Should Investment be Measured? The Role of Investors' Uncertainty

Abstract

We study the effect of alternative accounting methods (capitalizing versus expensing) of long-term asset on firms' investment behavior in such assets. We consider a setting where there is information asymmetry between firm insiders and outside market regarding the profitability of such investments and when firms are myopic in the sense that they care about short-term prices. We show that, contrary to conventional wisdom that myopia results in underinvestment of long-term assets, firms' investments are excessively sensitive to the profitability of those investments, implying overinvestment when the profitability is high and underinvestment when the profitability is low. In addition, capitalizing long-term investments results in an even higher sensitivity to the profitability than expensing and is unambiguously worse (better) when the information asymmetry regarding the profitability is sufficiently large (small). Our results thus provide a justification for the common practice of capitalizing tangible investments but expensing intangible investments, to the extent that information asymmetry of the profitability of tangible investments is much smaller than that for intangible investments.