Value Relevance Effects of R&D Capitalization in US Companies

Abstract

During the last few decades, investments in intangible knowledge have grown in importance. Along with this development, there has been an ongoing discussion on how to best treat such investments in the financial reports. This paper specifically focuses on expenditures labelled research & development (R&D). To this day, there are still significant differences regarding the treatment of such expenditures between the two major accounting standard-setters, FASB and IASB, and despite much critique in research, US GAAP still largely prohibits companies to recognize R&D spending as an asset in the balance sheet. Through the usage of standardized amortization schedules developed by Lev & Sougiannis (1996) and presented by Lev (1999), this paper sets out to investigate the overall value relevance effect of this prohibition. Hypothetical earnings and book values are created with the sole difference being the treatment of its R&D expenditures, and have subsequently been compared with its original counterparts in terms of ability to explain market value. The paper finds clear evidence suggesting that allowing for R&D to be capitalized increases the value relevance, however, still recognizes that all relevant factors might not be accounted for in the investigation. Furthermore, the paper continues by examining how this value relevance effect has developed over the years, but the evidence provided is weak and inconsistent, thus not completely supporting the notion that R&D accounting is an issue that has grown in importance over time.