Question

The article “GM to Take Charge of $20.8 Billion” here reproduced from The Globe and Mail (February 2, 1993) describes the potential impact of SFAS 106, “Accounting for Postretirement Benefits Other Than Pensions,” on General Motors and Ford. SFAS 106 was a 1990 FASB accounting standard that required firms to accrue a liability for estimated retirement benefits, such as health care. Previously, such costs were accounted for on a pay-as-you-go basis, under which the expense for the year equalled the cash paid out for retiree benefits during the year. From the article, General Motors planned to record a liability of $20.8 billion, reducing its shareholders’ equity by about 75 percent, from $27.8 billion to $7 billion.

Atlanta—General Motors Corp. will take a $20.8 billion (U.S.) charge against 1992 earnings to account for a new way of estimating retiree health care costs, the automaker’s directors decided yesterday. The charge, which will not affect the struggling automaker’s cash flow, will leave GM with the largest annual loss of any U.S. corporation, eclipsing the company’s 1991 loss of $4.45 billion, which was a record at that time. Including accounting changes, other charges and losses on its North American operations, GM’s 1992 loss could approach $23 billion. The $20.8 billion is a non-cash charge. It reduces GM’s net worth to about $7 billion, still sufficient to pay stock dividends under the laws of Delaware, where GM is incorporated. Separately, GM said it would take a $744 million fourth-quarter restructuring charge for its National Car Rental Systems business. In a recent U.S. Securities and Exchange Commission filing, GM estimated that charge at about $300 million. The accounting change, required by the Financial Accounting Standards Board of all publicly traded U.S. companies, has had a major effect on each of the Big Three U.S. automakers. Ford Motor Co. said it would take a $7.5 billion charge against 1992 earnings to account for the change. Chrysler Corp. said it has not decided whether to take its $4.7 billion charge as a lump sum in the first quarter or spread it over 20 years, as the standard allows. GM had estimated its charge for adopting the new accounting standard at $16 billion to $24 billion. The $20.8 billion actual charge includes its workers, GM Hughes Electronics Corp. and its financial subsidiary, General Motors Acceptance Corp. The company’s EDS Corp. subsidiary does not pay health benefits, so it was exempt.

Question:

Assume GM had chosen to spread the charge over 20 years rather than as a single annual charge. In this case, in an efficient market, would the market reaction to the write-off differ? Explain why or why not

Answer 1

The following points should be considered:

•                     The efficient securities markets would not react. One reason is that the liability does not affect GM's cash flow, since amounts actually paid out to retirees would not be directly affected. Another reason is that the market knew the charge to shareholders’ equity was coming

— GM had estimated it at $16 to $24 billion. Given market efficiency, any effects of the charge would already have been reflected in GM's share price.

•                   The share price might fall if the write-off exceeded the market's expectations. While cash flows are not directly affected by the writeoff, the amount of the writeoff provides relevant information about what future cash flows for retiree benefits will be. Prior to the writeoff, the market’s expectation may have been at the lower end of GM's previous estimate. Then, the writeoff contains new information — the actual liability of $20.8 billion is higher than the $16 billion expected — which could cause a share price decline.

•                   The share price would fall if the market anticipated that the charge would create problems for GM in meeting the terms of debt covenants.

•                   It can also be argued that share price might rise. GM's share price might rise if the market felt that the large amount of the charge might cause GM to exercise greater control over its postretirement benefits in the future, thereby reducing its costs and improving cash flow.

•                     Another reason for a rise in market price would be that the market may have expected the charge to be at the upper end of GM's previous estimate, namely $24 billion. Then, the lower-than- expected actual charge may lead the efficient market to bid up the share price in response to this “good” news.

•                     GM would only record the charge if it did not expect future problems with debt covenant would arise. The market may thus interpret the charge as indicating inside information that GM had an optimistic view of its future performance. If so, GM’s share price would rise.