Contemporary Issues in Accounting Solutions Manual

Solution Manual to accompany

Contemporary Issues in Accounting Michaela Rankin, Patricia Stanton, Susan McGowan, Kimberly Ferlauto & Matt Tilling PREPARED BY:

Sue McGowan

Chapter 1: Contemporary Issues in Accounting

CHAPTER 1 CONTEMPORARY ISSUES IN ACCOUNTING Contemporary issue 1.1 Abstracts from critical accounting research

1. In each of these abstracts the notion of true or fair accounting or financial statements is considered. Identify any requirements in accounting standards or corporations legislation that relate to the truth or fairness of financial statements or reports. (K) The accounting standards require that the financial statements provide a fair presentation and state: Financial statements shall present fairly the financial position, financial performance and cash flows of an entity. Fair presentation requires the faithful representation of the effects of transactions, other events and conditions in accordance with the definitions and recognition criteria for assets, liabilities, income and expenses set out in the Framework. The application of IFRSs, with additional disclosure when necessary, is presumed to result in financial statements that achieve a fair presentation. (IAS 1/AASB 101, para 15).

(It should be noted that the concept of faithful presentation and whether there can be a true and fair view is contested and this is discussed in Chapter 2).

In Australia Corporations Law, S297, requires that :

The financial statements and notes for a financial year must give a true and fair view of: (a) the financial position and performance of the company, registered scheme or disclosing entity; and (b) if consolidated financial statements are required--the financial position and performance of the consolidated entity.

This section does not affect the obligation under section 296 for a financial report to comply with accounting standards.

Note: If the financial statements and notes prepared in compliance with the accounting standards would not give a true and fair view, additional information must be included in the notes to the financial statements under paragraph 295(3)(c).

There is similar legislation in many countries.

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2. Can you think of reasons why there could be claims that financial statements that are prepared in accordance with accounting standards are not true or fair? (J, K, SM) The assumption made in the standards is that compliance with accounting standards will, expect in rare cases, result in a true and fair view. Reasons for considering that financial statements prepared in accordance with accounting standards may not present a true and fair view could include: • Some accounting standards do not allow professional judgment and have set rules, regardless of whether these rules reflect the substance. For example, in current leasing standards treat no assets or liabilities are disclosed for operating leases despite the fact that most of these leases would meet the definition and recognition criteria for such elements under the conceptual framework (Note: this deficiency is acknowledged and it is intended that this standard be revised). Another example is that internally generated intangible assets (such as goodwill, brands) are not permitted to be recognised under current standards, yet these may be valuable assets to an entity.

•

From a critical perspective, the limitations of information provided by accounting render these statements incomplete and biased, toward financially measurable elements, and so would not be considered true and fair (see answer to 3 below)

Students may identify further reasons.

3. The first extract states that current accounting “may disenfranchise those parties to the dispute whose issues are not readily expressed in the common vocabulary of business’. What do you think the author means by ‘the common vocabulary of business’? Given this, what type of issues may not be included in accounting reports/statements and how could their exclusion impact on decision making? (J, AS) • The common vocabulary of business here would refer to monetary or dollars values (so financially measurable elements). This is also normally restricted to ‘direct’ and measurable costs and benefits (so other factors, eg: externalities such as pollution or employee satisfaction/morale are not included unless directs costs associated with these). Further, the prime objective of business is ‘profit’ and this profit orientation is reflected in what is included and how measured and gives primacy to economic factors/issues and often short term outcomes.

• A few of the issues not included would be social justice, environmental concerns, and

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social equity issues. Typically decision making frameworks suggest that decision makers should take into account both qualitative and quantitative factors. However if the variable /factors considered are restricted to those in the financial statements this will effectively exclude most qualitative factors. A quote by John F Kennedy (although this is in the context of gross national product, this illustrates the limitations of quantitative information and hence can be extrapolated to accounting issues) Gross National Product counts air pollution and cigarette advertising, and ambulances to clear our highways of carnage. It counts special locks for our doors and the jails for the people who break them. It counts the destruction of the redwood and the loss of our natural wonder in chaotic sprawl. It counts napalm and counts nuclear warheads and armoured cars for the police to fight the riots in our cities. It counts Whitman's rifle and Speck's knife, and the television programs which glorify violence in order to sell toys to our children. Yet the gross national product does not allow for the health of our children, the quality of their education or the joy of their play. It does not include the beauty of our poetry or the strength of our marriages, the intelligence of our public debate or the integrity of our public officials. It measures neither our wit nor our courage, neither our wisdom nor our learning, neither our compassion nor our devotion to our country, it measures everything in short, except that which makes life worthwhile. (Robert F. Kennedy, University of Kansas, March 18, 1968)

Review questions 1. Define what is meant by ‘theory’ and explain how theory is useful. Do you think theory needs to be considered in financial accounting?

There is no simple definition of ‘theory’ and in usage it is simply an opinion or explanation.

Macquarie dictionary definition states that ‘theory’ is:

1. a coherent group of general propositions used as principles of explanation for a class of phenomena 2. a proposed explanation whose status is still conjectural, in contrast to well-established propositions that are regarded as reporting matters of actual fact 3. a body of principles, theorems, or the like, belonging to one subject 4. distinguished from the practice of it

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5. a particular conception or view something to be done or of the method of doing it; a systems of rules or principles 6. conjecture or opinion.

A theory may well be born in the human mind, and for it to be useful it must relate to the ‘real’ world. Theory needs to be considered in financial accounting to reflect the decisionmaking behaviour of managers and investors, company policies, political activity or professionalism of accountants.

Accounting theory definition therefore means as stated by Henderson et al. 2004 p. 4 ‘a description, explanation or a prediction [of accounting practice based] on observations and/or logical reasoning’…‘Logical reasons in the form of a set of broad principles that (1) provide a general framework of reference by which practice can be evaluated and (2) guide the development of new practice and procedures’

Students should discuss how theory can help in accounting. Theories can: •

describing and explaining current accounting practices.

•

predicting accounting practice.

•

providing principles to take into account when taking action or making decisions.

•

help to identify problems and deficiencies with current accounting practice and improve accounting practice.

Examples are that a theory of accounting can: a. provide a basis for action: for example, a theory of capital budgeting helps us with choosing among investments; a theory of revenue recognition helps to determine when and how revenue should be recognised; a theory of lease accounting helps with accounting for leases b. reveal deficiencies in practice: a theory of profit determination might reveal deficiencies in the way we presently measure profit c. improve practice: understanding deficiencies may promote change; understanding the behaviour of decision makers may help us to supply better information

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d

help with accounting standard setting; the conceptual framework is used as a basis for drafting accounting standards.

2. Explain what is meant by positive theory.

Positive accounting theory can: •

Describe what is actually happening

•

Explain what is happening

Positive theories are concerned with ‘what is’ and should relate to the facts or the real world through hypotheses. For example, there may be a theory about how individuals or groups actually use accounting information and this would result in predictions (hypothesis) about how we would expect information to be used by particular individuals/groups. The hypothesis is usually to test the theory. Many positive theories are generally concerned with predicting how accounting information is used in economic decision-making and often referred to as ‘empirical’ theories. In the main positive theories are developed from observation through the process of induction and deduction.

3. Explain what is meant by normative theory.

Normative accounting theory is concerned with ‘what should’ be done or ‘what ought to be’ as they prescribe. Prescriptions or recommendations of these theories aim to achieve some goal or objective. The normative theories deal essentially with measurement and are based on classic economic concepts, especially those of income, wealth and rational decision-making.

The conceptual framework is a normative theory. It prescribes the basic principles that are to be followed in preparing financial statements. Hence an accounting conceptual framework can be described as ‘A coherent system of concepts that underlie financial reporting’.

Please note that normative does not mean devoid of any empirical base — normative theories will use empirical theories/observations as assumptions from which prescriptions are deduced.

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4. Explain what is meant by induction and deduction.

Induction is the process of inferring general principles from particular instances; it is the process of moving from the specific observations (particular instances) to a general theory or conclusion.

Deduction is from the general to specific statement; it is the process of reaching a conclusion about particular instances from general principles.

The illustration explains:

Inductive

Theory

(specific > general)

Deductive (general > specific)

The inductive–deductive cycle is a common way in which researchers work and in which positive theories emerge. This is often referred to as the scientific method and is the common way in which positive theories emerge.

An example of the inductive-deductive cycle is below:

1. *Identify the research problem by observation (induction)

Theory development 2. Develop theoretical framework to resolve the problem (deduction).

3. Specific hypothesis to be tested 4. Construct the research design

Use of Observation Observe via sampling and gathering data 5. Analyse the observations 6. Evaluate the results — are these consistent with the hypothesis of the theoretical framework that has been developed 7. Assess any limitations

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1. Identify (induction) 2. Develop (deduction) 3. State Hypothesis 4. Research design 5. Observe

6. Analyse

7. Evaluate

8. Limitations

5. It has been stated that ‘many people accept theories without justification’. Identify reasons people may accept theories. Provide examples of theories that you accept or believe although you may not have direct knowledge in the area.

Students may identify various theories that they accept but have no expert or direct knowledge of: e.g. theories re global warming, theories on punishment (e.g. that deters crime), theories on black holes in space; theories on causes of diseases (such as genetic depositions).

For many theories that a person considers, that particular individual may not have an in-depth knowledge of the area relating to the theory. For example, I believe that the world is not flat and that in fact the theory that the world is round is true. However, I am not a scientist; I have not studied detailed evidence about this theory in any scientific or systematic manner, so what makes me accept this theory, or other theories that are not in my area of expertise.

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People accept theories everyday that they may not fully understand (such as theories of global warming; the theory of relativity; theories about how certain diseases are spread). There are a number of reasons why we may accept theories without ‘first–hand’ or direct knowledge, these include: 1.

The authority of the source of the theory If the theory comes from a source perceived as having specific knowledge and expertise then we may defer to their superior experience and wisdom. If the ‘experts’ in the area say it is true then we are more likely to believe it is true, particularly when the expert provides evidence to support the theory. Statements and theories from eminent scientists or researchers in an area, by teachers (such as university lecturers), from textbooks, even from media sources (such as television and newspapers) are often viewed as authoritative. We are willing to often accept a theory as correct due to who or where the information about the theory comes from (they wouldn’t say it if it isn’t true would they?).

2.

It ‘fits’ with our own experience We are also more willing to accept a theory if the theory matches our own experiences and observations. The theory that the earth is not flat and is in fact round agrees with my own observations of the slightly curved horizon, and the sun setting so I am willing to accept this theory.

3.

It makes sense If a theory seems reasonable and sensible we will often accept it.

‘If a man is offered a fact that goes against his instincts, he will scrutinize it closely, and unless the evidence is overwhelming, he will refuse to believe it. If, on the other hand, he is offered something which affords a reason for acting in accordance to his instincts, he will accept it even on the slightest evidence. (Bertrand Russell).

For example, there are various debates about how much alcohol is safe to drink and that one or two drinks a day may actually be of benefit to a persons health. Many people would believe this is reasonable and further it may fit with their own preference to drink alcohol so would accept this.

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4.

Perceived level of general acceptance A key influence on many people’s beliefs is what other people believe. If a theory appears to be accepted by many people, particularly if it is repeated. For example, if a poll shows that 82% of people believe that introducing gun controls will reduce violent crime, you may be more likely to accept this. This appeal to general acceptance is often used in advertising and political campaigns, such as ‘3 million Frenchmen can’t be wrong. Buy a Renault’. Of course, just because most people believe something does not make it true.

As we noted earlier, many people believed the world was flat but this did not mean that the world was in fact flat.

These approaches to accepting theories are intuitive rather than scientific or systematic and given that any individual’s expertise is necessarily limited, provide a practical and rational way of determining whether an individual accepts a specific theory.

6. Identify a positive theory (this can be about any area; e.g. global warming). Consider how you would test whether this theory was true. Do you think you could prove it?

Recall that a positive theory describes what is happening or explains what is happening. The first step in testing the theory would be to evaluate its logic. Is the theory logical and a valid conclusion given its premises. So for example, there may be a theory about global warming that measures the hole in the ozone layer and links this to changes in average temperatures.

For a positive theory to be able to be tested by observation it must then make a predication that can be tested. For example, if the theory regarding temperature change related to global warming simply predicted that the temperature may change whatever happened, would fit with the theory and this could not really be tested. However if it made a clear prediction — for example, that in 2008 temperatures in a particular region would increase by 1% then we could test this by observing the temperatures in that region. If the observations are not consistent with the predictions of the theory we have established then the theory is incorrect.

If the observations ‘fit’ with the theory then we can claim that the theory has not been falsified. It is generally accepted that theories cannot be ‘proved’ correct because of the problem of determining how many ‘correct’ observations are enough to establish the truth of a theory.

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Students should recognise that even well accepted theories (such as Einstein’s theory of the Big Bang) have been later proven wrong when better observations have been able to be made.

7. What is your understanding of the term ‘research’?

The Macquarie dictionary states that ‘research’ is:

1. diligent and systematic enquiry or investigation into a subject in order to discover facts or principles 2. to make researches; investigate carefully.

3. to investigate carefully; to research a subject exhaustively 4. of or pertaining to research A view of research taken from FASB’s research and development is:

Research is planned search or critical investigation aimed at discovery of new knowledge with the hope that such knowledge will be useful in developing a new product or service or new process or technique or in bringing about a significant improvement in an existing product or for a significant improvement to an existing product or process whether intended for sale or use. It includes the conceptual formulation, design and testing of product alternatives, construction of prototypes, and operation of pilot plants. It does not include routine or periodic alterations to existing products, production lines, manufacturing processes, and other ongoing operations even though these alternations may represent improvements and it does not include market research or market testing activities. 1

8. Explain the role of research and how this relates to theory.

Students should firstly understand that research is activity. The relationship to theory depends on the reason for the research being undertaken, the type of research and/or the results/findings of the research. Research can be undertaken before any theory has been formed or considered. The findings of such research could lead to the formation of a theory (either positive or normative). Research can also be used to test theories. For example, you Financial Accounting Standards Board, Statement of Financial Accounting Standards No. 2 ‘Accounting for Research and Development Costs’. Stamford, C.T: FASB, 1974).par 8.

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could test the hypothesis of a positive theory and see if the findings match the predictions of the theory.

Below some types of research are listed – these are not discussed in the text but may be useful to provide examples to students of research. It may also be useful to have students examine abstracts of academic articles and consider how the research in these relates to theory.

Research may be exploratory, descriptive, investigative, causal or some combination of these (Kent, 2001). Exploratory research aims at finding out whether or not something exists (Dane, 1990, p. 8). As such it is about generating ideas, insights or hypotheses rather than measuring, testing or evaluating those ideas, insights or hypotheses. For example, early research in environmental accounting was aimed at finding out if companies were providing environmental information in their annual reports. Descriptive research is concerned with providing more detail (a more complete picture) about something, and so may involve measuring the sizes, quantities or frequencies of characteristics, but not investigating the relationships between them. For example, research in environmental accounting has investigated the exact nature of the environmental disclosures made by companies by recording the quantities of words included in reports about the environment and the nature and type of environmental information provided. When the research focuses on the extent of association or correlation between two or more variables, the research is investigative. This may often involve predictions (i.e. if one event occurs can predict that another event will occur) although it may not explain the cause of this link or correlation. For example, researchers have investigated the question of what factors are associated with companies that report environmental information and others that do not. Findings in this area have indicated that there appears to be a correlation between the size of a company and the type of industry, and whether it reports environmental information (e.g. that larger companies or companies in more environmentally sensitive industries, such as mining, are more likely to include this type of information in their annual reports).

Causal research extends the investigation by distinguishing between dependent and independent variables, and examines the degree of, and reasons for, the influence of one or more independent variables upon the one or more dependent variables. For example, this may investigate the question as to why (what causes) companies that are large include

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environmental information in their annual reports more often? Researchers have considered that one reason could be to manage the relationships and expectations with stakeholders.

9. Is the following statement correct: ‘Empirical research is only related to positive theories.’?

This statement is incorrect. Recall that ‘empirical research’ is defined as ‘research based on observation and experience’. As the text states, this can also be associated with normative theories. As normative theories do not make predictions about what is happening we cannot use observations of the real world (what is happening) to test these theories — normative theories are making recommendations and stating what should happen, not what is happening. However empirical research is often a catalyst for normative theories. For examples, empirical research that identifies the impact that companies have on the environment may lead to a normative theory about requirements for companies to include information about their environmental performance in their annual reports.

10. Research can be classified in several ways. Outline them.

There are 2 broad classifications of accounting research. These are: •

research of or about accounting. This considers the broader role of accounting

•

research in accounting which focuses more on the actual practice of accounting.

In addition research in accounting can be classified into particular areas (although these overlap). The text identifies •

Capital markets research. Capital-market research was undertaken by Ball & Brown (1968) and Beaver (1968) that began the positive research stream. Their studies investigated the use and impact of accounting information by capital markets.

•

Accounting Policy choice research. Accounting policy choice research is commonly known as positive accounting theory for its domination of research which began with Watts & Zimmerman (1978). This research attempted to explain the motivation.

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•

Accounting Information Processing Research. Accounting information processing research investigates the use and users of information in the decision-making process and uses theories and models from psychology.

•

Critical Accounting Research. Critical accounting research considers the role of accounting in society and the social content.

•

International Accounting Research. International accounting research considers the call for uniform accounting standards worldwide and to harmonise financial accounting.

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Solution Manual to accompany

Contemporary Issues in Accounting Michaela Rankin, Patricia Stanton, Susan McGowan, Kimberly Ferlauto & Matt Tilling PREPARED BY:

Sue McGowan

John Wiley & Sons Australia, Ltd 2012

Chapter 2: The Conceptual Framework of Financial Reporting

CHAPTER 2 THE CONCEPTUAL FRAMEWORK OF FINANCIAL REPORTING Contemporary Issue 2.1 The usefulness of financial reporting 1. Should information in the financial reports be limited to financial or numerical information? (J)

First it should be noted that the information in the financial statements is supplemented by notes and in these there is non-finical and numerical information, although this could be argued to be restricted primary to explaining the numbers or financial information (so for example, explaining assumptions used , methods of estimations etc.

There are 2 views here: • One view is that the role of accounting is limited in scope to financial issues and, hence,

limited to largely financial information. Recall that the objective of financial reporting is not to provide all information users need but to meet information needs common to the specified users. It could be argued that providing information outside of this realm is not within the scope of financial reporting, by definition, and would also not be within the expertise of preparers. It is necessary to restrict information in these reports to make these comparable, understandable and also auditable. It should be noted, however, that in the annual reports (of which the financial statements and notes are a part) reviews by directors often provide some of this information (often required by corporations law), and many particularly larger companies voluntarily provide non-financial information about environmental and social performance.

• As noted in this extract relevant information is not limited to numbers. It could be argued

that given that accounting is about ‘accountability’ the scope and role of accounting should be broadened to reflect the wider accountabilities of corporations in particular, or even that limiting reporting to financial information is not providing the information

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required by decisions makers (users). The examples, provided in the extract: if a technology company hires one of the best minds in the field, would that information be an important factor in making an informed decision about the company’s future economic prospects? Or if a bioengineering company lost its most productive R&D scientist, might that information influence stakeholders’ decisions?- are pertinent ones. Given new technologies and developments (as outlined in the extract) is ‘traditional’ accounting failing its users.

2. What are the difficulties or problems in requiring companies to provide nonfinancial information about, for example, human capital, intangibles, or innovations?

(J, K AS)

Students may identify a range of problems or difficulties including: •

If there are no ‘standards;’ concerning such items and their disclosure this could lead to inconsistencies even as to what information should be provided about, as well as level of detail of information. This of course would reduce comparability.

•

How difficult would it be to provide assurance that this information is representationally faithful (i.e. how would you audit this information, particularly in relation to completeness).

•

The incorporeal nature of items such as (for items such as human capital, innovations) necessarily means that in many instances identifying these and deciding on what impact or significance they have or may have is inherently subjective. This could impact on the usefulness of any information provided.

It should be noted that IAS 38/AASB 138, para 128 encourages entities to provide a description of significant intangible assets that have not been recognised as assets due to failing the recognition criteria.

Cleary including as financial information would be problematic: •

Whether these items would meet definition of assets; if not should we introduce new elements into the financial statements

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•

How would we measure such items? These would be difficult to value (either in attributing costs or future economic benefits)

•

Inclusion of such items may involve subjectively. Could this result in difficulty auditing such information or provide directors or others with opportunities to bias results..

Note: a later chapter in this text discusses issue involved with accounting for intangibles.

Contemporary Issue 2.2 New lease accounting to have big impact 1. Consider the definitions of an asset and liability in the Conceptual Framework. Would a 5-year lease for land meet these definitions? (J, K)

Student should apply the definitions of an asset and a liability from the conceptual framework:

An asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity • Future economic benefits would be the right to use the assets (and the revenue/benefits that you obtain from using the land) • Control would be established as given the contract the lessee can obtain the benefits from using the asset (remember that assets do not need to be owned).

• Past event – would be lease contract that gave rise to lessee having right of use of asset and controlling and accessing benefits.

A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits • The future outflow of economic benefits/resources would be the meeting of lease payments) • Present obligation – under leasing contract would assume have legal obligation to make payments.

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Solution manual to accompany: Contemporary Issues in Accounting

• Past event – would be lease contract that gave rise to obligation.

Note:

The current accounting standard on leases, AASB 117 Leases, overrides the general

recognition criteria for liabilities and requires liabilities in relation to finance leases to be recognised.

