Accounting Theory, 7th Edition Jayne Godfrey, Allan Hodgson, Ann Tarca, Jane Hamilton, Scott Holmes

Accounting Theory, 7th Edition By Jayne Godfrey, Allan Hodgson, Ann Tarca, Jane Hamilton, Scott Holmes

Email: Richard@qwconsultancy.com

Solutions Manual to accompany

Accounting Theory 7e By

Victoria Wise Chapter 1 Introduction

© John Wiley & Sons Australia, Ltd

Chapter 1: Introduction

Chapter 1 - Accounting Theory THEORY IN ACTION Theory in Action 1.1 Theory implementation and politics 1.

The article describes how a particular theoretical approach has been replaced by another. Explain why one theory replaces another, and who, or what, determines whether an existing theory survives.

A theory is primarily meant to explain or predict an event, behaviour or outcome.

Proponents of a theory look for evidence to support the theory. This evidence should be independently observed and consistent after repeated observations. Some theories are speculative or ideas or guesses floated to encourage researchers to undertake the observations required to prove or disprove the theory. The question often debated is what comes first — the theory or the observation? For example, did Darwin start thinking about different species and the idea of natural selection or did evolution enter his thoughts? Did he detail these thoughts as a testable proposition and then set out to observe? Or did he observe aspects of nature which led him to formulate a theory of evolution? The latter is much more likely and for most theoretical development, observations result in development of propositions which are tested over time.

Where the body of evidence in support of the underlying theory appears to be supported by observations, then the theory is accepted. But not necessarily by everyone. Why not?

Some may not be satisfied with the methods adopted to test the propositions; others simply may not believe the theory explains or defines reality and propose alternative theories.

In the specific case of Bernanke’s theoretical choices based upon his detailed knowledge of the Great Depression, a similar process would be required and if the weight of evidence supported Bernanke’s propositions in explaining economic outcomes, then his theoretical perspective would supplant other theoretical perspectives.

In the social sciences it is even more complicated than the physical sciences. The interpretations of outcomes and behaviours are subject to individual research interpretations and the full range of factors impacting on the economy, for example, are much more difficult to control or isolate.

2.

Does the reintroduction of a theory mean that it should not have been replaced in the first place?

Theories about how the economy works and what will happen in the economy where there is monetary policy or fiscal policy intervention are appropriate in assisting policymakers understand the possible implications of decisions they make or are under consideration. However, they are rarely complete models and often outcomes cannot be predicted. Reintroduction of a theory suggests that new evidence in support of the theory has been reported.

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Solution Manual to accompany Accounting Theory 7e

3.

Should a theory be discarded if it does not specify the means of achieving a stated objective? Explain your answer.

The theory itself doesn’t have to specify the means of achieving a stated objective; however, it has to provide a sound basis for explaining, defining and predicting behaviour. The application of the theory can have many elements and it is in the interpretation of what will induce the predicted effects in the economy predicted by the theory which will result in predicted or other stated outcomes.

Instructors should ask the students to discuss how we would know whether a reduction of corporate interest rates resulted in an increase in the inflation rate?

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Chapter 1: Introduction

Theory in Action 1.2 Out of Control

1.

‘Rogue’ is defined in the Oxford dictionary as ‘that which lacks appropriate control; something which is irresponsible or undisciplined’. Given this definition, who is ultimately responsible for the rogue trading outlined in the Societe Generale scandal: the trader directly involved; management, who are responsible for the high-risk, high-reward framework in which the trader operated; or a combination of both?

Obviously all parties are responsible for their actions. The weak risk-management controls in place at Societe Generale allowed behaviour which ultimately could not be controlled by the employer. Why? Because Societe Generale created an environment where traders could become ‘rogues’. It is important to appreciate that the emergence of ‘rogue’ behaviour can be a function of environment and in particular the embedded controls designed to detect and inhibit such behaviour. In addition, if management was pushing for outcomes, in a way the ‘rogue’ was seeking to meet management’s performance expectations. Actions, demands, and also incentives, create and/or reinforce behaviour. The impact of financial performance benchmarks should not be underestimated. Students should discuss how controls, monitoring, and incentives can discourage/create behaviours and what types of factors are more likely to stimulate ‘rogue’ behaviour.

2.

Discuss the role played in the SocGen case by each of the three elements: personality, institutional framework, opportunity.

(1)

Personality — in a competitive environment people will either compete or leave.

In the competition itself behaviours will have to change and adapt, risk preferences will shift and consideration of the downside possibilities discounted.

Research shows that a group environment often results in different behaviour to individual or isolated thinking.

(2)

Institutional framework — SocGen was not controlling its risk associated with trading and this allowed the individual involved to operate outside the accepted parameters. Also, the individual’s knowledge of back-room trading operations and processes meant that significant ‘positions’ and losses could be hidden and offset against the upside, this gave the institution the result required and basically shifted the trader into rogue trades (possibly to ‘make budget’).

(3)

Opportunity — this relates to the first two points. The opportunity was created by the position and background experience and knowledge the trader held and the environment encouraging an unregulated approach.

The three elements are inter-related. Students should discuss which factor was the most critical in creating the behaviours documented, and the alternative view that the elements are equally important.

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Solution Manual to accompany Accounting Theory 7e

3.

How could Societe Generale have been unaware of the activity of its trader and of the environment that it had created for the trader to operate within?

The types of environments that might create such rogue behaviour may be predictable.

Students should consider what the role of theory is; is it to predict and explain behaviour? Then a good theory of rogue behaviour should do just that. However, most theories in accounting are usually better at explaining the elements of behaviour after they have occurred, rather than predict them. The problem is access to observable data.

Positive theories are based on predicting behaviour based on past observations. Would this approach work in the case of behaviour which the traders did not want observed?

4.

Do you think that the actions of ‘rogue’ traders are predictable under particular theories (such as agency theory)? Explain your answer.

Knowledge of appropriate behavioural theories will not stop behaviour of the type outlined. However, knowledge does empower management: the embedding of appropriate bonding and monitoring mechanisms and other relevant incentives and disincentives are predicted (under agency theory) to have a particular influence on an individual’s behaviour. Such a theoretical approach to risk-management could be used to identify the environmental factors that could lead to rogue behaviour. But we will not know whether applying the elements of the theories to register the existence of such environments and then action is taken to change the environment, actually changes/ed behaviour. Why? Because the rogue behaviour may exist undetected; or may never occur. This is a concern with positive research, particularly in the behavioural area, we just never have a complete set of observations.

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Solutions Manual to accompany

Accounting Theory 7e By

Allan Hodgson and Victoria Wise Chapter 2 Accounting theory construction

© John Wiley & Sons Australia, Ltd

Chapter 2: Theory and method

Chapter 2 - Accounting theory construction Questions 1.

‘A theory that is purely syntactic is sterile.’. Is this true? How can this statement relate to accounting?

Syntactical: This represents the logical relations in the theory. This concerns the rules of the language employed, e.g., the rules of grammar for English or the rules of mathematics for a mathematically expressed theory. Syntactical relations are logical connections that cement together and explain the important concepts of the theory.

A purely syntactic theory, whilst important, may be sterile if it doesn’t explain or predict anything about the real world. A less sterile theory can be concerned with predicting or explaining some phenomena or with prescribing a course of behaviour. It can be a collection of propositions and conclusions which are designed to illustrate the principles of a subject. Other terms such as ‘hypothesis’ or ‘supposition’ are often used instead of theory. In essence the syntactical part of the theory is the simplest form of the theory and is based on an explicit (or implied) statement of a belief expressed in a language such as written language or mathematical language.

Students should recognise that there are three recognised parts to a theory: the syntactic, semantic and pragmatic relations. Instructors should briefly review and explain each part.

At this point instructors may use a number of theories which have evolved in accounting and which probably reflect the different ‘views of the world’ or the way accountants see problems as individuals. For example theories of accounting can be described and classified as: (i) (ii) (iii) (iv) (v) (vi)

an historical record-keeping activity (pragmatic or syntactic theory) political theories (pragmatic theories) communication — decision making (pragmatic, syntactic and semantic theories) accounting as an economic good (pragmatic) accounting as magic or mythology (pragmatic) accounting as a social commodity to exploit or aid policies or as a social club for accountants (pragmatic)

That is strictly speaking, not all relations are required in theory formulation. We may have separate syntactical, semantic and pragmatic theories and a number of branches of scientific enquiry can be classified under each heading; e.g. mathematics (syntactical), physics (semantic), political science (pragmatics) and so on. However, the instructor should now pose the question whether all these relations exist in accounting. The answer is yes to varying degrees and also according to the perceptions of the student (and the instructor) of the importance of each relation. Students should then have some understanding of the complexity of defining and studying ‘accounting theory’. (see the chapter for further brief descriptions)

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Solution Manual to accompany Accounting Theory 7e

2.

One type of theory construction involves observing the practices and techniques of working accountants and then teaching those practices and techniques to successive accountants. (a) What type of theory construction is this?

This is a pragmatic theory construction. This relation pertains to the effect of words or symbols on the behaviour of people, in this case, the practicing accountant. (b) What are the advantages of this approach compared with a decisionusefulness approach to theory construction?

The advantage is that the theory (and practices) are formed by accountants who are at the coalface. If there is no special interests then they will produce the best accounting for their clients. They will react to the demand generated by the market. A pragmatic theory is where we observe the behaviour of practising accountants and then copy their accounting procedures and principles.

Advantages: (i)

the solutions of practising accountants are related to the requirements of the business world. (ii) they have developed (and been handed down) over a number of centuries. (iii) it is a pragmatic approach to solving the problems of accounting.

Disadvantages and comparison to a decision making approach: (i) (ii) (iii) (iv)

no logical assessment (not deductive) does not allow change (or change occurs slowly) we perpetuate current practice concentrates on pragmatics and ignores the measurement issues (semantics) that allows the accountant to make decisions on value and possible investment.

(c) What are the disadvantages of this approach?

Not all theories have a pragmatic orientation, but the nature of accounting makes this relationship an important one. The problem here is a circular role in this theory.

Accountants teach other accountants how they do things and they perpetuate this role by then teaching other accounting apprentices. The criticism of this approach is that it does not have syntactic or semantic input. See above (b). (d) Do you believe that this is a good approach to developing a theory of accounting? Why or why not?

This is a question that asks the student to recognise that there are alternative interpretations in accounting theory. An overall theory of accounting can be an ‘instrument’ for recognising and measuring income and capital. Essentially, it is a set of rules, a ‘blueprint’, for constructing specific accounting systems for the recognition and measurement of the income and capital of the particular entity. The results of an accountant driven specific accounting system of a particular firm provide an

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Chapter 2: Theory and method

‘explanation’ of what happened to the firm or serve as a basis for ‘prediction’ of what may happen. In other words the accountant may be the best judge.

Instructors should be aware that this debate is a common one argued between practising accountants and some normative decision oriented accounting theorists and will invoke a number of responses from students. A number will argue that an approach which lacks a decision making investor focus will have the danger of becoming dogmatic or self fulfilling. A pragmatic approach may mean that too much emphasis is placed upon the practices and techniques of accountants and little emphasis is placed upon the meaning of the actual ‘financial statements’. Accounting then may revert to a procedural art.

On the other hand, others may rightly argue that accounting theory may become too obtuse if a completely decision making approach is taken, without regard to the other roles accounting plays in the real world. Theoretical argument without pragmatic application is likely to be of little benefit to business and society.

At this point the instructor can point out there are several theories that have evolved in accounting and which reflect the different ‘views of the world’ or the way accountants see problems as individuals. For example, theories of accounting can be described and classified as: •

historical record-keeping activity Example: firms use accounting principles to keep a record of their transactions so that they can advise how resources have been used.

•

a language Example: financial statements are used by management to communicate to shareholders how well they have performed in running the business.

•

political theories Example: management use accounting reports to allocate resources among different divisions within the firm, or different levels of employees.

•

magic or mythology Example: Enron management used accounting techniques to hide the losses it suffered from transactions with its special purpose entities.

•

communication — decision making Example: a local bank decided to give loans to a small business after analysing the business’ financial position.

•

an economic good Example: there are costs involved in producing financial reports (not free).

Accounting information is demanded to make economic decisions, but there is a cost to its supply since accounting information is a scarce commodity itself.

•

a social commodity Example: government uses accounting numbers (such as profits or research expenditure) to decide whether to give grants to particular firms.

•

ideology and exploitation Example: firms cut down jobs in their unprofitable divisions.

Describe the semantic approach to theory construction.

3.

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Solution Manual to accompany Accounting Theory 7e

Semantics: Semantics is sometimes referred to as rules of correspondence or operational definitions. It connects symbols, words, terms or concepts with real-world objects, events or functions and is seen to make a theory realistic. (i)

In accounting semantic theory concerns itself with the correlation of propositions to objects or events and manifests itself in terms of measurement theories: for example measuring the effects of inflation on assets and liabilities and adjusting the accounts to reflect these adjustments. Theorists in this area argue that by applying these adjustments, the accounts then have semantic content and can be related to the real world (which they see as being market prices). Input semantics – assigning numbers to the transaction inputs of accounting, e.g. assets, liabilities, revenue, expenses. This transactions based approach is often criticised as a mathematical system divorced from logical analysis or output semantics. (ii) Output semantics – testing the outputs of the accounting system against some external reference, e.g. increases in profits against share price changes (see also Theory in Action 3.1). (iii) It seems logical to conclude that if the purpose of undertaking accounting is to impart semantic content to the numbers then they should be verified. This can be undertaken by checking market prices, stock prices or even the historical cost depending on the stated purpose of the accounting. However, this is a difficult question as there are very few external referents other than the stock market and market prices. Further, market prices exist for a minority of businesses. In most cases the financials determined by accountants are the sole determinant of a firm’s financial health. Many students, recognising this problem, will revert to a ‘reasonableness test’. (a) Should the outputs of accounting systems be verified?

The debate in the 1970’s about inflation was a normative debate in that researchers argued that we should change the accounting methods and output reports produced according to the prescriptive judgement of the writer. That is we should use some form of market based accounting to adjust for inflation instead of historical cost accounting.

Normative accounting research is more concerned with policy recommendations and is concerned with what should be done in contrast to explaining why current practice is carried out in the manner that it is.

Normative theorists usually attempt to derive either the ‘true income’ or adopt the ‘decision — usefulness’ approach whereby accounting reports are an input into users’ decisions (e.g., to buy or sell shares, management decisions on the financial wealth of firms, etc.).

The major issues are the impact of the changing price environment (prices) and the impact on income, assets, liabilities and equity. As a consequence many normative theorists are measurement theorists who attempt to incorporate the effects of inflation into accounting reports. In this sense they take a semantic viewpoint — relating the figures in the accounting reports to actual objects (assets, liabilities) or events (changes in inflation).

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Chapter 2: Theory and method

(b) If so, how can this be achieved? If not, why?

Certainly if we have a valuation approach to accounting then inflation affects value and should be taken into account in making decisions. Whether accounting should be purely a semantic science (or a syntactic or pragmatic science) is in itself a normative statement and whichever way students answer this point should be brought to their attention.

Inflation may matter to some accountants but not to others. For example a management accountant who is trying to control costs or projects may have to pay a great deal of attention to the inflation rates in various sectors, an accountant who is responsible for hedging money market funds will be interested in the real rate of return on funds or look to inflation induced hedges (e.g., in real assets). On the other hand taxation accountants, auditors or record keepers may have very little interest in the effects of inflation.

4.

In the 1970s there was much debate about how to account for inflation. (a) Did this debate involve positive theory or normative theory?

Compare the above normative approach to a positive approach, which would ask the empirical questions: ‘Why do accountants manipulate data under the accrual system?’ or, ‘Is accrual data more useful than cash flow data?’ Instead of simply normatively recommending change. The approach is basically whether we understand the world as it is or suggest change based upon assumed premise. (b) Is it important to account for the effects of inflation? Why or why not?

However both approaches may or may not be individually valid but compliment each other. Both approaches need to be more rigorously examined before any conclusion is warranted and normative theories should contain pragmatic and semantic input and similarly positive theories should have logical and normative reasoning.

5.

Researchers who develop positive theories and researchers who develop normative theories often do not share the same views about the roles of their respective approaches to theory construction. (a) How do positive and normative theories differ? (b) Can positive theories assist normative theories, or vice versa? If yes, give an example. If not, why not?

Normative accounting research makes policy recommendations and is concerned with what should be done in contrast to explaining why current practice is carried out in the manner that it is (positive theory).

Normative theorists usually attempt to derive either the ‘true income’ or adopt the ‘decision — usefulness’ approach whereby accounting reports are an input into users’ decisions (e.g., to buy or sell shares, management decisions on the financial wealth of firms, etc.). The major issues are the impact of the changing price environment (prices) and the impact on income, assets, liabilities and equity. As a consequence many normative theorists are measurement theorists who attempt to incorporate the effects of inflation into accounting reports. In this sense they take a semantic viewpoint — relating the figures in the accounting reports to actual objects (assets, liabilities) or

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Solution Manual to accompany Accounting Theory 7e

events (changes in inflation). To some extent the approach of the IASB is a normative approach.

Positive accounting theory was a reversion to testing or relating accounting theories back to the ‘facts’ or ‘experiences’ of the real world. Examples of such research were questionnaires and surveys of bank officers or investors regarding their use of financial reports for decision making; or whether inflation adjusted accounting reports actually aided decision making. Current positive accounting research is aimed at explaining the reasons for actual accounting practices and in predicting the role of accounting data in economic, political and social decision making. Positive theory has expanded accounting theory from the purely decision making focus of normative theorists into analysis of political and economic factors.

Using the normative recommendation of IFRS, that fair values should be used in financial statements, a positive theorists would first undertake a number of empirical tests to see if they are actually useful/used by decision makers in their valuation models.

In this sense they complement each other – normative theory the deductive analysis with positive theory the empirical verification.

6.

Can accounting theory be constructed as a purely syntactical exercise? Why or why not?

The major problem with syntactics is that the truth value of any proposition is ascertained by logic or reasoning alone. If the underlying accepted premises of the logic have no reference to the real world or are false, then the conclusions have either no pragmatic usefulness or the conclusion is incorrect. The tutor should mention here the reaction of logical positivism against metaphysical or abstract theorising (see text).

Logical positivism argued that all theoretical statements should be capable of being reduced to statements which can be immediately observed and that anything that cannot be empirically verified is meaningless. The reaction was against romantic theorising which had no practical application. Logical argument should be precise and serviceable.

Science usually progresses via logical debate and counter debate. However, syntactics alone cannot act as a source of true statements about the world. Syntactics alone are only concerned with the derivation of statements from other given statements. This is the real weakness of syntactics as a stand alone method.

As an example of syntactics in accounting theory the instructor can use the theory of double-entry and historical costs which has been confirmed and verified by auditors many times.

The criticisms of this approach are: (i)

all manipulations are correct as long as the rules of mathematical bookkeeping are applied (ii) there are many acceptable sets of ‘equations’ (iii) no semantic verification — not descriptive of real world objects or events.

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Chapter 2: Theory and method

Under this approach science progresses by trial and error. The non falsification of bold hypothesis or the falsification of cautious hypothesis mark significant advances in science.

See also the answer to question one.

In addition instructors may wish to channel discussion towards a discussion about how we view the world. For example, using ontological assumptions and the Morgan and Smircich six-way classification that we may assume reality as being anything from a concrete structure (realist — objectivist viewpoint) down to reality as a projection of human imagination (unstable — human specific).

If we have an ontological viewpoint that the accounting world is relatively concrete and stable then it is more appropriate to choose a syntactic-scientific approach to accounting theory. That means that we are more likely to have a structured, prior theoretical base but this must be backed up by empirical validation. On the other hand if we view the world of accounting as being a product of human imagination we are more likely to have an unstructured research methodology with no prior syntactic other than the assumption that we are facing a soft ontology.

7.

Classify the following hypotheses according to whether they are conclusions of positive or normative theories. Explain your answers. (a) Historical cost accounting should be replaced by a market value system. (b) Historical cost accounting provides information used by creditors. (c) Historical cost accounting is used by many managers to allocate costs in determining divisional performance. (a) (b) (c)

normative positive positive

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Solution Manual to accompany Accounting Theory 7e

8.

Give an example of the types of issues that might be resolved by accounting theories developed using the following methods of theory construction. (a) psychological pragmatic approach (b) scientific approach (c) naturalistic approach (d) normative approach (e) positive approach

(a) the behaviour of investors to the release of accounting data (b) the reaction of all stock prices to the release of accounting data and why (c) the reaction of employees in one particular firm to the release of accounting data (d) all accounting reports should be adjusted by inflation before they are released (e) what type of accounting do firms in one particular industry use for inventory before they release their accounting reports 9.

Explain the naturalistic and syntactic approach to theory construction. Are these approaches mutually exclusive?

The difference between scientific and naturalistic research is set out in table 2.2 on page 32. The instructor should aid students’ understanding by briefly categorising accounting research into scientific and naturalistic. The International View (2.2) is an excellent backdrop to illustrate the difference and to show how research has delineated.

10.

The decision-usefulness approach to theory development can be used to develop theories of accounting. (a) Explain what is meant by the decision-usefulness approach to theory development. (b) How can the decision-usefulness approach relate to accounting theory formulation? (c) Give two examples of decisions that require data obtained from accounting reports.

The decision-usefulness approach is an instrumentalist approach (see diagram p.25). In a narrower sense, one direct test of an overall theory of accounting would be to determine whether the output data of the accounting systems, which are constructed on the basis of the overall theory, are useful to users. The data of the accounting systems are utilised by users in their prediction models, and the conclusions (predictions) are then used in their decision models. The problem is that if the prediction is verified, it verifies the prediction model, not the accounting system and its output. There are other variables besides accounting data that affect the prediction. We do not know how the accounting data were utilised. Also, if the decision turns out to be right, it verifies the decision model, not the accounting system.

Interpreting the evidence on decision-making is extremely difficult. We do not know how to interpret the evidence to determine that accounting information is useful. Thus, a direct test is virtually impossible. Accounting standard setters usually determine usefulness with the weaker, more direct tests which are usually advanced by accounting committee setting bodies and include: relevance, verifiability, freedom from bias, timeliness, comparability, reliability and understandability.

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Chapter 2: Theory and method

Some decisions: (i) To invest in a firm’s stock (ii) To loan funds to a firm (iii) To purchase or buy an asset.

11.

What type of a theory is historical cost? How has it been derived? Do you have any criticisms of historical cost accounting?

Historical cost is usually described as a pragmatic theory whereby premises are determined by observing the practice of accountants. Criticisms: no logical analysis of accountants’ actions, does not allow change, does not focus on measurement, circularity of logic in the rules, outputs not verified, doublethink, conventions not subject to falsification. The argument is pragmatic positive as it is observable and descriptive of the behaviour of accountants over a number of centuries.

It is also true that historical cost accounting provides a system of allocating costs over different reporting periods (accrual accounting). In this sense it is a deductive argument. A point of logical contention, however, is whether the allocation of costs is truly systematic (in a deductive sense), because a number of the ways in which the costs are allocated appear to be done in an ad hoc fashion without inductive reference to events that occur in the real world of asset valuation.

12.

Explain the psychological pragmatic approach to accounting theory. Give a example of how it can be applied.

The psychological pragmatic approach to accounting theory is examining the reactions by investors and the general public to the release of accounting data. One research question is whether investors are fooled by cosmetic accounting numbers or are they financially rational. This research issue is covered in a later chapter but has gained greater prominence after the failure of ENRON and their questionable accounting practices.

13.

Give an example of an accounting convention usually adopted in historical cost accounting. Conventions govern the way accounting is practised, and conventions are, by definition, known from practice. (a) What theoretical approach is used to derive conventions? (b) What does your answer to (a) imply about the potential for accounting theories based on conventions to be innovative in providing useful information?

Accounting conventions (assumed premises) in historical cost are: • Conservatism – stewardship and accelerating the reporting of bad news over good news • Matching costs – calculation and focus on the income statement as a valuation metric (the balance sheet is the cost residual from this outcome) • They are innovative in providing solutions to stewardship problems and agency problems such as the payment of CEO bonuses.

14.

How do you think massive amounts of data now available from information technologies will affect

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Solution Manual to accompany Accounting Theory 7e

(a) (b)

the development of accounting theories the testing of accounting theories

The massive amount of data now available from information technologies will affect: the development of accounting theories by making theories capable of being tested in by the application of semantic (availability of prices, and accounting data) and pragmatics (the reaction of accountants, investors and society) to the release of accounting reports.

This means a probable move away from syntactic and normative theories towards more empirical based positive theories.

However, be aware of the British school that tends to have a closer relationship with syntactic arguments from sociology, history and psychology.

In combination the trend may be towards a combination of these two approaches.

15.

What are some common criticisms of a scientific approach to professions such as accounting and law? Are they valid? Why or why not?

The instructor should start by providing or asking for a brief overview of the scientific method, defined as a systematic approach of observation, hypothesis formation, hypothesis testing and hypothesis evaluation in testing a theory. A discussion of the methods used and the advantages/disadvantages should be analysed in class. (See the text for a more detailed description.)

The answers given by students to this question will be varied, but the tutor should aim to impart knowledge of the different forms of scientific methods and the way in which science is seen to advance. The essential components are: i. Syntactics ii. Semantics iii. Pragmatics iv. Hypothesis formulation v. Testing vi. Evaluation Whether the scientific method is valid is a question of degree but a comparison between alternatives will help. For example: The dogmatic basis is used when we believe in a statement because of confidence in the person or group issuing the statement. This confidence may be due to a religious or political belief, or due to the credentials, position or charisma of the speaker or writer.

We employ this basis frequently, since we cannot be expected to personally ‘test’ everything. We believe in what we read in the newspapers, in textbooks we use in school, in what our teachers tell us, etc. The weakness of this basis is that personal opinion, rather than evidence, is the critical factor. Introspective evidence is acceptable.

The self-evident basis is used when we believe in a statement because it appears to be sensible or obviously true, based on our general knowledge and experience. For example, the statement ‘children love to eat candy’ would be accepted as self-evidently true by most people. They would not feel an empirical study needs to be conducted. The weakness of this basis is that what is sensible or obvious to one person is not to another.

What appears to be so obvious may turn out to be incorrect.

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In contrast, the scientific basis is used when we believe in a statement because of the logical relationship of the terms and the objective, empirical evidence in support of the statement. The demand for objective, empirical evidence is the significant factor. The scientific basis was formulated to overcome the weaknesses of the other two.

16.

Early auditing theories were constructed by observing the practices of auditors. What type of theory construction is this? What are the advantages and disadvantages of this approach?

The theory construction is pragmatic positive as it is observable and descriptive of the behaviour of auditor practices over a number of centuries. The major system audited over this period is historical cost accounting that provides a system of allocating costs over different reporting periods (accrual accounting). Advantages: In this sense because it is historical the major advantage was the ease of confirming transactions by reference to vouchers. Another advantage of this approach is that auditors are close to clients and they are able to assess the accounting needs of business. Disadvantages: A point of logical contention, however, is whether the allocation of costs is truly systematic (in a deductive sense), because a number of the ways in which the costs are allocated appear to be done in an ad hoc fashion without inductive reference to events that occur in the real world of asset valuation. It may be that auditors are acting in the interests of managers rather than equity owners. It may also be that auditors are maintaining a system of accounting that is easy to verify rather than one that provides a more up-todate information set.

17.

How would you design an experiment to provide evidence on how auditors make judgements? What competing issues would arise?

The discussion should address the problem of making the experiment realistic enough for auditors to make decisions in the same way they would in ‘real life’ by providing the sort of information they would normally receive and under the conditions they would normally work. When the experiment is sufficiently realistic, it is said to have external validity.

The researcher would also have to design the experiment so that there are not too many variables, or factors being changed between the auditors. For example, if the researcher is trying to determine the effect of providing information in a different order on the auditors’ decisions, the experiment has to hold other factors constant. The aim is to be able to attribute the change in the decision to the change in the order in which information is provided. If this is achieved, the experiment has internal validity.

How many things could upset the internal validity of an experiment?

Examples include bias in selection of the auditors (more experienced auditors are assigned to one group), repeated testing (if the experiment is repeated auditors could learn, grow tired, start to anticipate the researcher’s aims) and experimenter bias (where the researcher unconsciously sends signals to the participant auditors about the desired action).

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International View 2.1 IFRS is a Big Four gravy train This is an article that succinctly points out the dangers of having (i) one vision of accounting, and (ii) the contagion effect of standard setting.

1. The differences – investor decision making and a balance sheet valuation approach matching expenses against revenues with a focus on stewardship and performance over time. Local authorities should not be assessed the same as listed stocks.

2. Students are encouraged to address this issue and consider that accounting is not one-dimensional. The “simple” answer is yes!

3. Murphy is using both a systematic argument - local councils have different objectives and a semantic argument – they require different measures. There is also a hint of pragmatics in the behaviour of the big 4.

4. Lack of scientific consideration but students should be encouraged to debate the issues raised.

International View 2.2 Financial accounting: an epistemological research note After reading this article students should realise the complexity of accounting and the far reaching impact of the various theories and different research approaches. All the primary accounting theories in the chapter are touched on but there is an emphasis on the competing North American and British approaches: 1.

(i) The North American approach − ontology – reality is objective to satisfy the man made concepts of investor and management financial decision making.

Epistemology is generally as described under scientific research in Table 2.2. (ii) The British approach – ontology – reality is socially constructed based upon the sociology, psychology, history and political disciplines. Epistemology is shaped by various social interactions and cannot be reduced to single normative statements or hypotheses to be tested.

2.

All accounting theories are normative. The instructor should encourage students to explain further with the view that a normative assumption is always made about the objective i.e. Decision making, stewardship, society etc.

3.

Effects on society are numerous. Questions of resource usage efficiency, decision making, there are economic gainers and losers, there are affects on accountants, investors, managers, and society at large. This list is not exhaustive and students are encouraged to explore their observations and ideas.

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Theory in Action 2.1 Do share prices rise when profit improves?

1.

The article describes a market reaction to accounting profit news. This description involves an example of which approach to theory: (a) Pragmatic (b) Syntactic, or (c) Semantic?

Explain your answer.

Describing this reaction to a profit announcement is an example of a semantic approach to theory, in particular output semantics. An output of the accounting system (that is, the profit figure) is being tested against an external reference (that is, share price). Share prices react to unanticipated increases or decreases in earnings, because these represent new information that will cause investors to revise their expectations regarding the firm’s future cash flows. In an efficient capital market, changes in expectations of a firm’s cash flows will lead to changes in the firm’s share price if share prices represent a capitalisation of future cash flows. The article describes how the shares in Metcash rose by 7 cents following the announcement of expected future organic and acquisition growth driving sales and earnings. This is because the market expected Metcash to perform better in the future.

The description is also pragmatic in that it is useful in terms of its potential to assist managers in knowing how to deal with earnings announcements in order to maximise firm value.

To the extent that the market reaction is compared against a theory developed using syntactic relations, there is a syntactic component to the theory as well. Overall, though, we would argue that the primary approach is semantic, by relating theoretical constructs to real world references.

2.

Consider the following syllogism: When a company reports better prospects than previously, investors force that company’s share price to increase.

• Metcash is a company that has reported better earnings per share than previously.

• Investors forced Metcash’s share price to increase. (a) Is there a flaw in the syntax or semantics within the syllogism that means its conclusion is not true? If so, what is the flaw? (Hint: Consider whether the general premise at the start of the syllogism must always be true.)

There is no flaw in the syntax of the syllogism. The syntatics is valid as it follows a logical reasoning, which means if both premises were true, the conclusion would also be true. The fact that the conclusion is not true is caused by a semantics problem.

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In the argument above, although the logic is sound, there is a problem with the semantics of the syllogism. After Metcash announced that it increased earnings by 13.3 per cent in 2009 its share price rose. The flaw is in the premise ‘When a company reports higher earnings than previously, investors force that company’s share price to increase’. The reality shows that when a company reports higher earnings, its share price may not always increase. A company’s share price will generally increase when its earnings exceed those anticipated by the market. But for numerous reasons, for example, the presence of short term traders on the share register of a company, its share price might fall as the traders exit the share as the earnings improvements are not expected to be affecting the very short term cash flows of the firm. (b)

What is the practical significance of this theory being invalid and its conclusion false?

The practical significance is that it is not sufficient for a firm just to make any earnings to increase its share price, as the market will only value any increase in earnings that is above or supplemental to its expectation. In other words, the firm has to exceed the market’s expectation to increase its share price.

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Theory in Action 2.2 Normative theories of investment 1.

What is a bull market? A bear market?

A bull market is a market which is experiencing a prolonged period of generally rising share prices. A bull market often occurs when the market is recovering from recession or experiencing an economic boom. A bear market is a market that is experiencing a prolonged period of decreasing share prices. A bear market often occurs when a market is moving towards or is in recession.

2.

Why would high commodity prices and low interest rates help to maintain share prices?

As Australia is a producer of commodities, high commodity prices due to increases in global demand and/or decreases in global supply will increase commodity export revenues. High commodity export revenue could enable Australian firms to increase their retained earnings and allow Australia to build its reserves and maintain a strong balance of payment position. This will encourage more investment in Australian businesses, and cause share prices to rise. Similarly, low interest rates will result in more consumer spending or investment in shares as there will be a larger portion of disposable income available to be spent after paying for debt and interest, and less incentive to invest in interest bearing securities since returns are lower.

3.

What is the theory underlying the advice to ‘buy the dips’? Is this a normative theory? Explain your answer.

The theory underpinning the advice to ‘buy the dips’ is that firms with volatile share prices may present opportunities for investors to acquire equity at competitive prices as the market is inefficient. Those investors who buy at lower prices may be able to reap profits by trading the shares when the market becomes more efficient (and the trend reverses) either on a short term or a longer term basis.

The advice that investors should look for firms with volatile share prices and ‘buy the dips’, is a normative statement, in that it prescribes what investors should do to achieve a desirable outcome (gains).

On the other hand, a theory that firms will (say) distribute higher dividends and thus push their share prices to increase, is a positive theory as it explains/predicts the movement of share prices in relation to rising revenues, profits, and dividends.

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Solution Manual to accompany Accounting Theory 7e

Theory in Action 2.3 Alternative approaches to accounting theory construction 1.

What market backlash do businesspeople fear if they do not meet their forecast earnings or growth targets? Why?

Businesspeople who do not meet their forecast earnings or growth target will face pressure first of all from their shareholders. As shareholders demand higher profits, inability to meet profit target will result in some sort of personal penalty, for example via reputation effects, reduced or removed performance bonuses, or threats to their employment tenure. In general, the market would penalise firms that do not meet their forecast target by marking the firms down, that is reducing the firms’ share prices.

2.

Mr. Fletcher describes how he has learned not to publicly disclose five-year annual profit growth targets. Explain what is likely to have caused him to learn that lesson. In coming to the conclusion, what approach to theory construction has Mr. Fletcher applied? Explain your answer.

Mr. Fletcher mentioned that he ‘has done it once’, that is he has publicly disclosed fiveyear annual profit growth targets before, against the board of directors advice. It is likely that during that five years he was not able to deliver the targeted performance, putting pressure on himself and risking his position as Coles Myer CEO, and putting pressure on the board of directors. Since then, he has learnt not to disclose any profit growth because the risk of doing that is too high in such a susceptible market. In this case, Mr. Fletcher applies the psychological pragmatic approach, which observes users’ responses to accountants’ outputs (the five-year profit growth targets). After profit targets are disclosed, users react when firm’s performance is not according to what was predicted. His is also an inductive approach, leading from an initial premise of individual personal experiences.

3.

Can the scientific approach to theory construction and testing be useful in relation to predicting when and how investors will react to earnings announcements? How/Why not?

Yes, the scientific approach can be used to predict when and how investors will react to earnings announcements. In this case, investors’ reactions are measured through the changes in share prices (increase/decrease) following the earnings announcements, allowing abnormal gains/losses to be made. The research problem to test is whether share prices will respond to new information associated with the announcements, and when that will happen relative to the announcement day. This can be examined by conducting an event study investigating the share returns associated with the release of information relating to share trades. It would be expected that investors would react to earnings announcements. The question, however, is when investors will react to the release of such information. Data associated with earnings announcements and any abnormal gains/losses can be gathered from a sample of firms. Data are then analysed

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and evaluated to determine how and when investors would react to earnings announcements.

4.

What is the importance to society of developing a theory to explain the relationship between earnings forecasts, earnings announcements, and share price movements?

The importance is to provide guidance to the society on how share prices move in relation to earnings forecasts and earnings announcements. By developing and then testing the theory, researchers will contribute to explain and predict what happen in the share market surrounding earnings announcements. Society would benefit in terms of gaining knowledge to guide them in making decisions. For example, firms will consider carefully whether they would announce earnings forecasts if there is a theory suggesting that share price will move downward when actual earnings do not reflect earning forecasts. Similarly, the theory will also help investors to make decisions, for example whether to buy or sell their shares, following earnings announcements. Overall, the pragmatic significance of the theory is that it affects individuals’ wealth distributions and the distribution of wealth amongst businesses, and also the generation of wealth by firms whose ability to raise capital is affected.

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Solution Manual to accompany Accounting Theory 7e

Theory in Action 2.4 Alternative approaches to accounting theory construction 1.

What market backlash do businesspeople fear if they do not meet their forecast earnings or growth targets? Why?

Businesspeople who do not meet their forecast earnings or growth target will face pressure first of all from their shareholders. As shareholders demand higher profits, inability to meet profit targets may result in some sort of personal penalty, for example via reputation effects, reduced or removed performance bonuses, or threats to their employment tenure. In general, the market would penalise firms that do not meet their forecast target by marking the firms down, that is reducing the firms’ share prices.

2.

Can the scientific approach to theory construction and testing be useful in relation to predicting when and how investors will react to earnings announcements? Why or why not?

Yes, the scientific approach can be used to predict when and how investors will react to earnings announcements. In this case, investors’ reactions are measured through the changes in share prices (increase/decrease) following the earnings announcements, allowing abnormal gains/losses to be made. The research problem to test is whether share prices will respond to new information associated with the announcements, and when that will happen relative to the announcement day. This can be examined by conducting an event study investigating the share returns associated with the release of information relating to share trades. It would be expected that investors would react to earnings announcements. The question, however, is when investors will react to the release of such information. Data associated with earnings announcements and any abnormal gains/losses can be gathered from a sample of firms. Data are then analysed and evaluated to determine how and when investors would react to earnings announcements.

3.

What is the importance to society of developing a theory to explain the relationship between earnings forecasts, earnings announcements, and share price movements?

The importance is to provide guidance to society on how share prices move in relation to earnings forecasts and earnings announcements. By developing and then testing the theory, researchers will contribute to explaining and predicting what happen in the share market at the time surrounding earnings announcements. Society would benefit in terms of gaining knowledge to guide them in making efficient decisions. For example, firms will consider carefully whether they would announce earnings forecasts if there is a theory suggesting that share price will move downward when actual earnings do not reflect earning forecasts. Similarly, the theory will also help investors to make decisions, for example whether to buy or sell their shares, following earnings announcements. Overall, the pragmatic significance of the theory is that it affects individuals’ wealth distributions and the distribution of wealth amongst businesses, and also the generation of wealth by firms whose ability to raise capital is affected.

Case Study 2.1 © John Wiley and Sons Australia, Ltd 2010

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New accounting rules ‘don’t add up’ 1.

What are International Financial Reporting Standards?

International Financial Reporting Standards are accounting standards developed by the International Accounting Standards Board (IASB), which is an independent international organisation supported by professional accounting bodies. Formerly known as the International Accounting Standards (IAS), the objective of IFRS is to achieve uniformity and transparency of accounting principles used by entities for financial reporting around the world.

2.

Many arguments are expressed in this article. List three factors that you think are causing concern about the impact of adoption of IFRS.

Three of the factors causing concern about the prospect of adopting IFRS include: • Companies are required to recognise, present or disclose information in a transparent way.

• The use of fair value accounting which requires asset and liability revaluations to be passed through the income statement both (a) increases earnings and leverage measures of volatility; and (b) takes more effort to implement.

• IFRS do not provide more insight into firm risk than existing accounting standards.

3.

Consider each of the three factors you mentioned in response to question 2. (a) Is there empirical evidence to support the factor? (b) Is the analysis leading from the factor to the concerns about adoption of IFRS scientific or naturalistic in its approach? Explain your answer.

(i)

Companies are required to recognise, present or disclose information in a different way.

Yes. For example, adoption of IFRS in Australia also requires companies to recognise share-based transactions, which was not the case previously. The accounts of companies adopting IFRS differ from those of firms using different national accounting standards.

The evidence used as the basis for the claims is naturalistic if it is evidence from firms’ individual accounts that underpins the claims by individuals in many cases. These accounts have been observed by individuals who have become concerned about the nature of the changes required under IFRS. However, if a research study has been conducted, say by academics, then that research study is likely to follow the scientific approach of analysing many firms’ financial statements, or reconstructions of their past financial statements, to come to a general conclusion regarding the view that firms are required to recognise, present or disclose information differently from their current approach. (ii)

The use of fair value accounting which requires asset and liability revaluations to be passed through the income statement both (a) increases earnings and leverage measure volatility; and (b) takes more effort to implement.

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Solution Manual to accompany Accounting Theory 7e

Yes, there is some empirical evidence that fair value accounting creates more volatility.

For example, Barth, Landsman, and Wahlen (1995) examined fair value of US banks’ investment securities and found that fair value-based earnings are more volatile than historical-based earnings.

The use of fair value accounting leads to a complaint that it introduces volatility into reported profits, as revaluations must be brought into the income statements. The evidence used as the basis for the claims is naturalistic if it is evidence from firms’ individual accounts that underpins the claims by individuals in many cases. These accounts have been observed by individuals who have become concerned about the increase in earnings and leverage volatility reported under IFRS. However, if a research study has been conducted, say by academics, then that research study is likely to follow the scientific approach of analysing many firms’ financial statements, or reconstructions of their past financial statements, to come to a general conclusion, statistically tested, regarding the view that volatility increases after IFRS adoption. (iii) IFRS do not provide more insight into firm risk than existing accounting standards.

The empirical evidence can include the type of risk disclosed and its impact on profit and financial position; the difficulty in risk compared with the audit of financial statements prepared under national standards, etc.

The evidence used as the basis for the claims is naturalistic if it is evidence from individuals learning to prepare/auditing firms’ individual accounts that underpins the claims by individuals in many cases.

However, if a research study has been conducted, say by academics, then that research study is likely to follow the scientific approach of analysing the time spent by accountants and/or auditors in relation to numerous firms’ financial statements, or reconstructions of their past financial statements, or statements pre- and post- IFRS adoption.

4.

How could researchers evaluate the decision-usefulness of adopting International Financial Reporting Standards?

The decision-usefulness approach builds from a basic assumption that the objective of accounting is to assist users of accounting reports in their decision-making process by providing useful and relevant information in the accounting reports. To evaluate the decision-usefulness of adopting IFRS, researchers need to examine whether financial reports prepared under IFRS are useful for users in making economic decisions. There are a number of ways to do that. One way is to undertake a value-relevance study investigating whether certain items disclosed in financial reports, such as financial instruments or intangible assets, are value-relevant (i.e. provide relevant and reliable information for users). Another way is to conduct a survey among firms that have adopted IFRS, or survey users of their financial reports. Other research methods can be teased out with the class.

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5.

What role can positive theory play in resolving the issue(s) described in the article?

Researchers can conduct positive accounting research to examine and find empirical evidence that can support or reject the issues described in the article. Investigating how adoption of IFRS works in the UK can be used to enhance the theory of how global accounting standards should provide more benefits, as it will describe and explain the issues and consequences associated with adopting IFRS. 6.

What role can normative theory play in resolving the issue(s) described in the article?

Commencing with premises regarding the desirable attributes of a global accounting system and premises regarding how well different national and other accounting systems (including IFRS) meet those attributes, (this may be the outcome of either positive or normative theories, depending upon the nature of the attribute in question).

A normative theory can lead to hypotheses regarding the best way to achieve accounting’s goals.

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Solution Manual to accompany Accounting Theory 7e

Case Study 2.2 The thrill is gone 1.

Lend Lease reported a 13.5% increase in profit for 2004–2005. Why was the share market unimpressed?

The Lend Lease 2004–2005 profit did not meet the market’s expectations. During that period, Lend Lease did well to produce a growth business through its retail and residential development, including some prominent projects in the US such as cleaning up the WTC site after the September 11, 2001 attack. However, the market expected Lend Lease to do more infrastructure works, such as toll roads and tunnels, which Lend Lease has no plans to do. Therefore, the market was unimpressed by the Lend Lease results.

2.

In trying to explain shareholders’ subdued reaction to Lend Lease reported earnings, explain whether and/or how you could use the following approaches to accounting theory construction: (a)

pragmatic

The pragmatic approach (especially the psychological pragmatic approach) observes how users respond to accounting outputs (in this case profit announcement). In the Lend Lease case, shareholders were unimpressed with the profit announcement, causing the share price to fall. To assess reasons for the subdued reaction, a study using protocol analysis of shareholders’ reactions to other firms’ earnings announcements and the Lend Lease earnings announcement, after subjects had been provided with different sets of prior information about analysts’ forecasts of earnings would be useful to build cumulative evidence. Alternatively, researchers could survey the users of the financial statements. This approach could also be undertaken under the positive accounting or scientific method approaches. (b)

decision-usefulness

The decision-usefulness approach assumes that accounting outputs provide useful information for users in the decision-making process. This approach would try to determine whether accounting outputs (Lend Lease profit announcement) provide useful information for the shareholders to make decisions. Shareholders could be given a set of prior information and the accounts of Lend Lease, and then in a separate experiment give a set of different prior information and the accounts of Lend Lease. At the end of each analysis of the financial statements, they might be asked to bid for shares, to see which set of accounts/prior information leads to the lower share price. (c)

positive accounting theory

Positive theory deals with explaining or predicting what actually happens in the real world. Using positive theory, researchers would try to explain why, in reality, shareholders were not impressed with Lend Lease performance despite its 13.5% profit.

They would probably collect data concerning earnings announcements and analysts’

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forecasts, and statistically compare the returns for different circumstances: when analysts’ forecasts are above, below, or at the amount of profit reported. (d)

normative theory

Normative theory is concerned with prescribing what should be done. One of the issues which becomes the focus of some normative theorists is how to derive the ‘true income’ (profit). In trying to explain the shareholders’ response to Lend Lease profit announcement, normative theory would concentrate on whether Lend Lease has measured its profit figure correctly, and if it is the case, whether the profit figure would provide useful information for shareholders (decision-usefulness approach). The normative theory approach does not explain the subdued reaction; rather it might come up with recommendations for how firms should calculate and report their profits. (e)

scientific approach

Based upon observations that firms’ share prices generally increase after positive earnings announcements, but sometimes do not, the scientific approach would cause researchers to develop theories about why that was the case. See the explanation for the positive theory approach. (f)

naturalistic approach

The naturalistic approach is appropriate to use in explaining an individual shareholder’s reaction to the Lend Lease announcements, as it focuses on firm-specific problems.

Using case study as a method, this approach will try to answer the question why the market is unimpressed with Lend Lease’s performance, although it has delivered 13.5% profits during 2004–2005 and predicted a double-digit growth in 2006.

3.

Which of the approaches described in answer to question (2) do you believe is most useful? Why?

The approaches are generally not necessarily incompatible. We would argue that the best approach is through triangulation: the use of multiple approaches to see if they all deliver consistent outcomes. Overall, though, we argue that the scientific approach provides a more generalisable result. This approach is likely to be applied in a positive accounting theory context. It could be supplemented by case studies conducted using the naturalistic approach.

4.

Are the approaches you described in answer to question (2) mutually exclusive, or can they be used to complement each other? Explain?

There are some approaches that are mutually exclusive within the one study and some others that are not. For example, positive accounting theory approaches are generally a subset of the scientific method approach. However, positive accounting theory simply refers to the development of explanatory theory, and it is thus consistent with the decision-usefulness approach, etc. All approaches can be used to complement each other. Scientific and naturalistic approaches, for instance, are mutually exclusive, in that they cannot be applied at the same time due to different perspectives. The scientific

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Solution Manual to accompany Accounting Theory 7e

approach is a highly structured approach to analyse problems based on prior knowledge.

It also relies on predetermined procedures and statistical techniques to validate or refute tested hypothesis, which results in answers that can be applied in general understanding.

The naturalistic approach, on the other hand, starts from the view that reality is socially constructed and a product of human imagination. In other words, reality is not objective, but a result of people’s interpretations of situations and events they experience. Hence, this approach is best used to analyse problems with unique setting and no preconceived assumptions or theories (such as shareholders’ reaction of Lend Lease profit announcement). It aims to solve individual problems, and thus the result may be difficult to generalise.

Some approaches can be used to complement each other. For example, the pragmatic approach provides a usefulness test for the decision-usefulness approach — one way to test whether accounting outputs provide useful information is by examining users’ responses to the reports. As mentioned in question 5(b), positive and normative theory can also complement each other. Normative theory prescribes what should be done, and one way to do that is by using the decision-usefulness approach. Positive theory identifies and tries to explain what is actually being practiced in the real world using scientific approach. This, in turn, can form the basis of developing normative theory to improve current practices.

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Case Study 2.3 Intergovernmental working group of experts on international standards of accounting and reporting 1.

What are International Financial Reporting Standards (IFRS)?

International Financial Reporting Standards are accounting standards developed by the International Accounting Standards Board (IASB), which is an independent international organisation supported by professional accounting bodies. Formerly known as the International Accounting Standards (IAS), the objective of IFRS is to achieve uniformity and transparency of accounting principles used by entities for financial reporting around the world.

2.

Many concerns are expressed in this article. List three factors that you think are causing concern about the impact of adoption of IFRS.

Three of the factors causing concern about the prospect of adopting IFRS include: • Companies are required to recognise, present or disclose information in a transparent way.

• The use of fair value accounting which requires asset and liability revaluations to be passed through the income statement both (a) increases earnings and leverage measures of volatility; and (b) takes more effort to implement.

• IFRS do not provide more insight into firm risk than existing accounting standards.

3.

Consider each of the three factors you mentioned in response to question 2. (a) Is there empirical evidence to support the factor? (b) Is the analysis leading from the factor to the concerns about adoption of IFRS scientific or naturalistic in its approach? Explain your answer. (i)

Companies are required to recognise, present or disclose information in a different way.

Yes. For example, adoption of IFRS in Australia also requires companies to recognise share-based transactions, which was not the case previously. The accounts of companies adopting IFRS differ from those of firms using different national accounting standards.

The evidence used as the basis for the claims is naturalistic if it is evidence from firms’ individual accounts that underpins the claims by individuals in many cases.

These accounts have been observed by individuals who have become concerned about the nature of the changes required under IFRS. However, if a research study has been conducted, say by academics, then that research study is likely to follow the scientific approach of analysing many firms’ financial statements, or reconstructions of their past financial statements, to come to a general conclusion regarding the view that firms are required to recognise, present or disclose information differently from their current approach.

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Solution Manual to accompany Accounting Theory 7e

(ii)

The use of fair value accounting which requires asset and liability revaluations to be passed through the income statement both (a) increases earnings and leverage measure volatility; and (b) takes more effort to implement.

Yes, there is some empirical evidence that fair value accounting creates more volatility. For example, Barth, Landsman, and Wahlen (1995) examined fair value of US banks’ investment securities and found that fair value-based earnings are more volatile than historical-based earnings.

The use of fair value accounting leads to a complaint that it introduces volatility into reported profits, as revaluations must be brought into the income statements.

The evidence used as the basis for the claims is naturalistic if it is evidence from firms’ individual accounts that underpins the claims by individuals in many cases.

These accounts have been observed by individuals who have become concerned about the increase in earnings and leverage volatility reported under IFRS. However, if a research study has been conducted, say by academics, then that research study is likely to follow the scientific approach of analysing many firms’ financial statements, or reconstructions of their past financial statements, to come to a general conclusion, statistically tested, regarding the view that volatility increases after IFRS adoption. (iii) IFRS do not provide more insight into firm risk than existing accounting standards.

The empirical evidence can include the type of risk disclosed and its impact on profit and financial position; the difficulty in risk compared with the audit of financial statements prepared under national standards, etc.

The evidence used as the basis for the claims is naturalistic if it is evidence from individuals learning to prepare/auditing firms’ individual accounts that underpins the claims by individuals in many cases.

However, if a research study has been conducted, say by academics, then that research study is likely to follow the scientific approach of analysing the time spent by accountants and/or auditors in relation to numerous firms’ financial statements, or reconstructions of their past financial statements, or statements preand post- IFRS adoption.

4.

Is the analysis leading from the factor to the concerns about adoption of IFRS scientific or naturalistic in its approach? Explain your answer. (i) The evidence used as the basis for the claims is naturalistic if it is evidence from firms’ individual accounts that underpins the claims by individuals in many cases. These accounts have been observed by individuals who have become concerned about the nature of the changes required under IFRS. However, if a research study has been conducted, say by academics, then that research study is likely to follow the scientific approach of analysing many firms’ financial

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statements, or reconstructions of their past financial statements, to come to a general conclusion regarding the view that firms are required to recognise, present or disclose information differently from their current approach.

5.

What role can normative theory play in resolving the issue(s) described in the article?

Commencing with premises regarding the desirable attributes of a global accounting system and premises regarding how well different national and other accounting systems (including IFRS) meet those attributes, (this may be the outcome of either positive or normative theories, depending upon the nature of the attribute in question).

A normative theory can lead to hypotheses regarding the best way to achieve accounting’s goals.

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Solution Manual to accompany Accounting Theory 7e

Case Study 2.4 Tabcorp costs trouble market 1.

Tabcorp reported an increase in profit for 2008–2009. Why was the share market unimpressed?

The Tabcorp 2008-2009 profit did not meet the market’s expectations. During that period, Tabcorp faced mounting licence fees and taxes and an upgrade of the Star City Casino – a cost that its managing director described as ‘challenging’. The market was concerned about the impact of these additional costs, and ‘pounded’ its shares by 5 per cent.

2.

In trying to explain shareholders’ subdued reaction to Tabcorp’s reported earnings, explain whether and/or how you could use the following approaches to accounting theory construction: (a)

pragmatic

The pragmatic approach (especially the psychological pragmatic approach) observes how users respond to accounting outputs (in this case profit announcement). In the Tabcorp case, shareholders were unimpressed with the extra costs announcement, causing the share price to fall. To assess reasons for the subdued reaction, a study using protocol analysis of shareholders’ reactions to other firms’ earnings announcements and the Tabcorp earnings announcement, after subjects had been provided with different sets of prior information about analysts’ forecasts of earnings would be useful to build cumulative evidence. Alternatively, researchers could survey the users of the financial statements. This approach could also be undertaken under the positive accounting or scientific method approaches. (b)

positive accounting theory

Positive theory deals with explaining or predicting what actually happens in the real world. Using positive theory, researchers would try to explain why, in reality, shareholders were not impressed with Tabcorp’s performance despite its improved profit. They would probably collect data concerning earnings announcements and analysts’ forecasts, and statistically compare the returns for different circumstances: when analysts’ forecasts are above, below, or at the amount of profit reported. (c)

naturalistic approach

The naturalistic approach is appropriate to use in explaining and individual shareholder’s reaction to the Tabcorp announcements, as it focuses on firm-specific problems. Using case study as a method, this approach will try to answer the question why the market is unimpressed with Tabcorp’s performance, although it has delivered improved profits during 2008–2009.

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3.

Are the approaches you described in answer to question (2) mutually exclusive, or can they be used to complement each other? Explain?

There are some approaches that are mutually exclusive within the one study and some others that are not. For example, positive accounting theory approaches are generally a subset of the scientific method approach. However, positive accounting theory simply refers to the development of explanatory theory, and it is thus consistent with the decision-usefulness approach, etc. All approaches can be used to complement each other.

Scientific and naturalistic approaches, for instance, are mutually exclusive, in that they cannot be applied at the same time due to different perspectives. The scientific approach is a highly structured approach to analyse problems based on prior knowledge. It also relies on predetermined procedures and statistical techniques to validate or refute tested hypothesis, which results in answers that can be applied in general understanding. The naturalistic approach, on the other hand, starts from the view that reality is socially constructed and a product of human imagination. In other words, reality is not objective, but a result of people’s interpretations of situations and events they experience. Hence, this approach is best used to analyse problems with unique setting and no preconceived assumptions or theories (such as shareholders’ reaction of the Tabcorp profit announcement). It aims to solve individual problems, and thus the result may be difficult to generalise.

Some approaches can be used to complement each other. For example, the pragmatic approach provides a usefulness test for the decision-usefulness approach — one way to test whether accounting outputs provide useful information is by examining users’ responses to the reports. Positive and normative theory can also complement each other.

Normative theory prescribes what should be done, and one way to do that is by using decision-usefulness approach. Positive theory identifies and tries to explain what is actually being practiced in the real world using scientific approach. This, in turn, can form the basis of developing normative theory to improve current practices.

4.

What is meant by ‘normalised earnings’? Why would a firm disclose ‘normalised’ earnings?

Normalised earnings are earnings that have been adjusted to take into account the effect of cyclical variations. A firm would disclose normalised earnings to remove the volatility effect of including one-off or non-controllable events, such as (say) the expropriation of foreign-located assets of a firm by a national government.

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Case Study 2.5 Alumina jumps on bad news 1.

Alumina reported an 86.3 per cent fall in first half-year profit, and suspended its final dividend. Why did its share price rise by 9.79 per cent on the announcement date?

Although the company reported an 86.3 per cent fall in first half-year profit to $14.6 million, it exceeded market expectations which predicted a loss of around $19 million.

The market reaction to this unexpected information was a rise in the share price of Alumina. Furthermore, the price of aluminium was also rising, a factor which the market regarded as positive to the expected level of future profits and cash flows of the company.

2.

In trying to explain the positive response to Alumina’s reported earnings, explain whether and/or how you could use the following approaches to accounting theory construction: (b) (c) (d) (a)

Decision-usefulness.

Normative.

Scientific.

decision-usefulness

The decision-usefulness approach assumes that accounting outputs provide useful information for users in decision-making process. This approach would try to determine whether accounting outputs (Alumina profit announcement) provide useful information for the shareholders to make decisions. Shareholders could be given a set of prior information (such as the expected price of aluminium) and the accounts of Alumina, and then in a separate experiment give a set of different prior information and the accounts of Alumina. At the end of each analysis of the financial statements, they might be asked to bid for shares, to see which set of accounts/prior information leads to the lower share price. (b)

normative theory

Normative theory is concerned with prescribing what should be done. One of the issues which become the focus of some normative theorists is how to derive the ‘true income’ (profit). In trying to explain the shareholders’ response to Alumina profit announcement, normative theory would concentrate on whether Alumina has measured its profit figure correctly, and if it is the case, whether the profit figure would provide useful information for shareholders (decision-usefulness approach). The normative theory approach does not explain the reaction; rather it might come up with recommendations for how firms should calculate and report their profits.

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(c)

scientific approach

Based upon observations that firms’ share prices generally increase after positive earnings announcements, but sometimes do not, the scientific approach would cause researchers to develop theories about why that was the case.

3.

Which of the approaches described in your answer to question (2) do you believe is most useful? Why?

The approaches are generally not necessarily incompatible. We would argue that the best approach is through triangulation: the use of multiple approaches to see if they all deliver consistent outcomes. Overall, though, we argue that the scientific approach provides a more generalisable result. This approach is likely to be applied in a positive accounting theory context 4.

Explain the importance to investors of developing a theory to explain the relationship between earnings announcements and share price movements.

The importance lies in the ability to accurately predict the reaction of share price movements to earnings announcements. A reliable theory provides a basis for making more accurate predictions, thus improving the efficiency of the market.

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Solutions Manual to accompany

Accounting Theory 7e by

Ann Tarca

Chapter

Chapter 3 Applying theory to accounting regulation

John Wiley & Sons Australia, Ltd 2010

Chapter 3: Applying theory to accounting regulation

Chapter 3: Applying theory to accounting regulation THEORY IN ACTION Theory in action 3.1 Companies should come clean on the value of leases in their books 1.

Describe current accounting practices for leases as outlined in this article.

Accountants distinguish between capital and operating leases. Capital leases go on the balance sheet while operating leases do not. Australian standards require that lease classification is based on the ‘substance’ of a transaction. However, the guidance criteria for what constitutes a capital lease (e.g. the requirements relating to the lease term covering a major part of an asset’s economic life) leave openings for companies to exercise discretion in classifying leases. US GAAP includes criteria such as the present value of minimum lease payments exceeding 90% of asset’s value.

2.

Why does the author call leasing standards ‘silly accounting rules’?

The author says the rules mean that companies exclude real assets and liabilities from their balance sheets. The effect of ‘off-balance’ sheet items is that a company’s assets and liabilities are understated and performance ratios such as return on investment are overstated. In addition, financial risk measures are not accurate and useful (‘bear no relation to reality’).

Off-balance sheet items attracted attention at the time of the collapse of Enron in the USA in 2001. A report by the SEC in 2005 estimated that US companies were committed to US$1.25 trillion in lease payments relating to leases which did not appear on balance sheet. The author estimates that 90% of Australian leases are offbalance sheet.

3.

Standard setters propose revising leasing standards to require capitalisation of all leases. Explain the financial impact for Coles and Woolworths in 2007-08 of having ‘off-balance sheet’ leases.

In the 2006-07 year, Woolworths had AUD $11.8 billion and Coles AUD $10.8 billion of off-balance sheet leases. Woolworths reports that net debt fell $1.3 billion, but when analysts adjust for off-balance sheet leases, it actually remains unchanged at $14.1 billion. Coles reported $900 million net debt, but the actual figure is $11.8 billion.

Invested capital (debt plus equity) is understated for both companies. Woolworths adjusted debt/capital ratio is more that double that reported (71.9% compared to 30.7%); Coles is 75.1% compared to 19.4%.

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4.

What are the advantages of capitalising leases? Given that most companies usually reporting operating leases, will they oppose new leasing rules?

The following points can be found in the article in relation to advantages of lease capitalisation: a.

More accurate performance measures (avoid overstated ROI); b.

Avoid misleading basis for assessing performance trends; c.

Allow better assessment of financial risk (determining risk/reward trade-off); d.

Allow more accurate comparisons between companies and operating units.

The author suggests that companies will resist changes to leasing standards. He notes there is a ‘huge industry’ which is involved in creating leases that can be classified as operating. Members of this industry can be expected to oppose changes to current rules.

We may expect companies to oppose rules to capitalise all leases because they currently favour operating leases (based on their current practice). However, as long as the new rules force all companies to show capitalised leases (that is, all companies are affected in the same way by the new rules) companies may not oppose the change.

It is difficult to provide convincing reasons why leases should be allowed to be ‘offbalance sheet’ so companies may be hard pressed to defend their current practices.

Off-balance sheet leases are an ‘open secret’, i.e. the impact of capitalising leases on balance sheet can be calculated from the financial statement information. The article states that analysts make adjustments to bring leases on balance sheet to improve the information they use when assessing and comparing companies. We may expect analysts to favour capitalisation of all leases. Analysts/investors are an influential user group who may support the standard setters in changing leasing rules.

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Theory in Action 3.2 Accountants draw the line at regulating 1.

The article refers to a view circulating at the time, that fair value accounting contributed to the ‘global financial crisis’ (from October 2008, the near collapse of many banks caused capital flows to dry up and share prices to fall dramatically.) How could fair value accounting exacerbate the financial crisis?

Critics of fair value accounting claimed that the method forced banks to write down asset values. The implication is that these write downs were not necessary and/or caused the banks to be portrayed as being weaker than they really were (write downs reduced their equity, affected their capital adequacy ratios and liquidity, and their ability to lend funds). The implied assumption is that asset prices will recover; that the impairment is only temporary and therefore should not be booked through profit and loss.

There are several issues to consider. First, students should discuss why the IASB mandated fair value for (at least some) financial instruments – to improve transparency and comparability of information, thus assisting investors in evaluating risk attached to the financial instruments. Fair value reporting shows market values for financial instruments which previously were unreported or reported at (irrelevant) historical cost, for example derivative contracts. Users benefit from more detailed and relevant disclosures.

Second, the article notes that fair value reporting should have been more, not less.

That is, fair value measurement was used for some, but not all, financial instruments.

The article says the IASB’s preferred position is that fair value measurement applies to all financial instruments not a selection as occurs under IAS 39. Wider use of fair value aims to provide relevant information for users (for decision making) and to avoid managerial discretion leading to manipulation of asset values.

Third, the banks’ claim that they should not have to book the write downs seems to be a public relations exercise, that is, an attempt to obtain rules which will let them present a favourable and optimistic picture. Avoiding taking a write down would be favourable because the current value of the loans (actual or estimated) is below book value and optimistic because it assumes the value of the loans will increase in the future. The situation emphasises the differences in incentives of preparers and users of financial reports. Preparers want to present the best possible picture of the company (to maintain share price, investor confidence, remuneration) while users want the most realistic picture to assist with decision making.

2.

Why does the IASB member refuse to accept responsibility for the financial crisis?

Mr Cooper of the IASB states that the role of the Board is not to promote financial stability, which is the job of prudential regulators. (The IASB’s role is to set accounting standards for private sector entities throughout the world. Those standards aim to assist companies to produce information which is useful for a range of users.)

He states that people should not be asking the IASB to do something which it is not equipped to do.

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He highlights areas where the regulators should be active – in avoiding lax rules which permitted companies to ‘make risky bets, dole out excessive bonuses and pay too much in dividends.’ He argues that the banking regulators are close to the banks and the markets and can make decisions about the extent of write downs necessary which cannot be made by the IASB. It is not their role and they do not have the expertise for this type of decision.

3.

The IASB considers adoption of IASB standards in the USA to be essential. Explain why it holds this view. To what extent does the IASB’s position reflect self-interest?

The IASB’s mandate is promoting the development and adoption of one set of international accounting standards around the globe. In favouring the use of IAS standards in the USA, the IASB is of course promoting its own self interest but that is to be expected. The IASB may also have informed economic views behind its position (e.g. to avoid the risk of regulatory arbitrage, that is, the comparison of different rules and use of more favourable rules on a selective basis to gain financial advantage) and if it can convince regulators in the USA of the soundness of its arguments then progress towards the adoption of IASB standards into the USA will continue.

At March 2009, adoption of IFRS in the USA had been delayed because of the impact of the global financial crisis, which was absorbing regulators’ attention. In 2008 adoption was planned for 2011-2014. By 2009, the date had been pushed back to 2016 in response to serious liquidity problems in financial markets and asset write downs among financial sector firms. In 2010 the SEC was reviewing its position on adoption of IFRS in the USA.

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Theory in Action 3.3 Enforcing requirements of accounting standards 1.

Do you consider that the company Brocade Communications complied with the requirement to record an expense for stock options?

The relevant accounting standard requires that a company recognises an expense in relation to the fair value of goods and services provided in exchange for equity instruments in the company. If the fair value of goods and services cannot be reliably measured, then the fair value of the equity instruments at grant date is used. Thus, companies must use a fair value (market value must be used if available, otherwise fair value can be estimated using an option pricing model e.g. Black Scholes Merton or Binomial) to determine the amount of the expense at grant date. The standard states that options are valued on grant date. The article suggests that Brocade falsified the grant date. If the grant dated used was incorrect, giving rise to a value which was different to that on the actual grant date, then the company has not complied with the accounting standard.

2.

Who benefits from the ‘backdating’ of stock options? Who is harmed?

The backdating of stock options is beneficial for the executives who receive the options. If the value at grant date is lower, then the ability to gain from the options is greater, that is, a smaller increase in share price is required for the options to be ‘in the money’. The larger the difference between value at grant date and value when exercised, the greater the benefit to the executive. A lower value on grant date also means that the expense recorded in the company’s accounts is lower, with a favourable effect on profit. If the vesting of options is linked to accounting earnings, then it may be easier for executives to achieve accounting earnings performance hurdles and thus qualify to exercise their stock options. The parties who do not benefit from the back dating of options are shareholders who are not receiving accurate information about the value of options granted. In addition, the incentive effects of the options scheme may not be transparent or operate as expected if the grant date is manipulated, to the detriment of shareholders.

3.

If options can be backdated, has the standard setting board (in the USA, the Financial Accounting Standards Board or FASB) been effective in role of promulgating accounting regulations?

The FASB promulgates accounting standards, but it does not enforce them. When we measure the effectiveness of an accounting standard, we consider how it works in practice. Does it achieve the desired outcome? In this case, the standard has not achieved the desired outcome (the recording of the fair value of equity instruments on grant date). However, the fault may not lie with the standard itself, but rather with the party required to follow the standard or the way the standard is enforced. When we come to a red light at an intersection with traffic lights, we are required by law to stop. If we fail to stop, the problem is not with the requirement to stop but with our wilful disobedience in relation to the law. Thus, the failure to comply with the accounting standard (determine the expense at grant date) does not mean that the standard is ineffective, but rather that companies have chosen not to comply with the standard. The enforcement of the requirements of the standard (via auditors or the securities market regulator) may be the weak link in the regulatory framework.

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4.

What is the role of the SEC in relation to the regulation of accounting practice?

