The Role of Audit Quality in Firm Valuation: The Case of R&D Capitalization in Australia

Abstract

This study investigates the link between audit quality and the market's perception of the value of discretion in accounting for R&D costs (Australian GAAP permits R&D costs to be capitalized) and the impact of changes in that discretion. The study examines companies reporting of capitalized R&D costs over the period 1992 to 1998. When management discretion is unencumbered (1992 to 1995), the use of a higher quality auditor appears to significantly enhance the value of the R&D asset. However, when management discretion is reduced, due to enhanced monitoring by the Australian Securities Commission (1996 to 1998), the use of a higher quality auditor does not increase the value relevance of the R&D asset. These results are consistent with the notion that in the absence of other monitoring mechanisms, audit quality signals the value relevance of the R&D asset. In addition, the R&D expensed by these capitalizers is not significant in the earlier sub-period but is significant in the later sub-period when management discretion is reduced.