Ebook Accounting for Intangibles, Earnings Variability and Analysts’ Forecasts: Evidence from the Software Industry
This study empirically investigates whether accounting for software development costs, required by the Financial Accounting Standards Board’s Statement No. 86 (SFAS No. 86), affects corporate earnings variability and earnings forecast errors. This research question is motivated by software firms’ growing opposition to the current accounting rule (SFAS No. 86) for software development costs. Their opposition was highlighted by the March 1996 petition of the Software Publishers Association (SPA) to the FASB seeking abolition of SFAS No. 86. As the only exception to the expensing-all rule for R&D expenditures, the Financial Accounting Standards Board (FASB) issued SFAS No. 86 in 1985.
The standard requires firms that develop software intended for external use to capitalize the later portion of development costs after technological feasibility is established. The firms then amortize these deferred costs proportionally against realized and expected future revenues. The capitalized costs are also required to be written down to net realizable value on a product-by product basis if the net realizable value is assessed at lower than the book value of the capitalized costs. Since software development costs are the primary operating expenditures of software companies (accounting for 18% of sales on average in my sample), either expensing or capitalizing them could have a dramatic impact on their financial statements. In general, capitalization could improve a company’s financial measures, leading to higher net income, higher return on equity (ROE), and higher retained earnings and assets (equal to accumulated capitalization of software costs).
Some evidence also shows that the expensing-all-R&D accounting has an adverse effect on a firm’s ability to raise capital (McGee, 1988). These apparent benefits from capitalization attracted as many as 12 to 20 percent of software companies to capitalize some portion of their software creation expenditures during the early 1980s (before SFAS No. 86 was issued, McGee 1988). After SFAS No. 86 became effective in 1986, a majority of the software companies switched to capitalizing a portion of development costs (around 68 percent of my sample from 1982 to 1987 adopted it, that percentage remained roughly the same during the 1990s). Then, why did those companies change their mind recently and lobby to revoke the capitalization rule which they enjoyed for a decade?
Aboody and Lev (1998) provide a motive for software producers’ change of attitude. Using recent 9 year (1987-95) software companies’ data, they provide convincing evidence that capitalization failed to continuously boost net income and return on equity in the mid-1990s. Because the income-decreasing amortization eventually exceeded the income-enhancing capitalization after companies matured (which took place on average in 1995 based on their sample). Hence, those companies lost their original incentives to continue capitalizing software creation expenditures.
The findings in this paper suggest an additional plausible motive underlying the software firms’ change of heart against capitalization. I show that adoption of SFAS No. 86 results in an increase in earning variability on average. The benefits of capitalization (higher earnings and higher ROE) diminish as time elapses while costs of adopting the rule, such as a more volatile earnings stream, still persist. When the costs exceed the benefits, firms would apparently have an incentive to abandon the capitalization rule.
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