Capital Market Motivation,Tax Enforcement And Classification Shifting Of R&D

China’s accounting principles allow managers’ discretion in deciding what costs are classified as R&D. This study investigates classification shifting from operating expenses to R&D as an earnings management tool. When classifying general expenses as R&D, the expensing part is still part of the core costs, but is assigned higher valuation by investors; the capitalized part can directly increase the profit. I hypothesize that managers may use R&D investment as an excuse for not achieving the earnings growth, and thus companies face profit declines have more incentives to classify other expenses as R&D. Using data on Chinese firms, I find results that support the hypothesis. The findings illustrate the financial reports of listed R&D investment may be over-reported. This study calls for attention of investors, regulators, and other related subjects.There are preferential tax policies for R&D investment in China. The over-reported R&D investment listed in financial reports may draw attention from tax department. I hypothesize that tax collection as an effective external governance mechanism, can also inhibit R&D classification shifting. Empirical research shows that in the low tax collection areas, R&D classification shifting remains significant; while in the high tax collection areas, the model becomes insignificant. Therefore, increasing the intensity of tax collection, especially for supervision of R&D investment, we can not only prevent the loss of state financial resources, but also inhibit malignant earnings management behavior by improving corporate earnings management costs, so as to better protect the interests of investors and the promote the healthy development of the capital market.