Economic Consequences of the Current Accounting Treatment for R&D Expenditure

• In Event: Financial Accounting and Reporting 1

Abstract

This study examines whether R&D productivity is associated with information risk factors and cost of capital. Due to the expensing rule for R&D expenditures, managers may potentially manipulate discretionary accruals upwards to offset the decrease in earnings caused by the rule. Such manipulation decreases accrual quality or equivalently increases information risk which results in investors requiring higher rate of return on investment. This paper finds that R&D productivity is associated with higher cost of capital and information risk factors directly through increasing the uncertainty of future cash flows and indirectly through motivating managerial accounting discretion. High R&D firms incur 23.4 (216) basis points higher cost of debt (equity) compared to low R&D firms. Also, R&D firms have relatively higher weight for the discretionary component of accruals quality compared to the innate component in cost of equity capital calculations. Finally, asset pricing tests show that the loadings on three-factor model risk factors augmented by accruals quality risk factor are significant for the discretionary risk factors only, but not for the innate risk factors, providing further evidence that the R&D effect is fundamentally related to discretion, as opposed to business risk.

Author

• Mohamed A Elbannan, American University Cairo