The US Securities and Exchange Commission is the US securities market regulator set up under the 1934 Securities Exchange Act. It has many responsibilities including monitoring trading on the stock exchanges and the provision of information by SEC registrants. It has many, many regulations relating to disclosure that require company compliance. It has delegated the specific function of setting accounting standards to the FASB. The SEC is responsible for ensuring compliance with accounting standards. When the SEC became aware companies were selecting grant dates to suit their own purposes rather than using the actual grant date, the SEC took action to indicate this breach of the law was not acceptable. The success in the case against Brocade Communications may serve as a deterrent to other companies.

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Theory in Action 3.4 Many small caps to flash orange What does the headline of the article mean by ‘small cap’ and ‘flash orange’?

1.

‘Small cap’ refers to companies with relatively smaller market capitalisation (i.e. smaller companies in terms of total assets or total revenue compared to the entire listed company sector). The article focuses on concerns about these companies because they have fewer resources and are more likely to have difficulties generating profits in adverse economic conditions. ‘Flash orange’ refers to a warning light, a signal that these companies could be risky and for investors to take care because returns are not guaranteed.

Explain the argument that merely by placing an ‘emphasis of matter’ section in an audit report you could start a chain reaction.

2.

When auditors place an emphasis of matter paragraph in an audit report they are making sure that the readers of the report have their attention drawn to a particular matter. In this case the emphasis of matter refers to doubt about going concern issues, which should be properly disclosed by management in the main body of the financial report. If the auditor believed that the issue was not properly disclosed by management then they would qualify the report. There is an argument that by drawing the readers’ attention to this issue they are emphasising it to the point that the investor would ‘take fright’ and believe the company was at very high risk of failure. This could then lead to a sell-down of the company’s shares and a refusal by its customers and other parties to do business with it. These reactions would serve to make the uncertainty about the company’s going concern turn into a definite failure of the company. Under this argument, if the auditor had not raised the issue in the audit report, this chain of events would not have happened.

3.

The article discusses bank covenants – explain the impact of asset values on bank covenants and the potential repercussions for a company.

Bank covenants are clauses in borrowing contracts between companies and banks where the company promises to meet certain conditions. For example, the company could promise to maintain certain debt/equity or profitability ratios. If the company fails to meet these ratios, the bank is entitled to seek penalty interest, and/or early repayment of the debt. The balance sheet based ratios rely on asset values. For example, the debt/equity ratio is the amount of debt divided by the amount of equity.

Any asset impairment loss will reduce equity, increasing the relative amount of debt in the company’s balance sheet. If this causes the relative amount of debt to exceed the amount the company promised it would not exceed, the company is in breach of its debt agreement. Given that the ratios are calculated using accounting numbers, the bank contracts make the financial reports very important to the survival of the business.

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Solution Manual to accompany Accounting Theory 7e

CASE STUDIES 3.1

Balancing the costs and benefits of regulatory intervention

1.

Explain the reasons for the introduction of the Sarbanes Oxley Act (SOA) in the United States in 2002.

The law was introduced in response to large-scale, highly publicised financial scandals and subsequent corporate collapses at Enron and WorldCom. These scandals resulted in the demise of the audit firm (Arthur Andersen who engaged in questionable professional practices while auditor of Enron).

SOA is a classic example of regulatory intervention by government in the operation of capital markets in the ‘public interest’. The government perceives it must be seen to take action in response to a significant corporate scandal such as Enron. It can also be argued that intervention reflected ‘vote buying’: politicians supporting SOA were acting to restore financial stability and trust to ensure they would be re-elected. SOA made changes to directors’ responsibilities for financial reporting and internal control and sought to increase the independence of external auditors. Intervention via congress reflected a view that action was necessary to (a) control unacceptable behaviour and (b) reassure investors that their interests were being protected.

2.

Why are some parties now opposed to SOA? Has their view changed from when the law was first introduced?

It has become apparent that compliance with Section 404 of the law (which requires managers to certify about the company’s internal control system) is a costly and time consuming exercise. Law makers may have underestimated the costs of implementing the section. Managers who initially supported the introduction of new regulation (because of its role in restoring confidence in capital markets and thereby improving share prices) may have become less enthusiastic as the cost of compliance became more apparent.

3.

According to John Snow, what criteria should be considered in determining financial reporting rules?

According to John Snow, what criteria should be considered in determining financial reporting rules?

Basically, his argument is that rules can have benefits, but they must be carefully framed so as not to destroy business initiative and confidence. Criteria referred to in the article include: (a) rules should not dampen economic growth; (b) there should be balance in enforcement (we can assume he means balance in

the extent to which government intervenes in the market place. Balance means

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that people’s interests are protected, but not to the extent that business cannot function efficiently); (c) rules should emphasise substance over form to avoid penalising people who make innocent mistakes.

4.

Would you recommend a repeal of SOA? Why or why not?

Would you recommend a repeal of SOA? Why or why not?

The aim of this question is have students consider the implications of making a law to regulate financial reporting in circumstances such as those surrounding SOA. Arguments for repeal The corporate governance process is ‘overdone’. Rationalisation is necessary to reduce companies’ aversion to taking risks. Compliance with the law is too expensive.

It imposes an unfair burden on business which in turn suppresses business activity.

Thus the law hinders business rather than promoting it, as was intended.

Arguments for retaining the law It would be difficult for the US government to repeal the law as this would imply that it was no longer necessary; that the behaviour which caused the law (greed and dishonesty?) was no longer a problem or did not occur any more. Since the government would be unlikely to want to give this impression, repeal of the law is unlikely. Of course, modification is possible but also unlikely as that would imply the legislators got it wrong in the first place. Recent experience suggests governments are more likely to add to regulations rather than remove them.

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Case Study 3.2

Are Bean Counters to blame?

1. List possible factors contributing to the banking crisis (the problem of bad debts relating to collateralised debt obligations, i.e. the so-called sub-prime crisis, which began in mid-2007 and became a more general global financial crisis in October 2008).

The article mentions several possible factors (a) ‘Rapacious lenders’: a reference to greedy bankers, who extended credit, without due regard to the riskiness of the loan. (b) ‘Deadbeat borrowers’: a reference to borrowers who did not have sufficient means to meet repayments in the long term, a fact which should have been apparent to the lenders. (c) FAS 157 fair value accounting rule: this US accounting standard sets out how fair value measurement is to be undertaken when it is required by accounting standards (FAS 133 requires the use of fair value for some financial instruments. It is similar to IAS 39). FAS 157 requires that fair value be based on the market value of an item at reporting date. If market value is not available, then fair value is based on market value of a similar item. If this is not available, then companies can estimate fair value based on an appropriate model.

2. Has the market benefited from the regulation requiring the use of fair value accounting for financial instruments?

Fair value accounting for financial instruments aims to improve the transparency and usefulness of information about financial instruments, assisting investors to better evaluate potential risk and return associated with the instruments.

Mr Schwarzman claims that FAS 157 is ‘accentuating and amplifying potential losses’. He claims that large write downs of CDOs are ‘theoretical’ because they are currently unrealised. Banks are forced to write down loans, creating paper losses which may not be realised but in the meantime are depressing earnings and adversely affecting ratios, leading to ‘unadvantageous’ (for existing shareholders) new capital raisings.

With the benefit of knowledge of subsequent events, we can see that the loans did not recover in value so the write downs were more accurate rather than less accurate.

However, the article raises the question whether the write downs overstated the extent of losses, causing a loss of confidence in some banks which was not warranted but nevertheless fed into a complicated situation of frozen credit flows, collapse of demand and a global economic recession by 2009.

The question of whether banks should reveal their losses can be discussed more generally, for example in relation to some Japanese banks which were insolvent in the 1980s but propped up by government funding. Such banks must eventually fail or be bailed out by taxpayer funds. The questions of whether this is an efficient use of scare

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resources should be discussed. The extent and timing of government intervention can be used to illustrate views about intervention in capital markets.

3. According to people quoted in the article, did the US capital market efficiently price the collateralised debt obligations (CDOs)?

According to the article, the Chicago University view is that the market is efficient, that is, ‘the market is always right’ and the current value is the current value. If loans have declined in value, they should be shown at the reduced value to capture the economic reality of the situation. However, the issue is complicated by the fact that the CDOs do not have an observable market price, so fair value is estimated, which may involve intentional or unintentional measurement error.

The article points out that an accounting rule should apply in all conditions (i.e. irrespective of whether markets are ‘up’ or ‘down’) to assist investors’ decision making. The rule should not be used selectively at managers’ choosing because this could lead to manipulation of reported values. Students seeking a better understanding of the financial crises should be directed to papers such as ICAA (2009) and Laux and Leuz (2009) in the end of chapter readings.

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Case Study 3.3 1. JUNE 2002 The European Commission announces plans to adopt international accounting standards (IAS) for consolidated financial statements of all listed companies in European Union (EU) member states from 1 January 2005.

The EU comprises 26 countries, some with markedly different accounting systems and requirements (see Nobes and Parker). Therefore, accounting lacked comparability and transparency making inhibiting the growth of investment and making capital raising more expensive. The EC has undertaken numerous initiatives to promote the development of a single capital market in Europe. If successful, a single EU capital market would rival the US market in size and provide European firms with large amounts of capital at attractive prices. The adoption of IAS is an integral part of promoting the development of a unified European capital market.

2. OCTOBER 2004 The European Commission endorses IAS for use in the EU, with the exception of certain provisions of IAS 39 relating to hedging accounting and fair value measurement of financial instruments. When complying with IASB standards from 2005, companies will not be required to follow the excluded provision of IAS 39.

The EC is committed to the use of a common set of accounting standards throughout the EU (at least for listed companies) to assist with capital raising and promote economic development. However, the commitments of the EC do not necessarily extend to individual companies. An individual company or groups of companies could support harmonisation in general but object to a particular accounting standard if they perceived it was not in their best interests. This is the case with the European banks (see C12 International View). Thus the banks have effectively lobbied and caused the ARC to withhold endorsement of some parts of the IAS 39.

3. APRIL 2005 The European Commission seeks rule changes to make it easier for EU companies cross-listed in the USA to de-list from USA stock exchanges. The Commission is seeking agreement from the USA securities market regulator the SEC to change the current requirement that companies show they have fewer than 300 shareholders before they are permitted to cease registration in the USA. The Sarbanes Oxley Act (see C12) significantly increases the reporting obligations and potential legal liability of EU firms cross-listed in the USA. Some US listed EU companies objected to the requirement to comply with the Sarbanes Oxley Act and have considered de-listing in the USA. They have sought assistance in expediting this process through discussions with the SEC by a EC representative. One might argue that the EC commissioner is encouraging companies to seek capital at home in Europe and thus promote the EU capital markets, but it is just a speculation. I don’t have evidence on this point.

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4.

NOVEMBER 2007 The SEC announces that companies cross-listed on US stock exchanges which prepare accounts based on IAS are permitted to file financial reports with the SEC without reconciling the reports in accordance with US GAAP.

It seems reasonable that EU companies want to be able to list in the USA without reconciliation to US GAAP following their adoption of IAS. Consequently, EU companies lobbied hard (through their EC representatives) for the US GAAP reconciliation requirements to be removed. Pressure on the SEC comes from several areas. First, the US stock exchanges do not want companies to be discouraged from listing or to de-list, which may occur while the US GAAP reconciliation requirements are in place. Second, the US standard setter FASB is converging its standards with IAS, suggesting that IAS are of acceptable quality. To converge US GAAP and IAS on the one hand, yet not accept the use of ‘converged’ IAS standards in US markets, seems inconsistent. In response to various markets pressures the SEC made the 2007 announcement.

5. OCTOBER 2008 The IASB announces amendments to IAS 39 which permit companies to choose to reclassify items out of categories requiring fair value measurement into categories where amortised cost is used. The amendments were announced in response to the 2007- 2008 financial crisis and were made without following the IASB’s due process.

The IASB amended IAS 39 and IFRS 7 to allow the reclassification of some financial instruments. As a result of the financial crisis, the Board was under pressure to amend the standards to permit a reclassification practice that was allowed under US GAAP. The Board did not follow due process because they considered an immediate response was required. Some parties were highly critical of the Board for making the change and doing so without consultation. The Board made an assessment of the political and economic situation and decided that their action was warranted in the circumstances.

It should be remembered that the view in October 2008 was that the world’s financial system was in crisis (market liquidity was frozen) so taking no action may have been politically unacceptable.

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QUESTIONS 1.

General acceptance of accounting standards is important to the accounting profession. By whom does the profession require general acceptance of the standards, and why is it important to the profession?

Until the establishment of the ASRB and subsequent legislative support for accounting standards, compliance with accounting standards could not be legally enforced. The profession could take disciplinary action against members for noncompliance; however, large-scale monitoring was impossible, and so discipline was on a very ad hoc basis. The problem of enforcing standards detracted from the professional status of the accounting profession and also meant that the standardsetting process may be lost to a third party. As such, the profession sought legislative backing for standards in order to enforce compliance and increase the professional status of the accounting bodies. The profession did not want to lose control of this standard-setting process, but sought to use legislation to enforce compliance.

The profession sought to make its standards ‘generally accepted’: • to ensure control of accounting outcomes and the regulatory process and to maintain effective barriers to entry to the accounting profession • to legitimise the accounting process, particularly in the face of increased

criticisms of the standards of accounting information reported • to increase status by virtue of association with legislative support • to increase demand for full GAAP statements and for interpretation of

accounting standards and financial statements • to reduce risk associated with abidance with a set of legislated rules.

2.

The standard-setting process is highly political. Describe an accounting regulation that would be politically controversial, and the types of political pressures that could be brought to bear in the standard-setting process.

Students might choose any accounting issue as long as they can explain why it is political in the sense of affecting the wealth of parties in the political process.

Legislating for accounting standards reduces the outcomes to one of the political trade-offs of competing interests. The political process, as identified by Watts & Zimmerman (1978), involves competition for wealth distributions between different interest groups. In the accounting arena it involves politicians who have incentives to increase government resources and retain their political positions; companies who have an incentive to avoid political costs, such as increased taxes or regulations; and voters whose participation in the political process is a function of the cost of interpreting and processing vast amounts of information. Managers have incentives to adopt procedures that would decrease the political sensitivity of reported earnings and/or increase their personal wealth.

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There are many groups who will lobby in the standard-setting process for preferred outcomes. The groups include trade unions, financial institutions, analysts and social groups. Individuals also lobby in the process.

Overall, the political process is seen as a means of pursuing individual or group selfinterest (Watts & Zimmerman, 1979).

Some ways in which organisations have lobbied to affect the requirements of an accounting standard include: • writing responses to exposure drafts • writing to members of the accounting standard boards putting forward their views • making oral presentations to the boards, or to individual members of the boards • holding meetings where key issues are discussed and ensuring that members of the accounting standard boards are invited, or get to hear of the meetings • holding demonstrations against a proposal that they do not favour — as occurred in Silicon Valley where executives demonstrated against proposals for accounting for executive stock options • releasing media releases expressing their disagreement with proposed accounting regulation; these releases would then result in articles in the media or announcements over the news • forming groups to lobby for using any or all of the above methods • offering to provide funding to the regulatory bodies for an accounting standard that suits them.

The lobbying may also be indirect and framed in a manner that draws attention away from the direct benefits of those lobbying.

3.

The text describes a theory of regulatory capture. (a) What is regulatory capture? (b) How can standard-setting bodies such as the AASB avoid regulatory capture? (c) If a standard-setting body is ‘captured’ by the profession, are there any steps that the government can take to make the body independent? If so, should the government take those steps? Justify your answer. (d) Do you believe that the current international accounting standardsetting arrangements, based around the IASB, are at risk of regulatory capture? Why or why not?

(a)

Regulatory capture is the domination (capture) of a regulatory agency by the industry it seeks to regulate, thus rendering it unable to balance competing interests when making social decision choices. The industry can then direct topics for possible legislation and reject others, which are not seen as important or in the interests of the industry. Walker (1987) argues that the ASRB was effectively captured by the accounting profession (see Chapter 3).

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(b) A possible means of avoiding capture for the AASB is to: • expand the number of members on the panel and/or restrict the number of members that can come from any one industry. However, a large panel may still see groups concentrate as a voting block, and the larger the panel, the greater the organisational costs and the potential for ineffective of inefficient decision making.

• provide the board with adequate resources to promulgate and review standards so that the board is truly financially independent.

• adopt a more relaxed format for proposed standards. This will allow nontechnical groups to make submissions for standards. However, this approach is also likely to result in less effective standards because of greater scope for misinterpretation.

• subject the board and the constitution of its members to annual review. (c) If the AASB is captured or there is a perception of capture, the government should conduct a review to determine the source of the capture. Then, it should take appropriate steps to remedy this particular problem. However, where will it end? One would expect an ongoing cycle of capture–adjustment–capture adjustment. The Financial Reporting Council was established as a result of reforms to accounting standard-setting arrangements pursuant to CLERP1.

The Council is responsible for setting the AASB’s agenda, but it is not to get involved in technical deliberations. The establishment of the FRC is designed to give more stakeholders a say in the accounting standard-setting process.

The FRC comprises members representing interests such as public and private entities, regulators, directors and shareholders. This reform reduces the possibility of regulatory capture as parties other than accountants are included in the accounting standard setting arrangements. (d) The structure of the IASB from 2001 aims to ensure the Board is independent.

Members are appointed based on their expertise and experience. They do not represent the countries from which they are drawn. The Board has an oversight body (the IASC Foundation) which acts to ensure the Board can operate without interference. Fund raising is the responsibility of the IASC, allowing the Board to be independent of parties providing contributions. A large number of parties are involved in the operations of the IASC and the IASB. These include organisations (companies, audit firms, government bodies, standard setters and professional bodies) which contribute cash resources and skilled personnel. A range of people serve on the Board, its technical staff and advisory committees. These organisations and people are drawn from many countries throughout the world, suggesting that any one country or group of constituents is unlikely to come to dominate the standard setting process.

Nevertheless, some commentators have expressed concern that the IASB is at risk of being captured by the USA, through the operation of the FASB. The concern is that IASB standards will align with US GAAP but the process will be one-way. Current participants in the standard setting process deny that the IASB is captured by the FASB, although the FASB is influential in the IASB’s processes and outcomes. The FASB makes a significant contribution to the IASB through its work on various IASB projects. IASB members point to the © John Wiley and Sons Australia, Ltd 2010

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fact that the IASB and FASB work together and that convergence involves changes to both sets of standards (US GAAP and IFRS) not just to IASB standards.

4.

In under 500 words, provide an argument for the regulatory approach to standard setting. Then, in under 500 words, provide an argument for the free-market approach to standard setting. Finally, analyse the arguments and conclude in favour of one approach rather than the other (which approach you favour is up to you, but you must decide which approach is better, at least under a set of assumed circumstances).

In favour of the regulatory approach (and against the free-market approach) • It is highly unlikely that existing authoritative, regulatory bodies will relinquish their present power in accounting. Therefore, the free-market theory is unrealistic.

• The free-market theory is unworkable, because a socially optimal

equilibrium price for accounting information cannot be achieved. This is true for the following reasons: – Accounting information is a public good. Once the information is released, it is available to everyone, not just those who paid for it. Since not all users can be charged for the information, suppliers will have little incentive to provide it.

– A firm has a monopoly on the supply of information about itself, and therefore the tendency will be for the firm to underproduce and sell at a high price.

• A regulatory board is still necessary even if a free market existed, because

accountants will not agree on the procedures to use to derive the desired information. A regulatory board is necessary to make the required decisions.

In favour of the free- market approach (and against the regulatory approach) • As with other products, information about a company is subject to the factors of demand and supply, with price as the operating mechanism. An equilibrium price can be found — this is the price where the supplier still finds it advantageous to furnish information, and users believe the price is equal to the benefits (value) of the information.

• Free-market forces would determine what type of accounting data to provide,

and therefore what standards are necessary in order to gather such data. In this way, unnecessary information is avoided — that is, information where the cost exceeds the benefits. This can be determined because people will not be willing to pay the price.

[The question could be raised — will regulation necessarily prevent fraud or flag the corporate collapses we have seen in recent years?]

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5.

If the IASB concludes that the economic consequences of a standard it is about to approve will disadvantage a powerful lobby group, what should the IASB do about the situation?

Since this is an opinion question, there is no right or wrong answer.

Die-hard proponents of the incrementalist view would argue that the IASB should withdraw its proposal and seek a compromise solution. The IASB needs to be political for its own survival, and compromise is a part of the political game. Depending on the circumstances, if an opponent is too powerful, the wise course of action is to retreat, because the possibility of defeat is great. As long as an incremental step forward is made, the Board would argue that the accounting profession should be satisfied. A series of incremental steps over time could result in eventual victory.

Others would argue that if a proposal has theoretical merit, and especially if there is also empirical evidence to support it, the IASB should seek to establish the proposed standards. The proposal would result in more relevant and reliable accounting information, which should be the primary consideration in the formulation of standards. Incrementalists argue that the IASB should retreat for its survival, but it is for the sake of survival that it should not back off. People are watching the profession to see if it favours special-interest groups. If the integrity of the IASB is tarnished, its survival will be jeopardised. However, if the theoretical-empirical support for a proposal is weak, a wait-and-see attitude may be justified.

6.

How do you think accounting standards should be set? Is that the approach currently taken by the IASB?

Here is one possible answer. The most feasible way may be to be aware of both the politics of the environment and the significance of scientific evidence in the formulation and implementation of standards. Where there is substantial theoretical and empirical evidence in support of a proposal, the IASB should be resolute in seeking to establish the standard. But presently such strong support does not occur often.

The fact is that pressing issues need to be resolved immediately, and there may be little, if any, empirical evidence pointing to any particular direction. In such cases, the IASB needs to follow a theoretical (rational) argument, based on the objective of providing more useful information.

There is no question that the IASB needs to be politically aware. However, to be aware of the political environment means different things to different people. If it means to do a better marketing job of explaining to all interested groups why a given proposal is being made, then that is acceptable. To receive and be aware of the points of view of various groups of a proposal should be helpful to the IASB because the proposed standard may not be as rational as the IASB believes. The due process procedure should be taken seriously and not be a perfunctory routine. Contrary arguments may have salient, legitimate points.

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The IASB does attempt to be independent in the formulation of accounting standards.

Because the support of its standards is mainly theoretical (based on rational arguments), and interpretation of theory can result in different viewpoints, strong opposition is seriously considered and is likely to cause a change in the proposed standard. Empirical evidence is considered. However, that the evidence is often not persuasive; perhaps because it is not understood by the non-academic community.

With the adoption of international financial reporting standards (IFRS), it has been suggested that the AASB and Australian constituents will have less influence over the IASB due process than was possible in the domestic standard setting environment.

The AASB has a specific strategy of contributing to standard setting at the IASB to maintain its influence.

7.

‘We should disband national standard setters. They are of no use following the adoption of international accounting standards.’ Explain whether you agree or disagree with this statement.

People who agree with this statement would argue that the national standard setters such as the AASB no longer have a role to play in standard setting. The standard setting function is carried out by the IASB and interpretations are issued by the International Financial Reporting Interpretations Committee (IFRIC). Australia has made a commitment to use IFRS and therefore it will be accepting all standards issued by the IASB. The AASB is no longer necessary as it will not be developing private sector standards. A common interpretation of IFRS is necessary to assist companies in producing comparable financial reports. However, this must come from an international body not the AASB or a body associated with the AASB. People who disagree with this statement would point to the fact the AASB has a role in developing standards for the public sector and not-for-profit entities. This role has not been assumed by the IASB. In addition, the IASB relies on the contribution of national standard setters in the development of its standards. National standard setters such as the AASB can contribute technical expertise based on its past experience and skill of current staff. They can work on research projects for the IASB. In this way, the AASB can actively contribute to international standard setting. By maintaining the AASB, Australia can contribute to international standard setting on issues of national importance. One example is the forthcoming extractive industry standard which could be important for Australian companies and the national extractive industry.

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8.

What are ‘free-riders’? How can a system ensure that those who benefit most from an accounting standard requiring certain disclosures also bear the greatest costs of it?

Free-riders are people that can utilise information once it is publicly available.

Although information may be sold to certain people only, others who did not pay cannot be easily excluded from using the information. Examples of free-riders are financial analysts and potential investors. There is no simple solution to the problem.

Students should be encouraged to offer ideas. Companies may act to restrict access to the financial statements to shareholders and associated parties. Companies may establish a user-pays system where financial information is available to nonshareholders on a fee-for-information basis. If the fee was sufficiently high, those who pay are less likely to share the information. Nonetheless, such systems would be difficult to administer and control, and are unlikely to be successful.

9.

The setting of accounting standards requires some assessment of economic and other benefits and costs. What are the ethical issues involved? Is it possible to avoid ethical issues in developing accounting standards?

There will always be ethical issues associated with the development of accounting standards because there are ethics involved in deciding between providing information that is representationally faithful for users and requiring information that may be detrimental to the interests of preparers. The most obvious example of this is where information is proprietary (that is, information that competitors could use to the disadvantage of the reporting firm) — the information may be useful to investors but disadvantage the firm that provides it. Furthermore, the provision of additional accounting information may provide information that is useful to investors and other users of accounts, but it may be expensive to acquire the data and process it, thereby imposing costs upon firms and reducing the value of the shares held by existing shareholders.

Accounting standards have the potential to affect levels of wealth and its distribution because they affect: • decisions made by individuals who rely upon the accounts • the terms of contracts that rely upon accounting numbers (for example, debt

covenants requiring that a company not exceed a certain ratio of debt to total tangible assets) • decisions made by regulators who base assessments of ability to pay or of the

harm felt from regulation on the financial statements of the firms.

As long as accounting has economic consequences, some people gain from certain regulations and others stand to lose. As such, its regulation necessarily has ethical implications. Even the decision to ensure that the accounts always give a faithful representation of the firm’s economic circumstances involves an ethical assessment that needs or preferences of the users of the accounts have primacy over the preferences of the preparers.

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10.

You have been appointed as chief accountant of a firm that will be adversely affected by the method of accounting that is proposed in an exposure draft. Write a report of 500 words or less explaining to your Board of Directors how you could lobby the AASB to change its mind and adopt an accounting practice other than the one proposed in the exposure draft. Also comment on the costs and benefits of each to the firm.

There are many ways in which organisations might lobby to affect the requirements of an accounting standard: • write responses to exposure drafts • write to members of the accounting standards boards putting forward their views • make oral presentations to the boards, or to individual members of the boards • hold meetings where key issues are discussed and ensure that members of the accounting standards boards are invited, or get to hear the meetings • hold demonstrations against a proposal that they do not favour — as occurred in Silicon Valley where executives demonstrated against proposals for accounting for executive stock options (the ‘Rally in the Valley’) • release media releases expressing their disagreement with proposed accounting regulation; these releases would then result in articles in the media or announcements over the news • form groups to lobby using any or all of the above methods • offer to provide funding to the regulatory bodies for an accounting standard that suits them.

The preceding methods have all been employed, and instructors may be able to think of others. Other less acceptable methods that have been employed include threats made to individual members of standard-setting bodies. Both financial and nonfinancial costs and benefits of each should be discussed, including reputational effects, the time and effort costs of organisation, and potential benefits from a standard that reduces information, bookkeeping, and contracting costs.

11.

In 2001 and 2002 there were several high-profile US corporate collapses associated with misleading financial statements and accounting practices.

Following these collapses, new laws were introduced to improve the quality of financial reporting. (a) In your opinion, will further regulation prevent deliberately misleading reporting? Explain. (b) Are additional laws likely to prevent corporate collapses? Why or why not? (c) How important is the enforcement of financial reporting requirements in promoting high quality reporting? (a)

Opinions may differ about the extent to which regulation can prevent deliberately misleading reporting. One effect of regulation may be to make directors and auditors more careful in relation to financial reporting.

That is, directors and auditors both want to see compliance with

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accounting standards to ensure there are no adverse monetary or reputational effects from non-compliance. We could expect that the effect of regulation which imposes harsher penalties for non-compliance would be to increase the extent of compliance, assuming non-compliance attracts penalties from regulators. However, deliberately misleading reporting implies the perpetrators know that they are breaking the law. We can assume they have a motivation to do so which must be weighed against the likelihood of being caught and the possible penalty. If the motivation for misleading reporting outweighs possible costs for the perpetrators, then regulation will not prevent misleading reporting. (b)

The extent to which additional laws can prevent corporate collapses will depend on the cause of the corporate collapse. If the cause is failure of the audit function, it is possible that effective regulation to improve independence and performance of auditors could reduce the likelihood of corporate collapse. However, if the corporate collapse stems from fraudulent behaviour of company officers, it will not be prevented by additional laws. If a person considers that the benefits of breaking the law outweigh the risk of being caught and punished, then the law will not be effective in preventing criminal behaviour leading to corporate collapse. It may be that a government introducing additional regulation will be satisfied with a law that makes corporate collapse less likely, even if it does not remove it completely.

(c)

Regulators have indicated that they consider enforcement to be an important element in promoting high quality reporting. In its Concept Release, issued in 2000, the US Securities and Exchange Commission (SEC) argued that high quality financial reporting required not only high quality accounting standards but that there should be enforcement mechanisms to ensure companies comply with standards. A similar view was endorsed by the Committee of European Securities Regulators (CESR) who required that all EU countries set up an independent enforcement body responsible for promoting compliance with IFRS following their adoption in the EU from 1 January 2005.

Enforcement agencies have increased their activities since the corporate scandals in 2001 and 2002. The SEC has been given a larger budget and increased its surveillance activities. In Australia, ASIC has been very active. The Federal Government provided funding for ASIC to review the financial statements of all listed companies in 2003. ASIC now has a program of reviewing all listed companies at least every four years. These activities suggest that governments consider the presence of an active regulator (i.e. one that conducts proactive, not just reactive, surveillance of financial reporting) is important to promote high quality reporting by companies, to ensure auditors are active in obtaining compliance with accounting standards and to improve investor confidence following significant corporate collapses.

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12.

Each of the three theories of regulation discussed in this chapter has its strengths and limitations in describing accounting standard setting, either past or present. What do you believe are those strengths and weaknesses?

Provide an example of where you believe each of the theories has applied, or is likely to apply.

Three theories of regulation are outlined in the text: • Public-interest theory − Legislation is intended to protect consumer interests

by securing improved performance when compared with an unregulated situation. This assumes that there is market failure and consequently some groups will need to be protected from the opportunistic behaviour of others.

If there is a market failure and the legislation can redress the failure’s impact then the public interest will be served. However, this assumes that the legislation will redress the failure and not introduce alternative forms of market failure. It ignores the fact that equity will often be a matter of viewpoint, and legislation is often the outcome of a complex lobbying process. Further, the theory assumes that the regulators do not have their own interest set.

• Private-interest theory − Private-interest theorists believe that there is a market for regulation with supply and demand forces operating as in the capital market. Within this political market, while there are many bidders, only one group will be successful, and that is the group that makes the highest bid. Theorists believe that regulation does not come into existence as a result of a government’s response to public demands, but rather (as a rule) regulation is sought by the producer private-interest group and is designed and operated primarily for its benefit.

But even if a group has a strong incentive to organise, there must still be a mechanism by which the group acquires and uses its influence. It also assumes that players are always seeking to maximise their wealth.

• Regulatory capture theory − This theory argues that those who are regulated

have an incentive to dominate the process, or in some way manipulate it to their advantage. Four such situations have been identified: –

where the regulated entities control the regulation and the regulatory agency

–

where the regulated entities succeed in coordinating the regulatory body’s activities, so that their private interest is satisfied

–

where the regulated entities manage to neutralise or insure nonperformance by the regulating body

–

where the regulated entities use a subtle process of interaction with the regulators to ensure a mutual perspective.

The concept assumes that the parties subject to regulation can form into a group or subgroup capable of capturing the process. In addition, capture will normally become apparent to observers in the community.

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13.

On 1 January 2005 Australia adopted IASB standards. (a) Do you agree with this change? Why or why not? (b) Who stands to gain from Australia’s adoption of IASB standards?

Explain. (c) Who stands to lose from Australia’s adoption of IASB standards?

Explain.

From 1 January 2005 the AASB will issue Australian equivalents to IFRS. This process involves the AASB issuing IASB exposure drafts as exposure drafts in Australia. Constituents can provide comments on standards to the AASB and IASB. Final standards issued by the IASB are subsequently issued in Australia with any additional paragraphs necessary to make the standards suitable for public sector and not-for-profit entities. (a)

Students’ answers will vary, but should cover the following points.

Australian accounting standard boards first articulated their goal of working towards harmonisation of Australian standards with international standards in 1996. The desire for uniformity is premised on the following advantages: • preparer preparation costs reduced • reduced investor confusion • increasing cross-border competition • consistency in external and internal reporting • enhancement of credibility of financial reporting • lower cost of capital.

Barriers cited against uniformity are: • different business environments • legal systems • culture • political considerations.

Commentators who support adoption will refer to the advantages of harmonisation of accounting standards listed above. In Australia the advantages of adoption of international standards are considered to outweigh any disadvantages. The main parties benefiting from adoption are large, internationally active companies and the government itself which can distance itself from the politics of standard setting. The adoption of IFRS in other markets such as the EU (particularly the UK) and New Zealand suggests that Australia has no choice but to participate in the global harmonisation process.

Critics of adoption refer to the costs involved, such as acquiring technical expertise, changing accounting systems and educating investors. Adoption affects all reporting entities in Australia, irrespective of whether harmonisation has any benefits for the company. For example, smaller firms may not benefit from improvements in international comparability. Critics also point to loss of influence in the standard setting process.

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(b)

Adoption of IFRS will benefit: • The users, as financial statements will be more comparable thereby enhancing their usefulness in decision making • Multinational companies may no longer have to prepare dual sets of

accounts providing that the exchange on which they are listed accepts financial statements prepared using IFRS without the need for reconciliation.

• The resources dedicated to standard-setting arrangements in Australia

may be reduced as a consequence of IFRS adoption, representing a cost saving to the Commonwealth Government. The Government can distance itself from the political aspects of standard setting, as reporting requirements are decided on an international, rather than national, basis. (c)

14.

If adoption of IFRS results in changes to preparers’ financial reporting then firms are potential losers if their existing choices are efficient and optimal. It will be necessary to restructure contracts to accommodate the financial reporting consequences associated with adoption. Australian constituents are unlikely to influence the standard setting process to the extent they did in the past. The future of the AASB is uncertain given the commitment to the adoption of IFRS. It can be argued that Australia’s intellectual capital in relation to accounting standard setting will be jeopardised.

What is the role of the Financial Reporting Council? Do you think that all members of the Financial Reporting Council should be qualified accountants? Why or why not?

The responsibilities of the FRC are: • to oversee the operations of the AASB (not involved in technical deliberations) • to monitor the development of international accounting standards • to promote adoption of international best practice accounting standards • to monitor the operation of Australian accounting standards to assess their continued relevance and effectiveness • to seek contributions towards the costs of the Australian accounting standardsetting process.

Members are appointed by the Treasurer and are to be representative of stakeholder organisations.

The FRC does not get involved in technical deliberations so it is not necessary that members be qualified accountants. (This would create the impression of regulatory capture theory.) It would be expected that the members of the FRC have significant business experience and are aware of accounting issues and the economic consequences associated with regulation. In their capacity as Council members they

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are interacting with the various stakeholders and should have an understanding of contemporary accounting issues.

15.

The IASB and FASB began a convergence project in 2002. (a) What are the expected benefits of the convergence project? (b) What factors make convergence difficult? (c) How is the future of the IASB tied to convergence? (a)

(b)

Convergence is the process of aligning US GAAP and IASB standards (See Chapter 3). The Norwalk Agreement (2002) was a memorandum of understanding entered into by the FASB and the IASB whereby they would work together to eliminate differences between the requirements of US GAAP and IAS/IFRS. They would also align their work agendas. The benefits of convergence are to reduce the differences between financial statements prepared in accordance with US GAAP and IFRS thus increasing international comparability of reporting. This has potential benefits for investors and companies.

There are some significant differences between US GAAP and IFRS which make convergence difficult. Resolution of these differences requires one party to make a significant adjustment to reporting practices which may not be supported by constituents. Two such examples are capitalisation of development expenses (required under IAS 38 but not permitted under US GAAP) and upward revaluation of fixed assets (prohibited in the US since the 1930s, but allowed under IAS 16).

Political issues also make convergence difficult. The FASB issued proposals to expense stock options in the early 1990s that did not become mandatory because of extensive lobbying by companies and employees with stock options and the threat of intervention by congress to prevent FASB from issuing the standard. The IASB issued IFRS 3 Share based payment, requiring expensing of stock options. Subsequently, the FASB introduced (from June 2005) similar but not identical requirements.

(c)

The future of the IASB is linked to convergence. The IASB’s aim is to develop private sector standards for use throughout the world. If the US does not use or recognise these standards as high quality, the IASB’s aim has not been achieved. If US GAAP are considered to be the ‘best’ standards, then IFRS are second best and the goal of one set of international standards has not been realised. Convergence is a process of dealing with the differences between US GAAP and IFRS and working toward one set of high quality international standards.

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16.

Should the SEC allow the use of IASB standards for US domestic listed companies? Discuss reasons for and against the use of IFRS by US companies.

Arguments in support of use of IFRS by US domestic companies 1. Improved international comparability. For some industries, major competitors use IFRS. All companies following the same standards will assist information users e.g. analysts.

2. The USA is the world’s major capital market. Adoption of IFRS in the USA means that common accounting standards are widely used throughout the world. Common standards are claimed to improve efficiency of information exchange.

3. US companies with subsidiaries that use IFRS will benefit from reduced accounting preparation costs. Use of common standards will help with budgeting, tax planning and control. Training costs (in multiple GAAPs) will be reduced.

4. All SEC registrants should have the same options in policy choices. Currently some SEC registrants follow IFRS and others US GAAP. There are differences between the standards that make reports not fully comparable.

5. Standard setting will be more efficient as standard setters can pool their resources and work on solutions to accounting issues that confront companies irrespective of their country of domicile.

Arguments against use of IFRS by US domestic companies 1. US GAAP and IFRS are not the same. It is not clear that IFRS is higher quality GAAP than IFRS. IFRS standards are not as comprehensive as US GAAP. 2. Standard setting benefits from competition between standard setters. One set of standards will not necessarily mean that the highest quality standards are developed.

3. The USA will lose sovereignty in standard setting. Use of IFRS will reduce the influence of the SEC and FASB. 4. Many US companies are not SEC registrants. The cost of changing to IFRS will be expensive, possibly without benefit for private companies lacking international operations.

5. US accountants and auditors are not technically proficient in IFRS.

17.

Why has IFAC established a Public Interest Oversight Board?

IFAC has established the PIOB to ensure the independence of the IAASB from the auditing profession. Most members of the IAASB are, or have been, professional auditors. This raises the suggestion that the IAASB has been captured by the auditing profession and causes doubt about whether the standards are written to protect the public interest or the interest of auditors. If IFAC (and the IAASB) are to be able to continue to write international auditing standards and exert influence, it needs to establish structures to guard against this accusation. The PIOB also offers a place for regulators to go to express their opinion about auditing standards and functions as a

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liaison body with the IASB’s Monitoring Group (see Chapter 14 for more details).

This assists a greater level of cooperation between the auditing and accounting standard setters.

18.

Why would the quality of accounting and auditing standards affect the development of financial markets? Why is the strength of enforcement of the standards and investor protection important in this relationship?

High quality accounting standards assist the production of high quality financial information which is useful for decision makers, including investors. High quality auditing standards guide auditors to conduct audits which are more likely to reduce the risk of material misstatement due to fraud or error in the financial statements.

High quality and credible financial information allows investors to have less uncertainty, and greater confidence in trading. Confident investors are more likely to participate in the share markets, providing greater liquidity. Greater trading volumes mean that share prices are more likely to reflect all publicly available information.

Enforcement of the standards and investor protection laws are vital to ensure the high quality accounting and auditing standards impact positively on share market trading.

Investors gain confidence from standards only if they are enforced. Unenforced standards are ‘not worth the paper they are printed on’, that is, they may as well not exist because all parties know there are no consequences of breaching the standards.

Investor protection laws give investors the right to sue if accountants and auditors are negligent, particularly when they also include provisions that ensure the audit firms are likely to have the resources to meet their negligence liability.

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Accounting Theory 7e Prepared by

Ann Tarca

Chapter

Chapter 4 A conceptual framework

John Wiley & Sons Australia, Ltd 2010

Chapter 4: A conceptual framework

Chapter 4: A conceptual framework THEORY IN ACTION Theory in Action 4.1: IFRIC 3 and Emissions Trading 1. What would be the likely impact of the ‘mismatch’ arising under IFRIC 3?

The mismatch described in the article relates to (1) assets and liabilities and (2) recognition of gains and losses on assets.

In relation to assets and liabilities the article implies that assets and liabilities are not reognised to the same extent, e.g. more assets recognised than liabilities (or the reverse).

Therefore the balance sheet does not accurately reflect a company’s position in relation to emissions trading. There is also a timing mismatch, with assets recognised when obtained and liabilities when occurred.

In addition, there is also a mismatch is the treatment of gains and losses, possibly leading to volatility in the income statement. Gains on assets are deferred (recognised in equity) while losses are recognised immediately in the period incurred.

2. To what extent is ‘matching’ a principle proposed by the IASB Framework?

The Framework addresses (1) objectives of financial reports (2) qualitative characteristics of the usefulness of information (3) definition, recognition and measurement of elements of financial statements and (4) concepts of capital and capital maintenance (Paragraph 5). The underlying assumptions are accrual basis and going concern (para 22-23). ‘Matching’ of revenue and expenses is not required by the Framework although it is mentioned in para 95 as a common accounting practice. In particular, para 95 states that matching not be used to create assets and liabilities which do not meet the definitions of assets and liabilities under the Framework. Para 95 states: Expenses are recognised in the income statement on the basis of a direct association between the costs incurred and the earning of specific items of income. This process, commonly referred to as the matching of costs with revenues, involves the simultaneous or combined recognition of revenues and expenses that result directly and jointly from the same transactions or other events. For example, the various components of expense making up the cost of goods sold are recognised at the same time as the income derived from the sale of the goods. However, the application of the matching concept under this Framework does not allow the recognition of items in the balance sheet which do not meet the definition of assets or liabilities.

3. In what ways can you see the influence of the IASB Framework on IFRIC 3?

If the Framework provides guidance to standard setters then we should observe that the requirements of IFRIC 3 are consistent with the Framework. Therefore, we should observe that IFRIC 3 meets the objective of financial reports (providing useful information for decision making) and that the information provided under IFRIC 3 meets the qualitative characteristics of financial reports (understandabilty, relevance, reliability and comparability, © John Wiley and Sons Australia, Ltd 2010

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paragraphs 24-42). Further, the elements’ definition and recognition criteria should be consistent with those in the Framework.

The discussion in the article does not suggest that IFRIC 3 was inconsistent with the Framework. Further, it specifically states that measurement of assets and liabilities would follow certain standards (IAS 38 for assets, IAS 37 for liabilities). However, the standards themselves may not be consistent with the Framework. IAS 38 applies stricter conditions to upward revaluation of intangible assets than are included for tangible assets under IAS 16 (the condition that an active market exists) thus distinguishing between how tangible and intangible assets are to be remeasured. This distinction is not made in the Framework. The IAS 37 is a more recent standard and brings in ideas not in the Framework. For example, the Framework refers to liabilities and provisions (paras 60-64) but not contingent liabilities. The IAS 37 requires a present obligation to an external party before a provision can be recognised.

Some people would argue that this is not consistent with a principle of prudence, which is part of the 1989 Framework (though likely to be removed in the revised framework).

4. In relation to IFRIC 3, do you consider that the IASB Framework provides a ‘theory of accounting’ That is, does the Framework explain and predict accounting practice?

The Framework fails to provide a ‘theory of accounting’ in relation to IFRIC 3. The Framework does not ‘explain and predict’ accounting practice. In fact, accounting practice (by or more precisely, practising accountants) has (have) rejected accounting for carbon trading as outlined by IFRIC 3. In Q3 we argued that IFRIC 3 recommendations were generally consistent with the Framework. Yet practitioners have rejected IFRIC 3 suggesting that the Framework is not effective in predicting how accounting will be carried out in practice.

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Theory in Action 4.2 Principles vs rules: Lease Accounting 1. What are the criteria in IASB and FASB standards for classifying a lease as a finance lease?

▪ ▪ ▪ ▪ ▪

the lease transfers ownership to the lessee; the lease contains a bargain purchase option to purchase that is expected to be exercised; the lease is for the major part of the economic life of the asset; the present value of the minimum lease payments amounts to substantially all of the fair value of the leased asset; only the lessee can use the leased asset.

2. What is meant by ‘bright lines’ in accounting standards? Give examples of the ‘bright lines’ in US leasing standards.

‘Bright lines’ refers to the practice of standard setters of stating specific thresholds. Consider for example the issue of materiality. IASB standard IAS 31 Materiality gives general guidance about materiality without stating a specific threshold. For instance, para 9 states that an item is material if its omission, misstatement or non-disclosure has the potential to influence the economic decisions of users taken on the basis of a financial report or affect the discharge of accountability by the management or governing body. Para 13 states that in determining if an amount is materia, the amount is compared to the total of equity and the appropriate asset or liability class total. In contrast, a bright line or specific threshold would be to say that an item is material if it is 5% of the applicable asset or liability class total.

In relation to US GAAP leasing standard FAS 13, specific numbers are provided as follows: Criteria (c) above: the lease is for the major part of the economic life of the asset (75% threshold); Criteria (d) above: the present value of the minimum lease payments amounts to substantially all of the fair value of the leased asset (90% threshold).

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3.

Mr Ketz does not believe the IASB approach of principles-based standards will be effective for leases. Provide details of the arguments he presents in favour of his case and consider the alternative view.

Ketz arguments

Opposing arguments

Bright lines are arbitrary but they assist ‘Bright lines’ can be worked around, preparers. principles are to be preferred.

The guidance is given by the standards setters.

Guidance should be given rather than left to discretion of preparers. Decisions about capitalisation are objective e.g. 75% threshold.

Preparers have to make decisions about when rules for capitalisation are met and defend these decisions to their auditors. Preparers should take responsibility for these judgements, not regulators.

Without thresholds decisions about Managers can behave opportunistically in capitalisation are subjective. Managers may relation to thresholds. behave opportunistically.

Auditors cannot rebut managers decisions Auditors can rebut managers’ interpretations about interpretation of leasing standards in relation to accounting standards. They already do so in many areas and can do so in relation to leasing.

4.

Do accounting practices under current IASB leasing standards comply with the definition and recognition criteria of the IASB Framework?

The IASB Framework definitions and recognition criteria are stated in the chapter. If companies followed these definitions they would show all leases on the balances sheet because: The lease is an asset as (1) it relates to an item controlled by the entity (2) there is a past transaction (the lease agreement) and (3) future economic benefits will flow from the transaction (benefits from using the leased asset). Lease payments are a liability because (1) there is a present obligation to an external party, the lessor (2) arising from a past event (the lease agreement) (3) which will involve the outflow of future economic benefits (lease payments).

In terms of recognition for both the asset and liability, (1) the amounts can be measured reliably (as per the lease contract) and (2) future economic benefits are probable (the use of the asset will generate net benefits, otherwise the contract would not have been entered into by the company).

Thus current practice, where most leases are classified as operating under IAS 117, is not consistent with the conceptual framework. Under the Framework criteria, leases would be capitalised and assets and liabilities recognised in the balance sheet. © John Wiley and Sons Australia, Ltd 2010

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Theory in Action 4.3 Guidelines for reporting ‘proforma’ earnings 1.

According to the article, what is meant by ‘underlying profit’? underlying profit differ from statutory profit?

How does

Underlying profit is a profit figure derived from adjusting reported (statutory) profit for oneoff and unusual items. Statutory profit is derived based on accounting standards (‘strict accounting rules’ in the article). Underlying profit is a ‘proforma’ profit measure. The adjustments to get to underlying profit are subjective, that is, they are under the managers’ discretion. The article states that there is ‘greater opportunity for malleability in the underlying profit figure’.

2.

Why did the AICD and Finsia release guidelines about reporting underlying profit?

The voluntary guidelines provide seven principles which can be used to produce more consistent reporting. Directors are encouraged to follow the principles so that investors and users can understand the adjustments to statutory profit and can compare underlying profit between entities. The guidelines are to ‘promote good reporting practice’ and to discourage poor practices such as ‘inappropriate adjustments to statutory profits or window dressing’.

Issuing voluntary guidelines shows that the organisation wants to be influential in improving the quality of reporting. Guidelines may also help members determine ‘best practice’ for reporting. Issuing voluntary guidelines may also pre-empt (prevent) government intervention through regulation.

3.

According to the article, why do some directors consider that statutory profit is not a ‘proper reflection’ of the underlying business? Explain whether you agree with the directors’ view.

With the adoption of IFRS, new standards have been introduced and some accounting methods changed. For example, there is more market value accounting (e.g. financial instruments, share-based payments) and greater focus on impairment and write-downs of goodwill. Directors may consider that these methods mean that the performance of the underlying business is not properly reflected in statutory profit.

The directors’ view suggests that they disagree with the requirements of some accounting standards. That is, they do not believe some accounting treatments measure position and performance appropriately for prediction of future performance. For example, they may disagree with the requirement to include unrealised gains and losses on certain financial instruments. They may consider that the gains and losses are not part of operating profit, and that the volatility introduced is misleading for analysts and investors. Restating statutory profit (excluding the unrealised gains and losses) allows directors to present what they consider to be ‘real’ (underlying, sustainable) profit of the entity.

4.

Discuss whether the actions of (a) directors in releasing an underlying profit figure and (b) the AICD/Finsia guidelines are supportive of the IASB/FASB’s conceptual framework project.

The actions of the directors suggest that they do not support some requirements of accounting standards and also some concepts of the Framework. Let us consider the example referred to © John Wiley and Sons Australia, Ltd 2010

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in part three of the question (above), namely the recognition of unrealised gains and losses on financial instruments in the income statement. This requirement comes from IAS 39 and is also consistent with the Framework, which states that income includes revenue and gains (para 74) and that expenses include losses and items which are unrealised (paras 78-80).

Therefore the directors do not appear to supportive of the underlying concepts of the Framework and standards, at least in terms of them being performance measures that are useful for evaluating the business and predicting future cash flows.

If the directors claimed that unreliability of measurement leads them to exclude items then they are following the Framework. However, this argument is not persuasive, since the items have been included in statutory profit. Presumably the firms’ auditors considered that they could be measured with sufficient reliability.

The actions of AICD and Finsia in releasing guidelines are consistent with the Framework in that the aim of the guidelines are to improve comparability and transparency and therefore the quality of information provided. So while the information itself is ‘outside’ the Framework and standards (that is, it is not consistent with either) the activity of issuing the recommendations is actually supportive because it is consistent with the objectives of the Framework (namely to produce high quality information which assists in decision making process of users).

In terms of the current IASB/FASB project, the directors’ views may suggest that they will have a particular opinion about measurement methods, i.e. a preference that unrealised gains and losses not be included in income (in the profit and loss statement). If they feel strongly on this issue, they may attempt to the discussion of measurement objectives and measurement methods in the project to revise the Framework.

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CASE STUDIES Case Study 4.1 BIG GAAP, SMALL GAAP: Accounting for SMEs Under the four headings in the article, discuss the possible benefits of an SME standard identified by the author. In your discussion, name the parties most likely to benefit from the SME standard and explain the extent to which you agree or disagree with the views presented by the author. You should also consider what factors may inhibit the success of the SME standard.

1. Comparability of financial information An SME standard will improve comparability within and between industries for private entities, regardless of where a company is domiciled. Transactions and economic circumstances will be accounted for and presented more consistently than under the present various national requirements. Different recognition and valuation principles make it difficult for users of financial statements to make informed decisions about a private entity’s performance and cash flows. The SME standard has the potential to improve comparability of information and the quality of communication with stakeholders, thus facilitating better investment decision making.

2. Acquisitions, partnerships and cooperation agreements The SME standard can assist with cross-border acquisition and partnerships or agreements with foreign entities. It may simplify the sale of an entity because the financial statements, which are fundamental in evaluating an acquisition and purchase price, are more transparent and comparable. Evaluation of each entity is simpler and agreement is more likely. The negotiation process is assisted by the use of common standards. Time and expense involved in restating financial information is avoided and post-integration financial reporting costs are lower.

3. Building relationships with overseas customers The SME standard can assist private entities that are buying and selling goods across national boundaries and those that seek to build new customer relationships. The IFRS for SMEs can be used to promote a good image of the company i.e. that the company has high quality financial reporting, and that it provides relevant information to assist customers’ decision making. Financial statements are regularly demanded as part of the supplier selection and evaluation process for a range of reasons, including assisting an assessment of solvency.

Companies that offer only national GAAP statements may be disadvantaged if their statements are seen as less transparent and comparable than those of entities using IFRS. 4. Dealing with finance providers Another positive effect from using IFRS is that the company may be in a better negotiating position and be able to achieve a lower cost of borrowing. The positive image of IFRS (high quality standards, that promote comparable and transparent information) may have a positive effect on credit ratings. The more comprehensive disclosures in IFRS may assist lenders in making a more accurate risk assessment, leading to a lower risk premium for the company.

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Use of IFRS may mean that the company can obtain new sources of equity finance because of the greater transparency and comparability of information.

Overall, we can see that a range of parties may benefit from the adoption of IFRS for SMEs by private entities. They include capital providers (investors and financiers) because they may receive better quality information (more comparable, more transparent, more detailed) to use in their decision making. Company managers can also benefit. They produce better quality information which assists them in communicating will all outside stakeholders. The IFRS reports assist them in a range of business operations. If the standards are useful for capital raising and for operations then the business benefits and so too do managers, employees and shareholders.

Of course, there are costs in adopting IFRS for SMEs. Companies incur costs of adopting the new set of standards and in adjusting their accounting systems. Personnel must be trained in use of IFRS. IFRS requirements are not necessarily straightforward, even within the IFRS for SMEs standard. There may be confusion generated if accountants try to understand simplified IFRS without reference to full IFRS. Staff will need to learn requirements and keep up to date. The standards may require disclosures that the company has not previously made, raising issues about proprietory information and the costs of disclosure.

The benefits of transparency and comparability can only be achieved if companies interpret IFRS the same way and comply with all IFRS requirements (in the IFRS for SMEs). Private companies may be subject to less rigorous auditing than large listed companies, thus they may have more leeway in how they interpret and apply IFRS leading to differences between companies. Private companies are subject to less oversight by enforcement bodies, so the level of comparability may not be as high as for public companies that are closely scrutinised by external regulators. Auditors are also faced with challenges. It is not yet clear the extent to which they will be able to audit just to the SME standard and ignore requirements of full IFRS.

Case Study 4.2: Usefulness of accounting information – Public sector and not-for-profit entities A model answer is not provided as students’ answers will vary according to the report selected.

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Case Study 4.3 Revisiting the conceptual framework 1.

Explain why principles-based standards require a conceptual framework.

The aim of principles-based standards is to build on previously agreed upon principles, which do not have to debated each time when a standard is being developed. For example, if definitions of elements are agreed upon, they can be used in standards and not debated again.

This approach aims to increase consistency among standards and to reduce time taken in their formulation. Principle based standards rely on the existence of underlying principles which can be used so that detailed rules do not have to be provided. The conceptual framework provides a source of principles which can be used in accounting standards. For example, if the conceptual framework provided an agreed approach to measurement e.g. measure all assets and liabilities at fair value, then it would provide a principle which could be applied in standards. The existence of a principle would make it easier and quicker to develop standards.

2.

Why is it important that the IASB and FASB share a common conceptual framework?

A study by the SEC has recommended that US standards be more principles based (see discussion Chapter 4). Therefore, additional work on the principles underpinning the standards, that is, the principles contained in the conceptual framework, is needed. The IASB/FASB convergence project has created a need to converge the bodies’ conceptual frameworks. Since standards are based on underlying conceptual frameworks, it is necessary to converge the frameworks to achieve convergence of standards.

3.

It is suggested that several parties can benefit from a conceptual framework. Do you consider that a conceptual framework is more important for some parties than others? Explain your reasoning.

Standard setters are the major beneficiary of a sound conceptual framework. It allows them to develop their standards based on agreed upon principles. The article states that the IASB and FASB base their accounting standards to a large part on the foundations of objectives, characteristics, definitions, and criteria set forth in their respective conceptual frameworks.

Further, it states that principles-based standards must be rooted in fundamental concepts that constitute a framework which is ‘sound, comprehensive and internally consistent’. Thus the conceptual framework is important to achieving the goals of setting high quality accounting standards and converging US GAAP and IFRS. However, the conceptual framework can also be of assistance to preparers of financial statements. It can provide guidance in relation to the interpretation of existing financial statements and on matters which are not covered by existing standards. Auditors can also benefit from the guidance in the framework in forming their opinions. Finally, the Framework may assist users in interpreting the financial information provided.

4.

What is meant by a ‘cross-cutting’ issue? Suggest some possible examples of cross-cutting issues.

Cross cutting issues are those which relate to more than one standard. That is, the issue comes up when various standards are being considered. Examples are the definition and recognition criteria for assets, liabilities and equity. Revenue recognition matters and financial instruments are other examples. In addition, measurement is a problem area. For example, © John Wiley and Sons Australia, Ltd 2010

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standard setters have not found an obvious way to decide when to value items at historical cost and when fair or market value should be used.

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QUESTIONS 1. How do conceptual frameworks of accounting attempt to create a theory of accounting? Describe the components of the IASB Framework and how they contribute to a theory of accounting.

Conceptual frameworks (such as those developed in the United States, Australia and at the IASC/IASB) do not employ the term ‘theory’ because of the difficulty of demonstrating logical consistency and in gathering empirical evidence to corroborate the theory. However, by following a structured program of inter-related concepts, accounting regulators aim to use the conceptual framework to achieve consistent accounting standards that will replace ad hoc solutions to specific problems. In this context, the components of the conceptual framework can be viewed as the building blocks of a theory of accounting.

The components of the IASB/Australian Framework are: objectives of financial statements; qualitative characteristics of financial information (such as relevance, reliability, comparability, timeliness and understandability); and definitions of the basic elements of accounting reports (such as assets, liabilities, equity, revenue, expenses and profit) and principles and rules of recognition and measurement of the basic elements, and the nature of the information to be displayed in financial reports.

2. Some people argue that there is no need for a general theory of accounting, as established in a conceptual framework. They argue that there is no overall theory of physics, biology, botany or psychology, so there is no need for an overall theory of accounting. Furthermore, attempts to develop an overall theory of accounting are futile and unnecessary, since accounting has not needed a conceptual framework so far. Debate this view.

It is true that in the physical sciences, there is no overall theory of a given field of study.

There is no theory of chemistry, or biology, etc. Some scientists have attempted to formulate such theories, but have failed. It is generally agreed that such theories would be beneficial because they would provide an integrated explanation of all aspects of the given field of study. At present, different theories in a given discipline — for example, in biology — remain as separate categories, and often the connection of one theory to another is not known.

Theories in the sciences are descriptive, but in accounting an overall theory would be normative, telling accountants what ought to be done. This would be very useful if it could be formulated. It would serve as a standard by which to judge practices. Although the probability is slim that in the near future a logically consistent overall theory can be constructed, a theoretical framework such as the conceptual framework can be helpful.

It is true that the profession has survived without a general theory, but a theory of some sort has always been in mind. Constant reference to generally accepted accounting principles reveals this. It would be easier to assess accounting practices and to formulate standards consistent with each other if a general theory existed. If a theory is empirically verified, accounting methods for particular purposes would also have empirical evidence to support them. In other words, we would be able to present evidence as to why a certain procedure (for example, FIFO inventory valuation) should be used rather than another method.

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3. What does the IASB Framework describe as the basic objective of accounting? What are its implications?

Stewardship looks primarily to the past, asking the question: What happened? Decision making looks to consequences in the future, asking the question: What will happen? A decision-making approach sees accounting information as inputs for the decision-making prediction models of users. If so, then we are concerned about what kind of accounting information is relevant to decision makers. Some believe that current value is implied. Also that statement of financial position accounts and their amounts are as important as those in the income statement. Traditional accounting emphasises income.

4. What type of information do you think is useful for shareholders, lenders and creditors? Is this the type of information that is currently provided?

Useful information is both relevant and reliable. Presumably, it is also ‘fair’.

Adopting a narrow perspective, useful information provides a basis for investors and creditors to assess the amount, timing and uncertainty of future cash flows for themselves based on the expected cash flows of the firm. Such a basis is provided by information concerning the profitability and financial condition of the firm. In turn, this information is presently reported in the statement of financial performance or the statement of financial position, and the statement of changes in financial position. For the latter, many believe a cash flow statement is especially pertinent.

Taking a broader view, useful information helps to efficiently allocate capital in the economy.

(Question 6 deals with this.)

5. The expressions ‘truth’, ‘justice’ and ‘fairness’ have all been applied to describe desirable characteristics of accounting information. What role do you think they play in practice? Are they included in the IASB Framework? If so, how? If not, why not?

Truth, justice and fairness are socially desirable goals. Accountants should be concerned that the information they report is true, just and fair. The audit opinion indicates a concern for the above-stated goals. Useful information is relevant and reliable, and these latter terms encompass the broader ones of truth, justice and fairness. However, we should understand that what is true, just and fair often depends on who is making the judgement. The company may believe that its financial statements meet the criteria of truth, justness and fairness, but the shareholders may not think so. Accountants are often caught in the middle. This is all the more reason why a general theory of accounting, especially one that is supported by evidence, is important to accountants.

Students should be asked if the following procedures cause information to be ‘true, just and fair’: LIFO inventory valuation; historical cost of land purchased 20 years ago.

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6. Explain the role of accounting in relation to: (a) individuals (b) firms (c) the Australian economy.

Accounting information helps to efficiently allocate capital in the economy.

The successful operation of a free economy depends, to a large extent, on the good judgements made by individuals about their investment opportunities and the investment opportunities of firms. People need information to decide where to invest or lend, and at what price.

In relation to firms, accounting information forms the basis for many contracts, such as debt contracts that include covenants specifying that the firm will not allow its leverage ratio to exceed a certain level, or management compensation plans that provide managers with bonuses based on reported corporate earnings. As such, the firm’s cash flows are tied to accounting numbers. Since the value of the firm is the present value of all future cash flows and those cash flows are tied to accounting numbers, accounting numbers determine the value of the firm.

In relation to the economy, accounting information plays a vital role in the equitable allocation of capital, and it contributes to the effective performance of the price system. The effective operation of our economy means that efficient and inefficient companies must be identified, so that resources are channelled to the former and away from the latter in order to have a ‘successful’ economic system. What would happen, after a long period of time, if ‘incorrect’ information is reported? The economic system would become inefficient (because of the existence of many inefficient firms), causing serious economic problems to all.

7. Can accounting ever provide an unbiased map of economic reality? Why or why not?

Yes. Criticisms of neutrality or freedom from bias take two forms. First, some argue it is a state of mind that is not attainable, because all of us are affected by personal values that have been shaped by our particular beliefs, traditions, environment, background and personality.

Granted that this is true, it is still meaningful to speak of neutrality or freedom from bias. We recognise the existence of these influences on our perceptions. The idea is to control them within an acceptable range.

Second, some contend that neutrality or freedom from bias is not operational, because we cannot be expected to read other people’s minds. However, it is possible to translate neutrality or freedom from bias into operational terms by establishing specific control devices that are external and subject to examination.

Control devices are the means by which the notion of objectivity receives operational meaning. Control devices have to do with making public or external what is essentially internal or introspective. Rules and procedures under the heading of disclosure, consistency, comparability, and materiality as well as GAAP are practical control devices.

In the accounting literature, practical control devices under the heading of objectivity have taken the following three forms: © John Wiley and Sons Australia, Ltd 2010

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• • •

to make specific and precise the concepts and procedures of accounting, and to obtain general agreement on them to determine a consensus of the measure among a number of experts to improve the standards of competence and ethics of the profession.

Accountants must construct unbiased or neutral financial maps of economic reality.

Otherwise, as Solomons warns, ‘If it ever became accepted that accounting might be used to achieve other than purely measurement ends, faith in it would be destroyed’.

8. Some argue that the development of a conceptual framework is inappropriate because accountants constantly deal with specific issues that will not be envisaged by an overall, general conceptual framework. In particular, a conceptual framework makes no allowance for differences in the social contexts where accounting is applied. They also argue that it would be preferable to develop case-specific solutions to accounting issues, based on case study research, and bearing in mind the social contexts of all accounting decisions. Discuss this view, presenting arguments for and against it.

Determining ‘best’ accounting methods for situation-specific problems can be accomplished in a more systematic and consistent manner if there exists an underlying theory to guide solutions to problems.

In the absence of an overall theory, the results of a micro or case study approach cannot be generalised to other situations. There is also the possibility that the same or a similar problem might be solved in an entirely different and contradictory manner if there is no overall theory or set of generally accepted principles to restrict the ad hoc subjectivity of the decision maker.

The results of case studies can, however, be used as empirical evidence in constructing a theory of accounting.

9. What is the difference between art and science? Is accounting an art or a science?

Does it matter? Why or why not?

Whether accounting is an art or a science has long been debated by accounting academics without coming to an agreement. One position in the middle of the two extremes is that accounting theory is a science whereas accounting practice is an art. According to Sterling, there is nothing inherently unscientific in accounting. In fact it is the approach adopted by the researchers in a discipline that makes the discipline scientific or otherwise.

Accountants who believe in the scientific approach seek empirical evidence to support accounting practices so that practitioners can recommend the most appropriate methods for given situations based on the evidence. The scientific approach in accounting is not an attempt to make scientists of practitioners, nor is it an attempt to discuss ‘absolute truths’, since there are no absolute truths in science.

Looking at the research in accounting, particularly during the last 30 years, one can see a great deal of analytical as well as empirical research; both being integral parts of a scientific theory. It is therefore inappropriate to claim that accounting is in the pre-science stage.

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10. ‘The development of a SME standard by the IASB will defeat the purpose of international harmonisation.’ Explain why you agree or disagree with this statement.

The rationale for international harmonisation of accounting is as follows: If companies use the same set of accounting standards, there will be greater transparency and comparability between financial reporting from companies from different countries, thus assisting international investors in efficient allocation of resources and leading to a reduced cost of capital for companies. In addition, companies will not be forced to meet the cost of using more than one set of national GAAP. These advantages are important for many companies in different countries, hence the global support for international harmonisation. However, they are not important for all companies.

For example, smaller less international companies may find the arguments less persuasive.

Smaller companies may not have international activities and investors, and therefore do not benefit from the use of international standards.

Smaller companies may argue that they do not need to use the full IASB standards because they do not have users who are dependent on the financial statements for information, or who need internationally comparable information.

The use of an SME standard does mean that all companies are not complying with full IASB standards, so comparability is reduced. However, if SME companies do not have international operations and investors, it is not a disadvantage that they do not comply with the full set of international standards. Thus an SME standard does not defeat the purpose of international harmonisation.

11. In Australia, the conceptual framework did not proceed to SAC 5 concerning measurement. (a) Why do you think that is the case? (b) Do you think that accounting standards have been moving towards a particular measurement method? If so, what is that method? (c) How can standards lead the development of a formalised conceptual framework? (a) SAC 4 was highly controversial. SAC 5, dealing with measurement, would be even more controversial. As such, it is fair to say that at the time the AASB felt that the business community was not ready to accept a standard prescribing measurement methods.

Furthermore, while the majority of the AASB might agree on a particular general approach to measurement (for example, current market values) it is likely that the AASB would have great difficulty obtaining agreement on more specific issues (such as how to treat transactions costs, discounts, etc.). It was deemed prudent to defer development of SAC 5 until the community was more supporting. Following adoption of IFRS, standards on measurement come from the IASB. (b) Increasingly, accounting standards have been requiring use of net market values, which are current market selling prices less transactions costs. Some regard this as a ‘back-door’ way of introducing fair value measurement requirements. (c) Standards can contribute to the development of a formalised conceptual framework. If they introduce concepts or methods that become more accepted once they are prescribed in an accounting standard, this provides a lead-in to a more general document such as a Statement of Accounting Concepts for the conceptual framework. For example, the more © John Wiley and Sons Australia, Ltd 2010

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standards require measurement at net market value or disclosures of net market values, the more acceptable the method becomes, and the easier it is likely to be to gain general acceptance of a Statement of Accounting Concepts that requires measurement at net market values.

12. Give reasons for your answers to the following questions. (a) How important is it that standard setters agree on objectives, concepts and definitions before they develop a conceptual framework of accounting? (b) How important is it that the conceptual framework is generally accepted by the business community before it is applied to develop accounting standards?

Although it is important that prior agreement be reached on concepts and definitions in the conceptual framework programs so that there is no confusion in understanding the subject matter, one must remember that substantive knowledge comes from investigation of the subject matter, not from prior agreement on definitions. We should take care that statements we make should never depend on the meaning of our terms. Unfortunately, this is not the approach of the conceptual framework projects. For example, when the standard setters define ‘assets’, ‘liabilities’ and so on, they intend that the valuation decisions should depend on the definitions. Similarly, prior agreement on the objective of financial reporting may be biased towards a particular valuation system. (c) Why do the FASB and IASB require a common conceptual framework.

