R&D Reporting Biases and their Consequences

Abstract

The immediate expensing of R&D expenditures is often justified by the conservatism principle. However, no accounting procedure consistently applied can be conservative throughout the firm's life. We ask the following questions: (a) When is the expensing of R&D conservative and when is it aggressive, relative to R&D capitalization? and (b) What are the capital market implications of these reporting biases? To address these questions we construct a model of profitability biases (differences between reported profitability under R&D expensing and capitalization) and show that the key drivers of the reporting biases are the differences between R&D growth and earnings growth (momentum), and between R&D growth and return on equity (ROE). Companies with a high R&D growth rate relative to their profitability (typically early cycle companies) report conservatively, while firms with a low R&D growth rate (mature companies) tend to report aggressively under current GAAP. Our empirical analysis, covering the period 1972-2003, generally supports the analytical predictions.In the valuation analysis we find evidence consistent with investor fixation on the reported profitability measures: we detect undervaluation of conservatively reporting firms and overvaluation of aggressively reporting firms. These misvaluations appear to be corrected when the reporting biases reverse from conservative to aggressive and vice versa.-1- R&D Reporting Biases and Their Consequences IntroductionThe immediate expensing of practically all internally-generated intangible investments in the U.S., a questionable procedure given the substantial future benefits of many such investments, is often justified by the conservatism principle. 1Conservative accounting procedures, goes the argument, counter managers' prevalent optimism, 2 and are appropriate given the generally high level of uncertainty associated with the outcome of intangible investments. We address these two questions in the current study. We focus on three widely-used indicators of performance-the return on equity (ROE), return on assets (ROA), and earnings growth (momentum)-and derive the general conditions under which R&D expensing (the 1 The only exception in the U.S. to intangibles' expensing is the capitalization of some software development costs, required by SFAS 86. For an empirical examination of software capitalizations, see Aboody and Lev (1998). For a discussion of the evidence concerning R&D benefits, see Lev (1999). 2 "Thus if the animal spirits are dimmed and the spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die." (Keynes, 1936, pp. 161-162).3 Kothari et al. (2002) report that the earnings volatility associated with R&D is three times larger than that associated with tangible investment in property, plant and equipment.-2-current GAAP procedure) will result in overstated or understated values of these indicators, relative to capitalized R&D. We then examine the validity of these general cons...

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