Do Firms Inappropriately Capitalize Development Costs? Evidence From China

Abstract

An ongoing, unresolved heated debate in accounting practice relates to whether capitalization of development costs should be allowed. This study contributes to the debate by developing a new approach to examining the implementation of development costs capitalization in the second largest economy – China ‒ and provides some evidence as to whether firms inappropriately capitalize development costs. We argue that capitalization of development costs should be positively associated with R&D outputs, and absence of such association indicates inappropriate implementation of capitalization. Using data from listed firms in China over the period 2007‒2017, we find that capitalization of development costs is, in general, positively associated with R&D outputs, and such association is stronger for State-owned Enterprises and qualified High- and New-technology Enterprises. This association can be strengthened by more restrictive scrutiny; however, it can also be weakened when firms have higher agency costs and financial constraints. Furthermore, results suggest that capitalization of development costs is significantly and positively associated with current and future firm value, and the correlation is strengthening over time. This study finds that, in general, the capitalization of (higher) development costs does have positive association with higher R&D outputs, however, inappropriate implementation is possible under some settings. It sheds some light on the ongoing debate between IFRS and US GAAP surrounding expensing versus capitalizing development costs, and has implications for practitioners, auditors, and investors with potential risks involved in the implicit R&D accounting choice.

Keywords: Capitalization, Development costs, Patent, Productivity

JEL Classification: M4, G18, O3