R&D Reporting Biases and Their Consequences

60 Pages Posted: 20 Aug 2004

See all articles by Baruch Lev

Baruch Lev

New York University - Stern School of Business

Bharat Sarath

Rutgers University

Theodore Sougiannis

University of Illinois at Urbana-Champaign - Department of Accountancy

Multiple version iconThere are 3 versions of this paper

Date Written: June 2004


The immediate expensing of R&D expenditures is often justified by the conservatism principle. However, no accounting procedure consistently applied can be conservative throughout the firm' life. We ask the following questions: (a) When is the expensing of R&D conservative and when is it aggressive, relative to R&D capitalization? and (b) What are the capital market implications of these reporting biases? To address these questions we construct a model of profitability biases (differences between reported profitability under R&D expensing and capitalization) and show that the key drivers of the reporting biases are the differences between R&D growth and earnings growth (momentum), and between R&D growth and return on equity (ROE). Companies with a high R&D growth rate relative to their profitability (typically early cycle companies) report conservatively, while firms with a low R&D growth rate (mature companies) tend to report aggressively under current GAAP. Our empirical analysis, covering the period 1972-2003, generally supports the analytical predictions.

In the valuation analysis we find evidence consistent with investor fixation on the reported profitability measures: we detect undervaluation of conservatively reporting firms and overvaluation of aggressively reporting firms. These misvaluations appear to be corrected when the reporting biases reverse from conservative to aggressive and vice versa.

Keywords: R&D Accounting, Reporting Biases, Market Valuation, Mispricing

JEL Classification: M41, O30, G14

Suggested Citation

Lev, Baruch Itamar and Sarath, Bharat Sarrukai and Sougiannis, Theodore, R&D Reporting Biases and Their Consequences (June 2004). Available at SSRN: https://ssrn.com/abstract=561602 or http://dx.doi.org/10.2139/ssrn.561602

Baruch Itamar Lev

New York University - Stern School of Business ( email )

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Bharat Sarrukai Sarath

Rutgers University ( email )

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Theodore Sougiannis (Contact Author)

University of Illinois at Urbana-Champaign - Department of Accountancy ( email )

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Champaign, IL 61820
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