Are Capitalized Software Development Costs Informative About Audit Risk?
June 6, 2014 Leave a comment
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.
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