Evidence on the Usefulness of Capitalizing and Amortizing Research and Development Costs

In this paper, we provide evidence on the potential informational benefits of capitalizing and amortizing Ramp;D costs by comparing the extent to which financial statements that reflect alternative Ramp;D accounting schemes explain the cross-sectional distribution of share prices. We find that adjusting reported earnings and book values to reflect capitalization and amortization of Ramp;D costs according to a one-size-fits-all accounting rule results in a small but statistically significant increase in the extent to which those measures explain the distribution of share prices. This improvement is even greater when the amortization period for Ramp;D costs is allowed to vary across industry groups. However, when the Ramp;D components of earnings and book values are disaggregated in order to permit them to relate to prices differentially, the difference in explanatory power between reported and adjusted accounting numbers is substantially reduced. Finally, we find that slope coefficients relating Ramp;D expense to price do not differ significantly from those relating depreciation to price, and that slope coefficients for the Ramp;D asset do not differ significantly from those for property, plant, and equipment. These results suggest that even simple capitalization and amortization rules for Ramp;D costs that allow little discretion have the potential to increase the usefulness of accounting numbers as a basis for valuation