See discussion in the chapter. The FASB and IASB have embarked on a convergence project, to remove differences between their respective standards and to align their work agendas. The standards produced by both bodies should reflect the underlying principles contained in their conceptual frameworks. For example, the financial statements elements (assets, liabilities, equity, income and expenses) are defined in conceptual framework and these definitions are used in standards. If the IASB and FASB have differences in their frameworks, they could flow through to differences in their standards. Thus, agreement about fundamental matters such as definitions and recognition criteria can help the boards to produce harmonised standards.

13. Explain the advantages and disadvantages of principle-based and rule-based standards.

The focus of principle based standards is on an underlying principle or principles. They require that the principle be interpreted by financial statement preparers and auditors. They do not set out what preparers are to do in a step by step manner. Rather, they provide guidance to be interpreted and applied in an appropriate manner. They are more flexible, as they allow companies to apply the principles in a way that is appropriate for their situation and business, in order to convey useful information for decision making.

Rule-based standards include detailed directions about actions required by preparers. They are more specific than principle-based standards, and may include ‘bright line’ thresholds such as “greater than 50%”. Rule based standards tend to be longer and more complicated, with more amendments, as standard setters try to cover all situations in which the rules apply.

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Specific rules are easier to follow and enforce so are favoured by some preparers, auditors and regulators. However, one problem with rule based standards is that rules can be “worked around” to give a result which is technically in compliance with the rules but does not meet the overarching objective of the standard (the substance over form debate). It is possible to comply with the substance of a rule based standard while not complying with its form. For example, leases which are in substance finance leases are structured to meet the tests for operating leases so that they can be shown as operating rather than financial leases in the financial statements.

14. Why has the FASB been directed to produce more principle based standards? Do you consider this to be a realistic standard setting objective?

Some corporate collapses in the United States have involved the abuse of accounting standards. For example, the collapse of Enron in 2001 showed how the company’s managers and auditors created special purpose entities which would not have to be consolidated under existing accounting standards. The managers and auditors were working around the rules contained in US GAAP. Their actions breached the underlying principle consolidation, that is, that entities under control of a parent entity be included in the consolidated financial statements.

The abuse of accounting standards in this way, that is, specifically working around the rules, brought attention to the rule-based nature of US GAAP. As a way of improving financial reporting and preventing events like Enron in the future, it was recommended that US GAAP be more principles-based. The idea is that principles are more difficult to work around than rules and will therefore be less open to exploitation. The SEC has recommended and the FASB has accepted that it should pursue a more principles-based approach (described as objectives based) because of the extent of financial havoc following Enron.

In theory, the objective of producing principles based standards is a reasonable one. It is the approach taken by the IASB. Because of the advantages of principles-based standards, it is a reasonable objective. In practice however, producing principles-based standards is complicated by two issues. First, if principles are unacceptable e.g. measure all financial instruments at market value, then the principle may get reduced by the application of specific rules e.g. measure available-for-sale securities at market value. Second, preparers seek guidance in the form of rules to assist them to comply with standards. In cases where these issues are affecting the standard setting process, it may be impossible for the standard setter to produce standards without rules. However, the changed focus in US standard setting should result in more use of principles and less use of rules in standards.

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15. Discuss whether the IASB Framework is merely a policy document based on professional values and self-interest, without scientific foundation. In your discussion, state your opinion on whether the conceptual framework should serve as a policy document in this manner.

This question covers the last part of the chapter under the heading ‘Professional values and self-preservation’. Students can expand on the following major points: • Accountants have a special status in the society. In Australia this is witnessed by the Royal Charter endowed on the Institute of Chartered Accountants, the profile associated with the CPA program of CPA Australia and the professional monopoly by the major accounting bodies.

• The ability of the accounting profession to retain legitimacy as a profession will be judged by society, in terms of the apparent coherence and theoretical defensibility of the profession’s body of knowledge; hence the need for a conceptual framework (Hines, 1989).

• The conceptual framework plays a vital political role in maintaining self-regulation and in lobbying against increased regulation by government bodies.

• A conceptual framework program alleviates the criticism of the diversity of accounting standards — a major threat to the profession’s loss of control of the standard-setting process.

• The conceptual framework project is not about setting rules for accounting practice; rather, it is about legitimising the process of accounting practice.

16. Assume that you have been contracted by the Australian Accounting Standards Board to develop a proposal regarding whether to issue an accounting standard on accounting for the costs of environmental damage. Draft a proposal of 1500 words or less outlining why you think it is appropriate, or inappropriate, to develop an accounting standard on this issue. Also outline the key issues that would need to be covered by the standard and how the conceptual framework can contribute to resolution of those issues.

The purpose of this question is that the students should be able to apply what they have learnt from the conceptual framework project and other readings to the general issue of standard setting. The best way to approach the question is to address the following key points: • alternative approaches to standard setting • the scope of the proposed standard • reference to academic accounting research • potential benefits or drawbacks of the standard.

Students could begin with a classification of various approaches to an accounting theory: • empirical inductive approach • the deductive approach (true income, user needs, information economics) • new empiricism.

They could then discuss the implications of these approaches for the standard setting bodies — for example, problems (or impossibility) of measuring true income; economic consequences of accounting standards; and the political nature of the standard setting process.

This should then lead into a discussion of the topic itself:

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Chapter 4: A conceptual framework

•

•

•

What is meant by the ‘costs of pollution’? What type of pollution are we talking about: air, water, noise? Does costs mean costs actually incurred by the company to avoid polluting the environment, or is it a valuation of the pollution costs to the company/society through the company’s operations? How can one measure these costs?

The subject matter is important as it has clear implications for the scope of the proposed standard. Is it to be a valuation standard (requiring auditors to check the company’s valuation of pollution costs) or is it a disclosure standard (requiring the company to disclose fines or reports by inspectors, etc.)? Students should include some comments on the past success of the standard-setting bodies on inflation accounting, research and development expenditure and other relevant issues.

This will eventually follow into a discussion about the political nature of the accounting standard-setting process. Does the standard-setting body have enough power to set such a standard? Will the powerful lobby groups frustrate any change? What is the benefit of loosely worded, vague and subjective standards? Would the standard achieve anything or is it just an exercise to show that something is being done so that the accounting profession’s self-regulation is not threatened?

17. Write a report of 1500 words or less to the chairpersons of the Financial Reporting Council and the Australian Accounting Standards Board, commenting on the following argument: Attempts to bring about radical change through the introduction of a conceptual framework have failed. When it appeared as though SAC 4 would require firms to report a greater number of liabilities, lobbying began in earnest and business ensured that any innovation was quashed. As such, the best that can be hoped for from a conceptual framework is that it legitimises current practice, maintains existing social and economic status, and staves off public sector attempts to control accounting standard setting.

This question covers the whole chapter. In addition to the answer to question 7, students should summarise the scientific criticisms levelled at the conceptual framework projects, and should also cover the material under the heading ‘The conceptual framework as a policy document’. In their answer, students should discuss the following points: • The purpose of the conceptual framework was that prior agreement on fundamental terms would minimise inconsistencies. SFAC No. 5 states that concepts are to be developed as the standard-setting process evolves. The question is: How can a conceptual framework guide choices from among alternative principles and rules if the elements of the framework are defined in those very same terms? (Dopuch and Sunder) • Definitions are general and vague.

• Recognition criteria are couched in terms of (subjective) probabilities.

• The measurement problem is open-ended.

• Contrary to Popper, the FASB sought for the definitions to bear as much weight as possible (Gerboth). This is true, also, of SAC 4’s role in Australia.

• Ontological assumption. The conceptual framework adopts an economic realism– measurement approach. According to Hines, ‘we communicate constructed reality’.

Hence, can we provide information that is neutral, independent and free from bias?

• Demski’s impossibility theorem • Epistemological assumption: – scientific truth has no absolute truth (Feyerabend).

– accounting researchers believe in a (confused) notion of empirical testability (Chua).

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• • •

Circularity of reasoning — for example, reliable information depends upon recognition and recognition depends upon reliability.

Conceptual framework ignores findings from capital market research.

Conceptual framework is a policy document. According to Tinker, it is merely an attempt to legitimise an ideological position at the theoretical level. Conceptual frameworks appear to reinforce existing principles.

18. What is business risk auditing? How does it differ from traditional substantive auditing? Why do critics believe it is used to justify selling more consulting services to audit clients? How could business risk auditing be blamed for failures such as Enron?

Business risk auditing is a form of auditing that considers client risk as part of the audit evidence process. Traditional substantive testing could be seen (simply) as based in transaction and balance testing. That is, the auditor gathers evidence that transactions have been correctly authorised, processed, and entered into the accounting records. Balances are tested by gathering evidence, for example, on the physical (or legal) existence of the assets and their correct measurement and depreciation allocations. In risk-based auditing auditors focus on high risk areas, and gather evidence on the risk reducing properties of control systems. They need to develop advanced understanding of business environments and strategies. The differences between the two approaches include the focus on the client as essentially a contained system in substantive auditing and an explicit consideration of the external factors in business risk auditing.

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Solutions Manual to accompany

Accounting Theory 7e Prepared by

Allan Hodgson Chapter 5 Measurement theory

© John Wiley & Sons Australia, Ltd 2010

Chapter 5: Measurement theory

Chapter 5: Measurement theory THEORY IN ACTION Theory in Action 5.1 Fair value measurement

1.

What do you think the authors mean by a principles- versus a rules-based system of accounting?

Examples are also given for valuation that depends on the attributes of a principle-based accounting system which is based upon some conceptual framework that defines accounting rules in terms of the entity, purpose of accounting system and some notion of wealth and derived income. An example is an accounting system that is based upon the conceptual notion of economic decision making using market prices and the maintenance of real purchasing power (instructors should briefly explain the principles of capital maintenance and market value accounting). A rules-based system is often delivered by fiat that pays little attention to a conceptual framework (the Napoleonic accounting system used in Europe). The fact that there are many accounting rules in historic cost is often used by critics who argue there is no underlying (and unifying) conceptual framework in this system.

2.

What is the measurement problem they allude to?

The instructor should use this question to introduce the concept of conceptual frameworks.

IAS proposes to use a ‘fair value’ concept seemingly based upon commercial principles and market prices. The fundamental measurement problem alluded to is that commercial influences such as inflation, changing market prices and the attributes of the asset being measured have a number of different interpretations and ways of being implemented into an accounting system (see below). Which way should they be implemented? No guidance is provided — for example, for assets measurement, reliability and accuracy may depend on a number of factors: • the level of inflation • different market prices • the level of subjectivity in estimating value • the degree of conservatism used • general economic conditions.

The attribute of the asset would also play a strong role in determining the valuation method.

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Solution Manual to accompany Accounting Theory 7e

3.

What does Macve mean by the underlying conceptual framework? What problems does he see with a ‘fair value’ approach?

A conceptual framework will provide the logical and empirical basis to apply the accounting principles. A ‘fair value’ approach, whilst having a commercial focus that relates to markets, is too general. Macve states that ‘fair value’ is left ambiguous with no conceptual framework that guides the valuation and measurement rules. Presumably in a political environment a more micro and definitive framework would not be agreed upon for international standards. The instructor may raise the question ‘Where does this leave us?’. The IAS has left it up to firms to decide on an individual basis.

The overall point is to ask students to consider measurement issues, to accept that the world is not black and white, and that in accounting we potentially have practical measurement rules that are appropriate for different circumstances. That is, there are answers, but they are complex. A number of times students will argue for one general solution or claim that ‘it is all too theoretical’ rather than practical. The question then is: Should we make one general framework through legislation and accounting bodies, or be aware of these shortcomings and adapt to different circumstances as they arise? The later suggests only general guidelines that are subject to interpretation.

4.

Do you think that there is any difference between measures and value?

These concepts are sometimes used interchangeably. Measures generally relate to something that is tangible and capable of scientific measurement. Values are more subjective. For example, an asset may have no measurable market price but have value in use to the business (specialised assets).

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Chapter 5: Measurement theory

Theory in Action 5.2 Capital or income?

1.

Why is the measurement distinction between capital and income important?

In theory (and practice) income is the incremental increase in beginning period capital.

Therefore income cannot be measured unless the beginning period capital amount is known.

2.

What do you think is real financial capital maintenance and what is physical capital maintenance?

Financial capital maintenance is having the same amount of financial resources (or net assets valued in money terms) at the end of the period as at the beginning of the period.

Real financial capital maintenance means maintaining the same purchasing power (so an adjustment for inflation is needed). Physical capital is the ability to produce the same level of goods and services at the end of the period.

3.

Is the increase in the value of a house you live in income or capital?

If you wish to continue to live in the same level of housing then any increase in value is capital. If you sell then you have to purchase a similar house that provides accommodation services at a similar price. However, some students will argue that you will eventually sell so it is some form of future income or increase in value.

4.

Does your answer to question 3 change if your house is an investment property?

Then you may legitimately use a financial (or real financial) concept of capital.

Students should now realise some of the complexity of the arguments about measuring income and capital.

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QUESTIONS 1.

Technically, what do we mean when we say ‘X was measured’?

First of all, we know that properties or characteristics of things are measured. That is, we do not measure people, but we might measure their weight or height. When we say, ‘X was measured’, we mean that a number (numeral) has been assigned to X according to certain rules governing the property, of which X is one. Therefore, X must be a characteristic of something. The number system used reveals the relationships involved, of which X is one. For example, if X is the income of Y Company, we mean that a number such as $115 000 has been assigned according to the accounting rules for determining income. The number system employed, having to do with dollars in this case, reveals the relative relationship of the $115 000 figure to other income figures.

2.

How is a scale related to the process of measurement?

To measure is to establish a scale — that is, every measurement is made on a scale and the set of operations used to assign the numbers creates a scale. The type of scale depends on the rule(s) that have been formulated to relate the numbers and the property of the things being measured. A scale shows how much information the numbers represent; it gives meaning to the numbers. For example, to measure the income of Y Company we follow the accounting rule on how this is to be done. By following these accounting rules, a scale is created in dollars, which relates the number (say $115 000) to the property being measured (income). The scale used in accounting is historical dollars.

3.

Describe the following scales: nominal, ordinal, interval, ratio. Give an example of each. Which scales are applied in accounting and where?

• Nominal scale. Numbers are used as labels or names. The number does not indicate a

quality or characteristic of the thing measured. The numbering of football players is a simple example. The use of this scale does not constitute an act of measurement.

• Ordinal scale. The number assigned to each object of a set indicates its rank order

with respect to a given property. An example is the assignment of numbers to investment alternatives according to their profitability (rate of return); or the assignment of numbers to candidates for a certain job according to the measurer’s preference. The weakness of this scale is that the intervals between the numbers are not necessarily equal, and the number does not indicate the ‘quantity’ of the property.

• Interval scale. For an interval scale, the numbers show the rank order of the objects

with respect to a given property, but unlike the ordinal scale the distance between the numbers is equal and is known. A ‘zero’ point is selected arbitrarily. An example is the Fahrenheit scale of temperature, where the freezing point (the ‘zero’ point) is arbitrarily set at 32 degrees. The weakness of the interval scale is that the zero point is arbitrarily established. In accounting, standard costs are based on an interval scale, since the ‘capacity’ is arbitrarily selected.

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Chapter 5: Measurement theory

• Ratio scale. The ratio scale conveys the most information. A ratio scale is one where: – the rank order of the objects with respect to a given property is known – the intervals between the objects are equal and are known – a unique origin or a natural zero point exists.

An example is the measurement of length. Zero is naturally no length. Another is the use of dollars to represent cost or value — zero is naturally no cost or value.

Ratio scales are applied to accounting. All measures used in the financial statements have a natural origin ($0.00). Intervals between measurement units are identical amounts of currency, and are known. And the rank order of the objects or events measured with respect to their values is known. However, to the extent that different measurement methods are applied — historical cost, net realisable value and present value, for instance — the scale is the same. But while the scale is ratio, the relative measures are not always meaningful because the attributes being measured are not the same.

4.

Determine whether the following statements are correct and state why: (a)

The historical cost of inventory is $60 000 at year-end. When it is converted to constant end-of-year dollars by multiplying by 110/100 to get $66 000, the $66 000 is still the historical cost of the inventory.

(b)

Last month the quantity variance was determined to be $12 000 favourable, and this month it is $24 000 favourable: therefore, the efficient use of materials has been doubled.

(c)

On the basis of saving income tax, Company X ascertained that the double-declining-balance depreciation method is better than the straight-line method. By using the double-declining-balance method for depreciation rather than the straight-line method, Company X saved $10 000 in income tax this year; therefore, the former method is 10 000 times better than the latter.

(d)

On the basis of the amount of assets, we can say that Company X is twice as large as Company Y, because its total assets amount to $1 000 000 compared with $500 000 for Y.

(a)

Correct. A ratio scale is used, and thus it remains invariant over all transformations when multiplied by a constant, which in this case is 110/100. The invariance of the scale makes the rule (historical cost) the same even though the scale is expressed in different units, such as from nominal dollars to constant endof-current year dollars. However, the value of inventory may or may not have appreciated at the same level as general inflation. Therefore this scaling is not an appropriate measurement tool for assets but is a base that can be used as a benchmark for the maintenance of purchasing power.

(b)

Incorrect. Variances are based on an interval scale, because the ‘zero point’ is arbitrarily selected — that is, it is not natural. The efficiency basis (capacity)

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Solution Manual to accompany Accounting Theory 7e

could be theoretical, average, practical or normal. One of these is selected by the company according to its preference. For the interval scale, we cannot multiply or divide with respect to the particular numbers. For example, if the temperature in a given room is 40 degrees Fahrenheit and in another room it is 80 degrees Fahrenheit, we cannot say the second room is twice as hot as the first. It is not mathematically permissible and empirically misleading. In this particular case, the point of ‘no efficiency’ is a matter of conjecture; it is not measurable by variance analysis. (c)

Incorrect. An interval scale is being used to determine which method is ‘better’ for saving income taxes. For the reasons given in (b) above, Company X cannot say the double-declining-balance method is 10 000 times better than the straightline method.

(d)

Correct, in theory. A ratio scale is used where zero means no value. For a ratio scale, it is correct to multiply and divide the numbers (that is, to speak in ratio terms). However, we know that, technically, because of inflation (or deflation) the dollars of the historical costs are not the same comparatively over the years, and therefore this causes a problem. We can correct this problem by adjusting for the change in the specific value of the assets. The statement would be correct without qualification if the two companies purchased their assets on the same day and those assets were exactly the same (with the same usage).

5.

Describe the following types of measurement: fundamental, derived, fiat. In what sense are fiat measurements ‘weak’? What type of measurement is inventory costing?

Fundamental measurement is one where the numbers can be assigned to properties based on natural laws (confirmed empirical theories), and which does not depend on the measurement of any other variable. Examples are length, electrical resistance, number and volume.

According to Campbell, derived measurement is one that depends on the measurement of two or more quantities. However, perhaps it is better to say that it depends on at least one other quantity. In any event, the measurement is still based on natural law. An example is density, which is based on the measurements of mass and volume. An example in accounting is income, which uses asset values as a basis to estimate cost (depreciation, bad debts, etc.).

A fiat measurement is one that depends on an arbitrary or stipulated definition rather than on a confirmed theory. The weakness is that because there is no confirmed theory underlying the measurement, there can be numerous ways to construct a scale for the measurement of the given property. For example, there are different ways to measure income. Which is the proper or best way? This type of measurement is prevalent in accounting. This basis was formulated by social scientists in order to justify the measurements in the social sciences; otherwise, there can be no measurement. There are some who do not believe in fiat measurement, and therefore question the use of the term ‘measurement’ in accounting and the social sciences. If accounting theory can be empirically validated, then instead of fiat measurements, we can have fundamental measurements.

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Chapter 5: Measurement theory

Inventory is a derived measure from fiat.

6.

What are the sources of error in measurement?

All measurements involve errors. The sources of error are: • Measurement operation (rule to assign numbers) stated imprecisely.

• Measurer. The measurer may misinterpret the rule, or be biased, or apply or read the instrument incorrectly.

• Instrument. The instrument may be flawed. The instrument could be physical (for example, a thermometer) or something abstract (such as a chart, graph or index or accountant’s judgement).

• Environment. The setting in which the measurement operation is performed can have an effect on the result, such as weather conditions, noise, pressure exerted by other people, or imperfect or numerous markets.

• Attribute unclear. What is to be measured may be unclear. For example, is the value of an asset the present value, acquisition cost, current cost or selling price?

7.

Explain whether the following statements are facts: (a)

Canberra is 320 kilometres from Sydney.

(b)

Depreciation expense for Kambah Pty Ltd for 2001 was $1 294 000.

(This is the amount reported on the statement of financial performance.)

(c)

Smoking leads to lung cancer.

(d)

Sales revenue for Telex Ltd for 2002 was $2 800 000. (This is the amount reported on the statement of financial performance.)

(e)

Equipment (net of accumulated depreciation of $400 000) for McNair Ltd for 2000 was worth $1 800 000. (This is the amount reported on the statement of financial position.)

(a) Since all measurements involve error, the question is: How much error are we willing to accept? This depends on the purpose of the measurement. The statement, for general purposes, can be considered factual. Canberra is, roughly speaking, 320 kilometres from Sydney. (b) Unlike the first statement, which had to do with length (a fundamental type measurement), this statement pertains to economic cost or value. This involves a fiat type measurement. Accuracy of a measurement relates to how close a number is to the ‘bull’s eye’ (the true standard). In a fiat type measurement, we do not have supporting evidence on the true standard, and so we cannot really say that $1 294 000 represents the true amount of depreciation, or how close it is to the true amount. The figure is simply that which is derived by use of generally accepted accounting methods. The statement is a factual statement in the sense that the amount was actually reported by Kambah Pty Ltd. But whether the amount is the ‘true’ amount, no-one knows. There is no objective, empirical evidence supporting

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Solution Manual to accompany Accounting Theory 7e

the accounting measurement of depreciation. This question reveals one weakness of applying fiat measurements. (c) There is empirical evidence to support the statement, but whether the evidence is persuasive is a matter of judgement. For some, the evidence is very persuasive; for others, it is not. The statement reveals the probability character of general statements. First, nothing is mentioned about the amount of smoking. The implication is that the greater amount of smoking (say, five packs of cigarettes a day as opposed to one pack), the truer the statement. Second, actual evidence will show that there are specific individuals who smoke, say, 10 packs of cigarettes a day and have done so for 50 years and have not yet contracted lung cancer. Yet, this does not necessarily negate the statement. The statement is a statistical one, appropriate to a large number of people. In reference to a particular person, this entails ‘subjective probabilities’. The theory of subjective probabilities is not presently supported mathematically. Considering the statistical nature of the statement, it can be regarded as factual if we believe the evidence is sufficiently persuasive. (d) Although the amount is derived by accounting methods, unlike the statement on depreciation in (b) above, this statement is based on observable data that can be verified. Assuming that this verification has been made by the auditors, this statement is factual. (e) Because the amount of $1 800 000 is mixed with accumulated depreciation, it cannot be accepted as a factual statement of market value except in the sense that it is the amount reported by McNair. The term ‘worth’ is used, which implies that the equipment can be sold for $1 800 000. It is doubtful that the book value is the same as the market value of the equipment. It is not a statement of fact with regards to value unless this is the case. The verifiable facts are that the equipment was purchased at a cost of $1 800 000 and that after amortising depreciation its book value is $400 000.

8.

What is the difference between accuracy and reliability in measurement?

How are these notions related to the testing of a theory?

Reliability refers to the proven consistency of a measurement or the operations from which the measurement is derived. We can speak of a measurement (the number) being reliable, or of the set of operations (instrument) being reliable. In statistics, reliability refers to the agreement of the results — consistency — among repeated application of the operation to a large number of cases. In statistics, the variable must be random; therefore, reliability relates to the random error in measurement, the unsystematic error component. If the random error is minimal, then the measurement is reliable.

Reliability does not necessarily lead to accuracy. The reason is that accuracy has to do with how close the measurement is to the ‘true value’ of the attribute measured. In statistics, the true value is presented by the mean. In accounting, ‘true value’ pertains to the pragmatic notion of usefulness, which is expressed in the objective of accounting.

Because the term ‘accuracy’ is so often misunderstood, the term ‘validity’ has been suggested to denote the same idea.

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Chapter 5: Measurement theory

We can speak of a valid measurement in the sense that it is appropriate for the stated purpose — that is, the measurement hits the ‘bull’s eye’ or is sufficiently close to it.

Another way of putting it is to say the measurement is relevant. Accuracy or validity relates to the relevance of accounting information.

The testing of a theory involves the determination that the numbers involved in the theory are reliable and accurate (valid). In accounting, we say that the data must be reliable and relevant — that is, useful.

9.

Discuss whether accounting measurement is fiat or fundamental. Can accounting numbers ever be related to fundamental values? If so, what are they?

This question underlies a good deal of the debate in accounting theory and will provoke a number of different answers from students. The tutor should lead discussion according to the response of students. Some discussion points are: • Accounting measurement, to a great degree, is determined by fiat, and is

generally imposed on society by accountants or government committees dominated by accountants.

• However, accounting outputs must have some fundamental value because there

is a correlation between outside referents such as stock prices, current prices, expected future cash flows and risk.

• Accounting theorists cannot agree on fundamental value because it changes

according to the nature of the asset, the use of the asset and the use to which the demanded value is put. Is it historical cost, buying price, selling price, discounted value or a variant of these?

• Some empirical researchers have examined these values to try and determine

which ones are more reliable or have the highest correlation with market or stock prices.

10.

Discuss how recent accounting standards using ‘fair value’ accounting such as IAS 39 and IAS 41 have moved away from fundamental measurement.

If we define fundamental measurement as a stewardship concept then this commercial focus has moved accounting towards a market price approach and away from historic cost.

On the other hand the ‘fair value’ approach is ambiguous as to which concept of market value (price) should be used, or if different concepts are appropriate in different firms and circumstances, then what are they? See also Theory in action 1.

11.

Why will international financial reporting standards induce an increased demand for risk management techniques?

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Solution Manual to accompany Accounting Theory 7e

• • • •

12.

Required to report ‘fair values’ which are subject to interpretation.

Possibility of overvaluation.

Fluctuating balance sheet valuations and income derivations may require managers to hedge values in the market place.

The movement towards measurement and valuation principle places more risk on managers to perform and report appropriate return on assets, capital etc.

How will the move towards fair values affect the role of auditors and the audit function? Do you think it will affect the training of accounting students? How so?

It could be argued that a movement away from historical costs towards fair values will affect the role of auditors and the audit function by placing greater emphasis on auditing management estimates instead of transaction based historical costs. The training of accounting students would then be expected to reflect this change by placing greater emphasis on teaching students how to deal with uncertainty in accounting and auditing.

The guidelines for auditing fair values are contained in ASA 540 (ISA 540). ASA 540 (ISA 540) discusses the requirements for auditing accounting estimates, including fair value accounting estimates and related disclosures.

The standard requires the auditor to obtain sufficient appropriate evidence about whether the estimates are reasonable. The auditor should assess how management makes the relevant accounting estimates and should also understand the data on which the estimates are based. The auditor would consider the relevant controls and whether external experts have been used. The auditor should determine whether the management has appropriately applied the relevant accounting standards, and whether the estimates have been made consistently and appropriately. The procedures used by the auditor include testing the method and data, and the reasonableness of the underlying assumptions. The auditor should also develop an estimate to compare with management’s estimate.

ASA 540 recognises that greater uncertainty exists for some estimates, and management could be more biased under some conditions. In some cases, the estimation uncertainly is so high that a reasonable accounting estimate cannot be made. This could be dealt with by additional disclosure of the range of the estimate and the uncertainty associated with them.

However, it could also be argued that management estimates are already inherent in traditional accounting. For example, managers are required to estimate the provision for doubtful debts, and auditors are required to audit these estimates by considering the underlying assumptions and data used by the management, and auditing the consistency and reasonableness of their methods of making the estimate. Another example is the requirement to show inventories at the lower of cost and net realisable value. As discussed in the text, inventory valuation in a manufacturing environment is already reliant on many estimates and calculations which are to be audited.

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Chapter 5: Measurement theory

13.

What would be included in overhead costs assigned to inventory? How many ways can you think of assigning these costs when there are multiple products and departments? What are the audit implications?

AASB 102 (IAS2) deals with inventories. This standard requires overhead costs to be allocated to inventories, if the costs are related to bringing inventory to their present location and condition. Standard costs take into account normal levels of materials and supplies, labour, efficiency and capacity utilisation. They are regularly reviewed and, if necessary, revised in light of current conditions.

Overhead costs include depreciation and maintenance of factory buildings and equipment, cost of factory management and administration, indirect materials and indirect labour (see para 12 AASB 102).

AASB 102 requires overhead costs to be allocated between products that share a production process on a ‘rational and consistent basis’. This could include using the relative sales value of each product. Auditors will need to make a judgement about what is ‘rational’ in each circumstance. If a particular ‘driver’ of cost allocation is used, such as indirect labour, the auditor needs to audit these cost drivers. The auditor also must understand what is normal production capacity and causes of variations, and whether these are persistent or temporary.

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Solution Manual to accompany Accounting Theory 7e

Case Study 5.1 12 ways to value intangibles and brands

1.

Evaluate the advantages and disadvantages of each suggested measurement technique.

Tutors should note that all methods of valuing brands and intangibles are highly subjective, because by their very nature they must be estimates of future cash inflows.

Some observations on each method follow: •

Net present value. This technique is derived from finance and requires the valuer to estimate the proportion of future cash flows (or earnings) attributed to the brand and its impact on risk. You need to question how to sort out the relative cash flows and how to derive the discount rate.

•

CAPM. CAPM will provide the discount rate to apply to the NPV method, but requires stock prices to estimate. Most firms are not listed, and this requires the valuer to use a surrogate for unlisted firms (such as a similar firm that is listed).

•

Cost of creation. This, in its simplest form, just means adding up all the costs of creating a brand. But some costs are sunk, some are irrelevant and some should be expensed.

•

Market based comparisons. Comparisons with listed brand values used by other corporations are valid if the techniques used by them are also valid and the asset being compared is the same. This technique may be acceptable for tangible assets, like land or buildings; but intangibles are not strictly comparable and values are subjective.

•

Royalty relief method. This method is valid if the brand can be leased or licensed because the payments are incremental cash flows. However, the market for these is limited and cash flow payments are unique to individual brands or intangibles.

•

Relative value. This method is subjective and qualitative, and difficult to estimate quantitatively.

•

Balanced scorecard. This method adds additional (mostly) qualitative measures. It enables the valuer to obtain a greater sense of the brand’s worth, but does not provide value by itself.

•

Competency models. These suffer from the subjective problems of determining who are the most successful employees determining market value.

•

Benchmarking. This provides an assessment of your performance against market leaders, but does not provide a market value. It assumes that the scorecard can be linearly transposed.

•

Business worth. Again, this technique provides benchmarks and has the same problems.

•

Business process auditing. This method is subjective and lacks structure.

•

Knowledge bank. This involves valuation by fiat that simply reverses the rules of accounting.

2.

Make a recommendation as to which measurement technique should be used.

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Chapter 5: Measurement theory

The most structured technique is the use of a discounted net present value model that applies CAPM to estimate the discount risk rate (techniques 1 and 2). These techniques are grounded in finance theory and the theory of diversification. It is suggested that the economic value-added model is the most appropriate model to apply to intangibles (see chapter 9 and the Ohlson model).

3.

Would you consider using more than one measurement technique? Why or why not?

Yes. Given the subject nature of the estimations, the more information gleaned the better the feel for the ultimate value. The use of qualitative factors — such as perceived customer loyalty, retention rates of staff, demand for staff, intellectual property, internal business processes and relative value — provide support for your ultimate calculations.

© John Wiley and Sons Australia, Ltd 2010

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Solution Manual to accompany Accounting Theory 7e

Case Study 5.2 Risk management survey 2005: Take a risk. No chance.

1.

Why would firms be concerned with increasing or reducing hedging activities under different accounting systems?

IAS focus on fair value requires many assets and liabilities previously not reported to be now be valued and reported on the balance sheet. If markets are volatile then assets and liabilities need to be hedged. If the valuations now have considerable impact on the income statement then managers may also wish to hedge against falling income and managers' own wealth if it is tied to reported income.

2.

What impact will international reporting standards have on the income statement?

Higher assets values mean higher depreciation or amortisation. Changes in asset and liability values may be recorded as impairments and reduce income.

3.

Why is the measurement and reporting of pension liabilities and assets a concern for risk management?

Essentially, the decision to hedge or not to hedge has costs. The cost of the hedging instrument (futures, options, leaseback etc.) itself and the possibility that firms will lock themselves into current economic conditions.

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Chapter 5: Measurement theory

Case Study 5.3 The trend toward fair value accounting 1.

What do you think is the fundamental problem with financial statements based upon the historic cost measurement principle used under US GAAP?

Accounting measures transactions at historical cost. Hence, the fundamental measurement problem is the divergence of written-down historical cost values from outside influences such as inflation, changing market prices and the attributes of the asset being measured. Historical cost accounting is a derived measurement system from allocating costs – assets are simply left over or balancing amounts and do not represent ‘financial value’.

2.

What do you think of the principle ‘…accounts must reflect economic reality’ as a core principle of measurement in accounting?

This is really the argument about relevance. Historical costs are outdated and hence not relevant as a measure of economic reality and therefore we need to take account of markets or estimates that measure economic reality and are relevant for financial decision making. Tutors should lead this discussion in order to challenge perceptions that there is only one measurement system.

3.

How would you measure economic reality?

This question boils down to: What is economic reality? It is a slippery concept that will vary. For example: • Valuation depends on the attributes of the asset being measured — monetary assets (cash), assets traded in established markets (market price) and intangibles (value derived from continued operations and future cash flows).

• Further, economic reality changes according to who demands the information.

Economic reality for investors is future cash flows or earnings; for traders it is current market selling price; for manufacturers it is current buying price;, for auditors it is historical transactions.

4.

What is reliability in accounting?

Historical costs can be reliable if you check simple mathematical calculations (ie. verifiability). But the article mentions other interpretations – precision, and verifiability against market prices or estimates. Tutors should lead discussion but essentially reliability is interpreted by historical cost accountants as verifiability and by market based accountants as reliability for making economic decisions (depending on ones ontology or view of the world).

© John Wiley and Sons Australia, Ltd 2010

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Solution Manual to accompany Accounting Theory 7e

Case Study 5.4

IFRS put damper on share options schemes

Instructors should use this case study to illustrate how changes in accounting standards and the measurement of income can have impacts on the behaviour of managers and employees.

1.

How do share option schemes affect the measure of income under international financial reporting standards?

Basically income will be reduced which may have an influence on the perception of managers' performance and firm performance by outsiders. Under IFRS companies are required to deduct the cost of issuing options from earnings for the first time. An example given from LogicaCMG estimates that it will reduce profits by about 13%.

2.

Why has this led to the reduction in stock-based packages for staff?

Stock options, as part of a remuneration package, has fallen because the stock market was previously flat and the requirement that the cost of options be expensed in the current period. On the other hand it is reported that share plans, whilst also required to be expensed under IFRS, are a viable alternative to the granting of options in salary packages. Stock options require the share price to reach a required level (strike price) before the share is granted, whilst the granting of shares occurs at the current price.

From the point of view of employees options are a much longer term payoff (more likely to occur in bull markets) and shares provide an immediate payoff.

3.

How is the form of structuring and reporting financial statements important to: (a) Management (b) Shareholders

If there is a link between short-term reported income and stock returns then the wealth of individuals (managers, shareholders) may be reduced or management practices placed under tighter control. Options are a longer term bonding arrangement, if options are no longer used because of accounting requirements then the focus of the firm may be directed towards shorter term (and more risky) goals.

© John Wiley and Sons Australia, Ltd 2010

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Solutions Manual

Accounting Theory 7e Prepared by

Allan Hodgson, Victoria Wise

Chapter 6 Accounting measurement systems

© John Wiley & Sons Australia, Ltd

Chapter 6: Accounting measurement systems

Chapter 6: Accounting measurement systems THEORY IN ACTION Theory in action 6.1 The effect of asset provisioning on earnings 1.

How does a provision for underperforming loans affect the earnings of a firm? Should a reduction in equity be recognised?

A provision for underperforming loans affects the earnings of a firm by increasing its expenses leading to reduced profits. A charge (expense) and a matching reduction against the relevant asset would be recognised. Note, that it has no effect on the cash position of the firm. The provision is a write-down and it would impact equity by reducing the retained profits component. Students should be asked to consider whether or not the asset can be identified (or merely the asset category), and to discuss the notion that under historic cost accounting changes in asset values are basically ignored until the asset is sold or disposed of by sale or write-down/off. However, students should also be aware of the conservatism principle of lower of cost or market value and the impairment rules under IFRS. They should also be aware of last year’s IFRS ruling that some bank liabilities can now be amortised rather than impaired. A good assignment would be to ask them to research this issue.

2.

What are the implications of a change in accounting policy affecting provisions for (1) shareholders, and (2) analysts such as credit rating agencies?

A change in accounting policy does not change the underlying value of the business or impact on operating assets. However, if the change impacts on the permanence of cash flows it may affect future dividends and may result in a shift in the share value of the firm. Students might have a look at share price movement around the earnings release and change in policy (note however this is a complex issue). The potential impact of a change in accounting policy on cash flows will be considered by analysts as it may have the potential to affect the size and scheduling of dividends, and the risk of a business.

3.

Should the $20 million provision or a larger provision be used in analysing the performance of the company? If so, how would you determine the size of the adjusted provision?

This question raises the issue of — what does the provision figure actually mean? This would be a good question to ask the students. It is made up of estimations and calculations. For example, how many of the investors will not pay back their loans, how many will partially repay the loans, and what percentage of the loans are they likely to repay? The estimate of 3 percent of bad debts from the total loan exposure of $556 million appears to have been based on an individual analysis of the ability of each investor to repay their loans. In analysing the performance of the company, any adjustment to the size of the provision would need to be based on an assessment of the adequacy of this approach in estimating the total loan exposure. Discussion should touch on how an accountant makes a bad debt provision from a schedule.

© John Wiley and Sons Australia, Ltd 2010

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Solution Manual to accompany Accounting Theory 7e

Theory in Action 6.2 Outsourcing and costs

1.

Identify the potential problems associated with allocating costs that ‘attach’ to services provided by firms such as Infosys Technologies.

The allocation of costs to a service provided by a firm can be problematic. While direct costs can normally be easily traced to a particular service, indirect costs such as depreciation and overheads may not be so easily determined for a particular service. The allocation of these costs may require the use of an arbitrary allocation method or the determination of cost drivers in order to allocate the costs over multiple services.

2.

What criteria would management use when deciding to expense or capitalise expenditures associated with its services?

Under the historical cost approach, management would need to determine which costs have ‘expired’ as these will need to be matched (expensed) against income. Any unexpired costs will be capitalised and carried forward as unmatched assets on the balance sheet. Ready to be matched against future revenue as it flows in.

3.

Why is the decision to expense or capitalise expenditures so important to the costs attach principle which underlies the historical cost system?

The historical system of accounting relies on the “correct” matching of expenses against revenues in determining profit. Expenditures under the historical system are broken into expense and asset components, with the asset component transferred progressively from the statement of financial position to the income statement as the future economic benefit of revenue is received. The reliability of this system relies on costs being measured and attached correctly and the correct allocation of these costs to expenses or assets. However, the decision to capitalise or expense is not always straight-forward and often judgement may need to be made on whether the expenditures have expired and what the probability is of that asset generating future revenue.

© John Wiley and Sons Australia, Ltd 2010

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Chapter 6: Accounting measurement systems

Theory in action 6.3 Review of deteriorating assets leads to write-downs

1.

What criteria would management use to decide when to write down impaired assets on the statement of financial position? Discuss the reasons underlying the write-down of Fox Interactive Media.

When assets have a value that is significantly lower than what is reported in the accounts they are considered to be ‘impaired’ and management must write-down these assets to their ‘true’ value. Normally this would require some level of independent valuation and an outline of the basis for the write-down decision. However, in reality, management has considerable discretion to determine which assets are written-down and when. If it appears that a significant write-off is required, management will ‘clear the cupboard’ and write-down any asset it feels has the potential for future losses in value, as it is better to lump the ‘bad news’ into one accounting period.

The reason for the write-down of Fox Interactive Media is due to impairment in value caused by restructuring changes and the rapid rise of a rival website ‘Facebook’. The restructuring changes may be the result of the plan to charge for news website usage.

The write-down may also be reflecting the significant advertising slump on the value of News Corp assets such as newspapers, movies, books and satellite TV.

2.

Comment on the timing of the decision by News Corp management to write down the MySpace networking site, given the ‘rapid rise of rival Facebook’.

The timing of such decisions predominantly rest with management. Management are often reluctant to write-down assets and tend to save up write-downs for one-off hits rather than consistent reductions in profits. However, it is likely that the loss of market share to rival Facebook will be accompanied by a significant drop in advertising revenue which will impair the value of News Corp’s Facebook asset.

3.

What effect would amortisation of News Corp’s media assets have on reported earnings under the historical cost system?

Amortisation is regarded as an expiration of the value of an asset and so it increases expenses and decreases reported earnings. Under the historical cost system management have choices as to the basis of measurement, the timing and the level or amount to be adjusted when determining amortisation.

© John Wiley and Sons Australia, Ltd 2010

6.4

Solution Manual to accompany Accounting Theory 7e

Theory in Action 6.4 Optimum resource allocation and required rate of return 1.

How will CCA based on physical capital maintenance help managers to make better resource allocation decisions?

Rates of return based on the firm’s ability to replace assets and continue operations. If this rate of return is less than the cost of capital (required rate of return) then managers should invest in other assets or certainly sell up the asset if sales price is close to purchase price (ii) Determination of asset maintenance policies (iii) Replacement of assets (iv) Pricing and output determination (v) Dividend policy (vi) Retain or sell assets (but need both buying and selling prices) (i)

2.

How will the use of CCA help investors make decisions about whether to buy or sell shares in a particular company?

Investors should calculate rates of return based on the company’s ability to replace assets and continue operations. If this rate of return is less than the cost of capital (required rate of return) then investors should invest in other firms. Investors can also rate investments based on the rate of return of the current buying cost of inputs.

Investments should be made in descending order based upon the calculated return or expected return on CCA. Using CCA means that financial statements between firms are now theoretically comparable.

3.

Will income and dividend decisions change under CCA? Explain.

Income effects will be a function of the industry. Industries that have raw materials and physical assets that are increasing in price will have lower income under CCA because of higher depreciation and amortisation charges (eg. manufacturing). Industries based upon lower technology input costs will have higher incomes (e.g. computer and technology industries). Dividend policies may not dramatically change because managers do not like to adjust dividend policies. However, at the lower end managers should be aware that dividend payments greater than CCA income will mean that managers, in order to maintain current operations, are required to raise funds from sources other than internal operations.

4.

Explain in your own words what is meant by the going concern assumption?

Barton explains the concept and measure of the going concern status of the firm are based on the ability of the firm to earn a normal rate of profit on owners’ investment, where all measures are based on the current market opportunity costs (buying prices) of resources. Instructors should use this question to fully explain the concept as it is outlined in corporate law – that is, the ability of the firm to pay its debts as and when they fall due.

© John Wiley and Sons Australia, Ltd 2010

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Chapter 6: Accounting measurement systems

QUESTIONS 1.

According to the historical cost system, what is the objective of accounting and the role of profit? What criticisms are made of profit calculated under the historical cost system?

Stewardship is emphasised as the objective of accounting in traditional historical theory — enunciated by Paton and Littleton. Accountability to equity holders is primary.

Owners and creditors are considered to be especially interested in what the firm (management) has done with the funds they have entrusted to it. Therefore, information should be provided to give an accounting of the performance of the firm in using the funds from a creditors point of view. Hence conservatism is required in valuation.

Determining ‘net worth’ to owners is not of primary importance.

Critics say that stewardship is too narrow an interpretation of the objective of accounting. The stewardship emphasis causes a preoccupation with the past. Users want information for decision making, which calls for a ‘forward looking’ position. This is now the principles based approach championed by the IASB for international accounting standards.

Because accountability and stewardship is emphasised, the belief is that equity holders are primarily interested in the results of the use of their funds. Thus an emphasis on flows and hence to earnings as the primary statement; the statement of financial performance is more important than the statement of financial position. After all, the objective of the firm is to make a profit a concept that is embedded in business. The balance sheet (now statement of financial position) is a link between two statements of financial performance. It is a repository (dumping ground?) of unamortised historical costs.

Critics charge that we claim the balance sheet is a statement of financial position; but, in effect, historical theory downplays this interpretation. We should be more serious about making the statement of financial position a meaningful statement, one that fits the claims we make about it. Useful information for decision making implies that the statement of financial position items should be as important as the income statement items. Current values would be more relevant.

2.

Explain the concept of ‘costs attach’. What do critics say about the concept?

What is meant by the terms ‘unexpired cost’ and ‘expired cost’?

The theory is that the dollar amount of the historical cost of purchased goods and services ‘attaches’ to those goods and services. As the goods and services are used in the production of the product, the cost of the product can be determined by counting the attached costs of the goods and services that constitute the final product. As Paton and Littleton said, ‘it is as if costs had a power of cohesion’.

Critics believe the notion of ‘sacrifice’ is the only meaningful cost. This is supported by economic theory. There is no evidence that dollar amounts of historical cost attach themselves to physical times. This is purely an abstract view, not supported by evidence. Why this attaching takes place only for acquisition (historical) cost is not

© John Wiley and Sons Australia, Ltd 2010

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Solution Manual to accompany Accounting Theory 7e

clear. If an item is valued at replacement cost because of the lower of cost or market method, then cost suddenly ‘detaches’.

These terms relate to the theory of costs attach. If the dollar amount of cost attaches to the physical items, then assets can be seen as ‘unexpired’ or ‘unamortised’ costs. Assets (or portions of them) and services that have been expensed are ‘expired’ costs. Paton and Littleton said the destiny of all costs is to ‘expire’ on the income statement.

3.

Would market value-adjusted statements be more ‘decision useful’ than those prepared applying historical cost measures? Would using current market values reduce the number of decisions required to prepare financial statements?

This of course very much depends on the decision proposed. If the decision was related to protecting creditors producing conservative accounting reports to monitor managers’ compensation then the answer is no. If financial statements were determined to aid decision making by investors then the answer is probably more positive. Edwards and Bell also argue that a current cost system is also appropriate as a management accounting system. Students after reading this chapter should realise that there are several accounting systems because the decisions to be made in the business world are varied and complex.

Using current market values requires a more complex accounting system and more decisions to be made in preparing reports.

4.

What are the three types of decisions managers are faced with in running a business? How does accounting enter the decision-making process?

The three types of decisions pertain to the allocation of resources within the firm in order to maximise profits. They are: 1.

Those relating to the expansion of the firm. What amount of assets should be held at any particular time?

2.

Those relating to the composition of the assets. What should be the form of the assets? How much working capital, how much of equipment, of plant, etc.?

3.

Those relating to financing. How should the assets be financed? How much debt financing, of new equity, of retained equity etc.?

To make decisions regarding the three problems mentioned above, managers need to form expectations about future events. Expectations are based on past events, and therefore past decisions relating to the past events must be evaluated. Accounting information helps managers to evaluate their past decisions. In so doing, accounting information serves as a basis for forming expectations.

© John Wiley and Sons Australia, Ltd 2010

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Chapter 6: Accounting measurement systems

5.

Explain the Edwards and Bell concept of ‘business profit’.

Business profit

= Current operating profit + Realisable cost savings

Current operating profit

= Excess of the current value of the output sold over current costs of related inputs

Realisable cost savings

= Increase in the current cost in the current period of assets held

Instead of using the term ‘realisable cost savings’, we prefer the term ‘holding gain’.

There are a couple of questions that need to be dealt with concerning holding gains/losses: do these involve all assets, and are liabilities to be also considered?

Although Edwards and Bell defined realisable cost savings in terms of assets, it is clear from a reading of their book (chapter 7) that they also included liabilities — they meant all assets and liabilities. However, because short-term monetary assets and liabilities are similar to cash, and the value of cash is constant (except in terms of purchasing power), they said that as a practical matter these could be ignored. Therefore, holding gains/losses refer to non-monetary assets and long-term liabilities.

6.

What are the benefits of separating out the holding gains (or losses) in profit determination? What are some shortcomings of this separation?

This question assumes the financial capital view. Benefits include: •

Can determine if holding activities are successful. Holding a certain composition of assets and liabilities is one way management tries to enhance the firm’s market position. The evaluation of holding activities can be made because it is separated from operating activities.

•

Gives credit where credit is due. The managers at certain periods are given credit for purchasing non-monetary assets when they were cheaper, or incurring debt when the interest rate was lower.

•

Can better evaluate the performance of management. Management usually has more control over operating activities than holding activities. Management is hired in order to direct the operating activities of the firm. Changes in current cost of nonmonetary assets are not always within the control of management. However, in some firms (for example, traders, builders) profit from holding activities is an important component of profit activities and it is economically desirable to be fully aware of the market prices and movements of these activities.

•

Can better predict future cash flows. Changes in the current cost of assets (that is, holding gains/losses) reflect changes in future cash flows that will occur because of the use of assets. These changes in cost relate to the ‘unexpected’ component of economic profit.

© John Wiley and Sons Australia, Ltd 2010

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Solution Manual to accompany Accounting Theory 7e

Shortcomings include: •

Some decisions of management affect both the operating and holding components.

Therefore, separating the holding gain or loss from operating profit may be misleading. For example, a company may purchase a machine this year where the cost falls, incurring a holding loss; but the use of the machine is expected to decrease operating expenses in the future. Management may be criticised for the holding loss this year, when in the long run, due to the decrease in operating expenses, they have actually made a ‘good’ decision.

•

The rationale for separating out holding gains/losses and including them in the statement of financial position is debatable. Questions 4 and 6 below deal with these issues.

7.

There are several explanations to justify the inclusion of holding gains as profit. Discuss them.

The explanations to justify the inclusion of holding gains as profit are given below.

Although not asked for, criticisms of each are also given.

• Holding gains represent a cost savings due to having purchased the assets at a lower

price. The comparison is between the actual acquisition cost of the asset and the current cost.

Critics say that this argument implies that the cost savings are an ‘opportunity gain’.

This means that a comparison should be made between what actually occurred and what might have happened. Theoretically, what might have happened is unlimited in number. Critics say that the opportunity gain concept also implies that a comparison should be made between what the firm did and what other firms did, because a cost saving measures the firm’s cash position relative to other firms. This would be extremely difficult to perform.

• Holding gains represent an increase in the value of the assets. This is an economic

event that has an effect on profit. The company is economically ‘better off’, because its assets are worth more.

Critics say that this argument is inappropriate, because in most cases the asset is expected to be used in the business, not sold. Therefore, the current exchange price is not relevant.

• Holding gains represent changes in the future cash inflow expected to be generated

because of the use of the assets. (This is the argument used by the FASB in Statement 33.) This theory believes that increases in current cost help investors in assessing the future cash flow of the company. Theoretically, holding gains relate to the unexpected profit component of economic profit.

Critics say that his argument is an empirical one, and there is no persuasive evidence to indicate that changes in the current cost of non-monetary assets relate to future changes in cash inflow.

It would be worthwhile to have students analyse each argument, pro and con, to determine how reasonable each is.

© John Wiley and Sons Australia, Ltd 2010

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Chapter 6: Accounting measurement systems

8.

Explain the difference between financial capital and physical capital.

The financial capital concept is the traditional view. It keeps track of capital in terms of the dollar amount invested in the company. A return on financial capital means that there is an excess of the dollar amount of capital at the end compared with the dollar amount of capital at the beginning, excluding the effect of transactions with owners. In other words, there has been an increase in the value of money capital.

The physical capital concept looks at capital in terms of its physical aspect, and then translates it into dollars. Usually, the physical aspect relates to the firm’s producing capacity. A return on physical capital results only if the physical productive capacity at the end of the period exceeds the physical productive capacity at the beginning of the period, excluding effects of transactions with owners. For example, if at the beginning of the year, X has the capability of producing 10 000 units of product, then profit occurs only after the current dollar amount of that capability at the end of the year is maintained. The capability to produce 10 000 units may be expressed in terms of plant and equipment. Only current cost (or replacement cost) is relevant for a physical capital view.

The main difference between the two is the placement of price changes of non-monetary assets and long-term debt during the period. Under the financial capital view, these price changes are included in profit as holding gains/losses. Under the physical capital view, these are placed directly into shareholders’ equity as a capital maintenance adjustment.

9.

Explain Samuelson’s argument for changes in current cost as a capital maintenance adjustment.

Samuelson argues first that the separation between holding activities and operating activities is not clear-cut; therefore, holding gains/losses should be excluded from income. Second, cost savings (holding gains) are an opportunity gain resulting from taking one course of action as opposed to another. But the alternative has already been forgone by the actual course of action taken. Once the asset is acquired, its cost is a sunk cost that cannot be avoided by any future action. The only choice is to sell or continue using the asset, but holding gains are not based on these choices. They are based on the course of action not taken and which no longer exists. Third, income relates to net cash flows, realised or expected. Cost savings (holding gains) are neither realised cash flows nor expected cash flows, but forgone cash flows. For these reasons, the physical view is more rational.

10.

According to MacNeal, why was the ‘going value’ theory, which assumes the firm is a going concern, formulated?

During the 18th and 19th centuries, the practice arose whereby creditors required owners to submit a statement of net worth and a statement of earnings prior to extension of credit. To ensure their reliability, creditors insisted that the statements be prepared by an independent accountant. Business firms were mostly owned by one person or a small group of partners. The independent accountant had an obligation only to the owner and

© John Wiley and Sons Australia, Ltd 2010

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Solution Manual to accompany Accounting Theory 7e

creditor. The accountant soon learned that a conservative posture satisfied both parties.

Creditors were mainly interested in knowing that the net worth and income were at least as great as reported. Since the owner was knowledgeable of their business, they could make their own personal adjustments to determine a more correct picture of their financial status. Creditors came to view with great esteem those businesspersons who made a practice of understating their net worth and earnings, and accountants began to see it as their duty to prevent overstatements of net worth.

However, when an understated asset was sold for a higher price, especially immediately after the issuance of financial statements, the accountant had to explain this discrepancy.

To justify the valuation at original cost, the ‘going value’ theory was created.

Is the theory realistic? Consider specific corporations, such as BHP, GMH, Bond Company. How long have these companies existed? What is the probability that they will still exist 50 years from now? Sterling argues that history shows that the lives of companies are finite.

11.

Explain the concept of ‘adaptive behaviour’ of the firm by Chambers, and how ‘financial position’ relates to it.

Chambers sees the firm as an adaptive entity engaged in buying and selling goods and services. The notion of adaptive behaviour implies a continual attempt to adjust to the environment for the sake of survival. Through its managers, the firm is aware of the expectations of the interested parties associated with it (for example, owners, customers, employees, creditors). A condition of a firm’s existence is that expectations of all interested parties are satisfied, at least to a greater degree than the satisfaction perceived in alternative courses of action. Ultimately, they are interested in cash receipts to themselves due to their association with the firm.

To continue in business, a firm must have the capability to engage in transactions. This capability is revealed by its financial position. This relates to the firm’s capability to go into the market with cash for the purpose of adapting itself to present conditions (to buy, sell, etc., whatever is necessary to survive). In the last analysis, the survival of the firm depends on the amount of cash it can command. Adaptive behaviour, therefore, calls for knowledge of the cash and current cash equivalents of the firm’s net assets at any particular time.

12.

Why is Chambers critical of the notion of ‘value in use’?

Chambers says value in use is basically a calculated amount of a present expectation. It represents beliefs about the future, not facts about the present. It is personal to the owner or firm, and therefore it is subjective. On the other hand, market value is determined by the market, and therefore is objective. Market value represents a firm’s capability to buy things and pay its debts, as of a given date. Market value is seen to be necessary for an evaluation of the financial position of a firm.

© John Wiley and Sons Australia, Ltd 2010

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Chapter 6: Accounting measurement systems

13.

What is the basis of Sterling’s conclusion that exit price should be used for the valuation of items?

Sterling used a simple model, a wheat trader in a perfect market with a stable price level, to determine which valuation method is superior to all others. Valuations are made because information is desired. The valuation method that provides the most information is the best method.

The decision model of users reveals what information is relevant. The problem then is to select the appropriate decision model, and the way to determine this is to consider the problematical situation and the ability of a model to predict the consequences of alternative courses of action. For the wheat trader, Sterling posed three decision problems: 1. to enter and stay in the market 2. to hold either cash or wheat 3. to evaluate past decisions.

Sterling’s analysis shows that one bit of information is relevant to all decisions: the present market (exit) price. Other pieces of information may be relevant to one or more decisions, but not to all. Even when the assumption of perfect competition and stable prices is relaxed, the present market (exit) price is superior to all other kinds of information.

14.

What is Chambers’s argument concerning the question of ‘additivity’? Is it fundamentally important to be able to add together ‘like’ valuations in the statement of financial position?

One cannot add together the purchase price of an asset to an amount of cash if the total is to be meaningful. The total should relate to the firm’s ability to enter the market and engage in transactions. To be meaningful, the parts which make up the total should all be on the same basis — that is, refer to a single characteristic. Liabilities are expressed at their current cash equivalent — what the company must pay to settle the liabilities.

To be comparable, assets should also be on the same basis — cash or current cash equivalent (exit price). Any amount whose basis is a future event or object is hypothetical, not objective, and cannot be added to a current cash amount. Present value and net realisable value are examples. If all items on the statement of financial position are on a current cash equivalent basis, then the financial condition of the firm and its ability to adapt to the environment can be better seen.

Critics charge that the current cash equivalent of an asset is to be determined on the assumption of a gradual, orderly liquidation, and therefore something of the future is assumed. If anticipations cannot be avoided, then the current cash equivalent (exit price) violates the principle of exclusion of anticipatory calculations.

Larson and Schattke argue that the cash equivalents of individual assets sold separately, and the same assets sold as a package, may be quite different. On this basis, they maintain that cash equivalents are themselves not additive. The logic of their argument needs to be considered. The price received on the sale may vary under different circumstances — does this fact preclude the additivity of the amounts?

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The results of the different indirect valuation methods are approximations of present value; they may be imperfect but they do refer to a common property — present value.

Therefore, in this sense, the results of the different methods are additive. Or we can also say that the different methods are all attempts to approximate ‘true’ value.

15.

What are the criticisms of the profit concept under exit price accounting?

Profit is a measure of how effective the performance of the company is in a given period. Performance has to do with the operations of a company. Exit price accounting puts emphasis on changes in the exit price of assets rather than operations. In most cases, the firm has little control over these price changes.

Performance relates to the decisions made by management, which are formulated into plans. An evaluation of the expected plans against the actual outcome must be made; then the firm can decide whether to continue to use the assets for the purpose they were acquired. One concept of profit is to measure performance in terms of what was originally intended. Only after the plan that resulted in a given profit is evaluated is it then rational to decide whether the plan should be changed. Chambers’ concept of profit, it is argued, ignores this type of evaluation. The plan for each period is to maximise the current cash equivalent of the net assets for that period. Exit price accounting does not match costs with revenues to measure the performance of the firm.

16.

Assume that you favour exit price accounting. Give at least three reasons for your support.

In support of exit price accounting: •

Exit prices are objective because they are market determined. If there is no market price, then the item is stated at zero.

•

Current (exit) values reveal the financial condition of the firm, its ability to adapt to the environment — that is, to go into the market to buy and sell.

•

All the values in the financial statements are additive — that is, they refer to one characteristic: cash or current cash equivalent.

•

Current values are relevant to users for their decision models.

•

There is no problem concerning the allocation of costs.

•

Exit price accounting is based on events that actually happened — increases and decreases in values as determined in the market, as well as items purchased, sold or paid. Values in the financial statements are based on reality.

•

Research studies show that in many cases current (exit) values are more objective than historical cost. In any event, current values are less subjective than most people believe.

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17.

How can exit value accounting be used to assess the financial risk of a balance sheet.

The difference between entry prices and exit prices indicates the liquidity (financial) risk of investing in an asset. If this difference is high then the operating risk of the asset should be lower as the value in use becomes the primary income recovery mechanism.

18.

Evaluate the argument that a mixed or piecemeal approach to standard setting is required in order to ‘better’ measure profit and financial position.

If the firm has assets that are mixed — financial, operating, intangible — then valuation would require the utilisation of different concepts. This appears to be the way that standard setting bodies are headed. However, the conceptual nature of the system becomes more and more complex, and gives the impression that the output is a result of compromise rather than being driven by one conceptual general model.

19.

Explain how both exit price and current entry price accounting systems can be used to make decisions about retaining or selling assets.

First, there are some assumptions made: • • • •

Market prices are more relevant for financial decision making Additivity and reliability are important requirements for accounting measurement systems Conventional historic cost has many defects Accounting outputs and decision making is similar when markets are liquid

When markets are very liquid and exit and entry prices are virtually the same they can be viewed as substitutes. However, when markets are not very liquid and prices deviate then these systems are compliments. They give information on value in use and liquidation value. The divergence in price can also be viewed as a measure of investment risk. See page 191 which also uses NPV. •

• •

20.

If CCAc > EXAc; and CCAc > NPVc, then assets have value in current use (c) — maintain current operations.

If EXAc > CCAc; and CCAa > NPVa, then liquidate assets currently used (c) — continually adapt assets to other alternative investments (a).

If EXAc > CCAc; and CCAa < NPVa, then liquidate and discontinue all operations.

Explain the concept of 'fair value' as defined in IAS 16/AASB 116 and outline benefits to financial statement users of continually revaluing assets to their current value.

Students are encouraged to read this standard before answering the question.

This standard relates to tangible assets - property, plant and equipment. First, fair value accounting has a commercial focus and is generally interpreted as current market price

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Solution Manual to accompany Accounting Theory 7e

accounting or else some form of discounted present value. General guidance is to use a market price if markets are reliable or discounted present value if they are not or the asset/liability is not traded. However, what market price is appropriate is not always spelt out (should you use selling prices or buying prices?). Some guidance is provided but one may use a cost model or a revaluation model. For example, PPE coulod have a mixture of current cost, selling prices, and historical cost.

21.

The following questions relate to the apparent divergence in view between the standard setters and the private sector, with respect to the need to shift from historical cost to current value accounting: (a) In your opinion, why do standard setters moving away from traditional historical cost accounting? (b) Why do think that the business community and the public accounting firms are so strongly opposed to a move away from historical cost accounting? (c) Measurement principles are fundamental to any accounting system.

Why does the Framework lack fully developed measurement concepts?

The answer to these questions relies on the students’ perspectives. These questions can be used to facilitate debate on moving from historical cost to market/current-value approaches. (a) Standard setters (in Australia) do not share agreement on the move to market-valuebased standards. However, the recent trend with SAC 5 and AAS 25 and AAS 26 indicates a growing acceptance by the AASB to alternatives to historical cost. This is largely a function of international trends and the increasing number of standards dealing with specific reporting and measurement issues. This is also consistent with the adoption of the conceptual framework, developed as a guide to appropriate reporting and measurement outcomes, which focuses on the most appropriate solution and which is outside the traditional constraints of the historical cost system. (b) Reasons for the opposition to move away from historical cost include: • the potential risk associated with auditing reports based on alternative measurement systems • costs associated with changing knowledge and audit techniques • costs associated with current-value systems • potential to reduce reported profits and in some cases asset values • significant changes which may be required to reporting systems. (c) This is subjective and a matter of perspective. Students should discuss this from the perspective of each key group, including management, shareholders, the Australian Securities & Investments Commission and the accounting profession.

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Chapter 6: Accounting measurement systems

22.

Has the complexity of alternatives to historical cost approaches become an excuse for keeping the historical cost system?

With the level of technology available, the complexity of alternative measurement and reporting models is not really an issue. The reasons could include: • both academics and practitioners cannot agree on what is an appropriate model • end users may not understand more complex information • the overall costs of reporting may prohibit adoption of alternative models • such models are still subject to the weaknesses of the historical cost system, particularly in terms of the ability of directors to pick and choose applications and the timing of disclosures.

23.

IAS 36AASB 136 requires the use of discounting techniques to assign a ‘value in use’ to assets. The discount rate used is required to take into account the risks associated with the asset for which the future cash flows are being estimated. Consider the implications of applying this in practice by determining how you would derive the present value of an asset in the transport industry and what risk premium you would apply? Detail how you would justify your approach to shareholders.

Determining an asset-specific discount rate to apply to future cash flows introduces uncertainty and subjectivity to the valuation process. AASB136 specifies the discount rate as a pre-tax rate that reflects current market assessments of the time value of money and the risks specific to the asset to the extent that the risks are not already reflected in the cash flows. It is stated that this rate is estimated from the rate implicit in current market transactions for similar assets or from a weighted average cost of capital of a listed entity that has a single asset similar in terms of service potential and risks to the asset under review. The difficulty of determining an appropriate discount rate in practice is illustrated by looking at the transport industry where risk is affected by a wide range of factors including the volatility of fuel prices and the diversity of competition existing in the industry. Where an implicit market rate cannot be determined, a surrogate rate would need to be determined and justified to shareholders on the basis of relevance and reliability.

24.

Explain the underlying approach to intangibles under IAS 38AASB 138. Is the approach consistent with the matching principle? Is the splitting of the research and development components of expenditure and the different accounting treatments justified given that the nature of the expenditure is the same?

IAS 38/AASB 138 requires an intangible asset to be recognised only if the future economic benefits are probable and can be reliably measured. This complies with the matching principle by ensuring that only those expenses that are probable and can be reliably measured are matched against revenues of the period. The standard also requires that all research and development costs be expensed as incurred, except for those development costs where certain criteria can be met with regard to technical feasibility, intention to complete, saleability etc. The standard therefore compartmentalises the treatment of research costs (which must invariably be expensed)

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Solution Manual to accompany Accounting Theory 7e

and development costs (which may only be capitalised under certain conditions). The need to distinguish between research costs and development costs is therefore crucial to the correct matching of expenses with revenues, regardless of the similar nature of these types of expenditure.

25.

If you were the auditor of the company in question 23, what evidence would you seek to support your opinion about the fair presentation of the asset?

ASA 540 and 545 (ISA540) require the auditor to consider the risk of material misstatement with respect to fair value measurements and disclosures. The auditor should evaluate whether a) the assumptions of management are reasonable b) the fair value measurement was determined using an appropriate model, if applicable; and c) management used relevant information that was reasonably available at the time.

This means that the auditor must specifically consider how management identified and considered the risks in relation to this asset, the process used to calculate the cash flows, and the assumptions and information which affected the choice of the discount rate. If all of these are considered reasonable, the auditor would normally accept the valuation. Note that it is not sufficient to recalculate the valuation. The auditor has to test management’s processes for identifying information which would impact on the valuation.

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PROBLEMS Problem 6.1 (Very difficult - this problem should only be attempted by students undertaking advanced studies) Sharp Ltd has traditionally maintained its accounting system on an historical cost basis.

However, because of continuing inflation, it has decided to prepare its financial reports on a current value basis. Its historical cost balance sheet as at 30 June 2011 (year-end) is shown below.

The company had its assets valued at their current buying prices on 30 June 2011, with the following results:

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Problem 6.1 (continued) Transactions for 2011-12 consisted of:

The following information should also be taken into account.

25. The new motor vehicles and equipment are subject to the same straight-line depreciation rates as the existing ones.

26. Income tax to be provided for is $75 850.

27. Dividends of 15% on the shares (including the new issue) are to be provided for.

28. The historical cost of 30 June inventories is $236 000.

29. The 30 June buying prices of equivalent physical assets owned by the company are:

30.

31.

The 31 December buying price of 1 July inventories was $204 000, while the 31 December buying price of 30 June inventories was $220 000.

Overall, the cost of original inventory increased by 35% during 2011-12 and the CPI increased from 100 to 110.

Required: A. Present a set of financial statements in accordance with the requirements of SAP 1 for the 2011-12 reporting period.

B. Show all calculations and appropriate general journal and ledger entries.

C. Explain why you calculated the adjustments for backlog depreciation and the gain/loss on monetary items in the manner which you chose.