A finance lease is a lease in which substantially all of the risks and rewards incidental to ownership have been transferred from the lessor (legal owner of the property) to the lessee (one who is using the property) (AASB 117 para 4). Given that land has an indefinite life a 5 year lease of land would be classified as an operating lease and would not give rise to an asset or liability. Under the proposed leasing standard this would change and an asset and a liability would be recognised.

2. The extract discusses the fact that these changes reflect the way in which accounting is moving — that is, towards putting all assets and liabilities on the balance sheet.

What reasons could there be for this move? Given the identified impact on key company ratios, do you believe this approach is justified? (J)

Reasons towards the move towards putting all assets and liabilities on the balance sheet would be: • Based on principles & objectives of financial reporting: To be consistent with the conceptual framework all items that meet the definition and recognition criteria of assets and liabilities should be included on the balance sheet. Also to be complete and so representationally faithful would argue that need to include all elements. Surely information about the assets and liabilities of an entity would be relevant to users.

• Improves comparability as does not distinguish on form or arbitrary rules but reflects economic substance. For example, under current lease accounting 2 entities could have identical items of land – one entity owns and one leases (as operating lease). The different accounting treatment would result in one entity including an asset but the leasing one not. This would distort rations such as return on assets etc and make comparison difficult.

• Reduces opportunities to structure transactions on order to reflect a particular financial position (this could include maintaining certain ratios).

If all assets and liabilities meeting the

recognition criteria are required to be included on the balance sheet then this limits the ability of entities to choose or plan transactions to avoid including these on their balance sheet or in particular to ‘hide’ obligations/ /commitments.

Under the current leasing arrangements

company may decide to lease land rather than purchase (even those costs and commitments may be relatively equal) as leasing will avoid the recognition of the lease liability and asset. It could be argued that the use of special purpose entities by Enron which were not required to be

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included on the balance sheet and were used to hide debt is an example of structuring transactions to reflect a particular financial position.

Cleary including all assets and liabilities on the balance sheet would impact on key financial ratios.

Whilst it could be argued that this could disadvantage some companies (for example, if they are now required to include such assets and liabilities this could mean that they may breach debt covenant ratios and incur costs unless they are able to renegotiate debt terms/covenants). However an alternative argument is that if all assets and liabilities are included then this provides a more complete and representationally faithful view of the financial position and hence the ratios are more ‘accurate’ and useful.

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Review questions 1.

What is a conceptual framework?

A conceptual framework is defined in the text as a set of broad principles that provide the basis for guiding actions or decisions. An accounting conceptual framework can be described as: a coherent system of concepts that underlie financial reporting. As the Conceptual Framework (page 26) states ‘This Conceptual Framework sets out the concepts that underlie the preparation and presentation of financial statements for external users.’

2.

What is the difference between a conceptual framework and accounting standards?

Essential points relate to: •

The conceptual framework provides high level concepts such as definitions of elements of financial statements, qualitative characteristics, definition of the objective of general purpose financial reporting. Standards apply the concepts in specific situations — for example, accounting for financial instruments, leases and inventory.

•

The standards setters base new accounting standards, and amendments to old, on the conceptual framework.

•

Standards take precedence in the event of conflict as the Conceptual Framework (page 6 notes). In Australia, the Conceptual Framework does not have legal force for reporting entities subject to the Corporations Law; accounting standards do. However, concepts from the conceptual framework are now included in all new and reissued accounting standards. Therefore, application of such embedded concepts is mandatory because these are included in accounting standards.

The differences are illustrated with the following examples.

IAS 1/AASB 101 para 9 outlines information about the purpose and elements included in a financial report:

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Financial statements are a structured representation of the financial position and financial performance of an entity. The objective of financial statements is to provide information about the financial position, financial performance and cash flows of an entity that is useful to a wide range of users in making economic decisions. Financial statements also show the results of the management’s stewardship of the resources entrusted to it. To meet this objective, financial statements provide information about an entity’s: (a) assets; (b) liabilities; (c) equity; (d) income and expenses, including gains and losses; (e) contributions by and distributions to owners in their capacity as owners; and (f) cash flows.

This information, along with other information in the notes, assists users of financial statements in predicting the entity’s future cash flows and, in particular, their timing and certainty.

The Conceptual Framework (para. 4.4) provides definitions of basic elements to be included in the statement of financial position such as: (a)

An asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity.

Accounting standards provide specific requirements for a particular area of financial reporting. These are required to be complied with via corporations law.

For example: IAS 1/AASB 101 Presentation of Financial Statements specifies that:

particular assets or liabilities must be included on the face of the report itself (such as intangibles).

AASB 102 Inventories (para. 5.2) specifies that:

inventories shall be measured at the lower of cost and net realisable value

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3.

Outline the technical benefits of a conceptual framework. What problems could occur if accounting standards were set without a conceptual framework?

The technical benefits relate to improving how financial reporting works — either though improving quality, or accounting practice, via improving understanding. The Conceptual Framework outlines these under its purpose section (page 6).

(a) to assist the Board in the development of future IFRSs and in its review of existing IFRSs; (b) to assist the Board in promoting harmonisation of regulations, accounting standards and procedures relating to the presentation of financial statements by providing a basis for reducing the number of alternative accounting treatments permitted by IFRSs; (c) to assist national standard-setting bodies in developing national standards; (d) to assist preparers of financial statements in applying IFRSs and in dealing with topics that have yet to form the subject of an IFRS; (e) to assist auditors in forming an opinion on whether financial statements comply with IFRSs; (f) to assist users of financial statements in interpreting the information contained in financial statements prepared in compliance with IFRSs; and (g) to provide those who are interested in the work of the IASB with information about its approach to the formulation of IFRSs.

In the AASB Framework these are listed para. 1 (a) to (g).

The problems that could occur if standards set without a conceptual framework is: • Inconsistencies between standards if different concepts/principles used to develop

different accounting standards • Time frame for developing standards could be longer as would need to debate underlying

principles/concepts each time new standard developed/changed.

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4.

How can the conceptual framework help users and preparers understand accounting requirements and financial statements?

The conceptual framework can assist users and preparers as: • Accounting standards based on the conceptual framework should be more consistent • Rationale for standards should be apparent as based on underlying concepts which are

explicitly stated in the conceptual framework.

5.

What is the objective of financial reports according to the Conceptual Framework?

Historically, external financial reports were prepared (and required) to ensure minimum information was given to investors to make informed judgements about the performance of management and the security of investments. The need to protect the rights of external users of information, who are not involved in the operations of the company, is the primary justification for the need for external financial reporting. Such reports are used as a source of information for those parties who are planning to transfer resources to an organisation.

The Conceptual Framework outlines the purposes of financial reports:

The objective of general purpose financial reporting* is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity. Those decisions involve buying, selling or holding equity and debt instruments, and providing or settling loans and other forms of credit. (OB2)

Hence should note: • Objective is to provide information for decision making • Identifies specific decision makers and types of decisions and limits to these.

Students should note that the revised Conceptual Framework: • Restricts users and decisions whereas previously these were much broader • Does not explicitly include in its objectives the discharge of accountability/stewardship.

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6.

How is the decision usefulness approach reflected in the Conceptual Framework?

An essential point to note is that the conceptual framework is based on the decision usefulness approach to accounting theory. The outputs of the accounting system are inputs to user decision processes.

This emphasis is reflected both in the objective of general purpose financial reporting (this is to provide information … that is useful to ... in making decisions) and in the qualitative characteristics.

Paragraph QC1 of the Conceptual Framework defines qualitative characteristics as:

The qualitative characteristics of useful financial information discussed in this chapter identify the types of information that are likely to be most useful to the existing and potential investors, lenders and other creditors for making decisions about the reporting entity on the basis of information in its financial report (financial information).

Although all aim of all of the qualitative characteristics is to ensure that information is useful the one that best reflects the decision–usefulness approach in the conceptual framework is relevance.

The qualitative characteristic, relevance, is one of the qualities that should be reflected in the information provided by general purpose financial reports. Relevance is outlined in the Conceptual Framework (para. QC6) as: Relevant financial information is capable of making a difference in the decisions made by users. Information may be capable of making a difference in a decision even if some users choose not to take advantage of it or are already aware of it from other sources.

Paragraph QC7 of the Conceptual Framework states:

Financial information is capable of making a difference in decisions if it has predictive value, confirmatory value or both.

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You should see that this has two roles: predictive and confirmatory (or feedback) and that these are interrelated (refer QC8 to 10).

Prediction: Part of the definition of relevance focuses on accounting information as an input to user prediction models. Information may help to predict future earnings or cash flows from future dividends, for example.

Confirmation (Feedback): Part of the definition notes that information is also relevant if it plays a feedback or confirmatory role in the decision process.

Most descriptions of decision processes view decision makers as seeking information: • to help predict the future values of variables of interest for a decision, for example future

revenues and future costs. Information plays a predictive role. Information about past events is fed into a decision model to help predict future values of the variables of interest (part (a) of the definition); and • for confirmation or feedback, to help monitor the outcomes of past decisions part (b) of

the definition).

7.

The Conceptual Framework states that ‘general purpose financial reports do not and cannot provide all of the information that existing and potential investors, lenders and other creditors need’ (para. OB6). What information is not provided and why?

As stated in the Conceptual Framework: IOB6 However, general purpose financial reports do not and cannot provide all of the information that existing and potential investors, lenders and other creditors need. Those users need to consider pertinent information from other sources, for example, general economic conditions and expectations, political events and political climate, and industry and company outlooks.

OB7 General purpose financial reports are not designed to show the value of a reporting entity; but they provide information to help existing and potential investors, lenders and other creditors to estimate the value of the reporting entity.

OB8 Individual primary users have different, and possibly conflicting, information needs and desires. The Board, in developing financial reporting standards, will seek to provide the

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information set that will meet the needs of the maximum number of primary users. However, focusing on common information needs does not prevent the reporting entity from including additional information that is most useful to a particular subset of primary users.

There are a number of key limitations and/or omissions to the information provided in the financial reports: • Information on general contextual issues (such as economic conditions) is not included.

• Information is limited to common information needs; so is not tailored to individuals or

even individual user groups, which may require information specific to their decisions.

• The financial reports do not provide future orientated information. The focus of

information provided in the financial statements is on past performance/position, and while these can be used to make predictions, these in themselves are not future orientated.

• Non-financial information is also limited. Although limited non-financial information is

provided, the main information in financial reports is financial. Relevant information is not limited to numbers. For example, if a technology company hires one of the best minds in the field, would that information be an important factor in making an informed decision about the company’s future economic prospects? Or if a bioengineering company lost its most productive R&D scientist, might that information influence stakeholders’ decisions?

It should be noted, however, that in the annul reports (of which the financial statements and notes are a part) reviews by directors often provide some of this information (often required by corporations law), and many particularly larger companies voluntarily provide non-financial information about environmental and social performance.

Why is this information not provided?

There are alternative views, and also advantages and disadvantages, in providing such information. One view is that the role of accounting is limited in scope to financial issues and, hence, limited to largely financial information. Others would argue that given that accounting is about ‘accountability’ the scope and role of accounting should be broadened to reflect the wider accountabilities of corporations in particular, or even that limiting reporting to financial information is not providing the information required by decisions makers (users).

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8.

What is the underlying assumption to be applied in preparing financial reports according to the Conceptual Framework? How does this assumption affect the financial report items?

The underlying assumption identified in the Conceptual Framework in the preparation of the financial statements is the going concern basis.

The going concern basis is described in paragraph 4.1 of the Conceptual Framework.

The financial statements are normally prepared on the assumption that an entity is a going concern and will continue in operation for the foreseeable future. Hence, it is assumed that the entity has neither the intention nor the need to liquidate or curtail materially the scale of its operations; if such an intention or need exists, the financial statements may have to be prepared on a different basis and, if so, the basis used is disclosed.

Applying this basis means that a longer term view of economic benefits and outflows can be considered. If this was not used (i.e. it was assumed that a company as at balance date would not be continuing in its operations) this would require assets/liabilities etc. to be measured on a liquidation basis. For many items this would significantly impact on their measurement and even whether they would be recognised at all (for example, prepaid insurance if the company was not continued would be unlikely to provide any future benefits). Of course if this does not apply (i.e. the entity is not a going concern) then as stated, disclosure of this is required and a different basis would normally be appropriate.

9.

Identify the qualitative characteristics of financial information in the Conceptual Framework. How are these related to the objectives of general purpose financial reports?

The Conceptual Framework states that: QC 1. The qualitative characteristics of useful financial information discussed in this chapter identify the types of information that are likely to be most useful to the existing and potential investors, lenders and other creditors for making decisions about the reporting entity on the basis of information in its financial report (financial information).

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QC4 If financial information is to be useful, it must be relevant and faithfully represents what it purports to represent. The usefulness of financial information is enhanced if it is comparable, verifiable, timely and understandable.

So the role of qualitative characteristics is to ensure that information provided to users has these qualities as they will help ensure that the information is useful to users. This is directly related to the objective of general purpose financial reports, which in the Conceptual Framework, is to provide information that is useful to range of users in making decisions.

The Conceptual Framework identifies 2 fundamental qualitative characteristics: relevance and faithful representation.

To be useful information must have both of these. As the

Conceptual Framework states: QC17 Information must be both relevant and faithfully represented if it is to be useful. Neither a faithful representation of an irrelevant phenomenon nor an unfaithful representation of a relevant phenomenon helps users make good decisions.

It also identifies a number of enhancing qualitative characteristics (comparability, verifiability, timeliness and understandability) which increase the usefulness of information, Each of these qualitative characteristics is outlined in the Conceptual Framework and these outlines link each qualitative characteristics with the usefulness and use of information by users.

For example the qualitative characteristic of timeliness states:

QC29 Timeliness means having information available to decision-makers in time to be capable of influencing their decisions. Generally, the older the information is the less useful it is.

However, some information may continue to be timely long after the end of a reporting period because, for example, some users may need to identify and assess trends.

Students should recognise that there may be a need to balance these qualities and trade these off. For example: • The cost of an item purchased 20 years ago is verifiable however, it may not be

relevant. A more relevant measure (such as what it could be sold for now, or the cash flows it is expected to generate in the future) may be less verifiable.

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This need to trade off is explicitly recognised in the Conceptual Framework

QC34 Applying the enhancing qualitative characteristics is an iterative process that does not follow a prescribed order. Sometimes, one enhancing qualitative characteristic may have to be diminished to maximise another qualitative characteristic. For example, a temporary reduction in comparability as a result of prospectively applying a new financial reporting standard may be worthwhile to improve relevance or faithful representation in the longer term. Appropriate disclosures may partially compensate for non-comparability.

It is important to understand these qualitative characteristics because these factors should be a key part of consideration in the areas where accountants are required to exercise judgement (e.g. in relation to accounting policies, etc.).

10.

Not all relevant and faithfully representative information will be included in financial reports due to the materiality aspect and cost constraint identified in the Conceptual Framework. Outline the materiality aspect and the cost constraint on the provision of information. Can you think of any problems in applying these?

Materiality can be considered as aspect of relevance and material information is outlined in the Conceptual Framework as:

QC11 Information is material if omitting it or misstating it could influence decisions that users make on the basis of financial information about a specific reporting entity. In other words, materiality is an entity-specific aspect of relevance based on the nature or magnitude, or both, of the items to which the information relates in the context of an individual entity’s financial report. Consequently, the Board cannot specify a uniform quantitative threshold for materiality or predetermine what could be material in a particular situation.

The cost constraint is outlined as:

QC35 Cost is a pervasive constraint on the information that can be provided by financial reporting. Reporting financial information imposes costs, and it is important that those costs are justified by the benefits of reporting that information. There are several types of costs and benefits to consider...

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Problems in applying would include: • Both of these require judgement. This leaves open the possibility of different

interpretations, which could cause inconsistencies, and also the opportunity for motivations such as self interest to distort or bias this judgement. This inherent subjectivity involved in applying the cost constraint is recognised explicitly in the Conceptual Framework (see QC39).

• These decisions are made by the preparers of the financial reports and yet these

constrain the information provided to users. For example, most of the costs of preparing reports are borne by preparers (and companies) yet the benefits are for users. However, the preparers weigh the costs to them against their perceptions of the benefits to users; is this a conflict of interest?

11.

What is the difference between recognition and disclosure in accounting?

According to the Conceptual Framework, when should an item be recognised in the financial reports?

Recognition is the process of recording information about an element in the body (on face) of the financial reports (Conceptual Framework, paragraph 4.37). Disclosure normally means that information is included (disclosed) either in the body (on the face of the reports) or in the notes to the accounts.

Recognition is the process of incorporating in the balance sheet or income statement an item that meets the definition of an element and satisfies the criteria for recognition set out in paragraph 4.38. It involves the depiction of the item in words and by a monetary amount and the inclusion of that amount in the balance sheet or income statement totals. Items that satisfy the recognition criteria should be recognised in the balance sheet or income statement. The failure to recognise such items is not rectified by disclosure of the accounting policies used nor by notes or explanatory material

Students may also refer to para. 48 of AASB 101:

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48. This Standard sometimes uses the term ‘disclosure’ in a broad sense, encompassing items presented in the financial statements. Disclosures are also required by other Australian Accounting Standards. Unless specified to the contrary elsewhere in this Standard or in another Australian Accounting Standard, such disclosures may be made in the financial statements.

The following illustrate the difference between recognition and disclosure and although we normally consider disclosure to mean either on the face of the reportss or in the notes, in some cases disclosure will be restricted to the notes: • A company may have a relatively small expense (e.g. for postage). This would meet the

definition and recognition criteria of an expense and thus be recognised (included in expense on the face of the relevant statement). However, this item (postage expense) would not need to be separately disclosed.

• A company may have a relatively large expense (e.g. for cost of sales). This would

meet the definition and recognition criteria of an expense and thus be recognised (included in expense on the face of the relevant statement). However, as this item is material (users need to know about this) it is required to be disclosed. Hence, would need to disclose the amount for this expense separately, either in notes or on the face of the relevant report.

• A company may have an item that meets the definition of a liability but not the

recognition criteria (for example, has been found liable in a court case but the amount to be paid has not yet been determined and cannot be estimated). In such cases, the relevant standard, AASB 137, requires disclosure of the item. As this does not meet both the definition and recognition criteria, it cannot be included or disclosed on the face of the financial statements. However, information about this item would be disclosed separately in the notes

Recognition is a two-stage process Firstly, the item must satisfy the definition of an element of the financial reports. Secondly, information about an element will be recognised in the financial reports if it satisfies certain recognition criteria (these relate to probability and reliable measurement).

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To know how this works we must understand the recognition criteria. The Conceptual Framework states that:

4.38 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.*

Probability test In the Conceptual Framework the term ‘probable’ refers to ‘the degree of uncertainty that the future economic benefits associated with the item will flow to or from the entity ‘ (para. 4.40). You need to consider the available evidence. In terms of probability levels, this is usually interpreted as saying that the chance of economic benefits arising, or of a disposition of economic benefits occurring, is more likely rather than less likely. Pierson (1988) interprets this to mean that the probability level must exceed.

Reliable measurement For an item to be recognised it is necessary that it possess a cost or other value that can be measured reliably. The qualitative characteristic ‘faithful representation’ has now replaced ‘reliability’ which was previously a separate qualitative characteristic. The Framework outlined reliability as:

31 To be useful, information must also be reliable. Information has the quality of reliability when it is free from material error and bias and can be depended upon by users to represent faithfully that which it either purports to represent or could reasonably be expected to represent.

Hence a measure that meets the qualitative characteristic of faithful representation could be presumed to meet this recognition criteria. The enhancing qualitative characteristic of verifiability would also improve the reliability of measures.

The appropriate measurement basis for assets and liabilities has not been addressed in the Conceptual Framework.

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Students should note that information about elements that are not recognised may be disclosed by way of notes to the reports (para. 4.4.3), or may be recognised later if the recognition criteria are subsequently met (para.4.4.2).

4.43 An item that possesses the essential characteristics of an element but fails to meet the criteria for recognition may nonetheless warrant disclosure in the notes, explanatory material or in supplementary schedules. This is appropriate when knowledge of the item is considered to be relevant to the evaluation of the financial position, performance and changes in financial position of an entity by the users of financial statements.

12.

Why is accounting said to be ‘political’ in nature? How can a conceptual framework help in the setting of accounting standards in a political environment?

The political nature of accounting is due to the fact that accounting information is used in, and influences, decisions. Thus, the accounting ‘rules’ determine what information is provided and therefore what information is used in decisions. Recall that the objective of financial reporting is to provide information useful to users in making economic decisions. If economic decisions change and are influenced by accounting then this means that accounting information has economic consequences (i.e. can result in transfers of wealth). Thus, people will try to influence the accounting rules (the accounting standard) to try to ensure that their own interests are met.

The claim is that the conceptual framework provides some defence against ‘political interference’ as the framework can be used to justify the choices/decisions made by accounting standard setters in determining accounting rules. Also, individuals arguing against standards will find this more difficult if their arguments are inconsistent with the agreed Conceptual Framework.

13.

It is claimed by some that the reason for conceptual frameworks in accounting is to protect the accounting profession rather than improve accounting practice.

Explain the basis for this claim.

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Students should note the following major points.

1.

Accountants have a special status in society. In Australia, this is witnessed by the Royal Charter endowed on the Institute of Chartered Accountants, the media profile associated with the CPA program of the Australian Society of CPAs, and the professional monopoly (or almost) by the two major accounting bodies.

2.

The hallmark of a profession is possession of a unique body of knowledge. Loss of professional status means that the power, prestige, self regulation and economic position of accountants are eroded.

