Evidence on the Usefulness of Capitalizing and Amortizing Research and Development Costs

Dennis Chambers The University of Illinois at Champaign-Urbana Ross Jennings The University of Texas at Austin Robert B. Thompson II Virginia Commonwealth University Current Draft April 2000

We thank Senyo Tse, Eddie Riedl and workshop participants at the University of North Texas, Pennsylvania State University, American University, Pontificia Universidad Catlica de Chile and the 1998 American Accounting Convention in New Orleans for valuable comments.

Evidence on the Usefulness of Capitalizing and Amortizing Research and Development Costs
Abstract The current requirement to expense R&D costs when incurred is often criticized on the grounds that it reduces the relevance of accounting numbers to investors, and defended because it eliminates a source of managerial discretion that may be used to "manipulate" those same numbers. This paper provides evidence on the potential informational benefits from substituting simple "no-discretion" capitalization and amortization rules for R&D costs for the current requirement to expense such costs immediately. We find that this substitution results in a small but statistically significant increase in the extent to which earnings and book values jointly explain the cross-sectional distribution of share prices. However, our results suggest that the economic significance of this improvement is very modest, and that uniformly applied no-discretion capitalization and amortization rules substantially reduce the usefulness of earnings and book values for a large minority of firms. Additional analysis indicates that a policy permitting selective capitalization of R&D costs can potentially result in a much greater increase in the extent to which share prices are explained by summary accounting measures.

Evidence on the Usefulness of Capitalizing and Amortizing Research and Development Costs

1. Introduction
Statement of Financial Accounting Standards No. 2Accounting for Research and Development Costs (FASB 1974) requires firms to expense R&D costs when incurred. However, many investors believe that the usefulness of accounting numbers for valuation would be greatly increased under an alternative policy that permits R&D costs to be recognized as assets and subsequently expensed as benefits from R&D activities are realized. This belief is supported by a growing body of empirical research documenting statistical associations between current R&D outlays and measures of interest to investors, including future earnings, current stock prices, and current stock returns. While these associations are well-documented, there is little evidence to date on the magnitude of the financial reporting benefits that might be achieved by adopting a policy that permits capitalization and amortization of R&D costs. In this paper, we provide evidence on this issue by comparing the extent to which observed share prices are explained by summary accounting measures based on immediate expensing of R&D costs and those based on capitalizing and amortizing R&D costs. Our evidence should be of interest to investors and analysts, financial statement preparers, and financial accounting policy makers. Investors have indicated a concern that failure to recognize R&D investments as assets may make it difficult to compare R&D-intensive

-2firms to firms that do not invest heavily in R&D activities.1 Because R&D activities are a material and growing source of value for many firms, this lack of comparability may be responsible in part for an alleged decline in the value-relevance of financial statements (Stewart 1995, Wallman 1995, Lev and Zarowin 1999). From a preparer's perspective, there is a more specific concern that this failure may place R&D-intensive firms at a disadvantage in competing for capital with firms that rely less on R&D activities to develop their resources (Brennan 1992). Given these concerns, the policy maker's challenge is to consider whether an alternative accounting standard that permits or requires capitalization and amortization of R&D costs can enhance the relevance of accounting numbers for valuation without decreasing their reliability.
3 2

Reliability is particularly at issue in the case of R&D accounting and reporting. The current "expense as incurred" rule was adopted in part because standard-setters believed that R&D costs were not highly correlated with subsequent benefits from R&D activities, and in part due to a perception that financial statement preparers made opportunistic use of the discretion permitted by pre- SFAS 2 accounting practice. In this paper, we consider two alternative R&D accounting rules that require firms to capitalize and amortize R&D costs, but which give

1 For example, adjusting reported accounting numbers to reflect capitalization and amortization of R&D

costs is a key feature of the Stern Stewart EVA valuation model (Stewart 1991, Biddle et al. 1999).
2 Recent research is divided on the issue of whether such a decline has occurred. See Lev (1996), Francis

and Schipper (1996), Collins, Maydew and Weiss (1997), and Brown, Lo and Lys (1999).
3 Standard setters have recently begun several initiatives that could lead to changes in the current

accounting treatments for intangibles in general and R&D activities in particular. The International Accounting Standards Committee has issued an exposure draft (IASC 1997) of a standard that would permit some capitalization of development costs. In addition, the FASBs current agenda includes an intangibles project that could be expanded to include the accounting treatment for R&D costs. Both of these standard setting efforts may benefit from the empirical evidence presented in this study.

-3preparers no more discretion than is presently permitted under SFAS 2. The first requires capitalization of all R&D expenditures, and imposes the same one-size-fits-all amortization period on all firms in the economy. The second differs by allowing amortization periods to vary across industries. If R&D costs in the aggregate are reasonable surrogates for future benefits, these alternatives have the potential to increase the informativeness of accounting numbers by making them more relevant for valuation and more comparable across R&D-intensive and nonR&D-intensive firms. At the same time, both avoid the criticism that capitalization and amortization schemes for R&D costs give managers too much discretion to determine the levels of reported earnings and book values. For each of these alternative R&D accounting rules, we compare the extent to which reported earnings and book values (based on the current requirement to expense R&D costs as incurred) and adjusted earnings and book values (based on capitalization and amortization of R&D costs) explain the observed cross-section of share prices. Specifically, we compare R2s from cross-sectional regressions of share prices on reported and adjusted earnings and book values for a large sample of NYSE-, ASE-, and NASDAQ-listed firms that engaged in R&D activities over the period 1986-1995. If R&D expenditures are good surrogates for future benefits from R&D activities, and if failure to recognize such expenditures as assets seriously impairs the comparability of financial statements, we would expect adjusted earnings and book values, as compared to reported earnings and book values, to explain a substantially greater proportion of the cross-sectional distribution of share prices. Consistent with previous studies, we find that adjusted earnings and book values explain a significantly larger fraction of the cross-sectional distribution of share prices than reported

-4earnings and book values. However, our results also suggest that the economic significance of this improvement is modest, and that for a large minority of firms, capitalization and amortization of R&D costs substantially reduces the usefulness of earnings and book values for valuation. This suggests that a policy permitting some R&D costs to be capitalized while others are expensed could result in earnings and book value measures that are more useful. To investigate this possibility, we construct surrogates for the accounting numbers that would be reported under such a policy, and compare the explanatory power of these surrogates to that of reported accounting numbers. Results from this analysis suggest that a policy of selective capitalization of R&D costs has the potential to increase the usefulness of summary accounting measures to a degree that is significant not only in statistical terms, but also in economic terms. Taken together, our results suggest that a shift in policy from immediate expensing to capitalization and amortization is likely to result in a meaningful increase in the usefulness of accounting numbers only if preparers are allowed more discretion than is permitted under current accounting standards. The next section of the paper summarizes relevant previous research and discusses the contribution of this study. Section 3 describes our sample selection procedure and provides a description of the resulting sample. Section 4 explains our research design. Section 5 presents our main results, including an analysis of their economic significance. Section 6 presents evidence on the potential for additional improvement from allowing firms to exercise some discretion. We provide a summary and offer some concluding comments in the final section of the paper.

