R&D Capitalization and Reputation-Driven Real Earnings Management

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Prior research finds that mandatory expensing induces underinvestment in research and development (R&D). The current study investigates whether capitalization can also create R&D investment problems. Abandoning a capitalized project requires asset impairment, a negative reporting effect which could damage managers’ reputations. In an experiment utilizing MBA student participants, I find that managers responsible for initiating an R&D project are more likely to overinvest when R&D is capitalized. I show that high self-monitors (those most likely to alter their behaviors to convey a positive image) are most likely to overinvest, suggesting that reputation concerns contribute to this behavior. A follow-up survey reveals that, when R&D is capitalized, experienced executives anticipate overinvestment and expect project abandonment to have a stronger negative impact on the responsible manager’s reputation and future prospects at their firm. The results suggest that managers are held responsible for the external reporting consequences of their projects, such that mandating R&D capitalization may not reduce real earnings management.NOTE: The survey section of this paper has been partially retracted as part of the large number of retractions related to data collected by James Hunton. I have replicated this data in Seybert (2015) which is available on SSRN at http://ssrn.com/abstract=2616810 Seybert (2010) can still be referenced and cited as usual but the conclusions drawn should be confined to the experimental results. Conclusions based on the survey results should instead reference Seybert (2015).