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Problem 6.1 (continued) Sharp Ltd financial statements SHARP LTD Income Statement for the year ended 30 June 2012

Sales Less Cost of sales Opening Inventory Purchases

$2 330 000

Closing Inventory Cost of sales Gross Profit Less Operating Expenses Wages Depreciation of Plant Depreciation of Building Depreciation of Vehicles Interest Current Cost Operating Profit before Tax Add Gain on Holding Monetary Items Current Cost Entity Profit Less Tax Current Cost Entity Profit after Tax Less Dividend Entity Profit for 2011-12 Add Retained Profit from 2010-11 RETAINED PROFIT CARRIED FORWARD

$ 204 000 1 490 000 1 694 000 220 000 1 474 000 $ 856 000 227 000 461 000 31 200 8 200 24 500 25 000

776 900 $ 79 100 2 018 $ 81 118 75 850 $ 0 5 268 6 000 ($054 732) 9 800 ($044 932)

A proprietary result may also be calculated as follows: Current cost operating (entity) profit after tax Add gain on loan capital Current cost proprietary profit after tax

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$ 5 268 25 000 $30 268

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Solution Manual to accompany Accounting Theory 7e

Problem 6.1 (continued) SHARP LTD Statement of Financial Position as at 30 June 2012

Current Assets Bank Accounts Receivable Inventories

$ 58 000 183 000 284 000 $ 525 000

Long-term Assets Motor Vehicles Less Accum. Depn

$160 000 78 000

Equipment Less Accum. Depn

369 000 150 750

Building Less Accum. Depn Land

420 000 92 400

TOTAL

Current Liabilities Accounts Payable Tax Payable Dividend Payable

$ 156 000 75 850 60 000 $ 291 850

Long-term Liabilities Debentures

250 000

82 000

218 250

327 600 400 000 $1 027 850 $1 552 850

Shareholders’ equity Paid-up Capital Share Premium Reserve Current Cost Reserve General Reserve Retained Earnings TOTAL

400 000 70 000 545 932 40 000 (44 932) $1 011 000 $1 552 850

Journal Entries June 30 2011

Inventories (172 000 – 182 000) Motor Vehicles (85 000 – 115 000) Equipment (188 000 – 260 000) Buildings (220 000 – 400 000) Land (160 000 – 380 000) Accum. Depreciation Motor Vehicles Accum. Depreciation Equipment Accum. Depreciation Buildings Goodwill Current Cost Reserve

Dr Dr Dr Dr Dr Cr Cr Cr Cr Cr

10 000 30 000 72 000 180 000 220 000 12 000 28 800 36 000 40 000 395 200

Initial revaluation of non-monetary assets at 30 June 2011 buying prices.

Jun 2012

Inventories (182 000 – 204 000) Current Cost Reserve

Dr Cr

22 000 22 000

Revaluation of July 2011 inventories at MOY Dec 2011 prices.

June2012 Inventories (220 000 – 284 000) Current Cost Reserve

Dr Cr

64 000 64 000

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* These inventory adjustments are to centre the current costs of inventory at the middle of the reporting period.

Motor Vehicles (145 000 – 160 000) Equipment (330 000 – 369 000) Buildings (400 000 – 420 000) Land (380 000 – 400 000) Current Cost Reserve

Dr Dr Dr Dr Cr

15 000 39 000 20 000 20 000

Dr Cr

24 500

94 000

Revaluation of non-monetary assets at June 2012 prices.

Depreciation of Motor Vehicles Accum. Depreciation of Motor Vehicles Depreciation at 20% on Dec value of Motor Vehicles   15 000 115 000 + = 122 500 2  

Depreciation of Plant Dr Accum. Depreciation of Plant Cr Depreciation at 10% on December value of Plant   34 000  260 000 + = 277 500 = 27 700 2   + 6 months depreciation on new plant = 3 500 31 200 Depreciation of Buildings Accum. Depreciation of Buildings Depreciation at 2% on Dec value of buildings   20 000  400 000 + = 410 500 2  

24 500

31 200 31 200

Dr Cr

8200

Current Cost Reserve Dr Accum. Depreciation of Motor Vehicles Cr

7500

8200

7500

Backlog depreciation charged on motor vehicles to cover shortfall on previous depreciation costs.

Calculation: 3 yrs depreciation at 20% on cost 130 000 = Less: amount charged in Accum. Deprec.

78 000 70 500 7 500

NOTE: December 2012 new cost excludes new vehicles.

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Current Cost Reserve Accum. Depreciation of Equipment

Dr Cr

15 550 15 550

Backlog depreciation charged on Plant to cover shortfall over past 4 years and December–June 2012.

Calculation: 5 yrs depreciation at 10% on cost of existing plant 6 mths depreciation at 10% on cost of new plant

294 000 =

147 000

75 000 = 150 750

3 750

Less: Amount charged in Accum. depreciation Backlog depreciation Current Cost Reserve Accum. Depreciation of Buildings

135 200 15 550 Dr Cr

4 200 4 200

Backlog depreciation charged on Buildings to cover shortfall over past 10 years and December–June.

Calculation: 11 yrs depreciation at 2% cost 420 000 92 400 Less: Amount charged in Accum. Deprec.

88 200 Backlog depreciation 4 200 Gain on monetary items: (a)

Loss of monetary assets Bank Accounts Receivable

46 000 58 000 +  110 − 100 2 100 112 000 + 183 000  0.35 2

=

$ 5 200

=

$51 625 $56 825

(b)

Gain on monetary liabilities (excluding long term) 110 000 + 156 000  0.35 Accounts Payable 2 110 000 + 156 000  0.35 2 (assume not related to the purchase of inventories) Gain on monetary liabilities Net gain on monetary items

Other Payables

Journal Entries Current Cost Reserve Statement of financial position

Dr Cr

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=

$46 550

=

$12 293 $58 843 $ 2 018

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Current Cost Reserve Ledger Account Debit June 2011 June 2012 June 2012 June 2012 June 2012 June 2012 June 2012 June 2012

Initial adjustments for Current Cost Inventory (BOY) Inventory (EOY) Adjustments Current Cost Depreciation Motor Vehicles (backlog) Depreciation Plant (backlog) Depreciation Buildings Net monetary items

Credit 395 200 22 000 64 000 94 000

7 500 15 550 4 200 2 018 $545 932

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Problem 6.2 (moderate) Company Y had the following transactions in Year 2. The perpetual FIFO inventory system is used.

1.

Purchased on credit, 4000 units of inventory at $5 each.

2.

Sold 3000 units for $12 each on credit. Replacement cost at this time is $7 each.

There were 1000 units in beginning inventory at $4 each, which represents both current and historical cost. The exit price of the 1000 units is $12 each.

3.

At year-end, the building’s current value is $150 000. The gross historical cost was $100 000. The building is 2 years old at year-end and is depreciated 10% per year. The current value at the beginning of the current year was $125 000.

4.

At year-end, the value of the land is $50 000. The historical cost was $30 000 and the current value was also $30 000 at the beginning of the year.

5.

At year-end, the market price of the debentures, which were issued by the company at the beginning of the year, is $40 168. The debentures were sold at par for $44 000 at the rate of 8%. The current rate of interest on 31 December is 10% and the average for the year was 9%. The remaining life of the debentures on 31 December is 6 years.

6.

Accounts receivable of $20 000 has an exit price at year-end of $19 000. The other receivables were collected during the year.

7.

At year-end, the selling price of the inventory is increased to $14 each.

8.

On 31 December, operating expenses of $12 000 are paid, including interest of $3520.

Required: Record the transactions as journal entries under the following methods: (a) conventional accounting (historical cost) (b) exit price accounting.

1.

2.

Inventory Accounts Payable (a)

(b)

(c)

3.

Accounts Receivable Sales Revenue

Conventional $20 000 $20 000

Exit Price $20 000 $20 000

36 000

36 000 36 000

Price Change Adjustment (see below) Inventory ($8  1000) Cost of sales Inventory

8 000 8 000 14 000

14 000 14 000

Building Price Change Adjustment Depreciation Expense Accumulated Depreciation

36 000

14 000 25 000 25 000

10 000

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0 10 000

0

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4.

5.

6.

Land Price Change Adjustment

20 000

Discount on Bonds Payable Price Change Adjustment

3 832

Price Change Adjustment Accounts Receivable

1 000

20 000

3 832

1 000

Cash (amount not specified) Accounts Receivable 7.

8.

Inventory [($14 – $5)  2000] Price Change Adjustment Operating Expenses Interest Expense Cash

18 000 18 000 8 480 3 520

8 480 3 520 12 000

12 000

For the exit price alternative, the books are assumed to be kept on an exit price basis for the previous year. It is assumed that an adjusting entry at the end of the previous year for inventory was made to record the 1000 units at the exit price of $12 each. Since the cost was $4, the difference of $8 per unit, or $8000 was recorded. The entry here (2(b)) is to reverse the previously recorded adjusting entry. The reversing entry should be made at the beginning of the period. Replacement cost in this problem is irrelevant.

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Problem 6.3 (moderate) Consider the balance sheet of Circle Ltd on an exit price basis at the beginning of the year:

The building was purchased for $90 000 and the shares and debentures were issued when the general price index was 90 on 1 January Year 9. The beginning inventory has an historical cost of $5 each. A FIFO basis is used. The general price index is 100 at the beginning of the year. The following events are mentioned in chronological order for Year 10.

1.

Purchased on account 5000 units of inventory at $6 each. The exit price is $15 each. The general price index is 105.

2.

Sold on account 5000 units for $15 each. The general price index is 105.

3.

At year-end, the building’s current value is $200 000 and the value of the land is $20 000. The sales price of the inventory is increased to $19 each. The market price of the share investment is $25 000. The market price of the debentures is $45 032 on 31 December. The current rate of interest is 12%. The average market rate of interest was 11% for the year. The remaining life of the debentures is 8 years on 31 December.

4.

On 31 December, half the land is sold for $10 000.

5.

On 31 December, operating expenses of $15 000 are paid. Interest of $5000, which is not included in the $15 000, is also paid.

6.

The general price index at the end of the year is 120. The average for the year is 108.

Required: Prepare journal entries to record the above events, as well as the statement of financial performance for Year 10 and statement of financial position as at 31 December Year 10, under the exit price method.

1.

2.

(a)

(b)

Inventory (5000  $6) Accounts Payable

$30 000

Accounts Receivable Sales Revenue

75 000

Price Change Adjustment Inventory (1000  $10)

10 000

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$30 000

75 000

10 000

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Problem 6.3 (continued) (c)

3.

4.

Cost of sales (1000  $5) + (4000  $6) Inventory

29 000

Inventory (1000  ($19 – $6)) Building ($200 000 – $90 000) Land ($20 000 – $10 000) Investment in Y Stock Discount on Bonds Payable Price Change Adjustment

13 000 110 000 10 000 5 000 4 968

Cash

10 000

29 000

142 968

Land 5.

6.

10 000

Operating Expenses Interest Expense Cash

15 000 5 000

Purchasing Power Adjustment Capital Maintenance Retained Earnings

17 000

20 000

16 667 333 January 1 Year 10

Capital Stock Capital Maintenance Adjustment Retained Earnings Stockholders’ Equity

December 31 Adjustment Year 10

$75 000  120/100 = 8 333  120/100 = 1 667  120/100 = $85 000

$ 90 000 10 000 2 000 $102 000

$15 000 1 667 333 $17 000

Circle Ltd Statement of Financial Position as at 31 December Year 10 Cash Accounts Receivable Inventory

$ 10 000 75 000 19 000

Investment in Y Building Land TOTAL

25 000 200 000 10 000 $339 000

Accounts Payable Bonds Payable Less: Discount

$ 50 000 50 000 4 968 45 032 Ordinary Capital 75 000 Capital Maintenance Adjustment 25 000 Retained Earnings 143 968 $339 000

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Problem 6.3 (continued) Statement of Retained Earnings as at December 31 Year 10 Beginning balance Add net income

$

1 667 141 968 $143 635 333 $143 968

Add purchasing power adjustment Ending balance

Circle Ltd Income Statement for the year ended 31 December Year 10 Sales Revenue Cost of sales: Beginning Inventory (at historical cost) Purchases Available for Sale Ending Inventory (at historical cost) Gross Profit (at historical cost) Price Change Adjustment — beginning inventory Price Change Adjustment — ending inventory Gross Profit (on exit price basis) Sale of land Less cost of land Changes in value: Investment in Y Building Land Bond Payable

$75 000 $ 5 000 30 000 $35 000 6 000

$10 000 5 000

5 000 110 000 5 000 4 968

29 000 $46 000 (10 000) 13 000 $49 000 5 000 $54 000

124 968 $178 968

Less: Operating expenses paid Interest paid Less Purchasing price adjustment Net income

15 000 5 000

20 000 $158 968 17 000 $141 968

The format above is recommended by Chambers. Because of criticism that the exit price income statement does not concentrate on operations, he has attempted to show the gross profit on an historical cost basis first, before adjusting to an exit price basis. This is the reason for journal entry 2(b). There are no accruals and deferrals of expenses.

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CASE STUDIES Case Study 6.1 Fair value or false accounting

1.

How are the assets and liabilities measured under IAS 39?

They are to be stated at their fair value defined as the amount for which an asset could be exchanged or a liability settled between knowledgeable willing parties at arm’s length. In an active market financial instruments would be measured at their exchange price (buying and selling prices having small margins). If the market is not active, then they are valued at the discounted present value or via an option pricing model.

2.

What impact according to the author, will fair value accounting have on the balance sheet and income statement?

Any gain or loss is recognised in the income statement and the financial instrument is valued at fair value in the balance sheet.

3.

What measurement requirement of historic cost accounting is violated?

The measurement requirement is that profit is only measured when an external transaction is realised. Departure from the realisation principle is covered in the criticism section. The problems are: • liquidation vs. going concern concept • recognition before confirmation by sale • definition of profit and meaningful profit • problems of obtaining selling prices • value in use concept of an asset.

Raymon pays particular attention to the concept of realisation. Comments such as ‘the relevance of a value change being a measure of financial performance is the result of a fallacy deeply entrenched in the conventional academic wisdom, and ‘the fundamental mistake is to report value change as a gain or loss’; summarise his position.

4.

Is a change in asset value an increase in wealth or income? Are they the same?

Of course this is a debate that has occurred amongst financial accounting theorists for nearly a century. Rayman uses the return on investment argument and no adaptive behaviour to support his case. That is if interest rates fall and investors do not realise the capital gain, then they are no better off. This is true as the rate of return has dropped to 5.5% from 8% and no realisation has occurred. However, the opportunity is there to realise the investment and adapt the investment to other classes of assets which will benefit from a fall in interest rates (e.g. stock market, housing). Is unrealised income an increase in wealth or income or not is answered by economists who define increases in wealth as income. Not all accountants agree. What does the general public think? Using the illustration of the recent housing boom can provide a case study. Certainly most people saw the increased prices as an increase in wealth and either realised the value or

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else used their greater equity to borrow and consume, thus fuelling recent consumer spending. Other case studies can be used by the instructor in this debate.

5.

What do you think fundamental value in accounting should be? Refer to the debate regarding value in use and value in exchange in this chapter when answering this question.

A difficult question. See the answer to case study 1, question 5 above which addresses the question of the fundamental value of assets and the above section in the text. If the firm has assets that are mixed — financial, operating, intangible — then valuation would require the utilisation of different fundamental value concepts. This appears to be the way that standard setting bodies are headed. However, the problem is that the conceptual nature of the system becomes more and more complex and the solution more vague. Moreover, any standard that attempts to address the problem gives the impression that the output is a result of compromise rather than being driven by one conceptual general model. Moreover, users must be sophisticated enough to understand that different components of fundamental value and because the solution may be a mixed system, the additive principle may be questioned.

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Case Study 6.2 The following article discusses the impact of exchange rates on earnings.

1.

Discuss the implications for Domino’s shareholders of the upgrade in reported earnings due to the weaker Australian dollar for the 2009 year, given that the operational margins were in line with analysts’ expectations.

The main concern of Domino’s shareholders would be the amount of earnings available for dividend distribution. While the weaker Australian dollar may have provided foreign exchange benefits from the European side of Domino’s business, these are not predicted to continue as the Australian dollar strengthens. Companies are exposed to exchange rate variations and risk by dealing across international borders and this poses a constant risk to earnings and therefore dividend levels. Many companies engage in hedging activities to counter the effects of such exchange variation risks. The question then is how to handle exchange rate risk and exchange rate hedges in accounting. These are issues attracting considerable academic research.

2.

How concerned should shareholders be with changes (increases or decreases) in earnings caused mainly by fluctuations in exchange rates?

As above, shareholders should mainly be concerned with the effect on dividend levels and on cash flows. However, shareholders should recognise that the change in earnings is some function of a change in the exchange rate.

It does not change the underlying value of the business or impact on operating assets if there is no substantial international funds flow or if there is full hedging. It therefore shouldn’t result in any shift in the value of the shares of the company.

However, if there is no hedging and considerable revenue or costs are sourced or expended in other countries then there will be an impact. Again to complicate matters it also depends on the natural hedge that the company has (assets and cash in the foreign country).

3.

How will Domino’s forecast earnings be affected by the relatively significant increase in the strength of the Australian dollar since the end of the 2009 financial year?

Domino’s forecast earnings will be adversely impacted downwards by the strengthening Australian dollar. Analysts have also predicted that the tax benefits are not recurring (they are one-off) and this will also result in a lower forecast profit. Students might look up the current performance and its correlation with the now high exchange rate.

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Solution Manual to accompany Accounting Theory 7e

Case Study 6.3 This article discusses the impairment of assets

1.

What is the impact of the impairment charges on the income statement and on the statement of financial position of the company?

The effect of the impairment charges is a reduction in the earnings of the company and on the carrying value of its assets. Profit reported in the income statement will decrease, and the assets reported in the statement of financial position will decrease.

2.

Should shareholders be concerned about the asset impairments on the Hong Kong and United Kingdom operations given that the expected improvement was largely restricted to ‘contract positions’? Explain your answer.

Yes — for those reasons outlined above. Shareholders should be concerned with the reduction in the value of assets and the consequent reduction in earnings. The effect of continual asset write-downs is to reduce the net assets and the net value of the company which will eventually flow through to firm and share valuation. Research also indicates that impairments usually follow a decline in share price – they do not lead the share price drop.

3.

What is meant by the statement that ‘a net loss … would make a return to shareholders unviable’?

Companies generally make returns to shareholders (dividend payments) only if they are generating profits. A dividend to shareholders when a company has incurred a loss or in the face of insufficient cash flows is not sustainable in the long term. While this approach may temporarily appease/impress shareholders, the company needs to be generating sufficient earnings and cash from operations to support the payment of dividends in the long term.

© John Wiley and Sons Australia, Ltd 2010

6.33

Chapter 6: Accounting measurement systems

Case Study 6.4 This article considers the costs attaching to business divisions.

1.

Contrast ‘displacement’ cost with ‘embodied’ cost.

‘Displacement’ cost denotes what has been given up or sacrificed and is synonymous with opportunity cost. On the other hand ‘embodied’ cost (or absorption cost) relates to the factors of production and has to do with what has been outlaid on inputs rather than what has been foregone.

2.

Identify the potential problems associated with allocating costs to various products and services.

The allocation of costs to various products and services relies on matching which requires the accountant to determine the matching “driver” (units of production, square metres of space used, number of personell etc). Costs of purchase, conversion and other costs must be measured and then apportioned on such a selected basis to particular products or services. The measurement of costs and the sometimes subjective nature of the allocation process may present a problem in determining the amount of costs to be apportioned to particular products or services.

3.

Comment on the impact on Bradken’s revenues in the second half of the year, from customers ‘destocking’.

Shareholders should be concerned with the underlying value of the company — which may change as a result of the ‘destocking’. Management will need to respond to destocking and cancellation of orders by customers by reducing its costs in line with the declining demand levels.

4.

Is the impact you identified in question (2) likely to have an influence on the amount of product and/or services cost that can be separated and categorised into new groups? Explain your answer.

As a result of challenging trading conditions the company may need to change its products/services mix. This may include adding new products/services and removing others. Some products/services may be altered and merged with others creating the need for a revision of the costs allocated to products/services. Matching is also a dynamic process that must constantly be adjusted to reflect changing business operations.

© John Wiley and Sons Australia, Ltd 2010

6.34

Solutions Manual to accompany

Accounting Theory 7e by

Ann Tarca

Chapter

Chapter 73 Assets

John Wiley & Sons Australia, Ltd 2010

Chapter7: Assets

Chapter 7: Assets THEORY IN ACTION Theory in Action 7.1 Outdated prices blamed in Credit Suisse Error 1.

How do European bankers determine the valuations of asset backed securities?

The article suggests that models which make use of market values are used by European banks to value asset backed securities. The approach differs to the US where valuation is based directly on market prices. Thus, the models are adjusted as conditions change in the market place in an attempt to approximate true economic value.

2.

What is meant by these phrases used in the article: (a) “pretty adverse market conditions” (b) “delinquencies of updating of pricing” (c) “some valuation issues where the pricing did not meet our standards”?

(a) The article refers to market conditions in February 2008 when the sub-prime crisis was affecting the value of bank securities. Banks holding such securities were writing down assets, thus reducing the value of their investments, their total equity and shareholder wealth.

Credit Suisse had written down debt and loans by 2 billion Swiss Francs in February 2008.

The market conditions were adverse in comparison with conditions in earlier years when markets were buoyant, asset prices were rising and banks were posting healthy profits. (b) “delinquencies of updating pricing” appears to be a public relations way of saying that there were errors in the prices used to update valuation models. The article states that it appears that traders used out of date prices. (c) Similar to (b) we have public relations terms for the errors (intentional or otherwise) which fed into the models. The company has admitted that errors occurred and the company discovered them in subsequent checking of valuations of trading positions. The company standards required that certain procedures be followed (presumably the use of current prices) and in this case the appropriate procedures for selecting the correct prices for valuation models inputs were not followed.

3.

What are the repercussions of the “errors” at Credit Suisse? Are they reasonable or do they represent an over-reaction?

The company is completing an internal review of the trades to ensure that valuations are correct and that other errors are not present. The review is important to demonstrate to stakeholders outside the company that systems and internal controls and sound and can be relied upon to produce appropriate valuations.

Uncovering errors in pricing by banks are taken seriously in the market, in case the error has revealed a deeper, previously unknown, problem. Given the vulnerability of banks’ positions and performance to the activities of their traders, the market would be watching closely the outcomes of reviews such as the one being undertaken by Credit Suisse in this situation. The bank would not appreciate the possible credit downgrade by S&P, reflecting S&P’s concerns

© John Wiley and Sons Australia, Ltd 2010

7.2

Solution Manual to accompany Accounting Theory 7e

about (a) internal controls and (b) transparency of operations (i.e. S&P says it is not clear why year to date losses are so much larger than 2007).

There are many examples where traders’ unauthorised behaviour has had extremely bad consequences for banks, thus supporting the market sensitivity of any disclosure of errors or irregularities in internal control. These include Sociétè Generale in early 2008, the National Australia Bank unauthorised trading in 2004 and the collapse of Barings Bank in the 1990s.

© John Wiley and Sons Australia, Ltd 2010

7.3

Chapter7: Assets

Theory in action 7.2 Agricultural assets: IAS 41 Agriculture Explain what is represented by the items shown in the above table: (a) Assets reclassified from fixed assets € 705.9m IAS 41 requires that agricultural assets are separately recognised in the financial statements (para 41). On adoption of IAS 41 the Stora Enso Group has removed the relevant assets from fixed assets and separately classified them as biological assets. (b) Fair valuation surplus € 855.8m IAS 41 requires that a biological asset is measured at its fair value less point of sale cost at each reporting date (para 12). Thus, the Stora Enso Group has revalued the biological asset on adoption of IAS 41, giving rise to a revaluation surplus, to be included in profit and loss for the year (para 26). (c) Carrying value at 31 December 2003 € 1 587.8m At the end of the first year after adoption of IAS 41, the biological asset is again measured at fair value less point of sale costs (para 12). Net fair value is the carrying value of the asset. (d) Additions € 4.5m and disposals € -1 541.2m During the year ended 31 December 2004 biological assets in the group have increased by € 4.5, presumably through acquisitions of forests (natural increase is possible, but it is more likely to be captured in the year end valuation of the forest rather than as an addition).

The disposal € -1 541.2m reflects the large divestment of forest assets noted in the text. (e) Changes in fair value € 37.5m At the end of the second year, the biological asset is again measured at fair value less point of sale costs (para 12). The increase in fair value gives rise to a fair value change which is recorded in profit and loss in the period in which it occurs (para 26). (f) Decrease due to harvest € -30.4m The value of harvested agricultural produce arising from an entity’s biological assets must be measured at fair value less point of sale costs (para 13). The harvesting of agricultural produce (i.e. the felling of trees) leads to a reduction in the value of the forest of € -30.4m.

© John Wiley and Sons Australia, Ltd 2010

7.4

Solution Manual to accompany Accounting Theory 7e

Theory in Action 7.3 Impairment The solution below makes use of material from: Theory in Action 7.2 Impairment Barclays reveals ₤1.7 bn loans write off Patrick Hosking The Times, November 16 2007

1.

What is a writedown?

In the article, a writedown refers to the process by which a bank reduces the value of assets recognised on its balance sheet. Barclays has written off ₤1.7bn on sub-prime mortgages and buyout loans. A writedown is an unrealised loss (that is, a paper loss) which occurs because the market price or estimated fair value of the asset is less than its carrying amount. In a situation where markets recover, the unrealised loss may not eventuate as the investment may be sold at a profit.

2.

At the time of the article, why were banks reporting writedowns?

The writedowns were necessary because the value of the bank’s investments declined in value as part of the global financial crisis. The value of investments declined as borrowers in the sub prime mortgage market defaulted, causing loss of liquidity in credit markets. Markets for some assets dried up, making them difficult to value and/or worthless, indicating that writedowns were required.

4.

What guidance is there about how to calculate the writedown?

IAS 39 provides guidance relating to the recognition and measurement of financial instruments. Managers classify financial instruments into one of four categories (see Chapter 7) and follow measurement methods based on these categories. The way in which a decline in value is to be treated is also specified according to category. Financial instruments at fair value through profit and loss will reflect any loss in value as market price (or an approximation of market price) is used to value the instrument. In determining impairment, market value must be used if it is available. For an asset with no market value, banks can use models to estimate fair value, making assumptions about interest rates and default rates relating to the assets underlying the securities.

For loans and receivables and held to maturity investments held at amortised cost, and impairment loss is recorded (in profit and loss) when the asset’s carrying amount is less than the present value of estimated future cash flows (IAS 39, para 63). When there is objective evidence that an available for sale investment is impaired, the impairment losses will be recognised in profit and loss (not in equity) (IAS 39, para 67).

Impairment losses which subsequently decrease may be reversed if there is objective evidence e.g. improvement in the debtor’s credit rating. The reversal will be recorded in profit and loss. At the date of the reversal, the value of the asset will not result in a carrying value in excess of the amortised cost applicable at that date had the impairment not occurred (IAS 39, para 65).

© John Wiley and Sons Australia, Ltd 2010

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Chapter7: Assets

5.

Do all banks use the same model to calculate a writedown?

No. Although they all follow the same accounting standard IAS 39, the way the standard is applied varies between banks. Hosking (2007) describes the valuation process in this way: “Each bank values its assets in-house. First, the bank’s traders put a price on their books.

Then its product or business unit control departments test the traders’ pricing. Finally, external auditors review the models and the underlying assumptions used by the bank to ensure they are in line with good accounting principles. But auditors sign off only on year end figures. For quarterly updates, the auditors discuss the figures with the banks, but do not sign off on them. Because there are no fixed rules on factors used in valuation models, and each banks’ investments are structured differently – with different weightings for each security for example, writedowns are not calculated in a uniform way….In turbulent times, valuations are highly judgemental.”

Source: The Times, 16 November 2007

© John Wiley and Sons Australia, Ltd 2010

7.6

Commented [a1]: Quote ok. We have the permission for this article.

Solution Manual to accompany Accounting Theory 7e

Theory in action 7.4 Class action targets ABC and auditors

By Nabila Ahmed Australian Financial Review 16 October 2008 p. 6 1.

The article states that ‘the auditors allowed them to book those guarantee payments as revenue’. What are the implications of this action for assets?

Booking something as revenue means that there is a credit entry to the revenue account.

There must also be a debit entry; in this case it seems to have been made to an account receivable or another asset. The debit to assets gives the impression that the business has more assets. The revenue entry increases profits, and thereby increasing shareholders equity.

The lawyer bringing the new action refers to ‘inflated profits and inflated values’. The inflated values appear to be the assets recognised as part of the transaction to recognise revenue.

2.

What is a class action? Why is it being brought against the auditors?

A class action has many plaintiffs acting together to sue another party or parties. They collectively bring an action to court. In this case the class action is being brought against both the auditors and the company ABC. (Note that the article refers to two class actions brought by different law firms.)

Auditors could be targeted because the lawyers expect that the company will try to shift blame to the auditors (rightly or wrongly), meaning that shareholders will not be able to recover damages from the company or its directors. If auditors are targeted, then shifting blame between the various parties will not defeat the shareholders’ action.

Another reason auditors could be targeted is that they are often regarded as having ‘deep pockets’. This means that if the audit firm is found responsible it is likely to be able to pay the damages, either from the partners’ own resources or from the firm’s insurance coverage.

Many possible legal actions do not proceed if it is likely that the defendant would not be able to pay, even if the plaintiff won.

3.

What do you think the auditor’s legal defence will be?

A third auditor, KPMG, (the original auditor is Pitcher Partners and the new auditor is Ernst & Young) provided an independent opinion that both types of accounting treatments were defensible. This opinion was sought by the ABC Board but seems to protect both Pitcher Partners and Ernst & Young from the class action. However, simply receiving a favourable third opinion does not mean that the court will accept the auditors’ views. The court will determine if the auditors’ actions were ‘reasonable’.

© John Wiley and Sons Australia, Ltd 2010

7.7

Chapter7: Assets

CASE STUDIES Case Study 7.1: Heritage assets Answer the following questions in relation to the issue of recognising the value of heritage assets in the financial statements of the organisations which are responsible for the assets.

1.

In what ways are heritage assets similar to the assets of for-profit entities and in what ways are they different?

Consider the conceptual framework definition of an asset (Framework, para 49): “..a resource controlled by the entity as a result of past events and from which future economic benefits can be expected to flow to the entity.”

The definition can be applied to assets held by for-profit businesses but it is difficult to apply to many heritage assets because of the special features of these assets. Do custodial entities have control of the heritage asset? This point can be debated by students. The custodial entity may manage and care for a park, but it cannot sell it. Art galleries can buy and sell assets, but purchases are scrutinised by external stakeholders (e.g. the public, for whom the managers are trustees in an equitable and/or legal sense).

Is there a past event? The purchase of a painting is a past event, but the creation of the Great Barrier Reef is an event possibly beyond the scope of accounting.

Do future economic benefits flow to the entity? Art galleries often do not charge for admission to view collections. Parks may charge admission, but to contribute to costs rather than make a profit. Heritage assets are often not held to make future economic benefit but rather have social, psychological and community benefits. Students should discuss the difficulty of applying concepts of ‘future economic benefit’ to heritage assets.

2.

Is it appropriate to recognise a heritage asset in the financial statements of the entity which has custody of and responsibility for the asset?

Consider the IASB Framework recognition criteria (para 89) ....it is probable that future economic benefits will flow to the entity and it has a cost or value that can be measured reliably.

Students should discuss if future economic benefits are likely in relation to holding heritage assets. In many cases such assets are held for social, political and community reasons rather than economic reasons. Future economic benefits are unlikely in many cases as the assets are not held for the purpose of wealth creation.

Further, future benefits (of any kind) are difficult to measure with any reliability in relation to heritage assets which are often unique (one of a kind) and thus lacking in a market value.

Where market values are available, such as for works of art or buildings, they are may not be relevant to stakeholders since the assets are not held for trading or sale.

© John Wiley and Sons Australia, Ltd 2010

7.8

Solution Manual to accompany Accounting Theory 7e

3.

Are there users for the information about the value of heritage assets?

Students should discuss whether the cost benefit requirement is satisfied in relation to the valuation of heritage assets. For example, is the cost of determining a valuation of a gallery’s art collection justified when the collection is not for sale? It can be argued that the collection must be valued for insurance purposes and that insurance is necessary to protect the asset.

Since a value is available it should be communicated to stakeholders, to assess the stewardship of management in maintaining, protecting and expanding the community asset.

It has been suggested that “businesses manage what they measure.” Should not-for-profit entities also measure their assets as part of an accountability and stewardship process? While there is some merit in this argument, it should be noted that heritage assets are not held to generate income in a manner similar to the assets of commercial enterprises.

4.

Can a financial value be assigned to a heritage asset?

It can be argued that heritage assets are priceless, that they belong to future generations, that they are not for sale and market values or financial values are academic and meaningless. It would appear that for many heritage assets financial value in no way represents their ‘real’ value or future value. Some assets have no ‘market value’ because they are unique and irreplaceable. The value of the assets is determined by reference to community values and may vary according to the stakeholders consulted. There may not be agreement about the financial value or even the social or cultural value. For example, we can determine both a purchase price and a current market value for Jackson Pollack’s Blue Poles owned by the Australian National Gallery. However, does the financial value represent the value of the painting to the community? Is the increase in financial value over the time it has been owned related to ‘income’ for the community? The answers to these question is likely to be no and can be discussed with students to explore the relevance of financial values to determining worth of heritage assets.

© John Wiley and Sons Australia, Ltd 2010

7.9

Chapter7: Assets

Case Study 7.2: Intangible assets

Intangible asset Valuation methodology Valuation issues Brands and Relief from royalty The valuer needs to know: (1) royalty rate, trade marks approach expressed as percentage of sales (2) the forecast sales of the intangible (3) the terminal value of an intangible with definite life (4) the cost of capital.

The most difficult item is (1) which requires qualitative and quantitative input from financial and marketing personnel. However, all model inputs are subjective and require experience and judgement in estimation.

Patents Relief from royalty As above, but the patent may have a definite life approach so an assumption is not necessary.

Customer Indirect approach Relevant assets which contribute to the valuation contract of the customer contract include fixed assets, working capital and the brand. A charge is made for the use of these assets against the cash flows generated over the forecast life of each contract.

The residual cashflows after making the charges are then discounted at the appropriate cost of capital.

Internally Cost approach. Forecast costs must be discounted at appropriate generated Considered the only cost of capital. The key issue is sourcing the computer method which can data for costs of development of the software. software approximate the cost of a unique set of software not available in the wider market place.

Note: market method is rarely used as outright sales and purchases of intangible assets are infrequent and details are rarely fully disclosed. There is no assurance that the intangible asset to be valued is the same as that in the market transaction.

© John Wiley and Sons Australia, Ltd 2010

7.10

Solution Manual to accompany Accounting Theory 7e

Case study 7.3: Fair Value Activity: Based on material presented in this article and in the chapter, compare and contrast views about the fair value measurement model and the mixed attribute measurement model.

Full fair value would require all financial instruments to be measured at balance date at fair value. Bankers consider that this would lead to negative consequences. They state that it will lead to volatility (an understatement and overstatement of net assets) and unrealised (or ‘paper’) losses. In addition, opponents claim fair value measurement is misleading and does not provide a faithful representation of an entity’s business model and how it generates earnings. For example, a loan at amortised cost shows the expected cash flows, which are contractual and can be measured reliably. A fair value calculation based on periodic marking to market of the loan can provide less predictive value because expected future cash flows are not represented.

Bankers express a preference for a mixed attribute measurement model, where held-fortrading financial instruments are measured at fair value while other financial instruments (loans, deposits and receivables) are measured at amortised cost.

The standard setters rebut the claims of bankers in relation to fair value. Herz argues that loans are financial instruments and should be covered by any overarching rule adopted for financial instruments. He notes that loans are not always held to maturity; they are often parcelled up in securitisation, which gives them a short term nature. David Tweedie (Chairman, IASB) argues that fair value measurement has a disciplining effect on an institution’s lending and investing decisions. He points to the example of Japanese banks in the 1990s when stating that historical cost accounting for financial instruments can delude investors that all is well. For derivatives, cost is often zero, making historical cost measurement irrelevant. Tweedie also notes that much of the ‘pain’ attributed to fair value accounting in the 2008-2009 financial crisis would still have been reported under historical cost accounting, because impairment principles, which are fundamental in the mixed attribute model, would have led to asset write downs.

Investors favour more fair value measurement, stating that, in their view, fair value improves transparency and assists risk assessment. This is in spite of the fact that fair value measurement can involve subjective management assessments of value. Nevertheless, some analysts favour full fair value and argue that the mixed attribute model is a burden. The CFA Institute (an organisation representing analysts) argues that fair values are useful for calculating whether loans will be repaid “because they are likely to reflect the most up to date assessments of that probability”. The CFA Institute argues that the mixed attribute model unduly burdens investors that rely on fair values to make decisions. Such investors rely on disclosures about fair values which may vary in quality.

© John Wiley and Sons Australia, Ltd 2010

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Chapter7: Assets

Formatted: Justified

Arguments in favour of fair value: The use of fair value provides relevant information for decision making. The use of historical cost for items such as financial instruments is misleading and potentially dangerous as it underestimates the risk of instruments. See for example the collapse of Australian miner, Sons of Gwalia, in 2005. Losses on hedge contracts were not recognised in the financial statements, making the financial statements misleading.

Standard setters argue that assets and liabilities should be carried in the balance sheet at fair value to provide relevant information for decision making. Fair value can be determined in exchange or by referring to the existing value of a comparable item in the market place. FAS 157 provides guidance on how to calculate fair value.

Arguments against the use of fair value: Fair values are not available for all assets. In some cases, fair values have to be estimated.

Therefore they are costly to obtain and are subjective. In the case of some financial instruments standard setters require the use of mathematical models to calculate the hypothetical market price.

Fair values may be misleading when they are based on estimation. Fair values may be subject to intentional and unintentional measurement error. Valuations are sensitive to the assumptions underpinning the models which may be wrong or may be manipulated in line with management incentives (see for example pricing of stock options).

Small changes in the assumptions and predictions used in the models can change the value of an item. Costs and gains shown in the income statements could vary widely, depending on the assumptions in the model. The fluctuations as a result of ‘mark to model’ may bear little or no relation to cash flows. Thus some fair value measurements are subjective, raising questions about their reliability and usefulness.

Fair value remeasurements introduce volatility into the accounts, which may influence investors’ views. Preparers may be concerned that the volatility is hard for investors to understand. Some preparers argue that fair value measurement requires firms to follow rules which do not reflect a firm’s economic view of the asset. Thus financial reporting and management reporting do not correspond. For example, IAS 39 requires that an available-forsale security be marked to market, but the firm may intend to hold the security indefinitely and not trade it in the current market, making current market value irrelevant (according to the managers’ perspective).

© John Wiley and Sons Australia, Ltd 2010

7.12

Solution Manual to accompany Accounting Theory 7e

QUESTIONS 1.

What attributes must something possess in order to be defined as an asset? Why? For something to be defined as an asset, it must possess the following attributes: ▪ future economic benefits or services will flow to the entity from it ▪ it must be controlled by the entity ▪ it must be the result of a past transaction or event.

These attributes ensure that whatever is defined as an asset is of economic value to the entity and is an asset of the entity itself rather than some other organisation that controls it.

2.

The Framework defines assets, liabilities and equity by reference to economic benefits. (a) What are the economic benefits that would be assets for AlexCorp, a government business enterprise that constructs the physical infrastructure (roads, bridges, etc.) for the city of Huntersville? (b) Must economic benefits be revenue-generating, or can parks, roads or statues provide economic benefits? (a)

An economic benefit is ‘scarce’ and has ‘utility’. Utility pertains to the future economic benefits or services. Because the resource is scarce and has future benefits, it has economic value in generating future cash flows (including reducing future cash outflows). AlexCorp — a government business enterprise constructing physical infrastructure for the city of Huntersville — would have assets comprising productivity resources to build the infrastructure (that is, equipment) and claims to receive money associated with contracts and money. If AlexCorp retains ownership of the infrastructure assets and they are leased to the city of Huntersville, the infrastructure assets provide economic resources to AlexCorp (that is, lease receipts) and constitute assets.

(b)

Examples of economic benefits include: 1. Cash inflows from sales of products produced by an entity using resources such as raw materials, equipment, patents, or contractual rights to the use of resources of other entities 2. money 3. claims to receive money 4. ownership interests in other enterprises.

Monuments, parks and/or roads provide service potential to the authorities providing and maintaining them because they enable those authorities to pursue their objectives. To the extent that the monuments, parks, and/or roads generate inflows (e.g. indirectly from increased rates or donations, etc.) or reduce outflows © John Wiley and Sons Australia, Ltd 2010

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Chapter7: Assets

of cash, (e.g. because other community resources do not need to be acquired in their stead) they contribute economic benefits.

© John Wiley and Sons Australia, Ltd 2010

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Solution Manual to accompany Accounting Theory 7e

3.

The Framework definition of assets requires future economic benefits to be controlled by an entity before they can be regarded as an asset. How does ownership differ from control? Which criterion (ownership or control) do you think should be applied in defining assets? Why? The term ‘ownership’ means different things to different people. Ownership is usually associated with legal ownership or entitlement. For accounting purposes, the criterion to meet the asset definition is that the entity controls the future economic benefits. The term ‘control’ is associated with the right to regulate access to, and use of, the future economic benefits. This implies that the entity has a legal or moral/equitable right to receive the benefits. For example, for an operating lease, the lessee does not legally ‘own’ the asset, but it does have the legal right to receive the benefits or services of the asset.

Students should debate whether legal ownership or control is the preferable criterion.

All sensible arguments should be entertained, but in the final analysis, what ‘should’ be done depends upon the opinions and assumptions of those developing the theory of accounting to be applied.

4.

According to the Framework, assets do not exist unless they result from past transactions or events. Determining whether a past transaction or event has occurred to give rise to an asset is not always straightforward. Explain the past transaction or event that triggers the existence of the following assets: (a) accounts receivable (b) prepaid insurance (c) inventory of work-in-process (d) inventory of raw materials (e) finance lease of manufacturing plant (f) goodwill (internally generated or purchased). (a) (b) (c) (d) (e) (f)

accounts receivable — sale of the product or service prepaid insurance — purchase of the insurance policy inventory of work-in-process — production activity inventory of raw materials — purchase of the inventory finance lease of manufacturing equipment — the signing of the lease agreement; or if the equipment is to be constructed, when the construction is completed goodwill — the purchase of a company (purchased goodwill); the activity/activities generating reputation (internally generated goodwill, which is not recognised, anyway).

Instructors might discuss the ‘reasonableness’ of the accepted past transaction or event for each of the assets mentioned above. For example, the relevant event for inventory could be the physical receipt of the inventory, especially because the timing of order, invoicing, receipt and payment, can vary in order and separation. It is also worth mentioning that the presence of an asset does not necessarily imply that the asset will be recognised in the financial statements (e.g. internally generated goodwill).

© John Wiley and Sons Australia, Ltd 2010

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Chapter7: Assets

5.

What is an agreement equally proportionately unperformed (AEPU)? According to strict interpretations of the Framework definitions of assets, liabilities and equity, should AEPUs be reported on the statement of financial position? Why or why not?

Wholly executory contracts (agreements equally proportionately unperformed, or AEPUs) are not recorded because they involve only an exchange of promises. There is no performance yet to give ‘economic substance’ to the contract. That is to say, the signing of the contract is not regarded as the relevant past transaction or event to give rise to an asset or liability. Yet they are in question (4) above. The instructor may wish to discuss the reasons why. For a financial lease, there is a transfer of the asset to the lessee for his or her use. For a forward exchange contract, the contract may be sold and therefore the contract itself has value. In both cases, as far as accountants are concerned, something of value has been exchanged, not just promises.

Most wholly executory contracts would be recorded by firms complying with the Framework, because the statement requires the recognition of both the asset and liability involved in such contracts. In practice many AEPUs are not recognised.

Proposals to recognise AEPUs in Australia under SAC4 were vigorously opposed by preparer groups certain AEPUs were excluded from its scope.

6.

Under some market-based systems of accounting, asset definitions require that to be defined as an asset, an economic benefit must be both ‘severable and saleable’, sometimes described as ‘exchangeability’. Is that a requirement in the Framework definition of assets? Why or why not? Do you think that severability is necessary to a definition of assets? Why or why not?

Those who favour exchangeability believe an asset should be ‘separable’, and have value of its own. They argue that the entity should be able to sell it, and an asset should be capable of separate identification in order that it can be measured (valued). Such a condition would exclude certain intangible assets (such as goodwill) and deferred charges (such as deferred income taxes) from assets. Using this approach, the purpose of financial accounting and of the statement of financial position is to report the value (cost) of a firm’s assets, not to report the value of the business as a whole. To value a business involves predicting its future earnings (or net cash flows) and is a function of the combination of resources rather than individual items.

Those who oppose exchangeability as a necessary feature of assets believe that this unduly emphasises a single way (exchange) of obtaining benefits from assets, and depends on a misguided view of ‘economic value’. They argue that value is only through their use rather than exchange. Assets are used jointly, and therefore in most cases their benefits cannot be precisely identified. There is no reason to believe that the contributions of certain intangible assets are proportionately less than tangible assets, or that they are less because there is no market to sell them separately. Because benefits received from using resources are unaffected by whether or not they are exchangeable, the condition of exchangeability is irrelevant in deciding whether an item is an asset.

Economic value depends on scarcity and utility, not exchangeability.

© John Wiley and Sons Australia, Ltd 2010

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Solution Manual to accompany Accounting Theory 7e

To include as assets certain intangibles, such as goodwill, is not an attempt to value the firm as a whole, but an attempt to include in total assets the future benefits obtainable by the firm as a result of past transactions or events.

The Framework does not regard exchangeability as a criterion to apply in defining an asset. It recognises that if something is exchangeable for something else of value, then it has future economic benefit and is presumably an asset. However, it recognises that some assets may not be exchangeable. For example, roads and monuments may be unsaleable, but they have service potential for the organisation controlling them and are therefore assets under the Framework.

7.

Are the following assets? If so, whose assets, and why? (a) Members of the Australian hockey team (b) A 9-month lease agreement to rent a business office (c) Expenditure on research and development (d) An unsigned, documented contractual agreement to build specialised equipment for a client (e) A building bequeathed to a firm (f) A 5-year option to acquire property, where the option was purchased by the company a year ago (a)

Human resources arguably meet the definition of assets of the Australian government, or the Australian Institute of Sport (depending upon whether it is accepted that they can be controlled to act in the interests of the reporting entity).

However, even if they are regarded as meeting the definition, because of the difficulty of placing a value on them they are not recognised. (A question to debate in class is: If the team is on a losing streak, are the players still assets? As long as they generate future economic benefits, they remain assets whose measurement and probability may not warrant capitalisation as assets.)

(b)

Operating lease. For the lessee (tenant), the future benefits that he or she has control over are the benefits under a contract specifying the rights to benefits, e.g. the right to use a motor vehicle for a month. According to AASB 117, there is no intent by the lessor to transfer substantially all ownership benefits and risks to the lessee. Nonetheless, once a contract is in place there is a right to control the inflow of economic benefits, and an obligation to pay for them. As such, both an asset and a liability do exist under the Framework definitions.

(c)

Research and development. AASB 138 does not allow intangible assets arising from research phase to be recognised by the firm paying for the R&D, as the existence of intangible assets that will generate future economic benefits cannot be demonstrated. AASB 138 only allows intangible assets arising from development to be recognised if the technical feasibility of the product or process that they relate to has been demonstrated, and there is a clear indication of a future market for the product; or if the item is to be used internally, its usefulness can be demonstrated. Students should debate whether the R&D is controllable by an organisation and gives rise to economic benefits. An important question to ask in this debate is why an organisation would undertake R&D if it did not give rise to future economic benefits under the control of the entity?

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Chapter7: Assets

(d)

An unsigned contract. There is no basis for believing future economic benefits exist. Because the contract has not been signed, it is possible that the buyer (client) may get out of the contract. The law does not recognise a sale for custommade goods unless performance has begun. In this case, the contract for performance has not even been signed. There is no asset.

(e)

Bequest. An asset does not need to have a cost. The land is now under the control of the company, it has future benefits, and it arose from a past transaction (the donation) — therefore, by definition it is an asset. The company should record it at fair market value.

(f)

Option. At the time the option is purchased, it should be considered an asset of the holder. It gives the company the right to purchase the building and therefore has future benefit. If the building is actually purchased, whether the option should be considered part of the cost of the building is another issue. It can be argued that the option was purchased as part of an integrated plan to acquire an appropriate building, and therefore it is part of the cost of the building. On the other hand, does the purchase of the option make the building more valuable than the actual bargained price of the building? If the option lapses, it should be expensed.

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7.18

Solution Manual to accompany Accounting Theory 7e

PROBLEMS Problem 7.1 1.

This problem demonstrates the difficulty of determining whether an asset or liability exists. There is an asset if the realisation of the tax benefits will occur because of future income. AASB 112 and the Framework are relevant. The reason for the loss can be identified as an isolated incident. The firm has been continuously profitable over a long period of time, and assuming that it is more probable than not there will be sufficient taxable income in the future that the benefit will be realised, and an asset can be recorded.

Deferred tax asset Income tax benefit from loss carry forward

$144 000 $144 000

2.

No entry should be made since there is no performance.

3.

The Framework is pertinent. At this point, there is insufficient evidence to say that it is ‘probable’ a liability has been incurred. There is no entry to record. Footnote only.

4.

Is there a liability? Su Lamp Ltd plans to appeal, and there is a possibility the decision could be reversed. However, there is presently an obligation as a result of past events, the payment is probable, and the amount is reliably determinable. As such, there is sufficient evidence to say it is ‘probable’ a liability has been incurred, and the amount can be reasonably estimated.

Loss from lawsuit Lawsuit liability

$400 000 $400 000

On the other hand, if the outcome of the appeal is favourable with more than 50% probability, then a liability should not be reported, although a contingency should be disclosed. Overall, the decision must be made exercising prudence, a concept under the Framework, whereby caution is exercised to ensure that assets are not overstated or liabilities understated.

5.

No entry is to be made. The contract has only been signed. The fact that the contract is with the city hall and is a cost-plus contract makes no difference. Some performance needs to occur before there is an actual obligation under the contract.

6.

A liability does not have to be a ‘legal’ liability. Firm policy can be the basis of an obligation. The bonus is based on past services rendered by the sales manager, and therefore an expense should be accrued.

Salaries and wages expense Salaries and wages payable

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$15 000 $15 000

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Chapter7: Assets

Problem 7.2 1.

Internally generated R&D is to be expensed under AIFRS. Research and development expense Cash or Accounts payable

2.

$250 000 $250 000

This is a 100% purchase of Austin Power Ltd. Austin Power Ltd will be merged with Zanadriana Ltd, and therefore Zanadriana Ltd absorbs the former’s assets and liabilities. Because the transaction is a ‘purchase’, there is a new basis of accountability.

Current assets Land and buildings Goodwill Liabilities Cash

$ 140 000 1 700 000 310 000 $ 150 000 2 000 000

It should be noted that goodwill is recorded. The accounting principle is that it can only be recorded when it is paid for. It may be interesting to discuss why. One reason is the cost principle. Another is the problem of measurability. It is difficult to know what the value of goodwill is until there is an actual transaction.

3.

Cost of purchase Market value of net assets acquired Excess of market value over cost

$1 900 000 1 990 000 $ 90 000

According to AASB 3 Business Combinations, paragraph 56, if the acquirer’s interest in the net fair value of the recognised identifiable assets, liabilities and contingent liabilities exceeds the cost of the business combination, the acquirer shall: (a) reassess the identification and measurement of the acquiree’s identifiable assets, liabilities and contingent liabilities and the measurement of the cost of the combination; and (b) recognise immediately in profit or loss any excess remaining after that reassessment.

As such, the assets and liabilities should be recognised at their fair values, and $90 000 written off, immediately, as an expense.

4.

The secret formula appears to meet the definition of an asset. But it will not be recorded, unless (a) a patent is taken out, and (b) a reliable measure can be obtained.

This is because it was not purchased and the research and development costs have been expensed. A reliable measure needs to be obtained, and control ascertained.

5.

According to AASB 117, this is a capital lease if there is a transfer of the rights and obligations of ownership, otherwise it is an operating lease. It is not possible to tell from the information given whether the lease is operating or capital, because the life of the machinery is not given, nor is the normal price of the machinery. Thus, it is impossible to tell whether the machinery can be acquired at a bargain purchase price at

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Solution Manual to accompany Accounting Theory 7e

the end of three years, or whether the machinery is leased for a significant portion of its useful economic life.

If the machine is leased under an operating lease: Lease expense Cash

$50 000 $50 000

If the machine is leased under a capital lease: Leasehold asset (PV of $50 000 @ (12√1.08)% for 35 periods + $50 000 + PV of 5 y3a4 annuity of $3000 per month or $40 000, whichever yields the lower amount) Lease liability (PV of $50 000 @ (12√1.08)% for 35 periods + $50 000 + PV of 5 y3a4 annuity of $3000 per month or $40 000, whichever yields the lower amount) Note that the tables at the back of the text do not offer the appropriate monthly compound interest rate to yield an 8% annual return, which is assumed at the start of this problem.

6.

The executives obviously represent future economic benefits to the firm. However, the economic benefits to be derived are difficult, if not impossible to measure. Despite the contracts being in place, the firm does not control the executives in a total sense, and when the services are received by the firm an expense will be recorded. Unless the salaries are prepaid, there is no asset to record.

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Chapter7: Assets

Problem 7.3 1.

At the time that Kalmers & Meehan provided taxation advice to Steph’s Tennis World Ltd, Kalmers & Meehan would have deemed it probable that there would be an inflow of $70 000 for taxation advice. As such, there was a probable inflow of economic benefits as a result of a past transaction (taxation advice provision), and revenue would have been recognised. It is only now that the firm realises that the inflow is unlikely. As such, there is a reduction in probable future economic benefits as a consequence of the debate about the appropriateness of the advice offered by Kalmers & Meehan (this is the past event, along with Steph’s Tennis World Ltd’s refusal to pay). The firm should recognise a reduction in the revenue receivable asset, and recognise an expense (doubtful debts) to offset against the previously recognised revenue. Possibly, the expense should be bad debts rather than doubtful: When advice was provided and it appeared probable that Steph’s Tennis World Ltd would pay: Dr Accounts receivable 70 000 Cr Taxation advice revenue 70 000

30 June 2005

Dr Cr 2.

Doubtful debts expense Accounts receivable

70 000 70000

The fact that Ranch Vineyards Ltd has not yet delivered the wine does not mean that it is unlikely that the firm will do so. If Kalmers & Meehan deem it probable that the wine will be delivered, they have an asset in the future economic benefits: the wine can either be used within the firm, or sold. Furthermore, it is measurable. If it is deemed probable that the wine will be delivered, the asset and associated revenue should be recorded.

When advice was provided and it appeared probable that Ranch Vineyards Ltd would pay (whether in money or in wine): Dr Cr

Accounts receivable Taxation advice revenue

5000 5000

The fact that the accounts are being prepared six weeks after the invoicing and the wine has not been received is not necessarily unusual, and should not necessarily trigger doubts about receiving the wine. However, it if is deemed improbable that the wine will be delivered, then no revenue or asset should be recorded. If they have already been recorded, they should be written-down or written-off, in the same manner as the entries recorded for part 1 of this problem (Steph’s Tennis World Ltd).

3.

The fact that Kalmers & Meehan was prepared to pay the cost of a walkway indicates that the firm deems it likely that the walkway will increase revenues (perhaps because it provides a more sophisticated/successful image). As such, it would be deemed an asset.

Dr Cr

Land & buildings Bank/Loan payable/…

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3000 3000

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Solution Manual to accompany Accounting Theory 7e

Problem 7.4 The purpose of this problem is to discuss what constitutes a liability, and when it is recorded.

Given historical trends, it is likely that there should be a liability recorded for probable future outflows of economic benefits related to labour, parts, etc. As such, option (a) below is the preferable answer. Option (b) is shown for comparative purposes only. (a)

Accrual method entries for 2009 year: Warranty expense Estimated liability on product warranty

$500 000

Estimated liability on product warranty Cash, Parts inventory etc.

$800 000

$500 000

$800 000

For ease of accounting, each year a warranty liability is increased for the probable warranty expenses based on the period’s sales. This liability is reduced as costs are incurred so that the balance should always be somewhere close to the expected cost of warranty repairs for the last two years’ worth of sales. There is no point reversing the warranty expense entry each year and starting afresh if warranty expense estimates are reasonably accurate.

(b)

Cash-basis method for 2009: During year

Warranty expense Cash, Parts inventory, etc.

$800 000 $800 000

The cash basis can be used if the amount of the warranty cost is not material, or the two criteria mentioned in the Framework — probability of incurrence of a liability and ability to estimate the amount — are not met. In this case, the firm should be using the accrual method. At least to a limited degree, both methods are acceptable. The question is: Why does one method yield a liability, and for the other, there is none? The circumstances of giving customers a warranty are substantially the same, so that the condition of the Framework should be met. If there is a liability, then only the accrual method should be used, and the cash method should be declared unacceptable.

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Chapter7: Assets

Problem 7.5 1.

As of the balance sheet date, there is no particular event to cause the firm to believe that an asset has been impaired or a liability has been incurred. Expected losses, even if subject to reasonable estimation, do not satisfy the requirements of AASB 137. The firm may record an appropriation for self-insurance.

Retained earnings $500 000 Retained earnings appropriation – self-insurance

$500 000

When the loss actually occurs, then the following entry is to be made: Loss from casualty Asset (specific asset damaged)

x x

The appropriation should not be debited for the actual loss.

2.

Salary expense (bonus) Paid up capital

$500 000 $500 000

3.

Labour strikes are considered a general risk contingency inherent in business operations. Although negotiations have terminated at present, they will probably continue at a later date. The threats and bluster of labour negotiations are common. No entry should be recorded. Disclosure is not necessary in the balance sheet.

4.

It is probable that a liability has been incurred, and the amount is reasonably determinable. The firm knows the cause of the demand for refund (for example, overcharging of items). Therefore, the following entry should be made.

Loss from Danlon & Dolland contract Liability on Danlon & Dolland Contract

5.

$75 000 $75 000

There is sufficient evidence of impairment of asset values at the balance sheet date, because the foreign government has actually given notice of intent to expropriate. The amount is subject to reasonable estimation. Therefore, according to the Framework, a loss should be recorded. At the time of actual expropriation, the specific assets would be written against the allowance for expropriation account.

Book value of subsidiary Expected amount from government Loss Loss from expropriation Allowance for expropriation

$12 900 000 9 000 000 $ 3 900 000 $03 900 000

© John Wiley and Sons Australia, Ltd 2010

$3 900 000

7.24

Solutions Manual to accompany

Accounting Theory 7e by

Ann Tarca

Chapter

Chapter 8 Liabilities and owners’ equity

John Wiley & Sons Australia, Ltd 2010

Chapter 8: Liabilities and owners’ equity

THEORY IN ACTION Theory in Action 8.1 Entity vs Proprietorship Perspective 1.

Explain the ways in which Barclays Bank has increased its equity in the past year. Why is raising more equity important in the 2007-2008 economic conditions?

The bank conducted a capital raising with investors from the Middle East, that is, it issued new shares in return for cash. The issue of new shares increases equity. In addition, the investment banking business of Barclays acquired the US assets of Lehman Bros. The acquisition generated revenue, which flows through to retained profits and thus increases equity.

The bank sought to increase equity as a result of the 2007-2008 global financial crisis.

In the crisis, liquidity dried up as banks stopped lending. In the period prior to the crisis banks had extended credit to risky parties and with the financial collapse, some of these loans were written off by banks thus depleting equity. Reduced equity meant that banks could not advance loans until equity was built up again. Banks breached their capital adequacy requirements i.e. the amount of capital to be held compared to loans made, according to banking regulatory requirements.

2.

Describe the process by which the sale of its funds subsidiary iShares could ‘boost capital reserves further’?

Barclays has a listed subsidiary iShares. If the company sells its interest at a profit the journal entry would be: DR Cash CR Gain on sale CR Investment in iShares The gain on sale flows through the income statement. It increases net profit which then increases retained profit which forms part of share capital and reserves. Thus the sale of iShares can be said to boost ‘capital reserves’ or the owners’ equity interest.

3.

Does the writer of the article take an entity view or proprietorship view of Barclays Bank?

The writer seems to take an entity perspective in relation to the bank. Several statements refer to the bank as an entity separate from shareholders (e.g. the bank has sufficient capital; the bank is boosting its reserves). The bank’s investment banking business is described as purchasing Lehman Bros, rather than describing the transaction as the existing shareholders making an investment.

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8.2

Solution Manual to accompany Accounting Theory 7e

4.

Could the proprietorship perspective apply to Barclays Bank if the UK government took an ownership (equity) interest in the bank, as occurred at Royal Bank of Scotland?

The proprietorship perspective could apply if the government took an ownership interest in the bank.

(Background: Following on from the sub-prime crisis in the USA in 2007 and the more general global financial crisis in 2008, many financial institutions were affected by bad debts, leading to large losses, an erosion of equity and consequently reduced lending by banks and a freezing of liquidity in capital markets. In some cases, governments intervened to inject capital into banks and to provide funds for borrowers. In 2008 the UK government acquired an 80% ownership interest in the Royal Bank of Scotland).

In Q3 we saw that the writer described the bank from an entity perspective, where the entity is separate from its owners and the accounting is conducted from the point of view of the entity. If the UK government had a majority ownership stake in Barclays, the proprietorship perspective would become relevant. The Government would be interested in the value of its investment, represented by the proprietorship of the company. If the Government influenced operating decisions of the bank through its majority stake, for example by appointing directors, then there is further evidence that the proprietorship perspective applies, because the bank’s assets (less liabilities) belong to the proprietor (in this case the Government) and the income generated by the business also belongs to the Government as the major shareholder.

© John Wiley and Sons Australia, Ltd 2010

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Chapter 8: Liabilities and owners’ equity

Theory in Action 8.2 New public-private flexibility 1.

Describe what is represented by a public-private partnership project (PPP)?

A public private partnership represents a contractual arrangement between a government controlled or funded entity (a government department, instrumentality, agency or government business enterprise) and a company (a private or public company, i.e. a company in which individuals, companies, funds or the general public own shares, not the government). The parties enter into a contract for the construction and/or operation of a public-use asset. For example, a prison could be built using a public private partnership. The government and company may jointly obtain the finance for construction, which is undertaken by a private sector agency. The asset may subsequently be operated by the private sector company, on behalf of the government. The project may benefit from government access to lower cost finance (based on the government’s credit rating; the government is likely to be considered lower risk than most private companies). It also benefits from the skills, expertise and efficiencies that the private sector company can bring to the project. However, PPPs may present some specific problems in relation to legal complexity, accounting, governance and management which can affect their success.

2.

What is meant by the phrase ‘Off-balance sheet’ liabilities?

‘Off-balance sheet’ liabilities refers to liabilities which exist for the entity but are not shown on the balance sheet. That is, the liabilities meet definition and recognition criteria of the IASB Framework (i.e. a present obligation to an external party for outflow of economic benefits in the future, which is probable and can be measured reliably) but because of current accounting practices and standards, entities are permitted to not recognise the liabilities. Leases are a classic example. Leases may involve lease liabilities which should be recorded on the balance sheet, but IAS 17 allows companies to classify leases as operating and to not recognise a liability on the balance sheet.

3.

Why did the government favour public-private partnerships (PPP) which allowed debt to be off-balance sheet?

The incentives for a government body to have liabilities ‘off-balance sheet’ are similar to those for a company. If the liability is not shown on the balance sheet, total reported debt is lower. Liquidity ratios are higher and debt (leverage) ratios lower.

The entity can access more capital and at a lower price because the entity’s risk appears relatively lower than it actually is. The article states that governments chose the ‘off-balance sheet’ model so as to report lower borrowing State Government borrowing levels and to support credit ratings (i.e. to ensure that credit rating are at the highest possible level).

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8.4

Solution Manual to accompany Accounting Theory 7e

4.

Explain the reasons in favour of recording economic infrastructure PPP projects on government balance sheets.

The article states that following adoption of IFRS, some government bodies reclassified PPPs as finance leases and then recorded the lease asset and liability on balance sheet. The benefit of recording assets and liabilities on balance sheet is to improve transparency and improve the information available to assess the position and performance of the government entity. Better information is provided when liabilities are on balance sheet. Stewardship can be better assessed and cash flow predictions may be better. Information available for decision making is of higher quality when liabilities are accurately recognised, potentially leading to better decision making by a range of stakeholders.

PPEs are by their nature complex. To determine whether the PPE is successful, reporting should be transparent to allow users to determine the costs and benefit of the contracts. The basis of accounting decisions should be disclosed (i.e. areas of estimation and judgment) to ensure information users are informed.

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8.5

Chapter 8: Liabilities and owners’ equity

Theory in Action 8.3 Contingent Liabilities

1.

Name the parties listed in the note that are taking legal action against the PTA. State the matters or matters under dispute and the amount of the claim if provided.

Parties bringing legal action 1. Leighton Contractors

2. John Holland Ltd

3. RailLink Joint Venture

4. Leighton Contractors

2.

Matter under dispute Rise and fall provisions and contaminated material provisions Relates to construction of three stations on the Southern Suburbs Railway Relates to civil, rail and structures portion of the Southern Suburbs Railway Misleading and deceptive conduct in relation to contracts work insurance

Amount of claim $64 million

$6.89 million

$2.62 million

Not stated

To what extent has the PTA incurred losses of economic benefits in relation to these matters?

All the matters are under dispute. The PTA states in the note that it denies all liability (items 1 and 4) and that it is defending the claims (items 1 - 4). At the time of the annual report, losses of future economic benefits have not occurred but there is a possibility that they may occur in the future. For this reason, the PTA provides information about the legal claims in progress.

The claims are contingent liabilities because they meet the definition provided in IAS 37 (preface) which defines a contingent liability as: (a) a possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity; or (b) a present obligation that arises from past events but is not recognised because: (i) it is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation; or (ii) the amount of the obligation cannot be measured with sufficient reliability.

The items disclosed in PTA’s note fit this definition. They relate to past events, but a liability will only come into existence if an event occurs, namely judgment against PTA. © John Wiley and Sons Australia, Ltd 2010

8.6

Solution Manual to accompany Accounting Theory 7e

3.

“Contingent liabilities are not liabilities of an entity; in fact, they may never eventuate so their disclosure is misleading.” Explain whether you agree or disagree with this statement and provide reasons for your view.

The statement is correct when it states that contingent liabilities are not liabilities.

They are not liabilities because they do not meet the Framework definition and recognition criteria. In relation to these pending legal cases, there is no present obligation to an external party because the decision about the case has not been reached. When the case is decided, a liability may come into existence, if the decision is against PTA. The disclosure of contingent liabilities should not be misleading. The Framework assumes that users have “a reasonable knowledge of business and economic activities and accounting and a willingness to study the information with reasonable diligence” (para 25). Therefore, users should be able to interpret the word contingent and the associated disclosures.

It is true that contingent liabilities may never eventuate. Nevertheless, they may do so. The fact that they may eventuate means that they are of interest to users of financial reports. Without information about contingent liabilities, users may be misled about the future position and performance of the entity.

4.

The PTA is a government business enterprise, with one shareholder, the Western Australian State Government. Discuss whether disclosure of contingent liabilities is less relevant for the PTA than for a publicly listed company with widely held shares.

The PTA may have only one shareholder but it has many stakeholders. These include employees, lenders, creditors and members of the public, which includes taxpayers who provide finance to the entity. All these parties have interests in the future position and performance of the entity and therefore need to be informed about contingent liabilities. These parties cannot obtain information directly from the entity and are therefore dependent on public information. The Framework explicitly states (para 9) that there are many users of financial information other than shareholders. Therefore, one cannot claim that disclosure is less important for a government business enterprise than a listed company with widely held shares.

© John Wiley and Sons Australia, Ltd 2010

8.7

Chapter 8: Liabilities and owners’ equity

Theory in Action 8.4: Hybrid Securities 1.

Outline the debt and equity situation of Orica at the time of the purchase of Dyno Nobel in 2005.

Orica had already used debt to fund acquisitions and investments. It required funding for the Dyno Nobel acquisition but it also wanted to protect its BBB+ credit rating, which could have been put at risk through more borrowing.

Orica had raised $500 million in equity through a rights issue. Issuing more equity would have been costly and reduced its earnings per share, a key performance metric used by analysts. In addition, equity finance is considered the most expensive form of finance and therefore the least attractive.

2.

Describe the features of Step-Up Preference Securities (SPS) created by the company.

Step-Up Preference Securities (SPS) are hybrid securities with specific features.

Payments to investors are discretionary but can only be suspended if all dividend payments are suspended. The securities are perpetual, but they can be redeemed by Orica at the end of 5 years. If the securities are not redeemed, the interest rate will increase by an additional 2.5 per cent.

3.

Explain how the securities can be considered as equity for accounting purposes but as debt by investors?

The article states that SPS were treated as equity for accounting purposes but were treated as subordinated debt by investors. The article states that the securities can be considered ‘intermediate equity’, that is, in some middle ground between equity and debt.

The Framework definition of equity is “the residual interest in the assets of the entity after deducting all its liabilities” (paragraph 49(c)). Therefore to classify the SPS as equity, the company had to demonstrate that the securities did not meet the definition and recognition criteria of a liability. A key feature of the SPS is that payments to holders are discretionary, meaning that the company does not have a present obligation to sacrifice future economic benefits. In addition, the company is not obligated to repay the holders. Therefore the company could classify the securities as equity. Their issue does not increase debt and therefore has no impact on credit ratings. Because of the features of the issue, the interest rate was 6.98% only marginally more than 6.25% that BBB+ rated corporates were paying at the time, hence the company described the securities as ‘cheap equity rather than expensive debt’.

However, the securities had restrictive features which made them attractive to lenders.

First, lenders will receive payments unless dividends are suspended, which the lenders may view as unlikely. So while payments are not guaranteed, lenders are confident they will receive them. Second, lenders are not guaranteed that repayment of principal will be made in five years, but if it is not, they will receive additional repayments (the interest rate payable increases by 2.25%). © John Wiley and Sons Australia, Ltd 2010

8.8

Solution Manual to accompany Accounting Theory 7e

CASE STUDIES Case Study 8.1 Disclosure of Environmental Liability 1.