-5-

2. Previous Research on the Value-Relevance of R&D Outlays

An extensive body of research in economics and accounting suggests that investors view R&D expenditures as investments that are expected to produce future benefits. Ben-Zion (1978) provides evidence that differences between firms market values and book values of equity are positively related to R&D outlays. Similarly, Hirschey and Weygandt (1985) provide evidence that the ratio of market value of assets to their replacement cost (Tobins Q) is related to R&D intensity (ratio of R&D outlays to sales). Megna and Klock (1993) conduct a similar analysis within the semiconductor industry, and find a strong association between R&D activity and Tobins Q. Shevlin (1991) provides evidence that both in-house R&D activities and the R&D activities of special-purpose R&D limited partnerships are reflected positively in the equity values of parent firms. Sougiannis (1994) presents some evidence that current and past R&D expenditures are positively associated with both current earnings before R&D expense and current share price. In addition to these valuation studies, Bublitz and Ettredge (1989) provide evidence of a positive association between innovations in R&D expenditures from one year to the next and changes in equity values. Also, a number of studies provide evidence that the stock market reacts positively at the time that a new R&D program is announced (Woolridge 1988, Chan et al. 1990) and at the time that success is announced for an existing R&D program (Austin 1993). Taken together, these studies leave little doubt that investors view R&D expenditures on average as investments that are expected to produce future benefits, and that capitalizing and amortizing R&D costs has the potential to make accounting earnings and book values

-6more useful as indicators of share values. Several recent studies provide more direct evidence on this issue. Loudder and Behn (1995) provide evidence that prior to adoption of SFAS 2, the correspondence between earnings and stock returns was greater for firms that elected to capitalize and amortize R&D costs than for firms that elected to expense R&D costs each period. Lev and Sougiannis (1996) provide evidence that both the incremental R&D expense and the incremental R&D asset that result from capitalizing and amortizing R&D costs capture information that is relevant for valuation beyond that contained in reported earnings.4 Monahan (1999) provides evidence that improvement in the usefulness of earnings and book value is greatest for firms with the largest adjustments to earnings and book value from applying a policy of capitalization and amortization equally across all firms.5 In this study we address two important issues not considered in previous research. First, we provide evidence on the extent to which accounting numbers can be improved as a basis for valuation by an accounting policy that requires all R&D costs to be capitalized and amortized over a uniform period. If most R&D expenditures produce future benefits, such a policy has the potential to enhance the usefulness of accounting numbers without giving managers more discretion than is available under the current requirement to expense R&D costs when incurred. Second, we provide evidence on the magnitude of the additional informational benefits from a selective capitalization policy that gives managers the discretion to expense some

4 In regressions of prices and returns on reported earnings and the incremental R&D expense that would be

reported under a policy of capitalization and amortization, Lev and Sougiannis (1996) find a significant positive coefficient estimate for incremental R&D expense. When they add the R&D asset implied by capitalization and amortization to these regressions, the coefficient estimate for the R&D asset is significantly positive, but the coefficient estimate for incremental R&D expense is no longer significant.

-7R&D costs and to capitalize and amortize others.

3. Sample Selection and Descriptive Statistics

This study is based on firms in the Compustat PST, full coverage, and merged research quarterly and annual databases for any year from 1986 to 1995. We first identified 9,941 firmyears for which at least 10 years of R&D expense (current year and preceding nine years) were available.6 Ten years of R&D expense were required to simulate various amortization periods, as described below. From this sample, we eliminated 2,372 firm-years for which other Compustat data required by our research design were not available. Our main sample is based on the remaining 7,569 firm-years, with yearly observations ranging from 708 to 808. This sample includes 1,472 firms distributed across 52 two-digit (263 four-digit) SIC codes. Table 1 presents percentiles of the distribution of various descriptive variables for the 7,569 firm-years in our final sample. The first three lines of the table indicate that our sample exhibits great variation in firm size, and that book value captures less than half of market value of equity (i.e., "economic" net assets) for nearly half of the observations in the sample. The next two lines of the table reveal that income is negative for slightly more than 25 percent of the sample. Note that sample firms might have negative earnings or book values because of current R&D accounting rules, and to eliminate these firms from the sample would eliminate a group for

5 Monahan (1999) partitions firms on the basis of R&D asset to reflect the size of the adjustment to book

value and on the basis of growth in R&D asset to reflect the size of the adjustment to earnings.
6 Compustat either reports the amount of R&D expense for the firm, or provides a code that indicates that

R&D expense was either missing or immaterial. To be in the final sample, a firm-year must have R&D expense that is not missing for the current year or for any of the previous nine years, and R&D expense must be material in at least one year in the ten-year time series. R&D expense was material for the current year and each of the nine previous years for 91.2 percent of the firm-years in our sample.

-8which capitalization and amortization of R&D costs can potentially provide the greatest informational benefit.7 The last section of table 1 provides information about the magnitudes of R&D expenditures relative to revenues and equity values. For ten percent of the sample, R&D costs were smaller than 0.5% (greater than 12.7%) of sales, and less than 0.6% (greater than 18.7%) of total equity value. This variation suggests that alternative R&D accounting rules have considerable potential to enhance the explanatory power of summary accounting measures for price.

4. Research Design
Our main interest is in the extent to which capitalizing and amortizing R&D costs uniformly across firms enhances the usefulness of summary accounting measures as indicators of share values. We provide evidence on this issue by comparing reported earnings and book values (based on expensing R&D costs as incurred) and adjusted earnings and book values (based on a policy of capitalization and amortization) in terms of their ability to explain the observed cross-section of share prices. This comparison assumes that security prices reflect all public, value-relevant data, and that the usefulness of accounting numbers lies in their ability to summarize these data.8

7 Income from continuing operations (book value of equity) is negative for 26% (3%) of the firm-years in the

final sample.
8 Several studies provide evidence that unrecorded R&D assets are positively associated with future

abnormal stock returns. Lev and Sougiannis (1996) and Lev, Sarath, and Sougiannis (1999) suggest that security prices may not fully reflect accounting information related to R&D costs. Chan, Lakonishok and Sougiannis (1999) report that the positive relation between R&D asset and future abnormal returns is restricted to small firms with growing R&D assets. Lev and Sougiannis (1999) conclude that the future

-9Regression Specification Our research design involves comparing R2s from cross-sectional regressions of price on reported and adjusted summary accounting measures. The structure of our regressions reflects three findings from previous research. First, both theory and empirical evidence indicate that earnings and book values are complementary indicators of share value, jointly explaining more of the observed distribution of share prices than either measure alone.9 This suggests that the usefulness of alternative R&D accounting schemes can best be assessed in the context of a model in which price depends jointly on both earnings and book value. Second, previous research (Lee et al. (1999), Collins and Kothari (1989)) indicates that coefficients relating accounting earnings to prices and stock returns are sensitive to variation in the level of interest rates over time. In addition, coefficients relating both earnings and book values to prices may vary over time in response to changes in their perceived usefulness as indicators of value (Collins et al. (1997)). Thus, our regression specification permits intercepts and slope coefficients to vary from year to year throughout our ten-year study period. Finally, previous studies (Burgstahler and Dichev (1997), Barth et al. (1998), Berger et al. (1995)) suggest that weights relating earnings and book value to price vary predictably with the profitability of current operations. For example, Burgstahler and Dichev model equity value

abnormal returns associated with unrecorded R&D assets is compensation for risk. To the extent that market prices do not reflect all publicly available information with respect to R&D activities, our tests will be biased against finding an improvement from capitalizing and amortizing R&D costs.
9 For theory, see Burgstahler and Dichev (1997), Barth et al . (1998), Berger et al . (1995), Ohlson (1995),

Feltham and Ohlson (1995), and Penman (1998). In the first three of these studies, the "complementarity" of earnings and book value arises because earnings surrogates for the "value in use" of the firm's net assets, while book value surrogates for their value in liquidation or in alternative uses. In the last three studies, share value is a weighted combination of earnings and book value, with weights that depend on the

- 10 as a convex combination of "expected earnings" from continuing the firm's current operations and the independent "adaptation value" of the firm's net assets for alternative uses. In this model, as the ratio of expected earnings to adaptation value increases (i.e., as the relative profitability of current operations increases), expected earnings becomes relatively more important than adaptation value for valuation. Its weight in the valuation relation increases, while that for adaptation value declines.10 Both Burgstahler and Dichev (1997) and Barth et al. (1998) report analogous empirical relations among price, reported earnings, and reported book value, suggesting that prices behave as if investors view accounting earnings and book value as surrogates for expected earnings and adaptation value. Our regression specification takes this predictable variation in weights into account. Specifically, we rank firms in our sample, within years, on the basis of the ratio of net income to total assets. We then assign observations in the top 25 percent, middle 50 percent, and bottom 25 percent of this ranking to high, "middle," and "low" earnings-to-assets groups, respectively, and permit intercepts and slope coefficients to vary across groups.11 This partitioning has two potential benefits. First, the studies cited above suggest that constraining regression coefficients to be equal across earnings-to-asset groups will likely result in an understatement of the extent to which both reported and adjusted accounting measures explain the distribution of prices.

