Are Capitalized Software Development Costs Informative About Audit Risk?

Accounting Horizons American Accounting Association Vol. 28, No. 1 DOI: 10.2308/acch-50580 2014 pp. 39–57

Are Capitalized Software Development Costs Informative About Audit Risk?

Gopal V. Krishnan and Changjiang (John) Wang

SYNOPSIS: Capitalization of software research and development costs (SDC) under

SFAS No. 86 is the only exception to SFAS No. 2 that calls for immediate expensing of

R&D costs. Although intangible assets have become increasingly relevant for firm

valuation, they remain largely unexplored in audit research. This is an important topic

because intangible assets, especially those that are internally developed, pose greater

challenges in assessing audit risk relative to tangible assets. Capitalization of SDC offers

a unique opportunity to study how auditors assess audit risk associated with the

recognition of this intangible asset. While capitalized SDC could shed light on software

products’ potential commercial success and inform the auditor about the client’s

business risk, the accounting flexibility allowed by SFAS No. 86 also increases the risk of

earnings management, and thus implies higher audit risk. Using audit fees as a proxy for

audit risk, our results indicate that capitalized SDC are negatively associated with audit

fees for firms where capitalization is inconsequential to beating analysts’ forecasts, and

also for firms with low analysts’ following. These results support the notion that

capitalized SDC signal lower business risk, especially for firms with low earnings

management risk or high private information.

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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