3.

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).

4.

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

5.

According to a social constructionist view, as put by Hines, the conceptual framework project is not about setting rules for accounting practice; rather, it is about legitimising the process by which accounting practice is done. That is, the accounting profession: •

does not really value a conceptual framework for its potential technical benefits

•

does value the appearance of having a conceptual framework to claim a unique body of knowledge to maintain its professional status, associated privileges and power.

14.

Some people argue that the conceptual framework is acceptable in theory but in practice it does not work. Explain possible problems with and criticisms of the current Conceptual Framework. Do you think these problems exist and criticisms are valid?

The problems or criticisms are: • Too ambiguous and open to interpretation. By definition a conceptual framework provides

broad concepts and, thus, any conceptual framework often will be open to interpretation. If

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too rigid, then the Conceptual Framework would not be broad enough or flexible enough to deal with the wide range of transactions, events and issues related to financial reporting.

However, this broadness also means it can lead to inconsistencies. Presumably this is why there are more detailed standards, and we need to think here about the purpose of the Conceptual Framework. Its key purpose is to guide accounting standard setters and to provide guidance where there are no standards.

• It is incomplete. This criticism, particularly in relation to measurement, is valid.

• It is too descriptive. This criticism argues that because much of the Conceptual

Framework reflects historical accounting practice, rather than driving and informing accounting practice, it merely codifies what is currently practiced. Whether you accept this criticism as valid or not will depend on your view of what accounting should do, and especially in relation to the scope and purpose. An alternative view is that accounting practice has developed over time and it is reasonable to assume that much of current practice is ‘correct’.

• The meaning of faithful representation is problematic. This is expanded on in the answer

to question 2.15.

15.

Explain why some people believe that the concept of faithful representation in the Conceptual Framework is incorrect.

First students should consider the definition of this term in the Conceptual Framework.

Faithful Representation QC12 Financial reports represent economic phenomena in words and numbers. To be useful, financial information must not only represent relevant phenomena, but it must also faithfully represent the phenomena that it purports to represent. To be a perfectly faithful representation, a depiction would have three characteristics. It would be complete, neutral and free from error.

Of course, perfection is seldom, if ever, achievable. The Board’s objective is to maximise those qualities to the extent possible.

This answer explains this rationale for those who believe that this is incorrect by considering the meaning of this term as it relates to different word views about the nature of accounting.

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Alternative views of nature of accounting Realist view — assumes that an objective reality exists independently of the observer; the world of theory and reality are separate. This assumes that there is an objective reality that exists independently of our accounts of it. The task is to ‘discover’ and record what it is that objectively exists. This assumes that the observer is independent of the events observed (and vice versa), and that our theories about the world do not affect the observers or observations made. Our observations are objective — we merely see what is ‘out there’ to be discovered.

In accounting, this view assumes that the transactions and events that accountants describe and report exist independently of the descriptions themselves.

Materialist or Social constructionist — this alternative view argues two points: • Our accounts of reality act upon reality and come to form part of that reality; ‘that our

knowledge of the world is just as much an invention as it is a discovery’. Our accounts construct the reality that they purport to describe. Therefore, accountants are not impartial, value-free score-keepers — they are involved in constructing the financial reality of a reporting entity; and • Once the account of reality is accepted, we act on that account. Our theories about the

world come to control us as they exert an irresistible influence on our actions. (Students should refer to the discussion of the scorers in the football game that is set out in the topic overview.)

View reflected in the representational faithfulness qualitative characteristic Representational faithfulness means the correspondence between a measure or description of events or objects and the events or objects themselves.

The definition assumes that the task of accounting is to faithfully represent, i.e. mirror economic transactions and events. The concept of representational faithfulness implies the assumption of ‘realism’. This implies that there is a reality that accountants can observe objectively/neutrally and faithfully describe — the realist view.

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Whether or not the view of reality reflected in the representational faithfulness (realist view is the correct view.

Accounting cannot mirror transactions and events if there is not an objective social reality that is unaffected by our accounts of it. Those who believe in the alternative world view (materialist or social constructionist) would hence argue that concept of representational faithfulness is based on a flawed view of reality. The key point here is that financial reality, or financial ‘facts’ (such as profit, liquidity, asset levels) do not exist independently of our measures of them. Accounting measures are not like natural phenomena (the sun, the moon etc.) that are there to be simply discovered. The problem is the numbers we report are not representations of objects. Accounting measures only arise via application of various rules and choices. Descriptions of abstractions such as net profit or financial position do not exist independently of our measures of them. In this way, accountants can be said to construct financial reality. See the example in the text in relation to different measures and different resulting profit figures.

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Application questions 2.1 As a group, identify two or three general principles to help guide the making of more specific rules in relation to a particular area, context or task. For example: • It may be that a group of students is planning on sharing accommodation (such

as an apartment).

• You may be required to undertake a group assignment.

Once you have agreed on the two or three principles, use these to form more specific rules in relation to the context or task. Then consider the following questions: (a) How easy was it to agree on the basic principles? (b) Are all the rules consistent with these principles? (c) Have any members interpreted the principles differently? (d) How useful were the principles in helping establish more specific rules? (e) Were there any problems with using principles as a basis for setting the rules?

(CT, SM)

There are no set answers here. You would expect that students have difficulty setting the initial principles. By attempting to apply these principles, it is likely that the original principles will be amended, or different interpretations allowed.

This should demonstrate a number of issues: • The difficulty (and time required) in arriving at agreement • The fact that individuals will interpret statements of principles differently (perhaps in

line with their own preferences, situation and experiences) even where other individuals have believed that the rules were clear.

• Once established, the principles do reduce time to agree on more specific rules and also

are used to justify agreement/disagreement of differing interpretations.

2.2 Look at the accounting standards. Then: (K, AS) (a) Find examples of how parts of the conceptual framework (e.g. the definitions, recognition criteria, qualitative characteristics) have been included in them.

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Students should be able to find numerous examples such as: • IAS 8/AASB 108 Accounting Policies, Changes in Accounting Estimates and Errors

includes criteria to change accounting policy, and the qualitative characteristics of relevance and reliability (which includes representational faithfulness).

• IAS 38/AASB 138 Intangible Assets includes recognition criteria before an intangible

asset can be recognised, identical to that in the Conceptual Framework • IAS 37/ AASB 137 Provisions, Contingent Liabilities and Contingent Assets includes

the definition of a liability as per the Conceptual Framework.

(b) Identify any inconsistencies between the requirements in accounting standards and the Conceptual Framework. Why do you think these occur?

Two inconsistencies are: • IAS 17/AASB 117 Leases does not allow non-cancellable operating leases to be

recognised as assets yet these would appear to meet the definition of an asset in the framework. Note: an exposure draft is expected to change this to be consistent (or at least more consistent) with the conceptual framework • IAS 38/AASB 138 Intangible Assets does not allow the later recognition of items that

have been expensed but now meet the definition and recognition criteria of an asset.

Yet the Conceptual Framework, para 4.42, states ‘ An item that, at a particular point in time, fails to meet the recognition criteria in paragraph 4.38 may qualify for recognition at a later date as a result of subsequent circumstances or events.’

• IAS 38/AASB 138 Intangible Assets does not allow recognition of some internally

generated assets (such as brands etc) even if these meet the definition and recognition criteria for an asset in the Conceptual Framework

Students may identify other inconsistencies. Possible reasons for inconsistencies could be: • Accounting standards originally evolved without Framework • Opposition to change by interest groups • Concern that any alternatives permitted would reduce consistency or provide

opportunities for manipulation.

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2.3 Find the comments letters received on a current exposure draft or proposal. (These can be found from the websites of most standard-setting organisations, such as IASB, AASB or FASB). Read a sample of comments from a range of respondents (e.g. from accounting bodies, industry, company or corporate bodies) and answer the following questions: (K, AS, SM)

No specific answers are provided here as this will depend on current exposure drafts and the nature of these as to comments and responses received. The following gives some issues to consider.

(a) Is there agreement among the various groups?

If there is disagreement is this related to groupings (e.g. smaller reporting entities; not-for– profit; accounting firms versus academics).

(b) If there are any concerns or objections, are they based in conceptual issues, practical issues or potential economic consequences? Does this vary among groups?

Again consider the nature and impact of proposed changes on the various groups — if economic consequences or impacts of changes vary across groups this is likely to influence reactions. You will often find a range of justifications — some will argue practical problems, others economic consequences, others conceptual issues (or a combination).

(c) Have any of the comments letters referred to the Conceptual Framework as a basis to support their views?

Again this will depend on current exposure drafts and the nature of these as to comments and responses received. An interesting (if old) exposure daft to consider is ED 140 Proposed Amendments to AASB 137 Provisions, Contingent Liabilities and Contingent Assets. Various comments and letters indicate proposal inconsistencies with the current conceptual

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framework (see comments from Deloittes), although others support in principle but argue pragmatic problems with measurement (see comments from Group of 100).

(d) Do the comments letters suggest that there is support for the current Conceptual Framework?

Again this will depend on current exposure drafts and the nature of these as to comments and responses received. However, think about the following question — are they supporting framework because the resulting outcome is in their interest or supports their viewpoint?

2.4 The following information is provided for two items of property for a company.

Property A was purchased five years ago for $400 000. It was intended to be used to build another factory but the company has now reorganised its original factory and it is no longer required. The company now intends to sell it. The current property market has dropped but is expected to rise when interest rates fall. If sold now the property is expected to realise $360 000.

Real estate experts have predicted that if the company waits for the property market to recover, it could realise $450 000.

Property B is the current factory. It was purchased ten years ago for $200 000. If sold now, it would be expected to realise $380 000 (and $500 000 if the property market recovers). The company has various estimates about its contribution to the profit of the company. Using current interest rates and various assumptions about future sales and costs, the property is calculated to have a present value (in terms of future cash flows) of $900 000. It is insured for $600 000 because this is the cost required to rebuild it.

The company has always recorded property using the historic cost basis. Other companies in the same industry have traditionally used the same basis, although about 40 per cent now use the fair value basis. (J, K)

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(a) For each of the properties identify which cost or value would best meet each of the following qualitative characteristics of: • faithful representation • relevance • verifiability • comparability • understandability

Faithful representation Recall that faithful representation requires to represent faithfully what it purports to represent and to be complete, neutral and free from error. This also requires a description of what the number represents. Hence: •

Cost, if clearly indicated as cost, for both is clearly a faithful representation (although remember we normally adjust cost via depreciation which involves estimates).

•

Current and future fair values would also be a faithful representation providing that it is clear is an estimate and ‘the nature and limitations of the estimating process are explained’ (refer QC15).

•

Likewise present values could also be considered a faithful representation providing that it is clear is an estimate and ‘the nature and limitations of the estimating process are explained’ in such a case it would also be required that assumptions etc made to achieve this estimate were outlined.

Relevance Recall that relevance will vary depending on the user’s perspective and the decision being made. For Property A the most relevant measure would be fair value as this is intended to be sold. Whether current fair value or expected fair value is more relevant will depend on users’ perspective and also whether or not the company is intending to ‘wait’ until market recovers before selling.

For Property B from shareholders perspective (as interested in long term cash flows) then the present value would appear most relevant, although cost obviously also relevant (as this will determine profit made that can be distributed as dividends et). For other users, perhaps

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assessing liquidity or safeguarding funds provided to the company current fair value may be most relevant.

Verifiability •

The original costs could be verified from documentation.

•

The verifiability of current fair value would be more problematic and would depend on whether information was available about recent similar sales etc. Recall that to be verifiable one aspect is that independent observers could reach consensus. Future fair values would be even less verifiable, as this relies on making assumptions about the property market in the future, which would be more likely to vary and be contestable.

•

The verifiability of present value for Property B would also be less as this requires estimates of future events and is also influenced by choices about interest rates used.

The insurance amount would generally be verifiable given it is part of a contract (this would vary, very reliable if set amount in policy; could vary if policy relates more generally to replacement costs).

Comparability.

As the companies have in the past used cost this would assist in comparison across time. As other companies use either cost or fair value these measures would be useful for comparisons.

Understandability The original costs, fair values and insurance value would be easily understood. The only value that could be more difficult to understand would be the present value for Property B as this requires an understanding of the item value of money and the impact of assumptions in relation to future cash flows, costs and interest rates. However the conceptual framework expects users to ‘have a reasonable knowledge of business’ (QC32).

(b) For each of the properties, choose which cost or value should be stated in the financial statements. Explain why you have chosen it and how you balanced the qualitative characteristics.

Students may arrive at different decisions. It could be argued:

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• For Property A choose current fair value. Although less verifiable than cost, providing

information is provided about this as an estimate it would be representationally faithful and it is more relevant given that the company intends to sell and future fair value is not sufficiently verifiable.

• For Property B choose cost. This is verifiable (especially as compared to present value)

and still comparable with most other companies in the industry. Fair value is not relevant as intending to use asset.

(c) Do you think everyone would agree with your choices?

No, particularly in relation to Property B; it could be argued that cost has no relevance.

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The following questions (2.5–2.7) require you to apply the definitions and recognition criteria in the Conceptual Framework to specific cases. After you have answered these questions, compare your answers with those of other students. Do your answers differ?

How did using the Conceptual Framework help you to make your decision?

2.5 A company has a copper mine in South Africa. It purchased the mining rights ten years ago for $20 million and has been operating the mine for the past ten years. It is estimated that there are about 8 million tons of copper in the mine. Because of a fall in world copper prices, the company has closed the mine indefinitely. At current world copper prices, the mine is uneconomic because the costs involved in extracting the copper are greater than the selling price. If copper prices rise by more than 25 per cent, the company has stated that the mine would be reopened.

Applying the principles in the Conceptual Framework, explain whether this mine would: (J, K, AS) • meet the definition of an asset

You would need to determine if the item has the 3 characteristics of an asset. Recall as asset is defined in the Conceptual Framework (para. 4.4) as:

An asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity.

• Are there future economic benefits?

– The company has no current economic benefits flowing as at present, given current

prices, the costs to extract are greater than the selling price of the copper extracted (but asset require future economic benefits not present economic benefits). It could be argued, however, that there are potential future economic benefits and thus, it meets the definition of an asset (whether these will be realised relates to the probability of copper prices increasing by 25%).

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– Others could argue that future economic benefits are expected only IF copper

prices rise by 25% and, hence, does not at present meet this characteristic.

• Does the entity have control?

– Assuming that have taken position that have potential future economic benefits

then company has control as is the only entity to have access to any potential benefits from the mine (given legal rights it only can extract copper and sell) and so can restrict access to any benefits that could be realised (no one else can mine) • As a result of past event?

– Assuming that have taken position that have potential future economic benefits

then control of these benefits due to past event of purchasing mining rights.

• Pass the recognition criteria.

Recall the recognition criteria are in the Conceptual Framework (para. 4.38): (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.

•

Is it probable that future benefits will eventuate?

– This is dependent on whether copper prices rise by 25% or more. Would need to

make a determination of this given expectations of the copper market/cycles/trends etc.

•

Is there a cost or value that can be measured reliably?

– It states that the company has purchased mining rights so presumably the cost of

this is known and could be determined — reliable measure available. The Conceptual Framework does not require a reliable measure of value — it states cost or other value.

Students should recognise that there is no ‘correct’ answer. Whether or not an asset is recognised in such a situation depends on interpretations of the Conceptual Framework and application to the particular case plus the actual circumstances of the entity.

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2.6 The company is currently growing and it is expected that in five years an additional factory will need to be built to meet product demand at a cost of $500 000. The directors wish to recognise an expense of $100 000 and a liability (provision for future expansion) for each of the next five years.

Applying the principles in the Conceptual Framework, explain whether: • the definition of an expense is met.

• the recognition criteria for an expense are met. (J, K, AS)

Recall that the definition of an expense is related to assets and liabilities: 4.4(b)

A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.

4.25(b) Expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrence of liabilities that result in decreases in equity, other than those relating to distributions to equity participants.

If we were to account for this as suggested by the directors, we would prepare the following journal entry: Dr Expense Cr Liability for Future Factory

It is probably easier to explain this in terms of the fact that there is no liability in this case.

This would not constitute a liability. Recall that a liability has three characteristics: 1.

Expected outflow of economic benefits

2.

A present obligation

3.

Due to past event

Although it is probable a future outflow of resources will be made (i.e. money will be spent on replacement) there is currently no obligation to an external party to make this outflow in the future, so not as yet any past transaction.

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As the Conceptual Framework states: 4.1.6 A distinction needs to be drawn between a present obligation and a future commitment. A decision by the management of an entity to acquire assets in the future does not, of itself, give rise to a present obligation. An obligation normally arises only when the asset is delivered or the entity enters into an irrevocable agreement to acquire the asset.

IAS 37/AASB 137 Provisions, Contingent Liabilities and Contingent Assets confirms this position and states that ‘only those obligations arising from past events and existing independently of the entity’s future actions (that is, the future conduct of its business’ satisfy the definition of a liability ‘because the entity can avoid the future expenditures by its future actions’ (para. 19).

As we have no incurrence of liabilities or decreases in assets there is no expense.

2.7 The company has recently issued some preference shares. The terms of these shares are: •

A fixed dividend of 3 per cent is payable each year. If no profit is available to pay dividends in one year, these will be back-paid in future years.

•

The preference shares will be redeemed (bought back) by the company in three years at their issue price.

Applying the principles in the Conceptual Framework, explain whether these preference shares should be considered as equity or a liability. (J, K AS)

First we need to consider the definitions of these items. In the Conceptual Framework these are: 4.4. The elements directly related to the measurement of financial position are assets, liabilities and equity. These are defined as follows: (b) A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.

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(c)

Equity is the residual interest in the assets of the entity after deducting all its liabilities.

The first point to note is that we consider the substance of the transaction not the legal form.

So the fact that these are called ‘shares’ does not determine whether or not they are considered equity or liabilities.

The definition of equity is a residual — we measure this by considering assets and liabilities — so we must first consider the liability definition.

Recall that a liability has three characteristics: 1.

Expected outflow of economic benefits

2.

A present obligation

3.

Due to past event

Applying these to the first component of these shares — the cumulative fixed dividends.

•

Expected outflow of economic benefits: Yes — if and when these dividends are paid will require an outflow of cash by the company

•

A present obligation: Technically there is no legal right to dividends unless declared (which is normally at the discretion of directors). Hence, until a dividend was declared there would be no present obligation of the entity to make these future outflows and this characteristic would not be met.

•

Due to past event: There is no event (until dividends declared which would then be past event) to obligate the company.

Therefore, this would suggest the share is equity.

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Applying these to the second component of these shares — the redemption by the company in 3 years at the issue price.

•

Expected outflow of economic benefits: Yes — when these shares are bought back this will require an outflow of cash by the company

•

A present obligation: The terms of the issue indicate that the company is legally obligated to purchase the shares from the shareholders in 3 years time for the issue price, therefore, this characteristic would be met.

•

Due to past event: There would be the issue of the shares under terms requiring company to redeem in 3 years time.

Therefore, this would suggest the share is a liability.

In practice the accounting standards require the separate classification of components into equity and liability respectively.

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Case Study Questions Case study 2.1 Code of Ethics 1.

Can you identify any potential problems or criticisms of the principles outlined in the Conceptual Framework in the case? (J, K)

The key problem with this set of principles is their broadness and the vagueness which is associated with conceptual frameworks in general. The advantages of this conceptual framework are identified at the end of the extract. The key disadvantage is in the vagueness of terms and in specific application of these principles to practice. For example, what level of professional knowledge is to be maintained to ensure competent service?

2.

Do you think using these principles would be interpreted and applied consistency between the accountants in determining whether an action is ethical? (J)

Students should recognise that there would be differences in interpretation and application of these concepts. For example, what would people interpret as honest? Would the idea of this vary between individuals and particular circumstances? (In terms not of lies, but missions or incomplete statements). Is honesty in business simply ensuring the letter of law is followed or is it more than this?

3.

How effective do you think such a framework is in (a) ensuring accountants act ethically and (b) enforcing or penalising unethical behaviour? (J, K)

Students should recognise that whether or not people, such as accountants, act ethically is influenced by a number of factors that interact. These would include: •

The moral code/conscience of the individual accountant

•

Expectations of the profession (such as set out in such a code)

•

Expectations of peers — this could include the culture of the company/context

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•

Risks of unethical behaviour being detected — would need to consider levels of enforcement of behaviour here

•

Consequences of being found to have acted unethically (e.g. would it mean going to prison)

•

Consequences of the unethical behaviour to the individual (i.e. the rewards/expected outcome — is it worth lots of $s) and to others (if seen as not hurting anyone specifically, often people are more willing to distort the truth)

•

Consequences of not acting ethically (e.g. if being pressured by management to distort accounts would you lose your job/promotion if you do not act unethically)

•

Personal circumstances

While a Framework can provide guidelines and can be used by individuals to defend ethical behaviour, in reality a number of factors combine. A key factor is the character of the individual; there will always be individuals who do the right thing regardless of consequences to themselves, and others who will readily ‘do wrong’ for their own benefits.

Re-enforcing or penalising in cases where there is debate about the whether a particular action is or is not unethical, it is likely that, as a broad set of principles, it is open to interpretation that this would make enforcement in these ‘borderline’ cases more difficult.

4.

Would a set of specific rules about what constitutes ethical and unethical behaviours in specific circumstances be more or less useful than the principles in the code of conduct outlined? (J)

A broad set of principles can mean different interpretations (so less consistency) and can lead to people interpreting events as outside the restrictions placed by the principles.

