The Value-Relevance of Intangibles: The Case of Software Capitalization

We examine in this study the relevance to investors of information on the capitalization of software development costs, as promulgated in 1985 by the Financial Accounting Standards Board in its Statement No. 86 (SFAS 86). We find that software capitalization is value-relevant to investors: The annually capitalized development costs are positively and significantly associated with stock returns and the cumulative software asset reported on the balance sheet is associated with stock prices. Furthermore, software capitalization figures are associated with subsequent reported earnings, indicating another dimension of relevance to investors. We also find that investors undervalue firms that expense all their software development costs. Finally, we find no support for the frequent argument that the judgment and subjectivity involved in software capitalization adversely affects the quality of reported earnings. We also investigate why the industry petitioned the FASB, in March 1996, to abolish SFAS 86. We document a significant shift in the mid-1990s in the impact of software capitalization on reported earnings and return-on-equity of software companies. Whereas in the early period of SFAS 86 application (mid- to late-1980s) software capitalization enhanced reported earnings considerably more than its detraction by the amortization of the software asset (since that asset was still small), during the early 1990s the gap between capitalization and amortization narrowed, and in 1995, the amortization?s negative impact on reported profitability roughly offset the positive impact of capitalization. This diminished impact of capitalization on reported performance may have been among the reasons underlying the petition to abolish SFAS 86. Finally, we find that analysts? earnings forecast errors are positively and significantly associated with the intensity of software capitalization.