Accounting Choice and Earnings Quality: The Case of Software Development

Abstract

In this study I explore how accounting choice affects earnings quality in the software development industry. SFAS No. 86, which requires capitalization of software development costs (SDC), is the only exception in the US to SFAS No. 2, which requires immediate expensing of all research and development (R&D) expenditures. Aboody and Lev (1998) suggest that capitalized SDC are value-relevant. Thus, expensing of these costs might introduce noise into earnings. However, it has been suggested that future benefits associated with SDC are highly uncertain (Software Publishers Association). Consequently, capitalization might introduce noise into earnings by capitalizing unproductive expenditures. Hence, it is not clear how managers' choice between capitalization and expensing will affect earnings quality. I first find that there is a decline in the quality of earnings in the software industry after the adoption of SFAS No. 86, whereas no such decline is observed in other high-tech industries. Second, I find that, within the software industry, the quality of earnings for expensers is greater than for capitalizers. Finally, I find that, among the capitalizers, those with a large increase in software capital have lower earnings quality than others. Overall, the results suggest that capitalization of software costs does not improve earnings quality.

Notes

While LaFond and Watts (2008) perform their analysis on conditional conservatism, they do not restrict their arguments to conditional conservatism. Therefore it is reasonable to expect that their arguments will also apply to unconditional conservatism (i.e. expensing of SDC).

There are several reasons why intangible-intensive firms have more information asymmetry. First, soft assets are unique: therefore investors cannot get any information about the economic performance of a specific product by looking at similar products. For example, the market success of a drug by Pfizer will not say much about the market success of a similar drug by Merck. In addition, there are no established markets for soft assets that can provide information about the value of these assets, whereas there are markets for tangible assets, from which investors can infer the prices of those assets (Lev, 2001).

The primary criticism against expensing is that R&D is expensed immediately, whereas the benefits are realized much later, which violates the matching principle (Lev and Zarowin, 1999). Amir and Lev (1996) suggest that earnings and book values do not represent firm value and performance, owing to expensing of R&D. However, Collins et al. (1997) (Francis and Schipper, 1999) did not find any evidence that accounting information is less value-relevant in intangible-intensive (high-tech) industries.

In certain situations capitalization might lead to lower reported earnings than expensing; however, these situations should be quite rare, because on average R&D expenditures grow not only nominally but also in real terms (e.g. Skinner, 2008, suggests that inflation-adjusted R&D has grown by 150% over the past 20 years). Hence amortization expense under capitalization, on average, would be smaller than a change in capitalized SDC, leading to greater earnings and book values under capitalization than under full expensing. I find that in 71% of the cases in my sample the change in capitalized SDC was larger than amortization expense.

‘The members of SPA CFO committee … have indicated the substantial majority of their investors, underwriters and financial analysts believe financial reporting by software companies is improved when all SDC are charged to expense as incurred. These users of financial statements do not believe that recording of soft assets for software being developed is particularly relevant and does not aid the user of financial statements. The users of financial statements … have a high degree of skepticism when it comes to soft assets resulting from capitalization of SDC.’ SPA letter, March 1996 (Aboody and Lev, 1998).

‘An asset should be recognized … only if ultimate realization of the assets is reasonably assured …. Due to factors such as the ever-increasing volatility in the software marketplace, the compression of product cycles, the heightened level of competition and divergence of technology platforms, realization of software assets has become increasingly uncertain even at the point of technological feasibility … We do not believe that software development costs are useful predictive factor of future product sales.’ This statement is quoted from a letter written by Ken Walsch, president of SPA, to the FASB (Aboody and Lev, 1998).

Consistent with this view, Kothari et al. (2002) suggest that variability of future earnings associated with R&D expenditures is almost four times greater than for capital expenditures. Uncertainty of future benefits is also important for standard setters. FASB provides the uncertainty of future benefits as the main reason to justify the requirement to expense the R&D in other all industries. In SFAS No. 4, FASB states that ‘… the relationship between current research and development costs and the amount of resultant future benefits to an enterprise is so uncertain that capitalization of any R&D costs is useful to investors.’

Capitalization of SDC: A Survey of Accounting Practices in the Software Industry Sponsored By Georgia Tech Financial Analysis Lab. CFO Magazine, December 18, 2007.

James Mandelson, software analyst at Morgan Stanley, testifying at the FASB public hearing, May 1985 (Aboody and Lev, 1998).

In fact, Mohd (2005) suggests that an alternative proxy to measure information asymmetry is dispersion in analyst forecasts. Thus, the evidence in Aboody and Lev (1998) suggests that there is an increase in information asymmetry, rather than a decrease.

