Unveiling Value: How Mandatory R&D Capitalization Improves Market Transparency
Overview: In the paper titled, “Can the Stock Market Capitalize R&D Expenditures?* (*When Firms Aren’t Mandated to),” NYU Stern Professor Paul Zarowin and PhD student Han Seong Ryu examine how the UK stock market valued companies’ spending on research and development (R&D) before and after the country changed its accounting rules in 2006, switching from UK Generally Accepted Accounting Practice (GAAP) to International Financial Reporting Standards (IFRS).
Why study this now: Under UK GAAP, companies could choose to either record certain R&D costs as expenses (immediate costs) or as capitalized assets (investments with future benefits). Under IFRS, companies had to capitalize eligible R&D costs if they met specific conditions, meaning they couldn’t choose to hide this information anymore.
What the authors found: The companies that were analyzed fall into two categories:
- Mandatory expensers: Companies whose R&D didn’t qualify for capitalization, so they expensed all R&D costs
- Voluntary expensers: Companies that could have capitalized some R&D costs but chose not to
Before the accounting rule change, the stock market valued R&D spending similarly for both types of companies because it couldn’t tell them apart. After the rule change, voluntary expensers had to capitalize their eligible R&D, revealing that they had more valuable R&D. The stock market started valuing their R&D higher than mandatory expensers’. This shows that mandatory capitalization provided crucial information to the market that voluntary disclosures didn’t.
What does this change: Capitalized R&D costs are seen as more valuable because they’re linked to future benefits. The study highlights the importance of accounting rules that require companies to provide clear, consistent information. Without these rules, the market struggles to properly value companies’ investments. The results have important implications for financial disclosure regulation generally -- and especially for the U.S., where almost all R&D is expensed. In essence, the switch to IFRS forced companies to be more transparent about their R&D spending, helping the market better understand and value these investments.
Key insight: “As we show, capitalization-eligible R&D expenditures have a higher market valuation than ineligible expenditures,” note the authors. “Without mandatory capitalization revealing firms’ types, the market was not able to properly value firms’ R&D expenditures.”