"persistence" of earnings. For empirical evidence of complementarity, see Burgstahler and Dichev (1997), Barth et al. (1998), Penman (1998), and Collins et al. (1997).
10 In the Burgstahler and Dichev model, as the ratio of expected earnings to adaptation value grows "large,"

their weights in the valuation relation converge to the inverse of the discount rate and zero, respectively -i.e., expected earnings becomes sufficient for valuation. Conversely, as the ratio of expected earnings to adaptation value grows "small," their weights converge to zero and one, and adaptation value becomes sufficient for valuation.

- 11 Second, and more importantly, removing this constraint allows adjusted earnings and adjusted book values to separately affect firms for which one measure or the other is most value-relevant, and failure to do so may understate the potential informational gains from capitalization and amortization. In summary, to compare the extent to which reported and adjusted earnings and book values explain cross-sectional variation in share prices, we use all firm-years in the sample described in section 3 to estimate the following cross-sectional regressions: Pi = Z ti D ji a0 jt + a1 jt ERi + a2 jt BVRi + ei
t =1 j =1 10 3

[
[

(1)

Pi = Z ti D ji b0 jt + b1 jt EAi + b2 jt BVAi + et
t =1 j =1

10

(2)

In these regressions, Pi is firm i's stock price three months after the end of its fiscal year. In (1), ERi ("reported earnings") is per share income from continuing operations available for common stockholders, and BVRi ("reported book value") is the per share book value of common stockholders' equity at year-end, both as reported based on the current requirement to expense R&D costs. In (2), EAi ("adjusted earnings") and BVAi ("adjusted book value") are per share income from continuing operations available for common stockholders and per share book value of common stockholders' equity, respectively, both adjusted to reflect capitalization and amortization of R&D costs. In both regressions, indicator variables Dji (j = 1,..,3) and Zti (t = 1,..,10) permit intercepts and slope coefficients to differ across the low, medium, and high

11 Burgstahler and Dichev (1997) group sample firms based on the ratio of earnings to book value of equity.

We use assets as the denominator because book value can be negative for firms in our sample. However,

- 12 earnings-to-assets groups and across the 10 years in the study period, respectively. Regressions (1) and (2), together with our sampling criteria, provide a basis for assessing whether capitalization and amortization rules for R&D costs, applied consistently over the past decade by firms engaging in R&D activities, would have increased the extent to which summary accounting measures explain the distribution of stock prices. If the R2 for regression (2) is significantly larger than the R2 for regression (1), we will conclude that substituting simple capitalization and amortization rules for the current requirement to expense R&D costs as incurred would have enhanced the usefulness of earnings and book values as indicators of share value. Measurement of Adjusted Earnings and Book Values As indicated above, we examine two alternative rules for capitalizing and amortizing R&D costs. The first rule requires capitalization of all R&D expenditures and imposes a single "one-size-fits-all" amortization period on all firms in the sample. The second allows the amortization period to vary across industries, but requires a single amortization period within each industry. Ex ante, we do not know the length of the one-size-fits-all amortization period that best reflects the underlying economics of investments in R&D activities for our sample as a whole. Therefore, we estimate regression (2) for a range of amortization periods, which are designated as having length K. For each K, R&D amortization is equal to the sum of all R&D costs incurred in the current and K - 1 previous years, divided by K, and earnings is adjusted by

our results are not sensitive to this substitution.

- 13 adding back reported R&D expense and subtracting R&D amortization. Similarly, book value is adjusted to reflect an R&D asset equal to the sum of all R&D costs incurred in the current and K - 1 previous years less the portion amortized through the end of the current year.12 We adjust earnings and book values in this way for K = 2 up to K = 10. (For K = 1, all R&D costs in a particular year are expensed, and regression (2) is identical to regression (1)). If the R2 for regression (2) varies with K, we will conclude that the version of regression (2) with the highest R2 is the one that best reflects the average economic lives of research and development assets for firms in our sample. To determine the industry-specific amortization periods required by our second rule, we estimate regression (2) for K = 2 to K = 10 separately for firm-years in each two-digit SIC code that contributes at least 250 observations to the sample, and for a miscellaneous industry that includes all observations from two-digit SIC codes with fewer than 250 observations.13 Based on these results, we select the K for each industry that maximizes the regression (2) R2 as the "best fit" amortization period for that industry.

5. Main Results
Comparisons of Explanatory Power Table 2 indicates how capitalizing and amortizing R&D costs over various "one-size-

12 Both of these adjustments are made on a net-of-tax basis because we assume that they affect the

computation of tax expense, but not the amount of taxes paid. Thus, the adjustment to net income is to add back reported R&D expense times (1 T) and subtract R&D amortization times (1 T), where T is the corporate statutory tax rate for each year. Similarly, the adjustment to net book value is to add the R&D asset times (1 T).
13 In estimating regression (2) for each industry, we divide the industry subsample into low, middle, and

high earnings-to-assets groups using earnings-to-assets cutoffs determined for the sample as a whole.

- 14 fits-all" amortization periods affects the extent to which earnings and book values explain the cross-section of prices. The first row of the table reports results for regression (1), based on reported earnings and book values (i.e., for K = 1). The remaining rows report results for regression (2), with amortization periods for capitalized R&D costs ranging from K = 2 through K = 10. Each row reports average coefficient estimates across the ten years in the study period, t -statistics based on the cross-year distribution of coefficient estimates, and the adjusted R2. The final column of the table shows differences between the adjusted R2s for regressions (2) and (1). The estimated slope coefficients for regression (1), based on reported earnings and book values, exhibit a pattern that is consistent with the empirical results reported in Burgstahler and Dichev (1997). Average coefficient estimates for earnings are positively associated with the ratio of earnings to assets, ranging from 0.62 for the low group to 6.54 for the middle group and 9.51 for the high group.14 Average coefficient estimates for book value are negatively associated with the ratio of earnings to assets, ranging from 0.76 for the low group to 0.70 for the middle group and 0.32 for the high group. Also consistent with Burgstahler and Dichev's results, a comparison of the R2 for regression (1) (0.7410) to the R2 for an "unpartitioned" version of the regression (0.6386, not reported in the table) indicates that permitting regression coefficients to vary across earnings-to-asset groups substantially increases the measured explanatory power of earnings and book values.

14 The negative (and significant) earnings coefficient estimate for the low earnings-to-asset group is

theoretically unexpected but consistent with empirical results reported in previous studies. Earnings is negative for all observations in this group, and similar results have been reported for negative earnings firms in Jan and Ou (1994), Collins et al. (1999), and Burgstahler and Dichev (1997).