The advantages of specific rules (rather than principles) are that it is clearer whether an action is or is not ethical. Therefore, less ambiguity, more consistency and it would be easier to enforce and penalise. However, requirements into narrowing rules means that as long as the rule meet actions outside of the specific rules are not ‘unethical’ as the rules specify ethical

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and unethical behaviours. Also, in practice you cannot specify rules for every possible scenario/situation. An analogy is the advantages and disadvantages of principles based accounting standards versus rules based as discussed in chapter 3.

While there may be ambiguities in a broad set of principles, it is often argued that principles require a higher level consideration of overall ethics (so place a higher burden of responsibility on the individual in making the judgement as to whether something is or is not ethical). To justify behaviour, if specific rules are set, the individual only needs to argue that they have followed the rules; not that their action is ethical in accordance with a set of higher order principles.

Case Study 2.2 What’s new in water and carbon accounting

1.

In the preface to the water accounting conceptual framework a wide range of users are identified including groups and associations with water related interests, water industry consultants, academics and interested citizens. This is much broader than the primary users that are the focus on the accounting conceptual framework. In the context of water reporting, is such a wide user groups appropriate and what possible problems could this result in? (J, K)

The users identified in this water conceptual framework are outlined in para 19 of the preface: 19. The users of GPWAR fall into a broad range of categories. These include: • water users – environmental, agricultural, urban, industrial and commercial • investors in water dependent enterprises and related parties such as lenders, creditors, suppliers, insurers and water traders and water brokers • government representatives and their advisors, including water related economic, environmental and social policy makers • water industry regulators • water managers including environmental water managers and water service providers, who may be interested in not just the water entities they manage but water entities they depend on or compare to • groups and associations with water related interests • water industry consultants • academics

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• interested citizens. ( http://www.bom.gov.au/water/about/consultation/document/WACF_August09.pdf)

There is no correct answer here but students may note the following: •

The group of users is extremely wide and as stated in the preface itself “The users information needs can vary enormously based on particular circumstances and the type of decisions or assessments being contemplated or undertaken’ (para 20). This is in sharp contrast with the Conceptual Framework (as revised) for accounting which narrows users to particular resource providers. Some may argue that such a wide user group is appropriate as water is one of our basic needs, and hence all society is directly or indirectly affected by water policy/availability/quality/cost. Others could argue that such a wide user group could make such reporting ‘less useful’.

•

Problems with such a wide user group could possibly include; it could restricting information to that common amongst all groups or alternatively, trying to provide information to meet most of these groups could make reports complex/ and detail provided could obscure (or at least not highlight) more important reporting aspects/outcomes. Also given such a wide range of users group issue such as understandability of reports could be problematic, as such wide user groups would have varied knowledge/skills. or

2.

Do you think the same qualitative characteristics would be equally important and appropriate to water accounting and reporting? (J)

Again there is no correct answer here but students could consider following: • The qualitative characteristics in the accounting Conceptual Framework are aimed at decision usefulness; i.e. ensuring that the information provided is useful in decision making. Although the types of decisions made will or will not vary using accounting and water reports, these basic qualities (i.e. relevance, representational faithfulness, verifiability, comparability understandability) would be required. It could be argued that the qualitative characteristics are broad enough (and also recall need to balance these) to be able to be used and interpreted to particular circumstances.

•

Of course this will not result in the same information being provided but should result in standards of the quality of information being met.

•

Logically it could be expected that relevance, representational faithfulness would be the key qualitative characteristics on any framework which has decision usefulness as its objective.

However, given issues such as the wide user group, whether the other qualitative characteristics would be equally important could be debated. For example, understandability

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may have primacy over some of the other characteristics if needed given broader user groups.

Or if reports being made about water allocation, then comparability may be paramount.

3.

What are the possible advantages and disadvantages of using the conceptual framework for financial reporting as a basis or starting point for conceptual frameworks for reporting in other contexts? (J, K)

Again there is no correct answer here but students could consider following: •

As the accounting conceptual framework is established and in place for some time (so in some ways already working or tested) this could be of advantages as could: reduce possible mistakes made (learn from what others have already done); reduce time taken to develop a conceptual framework as already have much of structure etc; could enhance acceptance if viewed as based on existing and already accepted framework

•

The disadvantages would be that this may result in a less than optimal conceptual framework for water. Whilst the accounting conceptual framework is in place there are criticisms of and problems with this as we have noted in this chapter. If it is believed that the nature of many

water entities and their users, and the decisions they make are sufficient different that than accounting entities and their general purpose financial reports is could be argued that basing a water conceptual framework on this is problematic. Perhaps with decision such as allocating water resources etc qualitative (rather than quantitative) factors such as social justice, environmental impacts may be more important. Can the accounting conceptual framework, which focuses primary on economic and quantitative information, be adequately adapted to such contexts?

Case Study 2.3 Companies brace for powerful impact of lease accounting changes

1.

The first extract above identifies a number of possible economic consequences if the proposed new lease standard is introduced. Outline the economic consequences identified and discuss whether you believe that the cost constraint in the Conceptual Framework would or should require consideration of these. (J, K, AS)

The economic consequences identified in the first extract are the potential changes in the leasing market. This may be reduced as companies may opt to purchase property rather than lease (this could

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also impact on property markets/prices). Lessors could also be affected if lessees do not wish to undertake long term leases (this could arguably increase risk profiles for lessor).

The basic principle of the cost constraint in the conceptual framework is that the benefits of providing information should out weight the costs. The conceptual framework itself identifies the following costs: •

Costs by preparers of providing the information

•

Costs by users of analysing information provided

•

Cost to users of reduced returns if sufficient information for decisions is not provided (or costs to obtain this information elsewhere).

These seem to focus costs primarily on the costs of information and this appears reinforced in the conceptual framework which states:

In applying the cost constraint, the Board assesses whether the benefits of reporting particular information are likely to justify the costs incurred to provide and use that information. QC38

However para QC37 of the conceptual framework notes that if appropriate information is provided (i.e. relevant and representationally faithful information) this will assist users in making decisions and this in turn will result in efficient capital markets and a lower cost of capital. This suggests that economic consequences (and costs) could or should be taken into account. There is there is still debate as to whether economic consequences should be considered when deciding on accounting standards.

It could be argued that the current lease accounting requirements (where operating leases are off balance sheet) have distorted the market.

2.

The second extract discusses the costs to preparers. (a) Discuss whether you believe the costs to preparers and valid and whether these should override the benefits? (b) The extract proposes that a simpler method be applied to leases for less than 12 months. Discuss any disadvantages with this approach and whether this approach could this be justified using principles in the Conceptual Framework?

(J, K)

(a)

The costs to prepares outlined in the second extract is of complying with the proposals to recognise an asset and a liability , using discounting techniques – as opposed to a simpler

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method of simply expensing payments and making additional disclosures. Validity could be argued either way: •

Cleary the proposals are more complex than the expense and disclose method suggested so could be argued therefore increased costs

•

However, accountants (or prepares) are required to use discounting methods for a range of accounting requirements (so expertise should already exist) and with computer programs already available (including those specific to accounting for leases) it could be argued that the actual additional costs in applying the requirements in the proposal would in fact by minimal.

(b)

Again student could argue either way: •

Could argue that costs would appear to be minimal if provide better information for users to make more informed decisions. Also, if there is ‘one’ method for accounting for all leases this should increase comparability (as all companies using these assets, whether leased or owned, would need to include n the balance sheet).

•

Could argue that simplified requirements for short term leases may be appropriate. How likely is it that such short term leases would significantly impact on decisions (i.e. are material). If not likely to influence decisions then more complex accounting treatment not required and so costs would outweigh benefits. However this could provide a ‘loop hole’.

3.

The proposed new leasing standard requires that contingent rental payments (for example, where lessee pays additional rent payments if revenue exceeds a certain amount) be included in lessees liabilities by lessee using the expected outcome approach that is described in the ED as “the present value of the probabilityweighted average of the cash flows for reasonable number of outcomes” (para 14).

The current leasing standard does not have such a requirement and contingent rentals are simply expensed as paid.

(a)

Which of these approaches do you believe is more consistent with the definition and recognition criteria for liabilities in the Conceptual Framework?

(b)

In undertaking this analysis, identify any problems or alternative interpretations that you had in applying the principles in the Conceptual Framework. (J, K, AS)

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Students should apply the definition and recognition criteria for liabilities from the framework.

•

Possible outflow of economic benefits – Yes — if revenue exceeds a certain amount then would be required to make additional rent payments

•

A present obligation due to a past event –

This could be debated.

–

One view is that the lease contract, which includes the requirement to pay additional lease rentals if and when certain conditions arise, is a present obligation due to the terms of the contract. This is the view taken by the Board.

–

As the Basis for Conclusions state:

The liability to pay contingent rentals and the right to receive lease payments exist at the date of inception of the lease. Such contingent rentals meet the definition of a liability for the lessee and an asset for the lessor. It is only the amount to be paid that is uncertain. BC 123

This is also consistent with approaches towards employee benefits.

•

An alternative view would be that a present obligation to pay these contingent rentals only arises when and if a future event occurs (such as revenue exceeding the amount specified). It should be noted that this view was rejected by the Board, who also noted that allowing this may also encourage creative structuring of leases.

Recognition criteria •

Probable that outflow will occur.

–

Presumably this would be based on facts available and likelihood that will be required to make payments (e.g. that revenue will exceed that specified) and if 50% or more then would be probable. Would assume that this was considered when entering into contract.

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•

Measure reliably –

This again would depend on facts and would assume that this was considered when entering into contract. There would be various ways of estimating and an outcome approach, as proposed by the Board , would seem reasonable.

The conceptual framework would justify these contingent rentals as meeting the definition of a liability. Also, depending on the facts, these would also meet the recognition criteria of the conceptual framework. However the proposed standards discussed did not require the probability threshold (or 50%) to be met; rather that regardless of the probability these should be recognised (and the probability would be reflected in the measure as this is to be based on an expected outcome approach.

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Solution Manual to accompany

Contemporary Issues in Accounting Michaela Rankin, Patricia Stanton, Susan McGowan, Kimberly Ferlauto & Matt Tilling PREPARED BY:

Patricia Stanton

John Wiley & Sons Australia, Ltd 2012

Chapter 3: Standard setting

CHAPTER 3 STANDARD SETTING Contemporary issue 3.1 Rules-based versus principles-based standards 1. The two principles for the design of the village were shelter and safety. In what ways do accounting standards also provide ‘shelter and safety’? (K)

Accounting standards shelter preparers by providing guidance in the preparation of financial statements. The standards can be used by preparers to defend their decisions when challenged by auditors.

2. Using the example in the above scenario, what are the advantages of principles over rules? (J)

Principles should remain unchanged with changing economic conditions so that standards derived under a principles based system should not have to be changed when conditions change. Standards can be form of fuzzy based law under a principles system. Under rules based standards, any change in the underlying conditions requires a change to the standard. Ways to circumvent the black letter law of rules based standards are more easily found than under principles based standards.

Contemporary issue 3.2 Treasury chiefs revolt over budget rules 1. What reasons can you offer for the International Monetary Fund issuing requirements for government financial reporting? (K)

The IMF is an organization of over 180 countries working to foster among other things global monetary cooperation, secure financial stability, and facilitate international trade. Its stated objectives are to promote international economic cooperation, international trade, employment, and exchange rate stability, including by making resources available to member countries to meet balance of payments needs. To this end, the IMF needs comparable and reliable reporting by governments of their financial situation.

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2. What do you think is the fundamental difference between company financial reporting and government reporting? (AS)

Companies need to make a profit. Governments do not have a profit motive. Their results are measured in terms of surplus or deficit.

2.

3. What do the letters GFS and GAAP stand for? (K)

GFS refers to Government Financial Statistics; GAAP to Generally Accepted Accounting Principles.

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Chapter 3: Standard setting

Review questions 1. In what sense are accounting standards ‘standards’ in the general meaning of the word?

Accounting standards are set by what can be referred to as ‘general consent’, which mirrors the dictionary definition of a ‘standard’.

2. How do principle-based standards differ from rules-based standards?

A principle-based standard is based on a concept or concepts which are derived from conceptual framework. Standards based on principles derived from a common conceptual framework should be constituent both within and across standards. A rules-based standard contains specific rules designed to meet as many contingencies as possible. Rules based standards often conflict with other rules-based standards. A rules-based standard is prescriptive; the principles-based one is broader.

3. What are the functions of accounting standards?

The main function of accounting standards is to guide preparers of financial reports so that information contained therein permits users to make useful decisions based on that information. Another function is to provide a defence for preparers of financial reports based on those standards if a reporting entity fails and misleading accounts are blamed for the failure. Additionally, standards raise the profile of the profession.

4. What do you think the standard-setting process should achieve?

As this question is targeting the views of those using the text, a single answer cannot be provided for this question. Perhaps views should include the features of consistency, transparency and due process.

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5. Justify Australia’s approach of imposing its set of accounting standards on all reporting entities, irrespective of whether they are profit seeking.

Under a principles based system, the definitions of the elements of financial reporting should apply universally. The recognition test arguably should also apply universally. A profit (loss) is derived from the difference between assets and liabilities over a period (itemised in the income statement). A surplus or deficit is also the difference between assets and liabilities, therefore, there is no need technically to have separate standards.

6. Define regulation.

Mitnick’s (1980) definition is that regulation is a policing of some activity by an entity which is not party to, or involved in, the activity being regulated.

7. In what ways does accounting standard setting conform to your definition of regulation?

This answer will depend on what answer was given to question 3.6. However, the profession’s historical intention to intervene in the production of financial information by reporting entities, and the restriction of choice that the intervention generated should be mentioned. The independence of the AASB also should be mentioned.

8. If the standard-setting process should achieve better information, what criteria would identify better information?

1.

common concepts underlying the information

2.

similar interpretations of guidance issued by the standards-setting authorities

3.

relevance

4.

reliability

5.

comparability

6.

understandability

.

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Chapter 3: Standard setting

9. Is the setting of accounting standards desirable for society? If so, who should set standards?

There are several facets to this question. Responses as to who should set standards will depend on the angle taken in answer to the first part. Students may respond in terms of:

1.

social contract theory — in which case standards setters should reflect the composition of society affected by the standards and the organisations to which they apply

2.

technical expertise — standards setters should have the expertise necessary to set appropriate standards

3.

public interest

4.

regulatory approaches, including the difficulty of monitoring and enforcement

10. How does good financial reporting add value to organisations?

Information is important to the good working of financial markets. Financial reporting makes an important contribution to the information set used by financial market participants. Good financial reporting enhances the reputation of the disclosing entity. Signalling theory suggests a hierarchy of disclosure so that the best reporters are seen as having nothing to hide, thereby adding value.

Good financial reporting also implies adherence to standards, which in turn implies that the information is relevant, reliable, understandable and comparable with other entities — qualities which should add value to the reporting entity.

11. Are interested parties behaving ethically when they try to influence the standardsetting process?

The answer will depend on the ethical stance of the person advancing the argument, as well as on how and why interested parties try to influence the standard-setting process. For example, if an interested party is trying to capture all the benefits of a particular standard to

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the detriment of all other interested parties, then they could be argued to be not acting ethically.

12. Explain the statement that ‘information is the oil that lubricates markets’. How can this statement be used to justify the regulation of accounting information?

A perfect market requires perfect information. Without accurate and useful information, the market cannot function. Regulation of accounting information ensures that accounting information, a public good, will not be under-produced. Some argue that without regulation, accounting information would not be produced at all and therefore, markets would not operate efficiently.

13. In your opinion, do the benefits from regulating accounting information outweigh the costs? Justify your answer.

The benefits relate to: 1.

increased efficiency in allocating capital

2.

cheaper production of accounting information

3.

checks on perquisites

4.

public confidence

5.

standardisation

6.

public good argument.

The costs relate to: 1.

attempting to achieve efficiency and equity through regulation

2.

determining the amount of optimal information

3.

the difficulty of reversing regulation once it is in place

4.

the restrictions placed on innovation of ways of presenting and communicating accounting information

5.

the imposition of standard reporting systems on entities which are very different

6.

regulation generates lobbying which advantages certain interest groups

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7.

the displacement of contracts as a means of negotiating with management as to the types of information to be disclosed, as well as place and time of information disclosure.

14. How do you reconcile the ‘adoption’ of international accounting standards with the process of ‘harmonisation’?

Answers will depend on the position taken by students. However, adoption implies that no changes will be made to the standards by the adopting country. Harmonisation implies that changes will be made to suit the requirements of the adopting country. Such changes reduce the comparability of the resulting financial statements.

15. With particular reference to the following opinion expressed by Watts and Zimmerman, discuss whether accounting standards setting is a ‘two-edged sword’:

Regulation affects the nature of the audit. It expands the audit … [R]egulation provides the auditor with the opportunity to perform additional services and lobby on accounting standards on clients’ behalf. Regulation also provides the auditor with the opportunity to lobby for increasing accounting complexity because of its audit fee effect.45

A suggested solution to this question is inappropriate, although reference to accounting/auditing incidents such as Enron, WorldCom suggest that Watts and Zimmerman ‘were on the money’!

16. Drawing on your knowledge of the Conceptual Framework and of principles based standards, discuss the following statement: Ultimately, it is the underlying economic substance that must drive the development of the scope of standards, if . . . standards are to remain stable and meaningful.46

Again, a suggest solution is inappropriate, although students should define the key terms of ‘economic substance’ and ‘principles based’.

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Solution manual to accompany: Contemporary Issues in Accounting

17. What is ‘lobbying’? Who would be expected to lobby an accounting standard, and why?

Lobbying is the attempt to influence decisions made by officials such as the members of the IASB when setting standards. Lobbying can be viewed as a mechanism by which regulators are informed about policy issues because lobbyists convey their specific knowledge about the issue being regulated. Management can afford to invest more than users in lobbying for their point of view. As a result, standards are more likely to reflect benefits for the reporters of financial information than for users of that information. Certain interest groups such as preparers and auditors seek and gain economic rents by investing resources in the pursuit of favourable regulations.

18. Sutton states that accounting standard setting is a political lobbying process, and as such offers several opportunities and means for interested parties to influence its outcomes.47 What are the opportunities that Sutton mentions?

Various points in the due process procedures; meetings with individual standard setters.

What methods do lobbyists employ to influence the outcomes?

Lobbying methods are classified as either direct or indirect. Direct methods involve communicating with members of the standard setting board. Indirect methods mean communicating via an influential third party.

How has Australia’s adoption of international standards affected lobbying activity by interested parties?

The adoption alters opportunities for lobbying. Decisions must be made whether to lobby various members of the IASB directly or only the Australian member; or to lobby members of the Australian liaison board so that the board conveys their viewpoint to the IASB; to make submissions via the Australian body or the international one.

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Chapter 3: Standard setting

19. Hoogendoorn suggests that there is tension between a principles-based interpretation of IFRSs and a rules-based interpretation.48 If IFRSs are principlesbased standards, why should there be such tension? When the US adopts IFRSs, is this tension likely to increase? Why? The tension arises from principles-based standards relying on preparers’ judgement when preparing financial statements. Judgement is likely to result in a diversity of outcomes so that the resulting financial statements are probably less comparable than under a rules-based system. To avoid the diversity in outcomes, rules for application of the principles-based standard are a solution. If, and when, the US adopts IFRSs, the tension is likely to increase as the US has used rules-based standards for a very long time.

20. In relation to the governance of the IASB, who governs the governor?

From the IASB’s website: “The IFRS Foundation is an independent, not-for-profit private sector organisation working in the public interest...

The governance and oversight of the activities undertaken by the IFRS Foundation and its standard-setting body rests with its Trustees, who are also responsible for safeguarding the independence of the IASB and ensuring the financing of the organisation. The Trustees are publicly accountable to a Monitoring Board of public authorities.”

“Trustees are appointed for a renewable term of three years. Each Trustee is expected to have an understanding of, and be sensitive to, international issues relevant to the success of an international organisation responsible for the development of high quality global accounting standards for use in the world’s capital markets and by other users.

Six of the Trustees must be selected from the Asia/Oceania region, six from Europe, six from North America, one from Africa, one from South America and two from the rest of the world.”

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Solution manual to accompany: Contemporary Issues in Accounting

Application questions 3.1

Laughlin stated the following: Accounting standard setting may not fulfil the litmus test of being ‘regulative and amenable to substantive justification’ due to its active rejection of a wider stakeholder commitment and the preferential treatment of finance capitalists.49 (J, K, AS)

(a) What is a ‘litmus test’?

A litmus test in chemistry is a test for chemical acidity using litmus paper. The term has been used to signify a test that uses a single indicator to prompt a decision; in this case Laughlin is suggesting that standard setting would fail the test of substantive justification for standards

(b) Why should accounting standards be ‘amenable to substantive justification’?

Accounting standards can redistribute wealth and in so doing effect many stakeholders.

Accounting needs significant social and political studies of accounting standard setting so that the effects of regulation can be assessed. The IASB appears to be largely indifferent to the information needs of any user other than finance capitalists. (c) Does the AASB’s User Focus Group provide evidence of ‘the preferential treatment of finance capitalists’ in the standard setting process?

The User Focus Group generally comprises eight to ten investment and credit professionals.

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3.2

The Australian reported that one of Australia’s top accountancy firms said that company annual reports have become too long and it wants IFRSs trimmed.

Representatives of the firm said that IFRSs had complicated accounting — for reporting financial instruments alone, there was now more than 300 pages of rules, and guidance that did not exist under ‘the old rules’. [J, K]

(a) Are IFRSs rules-based or principles-based?

