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R&D Reporting Biases and their Consequences

Posted: 1 Sep 2005  

Baruch Lev

New York University - Stern School of Business

Bharat Sarath

Rutgers, The State University of New Jersey - Accounting

Theodore Sougiannis

University of Illinois at Urbana-Champaign - Department of Accountancy

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Abstract

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's 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. This evidence is consistent with behavioral finance arguments about investor cognitive biases.

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

JEL Classification: M41, M44, O30, G14

Suggested Citation

Lev, Baruch and Sarath, Bharat and Sougiannis, Theodore, R&D Reporting Biases and their Consequences. Contemporary Accounting Research, Vol. 22, No. 4, Winter 2005. Available at SSRN: https://ssrn.com/abstract=795605

Baruch Itamar Lev

New York University - Stern School of Business ( email )

40 West 4th Street, Suite 400
New York, NY 10012
United States
212-998-0028 (Phone)
212-995-4001 (Fax)

HOME PAGE: http://www.baruch-lev.com

Bharat Sarrukai Sarath

Rutgers, The State University of New Jersey - Accounting ( email )

94 Rockafeller Road
Piscataway, NJ 08854
United States

Theodore Sougiannis (Contact Author)

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

360 Wohlers Hall
1206 South Sixth Street
Champaign, IL 61820
United States
217-244-0555 (Phone)
217-244-0902 (Fax)

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