- 15 The R2 for regression (1), 0.7410, indicates that summary accounting measures based on the current requirement to expense R&D costs as incurred explain a large proportion of the cross-sectional variation in prices. At all levels of K, however, the R2s for regression (2), based on adjusted earnings and book values, are greater than the R2 for regression (1). The R2 difference increases monotonically until it reaches a maximum at K = 9, and then declines slightly when K = 10, suggesting an amortization period of nine years as the empirical "best fit" onesize-fits-all rule for the firms and years in our sample.15 Table 3 compares the explanatory power of regression (2) at K = 9 to the explanatory power of regression (1). The first row of the table shows the R2s for the two regressions, their difference, and a Z-statistic based on Vuong's (1989) likelihood ratio test for equivalence of explanatory power.16 At K = 9, the R2 difference of 0.0135 has a Z-statistic of 4.14, which indicates rejection of the null hypothesis of equal explanatory power at or below the 1% confidence level.17 We also estimate separate versions of regressions (1) and (2) (at K = 9) for the low, medium, and high earnings-to-assets groups in order to determine how our one-size-fits-all rule affects each group. The R2s, R2 differences, and associated Z-statistics for these group-by-

15 In all three earnings-to-assets groups, the estimated slope coefficients for earnings and book value

generally diminish in magnitude as the amortization period (K) lengthens. This is consistent with earnings and book value measures that are generally increasing in magnitude over the range of K. That is, earnings and book value measures that are larger on average require smaller coefficients to compute the same share price.
16 Vuong's test compares the sum of squared residuals from two alternative non-nested regressions that

have the same dependent variable, and therefore the same total sum of squares. The Z-statistic has a unit normal distribution under the null hypothesis of equal explanatory power, and is constructed to be positive if the R2 for regression (2) exceeds the R2 for regression (1). See Dechow (1994) for a discussion and for computational details.

- 16 group regressions are reported in the next three rows of table 3.18 For the low and high groups the R2 difference is larger and more significant than for the sample as a whole, while for the middle group the R2 difference is not statistically significant. This indicates that capitalization and amortization results in the greatest improvement in explanatory power when that explanatory power is provided primarily by either earnings or book values. Our second capitalization and amortization rule for R&D costs permits amortization periods that vary across industries but which are identical for firms within industries. To provide evidence on the potential informational benefits from this rule, we first estimate "best-fit" industry-specific amortization periods using the procedure described in section 4. We then reestimate regression (2) for the entire sample, using these amortization periods as the basis for measuring EA and BVA. Table 4 reports the results for this analysis. The first panel lists the industry categories on which the analysis is based, the number of firm-years in each category, and the "best-fit" estimated amortization period for firms in each category. The second panel compares R2s for regression (2), based on earnings and book values adjusted using industry-specific amortization periods, to those for regression (1), based on reported accounting numbers. As in table 3, R2s, R2 differences, and Z-statistics are shown for the sample as a whole and for the low, middle, and high earnings-to-assets subsamples. For the sample as a whole, the R2 for regression (2) is significantly greater than that for regression (1) by 0.0157 (Z = 4.74). This difference is slightly

17 All R2 differences reported in the right-most column of table 2 are significantly different from zero (Z >

2.0).
18 By construction, the coefficient estimates and cross-year t -statistics for the group-by-group regressions

are identical to those reported in table 2.

- 17 greater than the difference reported in table 3 for the one-size-fits-all amortization period. R2 differences are also positive and significant for all three earnings-to-assets groups. Sensitivity Analyses and Specification Checks We conducted a variety of sensitivity analyses and specification checks to determine the robustness of the results reported in tables 2, 3, and 4. First, we computed the collinearity diagnostics discussed in Belsley, Kuh and Welsch (1980), and found no evidence that collinearity is an issue in any of the regressions reported in this paper. Second, we conducted randomization tests to determine whether our Z-statistics overstate the significance of the R2 differences reported in tables 3 and 4 due to dependence among the observations in the sample. For both K=9 and industry-specific amortization periods, we estimated 200 pairs of regressions where (for each firm-year in each pair of regressions) we randomly assigned reported earnings and book value to one regression and adjusted earnings and book value to the other. The resulting distributions of R2 differences simulate the distributions that would be expected under the null hypothesis of no difference in explanatory power, given the dependence structure of the data. We found that the actual R2 differences we report in tables 3 and 4 for the sample as a whole are both larger than all 200 differences from their respective simulated distributions, indicating significance at or below the 0.5% confidence level for a one-tailed test. This suggests that our Z-statistics are not overstated. Third, we replicated our industry-specific amortization period results using the industry categories and amortization periods reported in Lev and Sougiannis (1996, table 3). Unlike

- 18 ours, their amortization periods are estimated based on the relation between past R&D expenditures and future earnings. The results for this analysis are similar to those discussed above (R2 difference of 0.0152, Z = 5.46). Finally, we also replicated the R2 comparisons reported in table 4 for three additional specifications of regressions (1) and (2). The first alternative specification is based on the residual income model (see Ohlson 1995).19 The second alternative involves regressing raw stock returns for the 12 months preceding our valuation date on reported and adjusted versions of the level of annual earnings and the change in earnings. In the last alternative specification we return to the original versions of equations (1) and (2) and constrain the slope coefficients to be constant across earnings-to-assets groups. Overall the results for these three alternative specifications are similar to those reported above, except that the analysis using raw returns produces R2 differences that are smaller and not statistically significant. Economic Significance In this section, we evaluate the economic significance of the increase we observe in the ability of earnings and book values to explain prices. To address this issue, we use the estimated coefficients from regressions (1) and (2) to compute fitted prices for each sample observation. These fitted prices indicate what an investor's assessment of share price would have been if based solely on reported accounting numbers or solely on adjusted accounting numbers. We then compare absolute deviations of fitted price from actual market price for

19 The independent variables are reported and adjusted book values and reported and adjusted "residual

income," which is the difference between earnings and a "normal" return on book value. We used an interest rate of 12 percent to compute the normal return on book value.

- 19 regressions (1) and (2), each as a percentage of market price, in order to indicate the extent to which pricing error is reduced by relying on adjusted rather than reported accounting numbers. This comparison is equivalent to comparing regression residuals, and so technically provides no new information beyond that contained in tables 2-4. However, by expressing differences in units of price rather than units of explanatory power, this comparison provides a more interpretable scale for evaluating the economic significance of our results.20 Table 5 reports the distribution of differences between absolute pricing errors from regressions (1) and (2), as a percentage of actual market price, for the sample as a whole and for the low, middle, and high earnings-to-assets subsamples. This difference indicates the revision in absolute pricing error from capitalizing and amortizing R&D costs rather than expensing them. The final column in the table reports the percent of the sample for which the difference is positive. This indicates the frequency with which fitted prices based on adjusted accounting numbers predict actual prices more accurately than those based on reported accounting numbers. For the sample as a whole, the average decline in pricing error from capitalizing and amortizing R&D costs is 8.6 percent of market value of equity. However, the distribution of differences exhibits great variation, and the difference is positive, representing a reduction in pricing error using adjusted accounting numbers, for only 56 percent of the full sample. This percentage is higher for the low and high profitability groups, but is still below 60 percent for those two groups. A comparison of pricing error increases at the 5th, 10th, and 25th percentiles

20 Note that because this analysis is strictly in-sample, it cannot be used to infer what the out-of-sample

prediction accuracy of alternative accounting numbers would be. It is also important to note that this

- 20 to pricing error reductions at the 95th, 90th, and 75th percentiles indicates that adjusting accounting numbers to reflect capitalization and amortization of R&D costs tends to produce larger pricing error reductions than pricing error increases. However, the pricing errors increase by more than five percent for more than 25 percent of the sample. Thus, while there is substantial reduction in pricing error for some firms, for others there is a substantial increase in pricing error, suggesting that capitalization and amortization may reduce the usefulness of earnings and book values for a significant minority of firms. Summary of Main Results The results reported in tables 2-4 indicate that, for the sample as a whole, capitalizing and amortizing R&D costs using simple no-discretion rules applied uniformly by all firms results in a small but statistically significant increase in the extent to which earnings and book values jointly explain the cross-sectional distribution of share prices. In addition, the limited extent of pricing error reductions from capitalization and amortization reported in table 5 suggests that the economic significance of the improvement from requiring all firms to capitalize and amortize R&D costs is modest at best. Finally, the distribution of pricing error revisions in table 5 indicates that for a substantial number of observations in our sample, capitalizing and amortizing R&D costs appears to make earnings and book value less useful, not more useful. In the next section, we present evidence on whether a policy of selective capitalization and amortization, under which some R&D costs are expensed and others are capitalized and amortized, has the potential to further enhance the usefulness of summary accounting measures for valuation.

comparison assumes a symmetric loss function.

