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1、Capitalization of R&D Costs and Earnings Management：Evidence from Italian Listed CompaniesABSTRACT: The capitalization of research and development (R&D) costs is a controversial accounting issue because of the contention that such capitalization is motivated by incentives to manipulate earnings. Bas
2、ed on a sample of Italian listed companies, this study examines whether companies decisions to capitalize R&D costs are affected by earnings-management motivations. Italy provides a natural context for testing our hypothesized relationships because Italian GAAP allows for the capitalization of R&D c
3、osts. Using a Tobit regression model to test our hypotheses, we show that companies tend to use cost capitalization for earnings-smoothing purposes. The hypothesis that firms capitalize R&D costs to reduce the risk of violating debt covenants is not supported.KEY WORDS: Earnings management, Cost cap
4、italization, R&D accounting, Earnings smoothing, Debt covenants, Italian companies1 IntroductionIn the current era of globalization, a highly relevant issue facing regulators, academics, and practitioners is the determination of an appropriate accounting treatment for research and development (R&D)
5、costs. International Accounting Standards discuss accounting for R&D costs in IAS No. 38 “Intangible Assets” (IASB, 2004;IASB, 2004). Paragraph 54 of this standard states that no intangible asset arising from research (or from the research phase of an internal project) shall be recognized as an asse
6、t; and that research expenses shall be expensed in the income statement when they are incurred. Concerning development costs, paragraph 57 states that an intangible asset arising from development (or from the development phase of an internal project) shall be recognized if, and only if, an entity ca
7、n demonstrate all of the following: (a) the technical feasibility of completing the intangible asset so that it will be available for use or sale; (b) its intention to complete the intangible asset and use or sell it; (c) its ability to use or sell the intangible asset; (d) how the intangible asset
8、will generate probable future economic benefits; (e) the availability of adequate technical, financial, and other resources to complete the development and to use or sell the intangible asset; (f) its ability to measure reliably the expenditure attributable to the intangible asset during its develop
9、ment. Although IAS 38 allows companies to capitalize development costs, the inherent subjectivity of the validation process permits management to exercise discretion in deciding whether the conditions of IAS 38 have been satisfied. In essence, IAS 38 gives management considerable flexibility regardi
10、ng the treatment of development costs.US GAAP takes a stricter approach to the issue. SFAS No. 2Accounting for Research and Development Costs (FASB, 1974)requires that all R&D expenditures be expensed in the current period. The only exception to the full expensing rule is stated in SFAS No. 86. The
11、exception relates to the capitalization of software development costs (FASB, 1985). At the international level, certain national accounting standards (e.g., those of Italy) allow flexibility for the capitalization of R&D costs when some conditions are satisfied. These are conditions similar to those
12、 required by IAS.The capitalization of R&D costs has always been a controversial accounting issue. Supporters of capitalization report results suggesting that R&D is a long-lived asset that influences future profitability (e.g., Bublitz and Ettredge, 1989, January; Sougiannis, 1994, January; Ballest
13、er et al., 2003). Also, R&D costs are positively related to market value (Hirschey and Weygandt, 1985, Spring; Shevlin, 1991, January;Sougiannis, 1994, January) and yield value-relevant information to investors (e.g., Aboody and Lev, 1998; Lev and Zarowin, 1999; Healy et al., 2002;Monahan, 2005).Sup
14、porters of expensing are fewer. They stress the lack of reliable evidence of future economic benefits (e.g., FASB, 1974; Association for Investment Management and Research, 1993;Kothari et al., 2002) or refer to the benefits of consistency and comparability, pointing out that such benefits trump the
15、 costs identified by the supporters of capitalization. Additionally, reliability and the risk of earnings-management policies are underscored by supporters of the most conservative accounting treatment. In particular, expensing is preferable to capitalization because it increases the objectivity of
16、financial statements. That is, it eliminates the opportunity for managers to capitalize costs of projects that have low probabilities of success or to delay impairment of R&D assets ( Nelson et al., 2003;Schilit, 2002).The debate surrounding the most effective accounting method for R&D costs supplem
