Managerial Discretion and Accounting for Research and Development Costs

Abstract

This study investigates the extent to which potential financial reporting benefits from capitalizing and amortizing R&D costs depend on increasing the level of discretion permitted to financial statement preparers. To provide evidence on this issue, we examine the impact of alternative accounting schemes for R&D costs on the extent to which earnings and book values jointly explain the observed distribution of share prices. One alternative requires firms to capitalize and amortize R&D outlays, but provides them with no more discretion than that permitted under current rules. The other alternatives reflect increasing discretion over which R&D costs are recognized as assets and the periods over which these assets are amortized. We find that ability to explain the distribution of share prices increases with discretion, and conclude that substantial managerial discretion is likely to be a necessary (though hardly sufficient) ingredient of any alternative R&D accounting scheme that is capable of producing economically significant financial reporting benefits.