Capitalization of R&D Costs and Earnings Management: Evidence from Italian Listed Companies

Abstract

The capitalization of research and development (R&D) costs is a controversial accounting issue because of the contention that such capitalization is motivated by incentives to manipulate earnings. Based on a sample of Italian listed companies, this paper examines whether companies' decisions to capitalize R&D costs are affected by earnings management motivations. Italy provides a natural context for testing our hypothesized relationships because Italian GAAP allows for the capitalization of R&D costs. Using a Tobit regression model to test our hypotheses, we show that companies tend to use cost capitalization for earnings-smoothing purposes. The hypothesis that firms capitalize R&D costs in order to reduce the risk of violating debt covenants is not supported.