- 21 -

6. Selective Capitalization and Amortization

The SFAS No. 2 requirement to expense R&D costs when incurred is frequently criticized because it ignores legitimate assets resulting from R&D investments. At the same time, our main results suggest that a uniformly applied policy of capitalizing and amortizing R&D costs has at best a very modest impact on the extent to which summary accounting measures explain observed prices, and hence on their usefulness for valuation. One interpretation of these results is that the R&D asset and expense measures produced by our no-discretion capitalization and amortization rules are generally very noisy indicators of future benefits and their consumption. An alternative interpretation, suggested by the distribution of pricing errors reported in table 5, is that these measures are reasonable indicators of future benefits and consumption for most observations in the sample, but are very poor indicators for some observations. Table 5 indicates that remeasuring earnings and book values based on capitalization and amortization either reduces pricing error or leaves it nearly unchanged for about three fourths of the sample, but results in substantial pricing error increasesin excess of five per cent of pricefor the remaining fourth. This pattern of pricing error reductions and increases suggests that a policy which permits some R&D costs to be expensed, and others capitalized and amortized, has the potential to make summary accounting measures more useful for valuation than policies which require either uniform expensing or uniform capitalization and amortization. We refer to this alternative as selective capitalization and amortization. To provide evidence on the magnitude of the potential benefits from selective

- 22 capitalization and amortization, we reestimate regression (2) using two different proxies for the accounting numbers that would be generated under such a rule, and compare the adjusted R2s for these regressions to the R2 for regression (1). The first proxy is very simple and depends completely on hindsight. For observations that fall in the first quartile of the table 5 pricing error reduction distributionthose whose pricing errors increased substantially as a result of capitalization and amortizationwe measure EA and BVA as reported, i.e., based on immediate expensing of R&D costs. For all other observations, EA and BVA are based on capitalization of R&D costs with industry-specific amortization periods.21 For our second proxy we expense R&D for observations that have (a) large negative pricing errors from regression (1) and (b) large R&D adjustments from capitalization and amortization. Condition (a) insures that these observations are priced substantially below the level indicated by the average relation among prices, earnings, and book values, while condition (b) indicates that these are also firms that have made significant R&D investments in the past. Because these R&D investments do not appear to be valued by the market at present, these firms can be viewed as the subset of our sample for which capitalization and amortization is least appropriate.22 For all other observations, EA and BVA are based on capitalization of R&D

21 For this proxy, R&D costs are expensed for 1,890 observations and capitalized and amortized for the

remaining 5,679 observations.

22 To operationalize condition (a), we first rank the absolute values of pricing errors from regression (1),

within years, from largest to smallest, and then identify negative pricing errors from the upper two-thirds of each of the year-by-year rankings as large and negative. To operationalize condition (b), we combine R&D book value adjustments (BVA BVR) and earnings adjustments (EA ER) from capitalization and amortization using as weights the relevant book value and earnings coefficient estimates from regression (1), and then rank the resulting sums from largest to smallest, within years. Observations in the upper third of each year-by-year ranking are identified as those experiencing large R&D adjustments from capitalization and amortization.

- 23 costs with industry-specific amortization.23 Table 6 reports the results of this analysis. Each panel of the table compares R2s from regression (1) and from regression (2) based on selective capitalization and amortization. In panels A and B, respectively, the selective capitalization and amortization results are based on our first and second proxies for the accounting numbers that would be generated under such a policy. The results in both panels indicate that the potential increase in explanatory power from a policy of selective capitalization is much larger than that observed under a policy that applies capitalization and amortization uniformly across firms and time. For our first proxy, the R2 increase from selective capitalization is 0.0405 (Z = 15.91), about two-and-a-half times as great as the R2 increase of 0.0157 (Z = 4.47) from uniformly applied capitalization and amortization. For the second proxy, the R2 increase (0.0468, Z = 18.14) is somewhat larger.24 We also compare pricing error reductions from regression (1), based on reported earnings and book values, to the selective capitalization versions of regression (2). As before, we tabulate absolute deviations of fitted price from actual market price for the two regressions, each as a percentage of market price, in order to indicate the extent to which pricing error is reduced by relying on adjusted rather than reported accounting numbers. The results of this comparison are reported in table 7 for both versions of selective capitalization and amortization.

23 For this proxy, R&D costs are expensed for 862 observations and capitalized and amortized for the

remaining 6,709 observations. Of the 862 observations for which R&D costs are expensed, 525 (61 percent) are in the first quartile of pricing error reductions reported in table 5.
24 These results are consistent with the results of a simulation reported by Healy et. al. (1999), based on

hypothetical pharmaceutical firms. They find that accounting data based on expensing current R&D costs (cash accounting) and on one-size-fits-all capitalization and amortization rules (full cost accounting) exhibit no difference either in correlation with economic returns or in usefulness for predicting economic values. On the other hand, they find that selective capitalization (successful efforts accounting) does improve accounting numbers on these dimensions.

- 24 For our second proxy (panel B), the mean (median) pricing error revision from using selective capitalization is 0.19 (0.05), compared with 0.09 (0.02) reported in table 5 for uniformly applied capitalization and amortization. Selective capitalization and amortization results in pricing error reductions for 68 percent of the sample, as opposed to 56 percent for uniform capitalization and amortization, Finally, the number of firms with large increases in pricing error has decreased substantially. When we applied industry-specific amortization periods to all firms, 25.6 percent of the sample had pricing error increases of at least 5 percent. When we applied selective capitalization, that fraction drops to 15.6 percent. Very similar results are reported for our first proxy in panel A. Our main results, reported in section 5, indicate that no-discretion capitalization and amortization rules have very limited potential to increase the usefulness of summary accounting measures as indicators of value. In contrast, our analysis based on surrogates for selective capitalization suggests that allowing firms to exercise discretion in identifying costs to be capitalized can potentially result in a much greater increase in the usefulness of these measures. We expect that these results underestimate the potential for a discretionary R&D rule to provide more useful accounting measures to the extent that our implementation of selective capitalization could be improved upon by mangers intent upon communicating their superior information. On the other hand, these results may overestimate the informational benefits that would actually result to the extent that managers would use their discretion to obscure rather than reveal the economic position and performance of their firms. Whether this is the case will depend on the incentives of managers to report opportunistically and on the extent to which the