They are principles-based.

(b) If IFRSs are principles-based, why do you think the standard focusing on financial instruments is accompanied by 300 pages of rules and guidance?

Financial instruments are complex commercial instruments (as the Global Financial Crisis revealed). Describing unambiguously the instruments to be accounted for (and those to be excluded) is an issue for standard setters. “Fair value” requires many rules to provide guidance such as which market price should be chosen when there are several market prices for an instrument. The complexity of both financial instruments and fair value has generated the 300 pages of guidance.

(c) Do you think that the existence of such lengthy guidance notes is what Hoogendoorn was referring to when he commented on the tension between a principles-based interpretation of IFRSs and a rules-based interpretation?

Under a principles-based approach, the test is whether an accounting treatment is appropriate in the circumstances. If the IASB wants to avoid diversity in practice, the only solution according to Hoogendoorn is to have more and more detailed rules (or official interpretations).

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Solution manual to accompany: Contemporary Issues in Accounting

3.3 Coca-Cola Amatil conducted a campaign against Australia’s adoption of IFRSs in 2004. The company lobbied against requirements that meant Coca-Cola Amatil’s balance sheet values would have to be written down by as much as $1.9 billion. (J, K, AS) (a) What is meant by the term ‘lobbying’?

Lobbying is the attempt to influence decisions made by officials such as the members of the IASB when setting standards. (b) Who would be likely targets of Coca-Cola Amatil’s lobbying activities?

The FRC? AASB? Federal Government?

(c) Why would adoption of international standards so heavily affect Coca- Cola Amatil?

IAS 38 would prevent Coca-Cola Amatil from including valuable internally generated intangibles on their balance sheet. (d) Did harmonisation affect Coca-Cola Amatil’s balance sheet?

The note from the 2004 financial statements: Intangible assets Impact on retained earnings of previous revaluation at 1 January 2004 (reduce by approximately $1.9 billion) CCA’s investments in bottlers’ agreements are recognisable under IFRS. However, revaluation of CCA’s investments in bottlers’ agreements at fair value is not permitted under IFRS. This will result in the reversal of the previous revaluation (as was permitted under the previous version of AASB 1010 “Recoverable Amount of Non-Current Assets” and the current version of AASB 1041 “Revaluation of Non-Current Assets”), thereby impacting retained earnings and net assets on transition to IFRS.

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3.4 A New Zealand paper reported that the integrated nature of capital markets, the mobility of capital and the global nature of the financial crises highlighted the need for a single set of high quality globally accepted accounting standards. The report went on to state that banks particularly wanted to eliminate differing accounting treatments between jurisdictions. American banks were reported to have spent US$27.6 million on lobbying for such changes. (J, AS)

(a) Why, in particular, would banks be advocating for a single set of global accounting standards?

Banks borrow and lend internationally. A single set of global accounting standards would simplify their reporting requirements.

(b) Why might American banks be so willing to spend so much on lobbying?

You would have expected the banks to conduct a cost-benefit analysis before spending this amount on lobbying. The resulting standards would be expected to justify the expense.

(c) If you were an American bank, who would you be lobbying? And why?

IASB committee members? FASB? Federal US Government? Major accounting firms to lobby on their behalf?

3.5 Much publicity has been given to the move by James Hardie Industries, a company that mined, manufactured and distributed asbestos and its related products in Australia, to transfer its domicile to The Netherlands and later Ireland, and to move its asbestos liabilities to a foundation separate from the company. One of the reasons touted for these moves was the impending introduction of an accounting standard that would have required the company to include the present value of all likely future asbestos liabilities in its accounts. (J, K, AS, CT)

(a) What is the definition of a liability?

See chapter on conceptual framework: A present obligation of the entity arising from past

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Solution manual to accompany: Contemporary Issues in Accounting

events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.

(b) What are the recognition tests for the inclusion of liabilities in the financial statements?

(a) probable that any future economic benefit associated with the item will flow from the entity; (b) the item has a cost or value that can be measured with reliability.

(c) How does the long gestation period of diseases resulting from exposure to asbestos complicate the calculation of future liabilities for James Hardie?

Changes would be expected in the rates of interest used in the calculations – impossible to predict the future.

(d) Would you have expected the executives of James Hardie to have lobbied against the proposed standard? Yes On what would they have based their argument against its introduction?

The impact on their reported financial results (e) Debate the role that the public backlash against James Hardie’s moves played in subsequent changes to the foundation holding asbestos liabilities.

Public backlash is a form of lobbying – in this case, the directors were the target. The backlash also suggests that the public expects corporations to be good public citizens – trying to avoid liabilities is not what one would expect of a good corporate citizen, especially when the James Hardie’s decision makers would be receiving bonuses based on profitability. (f) Debate whether the executives who made the decisions could have behaved more ethically.

The debate could focus on the definition of ethics. Ethics can be defined in simple terms as

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Chapter 3: Standard setting

the common concept of “do unto others as you would have done to you”. Should this principle apply to executives? A corporation, although recognised as a legal entity, cannot make decisions – individuals within the corporation make the decisions that need to be taken.

The debate could also consider whether bonuses based on profitability could skew executive decision making.

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Solution manual to accompany: Contemporary Issues in Accounting

Case Study Questions Case Study 3.1 Greek bonds raise issue of enforcement of IASs 1. What is ‘GDP’? (K)

GDP (Gross Domestic Product) is one of the primary indicators used to gauge the health of a country's economy. It represents the total dollar value of all goods and services produced over a specific time period, usually a year.

2. What is meant by ‘par value’? (K)

The stated or par value of a share.

TThe 3. Do you consider the lack of a common legal enforcement mechanism for IASs a weakness of the concept of common international accounting standards? Give reasons for your answer. (J, K) J Auditing is the basic enforcement mechanism – the role of auditing in enforcing IASs? Auditors will enforce the interpretation of IASs implied by the country’s enforcement mechanisms – the impact on comparability?

4. (a) Why would commentators regard the letter by the Chairman of the IASB to the European Securities and Markets Authority as a form of lobbying? (J, K) Because the Chairman was asking the EU authorities to enforce one of the IASB’s accounting standards – it has no regulatory authority to make European banks conform with its standards. That power lies with the European Securities and Markets Authority.

JK (b) Does the need for the Chairman to lobby an authority highlight the weaknesses of the enforcement system for IASs?

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Chapter 3: Standard setting

Apparently so.

K (c)

Give reasons why you think the Chairman kept the letter secret.

International standards are supposedly principles based. To rewrite a standard as a rule implies that the standard setters are open to lobbying and can be coerced.

5. The broad principle set out for accounting for financial instruments was that they should be measured at fair value with gains and losses being recognised in the period in which they occur. Why do you think the IASB changed the principle to the rules in the current standard which allows companies to avoid measuring financial instruments at fair value and so violate the principle? (J,K, AS) EU’s threat to remove sections in the standard relating to fair value accounting. E AS 6. What theory would explain the actions of the IASB? Give reasons for your answer.

(J, K)

Capture theory holds that regulation is supplied in response to the demands of self-interested groups trying to maximise the incomes or interests of their members.

Bushfire theory highlights the political nature of regulatory influences by attempting to take into account the reactions of users to ‘failures’ in the regulatory processes. Regulations tend to arise from crises such as the GFC. The ideology theory of regulation introduces the role of lobbying in influencing the actions of regulators. Lobbying is viewed as a mechanism through which regulators are informed about policy issues. Interest groups such as the EU, lobby regulators to convey their specific knowledge about the issues being regulated.

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Solution manual to accompany: Contemporary Issues in Accounting

Case Study 3.2 International harmonisation of accounting standards

1. The conflict between the EU and the IASB suggests that accounting is a social construct. Do you consider accounting to be a social construct or a quasi-science based on precise facts? Justify your answer. (J)

Historically accounting has served as an instrument of various constituents in society. As a social construct, accounting is a tool among other tools to be used to ensure economic stability.

“Science” is defined by the Macquarie Dictionary as the systematic study of man and his environment from which general laws can be drawn and to the knowledge so obtained.

2. What is meant by ‘fair value accounting’? (K)

Accounting which records assets at amounts for which they could be exchanged between knowledgeable willing parties in an arm’s length transaction, and liabilities at amounts for which they could be settled in an arm’s length transaction between knowledgeable parties.

3. Why would accounting scandals occur less often with global accounting standards?

(J, K) J The argument goes along the lines that because capital would be allocated more efficiently with global accounting standards global companies would find it more difficult to pick regulators to suit them so that accounting scandals would occur less often.

4. Why would trying to establish a standard based on what an asset is worth result in controversy? (J, K) J

What an asset is worth is only known after an exchange transaction has taken place, so attempts to predict that worth prior to the transaction are speculative.

K 5. What lobbying activity, and by whom, would you expect in relation to a measurement standard? You might like to visit the literature about Australia’s attempt to resolve measurement issues. (J, K)J K

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Chapter 3: Standard setting

Large international accounting firms, preparers, multinational corporations, banks, auditors.

6. Sir David Tweedie has been described as ‘combative’. Is this a characteristic that would be desirable in someone who is trying to negotiate global standards and their acceptance globally? (J)

Not generally so! J 7. Discuss whether individual countries’ interpretations of principles-based accounting standards are likely to undermine the uniformity of global standards. (J, K) J K

While differing interpretations would undermine the comparability of global reporting, the interpretations should not undermine the uniformity of the standards.

8. Given the dangers identified by Meeks and Swann of a single monopoly standard setter such as the IASB, would it be better to have a duopoly of say, the IASB and FASB? Would regional accounting blocs be desirable from a competitive point of view? (J, K)

If you believe in competition, then competition between standard setters should result in “better” standards.

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Solution Manual to accompany

Contemporary Issues in Accounting Michaela Rankin, Patricia Stanton, Susan McGowan, Kimberly Ferlauto & Matt Tilling PREPARED BY:

Kimberly Ferlauto

John Wiley & Sons Australia, Ltd 2012

Chapter 4: Measurement

CHAPTER 4 MEASUREMENT Contemporary Issue 4.1 The standard setters search for the ‘best’ measurement basis 1. What is meant by the term market context? Why is context so important in accounting measurement? (K) Measurement methods used in the preparation of the financial statements should be selected with the market context in mind. Values determined without market context in mind may not be reflective of market conditions or meet user’s needs. In other words, to provide the most accurate and decision useful accounting information, the most appropriate measurement approach is likely to be dependent on specific circumstances such as the nature of the market for the asset at the time. If the market is to play a role in valuation, we want to ensure that the resulting value reflects the fundamental value of the asset and that the operation of market forces does not lead to over or under valuation of the asset. What is important to users may also change from time to time.

2. Is adoption of a single measurement base approach likely to work in practice? Justify your response. (J, K) Responses to this essay style question will vary from student to student. Students should be encouraged to form their own views and provide in depth discussion supported by references and examples. Some key points of relevance include: •

• • •

Arguments for adoption of a single measurement base approach are based on an idealised view of markets being complete and in perfectly competitive equilibrium.

In reality, markets are imperfect and incomplete and ideal unique market prices are not available for all assets and liabilities. This has led to the use of the fair value hierarchy. The lower levels of the hierarchy requiring estimation of what the market price might be if one existed. The information produced is therefore not ideal.

A single preselected measurement method may not best reflect market conditions or meet user needs at that time.

Assumes a particular measure will always be the most relevant and will always be able to be reliably measured.

Some argue that there is no single ideal measure and that the focus should be on identifying the information that is most likely to meet the needs of user’s decision models.

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Solution manual to accompany: Contemporary Issues in Accounting

•

Application of IAS 39 during the recent GFC as an illustration of the practical importance of market imperfection and incompleteness.

3. Why do you think standard setters have considered a single measurement base approach? In your response, consider the fundamental problems that such an approach could help resolve and how such an approach would fit with the qualitative characteristics of accounting information prescribed under the Conceptual Framework. (K, CT) Responses to this essay style question will vary from student to student. Students should be encouraged to form their own views and provide in depth discussion supported by references and examples. Some key points of relevance include: •

•

•

In perfect market conditions, there is a unique market price based on full information for every asset and liability. This provides a relevant, reliable and objective measure of an assets fair value when such observable market prices are available. This argument seems to be a key driver behind the push for fair value as the single ideal measurement base approach.

Mixing different measurement bases is believed to create mismatch problems. This problem refers to the fact that different items in the same set of accounts are measured on a different basis, making aggregation (totals) misleading. A single measurement base approach would promote consistency within accounts, avoiding this mismatch, and allowing more meaningful aggregation. This approach would also improve comparability of accounts between different entities.

Fair value favoured approach due to its relevance – measures market expectations of future cash flows to be derived by the entity and objectivity – reflecting the markets view rather than views of management associated with the entity.

Contemporary Issue 4.2 The subprime lending crisis and reliable reporting

1. In practice, which measurement base, historical cost or fair value, would provide the most relevant and reliable accounting information? Draw on the facts presented in the situation above, as well as your knowledge of the global financial crisis, to justify your response. (J, K) Responses may vary from student to student as there are many paths that discussion could take. Some key discussion points follow.

• •

Fair value or historical cost on their own are not likely to achieve both characteristics.

Inherent trade-off between relevance and reliability – the information which is most relevant is often less reliable. The information which is most reliable tends to be that which is less relevant.

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Chapter 4: Measurement

•

•

•

There has been a move towards fair value and away from historical cost on the basis of relevance. It is argued that reporting assets and liabilities at their fair values provides more relevant information for investment decisions than historical cost.

Reliability is difficult to achieve under fair value when we are dealing with hypothetical transactions that are not objectively measureable. This is the situation we face when observable market prices are not available. In other words, when an active and liquid market does not exist for the asset. Some argue that once reliability becomes compromised, the information produced also becomes less relevant.

Integration of the two measurement bases suggested. For example, historical cost financial reports could be enhanced by providing fair value information through footnote disclosures. A balance to achieve both greater relevance and reliability.

2. Discuss the role of market stability and the financial business cycle in determining the relevance and reliability of the accounting information produced. (J, K) Market stability and the nature of the financial business cycle play a large role in the determination of market prices, and therefore impact upon the relevance and reliability of accounting information produced using fair value.

Falling prices in an unstable market may worsen market stability. Companies tend to react to falling prices by rushing out to sell their assets before their competitors, causing a further downward spiral in prices.

In a market bubble, values may be overstated, and values will most likely not be realisable if many market participants decide to sell those assets at the same time. The bubble bursts and prices fall again.

Financial statements measuring assets and liabilities at fair value in unstable or illiquid markets are not likely to be relevant or reliable for the purpose of decision usefulness.

Students may refer to the subprime lending crisis or other examples to illustrate the role of market stability and the financial business cycle.

Contemporary Issue 4.3 Current debates on accounting for financial instruments: perspectives in the aftermath of a crisis 1. ‘The market is far too complex to be captured by an accounting system.’ Discuss this statement, providing evidence from the global financial crisis. (J, K, SM) Responses to this essay style question may vary from student to student. Some points of relevance include:

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Solution manual to accompany: Contemporary Issues in Accounting

•

•

•

It seems appropriate that under normal circumstances, assets should be valued at what they are worth from the markets point of view, the market being the only valid standard of value. We are comfortable with this concept when markets are functioning normally. However, we do not know what to do when the market does not function normally.

The financial crisis has played a role in highlighting issues and bringing light to debates concerning the concept of fair value. Recent events have made us more aware of the complexity of the market and the associated issues that may arise when we choose to use market prices as an indicator of fair value.

Concerns regarding operation of financial markets and whether market values/prices are really reflective of the fundamental value of assets.

The important thing here is that students are able to identify a few key arguments and discuss them in depth, providing specific examples to support and justify their views.

2. Analyse the players involved in the recent debate surrounding fair value and its contribution to the global financial crisis. Discuss how this demonstrates the political nature of accounting measurement. (J, K, SM) Responses to this question will vary from student to student. There were many players involved. Students should be encouraged to focus on two or three and analyse them in depth.

Key players include accountants, regulators, management, banks, investors, just to name a few. Encourage students to read widely the literature surrounding fair value and its contribution to the global financial crisis. The amount of literature contributing to this debate is amazing.

Students also need to be able to develop clear links to demonstrate the political nature of accounting measurement.

T

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Chapter 4: Measurement

Review Questions 1. Define measurement in the context of accounting and financial reporting.

The Conceptual Framework defines measurement as: The process of determining the monetary amounts at which the elements of the financial statements are to be recognised and carried in the balance sheet and income statement Measurement in an accounting context therefore refers to the way the figures on the financial statements are determined. It is described as an act or process which may involve calculations, making estimates and comparisons, and apportioning or distributing amounts.

2. Why is measurement so important in accounting?

Measurement is crucial to be able to provide decision-useful accounting information and to accurately appraise the performance of management. These are the primary purposes for which financial statements are prepared.

The way items are measured in accounting impacts on the quality of accounting information produced. In order to fulfil the decision-usefulness objective, the financial statements produced must contain good quality accounting information which will assist decision makers in making the right (appropriate) decisions. Poor quality accounting information, resulting from the use of inappropriate measurement methods, may mislead users and this could potentially cause them to make wrong (inappropriate) decisions. If accounting information leads to wrong or inappropriate decisions it is not useful.

The financial statements produced must also contain good quality accounting information in order to accurately determine how well management has performed its role in managing the resources of the entity. Poor quality accounting information, resulting from the use of inappropriate measurement methods, will give the wrong impression as to how well management has performed its role.

3. Discuss the current approach to measurement adopted by standard setters. Why have they adopted such an approach? What are the issues and problems associated with this approach?

Under the international standards we adopt what we call a mixed measurement model. Under this approach a number of different measurement bases are employed in the preparation of the financial statements. Historical cost, current cost, realisable value and present value are all employed to different degrees and in varying combinations during the preparation of the financial statements.

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The main reason for adopting such an approach is the need for flexibility. This model allows for use of a number of different measurement bases. This is necessary due to the differences in the substance or nature of transactions between entities and also due to the differing circumstances that entities can find themselves in.

Issues and problems associated with this approach include: • Variations in accounting practice – entities may choose to account for the same or similar items in different ways using different measurement methods. How they measure and account for an item may be appropriate for the individual entity but could reduce comparability across entities.

• Potential for different financial results being reported when different measurement methods are allowed and used.

• Discretion means opportunity for management to make opportunistic accounting choices, creating a biased picture of reality and perhaps even misleading users.

In summary, the approach is necessary but subjective in nature. This highlights the importance of professional judgement and ethics in accounting.

4. Explain the arguments for and against using historical cost as a measurement base.

Key arguments for historical cost include: • •

Most objective measurement approach - amounts are determined based on actual transactions.

Clear audit trail – amounts can usually be proven by documentation.

Key arguments against historical cost include: •

• • •

Amounts determined may not be relevant to current decision making if there is a long time span since the transaction occurred. Historical cost does not take into account changes in the value of money over time. In other words, it ignores price inflation.

The amount paid for an item or received for an item may not necessarily be indicative of its value.

Judgement involved in determining depreciation rates can create inconsistencies and opportunity for manipulation.

Inability to determine the cost of some items. Items may be donated with no actual cost to the entity. Items may be internally generated rather than purchased.

5. Explain the difference between current and replacement costs.

Current costs and replacement costs are both essentially the costs that would be incurred if we were to replace the items now. However, these terms represent two different methods of measuring the cost of replacing the items. Current cost requires the item be valued and

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recorded at the amount that would be paid at the current time to provide the future economic benefits expected to be derived from the current item. Replacement cost requires the item to be valued and recorded at the amount that would be paid at the current time to purchase an identical item.

Current cost is a broader concept in that it represents the cost of obtaining the same expected future economic benefits, but these benefits may be assumed to be achieved in different ways, not necessarily through purchase of an identical item. Replacement cost is much more specific in that it represents the cost of purchasing another item identical to the current one.

6. Explain the arguments for and against using fair value as a measurement base.

Key arguments for fair value include: •

•

Most relevant measurement approach for current decision making. The amount that will be received for an item or that will need to be paid for an item is decision useful information.

Objective if determined by reference to the market price for an item. The market price is set by forces outside the entity. It is not biased by judgement and cannot be manipulated or influenced by management.

Key arguments against fair value include: • •

•

Subjective where a market price is unavailable. Some items are not regularly traded in an active market and an estimate of the items fair value must be made.

The focus on exit values is not logical and contradicts the going concern assumption.

We are measuring as though we are going to sell off all the assets which is not usually the case.

Market prices can be volatile and therefore sometimes may not be indicative of the true value of an item. Short term fluctuations in fair value may be irrelevant and cause confusion from a user perspective.

7. What role does estimation and judgement play in accounting measurement? Discuss with particular reference to present value and deprival value.

The key issue to note here is that certain measurement methods are more subjective than others. As a consequence, the relevance, usefulness and reliability of the accounting information produced using these more subjective measurement methods becomes questionable.

Present value is a good example because managements estimations of cash flows expected to be received in the future can be quite subjective. The estimations are made at management’s discretion and their internal biases may come into play. Assertions and assumptions are made by management in forming such estimates, and for this reason, the values determined cannot

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Solution manual to accompany: Contemporary Issues in Accounting

be assumed to be objective. Present value is also subjective in the sense that there are also a wide range of discount rates to choose from. There is often much variation between entities in the discount rates applied.

Deprival value is also quite a subjective measurement method for similar reasons. There are a range of ways in which deprival value may be determined, depending upon the assumptions and decisions made by management.

8. Identify factors that may influence the choice of measurement approach. Discuss how the measurement approach adopted impacts on the quality of accounting information produced.

