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The Impact of Accounting Choices on Firm Valuation and Earnings Quality: The Case of Transition Obligaion under SFAS 106

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Intellectual Contribution by Su-Jane Hsieh

Contribution Title

The Impact of Accounting Choices on Firm Valuation and Earnings Quality: The Case of Transition Obligaion under SFAS 106

Publication

Review of Accounting and Finance

Co-author

C.S. Agnes Cheng and Yewmun Yip

Year

2007

Description

Statement of Financial Accounting Standards No.106 (SFAS 106) requires firms to use the accrual basis for recognizing service costs related to the post-retirement benefits other than pensions (PRB). The unfunded past service costs of PRB (i.e., transition obligation) can be either expensed immediately in the adoption year of SFAS 106 (referred to as immediate recognition) or amortized in the future (referred to as prospective recognition). Thus, in the adoption year, the earnings of firms applying immediate recognition method are severely understated but their book value is fairly stated. On the other hand, the earnings of prospective recognition firms are slightly understated and their book value is overstated.

Using a sample of 50 immediate recognition firms and 50 matched prospective recognition firms, we find that in spite of the significant difference in impact on earnings from the choice of treatment of transition obligation, the accounting choice has no significant impact on the total value relevance of earnings and book value. A further investigation reveals that when immediate recognition method is applied, investors ignore the one-time charge of transition obligation, and rely more on book value in the valuation of a firm. When prospective recognition method is applied, both earnings and book value are value relevant in the adoption year and also in the subsequent year. In addition, we find that the implementation of SFAS 106 improves the value relevance of earnings. This finding provides empirical support for the superiority of accrual basis over cash basis on earnings measurement.

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