Accounting Choice and Earnings Quality The Case of Software Development

European Accounting Review
ISSN: 0963-8180 (Print) 1468-4497 (Online) Journal homepage: https://www.tandfonline.com/loi/rear20
Accounting Choice and Earnings Quality: The Case

of Software Development
Mustafa Ciftci
To cite this article: Mustafa Ciftci (2010) Accounting Choice and Earnings Quality: The
Case of Software Development, European Accounting Review, 19:3, 429-459, DOI:
10.1080/09638180.2010.496551
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European Accounting Review
Vol. 19, No. 3, 429– 459, 2010
Accounting Choice and Earnings

Quality: The Case of Software
Development
MUSTAFA CIFTCI
SUNY at Binghamton, School of Management, Binghamton, New York, USA
(Received September 2008; accepted February 2010)
ABSTRACT In this study I explore how accounting choice affects earnings quality in the
software development industry. SFAS No. 86, which requires capitalization of software
development costs (SDC), is the only exception in the US to SFAS No. 2, which
requires immediate expensing of all research and development (R&D) expenditures.
Aboody and Lev (1998) suggest that capitalized SDC are value-relevant. Thus,
expensing of these costs might introduce noise into earnings. However, it has been
suggested that future benefits associated with SDC are highly uncertain (Software
Publishers Association). Consequently, capitalization might introduce noise into
earnings by capitalizing unproductive expenditures. Hence, it is not clear how managers’
choice between capitalization and expensing will affect earnings quality. I first find that
there is a decline in the quality of earnings in the software industry after the adoption of
SFAS No. 86, whereas no such decline is observed in other high-tech industries. Second,
I find that, within the software industry, the quality of earnings for expensers is greater
than for capitalizers. Finally, I find that, among the capitalizers, those with a large
increase in software capital have lower earnings quality than others. Overall, the results
suggest that capitalization of software costs does not improve earnings quality.
1. Introduction
In this study I investigate how accounting choice affects the quality of earnings.
SFAS No. 2, which requires immediate expensing of all R&D expenditures,
does not allow any choice in reporting. SFAS No. 86 is the only exception to
the universal expensing of R&D in the US. Under this regime, SDC must be
capitalized after the attainment of technical feasibility if the future benefits are
Correspondence Address: Mustafa Ciftci, SUNY at Binghamton, School of Management, PO Box

6000, Binghamton, NY 13902-6000, USA. E-mail: mciftci@binghamton.edu
0963-8180 Print/1468-4497 Online/10/030429–31 # 2010 European Accounting Association

DOI: 10.1080/09638180.2010.496551
Published by Routledge Journals, Taylor & Francis Ltd on behalf of the EAA.
430 M. Ciftci
probable. While capitalization is required under SFAS No. 86, some companies
never capitalize, due to the discretion allowed in application of the standard.
Hence, in practice, managers have a choice between capitalization and expensing.
Consequently, SFAS No. 86 provides us with an opportunity to see the impact of
managers’ reporting choice between expensing and capitalization on the quality of
earnings in the US setting.
Aboody and Lev (1998) find that capitalized SDC are value-relevant. If these
costs are value-relevant, expensing of them might introduce noise into earnings,
thus reducing their quality. On the other hand, the Software Publishers Associ-
ation (SPA) states that the future benefits associated with soft assets are so
uncertain that capitalization of these assets may not be reliable (Aboody and
Lev, 1998). A high level of uncertainty associated with future benefits might
lead to managerial errors in the amount of capitalized SDC. In addition, investors
cannot verify whether capitalized SDC correctly reflects productive expenditures.
Consistent with this view, the Association for Investment Management Research
(AIMR) states that ‘It is usually next to impossible to determine in any sensible or
codifiable manner exactly which costs provide future benefits and which not’
(AIMR, 1993). Thus, because of the high uncertainty associated with future
benefits, and the lack of verifiability associated with SDC, capitalization of
these costs might reduce earnings quality.
Hence, the impact of capitalization of soft assets on the quality of earnings is
unclear. I use the earnings response coefficient (ERC) – the association between
unexpected earnings and cumulative abnormal returns around earnings announce-
ments – to measure the quality of reported earnings. The ERC shows investors’
perceptions of earnings quality. Following Mohd (2005), I first compare the
quality of reported earnings in the software development industry, where SDC
are capitalized after SFAS No. 86, with that in other high-tech industries, where
all R&D expenditures are expensed. The results indicate that there is a decline in
the quality of reported earnings for the software industry after the adoption of
SFAS No. 86, but no such decline for other high-tech industries in the same period.
Second, I compare the quality of earnings among software firms based on their
reporting choice. Specifically, I compare the quality of earnings for firms that capi-
talize some or all of their SDC with that for firms that expense all of these costs
after SFAS No. 86. I find that the earnings quality of the firms that expense all
R&D is greater than that of those that capitalize. Moreover, I find that 10.72%
(10.30%) of capitalizers avoid reporting loss (decline in earnings) by capitalizing
SDC, raising the possibility that capitalization might be used for earnings manage-
ment. Third, I compare the quality of earnings among the capitalizers based on the
magnitude of change in software capital. More specifically, I compare the quality
of earnings for firms that have a large increase in software capital with that for
other capitalizers. I find that the quality of earnings for firms with a large increase
in SDC is significantly lower than for other capitalizers. Moreover, I find that
22.14% (19.15%) of large-increase firms avoid reporting loss (decline in earnings)
by capitalizing SDC, compared with 2.48% (5.88%) for other capitalizers.
Accounting Choice and Earnings Quality 431
This study contributes to the literature investigating the impact of accounting

choice on earnings quality. Earnings are important because they are used by stake-
holders for many purposes, such as contracting, investment, and debt (Schipper and
Vincent, 2003). While several studies investigate the impact of reporting choice on
value-relevance and information asymmetry, there is no study, to my knowledge,
that investigates its impact on earnings quality in the context of software develop-
ment. Moreover, the evidence in these studies is mixed, and hence the implications
of them for earnings quality are not clear. The results in this paper suggest that inves-
tors’ perception of earnings quality is higher for firms that make a conservative
reporting choice. The evidence in this paper is consistent with LaFond and Watts
(2008), who document that conservatism is an equilibrium response to mitigate
value reductions resulting from information asymmetries between managers and
investors.1 The results are also consistent with Ball and Shivakumar (2008), who
suggest that the demand for conservative accounting increases with information
asymmetry. Given that software industry is characterized by high information asym-
metry, conservative reporting seems to be a reasonable response to asymmetry.2
This study also contributes to the literature on the accounting treatment of R&D
expenditures. The economy in the US and other developed countries has been shift-
ing from tangibles to intangibles in recent years (Lev and Zarowin, 1999). Intangi-
ble-intensive firms are playing a greater role in the economy of these countries, and
hence the accounting treatment of intangible assets is quite important. In many
countries around the world, public companies are required to follow IFRS (Daske
et al., 2008), which requires capitalization of development costs (IAS 38). More-
over, even in the US, a step-by-step transition to IFRS has been proposed. Therefore,
it is very timely to investigate the impact of accounting choice in terms of capitali-
zation versus expensing on earnings quality. While the evidence in this paper is
based on one industry and one country, it might provide some general insights
into the impact of capitalization of R&D on earnings quality. The results here,
even interpreted conservatively, do not warrant the argument that capitalization of
SDC improves quality of earnings. They raise the possibility that capitalization can
make financial reporting more vulnerable to managers’ opportunistic reporting prac-
tices. In fact, these findings are consistent with conclusions suggested by the SPA:
‘Financial reporting and financial statements would be more reliable and consistent
if all SDC were required to be charged to expense’ (SPA letter March 14, 1996). The
rest of the paper is organized as follows. Section 2 provides the related literature and
research questions, and Section 3 presents the methodology. The sample selection
and results are given in Section 4. Finally, Section 5 concludes the study.
2. Literature Review and Research Questions

2.1. Prior Literature about Capitalization versus Expensing of SDC
Accounting choice is a broad topic, but the fundamental issue in most cases is
whether managers convey private information or engage in opportunistic
432 M. Ciftci
reporting practices (Fields et al., 2001). This study focuses on accounting

