Capitalization vs. expensing and the behavior of R&D expenditures

We examine the effect of capitalization vs. expensing on UK firms’ R&D expenditures. Our investigation is motivated by the UK’s mandatory switch from UK GAAP to IFRS in 2005. Under UK GAAP, firms could elect to expense or capitalize development expenditures, but IFRS mandates capitalization. Thus, “capitalizers” maintained their accounting method, while “switchers” were required to change from expensing to capitalization. We examine the effect of the rule change on the amount of the two groups’ R&D expenditures, and we find that switching firms increased their R&D expenditures more than firms that continued to capitalize. We subject our results to numerous robustness tests, and across all of them our results support the conclusion that the accounting method affects the amount that firms invest in R&D. Our results attest to the real effects of accounting policy on firms’ R&D investments.