A Disadvantage in IFRS Adoption in the UK: The Adverse Consequences of IAS 38

Abstract

We examine whether requiring versus allowing conditional capitalisation of development expenditure affects the extent to which capitalisation conveys more information about future earnings, relative to expensing. UK GAAP (SSAP 13) permitted, but not required, conditional capitalisation of development costs, unlike IAS 38, which requires conditional capitalisation. We show that capitalisation results in current returns incorporating more future earnings information than expensing under UK GAAP. By contrast, we find no such evidence under IFRS. Thus, the amount of information conveyed about future earnings by capitalisation, relative to expensing, and the amount of information incorporated into market prices of capitalisers, is diminished by the transition from UK GAAP to IFRS. We argue that this is because investors experience greater ambiguity in the post-IFRS period. Consistent with this, we further find an association between capitalised R&D and future earnings variability in the post-IFRS period only, as well as short-term positive abnormal returns for capitalisers relative to expensers in the pre-IFRS period only. Overall, these findings suggest that when moving from a standard that offers an overt option to capitalise or expense, capitalisation comes with greater ambiguity, which is resolved only in the long term.