Key influences include: •

•

•

Potential users of the financial statements - user needs must be understood in order to choose the measurement approach which will provide the most decision useful information.

Practical considerations – a particular cost or value may be too difficult or even impossible to determine. Choice of measurement approach also needs to be cost effective. The cost of obtaining or calculating the cost or value must be considered.

Management’s motivations and objectives – motivations, underlying objectives and time horizon can all influence management behaviour in terms of choice of measurement approach. For example, if management have a short term focus, are on a shorter term employment contract, or have bonuses tied to profits, they will most likely choose the measurement approach which produces the best results in terms of higher profits.

The measurement approach adopted impacts on the quality of accounting information because it has a direct impact on the relevance, faithful representation, understandability, comparability and verifiability of the information produced. Accounting information which possesses these characteristics is more decision useful, therefore fulfilling the decision usefulness objective, the purpose for which financial statements are prepared.

A detailed analysis of how each of the individual measurement approaches discussed in the text impacts on the quality of accounting information can be found on pages 104-107.

9. Why has measurement become such a controversial accounting issue in recent times?

In recent years there has been a significant paradigm shift in relation to accounting measurement. There has been a distinct move away from historical cost toward fair value and fair value is by far the most controversial measurement approach. Key reasons for such controversy include: •

Subjective nature of estimates involved in determining fair value where no active market exists for an item

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• • • •

Role of management assumptions and judgement make accounting information produced more prone to manipulation Variability in valuation techniques used between entities Volatility in earnings reported as a consequence of changes in fair value from period to period Potentially misleading nature of the earnings figure produced under fair value

Some points regarding the controversial nature of accounting measurement in a more general sense follow: • • • • •

Potential for inappropriate choices in measurement approach Variability in measurement approaches adopted for the same or similar assets Political influences on measurement decisions Subjectivity and discretion involved in determination of some values Impact of measurement on achievement of other organisational objectives

10. Discuss the political aspects of accounting measurement.

Key points are as follows: •

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Numerous different interest groups are involved in accounting regulation through the standard setting process. The process incorporates lobbying by the different interest groups with regard to measurement issues embedded within the standards. Interest groups are often biased or influenced by self serving objectives.

Wealth transfers often provide the basis or incentive for decisions made in relation to accounting measurement. Most parties and interest groups within our economy would act to maximise their own wealth, not necessarily with the best interests of stakeholders or the decision usefulness of information produced in mind.

Validity and acceptance of use of fair value as a measurement approach in times of economic downturn. Impacts on wealth within the economy need to be considered in the sense that certain types of entities may be disadvantaged by the decision to adopt fair value. The nature of an entities asset base and the transactions they undertake may mean they are more vulnerable to economic downturn and the operation of the capital market, causing them to report greater losses.

Use of fair value has also revealed the truth in some circumstances, highlighting losses that were masked by different accounting treatment adopted previously. This has brought financial reporting into the public eye and made it a public concern.

Reliability of accounting information produced using fair value as the measurement base. Where no active market exists for an item, determination of fair value becomes quite subjective. With discretion and judgement comes opportunity for potential manipulation of values. This issue has been highlighted in recent corporate collapses where the complex interactions of individuals within society and consideration of

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Solution manual to accompany: Contemporary Issues in Accounting

•

•

•

what motivates them to make particular accounting choices and decisions has come under great public scrutiny.

Accounting has been the scapegoat for many circumstances which have had far reaching impacts on the public. Views put forward in the literature have been inconsistent in that they are largely dependent on what issues are currently prevalent in the political arena. Players seem to change their view and opinion of the appropriateness of the various measurement approaches depending upon current political objectives and what needs to be achieved. In this sense, we can view accounting measurement as a political tool.

Difficult nature of managing the political relationships that arise due to stakeholders conflicting interests. For example, the conflict that arose between regulators and banks in the context of the recent GFC. Inadequate operation of financial markets, resulting in prices which are not necessarily indicative of market value. For example, during the GFC agency ratings were a key information source and therefore played a major role in the markets determination of price. The fact that the ratings agencies were paid by the entities means ratings given were not necessarily reflective of true risk and the whole market mechanism fell apart. In situations such as this, we even begin to question the accuracy of market prices and the whole market mechanism which we have come to rely on comes under scrutiny.

11. In your own words, explain what different stakeholders want from financial statements. Assess the impact of measurement on the extent to which accountants are able to fulfil stakeholder needs.

Different stakeholders all want something different from the financial statements. These differing needs must be considered and balanced out in the preparation of the financial statements.

Existing and potential investors are concerned about two key things. The risk they are exposing themselves to and the return they can expect from their investment in the entity.

They want accounting information that will assist them in deciding whether to buy, hold, or sell their shares in the entity. They also want accounting information which will help them to assess the entities ability to pay dividends. In other words, they are interested in the potential value and future viability of the entity, with a particular interest in current values and the entities ability to generate profits.

Lenders and other creditors want accounting information that will enable them to determine whether amounts owing to them will be paid when due. They are therefore most interested in the entities net position, the amount of liabilities it has compared to the assets it holds. They want information that reflects the current value of assets and liabilities, giving an indication of the future viability of the entity.

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There is a need for adoption of different measurement approaches in order to satisfy the needs of key stakeholders. In fact, even an individual stakeholder demonstrates a need for accounting information based on more than one measurement approach. It is evident that what is an appropriate measurement approach needs to be considered in context and is very much dependent upon the entity, its objectives and current circumstances. This reinforces the need for a mixed measurement model in order to satisfy stakeholder needs.

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Solution manual to accompany: Contemporary Issues in Accounting

Application Questions 4.1 Obtain the annual reports of three companies in the same industry and consider the items included in property, plant and equipment. Answer the following questions.

(J, K, SM) (a) What range of measures is used to determine amounts for these items in the reports of the individual companies? Do you think it is valid to add the items, given the measures used? How would you interpret the total amount for property, plant and equipment in the financial statements?

The range of measures used will vary depending upon the annual reports selected by the students. Students should however be able to describe succinctly the approach/approaches taken in measuring the company’s property, plant and equipment. If there is a wide range of measures used it may also be useful for students to think about and comment on why this is necessary.

Adding items determined using different measurement approaches gives rise to the additivity problem. It is not really logical to derive meaning from the total figure when a range of different measures are used. Even if the same measurement approach was used to determine the amounts for all property, plant and equipment items, the fact that the amounts were most likely determined at different points in time, makes the total less meaningful. (b) Compare the measures used by the different companies for similar items. Are there any inconsistencies in how similar items are measured by the different companies?

Responses will obviously vary depending upon the combination of reports selected by students. It is important to get students to tease out why any identified inconsistencies have occurred and develop their thoughts as to whether such inconsistency is justified.

4.2 Examine the requirements for measuring financial instruments in AASB 139/IAS 39 Financial Instruments: Recognition and Measurement. What measures are used to determine amounts for these items? (J, K) Students are required to examine AASB 139/IAS 39 and describe the measures required to be used for the different categories of financial instruments.

Do you think it is necessary to use different measurement bases for different types of financial instruments? Justify your response.

Encourage students to form their own view by exploring the nature of each of the different categories of financial instruments and thinking about how they differ from one and other. It is also important that students analyse the appropriateness of the measurement approach required for each category and determine whether there is justification for different

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measurement bases. The nature and characteristics of the different categories of financial instruments should come into the discussion here.

4.3 Examine the requirements for measuring assets at fair value in AASB 138/IAS 38 Intangible Assets. (J, K, AS) (a) How can fair value be determined under this standard?

Students are required to refer to AASB 138/IAS 38 and describe how fair value may be determined under this standard. (b) What impact would the differences in the methods allowed to determine fair value have on the financial reports? In particular, consider the potential impact on reported profits.

Students should be encouraged to explore this issue in depth, thinking about the specific impacts of each method on the financial report and then exploring the impact on reported profits in further depth. Some methods have a greater impact on reported profits than others and students should be encouraged to take their discussion further by thinking about the consequences of or motivations behind using a particular method to determine fair value.

4.4 Examine the requirements for measuring assets at fair value in AASB 141/IAS 41 Agriculture. (J, K, AS) (a) How can fair value be determined under this standard?

Students are required to refer to AASB 141/IAS 41 and describe how fair value may be determined under this standard. (b) What impact would the differences in the methods allowed to determine fair value have on the financial reports? In particular, consider the potential impact on reported profits.

Students should be encouraged to explore this issue in depth, thinking about the specific impacts of each method on the financial report and then exploring the impact on reported profits in further depth. Some methods have a greater impact on reported profits than others and students should be encouraged to take their discussion further by thinking about the consequences of or motivations behind using a particular method to determine fair value.

4.5 Do you think the requirement for an active market should be mandatory when measuring at fair value? What problems can occur when determining fair value of an item in the absence of an active and liquid market? Provide examples to justify your response. (J, K)

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Solution manual to accompany: Contemporary Issues in Accounting

Responses to this question will vary from student to student. Students may go either way but a good response will acknowledge arguments for and against. Some key points of relevance are outlined below.

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•

•

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Many argue that measurement at fair value can only be reliable and accurate when determined using market prices derived from an active and liquid market.

Reference to market prices is certainly the most objective way of determining fair value but do the prices accurately reflect the fundamental value of the asset being measured? In other words, can we be sure the market mechanism is operating effectively so as to not over/under price items.

Market price may not be reflective of the fair value of an item which makes the information produced less relevant and useful to users. It is often argued that in some circumstances a calculation using a specific internal model is necessary to accurately estimate fair value.

It is generally argued that determination of fair value in the absence of an active and liquid market is quite subjective. Market prices are determined by the interaction of forces outside the entity while other approaches used to estimate fair value in the absence of an active and liquid market require management to make various assertions and assumptions. Considerable judgment and discretion on the part of management is involved when an active market does not exist for the item.

Accounting information produced may be misleading if management makes inappropriate assumptions or makes other decision which when left to their judgement or discretion are made inappropriately.

Estimations of fair value can become quite complex and confusing from a user perspective. This then impacts on the understandability of information produced.

Students should draw on examples that they are familiar with to justify their response.

4.6 The following information is provided about a particular machine used by a company in its operations. The machine is technological in nature and new models are coming out all the time. The machine originally cost $80 000 and it would cost $140 000 now to replace this machine. The company expects to receive $112 000 (discounted to present value) in cash inflows from using this machine over the next 5 years. If we were to sell it now, the machine would bring in $60 000. Consider the decision usefulness of accounting information produced when using each of the above figures as a measure of the value of the machine. In particular, consider usefulness from the perspective of the following stakeholders: (a) Shareholders (b) Creditors (c) Employees Original cost $80 000 – This represents the amount paid for the machine when it was originally purchased. This amount is not necessarily very decision useful from a user

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perspective, especially if the machine was purchased a long time ago. Users are not really interested in how much was paid for an item in the past.

Cost $140 000 to replace the machine now – This represents the current amount we would have to pay to purchase a machine identical to the one being replaced. This amount is a good indicator of the current value of the machine and is decision useful from a user perspective.

However, if the machine is technological in nature and new models are coming out all the time, this method of measuring the value of the machine does not make sense. The current machine would most likely not be replaced with an identical one. It would be replaced with a better and more efficient model. In which case, the current cost of an identical machine is irrelevant. The cost of reaping the same benefits using a new and better machine may be quite different to the cost indicated above.

Present value $112 000 – This amount represents the benefits expected to be derived from the machine over the next 5 years in current dollars. This is a good indicator of the value of the machine and is decision useful from a user perspective because it is forward looking and provides information about current value and future viability.

Sell now $60 000 – This amount represents the current market value for this particular item.

In other words, the amount we would receive if we were to sell it now. This is a reasonably good indicator of the value of the machine but could also be misleading. For example, if the machine is still very efficient and productive, what it would sell for in the market a few years later is not necessarily going to reflective of its value. In other words, we can argue that use of this approach would lead to the machine being undervalued. The other side of the argument is that this particular model may not even sell, given the technological nature of the machine and the fact that there are new and better models on the market. One could also argue that use of this approach would lead to the machine being overvalued. Decision usefulness of the information produced using this approach to value the machine is therefore questionable.

Shareholders are interested in the current value of their investment and the ability of the entity to pay dividends in the future. Therefore present value as an indicator of the value of the machine would be most useful from their perspective.

Creditors are interested in the entities ability to pay its debts when they become due. They are interested in the entities current value and in particular it’s net position. The original cost of the machine would therefore be irrelevant from their perspective. Depending upon the particular circumstances of the machine, replacement cost, present value or even the sale value would provide information which is useful from a creditor perspective. The approach that will provide the most decision useful information depends on management’s intent with regard to the asset and how long it has been held.

Employees are interested primarily in the future viability of the entity, particularly their ability to pay their wages in the future. Therefore present value as an indicator of the value of the machine would be most useful from their perspective.

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Solution manual to accompany: Contemporary Issues in Accounting

4.7 Obtain the annual reports of two companies in different industries. Assess the decision usefulness of the accounting information contained within these reports from the perspective of the following stakeholders. In your response include an explanation of how the measurement approaches adopted have impacted on the usefulness of the information. (J, K, SM) (a) Shareholders (b) Managers (c) Government Student responses to this question will vary according to the entities selected. Discussion points raised will depend on the measurement approaches adopted by the entity and the nature of who the key stakeholders are.

The most important thing is that students are able to develop clear links and adequately explain these linkages between the measurement approaches adopted and the decision usefulness of accounting information. Students should be able to identify and analyse such linkages in some depth.

It is also important for students to note that the extent of the decision usefulness of accounting information is very much dependent upon who the key stakeholders are. For example, shareholders are most interested in information which reflects the current value of the entity, its future viability and ability to generate profits, while managers are more interested in information about the internal operation of the entity and its efficiency that will help them to make important decisions. Government is most interested in information which tells them about whether the entity has complied with particular rules and regulations.

Information about the general financial well being of the entity may also be useful from a government perspective, depending upon the relationship that exists between the entity and the government.

4.8 Obtain the annual reports of two companies in the forestry industry (usually available from company websites) and consider the items included in biological assets. Answer the following questions. (J, K, SM) (a) What range of measures is used to determine amounts for these items in the reports of the individual companies? Do you think it is valid to add the items, given the measures used? How would you interpret the total amount for biological assets in the financial statements?

The range of measures used will vary depending upon the annual reports selected by the students and the nature of the biological assets held by the entity. Students should however be able to describe succinctly the approach/approaches taken in measuring the company’s

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Chapter 4: Measurement

biological assets. If there is a wide range of measures used it may also be useful for students to think about and comment on why this is necessary.

Adding items determined using different measurement approaches gives rise to the additivity problem. It is not really logical to derive meaning from the total figure when a range of different measures are used. Even if the same measurement approach was used to determine the amounts for all biological assets, the fact that the amounts were most likely determined at different points in time, makes the total less meaningful. (b) Compare the measures used by the different companies for similar items. Are there any inconsistencies in how similar items are measured by the different companies?

Responses will obviously vary depending upon the combination of reports selected by students. It is important to get students to tease out why any identified inconsistencies have occurred and develop their thoughts as to whether such inconsistency is justified.

4.9 Find a current discussion paper or proposal on the IASB website. Discuss the measurement issues raised in the paper and examine the importance of resolving these issues from a standard-setting perspective. (J, K, SM) Responses to this question will vary depending upon what is on the IASB’s agenda at the time. It is important that students are able to identify and summarise the measurement issues raised in their selected paper, extending their discussion to incorporate analysis of the consequences of issues raised and explain why resolution is important.

4.10 Find the comment letters received on a current proposal or discussion paper on the IASB website and answer the following questions. (J, K, SM) (a) Have any of the comment letters referred to measurement issues?

Responses to this question will vary according to the proposal or discussion paper selected by the student. The nature and extent of the discussion will depend upon what is out for comment at the time. (b) Identify the key stakeholder groups. Establish whether there is agreement or disagreement within these groups and between the different groups, as to the appropriate measurement to be used.

Relevant stakeholders should be clearly identified and points of consensus and inconsistency discussed in some depth. It is important that students look for consensus and inconsistencies within each stakeholder group as well as between the different stakeholder groups. (c) Are there any major concerns in relation to measurement? Do you agree or disagree with the comments made?

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It is important that students are able to identify and explain the key concerns in relation to measurement. It is also important that students take a stand as to whether they agree or disagree with these concerns and are able to justify their view. Students might find it interesting to think about and consider the motivations underlying stakeholder concerns.

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Case Study Questions Case Study 4.1 Taking account of water 1. Is it appropriate to place a dollar value on water? Justify your response. (J) Responses will vary from student to student. The important thing is that students are able to justify their response and provide evidence in the form of references and examples to support their arguments.

Some argue that it is inappropriate to place a dollar value on water. Some argue that it would be very difficult given the seasonal uncertainty of environmental assets and the inconsistent relationship between cost and use across the various seasons.

However, the discussion in this case highlights that this complexity has actually created the need for better seasonal measurement of available water volume. This would allow us to make better decisions regarding the use of available water, promoting greater efficiency and sustainability of water use. Sustainability is the key driver behind the initiatives to place a value on water assets.

2. In the case above, what is actually measured and how is it measured? (K) What is measured?

• •

volume of water available disaggregated by the individual river systems Contributing to the basin how much water, in a particular season, should be made available for industrial and urban uses

How is it measured?

It is argued that the value of water is derived though the cost of making it available, reflected by a water planning and management charge which requires water authorities to determine their administrative, planning and management costs in providing water. A user pays approach should be adopted to fully recover these costs and the amount paid by users is therefore representative of the value of water. Hopefully this will highlight the value of water to users, portraying it as a valuable asset rather than a public good, and contributing to sustainability.

3. What are the potential issues associated with measurement of water? (J,K) Potential issues highlighted in this case include:

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Solution manual to accompany: Contemporary Issues in Accounting

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Lack of acceptance of a user pays approach. This approach promotes water as a valuable asset, while institutionalised low water usage charges in the past reflect the traditional emphasis on the ‘public good’ nature of water.

Effective pricing has proven to be important because water pollution has been found to be directly attributable to the lack of an effective pricing system.

If water authorities seek to fully recover costs, user charges may become unreasonable. The key industry impacted is agriculture which is one that we would expect to maintain low prices. The approach outlined in the case certainly has potential to adversely impact on agricultural produce prices and local communities.

Will disclosures in relation to the detail of the water authorities water planning and management costs and the methodologies used for calculating them really impact on the decision making of users? To promote greater efficiency and sustainability of water use the requirement for disclosures must focus on information which is critical in terms of relevance to users in sustainability decision making. This is difficult to ascertain and requires further understanding of this decision making process.

Seasonal uncertainty of environmental assets and an inconsistent relationship between cost and use across the various seasons, make information about user charges and how they relate to the costs of activities less meaningful from a user perspective.

Given that measurement of water and the provision of relevant information could become quite a costly process for water entities, can we be sure that governments will respond to the data appropriately and make the tough decisions about reducing allocations where appropriate, so that we are able to achieve that ecologically sensible net surplus and work toward the overall objectives of greater efficiency and sustainability.

4. Discuss whether such information is decision useful from the perspective of various stakeholders. (J) Responses will vary from student to student. Students should however provide a fairly in depth analysis of relevant stakeholder needs with a focus on the key issues such as a need for greater efficiency when it comes to water usage and long term sustainability. The main stakeholders include water authorities, water users and government. Students could also take this a step further and break down the different stakeholder groups mentioned above. For example, water users could be broken down into industrial and urban users. Industrial users could then be explored from the perspective of different industries. Students should be encouraged to explore decision usefulness of such information at a general level and then drill down to get as specific as possible when discussing key stakeholders.

5. What can we expect to achieve through accounting for water? Explain the connection to sustainability decision making. (J, K) The problem highlighted in the case is that in the MDB, the water available is insufficient to meet the demands of all agricultural and urban uses as well as the needs of the environment.

It is hoped that accounting for water will lead to greater efficiency with regard to water usage

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and longer term sustainability. The logic being that if we can highlight its value to users and decision makers by allocating a monetary value, it will be portrayed and treated as a valuable asset moving forward.

Case Study 4.2 CMG Worldwide: intangible assets 1. What is an intangible asset? Describe the nature of intangible assets that might be associated with celebrity personalities. (K) An intangible asset is essentially something of value which we cannot physically see or touch. For example, the reputation associated with a brand name, the goodwill associated with a business.

The nature of intangible assets that might be associated with celebrity personalities may include intellectual property rights. In this case, CMG worldwide is a licensing agency which works to manage, market and protect the valuable intellectual property of celebrity personalities. Something else which is also of great value is the goodwill associated with their name and with them as a person. It is important that this valuable asset be protected and managed.

2. Explain how we might measure such assets under AASB 138/IAS 38 Intangible Assets. (K, AS) Responses may vary from student to student. It is important that students explore the issue of measurement of these assets in their own way. It is important that students explore the issues in some depth, incorporating application of IAS 38 into their response. Points of relevance to guide discussion include: •

• •

Were the assets internally generated or acquired by the entity? These assets are of a nature that value is created internally by the entity. Students should explain their response in some depth. They should also be able to explain why this distinction is important. The key point being that it impacts on how the intangible asset will be recognised initially.

How should the assets be measured upon initial recognition? Refer to table 4.2, pg 119.

After initial recognition, should the cost model or the revaluation model be used to measure the asset? Students should provide some in depth analysis here in relation to the nature of the asset and each of the two models. Students should be encouraged to explore ideas thinking about what makes sense and what would be most indicative of the value of the asset. Relevance, accuracy and reliability from a user perspective should also be considered.

