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4-13 Accounting Theory

In: Business and Management

Submitted By yiranjack
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13. a. The following points should be considered:

 Revenue is the “lifeblood” of a business. Consequently, revenue growth suggests future profitability, particularly in the presence of fixed costs—once revenue rises to the point where fixed costs are met, profitability can rise very quickly. This suggests that revenue growth has potential as a predictor of future earning power.

 However, since net income includes both revenues and expenses, net income or loss has at least as much potential as a predictor of future earning power as revenue growth.

 The efficient market can adjust for R&D and startup costs, assuming these are disclosed, and will not penalize the firm for lack of reported earnings, or a reported loss, due to these items.
Consequently, immediate writeoff of these items is not an argument to concentrate on revenue growth as a predictor of future earning power.  The income statement contains information that may assist the efficient market in interpreting revenue growth. For example, in the case of Imax Corp., bad debt expense should incorporate the expected amounts of customer defaults on long-term contracts.
Also, Bid.Com will include the (net of commission) price paid by the buyer in cost of sales. Thus, its gross profit will not be misstated.

 MD&A contains information that assists in interpreting net income and assessing future firm performance. This adds to the ability of net income to help investors to predict future firm performance.
A reasonable conclusion is that revenue growth has some information content as a predictor of future earning power but that it is not a substitute for net income. Rather, revenue growth, net income or loss, and supplementary information such as MD&A should all be considered.

b. The earlier revenue is recognized in the firm’s operating cycle, the more relevant is revenue…...

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