choice with respect to capitalization versus expensing of SDC. SFAS No. 2,
which requires immediate expensing of all R&D expenditures, does not
allow any discretion for managers.3 Ryan (2006) defines expensing of R&D
as unconditional conservatism, since it leads to understatement of the book
value of assets.4 SFAS No. 86 is the only exception to universal expensing
of R&D in the US. It requires capitalization of SDC after technical feasibility
is reached until the product is released, if the future benefits are probable (the
latter is a general condition for all assets under SFAC No. 6). Aboody and Lev
(1998) suggest that capitalized SDC is associated with contemporaneous
returns, indicating that these costs are value-relevant. However, Eccher
(1995) finds that capitalized SDC is not value-relevant. Hence, there is no con-
sensus about the value-relevance of SDC in prior literature. Moreover, the SPA
does not believe that the capitalization of SDC will provide relevant infor-
mation to investors.5 If capitalized SDC is value-relevant, capitalization
might improve earnings quality by eliminating the noise that would have
been incorporated into earnings under an expensing regime, due to the deduc-
tion of value-relevant costs from earnings.
In contrast to the arguments by Aboody and Lev (1998), the SPA states that the
future benefits associated with SDC are highly uncertain: therefore, capitalization
of these costs would not be reliable.6 Moreover, Kanodia et al. (2004) suggests
that the value-relevance of capitalized R&D documented in prior literature is
not sufficient to justify capitalization, and suggests that capitalization will be pre-
ferred to expensing if and only if the true productive assets can be reliably esti-
mated; in all other cases expensing is preferred. Capitalization of SDC requires
estimation of the future revenues and economic life of a software product
before it is released to market. The future revenues and economic life depend
on many things that cannot be completely controlled by managers. Therefore
the prediction of future benefits of SDC is quite difficult, and it is likely that
there will be errors in the amounts capitalized. These errors might lead to
write-offs in subsequent periods.7 A survey by the GIT reports that eight out of
61 capitalizers in their sample make write-offs in capitalized SDC, even
though these write-offs lead to loss of prestige for managers. The magnitudes
of these write-offs are sometimes larger than the earnings.8
In addition, the capitalization of SDC involves subjective decisions by man-
agers that cannot be verified by outsiders, such as whether the project has
reached technical feasibility, or whether the future benefits are probable. Thus,
lack of verifiability of management decisions about capitalization might increase
information asymmetry between investors and managers, and make the account-
ing system vulnerable to earnings management. Consistent with this view, using
an Italian data set, Markarian et al. (2008) document that companies use capita-
lization of R&D for earnings smoothing. Hence, thanks to either unintentional
errors or earnings management, capitalization of SDC might introduce noise
into reported earnings by capitalizing unproductive expenditures, which will
reduce the quality of reported earnings. Accordingly, financial analysts argue that
‘software capitalization would reduce the quality of earnings. It would make it
more difficult to assess which companies are doing well or not.’9
Consistent with the greater information asymmetry associated with capitaliza-
tion, Aboody and Lev (1998) document that capitalization leads to greater absolute
analyst forecast errors and dispersion in analyst forecasts.10 However, Mohd
(2005) finds that the mean spread and volume over the whole year are lower for
capitalizers than for expensers, and interprets these results as a decline in infor-
mation asymmetry due to capitalization of SDC. Hence, there is an inconsistency
between the evidence presented by Mohd (2005) and that presented by Aboody and
Lev (1998). There are two possible explanations for this inconsistency. The first is
that the sample used by Mohd does not seem to properly represent the population of
capitalizers and expensers (i.e. the market value of equity for capitalizers is six
times larger than for expensers in their sample: $150 million for expensers
versus $913 million for capitalizers). His sample is not consistent with the
sample composition of most of the studies in this topic.11 Furthermore, Aboody
and Lev (1998) suggest that capitalization is negatively related to firm size.
Given that firm size is an important determinant of the information environment
(Atiase, 1985), Mohd’s results might be driven by his sample characteristics.12
Second, Mohd explores information asymmetry over a whole year, and attri-
butes the difference between capitalizers and expensers to SFAS No. 86.
However, it is not clear whether the decline in information asymmetry is
driven by capitalization per se, because he does not document whether this
decline is due to the disclosure of specific accounting information regarding capi-
talization. There might be many confounding events over an entire year that
might lead to a decline in information asymmetry, rather than capitalization
itself. In fact, Mohd claims that investors are pessimistic about capitalizers,
and narrates anecdotal evidence suggesting that capitalizers show every effort
to demonstrate that their judgments are well justified within the boundaries of
generally accepted accounting principles (GAAP).13 If investors are pessimistic
about capitalization, it is not clear how information asymmetry declines as a
result of capitalization.14
2.2. Earnings Quality and Accounting Choice

I use the ERC, the association of 3-day stock returns around earnings announce-
ment with unexpected earnings, to measure earnings quality. The announcement
period constitutes only 5% of 250 trading days in a given year. Kothari (2001)
suggests that short horizon studies are much cleaner than long horizon studies,
in that they are less likely to be contaminated by confounding events. Moreover,
even if there are voluntary disclosures at earnings announcements, they are likely
to be less extensive for expensers than for capitalizers, because conservative firms
tend to make fewer voluntary disclosures (Gigler and Hemmer, 2001). Prior lit-
erature also uses other measures of earnings quality, such as autocorrelation in
434 M. Ciftci
earnings (also called persistence), predictability, smoothness, and accrual quality.

However, these measures are all vulnerable to managerial intervention.15
However, assuming market efficiency, investors should be able to see through
managerial intervention, and hence, ERC is not likely to be affected by it.
ERC is the mapping of unexpected earnings onto stock returns (Scott, 2006).
Easton and Zmijewski (1989) suggest that ERC is determined by earnings persist-
ence and discount rate (cost of equity). To the extent that investors consider unex-
pected earnings more persistent (discount rate higher), ERC will be greater
(smaller).16 The errors in capitalization due to high uncertainty associated with
future benefits might lead to subsequent write-offs in capitalized SDC, and
reduce future earnings. In addition, if the reported earnings are achieved through
opportunistic use of capitalization, they may not be sustainable in future periods.
Hence, if investors are uncertain about the future benefits of capitalized SDC, or
suspicious of opportunistic use of capitalization, the persistence of unexpected
earnings reflected in stock prices will be lower for capitalizers. Moreover, for
the same reasons, the discount rate might increase, leading to a decline in ERC.17
2.3. Research Questions

There is no consensus about the impact of capitalization on value-relevance
(Aboody and Lev, 1998; Eccher, 1995). If capitalized SDC is value-relevant,
expensing would introduce noise into earnings. Therefore, the reported earnings
under capitalization might contain less noise and hence better reflect economic per-
formance than under expensing. On the other hand, capitalization might introduce
noise into earnings, because unproductive expenditures might be capitalized either
by error or opportunistically. In addition, the same reasons might lead to a decline
(increase) in investors’ expectation of earnings persistence (costs of equity). Schip-
per and Vincent (2003) suggest that earnings quality depends on the trade-off
between relevance and reliability. Thus, capitalization might either improve the
relevance or reduce the reliability of accounting information. Hence, I cannot
decide a priori which effect would be stronger: therefore, I do not have any predic-
tion about the impact of capitalization of SDC on the earnings quality.
My first research question is to investigate how the quality of earnings com-
pares between the software development industry and other high-tech industries
before and after SFAS No. 86. There is no change in the reporting practices for
R&D expenditures for other high-tech industries after SFAS No. 86, whereas
software firms are required to capitalize SDC. Thus, if capitalization of SDC
improves (deteriorates) earnings, one should observe an increase (decrease) in
earnings quality for the software development industry after SFAS No. 86, rela-
tive to other high-tech industries. The above arguments also apply to a compari-
son of firms within the software development industry between those that
capitalize SDC and those that expense them. Therefore, my second research ques-
tion is to investigate how earnings quality within the software industry compares
between expensers and capitalizers after SFAS No. 86.
An important concern about capitalization is that managers might exploit the

capitalization scheme to manipulate earnings. Capitalizing firms can achieve per-
formance targets by capitalizing SDC. Moreover, even if these large increases are
not due to earnings management, there might be possible errors in capitalization
that might reduce the persistence of earnings. Hence, large increases in capita-
lized SDC might severely deteriorate the quality of reported earnings. On the
other hand, if large increases in software capital are due to firms’ normal
growth, they should not lead to a decline in earnings quality. Thus, my third
research question is to compare the quality of earnings for firms that have a
large increase in capitalized SDC with that of other capitalizers.
3. Research Design
I use ERC to measure the quality of financial information.18 The research design
in this study is similar to Mohd (2005) in several aspects. I first compare the
quality of reported earnings in the software development industry, where SDC
are required to be capitalized after SFAS No. 86, with that in other high-tech
industries, where all R&D expenditures are expensed. Mohd (2005) suggests
that the software development industry and other high-tech industries are both
R&D-intensive, but that they differ in their accounting treatment of R&D expen-
ditures. Second, I compare software firms after the adoption of SFAS No. 86,
based on their decision to capitalize. Third, I compare the capitalizers based on
the magnitude of change in capitalized SDC. The following three subsections
describe the research method for each research question.
3.1. Earnings Quality for Software and Other High-tech Industries

The first research question requires comparison of the quality of earnings for the
software industry, where SDC are required to be capitalized after SFAS No. 86,
with that in other high-tech industries, where R&D expenditures are expensed.
Following Mohd (2005), I estimate the following model:
CARit = b0 + b1 UNEXit + b2 (UNEXit∗ SOFTit ) + b3 (UNEXit∗ PERIODit )+

b4 (UNEXit∗ PERIOD∗it SOFTit ) + b5 (UNEXit∗ SIZEit ) + b6 (UNEXit∗ BMit )+
b7 (UNEXit∗ LOSSit ) + b8 (UNEXit∗ BETAit ) + b9 (UNEXit∗ LEVit )+
b10 (UNEXit∗ PERSISTit ) + b11 (UNEXit∗ FOLLOWit )+
b12 (UNEXit∗ AVLOSSit ) + b13 (UNEXit∗ AVDECit )+
b14 (UNEXit∗ PREDISCit ) + 1it (1)
CARit = EQUATION(1) + b15 (UNEXit∗ SMOOTHit ) + 1it (1A)
The definition of variables is in the Appendix. Unexpected earnings are the change
in earnings in year t relative to year t 2 1, scaled by the market value of equity. The
436 M. Ciftci
change in earnings might contain measurement error as a proxy for UNEXit,