The article states that the US standard setter FASB requires companies to record provision in relation to environmental costs of retiring an asset (‘to reserve environmental liabilities’) if its fair value could be reasonably estimated. How do you think companies would go about estimating such a provision?

To estimate a provision for the cost of retiring an asset the company would engage suitably qualified personnel (e.g. environmental engineers, builders) to estimate the cost of removing and disposing the materials of which the asset was constructed. Next they would estimate the costs involved in restoring the land on which the asset was based. The date that the costs are expected to be incurred would be determined. Cost accountants would work with these predicted future expenses to estimate the present value of the outflows and to arrive at the amount of the provision to be recognised in the accounts.

2.

What aspects of the requirements were used by US companies to defer recognition of a liability? Why would companies want to do this?

The US requirement stated that a provision was to be recorded in the accounts if its amount could be reliably estimated. Some companies responded by stating that they could not reliably estimate costs and therefore they avoided recognition of the provision.

A reduction in profit and an increase in liabilities which result from recognising a provision may not be viewed favourably by managers because of the impact on share price, financial ratios and remuneration. Students should consider the incentives at play behind decisions to record (recognise) an item in the accounts or to disclose information.

3.

In what ways does the recognition of the liability in relation to future restoration activity affect (a) net profit and cash flow in the current year and future years; and (b) liabilities in the current and future years?

A provision for restoration involves the following journal entry to initially raise the provision: Year 1 DR Restoration expense Year 1 CR Provision for restoration.

It reduces profit (by creating a restoration expense) but not cash flow in the year it is recorded. It increases liabilities in the year it is recorded. In the future when the liability is settled, the following journal entry is recorded Year x DR Provision for restoration © John Wiley and Sons Australia, Ltd 2010

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Chapter 8: Liabilities and owners’ equity

Year x CR Cash There is no effect on profit but there is an outflow of cash for the amount of the restoration expense. At this time the liability is reduced. The entries are basic accrual accounting. Students should refer to discussion in the chapter about IAS 37 and the limitations on the use of provisions.

4.

The article refers to changes in disclosure requirements relating to environmental liabilities in many countries around the world. How important is it that companies recognise the liability? To what extent is disclosure about the liability sufficient?

Ideally, accounting measures transactions and reports information which is useful for decision making. One argument is that as long as information is disclosed, users can factor it into their decision making. That is, disclosure is sufficient for competent users. As long as they are aware of the amount and timing of the expected outflow of future economic benefits they can include it in their models predicting cash flows and profit and make informed decisions. Recognition of the amount in the accounts is not necessary.

However, the counter argument is that less attention is given to note disclosure by users and auditors compared to when items are recognised. Potentially, users could miss the information if it is not recognised in the accounts and they focus on amount recognised in the accounts. One view is that companies may give lower importance to amounts which are disclosed (not recognised). When an amount must be recognised, it has economic consequences which will ensure that managers give close attention to the management of the underlying item. That is, if amounts are included in the accounts, managers will endeavour to make accurate assessments of these amounts.

Remember that accounting is a means of holding managers accountable and recognition of liabilities is a more effective way of doing this than simply disclosing an item. In addition, research shows that auditors apply stricter tests and closer scrutiny to amounts which are recognised compared to those which are disclosed.

© John Wiley and Sons Australia, Ltd 2010

8.10

Solution Manual to accompany Accounting Theory 7e

Case Study 8.2 Post-retirement employee benefits PART A 1.

Compare BT’s pension liabilities and market capitalisation at December 2007. What are the implications of what you observe?

BT has pension liabilities of ₤39 billion, which exceed the market value of the company (at December 2007 ₤18 billion). The implication of these numbers is that the company would be unable to meet the pension commitment if it was required to do so at December 2007. Even if liquidated, the company could not meet its pension commitment, which exceeds the value of the company. Hence, BT has been described as UK’s biggest pension fund which happens to run a telecom business. The point of this comment is that the pension liability could overwhelm the business, which is not a favourable position for a company. The members of the fund are also at risk of not receiving their entitlements.

2.

Should changes in pension assets and liabilities be included in net finance income? Giver reasons for your answer.

The question is whether finance income and finance expense relating to the pension plans are expenses of the business. If we consult the IASB Framework, we can see that these items do represent revenues and expenses of the business because they represent future inflows and outflows of economic benefits which relate to past transactions or events. It is probable that they will occur and we can estimate their amount. While it could be argued that the pension plan is not part of core business operations for the telecom company, the plan is part of daily business operations in the sense that it is part of the employees’ remuneration. Employees would want the net assets of the plan to be recognised by the company to ensure that employees’ interests are protected. Investors would also want to see recognition of assets and liabilities relating to the plan so that future commitments are fully disclosed. If assets and liabilities are recognised in the accounts, then it follows that net income derived from the change in the assets and liabilities should also be recognised.

Poor performance in equity markets since March 2007 means that returns on the pension assets are low. If the loss on plan assets is included in finance income in the 2008 accounts, it is predicted that BT’s pre-tax profit will be ‘wiped out’. These statements show the severity of the problem, which needs to be clearly disclosed to protect the interests of employees and investors. Revealing the problem means that action must be taken to address it. Omitting an amount from the accounts so that they will ‘look better’ does not suggest sound economic management of the business.

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3.

The company has a pension asset/liability mismatch because it holds mainly equities not long-dated bonds in its pension plans (pension asset portfolio).

Explain the risk of this approach.

The company needs long-dated bonds to provide the cash flow to meet its current and ongoing pension commitments, which are a long term commitment. In fact, it needs ₤28 billion of 5% yield bonds just to meet is current pension commitments but it has only ₤8 billion on hand. The collapse of asset prices in equity markets from 2007 means that the company is limited in the extent to which it can sell equity securities to purchase the amount of long-dated bonds needed.

These numbers reveal the riskiness of the company’s position: it must use operating cash flow to meet annual pension commitments as the pension assets do not generate sufficient cash flows to meet obligations. If the company uses operating cash flows to pay pensions then such cash flows are not available to finance the business.

4.

Companies must make assumptions when measuring the value of pension assets and liabilities. Assume you are an investor in BT. What information do you require about the assumptions made by the company?

Measuring the pension assets and liabilities is a complicated process involving market data, price estimations and actuarial assumptions (assumptions made by actuaries about life expectancy of fund members). The company employs suitably qualified experts to provide actuarial assumptions and it also collects other data about actual and estimated market prices for equities and bonds. The superannuation liability relates to an amount to be paid in the future, so estimations of future interest rates and market returns must be made.

An investor would be interested in disclosure of the assumptions made in estimating the liability (e.g. assumptions about future interest rates) because a small change in assumptions can have a large impact on the amount of the liabilities. Investors may be interested in disclosure of a range of estimates (a sensitivity analysis) and information about the likelihood of factors occurring which will cause interest rates to change.

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PART B

1.

What has caused the large increase in unfunded superannuation (pension) liabilities during the period July – December 2008?

During the period July – December 2008 capital markets throughout the world experienced falling share prices as part of the ‘global financial crisis’. Many Australian superannuation funds hold investments in the Australian share market. As the market crashed, the value of these investments declined creating the ‘unfunded’ liability, i.e. the superannuation fund liability was greater than the amount of the superannuation assets held by the fund.

In addition to the value of assets falling, the value of liabilities also increased. During the period July – December 2008 funds were also affected by the decline in interest rates. The 10 year government bond yield fell from 6.5 per cent to 4 per cent.

Therefore present value of the future liability of the superannuation funds increased.

In present value terms, more money is required to settle a future liability when the interest rate is lower because the amount which can be earned over time on investments and used to settle the liability is less.

2.

Should the unfunded superannuation liability be shown on the balance sheets of companies such as Qantas, Telstra, Rio Tinto, Westpac, BlueScope Steel, Amcor and ANZ?

The ‘unfunded liability’ meets the definition and recognition criteria in the IASB Framework. The liability represents a present obligation to an external party i.e. a currently in force legal, moral and equitable obligation of the company to ensure that the superannuation fund has sufficient resources to pay benefits to members. There will be a future outflow of economic benefits (resources used to top up the shortfall in fund assets) which can be measured reliably. Measurements techniques include calculating the fair value of plan assets based on observed market values or estimations of market value and estimating the present value of plan liabilities using present value techniques.

3.

What are the implications for employees of belonging to defined benefit schemes? What are the implications for employers of providing defined benefit schemes?

In a defined benefit fund, employees expect a certain amount for retirement e.g. a specified percentage of final average salary. The amount is not affected by share market movements or earnings on investments, so members do not benefit when share prices or interest rates increase and, equally, they are not adversely affected when they decline.

When they offer a defined benefit fund, employers are committed to providing a specified amount of employment benefits. If the value of investments held in share markets has declined or interest earned on investments is lower, the companies must fund the superannuation fund liability from other sources besides the fund assets.

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4.

Why are defined benefit funds being phased out and replaced by defined contribution schemes?

In defined contribution schemes employees are entitled to receive the amount of contributions (from employee and employer) and the earnings on the contributions.

When markets perform well and assets increase the employees receive the increase in value, but when markets decline and/or the superannuation fund investments lose money, the loss is borne by the fund members (employees) not the employer.

Australian companies favour defined contribution schemes because investment risk is borne by the employees.

© John Wiley and Sons Australia, Ltd 2010

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Solution Manual to accompany Accounting Theory 7e

QUESTIONS 1.

With respect to the proprietary theory: (a) What is the objective of the firm? (b) How important is the concept of ‘stewardship’? (c) What is the relationship between assets/liabilities and the owner? (d) How would you define revenues, expenses, profit? (e) What are three effects on current practice? (f) What are the theory’s limitations? (a)

The firm essentially is the proprietor. The firm is simply the proprietor’s instrument to achieve his or her purpose, which is to increase his or her wealth. Income represents the increase in the wealth of the proprietor in a given period.

(b)

Stewardship is relatively unimportant, because accountability to outside parties is not critical. The proprietor is, in effect, the firm, and therefore is in a privileged position to know what is happening. Liabilities are usually short term, and therefore there is no need to give a continual accounting to creditors.

(c)

The assets are ‘owned’ by the owner, and the liabilities are ‘owed’ by the owner. This shows that there is no separation between the firm and the owner. In the accounting equation, P stands for the net worth of the owner.

A–L=P (d)

Revenue is the increase in proprietorship; expense is the decrease in proprietorship; and profit is the net effect of proprietorship, excluding additional investments and withdrawals by the owner. Revenue and expense accounts are truly subsidiary accounts of P. They have the same algebraic characteristic as ‘net worth’ — increases in net worth are credits and decreases in net worth are debits. The proprietary theory focuses on P in viewing income. Revenues and expenses are caused by the decisions and actions of the proprietor. The profit of the firm belongs to the proprietor and that is why P is affected in the accounting equation.

(e)

The following are examples of the effect of the proprietary theory on accounting practice: • Dividends paid are a distribution of earnings, not an expense; and interest charges are an expense.

• In a sole proprietorship or partnership, salaries to owners who work in the firm are not considered an expense of the business. The reason is that the firm and the owner are not separate entities; they are the same.

• The equity method for long-term investments focuses on the proprietary interest of the investor company in the invested company. © John Wiley and Sons Australia, Ltd 2010

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•

•

• •

•

(f)

2.

The parent company theory for consolidating financial statements views the parent as ‘owning’ the subsidiary. Minority interest is considered an ‘outside’ claim, and logically should therefore be a liability on the consolidated statement of financial position.

The pooling of interests method for business combinations emphasises the uniting (pooling) of the owners’ interests of the two combining companies.

Common terms used reveal the proprietary interests of owners are: book value per share, earnings per share and income to shareholders.

The use of the consumer price index for general price level adjustments shows that the ‘consumer desires’ of owners are considered.

The financial capital view is pertinent to owners.

The proprietary theory does not accord with the realities of the large corporation. The law recognises the corporation as a separate entity, distinct from the owners. The corporation — not the shareholders — owns (controls) the assets, and is liable for the debts. For the large corporation, withdrawals of cash or other assets by shareholders cannot be made without running afoul of the law. This shows that the ownership rights of shareholders are limited. Accountability to shareholders is significant; otherwise, shareholders have no knowledge of the status and operations of the business. The assumptions of the proprietary theory are not relevant to the shareholders of large firms.

With respect to the entity theory: (a) What are the reasons for concentrating on the entity as a unit of accountability rather than the proprietor? (b) What is the objective of accounting? (c) How important is the concept of ‘net worth’? (d) What is the reason for modifying the accounting equation to Assets = Equities? (e) On what side of the equation in (d) would retained profits appear? (f) Why is there a stress on profit determination? (g) How do the concepts of revenues, expenses and profits differ from the proprietary theory? What about interest charges, dividends and income tax? (h) What are three effects on current practice? (a)

Emphasis is on the entity, because in the 20th century the separation of owners from management in the corporate form of business is common.

Shareholders of large corporations have little power to make decisions for the company. The corporation, the entity, has a life of its own. It is therefore more realistic to view the entity as the unit of accountability — that is, to see the accounting process from the point of view of the entity. It is the entity (through its management) that has the power to make decisions that affect the financial status and operations of the business.

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(b)

Stewardship or accountability to equityholders is of primary significance.

The entity needs to account to those who have supplied funds (shareholders and creditors). There are two views of entity theory, but both stress accountability to equityholders. The conventional view emphasises stewardship because equityholders are seen as ‘associates’ in business. The newer view focuses on stewardship because of legal, contractual requirements, and also to maintain good relations with equityholders in the event of the company needing more funds.

(c)

The net worth of the owner is not a meaningful concept, because the owner is not recognised as such but as an equityholder, a provider of funds. Socalled owners are not seen as having the power to make decisions for the firm. The net assets belong to the entity. However, net worth can be a meaningful concept. An argument can be made that the entity needs to know the worth of its net assets for its own purposes.

(d)

The reason is that the entity is the focus of attention, and therefore creditors and owners are seen simply as those who supplied the funds to the entity. Their financial interest in the company is ‘equities’ — claims on the assets. Thus, they are seen as equityholders. Their relationship with the company is a contractual one.

(e)

Paton and Littleton argue that the shareholders have a contractual residual claim on the assets, and it is for this reason that income is placed in the retained earnings account. Shareholders get the leftovers after the creditors have been paid, in the event of liquidation of the company. The newer view of entity theory sees retained earnings as the firm’s equity or investment in itself.

(f)

Profit is stressed for two reasons: • Profit is what equityholders are interested in, because it represents the results of their investment in the company • The firm is in business to make a profit — profit is essential to the

firm’s survival. (g)

Revenue is the inflow of assets (increase in total assets) due to the events undertaken by the firm with regard to its output. Under the proprietary theory, revenue is the increase in proprietorship. Expense is the decrease in assets or increase of liabilities due to the consumption of assets and services by the firm to generate current revenue. Under proprietary theory, expense is the decrease in proprietorship.

For both the entity and proprietary theories, profit is the difference between revenues and expenses. Entity theory, however, emphasises the left side of the accounting equation (assets), whereas the proprietary theory concentrates on the right side (proprietorship). Entity theory focuses on what the entity does, its performance; whereas proprietary theory focuses on the effect on proprietorship.

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For traditional entity theory, interest charges, dividends and income taxes should be distributions of earnings. The theory considers these as payments to the equityholders for the use of their funds. Of course, the government does not provide funds as the others, but provides intangible services (funds?) such as protection from foreign powers. The newer version of entity theory sees interest charges, dividends and income taxes as payments to ‘outsiders’, and therefore they are expenses. (h)

Although conventional accounting theory subscribes to entity theory, the theory has had little effect on actual practice. The reason is that the theory was formulated in the 20th century, and many current practices were devised since the time of the Italian city–states and are based on the proprietary theory. The following show the effect of the entity theory on practice: • The physical capital view is in consonance with the entity theory.

• Salaries to corporate employees who are also shareholders are

expenses, because the company is a separate, distinct entity from the holders.

• In consolidating financial statements, an entity theoretical approach can

be taken. Instead of concentrating on the proprietary interest of the parent (parent company theory), entity theory sees the consolidation from the point of view of the consolidated entity.

• The use of profit and cost centres for internal purposes is based on

entity theory. The centre is seen as an individual entity.

3.

Liabilities are all ‘obligations’ under the Framework definition of liabilities.

What is an obligation, and why does the Framework rely heavily on it in the definition?

A liability is a present obligation to act or perform in a certain way. An obligation is a duty; a responsibility or requirement. It may be legally enforceable in the courts or simply ‘equitable’ or ‘constructive’. The Framework definition emphasises the future sacrifice, but it should be remembered that a liability exists now — it is also a presently existing requirement.

© John Wiley and Sons Australia, Ltd 2010

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4.

If a liability is a present obligation, does that mean that a legally enforceable claim must exist before a liability exists? Explain. Conversely, if a legally enforceable claim exists, does that mean that a liability must exist? Explain.

A liability need not be legally enforceable. According to the Framework for the Preparation and Presentation of Financial Statements, it may be equitable or constructive. Most liabilities are legal liabilities, but company policy of a ‘moral obligation’ may give rise to a recordable liability as long as the intent is to transfer assets or render a service to settle the obligation. Examples are Christmas bonuses that may be accrued if not paid in December, or vacation pay. The past transaction or event is not as clear for non-legal liabilities as for legal liabilities, and thus may be more difficult to recognise. For such liabilities, the future sacrifices cannot be avoided without significant penalty, such as a decrease in employee morale. Interpreting the meaning of significant penalty is a matter of opinion.

A legally enforceable claim need not exist for an asset to exist according to the Framework. Control is the main criterion, not ownership.

On the other hand, if a legally enforceable claim against the entity exists, it is clear that there is a present obligation, and presumably a liability.

5.

Under some countries’ accounting regulations, unrealised foreign exchange gains and losses are not immediately recognised in a firm’s statement of financial performance. Instead, unrealised gains are put into a deferred credit account. Is this a liability? Why or why not?

It is not truly a liability because it does not meet the definition of a liability.

There is no present obligation to sacrifice future economic benefits. To the contrary, there is a potential inflow of future economic benefits (foreign currency asset) or a potential reduction in outflows of future economic benefits.

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6.

Hunter Ltd is attempting to bring its accounts in line with Australian accounting standards and statements of accounting concepts. Advise the accountant of Hunter Ltd whether a liability exists in each of the following cases and, if so, what the liability is: (a) The company is being sued for injuries sustained by an employee who claimed that the workplace steps he fell down were unsafe. The outcome of the lawsuit is highly uncertain. (b) An order for raw materials has been placed with the firm’s regular supplier. (c) There is a signed contract for the construction by Suzanna Ltd of a major item of plant for Hunter Ltd. (d) The firm has unsecured notes of $1 000 000 outstanding. Interest is payable 6-monthly in June and December. It is now August. (e) At the end of the year, half of the firm’s employees have non-vested sick leave owing. (a)

Contingent liabilities are not recorded, but are disclosed. A decision must be made on whether these items are ‘straight’ liabilities or contingent liabilities. This decision is based on two criteria: (1) it is probable that a liability has been incurred; and (2) the amount can be estimated reliably.

In this case, there is no liability. According to the Framework for the Preparation and Presentation of Financial Statements,, the event must make it ‘probable’ that a liability has been incurred and the amount must be ‘estimable’. These two conditions are not met.

(b)

No liability. The pertinent event is not placing an order but receiving title to the goods. When title passes, then a purchase has been made, and accounts payable is recorded.

(c)

Unclear. Until there is performance, there is nothing to record as no party has an obligation under the contract until there is some performance under that contract. On the other hand, if signing the contract has created that legal obligation, then a liability and an equal asset should be recorded — the event is the signing of the contract and the passing of some form of consideration that creates rights and obligations under the contract.

(d)

Interest payable for two months. Accrued interest is to be recorded. The event is the passing of time; the company is using the money that was borrowed each day.

(e)

No liability exists for the non-vested rights. The following four conditions can be considered for the recording of an accrued liability for sick pay: the sick pay is based on services already rendered rights to sick pay are vested or ‘accumulated’ (earned but unused) payment is probable the amount can be reasonably estimated.

• • • •

If sick pay benefits vest, an accrual should be made. If they ‘accumulate’ but do not vest, accrual is not required. © John Wiley and Sons Australia, Ltd 2010

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7.

Does the IASB/AASB Framework adopt the principle of conservatism?

Why or why not? Do you think that conservatism is desirable in the definitions of assets, liabilities and equity, or in their recognition criteria?

Why or why not?

Conservatism calls for the recognition of liabilities on less stringent grounds than assets. According to the Framework for the Preparation and Presentation of Financial Statements, if it is ‘probable’ that a liability has been incurred and the amount can be reasonably estimated, then it is to be recorded.

The Framework is conservative in its approach since it incorporates the concept of ‘prudence’. Paragraph 37 of the Framework, for example, includes the following: ‘Prudence is the inclusion of a degree of caution in the exercise of the judgements needed in making the estimates required under conditions of uncertainty, such that assets or income are not overstated and liabilities or expenses are not understated.’ As such, liabilities (like assets) are to be recognised when they are more likely than not to require a flow of service potential or economic benefit, and when they can be measured. Since conservatism is a virtue according to general practice, it is likely that the Framework will lead to less conservative recognition of liabilities than general practice.

8.

How does owners’ equity differ from liabilities? Give examples where they are closely aligned, and examples of where they are not.

Owners’ equity represents the owners’ claim on the assets of the company. The owners have a residual interest in the firm. They share in what is left over after liabilities are paid out of assets. The accounting equation (Assets – Liabilities = Owners’ equity) expresses in mathematical terms the relationships involved.

The amount of net assets equals the amount of owners’ equity. We should remember that the valuation of owners’ equity is not necessarily the same as the concept of owners’ equity. Owners’ equity can be described without reference to a sum of money.

Owners’ equity differs from liabilities in that liabilities are claims that the entity is presently obliged to settle with an outflow of economic resources. Owners’ equity is a residual attributable to the owners after liabilities are discharged.

Preference shares and convertible notes possess characteristics of both liabilities and owners’ equity. Accounts payable and general reserves are examples where liabilities and owners’ equity clearly differ.

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9.

In your opinion, when should the following be recognised as assets or liabilities? Explain whether, how and why, your answer deviates from Australian accounting standards. (a) Accounts payable (b) Put options (c) Call options (d) Raw materials inventory (e) Finance lease obligations (f) Operating lease obligations (g) Warranty commitments (a)

Accounts payable. A purchase has occurred on account; payment is probable. Record a liability at the time of the transaction. Consistent with IAS 39.

(b)

Put options (the holder has option but not the obligation to sell the underlying item). A derivative financial instrument under IAS 139. The standard requires recognition at fair value at date of transaction and remeasurement at subsequent balance date, with increases and decreases in value to be recorded in the income statement. Derivates are in the ‘fair value through profit and loss’ category of IAS 39.

(c)

Call options (the holder has the right to buy the underlying item). As for (b).

(d)

Raw materials inventory. If a perpetual system is used, a purchase (expense) has occurred and the amount of asset remaining at the end of the period is recorded in a stocktake. If a periodic system is used, the amount of inventory that the firm has title to is recorded as an asset at the date of purchase of the raw materials.

(e)

Finance lease obligations. According to AASB 117, a finance lease obligation occurs when the lease transfers substantially all the risks and rewards incidental to ownership of an asset. The standard mandates that at the commencement of the lease term, lessees shall recognise finance leases as assets and liabilities in their balance sheets at amounts equal to the fair value of the leased property or, if lower, the present value of the minimum lease payments, each determined at the inception of the lease.

Lessors shall recognise assets held under a finance lease in their balance sheets and present them as a receivable at an amount equal to the net investment in the lease.

(f)

Operating lease obligations. AASB 117 specifies that in the books of the lessee, lease payments under an operating lease shall be recognised as an expense on a straight-line basis over the lease term unless another systematic basis is more representative of the time pattern of the user’s benefit. For lessors, lease income from operating leases shall be recognised in income on a straight-line basis over the lease term, unless another systematic basis is more representative of the time pattern in which use benefit derived from the leased asset is diminished. © John Wiley and Sons Australia, Ltd 2010

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Solution Manual to accompany Accounting Theory 7e

(g)

10.

Warranty commitments. A liability arises with the sale of the product and the existence of warranty contract. At this stage, the amount can be reasonably estimated. The contract means there is a present obligation to an external party. The amount to be claimed can be reasonably estimated based on the company’s past experience.

When, if ever, should a firm recognise a superannuation liability, and why?

Superannuation commitments meet the definition of a liability. The important elements of a liability are: • present obligation • asset or service to be transferred at a future date to another entity past event.

Superannuation is based on services already rendered by employees, but compensation will be paid to them in the future in the form of pension benefits.

Therefore, a present obligation exists as the employee renders service.

The obligation is settled by payment of cash in the future.

The liability is created by a past event, the rendering of services by the employees. Under the terms of most superannuation agreements, not only is the superannuation payment probable, but also its measurement is reasonably reliable; so recognition should occur as the obligation accrues by virtue of the employee’s provision of service.

11.

Explain the concept of capital maintenance, and how it can apply to different concepts of capital.

The main source of income for an entity is an increase in the wealth of a firm resulting from operations for the period. This can be described as the maximum amount that can be distributed to owners and still leave the firm as well off at the end of the period as at the beginning. This maximum amount that can be distributed is income; the amount that needs to be retained to leave the firm as well off at the end of the period as at the beginning of the period is capital.

Under the concept of capital maintenance, then, income is only that amount that can be distributed without impairing the capital of the firm. So, capital cannot be distributed to owners as dividends, only income.

Current cost accounting aims to ensure the firm’s physical/operating capital base is not eroded during periods of inflation, as the otherwise inflated profits reported can result in increased dividends that actually result in reducing the ‘real’ capital of the firm.

Under a general price level accounting system (GPLA or CPP), income is recognised only after the purchasing power of the start-of-period owners’ equity has been maintained. © John Wiley and Sons Australia, Ltd 2010

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Under CoCoA, the concept of capital is ‘adaptive capacity’ so income is not recognised until the firm earns enough to maintain its operating adaptive capacity, as reflected in the net realisable value of its assets, less liabilities.

12.

A benefactor pays off a loan for a university. How should the university record the transaction, and why?

The university should record the transactions as a donation. The entry is: DR Loan CR Revenue According to the Framework, donations should be classified as revenue because they are inflows of probable future economic benefits other than contributions by owners.

13.

How should a mining company account for (a) a contract which stipulates that on maturity of a cash loan to the company, it must pay the principal in cash or provide a given quantity and grade of extracted minerals, whichever is the higher? And (b) a contract which stipulates that $1 000 000 is to be spent on mine restoration at the end of the project in 10 years’ time?

Part (a) The recording of a liability is justified, because: • a present obligation exists. The company is using borrowed money.

• the company will pay cash (an asset) or minerals (an asset) at a future date to settle the obligation.

• the obligation arose out of a past event — the use of the borrowed money.

The liability meets recognition criteria in that a future outflow of economic benefits is probable. Also, there is a reliable measure, even if it is not exactly the amount that will be required to be repaid if the minerals extracted have a high value.

DR CR

Cash Loan (PV of expected cash outflows)

Part (b) The recording of a liability is justified, because: • a present obligation exists. The company has a contractual commitment (a legal obligation) to complete the restoration.

• There will be an outflow of future economic benefits in ten years’ time in relation to activities over the prior ten years.

• the obligation arose out of a past event — the mining activity.

The liability meets recognition criteria in that a future outflow of economic benefits is probable. Also, there is a reliable measure as the restoration cost is © John Wiley and Sons Australia, Ltd 2010

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Solution Manual to accompany Accounting Theory 7e

stated at $1 000 000. The company should capitalise the expected restoration cost as part of Mine Development asset and amortise it over the ten year life of the mine (thus allocating the restoration expenses over the prior ten years and offsetting it against production revenue). When production commences: DR CR

Mine Development Asset 1 000 000 Provision for restoration 1 000 000

Each year a proportion of the total mine development asset (which includes other capitalised costs relating to the development of the mine) is expensed as a cost of production.

When mining is complete and restoration expense is paid: DR Provision for restoration 1 000 000 CR Cash 1 000 000

14.

How should Shannondoah Ltd account for a cash loan to the company where the contract requires that the principal will be redeemed in ordinary shares at maturity? Ten shares will be given for each $1 000 bond. The current market value of the shares is $120.

Because shares are to be given on the date of maturity, two questions arise: 1.

Is the issuance of the bonds that convert to company shares a liability?

2.

What amount should be recorded now?

According to the definition of a liability, a liability must be settled by transferring assets or services at a future date. The ordinary shares of the company are not assets or services. Therefore, the bonds do not appear at first to qualify as a liability. However, the classification is not that straightforward, as explained below, and in AASB 132 ‘Disclosure and Presentation’.

If the converting notes convert to a variable number of shares, depending on the market value of the shares at the time of the conversion, then the issue of the converting notes is equivalent to an issue of debt that is then repaid in cash, which the lender then invests in the shares of the borrowing entity. The lender is not exposed to residual risk at all during the period of holding the converting notes. As such, during the period prior to conversion, it is appropriate to classify such converting bonds as liabilities.

On the other hand, if the converting notes convert to a fixed number of shares, then the issue of the converting notes exposes the holder of the notes to residual risk from the outset. As such, the converting notes are equivalent to an issue of equity, with a fixed dividend stream. The lender is exposed to residual risk during the period of holding the converting notes. As such, during the period prior to conversion, it is appropriate to classify such converting bonds as equity.

In this case, the loan converts to a fixed number of shares, so it should be treated as equity. The holder is subject to residual risk: if the value of the firm changes, they receive the same number of shares on conversion (10 per $1000 bond), so they bear the risk of changes in the value of the shares, and in the value of the equity. © John Wiley and Sons Australia, Ltd 2010

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What amount should be recorded? If we knew what the market value of the shares should be on the date of maturity, we could find the present value of the amount of the total market value of all the shares involved. But we do not know that.

Although the bondholders must have taken into account the current market price of the shares when they purchased the bonds, and probably expected the market price to increase, the recording of the sale of the bonds should be based on the value of the shares. The reason is that it is too difficult to estimate market values of shares. The method used when a large share dividend is declared provides a guideline.

On a per-bond basis, the following appears to be an appropriate record: 10 shares  $120 par = $1200 Cash $1000 Deferred discount on converting note issue $ 200 Share capital

$1200

Interest will be paid each year based on the principal of $1 000 000. Should this be considered interest expense or dividends? The interest is a periodic payment on an equity instrument Therefore, it should be treated as a direct debit to equity, and as dividends.

Perhaps this bond issue is attractive to investors, because a specific amount of ‘interest’ each year will be received by contract as opposed to actual dividends that may or may not be paid, and the expectation of receiving more than the stated principal amount because of the likelihood of the market value of the shares increasing in value.

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15.

Skipper Ltd financed the construction of its new office block by issuing securities for $50 000 000 in 2000. Buyers of the securities received a 30% ownership interest in the office block, and receive 30% of the rent revenue related to letting the offices. The securities mature on 30 April 2015, when Skipper Ltd must redeem the securities at 30% of the value of the office block or $50 000 000, whichever is higher. What should Skipper Ltd have recorded in its accounts on 30 April 2000, and what other journal entries should be recorded throughout the term of the securities?

The $50 000 000 issue constitutes a loan. It has the features of a loan because of the following: • It has a definite maturity date — 30 April 2015.

• It has a specified amount to be paid on the maturity date — either $50 000 000 or 30% of the appraised value of the shopping centre, whichever is higher.

• It does not confer a residual claim to the value of the firm. The variable component of the value of the loan is in relation to one specific asset, buildings.

Although an interest rate is not stated, there is something similar, which is 30% of the income per year. The amount each year would not be the same, but this is true also for variable rate bonds.

The 30% ownership of the shopping centre by the holders of the securities is, in effect, the collateral on the loan. The ownership of the holders is temporary, only until the maturity date, unless the company defaults.

Entries: 30 April 2000 Cash Loan payable

$50 000 000 $50 000 000

When payment of the 30% of income is made each year: Interest Expense Cash

x x

If the value of the probable payment on maturity exceeds $50 000 000, the loan should be restated: DR CR

Buildings Loan Payable

Upon maturity: DR CR

Loan Payable Cash

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PROBLEMS Problem 8.1 The purpose of this problem is to show that determining cost or value in practice is not always simple. (a) The question indicates that the two blocks of land have identical values. As such, the appropriate entries would be: Gibson Land Cash/other consideration To record purchase of land at cost

$1 000 000

Loss on land development Old Land To record loss on land development

$50 000

$1 000 000

$50 000

Since the Revals is in the business of property development, the loss will be taken to the income statement. Conservatism (or prudence, para 37 in Framework) suggests that the loss will be recognised as soon as it is foreseeable. Refer to Framework definitions: an expense arises in the ordinary course of business. It takes the form of an outflow or depletion of assets (para 78). The expense is recognised because decrease in future economic benefits has occurred, and can be measured reliably (para 94). Note that this is not a land revaluation under AASB 116, which allows firms to revalue property to fair value (para 31). Under AASB 116, an asset revaluation creates an asset revaluation reserve and a devaluation of the asset (previously revalued) goes against the reserve (para 39).

(b) This is an investment in a financial asset, so AASB 139 applies. The question states that the ‘shares are held for investment purposes’. Assuming Jessica’s Revals classifies the investment as available for sale the investment should be recorded at fair value.

7 Sept 2009 Available for sale securities Cash

$18 000

31 July 2010 Loss on securities Available for sale securities

$2 000

$18 000

$2 000

Note: Loss on securities is shown in Statement of Changes in Equity for available for sale securities.

AASB 139 allows items to be written off directly against asset or via use of an allowance account.

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Solution Manual to accompany Accounting Theory 7e

(c) If Jessica’s Revals Ltd applied a strict historical cost measurement system, it would do nothing about these increases in value, because to do so would violate the historical cost principle.

Under the mixed measurement system in use by the vast majority of firms, an entry would not be made in relation to the current assets, however the fixed assets can be revalued under AASB 116. We recommend the following entry if the firm adopts a mixed measurement system: 31 July

Fixed assets Asset revaluation reserve

$600 000 $600 000

If the current assets include trading or available for sale financial assets then market value should be recorded as per AASB 139 31 July

Trading/available for sale securities Gain on securities

$20 000 $20 000

Note: Gain on securities is shown in the Income Statement for trading securities and in the Statement of Changes in Equity for available for sale securities.

(d) Initial acquisition: July 31 Land Cash/other consideration

$81 000 $81 000

The receivable arising on sale of land must be recorded at fair value (AASB 139, para 43). Therefore, the present value of the note must be recorded. Using the present value of an ordinary annuity for 10 periods at 10%, the present value is: $13 000 × 6.144567 = $79 879 Notes receivable Loss on Sale of Land Land

$79 879 1 121 $81 000

Jessica’s Revals Ltd will receive principal repayments in relation to the loan each year. No interest revenue is recorded each year as the note was non-interest bearing. In subsequent years, the receivable is to shown at amortised cost, using the effective interest method. (e) In this instance there is an exchange of dissimilar non-monetary assets, for which we are able to estimate market values. If an objective value is available, it can be used as the basis for determining the value of the asset received. Assuming Jessica’s Revals Ltd works for others at an established sales price, the contract price of $17 000 can be considered objectively determinable.

A case could be made for recording the bricks at $16 500. This is a lower figure, and on the basis of conservatism it can be argued that it should be recorded. © John Wiley and Sons Australia, Ltd 2010

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However, following the cost principle, the asset received should be valued based on a measure of the benefit sacrificed, which in this case is a service worth $17 000. By working for the brick manufacturer, Jessica’s Revals Ltd is forgoing $17 000 in revenue from another contract. Hence, this is the cost.

Materials (Bricks) Sales revenue

$17 000

Cost of goods sold Inventory, labour, etc.

$12 000

$17 000

$12 000

(f) There are two choices here: to record the land at $83 000 or $82 000. Following the cost principle, the land should be stated at $83 000 because that is what was sacrificed: 1,000 shares at $83 per share. There is a question as to whether 1000 shares constitute such a large number that the share price would be affected.

Assuming that 1,000 shares would not materially affect the share price, and given that the market quotation can be relied upon because it is from the Australian Securities Exchange, the $83 000 represents the cost of the land.

Land Paid-up capital (1000 × $50)

$83 000 $83 000

To be consistent assumptions used in (a), land would be written down to fair value Loss on land development Land To record loss on land development

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$1 000 $1 000

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Solution Manual to accompany Accounting Theory 7e

Problem 8.2 1.

Present value. For the decision at hand, this figure is highly relevant. Its reliability depends on how good the estimates are. The use of 15% as the discount rate of return is acceptable. The calculation is based on past experience. Future circumstances may change, perhaps drastically over the next 20 years. However, anyone making a decision to buy or sell an apartment building should make projections about expected cash flows in order to have a rough price to work with. Any offer that is substantially lower than the present value would be rejected. When compared with the fair value, the present value seems to be conservative, which should give the seller confidence that it represents a minimum value.

2.

Fair value. This value is the most relevant of the four. It represents the market’s assessment of what the property is worth, and is therefore a more objective value than present value. Present value represents the seller’s expectations of the value in use of the assets over 20 years; fair value represents the market’s expectations if the asset were to be sold now. In this case, you have the opinion of two appraisers as to the market value of the property. Their estimates are presumably based on their expert knowledge of the market. The average taken by the accountant of the two figures is a reasonable approach.

3.

Carrying amount. The carrying amount is only relevant for computing the accounting gain when the property is sold. It should not be used to determine whether the property should be sold. Exchange value is determined in the marketplace.

One of the assumptions of accounting theory is the ‘going concern’. Based on this, the notion is that allocated cost on the income statement is more pertinent than current value because it shows the cost to the business for using the asset in a given period. Thus, the purpose of the carrying amount is not for making decisions about the sale of the asset in question. It represents unallocated cost — that is, cost that is still waiting to be allocated to the income statement.

Because land is assumed to have an indefinite life, the original cost remains the unallocated cost.

If it were not possible to determine current value, at least the carrying amount can be seen as a very conservative estimate of current value. It is conservative, because of the use of historical cost in accounting and the existence of inflation.

4.

Current cost. The current cost calculated on the basis of price indices involves a great deal of estimation. Are price indices market prices? Although the price indices are market based, they are very general and do not necessarily reflect the current costs in the particular area where the property is located. Construction costs in Sydney could be quite different from those in Hobart, Melbourne, Darwin or Oodnadatta. The deduction of five years of depreciation is an accounting procedure, and is not market-based.

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The current cost of constructing a building is not necessarily what it will sell for. A contractor would wish to sell to make a gain. Also several buyers may want a particular building and bid the price up.

The relevance of this figure depends on the reliability of the computation. If the computed current cost is reflective of the market prices of the component factors in the area, then it is very relevant. If for some reason, fair value cannot be determined then the computed current cost is an alternative.

In summary, the relevance of the four figures in priority order is: • Fair value • Current cost (computed) • Present value • Book value.

Note, however, that present value is highly relevant as a comparison with fair value or current cost to determine the merits of sale or replacement, based on the value in use of the block of units.

© John Wiley and Sons Australia, Ltd 2010

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Solutions Manual to accompany

Accounting Theory 7e Prepared by

Ann Tarca

Chapter

Chapter 9 Revenue

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Chapter 9: Revenue

Chapter 9: Revenue THEORY IN ACTION 9.1 AFR 14 March 2007 No income gained from revaluations 1.

Explain why Westfield’s result for 2006 was 30% better than the previous year.

How do reporting requirements of AIFRS differ to AGAAP for companies in the property sector?

The increase in operating profit reflects the adoption of IFRS. Westfield has elected under AASB 140 Investment Property to include increases in value of property in the income statement when they occur, irrespective of whether the gains are realised or not. Under IFRS the company included $5.1 billion of asset revaluations in income.

Previous AGAAP did not include a specific investment property standard. It allowed, but did not require, companies to revalue property under the general rules for measurement of property, plant and equipment. Companies recording asset revaluations under AGAAP showed an increase in assets but the increase was not taken to the income statement, but rather directly to equity.

DR Property (Asset, balance sheet) CR Asset revaluation reserve (Reserve, equity) Thus the change under AIFRS is that AASB 141 allows companies to choose a policy of including increases/decreases in value of investment property to form part of property trusts’ income.

DR Property (Asset, balance sheet) CR Gain on remeasurement of asset (Gain, income statement)

2.

Why does the IASB consider that revaluation gains are part of income?(Refer to material in the chapter)

The IASB Framework states that ‘income is recognised in the income statement when an increase in future economic benefits related to an increase in assets or decrease in liability has arisen and can be measured reliably’ (paragraph 92). This approach to income measurement has been called the asset/liability approach and means that ‘recognition of income occurs simultaneously with the recognition of increases in assets or decreases in liabilities’ (paragraph 92). Gains and losses are recognised in the period they occur, and form part of income of the period, irrespective of realisation. The IASB approach is based on Hicks’ (1934) concept of income: that changes in net assets (excluding transactions with owners) represent an increase/decrease in net income. It is argued by members of the IASB (e.g. Mary Barth) that there is indeed no other way to measure income than based on the changes in net assets.

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Solution Manual to accompany Accounting Theory 7e

3.

What is meant by the statement that “IFRS has made the production of financial statement a compliance exercise; the market does not use the financial statements to assess financial performance.”

The IFRS approach is that the return for investors in property trusts reflects both cash income and capital gain. Therefore both should be included in profit. However, in the view of the CFO quoted in the article (Kieran Pryke), investors regard property trusts as a cash flow business and are therefore interested in the cash flow generated by the business, not the value of the assets.

Property investment companies have responded by providing a distribution reconciliation statement which shows the source of income (both cash income and remeasurement gains) so that investors can distinguish between distributable income and gains relating to revaluation.

It seems unrealistic to suggest that investors are not interested in the increase in property values, as in the long term these are increases in wealth for the owners of the trust. In the short term, the reconciliation statement should mitigate any confusion among investors as to the nature of the gains, i.e. realised cash flows or unrealised remeasurement gains.

Another point of interest is that companies have a choice under AASB 140; to use the cost or revaluation model for investment property. The article implies trusts must use the revaluation model, but they choose to use it, implying some benefits from the revaluation model.

Students could explore the incentives for companies/trusts to use the revaluation model and the costs and benefits of their choice.

© John Wiley and Sons Australia, Ltd 2010

9.3

Chapter 9: Revenue

Theory in Action 9.2 ‘Revenue recognition is Isoft’s curse’ P. Stafford, Financial Times 9 August 2006, p. 17 1.

When did Isoft traditionally recognise revenue? Is the policy acceptable under GAAP?

Revenue was recognised in a two stage process. The value of product licences was recorded as sales at the time the licences were delivered. The subsequent support and services were recognised in the accounts when they were performed, rather than when they were paid for.

Current work of the IASB and FASB in project on Revenue recognition supports the ‘unbundling’ of contracts (see Chapter 9). The standard setters consider that the separate recognition of each stage of the contract is necessary to accurately reflect the underlying economics of the contract. Thus, Isoft’s approach is consistent with the standard setters’ views.

The policy of recognition on performance rather than receipt of cash is acceptable under GAAP. Traditional accrual accounting allows for (indeed encourages) recognition when the service is completed and the revenue earned. If analysts are questioning the recognition policy, can we assume that there is some significant delay between performance and receipt of cash or some uncertainty about the amount to be received which suggests revenue recognition be delayed? The article is silent on this point.

2.

What accounting issues were identified by analysts in relation to recognition of revenue for software companies?

An analyst suggested that the purchaser may see the sale as one contact because they want to have a working end product. On the other hand, the provider sees the contract as having two parts: buying the software and providing the service to maintain it. The implication in the article is that the different views could lead to different timing for revenue recognition.

However, the amount of revenue should be the same irrespective of which view is taken.

Analysts are querying the company’s recognition policy, implying that they suspect the company has been aggressive in the early recognition of revenue. Analysts want sufficient information to understand the persistence of revenues. Factors affecting persistence include timing (when will cash be received?) and subjectivity (to what extent is reported revenue subject to intentional and unintentional measurement error?). The article implies that analysts have been suspicious of the company’s policy for some time. The statement that Deloitte found revenue has been recognised earlier than it should be seems to confirm analysts’ concerns.

3.

Why did the company restate revenue and/or change its accounting policies?

The article states that revenue ‘irregularities’ uncovered by the company’s auditor Deloitte would not have a material impact on revenue in the coming year (estimated at GBP 195 – 200 million). However, the company decided to change its revenue recognition policy resulting in a reduction in revenue of GBP 70 million in 2005 and GBP 55 million in 2004. The company denied a link between the ‘irregularities’ and the policy change. However, both seem to relate to the same issue: the early recognition of revenue. The company’s response is to recognise revenue later for the current (2006) and prior years (2004 and 2005). Is the company in

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Solution Manual to accompany Accounting Theory 7e

‘damage control’? Are they concerned about how they are perceived in the market place, for example, that analysts do not consider the company’s reported revenue to be reliable?

The company has attempted to reassure the market about its revenue recognition policy. For example, although a contract was signed on the last day of the financial year, the company indicated that the revenue was not included in that financial year. Students could discuss why the company would make this announcement and to what extent the announcement should alleviate analysts’ concerns about the company’s revenue recognition policy.

© John Wiley and Sons Australia, Ltd 2010

9.5

Chapter 9: Revenue

Theory in Action 9.3 Banking group attacks IFRS with double set of accounts

1.

Why does HBOS provide a second set of financial results?

HBOS provides a second set of results based on ‘embedded value criteria’. It provides the second set of financial results so that HBOS can provide more detail of contracts with expected future revenues (i.e. HBOS’s insurance contracts). The article states that investors find the additional information helpful. Analysts state that IFRS valuations are ‘misleading’.

The implication is that revenue recognition rules for insurance contracts under IAS 39 are according to a set of criteria which may not accurately reflect underlying earnings in relation to the contracts.

2.

What is the revenue recognition rule of IFRS, according to this article? What are the differences in profit for HBOS under IFRS and embedded value?

The article states that IFRS requires the recognition of revenues when they are accrued. It also claims that under IFRS, growing firms are disadvantaged compared to their more mature competitors as IFRS allows mature firms to report higher profits. Insurance contracts are accounted for under IAS 39, which delays recognition of profit on these contracts.

‘Embedded value’ (EV) is a voluntary method of accounting for insurance contracts which has been developed in Europe by banks and insurance companies. Under ‘embedded value’ reporting, firms recognise new business on point of sale, with the contribution of existing business only including changes in the value of future cash flows compared to predictions.

The embedded value approach allows earlier recognition of revenue; revenue which is expected over the life of the insurance contract but cannot be recognised under IAS 39.

HBOS profit under EV was GBP 262m higher than under IFRS. The contribution of new business was GBP 474 million higher under EV than IFRS. 3.

What do you consider are the incentives to report embedded value results? To what extent are managers likely to manipulate embedded value results?

Managers of growing firms want to report results using the ‘embedded value’ approach to provide information about the value of new business being written by the firm. This allows analysts and investors to make a more accurate assessment of firm value and to price the firm’s shares accordingly. Without embedded value results, a growing firm could be undervalued by investors and ranked less favourably than a more mature firm. Under IFRS, the value of new business is not captured and mature firms look more profitable compared to young firms. Therefore, mature firms would not have the same incentive to provide embedded value results.

The embedded value measures are estimates of the present value of insurance contracts which have been written and will earn revenue in the future. They are based on managers’ estimates of future cash flows and discount factors. Nevertheless, managers providing embedded value information have an incentive to provide accurate information because the information is used to value the firm. There will be ex-post settling up in the market (i.e. analysts will downgrade stocks for which embedded value estimates prove inaccurate) if managers’ estimates are inaccurate.

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Solution Manual to accompany Accounting Theory 7e

Theory in Action 9.4 EPG’s auditor queried on sales AFR 9 May 2008 by Ashley Midalia 1.

Contracts for the sale of the two properties were initially exchanged during the year ended 30 June 2005, and eventually were finalised before the end of 2005, so why were the auditors criticised for allowing the revenue to appear in the 2004/2005 accounts?

It is argued that the revenue should not be recognised in the accounts until ‘control’ of the properties had passed to the purchaser. Although contracts were initially exchanged in June 2005, these contracts were replaced by new contracts which were signed on October 28 2005.

It is argued that the rescission of the original contracts meant that control did not exist until the later date. The article does not explain when the rescission took place. A counterargument that the auditors could make is that as at 30 June 2005 it appeared that the exchange of contracts was final. However, auditors are required by ASA 560 Subsequent Events to consider the effect of subsequent events on the financial report and on the auditor’s report (paragraph 5). Auditors are required to perform audit procedures during the period after 30 June and up to the date the audit report is signed to detect subsequent events (paragraph 8). If the rescission took place before the auditor signed the audit report, then these procedures should have provided evidence that the contracts were not final on 30 June 2005.

2.

Why is there doubt over whether the revenue should have been recognised at all?

The article mentions ‘vendor financing arrangements’ between the parties to the contract.

Although these arrangements are not detailed in the article, it appears that the contracts allow the EPG companies to retain ‘effective control of the development of the properties’. In addition, the EPG companies could have received a share of the profits from the development. It appears that the contracts of sale may have given legal ownership to the purchaser, but did not give the purchaser true control over the properties. ‘Control’ of an asset is not synonymous with legal ownership, the test is related to the eventual disposition of the benefits that flow from an asset (see paragraph 58, AASB Framework). The form of the contract was that legal ownership passed, but the substance was that the ‘vendor’ retained an element of control over the property development and its benefits.

© John Wiley and Sons Australia, Ltd 2010

9.7

Chapter 9: Revenue

CASE STUDIES Case Study 9.1 Property development companies: When to recognise revenue?

1.

For companies which construct and sell residential property units, what would be the conservative accounting treatment for revenue under IFRS? Identify the sections of IAS 18 which support this treatment.

The conservative treatment would be to record all revenue when the property is sold. If the transaction is classified as sale of goods (rather than provision of services) under IAS 18, the following will apply: IAS 18 para 14 states that revenue arising from the sale of goods shall be recognised when all the following conditions have been satisfied: (a) the entity has transferred to the buyer the significant risks and rewards of the ownership of the goods; (b) the entity retains neither continuing managerial involvement in the degree usually associated with ownership nor effective control over the goods sold; (c) the amount of revenue can be measured reliably; (d) it is probable that the economic benefits associated with the transaction will flow to the entity; and (e) the costs incurred or to be incurred in respect of the transaction can be measured reliably.

Recognition of revenue when the residential units are completed satisfies these conditions.

Further guidance is provided in the IAS Appendix for situations where title passes before completion and where the seller has continuing obligations after title has passed.

2.

Emaar Properties uses the percentage of completion method under IAS 11. Explain when revenue is recognised under this method. Why would a company want to use the percentage of completion method?

If IAS 11 applies, revenue is recognised on a percentage-of-completion basis provided that reliable estimates of construction progress and future costs can be made. Revenue is recognised in proportion with the amount of work which has been completed compared to the amount required under the contract.

A company may want to use percentage of completion to enable it to recognise revenue earlier in the business cycle. Jose (2008) quotes a spokesperson from Emaar Properties as saying ‘Companies would always want to be liquid right from the beginning and the cash flow to start early.’ This statement implies that companies set up their contracts to ensure progress payments are received in relation to the stage of completion of the project. As cash is received, it may be appropriate to recognise revenue. Percentage of completion provides for more even recognition of revenue and profit for projects which continue over more than one financial year because recognition of revenue is spread out over the lifetime of the project. Some argue that revenue recognition in stages is a more accurate reflection of the progress of construction and provides for better matching of revenue and expenses.

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Solution Manual to accompany Accounting Theory 7e

3.

How does the IFRIC 15 affect revenue recognition for property development companies?

IFRIC 15 requires property developers to follow certain conditions which make applying the percentage of completion method under IAS 11 difficult. The main change will be to prevent some companies from recognising revenue as construction progresses. Instead they will recognise revenue at a single time, at completion upon or after delivery. IASB (2008) states that agreements that will be affected will be mainly those currently accounted for in accordance with IAS 11 that do not meet the definition of a construction contract as interpreted by the IFRIC and do not transfer to the buyer control and the significant risks and rewards of ownership of the work in progress in its current state as construction progresses.

4.

Why do you think the IFRIC issued IFRIC 15?

IFRIC’s principal role is to consider accounting issues that are likely to receive divergent or unacceptable treatment in the absence of authoritative guidance (IASB 2008). The case study material suggests that there was diversity in practice. Improving consistency is one reason why an interpretation may be issued. Another reason is because a standard is not being applied correctly. IFRIC was of the view that under IAS 11 property developers were recognising revenue when the risks and rewards of ownership had not transferred to the buyer but remained with the seller.

IFRIC 15 seeks to improve comparability in practice of real estate companies. Introducing IFRIC 15, Robert Garnett, IFRIC Chairman and IASB member, said: The real estate industry is an important sector across countries and, especially in times of volatile markets, transparency and comparability of the accounting are important. However, at present there is widespread divergence in practice when accounting for the recognition of revenue for ‘off plan’ contracts. IFRIC 15 clarifies how the existing principles in IAS 11 and IAS 18 apply for the revenue recognition in the real estate sector and by doing so will ensure consistent accounting.

© John Wiley and Sons Australia, Ltd 2010

9.9

Chapter 9: Revenue

Case Study 9.2 Improper revenue recognition The violations outlined involve techniques to boost revenue, including: • improper sales cut-off • consignment sales recorded as revenue • parking, bill and hold and channel stuffing • back-to-back swaps • fictitious sales.

Describe each of these techniques and explain whether they would be in breach of Australian accounting standards. In your answer, refer to the recognition criteria of IAS 18/AASB 118 Revenue presented in figure 9.3.

Improper sales cut-off US GAAP requires a firm to record sales in the period the goods are shipped or services performed. Intentionally holding open the books of account beyond the end of the period is a violation of GAAP. Although sale or delivery is an accepted point for revenue recognition, this has not occurred at the period end date.

AASB 118 para 14 (a) requires risks and rewards of ownership to be transferred to the buyer.

Tranfer of title for sale of goods did not occur within the period, so a sale should not be recorded. Although sale or delivery is an accepted point for revenue recognition, this has not occurred at the period end date.

For a service transaction, the transaction was not complete at the reporting date (AASB 118 para 20). The transaction should not be included in revenue.

Consignment sales recorded as revenue Consignment sales usually feature an agreement whereby the buyer (consignee) has the unconditional right to return the merchandise to the seller (consignor). Title does not pass.

AASB 118 para 14 (a) requires risks and rewards of ownership to be transferred to the buyer.

Tranfer of title for consigned goods did not pass, so the transaction should not be recorded as a sale. Appendix para 2(c) states that a sale should be recognised by the seller (consignor) in a consignment sale when the consignee sells the goods to a third party.

Parking, bill and hold and channel stuffing Premature revenue recognition by negotiating sales with customers who do not need, or cannot take delivery, of goods in the period. The goods are held with an intermediary (parking), left in seller’s inventory (bill and hold), or shipped to the buyer (channel stuffing).

Deferred payment terms are included in the agreement.

The guidance of AASB 118 para 14 (a) requires that risks and rewards of ownership to be transferred to the buyer. In the cases descibed above, ownership of the goods remains with the seller. The risks and rewards of ownership have not passed, irrespective of the location of the goods. Therefore a sale should not be recorded. Appendix to AASB 118 provides further guidance in relation to the above situations. For example, bill and hold sales can be recognised when the buyer takes title and accepts billing, subject to additional conditions (delivery is probable; item is ready for delivery; buyer acknowledges deferred delivery instructions and usual payment terms apply). Under these conditions, sales such as those in item 3 would not be recorded as revenue.

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Solution Manual to accompany Accounting Theory 7e

Back-to-back swaps Firm A sells assets to Firm B at a gain, and in turn agrees to buy assets from Firm B in the same or subsequent period, also at a gain.

These transactions may appear to be within the revenue recognition guidelines of AASB 118 para 14. However, Appendix to AASB 118 provides further guidance. Para 5 states that sales and repurchase agreements need to be analysed to determine whether there is an in substance transfer of the risks and rewards of ownership. If not, despite the fact of legal transfer of title, a sale should not be recorded.

Fictitious sales Company goods may be ordered, but not shipped; shipped but not ordered; or never ordered or shipped. The company may fabricate purchase orders or shipping records (fictitious customers), or not produce any records.

These transactions cannot be recorded as revenue because it is not probable that economic benefits associated with the transaction will flow to the entity (AASB 118, para 14c)

© John Wiley and Sons Australia, Ltd 2010

9.11

Chapter 9: Revenue

Case Study 9.3 New research finds red flags to uncover accounting fraud

1.

What is meant by the term ‘earning management’? What are the incentives for managers to manage earnings?

Earnings management occurs when managers use judgment or discretion within GAAP, or structure transactions, to affect the information in financial reports. The purpose of earnings management is to influence users’ perceptions of financial statements about the firm’s underlying economic performance or to influence outcomes that contractually depend on reported accounting numbers. For example, if financial information is used in determining bonus payments as part of executive remuneration, managers may have an incentive to arrive at the financial results necessary to achieve the bonus. Another example relates to debt covenants. A firm at risk of breaching a loan covenant has an incentive to manipulate financial information to avoid the breach and thus avoid cost of refinancing the loan.

Earnings management may be undertaken so that a firm reports a smooth income stream rather than a volatile one. The practice of earnings management may potentially affect transparency of the underlying economic reality of a firm’s financial performance or position.

Consequently, investors’ decisions with respect to the allocation of resources may be affected, with adverse consequences. The authors note that earnings management may be used to disguise declining operating performance to protect share price to ‘ensure their stock based compensation remains valuable’ and to allow capital raising on favourable terms.

2.

What types of firm score poorly on the F score?

The researchers found that growing firms with deteriorating operating performance are the firms most likely to score poorly. The researchers suggest that manipulations could reflect managers’ desire to disguise moderating operating performance in these firms.

Manipulating firms are more likely to be large firms. They were more likely to be in the computer industry, followed by retail and service industries, and to relate to the period 1999 and 2000.

The results are consistent with UK research related to firms subject to action by the Financial Reporting Review Panel (FRRP) in the 1990s. Peasnell, Pope and Young (2001) report that UK companies subject to adverse rulings were average performers experiencing temporary performance difficulties, rather than being perennial underachievers. [Peasnell K., Pope P. and Young, S. (2001), “The characteristics of firms subject to adverse rulings by the Financial Reporting Review Panel”, Accounting and Business Research vol. 31, pp. 291306.]

Students should note that the results are specific to the period studied. The tech stock bubble ended early in 2001. During the prior years, managers with stock compensation had incentives to ensure share prices continued to increase, giving rise to the manipulations observed in the study. Thus the findings reflect the conditions during the latter years of the study. A study of a different period may capture different economic conditions and incentives.

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Solution Manual to accompany Accounting Theory 7e

3.

Explain the relationship of cash flow and earnings management. Is it possible for managers to ‘manage’ cash flows?

One way to achieve earnings management is through the use of accruals. Recall that accruals are period end adjustments to financial accounts which do not involve cash. Managers have discretion about the amount and timing of accrual adjustments and thus can use them to manage earnings. For example, an adjusting entry to record sales for which cash is not yet received (accrued revenue) increases revenue and boosts earnings. Managers seeking to increase earnings can increase revenue or decrease expenses by using accruals. The study reported that most manipulations related to revenue and many of these involved accruals e.g. front loading sales from future quarters and creating fictitious sales.

It is more difficult to manage earnings using cash flows since they reflect actual cash received or paid by the business. While accrual accounting information is useful for investors, analysts also keep a close watch on cash flows because they are harder to manipulate and thus are used for predicting the firm’s future cash flows. However, cash flows can be manipulated through such techniques as improper sales cut-off (including next period sales in the current period) and back to back swaps with cash transfers (see Case Study 9.2 for further discussion).

4.

What are the practical applications of the F score? In what ways can the F score assist auditors?

The F score provides an indicator that there are inconsistencies in the firm’s accounts. It is an objective measure that can be used by investors, auditors and regulators as a ‘red flag’, that is, a suggestion that there are possible inconsistencies in the firm’s actual and reported financial performance and position that warrants further investigation.

The authors note that the manipulating firms have abnormally low free cash flows and that many firms were seeking new financing to cover negative operating and investing cash flows.

The low free cash flows and high accruals can be seen as a ‘red flags’ for investors because of the difficulty of manipulating cash flows and the ease of manipulating accruals.

The article notes that Enron had an F score more than twice that of an average firm, indicating it was a high risk firm. Auditors could use the F score to highlight risky firms and suggest that additional testing be carried out.

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QUESTIONS 1. What is revenue? Is it an object or an event?

Revenue is defined in AASB 118 (paragraph 7) as follows: Revenue is the gross inflow of economic benefits during the period arising in the course of the ordinary activities of an entity when those inflows result in increases in equity, other than increases relating to contributions from equity participants.

The definition implies that revenue is an event (an increase or flow), not an object. Revenue applies definitely to value, which is monetary. Although assets are economic objects, revenue relates to enhancement in value of the assets. ..

2. What is the difference between revenue and gains? How does the Framework definition of ‘income’ treat revenue and gains?

The AASB framework defines income as including both revenue and gains (para 74). Thus the Framework makes no conceptual distinction between revenue and gain. Both are consistent with the concept of income as something which increase assets (an inflow or enhancement) or decreases liabilities with a resulting increases in equity (para 70(a)). Gains are included in income because they represent future economic benefits flowing to the entity.

They may or may not arise from ordinary operations of the entity, while revenue is defined as arising from ordinary operations. It should be noted that gains may also include unrealised gains.

3. Explain the ‘earning process’. How does the earning process concept relate to the operational view of revenue?

Accounting theory assumes that revenue (and income) cannot arise unless the firm performs — that is, it must do something to make revenue happen. The earning process consists of the activities that cause revenue to occur. For a manufacturing firm, the sequence of events is typically the following: • purchase of service inputs (labour, materials, etc.)

• production • storage of product • sale of product (on credit) • collection of cash (from customers) • warranty service.

The operational view is essentially the same as the view expressed above, except that revenues (and income) are defined more explicitly in terms of the particular operations that generate revenues (and income). Professor Bedford, who stresses this viewpoint, lists the following business operations: • acquisition of money resources • acquisition of services • utilisation of services

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• • •

recombination of acquired services disposition of services distribution of money resources.

4. What are the differences between general criteria for revenue recognition and revenue recognition principles contained in AASB 118 Revenue?

The general criteria for revenue recognition are: • measurability of asset value • existence of a transaction • substantial completion of the earning process.

The revenue recognition principles contained in IAS 18/AASB 118 are stated in Figure 9.3.

They do not state the criteria in the above form. IAS 18/AASB 118 recognition rules are formulated around the concept of a probable inflow of future economic benefits and reliable measurement of such an inflow. Therefore, the first general criterion (measurability of asset value) forms part of IAS 18/AASB 118 as reliable measurement is a recognition criterion.

The existence of a transaction (second criterion) is specifically mentioned in para 20 and forms part of the discussion in IAS 18/AASB 118. Substantial completion of the earning process is not specifically mentioned in para 14, 20 and 29. However, completion of the earnings process underpins these paragraphs. For example, a sale occurs when the significant risks and rewards of ownership have transferred. This implies substantial completion of the earnings process. Similarly in the rendering of services, recognition depends on the extent to which the transaction is complete. Also for interest royalties and dividends, the process of earning the item is discussed. For example, interest is recorded as it is earned based on the effective interest method.

5. Why are revenue recognition principles needed? Does it matter which principles are adopted, as long as they are applied consistently across time? Discuss.

Revenue recognition principles emerged in GAAP because prior to specific standards (such as IAS 18/AASB 118) the definition of revenue was too general and did not provide sufficient guidance. Rules were needed about when to identify (recognise) revenue and to ensure that the revenue figure was reliable. It does matter which principles are adopted because they affect the reliability of the figure presented. The use of wrong principles, even if they are consistent over time, can lead to misleading information that has adverse economic effects. For example, recognition rules which permitted overstatement of revenue could prevent investors from making efficient resource allocation decisions.

6. What is the significance of the criterion of measurability of the consideration received?

AASB 118 para. 9 states that revenue shall be measured at the fair value of the consideration received or receivable. Measurability of the consideration (whether in cash or another form) is therefore required before revenue can be recognised.

It should be noted that para. 12 of AASB 118 states that if goods or services are exchanged for goods or services of a dissimilar nature, the fair value of the goods or services received establishes the amount of revenue. Where it is not possible to reliably measure this fair value,

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the revenue will be measured at the fair value of the goods or services given up, adjusted by any cash or cash equivalent transferred.

7. Explain the concepts of realisation and recognition as they relate to the measurement and disclosure of revenues under the historical cost system and under a system of mark-to-market or fair value for financial instruments.

See discussion in text as follows: Recognition requires an inflow of assets or a measurable (quantifiable) change in the value of an asset, whereas realisation requires an inflow of liquid assets. For example, a bank that holds shares in public companies can mark the investment to market and recognise any gain or loss at balance date (that is, use fair value accounting). This is an example of revenue being recognised before it has been realised.

As an example of a financial instrument, let’s say that a bank holds 1 000 shares in B Limited, which were purchased at the beginning of the financial year for $1 per share. At balance date, they have a value of $1.20 per share.

Under historical cost accounting, the gain or loss on the shares would not be recognised until realised. That is, in the increase or decrease in value would not be recorded in the accounts (recognised) until the shares were sold and the gain/loss was realised.

Under fair value or mark-to-market accounting the assets are valued at $1 200 at balance date and revenues increase by the incremental gain of $200. If the year-end value was 80 cents per share, then the incremental expense of holding the shares of $200 would be recognised in the statement of financial performance. The gain/loss has not been realised, but is recognised each accounting period. When a gain or loss is realised through the sale of the shares then the adjustment is directly against the asset, to remove it from the books, and to cash (or whatever asset is received for the shares). So, in the example, if the balance date assets are valued and recognised at $1 200, and they are subsequently sold for $1 200 cash, then the journal entry would be a debit to cash and a credit to ‘shares in B Ltd’ of $1 200. No gain or loss would be recognised at the point of realisation.

8. What do we mean when we suggest that applying the principles adopted in

accounting standards which make use of fair value measurement, such as IAS 39, 40 and 41 (AASB 139, 140 and 141), lead to an even greater mix of values presented in a company’s balance sheet?

Current accounting standards require/allow that a mixed attribute measurement model be used in the financial statements. That is, some items are valued at historical cost while others are measured at fair value. Initially, historical cost represents fair value. However, over time the two values may diverge. Current accounting standards require/allow a range of measurement methods to be used. For example, fixed/capital assets are held at cost and systematically depreciated in value over their expected useful life. They may or may not be systematically revalued (by independent or directors’ valuation). Intangible assets such as goodwill and brand names are valued at cost. Amortisation or impairment testing may reduce their reported value. Other assets, such as some financial instruments, investment properties and biological assets are revalued each accounting period to reflect current net market value.

This means a variety of measurement methods are reflected in the financial statements,

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without any conceptual basis for doing so. Measurement methods reflect more the politics of standard setting than they do sound conceptual reasons for adopting a particular approach.

9. Suppose you are a manufacturer of plastic products. A new customer, X Ltd, has purchased a large quantity and gives you a note as payment. The note requires X Ltd to make four equal instalments over a period of 2 years. How do you determine the collectability of the note? When should revenue be recognised?

The collectability of the note is determined be assessing the ability of X Ltd to pay. One would analyse its financial statements for liquidity and solvency, and consider the customer’s credit rating (Information can be gained from credit rating agencies.) Presumably this would have been done before the sale was finalised. If so, it would be reasonable to assume that, once accepted, the collectability of the note is considered to be reasonably assured.

The transaction meets the criteria for revenue recognition under AASB 118 para 14 (see text, figure 17.3). As soon as the company considers that it is probable that economic benefits will result, i.e. the amount outstanding will probably be collected, then revenue should be recognised. This assumes that the significant risks and rewards of ownership have been transferred from the manufacturer to X Ltd.

10. Should accountants insist that revenue be recognised by a firm only on receipt of a liquid asset in a sale transaction? Why or why not?

NO! For revenue to be recognised it has to be earned, be capable of reliable measurement and it must further meet the requirement that the ‘inflow or other enhancement or saving in outflows of service potential or future economic benefits’ will occur. That is, revenue must be realisable to be recognised, rather than realised.

The term ‘realised’ refers to the inflow of liquid assets, which, if revenue were only recognised when realised, would imply that only sales would be recorded as revenue.

For example, suppose Company X sold a machine to Mr Y on ‘net 30’ terms. Revenue should be recognised when earned (the goods have been provided) and the inflow will probably occur. If revenue has to be realised before it were recognised, then Company X would have to wait until Mr Y paid cash under the strictest interpretation of ‘realised’, or when the sale occurred and the firm acquired an account receivable under a less stringent interpretation of ‘realised’.

Generally, revenue recognition requires that the resulting inflow (or saving in outflow) be probable — the amount owed represents a valid claim or is collectable. However, some circumstances exist where collectability of an inflow is not assured — for example, where a creditor forgives a debt the entity owes. Under the Framework this forgiven liability would contribute revenue (being a saving in future outflows of assets), although no amount will even be ‘realised’ in the form of a physical inflow.

