Financial Accounting Theory Essay

The article â€Å"GM to Take Charge of $20. 8-Billion† here reproduced from The Globe and Mail (February 2, 1993) describes the potential impact of SFAS 106, â€Å"Accounting for Postretirement Benefits Other Than Pensions,† on General Motors and Ford. For example, it appears that General Motors will be required to record a liability of $20. 8 billion, reducing its shareholders’ equity from $27. 8 billion to $7 billion, about a 75% reduction. Describe and explain how you would expect the efficient securities market to react to this information. SFAS 106, Accounting for Postretirement Benefits Other Than Pensions: â€Å"This Statement establishes accounting standards for employers’ accounting for postretirement benefits other than pensions. It will significantly change the prevalent current practice of accounting for postretirement benefits on a pay-as-you-go (cash) basis by requiring accrual, during the years that the employee renders the necessary service, of the expected cost of providing those benefits to an employee and the employee’s beneficiaries and covered dependents. In exchange for the current services provided by the employee, the employer promises to provide, in addition to current wages and other benefits, health and other welfare benefits after the employee retires. It follows from that view that postretirement benefits are not gratuities but are part of an employee’s compensation for services rendered. This Statement relies on a basic premise of generally accepted accounting principles that accrual accounting provides more relevant and useful information than does cash basis accounting. Accrual accounting goes beyond cash transactions and attempts to recognize the financial effects of noncash transactions and events as they occur. Recognition and measurement of the accrued obligation to provide postretirement benefits will provide users of financial statements with the opportunity to assess the financial consequences of employers’ compensation decisions. In applying accrual accounting to postretirement benefits, this Statement adopts three fundamental aspects of pension accounting: delayed recognition of certain events, reporting net cost, and offsetting liabilities and related assets. (FASB, 2012) I would expect the efficient securities market to find this practice acceptable. â€Å"Accrual-based accounting is more effective than cash-based accounting. A few arguments to support this theory are: certain cash receipts and disbursements are â€Å"lumpy,† within operating cash flows receipts and payments can be lumpy, accrual-based accounting is a better predictor of a company’s long-term financial performance. Also all formal statements need to be set up using accrual-based accounting, and publicly traded companies need to use accrual-based accounting to conform to GAAP standards (Keener, 2012). 2. Chapter 4: Problem 12 (Imax) a. To what extent can revenue growth substitute for net income as a predictor of future earning power? Explain. Use efficient securities market concepts in your answer, and consider the requirement under GAAP for immediate writeoff of research and startup costs. â€Å"Both revenue growth and net income are useful in determining the financial strength of a company, but they are not interchangeable. Net income describes how efficient a company is with its spending and operating costs and how effect ively it has been controlling total costs. Revenue, on the other hand, only indicates how effective a company is at generating sales and does not take into consideration operating efficiencies which could have a dramatic impact on net income (Investopedia, 2012). † â€Å"Start-up costs are defined as â€Å"those unusual one-time costs incurred in putting a new plant into operation, opening a new sales outlet, initiating a new process in an existing plant, or otherwise commencing some new operation (FASB, 2012). † †Costs of start-up activities, including organization costs, should be expensed as incurred (FASB, 2012). â€Å"Definition of ‘Revenue Recognition’ An accounting principle under generally accepted accounting principles (GAAP) that determines the specific conditions under which income becomes realized as revenue. Generally, revenue is recognized only when a specific critical event has occurred and the amount of revenue is measurable. ‘Revenue Recognition’ explained For mo st businesses, income is recognized as revenue whenever the company delivers or performs its product or service and receives payment for it. However, there are several situations in which exceptions may apply. For example, if a company’s business has a very high rate of product returns, revenue should only be recognized after the return period expires. Companies can sometimes play around with revenue recognition to make their financial figures look better. For example, if XYZ Corp. wants to hide the fact that it is having a bad year in sales, it may choose to recognize income that has not yet been collected as revenue in order to boost its sales revenue for the year (Investopedia, 2012). † b. Use the concept of relevance to defend the revenue recognition policies outlined above. Relevant financial statements give information to investors about the firm’s future economic prospects (Scott, 2009). † c. Use the concept of reliability to criticize the revenue recognition policies outlined above. â€Å"To be reliable, information must have representational faithfulness and it must be verifiable and neutral (Scott, 2009). † d. To the extent that investors are awar e of the possible use of revenue recognition policies that overstate revenues (even though, for a specific firm, they may not know the extent to which that firm is using such policies), what is the effect on the operation of the capital market? Explain. â€Å"Investors have prior beliefs about a firm’s future performance. These prior beliefs will be based on all available information. If net income is high, or higher than expected, this may be good news. If so, investors would revise upward their beliefs about future performance. Other investors, who perhaps had overly high expectations for what current net income should be, might interpret the same net income number as bad news. Investors who have revised their beliefs about future performance upward will be inclined to buy the firm’s shares at their current market price, and vice versa for those who have revised their beliefs downward. We would expect to observe the volume of shares traded to increase when the firm reports its net income. Furthermore, this volume should be greater the greater are the differences in investors’ prior beliefs and in their interpretations of the current financial information (Scott, 2009). †