Accounting Theory and Policymaking
Accounting Theory and Policymaking
Accounting Theory and Policymaking
General Instructions:
1)
Answer the question listed below.
2)
You answer should be well thought out, well organized, and well written. These are all criteria that will be used as part of the grading.
3)
Your submitted document should be formatted as: one inch margins on all sides, double spacing, and font size 12.
4)
Make sure to use spell check.
5)
Your answer must not exceed three (3) double-spaced pages. Quantity is not the objective here, quality is what counts. A strategy of writing everything you think is remotely connected to the issue will not work. Points are deducted for unrelated material stuffed into an otherwise correct answer. Think through the question first, structure your answer logically, and write clearly. Re-read your answer before submitting. Check the logical when you re-read your answers.
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Academic Integrity You must honor Baruch College’s standards regarding integrity, honesty, and cheating at all times. Sharing of information in any capacity in any form during this exam is strictly forbidden. Any breach of these standards will be dealt with in accordance with Baruch College’s Code of Academic Integrity.
Your submitted answer must be entirely your own work. Copying any material from any source is considered cheating. You can of course read anything to inform your thinking on a topic, but your written answers must be your own work. The sanction for a proven case of cheating can include an “F” grade for the entire course.
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Question
Goodwill is an intangible asset recorded when one firm acquires another. In 2001 the FASB issued SFAS 142 which changes the US GAAP treatment of goodwill. Prior to this change, a firm would record a goodwill asset on an acquisition, and then amortize (i.e., expense) this goodwill asset over a period not to exceed forty years. After the adoption of SFAS 142, goodwill assets are still recorded at acquisition, but are not automatically amortize (i.e., expense) through the income statement. Instead, goodwill is subject annual impairment testing. If the goodwill asset is not impaired, then it continues unchanged; if, however, the goodwill asset is deemed to be impaired, then the firm must record a large, once-off, impairment write-off its goodwill asset(s).
Financial accounting information serves a number of different roles, including: (1) providing useful information to investors for valuation purposes, i.e., helping investors value stocks, (2) providing useful information for “stewardship” purposes, i.e., providing stakeholders with information that is useful for judging how effectively management is running the business (or, how well management is providing “stewardship” over the assets of the business), and (3) providing information that can be used for contracting, i.e., information that can be used to write managerial incentive contracts, debt contracts etc.
Requirements:
The adoption of SFAS 142 likely impacted the usefulness of US GAAP financial reporting information in fulfilling all three of these roles. In the deliberations that preceded the adoption of SFAS 142, the following issues were raises. Please explain each of these arguments/issues.
1)
Proponents of the change argued that adopting SFAS 142 would provide more transparency regarding bad acquisitions by management (i.e., acquisitions that destroyed shareholder value), thus improving stewardship. Explain. Why might this be an important issue? Which types of firms are most likely affected by this concern?
2)
Value investors using earnings-based valuation models had conflicting views regarding the new standard. SFAS 142 may have increased or decreased the usefulness of firms’ earnings for valuation purposes. Outline both sides of this argument (i.e., why the change may have made earnings more or less useful to equity investors who use earnings-based valuation models).
3)
For firms with bank loans the adoption of SFAS 142 may have been a concern. Here the concern revolved around the potential impact of the change in goodwill accounting on the balance sheet-based covenants that are included in most loan contracts. Balance sheet covenants are loan covenants that use balance sheet information. A loan covenant that states that the borrowing firm’s debt-to-total assets ratio must not exceed 70% is an example of a balance sheet covenant. Please explain this issue.