because investors’ expectation of earnings might be different from past earnings.
However, there is no reason to believe that the measurement error in UNEXit is cor-
related with the accounting choice. Therefore, I do not expect it to bias the results in
any systematic way; rather, it might only reduce the power of the tests. Even though
analyst forecasts are considered a better proxy for investors’ expectation of earn-
ings, I did not use them, because the actual earnings reported in I/B/E/S files are
not comparable to earnings under GAAP (analyst forecast error is calculated by
deducting analyst forecasts from actual earnings reported in I/B/E/S files).19 In
equation (1), b2 shows the difference in ERC for software firms before the adoption
of SFAS No. 86, and b3 shows the change in ERC for other high-tech firms after the
adoption of SFAS No. 86. I do not expect any systematic change in ERC for high-
tech firms after 1986: thus I do not have any prediction for this coefficient. b4
shows the difference in ERC for the software industry after 1986. If SFAS No.
86 positively (negatively) affects the quality of earnings by decreasing (increasing)
the noise in earnings, the coefficient estimate of b4 should be positive (negative).
There might be differences in earnings quality between the software industry
and other high-tech industries due, not necessarily to the enactment of SFAS
No. 86, but to some other, uncontrolled factors. The above research design
allows me to compare the earnings quality for the software industry with that
for other high-tech industries after controlling for differences in the period
before SFAS No. 86. Without controlling for these differences, one cannot con-
clude that the results are attributable to SFAS No. 86. An advantage of comparing
industries is that I do not have to select firms based on their choice of expensing
or capitalizing. The choice of accounting method might be endogenous, so that
the underlying reason for differences in ERC cannot be identified. Therefore,
comparing industries eliminates the problems associated with endogeneity.
Collins and Kothari (1989) state that there is a negative relationship between
firm size, SIZEit, and ERC. In addition, Atiase (1985) suggests that information
production and dissemination are better in larger firms. Thus, I expect a negative
sign on b5. Book-to-market ratio, BMit, controls for growth opportunities (Collins
and Kothari, 1989). High book-to-market firms have lower growth opportunities.
Hence, I expect b6 to be negative. Hayn (1995) observes that losses are not
expected to persist. Additionally, she states that when firms disclose bad news
early, this leaves less information to be disclosed at the earnings announcements.
Thus, I expect b7 to be negative. BETAit is a proxy for systematic risk. Consistent
with Collins and Kothari (1989), I expect a negative sign on b8, because the
greater the riskiness of a firm, the greater the discount factor will be. I use lever-
age, LEVit, as another control for risk, and I expect b9 to be negative as well.
Following Ali and Zarowin (1992), I include PERSISTit as a measure of earnings
persistence. Collins and Kothari (1989) state that ERC is positively related to
earnings persistence. Thus, I expect b10 to be positive. I include FOLLOWit as
a proxy for information environment quality. Following Teoh and Wong
(1993), I expect a negative sign on b11.
Software firms might have low earnings quality due not to differential account-
ing treatment per se but earnings management. Hence, I need to disentangle the
impact of earnings management on earnings quality from that of accounting treat-
ment. Managers might use capitalization to avoid reporting loss or a decline in
earnings, or to smooth earnings. To control for earnings management, I include
three variables in the regression: AVLOSSit, AVDECit, and SMOOTHit. The first
variable, AVLOSSit, controls for managers’ use of capitalization to avoid reporting
loss. The second variable, AVDECit, is included to control for managers’ use of
capitalization to avoid reporting a decline in earnings. To the extent that these
variables capture earnings management, there should be a decline in the quality
of earnings, and hence I expect a negative sign on both b12 and b13. Consistent
with Francis et al. (2004), I also add SMOOTHit to control for earnings smoothing
in equation (1A). Francis et al. (2004) define smoothness in earnings as the ratio of
the standard deviation of earnings to that of cash flows. If managers are using
accruals to reduce the standard deviation in cash flows, the standard deviation
of earnings should be smaller than that of cash flows. In the same spirit, if man-
agers are smoothing the volatility of earnings by using capitalization, then the
standard deviation of the reported earnings under capitalization will be smaller
than that of earnings under expensing (from hypothetical expensing of SDC).
Given that earnings smoothing for earnings management would reduce earnings
quality, I expect a negative sign on b15 in equation (1A). To control for disclosures
in the pre-announcement period, consistent with Christensen et al. (2004), I add
PREDISCit in equation (1). Christensen et al. (2004) use cumulative returns as
a proxy for predisclosure information environment quality. I use average abnor-
mal returns over the pre-announcement period, scaled by the standard deviation
of returns in that period. To the extent that information about a firm’s earnings
is disclosed prior to earnings announcements, the reaction around earnings
announcement will be smaller. Hence, I expect a negative sign on b14.
3.2. Earnings Quality for Expensers versus Capitalizers

To compare the ERC for firms that capitalize some or all of SDC with those that
expense all of these costs, I estimate the following model in the post-SFAS No. 86
period:
CARit = b0 + b1 UNEXit + b2 (UNEXit∗ CAPITALit ) + b3 (UNEXit∗ SIZEit )+

b4 (UNEXit∗ BMit ) + b5 (UNEXit∗ LOSSit ) + b6 (UNEXit∗ BETAit )+
b7 (UNEXit∗ LEVit ) + b8 (UNEXit∗ PERSISTit ) + b9 (UNEXit∗ FOLLOWit )+

438 M. Ciftci
However, as suggested by Mohd (2005) and Aboody and Lev (1998), the
decision to capitalize SDC might be endogenous, and hence the coefficient esti-
mate of CAPITALit in equation (2) might be biased. To eliminate the impact of
endogeneity, consistent with Mohd (2005) and Aboody and Lev (1998), I esti-
mate a two-stage model (2SLS), instead of OLS. The variables that are related
to the capitalization decision are firm size, leverage, firm beta, development
intensity, and income. Consistent with Mohd (2005) and Aboody and Lev
(1998), I estimate the following logit model and generate the predicted value,
PCAPITALit, from the equation below:
CAPITALit = b0 + b1 SIZEit + b2 INCOMEit + b3 DEVINTit + b4 LEVit

+ b5 BETAit + 1it (3)
After generating the predicted values of CAPITALit from equation (3), I rank
these estimates into two groups, and estimate equation (2) using the ranked
PCAPITALit. It is possible that there might be differences in earnings quality
between capitalizers and expensers, even in the pre-SFAS No. 86 period:
hence, it would be more appropriate to estimate ERC for expensers and capitali-
zers in the pre-SFAS No. 86 period. However, I cannot extend this analysis to the
pre-SFAS No. 86 period, because I cannot estimate the corresponding
PCAPITALit in that period.
3.3. Earnings Quality for Firms with Large Increase in Capitalized SDC
To investigate the third research question, I explore earnings quality among capi-
talizers only. The test involves a comparison of ERC between capitalizing firms
that have a large increase in software capital and other capitalizers. I estimate the
following model.
CARit = b0 + b1 UNEXit + b2 (UNEXit∗ LARGE INCit ) + b3 (UNEXit∗ SIZEit )+

b12 (UNEXit∗ PREDISCit )1it (4)
The coefficient estimate of b2 in equation (4) shows the difference in ERC for
firms that have a large increase in software capital relative to other capitalizers. If
there is a significant decline in the quality of earnings for firms with a large
increase in software capital, the coefficient estimate of b2 should be negative.
4. Empirical Results
4.1. The Results for Software versus Other High-tech Firms
4.1.1. Sample selection and descriptive statistics
The capitalized SDC are not available in machine-readable form in Compustat.
Therefore, following a procedure similar to Mohd (2005), they are hand-collected
from financial statements using LexisNexis. Similar to Mohd (2005), the software
firms in my sample are those in four-digit SICs 7370 – 7374. Consistent with
Francis and Schipper (1999), other high-tech firms are 283 (drugs), 357 (compu-
ter and office equipment), 360 (electrical machinery and equipment), 361 (elec-
trical transmissions and distribution equipment), 362 (electrical industrial
apparatus), 363 (household appliances), 364 (electrical lighting and wiring equip-
ment), 365 (household audio, video equipment, audio receiving), 366 (communi-
cations equipment), 367 (electronic components, semiconductors), 368
(computer hardware), 481 (telephone communications), 873 (research develop-
ment, testing services), and firms other than the software industry in three-digit
SIC code 737.
The sample period is 1981 – 1990. The pre-SFAS No. 86 period is 1981– 1985,
and the post-SFAS No. 86 period is 1986– 1990. To be included in the sample
each firm should have at least one observation in both the pre-SFAS No. 86
and post-SFAS No. 86 periods. The sample period ends at 1990. If I extend
the analysis into future years such as 1995, I can have more observations,
which might increase the power of the tests. However, over a 15-year time
period there might be structural changes in the economic characteristics of the
industries being compared, which might raise questions about whether the
results are due to a structural change or to SFAS No. 86. I delete extreme obser-
vations in the top and bottom 1% of UNEXit. The breakpoints for extreme obser-
vations are determined using all R&D firms. In addition, following Collins et al.
(1997), I check for the extreme observations with studentized residuals greater
than 4 in the regression of equation (1). No observation is deleted by this cri-
terion. There are 429 firms and 2694 firm – year observations in the other high-
tech group, and 80 firms and 451 firm– year observations in the software industry.
Panel A of Table 1 presents the descriptive statistics for software and other
high-tech firms before the adoption of SFAS No. 86. There are significant differ-
ences in EPit (earnings-to-price ratio), BMit (book-to-market ratio), BETAit (beta),
MVit (market value of equity), and PERSISTit (persistence of earnings) between
other high-tech industries and the software industry. Overall, the descriptive stat-
istics show that there are systematic differences in firm characteristics between
the software industry and other high-tech industries, indicating the importance
of controlling for these characteristics.
Panel B reports the descriptive statistics after the adoption of SFAS No. 86. The
differences in EPit between software and other high-tech firms are reversed after
SFAS No. 86: the mean EPit for software firms is significantly greater than that
for other high-tech firms. This suggests that, after SFAS No. 86, software firms
440 M. Ciftci
Table 1. Descriptive statistics for software and other high-tech industriesa

