Discretionary Capitalization of R&D - The Trade-Off Between Earnings Management and Signaling

We analyze the trade-off between the benefits of signaling and the distortions from opportunistic earnings management resulting from the discretionary capitalization of Research amp; Development (Ramp;D) expenditures. The latter can be used by managers to signal private information to the market. It can however also be used for opportunistic earnings management. Based on signaling theory, we argue that the market may use an overall assessment of earnings management to identify Ramp;D capitalizations which are credible signals of future economic benefits. Based on Subramanyam 1996 who analyzes the pricing of discretionary accruals in general, we provide evidence that the pricing of the Ramp;D accrual in particular is conditional on the company's degree of earnings management. Using German data for 2001-2006 we find that the market prices the Ramp;D accrual only when the level of earnings management the firm is engaged in is low. In the spirit of Oswald (2008) we detect determinants of Ramp;D capitalization and additionally distinguish between fundamental factors (firm size) and opportunistic determinants (profitability, leverage, accounting uniformity, and total Ramp;D) that are indicative for managers' opportunistic behavior