Does R&D capitalization provide information about risk?: Evidence from the R&D-to-market anomaly

Abstract

We examine the information benefits of R&D capitalization by analyzing the R&D-to-market anomaly. Two contrasting explanations are offered in the literature for the positive R&D-returns relationship: mispricing of R&D resulting from limited investor attention to R&D and the failure of conventional risk factors to fully capture the risk associated with R&D. Exploiting R&D accounting treatments in Korea, in which some R&D expenditures are capitalized, we find that the positive R&D-returns relationship weakens as the capitalized portion of R&D increases, consistent with a risk-based theoretical prediction. The weakening of the relationship is fully explained by conventional risk factors, which is inconsistent with the mispricing-based explanation. Furthermore, both the expensed and capitalized portions of R&D are positively associated with returns, suggesting that investor inattention that arises from conservative accounting treatments cannot explain the R&D-returns relationship. The results suggest overall that the positive R&D-returns relationship is consistent with investors’ demanding compensation for bearing risk and that R&D capitalization provides useful information to investors regarding risk.

Keywords: R&D capitalization, risk, R&D, risk premium, mispricing

JEL Classification: G12, O32