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3. What are the practical difficulties in measuring an asset of this kind? (J, K) Practical difficulties include: •

•

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Intangible assets lack physical substance and are not usually something that can be bought and sold in an active market. This makes measurement at fair value very difficult.

Intangible assets such as these are often unique in nature. There are no readily observable market prices available for the same or similar assets. This also makes measurement at fair value very difficult.

There may be little reliable information available regarding costs of developing the asset.

Ability to generate revenue may be considered to be most indicative of the value of the asset. The issue with this approach is that the estimates made reflect management’s own assumptions and biases, making it less reliable.

In summary, determining an accurate and reliable measurement presents a challenge. The nature of an intangible asset does not really fit or work with the concept of fair value and depending on the nature of the asset and how it is developed or generated, associated costs and relevant expenditure may be difficult to determine.

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Solution Manual to accompany

Contemporary Issues in Accounting Michaela Rankin, Patricia Stanton, Susan McGowan, Kimberly Ferlauto & Matt Tilling PREPARED BY:

Michaela Rankin

John Wiley & Sons Australia, Ltd 2012

Chapter 5: Theories in accounting

CHAPTER 5 THEORIES IN ACCOUNTING Contemporary Issue 5.1: News Corp reduces agency problems through executive remuneration plans 1. Both the horizon problem and risk aversion are agency problems that relate specifically to the relationship between owners and managers and which contracting can assist in overcoming. Explain these two problems. (K) Managers and owners have differing time horizons in relation to the entity. This is known as the horizon problem. Owners are interested in the long-term growth and value of the entity as the share value today reflects the present value of the expected future cash flows. As such, shareholders want managers to make decisions that enhance these future cash flows over the long term. Managers, on the other hand, are interested in the cash flow potential only as long as they expect to be employed by the entity. This is particularly an issue for managers who are approaching retirement.

Managers who are seeking to move to another entity within the short term are also more likely to want to demonstrate the short-term profitability of the entity as evidence of effective management.

Managers generally prefer less risk than shareholders. This is known as the risk aversion problem. Shareholders are not likely to hold all their resources as shares in one entity. They are able to diversity their risk through investing across multiple entities, cash or property investments. Shareholders may also receive regular income from other sources such as a personal salary from employment. As such, shareholders have ‘hedged’ or minimized the risk of one of these investments losing value. In addition, the liability of owners is limited to the amount they are required to pay for their shares. Managers, on the other hand, have more capital invested in the entity than shareholders through their ‘human capital’ or managerial expertise. It is likely that their remuneration is their primary source of income. As such, losing their job or being paid less can substantially impact on their personal wealth. Given higher risk has the potential to generate higher returns shareholders prefer managers to invest in higher risk projects. Conversely, managers wish to take less risk when deciding on projects for the entity because they have more to lose – they are more risk averse than owners.

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Solution manual to accompany: Contemporary Issues in Accounting

2. News Corp Ltd has recently introduced a new pay scheme to link executive pay to a range of performance measures, including share performance through ‘total shareholder return’. How does linking bonuses to share performance reduce the horizon problem and risk aversion? (J) Linking managerial bonuses to share performance by using a measure such as ‘total shareholder return’ encourages managers to focus on long-term performance because it is likely to affect their own wealth. Tying a greater proportion of managerial pay to share price movements as the manager approaches retirement is also likely to encourage managers to maximise long-term performance and to more closely align managerial time horizon with that of owners.

Paying managers a cash bonus based on measures of share performance encourages managers to invest in potentially more risky projects that are likely to maximise the performance of the entity into the future.

3. Why is it important to link executive bonuses to a range of entity performance measures rather than one, as was previously the case with News Corp? (J) Linking executive bonuses to a range of entity performance measures plays two main roles. First, it encourages managers to consider different aspects of the entity’s performance – both short and long term – that will lead to an overall strengthening of the entity, and be more likely to lead to longer-term increases in firm and shareholder value. If managerial pay is tied to only one measure, such as profits, it will encourage managers to take a short-term focus and to engage in activities that might benefit the organization in the current year, but are less likely to be beneficial over the longer term. It might also encourage managers to use accounting methods, such as accruals management, to maximise profits in the current year rather than future periods.

Second, given managers bear a large amount of risk, through their human capital investment in the organization, and it is likely to be their main source of income, it is more beneficial for managers to have their pay linked to a range of performance measures. If the company performs poorly on one measure in a year and managers do not meet targets for that performance target, for example profit, they are still likely to receive a bonus based on other measures of performance where targets were met.

Contemporary Issue 5.2: Banks breaching an implied social contract 1. What is a ‘social contract’? (K) The term ‘social contract’ has often been used to describe how business interacts with society. It relates to the explicit and implicit expectations society has about how entities should act to ensure they survive into the future. A social contract is not necessarily a written agreement, but is what we understand society expects of entities.

Some expectations could be explicit (legislation relating to pollution or employee health and safety are examples), while others are implicit. Evidence of implicit terms

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of the social contract can be gained from communications and writing of a society at a point in time. Media attention to high executive bonus payments when share prices are declining could be an example of the degree of public importance placed on these issues, and therefore an implied component of a social contract.

2. What do you think might be the implied terms of the social contract between banks and customers with respect to interest rates and charges? (J) While there is no explicit contractual responsibility of banks to pass on interest rate cuts announced by the Reserve Bank, there is an implicit expectation, as part of ‘social contract’ between banks and society, including customers, that banks do so.

Some implied terms of the social contract between banks and customers might include (but are not limited to) the following: • When banks receive rate cuts from the Reserve Bank they will be passed on to customers in a timely manner so that banks benefit from rate cuts to a greater extent than their customers • Any interest rate cuts will be passed on in full so the bank does not benefit more than customers from any federal rate cuts • Banks are expected to charge for customers in a realistic manner, and not penalize customers unduly for services • Banks are expected to provide services to customers and not penalize those living in remote or rural areas

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Solution manual to accompany: Contemporary Issues in Accounting

Review Questions 1. Differentiate a normative theory from a positive theory. Provide an example of each.

Normative theories provide recommendations about what should happen. They prescribe what ought to be the case based on a specific goal or objective. It is not based upon what is happening in the world, but on what should be the case given the objective upon which it is based.

A positive theory, on the other hand, describes, explains or predicts activities. Positive theories can help us to understand what is happening in the world, and why organisations act the way they do. As such they rely on real world observations.

2. Explain what an agency relationship is, and explain the following costs: monitoring costs, bonding costs, residual loss.

An agency relationship is one where a person, or group of persons – known as the principal – employs the services of another – referred to as the agent – to perform some activity on their behalf. In doing so the principal delegates the decision making authority to the agent.

Monitoring costs are incurred by the principal, and relate to measuring, observing and controlling the agent’s behavior. They could include audit of financial reports, putting in place rules, or costs incurred to set up a management compensation plan.

Bonding costs are costs incurred by managers in an attempt to provide some assurance that they are making decisions in the best interest of principals.

Residual loss refers to the additional divergence between agents and principals that can’t be contracted for, or cannot be monitored in its entirety. It is likely to be too costly to guarantee an agent will make decisions optimal to the principal at all times and in all circumstances.

3. Why would managers’ interests differ from those of shareholders?

Managers’ interests might differ from owners for a number of reasons, given both managers (agents) and owners (principals) are assumed to act in their own interest, and these actions might not necessarily align. Agency theory points to three main problems which highlight differences between interests of managers and owners: the horizon problem (managers and owners have differing time horizons in relation to the entity); risk aversion (managers generally prefer less risk than shareholders); and dividend retention (managers prefer to maintain a greater level of funds within the entity, and pay less of the firm’s earnings to shareholders as dividends).

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Chapter 5: Theories in accounting

4. Outline the three agency problems that exist in the relationship between owners and managers.

The three main agency problems that exist in the relationship between owners and managers are: the horizon problem; risk aversion; and dividend retention.

The horizon problem exists because managers and owners have differing time horizons in relation to the entity. Shareholders have an interest in the long-term growth and value of the entity as the share value of the entity today reflects the present value of the expected future cash flows over the long-term. Managers, on the other hand, are interested in the cash flow potential only as long as they expect to be employed by the entity.

Risk aversion refers to the fact that managers generally prefer less risk than shareholders. Owners diversify their risk through investing across multiple entities, and are also likely to receive income from other sources. Managers have a large amount of ‘human capital’ tied up in the entity and rely on the entity as their main source of income. As such they are likely to be more risk averse than owners, and are less likely to want to invest in risky projects.

Managers prefer to maintain a greater level of funds within the entity, and pay less of the firm’s earnings to shareholders as dividends. This is referred to as dividend retention. Managers wish to expand the business they control, whereas shareholders wish to maximize the return on their investment in the entity through increased dividends.

5. Outline the four agency problems that exist in the relationship between lenders and managers.

The four agency problems that exist in the relationship between lenders and managers are: excessive dividend payments; underinvestment; asset substitution; and claim dilution.

When lending funds, lenders price debt to take account of an assumed level of dividend payout. Excessive dividend payments, while good for shareholders, could lead to a reduced asset base securing the debt or leave insufficient funds in the entity to service the debt.

Underinvestment arises when managers, on behalf of owners, have incentives not to undertake positive NPV projects if the projects could lead to increased funds being available to lenders. This might particularly be the case when the entity is in financial difficulty. Given creditors rank above owners in order of payments in the event of liquidation, any funds form these projects would go towards debt rather than equity.

Managers have incentives to use debt finance to invest in alternative, higher risk assets in the likelihood that it will lead to higher returns to shareholders. This is referred to as asset substitution. Lenders bear the risk of this strategy as they are subject to the ‘downside’ risk of this strategy but do not share in any ‘upside’ returns.

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When entities take on debt of a higher priority than that on issue it is referred to a claim dilution. While taking on additional debt increased funds available to the entity, it decreases security to lenders, making lending more risky.

6. What is a debt covenant and why is it used in lending agreements?

A debt covenant is a restriction or a term included in a debt contract that is designed to protect the interests of lenders. They could include things such as a dividend payout ratio, working capital ratio, leverage ratios, or the restriction of the borrowing of higher priority debt.

7. Why would managers agree to enter into lending agreements that incorporate covenants?

As a result of agreeing to the terms of debt covenants managers are able to borrow funds at lower rates of interest, to borrow higher levels of funds or to borrow for longer periods of time.

8. What role does accounting information play in reducing agency problems?

Accounting information plays two roles in reducing agency problems. The first is where the terms of managerial compensation or lending agreements are written in terms of accounting information; and the second is where accounting information is used to determine performance against the terms of the contracts.

9. How might institutional theory explain accounting disclosures?

Institutional theory is used to understand the influences of organizational structures such as rules, norms and guidelines. Accounting disclosures are likely to be a way of demonstrating corporate legitimacy by disclosing how the organization is meeting the expectations of these rules, norms and guidelines.

10. What is a social contract and how does it relate to organisational legitimacy?

A social contract is used to describe how business interacts with society. It relates to the explicit and implicit expectations society has about how businesses should act to ensure they survive into the future. A social contract is not necessarily a written agreement, but is what we understand society expects. While the relationship between society and business is explained by the social contract, organizational legitimacy describes the state in which an organization has met the terms of the social contract. It explains the process by which the terms of a social contract is gained or maintained.

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11. How can corporate disclosure policy be used to maintain or regain organisational legitimacy?

Four ways an organization can obtain or maintain legitimacy have been identified in the academic literature: (a) Seek to educate and inform society about actual changes in the organisation’s performance and activities (b) Seek to change the perceptions of society, but not actually change behavior (c) Seek to manipulate perception by deflecting attention from the issue of concern to other related issues (d) Seek to change expectations of its performance Disclosure can be used as a technique in each of these strategies. An entity might provide information to offset negative news that may be publicly available. They could also use disclosure to draw attention to strengths or to down play information about negative activities. Disclosure can also be used to advertise actual changes in performance or activities.

12. Why would managers decide to voluntarily disclose environmental performance information in an annual report?

Public reporting of information that is not mandated, such as details of environmental performance is a powerful tool in showing an organization is meeting the expectations of society, and therefore maintaining organizational legitimacy. This can be used to draw attention to the company’s strengths, and to play down any weaknesses.

13. There are two branches of stakeholder theory. How do they differ?

The two versions of stakeholder theory are: a normative theory, known as the ‘ethical branch’ and an empirical theory of management. The normative branch of stakeholder theory relates to the ethical or moral treatment of organizational stakeholders. It is argued that organization should treat all stakeholders fairly, and the organization should be managed for the benefit of all stakeholders.

The managerial branch of stakeholder theory is a positive theory that seeks to explain how stakeholders might influence organizational action. Rather than considering each stakeholder as equal (as is the case under the normative branch), the managerial branch proposes that the extent to which an organization will consider its stakeholders is related to the power or influence of those stakeholders, with executives managing these competing interests.

14. The managerial branch of stakeholder theory proposes that stakeholder power will affect the extent to which an entity meets the stakeholders’ needs and expectations. Identify two stakeholder groups and outline how they might have ‘power’ relating to an organisation’s activities.

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Solution manual to accompany: Contemporary Issues in Accounting

Any two of the following organizational stakeholders can be identified and discussed: •

•

•

•

•

•

•

•

Investors/owners – investors, and particularly institutional investors have power through the provision of equity funds, and their role in appointing the board of directors. Some investors will have more power or influence than others, and this is likely to be related to the extent of their shareholding in the organization.

Political groups – these groups can incorporate community groups, lobby groups and shareholder associations amongst others. Their power lies in their ability to influence the operations of the organization with respect to their area of influence. For instance environmental lobby groups can influence public opinion about an entity’s environmental performance, so the entity needs to ensure they manage this relationship.

Customers – these are major providers of cash funds to the entity. In many industries meeting consumer needs is the driving force behind the organization, and it will find it difficult to operate successfully without the source of customers.

Communities – some companies have a major impact on local communities.

A specific example is the mining sector where towns and the communities which live there are significantly impacted by the organization, and the entity is reliant on local communities for support including labour, services and other resources. In these circumstances community groups can be seen as powerful parties, as it is important for entities to ensure a close working relationship.

Employees – as the suppliers of one major resource to companies – labour – employees are important to the smooth operation of the entity. Issues with employee conditions can significantly affect this supply of labour and therefore the continuous operation of the entity.

Governments – government at all levels have a significant amount of power over the operations of entities through legislation that impacts on operations.

This can relate to corporations legislation, legislation that dictates taxes, fees, tariffs and allowances the entity receives, and that dealing with how entities need to treat employees, the surrounding environment and consumers, as just some examples. These all have the potential to incur financial costs on the entity in terms of compliance.

Suppliers – raw materials are also a major cost to the entity, so any demands from suppliers for information, performance expectations etc are likely to significantly impact on the entity. Decisions not to supply to an entity can also be costly as it requires the entity to seek out alternative sources.

Trade associations – these bodies oversee the terms and conditions provided to the labour forces employed by entities. They are in a position to significantly impact on the ongoing operations of the organisation

15. What are the factors a manager might consider in making various expensing–capitalising choices?

Agency theory would propose that where a manager has discretion about the timing and the nature of activities, they are likely to choose to expense or capitalise in order to maximize profits, which would lead to increased bonuses to managers. It is also

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likely to ensure the entity is not close to breaching any debt covenant that might be in place.

16. How can positive accounting theory explain corporate social and environmental reporting?

Positive accounting theory highlights the importance of minimising information asymmetry between owners and managers. Managers need to be mindful of presenting both good and bad news about the entity as it impacts on reputation and future share values. As such they are likely to provide information about social and environmental performance to ‘bond’ themselves to shareholder expectations regarding sustainability performance, and to reduce information asymmetry, thus leading to a reduction in the cost of capital.

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Solution manual to accompany: Contemporary Issues in Accounting

Application questions 5.1 Making managerial pay contingent on measures of managerial and/or firm performance motivates them to deliver good performance for shareholders.

However, it also burdens them with greater risks than they may like. How do organisations balance these two considerations when choosing managerial pay and performance measures? (J) The board of directors will choose a range of measures, both accounting and nonaccounting to use as performance target for managers. This will ensure managers work towards improving firm performance on a number of levels – both short and long term, which is in the best interest of owners. It also serves to reduce the risk to managers. If managerial pay is only linked to one measure of performance, and it is not met, managers arguably receive no bonus. With a range of performance measures, if the managerial team meets performance on some measures but not others it means they will not lose all bonus.

5.2 Obtain the Remuneration Report for a publicly listed company. Examine the compensation contract for the Chief Executive Officer (CEO). Prepare a report which summarises your findings relating to the following issues: (a) What amount is short-term in nature (salary and cash bonus) and what is based on long-term firm or managerial performance? (b) What proportion of the CEO’s pay is performance based, and what proportion is not? (c) What measures of accounting performance are used to determine the CEO’s bonus? (d) Given the accounting firm performance measures in the contract, what accounting decisions could the CEO might make in order to maximise their bonus? (e) Can agency theory provide an explanation for the various remuneration components? Justify your answer. (SM, CT and K) The responses to each of the above questions will depend upon which company students choose. All the information in parts (a) to (c) are required to be disclosed in the Remuneration Report. The answer to (d) will depend upon the accounting performance measures disclosed in the report. It is likely that they are all short term measures such as return on assets (ROA) and profitability. These will lead to managers taking a short term approach to performance, perhaps decreasing expenses and capitalizing costs where possible. In answering (e) students should refer to the use of remuneration contracts to limit the following agency problems: horizon problem, dividend retention, risk aversion.

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5.3 Bonus plans are used to reduce agency problems that exist between managers and shareholders. Discuss two (2) of these problems specific to the relationship between shareholders and managers and identify how bonus plans can be used to reduce the agency problems you have identified. In your answer you should provide examples of specific components that should be added to a bonus contract to address the issues identified. (K, J) There are three agency problems: the horizon problem, dividend retention and risk aversion.

Bonus plans will be used in different ways to reduce each of these problems. To reduce the horizon problem, long-term bonuses such as shares or options are useful, as it encourages managers to improve long-term performance, and take a longer-term focus. Tying a greater proportion of managerial pay to share price movements, using ratios such as total shareholder return, particularly as the manager approaches retirement is also likely to encourage managers to maximize long-term performance.

Linking bonuses to ratios such as a dividend payout ratio will likely encourage managers to enhance dividend payouts to shareholders. Similarly, linking bonuses to profits will also encourage managers to seek additional profits, which in turn are going to be available for dividends, thus alleviating the dividend retention problem.

Including incentives to encourage managers to invest in more risky projects can reduce the risk aversion problem. For instance, linking a bonus partly to profits can encourage managers to consider more risky projects that have the potential to increase profits. Limiting the share-based compensation as a manager’s ownership in the company increases is also likely to encourage managers to invest in more risky opportunities as it increases a manager’s ability to diversify their own risk.

5.4 You have recently been appointed as a lending officer in the commercial division of a major bank. The bank is concerned about lending in the current economic environment, where there has been an economic downturn. You have been asked by your supervisor to provide a report indicating how you can safeguard the bank against the risks of lending. In your report you should outline how covenants in debt agreements can be used to reduce the risks, what agency problems the bank should be concerned with, and how accounting information can be used to assist in this process. (CT, SM, K) Debt covenants are designed to protect the interests of lenders. They also bond managers, representing the firm, and allow managers to borrow funds at lower rates of interest, to borrow higher levels of funds or to borrow for longer periods.

The bank should be concerned about the following agency problems: Excessive dividend payments: if managers issue a higher level of dividends than the payout ratio assumed in the calculation of a lending agreement this can lead to a reduction in the asset base securing debt, and potentially leave insufficient funds within an entity to service the debt. A restriction on dividend policy, or including a maximum dividend payout ratio can reduce this problem.

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Solution manual to accompany: Contemporary Issues in Accounting

Underinvestment: arises when managers have incentives not to undertake positive NPV projects if the projects would lead to increased funds being available to lenders.

Covenants that restrict the investment opportunities of the entity, or working capital ratios can reduce the problem.

Asset substitution: managers have incentives to use debt finance to invest in alternative, higher risk assets in the likelihood that it will lead to higher returns to shareholders. Debt covenants can restrict investment opportunities, including merger activity. Including clauses that secure the debt against specific assets, or including a leverage ratio in the covenant can also reduce the risk of asset substitution.

Claim dilution: entities take on debt of a higher priority than that on issue. Debt covenants could restrict the borrowing of higher priority debt, or debt with an earlier maturity date.

Accounting information can play two roles in this process. (1) it can be used as part of the covenants in debt contracts, and (2) can be used to assess performance against these covenants. The bank can require lenders to provide audited financial statements half-yearly or annually so it can ensure restrictions in debt contracts are not being breached.

5.5 A clothing manufacturer has decided to close its factory in a regional Australian town and move its operations offshore to another country where they are going to be able to employ workers at a substantially reduced cost.

Closing the factory will result in the loss of 400 jobs in the town. Outline the issues the company might face with regards to its implied social contract.

You should identify what groups or people are likely to be concerned or affected by the decision and whether the decision is likely to be seen as advantageous or disadvantageous to these groups. You should also discuss actions the company could take to reduce any potential negative reaction to the decision. (J, K) In a regional town a clothing factory that employs 400 workers is likely to be responsible for employing a major proportion of the community, in fact it may be the major employer in the region. This means closure will have a significant effect through increased unemployment. This will have a flow-on effect to other businesses in the area which are supported by the clothing factory employees (e.g. retail stores, housing, medical services, child care services etc).

