The Riskiness of Future Benefits: The Case of Capitalization of R&D and Capital Expenditures

Abstract

ABSTRACT: This study contributes to the ongoing debate on whether to allow capitalization of R&D expenditures. Although prior studies suggest that capitalization of R&D expenditures is more value-relevant than immediate expensing, limited evidence is available outside the U.S. on whether R&D capitalization increases the riskiness of future benefits. In contrast to the U.S., where R&D capitalization is not permitted, Australian’s GAAP allowed, until 2005, capitalization of R&D expenditure if the derived benefits recovered the cost “beyond reasonable doubt.” Using this unique setting, we employ a sample of 912 Australian firm-year observations for 298 firms over the years 1988 to 2000 to examine the association between current R&D expenditure and risk in future earnings, where earnings variability is used as proxy for risk. We find that expensed R&D expenditures generate higher risk in future earnings than current capital expenditures, and that both expensed current R&D expenditures and current capital expenditures generate higher risk in future earnings than do discretionary capitalized R&D expenditures.