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    Are Capitalized Software Development Costs Informative About...
    research summary posted March 10, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 02.02 Client Risk Assessment 
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    Title:
    Are Capitalized Software Development Costs Informative About Audit Risk?
    Practical Implications:

    In general, the results of this study provide empirical evidence that capitalized software development costs are incrementally informative about the client’s business risk and the overall audit risk.

    • First, although intangible assets play an increasing role in firm valuation, very little is known about whether and how auditors regard these assets in assessing audit risk. Thus it fills a void in the literature on the auditor’s assessment of capitalized software development costs.
    • Second, this study examines a setting that mitigates the client’s business risk. It is important in that while economic models predict that audit fees reflect business risk, there is some evidence that audit practice does not support a relation between business risk and audit fees
    • Third, this study could be viewed as a ‘‘bridge’’ between the limited literature on investor valuation of capitalized software assets and auditing
    • Fourth, this study also shed light on how auditing under certain circumstances could potentially enhance the informativeness of recognized assets that are subject to a high degree of information asymmetry and managerial discretion

    For more information on this study, please contact Gopal V. Krishnan.

    Citation:

    Krishnan, G. V., and C. Wang. 2014. Are Capitalized Software Development Costs Informative About Audit Risk? Accounting Horizons 28(1): 39-57.

    Keywords:
    audit fees; SFAS No. 86; business risk; software development costs; earnings management.
    Purpose of the Study:

    Capitalization of software research and development costs (SDC) is controversial and is the only exception to SFAS No. 2 that calls for immediate expensing of R&D costs. The purpose of this study is to examine whether capitalized SDC are informative about audit risk. Audit risk is the risk that the auditor renders an incorrect opinion on whether the financial statements are in compliance with GAAP.

    Design/Method/ Approach:

    This sample consists of 564 firm-year observations representing 157 software firms (SIC code 7372) for the period 2004 through 2009. The authors estimate a regression of the log of audit fees on a variety of determinants of audit fees and two measures of lagged capitalized SDC.

    Findings:
    • The authors find that on average capitalized SDC has a negative impact on audit fees after controlling for traditional measures of client risk (e.g., negative return on assets, high leverage, going concern opinions, accounting restatements, and internal control problems).
    • The results hold for firms where capitalization is inconsequential to beating analysts’ forecasts, firms that are older or have low analysts’ following.
    • The study does not find a significant association between audit fees and capitalized software development costs for firms that meet or beat analysts’ forecasts or have high analysts’ following.

    The authors claim their results support the notion that capitalized software development costs signal lower business risk—especially for firms with low earnings management risk or high private information (information asymmetry).

    Category:
    Auditor Selection and Auditor Changes, Client Acceptance and Continuance
    Sub-category:
    Audit Fee Decisions, Client Risk Assessment