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).     

Reliability of R&D capitalization: Evidence from ex post impairment in China

Unlike prior studies that investigate research and development (R&D) accounting as a dichotomous choice between capitalizing vs. expensing, this study identifies low-reliability R&D capitalization by the occurrence of ex post impairment of capitalized R&D costs. I find that low-reliability capitalization is associated with higher discretionary accruals but fails to signal future innovation, whereas normal capitalization without subsequent impairment lacks earnings aggressiveness and predicts future innovation positively, compared to expensing firms. Next, this study shows that Big 4 and industry specialist auditors improve reliability by notably decreasing the likelihood of low-reliability R&D capitalization. The results remain robust after controlling for R&D investment intensity and potential endogeneity in the capitalization decision. Additional tests show that managers strategically time the recognition of impairment for big-bath and earnings-smoothing purposes, and that analyst coverage does not help differentiate between low-reliability and normal R&D capitalization. Collectively, this paper increases our understanding of R&D accounting and auditing and contributes to the debate on the reliability of R&D capitalization.     

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 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     

Peer R&D disclosure and corporate innovation: Evidence from American depositary receipt firms

In this paper, we examine the effect of peer research and development (R&D) disclosures on corporate innovation. R&D disclosures can generate externalities for related firms, enabling those firms to better infer a project's likely payoffs and thus prioritize projects with higher net present values. We use a sample of foreign firms cross-listed on U.S. exchanges to investigate whether U.S. peer firms experience externalities from the cross-listing firm's R&D disclosures. We find that R&D disclosures by cross-listing firms are associated with greater innovation for industry peers in the U.S. market, especially when product market competition is high. The effect also varies with the home country's legal protection systems, disclosure environments, and accounting reporting rules. Cross-sectional analyses indicate that the externalities are more pronounced in industries or firms that rely more on external financing and firms subject to higher financial constraints; disclosures of higher quality appear to promote innovation by ameliorating financing frictions. Overall, this study provides evidence of R&D disclosure as an industry-wide determinant of innovation, thereby contributing to literature on the real effects of peer disclosures.     

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.     

INTERNATIONAL DIFFERENCES IN RESEARCH AND DEVELOPMENT REPORTING PRACTICES: A FRENCH AND CANADIAN COMPARISON

This paper compares the research and development (R&D) disclosure practices in France and Canada, as evidenced in the annual reports of 76 French and 110 Canadian listed companies. It finds that Canadian high-tech companies (hardware, software, and biotechnology) disclose significantly more information on their R&D activities than their French counterparts. It also finds a strong link between R&D intensity and R&D disclosure among Canadian high-tech companies. Canadian companies overall are also found to be more likely to use non-financial disclosure as a means to resolve any R&D information asymmetry, while French firms disclose more traditional financial and accounting information. Canadian companies are also more willing than French firms to provide information concerning their future R&D expenditures. These results are consistent with inherent cultural and capital market differences between France and Canada. In contrast, the study does not find any significant difference in R&D expenditure capitalization policies between French and Canadian firms.     

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.     

R&D Accounting and the Tradeoff Between Relevance and Objectivity

We use a simulation model for a pharmaceutical R&D program to examine the tradeoff between objectivity and relevance of accounting information under various methods of R&D reporting. A simple capitalization rule, similar to the successful-efforts method of capitalizing oil and gas exploration costs, provides a stronger relation between accounting information and economic values than immediate expensing of R&D outlays or capitalizing the full cost of outlays. The superior relevance of this "successful-efforts" method persists even when earnings management is widespread.     

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.     

Discretionary Capitalization of R&D: Evidence on the Usefulness in an Australian and Canadian Context

This study addresses the discretionary capitalization of R&D costs in Australia and Canada. We demonstrate, for both samples, that the discretionary capitalization of development costs (hereafter capitalized D) by the manager results in balance sheet and income numbers that are more highly associated with market value, relative to the corresponding “as-if” numbers generated by expensing GAAP. Moreover, we show that a dollar worth of capitalized D is worth more than a dollar worth of expensed R&D, for the same firm. This points to a corroboration role for capitalization. As a caveat, our results hold only when the samples are partitioned on the materiality of capitalized D. Our results point to a potentially useful signalling role for discretionary capitalization, in Australian and Canadian capital markets. However, while the manager’s capitalized D is associated with firm value, it has at best a modest advantage over what the analyst can do, using the researcher-created capitalized R&D. Thus, the regulatory policy debate must consider the small incremental benefits from allowing discretionary capitalization compared to the costs associated with earnings management when discretion is allowed.     

Market Valuation of Research and Development Spending under Canadian GAAP*

Section 3450 of the Canadian Institute of Chartered Accountants (CICA) Handbook requires Canadian firms to capitalize development costs that meet certain criteria and to expense those that relate to research. International Accounting Standard (IAS) No. 38 favours a similar approach. In the United States, Statement of Financial Accounting Standard (SFAS) No. 2 recommends the immediate expensing of all research and development (R&D) spending. The only exception is SFAS No. 86, which requires software development costs to be capitalized when a product successfully passes a technological feasibility test. Consequently, the Canadian financial disclosure regime provides a rich setting for testing the market valuation of capitalized R&D. Our primary research question asks whether capitalized R&D provides useful information to market participants investing in Canadian firms. We use price‐level and return models to assess the value relevance of capitalized R&D disclosed in the financial statements under Canadian GAAP. In line with expectations, using a price‐level model, we find that capitalized R&D and R&D expense as disclosed in the financial statements provide information that is value relevant to market participants. However, we find that R&D capitalized during the year helps explain returns while R&D expense does not. Thus we conclude that the application of section 3450 of the CICA Handbook produces value‐relevant information.     

