Garen Markarian,Lorenzo Pozza,Annalisa Prencipe,International Jou rnal of Accounting2008-3 爱思唯尔期刊Capitalization of R&D Costs and Earnings Management：Eviden ce from Italian Listed CompaniesABSTRACT: The capitalization of research and development (R&D) costs is a controversial accounting issue because of th e contention that such capitalization is motivated by incenti ves to manipulate earnings. Based on a sample of Italian list ed companies, this study examines whether companies' decision s to capitalize R&D costs are affected by earnings-management motivations. Italy provides a natural context for testing ou r hypothesized relationships because Italian GAAP allows for the capitalization of R&D costs. Using a Tobit regression mod el to test our hypotheses, we show that companies tend to use cost capitalization for earnings-smoothing purposes. The hyp othesis that firms capitalize R&D costs to reduce the risk of violating debt covenants is not supported. KEY WORDS: Earnin gs management, Cost capitalization, R&D accounting, Earnings smoothing, Debt covenants, Italian companies1 Introduction In the current era of globalization, a high ly relevant issue facing regulators, academics, and practitioners is the determination of an appropriate accounting treatm ent for research and development (R&D) costs. International A ccounting Standards discuss accounting for R&D costs in IAS N o. 38 “Intangible Assets” (IASB, 2004; IASB, 2004). Paragrap h 54 of this standard states that no intangible asset arising from research (or from the research phase of an internal pro ject) shall be recognized as an asset; and that research expe nses shall be expensed in the income statement when they are incurred. Concerning development costs, paragraph 57 states t hat an intangible asset arising from development (or from the development phase of an internal project) shall be recognize d if, and only if, an entity can demonstrate all of the follo wing: (a) the technical feasibility of completing the intangi ble asset so that it will be available for use or sale; (b) i ts intention to complete the intangible asset and use or sell it; (c) its ability to use or sell the intangible asset; (d) how the intangible asset will generate probable future econo mic benefits; (e) the availability of adequate technical, fin ancial, and other resources to complete the development and t o use or sell the intangible asset; (f) its ability to measur e reliably the expenditure attributable to the intangible ass et during its development. Although IAS 38 allows companies to capitalize development costs, the inherent subjectivity of the validation process permits management to exercise discret ion in deciding whether the conditions of IAS 38 have been sa tisfied. In essence, IAS 38 gives management considerable fle xibility regarding the treatment of development costs.US GAAP takes a stricter approach to the issue. SFAS No. 2—Accounting for Research and Development Costs (FASB, 1974)—requires that all R&D expenditures be expensed in the curre nt period. The only exception to the full expensing rule is s tated in SFAS No. 86. The exception relates to the capitaliza tion of software development costs (FASB, 1985). At the inter national level, certain national accounting standards (e.g., those of Italy) allow flexibility for the capitalization of R &D costs when some conditions are satisfied. These are condit ions similar to those required by IAS.The capitalization of R&D costs has always been a controve rsial accounting issue. Supporters of capitalization report r esults suggesting that R&D is a long-lived asset that influen ces future profitability (e.g., Bublitz and Ettredge, 1989, J anuary; Sougiannis, 1994, January; Ballester et al., 2003). A lso, R&D costs are positively related to market value (Hirschey and Weygandt, 1985, Spring; Shevlin, 1991, January; Sougia nnis, 1994, January) and yield value-relevant information to investors (e.g., Aboody and Lev, 1998; Lev and Zarowin, 1999; Healy et al., 2002; Monahan, 2005). Supporters of expensing are fewer. They stress the lack of reliable evidence of futur e economic benefits (e.g., FASB, 1974; Association for Invest ment Management and Research, 1993; Kothari et al., 2002) or refer to the benefits of consistency and comparability, point ing out that such benefits trump the costs identified by the supporters of capitalization. Additionally, reliability and t he risk of earnings-management policies are underscored by su pporters of the most conservative accounting treatment. In pa rticular, expensing is preferable to capitalization because i t increases the objectivity of financial statements. That is, it eliminates the opportunity for managers to capitalize cos ts of projects that have low probabilities of success or to d elay impairment of R&D assets ( Nelson et al., 2003; Schilit, 2002). The debate surrounding the most effective accounting method for R&D costs supplements other literature that examin es the trade-off between relevance (i.e., the predictive