- 25 audit process is capable of counteracting those incentives.25

7. Summary and Conclusions

The current requirement to expense R&D costs when incurred is often criticized on the grounds that it reduces the relevance of accounting numbers to investors. This paper begins by examining whether simple capitalization and amortization rules for R&D costs that give managers no more discretion than is available under current R&D accounting standards have the potential to increase the usefulness of accounting numbers as a basis for valuation. We provide evidence on this issue by documenting the impact of such rules on the extent to which earnings and book values jointly explain the cross-sectional distribution of share prices for a large sample of publicly-traded firms over the period 1986-1995. Consistent with prior research, we find that summary accounting measures explain a significantly greater fraction of the distribution of share prices when adjusted to reflect capitalization and amortization of R&D costs. However, the economic benefit from nodiscretion capitalization and amortization appears to be small, and for a substantial minority of firms, this alternative accounting policy appears to reduce the usefulness of summary accounting measures for valuation. Finally, we find that surrogates for a policy of selective capitalization

25 Evidence from two recent studies suggests that on balance permitting some discretion may increase the

usefulness of accounting numbers. Chambers et al. (1999) report that earnings and book values based on reported depreciation (which reflects managers' estimates of useful life and residual value) explain significantly more of the variation in share prices than earnings and book values based on a "no-discretion" depreciation rule (in which past capital expenditures are averaged over industry-specific useful lives). Healy et al. (1999) provide simulation evidence suggesting that managerial discretion has the potential to greatly increase the usefulness of R&D accounting numbers, even when preparers have (simulated) incentives to manage earnings. See Verrecchia (1990), Healy and Palepu (1993), and Newman and Sansing (1993) for

- 26 and amortization, which permits firms to expense some R&D costs and to capitalize and amortize others, result in earnings and book value measures that explain substantially more of the cross-section of prices than those produced by either requiring all firms to expense all R&D costs or requiring them to uniformly capitalize and amortize these costs. Thus, our results suggest that substantial managerial discretion over the choice of costs to be capitalized and the rate at which such costs are expensed is likely to be a necessary (though hardly sufficient) ingredient of any alternative R&D accounting scheme that is capable of producing economically significant financial reporting benefits. The extent of such benefits would depend on managers incentives to use their discretion opportunistically and on the ability of the audit process to place reasonable bounds on such behavior.

additional discussion of incentives to disclose, and see Schipper (1989) for discussion of earnings management.

- 27 References Austin, D. H. 1993. An event-study approach to measuring innovative output: the case of biotechnology. The American Economic Review 83: 253-58. Barth, M. E., W. H. Beaver, and W. R. Landsman. 1998. Relative valuation roles of equity book value and net income as a function of financial health. Journal of Accounting and Economics 25: 1-34. Belsley, D. A., E. Kuh, and R. E. Welsch. 1980. Regression Diagnostics: Identifying Influential Data and Sources of Collinearity. New York: John Wiley & Sons. Ben Zion, U. 1978. The investment aspect of nonproduction expenditures: an empirical test. Journal of Economics and Business 30: 224-29. Berger, P.G., E. Ofek, and I. Swary. 1995. Investor evaluation of the abandonment option. Working paper, University of Pennsylvania. Biddle, G. C., R. M. Bowen, and J. S. Wallace. 1999. Evidence on EVA . Working paper, University of Washington. Brennan, B. A. 1992. Mind over matter. CA Magazine: 21-24. Brown, S., K. Lo, and T. Lys. 1999. Use of R2 in accounting research: measuring changes in value relevance over the last four decades. Working paper, Kellogg Graduate School of Management, Northwestern University. Bublitz, B., and M. Ettredge. 1989. The information in discretionary outlays: advertising, and research and development. The Accounting Review 64: 108-24. Burgstahler, D. C., and I. D. Dichev. 1997. Earnings, adaptation and equity value. The Accounting Review 72: 187-215. Chan, L. K. C., J. Lakonishok, and T. Sougiannis. 1999. The stock market valuation of research and development expenditures. Working paper, University of Illinois at Urbana-Champaign Chan, S., J. Martin, and J. Kensinger. 1990. Corporate research and development expenditures and share value. Journal of Financial Economics 26: 255-76. Chambers, D., R. Jennings, and R. Thompson. 1999. Evidence on the usefulness of capital expenditures as an alternative measure of depreciation. Review of Accounting Studies 4: 169-195. Collins, D.W. and Kothari, S.P. 1989. An analysis of intertemporal and cross-sectional determinants of earnings response coefficients. Journal of Accounting and Economics 11: 143-181. Collins, D. W., E. L. Maydew, and I. S. Weiss. 1997. Changes in the value-relevance of earnings and book values over the past forty years. Journal of Accounting and Economics 24: 39-67. Collins, D. W., M. Pincus, and H. Xie. 1999. Equity valuation and negative earnings: the role of book value of equity. The Accounting Review 74: 29-61.

- 28 Dechow, P. M. 1994. Accounting earnings and cash flows as measures of firm performance: the role of accounting accruals. Journal of Accounting and Economics 17: 3-42. Feltham, G., and J. A. Ohlson. 1995. Valuation and clean surplus accounting for operating and financial activities. Contemporary Accounting Research 11: 689-732. Financial Accounting Standards Board. 1974. Statement of Financial Accounting Standards No. 2: Accounting for Research and Development . Norwalk, CN: FASB. Francis, J., and K. Schipper. 1996. Have financial statements lost their relevance? Working paper, University of Chicago. Healy, P. M., and K. G. Palepu. 1993. The effect of firms financial disclosure strategies on stock prices. Accounting Horizons 7: 1-11. Healy, P. M., S. C. Myers, and C. D. Howe. 1999. R&D accounting and the tradeoff between relevance and objectivity. Working paper, Harvard Business School. Hirschey, M. and J. Weygandt. 1985. Amortization policy for advertising and research and development expenditures. Journal of Accounting Research 23: 326-35. International Accounting Standards Committee. 1997. Proposed International Accounting Standard: Intangible Assets (Exposure Draft E60). London: IASC. Jan, C., and J. Ou. 1994. The role of negative earnings in the valuation of equity stocks. Working paper, New York University. Lee, C. M. C., J. Myers, and B. Swaminathan. 1999. What is the intrinsic value of the Dow? Journal of Finance 54: 1693-1741. Lev, B., and P. Zarowin. 1999. The boundaries of financial reporting and how to extend them. Journal of Accounting Research 37: 353-385. Lev, B., and T. Sougiannis. 1996. The capitalization, amortization and value-relevance of R&D. Journal of Accounting and Economics 21: 107-38. Lev, B., and T. Sougiannis. 1999. Penetrating the book-to-market black box: the R&D effect. Journal of Business Finance & Accounting 26: 419-449. Lev, B., B. Sarath, and T. Sougiannis. 1999. R&D-related reporting biases and their consequences. Working paper, New York University. Loudder, M. L., and B. K. Behn. 1995. Alternative income determination rules and earnings usefulness: the case of R&D costs. Contemporary Accounting Research 12: 185205. Megna, P., and M. Klock. 1995. The impact of intangible capital on Tobins q in the semiconductor industry. The American Economic Review 83: 265-69. Monahan, S. 1999. Conservatism, growth and the role of accounting numbers in the equity valuation process. Working paper, University of Chicago.