17、ents other literature that examines the trade-off between relevance (i.e., the predictive ability) and reliability (i.e., the representative faithfulness) of accounting information (FASB, 1980; AICPA, 1994; IASB, 2004; IASB, 2004). Thus far, empirical research on R&D costs has focused mainly on the
18、relevance side of the trade-off, while little has been written about the reliability side that is, the possibility that R&D costs are subject to earnings management.However, a few studies have indeed shown that R&D expenditures are subject to real earnings management. In short, this means that compa
19、nies cut their R&D investments in order to achieve their earnings goals (e.g., Perry and Grinaker, 1994; Bushee, 1998; Mande et al., 2000). But there is still a paucity of research that explores the motives behind the accounting treatment of R&D costs within a setting where flexibility is allowed. T
20、esting whether companies engage in earnings management through R&D cost accounting can significantly contribute to the debate around the best treatment for such costs. This debate has recently been raised within the convergence project by US GAAP and IAS/IFRS. Illustrating that R&D cost capitalizati
21、on is motivated by incentives to manipulate earnings would support the current U.S. GAAP position, which does not allow the capitalization of such costs. On the contrary, showing that companies do not use R&D cost accounting for earnings-management purposes would support the approach now stated by I
22、AS/IFRS, in which capitalization is allowed under certain conditions.This study contributes to this debate by providing empirical evidence on the motivations for R&D cost capitalization. We hypothesize that the decision to capitalize R&D expenditures is related to two primary motivations: income smo
23、othing and debt contracting. We test our hypotheses using a sample of firms listed on the Milan Stock Exchange. Multivariate results indicate that firms use capitalization of R&D costs to smooth earnings, while there is no support for the debt-covenant hypothesis. These results are robust within a v
24、ariety of firm characteristics, such as firm size, risk, opportunities for growth, profitability, governance characteristics, industrial membership, and time control.The paper proceeds as follows. Section 2 introduces accounting in Italy and the institutional background relating to R&D accounting. S
25、ection 3 discusses the previous literature. Section 4 presents the hypotheses and is followed by the research methods in Section 5. Section 6 presents the results and Section 7 concludes the study. 2 R&D accounting in ItalyItalian accounting regulation has always allowed for some flexibility in the
26、capitalization of R&D costs. This allowance is similar to that of IAS. Accounting for intangibles, including R&D costs, is regulated by Principio Contabilen. 24 (Accounting Standard No. 24). This standard distinguishes three different types of R&D costs as follows: 1) “Basic research,” which consist
27、s of studies, surveys, and experiments that do not refer to a specific project; this type of R&D cost is normally carried out for the general utility of a company (e.g., market research, updating, etc.);2) “Applied research,” which consists of studies, surveys, and experiments that refer to specific
28、 projects; 3) “Development,” which consists of the application of research results to specific materials, tools, products, and processes preceding production.The costs for basic research are to be expensed in the income statement. However, costs related to applied R&D can be capitalized if the follo
29、wing conditions are met: a) the costs refer to a project for the realization of a clearly defined product or process; b) the costs are identifiable and measurable; c) the project to which the costs refer is technically feasible; d) the company owns the necessary resources to complete and exploit the
30、 project; and e) the costs are recoverable through the revenues generated by exploiting the project.It is evident that the conditions stated by the Italian accounting standards are similar to those stated by IAS for development costs. In fact, the definition of applied research under Italian standar
31、ds also fits into the definition of development costs provided by IAS 38. The Italian standards differ from IAS in that they do not require R&D capitalization when the abovementioned conditions occur, leaving flexibility in the hands of the companies. However, this difference is more formal than sub
32、stantive. Given the subjectivity in assessing the occurrence of some of the conditions, it seems that, even under IAS, companies that prefer immediate expensing can easily justify this approacheven when the aforementioned conditions are met.Concerning the amortization of R&D costs, the Italian accou
33、nting standards require that the amortization be carried out over a period of no longer than five years beginning from the moment the outcome (product or process) is ready to be used. The Italian Civil Code (art. 2426) states that the capitalization of R&D costs shall be authorized by the collegio s