The Determinants of Investor Valuation of R&D Expenditure in the Software Industry

This paper examines the cross-sectional variability in the market valuation of R&D expenditures in the pre-packaged computer software industry. Consistent with some prior research, this paper argues that R&D spending is valued heterogeneously by the stock market, and derives hypotheses regarding the determinants of the cross-sectional heterogeneity in the market valuation of R&D. The empirical tests use an extensive database containing product level information of software firms between 1994 and 1998, along with accounting and stock price data of the same period. The test results, consistent with our hypotheses, show that R&D spending is more valuable for firms with larger market shares, higher percentage of technical employees, and those that have diversified into different product categories. The results also indicate that market valuation of R&D spending is a function of product life cycle.     

How to improve IFRS for intangible assets? A milestone approach

This study focuses on the decreasing relevance of financial information associated with current financial reporting standards for intangible assets. We summarize and compare three approaches to improving financial reporting standards for internally generated intangibles—the recognition approach, the fair value approach and the disclosure approach, among which we focus on the recognition approach. We investigate the impact of current International Accounting Standard 38 on the R&D capitalization policies of the high-tech industry, particularly among medical device firms in China. We conclude that the current recognition criteria are so stringent that they disincentivize firms from capitalizing their R&D investments. A large variation exists in capitalization timing within the medical device industry. Accordingly, we propose the milestone approach to revising financial reporting standards for intangible assets. We suggest that determining the capitalization criteria for intangibles based on the R&D cycle and capitalization timing should be moved forward.     

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.     

The effect of capital market pressures on the association between R&;D spending and CEO option compensation

We examine the effect of capital market pressures for meeting earnings benchmarks on the relationship between R&D spending and CEO option compensation. We consider a particular scenario when firms face small earnings declines but could opportunistically reduce R&D spending to increase reported earnings. We find that firms with income reporting concerns punish their CEOs with lower option compensation when R&D spending increases but reported earnings decreases. Further, for firms with income reporting concerns, we find that the penalty for increasing R&D is greater when the firms frequently miss quarterly earnings benchmarks in the year. Overall, our findings suggest that the adverse consequence on CEO options encourages short-run compensation-motivated actions to eliminate or postpone R&D projects with positive net present values.     

The relation between R&;D intensity and future market returns: does expensing versus capitalization matter?

The Australian accounting environment provides an ideal setting for examining the impact of different accounting treatments of firms’ R&D activities on their subsequent returns. Unlike US firms, which can only expense R&D, Australian GAAP permits firms to either expense or capitalize their R&D expenditure. We examine separately the market impact of the R&D intensity of all R&D active firms, ‘capitalizers’ and ‘expensers’. Our results suggest that firms with higher R&D intensity perform better, regardless of the accounting method used, consistent with the resource-based view of the firm. We also find some evidence that firms which expense R&D outperform those which capitalize R&D after controlling for R&D intensity.

The positive externalities of IFRS R&D capitalization: enhanced voluntary disclosure

Studies comparing IFRS with U.S. GAAP generally focus on differences in the attributes and consequences of the recognized financial items. We, in contrast, focus on voluntary disclosure resulting from arguably the most significant difference between IFRS and GAAP: the capitalization of development costs—the “D” of R&D—required by IFRS but prohibited by GAAP. Using a sample of Israeli high-technology and science-based firms, some using IFRS and others U.S. GAAP, we document a significant externality of IFRS development cost capitalization in the form of extensive voluntary disclosure of forward?looking information on product pipeline development and its expected consequences. We show that this disclosure is value-relevant over and above the mandated financial information, including the capitalized R&D asset. We also show that the capitalized development costs (an asset) is highly significant in relation to stock prices, and enhances the relevance of the voluntary disclosures.     

The relationship between R&D intensity,conservatism, and management earnings forecast issuance

R&D-intensive firms suffer from high information asymmetry and high proprietary costs and are prone to exhibit bottom-line losses given the unconditional conservative accounting treatment of R&D expenses. We examine how R&D intensity influences the issuance of management earnings forecasts (MEFs) across levels of accounting conservatism, controlling for proprietary costs and other earnings guidance determinants. We provide insights into how managers view the tradeoffs of using MEF disclosures to lower information asymmetry versus the costs of releasing proprietary information to competitors and the loss of reputational capital that could arise from providing inaccurate forecasts. We find that although R&D intensity and conditional conservatism are negatively related to the issuance of MEFs, as shown in prior research, at high levels of research intensity and the accompanying uncertainty about future payoffs, the negative association between conditional conservatism and MEF issuance is mitigated. These findings point to a role for conditional conservatism as a credibility enhancer for managers of R&D intense firms.     

Changes in the value relevance of research and development expenses after IFRS adoption

We investigate whether the nature of differences between national GAAP and IFRS is associated with differential changes in the value relevance of R&D expenses after the adoption of IFRS across countries. Using a difference-in-differences study on a sample of public companies in nine countries that covers pre-IFRS and post-IFRS periods during 1997–2012, we find that the value relevance of R&D expenses declines after IFRS adoption in countries that previously mandated immediate expensing or allowed optional capitalization of R&D costs. On the contrary, there is no change in the value relevance of R&D expenses for countries that switched from the mandatory capitalization rule to IFRS. We also investigate the moderating effects of national institutions on the changes in the value relevance of R&D expenses after IFRS adoption. We find that in countries with stronger investor protection, the changes in the value relevance of R&D expenses are larger. In addition, changes in the value relevance of R&D expenses are smaller for countries whose national culture is characterized by higher uncertainty avoidance. Our findings highlight the importance of both accounting standards and national institutions in explaining the changes in the value relevance of accounting information after IFRS adoption.