There are several reasons why we should pay attention to accounting earnings numbers.
First, net income predicts a company’s future cash flow better than current cash flow does.
Second, net income is potentially informative when there is information asymmetry between corporate managers and outside investors.
Question 5(a). If management reports truthfully, what economic events are likely to prompt the following accounting changes?
Increase in the estimated life of depreciable assets. Managers may increase the estimated life of depreciable assets when they realize that the assets are likely to last longer than was initially expected.
Decrease in the uncollectibles allowance as a percentage of gross receivables. The firm’s change of customer focus may prompt managers to decrease the allowance for uncollectible receivables.
Recognition of revenues at the point of delivery, rather than at the point cash is received. Revenues can be recognized when the customer is expected to pay cash with a reasonable degree of certainty.
Capitalization of a higher proportion of software R&D costs. According to SFAS No. 86, costs incurred on software development after the establishment of technical feasibility and commercial feasibility are to be capitalized.
Question 5(b). What features of accounting, if any, would make it costly for dishonest managers to make the same changes without any corresponding economic changes?
Third-Party Certification. Public companies are required to get third-party certification (auditor’s opinion) on their financial statements. Unless the accounting policy changes are reasonably consistent with underlying economic changes, auditors would not provide clean auditor’s opinion.
Reversal Effect. Aggressive