Capitalization vs Expensing and the Behavior of R&D Expenditures

Abstract

We examine the effect of capitalization vs expensing on UK firms’ R&D expenditures. Our investigation is motivated by the UK’s mandatory switch from UK GAAP to IFRS in 2005. Under UK GAAP, firms could elect to expense or capitalize development expenditures, but IFRS mandates capitalization. Thus, “capitalizers” maintained their accounting method, while “switchers” were required to change from expensing to capitalization. Using a difference-in-difference design, we examine the effect of the rule change on the amount and riskiness of the two groups’ R&D expenditures. Consistent with arguments that expensing’s deleterious effect on income causes firms to reduce their R&D outlays, we find that switching firms increased their R&D expenditures more than firms that continued to capitalize. We subject our results to numerous robustness tests, using propensity score matched samples, comparing early vs late switchers, switchers with high vs low R&D expenditure growth, examining R&D behavior in the last year before IFRS adoption, and a placebo test in which we alter the switch date. Across all of these tests, our results support the conclusion that the accounting method affects the amount that firms invest in R&D. Our results attest to the real effects of accounting policy on firms’ R&D investments.