The Determinants and Value Relevance of the Choice of Accounting for Research and Development Expenditures in the United Kingdom

Abstract:  This paper investigates the determinants and value relevance implications of the accounting method choice for development expenditures for firms with research and development (R&D) programs in the United Kingdom (UK). Using a sample of 3,229 UK firm-year observations over the period 1996–2004, I find that the decision to expense versus capitalize development expenditures is influenced by earnings variability, earnings sign, firm size, R&D intensity, leverage, steady-state status of the firm's R&D program, and R&D program success. Additional results indicate that there is little difference in value relevance between reported and adjusted numbers for both the Expensers and the Capitalizers. The evidence in this paper suggests that managers choose the 'correct' method for accounting for R&D in order to best communicate the private information which they hold.     

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.     

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.     

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.     

International Financial Reporting Standards and the value relevance of R&D expenditures: Pre and post IFRS analysis

This study examines the value relevance of research and development (R&D) expenditures in the pre and post International Financial Reporting Standards (IFRS) periods in the UK. It also examines firm size and sector-based differences in the value relevance of R&D during the sample period between 2001 and 2011. The results indicate that capitalized R&D has value relevance during the 11 years sample period. However, the value relevance of capitalized R&D does not appear to have improved in the post-IFRS period. Large firms present higher value relevance of capitalized R&D than small firms which suggest that firm size has significantly different valuation effects on the value relevance of R&D expenditures. Sectors, however, do not appear to present valuation differences across manufacturing and nonmanufacturing firms. The overall findings of this study report no difference in the value relevance of expensed R&D in the pre and post-IFRS periods; however, the value relevance of capitalized R&D appears to decrease from pre to post-IFRS period. We thus argue that these findings have implications for the regulators and accounting professionals.     

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.     

Capitalizing R&D expenses versus disclosing intangible information

We study how to improve the value-relevance of financial information for intangible-intensive firms by investigating two alternatives: capitalizing research and development (R&D) expenses and disclosing intangible information. Using patent counts/citations to proxy for intangible intensity, we find that the incremental value-relevance of disclosing patent counts/citations is greater than that of capitalizing R&D expenses for the high-patent group and vice versa for the low- or medium-patent group. Investors favor the disclosure of patent information for firms with more successful innovations. Since disclosing intangible information may lead to appropriation by rivals, we find that, for the high-patent group, the incremental value-relevance of disclosing patent counts/citations is more pronounced for firms in industries with stronger protection of intellectual property. Overall, our results suggest that disclosing R&D outputs can improve the value-relevance of financial statements for firms rich in intangibles and the incremental benefits of such disclosure will be greater in industries with strong protection of intellectual property.     

Earnings Variability and Disclosure of R&D: Evidence from Press Releases

This study explores press releases in the pharmaceutical industry to expand our understanding of how investments in R&D outlays influence uncertainty of future earnings. The findings make two contributions to the literature. First, they provide evidence that equal investments in different R&D ventures are associated with differential variability of future earnings. This result suggests that non‐financial information contained in press releases captures attributes of firm‐specific R&D investments that are not revealed through R&D expenditures reported in financial statements. Second, prior studies have indicated that investments in pharmaceutical R&D are associated with the highest variability of future earnings among all industries. The results, however, suggest that for a large class of low‐risk pharmaceutical R&D investments, the relative variability of future earnings is low and similar to that generated by capital expenditures. The findings hold when we control for endogeneity in voluntary disclosure of press releases.     

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 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.     

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.

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.     

Analysts’ forecast revisions and firms’ research and development expenses

This study examines whether reported values for firms’ research and development (R&D) affect analysts’ annual earnings forecast revisions following quarterly earnings announcements. Because R&D introduces uncertainty into earnings forecasts, analysts may benefit from additional information searches in an effort to increase forecast accuracy. Also, accounting standards mandate an immediate expensing of R&D, in essence projecting a zero value for the R&D. To the extent that R&D will produce future payoffs, the expense treatment reduces the informativeness of reported earnings for forecasting future earnings. Thus, the marginal benefit of analysts’ efforts to produce more information may increase with the magnitude of the R&D component of earnings announcements and trigger additional forecast revisions. Alternatively, if the cost of information searches exceeds the benefit, analysts’ forecast revisions may decrease. Our results show a positive relation between R&D expenses and analysts’ forecast revision activity. We also find a positive and significant association between the level of R&D expenses and the magnitude of analysts’ forecast revisions following quarterly announcements. These results point to a greater amount of analyst scrutiny when reported earnings are accompanied by high levels of R&D expenses.

