Does the Capitalization of Development Costs Improve Analyst Forecast Accuracy? Evidence from the UK

Abstract

It has been documented that investments in Research and Development (R&D) are associated with increased errors and inaccuracy in earnings forecasts made by financial analysts. These deficiencies have been generally attributed to information complexity and the uncertainty of the future benefits of R&D. This paper examines whether the capitalization of development costs can reduce analyst uncertainty about the future economic outcome of R&D investments, provide outsiders with a better matching of future R&D-related revenues and costs, and therefore promote accuracy in analyst forecasts. UK data is used, because accounting rules in the United Kingdom permitted firms to conditionally capitalize development costs even before the introduction of the International Financial Reporting Standards. The choice to expense R&D rather than conditionally capitalize development costs is found to relate positively to signed analyst forecast errors. This finding is robust to controlling for the influence of other factors that may affect errors, as well as for the influence of R&D investments on forecast errors. The decision to capitalize versus expense is not observed to have a significant influence on analyst forecast revisions. The findings are interpreted as evidence that the choice to capitalize as opposed to expense may help to reduce deficiencies in analyst forecasts; hence, is informative for users of financial statements. Increased informativeness is expected to have repercussions for the effectiveness with which analysts produce earnings forecasts, and, as a result, market efficiency.

Research and Development, Uncertainty, and Analysts’ Forecasts: The Case of IAS 38

“…For the Dutch setting, Peek () also provides evidence that a change from expensing to capitalization improves forecast accuracy. Anagnostopoulou () finds similar results for the United Kingdom.…”

“…In other settings, however, the evidence points to the contrary. Some studies find evidence for higher forecast accuracy (Anagnostopoulou, ) associated with capitalized development costs. Similarly, research has found higher value relevance associated with R&D capitalization (Lev and Sougiannis, ) and lower information asymmetries for capitalized software development (Mohd, ).…”

Intangible assets, IFRS and analysts’ earnings forecasts

“…Wyatt, 2005; Ritter and Wells, 2006; Kohlbeck and Warfield, 2007). This expectation is supported by the evidence in Matolcsy and Wyatt (2006) as well as Anagnostopoulou (2010) and Jones (2007), who report a positive association between forecast accuracy and intangibles‐related disclosures. Their own findings, and those of prior research, led Matolcsy and Wyatt (2006) to conjecture that the adoption of IFRS by Australian firms may result in a loss of potentially useful intangibles‐related information as internally generated intangibles were required to be de‐recognized and revaluation of recognized intangible assets is only permitted in the unlikely event that an active and liquid market exists.…”

“…This information risk may be mitigated by disclosures and the capitalization of intangible assets (Dehning et al. , 2006; Matolcsy and Wyatt, 2006; Wolfe, 2009; Anagnostopoulou, 2010). If so, then removing potentially relevant intangibles‐related information from financial reports, as occurred in Australia with the adoption of IFRS, would increase information risk faced by analysts and investors.…”

Accounting for intangible assets – insights from meta-analysis of R&D research

“…Table 9 reports the meta-analysis of the relation between R&D expenses and analyst earnings forecast errors based on results from four primary studies (Anagnostopoulou, 2010; Ciftci et al , 2011; Gu and Wang, 2005; Jones, 2007). None of the studies are adequately powered (Panel A).…”