- 29 Newman, P., and R. Sansing. 1993. Disclosure policies with multiple users. Journal of Accounting Research 31: 92-112. Ohlson, J. A. 1995. Earnings, book values, and dividends in equity valuation. Contemporary Accounting Research 11: 661-687. Penman, S. H. 1998. Combining earnings and book value in equity valuation. Contemporary Accounting Research 15: 291-324. Schipper, K. 1989. Commentary on earnings management. Accounting Horizons 3: 91-102. Shevlin, T. 1991. The valuation of R&D firms with R&D limited partnerships. The Accounting Review 66: 1-21. Sougiannis, T. 1994. The accounting based valuation of corporate R&D. The Accounting Review 69: 44-68. Stewart III, G.B. 1991. The Quest for Value. HarperCollins. Stewart, T. A. 1995. Trying to grasp the intangible. Fortune (October 2): 157-58. Verrecchia, R. 1990. Information quality and discretionary disclosure. Journal of Accounting and Economics 8: 365-80. Vuong, Q. H. 1989. Likelihood ratio tests for model selection and non-nested hypotheses. Econometrica 57: 307-33. Wallman, S. M. H. 1995. The future of accounting and disclosure in an evolving world: the need for dramatic change. Accounting Horizons 9: 81-91. Woolridge, R. 1988. Competitive decline and corporate restructuring: is a myopic stock market to blame? Journal of Applied Corporate Finance 1: 26-36.

- 30 -

Table 1 Distribution of Descriptive Variables for Final Sample

Variable

10

25

Percentile 50

75

90

MV of common equity ($millions) BV of common equity ($millions) BV of common equity/MV of common equity (%)

6.2 3.1 16.5

20.9 12.0 33.2

99.7 57.2 56.1

747.8 323.4 87.2

3,583.7 1,495.4 130.6

Income from continuing operations/Assets (%) Income from cont. operations/MV of com. equity (%)

-12.7 -20.7

-0.4 -0.6

4.2 4.8

8.0 7.4

11.9 10.4

R&D expense, as reported ($millions) R&D expense/Sales (%) R&D expense/MV of common equity (%)

0.2 0.5 0.6

0.9 1.2 1.7

4.4 3.1 4.1

23.0 7.1 9.5

123.3 12.7 18.7

- 31 -

Table 2 Regressions of Share Price on Per-Share Earnings and Book Values For Alternate "One Size Fits All" R&D Accounting Rules

Quartile 1 (Lowest E/A) K Int E BV Int

Quartiles 2&3 E BV

Quartile 4 (Highest E/A) Int E BV R2 R2 Difference

1 (As Reported) 2

3.13 (3.78) 3.10 (3.76) 3.06 (3.75) 3.03 (3.75) 3.00 (3.76) 2.98 (3.77) 2.96 (3.79) 2.95 (3.81) 2.93 (3.83) 2.93 (3.85)

-0.62 (-2.50) -0.52 (-2.07) -0.36 (-1.76) -0.29 (-1.41) -0.29 (-1.11) -0.23 (-0.85) -0.17 (-0.63) -0.12 (-0.45) -0.08 (-0.30) -0.05 (-0.17)

0.76 (10.70) 0.75 (10.74) 0.74 (10.86) 0.73 (10.95) 0.71 (11.09) 0.70 (11.23) 0.69 (11.40) 0.67 (11.57) 0.66 (11.75) 0.65 (11.93)

4.28 (14.00) 4.09 (13.00) 3.95 (12.03) 3.84 (11.36) 3.76 (10.89) 3.69 (10.52) 3.65 (10.27) 3.62 (10.09) 3.60 (9.94) 3.59 (9.83)

6.54 (20.55) 6.35 (20.85) 6.22 (21.32) 6.12 (21.50) 6.05 (21.50) 5.99 (21.48) 5.94 (21.32) 5.90 (21.28) 5.86 (21.53) 5.82 (21.70)

0.70 (10.58) 0.71 (10.53) 0.71 (10.46) 0.71 (10.37) 0.70 (10.28) 0.69 (10.25) 0.68 (10.20) 0.66 (10.11) 0.65 (9.99) 0.64 (9.88)

7.72 (10.05) 7.51 (9.94) 7.35 (9.81) 7.25 (9.73) 7.16 (9.78) 7.10 (9.85) 7.08 (9.95) 7.06 (10.00) 7.06 (10.07) 7.06 (10.10)

9.51 (7.77) 9.45 (7.82) 9.38 (7.93) 9.32 (7.98) 9.28 (8.06) 9.25 (8.15) 9.21 (8.28) 9.17 (8.45) 9.14 (8.60) 9.10 (8.71)

0.32 (1.77) 0.31 (1.74) 0.31 (1.73) 0.30 (1.71) 0.29 (1.67) 0.28 (1.62) 0.27 (1.59) 0.26 (1.56) 0.25 (1.53) 0.24 (1.50)

0.7410

0.7447

0.0037

0.7475

0.0064

0.7496

0.0086

0.7516

0.0106

0.7531

0.0121

0.7539

0.0129

0.7544

0.0134

0.7545

0.0135

10

0.7542

0.0132

- 32 -

Table 2 (continued) The table summarizes estimation results for regressions (1) and (2):

Pi = Z ti D ji a0 jt + a1 jt ERi + a2 jt BVRi + ei
t =1 10 j =1 3

10

[
[

(1)

Pi = Z ti D ji b0 jt + b1 jt EAi + b2 jt BVAi + et
t =1 j =1

(2)

Each regression is estimated using our final sample of 7,569 firm-years from the period 1986-1995. Pi is firm i's share price three months after year-end. In regression (1), ERi is per-share income from continuing operations and BVRi is per-share book value of common stockholders' equity at year-end, both as reported based on the current requirement to expense R&D costs as incurred. In regression (2), EAi and BVAi are per share income from continuing operations and book value of equity adjusted to reflect capitalization of R&D costs with straight line amortization over K years. Z is an indicator variable that permits intercepts and slope coefficients to vary from year to year. D is an indicator variable that permits intercepts to vary across three regions (lowest quartile, second and third quartiles, and highest quartile) of the distribution of earnings to beginning-of-year total assets. For each regression, the table reports average coefficient estimates across the 10 years in the study period, t-statistics based on the cross-year distribution of coefficient estimates, and the adjusted R2. The "K = 1" row shows results for regression (1), while the "K = 2" through "K = 10" rows show results for regression (2). The final column of the table shows the gain in explanatory power, relative to that for "As Reported" earnings and book values, that results from applying a Kperiod capitalization and amortization rule uniformly across all firms and years in the sample.

- 33 -

Table 3 Comparison of R2s for Regressions of Share Price on Per-Share Reported Earnings and Book Values and on Per-Share Adjusted Earnings and Book Values Based on "One-Size-Fits-All" (K = 9) Capitalization and Amortization Rule -- Full Sample and Three E/A Subsamples --

Sample/Subsample

R2 AsReported

R2 Adjusted

R2 Difference

Full sample

7,569

0.7410

0.7545

0.0135

4.14

E/A quartile 1 E/A quartiles 2&3 E/A quartile 4

1,890 3,788 1,891

0.4818 0.7422 0.6741

0.5142 0.7511 0.6964

0.0324 0.0089 0.0223

3.81 1.53 4.25

This table compares R2s from regressions of share price on per-share reported earnings and book values (regression (1)) to those from regressions of share price on per-share earnings and book values adjusted to reflect capitalization R&D costs with straight line amortization over 9 years for all firms (regression (2)). Comparisons are reported for our full sample of 7,569 firm-years and for three subsamples representing regions of the distribution of earnings to total assets (E/A). In the full sample regressions, intercepts and slope coefficients are allowed to vary across years and across regions of the E/A distribution. In the subsample regressions for individual regions of the E/A distribution, intercepts and slope coefficients are allowed to vary across years. The final column of the table shows Z-statistics based on Vuong's [1989] likelihood ratio test for equivalence of explanatory power in non-nested models.

