R&D Reporting Biases and their Consequences

Abstract

The immediate expensing of R&D expenditures is often justified by the conservatism principle. However, no accounting procedure consistently applied can be conservative throughout the firm' life. We ask the following questions: (a) When is the expensing of R&D conservative and when is it aggressive, relative to R&D capitalization? and (b) 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 cycle companies) report conservatively, while firms with a low R&D growth rate (mature companies) tend to report aggressively under current GAAP. 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.