The accounting profession has abandoned the position of insistence of receipt of a liquid asset before revenue can be recorded. The basis of insisting on the receipt of a liquid asset is to

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protect the working capital position of the firm. But accountants now believe that this is a managerial function. Revenue may be recognised even though a non-monetary asset is received. However, the first criterion of measurability is important — that the non-monetary asset be subject to reasonable valuation.

11. Is it important to have an external transaction to support the amount of revenue recorded? Name a case in present accounting practice where revenue or gain is not directly based on an external transaction and state the reasons for this exception.

An external transaction is one with an outside party on an arm’s length basis. Such a transaction provides objective evidence of the value of the firm’s product or service. Many accountants believe that such objective evidence can be obtained without an external transaction. Where, for example, units are interchangeable and have an immediate marketability at quoted prices, it would seem reasonable to assume that the amount of revenue can be objectively determined.

The requirement for an external transaction may be seen as a necessary but not a sufficient condition to establish revenue.

Exceptions that are acceptable today are: • short-term investments — recovery to original cost may be recorded as a gain. The gain is permitted because it is an increase of a previously recorded decrease (loss).

• accrued revenue, such as interest revenue. For accruals, the revenue is earned continuously as time passes, rather than at a specific point in time. For instance, interest revenue denotes the sale of a service, the use of money.

• an exchange gain may be recorded based on the difference in exchange rates for relevant assets or liabilities on the original transaction date and the financial statement date. The change in exchange rate connected to the relevant asset or liability is considered an important economic event.

12. If the criterion of ‘existence of a transaction’ is relaxed so that the firms involved need not be direct participants in the transaction, what are the implications?

If the firms involved need not be direct participants in the transaction, then objective evidence to support the amount of revenue would be obtained through observation of a market transaction. Providing the output is practically guaranteed to be sold, the objective evidence to measure the amount of revenue and the probability may be significantly assured, and thus revenue can be recognised. The implications would be that a sales transaction would not always be required before revenue could be recognised – i.e. revenue could be recognised before it is realised.

The instructor may wish to discuss with students whether, in their opinion, the criterion should be relaxed.

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13. What is meant by ‘substantial completion of the earning process’? What is the significance of this criterion? How is the criterion incorporated into IAS18/AASB 118?

The meaning of the phrase is that the activities that generate revenue have been mostly undertaken. Usually, substantial completion of the earning process indicates sale or production has occurred. The significance of the criterion is that there is sufficient performance by the company to say it has ‘earned’ the revenue. In other words, the company has done enough to warrant the recording of revenue.

Another reason that the recording of revenue may be justified at this point is that uncertainty of the costs to match against revenue is minimised, since most of the costs have already been incurred and whatever remains is predictable and estimable.

This ‘substantial completion of the earnings process’ criterion, not explicitly stated in the AASB Framework, focuses on the notion that revenue is not generated (earned) until the firm has performed most of the activities for which the firm earns revenue. For this criterion to be applicable, revenue is not regarded as having been earned until the firm has done something.

For example, the signing of a contract in most cases does not create revenue because there is no performance by the seller at that point.

The criterion is not specifically stated in para 14, 20 and 29 of AASB 118 (see text figure 17.1). But completion of the earnings process underpins these paragraphs. For example, a sale occurs when substantially all the risks and rewards of ownership have transferred. This implies substantial completion of the earnings process. Similarly in the rendering of services, recognition depends on the extent to which the transaction is complete. Also for interest royalties and dividends, the process of earning the item is discussed. For example, interest is recorded as it is earned based on the effective interest method.

14. Does the percentage-of-completion method meet the criterion of substantial completion of the earning process? Explain.

If the earning process is considered complete only when the project is finished, then the criterion is not met by the percentage-of-completion method. But if the intent of the criterion is considered, which is to ensure that revenue is recorded when there is sufficient performance by the firm, then it is met. Each period is a definable, separate segment of the total performance. Since revenue is based on the performance by the firm, then it is met.

Since revenue is based on the performance of a given period, there is completion of the earning process for that period. Revenue is not recorded for any performance not yet undertaken.

15. What are the reasons for selecting the point of sale as the general revenue recognition principle?

The point of sale basis is selected, because it is the earliest time when the three criteria for revenue recognition are met. The three criteria are: receipt of a measurable asset, existence of

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a transaction, and substantial completion of the earning process. At the point of sale, there is sufficient, objective evidence to support the amount of revenue.

16. What is the significance of ‘title passing’ in determining whether a sale has taken place?

Legally, title passing is part of the meaning of a sale of a good. In accounting, we use this aspect of a sale to determine in many cases that a sale has taken place. But it is used as a guideline only, not a requirement. For example, in a sale-type capital lease, sales revenue is recorded by the lessor although title has not passed. Economic substance is more important than legal form. For this reason, accounting looks more at the transfer of significant risks and rewards of ownership in the sale of goods rather than the passing of legal title.

17. What are the reasons proposed for recognising revenue at the end of production?

Objective evidence is the primary concern in revenue recognition. Certain companies can recognise revenue at the end of production (before sale), because there is sufficient evidence of the increase in value without the confirming evidence provided by a sale transaction. This will be the case for firms with forward contracts or a guaranteed buyer, such as gold to the Australian government. In these cases, production, rather than sale, is the ‘critical’ event.

Once produced, the output is guaranteed to be sold, at least at the price specified by the contract or government.

18. ‘Revenue should be recognised only where it is supported by the existence of an external transaction.’ Discuss.

While the existence of an arm’s-length external transaction provides objective evidence that revenue has been earned, revenue can still be earned without the existence of an external transaction. In certain circumstances standards allow revenue to be recognised other than the time of sale. These include: • during production AASB 111 Construction Contracts • end of production and AASB 6 Exploration for and Evaluation of Mineral Resources (provided there is a legally binding contract which establishes sales price) • unrealised foreign exchange gains AASB 121 The Effects of Changes in Foreign Exchange Rates The Framework criteria for revenue recognition are that it must be probable and measured reliably, this is generally consistent with the existence of an external transaction. However, the criteria are broad enough to encompass revenue recognition in certain situations without the requirement of an external transaction (provided there is sufficient objective evidence).

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19. Explain how Myers’ concept of ‘critical event’ can influence the point at which revenue is recognised.

Myers suggests that profits are earned (and therefore revenue can be recognised) upon the happening of the ‘critical event’ in the earnings process. This critical event differs from one business to the next and is the most critical decision or task within the transaction cycle. So, for example, in a service based business the critical event may be the delivery of a substantial portion of the service, in a retailer it may be the delivery of the goods, in a financial institution it may be the advance of a loan. Although this leads to inconsistent revenue recognition points, it can be useful in assisting accountants to identify when it may be appropriate to recognise revenue.

20. What are the conditions for use of the ‘cash received’ basis for revenue recognition?

The ‘cash received’ basis of revenue recognition leads to revenue being recognised only when cash has been received, even though the sale had occurred prior to that. On the one hand, companies are encouraged to employ the sales basis for revenue recognition unless there is great uncertainty about the collectability of the periodic payments in an instalment sale. Then the instalment or cost recovery method is recommended. On the other hand, companies are forbidden to use the sales basis for revenue recognition and are required to use the instalment or cost recovery method if collectability is very uncertain, or if performance is not substantially complete. For example, retail land sales and construction contracts fall in this second category.

The position of the profession at present appears to be this: • For instalment sales for typical retail and manufacturing companies, use the sales basis for revenue recognition, unless there is evidence of great uncertainty about collecting the payments — then use the instalment or cost recovery method.

• For certain other industries, such as retail land sales and construction contracts, where it is typical for customers to give a long-term note in a sale, use the instalment or cost recovery method unless there is evidence of substantial performance by the seller and collectability of the note is assured — then the company may use the sale basis for revenue recognition. In some cases, the AASB has spelled out rules to determine collectability e.g. AASB 118.

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21. When should revenue be recognised for the following businesses? (a) a soft-drink manufacturer (b) a legal firm (c) a theatre that sells season tickets to musical productions (d) a magazine publisher producing monthly titles (e) a gold-mining company (f) a farmer who grows wheat (g) a company which sells houses on an instalment plan; term of payment extending to 20 years; buyers assume all risks of ownership; buyers pay a deposit of 25% of the sales price (h) a contractor building a bridge for the government (a)

When the soft drinks are delivered to the customers

(b)

When services are rendered (after the last act is performed)

(c)

After the musical production is performed. In most cases, refunds are not given to those who do not show up (no-shows).

(d)

When the magazines are delivered. For advertising revenue, when the advertising appears in the magazine.

(e)

Either at end of production (after the gold is mined) or at time of sale. A gold mining company has a choice of using end of production or sale basis for revenue recognition.

(f)

Sale as in (e) above. A wheat farmer has a choice between end of production or sale basis for revenue recognition because the wheat board guarantees prices.

(g)

It seems the full accrual method (sales basis) can be used. The main points are collectability and the degree of continuing involvement of the seller.

(h)

Percentage of completion method or completed contract method can be used.

22. On 20 December, E Ltd sold a portion of its inventory to W Ltd for $200 000 cash.

The cost of the inventory was $80 000. In a related transaction, E Ltd agreed to repurchase the inventory from W Ltd 2 months later for $200 000, to be paid in four equal monthly instalments at 10% interest. What transactions should be recorded

by E Ltd? According to AASB 118 para. 13, when an entity sells goods and, at the same time, enters into a separate agreement to repurchase the goods at a later date, the substantive effect of the transaction is negated, and the two transactions are dealt with together. The transaction will not give rise to revenue, even though legal title has passed.

When repayment of the loan commences, the capital portion of the loan will be offset against liability, and the relevant interest expense on the outstanding balance will be recorded each month until it is repaid in full.

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23. Lee Ltd agreed to manufacture Product A according to Smith Ltd’s specifications over a 2-year period. Because special machinery is needed to produce Product A, Smith Ltd is to pay for it. Lee Ltd purchased the machinery for $1 000 000. It debited Machinery and credited Cash. A month later, Lee Ltd received $1 000 000 from Smith Ltd as reimbursement of the cost. What entry should Lee Ltd make for the cash received? When Lee Ltd uses the machinery each year, what entry should be made?

This is what Lee has done: Machinery Cash

$1 000 000 $1 000 000

This agreement specifies that Smith is to pay for the machinery. The contract is only for two years. The problem does not state what will happen to the machinery at the end of the 2-year period. Will Lee keep it or will Smith expect to receive it?

The assumption made here is that it does not appear that Smith intends this to be a donation to Lee (there is no information to support the view that it may be a donation). Probably, Lee did not want to take the risk of purchasing the special machinery for the sole purpose of making this product for Lee for only two years. Lee should not show the machinery in its statement of financial position as an asset and should not be depreciating it.

Based on the fact that the original entry processed by Lee was incorrect, Lee should now record the following: Cash

$1 000 000 Machinery $1 000 000

Presumably, the agreement specifies a certain (lower) price that Smith will pay for product A, which considered the fact that the special equipment will be purchased by Smith.

When Lee uses the machinery, it will make no entry. When Smith purchases the product from Lee, it should increase the pertinent amount of depreciation expense. Smith should record the depreciation expense, and then, if considered appropriate, allocate the expense to the cost of its products through an overhead recovery account.

24. If revenue is recognised, does that mean that the revenue has been realised? Explain your answer and provide an example to support your view.

If revenue is recognised that does not mean necessarily that the revenue has been realised.

Recognising revenue is the process of including the earning activities conducted by the entity into the financial performance and position of the entity. Recognising that the earning activity has taken place, it therefore must be recorded. Realisation is the conversion of assets into cash or cash equivalence (such as a receivable). It can be said recognition requires an inflow of assets whereas realisation requires an inflow of liquid assets.

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There are many examples of revenues being recognised without being realised such as when a firm sells its product and receives raw materials or a fixed asset in return (bartering).

Revenue can also be in the form of increases in the fair value of biological assets — whereas the revenue has been earned, a cash benefit associated with the revenue may not be realised for several reporting periods in the future.

25. Kalbarri Ltd began operations on 1 January 2008 by purchasing 3 000 orange tree saplings at a cost of $4 per sapling. Delivery charges were $500 and it cost $1 200 to plant the trees on Kalbarri Ltd’s land, which 2 years earlier cost $60 000. During 2008, the saplings produced fruit that was used to generate 1 000 seedlings. The only other expense during the year was herbicidal spraying, which cost $400. At the end of the year the saplings had a market value of $4 per sapling and the seedlings $1 per seedling. Show all journal entries for the calendar year 2008 and the calculation of profit for the year.

Entries for the Year 2008: Biological assets — Saplings $13 700 Cr Cash $13 700 Purchase of 3 000 orange tree saplings (incl. transport & planting costs) 01.01.2008 Dr

01.01.2008 Dr

Decrement in market value account $1 700 Cr Biological assets — Saplings To recognise net market value of orange trees at $4 per tree.

31.12.2008 Dr

Spraying Costs Cr Cash

$1 700

$400 $400

Biological assets — Seedlings $1 000 Cr Revenue — Increment Account $1 000 1 000 seedlings at a current market value of $1. We do not have sufficient information to calculate net value as we do not have an estimate of the costs associated with the sale of the seedlings. So record at $1 each and assume this is the net value.

31.12.2008 Dr

Calculation of profit/loss for 2008: Seedlings Increment Saplings Decrement

$1 000 ($1 700)

Net decrease in Market Value Add: Operating expenses

($ 700) ($ 400)

Net Loss for 2008

($1 100)

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26. Why have the IASB and FASB begun a project to reconsider revenue recognition and measurement? What apects of their approach in this project may cause changes to the way companies recognise and measure revenue?

The IASB and FASB have both admitted that there are inconsistencies between their conceptual framework and some standards. For example, the IASB has stated the application of recognition criteria in the Framework and IAS 18 may create deferred assets and liabilities which do not accord with the Framework’s definition of assets and liabilities. A similar situation occurs in the US, based on SFAC 5 and 6. Current guidance does not deal well with transactions involving components (multi-element revenue arrangements). Revenue recognition guidance is incomplete. There is diversity in current practice and revenue recognition policies of US companies have been the subject of the majority of the SEC’s requests for restatement of financial statements. Thus, standard setters have turned their attention to revenue recognition.

Their approach is to focus on changes in assets and liabilities rather than the notions of realisation and earned (such as those contained in SFAC 5). This approach is consistent with SFAC 6 and avoids the problem of recognising debits and credits which do not meet the definitions of assets and liabilities. In addition, it avoids problems arising because notions of realised and earned are not precisely defined. However, the asset-and-liability approach represents a change from current practice, which may not be accepted by preparers and users of financial statements.

The proposed measurement criterion requires that the change in assets or liabilities can be appropriately measured. Specifically, (1) assets or liabilities are measured by means of a relevant attribute; and (2) the increase in assets or decrease in liabilities is measurable with sufficient reliability. A relevant attribute suggest consideration of fair value measurement.

The criterion does not refer to probability which was used in the past, eg AASB Framework para 83 (probable that future economic benefits associated with the item will flow to or from the entity). The measurement criterion places less emphasis on substantial completion of the earnings process.

27.

What is meant by ‘revenue cut-off’? Why do auditors verify the date of sales transactions around the end of a financial period?

The revenue cut-off assertion is that revenue transactions have been recorded in the correct accounting period. If sales transactions that occur in the first few days of an accounting period are backdated to the final days of the previous accounting period, revenue for the earlier period is overstated and revenue for the later period is understated. Auditors will perform procedures to test whether revenue transactions are recorded in the correct accounting period. These procedures include matching the date of the transaction recorded on the sales invoice or cash sales receipt to the date under which the transactions is recorded in the journals and ledgers. The procedures are designed to provide evidence to support the conclusion that the revenue for the period is fairly stated.

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28.

Explain why an auditor would be interested in the terms of the senior executives’ remuneration contracts, in particular, how bonuses for outstanding performance are calculated.

An auditor would be interested in the terms of senior executives’ remuneration contracts because such contracts potentially create incentives for accounting misstatements. For example, if the contract specifies that the executive is paid a bonus based on revenue growth, auditors need to be alert to the possibility that revenue is overstated. If the bonus is based on profit growth, there are incentives to misstate both revenue and expense transactions.

However if the contracts specify bonuses based on other performance targets, for example, share price increase or opening new branches, the incentives to overstate revenue are likely to be less.

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Problems 9.1

In the following examples, indicate whether it was proper for X to record the particular amount of revenue according to accepted recognition principles (accrual system). Your answer should be ‘yes’ or ‘no’. Give reasons for your answers.

1.

No. The common carrier is the agent of X and it still has possession of the goods. There is no sale, because delivery has not been made, not until the point of destination.

2.

Yes. For the sake of convenience to the customer, delivery has not been made. In such a case, delivery is not insisted upon in order to record revenue. If X wished to, X could wait until delivery to record the sale.

3.

No. Since Y’s credit rating is good, there is no basis for belief that collectability is very uncertain; therefore, X should not use the instalment method. This assumes that delivery of the vehicle has been taken by X, and that there is nothing in the sale agreement which would vary the point at which control passes from seller to buyer.

4.

No. There is also accrued interest for the four months from September 1 to December 31.

5.

No. X should have recorded the $600 as revenue last year when the repair service was rendered.

6.

No. The consignee is, in effect, an agent of X. Until the consignee sells the goods, there is no sale.

7.

No. Until the study is completed, there is no sale of services. The completion of the study is necessary to the meaningfulness of the study. The last act must be performed before there is recognition of revenue.

9.2

State whether revenue (or gain) is to be recorded in the following cases:

1.

Yes. In this case, the orchard is a biological asset, and according to AASB 141, changes in the fair value of biological assets are taken to profit or loss at the end of each accounting period. The trees will be measured at fair value less estimated costs to sell.

2.

Yes. The tax refund qualifies as ‘other income’. It is not extraordinary and it is not a prior period adjustment. There is a realised increase in assets (increase in wealth) and the transaction is not a capital or financing one.

3.

Yes. The cash from the lawsuit qualifies as ‘other income’. It is not a prior period adjustment. There is a realised increase in assets and the transaction is not a capital or financing one.

4.

No. Production of paper does not qualify for the end of production revenue recognition principle, unless the firm has a financial contract.

© John Wiley and Sons Australia, Ltd 2010

9.27

Chapter 9: Revenue

5.

Yes. There is a gain of $10 000. Since the amount of recovery from the insurance company exceeds the carrying value, a gain will be recorded.

6.

Yes. An exchange of non-monetary dissimilar assets completes the earning process, and therefore a gain of $10 000 is to be recorded.

7.

The receipt of a cash dividend is usually treated as income. Where a dividend is not received in cash, but rather in shares, the decision of whether it is income or not depends on how the market views the share dividend. If the market value of the shares drops, so that in total Company X’s investment value (and therefore net asset base) has not changed as a result of the share dividend, then there would be no income. However, if the overall value of the assets has increased by the receipt of the additional shares, then the definition of revenue is met and the dividend would be treated as income.

There is insufficient information here to give a definitive answer, but students should be encouraged to discuss the issues around this.

8.

Yes. An inflow of economic benefits has occurred and can be measured reliably.

9.3 Required: Calculate the amount of revenue for each year under each of the following recognition principles: (a) sales recognition principle (completed contract method) (b) production recognition principle (percentage-of-completion method) (c) instalment recognition principle (cash received method). (a)

Completed contract method:

Revenue

2005 0

2006 0

2007 0

2008 $600 000

2009 0

The project was completed in 2008, and therefore the ‘sale’ is consummated in that year. (b)

Percentage-of-completion method: 2006 $150 000

Revenue

(c)

2007 $375 000

2008 $75 000

For 2006:

$100 000/$400 000 = 25% 25%  $600 000 = $150 000

For 2007:

$350 000/$400 000 = 87½% less 25% = 62½% 62½  $600 000 = $375 000

For 2008:

$400 000/$400 000 = 100% less 87½ = 12½% 12½%  $600 000 = $75 000

Cash received method: 2006 Revenue

0

2007 $100 000

2008 $200 000

2009 $300 000

© John Wiley and Sons Australia, Ltd 2010

9.28

Solution Manual to accompany Accounting Theory 7e

9.4

Revenue was recognised when the events below occurred (accrual system). State whether it was proper or improper according to accepted recognition principles.

1.

No. There is no sale – there was no transfer of significant risks and rewards of ownership.

2.

No. Revenue should have been recorded a year ago when the repair was done.

3.

Yes. There is a credit sale. The transfer of goods and the risks and rewards of ownership have passed.

4.

No. Title does not pass until the common carrier has possession of the goods. The common carrier is the agent of the buyer in this case, and the goods have not been delivered to the agent yet.

5.

No. Title passes at point of destination, and presumably the goods are still in transit.

6.

Yes. The sale has occurred for two reasons. First, delivery is delayed at the convenience and request of the buyer. Second, the item is unique and costly, and therefore, legally, the sale is made when the buyer agrees to purchase the 1912 automobile. The presumption here is that delivery is the only outstanding action, and that the significant risks and rewards of ownership have passed to the buyer.

7.

No. This is cash received in advance of the sale of the service. This is unearned revenue.

8.

It depends on whether the conditions specified in AASB 118 are met. If significant risks and rewards of ownership have passed to the buyer and the seller effectively no longer controls the goods and it is probable that the sale will take place, they could recognise the revenue now. If not, recognition should be delayed.

9.

No. This is a consignment, not a sale.

10.

No. There is no performance yet. If the company had already begun to construct the yacht, then it could record the full amount as revenue. If there is performance, then a sale has been made. This assumes that the contract is not cancellable and that costs to be incurred can be measured reliably.

11.

Yes. The sale was made because the truck was delivered. This is not an instalment sale, since there will be no periodic payments. Despite the fact that legal title has not passed, this is simply a credit sale.

12.

Yes. Although this is an instalment sale, the sales basis should be used, because there is no evidence of great uncertainty in collecting the payments.

© John Wiley and Sons Australia, Ltd 2010

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Chapter 9: Revenue

9.5 Required: According to generally accepted accounting principles, determine the total amount of sales revenue Steele Ltd should report on its statement of financial performance for 2008.

1.

There is no sale.

2.

Sale made for $300 000. Risks and rewards of ownership pass when the goods are shipped (EXW shipping point), which has occurred.

3.

Sale of $12 000 000 made. It does not matter that $200 000 has not been received in cash, since the accrual method is used.

4.

This is a consignment, not a sale.

5.

The sales basis should be used, since there is no great uncertainty of collecting the payments. Sales of $150 000 to be recorded. There is interest income of $3 000.

6.

There is no sale. Paper products do not qualify for the revenue recognition exception of recording revenue at end of production. $

300 000 12 000 000 150 000 $12 450 000

Sales revenue for 2008

The interest income is not sales revenue.

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9.30

Solution Manual to accompany Accounting Theory 7e

9.6 Required: Prepare entries to record the sale of the franchise to T under each of the following assumptions: (a) The deposit is not refundable, no future services are required by the franchisor and collection of the note is reasonably assured. (b) The franchisor has substantial services to perform and the collection of the note is very uncertain. D Ltd will charge an annual fee of $4 000 for services rendered. (c) The deposit is not refundable, collection of the note is reasonably certain, the franchisor has yet to perform substantial services and the deposit represents services already performed. (a)

Cash Notes Receivable (at present value) Revenue from Franchise Fees

$150 000 128 855 $278 855

It is possible to record the note at $150 000 and credit a discount account for the difference (150 000 – 128 855 = 21 145) Present value of ordinary annuity, 3 periods, 8% 2.5770  $50 000 = $128 855 (b)

Cash

150 000 Unearned Franchise Fees

(c)

Cash Notes Receivable (at present value) Revenue from Franchise Fees Unearned Franchise Fees

150 000 150 000 128 855

© John Wiley and Sons Australia, Ltd 2010

150 000 128 855

9.31

Chapter 9: Revenue

9.7

Required: Prepare separate statements of financial performance for Divisions A and B for Year 1. For Division B, use the end of production revenue recognition principle.

For Division A, using the percentage-of-completion method: $190 000 350 000 100 000 80 000

materials used direct labour overhead administrative expenses (to be used because there is only one project)

$720 000 720 000 $1 440 000

total costs to date additional costs to complete, including administrative expenses total costs

$720 000/$1 440 00 = 50%, percentage of completion 50%  $2 000 000 = $1 000 000 revenue Statement of Financial Performance For the Year Ended December 31, Year 1 Revenue Cost of construction Gross profit Administrative expenses

$1 000 000 640 000 $ 360 000 80 000 $ 280 000

For Division B, using the end of production method: Statement of Financial Performance For the Year Ended December 31, Year 1 Sales revenue: Barley (8 000 m3  $5.00) Rye (12 000 m3  $3.00) Total NRV of ending inventory: Barley (2 000 m3  $5.00) Rye (8 000 m3  $2.70) Total revenues Less operating expenses Operating income Other items: Loss on sale of beginning inventory of barley (1000 m3  $0.40) Gain on sale of beginning inventory of rye (2 000 m3  $0.10) Net income

$40 000 36 000 $76 000 $10 000 21 600

31 600 $107 600 50 000 $57 600

-400 200

-200 $57 400

The NRV for ending inventory was calculated as follows: Barley:

$5.50 expected sale price less $0.50 expected cost of disposition = $5.00

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9.32

Solution Manual to accompany Accounting Theory 7e

Rye:

$3.20 expected sale price less $0.50 expected cost of disposition = $2.70

The sale of the beginning inventory is made for speculative profit. The beginning inventory was considered revenue in the previous year at NRV. Any difference between the NRV of the previous year and the net realised amount this year is gain or loss.

The NRV for the previous year was: Barley: $5.40 less $0.50 = $4.90 Rye: $2.90 less $0.50 = $2.40 The net amount realised this year was: Barley: $5.00 less $0.50 = $4.50. Therefore a loss of $0.40 was realised when sold ($4.90 –$4.50) Rye: $3.00 less $0.50 = $2.50. Therefore a gin of $0.10 was realised when sold ($2.40 - $2.50) The expenses related to the sale of the beginning inventory were deducted in the previous year, since NRV was taken.

© John Wiley and Sons Australia, Ltd 2010

9.33

Chapter 9: Revenue

9.8

Required: A. Record the journal entries relating to the instalment sales, using a deferred gross profit account.

B. Calculate the realised gross profit, showing it as the difference between revenue and cost of goods sold.

A.

(a) (b) (c)

Instalment accounts receivable Instalment sales

$700 000

Cost of instalment sales Inventory

420 000

Cash

300 000

$700 000 420 000

Instalment accounts receivable (d) (e)

(f)

General — administrative expenses Cash or Accounts payable (At end of period) Instalment sales Cost of instalment sales Deferred gross profit Deferred gross profit Realised gross profit

300 000 70 000 70 000 700 000 420 000 280 000 120 000 120 000

$280 000/$700 000 = 40%, gross profit rate 40%  $300 000 (cash received) = $120 000 or $300 000/$700 000 = 42.857% 42.875%  $280 000 = $120 000 (g)

B.

Realised gross profit General — administrative expenses Income summary

Revenue (cash received) Cost of goods sold Realised gross profit

120 000 70 000 50 000

$300 000 180 000 $120 000

As can be seen in the entries above, Revenue and Cost of goods sold are not recorded as accounts. Instead, the realised gross profit is an account from the ledger. They are put in this format so that the student can see that the cash received is actually the revenue, when the instalment method is used.

Cost of goods sold is 60% of revenue or it can be calculated as 42.857% of $420 000 = $180 000.

© John Wiley and Sons Australia, Ltd 2010

9.34

Solution Manual to accompany Accounting Theory 7e

9.9 Required: A. Prepare all journal entries to record the establishment of Brockelsby Station Ltd. B. Prepare journal entries to reflect the change in net market value of cattle at 30 June 2008 and the sale of calves during the period.

C. Assume the only transaction was veterinary fees of $20 000. Show the calculation of reported profit/loss for Brockelsby Station Ltd at 30 June 2008.

(Note: All transactions are cash transactions. Brockelsby Station Ltd has been established to buy, breed, sell or slaughter and process cattle for sale at retail outlets.)

A. Prepare all journal entries to record establishment of Brockelsby Station: Note: Cannot record purchase of land as we do not know the purchase price.

Dr Biological assets — livestock Cr Cash Purchase and transport of livestock 01.01.2008

$1 115 000 $1 115 000

Dr Decrement in value of Biological assets (Recognised as expenses) $120 600 Cr Biological assets — livestock $120 600 Cost of purchase, transport costs to buy, point of sale costs, and 1% auction fee ($55 000 + $55 000 + $10 600) B. 30.06.2008

Dr Cash Cr Sales

$8 000 $8 000

Sale of livestock Dr Biological assets - livestock $225 600 Cr Net Increment in value (Revenue) Net increment in market value of livestock

$225 600

Net value start of year ($1 115 000 – $120 600) is $994 400.

Net change is $1 220 000 – $994 400 = $225 600.

C. Calculation of profit for period: Sales Market increment Decrement expense less: Expenses Profit

$ 8 000 $225 600 $233 600 $120 600 $113 000 $ 20 000 $ 93 000

© John Wiley and Sons Australia, Ltd 2010

9.35

Chapter 9: Revenue

9.10 See Pty Ltd began operations on 1 January 2008 by purchasing 5 000 apple tree saplings at a cost of $2 per sapling. It costs $3 600 to transport and plant the trees on land purchased 3 years earlier for $100 000. During 2008, the only expenses were insecticide spraying and pruning costs totalling $8 000. On 15 August an additional 1 000 saplings were purchased for $3 each (with transport and planting costs of $1 800). In November a bushfire destroyed 25% of the planted trees. The year-end market valuation of the remaining trees was $11 000.

Show all journal entries for the calendar year 2008 and the calculation of profit/loss for the year. Assume all transactions are cash-based.

01.01.2008

Dr Biological assets $13 600 Cr Cash Purchase of saplings including transport and planting costs

$13 600

Dr Decrement in fair value —Expense $3 600 Cr Biological assets $3 600 To recognise net market value (assume net market value would be $2 per sapling) 15.08.08

Dr Biological assets $4 800 Cr Cash Purchase of saplings including transport and planting costs

$4 800

Dr Decrement in fair value —Expense $1 800 Cr Biological assets $1 800 Recognise net market value (assume net market value would be $3 per sapling) 31.12.2008 Dr Spraying & Pruning Costs Cr Cash Operating expenses

$8 000

Dr

$3 250

Natural disaster expense Cr Biological assets Loss of 25% of trees (25%  $10 0000; 25%  $3 000)

$8 000

$3 250

Dr Biological assets $1 250 Cr Market Value Increment Revenue $1 250 Net value at year of saplings was $9 750 and market value was $11 000 difference is a gain.

Calculation of profit/loss: Net Increment

$1 250

Less: Loss of Biological assets Operating Expenses Net Loss

($3 250) ($2 000) ($8 000) ($10 000)

© John Wiley and Sons Australia, Ltd 2010

9.36

Solutions Manual to accompany

Accounting Theory 7e BY

Ann Tarca Chapter 10 Expenses

© John Wiley & Sons Australia, Ltd 2010

Chapter 10: Expenses

Chapter 10 - Expenses CASE STUDIES Case study 10.1 Emissions trading: recognising the cost of pollutants

1.

What are emission allowances? Do they meet the IASB Framework definition of assets or expenses?

Emissions allowances are credits or allowances that a company receives from a regulatory agency that represent the right to emit a specified amount of pollution. Emission allowances are created as part of an emissions trading program.

An emission allowance is an asset because it represents a future economic benefit. When the emission allowance is used up, it becomes an expense or consumption of future economic benefits. A company with surplus credits can sell them, giving rise to an inflow of future economic benefits or revenue while a company with insufficient credits will need to purchase them, giving rise to an outflow of future economic benefits and therefore an expense.

2.

How do businesses obtain emission allowances?

Emission allowances are issued by the regulatory agency responsible for the emission trading program. A number of allowances are given, based on political and economic considerations.

Companies can buy, sell or hold their allowances so allowances can also be purchased from other companies which have surplus credits.

3.

How are emission allowances accounted for in the USA?

Emission allowances are accounted for on an accrual basis. When issued by the regulatory agency, the allowances have a zero cost basis for the receiving entity. Allowances purchased in the market place are recorded as inventory, using lower of cost or market valuation. When allowances are consumed, inventory is reduced and an expense recognised. Sales of allowances give rise to gains and losses, which are recognised in income.

4.

Why are the IASB and FASB involved in setting guidelines for accounting for emission trading?

The standard setters have proposed that the emission rights be measured at fair value (at balance date) with gains and losses on remeasurement recognised in income in the period in which they accrue. The standard setters are involved in setting guidelines to ensure comparability and consistency in the way in which companies account for emission allowances. The boards aim to ensure that all assets, liabilities, revenues and expenses are recognised in the period to which they relate. Emission trading can gives rise to assets, liabilities, expenses and revenue (as per the IASB Framework) so these transactions should be recognised in the accounts. The standard setters have active projects on their agendas to ensure that suitable guidance for emission trading is issued in the future.

© John Wiley and Sons Australia, Ltd 2010

10.2

Solution Manual to accompany Accounting Theory 7e

Case Study 10.2 Accounting for frequent flyer points: fact or fiction?

1.

Describe the accounting process used to account for frequent flyer points prior to the adoption of IFRS. How was the matching principle breached by this practice?

Revenue was recorded when points were sold. An expense (the cost of the FF seat) was not recorded at the same time. This was recorded later when travel occurred. The matching principle was breached by early recognition of revenue, without a corresponding increase in expense (‘cost of goods sold’ or cost of ticket given away).

2.

How could companies benefit from this accounting practice? Consider both the short and long term.

In the short term, the accounting policy of recognising revenue immediately while deferring the FF expense to a later period allows a company to report more revenue and greater profit.

However, in the long term there is no benefit as earnings will be reduced by the expense in later years.

Presumably companies are concerned about looking good in the short term. Perhaps they are hoping business will improve, so that the deferred expense has relatively lesser impact when it is recognised in the later period.

3.

Why was Qantas keen to correct the errors reported in the AFR article?

As a major listed company, Qantas would not want to be seen as breaching accounting standards or Corporations Law requirements. Such an action would be viewed badly in the market place. It suggests the company does not employ competent accountants, or does not obey the law. It may imply the company has engaged in earnings management. Such action would raise questions about the corporate governance practices of the company, which could have adverse effects on its reputation. Qantas would seek to protect its reputation as it makes use of public finance and depends on support of investors. It would want to avoid negative publicity arising from inaccurate reporting.

4.

Explain the difference between the cost/provision and the deferred revenue approaches.

Under the cost/provision approach Qantas recorded an expense at the time of the award, thus effectively reducing the revenue recognised in relation to the associated ticket sale. In addition, liabilities were increased by the value of the seat to be given up in the future. The deferred revenue approach will require Qantas to separate the value of the ticket sold into two parts: revenue relating to the current service (the airline seat) and revenue relating to the future award. Only the current service revenue is recognised and future revenue is allocated to a liability account (deferred revenue) to be settled when the award is exercised.

© John Wiley and Sons Australia, Ltd 2010

10.3

Chapter 10: Expenses

5.

What impact do you expect adopting the deferred revenue approach to have on Qantas’s financial statements?

Although the deferred revenue method is different to that previously used by Qantas and different accounts are used, the net effect on Qantas’s accounts is the same. The amount of net revenue is the same and a liability is recognised in relation to the future award. For Qantas IFRIC 13 will not affect net revenue or total liabilities.

© John Wiley and Sons Australia, Ltd 2010

10.4

Solution Manual to accompany Accounting Theory 7e

THEORY IN ACTION Theory in Action 10.1 Options deal dwarfs salary of ANZ chief 1.

Since 2005, IFRS 2 (AASB 2) requires companies to record an expense in relation to stock options plans. Explain the requirements of IFRS 2 (AASB 2) and how they differ to previous requirements. (Students will need to consult additional resources. See the list at the end of this chapter).

Prior to the application of IFRS 2 Share-based Payment many companies did not include an expense in relation to the cost of providing employee remuneration via stock options. Some managers did not support the recognition of an expense, which would reduce earnings.

Under IFRS 2 (AASB 2) companies are required to account for equity-settled and cashsettled share-based payment transactions as well as transactions where an entity receives goods and services and the transaction can be settled with cash, equity instruments or other assets (para 2). For equity-based transactions, the entity measures goods or services received (and the corresponding increase in equity) directly at their fair values. If the entity cannot estimate reliably the fair value of goods or services received, then their value is measured indirectly by reference to the fair value of the equity instruments granted (para 10). Fair value is to be based on market prices at grant date (para 16). If market prices are not available, the fair value is to be estimated using a valuation technique, to reflect measurement based on an arms’ length transaction between knowledgeable and willing parties. The valuation technique used should reflect generally accepted practice for valuing financial instruments and should incorporate factors and assumptions used by knowledgeable and will market participants (para 17).

2.

Provide an overview of the advantages and disadvantages of the requirements of IFRS 2 (AASB 2).

Standard setters argue that including the cost of share-based payments improves the relevance, reliability and comparability of financial statements. The information helps users of financial reports to better understand the company’s financial expenditure and commitments. Recognising share based payments, and provided associated disclosures, improves the information set with which investors work and thus assists them in analysing and evaluating companies. The information has the potential to enable users to make better resource allocation decisions.

Some commentators argue that recognition of share based payments introduces volatility and subjectivity into the accounts. The argument is that since the expense is based on fair value measurement (actual or estimated market prices, which can be volatile) it may introduce volatility into reported earnings. Standard setters argue that volatility is an economic phenomenon and should be captured. However, some managers oppose fair value measurement which they claim introduces volatility because they consider it makes the analysts’ prediction task more difficult and complicates the communication process between managers and analysts. Whether IFRS 2 leads to increased volatility is an empirical question still under investigation.

The second argument relates to subjectivity of measurement. Option pricing methods currently in use include the Black-Scholes-Merton model and the binomial valuation model.

© John Wiley and Sons Australia, Ltd 2010

10.5

Chapter 10: Expenses

Obviously these models are based on assumptions, which may vary from reality. Intentional or unintentional error may result. They are also subject to managerial incentives, i.e. managers can influence model inputs and therefore the resulting valuation. There is US evidence of managers controlling valuation inputs to achieve desired option valuations (e.g.

Google company in 2007).

3.

The article states that certain executives gain much more on options plans than is shown in their company’s accounts. For example, the ANZ CEO gained $19.7m cashing in options, but his pay was shown as $7.2m in the 2006 annual report.

Given that IFRS 2 requires the recording of an expense for share based payments, explain how this could occur.

As explained in part (1) IFRS 2 requires that options be valued at grant date and that an expense reflecting this value be included in the accounts over the life of the option. Therefore the expense recognised in the accounts is the value at grant date (e.g. at t = 0) not the value when the options are exercised (e.g. t = 3, if options vest in three years). The value at grant date can be less than the value when the option is exercised because the value at grant date is an estimation which can prove to be incorrect. For example, if share prices rise more than predicted the estimated value will be less than actual value and the amount for stock options expense will be less than the amount received by the employees when they exercise the options.

4.

In light of your answer to question 3, do you consider that the requirements of IFRS 2 should be changed? Why or why not?

It is not necessary to change the requirements of IFRS 2. The difference explained in (3) above arises due to the use of estimation models. Estimation is inevitable in relation to valuing options in many cases so it is not a weakness of the standard which leads to the discrepancy between value at grant date and exercise date. If the difference results from the technique used, it is not a weakness of the standard per se. Of course, the standard could require different techniques, however, it recommends ‘current best practice’ so a change in recommendations is not required.

The matter can be resolved by disclosure. Indeed, the information quoted in the article relies on existing disclosures which occur in two places: the value of options at grant date as shown in the financial statements and the value of options at exercise date as shown in the remuneration report included in the annual report. Therefore stakeholders can see the amount of remuneration received via options.

Perhaps the writer is concerned about the ability of readers to locate the information and understand the difference between value at grant date and exercise date. Writers of accounting standards assume reasonable ability among people using financial reports. On this basis, standards setters or regulators would claim that in this case the information is transparent and it is therefore up to users to make use of the information provided as they see fit.

© John Wiley and Sons Australia, Ltd 2010

10.6

Solution Manual to accompany Accounting Theory 7e

Theory in Action 10.2 Share option plans worthless 1.

Outline the difference between an option plan and a performance rights plan.

A share option plan grants employees the right to receive company shares in the future subject to certain conditions being met. Share options may be granted at reduced cost, minimal cost or no cost to employees. When vesting conditions are met, employees have the choice of exercising their options and obtaining company shares. Vesting conditions typically include the share price reaching a particular target and the employee remaining with the company for a particular period (e.g. three years).

Instead of increases in share price, performance rights plans use the company’s performance relative to its peers as the benchmark for exercising options. The article states that the performance hurdle usually involves comparing a company’s total shareholder return against a group of similar companies. If the company achieves the performance hurdle (a certain shareholder return compared to its peers) then executives can exercise their options and obtain shares at a favourable price.

2.

The article states that almost three quarters of employee share option plans issued by the top 50 ASX firms are now worthless. Explain how options can be worthless when companies have billions of dollars of assets.

Share option plans are ‘in the money’ when the value of the share is greater than the cost of the option. In this situation, a wealth maximising individual will exercise the option and obtain the shares. If options are granted at a discount to share price, then as long as the share price rises they are ‘in the money’ and have value for the employee. By January 2009, share prices had declined dramatically as part of the global financial crises which took hold of markets from October 2008. The value of option plans is linked to share price (not to the value of the company’s assets) so the fall in share prices rendered options worthless because the cost of exercising the option was greater than the value of the share obtained when the option was exercised. Options became ‘out of the money’ and had no value to the holder.

3.

What does an environment of falling share prices reveal about the effectiveness of incentive plans as motivational tools?

Share option plans were introduced as a way of incentivising employees and aligning their interests with those of shareholders. If employees are able to increase their company’s share price to meet the conditions of the option plan, then shareholder wealth increases but so too does the value of employee options and consequently the employees’ wealth. Share option plans were popular prior to the tech stock crash in April 2001. Options permitted firms to compensate employees without an outflow of cash and without a remuneration expense being recorded (because of accounting standards in force at the time) which would have reduced earnings.

However, when stock prices crashed after April 2001, in some cases options became worthless. Consequently, companies adopted performance rights plans. They were set up with different performance hurdles which were not as sensitive to overall movements in the share price. As we can see by observing markets, share prices move in response to many factors and in many circumstances these factors are outside the control of individual managers (e.g. share prices move in response to the weather and terrorist acts). Therefore it is in the

© John Wiley and Sons Australia, Ltd 2010

10.7

Chapter 10: Expenses

managers’ interests to link their remuneration to factors over which they have relatively more control. Instead of requiring a certain level of increase in share price (difficult to achieve when the market falls) the test for exercising the options is based on comparing the performance of the company to that of other similar companies. Thus employees benefit when their firm outperforms others but the award of options is not affected by overall market movements (which affect all firms).

This situation shows that option plans can still be used to motivate employees in times of falling prices if they are set up in an appropriate way. It also shows that the principles of incentive plans do not change, but the way plans are set up evolve as market conditions change.

© John Wiley and Sons Australia, Ltd 2010

10.8

Solution Manual to accompany Accounting Theory 7e

Theory in Action 10.3 Loophole lets bank rewrite the calendar 1.

Outline the events which led to Société Générale recording a 2008 loss in the company’s 2007 accounts. How did the bank justify its action?

In 2008 the French bank suffered an enormous loss due to the unauthorised trading activity of employee Jérôme Kerviel. The loss occurred in January 2008 but since the 2007 accounts had not been finalised the bank decided to include the loss in 2007. The bank offset the 2008 loss against the 2007 profit to give a result of a net loss of Euro 4.9 billion. In the annual report the bank stated that applying IAS 39 Financial Instruments: Recognition and Disclosure and IAS 10 Events after Balance Sheet date would have been inconsistent with a ‘fair presentation’ of its results.

The article states that the bank does not elaborate on why this would be so. Therefore, readers are left to draw their own conclusions. One view is that the event was not a positive one for the bank (either in terms of financial performance or corporate image) or for the banking sector in general or the French securities market. Therefore management included the loss in 2007 (despite it having occurred in the 2008 financial year) possibly because the managers (or major investors or the French banking/company regulator) wanted to ‘get it out of the way’ i.e. it wanted to take the loss, make the disclosure, and move on.

2.

On what grounds has the bank’s approach been criticised?

The bank’s action has been criticised for several reasons. First, the loss had not occurred at the end of 2007. If Kerveil’s actions had been discovered in 2007, the loss would not have been incurred as his positions were profitable in that year.

Second, the bank made use of the ‘carve out’ related to IAS 39,which was itself controversial.

For many parties, the use of the ‘carve out’ is not best practice. In addition, the company did not disclose what results would have been if the carve out had not been used, thus their reporting was not transparent for investors.

3.

Evaluate the role of the auditors in this situation.

The role of the auditors is to attest that the financial statements provide a fair presentation of the company’s position and performance in compliance with accounting standards. On the face of the situation, it seems difficult to understand how accounts can be in accordance with accounting standards if IAS 39 and IAS 10 have not been followed.

IAS 1 Presentation of Financial Statements requires that a company’s financial report fairly present the financial position, financial performance and cash flows of an entity. The application of International Financial Reporting Standards, with additional disclosure when necessary, is presumed to result in a financial report that achieves a fair presentation (paragraph 13).

Further, IAS 1 para 21 allows that a company can depart from the rules in the extremely rare circumstance that management concludes that compliance with the rules would be so misleading that it would conflict with the objective of financial statements.

© John Wiley and Sons Australia, Ltd 2010

10.9

Chapter 10: Expenses

The bank has taken advantage of para 21in IAS 1 to depart from accounting standards. But whether this action results in a fair presentation is debatable. The bank has taken the position that departure from IAS 39 and IAS 10 is necessary to provide a fair presentation. The auditors have concurred with the company’s view. Observers have questioned the independence of the auditors and the French regulator because they have concurred with the managers’ treatment. We are told that the IAS 1 fair presentation override is rarely invoked in Europe. The article quotes one auditor who said he had not seen it used in 40 years. The issue is politically sensitive, with possible implications for investment in the banking sector and/or French market, so it is possible that the independence of the auditors and the regulator was compromised in this case.

4.

Comment on the implications of this case for the consistent application of IFRS in the European Union and elsewhere.

This case generated much discussion because it raised the question of whether IFRS could be applied consistently in different jurisdictions. In this case, the bank, its two auditors and the French regulator all agreed with the treatment. However, the treatment was questioned by other parties, such as European auditors and ex-IASB and FASB Board members, who stated that the treatment was a manipulation of earnings. The implication is that the treatment was incorrect and should not have been accepted by the auditors and regulator.

Accounting standards are enforced at a national level. Although there are European bodies involved with the co-ordination of enforcement (e.g. CESR), national bodies retain sovereignty. This case is an example of national sovereignty being exercised in the national interest, ahead of the goal of consistent application of accounting standards. Thus, it highlights that consistent application of IFRS and comparable financial reporting is subject to political will and thus is vulnerable to circumstances and personalities.

© John Wiley and Sons Australia, Ltd 2010

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Solution Manual to accompany Accounting Theory 7e

Questions 1.

How is the cash outflow of an entity related to expenses?

In the ideal case, liabilities are payables whose value is the present value of the future cash outflow of the firm, and expenses are the increase in value of the liabilities. This shows that expenses relate to cash payments. In other words, eventually all expenses are paid in cash. In the real world of uncertainty, expenses are related to the using up of assets and services in the operations of the business. The assets and services are paid for at some time. Under accrual accounting, the payment may be made before the use of the asset or service or at the same time or after. In this sense, we can say that expenses are paid in cash at some point(s) in the life of the firm.

2.

What is the ‘monetary event’ associated with the notion of expense? How is the ‘using up of goods or services’ related to expense?

The monetary event is the increase in the value of liabilities (or shareholders’ equity) or the decrease in the value of the assets. The monetary event relates to the abstract portion of the definition of an expense — that is, that part which relates to the accounting equation. The reason why the monetary event occurs is that the firm does something to make it happen. In particular, the firm uses up goods (assets) and services.

The using up of goods and services refers to the real-world part of the definition of expense.

3.

What is the difference between expense and loss? How does the AASB Framework apply to expenses and losses?

In the AASB Framework paragraph 70, expenses are defined as follows: Expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants.

Expenses arise in the course of the ordinary activities include, for example, cost of sales, wages and depreciation. They usually take the form of an outflow or depletion of assets such as cash and cash equivalents, inventory, property, plant and equipment (Framework, paragraph 78).

Expenses encompass losses as well as expenses which arise in the course of ordinary activities of the entity. Losses may or may not arise in the course of ordinary activities of the entity. However, the Framework states that losses represent decreases in economic benefits and are therefore not different in nature from other expenses.

Therefore they are not regarded as a separate element (paragraph 79).

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Chapter 10: Expenses

4.

Explain the connection between accruals and deferrals on the one hand and the process of matching on the other. Give two examples.

Matching is an attempt to deduct the cost of using up assets and services (expenses) with the revenues that were generated (supported) by that ‘using up’ activity. That is to say, matching attempts to associate the real world operations that give rise to expenses and revenues.

Abstract Revenue:

Real-world operations Inflow (increase) in assets Production or sale of product in or decrease in liabilities current period

Expense:

Decrease in assets increase in liabilities

or Using up of assets and services in support of the production or sale activity

Given a certain amount of revenue that is determined by the revenue recognition principle, the matching process focuses on the ‘using up’ operations that helped to generate the amount of revenue recognised in the current period. In the matching process, accruals refer to ‘using up activities’ that occurred in the current period, but which have not been recorded, mainly because they have not been paid. Deferrals refer to ‘using up activities’ that occurred in the current period, but which have not been recorded — mainly because they have not yet been paid. Deferrals refer to ‘using up activities’ that will occur in the future, but which have been recorded (usually as assets) — mainly because they were paid in the current or past period. Accruals and deferrals also refer to revenue, but this question pertains to matching and therefore the focus is on expenses.

Accrual accounting and the matching process concentrate on certain operations that, by theory, will generate income. If not for theory, these particular operations would not have such significance. Accruals and deferrals are done because of accounting theory — they are imposed on the actual cash flow to ascertain periodic income according to theory.

Examples of accrued expense: Interest, rent, salaries and wages, taxes.

Examples of deferred (prepaid) expense: Interest, insurance, rent, wages, taxes.

5.

Name the three basic methods of matching. Give an example of each. How do they align with the expense recognition criteria outlined in AASB Framework?

The three basic principles of matching are: (1) Cause and effect: cost of goods sold, sales commissions, salaries and wages, certain selling costs (2) Systematic and relational allocation: depreciation, amortisation, depletion, insurance (3) Immediate recognition: R&D, advertising, utilities.

Some expense can be said to be due to cause and effect and are immediately recognised — for example, utilities, salaries and wages.

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Solution Manual to accompany Accounting Theory 7e

The AASB Framework focuses on the recognition criteria more than on matching. The two criteria for the recognition of expenses are stated in paragraph 83: An item that meets the definition of an element should be recognised if: (a) it is probable that any future economic benefit associated with the item will flow to or from the entity; and (b) the item has a cost or value that can be measured with reliability.

For an expense to be recognised in the financial statements, it must meet both of the recognition criteria. These criteria imply that any matching of expenses and revenue is limited by the extent to which the recognition criteria are met. Therefore, under the Framework expenses should be matched to the period in which the asset expiry or liability increase occurs rather than being matched against the revenues that they have contributed to earning. The recognition criteria relate to the outflow of service potential or future benefits having occurred, and the need for the amount to be reliably measurable. The application of the matching concept under the Framework does not allow the recognition of items in the balance sheet which do not meet the definition of assets and liabilities.

However, the matching concept underpins accrual accounting. Therefore, the Framework recognises the matching concept in paragraph 95 which states ‘Expenses are recognised in the income statement on the basis of a direct association between the costs incurred and the earning of specific items of income’. The matching process involves the simultaneous or combined recognition of revenues and expenses that result directly and jointly from the same transactions or other events. For example, the various components of expense making up the cost of goods sold are recognised at the same time as the income derived from the sale of the goods (paragraph 95).

6.

What are some of the problems connected with the cause-and-effect method?

On the surface, the cause and effect rule looks reasonable. As certain costs are incurred, these result in revenue. But these associations are difficult to substantiate, although they seem to be very sensible. Critics say that the basis of this rule is costs attach. Since the costs attach theory cannot be verified, then it is not surprising that cause and effect relationships cannot be confirmed. The implication of the rule is that a particular amount of expense can be associated with a particular amount of revenue; but in almost all cases, this cannot be proven.

7.

What are some of the problems related to the immediate recognition method?

The immediate recognition rule is applicable when future benefits of a given expenditure cannot be measured, except in an arbitrary manner. Trying to decide if future benefits exist or not and estimating the amount is a difficult task. Because of the difficulty involved, expenses can be manipulated. For example, capitalising or expensing the cost of rearrangement of machinery could go either way. In relation to R&D expenditure, AASB 138 requires that research be expensed, but development costs are to be capitalised when certain circumstances are met. Another example is advertising, which is normally expensed as incurred (required by AASB 138).

© John Wiley and Sons Australia, Ltd 2010

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Chapter 10: Expenses

8.

What is the ‘allocation problem’ as argued by Thomas? What is your opinion of this problem? How is it dealt with under the AASB Framework?

Thomas argues that allocations are theoretically unjustified, because they do not meet the three criteria he poses: additivity, unambiguity and defensibility. A variety of methods of allocation exist, each of which can be defended, but there is no conclusive way to select one over another.

Accountants defend allocations in two ways. First, they say, the allocation patterns reflect the cost of the services received in given periods. Thomas argues that accountants must demonstrate that the service received contributed to a given amount of cash inflows or revenue or cost savings. They can’t, Thomas says, because allocations do not reflect anything real. Also, input patterns cannot be associated with output patterns because of interaction. There is an ‘extra’ amount of output due to interaction that cannot be related to particular inputs.

The second way accountants defend allocations is to argue that allocated data are useful. Thomas says people are conditioned to believe such data are useful.

The fact that accountants continue to allocate shows that they still believe allocations are meaningful. Whether Thomas is correct or not is debatable. Even if his argument is not accepted, Thomas has made accountants more conscious of the need for evidence to support accounting practices.

Under the Framework, the allocation problem is dealt with indirectly. Expenses are determined by reference to assets and liabilities, not costs. As such, and because the Framework encompasses a variety of accounting measurement systems, the allocation problem is not a major concern in the Framework.

9.

How has allocation been defended by some researchers?

Eckel believes that allocations could be considered rational if the objective of allocations is redefined. Presently, the objective is to determine income by matching (mainly, cause and effect). Eckel suggests that the objective of allocations can be changed to simply the determination of income by the difference between revenue and allocated costs.

Callen used ‘Shapley’ values in game theory to show that the interactive element can be dealt with so that allocations of individual input costs can be made rationally.

Zimmerman demonstrated that allocations of costs for internal purposes are useful for controlling and motivating managers, and therefore are justified. He showed that cost allocations represent certain hard-to-observe ‘costs’ when managers are given decisionmaking responsibilities. That is, cost allocations help to lessen some of the problems of control and coordination that arise when managers within the firm are given the right to make certain decisions.

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Solution Manual to accompany Accounting Theory 7e

Miller and Buckman showed that there is a logical reason for the allocation of fixed costs by a service department in setting a price to charge a user department.

10.

Determine whether an asset or expense should be charged for the following, and state your reasons: (a) cost of removing two small machines to make way for a larger new machine (b) cost of repairing a floor damaged when a new machine was dropped while being unloaded (c) cost of a new calculator, $48 (d) cost of major repairs to equipment. The need for repair was discovered immediately after acquisition. There is no warranty on the equipment. (a) It depends. If the estimated salvage value of the two small machines had taken into consideration expected costs of removal so that a net salvage value was used in the calculation of depreciation, then the present cost of removal is an expense.

If not, then the cost would be capitalised to the new machinery. (b) Expense. The cost of repairing the floor is not a ‘necessary’ expenditure to acquire the machine or to put the machine in operating condition. The cost is due to carelessness. (c) Expense. The amount is not material. (d) Expense. The company should have inspected the equipment more carefully before purchase. If the need had been discovered, presumably the purchase price would have been reduced to account for the necessary repair.

11.

What guidance is provided by the AASB Framework in relation to the convention of conservatism ?

The recognition criteria of the Framework are part of a Framework which includes both neutrality and prudence as qualitative characteristics of financial information. The two criteria for the recognition of expenses (paragraph 83) are: (a) (b)

it is probable that any future economic benefit associated with the item will flow to or from the entity; and the item has a cost or value that can be measured with reliability.

These criteria should be applied following the principles of neutrality and prudence.

The principle of neutrality suggests that to be reliable information should be free from bias (paragraph 36). Further, information is not neutral if by its selection or presentation decision making or judgement is influenced to achieve a predetermined result or outcome.

Prudence is the inclusion of a degree of caution in the exercise of the judgements needed in making estimates under conditions of uncertainty such that assets or income are not overstated and liabilities and expenses understated (paragraph 37).

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Chapter 10: Expenses

The doctrine of conservatism describes the view that it is better for accountants to err on the conservative side when preparing statements that present a reporting entity’s financial position and performance. By applying this doctrine it reduces the risk of overstatement of net assets and profits of an entity.

Australia’s pre-2005 conceptual framework included SACs 3 and 4. These concept statements did not consider prudence to be a qualitative characteristic of financial information. They recommended that financial information should be neutral and free from bias (the neutrality principle stated above). Conservatism was considered a bias and therefore to be avoided. The IASB/AASB Framework is not as strong in its stand against conservatism.

Although a more conservative interpretation is permitted under the Framework than under SAC 3 and 4, the Framework does explicitly state that the principle of prudence does not allow the creation of hidden reserves or excessive provisions or the deliberate understatement of assets or income or the deliberate overstatement of liabilities and expenses because this would mean the financial report was not neutral and therefore not reliable (paragraph 37).

12.

Standard setters have been criticised for being ‘balance sheet biased’. What does this mean? What evidence is available to support this criticism?

Standard setters have been criticised as ‘balance sheet biased’, that is, there is a bias toward the statement of financial position (or balance sheet) rather than the operating statement. The evidence for this view includes the following: (1) revenues and expenses were defined in terms of changes in assets and liabilities (2) the requirement that an item needed to satisfy the definition of assets, liability or equity. Standard setters took the view that the balance sheet should contain only items which met the recognition criteria for assets and liabilities. Some deferred assets and liabilities could no longer be recognised. (Previously deferrals had been used so that the effect of certain events in the operating statement could be recorded over a number of reporting periods.)

It was argued by the AASB that defining revenues and expenses in terms of changes in assets and liabilities provides a framework for reporting those elements according to their economic substance, and limits the scope for bias in the reporting of revenues and expenses.

The Board also maintained that the recognition criteria for revenues and expenses cannot be applied independently of the recognition criteria for assets and liabilities if the operating statement and the statement of financial position are to appropriately link with each other. Hence the criteria for recognition of assets and liabilities ‘drive’ the application for the criteria for recognition of revenue and expenses.

© John Wiley and Sons Australia, Ltd 2010

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Solution Manual to accompany Accounting Theory 7e

13.

Explain the arguments for and against expensing share (stock) options.

The arguments commonly proposed for the recognition of assigning share options to employees as an expense, include: 1) They are basically another component of salary expense and should be recognised as such.

2) There is a legal obligation created at the point that the options are assigned and this requires recognition.

3) It would provide a clear indication to all stakeholders as to the full remuneration costs of management and the incentives such options create.

Arguments against include: 1) There is no expense until the option is actually exercised and the option may never be exercised.

2) Options are difficult to value. How do we decide what value to ascribe to the option?

14.

Leonard Ltd is a small firm. For the 6-month period ending 30 June of the current year, it made sales totalling $40 000. These sales were on credit and were all made in the last 4 months. To determine its bad debts expense, it uses an ageing schedule of accounts receivable that has proven to be relatively accurate. For the 6-month period, the following calculation was made of accounts receivable multiplied by the uncollectable percentage:

There was no remaining balance in Provision for Doubtful Debts at the end of the 6-month period. Leonard Ltd recorded $1560 as a bad debts expense, which was one of the expenses deducted from sales revenue of $40 000 on the income statement. Is the $1560 the proper amount of expense to match against the $40 000 sales revenue? Explain. Where the Provision for Doubtful Debts is inadequate, leading to a significant expense affecting current year profits but relating to revenue from a previous period, is it consistent with the matching concept to write off the debt in the current period?

The bad debts estimate is based on accounts receivable, a statement of financial position account. This is an acceptable procedure. Since the estimate is based on accounts receivable rather than on sales, the bad debts expense does not match well with the sales revenue for the current period. Receivables in this problem include those that were from sales made in the previous 6-month period. The sales for the current period were all made in the last four months, and therefore proper matching would call for bad debts expense related to sales made in the last four months.

Bad debts expense is considered a cost of generating credit sales. Two ways of ascertaining the amount exist: the statement of financial position approach (% of

© John Wiley and Sons Australia, Ltd 2010

10.17

Chapter 10: Expenses

accounts receivable) and the income statement approach (% of sales). Logically, only the latter method would give a proper matching.

15.

16.

Decide whether the following expenditures should be put into an asset or expense account: (a) The cost of an insurance policy, which had been purchased by Y Ltd to cover goods in transit to the company from suppliers for the current year. (b) The salary for the general manager in charge of plant operations for Z Manufacturing Ltd. The cash component of the salary is $100 000; employercontributed superannuation is $20 000, and the general manager is offered 40 000 share options in the company to be exercised after 2 years at 50% of the market value of the shares at the date the options are exercised. Cover each component of the general manager’s remuneration in your answer. (c) The legal fees incurred in the unsuccessful prosecution of a patent infringement suit. (d) The fees paid to a consultant who designed a more efficient layout for plant operations. (e) The fees paid to an underwriter for handling the share issue when T Ltd was first established. (a)

Capitalise to purchases or inventory. The cost of the insurance is a ‘necessary’ business expenditure to acquire merchandise.

(b)

The salary of the general manager is considered a general administrative expense.

It does not qualify as direct labour for product costing nor overhead, because the general manager is not involved in the actual manufacturing process.

(c)

This is an expense because the case was unsuccessful.

(d)

It depends. Theoretically, since the layout is more efficient (greater productivity), the cost should be placed in an intangible asset account. But the materiality of the amount should be considered — if small, expensing would be justified.

(e)

This would be part of establishment costs, which are an intangible asset.

The following items are typical expenses. Identify the asset or service that is used up: (a) income tax expense (b) interest expense (c) cost of goods sold (d) warranty expense (e) goodwill amortisation expense (f) research and development expense (g) life insurance expense (on life of chief executive) (h) superannuation expense (i) rates expense. (a)

Government services, such as protection from foreign powers, etc

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Solution Manual to accompany Accounting Theory 7e

(b) (c) (d) (e) (f) (g) (h) (i)

17.

Cash borrowed Inventory Service to make good the deficiency of the product sold (includes labour, parts) Goodwill (intangible factors that create superior earning power) Services expended doing research and development (includes labour and assets such as equipment) Service of insuring against any loss to company during the past period, because of death of chief executive Services of employees rendered during the past period, but this portion is payable to them after they retire State government services, such as fire and police protection.

An entity receives 100 emission trading allowances from the government. It purchases an additional 50 allowances for $3,000 each. (a) What is the average cost of the allowances? What journal entries are required to record these transactions?

The total cost of the 150 allowances is $150,000. The average cost is $1,000 each.

DR Inventory – emission allowances CR Cash at bank

150,000 150,000

(b) How should the entity record sale of one allowance for $4,000? What entry is required if the entity uses all 150 allowances?

The entity should reduce inventory by $1,000 and record a profit of $3,000.

DR Cash at bank CR Profit on sale of emission allowance CR Inventory If all 150 allowances are consumed: DR emission trading expense CR inventory – emission allowances

4,000 3,000 1,000

150,000 150,000

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Chapter 10: Expenses

PROBLEMS Problem 10.1 1.

2.

An expense representing the fair value of the options issued must be recognised in the financial statements. An expense is recorded at grant date and over the life of the options. Estimated fair value of options at exercise date is 10 000 shares at $250 = 2 500 000 less cash payment on exercise $1 800 000 = 700 000. Spread over three years = $233 333 per annum. Therefore expense to be recorded in each of the three years: Employee benefit expense Share options

$233 333

Patent

$64 000

$233 333

Cash

$64 000

Amortisation Expense Patent

4 000 4 000

The journal entries are simple enough to record, but how does one determine the economic life of eight years? How do we know that a good estimate of the cost of the services provided by the patent is $8000 a year? How do companies arrive at their estimates?

3.

Development Expense Cash, etc.

$140 000 $140 000

Development expenses written off, assuming criteria of AASB 138 paragraph 57 are not met. Some students may capitalise the development expense on the assumption that the criteria are met.

Patent

13 600 Cash

13 600

The economic life of 20 years implies future economic benefits which are expected to exceed the cost of the patent. An asset is recognised and amortised over its legal life (paragraph 94).

Amortisation Expense (3/12  $800 a year) Patent

200 200

If development expenses been capitalised, the amortisation expense would be $1920 rather than $200.

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Solution Manual to accompany Accounting Theory 7e

4.

According to AASB 3, goodwill is not amortised but tested annually for impairment.

Ryder must review goodwill for impairment as per AASB 136 (paragraph 12). If an entry is required, it would be: Dr

Goodwill impairment Cr Goodwill

xxx xxx

to write down goodwill to cost less any impairment losses.

5.

Depreciation Expense of Trucks Accumulated Depreciation $35 000  5 trucks = $175 000 $175 000 less $25 000 salvage value = $150 000 $150 000/1 000 000 miles = $0.15 a mile $0.15  120 000 actual miles = $18 000

$18 000

Depreciation Expense — Equipment Accumulated Depreciation

$500 000

$18 000

$500 000

The amount of depreciation of the trucks was affected by the strike, since the trucks were not used for three months. The amount of depreciation of the equipment was not affected by the strike, because the straight-line method is based on time rather than use.

Both methods are acceptable. The depreciation for the trucks could have been on a straight-line basis, and the equipment could have been on the service basis. If so, the depreciation recorded for the trucks and equipment would have been different from that actually recorded. For example, for the trucks, depreciation under straight-line, based on five years, would have been $30 000 instead of $18 000. Both figures are correct, in the sense that both are based on accepted methods of calculation. But the effect on income is quite different.

6.

Is this to be capitalised or not? Two factors should be considered. First, when the company estimated the economic life of the building, say, at 20 years, did it expect that the building would be painted in order that it last for 20 years? The answer should be yes; and therefore, the expenditure should be maintenance expense. The second factor has to do with the materiality of the amount. If it is not material, not expensing it confirms the previous conclusion. If material, then capitalising would be acceptable.

Maintenance Expense Cash or Accounts Payable

$20 000 $20 000

The entry shows the amount to be expensed, but if someone or the company insisted that it be capitalised, it would be difficult to say that capitalisation is incorrect.

7.

Write down due to storm damage Building

$50 000 $50 000

The amount must be recorded as an expense in the income statement. AASB 101 does not permit items to be as extraordinary (para 85). If an item is material its nature and amount should be separately disclosed (para 86).

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Chapter 10: Expenses

8.

2005

2004

2003

Depreciation — new method Depreciation — old method

$19 200 15 000

$24 000 15 000

$30 000 15 000

Decrease in Income

$4 200

$9 000

$15 000

Depreciation Expense Cumulative Effect Due to Change Accumulated Depreciation

4 200 24 000 $28 200

Discuss whether the 2005 income be decreased by $24 000 for the effect of the change pertaining to 2004 and 2003. Does it reflect the matching principle or expected future useful life or the warehouse?

9.

Legal settlement Cash

$125 000 $125 000

The legal settlement is recorded as an expense of the current year. Although the case was initiated in 2004, adjustments to prior period’s retained earnings are not permitted except in limited circumstances (AASB 101 paragraphs 98–100).

10.

This is a change in estimate. $300 000/20 years = $15 000 a year $15 000  10 years = $150 000 accumulated depreciation $150 000 book value on 1 Jan. 2010/20 remaining years = $7500 depreciation a year.

Depreciation Expense Accumulated Depreciation

$7 500 $7 500

Is the amount of $7500 proper matching of depreciation? If the company had correctly determined its estimated life at the very start, depreciation would have been $10 000 a year (= $300 000/30 years).

11.

It is conventional to expense advertising expenditures, because of the difficulty of measuring the future benefits. Despite the fact that the benefits are acknowledged, the uncertainty of the length of time would only make allocation arbitrary.

Advertising Expense Cash of Accounts Payable

$200 000 $200 000

AASB 138 does not permit capitalisation of advertising expenditure.

12.

For the sake of matching, we are willing to estimate and guess at the future amount of the repair cost. There should be past experience to give us a basis for this estimate.

Warranty Expense Estimated Liability on Product Warranty

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$68 000 $68 000

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Solution Manual to accompany Accounting Theory 7e

13.

On 31 December 2009, the following entry is to be made: Loss on Purchase Commitment Liability from Purchase Commitment

$90 000 $90 000

This is a promise in exchange for a promise. The transaction of purchasing the material will occur in 2010, but because of conservatism we anticipate and record the loss now (7500 tonnes  $12 = $90 000). Since the transaction has not occurred yet, the matching principle is violated by recording the loss now. This entry shows that conservatism is more important than matching.