- 34 -

Table 4 Comparison of R2s for Regressions of Share Price on Per-Share Reported Earnings and Book Values and on Per-Share Adjusted Earnings and Book Values Based on "Industry-Specific" Capitalization and Amortization Rule -- Full Sample and Three E/A Subsamples --

SIC Code/Industry 28 34 35 36 37 38 73 n/a Chemicals/pharmaceuticals Fabricated metal products Machinery/computer hardware Electrical/electronics Transportation vehicles Scientific instruments Business services All other

N 893 264 1,356 1,310 333 1,153 334 1,926

Industry-Specific Amortization Period 10 10 6 10 10 8 5 10

Sample/Subsample

R2 AsReported

R2 Adjusted

R2 Difference

Full sample

7,569

0.7410

0.7567

0.0157

4.74

E/A quartile 1 E/A quartiles 2&3 E/A quartile 4

1,890 3,788 1,891

0.4818 0.7422 0.6741

0.5182 0.7538 0.6985

0.0364 0.0116 0.0244

4.65 1.90 4.98

This table compares R2s from regressions of share price on per-share reported earnings and book values (regression (1)) to those from regressions of share price on per-share earnings and book values adjusted to reflect capitalization of R&D costs with straight line amortization over industry-specific amortization periods (regression (2)). These amortization periods are summarized in the first panel of the table. Comparisons are reported for our full sample of 7,569 firm-years and for three subsamples representing regions of the distribution of earnings to total assets (E/A). In the full sample regressions, intercepts and slope coefficients are allowed to vary across years and across regions of the E/A distribution. In the subsample regressions for individual regions of the E/A distribution, intercepts and slope coefficients are allowed to vary across years. The final column of the table shows Z-statistics based on Vuong's [1989] likelihood ratio test for equivalence of explanatory power in non-nested models.

- 35 -

Table 5 Selected Percentiles From the Distribution of Pricing Error Reductions From Regression (1) (Based on Immediate Expensing of R&D Costs) to Regression (2) (Based on Capitalization of R&D Costs with Amortization Over Industry-Specific Periods)

Average

10

25

50

75

90

95

99

% Positive

Full sample E/A quartile 1 E/A quartiles 2&3 E/A quartile 4

0.086 0.144 0.067 0.066

-0.689 -1.630 -0.620 -0.388

-0.271 -0.396 -0.272 -0.144

-0.139 -0.194 -0.150 -0.083

-0.052 -0.055 -0.062 -0.031

0.016 0.032 0.008 0.019

0.108 0.164 0.104 0.050

0.280 0.462 0.243 0.185

0.536 0.880 0.462 0.335

2.090 4.685 1.310 1.308

56.0 59.5 52.7 59.1

This table reports the distribution of (|P - PR| - |P - PA|)/ P, the difference between (a) the absolute value of the error in estimated price based on reported earnings and book values and (b) the absolute value of the error in estimated price based on adjusted earnings and book values, divided by the actual share price (P). Adjusted earnings and book values are based on industry-specific R&D amortization periods.

- 36 -

Table 6 Comparison of R2s for Regressions of Share Price on Per-Share Reported Earnings and Book Values and on Per-Share Adjusted Earnings and Book Values Based on Selective Capitalization and Amortization of R&D Costs -- Full Sample and Three E/A Subsamples --

Sample/Subsample Adjusted earnings and book values based on Selective Capitalization Rule 1 Full sample E/A quartile 1 E/A quartiles 2&3 E/A quartile 4

R2 AsReported

R2 Adjusted

R2 Difference

7,569 1,890 3,788 1,891

0.7410 0.4818 0.7422 0.6741

0.7815 0.5406 0.7849 0.7251

0.0405 0.0589 0.0427 0.0510

15.91 7.08 9.47 13.41

Adjusted earnings and book values based on Selective Capitalization Rule 2 Full sample E/A quartile 1 E/A quartiles 2&3 E/A quartile 4 7,569 1,890 3,788 1,891 0.7410 0.4818 0.7422 0.6741 0.7878 0.5488 0.7957 0.7275 0.0468 0.0671 0.0535 0.0534 18.14 8.10 11.91 14.50

This table compares R2s from regressions of share price on per-share reported earnings and book values (regression (1)) to those from regressions of share price on per-share adjusted earnings and book values. Adjusted earnings and book values are measured according to two selective capitalization rules: Selective Capitalization Rule 1 : Adjusted earnings and book values are measured as reported, based on immediate expensing, for observations that fall in the lowest quartile of the table 5 pricing error reduction distributioni.e., those for which capitalization and amortization results in the largest pricing error increases. For all other observations, adjusted earnings and book values reflect capitalization with amortization over industry-specific periods. Selective Capitalization Rule 2 : Adjusted earnings and book values are as reported for 862 observations that had large negative pricing errors from regression (1) and large R&D adjustments from capitalization and amortization. For all other observations, adjusted earnings and book values reflect capitalization with amortization over industry-specific periods. Comparisons are reported for our full sample of 7,569 firm-years and for three subsamples representing regions of the distribution of earnings to total assets (E/A). In the full sample regressions, intercepts and slope coefficients are allowed to vary across years and across regions of the E/A distribution. In the subsample regressions for individual regions of the E/A distribution, intercepts and slope coefficients are allowed to vary across years. The final column of the table shows Z-statistics based on Vuong's [1989] likelihood ratio test for equivalence of explanatory power in non-nested models.

- 37 Table 7 Selected Percentiles From the Distribution of Pricing Error Reductions From Regression (1) (Based on Immediate Expensing of R&D Costs) to Regression (2) (Based on Selective Capitalization and Amortization of R&D Costs)

Average

10

25

50

75

90

95

99

% Positive

Adjusted earnings and book values based on Selective Capitalization Rule 1 Full sample E/A quartile 1 E/A quartiles 2&3 E/A quartile 4 0.132 0.163 0.119 0.126 -0.247 -0.532 -0.177 -0.092 -0.102 -0.176 -0.093 -0.060 -0.070 -0.108 -0.068 -0.038 -0.017 -0.032 -0.020 -0.007 0.042 0.044 0.043 0.039 0.121 0.161 0.120 0.098 0.281 0.387 0.263 0.218 0.509 0.747 0.434 0.422 2.095 3.562 1.367 1.599 68.0 65.8 67.7 70.9

Adjusted earnings and book values based on Selective Capitalization Rule 2 Full sample E/A quartile 1 E/A quartiles 2&3 E/A quartile 4 0.190 0.253 0.187 0.133 -0.464 -1.199 -0.368 -0.199 -0.155 -0.309 -0.146 -0.074 -0.086 -0.143 -0.087 -0.044 -0.020 -0.040 -0.020 -0.009 0.049 0.057 0.053 0.040 0.151 0.231 0.152 0.099 0.408 0.646 0.374 0.231 0.772 1.244 0.697 0.478 3.162 5.705 2.356 1.947 68.0 65.2 68.0 70.9

This table reports the distribution of (|P - PR| - |P - PA|)/ P, the difference between (a) the absolute value of the error in estimated price based on reported earnings and book values (regression (1)) and (b) the absolute value of the error in estimated price based on adjusted earnings and book values (regression (2)), divided by the actual share price (P). Adjusted earnings and book values are measured according to two selective capitalization rules: Selective Capitalization Rule 1 : Adjusted earnings and book values are measured as reported, based on immediate expensing, for observations that fall in the lowest quartile of the table 5 pricing error reduction distributioni.e., those for which capitalization and amortization results in the largest pricing error increases. For all other observations, adjusted earnings and book values reflect capitalization with amortization over industry-specific periods. Selective Capitalization Rule 2 : Adjusted earnings and book values are as reported for 862 observations that had large negative pricing errors from regression (1) and large R&D adjustments from capitalization and amortization. For all other observations, adjusted earnings and book values reflect capitalization with amortization over industry-specific periods.