Capitalization of Costs and Expected Earnings Growth

Abstract

This paper offers a model that shows how the capitalization of costs affects contemporaneous earnings and the growth path of expected earnings. It makes three points. First, reported earnings under successful efforts are more price relevant than earnings under full costing or full expensing. Second, whether conditional or unconditional, conservatism always enhances the growth rate of expected earnings. Third, independent of capitalization policy, the long-run expected earnings growth rate converges either to the long-run expected free cash flow growth rate or to the depreciation rate. Therefore, while capitalization policy affects the price relevance of earnings and short-run expected earnings growth, it does not affect long-run expected earnings growth.