The value-relevance of alternative accounting treatments of software development costs

This paper analyzes the value-relevance of accounting information based on alternative accounting treatments of software development costs. This research is motivated by opposing views about which accounting treatment for software development costs best communicates firm value. Some have argued that software capitalization allowed by current accounting standards does not provide users with value-relevant information and should be eliminated. Others have argued that current accounting standards prohibitively limit software capitalization and that increased capitalization would improve the value-relevance of accounting information.; This paper compares three alternative accounting treatments for software development costs to current practice: full expensing, ffull capitalization with uniform amortization, and full capitalization with firm-specific amortization. Full expensing eliminates software capitalization by requiring all software development costs to be expensed as incurred. Full capitalization with uniform amortization allows for increased capitalization relative to current practice and requires all software development costs to be amortized over a uniform three-year period. Full capitalization with firm-specific amortization also allows for increased capitalization relative to current practice but uses software firms' currently reported amortization rates.; Test results indicate that full capitalization with uniform amortization is most consistent with observed stock prices. Accounting information based on this treatment explains more of the variation in observed stock prices than reported accounting information based on current practice. Conversely, full expensing and full capitalization with firm-specific amortization do not explain more of the variation in observed stock prices relative to current practice. Overall, the results suggest that market participants adjust currently reported accounting information to reflect full capitalization of software development costs. The results are consistent, however, with the market using a uniform amortization rate for all firms instead of using software firms' currently reported amortization rates.