Accounting for Intangibles: Can Capitalization of R&D Improve Investment Efficiency?

Abstract

This paper investigates the potential for accounting rules to mitigate under‐investment induced by myopic managerial incentives. It exploits the difference within US GAAP requiring the capitalization of some research and development (R&D) costs in software development but proscribing the capitalization of R&D in other industries. We first investigate whether other hi‐technology firms with no capitalization of R&D costs suffer higher levels of under‐investment in myopic settings relative to software development firms. Second, we investigate whether the capitalization rule assists in mitigating under‐investment within the software development industry, and whether this comes at the cost of over‐investment in the presence of financial flexibility. Our findings are consistent with the mitigation of under‐investment in the software development setting but we find no evidence of over‐investment in the presence of high financial flexibility. Other hi‐tech firms that cannot capitalize R&D costs suffer higher levels of under‐investment relative to software development firms. Finally, we find that the ability to capitalize for the sample of software firms does reduce the probability of cutting R&D investment when managers are under earnings pressure. The findings in this paper are relevant to standard setters seeking to understand the costs imposed by (understandably) conservative accounting rules, and how verification of points of feasibility alongside less conservative accounting can prevent dysfunctional investment outcomes. This is the first study to consider whether the ability to (justifiably) capitalize the costs of internally generated intangibles can improve investment efficiency (the allocation of resources).