Does Current R&D Accounting Allow Investors to Assess the Value Relevance of R & D Expenditures?

• In Event: Financial Accounting and Reporting 11

Abstract

Under US GAAP, R&D accounting systematically understates the future value of R&D expenditures because it requires expensing all of those expenditures. However, when they generate future benefits, R&D expenditures will have some future value. US GAAP uses this conservative approach because of the difficulty in assessing the amount of any future value that R&D expenditures might generate. This study examines the effects of alternative accounting treatments for R&D expenditures (expense versus capitalize). In addition, we examine the effect of the accounting treatment on net income properties (unfavorable versus favorable) and alternative presentations of R&D expenditures (high versus low transparency) on the value relevance of R&D expenditures. Our research design allows us to disentangle the effects of these variables on value relevance.

For successful R&D projects, investors must decide whether to (1) add back R&D expenses to reported net income (i.e., adjust reported EPS) and (2) include the earnings potential of the R&D project when making stock price predictions. We find that investors are less likely to make these adjustments when the expense accounting treatment is used and when this treatment has an unfavorable effect on net income properties. The only setting where investors consider the future earnings potential of the R&D project is when the firm capitalizes R&D costs. In addition, we find that while higher levels of transparency increased investors’ ability to adjust financial statements when R&D expenditures are expensed, their adjustments are less complete relative to when the costs are capitalized. One reason for this incomplete adjustment is that expensing significant R&D expenditures can create unfavorable time series properties for net income, which in turn may divert attention from the more relevant R&D information.

Authors

• Richard W Houston, University of Alabama-Tuscaloosa

• Stephen L Liedtka, Villanova University

• James M Peters, New Mexico Highlands University

• Michael Francis Peters, Villanova University