14.

(a)

(b)

(c)

Construction in Progress Cash, Materials, etc.

$424 000

Accounts Receivable Partial Billings

350 000

Cash

310 000

$424 000

350 000

Accounts Receivable (d)

Loss on Long-term Contracts Construction in Progress (or a liability) $424 000 106 000 $530 000 520 000 $ 10 000

310 000 10 000 10 000

actual costs incurred expected costs to complete total costs contract price loss

Again, because of conservatism the loss is recorded now. According to the completed contract method, there is no revenue until the project is completed; yet, a loss is recorded now when the project is not completed.

15.

The new asset has a more objectively determinable fair value; therefore, the loss is calculated as follows: Value received: fair value of new asset cash Value given: book value of old asset Loss Cash Machine (new) Loss on Exchange Accumulated Depreciation Machine (old)

$50 000 5 000

$55 000 70 000 $15 000

$ 5 000 50 000 15 000 20 000 $90 000

A loss is always recorded in an exchange of non-monetary assets.

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Chapter 10: Expenses

16.

First debit the provision for doubtful debts. Since the amount is large, it will be greater than the provision so the excess must be charged to bad debts expense. The amount may be separately disclosed because it is material.

Bad Debts Expense/ Provision for Doubtful Debts Accounts Receivable

17.

$60 000 $60 000

The building must be recorded, and accumulated depreciation against it should be recorded over the life of the building. But depreciation should be offset in some way, because really there is no ‘cost’ to the company.

2 Jan. 2009

31 Dec. 2009

Land Building General Reserve

$300 000 $100 000 $400 000

General Reserve Accumulated Depreciation

10 000

or Depreciation Expense Accumulated Depreciation

10 000

General Reserve Revenue (donation)

10 000

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10 000 10 000 10 000

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Solution Manual to accompany Accounting Theory 7e

Problem 10.2 Mangold Ltd received several donations. Record the journal entries for the following events: 1.

Cash of $10 000 is received from a shareholder as a donation.

2.

The cash donation is used to pay salaries and wages expenses.

3.

Equipment is received at the beginning of the year from Lin Pty Ltd as a donation. The fair value is $20 000. The carrying amount for Lin Pty Ltd is $15 000. Estimated useful life at the time of receipt of the equipment is 10 years.

4.

The equipment received from Lin Pty Ltd is used in operations for the year.

5.

Land is received from a shareholder as a donation. The fair value is $50 000.

6.

The land is sold for $55 000.

Solution 1.

It is conventional that when cash is received as a donation, to consider this to be other income, because it can be used immediately in the business.

Cash

$10 000 Other income

2.

Salaries and wages expense Cash

$10 000 10 000 10 000

Notice that although other income is offset by the expense the net income is affected by the donation. If not for other income, the net income for the period would have been less.

3.

Although there is no cost, the company does have an asset that should be recorded.

Equipment Revenue

4.

5.

20 000 20 000

Journal Entry Depreciation Expense Accumulated Depreciation

2 000

Land

50 000

2 000

General Reserve 6.

50 000

Most accountants would record the following entry: Cash

55 000 Land Gain

50 000 5 000

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Chapter 10: Expenses

Problem 10.3 The Flying Fox Group of companies owns the tollway from the centre of a major city to the airport. Under the agreement with the state government, Flying Fox must upgrade the road every 10 years. Flying Fox has established a provision account to allocate the future cost of upgrading the road over the next 10 years. Outline the accounting entries to provide for such a provision. Is this approach consistent with the matching principle? How does this approach relate to IAS 16/AASB 116 Property, Plant and Equipment and IAS 37/AASB 137 Provisions, Contingent Liabilities and Contingent Assets?

Solution Accounting entries: Dr Maintenance Expense Cr Provision for Maintenance When the maintenance expenditure is incurred then: Dr Provision for Maintenance Cr Cash This approach is inconsistent with the depreciation approach adopted under historical cost in that there is a systematic write-down of value; however, the maintenance provision indicates that there will be an extension or at least maintenance of value. Perhaps the provision for maintenance is sufficient; however, the HC system requires the systematic allocation of depreciation.

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Solutions Manual to accompany

Accounting Theory 7e BY

Allan Hodgson, Victoria Wise Chapter 11 A positive theory of accounting policy and disclosure

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Chapter 11: A positive theory of accounting policy and disclosure

Chapter 11: A positive theory of accounting policy and disclosure THEORY IN ACTION Theory in Action 11.1 Objections to crackdown 1.

What are the likely components of a chief executive officer’s (CEO) management compensation package that might be affected by the proposed changes?

It is most likely that the cash component of CEO compensation packages would be increased if ‘caps’ (upper restrictions) were to be placed on other components (such as share bonuses and options) of the packages. The article also suggests that total salary may have to be increased.

2.

How is the introduction of a ‘cap’ (upper limit) on termination payments likely to affect CEO’s remuneration if firms make no adjustments to the compensation packages?

Other components consisting of bonuses and equity-based compensation (such as shares or options to acquire shares) on top of base salary is likely to increase, particularly in the period leading up to termination of employment. To provide an incentive to the CEO to outperform the market in the pre-termination period non-salary components of the compensation package may be added to the remuneration package.

The instructor might mention at this point the tie in with agency theory: According to agency theory, agents (managers/executives) are utility maximisers and there is no reason to believe that they will necessarily act in the best interest of principals (shareholders) unless the principals’ and agents’ interests are aligned. For example, managers have incentives to increase perquisite consumption at the principal’s expense.

In order to solve this agency problem, shareholders need to align managers’ remuneration with their performance in maximising the firm’s value. By including nonsalary components in the CEO’s remuneration package, firms will provide incentives to CEOs to act in a manner that will increase firm value.

3.

How could researchers evaluate the general impact of a ‘termination pay cap’ on the structure of management compensation packages?

This question is aimed at starting the students to think empirically (positive) about consequences. Suggestion: By analysing the components, structure and size of executive compensation packages pre- and post- the imposition of a termination pay cap, and attempt to identify any impact on firm value as measured by market capitalisation or other factors. This analysis might need to consider lagged share prices

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as the new compensation packages might have behavioural impacts that might not have an immediate impact on the firm’s market value.

4.

What sort of key performance indicators are likely to be included in CEOs’ compensation packages? What role might accounting numbers play in these indicators?

The most likely key performance indicators would be linked to the financial structure and the market value of the firm. Indicators could include: • Percentage and absolute change in share price • Percentage and absolute change in debt level • Constancy/improvement of earnings • Levels/increases in Earnings Per Share (EPS) Also, the firm’s performance could be compared to the relative performance of an index or group of firms that operate in similar sectors. It is possible that the CEOs might choose accounting policies to best suit the achievement of key performance indicators, in which case a key performance indicator could be consistency in accounting policies.

Accounting numbers are often used as thresholds or ceilings in setting targets for the incentive components of management remuneration. For example, it is not uncommon for a CEO’s salary package to contain an incentive bonus that is paid only after the firm achieves a certain level of profits that is deemed challenging, but not impossible. From there, the manager achieves a bonus, possibly payable at a particular percentage of the firm’s earnings in excess of that threshold. There might also be a ceiling on the profit that forms the basis for the bonus payment. This recognises that sometimes, profits can only be achieved at the expense of future earnings (e.g. by not maintaining equipment, or not conducting any research and development). As such, the role of accounting numbers in this case is to motivate the manager to achieve higher, sustainable, profits that are challenging, and increase the value of equity.

Sometimes, these accounting numbers are set as overall targets for the firm; sometimes they might be set as targets per share, recognising that it is the return to individual shareholders that the manager is to maximise. Students may think of other roles that accounting numbers play in these targets. Consider each on its merits.

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Theory in Action 11.2 Debt Contracting 1.

Explain why the Stella Group’s debt position would have ‘dragged down’ the CVC Asia Pacific organisation’s balance sheet?

If debt forms a significant part of a firm’s financial structure, the risk that the firm will not be able to meet its interest obligations increases, as does the chance that it will breach its debt covenants. If debt had been issued under more onerous terms and conditions than are currently available and if the organisation was not able to repay and reissue the debt under more favourable terms, then the existing debt would be burdensome.

Generally, shareholders are likely to prefer debt financing to equity in order to (a) obtain tax deductions for the interest on the debt (dividends are not tax deductible to the company); (b) avoid diluting their control over the firm; and/or (c) ensure that future profits in excess of the interest paid on debt accrue to them and are not spread across a broader shareholder base. Note that, in relation to the above: • Interest is tax deductible for companies; their own dividend payments are not.

• Debt has little or no impact on control of the firm. Debt holders do not share

ownership of the firm, and therefore they cannot have influence in managing the firm. Shareholders, on the other hand, share ownership of the firm through the possession of their shares. Consequently they share control of the firm and may influence its management by imposing some restrictions to protect their interests.

Note that the level of control for an individual shareholder is generally very small unless the firm is small or the shareholder is extremely large.

• In terms of firm profits, debt holders cannot share the firm’s profits, whereas

shareholders will share the firm’s profits through dividend payments.

2.

From a lender’s perspective, what are the costs associated with high leverage? How can these costs be mitigated?

There are some agency costs associated with high leverage from a lender’s perspective.

When leverage increases, managers (acting for shareholders) will have incentives to transfer wealth away from debt holders to shareholders. This can be done through different ways such as excessive dividend payments, asset substitution, underinvestment, and claim dilution. These costs can be mitigated by establishing a debt covenant, in which the lender specifies terms and conditions that restrict the activities of management or require management to take certain actions upon receiving the borrowings. For example, the lender might require the firm to not pay beyond a certain level of dividend, have its accounts audited by an industry specialist audit firm, or to not borrow money from any other lenders without approval from the current lender, or to covenant that it will not allow leverage to exceed a certain ratio, etc.

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3.

From a shareholder’s perspective, what are the costs of high leverage? How can these costs be mitigated?

From a shareholder’s perspective, high leverage may impair the firm’s credit rating since the firm appears risky, and may affect the firm’s ability to raise money in the future. If the firm’s ability to raise money in the future decreases due to excessive current borrowings, the firm may not be able to obtain sufficient funds needed for its expansion and growth. This is the cost that shareholders will bear, as inability to grow will prevent shareholders from maximising their wealth in the firm. In addition, a high leverage firm may also be considered as a risky and unsafe investment by the market.

This will cause the share price to fall, which reduces the value of shareholders’ investment in the firm. These costs can be mitigated by aligning management’s interest to shareholders’ interest, and thus preventing management from borrowing excessively at the shareholders’ expense. One way to align management’s interest with shareholders’ is through equity-based remuneration, whereby manager’s remuneration is tied to the firm’s share price. By doing so, management will be more cautious in making decision that can damage the firm’s share price, such as excessive borrowings.

Students may raise other ways in which shareholders’ and lenders’ interests are aligned to reduce the likelihood that high leverage will reduce the value of equity.

4.

What are some incentives that might explain why CVC chose to restructure the Stella Group by contributing further equity (by buying Octaviar’s 35 per cent stake)?

The contribution of further equity would have resulted in a restructuring of the financial position of the group. If the debt/equity ratio was high and approaching the level of any existing debt covenants, the equity injection would have mitigated this unfavourable situation by reducing the level of debt relative to the level of equity. This alone would provide a significant incentive for the equity contribution.

A further reason for increasing the level of equity is to ensure that it had greater influence or to secure control, over the group. This could provide it with the ability to determine the future financial policies and actions of the group including the flow of dividends.

5.

What are the potential ‘covenants’ and ‘ending terms’ that are likely to have been overhauled in the Stella Group’s financial restructure?

The financial covenants that are likely to have been overhauled could include: • Links between level of debt and equity, revenue, profit, dividends (and potentially a range of other accounting number) • Links between debt and financial statistics such as EPS, Diluted EPS, Dividend ratio (to profit) Lending terms that are likely to have been changed could include: • Interest rate • Repayment schedule including final repayment date(s) • Events likely to crystallise (trigger repayment) the outstanding debt

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Theory in Action 11.3 What do profits signal?

1.

Navitas’s announcement of soaring profit is a strong signal of the firm’s earnings prospects. Other comments in the article reinforce that signal. What could Navitas do in relation to its profits to strengthen the signal even further? Explain your answer.

To strengthen its signal even further, Navitas could announce a dividend policy. As firms normally smooth their dividend payments, an increase of dividends in the future would give a signal that Navitas is expecting its business operations and outcomes to improve and be sufficient to support the higher level of dividends.

2.

What factors might increase or decrease the credibility of the signal provided

by Navitas’s announcements and press attention?

Some factors that might increase the credibility of the signal provided by Navitas are: • upward trend in global demands for its product/service as a result of the global financial crisis • the fact that Navitas has low debt and good cash flow in a period when other firms are struggling to raise debt and are facing diminishing cash flows • positive press releases by Navitas • positive forecasts and buy recommendations by analysts.

Some factors that might decrease the credibility of the signal provided by Navitas are: • increased competition from other education providers • uncertainty about the length and depth of the global financial crisis • changing regulations in the education export sector • negative analysts’ forecasts, or ‘sell’ recommendations • increased exchange rate which increases the relative cost of Australian education • unfavourable press about overseas student experiences in Australia.

3.

What do you expect will be the impact of the ‘soaring’ profits on management compensation contracts of Navitas?

As top management compensation is often partially based on accounting profits as a proxy for management performance, record earnings produced by Navitas would probably increase the amount of remuneration received by management. In addition, management remuneration is often tied with the company’s share price to align management’s interest with shareholders’ and minimise agency costs. Assuming Navitas’s share price increases after the announcement of its record earnings, its management would also receive even higher remuneration.

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Theory in Action 11.4 The politics of promoting products 1.

What is the potential impact of the increased fines on the content of the accounting reports of firms in the pharmaceutical industry, particularly in relation to accounting information?

It is likely that the increased fines would result in a decrease in profits of firms in the pharmaceutical industry as a direct consequence of the increased fines. This would be offset by reduced corporate taxes however the net impact would be a reduction in profit.

Future accounting policies chosen by firms in the pharmaceutical industry could address the profit reduction, perhaps through the capitalisation of research and development expenditure that had previously been written off as incurred, or adjustments to depreciation and/or impairment adjustments. Or, the accounting policies could be selected in order to further reduce profits and thus diminish the political profile of the firm. These accounting policies might be chosen on the basis that they defer profits to future periods.

2.

How does the article demonstrate political processes? In your answer, explain what, if anything, firms in the pharmaceutical industry can do to manage political costs.

The political process is a competition for wealth transfers. The likely wealth transfer is away from firms in the pharmaceutical industry, to other sectors most notably, to government in the form of increased fines. The pharmaceutical industry also faces a wealth transfer in the form of increased compliance costs it must bear. It is likely that firms in this sector will choose accounting policies that will reduce profits, defer profits, or otherwise reduce the public profile of the firm.

3.

What do you expect will be the impact of the increased fines in the (1) earnings and (2) management compensation contracts, of firms in the pharmaceuticals industry?

If fines are imposed it is likely that the earnings of the firms will reduce. If so, management contracts are likely to be adjusted to counter the impact of performance indicators that are based on profit/earnings measures, so that the compensation of management is not adversely impacted by the effect of the fines on profit.

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QUESTIONS 1.

What is the difference between normative and positive accounting theory?

Give examples of each.

Positive accounting theory (PAT) is concerned with explaining and predicting current accounting practices. This means that the focus is on understanding and explaining the techniques and methods that accountants currently use and why we have ended up with the conventional historical cost accounting system. Examples of PAT include: • explaining why firms select specific accounting policies • predicting which firms will oppose new or revised accounting rules • explaining share price reactions associated with accounting information releases.

This approach can be compared with normative accounting theories that dismiss conventional historical cost accounting as being meaningless or not decision useful and prescribe the use of more ‘useful’ systems of accounting (usually) based on inflation adjustments. Examples of normative theories include: • specification of the preferred measurement system • theories as to the objective of general purpose financial reporting • defining elements of financial statements.

2.

What were some of the factors that led to the development of positive accounting theories of accounting policy choice?

In the 1970s, positive accounting theory gained dominance in accounting research, mostly through the publication of capital market research, as it became clear that researchers could not prescribe how to prepare financial statements until they knew whether and/ or how investors used financial statements in their decision-making.

However, the early positive accounting research relied on perfect market assumptions where, for example, information is available freely, there are no transaction costs, taxes, and monopolistic control. These assumptions imply that capital market researchers could not explain why share prices did not respond immediately to reflect accounting information as predicted. It then became apparent to the researchers that they needed a theory to explain why accounting reports were prepared, before they could explain capital market reactions to accounting information. In investigating market reactions to firms’ accounting practices and earning releases, researchers observed some factors that led to the development of positive accounting theories of accounting policy choice such as: • There should be benefits in preparing financial reports as many firms

voluntarily incurred the costs of preparing financial reports even prior to any regulation requiring them to do so.

• Companies lobbied in relation to proposed accounting standards, which is a

costly activity that would be only conducted by rational managers if the benefits outweighed the costs.

• Firms made consistent patterns of accounting policy choice that were related to

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• Firms tended to choose accounting methods that offered conservative measures

of profit, assets, and equity.

Neither normative theories nor capital markets theories could explain these observations. Positive accounting theory developed as a means of doing so.

3.

Why might managers choose accounting methods that increase current period reported earnings?

Managers might choose accounting methods that increase current period reported earnings in order to increase their remuneration. Normally managers’ remuneration is tied with accounting numbers, such as profits, as a benchmark in determining how shareholders compensate them for their performance. Therefore, managers tend to choose accounting methods that result in increased profits so that they can maximise their remuneration. In addition, increased current period reported earnings usually will give positive signal to the market. If the investors believe the signal, the firm’s share price will increase and both shareholders and managers will benefit as well (the purpose of managers is to maximise shareholders’ wealth). Shareholders will benefit from capital gains, whereas managers will get more remuneration as some components of their remuneration are determined by the firm’s share price.

4.

Why might managers choose accounting methods that reduce current period reported earnings?

Managers might choose accounting methods that reduce current period reported earnings in order to avoid political costs. For example, high reported earnings can be seen by employees as the results of exploiting their labour, and consequently they might lobby for increased salary through labour unions. Alternatively, managers might reduce current period reported earnings if high earnings are considered to be an indication of a mature industry, and the government might then remove tariff or subsidies that protect the industry.

Other reasons why managers might choose accounting methods that reduce current period reporting include: (a) to smooth income trends in a high profit year (saving this period to boost the next periods’ reported earnings) (b) to ‘take a bath’ by reducing profits this year in order to have higher profits next year, when earnings might be sufficiently high to earn a performancebased bonus for the manager (c) to signal to shareholders that there are reduced earnings in the future (rather than have future profits suddenly slump, the signal might be gentler to shareholders) (d) to warn of bad news early so that management mitigates the likelihood that shareholders or others will litigate against them for misleading their investment or other decisions with high reported earnings.

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5.

What does it mean when researchers claim that for a signal to be credible, it must be ‘costly’ to replicate? Consider an example where accounting information is used for signalling purposes. Is the signal credible? What are the potential costs of replicating that accounting signal?

For a signal to be credible, that signal must not be easily and costlessly replicated by other firms. A good example of credible signalling is when BHP Billiton announced their record profit of US$6.4 billion in 2005, which is a strong signal of the firm’s future earning prospects (see Theory in Action 10.3). Billiton’s earnings were the biggest profit in Australian corporate history at the time they were reported, which is very difficult (if not impossible) for other Australian firms to replicate. If the profit announcement was followed by an increase in divided payments, that would make the signal even more credible. Dividend payments are costly as they involve cash payments to shareholders. Moreover, as firms normally smooth their dividends over the years, if BHP Billiton increased its dividends this would indicate that the firm would be able to maintain its high earnings in the future to support the higher level of dividends. The potential costs of replicating BHP Billiton’s accounting signal could involve cash payments if other firms also tried to increase their dividends to signal good news to the market. Alternatively, if other firms tried to give similar earnings signals to the market, the costs can include the long-term loss of credibility if actual future performance did not match the level that was signalled.

6.

What is the debt hypothesis? Explain the logic (theory) underpinning it.

The debt hypothesis predicts that as a firm’s leverage (that is, proportion of debt relative to the firm’s assets) increases, managers will select accounting procedures that shift reported profits from future periods to the present period. The theory underpinning the debt hypothesis comes from agency theory where managers (acting on behalf of shareholders) have incentives to transfer wealth away from debt holders to shareholders.

In other words, they have incentives to decrease the value of debt so that residual equity increases in value. Recognising this incentive, debt contracts often include covenants whereby firms covenant to not allow their debt to exceed a certain percentage of total assets or total tangible assets. This is intended to ensure that there is sufficient equity to buffer the value of debt if assets lose value and/or the firm makes future losses.

As the firm’s leverage increases and the firm gets closer to breaching its debt covenants, managers have incentives to ensure that the firm does not violate its debt covenants.

Therefore, managers would choose accounting methods that increase assets or decrease liabilities in order to reduce the reported leverage.

7.

Why might managers’ interests differ from those of shareholders? What can shareholders do to ensure that they do not suffer financially because managers’ interests differ from their own?

Managers’ interests might differ from shareholders’ interests due to the separation of ownership and control. As managers generally have zero or a small ownership in the firm, they do not bear the costs of any dysfunctional behaviour. If the firm suffers from any loss due to their action, the shareholders would bear the loss, while managers still

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receive their salaries. To ensure that shareholders do not suffer financially because managers’ interests differ from their own, shareholders can:

8.

•

price-protect against managers’ dysfunctional behaviours Price protection is the way the principals protect themselves against bearing agency costs by paying management compensation according to the level of monitoring costs expected. That is, the principal initially will incur monitoring costs to monitor agents’ behaviours, but then adjust the agents’ remuneration accordingly so the agents ultimately will bear the costs.

•

align managers’ interests with their interests This can be done by remunerating managers on the basis of share-price movements, or using share-based compensation to increase managers’ ownership of the firm. As managers’ ownership increases, the more likely it is that their interests will align with shareholders’ interests.

Why might politicians choose, rationally, not to be fully informed about issues they are charged to resolve?

In the political market, there is low marginal benefit for individuals to demand information because it is harder to capture benefits from the production of information.

Moreover, in the political environment, there is small probability that individuals’ actions will affect their wealth as there are many individuals in the political arena and many decisions being made at any time. Consequently, to be fully informed on all issues is unlikely to be cost-beneficial given the low probability that the individuals will affect the political outcome. For this reason, politicians might choose rationally not to be fully informed about issues they are charged to resolve, because it is costly to gather the information to be fully informed, and at the same time there is low probability that the decision they make based on the information will affect their wealth (costs outweigh benefits).

9.

What are debt covenants, and why are they used?

Debt covenants are terms and conditions written into debt contracts that restrict the activities of management or require management to take certain actions. As specified by agency theory, managers acting on behalf of shareholders do not always act in the best interest of debt holders. In other words, managers tend to transfer wealth from debt holders to shareholders via excessive dividend payments, asset substitution, underinvestment, or claim dilution. Therefore, debt covenants are used to protect the interests of debt holders thereby reducing agency problems. For example, a debt covenant might require management to maintain the firm’s gearing below a certain level to ensure there is a buffer for debt if the firm generates negative earnings.

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10.

What are the costs of breaching a debt covenant? How significant do you think these costs might be?

As debt covenants normally stipulate the responsibilities and rights of both parties, breach of debt covenants constitutes technical default on the contracts and provides debt holders with rights to institute agreed-upon action such as the seizure of collateral. More importantly, breaching a debt covenant would send negative signals to the market through the reduction of the firm’s debt rating, which is likely to be followed by loss of reputation and a fall in the share price and a rise in the cost of debt. Hence, the costs of breaching a debt covenant does not only include material costs (i.e. seizure of collateral), but also includes the loss of reputation and credibility in the market, with consequences for the cost of capital. The latter cost is much more significant, and could have long-term impact on the firm. Therefore, managers have incentives to ensure that the terms of debt covenants are not violated.

11.

Agency relationships give rise to agency costs that are borne, at least initially, by different parties. Briefly explain how agency relationships arise and give rise to agency costs.

Agency theory is based on the more general contracting theory that the most costeffective form of organising economic activity is through a firm-based structure. Using this structure and assuming that contracting is a costly activity, then a firm-based structure leads to a reduction in the number of contracts written (factor suppliers and consumers only contract with the firm rather than directly). The firm thus becomes a nexus of contracts between suppliers of factors of production and consumers of their productive efforts.

In agency theory attention is concentrated on the specific contracts involving agency relationships. The main agency relationships are between shareholders/managers and shareholders/debtholders. In agency theory, agents have incentives to not always act in the best interest of the principal. The principal is aware of the possibility of such aberrant behaviour and therefore introduces constraints into the principal–agent contract to modify such behaviour. The costs of such controls are called agency costs.

12.

Explain the three types of agency costs and their relationships to each other in the context of: (a) debt contracts (b) equity contracts.

The three types of agency costs are: • monitoring costs • bonding costs • residual loss.

Monitoring costs are the costs of monitoring the agent’s performance. Initially, they are borne by the principal (e.g. shareholders, debtholders) to monitor the agent (that is, the manager). For example, shareholders or lenders could appoint an outside accounting firm to investigate the manager’s performance in managing the financial affairs of the firm. Being rational, the shareholders or lenders would reduce the remuneration to the

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agent by an amount that increases as monitoring costs increase. In the case of a shareholder–manager agency relationship, the manager’s remuneration will be reduced by the monitoring costs incurred by the shareholders. In the case of a lending contract, the lender (principal) will impose higher costs on the agent (management acting on behalf of shareholders) by demanding lower interest rates or other lending terms that are favourable to the lender. Either way, costs are incurred initially by the principal, but are then passed on to the agent.

The agent, as an insider who has access to information about his or her performance, is deemed to be a wealth-maximiser. Therefore, they are likely to bond their actions to align them with the interests of the manager. The agent will incur bonding costs (for example, the costs of providing audited financial statements and voluntarily providing financial information to lenders) to the limit whereby the marginal cost of bonding equals the marginal cost of monitoring that is imposed by the principal. As such, bonding costs are incurred by the agent.

Generally it is not possible to eliminate all agent behaviour that is inconsistent with principals’ interests. The cost of this remaining behaviour is known as residual loss. The residual loss is borne by the principal in the first instance. However, if the principal anticipates the level of residual loss that eventuates, the residual loss will be priced into the agency contract. For example, the residual loss could be ‘charged back’ via reductions in the amount of management remuneration or the interest rate on debt in the case of shareholder–manager contracts and lending contracts respectively. The extent to which the principal or the agent bears the residual loss depends on the completeness of the ‘pricing’ in ex post settling up or ex ante price protection

13.

Although managers have incentives to transfer wealth from shareholders to themselves or from lenders to shareholders, there are various factors that can limit the wealth transfers. What are those factors, and how do they work to constrain the wealth transfers?

Opportunistic behaviour by management can be constrained by: • monitoring costs • bonding • informed and efficient markets.

Monitoring costs are the costs of monitoring the agent’s performance. Initially, they are borne by the shareholders to monitor managers. For example, shareholders could appoint an outside accounting firm to investigate the manager’s performance in managing the financial affairs of the firm. Being rational, the shareholders would reduce the remuneration to the manager by an amount that increases as the monitoring costs increase. The manager’s remuneration will therefore be reduced, relative to what it would be in the absence of the need for monitoring, by the full amount of the monitoring costs incurred by the shareholders. The monitoring costs are incurred initially by the principal, but are then passed on to the agent.

The greater the shareholders’ expectations that managers will opportunistically transfer wealth from the shareholders, the greater the monitoring costs are likely to be. Since

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monitoring costs are ultimately borne by management, management has less incentive to behave opportunistically the higher the monitoring costs.

Managers, as insiders who have access to information about their performance, are deemed to be wealth-maximisers. Therefore, they are likely to bond their actions to align them with the interests of managers if that reduces monitoring costs. Managers will incur bonding costs (for example, the costs of providing audited financial statements) to the limit whereby the marginal cost of bonding equals the marginal cost of monitoring that is imposed by the shareholders. As such, bonding is initiated by managers, and is designed to reduce the potential for them to opportunistically transfer wealth from shareholders.

If markets are informed and strongly efficient then the market has full information regarding the incentives and opportunities for managers to act in a manner that is contrary to the interests of shareholders, and the managerial labour market will impound that information into the agent’s price of remuneration. As such, if managers behave opportunistically, this will be known to the internal and external labour markets, and the potential remuneration for the managers will be reduced accordingly. Hence, managers have incentives to protect their reputations by not engaging in wealth transfers from shareholders.

If we relax the assumption of strong form efficiency then there will be incentives for the joint sharing of agency costs, and this will differ according to the degree of efficiency and the respective costs and the specificity of the relationship.

14.

Because of ex post settling up and price protection, much opportunistic behaviour is prevented or compensated for. What is price protection, and how does it reduce the cost of opportunistic behaviour?

Price protection occurs when markets are efficient and impound all relevant information into the agent’s price of remuneration (for example, management salary, rate of interest on debt). Thus, the agent bears the cost of the principals’ expectations regarding the agent’s behaviour. The principals are protected because the value of the expected dysfunctional behaviour of managers is built into reducing the salary that the principals pay to the agent. The agent bears the costs of agency. Therefore, the agent has incentives to behave in a manner that is aligned to principals’ interests because this will reduce principals’ expectations of opportunism, and will impose a lower cost of price protection on the agent.

Complete price protection is only achieved when markets are fully (information) efficient. Where markets are less than fully efficient then we will observe some price protection and a sharing of costs between principals and agents (this seems to be more descriptive of reality).

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15.

Who bears agency costs?

In a perfectly efficient market, agency costs are borne by agents either through price protection mechanisms implemented by principals and/or ex post settling up. In a market that is not perfectly efficient, agents perceive that they will not be fully penalised for dysfunctional behaviour. The incomplete price protection and ex post settling up results in the residual loss being partially borne by the principal.

16.

Bonus plans are used to reduce the agency costs of equity. Describe the agency relationship giving rise to the agency cost of equity and explain how bonus plans can reduce particular types of agency problems.

The separation of ownership and control means that managers can act in their own interests, which may be contrary to the interests of shareholders. This can be broken down into a number of specific difficulties: • Risk aversion problem. Managers prefer less risk than shareholders because

their human capital is tied to the firm. They prefer to diversify their own risk rather than maximising the value of the firm through higher risk projects.

• Dividend retention problem. Managers prefer to pay out less of the firm’s

earnings in dividends in order to pay for their own perquisites.

• Horizon problem. Managers are only interested in cash flows affecting their

remuneration for the period they remain with the firm, whereas shareholders have a long-term interest in the firm’s cash flows because share prices equal the present value of shareholders’ expectations of all future cash flows.

Bonus schemes can reduce these problems by tying the manager’s remuneration to an index of the firm’s performance that has a high correlation with the value of the firm (for example, share prices, earnings). This aligns managers’ and shareholders’ interests by tying managerial compensation to performance ex ante without the need to rely on ex post mechanisms, such as renegotiating salary. Remuneration can also be tied to dividend payout ratios or to options or share bonus schemes. It is likely that a bonus plan will reward managers only after they have achieved an ‘expected’ level of firm profits for a period — then the remuneration will increase as profitability increases, thereby providing incentives for managers to increase their bonuses by increasing firm profitability. There may also be a ceiling on the amount of bonus paid to managers, to reflect the fact that profits can sometimes be increased to artificially high levels by actions that are not in the shareholders’ long-term interests (for example, by reducing repairs and maintenance, not undertaking research and development).

17.

Explain the role, if any, played by accounting numbers in specifying the contractual terms of bonus plans designed to reduce agency problems.

The major role that accounting numbers play is to provide a measure of the firm’s performance and to provide input to shareholders’ expectations of future cash flows. As different accounting policies and estimates yield different accounting profits, and accounting numbers are used in the determination of bonuses, managers have incentives to manage reported earnings through accounting practices.

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18.

Explain the main agency costs of debt, and how debt contracts can be designed to reduce those costs. In particular, explain how accounting specifications within the contracts can be used to reduce the agency problems.

The main agency problems involved in debtholder–shareholder relationships are: • Excessive dividend payments. This lowers the value of debt because it reduces available funds to service the debt. It transfers wealth from within the firm, where it is available to lenders, to the shareholders.

• Claim dilution. When further debt is issued, this makes the original debt riskier and lowers its value to the original debtholders.

• Asset substitution. When debt is issued that reflects (and subsequently projects) a particular risk, a higher risk is undertaken.

• Underinvestment. This occurs when management or shareholders reject desirable positive NPV projects on the grounds that most of the benefits accrue to debt holders.

Debt covenants can be structured to restrict conflicts by bonding managers and shareholders to act in the interest of creditors, such as: • covenants to restrict the production-investment opportunities of the firm (asset substitution and underinvestment) • covenants restricting dividend policy to a function of net income • covenants restraining financing policy, usually expressed as gearing ratios • bonding covenants — such as increased financial reporting.

Accounting would play a primary role if the above covenants were expressed in terms of accounting numbers. Whittred and Zimmer (1986) and Stokes and Tay (1988) found that debt covenants in Australia were mainly expressed in the form of accounting numbers.

19.

When Kezza Ltd approached Steffs Banking Corporation Ltd for an unsecured loan of $100 million, Kezza Ltd had a good credit rating.

However, the economy was depressed and Steffs Banking Corporation Ltd was concerned about lending such a large sum. You have been asked by Steffs Banking Corporation Ltd to provide a short report to the finance manager, Mike Hanshe, explaining how debt agreements and restrictive covenants can be used to safeguard debt in general. Mike wants the report to explain which agency costs of debt are controlled by specific covenants.

Furthermore, he is interested to know how accounting numbers can be used in the debt covenants to help control any opportunistic behaviour on the part of Kezza Ltd.

Students should provide an appropriately formatted report in answer to this question.

The following are points that should be covered in such a report: • Shareholder–debtholder agency problems, discussed in detail in the text, can be categorised as relating to: – excessive dividend payments — this lowers the value of debt because it reduces available funds to service the debt. It transfers wealth from within the firm, where it is available to lenders, to the shareholders. © John Wiley and Sons Australia, Ltd 2010

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Solution Manual to accompany Accounting Theory 7e

– claim dilution — when further debt is issued this makes the original debt

riskier and lowers its value to the original debtholders – asset substitution — when debt is issued which reflects a particular risk a higher risk is undertaken.

– underinvestment — when management or shareholders reject desirable positive NPV projects on the grounds that most of the benefits accrue to debt holders.

• In general, a default covenant allowing debtholders to insist on immediate

repayment of the debt or renegotiation of the terms of the loan (including interest rates) can be implemented. Some possible ways in which debt agreements and restrictive covenants can be used to safeguard debt include: – the dividend problem may be controlled by tiering dividend payments to net income where the income calculation is stipulated, or by restricting dividends to a function of the debt–equity ratio – the claim dilution problem may be controlled by restricting the amount of debt that is allowed to be issued with priority over the existing debt, by controlling the debt to equity ratio, or by controlling the times–interestearned ratio – the asset substitution problem can be controlled by restricting the ability of management to undertake high-risk projects (for example, not allowing merger or takeover activity without the explicit approval of the lenders), or by having as a condition of the debt agreement that the interest may be altered with the changing risk profile of the firm – the underinvestment problem can be controlled by tying management compensation packages to a risk-adjusted measure of performance, or by using covenants that restrict or control the production-investment activities.

Constraints on dividend distributions ensure that funds are retained within the firm, thereby encouraging managers to invest in positive NPV projects rather than leaving cash idle. The underinvestment problem is the most difficult agency problem to control since underinvestment is unobservable • Overall, bondholders can be protected by making debt rank higher than other

repayments in the event of winding up. Regular financial reporting using prespecified accounting methods can be used to control opportunism by managers.

Furthermore, most of the covenants should be more effective if they are tied to accounting numbers.

See also the empirical evidence in Whittred & Zimmer (1986), Stokes and Tay (1988), Stokes and Whincop (1990), Williamson (1988) and Begley (1990).

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20.

In the context of positive accounting theory, political costs can reduce the value of firms significantly. (a) Give examples of how firms can be exposed to political costs. (b) Give examples of how a firm’s exposure to political costs can influence the nature and/or content of the firm’s annual report, particularly in relation to its accounting information.

Political costs arise because a firm has a high public profile and is deemed to be an appropriate ‘target’ for political action that transfers wealth away from the firm. The ‘politician’ who initiates actions to transfer wealth from the firm to another group in society does so because he or she is rewarded with votes. Votes may be interpreted liberally to mean political votes or financial reward, depending upon the circumstances. (a)

Examples of how firms can be exposed to political costs: • high sustained profits that indicate, over time, that they are earning noncompetitive monopoly rents at the expense of consumers • volatile profits whose peaks draw attention and public concerns about excessive profits — again, at the expense of consumers • operating in publicly sensitive industries such as tobacco growing/manufacturing or highly polluting industries • use of a militant labour force that campaigns actively to increase labour’s remuneration or to improve working conditions • dealings with governments of countries engaging in politically sensitive activities such as war, human rights violations, trade sanctions, etc.

(b)

The political process is assumed to be a less efficient market than capital markets. Accounting is a source of information in these markets. Therefore, there is greater opportunity for wealth transfers in political markets due to the use or misuse of accounting information. Politically sensitive firms tend to understate income in order to avoid or reduce political costs — for example, higher cost regulation by politicians, public demands for price or rate decreases, union pressure for wage increases. Also, they tend to smooth reported income to ensure that, as a long-term strategy, they draw less attention than they would with volatile earnings and high earnings peaks.

Examples of how a firm’s exposure to political costs can influence the nature and/or content of the firm’s annual report include: • High tariff or quota-protected firms have political cost incentives to

reduce reported earnings or smooth reported income at a low level so that their industry appears in need of protection.

• Firms that have a high degree of unionisation of the workforce also have

incentives to reduce reported income or smooth reported earnings at a low level in order to avoid attracting attention to high profits that might be deemed to be earned through the exploitation of labour.

• Government business enterprises that have monopolies on services are

expected to employ accounting techniques to reduce reported income to ensure that they are not deemed to be exploitative, and in need of competition from other entities.

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Solution Manual to accompany Accounting Theory 7e

• Firms in politically sensitive areas (for example, banks in high interest

rate years) are more likely to employ income-reducing accounting techniques.

21.

Positive accounting theory has been criticised by many. Outline the criticisms and comment on their validity.

Statistical criticisms: • explanatory variables in a number of studies are insignificant and not of the predicted sign • established R2s of the models are low • colinearity among explanatory variables • cross-sectional models not well specified • the use of crude proxies (for example, firm size as a proxy for political costs) are not well defined in a theoretical or measurement sense.

However, when the evidence is aggregated (Holthausen and Leftwich, 1983; Watts and Zimmerman, 1990; Christie, 1990) there are six variables that have statistical validity, namely: • managerial compensation • interest coverage • leverage • size • dividend constraints • risk.

Theoretical and measurement criticisms: Leftwich (1990) points out that positive theory is driven by contracting and monitoring costs but until the mid 1990s there was no real attempt to operationalise or measure these costs (such as the costs caused by covenant defaults). This leads to two risks — high correlation of significant variables and the risk of rejection because of the use of poor proxies (even if the theory is correct).

Single versus portfolio accounting policy choices: Zmijewski and Hagerman (1981) were the first to formally recognise that accounting policy choices may relate to portfolios rather than single policies in efforts to affect total income rather than components.

Philosophical criticisms: • positive research is value laden — the topics chosen, methodology, methods and assumptions are value laden (Merino and Neimark) • positive theory is a sociology of accounting rather than a semantic or measurement approach (Christenson) • the logical positive philosophy is outdated and inappropriate as a philosophy of science (Christenson) • positive theory is constrained to analyse ‘what is’ rather than what ‘could be’ — doesn’t encourage change or improvement.

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Chapter 11: A positive theory of accounting policy and disclosure

Other criticisms: • little or no analysis of anomalies • testing positive theories against competing theories • dismissing other theories (such as normative) out of hand, and giving the impression of a biased presentation of arguments and evidence • assumptions of positive theory should be more rigorously tested and established.

Validity of criticisms: This is something that should be debated in class. Researchers clearly have their own views, largely conditioned on their own research interests and exposures.

• Statistical criticisms are valid. Research is continuing to refine statistical

specifications.

• Philosophical criticisms are more subjective. It appears that all research in

science is value laden and myopic to varying degrees. (See Watts and Zimmerman (1990) for some counter views.)

• The criticism of the validity of assumptions in our view is also valid. Research

is being undertaken in this area.

• Positive theory has sometimes rejected competing theories out of hand when

they have a role. Some prefer to be more eclectic in their approach. A key role for positive theory is as the basis of normative theoretical debate. Normative debate should be informed by an understanding of how, and why, particular accounting practices occur.

• The increasing empirical evidence points to positive theory as a fundamental

hypothesis of accounting, and at the moment it is our view that competing theories do not have superior explanatory or predictive power.

22.

Positive accounting theory does not prescribe how accounting reports should be prepared. How, then, can it make any contribution to the advancement of accounting as an information system? Do you think that positive accounting theory has played any role in the development of accounting practices or regulation?

The contributions made to accounting theory by the positive approach can be categorised along the lines of chapters 9 and 10 as follows: Capital market research (chapter 9): • Historical cost income figures have information content for capital markets.

• Capital markets use a continuous information set (accounting is only one source of information).

• There are few opportunities for abnormal results in markets after the release of accounting reports.

• Many issues about ‘proper’ income measurement are relatively unimportant to capital markets.

• There is no compelling evidence to suggest that markets are mechanistic (or fooled by cosmetic accounting numbers).

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Solution Manual to accompany Accounting Theory 7e

This research played a major role in testing a number of assumptions made by normative theorists and led to a greater understanding of the relationship between accounting numbers and pricing in capital markets.

Later positive research (chapter 10): • The major contribution made by this research is to offer a market based explanation as to why we have ended up with the historical cost accounting system as practised by accountants: • Agency theory provides an explanation of the role of accounting in agency contracts.

• The contention is that other markets (such as political markets) are relatively less efficient than capital markets and will lead to attempts to maximise wealth by manipulation of accounting figures through those markets.

• An understanding of these forces enables positive theorists to offer explanatory and predictive theories to accountants about the role of accounting numbers in market places.

Probably, the overall contribution made by positive research has been to lead to a greater questioning of the incentives and effects of prescriptive (normative) theories.

The call for more empirical research before implementing changes to accounting methods, which have been derived in a market environment, has led to more analytic and empirical argument about accounting standards.

A major role of positive accounting research should be to inform normative debate. By providing an understanding of the effects of alternative accounting practice, positive accounting research has the capacity to contribute to the development of appropriate regulations in the area. Positive research has been used in this capacity, and in the development of regulation — the AARF has examined some of the relevant positive accounting research in relation to key issues. However, regulation is essentially a political process itself (see chapter 12), and the benefits of positive research are not always evident in regulatory pronouncements.

23.

Are the contracting and information perspectives of positive accounting theory different in any significant ways? If so, how and why? Which of the two perspectives is more consistent with the efficient market hypothesis, and why?

According to the information perspective of positive accounting theory, accounting information is produced to enable investors to make ‘good’ investment decisions. That is, accounting information helps investors, amongst others, to ascertain likely cash flows and wealth transfers accruing to them as a result of their investment.

According to contracting theory, accounting is a way in which the various claims on an entity’s resources are affected. Contracts are struck between various parties, and some terms of the contracts are specified in accounting numbers (for example, management bonuses paid as a percentage of reported earnings before interest and tax (EBIT) if EBIT exceeds a given level). Accounting is a mechanism by which contracted wealth transfers are affected between the various parties who have an ‘interest’ in the entity.

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The above two functions are not mutually exclusive — the parties with claims on an entity’s resources, such as shareholders and lenders, use accounting information not only to monitor wealth transfers but also to provide information about the effects of accounting choices on their welfare. That is, accounting information has a role for providing information in both the capital and political marketplaces.

The information function of accounting sits more easily with the efficient market hypothesis (EMH) because this paradigm views accounting numbers as providing information regarding future capitalisation of cash flows to investors, rather than viewing accounting as contributing directly to monitoring and bonding activities. That is, the EMH sees accounting numbers as having information content that assists in making investment decisions, rather than viewing accounting numbers as fulfilling a wider function of explaining why accounting reports are prepared. The EMH, in its strongest form, relies solely on accounting reports being prepared to fulfil the information function. However, many observations regarding the preparation and use of accounting reports and accounting policy choices could not be explained by the EMH’s view that accounting served the information needs of investors.

24.

What is unconditional and conditional accounting conservatism? How would an unbiased (neutral) approach to recognition of all gains and losses reduce the stewardship (monitoring) role of accounting?

Ball and Shivakumar (2005) note two distinct concepts of conservatism. Unconditional conservatism results in a downward bias on reported net worth so as to offset managers’ tendencies to bias net worth upwards – this is normally associated with the conservatism principle in accounting – recognize expenses early and delay recognition of revenue, etc. Conditional conservatism commits managers to recognising bad news in a timely manner.

Ball and Shivakumar (2005) specify that conditional conservatism improves contracting efficiency. This form curbs negative net present value (NPV) projects, thereby improving the efficiency of equity contracting, and quickly triggers debt covenant violations, thereby enhancing the efficiency of debt contracting. Unconditional conservatism, which lowers equity book value and earnings as well, can also curb negative NPV projects and quickly trigger debt covenant violations.

Under neutral non-conservative accounting, negative NPV projects are not curbed.

However, Basu (2005) notes that this form does not utilize new information, and Ball and Shivakumar (2005) argue that this form adds noise to payoffs to contracting parties and thus could reduce contracting efficiency. Furthermore, contracting parties are expected to be able to readily contract around bias. Thus, efficiency of contracting is expected to improve through the conditional form only (Qiang, 2007; Guay, 2008).

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Solution Manual to accompany Accounting Theory 7e

25.

The role of financial accounting is to provide information for making economic decisions to buy and sell shares. Evaluate this argument from a contracting perspective.

According to the information perspective of positive accounting theory, accounting information is produced to enable investors to make ‘good’ investment decisions. That is, accounting information helps investors, amongst others, to ascertain likely cash flows and wealth transfers accruing to them as a result of their investment.

According to contracting theory, accounting is a way in which the various claims upon an entity’s resources are affected. Contracts are struck between various parties, and some terms of the contracts are specified in accounting numbers (e.g., management bonuses paid as a percentage of reported earnings before interest and tax (EBIT) if EBIT exceeds a given level). Accounting is a mechanism by which contracted wealth transfers are effected between the various parties who have an ‘interest’ in the entity.

The above two functions are not mutually exclusive in that the parties with claims upon an entity’s resources, such as shareholders and lenders, use accounting information not only to monitor wealth transfers but also to provide information about the effects of accounting choices upon their welfare. That is, accounting information has a role for providing information in both the capital and political market places.

The information function of accounting sits more easily with the EMH since this paradigm views accounting numbers as providing information regarding future capitalisation of cash flows to investors, rather than viewing accounting as contributing directly to monitoring and bonding activities. That is, the EMH sees accounting numbers as having information content which assists in making investment decisions, rather than viewing accounting numbers as fulfilling a wider function of explaining why accounting reports are prepared. The EMH, in its strongest form, relies solely upon accounting reports being prepared to fulfil the information function. However, many observations regarding the preparation and use of accounting reports and accounting policy choices could not be explained by the EMH’s view that accounting served the information needs of investors.

26.

Explain the role of auditing in agency theory and the information perspective.

Auditing costs are an example of monitoring costs. They are borne in the first instance by the principal then passed to the agent through price protection. Auditing provides assurance about the accounting numbers used in management compensation and debt contracts. They can also provide assurance to investors who are purchasing shares in a company with a majority shareholder that agency conflicts between the two groups of shareholders will be minimised (see Fan and Wong).

The information perspective emphasises the signalling role of auditing. Datar, Feltham and Hughes explain how a promoter of a new company uses a high quality auditor to signal to the new investors that the company is of high quality. It is difficult for new investors to judge the quality of a new company because information about the company has not been publicly available through financial statements. The promoter

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can retain a large holding of shares to convince the new shareholders (i.e. place their own money on the line) or use a high quality auditor. In both cases, the signal is credible because it is costly. It is costly to hire a high quality auditor, and it is costly to retain some shares in a newly floated company.

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Solution Manual to accompany Accounting Theory 7e

CASE STUDIES Case Study 11.1 Further concessions sought on share plans 1.

This article describes certain components of executive remuneration. What are those components?

The components of executive remuneration described in this article are equity based compensation (shares, options) arrangements. To the extent that earnings of a firm affect share prices, share-based compensation is also affected by reported earnings. This article reports on proposals by government to tax employee share arrangements and on the political pressures to mitigate those proposals.

2.

Why would an employee’s remuneration package contain non-cash components?

The purpose of incorporating non-cash components (such as equity based compensation and other incentives) in a remuneration package is to align managers’ interests with shorter and longer term shareholders’ interests. Changes in stock price can be viewed as a short term relation, option incentives as longer term (because share price has to meet the exercise price), and profits can be either short term or long term.

Profit is commonly used as a benchmark because profits indicate increases in shareholder wealth — obviously something that is in the interests of shareholders. By remunerating managers based on profit, managers have at least one of the same interests as shareholders, which is to maximise profit. Hence, managers should theoretically cease dysfunctional behaviour that might affect profit adversely. Incorporating nonsalary components is also one way for shareholders to monitor managers’ behaviours.

However, this depends on how it is measured. If it is measured using fair value it approaches the short term sharemarket more closely. If historical costs are used then this more conservative approach means that changes in prices leak into profits at a slower rate. Hence giving a longer term perspective.

Shareholders seek to incorporate this portfolio of non-cash components in management compensation to inter-temporally align managers’ interests with theirs. Managers are prepared to accept this ‘at-risk’ compensation because it demonstrates that they are prepared to act in the interests of shareholders, and should lead to a reduction in the costs of shareholders monitoring their performance, thus increasing their overall remuneration.

3.

What sort of benchmarks and hurdles are likely to be included in a ‘sound’ remuneration package?

A sound remuneration package that contains non-cash components including equitybased compensation arrangements will also contain hurdles that are realistic and that increase the value of the firm. Examples include percentage increases in share price © John Wiley and Sons Australia, Ltd 2010

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Chapter 11: A positive theory of accounting policy and disclosure

linked to the movements in appropriate share-indexes; increases in earnings per share (EPS) and perhaps progress towards achieving desired debt/equity levels, cash balances, or other critical accounting measures of success or improvement in firm performance.

Finally, a portfolio approach that combines short, medium and long term incentives should be borne in mind.

4.

Why do you think unions reacted negatively to the government’s proposal to tax employee share schemes up-front?

Many unions have successfully negotiated equity-based compensation components for their members, Although these compensation arrangements tend not to be in the same order of magnitude as they are for CEOs, unions are reluctant to see the benefits diminished as would occur if taxation arrangements were altered.

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Solution Manual to accompany Accounting Theory 7e

Case Study 11.2 Results blamed on accounting 1.

How does this article and the underlying profit decrease demonstrate signalling theory? In your answer, explain what, if anything, is costly to replicate and therefore gives the signal credibility.

Signalling theory proposes that managers use the accounts to signal expectations and intentions regarding the future of firms. By announcing the fund’s performance compared favourably to the All Ordinaries Accumulation index, Argo Investments management is giving a positive signal to the market that the firm is expected to perform well in the future. To be considered credible by the market, the signal must be costly to replicate by other firms. In Argo Investment’s case, the signal is costly to replicate in it has outperformed the index. This is something which is difficult to replicate by other firms. In particular, the market will punish firms if investors believe that inappropriate means have been used to alter reported earnings (e.g. earnings management through changes in accounting policies or deferral of maintenance and other expenditure that affects the long-term viability of an entity but reduces profits in the periods of the expenditure). In Argo’s case the earnings deterioration, it argued, was not caused by poor operations, rather, it was the result of an enforced change in regulations (accounting standards).

2.

Apply the theories described in this chapter to explain the decrease in reported earnings from the information perspective.

Under this approach, managers provide accounting information to investors to assist in their decision making. The accounting information is used to indicate how the value of the firm and claims against it will change. In Argo Investment’s case, management provides information to the market by announcing its annual reported earnings for the current year. This information will help the market, particularly investors, to make economic decisions. For example, after Argo announces its earnings some potential investors might decide to sell Argo shares due to its possible unprofitable future prospects.

3.

How is the application of Accounting Standard 139 likely to have affected Argo Investment’s approach to the structuring of CEOs’ remuneration packages?

If the earnings of a firm are likely to have been adversely affected by the introduction of the new accounting standard, we may expect to see adjustments to the remuneration packages of CEOs’ as firms move to alter the structure according to the anticipated impact. The imposition of new accounting standards is beyond the control of CEOs and as such compensation committees are likely to have protocols/processes in place that facilitate restructuring under such conditions.

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Solutions Manual to accompany

Accounting Theory 7e PREPARED BY

Allan Hodgson and Victoria Wise Chapter 12 Capital market research

© John Wiley & Sons Australia, Ltd

Chapter 12: Capital market research

Chapter 12: Capital market research THEORY IN ACTION Theory in Action 12.1 Deregulation aids earnings at GrainCorp Instructors should use this question to consider an earnings valuation model and to analyse excess returns. Also questions are raised about market efficiency in the short term.

1.

What impact has the unexpected increase in earnings had on GrainCorp’s share price?

Students are required to examine the impact of this news on share prices on or about the day of release on 4th August 2009. A simple exercise and an introduction to event studies is to ask students to gather the return on the market and then deduct it from GrainCorp returns to derive an abnormal return (alternatively use CAPM to derive expected returns). Are there any spikes in share price that can be observed that might indicate that the market (as a whole) has reacted to the increased earnings figures.

2.

Apart from higher than expected grain receivals, what other factors have had a positive impact on earnings?

Earnings are not always the only indicator of an increase in share price as increased sales do not always translate into profit. In GrainCorp’s case, the company benefited from a deregulated wheat export market. As a result grain receivals increased and this underpinned increased export tonnages – both contributed to the improved earnings.

GrainCorp’s interest expense decreased which was also a contributing factor in the improved earnings. GrainCorp also acknowledged that the continuing quality of its earnings is associated with normal rainfall patterns. Hence, analysts look to the quality of earnings.

3.

Does the article suggest market efficiency? Why or why not?

The article certainly indicates market efficiency from the point of view of analysts.

Analysts are able to quickly see through the impact of an increase in revenue and hence influence the impact on earnings. Whether the wider investment community is able to delineate to the same extent is an empirical question. Discussion should now revolve around analysts vs. wider market perceptions of firm value and which one is more important. Long run and short run perceptions should also be discussed and instructors could set an exercise for students to gather data and analyse the long run impact.

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Solution Manual to accompany Accounting Theory 7e

Theory in Action 12.2 Managing costs doing business better 1.

Wattyl has announced that its debt is equivalent to 70 per cent of its outstanding shares and it aims to drastically cut costs in response to falling profits - yet its share price increased. Can you explain this?

Share prices take into account information other than that published in financial reports. Share prices are determined partly by general market conditions and partly by firm-specific information (of which accounting information comprises a subset). Therefore, any share price movements experienced may be partly in response to fluctuating market conditions and partly in response to the release of new information about the firm itself. Firm-specific information that is price relevant may include accounting information (such as news about the firm’s earnings and/or cash flows) as well as non-accounting information (such as news about new product lines or markets, technological developments and management changes) that cause investors to revise their expectations about the firm’s future performance. Mentioned in the article are cost cutting measures, the expected reduction in staff numbers, the use of cheaper packaging materials, and a changed management focus.

2.

What other economic information besides the reported accounting profit does the market appear to be using to price shares in Wattyl?

In addition to the factors mentioned in Solution 1 above, the market appears to be pricing in the change in management. The company has experienced a series of management changes, and the conclusion of two failed takeover attempts (of Wattyl) in recent years. The market might be perceiving a stable period ahead and the consolidation of new practices that could translate into improved earnings and returns.

3.

What is the likely impact on the share price of Wattyl if it were to become the target of a takeover bid as implied by the anonymous analyst?

The analyst appears to be suggesting that Wattyl is faced with very tough operating conditions against very strong competitors in the same industry and that overcoming these will be a struggle. This could translate into a decrease in the share price. However, when considering the projected share price under takeover conditions one needs to consider the premium that might be offered in a takeover struggle. A takeover premium could result in an increased share price.

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Chapter 12: Capital market research

Theory in Action 12.3 AIFRS – a work in progress 1.

On the evidence presented in this article, are financial analysts well equipped to efficiently factor into prices the impact of switching to international financial reporting standards?

The evidence presented does not give one confidence that financial analysts are well equipped to factor into prices the impact of international financial reporting standards. There is mixed reaction over the impact, few agree that IFRS helps investment decision making or a strengthening of the capital markets (30/30, 40% undecided).

2.

What do you think will be the impact on share prices if analysts disagree on the information content?

This question implicitly assumes that analysts are a major determinant on pricing or that they have to have considerable agreement in order to impact prices.

Some points of debate: 1.

Analysts have never fully agreed on valuations 2.

Research by Beaver suggests that only very few smart analysts are required to make markets informationally efficient.

3.

This question also considers the role of financial analysts in the marketplace and the economic incentives they face. Recent research suggests that analysts are not arbiters or assessors of firm quality and do not provide independent advice. They are compensated by initial public offerings (IPOs) and merger and acquisition (M&A) capital raising deals and face certain economic conditions, which could compromise the advice given, such as: • they function as an arm of investment banks • they face competition from the Internet • their rewards are mainly driven by the trading behaviour of clients (commissions) rather than the quality of advice • they hold inventories of stock, which must be cleared from time to time • they have close personal connections with some firms.

3.

What other methods could you use to assess the value relevance of AIFRS? Empirical evidence such as: before and after AIFRS association studies; event studies; impact of various valuations under AIFRS.

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Solution Manual to accompany Accounting Theory 7e

Questions 1. What is positive accounting theory? How does it differ from normative accounting theory? What was/were the major dissatisfaction(s) with normative accounting theory which led to the development of a positive theory of accounting?

Positive accounting theory is concerned with explaining and predicting current accounting practices. This means that the focus is on understanding and explaining the techniques and methods that accountants currently use and why we have ended up with the conventional historic cost accounting system. This approach can be compared with normative accounting theories which dismiss conventional historic cost accounting as being meaningless or not decision useful and prescribe the use of more ‘useful’ systems of accounting (usually) based on inflation adjustments. One technique which can be used to show students the different approaches is to contrast the assumptions used by each theory as follows:

Normative Decision making

Objective of accounting Behavioural assumptions

Economic assumptions

Semantic assumptions

Pragmatic assumptions

Positive Stewardship/Agency relationship Functional fixation/fooled Rational economic manby cosmetic accounting able to analyse and distinguish Little comment costs Financial reports are an economic commodity.

Information has a price.

Accounting serves a Measurement role is a measurement role secondary function to monitoring and bonding Accounting is Accounting is a political neautral/unbiased economic/social commodity

The dissatisfactions with normative accounting are: (i)

To be normative one must specify an objective function, e.g., economic efficiency, decision usefulness, estimation of future share prices, improved quality of financial reports etc. However, many of the above objectives are conflicting and it is difficult to decide which one is a superior objective. It should be noted that the definition of an objective of accounting continues to be a contentious issue (note that the objective is usually defined in a very broad, non-specific manner).

Popper also makes the point that no amount of empirical testing can prove or disprove the validity of normative accounting prescriptions — they are irrefutable — therefore they are weak hypotheses.

(ii)

There was usually no attempt to justify — empirically — that the prescriptions from normative theories are ‘better’ than the status quo. For © John Wiley and Sons Australia, Ltd 2010

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Chapter 12: Capital market research

example, the redefinition of the objective of financial accounting from the traditional stewardship role into a decision making role (usually to aid investors) was never justified by empirical research. (iii) Before condemning the usefulness of conventional accounting as a decision making tool it would be more scientific to analyse and compare the decision making processes induced by conventional accounting and the proposed alternatives. Part of this research would encompass whether cosmetic manipulations fooled market participants and the role that financial accounting played in economic decision making.

1.

Normative inflation models have been widely known in the literature for over 30 years, and have not been readily accepted by the market place. Positive theories sought to obtain a rational explanation for the status quo.

2.

This leads positivists to attempt to model the connection between financial accounting, firms and markets in a rational economic framework, rather than to take the stance of normative theorists who dismissed current practice and took a prescriptive attitude.

2. Explain the meaning of an efficient market. What is meant by the following terms: weak-form efficiency, semistrong-form efficiency and strong-form efficiency? Which form is the most important to accounting research? Why? An efficient market, in the context of the sharemarket, is a market which adjusts rapidly to new information and fully reflects the available information in an unbiased manner.

The implication of this theory is that if sharemarkets fully reflect all the available information in prices, then there is no marginal benefit in collecting and analysing information which bears on the price of any individual share.

Market efficiency only refers to information efficiency and does not relate to exchange efficiency or production efficiency.

Furthermore, it does not mean that all financial information has been ‘correctly’ presented by firms or ‘properly’ interpreted by individual analysts. Nor does it imply that managers make optimal management decisions or that investors can predict future events with certainty. EMH means that, in aggregate, all information which is relevant is impounded into security prices in an unbiased and rapid manner — hence the term — market prices are a fair game.

To accommodate different types of information sets and to enable empirical testing (capital market research), Fama distinguished between three information sets (past price movements, publicly available information and all information, both public and private) as follows: (i)

The ‘weak form’ of market efficiency implies that a security’s price at a particular time fully reflects the information contained in its sequence of past prices — that is, there are no trading strategies based on cycles in prices (Dow theory), price patterns (head and shoulders) or other rules such as © John Wiley and Sons Australia, Ltd 2010

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Solution Manual to accompany Accounting Theory 7e

oddlot behaviour, moving averages and relative strength which will give excess profits. (ii)

The ‘semistrong form’ asserts that a security’s price fully reflects all publicly available information which includes past prices. This means that there are no trading strategies available to make excess profits from analysing publicly available economic, political, legal or financial data.

(iii) The ‘strong form’ suggests that a security’s price fully reflects all information, including information that is not publicly available — for example, insider and private information.

Of the three, the semistrong form is the one most directly related to the accounting profession, because accounting information, when released, is part of the subset of publicly available information. Normative accounting theorists and accounting standard-setting bodies give quite considerable effort to arguing the merits of the form in which accounting statements are disclosed to the public. However, if prices already reflect all publicly available information, which includes current values and general inflation, then their arguments for ‘proper’ measurement are considerably weakened.

It is also important to distinguish the market related effects that different accounting standards may have on share prices. These effects may be caused by a higher cost structure (e.g., more complex accounting systems or regulation), or by the imposition of political, social or renegotiation costs by participants who are located outside the relatively efficient security market.

Addendum: Relation between efficient markets and capital market research An article by Wyatt attempts to explain the impact of capital market research and the efficient capital market hypothesis on practising accountants.

Wyatt gives a number of examples which he argues denies the propriety of the efficient market hypothesis (EMH). For example: (i)

LIFO — accountants report higher profits by using LIFO even though (in the US) it has the economic consequence of a higher taxation payment.

(ii)

Off balance sheet finance — one of the predictions of EMH is that the form of accounting has no effect on share prices. However, Wyatt points out that some accountants use off-balance sheet lease financing even though it has a higher cost than on-balance sheet debt.

(iii) Business combinations — EMH predicts that company share prices will be unaffected by the accounting method of merger accounting. However, one company Wyatt was aware of didn’t go ahead with a merger because it believed that the purchase method of accounting would knock down the market value of its shares to unacceptable levels. (iv) Foreign operations — Wyatt states that there is some evidence of managers changing their cash management and hedging operations to hedge accounting risks associated with foreign exchange accounting.

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Chapter 12: Capital market research

Overall, Wyatt concludes that accountants, in general, ignore or dispute EMH. ‘If EMH is valid why do businessmen continue to act as if it isn’t?'

Counter Arguments (a)

Wyatt uses casual or anecdotal evidence. The value of such evidence is strengthened by expanding and analysing the evidence so that it is statistically acceptable.

It is also questionable whether the behaviour of market participants (pragmatics) is appropriate evidence when analysing EMH and CMR.

(b)

Managers’ actions may be justified in choosing accounting techniques for rational reasons other than trying to fool the market. For example, to increase their own compensation, to meet debt or equity convenants, for political expediency or for other reasons which might affect the economic well being of the firm or managers.

(c)

The focus of EMH is to present an hypothesis about the reaction of share prices to information sets. CMR is statistically based research which examines the reaction of share prices — it is a semantic theory. Therefore, the question can be raised whether the beliefs and reactions of managers (pragmatics) is appropriate evidence to counter a statistical theory (semantics) about the movement of share prices.

3. Explain the importance of examining the impact of profits on share prices for financial analysis. Can this analysis be used to make abnormal returns from share markets?

In general the empirical research on the information content of accounting earnings has the following implications: (i)

historical cost income releases have significant information content for the marketplace in terms of CAR’s and the effect on volatility and trading volume

(ii)

there is a continuous information set which is employed by the market and, therefore, accounting reports are not the only source of information

(iii) there are limited opportunities for abnormal returns after the release of earnings. Hence the analysis of financial reports well after the release of those reports is unlikely to result in abnormal returns for the analyst. (iv) empirical research on the mechanistic and no-effects hypotheses are inconclusive, but these tests were hampered by the lack of a well-formed predictive theory about accounting policy choice. (v)

current earnings are correlated with contemporary movements in share prices.

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Solution Manual to accompany Accounting Theory 7e

(vi) Most of the research has been undertaken on large firms in the US stock market. There is evidence that financial analysts who concentrate on small firms may earn excess returns. Furthermore, there is no mention of the important role that financial analysts play in keeping the market efficient or in making the market when the stock is unlisted.

Further, Beaver argues that CMR has the following implications for accounting standard setting: (i)

many accounting issues are capable of a simple disclosure solution (for example, by footnote)

(ii)

the role of accounting data is to prevent superior returns accruing to insiders and can be achieved by a policy of fuller disclosure

(iii) financial statements should not be reduced to the level of naive investors (iv) accounting policies should take into account excessive costs and their economic consequences.

Additionally, Deitrick and Harrison believe that the EMH and CMR have important implications for practising accountants, such as: (i)

counselling clients against making costly accounting changes if their sole purpose is to ‘fool’ share markets (ii) the fact that the substance of an accounting disclosure is more important than its form or location (iii) as a defence against claims for damages in courts of law and to quantify estimates of economic loss.

4. Does a study of the information content of profits announcements explain why firms use particular accounting practices? Does it help to predict which firms will use particular accounting practices?

No. This is one of the major shortcomings of this type of research which simply looks at the aggregate effects of accounting practices (earnings) on share prices. There is no theoretical background to explain why firms use particular accounting techniques or no predictive theory as to the circumstances in which a firm would be expected to change its accounting policy (see Leftwich 1990 ). This leads into the second stage of positive theory — covered in chapter 10 — which encompasses rational economic models of voluntary and mandatory changes of accounting techniques.

5. Give reasons that non-linear models relating unexpected returns to share prices would provide a more precise estimate of the earnings response coefficient (ERC).

Non-linear models would provide a more precise estimate for the ERC because:

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Chapter 12: Capital market research

—

high persistence earnings have a greater valuation impact (arctan model)

—

as surprise in earnings increases then the likelihood that earnings surprise is permanent will decrease (arctan model)

—

bad news and good news have differential impacts (exponential model).

6. Why would share prices have a greater reaction to the profit announcements released by small firms compared with those released by large firms? Do you think this research has any implications for ‘measurement’ issues in accounting or for the formulation of accounting standards?

Large firms have greater potential information sources other than accounting reports from: —

analyst research

—

information releases

—

media coverage

—

interim reports

—

private information trading

—

institutional investment.

Therefore, small firm financial reports (earnings) will have greater impact on release because information from alternative sources is less.

If small firm accounting reports contain more price-relevant information then there may be an argument for differential accounting standards. However, more detailed reporting may impose higher preparation costs on small firms. Instructors should encourage discussion for and against.

7. Outline the research that has been undertaken on the impact of permanent and temporary increases in profits. Why is this research important?

Research is summarised in the chapter. Permanent and temporary earnings will have differential impacts on share prices in an efficient market. This has important impacts on research design (linear vs non-linear models) and assessing the sophistication of the market in analysing the impact of earnings on stock prices (see the next question).

8.

How will risk and uncertainty affect the valuation of a firm and, through this valuation model, the ERC?

Risk and uncertainty affect the value of the firm in two basic ways. First, increased risk affects the discount rate and therefore lowers the value of the firm. Increased uncertainty about current and future operations lowers the permanence of the earnings (cashflow) stream and also the value of the firm. This in turn reduces the ERC. © John Wiley and Sons Australia, Ltd 2010

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Solution Manual to accompany Accounting Theory 7e

9.

The impact of profits for valuation has diminished over the years. What is the impact? How has the research adjusted to reflect this fact?

Over the years it appears that the relevance of historical cost income for valuation has declined in value relevance (see Francis and Schipper 1999, p. 425). The research has adopted by focusing more on the balance sheet (statement of financial position under IFRS) and estimating the value of goodwill and intangibles as a valuation concept.