Panel A: Descriptive statistics before SFAS No. 86
Mean Median
p-value of p-value of
Variable High-techb Softwareb t-statc High-techb Softwareb Wilcoxond
CARit 20.0049 0.0021 0.27 20.0017 20.0035 0.30
UNEXit 20.0060 0.0014 0.20 0.0063 0.0094 0.03
BMit 0.5548 0.3859 0.00 0.4629 0.3414 0.00
LEVit 0.3193 0.1354 0.00 0.1677 0.0286 0.00
BETAit 1.1650 1.3892 0.00 1.0924 1.2847 0.00
LOSSit 0.1453 0.1639 0.20 0.0000 0.0000 0.58
PERSISTit 0.8737 0.9262 0.09 1.0000 1.0000 0.09
EPit 0.0548 0.0303 0.00 0.0620 0.0365 0.00
MVit 1224.48 249.63 0.00 138.61 63.54 0.00
FOLLOWit 1.0867 1.1211 0.53 0.6923 0.6895 0.32
PREDISCit 1.0522 1.0585 0.79 1.0596 1.0711 0.38
Panel B: Descriptive statistics after SFAS No. 86
Mean Median
p-value of p-value of
Variable High-techb Softwareb t-statc High-techb Softwareb Wilcoxond
CARit 0.0023 0.0057 0.48 20.0009 20.0006 0.70
UNEXit 0.0034 20.0011 0.36 0.0089 0.0103 0.82
BMit 0.5148 0.4946 0.37 0.4328 0.4029 0.34
LEVit 0.4294 0.2283 0.02 0.1347 0.0342 0.00
BETAit 1.0843 1.0846 0.99 1.1127 1.0366 0.60
LOSSit 0.2687 0.1923 0.00 0.0000 0.0000 0.00
PERSISTit 0.8167 0.9172 0.00 1.0000 1.0000 0.00
EPit 0.0070 0.0267 0.00 0.0430 0.0413 0.74
MVit 1877.78 362.93 0.00 99.55 69.83 0.00
FOLLOWit 1.1867 1.3011 0.03 0.7382 0.9877 0.01
AVLOSSit 0.0000 0.0696 0.00 0.0000 0.0000 0.00
AVDECit 0.0000 0.0633 0.00 0.0000 0.0000 0.00
PREDISCit 1.0519 1.0575 0.82 1.0669 1.0806 0.46
SMOOTHit 1.0000 0.8739 0.00 1.0000 0.7021 0.00
a
Before SFAS No. 86 is fiscal years 1981–1985 and after SFAS No. 86 is fiscal years 1986– 1990.
b
High-tech industries are, consistent with Francis and Schipper (1999), 283, 357, 360, 361, 362, 363,
364, 365, 366, 367, 368, 481, 873, and firms in 737 other than those in the software industry. Software
development industry is four-digit SICs 7370–7374. Variable definitions are in the Appendix.
c
p-value of t-statistics for the difference between high-tech and software firms (two-sided).
d
p-value of Wilcoxon rank sum test whether the populations of high-tech and software firms are equal
(two-sided).
become more profitable than other high-tech firms. Additionally, even though there
was not a significant difference between the two groups in the frequency of report-
ing loss prior to SFAS No. 86, the mean loss frequency for other high-tech firms is
significantly greater than that for software firms after SFAS No. 86. More interest-
ingly, the mean value of AVLOSSit is 0.0696, suggesting that 6.96% of software
firms avoid reporting loss by capitalizing SDC. Moreover, the mean value of
AVDECit is 0.0633, suggesting that 6.33% of software firms avoid reporting a
decline in earnings by capitalizing SDC. Finally, the mean value of SMOOTHit
is 0.8739 for the software industry, whereas by definition it is 1.00 for other
high-tech industries, suggesting that software firms smooth earnings by capitaliz-
ing SDC. Overall, the results in Panel B raise the possibility that software firms use
capitalization of SDC to achieve performance targets or to smooth earnings.
4.1.2. Regression results

Table 2 presents the pooled estimation results of equation (1). I cluster the firm-
year observations per firm to eliminate autocorrelation (Petersen, 2009). The
first column reports the regression results without control variables. The coeffi-
cient estimate of UNEXit is 0.1370 (p-value , 0.01), indicating that unexpected
earnings are positively related to returns around earnings announcements. The
coefficient estimate for (UNEXit∗ SOFTit) is 0.0321 (p-value ¼ 0.47), indicating
that there is not a significant difference in ERC between software firms and
other high-tech firms prior to SFAS No. 86. The coefficient estimate for
(UNEXit∗ PERIODit) is 20.0285 (p-value ¼ 0.49), indicating that there is not
a significant change in ERC for other high-tech firms in the period after
1986. The coefficient estimate for (UNEXit∗ PERIODit∗ SOFTit) is 20.1432
(p-value , 0.01), suggesting that the change in ERC for software firms after
SFAS No. 86 is significantly more negative than for other high-tech firms.
The second column reports the regression results with control variables. The
adjusted-R2 increases from 0.0105 to 0.0172 with the inclusion of control variables,
suggesting that this model has a better fit. The coefficient estimate of UNEXit is
0.3761 (p-value , 0.01), indicating that the ERC becomes larger with control
variables. The coefficient estimate for (UNEXit∗ PERIODit∗ SOFTit) is 20.1695
(p-value , 0.01), confirming the earlier result that the change in ERC for software
firms after SFAS No. 86 is significantly more negative than for other high-tech
firms. The last column reports the results of equation (1A), which includes
control for earnings smoothing. The estimation of SMOOTHit requires a firm to
have earnings available in the past three years. Thus, in the estimation of equation
(1A), I consider the post-SFAS No. 86 period as 1988–1990, instead of 1986–
1990 as in equation (1). The coefficient estimate for (UNEXit∗ PERIODit∗ SOFTit)
is 20.1521 (p-value , 0.05), suggesting that, even after controlling for earnings
smoothing, the change in ERC is more negative for software firms. Overall, the
results in Table 2 indicate that the quality of earnings for software firms is lower
than for other high-tech firms after SFAS No. 86. The coefficient estimates for
SIZEit, BMit and LOSSit are significant in the expected signs, while the coefficient
estimates for FOLLOWit and PERSISTit are marginally significant.
4.1.3. Robustness
In this section I perform several robustness checks. I first estimate equation (1)
using only the firms that (a) capitalize SDC, (b) expense all SDC, rather than
442 M. Ciftci
Table 2. Comparison of earnings quality between software and other high-tech industriesa
Equation (1) without
Variable controlb Equation (1)b Equation (1A)b
UNEXit 0.1370∗∗∗ 0.3761∗∗∗ 0.3975∗∗∗
(3.96) (3.79) (3.06)
UNEXit∗ PERIODit 20.0285 20.0332 20.0356
(20.69) (20.60) (20.55)
UNEXit∗ SOFTit 0.0321 0.0423 0.0521
(0.47) (0.51) (0.62)
UNEXit∗ PERIODit∗ SOFTit 20.1432∗∗∗ 20.1695∗∗∗ 20.1521∗∗
(22.73) (23.21) (22.21)
UNEXit∗ SIZEit 20.0278∗∗ 20.0232∗
(21.95) (21.81)
UNEXit∗ BMit 20.1424∗∗∗ 20.1152∗∗
(22.95) (22.35)
UNEXit∗ BETAit 20.0269 20.0141
(20.75) (20.36)
UNEXit∗ LOSSit 20.1345∗∗∗ 20.1643∗∗∗
(22.68) (22.83)
UNEXit∗ LEVit 20.0290 0.0221
(21.43) (0.86)
UNEXit∗ PERSISTit 0.0671∗ 0.0772∗
(1.72) (1.68)
UNEXit∗ FOLLOWit 20.0312∗ 20.0225
(21.65) (21.17)
UNEXit∗ AVLOSSit 20.1311 20.0361
(20.52) (20.14)
UNEXit∗ AVDECit 20.2541 20.2241
(20.69) (20.55)
UNEXit∗ PREDISCit 20.0402 20.0287
(20.95) (20.49)
UNEXit∗ SMOOTHit 20.3482
(21.51)
Adjusted-R2 0.0105 0.0172 0.0174
N 3,145 3,145 2,435
a ∗ ∗∗
, , and ∗∗∗ denote significance at 0.10, 0.05 and 0.01 respectively. The t-values are in parenthesis.
Before (after) SFAS No. 86 is fiscal years 1981–1985 (1986– 1990). Industry definitions are in Table 1.
Variable definitions are in the Appendix.
b
The model used in estimation:
CARit =b0 + b1 UNEXit + b2 (UNEXit∗ SOFTit ) + b3 (UNEXit∗ PERIODit )+
b10 (UNEXit∗ PERSISTit ) + b11 (UNEXit∗ FOLLOWit ) + b12 (UNEXit∗ AVLOSSit )+
b13 (UNEXit∗ AVDECit ) + b14 (UNEXit∗ PREDISCit ) + 1it (1)
including all software firms.20 Panel A of Table 3 reports the estimation result
when I include only capitalizers in the software industry. The first column
reports the estimation results without control variables. The coefficient estimate
for (UNEXit∗ PERIODit) is 20.0316 and for (UNEXit∗ PERIODit∗ SOFTit) is
20.1499 (p-value , 0.01), similar to the results in Table 4. The next column
reports the estimation results with control variables. The coefficient estimate
for (UNEXit∗ PERIODit∗ SOFTit) is 20.1975 (p-value , 0.01), which is even
more negative than the results with all software firms. The last column shows
the estimation results when I also control for earnings smoothness. The coeffi-
cient estimate for (UNEXit∗ PERIODit∗ SOFTit) is 20.1683 (p-value , 0.05).
Overall, the results in Panel A indicate that, when I consider only the firms
that capitalize SDC in the software industry, the results are similar to those
with all firms in this industry. In Panel B of Table 3, I include only expensers
in the software industry. The coefficient estimate for (UNEXit∗ PERIODit∗ SOFTit)
is 20.0291, which is statistically insignificant, and suggests that there is not a sig-
nificant difference in ERC between expensers in the software industry and other
high-tech firms. This result confirms that low earnings quality in the software
industry is driven by capitalizers rather than by expensers, and that the differ-
ences in industry characteristics between the two industry groups are not respon-
sible for the results documented in Table 2.
In Tables 2 and 3, I delete extreme observations in the top and bottom 1% of the
distribution. The breakpoints are generated using all R&D firms. To explore
whether the above results are robust to alternative breakpoint choices, I also try
2%, 3% and 5% as breakpoints for extreme observations. The results get stronger
at higher breakpoints. This result is consistent with Freeman and Tse (1992),
which suggests that ERC has a nonlinear S-shape, being largest around the
center and getting smaller at the tails. However, I report the results with 1% break-
points because it is the most commonly used benchmark, and other choices are ad
hoc. UNEXit is calculated as change in earnings assuming that last year’s earnings
is a reasonable proxy for investors’ earnings expectations. To check the robustness
of the results I use a seasonal random-walk model and calculate UNEXit as earn-
ings in the fourth quarter in year t minus earnings in the same quarter of year t 2 1.
I find that (UNEXit∗ PERIODit∗ SOFTit) is still significantly negative.
Moreover, I calculate CARit over two days around earnings announcements, at
days 21 and 0, instead of the three days over 21 to +1. The magnitude of coef-
ficients is smaller, because CARit is accumulated over only two days, but the
main conclusions do not change. In addition, I scale the change in earnings by
the book value of equity (Compustat item #60) rather than the market value of
equity to calculate UNEXit, and use market-adjusted returns or market-model-
adjusted returns instead of size-adjusted returns. The main conclusions are not
altered by these changes.21 Furthermore, I use industry-adjusted unexpected
earnings, instead of raw unexpected earnings. The industry-adjusted unexpected
earnings are calculated by deducting the mean unexpected earnings in the firm’s
industry from the unexpected earnings of the firm. The coefficient estimate of
444 M. Ciftci
Table 3. Comparison of earnings quality for expensers and capitalizers in software with
other high-tech industriesa

