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 fromopportunistic earnings management resulting from the discretionary capitalization ofResearch & Development (R&D) expenditures. The latter can be used by managers to signalprivate information to the market. It can however also be used for opportunistic earningsmanagement. Based on signaling theory, we argue that the market may use an overallassessment of earnings management to identify R&D capitalizations which are crediblesignals of future economic benefits. Based on Subramanyam 1996 who analyzes the pricingof discretionary accruals in general, we provide evidence that the pricing of the R&D accrualin particular is conditional on the company’s degree of earnings management. Using Germandata for 2001-2006 we find that the market prices the R&D accrual only when the level ofearnings management the firm is engaged in is low. In the spirit of Oswald (2008) we detectdeterminants of R&D capitalization and additionally distinguish between fundamental factors(firm size) and opportunistic determinants (profitability, leverage, accounting uniformity, andtotal R&D) that are indicative for managers’ opportunistic behavior.