abil ity) and reliability (i.e., the representative faithfulness) of accounting information (FASB, 1980; AICPA, 1994; IASB, 2004; IASB, 2004). Thus far, empirical research on R&D costs has focused mainly on the relevance side of the trade-off, while little has been written about the reliability side that is, the possibility that R&D costs are subject to earnings manage ment.However, a few studies have indeed shown that R&D expendit ures are subject to real earnings management. In short, this means that companies cut their R&D investments in order to ac hieve their earnings goals (e.g., Perry and Grinaker, 1994; B ushee, 1998; Mande et al., 2000). But there is still a paucit y of research that explores the motives behind the accounting treatment of R&D costs within a setting where flexibility is allowed. Testing whether companies engage in earnings manage ment through R&D cost accounting can significantly contribute to the debate around the best treatment for such costs. This debate has recently been raised within the convergence proje ct by US GAAP and IAS/IFRS. Illustrating that R&D cost capita lization is motivated by incentives to manipulate earnings wo uld support the current U.S. GAAP position, which does not al low the capitalization of such costs. On the contrary, showin g that companies do not use R&D cost accounting for earnings-management purposes would support the approach now stated byIAS/IFRS, in which capitalization is allowed under certain co nditions. This study contributes to this debate by providing empirical evidence on the motivations for R&D cost capitaliza tion. We hypothesize that the decision to capitalize R&D expe nditures is related to two primary motivations: income smooth ing and debt contracting. We test our hypotheses using a samp le of firms listed on the Milan Stock Exchange. Multivariate results indicate that firms use capitalization of R&D costs t o smooth earnings, while there is no support for the debt-cov enant hypothesis. These results are robust within a variety o f firm characteristics, such as firm size, risk, opportunitie s for growth, profitability, governance characteristics, indu strial membership, and time control. The paper proceeds as fo llows. Section 2 introduces accounting in Italy and the insti tutional background relating to R&D accounting. Section 3 dis cusses the previous literature. Section 4 presents the hypoth eses andis followed by the research methods in Section 5. Section 6 presents the results and Section 7 concludes the study. 2 R &D accounting in Italy Italian accounting regulation has alwa ys allowed for some flexibility in the capitalization of R&Dcosts. This allowance is similar to that of IAS. Accounting f or intangibles, including R&D costs, is regulated by Principi o Contabilen. 24 (Accounting Standard No. 24). This standard distinguishes three different types of R&D costs as follows: 1) “Basic research,” which consists of studies, surveys, and experiments that do not refer to a specific project; this ty pe of R&D cost is normally carried out for the general utilit y of a company (e.g., market research, updating, etc.);2) “Applied research,” which consists of studies, surveys, and experiments that refer to specific projects;3) “Development,” which consists of the application of re search results to specific materials, tools, products, and pr ocesses preceding production.The costs for basic research are to be expensed in the inc ome statement. However, costs related to applied R&D can be c apitalized if the following conditions are met: a) the costs refer to a project for the realization of a clearly defined p roduct or process; b) the costs are identifiable and measurab le; c) the project to which the costs refer is technically fe asible; d) the company owns the necessary resources to comple te and exploit the project; and e) the costs are recoverable through the revenues generated by exploiting the project. Itis evident that the conditions stated by the Italian accounti ng standards are similar to those stated by IAS for developme nt costs. In fact, the definition of applied research under I talian standards also fits into the definition of development costs provided by IAS 38. The Italian standards differ from IAS in that they do not require R&D capitalization when the a bovementioned conditions occur, leaving flexibility in the ha nds of the companies. However, this difference is more formal than substantive. Given the subjectivity in assessing the oc currence of some of the conditions, it seems that, even under IAS, companies that prefer immediate expensing can easily ju stify this approach—even when the aforementioned conditions are met. Concerning the amortization of R&D costs, the Italia n accounting standards require that the amortization be carri ed out over a period of no longer than five years beginning f rom the moment the outcome (product or process) is ready to b e used. The Italian Civil Code (art. 2426) states that the ca pitalization of R&D costs shall be authorized by the