34、indacale (statutory auditors) and that it is not possible to pay dividends until there are enough retained earnings to cover the carrying amount of the capitalized R&D costs. This stipulation limits the incentive to capitalize R&D costs for the purpose of increasing the amount of dividends paid. The
35、 Civil Code also requires that R&D activities be discussed in the relazione sulla gestione (management discussion and analysis section); however, there is no clear requirement as to what quantitative or qualitative disclosures should be relayed with regard to the capitalization of R&D costs. Finally
36、, the Civil Code states that information regarding the amortization schedules of such R&D costs be provided in the explanatory notes of the financial statements.3 Earnings management and specific accrualsEarnings management is defined as a “purposeful intervention in the external financial-reporting
37、 process, with the intent of obtaining some private gain” (Schipper, 1989, p. 92). In generally accepted terms, earnings management occurs “when managers use judgment in financial-reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the under
38、lying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers” (Healy & Wahlen, 1999, p. 368).The large amount of research carried out thus far indicates that managers exercise discretion and manage earnings using a wide variety of methods,
39、 ranging from carrying out special transactions (so-called real earnings management) to the manipulation of accruals. Several of the main incentives for earnings management include debt covenants, bonus plans, and income smoothing. The debt-covenant hypothesis suggests that managers have an incentiv
40、e to manage earnings in order to avoid violating covenants in debt contracts, which are typically stated in terms of accounting numbers or ratios. The bonus-plan hypothesis suggests that managers manage earnings in order to maximize compensation. Healy (1985) shows that managers tend to reduce earni
41、ngs if they fall either above or below bonus-plan bounds. In contrast, they tend to increase earnings when they fall between the two bounds. Finally, the income-smoothing hypothesis suggests that firms aspire to reduce earnings fluctuations.Empirical earnings-management studies find support for the
42、abovementioned motives in a variety of contexts. Many of these studies test the relationship between aggregate accruals and incentives for earnings management (e.g., Healy, 1985; DeAngelo, 1986;Dechowet al., 1995). As an alternative approach, other studies focus on single items, suggesting that inco
43、me from specific accruals is related in a systematic way to earnings-management incentives. Among these latter studies, McNichols and Wilson (1988) show that companies manage their bad-debt provisions according to the bonus-plan hypothesis (Healy, 1985). Zucca and Campbell (1992) examine discretiona
44、ry asset write-downs, showing that companies use these accruals either for “big bath” strategies or for earnings smoothing. Francis, Hanna, and Vincent (1996) confirm that earnings-management incentives play a significant role in explaining goodwill write-offs and restructuring charges. Other studie
45、s focus on allowances for deferred taxes (e.g., Miller and Skinner, 1998; Schrand and Wong, 2003). These studies provide mixed results. Finally, Dowdell and Press (2004) analyze the in-process R&D write-offs, but they do not find evidence to support their bonus-plan hypothesis.In line with the afore
46、mentioned studies on earnings management and specific accruals, this study aims at testing whether the decision to capitalize or to expense R&D costs (when flexibility exists) is affected by earnings-management motives.4 Hypotheses developmentPrevious research investigates three main incentives for
47、earnings management: earnings smoothing, debt covenant, and bonus-plan incentives. In this study, we focus on the first two since disclosure of data on the existence and structure of bonus plans by Italian companies is limited. The income-smoothing hypothesis suggests that a managers accounting disc
48、retion is driven by his or her desire to reduce income-stream variability (Fudenberg and Tirole, 1995). The process of smoothing serves to moderate year-to-year fluctuations in income by shifting earnings from peak years to less successful periods. This process lowers the peaks and makes earnings fl
49、uctuations less volatile (Copeland, 1968).Income smoothing has been viewed both as a positive strategy, whereby managers transmit private information to investors (e.g., Gordon, 1964, April; Beidleman, 1973; Ronen and Sadan, 1981; Tucker and Zarowin, 2006), and as a manipulative practice driven by opportunistic aims ( Gordon, 1964, April; Imhoff, 1977, Spring;Kamin and Ronen, 1978). In this study, we do not intend to argue for either one of these two views. Rather, we test whether R&D cost capitalization is used for purposes