the study shows that firms that provide voluntary accounting disclosures appear to be less inclined to make use of earnings management.     

The Allowance for Uncollectible Accounts,Conservatism, and Earnings Management

We study the interrelation between conservatism and earnings management by examining the allowance for uncollectible accounts and its income statement counterpart, bad debt expense. We find that the allowance is conservative and that it has become more conservative over time. Conservatism may, however, facilitate earnings management. We find that firms manage bad debt expense downward (and even record income‐increasing bad debt expense) to meet or beat analysts’ earnings forecasts and that conservatism accentuates the extent to which firms manage bad debt expense. Further, we find that firms manage bad debt expense downward by drawing down previously recorded over‐accruals of bad debt expense that have accumulated on the balance sheet. An implication of our study is that tighter limits on the amount by which firms are permitted to understate net assets may reduce their ability to manage earnings.     

Capitalized intangibles and financial analysts

We examine whether firms that capitalize a higher proportion of their underlying intangible assets have higher analyst following, lower dispersion of analysts’ earnings forecasts and more accurate earnings forecasts relative to firms that capitalize a lower proportion. Under Australian generally accepted accounting principles, capitalization of intangible assets has become increasingly ‘routine’ since the late 1980s. It is predicted that this experience leads Australian analysts to expect firms with relatively more certain intangible investments to signal this fact by capitalizing intangible assets. Our results are consistent with this. We find that capitalization of intangible assets is associated with higher analyst following and lower absolute earnings forecast error for firms with a stock of underlying intangible assets. Our tests suggest a weaker association between capitalization and lower earnings forecast dispersion. We conclude that there are benefits for analysts, for management to have the option to capitalize intangible assets. These findings suggest that IAS 38 Intangible Assets and AASB 138 Intangible Assets reduce the usefulness of financial statements.     

Accounting for Intangibles: Can Capitalization of R&D Improve Investment Efficiency?

This paper investigates the potential for accounting rules to mitigate under-investment induced by myopic managerial incentives. It exploits the difference within US GAAP requiring the capitalization of some research and development (R&D) costs in software development but proscribing the capitalization of R&D in other industries. We first investigate whether other hi-technology firms with no capitalization of R&D costs suffer higher levels of under-investment in myopic settings relative to software development firms. Second, we investigate whether the capitalization rule assists in mitigating under-investment within the software development industry, and whether this comes at the cost of over-investment in the presence of financial flexibility. Our findings are consistent with the mitigation of under-investment in the software development setting but we find no evidence of over-investment in the presence of high financial flexibility. Other hi-tech firms that cannot capitalize R&D costs suffer higher levels of under-investment relative to software development firms. Finally, we find that the ability to capitalize for the sample of software firms does reduce the probability of cutting R&D investment when managers are under earnings pressure. The findings in this paper are relevant to standard setters seeking to understand the costs imposed by (understandably) conservative accounting rules, and how verification of points of feasibility alongside less conservative accounting can prevent dysfunctional investment outcomes. This is the first study to consider whether the ability to (justifiably) capitalize the costs of internally generated intangibles can improve investment efficiency (the allocation of resources).     

How Do Capital Structure Policies of Emerging Markets Differ from Those of Developed Economies? Survey Evidence from Korea

We examine the capital structure policies of Korean firms using survey data for business group (chaebol) firms and independent firms. Our results are compared with findings in earlier studies for developed economies: Graham and Harvey (2001) for the United States and Brounen et al. (2004, 2006) for Europe. Korean chief financial officers are concerned about financial flexibility and volatility of earnings when issuing debt; they are concerned about target debt ratio maintenance and recent stock price increases when issuing equity. In contrast to independent firms, chaebol firms are more concerned about differences in corporate tax rates between foreign and domestic markets and the risk of refinancing in bad times. Chaebol firms are less likely to issue debt when faced with insufficient internal funds, which indicates that active internal capital markets are at work among the firms in a business group. Our results suggest that, compared to U. S. and European firms, Korean firms are under more pressure from their peers in formulating capital structure policies, consider equity a cheap source of financing, are less concerned with the dilution of earnings per share, and less frequently provide shares to employees as compensation.     