The Association of R&D and Capital Expenditures with Subsequent Earnings Variability

Abstract:  We estimate the association of investments in R&D and in physical assets (CAPEX) with subsequent earnings variability. We estimate these relations in different time periods and across industries. We find that R&D contributes to subsequent earnings variability more than CAPEX only in relative R&D-intensive industries – industries in which R&D is relatively more intensive than physical capital. In physical assets-intensive industries, we do not find similar relations. The findings suggest that with respect to subsequent earnings variability, fundamental differences between investment information about R&D and CAPEX exist. However, they are mainly noticeable in firms that operate in relatively R&D-intensive industries. The evidence also suggests there was a shift in the relations between R&D and CAPEX over time. Our findings contribute to the debate on accounting for R&D expenditures.     

The value-relevance of R&D and advertising expenditures: Evidence from Korea

This study examines the value-relevance of R&D and advertising expenditures of Korean firms, using a regression model based on the Ohlson [Contemp. Account. Res. (1995) 661] equity-valuation framework. Results indicate that R&D expenditures are positively associated with stock price, suggesting that capitalizing R&D expenditures is appropriate. The association is stronger for the portion of R&D expenditures that is capitalized, rather than expensed, suggesting that investors agree with management that the capitalized expenditures represent greater future economic benefits. Investors also appear to interpret fully expensed R&D expenditures as positive net present-value investments, however, suggesting that these expenditure should also be capitalized. Additional results indicate that advertising expenditures are negatively associated with stock price, and the magnitude of this negative association is similar to the association between other expenses and stock price. These findings suggest that investors believe the economic benefits of advertising expenditures expire in the current period, similar to other expenses.     

Intangible Assets and Corporate Signaling

Research and development (R&D) and advertising expenditures often result in patents, technologies and brand names which are difficult to accurately value. Under current generally accepted accounting principles (GAAP) these intangible assets are generally not recognized in the financial statements, but instead are expensed in the period that they occur. Prior studies note that the market-to-book ratios of firms with significant levels of R&D and advertising expenditures suggest that investors, at least partially, value these assets. Researchers and practitioners argue that current GAAP, by not recognizing these intangible assets, reduces the usefulness and relevance of accounting reports.We investigate whether companies with significant levels of intangible assets are more likely to emphasize dividend increases and stock repurchases (which are generally perceived as signaling favorable investment opportunities), instead of traditional accounting disclosures, as a means of overcoming adverse selection. Because these assets are difficult to measure, cash distributions may be viewed as a more credible means of signaling firm value to investors. Using analysts' ratings of firms' accounting disclosures, we find that companies with higher levels of R&D and advertising expenditures are less likely to provide extensive accounting disclosures and instead tend to employ dividend and stock repurchase signals. We obtain these results even after controlling for other firm attributes, such as size, stock returns performance, leverage, liquidity and investors' expectations of growth opportunities. We also find that the market reaction to dividend increase and stock repurchase announcements is greater for firms with higher levels of R&D and advertising expenditures, indicating that these announcements are more informative for such firms.     

Relative Value Relevance of the Successful Efforts and Full Cost Accounting Methods in the Oil and Gas Industry

This paper examines the value relevance of two alternative accounting methods for exploration and development (E&D) expenditures for oil and gas firms. I find that full cost (FC) accounting data is more value-relevant than successful efforts (SE) accounting data. Further analysis reveals that the smooth earnings provided by the FC method contributes to the higher value relevance of the FC method. This study concludes that a policy of full capitalization of expenditures with uncertain future economic benefits better summarizes information relevant to investors relative to a policy of partial capitalization.     

Conservatism, Growth and the Role of Accounting Numbers in the Fundamental Analysis Process

I evaluate the effects of conservative accounting for research and development (R&D) and past growth in R&D on: (1) the relation between aggregate earnings (deflated by price) and contemporaneous stock return, and (2) the association between estimates of value derived from the residual income valuation model (i.e., RIV estimates) and equity market value. I show that the conservative treatment of R&D affects the earnings/return relation only for firms that experience high growth in R&D during the return interval of interest. I also demonstrate that the effect of conservative accounting for R&D on the association between RIV estimates and equity market values is increasing in past growth in R&D.This revised version was published online in August 2005 with a corrected cover date.     

The Relevance to Firm Valuation of Capitalised Research and Development Expenditures

Although the relevance of research and development to firm value has been extensively documented, some apparently contrary results were recently reported using Australian data. Godfrey and Koh (2001) reported that capitalised R&D costs do not seem to contain information relevant to the valuation of Australian companies. As the Godfrey and Koh study was designed to test the value-relevance of intangible assets in general, it is likely that the sample did not include sufficient research-intensive companies to test the relevance of R&D to firm value. This research note confirms results from other previous studies indicating that capitalised R&D is relevant to firm value.