Accounting for Software Development Costs and the Cost of Capital: Evidence from IPO Underpricing in the Software Industry

Abstract

The paper assesses the value of the information contained in management's determination of the accounting treatment for software development costs. The assessment is made in the context of the initial public offerings (IPO) market and is based on the effect of the accounting treatment on information asymmetry and hence IPO underpricing. We hypothesize that by sharing information about the probability of recoverability of software development costs and the amortization period, management that elects capitalization reduces information asymmetry and thus underpricing. The results, based on a sample of 390 IPOs in the software industry, are consistent with the hypothesis. The findings suggest that the option to capitalize, through its information impact, lowers the cost of capital. Alternative interpretations of the findings are discussed as well.

Keywords: Accounting for software development costs (SDC), IPO underpricing, information asymmetry, cost of capital

JEL Classification: M41, M43, M44, G24, D82, G12, G14