R&D Reporting Biases and Their Consequences*

Baruch Lev, Bharat Sarath and Theodore Sougiannis

Contemporary Accounting Research, 2005, vol. 22, issue 4, 977-1026

Abstract: The immediate expensing of research and development (R&D) expenditures is often justified by the conservatism principle. However, no accounting procedure consistently applied can be conservative throughout the firm's life. We therefore ask the following questions: (1) When is the expensing of R&D conservative and when is it aggressive, relative to R&D capitaliza†tion? (2) What are the capital†market implications of these reporting biases? To address these questions we construct a model of profitability biases (differences between reported profitability under R&D expensing and capitalization) and show that the key drivers of the reporting biases are the differences between R&D growth and earnings growth (momentum), and between R&D growth and return on equity (ROE). Companies with a high R&D growth rate relative to their profitability (typically early life†cycle companies) report conservatively, while firms with a low R&D growth rate (mature companies) tend to report aggressively under current generally accepted accounting principles. Our empirical analysis, covering the period 1972†2003, generally supports the analytical predictions. In the valuation analysis we find evidence consistent with investor fixation on the reported profitability measures: we detect undervaluation of conservatively reporting firms and overvaluation of aggressively reporting firms. These misvaluations appear to be corrected when the reporting biases reverse from conservative to aggressive and vice versa. This evidence is consistent with behavioral finance arguments about investor cognitive biases.

Date: 2005
References: Add references at CitEc
Citations: View citations in EconPapers (61)

Downloads: (external link)
https://doi.org/10.1506/7XMH-QQ74-L6GG-CJRX

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:wly:coacre:v:22:y:2005:i:4:p:977-1026

Access Statistics for this article

More articles in Contemporary Accounting Research from John Wiley & Sons
Bibliographic data for series maintained by Wiley Content Delivery ().