The Investment Opportunity Set and Capitalization versus Expensing Methods of Accounting Choice

This paper examines the effects of the investment opportunity set (IOS) on management’s decision to capitalize or expense significant costs in two diverse settings: (1) in accounting for exploration and development (E&D) costs by firms in the oil‐and‐gas industry, and (2) in accounting for research and development (R&D) costs by firms (across industries) prior to 1974. We argue that the relation between the IOS and the decision to capitalize versus to expense is based upon managerial incentives to reduce the variance of accounting earnings. High‐growth firms are more likely to have more variable earnings, which therefore creates greater incentives to reduce earnings variability. Because the capitalization method generally results in a lower variance of reported earnings than does the expensing method, high‐growth firms are more likely to select capitalization. Our results show that, after controlling for firm size and for the indirect effects of the IOS mediated by debt contracts, high‐growth firms (firms with fewer assets‐in‐place) are more likely than low‐growth firms to select the capitalization method of accounting for E&D and R&D expenses. JEL classification: M41; G31