Seminar – R&D accounting and innovation signaling: Insights from Japan’s pre-regulation era

Leveraging pre-2000 Japan as a natural experiment, where R&D activities flourished in the absence of formal accounting regulations, we examine the role of R&D capitalization as a signal of project quality. By using patent citations to gauge long-term outcomes, we find that boutique inventing firms capitalized R&D costs as long-term assets to signal high-quality projects—projects that later garnered significant patent citations 5 to 10 years after the investment. However, the adoption of U.S. GAAP-like R&D expensing regulation post-2000 eliminated this signaling mechanism. Before the regulation, equity market reactions were positively correlated with capitalized R&D but not with expensed R&D. After the expensing mandate, the market’s ability to differentiate firms based on project quality weakened. In response to the loss of signaling through capitalized R&D, boutique firms pivoted toward more diverse project portfolios, pooling their efforts with larger companies. This strategic shift reduced risk, resulting in lower interest rates on debt financing. However, the equity market struggled to discern high-quality projects, leading to muted reactions to R&D investments. This natural experiment provides valuable insights into how varying R&D accounting treatments can shape innovation strategies, capital allocation, and overall firm competitiveness.

REC M4.02