Capitalizing R&D expenditures or expensing them all?: Evidence from the accounting environment of South Korea

Abstract

This study first aims to introduce the accounting environment of South Korea including standard-setting bodies, the procedures of establishment and amendment of accounting standards, and accounting conventions for research and development (R&D) expenditures. Furthermore, this study investigates the veiled ambilaterality of accounting treatments for capitalization of R&D as (i) a communication channel and (ii) a tool of opportunistic earnings management. Using data from South Korea specifically focused on the transition period toward full adoption of the International Financial Reporting Standards (IFRS), this study tests whether the uncertainty of future economic benefits can be reflected in R&D capitalization and whether managers can engage in managing earnings through discretionary accounting choice of R&D capitalization. Through simple statistics and visual inspection, this study finds that the variability of future economic benefits from R&D expenditures decreases as the degree of R&D capitalization increases, suggesting that R&D capitalization can play a role in communicating R&D-specific knowledge with information users outside the company. On the other hand, following Burgstahler and Dichev's test, this study also finds that the discontinuity at the zero-profit point in the distribution of earnings intervals is alleviated when capitalizing R&D expenditures is not allowed, implying that a possibility of opportunistic earnings management may exist. This study can provide a meaningful implication to the United States and countries still considering the adoption of IFRS.