10. Outline a research project which explains how share prices are determined.

Would this project include factors other than accounting data?

This question follows on from the one above. A typical example is to use the model of Lev and Thiagarajan (1993) where the income statement and balance sheet are decomposed. Other factor variables can be the quality of management, intangibles, analyst forecasts, industry growth, degree of monopoly power, barriers to industry, liquidity of the stock, corporate governance, and other macroeconomic variables that students can put forward.

11. Briefly explain and outline the research on the ‘mechanistic’ hypothesis. What are the implications of this research?

‘Mechanic hypothesis’ — the market is systematically deceived by accounting changes which increase reported profit. In other words the market is misled by cosmetic accounting techniques.

‘No-effects hypothesis’ — the market ignores accounting changes which have no cash flow consequences.

That is, accounting changes which are carried out solely to window dress profit figures are discounted by the market place. This hypothesis accepts the market place as being economically rational and efficient; able to see through cosmetic accounting changes.

The tests of the two hypotheses considered the behaviour of abnormal rates of return at and around the time of a change in accounting policy. According to the no-effects hypothesis, there should be no abnormal returns when there is a ‘cosmetic change’ in accounting policy, since there will be no effect on cash flows. This is because the creative accounting change is understood by capital market participants, and they are able to unravel and determine its effects at zero cost. On the other hand, if an accounting policy has an effect on cash flows, for example as a result of tax regimes, then we would expect to see positive abnormal returns at the date of announcement. Therefore, the no-effects hypothesis is a joint hypothesis of the EMH, the CAPM and zero monitoring costs. In contrast, under the mechanistic hypothesis we would expect to see positive abnormal returns at the date of announcing an accounting change even though the change has no effect on cash flows — that is, cosmetic or creative accounting can fool market participants.

Empirical evidence cited in this text grouped under the hypothesis supported © John Wiley and Sons Australia, Ltd 2010

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Chapter 12: Capital market research

Inconclusive

No Effects

Mechanistic

Kaplan & Roll, 1972 Sunder, 1975 Ricks, 1982 Biddle & Lindahl, 1982 Brown & Hancock, 1977 Brown, Finn and Hancock, 1977 Sharpe & Walker, 1975 DeBondt & Thaler 1985 Lakonishok et al, 1994 Sloan, 1996

Overall, the literature initially supported the ‘no effects’ hypothesis but more recent research supports a mechanistic argument.

12. Why would financial analysts be fooled by accounting numbers and provide optimistic and biased estimates of profits? Can you offer a positive economic reason for their actions?

Financial analysts may not have an in depth knowledge of accounting procedures and accounting manipulations may garble the true underlying economic value. Financial analysts may have economic ties to produce positive reports (access to information), have less power than firm management, have incentives to hide in the crowd and not produce ‘bad’ reports. See also Theory in Action 12.3.

13. Outline the different procedures that can be used to determine whether accounts have quality accruals or whether they create more noise.

Procedures or red flags to determine manipulations are: firms with debt covenants and high debt/equity ratios, insider trading, low cash flows to earnings, high levels of intangibles, corporate governance, and outside directors. See also Figure 12.7 page 431 and Figure 12.8 p. 432.

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Solution Manual to accompany Accounting Theory 7e

14. What are the two main explanations for the association between the choice of a high-quality auditor and a lower cost of debt or equity capital?

The insurance hypothesis is that capital providers (equity or debt) rely on securities laws to protect them against misstatement by company managers in audited financial statements by allowing them to take action against the auditor who provided an opinion on those statements. Capital providers are willing to pay more (or charge less) based on their belief of the value of the insurance protection provided by the auditor. If they believe the auditor has ‘deeper pockets’, that is, have more resources available to pay successful claimants, they value the insurance protection more highly, and thus the company has a lower cost of capital.

The information hypothesis, or brand name hypothesis, is that large or specialist auditors perform better audits and thus add greater credibility to the financial statements. This lowers the risk to capital providers that the audit is poor quality and therefore the risk of undetected material misstatement in the financial statements.

15. Why do we have to be careful drawing conclusions about casuality based on studies using archival data?

Causality is a function of the research design and requires the elimination of all other possible explanations. The soundest (if not the only) method of ruling out other possibilities is to conduct a controlled experiment. In a study of auditing and cost of capital, this would require the researcher to control which auditors were engaged by all the companies studied. This is obviously not possible for existing companies. Therefore, the researcher must observe the actual auditor choices made by companies in the market, and also observe the share prices and loan interest charges that are the result of negotiation and transactions between the company and the capital providers. Even if you asked the company managers, auditors, and capital providers about the reasons for their actions, they may not be willing to tell you, or may not really understand all the reasons for their actions. Therefore, researchers rely on archival data, or data from the records. Researchers gather data on other factors that could explain the relevant outcomes and use this data to control for the alternative possible explanations to isolate the effect, if any, of their hypotheses or predictions which, in turn, are based on the theory. There are many possible sources of error in this process – faulty reasoning or theoretical development, corrupt or incomplete data, poor measurement by researchers, and inappropriate choice of statistical techniques to analyse the data. Even if the researcher takes extreme care, the results could still be due to chance or isolated to a particular set of circumstances.

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Chapter 12: Capital market research

CASE STUDIES Case Study 12.1 DJ sales pick up but shares dive 1.

Why do you think David Jones’ shares have dropped in value when fourthquarter profits have increased?

According to the Ball and Brown model, share prices react to unanticipated increases or decreases in earnings, since these represent new information that will cause investors to revise their expectations regarding the firm’s future cash flows.

There are two types of new information: economy wide information affecting all firms and firm specific new information. Part of the fall could have been induced by a general sharemarket fall, whilst the information about specific project nonperformance would reduce future cashflows. Students should be encouraged to sift out both effects by using the CAPM.

2.

What other economic information is the market using besides accounting reports?

• • • • • •

Current market wide information (GDP, inflation, unemployment) Industry information Specific information about firm operations Regulations and political interference or support Expectations about future conditions Changes in risk levels

Falling interest margins, slower consumer activity and housing investment, and the loss of market share in home lending are sometimes considered by investors as a better predictor of future returns than the current accounting report based on past financial performance. The question is, what is continuing or permanent income.

The volatility of that income will change from industry to industry.

3.

One analyst suggests that there wasn’t enough ‘upside surprise or news to really keep the (share price) momentum going’. What does this comment suggest to you about market efficiency?

The release of unanticipated news should cause a market reaction as investors adjust their expectations. As investors digest the news and revise their expectations regarding the firm’s future cash flows share prices tend to stabilise.

This comment suggests that the market is relatively efficient.

4.

Given the analyst’s comment in question 3 how would you classify the market efficiency: weak-form; semistrong-form; strong-form? Explain your answer.

The market appears to be semi-strong-form: it reacted to the release of new information suggesting that the news was unknown’. This reaction was followed by a stablising period where share price momentum dissipated – as the ‘informed’ market had digested the news and priced it in.

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Solution Manual to accompany Accounting Theory 7e

Case Study 12.2 Nufarm buys US companies

1.

List the ways that you think Nufarm is changing its core operations.

• Addition of seed production to its operations • Expansion of export markets in the US, Mexico, South America and Europe.

2.

If the acquisition is expected to deliver significant growth, why do you think the share price is falling? In your answer, consider the potential impact of both market-wide events and firm-specific information.

This question requires further research on the market in general as well as the company. It may be that the wider market is falling and that relative to this general trend, Nufarm’s share price decrease is minor (or major). Some general observations regarding the company that may have an impact on the share price are: • It is acquiring new assets – this carries risk • Moving into new markets – this is also risky • Exisiting management of the acquired organisation is being retained – this may (or may not) be viewed as positive by the market.

3.

Does this article suggest market efficiency? Explain your answer.

The market has reacted to the announcement of an acquisition by reducing the share price of Nufarm. This would suggest that the market expects cash flows of the merged enterprises to diminish. This reaction suggests market efficiency.

However, if the projected outcomes of the M&A activity are difficult to estimate, this suggests the market reaction is likely to be cautionary and negative. The market is likely to re-adjust if/when new information becomes available.

4.

Does the volatility hypothesis predict greater or less variance in the share price on the days following the announcement date? What other factors might affect the volatility of the share price following the announcement?

The volatility hypothesis predicts that if there is information content in earnings announcements, we would expect to observe ‘larger’ price changes on the announcement date. The weeks/days immediately surrounding the announcement date are likely to be more volatile relative to an extended period (pre- and postannouncement). Other factors that might affect the volatility of the share following the announcement include whether there are other sources of information, and, the size of the firm.

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Chapter 12: Capital market research

Case Study 12.3 Market cheers Axa’s Asian plan

1.

Axa’s share price increased by 2.3 per cent when its annual results were announced. What does this reaction suggest about market efficiency.

The market is less than strong-form as it had a sizeable reaction to the news.

Clearly there was information asymmetry, and once news became available the market interpreted the information and reacted.

2.

The article indicates that Axa experienced a sharp slump in sales, yet its share price increased. Explain why sales are not the most relevant indicator of Axa’s value.

Sales are only one indicator of an increase in share price. In Axa’s case, the company was able to show that it was well-funded and this points to an increase in operating activities in the future. In this case analysts and investors looked to the predicted quality of future sales and earnings.

3.

List the factors that appear to have had an in impact on Axa’s share price and indicate the likely direction of that impact: that is, an increase or decrease.

Factors that appear to have had an impact on Axa’s share price include: • Sharp slump in sales –decrease • Absence of negative news (no surprises) – increase • Sales figures in line with analysts’/investors’ expectations – increase • Earnings (profit) in line with expectations – increase • Axa, first to report – increase • Surplus capital level showing that it is well-funded – increase • Asia directed growth prospects – increase • Cost management – increase • Diversification strategy – increase.

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Solutions Manual to accompany

Accounting Theory 7e Jayne Godfrey, Allan Hodgson, Scott Holmes, Ann Tarca

PREPARED BY

Bryan Howieson and Jane Hamilton

© John Wiley & Sons Australia, Ltd

Chapter 13: Behavioural research accounting

Chapter 13: Behavioural research in accounting THEORY IN ACTION Theory in Action 13.1The power of interest group perceptions 1.

On what type of information would the ASA decide that a company board or chairperson should be censured for poor performance?

According to the article, the ASA rates the relative performance of management and directors on the basis of returns to shareholders. This ignores past performance, industry-wide issues and the manipulation of accounting information (through timing and other accounting differences) in the calculation of returns. The ASA would have considered the overall business performance of management and the expected future returns based on the decisions of current management. In more recent times, the ASA, among others, has also focused on the link between company performance to executive share options and other forms of reward to managers. It has publicly attacked several high profile cases where the rewards to senior managers do not seem to be justified by their company’s performance.

2.

What is motivating shareholders to operate as a group to censure company boards which do not appear to be managing the company in an appropriate fashion?

Within Australia there is a growing number of small investors. They see that acting as a group will have greater influence on companies than acting in isolation. Obviously there is strength in numbers and this is, in effect, the only way they can actually influence the company. They are joining forces with a lobby group that benefits from support from shareholders, and in effect they seek the power and control associated with any lobby group. Given recent high profile corporate collapses, acting as a group is one means of enforcing good corporate governance.

3.

Is the ASA concerned about corporate governance or raising its own profile to increase its membership and relative power? What type of value judgements did you make to answer this question?

The ASA is an organisation in its own right. It has employees and elected representatives. Its activities are the net sum of the resourcing and power plays that operate within any organisation. It is funded based on performance and its profile among sponsor groups, such as minority shareholders. Its actions will be influenced by how they will attract support. The students should be asked to discuss whether the motivation of the ASA is evaluation of the performance of companies or identifying the issues that will maximise publicity and ongoing survival. In this regard, are they any different to the management of the companies they seek to review? Can they be truly independent? On the other hand, it would be too extreme to summarily dismiss the notion that the ASA is not genuinely concerned about good corporate governance.

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Solution Manual to accompany Accounting Theory 7e

QUESTIONS 1.

Consider a decision task, other than a bankruptcy prediction task, that uses accounting information (for example making recommendations for share investors). Assume that you are intending to conduct a Brunswik lens model experiment on your selected decision task. List seven information cues you think would be important variables to use in making your decision. Why did you choose these cues? Compare and contrast your list of information cues with a colleague. Discuss with each other the similarities and differences in your choices.

Example 1 Event ‘Will the Company pay a • dividend this period?’

• • • • • •

Example 2 Event ‘Sell or hold an asset’

• • • • • • •

Information Cues Past dividend payments Past dividend payout ratios Budgeted operating results Liquidity — Quickratio, Cash flow budgets Quarterly operating results released so far in the reporting period Past operating results Current claims on the company’s liquidity/current liabilities

Decision Maker Investors, investment analysts and advisers

Information Cues Decision Maker Company management Estimated useful life of asset division managers in Significance of asset to which asset held operations Impact of new technologies Alternative uses of the asset Present value of expected cash inflows or savings from the current asset Current selling price for the asset held Legal requirements — for example, is the asset needed for occupational health and safety, or to satisfy environmental laws?

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Chapter 13: Behavioural research accounting

Example 3 Event ‘Should we loan money • to the company?’

• • • • • •

Information Cues Decision Maker Bank managers; Past credit history and present debenture purchasers credit rating Outstanding liabilities (current or non-current) Past profits and cash flow statements Budgeted operating results and cash flows Current and projected interest rates Liquidity ratios — Quickratio, T.TA:TL, working capital Saleability and expected proceeds from assets: inventory, receivables financial instruments

Students should be encouraged to explain and justify the causal links between the cues they selected and the event of interest. The question could be extended by asking students to rank the relative importance of these cues and to justify their ranking.

2.

Most human judgement research is undertaken in an experimental setting.

How would you respond to the assertion that experiments cannot be generalised to the real world? What are the weaknesses and strengths of this research method? (Hint: See R. J. Swieringa and K. E. Weick, ‘An assessment of laboratory experiments in accounting’, Journal of Accounting Research, vol. 20, Supplement, 1982, pp. 56–93.)

Swieringa and Weick (1982) identify two types of ‘realism’ of interest in accounting laboratory experiments: • Experimental realism. Are the laboratory experiments ‘believed’ by the

subjects? Are these experiments attended to and taken seriously by the subjects?

• Mundane realism. Are the laboratory events similar to real world events?

Swieringa & Weick argue that all experimental research should have present experimental realism. However, in terms of the correlation of events and results to the real world, they identify several reasons why mundane realism need not be a prerequisite for laboratory experiment research designs. The following reasons are also strengths of the experimental method: • Experiments can be undertaken to create conditions that do not presently exist

in the ‘real world’ of accounting practice to deal with ‘what if?’ issues — for example, effect of a change in disclosure requirements, change in valuation of assets.

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Solution Manual to accompany Accounting Theory 7e

• The experimental setting enables the isolation of specific variables affecting a

subject’s decision. Such factors are often difficult, if not impossible, to detect and/or isolate by observing ‘real world’ practice.

• The experimental setting may reveal relationships between variables that are

not readily observable in the ‘real world’ because of the influence of many other forces that may cloud the visibility of such relationships. That is, by making settings more real world, the experiments may conceal or remove much of which researchers wish to observe.

A definition of behavioural research in accounting: ‘The study of behaviour of individuals as they are influenced by accounting functions and reports’.

Studies are undertaken generally by observing people (individually or in groups) in either the field (the real world) or in an experimental laboratory setting.

Often, to be able to explain and predict the influence of accounting upon decisionmaking processes, certain non-accounting influences need to be controlled or removed.

When such other (non-accounting) influences exist, experimental research designs are necessitated. Similarly, to study the effects of accounting influences not yet observed in the field, experimental settings are required.

There is a danger, however, that the experimental setting is too far removed from conditions in which accountants and auditors operate. That is, the effect of nonaccounting influences on individual behaviour is so great that an experimental setting, while explaining and predicting the impact of accounting, cannot explain or predict real world actions and decisions that are largely determined or influenced by non-accounting influences.

Nonetheless, provided that experimental realism is present, the experimental research design is a strong indicator of behaviour influenced by accounting. That is, experiments generally give a good indication of how we could expect decision makers and members of the profession to behave under certain conditions and given certain assumptions.

3.

Use the probabilistic judgement framework to describe an accounting or auditing related decision task

Students should be encouraged to think of examples in accounting or auditing in which they have to assess the likelihood of some event occurring. This occurs all the time in financial reporting when we are required by the Statement of Accounting Concepts or relevant accounting standards to apply the recognition criteria — for example, ‘probable’, ‘virtually certain’. All sorts of examples suggest themselves in this context — for example, the recognition of various liabilities and provisions, the extent to which provision should be made for bad debts, whether assets have been impaired, should research and development costs be carried forward. Students should be asked to identify what decision rule is to be used and what evidence and information cues might be important in making the probabilistic judgement decision.

Another example is given of auditors’ determination of control risk assessment pertaining to the valuation of inventory. Prior research has found: © John Wiley and Sons Australia, Ltd 2010

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Chapter 13: Behavioural research accounting

• Ten per cent of inventory items are not valued according to the lower of cost or

NRV rule • Probability that the internal control pertaining to inventory valuation will

prevent an incorrect valuation of an inventory item is 94% • Probability that the internal control will identify and prevent a valuation which

is correct is 7%.

What is the probability that if the internal control in question identifies and prevents an incorrect inventory valuation, the item is in fact valued incorrectly?

Posterior odds

=

Likelihood ratio  Prior odds

Posterior odds

= =

0.94  0.07 1.492

= =

1.492/2.492 59.87%

Probability

4.

0.1 0.9

Explain the implications for accounting if decision makers in an accounting context display any or all of the representativeness, availability, or anchoring and adjustment rules of thumb.

The key thing for students to recognise in this question is that although heuristics are a practical means of coping with a complex world, their uncritical use can lead to less than optimal decision making on the part of accountants and auditors. This in turn increases the risk of financial loss and unfavourable legal consequences.

•

Representativeness. The base rate or model provided to decision makers is misused in many instances, or even ignored altogether. This implies that the usefulness of such ‘base’ information to decision makers is largely ignored and rarely used.

Rather, auditors and accountants employ their own judgements and rules when making decisions.

•

Availability. Decisions related to ‘sensational events’, and the probability assessments thereof, are likely to be overestimated. For example, consider a financial report of a company. Most information indicates the firm is profitable and liquid. Now assume that a news story is aired that suggests an individual is seeking to sue the company. Users of the reports, particularly shareholders, may weigh this piece of information very heavily and assess the company as being close to collapse — even though no writ has been issued, no disclosure of the amount claimed, nor an assessment made of the grounds on which the claim is alleged and the likelihood of success.

•

Anchoring and adjustment. In the light of changed circumstances, insufficient adjustments are made. Assume that an auditor’s prior period control risk assessment (as very low) is used as the anchor for the current period’s assessment. Changes in the internal control structure of the client indicate a higher assessment is needed,

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Solution Manual to accompany Accounting Theory 7e

but the auditor, using an initial very low risk anchor, does not adjust upwards enough. This low anchor may lead to ineffective and/or inefficient auditing.

5.

Describe how (and why) the information processing systems of expert accountants might be different from those of accounting students. How might the expertise of experienced accounting practitioners be effectively passed on to accounting students?

Experts appear to increase memory capacity by employing ‘standard’ models, checklists, strategies and trends, or representativeness heuristics to recognise a familiar pattern and prompt the recall of one such standard model or prototype from memory.

From this model, the information given to an ‘expert’ is then compared to isolate deviations from the standard or expectation. Thus, experts need only to know or remember such strategies, models or checklists, and the constant use of such models improves the experts’ memory recall and ability to integrate learned models with current situations and faults.

Furthermore, the more situations such models are applied to, and the more experienced the expert becomes, the easier it becomes to recall such models and recognise more diverse situations in which to apply such models.

Experts clearly have had more time and experiences to assist them in developing their ‘expertise’ relative to most accounting students. Experts can pass on their expertise to students by mentoring, formal training sessions, seeking opportunities to broaden the range of experiences available to students (for example, auditing firms in different industries), and regular supervision of the work of the novice.

6.

‘Most people are not good intuitive statisticians.’ Discuss this statement in an accounting context, drawing on research using the probabilistic model.

Probabilistic judgement theory and research suggests that most individuals are not good intuitive statisticians because tasks employing probability assessments and reassessments require multiplicative rules, such as Bayes’s Theorem, to be used.

However, individuals do not readily ‘think’ multiplicatively, but rather use additivity or employ heuristics to simplify the task at hand. Students might be asked to think of specific examples (not necessarily accounting examples) of the accuracy of their own likelihood judgements (for example, will it rain today?, ‘how well will I do in the exam or assignment?’). What factors influence the accuracy of these judgements?

Research in the accounting context of probabilistic judgement, particularly auditing, indicates that probability revisions are made by employing the heuristics of representativeness, availability, and anchoring and adjustment. Furthermore, research suggests that auditors tend to revise probabilities to a lesser extent in the light of changed circumstances than Bayes’s Theorem suggests, due to the use of heuristics and judgement bias that are adopted to simplify complex judgement tasks.

For example: • Representativeness. Joyce and Biddle’s (1981) study of auditors’ judgements regarding the incidence of management fraud. Auditors did not consider the ‘base © John Wiley and Sons Australia, Ltd 2010

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rate’ (basis of using Bayes’s Theorem is to consider explicitly the base rate or prior odds) sufficiently.

• Availability. Maser (1989) found some environmental event pertaining to a particular

company that led to disproportionate news coverage may systematically affect or influence the predictive judgements of investors.

• Anchoring and adjustment. Joyce and Biddle (1981) found no evidence of anchoring

and adjustment in auditors’ adjusting the scope of the audit following changes in internal control systems. Kinney and Uecker (1982) found evidence of anchoring and adjustment in analytical review and compliance test tasks.

7.

Compare and contrast the efficient markets hypothesis and human judgement theory. Are they inconsistent with each other? Explain.

Both the EMH and HJT deal with the production of accounting information and reactions to information. However, this is where any similarity between the two paradigms ends.

The EMH focuses on the utility or information content of accounting information whereas HJT generally deals with the usages of accounting information by focusing on the input perspective of accounting. That is, accounting as an input in human decisionmaking processes. Furthermore, the EMH differs from the HJT in that the EMH deals with aggregate (‘on average’) behaviour of the capital market, whereas HJT deals with individual or group decision-making processes of reaching a decision with given information. Also, EMH focuses on behaviour of capital market participants only. HJT applies to all users of information. Rather than saying that the two perspectives are ‘inconsistent’ with each other, it might be more useful to recognise that they are complementary. EMH identifies ‘new’ information and then the reaction (if any) of stock prices to that news, but not what goes on in between those two events. HJT offers the possibility of learning how decision makers take the ‘new’ information and process it to arrive at their share price or valuation decisions (as ultimately reflected in their share market activity).

The assumptions underlying the two theories also differ, as shown below:

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EMH/CMR • Homogeneity of users’ expectations • Rational users • Efficient impounding of information into share prices • Does not assume correct or perfect usage and/or interpretation and/or presentation of information • Does not assume nor suggest optimal decision making and trading ➔ Is accounting information useful?

8.

• • • •

HJT Heterogeneity of users’ assessments Irrationality of users allowed and controlled for Imperfect use of information Seeks to identify the processes by which information is analysed and judgements formed

➔ How is accounting information used?

Does consensus always imply accuracy in studies of accounting decision making? Justify your answer.

In the absence of a correct or model solution to a judgemental task, researchers within the sphere of accounting, and in particular auditing, assess accuracy in terms of a level of consensus achieved by subjects in a given judgement task. Consensus is argued to be indicative of accuracy, especially in auditing where a high degree of consensus is a desired characteristic between members of the profession.

However, since accuracy in the absolute sense cannot be readily determined, the question of whether consensus will equal accuracy in judgement tasks is arguable.

Studies such as Campisi & Trotman (1985), which looked at the level of auditor consensus in going-concern judgements, justify the use of consensus as a measure of the quality of the audit decision-making process. That is, even though consensus may not always mean accuracy, it is suggested that consensus, at a given point in time with a given set of facts among auditors, indicates that the judgement made at the time was ‘correct’. However, there is always a risk that consensus can mean consistently incorrect judgements as well as consistently ‘correct’ judgements. For instance, it may be that a group of auditors has all been taught the same methods for making internal control assessments. When asked to make their assessments in a particular case, all the auditors may apply the same method and arrive at the same judgement. However, if the method is flawed in the first place (for example, it consistently understates internal control risk), there may be a consensus but the auditors will be consistently wrong!

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9.

Why is a ‘model of human behaviour’ generally superior to human judgements?

A model of man is essentially a mathematically developed decision-making model based on individual patterns of information use. Such a model is then applied to various analytical or judgement tasks. Because this model of man consistently applies the decision rules and weightings of information cues (it doesn’t tire or become bored and distracted), studies have found that such a model consistently outperforms the human ‘experts’ on whom it is based. This outperformance stems from the model of man being free from inherently ‘human factors’, which see inconsistent application of decision rules and emphasis or weightings placed on various pieces of information. Note, however, as in the solution to question 8, the superiority of the mathematical model relative to human judges does not necessarily mean that the model is error-free (if it consistently applies the ‘wrong’ rule).

10.

What alternatives exist for improving the format and presentation of accounting information? What is the research evidence regarding the merit of the various alternatives?

•

Chernoff Faces. Moriarty (1979) found subjects using financial information represented diagrammatically by Chernoff faces outperformed a well-accepted financial distress model. However, Chernoff faces are not yet seen in practice as a ‘serious’ alternative form of presentation.

•

Tables and colour graphics. Blocher, Moffie and Zmud (1986) found that the effectiveness of different forms of presentation of financial information is a function of the amount of information presented to and processed by the decision maker. Graphic reports are better suited to low levels of task complexity. Tabular reports are better suited to high levels of task complexity.

•

Davis (1989). No form of graphical presentation is superior/better in all situations.

•

Desanctics & Jarvenpan (1989). The researchers found only a small or modest improvement in the accuracy of forecasting judgements associated with the use of graph formats. They suggest that this indicates that users have to go through an adjustment or learning process before graphical information becomes meaningful.

•

The above results confirm Wainer and Thiessen’s (1981) findings that no welldeveloped and tested theory exists that can be used to determine the circumstances under which different forms of presentation are most appropriate at least in part.

•

These findings are more recently confirmed in the So and Smith (2002, 2003) papers.

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11.

•

• •

Human judgement theory does not purport to penetrate the ‘black box’ of cognitive processing. Verbal protocol research, however, has that ability.

What are the strengths and weaknesses of this research methodology? (Hint: See G. F. Klersey and T. J. Mock, ‘Verbal protocol research in auditing’, Accounting, Organizations and Society, vol. 14, no. 1/2, 1989, pp. 133–51.)

Strengths Can trace the connection between the decision makers, decision process and the actual decision made or action taken, thus enabling researchers to understand subjects’ cognitive processes.

Good description of decision-making process Findings enable tentative conclusions and recommendations to be drawn regarding: – the quality of subjects’ decision making – identification of decision rules for use in expert systems or to be taught to others in the profession – why a decision is reached – influences on the decision, other than the process and information considered.

•

• •

• • •

Weaknesses Information derived regarding deliberately selected decision-making strategies is useful, but not for more initiative decision-making processes Predictive ability re the use of decisionmaking strategies is low Subjects may fabricate answers as to ‘how’ they reached a conclusion and assessed the evidence using prior knowledge of how the task ‘should’ be performed Questionable statistical validity as typically small sample sizes are used Difficulty in coding verbal responses Time consuming nature of codification dictates use of small sample sizes.

The comments in the above table need to be seen in the context of the level of the decision maker’s familiarity with the decision task. Research suggests that verbal protocols are typically incomplete for tasks with which decision makers are highly familiar because some of the decision steps are so familiar that they do not even recognise them when asked to explain their decision. On the other hand, where the decision makers are asked to describe their decision steps in a highly unfamiliar task, they tend to give far more comprehensive and explicit descriptions.

12.

Reconcile normative accounting studies and human judgement theory.

Normative accounting theories seek to prescribe what should be, whereas HJT and associated research seek to explain what is and what could be.

That is, HJT can focus on explaining the effect of information disclosures, formats and presentations on a decision maker’s assessment of the information and conclusion reached. HJT, however, also deals with as yet unobservable accounting practices to consider the issue of ‘what would be the impact on users if this requirement were to be changed’?

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Furthermore, normative theory seeks to develop a ‘theoretical blueprint’ or prescription of what ought to be done based on what information users should need. However, HJT can be distinguished from the normative paradigm in that it looks to users to explain what users’ needs are — and then to observe the impact of various accounting practices and changes thereof to observe such information fulfils this need.

One point of reconciliation between these two schools of thought is that HJT studies can be undertaken to handle ‘what if?’ questions. If the effect of the change studied indicates an improvement to the satisfaction of users’ information needs (as perceived by users), then there may be a normative argument that emerges to prescribe what should be, based on the results derived from experimental research in HJT. In this sense, HJT research ‘informs’ the normative decisions of accounting regulators. For instance, accounting standard setters usually have to make rules about what disclosure provisions should be included in accounting standards — HJT research could help tell the standard setters what types of information are the most informative or that facilitate their decision-making processes. A normative argument may then follow that such practice should be adopted.

13.

Why do individuals form lobby groups to influence companies’ behaviour and information disclosures? What types of information would shareholder groups require to determine whether company directors should be censured for poor performance?

Lobby groups are formed to influence the behaviour of lobby group targets. This may directly focus on the individual companies, on an industry or through political means by way of government and government regulations. Often the formation of a lobby group is a sufficient signal to garner change on the part of those responsible for disclosures or the actions of target companies. The level of response will depend on the perceived capacity of the lobby group to affect the firm. Responses to lobby groups are not costless and are considered carefully by the management of a firm. Individuals form lobby groups as their individual concerns are not considered. They do not rate as a stakeholder of interest — but as a group they warrant attention. The information sought to evaluate management will depend on the focus of the group. If the focus is equitable behaviour toward all shareholders, the focus will be on management’s activities with respect to majority or institutional shareholders compared to the minority shareholders.

The focus may be on overall performance and future returns; it may be on environmental issues; or it may be on contributions to the community through the tax system. Lobby groups have every right to sanction performance inconsistent with their objectives, just as management has the right of response. Again the definition of poor performance will depend on the focus of the lobby group. It is perhaps worthwhile recognising that it will usually be the case that shareholder (or other lobby) groups will be less informed than managers (except, perhaps, after the fact when it is too late — consider Enron, for example). The question could be extended to ask students whether the provision of information to shareholder groups can realistically improve corporate governance or whether other mechanisms are as, if not more, important — for example, role of auditors.

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14.

What is more important for an organisation — the ‘right’ physical assets or the ‘right’ people? Explain.

Both physical and human assets are essential to the effective operation of organisations.

Without any physical assets, firms have no means of production or service delivery.

But, the assets are purchased, applied and maintained by humans. If the physical assets are appropriate, but human capital is underskilled or lacks motivation, then the firm will not operate as well as if it had a skilled and motivated workforce. The same applies with respect to the assets of a firm. If they are not a good fit with respect to the activities of the firm, then the best human intervention will normally result in less than optimal performance. The research literature has tended to focus on the investments by firms in physical assets and in returns on those assets. The class might like to consider how we could value and measure the return on investment in people. Answers to this question should also focus on the growing importance of intangible assets that might, for some companies, form the majority of the ‘assets’. Many of these intangibles represent intellectual capital, but conventional accounting is highly limited in how it ‘captures’ the value of these intangibles in financial statements — for example, capitalised costs do not represent ‘value’. This issue could open into a discussion as to how accounting could be modified to reflect the value of intellectual capital.

15.

Accounting is a function of human behaviour and activity. As such, is not all accounting research behavioural? Justify your answer.

The answer to this question is a matter of theoretical perspective. Most research in accounting and finance focuses on measuring the readily measurable, and ignoring or assuming away all else. The readily measurable is usually the net product of human activity and interaction, such as return on assets and share price. In this sense, all accounting research is behavioural — the performance of the firm, the information measured and disclosed is a function of human judgements and application. As such, perhaps more emphasis should be placed on understanding the decision processes and the performance of individuals in generating economic returns. In a sense, we are engaging in an exercise in historical studies in that we observe past performance and interpret the factors underlying the performance of firms and the factors motivating reporting and disclosure practice.

Have the class discuss how we could improve on our current knowledge of accounting choice decision making and perhaps design a research project to consider the issues discussed. Alternatively, students could be asked to compare and contrast HJT with EMH and agency theory. The latter two models may be interested in the consequences of behaviour (for example, share price or choice of accounting policy), but they assume a particular model of behaviour (that is, rational wealth maximisation). As such, they do not explain behaviour at all and so could be argued not to be behavioural research.

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16.

List nine or more factors that will influence the accounting system adopted by a firm and the information disclosed. Which of these factors are a direct function of human behaviour?

There are any number of factors that will influence the accounting system adopted including: • technologies available • industry • management performance and compensation schemes • historical practice and market expectations • government legislation • requirements of the accounting profession • requirements of the stock exchange • relationship to other entities, both foreign and domestic • organisational reporting and management structures • requirements of debt providers and funding institutions.

All of these factors are a function of human behaviour. A management accounting focus could also be adopted here by considering more explicitly the internal factors that shape an accounting system — for example, the performance measurement and reward or sanction processes; budgeting; control and the assignment of responsibility.

17.

What is an industry specialist auditor? Will an industry specialist auditor always perform better than a non-specialist auditor? Explain.

An industry specialist auditor is an auditor who audits clients from one particular industry all, or most, of the time. Most research evidence suggests that specialist auditors outperform non-specialist auditors in the specialist’s industry. However, outside that setting, specialists are unlikely to outperform other auditors unless their knowledge is generalisable.

For example, if the new industry is similar to the specialist auditors’ ‘home’ industry, then we would expect the specialists to be able to utilise more of their existing knowledge in the new setting. If we placed a financial services industry specialist auditor and a retail industry specialist auditor on an audit of a manufacturing client, the retail specialist could be expected to outperform the financial services industry specialist if we consider retail to be closer than financial services in ‘type’ to manufacturing.

A second consideration which is not addressed in the chapter is the extent of task knowledge (such as reviewing lease contracts) which are utilised in the audit. If specialist auditors gain such task specific knowledge in one setting they are likely to be able to utilise it in a new setting, regardless of the industry type.

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18.

What is the difference between independence in fact and independence in appearance? Which is more important?

Professional and legal rules (for example, APES 110 Code of Ethics for Professional Accountants) require auditors to comply with the fundamental principles of integrity and objectivity and identify them as essential to maintaining independence. The principle of integrity imposes an obligation to be straightforward and honest in professional and business relationships. Integrity also implies fair dealing and truthfulness. Objectivity imposes an obligation not to compromise professional or business judgment because of bias, conflict of interest, or the undue influence of others.

To comply with the independence requirement and auditor must have an independent state of mind and maintain the appearance of independence.

Actual independence, or having an independent state of mind, means that the auditor will express a conclusion without being affected by influences that compromise professional judgment. An independent auditor will not fail to report a discovered misstatement in the client’s financial reports.

An independent auditor could appear to be affected by influences that compromise professional judgment without actually failing to be independent. For example, an auditor who receives substantial non-audit service fees from an audit client may not allow the existence of those fees and the threat of losing them in the future to affect the decision to qualify the audit report. However, despite this, an outside observer could believe that the auditor has compromised the audit report.

If investors lose confidence in the independence of the auditor and therefore do not rely on the audit report, the auditor is not able to provide assurance to investors. In this case, the share prices will not carry the premium normally present when investors believe that the auditor reduces agency conflicts and provides assurance about the quality of the financial statements.

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Case Study 13.1 Telstra opts for David Thodey as replacement for Sol Trujillo

1.

Why would the Telstra board appoint an internal candidate to the position of chief executive, rather than an external candidate?

This question is a good opportunity for students to reflect on what constitutes ‘expertise’. On the surface of the facts, David Thodey may seem like an unusual choice given that his proposed management changes are unknown. However, when the facts are considered in more detail, his selection might be more understandable given that he is likely to move quickly to end the acrimonious relationship that has developed between the company and the government. The article notes that Mr Thodey does not have a close relationship with key government ministers and has the political advantage of not being associated with his predecessors aggressive strategy against government.

2.

Why might David Thodey have been preferred to other internal candidates one of whom had finance experience and the second of whom had other telco industry experience?

As implied in the answer to question 1, having no association with government minister would be a decided advantage when it came to negotiating the proposed $43 billion national broadband network. Mr Thodey would bring a ‘fresh’ perspective to the situation at Telstra and would not be burdened by an association with its past history.

An internal appointment might also be a source of inspiration to Telstra employees if he was to offer hope of a successful financial turnaround.

3.

The article reports that David Thodey had internal experience. How might his skills set have changed during his time with Telstra and what might have been his main means of learning new skills?

Early in his career, Mr Tilton’s skills would likely have been relatively narrow.

However, as he rose through the ranks, higher positions would have brought with them more responsibility and a requirement to take a more strategic and ‘broad brush’ approach to his job. As CEO, it is very unlikely that he would be concerned with the minutiae of the day-to-day running of a firm (although this may be necessary to some extent in the case of turning around a firm in financial crisis). Rather, he would be responsible for setting the broad strategy and direction of a company and overseeing its operations.

As a result, his skills set would now be very different, with an emphasis on things like strategic management, planning and people management. Many of these skills he will have learnt on the job, either through direct experience or by being mentored (‘groomed’) by other managers. It is likely that he would also have developed some of these skills through formal professional development, such as an MBA or short courses.

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4.

Describe the complex environment in which Telstra is operating and identify the particular skills that the new chief executive might be able to use to influence that environment.

Telstra is operating in a dynamic environment where it is facing enormous pressure from government to participate in the development of a national broadband network. It must balance this government strategy with the need to provide shareholders the best return on their investment and the public with an affordable and high quality service.

Telstra is a large organisation and its performance is closely scrutinised by investors and the general public. Its chief executive office must be able to balance government, public and shareholder pressure. This would require the CEO to have technical experience or be able to select experts in the area on whom he could rely. Further the CEO would require excellent negotiating skills and much patience as the discussion between the firm and government are likely to be protracted and at times acrimonious.

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Case Study 13.2 Reporting season’s moment of truth 1.

If cash is the best measure of success, why have the accounting profession and regulators persevered with analysing debt-to-equity ratios?

There is far less discretion as to the timing of disclosures under the cash flow model.

Adoption of cash flow can distort earnings and reduce the capacity of management to smooth income. Arguably however, accrual accounting may allow investors to form unbiased or more informed judgements about the long-term prospects of a company, or accrual-accounting-based information cues may be better predictors of future cash flows than current cash flows. The debt-to-equity ratio provides a different perspective that is still linked to cash flows. It considers the total level of debt compared to the total level of finance provided by equity and allows for an evaluation of the ability of the firm to service its level of debt.

2.

What do the analysts mean by the term ‘nasty surprise’?

A ‘nasty surprise’ is reported earnings or some other accounting measure that have not been anticipated (or fully anticipated) and have the potential to adversely affect the future cash flows or other aspects of the operations of a firm.

3.

Why does the market so readily interpret a cash-flow problem as a sign that a company’s financial position might be deteriorating but was apparently prepared to focus on debt-to-equity ratios for a number of years?

The literature indicates that the market is not ‘fooled’ by the debt-to-equity ratios – that the market adjusts in order to provide a measure of actual value. Markets can still be wrong (‘fooled’) in their assessments of companies of course — if there is fraud or unexpected risk. Focussing on the debt-to-equity ratio might lead some to interpret a company as being an efficient manager of financing opportunities. However, cash flow analysis is also important as it provides an opportunity to assess whether a firm is able to adequately service escalating levels of debt.

4.

The article refers to the need to ‘sort the wheat from the chaff’ by focusing on companies that are coping well. How are such judgements made?

Expectations about good or bad investments are based on a range of factors including: • industry trends and past performance • current and expected factors impacting on the industry and the individual firms • statements made by the firm about expected performance • media commentary • past performance of the firm • independent evaluations by analysts • statements by the ASX. Research has the potential to help us understand the process and information cues by which these expectations are formed (at least at the level of individual investors).

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Solutions Manual to accompany

Accounting Theory 7e by

Jane Hamilton

Chapter

Chapter 14 Emerging issues in accounting and auditing

John Wiley & Sons Australia, Ltd 2010

Chapter 14: Emerging issues in accounting and auditing

Chapter 14: Emerging issues in accounting and auditing QUESTIONS 1. What is XRBL? What are the arguments for and against disaggregation of data in financial statements?

XBRL = Extensible Business Reporting Language. It is a process of tagging individual data items within a company’s financial report. It allows software applications to source the required piece of data to produce custom designed reports for users. Essentially, instead of relying on a company’s statements of financial performance and position, users are able to create their own reports.

In favour of disaggregation of data: Users interested in calculating profit including or excluding specific items, can produce such reports easily using the raw data rather than working backwards from the company reports. This allows easier comparisons across companies and time periods.

Ease of access to the data encourages more users to analyse the data in greater detail.

This encourages the use of the data and makes the financial data more valuable.

If greater numbers of users investigate a company’s financial reports, it is more likely that any errors or other problems are discovered, and they are likely to be discovered more quickly. This will assist the SEC investigate the relevant companies.

If there are more users of the data, it is likely that there will be more investors, increasing the market liquidity for that company’s stock. This has positive effects on the ability of companies to raise equity capital, increasing the depth of the financial markets and the speed of obtaining finance for new projects.

Against disaggregation Accountants are experts in making judgements about the relevance of particular pieces of data to each other. Thus, aggregation decisions should be made by accountants. If novices try to organise and aggregate the financial data, they are likely to make mistakes, decreasing the usefulness of the financial data.

Aggregation of data creates meaning, if this is not done, financial statements will be less useful to decision makers, meaning that fewer people will use the information, decreasing the chances of fraud detection, stock market liquidity etc.

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2. “I do not know of any auditing regulation that originated in a research study.” What does this statement mean for the relationship between auditing research and public policy?

This statement reflects the view that regulations are not based on research but are promulgated for other reasons. These other reasons could include a search for popularity by politicians. That is, if a regulation is likely to be perceived favourably by the electorate, the politician will be motivated to introduce it, regardless of its likely effects on the affected parties.

The debate surrounding the effects of the Sarbanes-Oxley Act’s restrictions on nonaudit services can be used as a context to discuss the issues. For example, audit fees and nonaudit service fees were not disclosed in the US prior to 2000. SOX was introduced in 2002, very quickly after the collapse of Enron and Arthur Andersen audit firm. Early research evidence supported the SOX regulations but later evidence did not. In addition, there appeared to be no evidence from other countries to support the regulations.

Overall, auditing research has the potential to influence public policy, but the level of its influence is likely to be affected by other factors and politicians’ incentives.

3. What is the Global Financial Crisis? Why has it created intense discussion about accounting for fair values?

The Global financial crisis refers to the problems in the equity and debt markets around the world, including falling share prices and difficulties facing companies wishing to borrow.

Prior to the GFC, there was a rapid and dramatic growth in lending (mainly in the US, but including other countries) for the purchase of houses to borrowers with lower levels of documentation and security (subprime mortgages). These loans were securitised and sold on the financial markets to institutional investors. It is claimed that the securities were sold with incomplete information about their risk, or without regard to their default risk because it was believed that the mortgaged properties could be sold easily to repay the debts. As borrowers defaulted on their repayments, the value of these securities fell and banks faced considerable difficulty selling the houses for their estimated values.

Mark to market, or fair value accounting, requires the securities and the associated financial instruments to be shown on the institutions’ balance sheets at fair values (where they were not held off balance sheet through various complex arrangements).

As the problems spread, there was greater uncertainty about the asset values and more entities faced difficulties caused by either the loss of value of the subprime mortgages, or the loss in value of institutions that owned the securities. The chain reaction in write-downs caused loss of faith in fair value accounting.

Many opponents of fair value accounting claim that it has made problems worse.

Sound companies are unable to borrow because either their own balance sheets are

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Chapter 14: Emerging issues in accounting and auditing

affected adversely by write-downs, or because banks are suffering and so reducing their lending to all companies.

The supporters of fair value accounting claim that it has simply made the existing problems more transparent, increasing the likelihood of a speedy resolution. Ignoring fair values would mean that reality is being ignored, and problems loans would continue to be made.

4. What specific issues does the Global Financial crisis create for auditors?

Auditors face problems in assessing managers’ valuations of assets and liabilities.

Financial assets and liabilities are directly affected by the problems in the financial markets. However, other asset values are also potentially affected if they relate to business operations that are suffering because of the recession that has followed the crisis on financial markets. In addition, information on market values for all assets is difficult to verify when economic conditions are changing at a rapid rate and regulators are responding to situations with new laws and assistance packages.

Auditors must also gather evidence on the going concern assertions by managers.

Where companies are facing significant problems doing business during the recession, there are likely to be significant doubts about the entity’s ability to continue as a going concern. The auditor has to assess the plans made by managers to deal with the adverse events in financial and product markets.

Pressure on company managers to avoid adverse effects could increase the risk of financial misstatement, either deliberately or otherwise. Auditors need to be alert to such pressures when assessing the risk of fraud.

5. What are the latest pronouncements from the IASB and FASB on fair values?

Get updated information from the IASB and FASB through their websites: http://www.iasb.org/Home.htm http://www.fasb.org/ Also, check the websites for relevant national standard setters, for example, the Australian Accounting Standards Board http://www.aasb.com.au/Home.aspx

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6. Leon Getter wrote in a recent article: ‘As former analyst Henry Blodget points out, the US is adopting the model used by Japan in the 1990s when it refused to acknowledge its banks were insolvent and pretended they were healthy. History, as Mark Twain said, does not repeat itself, but it rhymes.

The G20, banks and standard setters should remember this: to borrow from Winston Churchill’s line on democracy, fair value is the worst form of accounting except for all the other forms that have been tried.’

(Getter, L. ‘Standard-setters rendered toothless by G20’, The Age BusinessDay, (April 15, 2009), p. 14.) (a) (b)

Does fair value convey ‘reality’ better than any other form of valuation?

Is it better for banks to report stable asset values or to provide information about those assets? What are the arguments for each view?

(a) The article is referring to the situation in the US in early 2009 when the regulations surrounding the use of fair values were being changed. Banks were permitted to use their own judgement to value assets, rather than a strict applicable of market values. This was done on the basis that the turmoil in financial markets has made fair values unreliable.

The author is drawing parallels between the situation in 2009 and the circumstances in Japan in the 1990s when the Asian financial crisis affected asset values in that country. The author believes that attempts to allow banks to avoid recognising the fall in asset values in those circumstances actually prolonged the recession.

The author appears to be of the view that fair value conveys reality better than any other form of accounting measurement – asset values have fallen, fair value accounting recognises this reality and conveys the information through the financial reports to the broader financial system.

Students could discuss the competing arguments, primarily, whether the market values are ‘real’ in the sense that the particular asset being valued has not been sold, so any value arising from an actual sale is not relevant to an unsold asset. They could also consider the arguments that market values in this type of situation are ‘temporary’, in that if you valued an asset one day you would get a very different valuation than if you valued it on another day. (b) Banks are arguing in favour of stable asset values, such as historical cost, or values produced by another valuation system. Stable values don’t allow temporary market fluctuations to impact on real decisions, such as borrowing money and buying property. The opponents are arguing that market values are information and as such, are useful to decision makers. If someone wants to lend to a company they can still make that lending decision knowing that market values are currently low. The problem is that lending regulations make this difficult for banks to do, so the valuation and lending decisions are unable to be separated.

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7. What are the arguments for and against convergence between the FASB and the IASB? Convergence would produce one global accounting standard setter, meaning that there were no differences in accounting standards used around the world (or at least the US and the part of the world following IFRS). This would make it easier for companies to cross-list and raise capital in different countries. All lenders and equity providers would use the same set of financial statements to assess the company, reducing companies’ reporting costs.

However, if there is only one standard setter, there is no possibility of using a more suitable set of standards by shifting company domicile to another financial market. At present, if a company does not like IFRS, it can seek to register as a US company, and vice versa.

One single standard setter also means that there is no competition between standard setters, thus losing the potential advantage provided by competition on seeking to improve the quality of standards in order to attract ‘customers’ (ie companies choosing to use the standards). There is a danger that one powerful interest group can get control of the standard setter and encourage the development of standards that promotes its view of the world (or deny views of the world held by its opponents or any other interested party).

A key issue in standard setting is the enforcement of those standards. At present, there is doubt about the ability of the IASB to enforce its standards and to avoid political influence. In the US, it is sometimes argued that the US Congress (ie politicians) place pressure on the FASB to produce a politically acceptable set of standards. The proper role of governments in accounting standard setting can be debated.

8. Is it important to harmonise both accounting and auditing standards around the world? Why? The IASB and IAASB are separate bodies with different influences, although ultimately both are interested in the quality of financial statements. To the extent that auditing standards around the world differentially emphasise compliance with the rules in accounting standards and presentation of a true and fair view, there will be differences in approach by auditors to the audit of the financial statements. Therefore, there are some difficulties in having a unified set of auditing standards when there is a unified set of accounting standards which the standard setters are hoping will be interpreted in similar ways around the world.

A harmonised set of auditing standards would complement the harmonised accounting standards, and the IAASB and IASB are currently working together on a common approach.

An alternative view is that one set of auditing standards would face the same difficulties as one set of accounting standards, that is they would potentially be dominated by a particular interest group, and there would be no competition to find the best set of standards. © John Wiley and Sons Australia, Ltd 2010

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9. What is sustainability reporting? How does sustainability reporting relate to social accounting?

Social accounting is a combination of accounting for different things, in different media, to different users, for different purposes (refer to Gray, Owen and Adams). It goes beyond financial measurement of economic events and reporting to a defined set of users, in accordance with accounting standards and regulations. Sustainability reporting is a subset of social accounting. It uses non-financial information and recognises non-economic events. It also reports to a broader range of users and uses guidelines and influences beyond the accounting standards.

Sustainability reports often report on the entity’s interactions with its community, including customers and other interested parties and those living in regions where the entity operates. Sustainability reports also usually provide information about the wellbeing of the entity’s employees on a number of dimensions, such as health, education, and safety.

Sustainability reports also typically include information about the entity’s impact on the environment, including waste, greenhouse gas emissions, and general climate change issues.

10. Why do companies issue sustainability reports?

Companies often claim to be motivated by a concern for their environment and the quality of their interactions with various sections of the community, and use sustainability reporting to communicate their concerns, activities, and progress.

Others argue that sustainability reporting is an extension of the entity’s public relations department and an attempt to avoid sanction. For example, it is possible to see sustainability reporting as an attempt to minimise political costs. Political costs are those costs incurred by the entity to satisfy government or other organisations’ requirements or restrictions. For example, sustainability reporting might convince stakeholders that a mining company is doing all that is reasonably possible to minimise any potential adverse effects of its operations on the local environment. The report could include data about tree planting to offset its mining activities, and its efforts to provide education for children of local communities. This could be used to convince the relevant governments not to impose new laws in these areas.

Other companies could be producing sustainability reports to communicate more broadly information that it is already providing to relevant agencies about GHG emissions etc. There is a low marginal cost of making this information available and greater benefit from conveying more complete information to interested stakeholders.

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11. What advantages do companies perceive in obtaining assurance for sustainability reports?

In general, assurance provided by an independent third party increases the credibility of the subject matter. The level of credibility depends on the degree of independence and competence of the assurance provider, the extent of work done (evidence gathering), and the scope of the assurance engagement.

Overall, the advantages perceived by companies from obtaining assurance for a sustainability report relate to the increase in credibility. More credible reports are more useful in relations with external stakeholders (that is, they are more likely to be convincing as evidence of the company’s performance in the relevant areas).

If companies are seeking greater acceptance of their sustainability reports, they are more likely to seek assurance. Therefore, an understanding of which companies obtain assurance requires a consideration of which companies are likely to seek greater acceptance of the sustainability reports. Some examples could include companies that face greater political costs and companies that are seeking to influence public opinion because of more sensitive business operations (eg mining, forestry, etc).

12. Why has the practice of sustainability reporting (and assurance) varied around the world?

Some countries have laws that encourage sustainability reporting. For example, if the country requires certain information to be provided to the government and it is likely that this information will be made public, the companies in that country could be more likely to publish the information in sustainability reports so that they can control its release and reap the benefits of their compliance.

Some countries have a political environment that encourages or discourages discussion of sustainability issues. Relevant factors include attitudes towards private companies’ use of natural resources, the public’s right to know certain information about the companies in the economy, progress towards an emissions trading scheme etc.

Another influencing factor could be promotion of this type of reporting by the accounting profession and other interested parties in that country.

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Solution Manual to accompany Accounting Theory 7e

13. Who do you think should be involved in sustainability assurance?

Accountants or physical scientists and engineers? Why? Accountants are experts in forming opinions on whether the information presented in reports gives a true and fair representation of an entity’s position and performance and the report’s compliance with the relevant standards. In this respect they are well qualified to give assurance on sustainability reports.

However, it could be argued that accountants are not experts in environmental and social impacts and information. In this respect they are not well qualified to assess the reports.

It is possible that a team approach is the best solution. Accountants provide expertise on evidence gathering, judgement, and assurance concepts. Physical scientists and engineers can provide expertise on measuring environmental impacts and whether the entity is reporting relevant and reliable information.

14. What is the Carbon Disclosure Project? Who would use the information provided by the Carbon Disclosure Project? Why? The material on the CDP website (see below) claims that it is an independent non-forprofit organisation which compiles a database of corporate climate change information (the largest in the world). The CDP sends a request to selected companies for climate change information. The company’s participation is voluntary.

Information is made available on the CDP website and is available to all interested parties. The main users are institutional investors, purchasing organisation and government bodies.

In addition to providing information, the CDP’s actions encourage organisations to ‘measure, manage and reduce emissions and climate change impacts’. It provides a focus for an ‘ongoing dialogue’ between institutional investors and senior corporate management on climate change.

Carbon Disclosure project http://www.cdproject.net/

15. What is the Global Reporting Initiative? Is this the same as the Greenhouse Gas Protocol Initiative?

The material on the global reporting initiative website (see below) is that the GRI aims to promote disclosure on economic, environmental and social performance. It provides guidance for the transparent and reliable exchange of sustainability information through the GRI Sustainability Reporting Framework.

The purpose of the reporting framework is to provide a widely adopted method of reporting organisational performance in a number of non-financial areas. This facilitates comparisons across organisations and across time.

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The GRI claims that more than 1500 companies worldwide have indicated that they have voluntarily adopted the guidelines, making the GRI guidelines the de facto global standard for sustainability reporting.

Global reporting initiative http://www.globalreporting.org/Home The Greenhouse Gas Protocol (GGP) Initiative has a more limited ambition than the GRI. The GGP provides standards for the reporting of greenhouse gases, not all environmental issues, and it is not relevant to reporting of performance on social benchmarks. The GGP initiative also provides a tool for business to manage its GHG emissions and to make informed decisions about climate change.

The Greenhouse Gas Protocol Initiative http://www.ghgprotocol.org/

16. What is water accounting? Why would we want to account for water?

The discussion should centre around defining water accounting and analysing the reasons for accounting for water. The Government has proposed the development of water accounting to assist entities with control over water to discharge their duties of accountability of entities, and to aid the management of water resources.

For more information go to the Water Accounting Conceptual Framework: http://www.bom.gov.au/water/wasb/wacf-download.php

17. What is a water asset? What is a water liability? How would water assets and liabilities increase or decrease?

The Water Accounting Conceptual Framework adopts an accrual basis of accounting for water and defines the elements of the reports using concepts similar to those used in financial accounting. For example, water assets include water or rights or claims to water (similar to the concept of resource in the definition of financial assets). The entity could hold or manage the water (similar to the concept of control of financial assets), and the entity derives future benefits from the water assets (similar to the concept of future economic benefits).

Increases in net water assets occur when there are inflows of water or rights or claims to water or reductions in present obligations of the water reporting entity.

Example: increase in ground water due to inflows from streams.

For more information go to the Water Accounting Conceptual Framework: http://www.bom.gov.au/water/wasb/wacf-download.php

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18. What attributes of water could be measured? Who would use information about these water attributes? What decisions would they be making?

The Water Accounting Conceptual Framework refers to the process of ‘quantification’, instead of measurement. The framework acknowledges that there are various attributes of water that could be quantified – these include volume, salinity or monetary value. The discussion should focus on what attributes would be useful to different users of the information. For example, is it useful to know that there is a large volume of water without also knowing whether it is too saline for human consumption? When would users be more interested in the monetary value of water?

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THEORY IN ACTION

14.1

Watch the SEC chairman explain why XBRL is important on Youtube: “SEC chair on XBRL” http://www.youtube.com/watch?v=oYaLeXowl5A (accessed April 14, 2009) (1) Why would XBRL help the SEC detect fraud instantly?

(2) What do these statements mean? (a) "The best investor protection is a growing economy and a rising market." (b) “Markets function best when all the information that market participants need is available to them when they want it and in a form they can use it.”

(3) Why doesn’t the SEC simply prescribe a chart of accounts for all companies to use instead of devoting resources to developing XBRL?

(1) XBRL is designed to allow the extraction of individual pieces of data from financial statements. This means that the user is not so reliant on the company’s form of presentation of the fianncial statements. If the regulatory authorities wish to investigate the details of the financial statements the data are easier to find and manipulate using routines which investigate the relationships between pieces of data within financial statements and across time. The extraction of data and their manipulation can be automated. This could mean that almost the moment the company lodges its financial statements, it can be analysed for fraud.

Also, because the data are much easier for all parties to use, it is more likely that a concerned user will alert the regulatory authority to an unusual transaction or set of results.

However, if company managers are aware of the SEC’s data investigation methods, they could try more complex methods of hiding their frauds.

(2) (a) The mission of the US SEC is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.

It is believed that if the economy is growing, jobs will be created, the standard of living of the citizens will improve, and the value of their savings will be protected.

Therefore, the SEC aims to promote capital formation to sustain economic growth. A rising share market also indicates the existence of confidence in the financial system and encourages businesses to invest and grow. Further, as more people purchase shares, they are able to assist the SEC do its job, by scrutinising accounts and alerting the SEC to possible breaches of securities laws.

Good information flows, including accounting information, facilitates the growing market and is part of the system that protects investors. © John Wiley and Sons Australia, Ltd 2010

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(b) Refer to chapter 11 and the discussion of capital markets research.

The efficient market is defined as one in which prices fully reflect available information (Fama 1970). In this view, information is rapidly impounded into share prices, that is, as soon as information is available it is traded on and the share prices adjust accordingly. So positive information about a company encourages investors to buy at a higher price.

Also, the more information that is available, the more likely that share prices are trading close to their ‘true’ price. That is, the price set in the market is a reflection of the expected risk and return of the shares if all participants knew all the information about the company. More information reduces uncertainty about the future prospects of the company, decreasing the risk premium demanded by investors when they are not sure about the company’s prospects.

If XBRL makes information more available to more users, it is less likely that some privileged investors (either better educated or better connected) will be able to trade on the information to the detriment of other investors. Increasing confidence in the market encourages more investors to participate, increasing the ‘depth’ or liquidity of the market.

(3) One of the reasons cited for the development of XBRL is that companies have ‘idiosyncratic’ ways of accounting and reporting. This means that any one item could be treated in a different way by different companies. Companies are different in their operations, financing, and governance. A pharmaceutical company investing heavily in research and development is different to a bank, which is different to a retailer, and so on. The different companies will be focused on different goals and use different methods to achieve those goals. The accounting systems are a product of these differences.

In the video, the SEC chairman acknowledges the difficulty of the task of devising a method of tagging the individual data items because of these different accounting systems. The SEC recognises that companies are different in their operations, financing, and governance and does not want to discourage these differences. It is unlikely that the SEC could devise one accounting system (or chart of accounts) that would serve all the different companies needs. In addition, it could be argued that such an approach would be in conflict with the SEC’s emphasis on helping a growing economy and free market capitalism.

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14.2

Ashton Kutcher is fair value’s newest foe

http://www.nysscpa.org/blog/2009/3/20/ashton-kutcher-fair-values-newest-foe, accessed March 26, 2009.

(1) What is FASB 157?

(2) How could an accounting standard cause a share market crash?

(1)

Summary of Statement No. 157

Fair Value Measurements Extracts: This Statement defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements.

The changes to current practice resulting from the application of this Statement relate to the definition of fair value, the methods used to measure fair value, and the expanded disclosures about fair value measurements.

The definition of fair value retains the exchange price notion in earlier definitions of fair value. This Statement clarifies that the exchange price is the price in an orderly transaction between market participants to sell the asset or transfer the liability in the market in which the reporting entity would transact for the asset or liability, that is, the principal or most advantageous market for the asset or liability. The transaction to sell the asset or transfer the liability is a hypothetical transaction at the measurement date, considered from the perspective of a market participant that holds the asset or owes the liability. Therefore, the definition focuses on the price that would be received to sell the asset or paid to transfer the liability (an exit price), not the price that would be paid to acquire the asset or received to assume the liability (an entry price). http://www.fasb.org/st/summary/stsum157.shtml, accessed April 15, 2009.

(2) Critics of fair value accounting (and FASB 157) argue that it is designed to work only in an orderly market, not in a free falling market. In an orderly market it is possible to use market prices (ie the price paid by a willing buyer to a willing seller) as a guide to the value of similar assets and liabilities. In a distressed market, the seller is not willing and is therefore taking whatever price is offered. Under these circumstances the market price is not a guide to the value of a similar asset or liability.

If organisations that hold assets or liabilities are not likely to be trading those items, then using market prices from distressed sales creates ‘unreal’ values. Writing down assets using distressed prices means that the organisations (typically banks in this scenario) have fewer assets to support their lending and borrowing activities. They © John Wiley and Sons Australia, Ltd 2010

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have to halt these activities, meaning that other businesses cannot access funds, so they are forced to sell assets or layoff workers and the cycle continues.

Supporters of fair value accounting argue that pretending the prices haven’t fallen doesn’t make the assets more valuable, so any borrowing or lending activities are not supported, making them more risky. It is better to know the ‘truth’ than to keep pretending, even if this causes some organisations (and people) to suffer in the short term, because the alternative is to create even more harm in the long term.

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14.3

PwC and IETA, Trouble-entry accounting Revisited, PricewaterhouseCoopers and the International Emissions Trading Association (IETA), 2007, page 28.

(1) Recalculate each company’s financial statements using the following assumptions: a. Each company requires 250 allowances to cover its obligation for the compliance year b. The market price at 31 December 2006 was ₤40 per allowance.

(2) Recalculate each company’s financial statements using the following assumptions: a. Each company requires 100 allowances to cover its obligation for the compliance year b. The market price at 31 December 2006 was ₤40 per allowance.

(3) Comment on the differences between your solutions and the above example.

SOLUTION (1) Figures in GBP Income statement Release of deferred income Emissions cost Net result Balance sheet Intangible assets Liability Net assets

(2) Figures in GBP Income statement Release of deferred income Emissions cost Net result Balance sheet Intangible assets Liability Net assets

Company A

Company B

Company C

3000 7000 -4000

4000 -4000

3000 10000 -7000

3000 7000 -4000

4000 -4000

3000 10000 -7000

Company A

Company B

Company C

3000 2000 1000

0 0

3000 4000 -1000

3000 2000 1000

0 0

3000 4000 -1000

(3) The IFRIC approach requires the liability to be measured as the number of allowances to be delivered and based on market value at period end – this results in a higher liability for Company C than the other two companies in all solutions because the price of the allowances has risen. © John Wiley and Sons Australia, Ltd 2010

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In the original example the net result of Company A and B was the same, but in the new solutions it is the same only in the first case because in the second case fewer allowances are required to be settled than are on hand. Company B recognises an emission cost based on the market value of the shortfall of allowances held. There is no shortfall of allowances in the second case, so there is no emissions cost and no liability.

Overall, the greater the shortfall of allowances and the greater the rise in market price, the greater impact on all results. However, if the companies hold allowances at a low cost and they have sufficient allowances to cover their obligation, they can report a positive net result (or at least avoid a negative net result) by avoiding the IFRIC approach.

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CASE STUDIES 14.1 Accounting & Assurance News Today (ANT) Issue 14 - 9 April 2009 Chartered Accountants ANT [ant@charteredaccountants.com.au] (1) How would you ‘improve standards for the valuation of financial instruments based on their liquidity and investors’ holding horizons, while reaffirming the framework of fair value accounting’?

(2) What is the IASB’s constitutional review? What implications does this review have for the acceptability of IFRS? (1) The statement in quotes is taken from the G20 Declaration on Strengthening the Financial System. The leaders of the G20 are recognising the merit of two of the arguments against fair value accounting. First, if there is no liquidity in the market for financial instruments, then the market prices are not useful in valuing similar financial instruments. This is because liquidity means there are many willing buyers and sellers, and the interactions between them are setting a fair market price. If the market is illiquid, then any trades are not likely to fully reflect both sides. For example, if there are few buyers, the sellers must take any price on offer. If there are few sellers, the buyers who need to buy will pay any price in order to secure their purchase.

Second, holders of financial instruments claim that their financial instruments are being held to maturity and not for the purpose of trading. If the instruments are being held to maturity (or at least, for a lengthy period) then current market prices are irrelevant for valuation purposes. A more realistic valuation method would be discounted cash flows.

However, the leaders of the G20 are also recognising the importance of fair value accounting as a crucial concept in accounting measurement. Given recent statements by the SECi affirming the merits of the fair value method, it is politically difficult for the leaders of the G20 to publicly go against such expert advice and the associated work done to date by the IASB and the FASB on the fair value model.

Therefore, the G20 is asking standard setters to find a way to recognise the concerns of the critics of the fair value method whilst appearing to continue with fair value accounting. One possible solution is to create exceptions, for certain assets, certain entities, or during certain time periods. Another method is to allow ‘variants’ on fair value accounting which are effectively a different valuation system with the trade-off of additional disclosures. (This was the option chosen by the IASB in late 2008 when it came under pressure from European banks).

1

United States Securities and Exchange Commission (SEC) Report and Recommendations Pursuant to Section 133 of the Emergency Economic Stabilization Act of 2008: Study on Mark-to-Market Accounting, December 2008, Washington.

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(2) The IASB is overseen by the IASC (International Accounting Standards Committee) Foundation. The IASCF is a non-profit non-government organisation. It does not report to any sovereign government, so does not receive the legal backing of a government. This makes the IASB vulnerable to interference and pressure from interested parties, including governments. This is in contrast to FASB, which reports to the US Congress, or the Australian Accounting Standards Board, which is ultimately responsible to the Australian Government.

One of the proposed outcomes of the IASB’s constitutional review is the creation of a body which will give it greater ability to withstand pressure from external parties. Its membership is drawn from capital markets authorities from various jurisdictions who have an interest in supporting the development of high quality international accounting standards.

See http://www.iasb.org/News/Press+Releases/Press+release+from+IASC+Foundation+ Monitoring+Board.htm (accessed April 15, 2009) for details of the IASB Foundation monitoring board’s first meeting.

Current progress on the IASB’s constitutional review is at: http://www.iasb.org/About+Us/About+the+IASC+Foundation/Constitution/Constituti on+Review/Constitution+Review.htm

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14.2

Egan, C. “Authority ‘fabricated’ water data”, The Sunday Age, (March 29, 2009), p.9.

http://www.theage.com.au/national/authority-fabricated-water-data-200903289evj.html?page=-1 (accessed April 16, 2009) (1) Explain the accusation that the water authority fabricated data. How was it done?

(2) What are the difficulties faced by the water authority in providing accurate data? What water attributes are they supposed to measure?

(3) Who are the stakeholders in this case? What are their interests?

(1) The Southern Rural Water authority has admitted that it has been calculating river flow readings from a measuring station near Sale that does not exist. The readings have been invented because the station supposedly at Swing Bridge, south of Sale, was never installed. The station was supposed to have been installed in 2000, but it wasn’t. The site is at a bridge spanning the Latrobe River at its junction with the Thomson River.

Readings for this site have been calculated based on readings taken kilometres upstream at other sites, and then adjusted for irrigation and industry water entitlements.

(2) The reading station was supposed to have been installed at a point where the Thomson and Latrobe rivers flow into the Gippsland lakes.

The reading station was supposed to be measuring the level of freshwater flowing to Lake Wellington in the Gippsland lake system.

The water authority claims the reading station was not installed because of difficulties in splitting fresh water from salt water than comes to this site with the tide. However, critics claim that the technology for making these readings had been available for a decade, so they accuse the water authority of avoiding accurate measurement for other reasons.

(3) Water authority – has to meet government guidelines and obligations under the Water Act of 1989 to maintain river flow gauging stations at designation points.

State government – political pressures to provide water to irrigators, industry, households and for recreation and the environment.

Conservationists and environmental groups – want designated water flows into the ‘internationally recognised Gippsland lakes and wetlands’ Local landowners – need water for irrigation and are relied upon by the water authorities for ‘dobbing in suspected water thieves’.

The environment itself ... (the environment is often treated as a stakeholder, even though it’s not a person).

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Taxpayers and ratepayers who are not getting what they have paid for, and who might be short-changed in terms of the water available to their use (other than irrigation).

Infrastructure suppliers who have not had the opportunity to install the station, despite funding being made available.

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