Panel A: Comparison of capitalizers with other high-tech industries
UNEXit 0.1392∗∗∗ 0.3998∗∗∗ 0.4109∗∗∗
(3.85) (4.01) (3.06)
UNEXit∗ PERIODit 20.0316 0.0221 0.0351
(20.73) (0.45) (0.54)
UNEXit∗ SOFTit 0.0291 0.0486 0.0702
(0.43) (0.53) (0.69)
UNEXit∗ PERIODit∗ SOFTit 20.1499∗∗∗ 20.1975∗∗∗ 20.1683∗∗
(22.67) (23.02) (22.17)
UNEXit∗ SIZEit 20.0266∗∗ 20.0239∗∗
(21.97) (21.94)
UNEXit∗ BMit 20.1538∗∗∗ 20.1213∗∗
(23.01) (22.39)
(20.81) (20.34)
UNEXit∗ LOSSit 20.1378∗∗∗ 20.1602∗∗∗
(22.71) (22.79)
UNEXit∗ LEVit 20.0259 0.0238
(21.38) (0.91)
(1.69) (1.66)
UNEXit∗ FOLLOWit 20.0298 20.0229
(21.60) (21.21)
(20.54) (20.17)
(20.71) (20.59)
UNEXit∗ PREDISCit 20.0512 20.0302
(21.02) (20.51)
(21.54)
Adjusted-R2 0.0110 0.0174 0.0177
N 2,983 2,983 2,282
Panel B: Comparison of expensers with other high-tech industries

Variable controlb Equation (1)b
UNEXit 0.1423∗∗∗ 0.4103∗∗∗
(4.05) (4.17)
UNEXit∗ PERIODit 20.0216 0.0196
(20.61) (0.41)
UNEXit∗ SOFTit 0.0303 0.0502
(0.47) (0.55)
(Continued)
Table 3. Continued
UNEXit∗ PERIODit∗ SOFTit 20.0143 20.0291
(20.21) (20.47)
UNEXit∗ SIZEit 20.0271∗∗
(22.01)
UNEXit∗ BMit 20.1529∗∗∗
(23.03)
UNEXit∗ BETAit 20.0303
(20.83)
UNEXit∗ LOSSit 20.1401∗∗∗
(22.76)
UNEXit∗ LEVit 20.0281
(21.41)
UNEXit∗ PERSISTit 0.0709∗
(1.67)
UNEXit∗ FOLLOWit 20.0312∗
(21.64)
UNEXit∗ PREDISCit 20.0481
(20.99)
Adjusted-R2 0.0103 0.0161
N 2,863 2,863
a ∗ ∗∗
Before SFAS No. 86 is fiscal years 1981– 1985 and after SFAS No. 86 is fiscal years 1986– 1990.
Variable definitions are in the Appendix. Industry definitions are in Table 1.
b
The model used in estimation:
CARit =b0 + b1 UNEXit + b2 (UNEXit∗ SOFTit ) + b3 (UNEXit∗ PERIODit )+

b10 (UNEXit∗ PERSISTit ) + b11 (UNEXit∗ FOLLOWit ) + b12 (UNEXit∗ AVLOSSit )+
b13 (UNEXit∗ AVDECit ) + b14 (UNEXit∗ PREDISCit ) + 1it (1)
(UNEXit∗ PERIODit∗ SOFTit) is marginally significant with industry-adjusted

unexpected earnings. Finally, I run the above analysis using data between
1981 and 1995. This data set is larger, containing ten years in the post-SFAS
No. 86 era, and hence the power of the test is higher. The results are even slightly
stronger than those in Table 2.
4.2. The Results for Expensers versus Capitalizers

The analysis for the comparison of expensers with capitalizers is performed over
the period 1986 – 1995, because one cannot distinguish between these two groups
446 M. Ciftci
Table 4. Descriptive statistics for expensers and capitalizers

Mean Median
p-value p-value of
Variable Expensersa Capitalizersb of t-stat c Expensersa Capitalizersb Wilcoxond
CARit 0.0045 0.0074 0.68 20.0003 0.0032 0.81
UNEXit 20.0018 20.0027 0.91 0.0085 0.0107 0.60
BMit 0.4017 0.4325 0.27 0.3063 0.3254 0.18
LEVit 0.1216 0.1140 0.61 0.0187 0.0361 0.10
BETAit 1.1650 1.1938 0.64 1.1062 1.2171 0.65
LOSSit 0.3056 0.2057 0.01 0.0000 0.0000 0.01
PERSISTit 0.8056 0.8594 0.08 1.0000 1.0000 0.08
CPINTit 0. 0000 0.2926 0.00 0.0000 0.1955 0.00
DEVINTit 0.1523 0.1697 0.00 0.1284 0.1591 0.00
EPit 20.0030 0.0063 0.47 0.0354 0.0409 0.04
MVit 964.41 547.10 0.00 113.87 114.45 0.80
FOLLOWit 1.3145 1.3398 0.60 0.9869 0.9855 0.87
AVLOSSit 0.0000 0.1072 0.00 0.0000 0.0000 0.00
AVDECit 0.0000 0.1030 0.00 0.0000 0.0000 0.00
PREDISCit 1.0782 1.0561 0.05 1.0898 1.0693 0.08
SMOOTHit 1.0000 0.7760 0.00 1.0000 0.9875 0.01
a
Expensers are firms that expense all R&D expenditures after SFAS No. 86. Variable definitions are in
the Appendix.
b
Capitalizers are firms that capitalize some or all R&D expenditures after SFAS No. 86.
c
p-value of t-statistics for the difference between expensers and capitalizers (two-sided).
d
p-value of Wilcoxon rank sum test whether expensers and capitalizers are equal (two-sided).
before 1986. I estimate PCAPITALit from the logistic regression of equation (3).
The pseudo-R2 from this estimation is 17.12%. The procedure for data collection
and elimination of extreme observations is the same as that in the earlier analysis
in section 4.1.1. A firm is considered as a capitalizer if it capitalizes some or all of
its SDC, and as an expenser if it expenses all of its R&D expenditures. The
sample consists of 208 firm-year observations for expensers and 392 firm-year
observations for capitalizers in the sample in the period 1986 – 1995.
Table 4 reports the descriptive statistics for expensers and capitalizers. The
mean EPit for capitalizers is not significantly different from that for expensers.
The mean capitalization intensity, CPINTit, for capitalizers is 0.2926, indicating
that capitalizers capitalize 29% of their total R&D spending. The mean and
median DEVINTit, development intensity, for capitalizers is 17% significantly
greater than for expensers. This is consistent with the argument in Aboody and
Lev (1998) that firms that spend more on R&D are more likely to capitalize.
The mean and median of UNEXit, LEVit, BMit FOLLOWit, PREDISCit and
BETAit for expensers are not significantly different from those for capitalizers.
The mean value of PERSISTit for capitalizers is greater than for expensers
(p-value ¼ 0.08). Interestingly, the mean of LOSSit for expensers is significantly
greater than for capitalizers, raising the possibility that capitalizers use the capi-
talization of SDC to avoid reporting loss. In fact, the mean value of AVLOSSit is
0.1072, suggesting that 10.72% of capitalizers avoid reporting loss by capitaliz-
ing SDC. The mean value of AVDECit is 0.1030, suggesting that 10.30% of capi-
talizers avoid reporting a decline in earnings by capitalizing SDC. In addition, the
mean value of SMOOTHit is 0.7760, suggesting that capitalizers smooth earnings
by capitalizing SDC. This result is consistent with the earnings smoothing by
capitalization of R&D documented by Markarian et al. (2008) in the Italian
setting. The mean MVit (market value of equity) for expensers is greater than
that for capitalizers, indicating that capitalizers are larger firms than expensers.
This result is consistent with Aboody and Lev (1998), who suggest that capitali-
zation is negatively related to firm size. Moreover, the results here also suggest
that my sample is quite different from that in Mohd (2005) (the market value
of capitalizers is six times larger than that of expensers in his sample).

