Personal Finance Case 4-4

Problem #4-13
a) In order to answer the question, we first need to consider what do revenue growth and net income represents. Revenue growth suggests the company’s future profitability, which means that revenue growth has the potential to be a predictor of future earning power. The income statement contains both revenue and expense information. Furthermore, in an efficient market, R&D and startup costs can be adjusted, and as long as these information are available to the public, the company will not be penalized if the company incurs high R&D and other startup cost that delay the advent of profitability. Therefore, net income also has the potential as a predictor of future earnings.

Next we need to compare the ability of revenue growth and net income to predict future earnings. Income statement contains information that may help the efficient market to better interpreting
Thus, an efficient securities market will react to the profitability of a contract once both parties signed the contract, assuming contract information is available to the public. This means that market price will change immediately regardless of whether the company chooses to recognize the revenue early or late. In other words, it is the content of the contract, not the timing for revenue recognition, which will affect the market price. For companies that recognize revenue early, the reported net income will change with the share price because the companies include expected profit in its net income in the same period the contract is signed. On the other hand, for companies that recognize revenue late, net income will not be affected by the signing of the contract, even though share price will react to it. Therefore, revenues of early recognizers will be more highly associated with their share returns than revenues of late