Abstract
We examine the effect of capitalization vs. expensing on UK firms’ R&D expenditures. Our investigation is motivated by the UK’s mandatory switch from UK GAAP to IFRS in 2005. Under UK GAAP, firms could elect to expense or capitalize development expenditures, but IFRS mandates capitalization. Thus, “capitalizers” maintained their accounting method, while “switchers” were required to change from expensing to capitalization. We examine the effect of the rule change on the amount of the two groups’ R&D expenditures, and we find that switching firms increased their R&D expenditures more than firms that continued to capitalize. We subject our results to numerous robustness tests, and across all of them our results support the conclusion that the accounting method affects the amount that firms invest in R&D. Our results attest to the real effects of accounting policy on firms’ R&D investments.
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Notes
EU Regulation No. 1606/2002 required that the consolidated financial statements of European companies whose securities are traded on a regulated market (e.g., the London Stock Exchange) be prepared under IFRS for fiscal years beginning on or after January 1, 2005. The listing requirements of the Alternative Investment Market (AIM), which is not considered a regulated market by the EU, required European firms to adopt IFRS for fiscal years beginning on or after January 1, 2007. One of our AIM listed sample firms (Forbidden Technologies Plc) delayed adopting IFRS until their 2009 fiscal year. For brevity, we refer to the adoption year as 2005. We provide the detailed discussion of our data and sample (Section 4) and empirical tests (Section 6). As discussed below, only development expenditures may be capitalized. We use the term R&D to maintain consistency with the literature, and because both R and D expenditures are aggregated into one line item (so we could not separately analyze them anyway).
Statement of Financial Accounting Standard No. 2: Accounting for Research and Development Costs, Financial Accounting Standards Board 1974. The one exception is SFAS No. 86, which allows capitalization of software development costs.
We also used propensity score matching and coarsened exact matching, with similar results (untabulated).
We have also run all of our tests with industry adjusted variables, and with standard errors clustered by industry, with very similar results.
Under UK GAAP, SSAP 13 (para. 25) states that development expenditures should be written off in the year of the expenditure, but it does allow for the deferral of these expenditures to future periods if the following conditions are met: (a) there is a clearly defined project; (b) the related expenditure is separately identifiable; (c) the outcome of the project is examined for its technical feasibility and its ultimate commercial viability considered in light of factors such as likely market conditions (including competing products), public opinion, and consumer and environmental legislation; (d) the aggregate of deferred development costs, any further development costs, and related production, selling and administrative costs is reasonably expected to be exceeded by related future sales or other revenues; and (e) adequate resources exist, or are reasonably expected to be available, to enable the project to be completed and to provide any consequential increases in working capital [Statement of Standard Accounting Practice (SSAP) No. 13, Accounting Standards Committee 1989]. Any expenditures on research (pure or applied) must be expensed in the period incurred. In summary, the conditions are intended to ensure that an asset is indeed created by the R&D expenditures (this applies to IAS 38 as well). See Section 5 for a discussion of the costs and benefits of capitalization under UK GAAP.
In both SSAP 13 and IAS 38, research expenditures must be expensed; only development expenditures may be capitalized, resulting in a development asset. We use the term R&D to maintain consistency with the literature. Furthermore, both R and D expenditures are aggregated into one line item, so we cannot separately analyze them anyway. While managers may have some discretion in classifying their expenditures, we do not believe that this biases our test results, for many reasons. First, nothing has changed for UK GAAP capitalizers, so any bias story cannot be about them. If switchers exercise discretion to classify expenditures as R, it is difficult to understand why this would cause them to increase expenditures, since R must be expensed. Using discretion to classify expenditures as D allows switchers to take more advantage of the expense deferral, and they can increase their expenditures without suffering an income penalty, which is exactly what we predict. Thus, although we cannot know for sure which component increased, it is hard to imagine that switchers increased R right at the time of the switch.
We choose four years on either side of IFRS adoption to ensure we have enough data for precise estimation of coefficients but also to be confident that any effects are due to mandatory capitalization and not to other changes. We also ran our tests on the three-year window around IFRS adoption. Results (untabulated) are consistent with those in the paper.
For example, for a firm that adopted IFRS in 2005, we deleted the 2009–2012firm-year observations. Similarly, for a firm that adopted IFRS in 2008, we deleted the 2001–2003 and 2012 firm-year observations.
Koh and Reeb (2015) discuss solutions to the problem of missing R&D observations when R&D is the independent variable. However, in our paper, R&D is the dependent variable, so we cannot use their methods.
In supplemental tests, we include the non-switchers; we apply the same sample construction criteria as above to obtain a balanced sample. This results in 736 firm years (92 firms).
In order to understand why some expensers did not switch, we compared these non-switchers to the switchers by estimating a Logit model with the two groups and by examining all 167 non-switchers’ R&D footnotes. While the Logit model (results, untabulated for brevity, are available from the authors on request) found some statistically significant differences between the two groups, industry membership was an important determinant of whether a firm switched to capitalization. The importance of industry membership was confirmed by our analysis of the non-switchers’ R&D footnotes, as firms in particular industries (e.g., healthcare) explicitly mentioned that their development expenditures did not meet the capitalization conditions.