Debt Financing and Earnings Management: An Internal Capital Market Perspective

This paper investigates the role internal capital markets play in mitigating earnings management of group firms. We predict that the funding advantages of internal capital markets from business affiliates obscure solvency problems resulting from higher leverage for individual firms within a group, which in turn mitigates their incentives for earnings management. Using Taiwanese firms as a sample, we provide evidence that is consistent with such a prediction. In particular, we show that higher group profitability reduces its member firms’ sensitivity of earnings management to debt levels. Among business groups, earnings management in pyramidal groups is less sensitive to debt levels. We also find that the debt‐abnormal accrual curve becomes smoother as group profitability increases when considering the non‐monotonic relationship between firm leverage and earnings management.     

Effect of cash flow risk on corporate failures,and the moderating role of earnings management and abnormal compensation

In this study, we find that United States firms' average cash flow risk (CFR) shows a significantly increasing trend over the past four decades or so. This does not portend well considering the significance of cash flows in maintaining a firm's financial health and going concern status. The CFR also increases dramatically for firms approaching financial distress or bankruptcy, suggesting its important role in predicting a firm's failure. Empirically, we find that CFR has a strong positive effect on a firm's financial distress likelihood. We also find that the association between CFR and financial distress is negatively moderated in firms with high earnings management and abnormal compensation. The results suggest that managers in firms with high CFR are more likely to use heuristics in form of earnings management. Thus, supporting the upper echelons theory related to managers under performance pressure. Meanwhile, consistent with the notion in the agency theory that financial incentives serve as effective monitoring mechanisms, compensation packages can incentivize better risk management practices and decrease the likelihood of a firm's failure. Our findings are also robust to alternative definitions of a firm's failure: financial constraints, presumed debt covenant violation and legal bankruptcy filings.     

Why do managers avoid EPS dilution? Evidence from debt–equity choice

Survey evidence reveals that managers prefer to avoid dilution of earnings per share (EPS), though financial theory suggests it is irrelevant in firm valuation. We explore contracting and behavioral explanations for this apparent paradox using a large sample of debt–equity issuers. We first provide evidence that firms with greater agency conflicts between managers and shareholders are more likely to use EPS as a performance measure in bonus contracts. After controlling for possible endogeneity related to compensation contract design, we find that managers are more likely to avoid earnings dilution when their bonus compensation explicitly depends upon EPS performance. This effect is increasing in the magnitude of bonus compensation for this subset of firms; we document no such associations for the firms that do not use EPS in setting bonus pay. Additional tests of firms’ speed of adjustment to target leverage ratios and firms’ debt conservatism levels indicate that explicitly rewarding executives on EPS performance helps to resolve underleveraging problems. We also find that clientele effects are associated with managers’ aversion to earnings dilution. Our findings provide a deeper understanding of the factors that underlie the use of accounting performance in compensation contracts and new evidence on the implications of the contracting role of accounting in firm decision-making.     

Firms' Voluntary Recognition of Stock-Based Compensation Expense

We investigate factors associated with firms' decisions in 2002 and early 2003 to recognize stock‐based compensation expense under Statement of Financial Accounting Standards (SFAS) No. 123. We find that the likelihood of SFAS 123 expense recognition is significantly related to the extent of the firm's participation in capital markets, the private incentives of top management and members of the board of directors, the level of information asymmetry, and political costs. Although recognizing firms have significantly smaller SFAS 123 expense, we find no significant incremental relation between recognition likelihood and SFAS 123 expense magnitude after controlling for other factors that we expect explain the recognition decision. We also find positive and significant announcement returns for earlier announcing firms, particularly those stating that increased earnings transparency motivates their decision.     