Cazavan-Jeny and Jeanjean (2006) suggest that capitalizers are the smallest firms (the market capitalization of expensers in their sample is $6.9 billion – 22 times larger than the $310 million for capitalizers). Similarly, Oswald (2008) reports that the market value of equity for expensers is seven times larger than for capitalizers ($1529 million versus $216 million).

While he controls for size, it may not eliminate the size effect completely in a pooled regression setting. His sample covers 1986–1995 – ten years, like ours. A large firm in 1986 might seem small in 1995. A better approach would be to adjust the relative size comparison every year.

Consistent with this, Mohd (2005) reports from Davey (1992) that ‘Sulucus Computer has made every effort to demonstrate that its judgment to [capitalize] is well justified … The company even included, with each investors relations packet it sent out, a cogent and favorable examination prepared by an analyst from a big, fancy brokerage house.’

As long as management is not providing more specific information that will help investors better understand the relationship between R&D investments and future revenues, disclosing a lump-sum number for capitalized SDC can hardly be informative. This argument is consistent with Skinner (2008), who suggests that in industries where full expensing is required there are no voluntary disclosures for estimated R&D capital, indicating that there is no demand for such information. Thus, the lack of voluntary supply of estimated R&D capital in industries with full expensing suggests that there is no such demand.

Lipe (1990) defines earnings persistence as autocorrelation in earnings. Schipper and Vincent (2003) define earnings predictability as the ability of past earnings to predict future earnings, and earnings smoothness as the lack of variability in earnings across time. Accrual quality is mapping of accruals into cash flows.

Persistence reflected in ERC is different from autocorrelation in earnings (another measure of persistence used in prior literature), such that the latter might be affected by earnings management, whereas the former would not (assuming market efficiency, investors should be able to see through earnings management).

Accounting rules might also affect investment decisions. Oswald and Zarowin (2005) suggest that expensers engage in real earnings management by cutting R&D, whereas capitalizers engage in accrual earnings management using capitalization. However, Seybert (2008) suggests that capitalization of R&D might lead to overinvestment.

ERC indicates the extent of a security's abnormal market return in response to an unexpected component of reported earnings. Kim and Verrecchia (1991) show analytically that the price response to a signal is positively related to signal quality, suggesting that the greater the ERC, the greater the earnings quality. ERC shows investors' assessment of earnings quality. It is widely used to measure the quality of information (Christensen, 2002). Ghosh and Moon (2005) investigate the impact of auditor tenure on earnings quality by using ERC. Collins and Slatka (1993) use ERC to investigate how the adoption of SFAS No. 52 affects the quality of earnings. Similarly, Teoh and Wong (1993) use ERC to measure the impact of auditor quality on earnings quality.

Consistent with this argument, Bhattacharya et al. (2003) suggest that actual earnings from I/B/E/S are significantly different from earnings under GAAP, and argue that GAAP earnings are more conservative than actual earnings in I/B/E/S. Similarly, Collins et al. (2009) use I/B/E/S actual earnings as a proxy for street earnings, an earnings definition that is not consistent with GAAP. Therefore it may not be reasonable to test the impact of accounting choice under GAAP using analyst forecasts.

This analysis might suffer from selection bias, because we are selecting firms in the software industry based on their accounting choice. However, consistent with Mohd (2005), I perform this analysis as a robustness check to see whether the results are driven by expensers within the software industry.

Size-adjusted returns are better than market- or market-model-adjusted returns because market capitalization in the calculation of size-adjusted returns is updated every year. Given that market capitalization grows over time, adding a control variable for firm size may not eliminate the size effect completely in pooled regressions, because the sample period covers ten years.

Mohd (2005) suggests that DEVINT _it increases the chance of success in software projects. Given that large capitalizers have lower DEVINT _it , they might have less success in these projects.

Oswald and Zarowin (2007) use capitalization data based on the UK. They argue that their findings are comparable to the US, because UK capital markets are well-developed, liquid markets, similar to those of the US and other developed nations. Following their arguments, it is reasonable to assume that European data, at least in some countries, are comparable to those for the US.

There are several studies that explore the impact of capitalization with European data; however, the results are also mixed. Cazavan-Jeny and Jeanjean (2006) find that capitalized costs are not value-relevant. Oswald (2008) did not find any economically significant improvement from the hypothetical capitalization of R&D for firms that expense it in the UK. However, Oswald and Zarowin (2007) find that stock prices are more informative capitalizers than expensers, suggesting that capitalization is informative.

Oswald (2008) investigates the determinants of the decision to capitalize or expense. However, to my knowledge, no study investigates the impact of capitalization versus expensing on voluntary disclosures.