Table 5 reports the regression results for equation (2). The first column reports the
regression results without control variables. The coefficient estimate of UNEXit is
0.1464 (p-value , 0.01), similar to the estimation results in the first column of
Table 2, which compares software firms and other high-tech firms. The coeffi-
cient estimate of (UNEXit∗ PCAPITALit) is 20.1515 (p-value , 0.01),
suggesting that the ERC for capitalizers is smaller than for expensers. The
second column reports the estimation results of equation (2) with control vari-
ables. The coefficient estimate of UNEXit is 0.7002 (p-value , 0.01). The coef-
ficient estimate of (UNEXit∗ PCAPITALit) is 20.1792 (p-value , 0.01),
indicating that the inclusion of control variables does not eliminate the difference
in ERC between capitalizers and expensers. The results are also economically
significant. The ERC for capitalizers is 25% lower than that for expensers. The
last column reports the results of equation (2A), where I also control for earnings
smoothness. As explained above, the calculation of SMOOTHit requires the firm
to have capitalization in the past three years. Hence, the estimation of equation
(2A) is performed over 1988 – 1995, instead of 1986 – 1995 as in equation (1).
The coefficient estimate of (UNEXit∗ PCAPITALit) is 20.1640 (p-value ,
0.05) – again, significant. Overall, the results in Table 5 suggest that the
quality of earnings for firms that capitalize SDC is lower than for those that
expense these expenditures after SFAS No. 86.
4.2.3 Robustness
In the above analysis I use predicted values (PCAPITALit) instead of actual
choice to capitalize: hence, I could not extend the estimation into the pre-
SFAS No. 86 era. One concern with the above analysis is that there might be sys-
tematic differences between expensers and capitalizers, even in the pre-SFAS No.
86 period. To investigate this issue, I use the actual decision to capitalize or
expense instead of predicted values. Specifically, I consider a firm as a capitalizer
448 M. Ciftci
a
Table 5. Comparison of earnings quality for expensers and capitalizers
Variable Equation (2) without control b Equation (2)b Equation (2A)b
UNEXit 0.1464∗∗∗ 0.7002∗∗∗ 0.7400∗∗∗
(2.96) (5.09) (3.98)
UNEXit∗ PCAPITALit 20.1515∗∗∗ 20.1792∗∗∗ 20.1640∗∗
(22.77) (23.41) (22.38)
UNEXit∗ SIZEit 20.0421∗∗ 20.0541∗∗∗
(22.38) (22.95)
UNEXit∗ BMit 20.2557∗∗∗ 20.2570∗∗∗
(23.21) (23.35)
(20.92) (20.89)
UNEXit∗ LOSSit 20.0651 20.0882
(20.72) (20.98)
UNEXit∗ LEVit 20.0744 20.0749
(21.01) (20.98)
(1.65) (1.70)
(21.49) (21.51)
(20.48) (20.93)
(20.36) (20.34)
UNEXit∗ PREDISCit 20.0739∗ 20.0435
(21.68) (20.89)
(1.26)
Adjusted-R2 0.0113 0.0398 0.0405
N 600 600 489
a ∗ ∗∗
Expensers are firms that expense all R&D expenditures after SFAS No. 86. Capitalizers are firms that
capitalize some or all R&D expenditures after SFAS No. 86. Variable definitions are in the Appendix.
b
The models used in estimation:
CARit =b0 + b1 UNEXit + b2 (UNEXit∗ CAPITALit ) + b3 (UNEXit∗ SIZEit )+

(expenser) in both the post- and pre-SFAS No. 86 periods if it chooses to capita-
lize (expense) in all the post-SFAS No. 86 era. The results are slightly weaker, but
the coefficient estimate of (UNEXit∗ PCAPITALit) is still significantly negative in
the post-SFAS No. 86 era. I also run the robustness checks used in Section 4.1.3.
The tenor of the results does not change for most of the robustness checks, except
that the difference between expensers and capitalizers is insignificant when I use
industry-adjusted UNEXit, probably because industry adjustment introduces noise
into earnings.
4.3. Large Increases in Software Capital and Earnings Quality

The sample for investigating the third research question includes only firms that
capitalize SDC. The sample period is 1987 – 1995, because I need to calculate the
change in capitalized SDC. There are 360 firms in the sample. Table 6 presents
the descriptive statistics for firms with a large increase in software capital and
other capitalizers. The mean CH_SOFTit (change in software capital) for large-
increase firms is 5.03%, quite large compared with 20.31% for other capitali-
zers. The mean CPINTit (capitalization intensity) for large-increase firms is
38.49%, significantly greater than 22.79% for other capitalizers. On the other
Table 6. Descriptive statistics for firms with large increase in capitalized SDC and other
capitalizers
Mean Median
Other Large Other Large
Variable capitalizersa increaseb Differencec capitalizers a
increaseb Differenced
CARit 0.0088 0.0048 0.63 0.0050 20.0023 0.37
EPit 0.0046 20.0120 0.42 0.0380 0.0414 0.04
CH_SOFTit 20.0031 0.0503 0.00 0.0013 0.0309 0.00
CPINTit 0.2279 0.3849 0.00 0.1592 0.3092 0.00
DEVINTit 0.2048 0.1667 0.00 0.1814 0.1566 0.03
UNEXit 20.0440 0.0009 0.02 0.0105 0.0074 0.65
BMit 0.3902 0.5039 0.00 0.3043 0.3860 0.00
LEVit 0.0915 0.1424 0.00 0.0235 0.0599 0.03
BETAit 1.2506 1.1204 0.11 1.2806 1.0816 0.07
LOSSit 0.2712 0.2065 0.10 0.0000 0.0000 0.14
PERSISTit 0.8983 0.7871 0.00 1.0000 1.0000 0.00
MVit 707.84 281.04 0.00 186.75 72.07 0.00
FOLLOWit 1.3142 1.3341 0.42 0.9845 0.9867 0.59
AVLOSSit 0.0248 0.2214 0.00 0.0000 0.0000 0.00
AVDECit 0.0588 0.1915 0.00 0.0000 0.0000 0.00
PREDISCit 1.0544 1.0607 0.54 1.0845 1.0751 0.41
SMOOTHit 0.8012 0.7342 0.02 0.7413 0.6351 0.01
a
Other capitalizers are firms in the bottom three quartiles of change in software capital, CH_SOFTit.
Variable definitions are in the Appendix.
b
Large-increase firms are those in the top quartile of change in software capital, CH_SOFTit.
c
p-value of t-statistics for the difference between large-increase firms and other capitalizers (two-
sided).
d
p-value of Wilcoxon rank sum test whether the populations of large-increase firms and other
capitalizers are equal (two-sided).
450 M. Ciftci
hand, the mean (median) DEVINTit (development intensity) is 16.67% (15.66%),

significantly smaller than 20.48% (18.14%) for other capitalizers. This result
suggests that large-increase firms capitalize a greater portion of their R&D rela-
tive to other capitalizers, even though their development intensity is smaller.
High capitalization rates suggest that either their R&D projects are more success-
ful or they exploit capitalization to meet performance targets. Considering that
these firms have lower development intensity, they are less likely to be more suc-
cessful in R&D projects than expensers, raising the possibility that capitalizers
use capitalization to manage earnings.22 In addition, large-increase firms have
greater BMit, suggesting that the market does not consider that these firms have
greater growth opportunities than other capitalizers. Moreover, the mean fre-
quency of loss for large-increase firms is 20.65%, significantly lower than
27.12% for other capitalizers. The mean AVLOSSit is 22.14%, greater for
large-increase capitalizers compared with 2.48% for other capitalizers, indicating
that the use of capitalization to avoid reporting loss is more frequent among large-
increase firms than among other capitalizers. In addition, the mean AVDECit for
large-increase firms is 19.15% compared with 5.88% for other capitalizers,
indicating that large-increase firms use capitalization more frequently to
avoid reporting decline in earnings than other capitalizers. Finally, the large-
increase firms are smaller in the market value of their equity than other
capitalizers.

Table 7 reports the regression results for equation (4). The first column reports the
regression results without control variables. The coefficient estimate of UNEXit is
0.0134 (p-value ¼ 0.46), which is insignificant. The coefficient estimate of
(UNEXit∗ LARGE_INCit) is 20.0469 (p-value ¼ 0.15). The next column
reports the results with control variables. The adjusted-R2 increases from
0.0027 to 0.0371. The coefficient estimate of UNEXit is 0.5569 (p-value ,
0.01). The inclusion of control variables also increases the coefficient estimate
for the interaction term. The coefficient estimate of (UNEXit∗ LARGE_INCit) is
20.1535 (p-value , 0.01). This result is also economically significant. The esti-
mated value of ERC for large-increase firms is 27% less than for other capitali-
zers. The last column shows the results when we estimate equation (4A), the
model that controls for earnings smoothing. The sample period is 1988 – 1995,
due to the additional data requirement of SMOOTHit. However, the results are
still statistically significant: the interaction term, (UNEXit∗ LARGE_INCit), is
20.1242 (p-value , 0.05). Overall, the results in Table 7 suggest that the
quality of earnings for firms that have a large increase in software capital is
lower than for other capitalizers. I also apply robustness checks similar to
those in Section 4.1.3. The difference between large-increase firms and other
capitalizers is insignificant when I use industry-adjusted unexpected earnings.
In addition, the results are marginally significant when I calculate unexpected
earnings based on a seasonal random-walk model. The rest of the robustness
Table 7. The impact of large increase in capitalized SDC on earnings qualitya

Variable Equation (4) without controlb Equation (4)b Equation (4A)b
UNEXit 0.0134 0.5569∗∗∗ 0.5582∗∗∗
(0.94) (3.50) (3.08)
UNEXit∗ LARGE_INCit 20.0469 20.1535∗∗∗ 20.1242∗∗
(21.47) (22.75) (22.03)
UNEXit∗ SIZEit 20.0990∗∗∗ 20.1220∗∗∗
(22.68) (22.99)
UNEXit∗ BMit 20.2741∗∗∗ 20.2862∗∗∗
(23.12) (23.21)
(20.39) (20.75)
UNEXit∗ LOSSit 20.1503∗ 20.1734∗
(21.63) (21.68)
UNEXit∗ LEVit 20.0429 20.0494
(20.23) (20.49)
UNEXit∗ PERSISTit 0.0542 0.0992
(0.66) (1.27)
(21.11) (21.28)
(20.59) (20.69)
(20.32) (20.39)
UNEXit∗ PREDISCit 20.1372∗ 20.519
(21.74) (20.54)
(0.99)
Adjusted-R2 0.0027 0.0371 0.0386
N 360 360 324
a ∗ ∗∗
Other capitalizers are firms in the bottom three quartiles of change in software capital, CH_SOFTit.
Large-increase firms are those in the top quartile of change in software capital, CH_SOFTit. Variable
definitions are in the Appendix.
b
The models used in estimation:
CARit =b0 + b1 UNEXit + b2 (UNEXit∗ LARGE INCit ) + b3 (UNEXit∗ SIZEit )+

b12 (UNEXit∗ PREDISCit )1it (4)
check does not affect the results. In addition, when I define large-increase firms as
those with a change in SDC greater than the median change, instead of the top
quartile, the results are weaker than those reported above, but still statistically
significant.
452 M. Ciftci
5. Conclusion and Future Research