A Critical Look at SFAS 34: Capitalization of Interest Cost

In 1974, the Securities and Exchange Commission (SEC) noted that an increasing number of companies were capitalizing interest costs, and that this practice was not being adequately disclosed (FASB, 1979, par. 26). In light of the alternative practices concerning the accounting for interest and lack of adequate disclosure by companies that were already capitalizing interest, the SEC recommended that the Financial Accounting Standards Board (FASB) consider the issue of accounting for interest cost. As a result of the SEC's initiative, in 1979 the FASB issued Statement of Financial Accounting Standards [SFAS] No. 34, Capitalization of Interest Cost, which mandated uniform interest capitalization rules in accounting for interest costs associated with the acquisition of qualifying non-current assets. The purpose of this article is to examine SFAS 34 in terms of its financial statement impact, the congruence of its assumptions with economic behaviour, its effect on subsequent standards related to interest capitalization, and its implications on financial accounting standard setting. To explore these issues we first illustrate the extent to which interest capitalization affects financial statements. We then empirically analyse the measure employed in SFAS 34 for the capitalization of interest cost in cases where debt is not directly linked with the acquisition of qualifying non-current assets. In addition, we critically examine the treatment accorded interest cost in subsequent FASB standards. Our research suggests that SFAS 34′s rationale for interest capitalization is incompatible with firm behaviour, and that the rules for interest capitalization as reflected in various accounting standards are inconsistent. These findings suggest that in the case of interest capitalization the benefits of comparability in financial reporting are not realized. A policy recommendation is then offered to alleviate some of these difficulties. The recommendation is to disallow the capitalization of interest cost in the absence of a direct link between the debt and the acquisition of qualifying assets.     

Impact of proximity to debt covenant violation on earnings management

We examine the impact of differential incentives arising from proximity to debt covenant violation on earnings management. We reason that firms with loans close to violation or in technical default of their debt covenants have a stronger incentive to engage in earnings management than firms that are far from violating their debt covenants. We find results consistent with this expectation. Firms close to violation or in technical default of their debt covenants engage in higher levels of accounting earnings management, real earnings management, and total earnings management than far-from-violation firms. In additional analysis, we find that firms with a stronger incentive to avoid covenant violation switched from using more accounting earnings management before the Sarbanes–Oxley Act to using more real earnings management and more total earnings management afterwards. We also document that the earnings management implications of debt covenant violation are observed primarily for firms with poor credit ratings and for firms that do not meet analyst forecasts.     

Sensitivity of executive pay to accounting performance measures in all-equity firms

We investigate the relation between chief executive officer compensation and accounting performance measures as a function of the firm's capital structure. We specifically analyse pay–performance relationships for all‐equity firms relative to high‐levered firms. We find a significant positive association between return on equity and the level of compensation for all‐equity firms. Consistent with optimal contracting theory, we cannot discern any such relationship for high‐levered firms. Because of agency costs of debt, managerial compensation in high‐levered firms plays the role of a precommitment mechanism in addition to its conventional role of aligning management incentives with shareholder interest.     

Do UK firms manage earnings to meet dividend thresholds?

This paper examines earnings management by dividend-paying firms in cases where pre-managed earnings would fall below the expected dividend, and by non-dividend paying firms aiming to avoid reporting losses. We find that within the UK market the likelihood of upward earnings management is significantly greater in the former case than the latter, though both are drivers for earnings management. Large firms are less likely to upwardly manage earnings to reach dividend thresholds, consistent with prior UK evidence on the ability of the largest firms to avoid restrictive debt covenants. We also find that earnings management is more clearly observable through examining working capital discretionary accruals than through examining total discretionary accruals.     

Pay Me Later: Inside Debt and Its Role in Managerial Compensation

Though widely used in executive compensation, inside debt has been almost entirely overlooked by prior work. We initiate this research by studying CEO pension arrangements in 237 large capitalization firms. Among our findings are that CEO compensation exhibits a balance between debt and equity incentives; the balance shifts systematically away from equity and toward debt as CEOs grow older; annual increases in pension entitlements represent about 10% of overall CEO compensation, and about 13% for CEOs aged 61–65; CEOs with high debt incentives manage their firms conservatively; and pension compensation influences patterns of CEO turnover and cash compensation.     

R&D capitalization and audit fees: Evidence from China

Our study investigates the association between capitalized R&D costs and audit fees and whether this association reflects the effect of earnings management. By exploring Chinese listed firms, we find that capitalized R&D costs are positively associated with audit fees, where such positive association holds for both the discretionary and nondiscretionary portions of capitalized R&D costs. Moreover, the positive association between the discretionary portion of capitalized R&D costs and audit fees is more pronounced for firms with stronger incentives to manipulate earnings. Overall, our findings imply that firms' reporting incentives affect how auditors react to clients' accounting choices. This in turn suggests that auditors believe some firms capitalize R&D to manipulate earnings, and the resulting earnings-management concerns lead them to charge higher fees.