Discretionary capitalization of R&D expenditures in Canada and Australia

Read the full thesis (PDF).

The purpose of this thesis has been to provide evidence that the market is capable of determining value from the manager’s selective capitalisation of deferred development costs. An existing model, the Feltham and Ohlson (1996) valuation model, is used to determine the association between market value, book value of equity, abnormal earnings and selected R&D variables. Research on value-relevance shows that the market is capable of valuing intangible assets, particularly R&D.

Empirical results are consistent with the voluntary disclosure hypothesis. Market value is positively associated with capitalised development costs when the sample has been partitioned on materiality. Materiality is defined as the ratio of capitalised development costs to total market value. Furthermore, the results are robust to numerous sensitivity checks.

Although other studies have examined the association between market value and R&D expenditures, this is one of the first studies to examine the association in a Canadian and Australian setting and to address the issue of manager’s selective capitalisation of R&D related development costs. Previous U.S. studies investigate the association between market value and a researcher synthesised R&D asset. The United States standard, SFAS #2, mandates the immediate expensing of all R&D expenditures, other than certain software costs, in the current year. Researchers using U.S. data must therefore create the R&D asset.

This study should be useful in the ongoing debate on allowing managers choice in their selection of accounting policies, particularly on whether managers will use this discretion to engage in earnings manipulation. The positive association between market value and capitalised development costs tells regulators that despite the potential for manipulation the market values the asset placed on the balance sheet by the manager. Since regulatory bodies like the Ontario Securities Commission, the Australian Securities Commission, and the International Accounting Standards Committee and various users of financial information are interested in how R&D is accounted for and disclosed, research of this nature should be useful.