In this study, I investigate the impact of accounting choice on the quality of earn-
ings. SFAS No. 86 is the only exception to the universal expensing of R&D in the
US, in that it requires capitalization of SDC. The quality of earnings depends on
the trade-off between relevance and reliability (Schipper and Vincent, 2003). On
one hand, Aboody and Lev (1998) suggest that capitalized SDC is value-relevant.
On the other hand, the SPA and AIMR raise serious concerns about the reliability
of the reported SDC in the software development industry. I investigate the val-
idity of these opposing arguments about the impact of capitalization on the
quality of earnings. The results in this paper indicate that capitalization of
SDC leads to a decline in the quality of earnings.
IAS 38, which is widely used in numerous countries around the world (Daske
et al. 2008), requires the capitalization of development costs of intangible
assets, if the entity can demonstrate all of the following: (a) the technical feasibility
of completing the intangible asset; (b– c) its intention and ability to complete the
intangible asset, and use or sell it; (d) how the intangible asset will generate prob-
able future economic benefits; (e) the availability of adequate technical, financial
and other resources to complete the development; and (f) its ability to measure
reliably the expenditures attributable to the intangible asset (IAS 38 paragraph
57). Hence, SFAS No. 86 does not include the above requirements from (b) to
(f). Thus, it is reasonable to say that IAS 38 is more elaborate in the conditions
that it requires for capitalization. These additional conditions can make managers
more cautious about capitalization under IAS 38 than under SFAS No. 86, but it is
questionable whether these differences can have a material impact on the quality of
financial reporting,23 because the two key characteristics of intangible assets are
same, such that the future benefits of intangible assets are highly uncertain, and
the information about the value of intangibles cannot be verified by outsiders.24
Another main difference between the two standards is that SFAS No. 86 requires
capitalization of SDC for software products developed only for sale, not for
internal use. However, IAS 38 requires the capitalization of development costs
of intangible assets both for sale and internal use. When intangible assets are devel-
oped for internal use, it is harder for outsiders to assess the economic value of the
asset being developed, because there is often no market for intangible assets that
will aid investors in assessing the value of these assets (Lev, 2001). Consequently,
information asymmetry between investors and managers might be even greater for
intangible assets developed for internal use.
A limitation of my study is that it is based on one country and one industry.
Consequently, it might be of interest to investigate the impact of capitalization
on earnings quality in countries where capitalization of development costs is
required in all intangible-intensive industries under IAS 38. This will further
clarify whether in fact the differences between SFAS No. 86 and IAS 38 lead
to different conclusions. Another extension of this study might be to investigate
the voluntary disclosure practices of capitalizers and expensers. Given that
investors are pessimistic about capitalizers, they might make more voluntary dis-
closures to increase investor confidence (Mohd, 2005). This argument is also con-
sistent with Gigler and Hemmer (2001), who argue that conservative firms make
fewer voluntary disclosures. Therefore, it would be interesting to investigate the
disclosure practices for firms with different reporting choices.25
Appendix
Definition of Variables
CARit ¼ Cumulative size-adjusted returns to firm i’s year t earnings

announcement (over days 21, 0, and +1). The size-adjusted
returns are calculated using a companion portfolio approach.
Specifically, I allocate all the firms in Compustat and CRSP
return files into companion portfolios based on their market
capitalization in December of the previous fiscal year. There
are ten companion portfolios each year. Breakpoints of
market capitalization for companion portfolios are determined
using NYSE stocks only. The size-adjusted returns are calcu-
lated by deducting the mean value of the companion portfolio
return from the firm’s daily raw return.
UNEXit ¼ The unexpected earnings: the change in earnings between year t
and year t 2 1 scaled by the market value of equity at the end of
fiscal year t.
PERIODit ¼ An indicator variable that equals 1 if year t is after 1986 (i.e.
after adoption of SFAS No. 86) and 0 otherwise.
SOFTit ¼ An indicator variable that equals 1 if firm i in year t is in the soft-
ware industry and 0 otherwise.
SIZEit ¼ Log of market value of equity at the end of fiscal year t. Market
value of equity is shares outstanding (Compustat item #25)
times share price at the end of fiscal year (Compustat item
#199).
BMit ¼ Book-to-market ratio: book value of equity (Compustat item
#60) at the end of year t divided by the market value of
equity at the end of fiscal year t.
LOSSit ¼ An indicator variable that equals 1 if the earnings before extra-
ordinary items (Compustat item #18) in year t for firm i are less
than zero and 0 otherwise.
BETAit ¼ Beta for firm i in year t. The firm’s beta is estimated using a
market model from 2211 days to 211 days relative to the
year t earnings announcement.
LEVit ¼ Leverage in year t. The leverage is long-term debt (Compustat
item #9) divided by total equity (Compustat item #60) in year t.
454 M. Ciftci
PERSISTit ¼ An indicator variable that equals 1 if firm i’s earnings-to-price

ratio in year t has a decile ranking from 3 to 8, and 0 otherwise.
The earnings-to-price ratio is earnings before extraordinary
items divided by market value of equity.
FOLLOWit ¼ Log of number of analyst following +1. Analyst following
is measured at the end of the fiscal year and generated from
I/B/E/S summary files.
AVLOSSit ¼ An indicator variable that equals 1 if firm i avoids reporting loss
by capitalizing SDC (i.e. earnings would have been negative if
all SDC were expensed, but the reported earnings based on capi-
talization is positive), and 0 otherwise.
AVDECit ¼ An indicator variable that equals 1 if firm i avoids reporting a
decline in earnings by capitalizing SDC (i.e. firm i would
have reported a decline in earnings if all SDC were expensed,
but reports an increase in earnings due to capitalization), and
0 otherwise.
PREDISCit ¼ The amount of information disclosed in the pre-announcement
period. It is the mean absolute abnormal returns in the pre-
announcement period (it starts five days after earnings
announcements in year t 2 1 and ends five days before earnings
announcements in year t) scaled by the standard deviation of
these returns in the same period. Abnormal returns are size-
adjusted returns.
SMOOTHit ¼ Smoothness in the reported earnings generated by the capitali-
zation of SDC. It is the ratio of the standard deviation of
reported earnings to that of earnings if SDC were expensed.
PERIODit ¼ An indicator variable that equals 1 if year t is after 1986 (i.e.
after SFAS No. 86).
SOFTit ¼ An indicator variable that equals 1 if firm i in year t is in the soft-
ware industry and 0 otherwise.
CAPITALit ¼ An indicator variable which equals 1 if the firm capitalizes some
or all of its R&D spending.
PCAPITALit ¼ The rank of predicted value of CAPITALit estimated from
equation (3). (There are two ranks.)
INCOMEit ¼ Earnings before SDC (i.e. I deduct the capitalized SDC from
earnings and add back the amortized SDC to earnings).
CPINTit ¼ Capitalization intensity, defined as the capitalized software
development cost divided by the sum of capitalized software
development cost and expensed R&D.
DEVINTit ¼ Development intensity, defined as the sum of R&D expense and
capitalized SDC scaled by sales revenue.
CH_SOFTit ¼ Change in software capital in year t scaled by market value of
equity.
LARGE_INCit ¼ An indicator variable that equals 1 if the change in software

