Does a consistently capitalized R&D ratio improve information effects of capitalized development expenditures?

Abstract

This study examines whether a consistently capitalized R&D ratio provides value relevant information that is faithfully represented to investors. Given that R&D investment generally remains stable over time to create sustainable competitive advantages, we posit that a high consistency in the R&D capitalization ratio represents less bias and lower error in the accounting choice of R&D expenditures. To measure the extent of consistency, we use the coefficient of variation of a firm-level ratio of capitalized development costs to total R&D expenditures over five consecutive years. Using a sample of publicly listed Korean firms from 2003 to 2019, we find that capitalized development expenditures are value relevant only for firms with a high level of consistency in their capitalization ratios. Moreover, stable R&D capitalization ratios also allow stock returns to better reflect more information about future earnings. Finally, we observe that the positive effect of consistent capitalization ratios on the value relevance of capitalized development expenditures and informativeness of stock prices becomes more pronounced after the adoption of International Financial Reporting Standards (IFRS). Overall, our findings suggest that maintaining a stable R&D capitalization ratio conveys value relevant financial information to the market, thus improving the quality of accounting information for investors by representing the economic reality of R&D activities faithfully.