collegio sindacale (statutory auditors) and that it is not possible t o pay dividends until there are enough retained earnings to c over the carrying amount of the capitalized R&D costs. This s tipulation limits the incentive to capitalize R&D costs for the purpose of increasing the amount of dividends paid. The Ci vil Code also requires that R&D activities be discussed in th e relazione sulla gestione (management discussion and analysi s section); however, there is no clear requirement as to what quantitative or qualitative disclosures should be relayed wi th regard to the capitalization of R&D costs. Finally, the Ci vil Code states that information regarding the amortization s chedules of such R&D costs be provided in the explanatory not es of the financial statements. 3 Earnings management and spe cific accrualsEarnings management is defined as a “purposeful interventi on in the external financial-reporting process, with the intent of obtaining some private gain” (Schipper, 1989, p. 92). In generally accepted terms, earnings manageme nt occurs “when managers use judgment in financial-reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying econom ic performance of the company or to influence contractual out comes that depend on reported accounting numbers” (Healy & Wa hlen, 1999, p. 368). The large amount of research carried out thus far indicates that managers exercise discretion and man age earnings using a wide variety of methods, ranging from carrying out special transactions (so-called real earnings mana gement) to the manipulation of accruals. Several of the main incentives for earnings management include debt covenants, bo nus plans, and income smoothing. The debt-covenant hypothesis suggests that managers have an incentive to manage earnings in order to avoid violating covenants in debt contracts, whic h are typically stated in terms of accounting numbers or rati os. The bonus-plan hypothesis suggests that managers manage e arnings in order to maximize compensation. Healy (1985) shows that managers tend to reduce earnings if they fall either ab ove or below bonus-plan bounds. In contrast, they tend to inc rease earnings when they fall between the two bounds. Finally, the income-smoothing hypothesis suggests that firms aspire t o reduce earnings fluctuations.Empirical earnings-management studies find support for the abovementioned motives in a variety of contexts. Many of the se studies test the relationship between aggregate accruals a nd incentives for earnings management (e.g., Healy, 1985; DeA ngelo, 1986; Dechowet al., 1995). As an alternative approach, other studies focus on single items, suggesting that income from specific accruals is related in a systematic way to earn ings-management incentives. Among these latter studies, McNichols and Wilson (1988) show that companies manage their bad-d ebt provisions according to the bonus-plan hypothesis (Healy, 1985). Zucca and Campbell (1992) examine discretionary asset write-downs, showing that companies use these accruals eithe r for “big bath” strategies or for earnings smoothing. Franc is, Hanna, and Vincent (1996) confirm that earnings-managemen t incentives play a significant role in explaining goodwill w rite-offs and restructuring charges. Other studies focus on a llowances for deferred taxes (e.g., Miller and Skinner, 1998; Schrand and Wong, 2003). These studies provide mixed results. Finally, Dowdell and Press (2004) analyze the in-process R&D write-offs, but they do not find evidence to support their b onus-plan hypothesis. In line with the aforementioned studies on earnings management and specific accruals, this study aim s at testing whether the decision to capitalize or to expense R&D costs (when flexibility exists) is affected by earnings-management motives. 4 Hypotheses development Previous researc h investigates three main incentives for earnings management: earnings smoothing, debt covenant, and bonus-plan incentives. In this study, we focus on the first two since disclosure of data on the existence and structure of bonus plans by Italia n companies is limited. The income-smoothing hypothesis suggests that a manager's accounting discretion is driven by his o r her desire to reduce income-stream variability (Fudenberg a nd Tirole, 1995). The process of smoothing serves to moderate year-to-year fluctuations in income by shifting earnings fro m peak years to less successful periods. This process lowers the peaks and makes earnings fluctuations less volatile (Cope land, 1968).Income smoothing has been viewed both as a positive strate gy, whereby managers transmit privateinformation to investors (e.g., Gordon, 1964, April; Beidl eman, 1973; Ronen and Sadan, 1981; Tucker and Zarowin, 2006), and as a manipulative practice driven by opportunistic aims ( Gordon, 1964, April; Imhoff, 1977, Spring ;Kamin and Ronen, 1978). In this study, we do not intend to argue for either o ne of these two views. Rather, we test whether R&D cost capit alization is used for purposes of earnings smoothing.。