capital of firm i in year t is in the top quartile of the change in
software capital of all firms in the software development indus-
try, and 0 otherwise. The change variable is scaled by the
market value of equity.
Notes
1
While LaFond and Watts (2008) perform their analysis on conditional conservatism, they do
not restrict their arguments to conditional conservatism. Therefore it is reasonable to expect
that their arguments will also apply to unconditional conservatism (i.e. expensing of SDC).
2
There are several reasons why intangible-intensive firms have more information asymmetry.
First, soft assets are unique: therefore investors cannot get any information about the economic
performance of a specific product by looking at similar products. For example, the market
success of a drug by Pfizer will not say much about the market success of a similar drug by
Merck. In addition, there are no established markets for soft assets that can provide information
about the value of these assets, whereas there are markets for tangible assets, from which inves-
tors can infer the prices of those assets (Lev, 2001).
3
The primary criticism against expensing is that R&D is expensed immediately, whereas the
benefits are realized much later, which violates the matching principle (Lev and Zarowin,
1999). Amir and Lev (1996) suggest that earnings and book values do not represent firm
value and performance, owing to expensing of R&D. However, Collins et al. (1997) (Francis
and Schipper, 1999) did not find any evidence that accounting information is less value-relevant
in intangible-intensive (high-tech) industries.
4
In certain situations capitalization might lead to lower reported earnings than expensing;
however, these situations should be quite rare, because on average R&D expenditures grow
not only nominally but also in real terms (e.g. Skinner, 2008, suggests that inflation-adjusted
R&D has grown by 150% over the past 20 years). Hence amortization expense under capita-
lization, on average, would be smaller than a change in capitalized SDC, leading to greater
earnings and book values under capitalization than under full expensing. I find that in 71%
of the cases in my sample the change in capitalized SDC was larger than amortization
expense.
5
‘The members of SPA CFO committee . . . have indicated the substantial majority of their inves-
tors, underwriters and financial analysts believe financial reporting by software companies is
improved when all SDC are charged to expense as incurred. These users of financial statements
do not believe that recording of soft assets for software being developed is particularly relevant
and does not aid the user of financial statements. The users of financial statements . . . have a
high degree of skepticism when it comes to soft assets resulting from capitalization of SDC.’
SPA letter, March 1996 (Aboody and Lev, 1998).
6
‘An asset should be recognized . . . only if ultimate realization of the assets is reasonably assured
. . .. Due to factors such as the ever-increasing volatility in the software marketplace, the com-
pression of product cycles, the heightened level of competition and divergence of technology
platforms, realization of software assets has become increasingly uncertain even at the point
of technological feasibility . . . We do not believe that software development costs are useful
predictive factor of future product sales.’ This statement is quoted from a letter written by
Ken Walsch, president of SPA, to the FASB (Aboody and Lev, 1998).
7
Consistent with this view, Kothari et al. (2002) suggest that variability of future earnings
associated with R&D expenditures is almost four times greater than for capital expenditures.
Uncertainty of future benefits is also important for standard setters. FASB provides the uncer-
tainty of future benefits as the main reason to justify the requirement to expense the R&D in
other all industries. In SFAS No. 4, FASB states that ‘. . . the relationship between current
456 M. Ciftci
research and development costs and the amount of resultant future benefits to an enterprise is so
uncertain that capitalization of any R&D costs is useful to investors.’
8
Capitalization of SDC: A Survey of Accounting Practices in the Software Industry Sponsored
By Georgia Tech Financial Analysis Lab. CFO Magazine, December 18, 2007.
9
James Mandelson, software analyst at Morgan Stanley, testifying at the FASB public hearing,
May 1985 (Aboody and Lev, 1998).
10
In fact, Mohd (2005) suggests that an alternative proxy to measure information asymmetry is
dispersion in analyst forecasts. Thus, the evidence in Aboody and Lev (1998) suggests that
there is an increase in information asymmetry, rather than a decrease.
11
Cazavan-Jeny and Jeanjean (2006) suggest that capitalizers are the smallest firms (the market
capitalization of expensers in their sample is $6.9 billion – 22 times larger than the $310
million for capitalizers). Similarly, Oswald (2008) reports that the market value of equity for
expensers is seven times larger than for capitalizers ($1529 million versus $216 million).
12
While he controls for size, it may not eliminate the size effect completely in a pooled regression
setting. His sample covers 1986–1995 – ten years, like ours. A large firm in 1986 might seem
small in 1995. A better approach would be to adjust the relative size comparison every year.
13
Consistent with this, Mohd (2005) reports from Davey (1992) that ‘Sulucus Computer has made
every effort to demonstrate that its judgment to [capitalize] is well justified . . . The company
even included, with each investors relations packet it sent out, a cogent and favorable examin-
ation prepared by an analyst from a big, fancy brokerage house.’
14
As long as management is not providing more specific information that will help investors better
understand the relationship between R&D investments and future revenues, disclosing a lump-
sum number for capitalized SDC can hardly be informative. This argument is consistent with
Skinner (2008), who suggests that in industries where full expensing is required there are no
voluntary disclosures for estimated R&D capital, indicating that there is no demand for such
information. Thus, the lack of voluntary supply of estimated R&D capital in industries with
full expensing suggests that there is no such demand.
15
Lipe (1990) defines earnings persistence as autocorrelation in earnings. Schipper and Vincent
(2003) define earnings predictability as the ability of past earnings to predict future earnings,
and earnings smoothness as the lack of variability in earnings across time. Accrual quality is
mapping of accruals into cash flows.
16
Persistence reflected in ERC is different from autocorrelation in earnings (another measure of
persistence used in prior literature), such that the latter might be affected by earnings manage-
ment, whereas the former would not (assuming market efficiency, investors should be able to
see through earnings management).
17
Accounting rules might also affect investment decisions. Oswald and Zarowin (2005) suggest
that expensers engage in real earnings management by cutting R&D, whereas capitalizers
engage in accrual earnings management using capitalization. However, Seybert (2008) suggests
that capitalization of R&D might lead to overinvestment.
18
ERC indicates the extent of a security’s abnormal market return in response to an unexpected
component of reported earnings. Kim and Verrecchia (1991) show analytically that the price
response to a signal is positively related to signal quality, suggesting that the greater the
ERC, the greater the earnings quality. ERC shows investors’ assessment of earnings quality.
It is widely used to measure the quality of information (Christensen, 2002). Ghosh and Moon
(2005) investigate the impact of auditor tenure on earnings quality by using ERC. Collins
and Slatka (1993) use ERC to investigate how the adoption of SFAS No. 52 affects the
quality of earnings. Similarly, Teoh and Wong (1993) use ERC to measure the impact of
auditor quality on earnings quality.
19
Consistent with this argument, Bhattacharya et al. (2003) suggest that actual earnings from I/B/
E/S are significantly different from earnings under GAAP, and argue that GAAP earnings
are more conservative than actual earnings in I/B/E/S. Similarly, Collins et al. (2009) use
I/B/E/S actual earnings as a proxy for street earnings, an earnings definition that is not
consistent with GAAP. Therefore it may not be reasonable to test the impact of accounting
choice under GAAP using analyst forecasts.
20
This analysis might suffer from selection bias, because we are selecting firms in the software
industry based on their accounting choice. However, consistent with Mohd (2005), I perform
this analysis as a robustness check to see whether the results are driven by expensers within
the software industry.
21
Size-adjusted returns are better than market- or market-model-adjusted returns because market
capitalization in the calculation of size-adjusted returns is updated every year. Given that market
capitalization grows over time, adding a control variable for firm size may not eliminate the size
effect completely in pooled regressions, because the sample period covers ten years.
22
Mohd (2005) suggests that DEVINTit increases the chance of success in software projects. Given
that large capitalizers have lower DEVINTit, they might have less success in these projects.
23
Oswald and Zarowin (2007) use capitalization data based on the UK. They argue that their find-
ings are comparable to the US, because UK capital markets are well-developed, liquid markets,
similar to those of the US and other developed nations. Following their arguments, it is reason-
able to assume that European data, at least in some countries, are comparable to those for the
US.
24
There are several studies that explore the impact of capitalization with European data; however,
the results are also mixed. Cazavan-Jeny and Jeanjean (2006) find that capitalized costs are not
value-relevant. Oswald (2008) did not find any economically significant improvement from the
hypothetical capitalization of R&D for firms that expense it in the UK. However, Oswald and
Zarowin (2007) find that stock prices are more informative capitalizers than expensers,
suggesting that capitalization is informative.
25
Oswald (2008) investigates the determinants of the decision to capitalize or expense. However,
to my knowledge, no study investigates the impact of capitalization versus expensing on volun-
tary disclosures.
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Accounting Choice and Earnings Quality The Case of Software Development

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European Accounting Review

ISSN: 0963-8180 (Print) 1468-4497 (Online) Journal homepage: https://www.tandfonline.com/loi/rear20

Accounting Choice and Earnings Quality: The Case

To link to this article: https://doi.org/10.1080/09638180.2010.496551

Published online: 08 Sep 2010.

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Accounting Choice and Earnings

(Received September 2008; accepted February 2010)

Correspondence Address: Mustafa Ciftci, SUNY at Binghamton, School of Management, PO Box

0963-8180 Print/1468-4497 Online/10/030429–31 # 2010 European Accounting Association

This study contributes to the literature investigating the impact of accounting

2. Literature Review and Research Questions

reporting practices (Fields et al., 2001). This study focuses on accounting

2.2. Earnings Quality and Accounting Choice

earnings (also called persistence), predictability, smoothness, and accrual quality.

2.3. Research Questions

An important concern about capitalization is that managers might exploit the

3.1. Earnings Quality for Software and Other High-tech Industries

CARit = b0 + b1 UNEXit + b2 (UNEXit∗ SOFTit ) + b3 (UNEXit∗ PERIODit )+

CARit = EQUATION(1) + b15 (UNEXit∗ SMOOTHit ) + 1it (1A)

change in earnings might contain measurement error as a proxy for UNEXit,

3.2. Earnings Quality for Expensers versus Capitalizers

CARit = b0 + b1 UNEXit + b2 (UNEXit∗ CAPITALit ) + b3 (UNEXit∗ SIZEit )+

CARit = EQUATION(2) + b13 (UNEXit∗ SMOOTHit ) + 1it (2A)

CAPITALit = b0 + b1 SIZEit + b2 INCOMEit + b3 DEVINTit + b4 LEVit

CARit = b0 + b1 UNEXit + b2 (UNEXit∗ LARGE INCit ) + b3 (UNEXit∗ SIZEit )+

CARit = EQUATION(4) + b13 (UNEXit∗ SMOOTHit ) + 1it (4A)

Table 1. Descriptive statistics for software and other high-tech industriesa

4.1.2. Regression results

Equation (1) without

Panel B: Comparison of expensers with other high-tech industries

CARit =b0 + b1 UNEXit + b2 (UNEXit∗ SOFTit ) + b3 (UNEXit∗ PERIODit )+

CARit = EQUATION(1) + b15 (UNEXit∗ SMOOTHit ) + 1it (1A)

(UNEXit∗ PERIODit∗ SOFTit) is marginally significant with industry-adjusted

4.2. The Results for Expensers versus Capitalizers

Table 4. Descriptive statistics for expensers and capitalizers

4.2.2. Regression results

CARit =b0 + b1 UNEXit + b2 (UNEXit∗ CAPITALit ) + b3 (UNEXit∗ SIZEit )+

CARit = EQUATION(2) + b13 (UNEXit∗ SMOOTHit ) + 1it (2A)

4.3. Large Increases in Software Capital and Earnings Quality

hand, the mean (median) DEVINTit (development intensity) is 16.67% (15.66%),

4.3.2. Regression results

Table 7. The impact of large increase in capitalized SDC on earnings qualitya

CARit =b0 + b1 UNEXit + b2 (UNEXit∗ LARGE INCit ) + b3 (UNEXit∗ SIZEit )+

CARit = EQUATION(4) + b13 (UNEXit∗ SMOOTHit ) + 1it (4A)

5. Conclusion and Future Research

CARit ¼ Cumulative size-adjusted returns to firm i’s year t earnings

PERSISTit ¼ An indicator variable that equals 1 if firm i’s earnings-to-price

LARGE_INCit ¼ An indicator variable that equals 1 if the change in software

Collins, D. W. and Kothari, S. P. (1989) An analysis of intertemporal and cross-sectional determinants

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