Another related paper is Miller and Rock (1985). Although their signaling mechanism is dividends, not conservative accounting, in both their paper and ours the need to signal results in lower investment.
Those sent to the ASC related to the following two exposure drafts: (1) ED 14 – Accounting for Research and Development (Accounting Standards Committee 1975), and (2) ED 17 – Accounting for Research and Development – Revised (Accounting Standards Committee 1976). ED 14 proposed immediate expensing, whereas ED 17 proposed mandatory capitalization. Those sent to the IASC related to following two exposure drafts: (1) ED 37 – International Accounting Standards Proposed Statement – Research and Development Activities (International Accounting Standards Committee 1991), and (2) ED 60 – Proposed International Accounting Standard – Intangible Assets (1997). ED 37 also proposed mandatory capitalization. ED 60 was soliciting opinions on three possible options including immediate expensing, the option to capitalize and mandatory capitalization.
Although their dividend signaling mechanism is different from ours (see footnote 12), this switching evidence is consistent with Miller and Rock (1985), who state, “The best evidence to look for dividend signaling may well be among firms falling into adversity, not because they then start signaling, but because they stop” (pg. 1046).
As-if-expense earnings equals reported earnings minus R&D capitalized in the year plus R&D amortized in the year. As-if-expense book value of equity (assets) equals reported book value of equity (assets) minus the net R&D asset.
In the first year of using IFRS, firms were required to report comparative financial statements on an as-if-IFRS basis for the prior year (i.e., the last year under UK GAAP). From these disclosures we are able to determine expensers CAP% for the last year under UK GAAP. Since we have CAP% for only this year, we assumed the same percentage for all years. To validate this assumption, we examined the behavior of CAP% and found that it varies very little over time for a given firm. Note that since we use expensers’ pro-forma CAP% in Eq. (2), the positive coefficient on CAP% is not tautological.
Note that year −4 is dropped because of collinearity, and that the number of observations differs slightly per regression, due to the differing data requirements.
We have also estimated our tests in Table 6 winsorizing at (1.5%, 2.5%) at the bottom and top, respectively. Due to large outliers at the top of the distribution, when we winsorize at less than 2.5% at the top, the SWITCH*IFRS year coefficient is not always significant for all three R&D metrics.
Horowitz and Kolodny (1980) document that firms that were capitalizing prior to SFAS 2 have approximately a 1.5% decrease in their R&D/Sales, whereas firms that were expensing have approximately a 1% increase in R&D/Sales. This difference of approximately 2.5% is consistent in both magnitude and direction with our coefficient estimates of 3%.
As per Christensen, Hail, and Leuz (2017), we also estimated a trend regression with both linear and quadratic terms over the 1991–2004 and 1998–2004 periods for each dependent variable: R&D Growth = β1 + β2TREND + β3TREND2 + β4SWITCH + β5SWITCH*TREND + β6SWITCH*TREND2 + β7MVE + β8M/B + firm fixed effects + year fixed effects + ɛ; TREND is a linear time trend that equals year minus 1991 or year minus 1998. The results, not reported in the interest of brevity, show insignificant coefficients on SWITCH*TREND and SWITCH*TREND2 for all R&D variables, providing further evidence that the parallel trends assumption is not violated.
Zhong (2018) also finds that R&D expenditures increased after the introduction of IFRS, but she does not compare capitalizers vs. switchers.
It is possible that switching firms begin to overinvest, but based on the analysis of Miller and Rock (1985), we believe that the switchers underinvested under UK GAAP (see footnote 12).
Reduction in cost of capital could increase investment even without external financing, as more projects exceed the lower hurdle rate and are internally funded. It is important to keep this in mind for switchers, who are successful firms (Section 5) and may not need external financing.
Roychowdhury et al. (2019) also discuss an external learning channel where firms learn from peers, but this does not apply in our setting, because switchers could already have learned from their capitalizing peers before IFRS.
For LSE listed firms, 80% (67%) use a profit-based metric for the annual bonus (long term incentive) plan in the last year of UK GAAP. For the first year of IFRS, 84% (72%) of firms use a profit-based metric for the annual bonus (long term incentive) plan. For the AIM listed firms, 13 of the 16 firms (9 of the 12 firms) reporting the details of their annual bonus (long term incentive) plan use a profit-based metric in the last year of UK GAAP. Similarly, in the first year of IFRS, 14 of the 19 firms (13 of the 16 firms) reporting details of their annual bonus (long term incentive) plan use a profit-based metric. The widespread use of profit-based metrics is consistent with our conjecture that UK firms are concerned about the impact of expensing R&D on earnings.
In another example of learning from an accounting rule change, Mittelstaedt et al. (1995) find that firms learned about the value of their promised retiree health benefits when they had to recognize retiree health care liabilities upon adoption SFAS No. 106.
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Oswald, D., Simpson, A. & Zarowin, P. Capitalization vs. expensing and the behavior of R&D expenditures. Rev Account Stud 27, 1199–1232 (2022). https://doi.org/10.1007/s11142-021-09631-7
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DOI: https://doi.org/10.1007/s11142-021-09631-7