Capitalization of Costs and Expected Earnings Growth

Abstract

This paper offers a model that shows how the capitalization of costs affects contemporaneous earnings and the growth path of expected earnings. It makes three points. First, reported earnings under successful efforts are more price relevant than earnings under full costing or full expensing. Second, whether conditional or unconditional, conservatism always enhances the growth rate of expected earnings. Third, independent of capitalization policy, the long-run expected earnings growth rate converges either to the long-run expected free cash flow growth rate or to the depreciation rate. Therefore, while capitalization policy affects the price relevance of earnings and short-run expected earnings growth, it does not affect long-run expected earnings growth.

Acknowledgements

I would like to thank the guest editors James Ohlson and Laurence van Lent as well as two extremely thorough anonymous referees for extensive comments and suggestions.

Notes

1. Bryant (2003) finds that regression models with both FC book values and FC earnings as explanatory variables have more explanatory power than analogous models with SE book values and SE earnings as explanatory variables. In light of Harris and Ohlson, Bryant's results imply that FC book values and FC earnings provide better incremental information than SE book values and SE earnings to the other information variables in her regressions.

2. This formula, which is valid for all τ≥, is derived in the proof of Proposition 3.

3. Formally lim _τ→∞ A ∼ B if, and only if, for any ϵ > 0, there exists a T > 0 such that ‖ A − B ‖ < ϵ for all τ > T.