The Information Benefits of R&D Capitalization

Abstract

We examine the information benefits of R&D capitalization in the UK after the adoption of IFRS (which mandates capitalization of development costs). Using the successful efforts model of Healy et al (2002), we examine whether information provided by capitalization helps to explain current stock returns, and to predict future earnings. We also examine whether the market could deduce the unrecognized capitalization information under expensing, by examining the market’s pricing of pro-forma capitalization information from the year before IFRS. We find that the capitalization variables have significant explanatory power for both returns and earnings, that the market values the decomposition of current R&D expenditures into their expensed vs capitalized components, and that firms’ switch to capitalization under IFRS revealed new information to the market. Together, these results attest to both the relevance and reliability of the capitalization information, and to the importance of its recognition.