Because of this close association with the community it has an implied social contract with the local community to communicate with employees and the broader community with regards to its intentions. Many employees may have moved themselves and their families to the area to seek employment. The company is likely to face opposition and lobbying by employees themselves, other businesses in the area, local government and employer associations. The decision is likely to be disadvantageous to all these groups.

Shareholders of the company are also likely to be affected by the decision, and are likely to be supportive, given reduced costs is likely to lead to increase profits.

Customers of the company are also going to be affected, and may make a decision to boycott the company’s products if they are not supportive of the company’s move

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offshore. This is likely to lead to adverse publicity, which may also be seen by shareholders as negative.

The company can take a number of actions to reduce the potential negative reaction to the decision. They should communicate with all interest groups, both in the local community and externally, to explain fully their decision. They need to highlight the advantages to the Australian economy, and to interest groups. They should also seek ways to reduce the impact on employees and the local community by seeking alternative employment opportunities for employees etc.

5.6 You work for a mining entity which is about to commence exploration in a remote area of the Northern Territory. You have been asked to assist the mining entity to manage its stakeholders to ensure the exploration permit is approved and there is no negative publicity associated with the operation.

You are to identify the various stakeholders the mining entity needs to consider, and identify the issues each might be concerned with. In your answer you should identify whether these issues are potentially costs or benefits to the organisation. (J, K) There is a range of stakeholders who will be concerned with the operation. Some of these include: Shareholders: As one of the major financial supporters of the company shareholders have an interest in future operations as it is likely to affect future shareholder value.

Shareholders expect the company to keep them informed on any issues regarding the venture – likelihood of success, issues it faces of a legal nature and issues that are likely to impact on the future successful operation of the venture. It is anticipated that shareholders will be supportive of the venture, if there is no negative publicity and the permit is approved. If not, shareholders might see the negative publicity as a potential to impact negatively on firm value so may look to sell shares.

Government: the government will be responsible for issuing any permit. This will be related to the location, indigenous ownership issues, environmental impacts and the potential for national income. It is important the company communicate with a range of government departments, as the success of the venture, and the granting of the exploration permit will rest upon government decisions.

Indigenous landowners: It is important that the company consider any land rights issues and the possibility that the exploration might impact on indigenous sacred sites.

The company needs to communicate with local elders to manage these issues to ensure the success of the project.

Employees and potential employees: the successful exploration could increase employment prospects within the area and the company generally, which would be a benefit to current and future employees. It is important that the company communicate with employees about benefits and costs of working in a remote location.

Local communities: If the exploration is successful then local communities are going to be affected by an influx of company employees. This could put a strain on existing infrastructure so the company needs to consider this and manage the provision of

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Solution manual to accompany: Contemporary Issues in Accounting

additional infrastructure to support the mine, employees and families, as well as contributing to the community.

Lenders: costs of exploration and development need to be managed through the provision of financial resources. The company needs to manage its relationship with lenders to ensure their financial support of the project. Borrowings, and their cost are likely to be affected by the probability of success so it is important that lenders are kept informed of developments, including successful application for exploration permits, and environmental impacts.

Case Study Questions Case study 5.1: Boral hoses down concerns over debt covenants 1. Debt covenants or restrictions are commonly used in Australian lending agreements. Discuss how they are used to reduce agency problems that exist in the relationship between entities and lenders. (J, K) Excessive dividend payments: A restriction on dividend policy, or including a maximum dividend payout ratio can reduce this problem.

Underinvestment: Covenants that restrict the investment opportunities of the entity, or working capital ratios can reduce the problem.

Asset substitution: Debt covenants can restrict investment opportunities, including merger activity. Including clauses that secure the debt against specific assets, or including a leverage ratio in the covenant can also reduce the risk of asset substitution.

Claim dilution: Debt covenants could restrict the borrowing of higher priority debt, or debt with an earlier maturity date.

2. Why would a company choose to enter into a lending agreement which contains a covenant that puts a restriction on the maximum debt to assets (leverage) that a company can take on? (J, K) As a result of agreeing to the terms of debt covenants managers are able to borrow funds at lower rates of interest, to borrow higher levels of funds or to borrow for longer periods of time 3. If a company is close to breaching its leverage covenant what actions can it take? (J, K) The company can take a number of actions. These could include, but are not restricted to: manage accruals to move expenses to later periods, where the company has some

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discretion, thus increasing assets and lowering the leverage ratio. The company could also look at asset values and revalue fixed assets to fair value, if it is an increasing market. This will also serve to lower the leverage ratio. It is costly to renegotiate debt, so using discretion to alter accounting values and capitalizing/expensing decisions is less costly and will ensure the company does not breach its leverage ratio.

Case study 5.2: Pay backlash prompts shift to bonuses 1. One of the problems in the shareholder/manager agency relationship that pay contracts are designed to overcome is the risk aversion problem. Outline what this problem is, and how the contract between managers and shareholders can be designed to reduce risk aversion. (J, K) Managers prefer less risk than shareholders because their human capital is tied to the firm. Shareholders have a greater diversification of risk, as they are likely to have investments across a variety of projects/property/shares. Managers are less likely therefore to invest in risky projects as if it fails they will lose more than shareholders with diversified risk.

Including incentives to encourage managers to invest in more risky projects can reduce the risk aversion problem. For instance, linking a bonus partly to profits can encourage managers to consider more risky projects that have the potential to increase profits.

2. How does equity as a pay component work to reduce the horizon problem?

What role, if any, does accounting information play in specifying the contractual terms of bonus plans designed to reduce the horizon problem? (J, K) Equity as a pay component in the form of shares or options are useful, as it encourages managers to improve long-term performance, and take a longer-term focus. Tying a greater proportion of managerial pay to share price movements, using ratios such as total shareholder return, particularly as the manager approaches retirement is also likely to encourage managers to maximize long-term performance.

Accounting information is used within pay contracts to specify the performance targets against which managerial performance is assessed. This dictates the number of shares and/or options to be paid, and to assess performance against these contracts.

3. The article discusses a range of non-salary components that are contained within the management compensation packages of top-100 companies. What is the purpose of including non-salary components in executive pay arrangements? (J, K)

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The non-salary components mentioned in the article include: cash bonus, shares, options or other equity schemes. The purpose of these is to align managerial interests with those of shareholders. If managers are just paid a base salary, they have no incentives to maximize firm value as they do not benefit in any growth in value.

Managers are rational self-interested parties and as such are motivated to perform if they are likely to receive some financial reward for this. Shareholders wish managers to run the company for their long-term benefit, so wish managerial pay to align with this. As such paying managers shares and options ensures they seek to perform over the longer-term. Similarly a cash bonus as part of a comprehensive package ensures managers maximize profits in the short term too.

4. Why would managers prefer short-term cash over long-term equity bonuses?

Why does this not align with shareholder interests? Explain your answer. (J, K) There is less risk for a manager in receiving short-term cash payments. It aligns more with managers’ preferences not to have funds tied up for the long term. Managers could choose to invest their cash whatever way they choose, which might involve property, other shares or shares in their own firm, so they would prefer this flexibility.

In addition, managers tend to have a short-term rather than long-term focus, so prefer to be rewarded on this basis.

This time horizon does not align with shareholder interests because short-term cash bonuses lead managers to have a shorter time horizon for decision making, while owners prefer long-term decision making. In addition, managers will not be looking to invest for future growth of the firm, whereas shareholders prefer positive investments for the future.

5. Shareholders of Australian entities have the ability to vote to show either their support or dissatisfaction with companies’ remuneration reports. While this is non-binding on the Board, they are obliged to take note of shareholders’ views. Explain why shareholders might choose to vote against reports with too high a proportion of pay as short-term cash bonuses rather than long-term incentives. (J, K) Cash bonuses imply a short term focus, rather than a long-term focus as required by shareholders. As such short-term methods to contract with and pay managers are not aligning the interests of managers with the owners. Paying out large amounts of cash to managers means reduced cash flow in the business, which might leave less available for future expansion of the business etc. In addition, cash bonuses do not indicate a clear relationship to the shareholders understanding of the goals of the firm – which is long-term growth.

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Solution Manual to accompany

Contemporary Issues in Accounting Michaela Rankin, Patricia Stanton, Susan McGowan, Kimberly Ferlauto & Matt Tilling PREPARED BY:

Patricia Stanton

John Wiley & Sons Australia, Ltd 2012

Chapter 6: Products of the financial reporting process

CHAPTER 6 PRODUCTS OF THE FINANCIAL REPORTING PROCESS 6.1 Contemporary Issue Corporate accounting systems are out of date 1. Why do financial statements prepared under the IASB’s Conceptual Framework and standards fail to meet the objective of financial reporting as outlined in the Conceptual Framework? (K) Financial statements are unable to achieve the objective of financial reporting because firms do not report information that explains the main trends and factors that underlie their development, performance, and position. Examples of such information include details about the nature of the business, key resources, risks and relationships, and performance measures and indicators.

2. Why do you think the author of the extract would expect readers of a marketing journal would be interested in financial reporting? (J, AS) Marketing focuses on the consumer and getting a “better deal” for them. Uses of financial statements are consumers of the information; closing the gap in what is reported is a step in getting a “better deal” for users. Additionally, the information that Management Commentary should disclose specifically mentions customer measures (derived by marketers) as crucial for assessing operating performance and, therefore, key information that should be reported to investors.

3. What difficulties do you see in requiring the disclosed information to be ‘reliable and comparable’ and ‘future oriented’? (J, AS) Metrics about customer measures derived by marketing and other metrics related to key resource would be reliable and comparable in the accounting sense. Other measures are more subjective.

6.2 Contemporary Issue Be kind to shareholders: keep it short, sweet and informative 1. Despite reiterating that the annual report is the single most important document a company sends to its shareholders, the writer is critical of annual reports. Outline those criticisms. (K) • • • •

too long, providing information with too much corporate spin, providing information that is too diverse, providing information that is incomprehensible to the average person,

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Solution manual to accompany: Contemporary Issues in Accounting

• •

space wasted with superfluous photographs and over-the-top graphic design as if the report has been hijacked by the public relations team and graphic artists, and too many statements that suggest that a good spin doctor has edited the report.

2. If annual reports are so important to shareholders, why are fewer people reading them? (K) Because of the factors listed in (1) and it may be also that many shareholders own shares in both their own name and their superannuation fund, and have requested only one annual report.

3. Why do you think the shareholder friendly report initiative will not be a ‘perfect replacement’ for a concise report? (J, K) The author states that the numerous required disclosures may defeat the initiative.

6.3 Contemporary Issue Standardised business language cuts operating jargon confusion 1. What is XBRL? (K) Extensible business reporting language, or XBRL, is a computer-based language that converts business and financial data to a standardised form.

2. What are the advantages of XBRL as outlined in the extract? (K) • • •

Consistency Transparency Financial data easily accessible and interchangeable

3. Why will companies such as Edgar Online Inc. have to change their focus if they are to survive widespread adoption of XBRL? (J, AS) Companies such as Edgar Online Inc. Provide normalised data to analysts but XBRL is able to do this without spending large amounts of expensive time converting data into a searchable and analysable form. Their focus is likely to change to ways to make XBRL data more marketable.

John Wiley and Sons Australia, Ltd 2012

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Chapter 6: Products of the financial reporting process

Review questions 1. Why does accounting have regular reporting periods?

• • • • •

Aids comparability and analysis Conventional Check on arithmetical accuracy Report to absentee owners Legal requirement

2. Consider the arguments for and against standardised reporting periods. Do you agree that accounting periods should be more flexible? Give reasons for your answer.

There are several arguments given to support a more flexible approach to reporting periods.

For example, any standardised period cuts across many uncompleted transactions.

Standardisation may result in accountants apportioning unfinished operations and allocating assets to an arbitrary accounting period of 12 months.

Chambers (cited by Luther) argued that the appropriate accounting period is determined by the nature of the entity, so that it should reflect the earnings cycle of the reporting entity.

This view was supported by the American Institute of Certified Public Accountants in 1973 but has not been adopted.

Johnson & Kaplan argue that standardisation puts pressure on managers to produce profits over short-term periods. Luther quotes several authors who argue that to overcome the problems created by standardisation, annual accounts should have a cumulative component because they are tentative and conjectural statements, the truth of which cannot be verified until the reporting entity has run its entire course.

3.

What are the perceived purposes of an annual report?

• • • •

Accountability of managers to absentee owners Provides information for decision making by non-management stakeholders Means of reporting corporate achievements Means of impression management, especially of positive images

4.

Why are financial statements ‘highly valued’?

They are ‘highly valued’ because financial statements have been attested to by a third party (auditor) who is supposedly independent of management.

5.

What do you understand by the term ‘fair presentation’? Give an example to support your answer.

To understand the term ‘fair presentation’ see chapter 2. The term means that the representation should be free from bias. In this light it can be equated with “faithful .

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representation” where the financial statements correspond to the actual events and transaction that are being reported.

6.

Financial reports have been criticised for their lack of completeness. In what ways do financial reports fail the completeness test?

• Financial reports report on only those activities sanctioned by GAAP (including IASs).

• Reporting entities engage in activities that are not captured in the reporting process. For

example, social and environmental activities largely go unreported in financial reports.

• Reporting of Intangibles is restricted by accounting standards so that many intangibles are

not included in financial statements.

7.

Defend the stand taken by accounting authorities in AASB138/IAS38 Intangible Assets in relation to the treatment of intangible assets.

The stand by accounting authorities is based on three grounds: • probability of the future benefits flowing to the reporting entity is too low • lack of reliable measurement for intangibles • the inability to separate many intangibles from their controlling entity.

8.

Define ‘earnings management’. Do you consider it to be good or bad? Why?

Earnings management is defined as a ‘manager’s use of accounting discretion through accounting policy choices to portray a desired level of earnings in a particular reporting period’.

Whether it is considered good or bad will depend on the acceptance of the arguments of Macintosh et al. 2000 or those of Parfet, 2000.

Because the measure of corporate success has become whether a corporation has reached its earnings predictions, the temptation for management is to ‘manage’ earnings to match analysts’ forecasts. In this process, as outlined by Macintosh et al., accounting earnings do not reflect the outcomes of an enterprise’s strategic decisions. Instead, analysts’ predicted earnings determine the strategy of an enterprise to satisfy the prediction. This means management may take predictions about earnings as targets and select investments that are likely to produce reported income equal to or exceeding the analysts’ forecasts. Meanwhile, the market incorporates analysts’ earnings forecasts into share prices. In this way, share prices, analysts’ forecasts and reported income all relate to each other but not to ‘true’ or underlying income.

Parfet, a representative of preparers of financial reports, defends earnings management by differentiating ‘bad’ from ‘good’ earnings management. The bad involves intervening to hide true operating performance by creating artificial accounting entries or by stretching the estimates required in preparing financial statements beyond reasonableness. This, he points out, is the realm of hidden reserves, improper revenue (income) recognition and overly aggressive or conservative accounting judgements.

John Wiley and Sons Australia, Ltd 2012

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Chapter 6: Products of the financial reporting process

Good earnings management, on the other hand, involves management taking actions to try to create stable financial performance by acceptable, voluntary business decisions in the context of competition and market developments. The market tends to reward corporations that achieve stable trends of growing income. Good earnings management involves spotting the most beneficial use for the corporation’s resources and quickly reacting to unforeseen circumstances. Parfet declares earnings management not to be a bad thing but a reflection of expectations and demands, both inside and outside a business, on the part of all stakeholders in the capital market.

9.

Why are annual reports so well regarded?

• • • •

Chief means of communication between management and non-management stakeholders Contain the audited financial statements The audited statements give credibility to the annual report.

Annual reports also contain information not recognised in the financial statements, information which is often complementary to the financials.

• Annual reports are the main source of voluntary disclosures by management.

10. Researchers speculate that management is motivated to disclose information voluntarily either because it feels accountable or because it wishes to legitimise its activities. Which do you think is the more likely reason and why?

“Accountable” invokes a responsibility or liability to be called to account whereas legitimacy implies being in accordance with the values of society. The argument should be based on who or what can call management to account and whether they would so. In relation to legitimacy, scholars argue that an organisation’s survival will be threatened if society perceives that it has breached its social contract in which societal values are embedded. Management will be “called to account" societal concerns.

11. Debate whether management should solely pursue profits.

The pursuit of profit is normally the concern of shareholders to whom management is accountable in a broad sense. However, the sole pursuit of profits may cause harm such as in the case of James Hardie. In that situation, the changes by management to their liability to those harmed by asbestos potentially created great harm. Profits were being pursued to the detriment of those harmed by the company’s product. A notable case was the Ford Pinto (USA) where even minor accidents ignited the car causing serious injury to those travelling in the car. Ford has pursued profits rather than acknowledging a duty of care to those who bought the vehicle.

12. What factors appear to instigate voluntary disclosure by management in annual reports?

• Accounting standards prevent the recognition of many assets that contribute to the market

value of the reporting entity — voluntary disclosures make this information available.

• To improve corporate reputations .

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Solution manual to accompany: Contemporary Issues in Accounting

• • • • • • • •

Concern for stakeholders — a concern wider than that for shareholders The philosophy that an entity has responsibilities beyond its legal responsibilities.

Accountability To legitimise various aspects of a reporting entity To comply with community expectations, legal requirements and industry requirements Borrowing requirements require such disclosures To forestall regulations or actions by pressure groups To win reporting awards and/or to secure endorsements

13. Why should management explain poor performance in technical accounting terms?

Investors and other information users are assumed to be non-sophisticated users who are unlikely to understand technical accounting terms and so, can be mislead in relation to the socalled factors leading to a poor performance. The aim is to assign responsibility for the poor performance to factors other than those in the control of management. In contrast, good performances are reported in clear non-accounting terms, with responsibility for the performance given to management.

14. Why do you think environmental disclosures are more researched than other social disclosures?

Answers can be based on the reasons for disclosures: Deegan lists ten reasons management might voluntarily disclose information in annual reports: 1. to comply with legal requirements 2. because of economic rationality arguments 3. because of management’s feeling that it is accountable to stakeholders 4. because of borrowing requirements 5. to comply with community expectations 6. to ward off threats to organisational legitimacy 7. to manage powerful stakeholders 8. to forestall regulations 9. to comply with industry requirements 10. to win reporting awards.

O’Donovan’s research suggests that management discloses environmental information in annual reports to: 1. align management’s values with social values 2. pre-empt attacks from pressure groups 3. improve corporate reputations 4. provide opportunities to lead debates 5. secure endorsements 6. demonstrate strong management principles 7. demonstrate social responsibilities

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Chapter 6: Products of the financial reporting process

15. Why is XBRL a ‘language’?

Language can be thought of as the communication of data, ideas, thoughts and feelings through a system of arbitrary signals, such as voice sounds, gestures, or written symbols. As a language, XBRL creates data is created by ‘tagging’ financial information. The XBRL tagging process converts the financial information contained within a document such as an excel spreadsheet into a ‘document’ or computer file with XBRL codes.

16. Debate whether XBRL is the likely future of financial reporting.

XBRL fulfils many of the desired conditions of financial reporting such as timeliness and comparability as well as satisfying the reliance on electronics as a means of communication.

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Solution manual to accompany: Contemporary Issues in Accounting

Application questions 6.1 (a-j) Answers will depend on the annual report chosen and its financial year. Students should be encouraged to select an annual report from a non-listed entity so that comparisons can be made with a listed company’s annual report (case study 6.1).

Most answers can be supplied in tabular form.

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Chapter 6: Products of the financial reporting process

Case Study Questions Case study 6.1 Reading the annual report: ten issues to consider 1.

Obtain a copy of an annual report issued by a listed company. (K)K

2.

Follow the suggestions of the corporate regulator, and analyse the annual report:

(a) Examine the figures in the financial statements to get an overall impression of the financial performance of the company.

Calculation of the commonly used financial ratios would be helpful in answering this question. (b) Note which figures you think are important to an understanding of the financial performance of the company you have chosen.

The calculated ratios especially those relating to liquidity, profitability, debt, cash flows and operating performance should be helpful. (c) Read what management has to say about these figures in the front half of the report.

Care should be taken to align the numbers reported in the financial statements and those reported in the front half of the annual report. Management discussion can enlighten the reported numbers; it can also obfuscate them. Impression management has been identified as a tool used in annual reports. Positive images will be promoted; negative images will be avoided. This strategy has been shown to be applied to the figures reported in the front half, especially where those figures are reported graphically. Students should be aware that the figures may reflect earnings management and realise that earnings management is difficult to detect from a public document such as the annual report. (d) Return to the financial report and examine the figures again, taking into account what management has said in the front half. Has your assessment changed in any way? How? (J, K, AS, CT) Students should be guided by the questions identified by ASIC especially those relating to the year’s highlights and the comparison with the previous annual report if it is available.

3.

Write a short assessment of the company as a potential investment. (J, K, AS, CT)

The assessment should include the key areas identified by the regulator: operational and strategic activities of the company, the financial results and the future strategic directions and performance. The 10 questions identified in the case study should give the assessment its structure.

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Solution manual to accompany: Contemporary Issues in Accounting

Case study 6.2 The impact of the global financial crisis on IAS 39 Financial Instruments: Recognition and Measurement 1. Suppose you are a company holding large quantities of financial instruments the market value of which had declined markedly since purchase. How would you classify those instruments and why? (J, AS) The changes to IAS 39 created incentives for those holders of large quantities of financial instruments with large impairment charges to classify the financial instruments as assets “held to maturity” or as “loans and receivables”.

2. Compared to the pre-change IAS39, what are the likely impacts of the changes to IAS 39 on balance sheet values of companies holding large amounts of financial instruments? (K, AS) Impairment charges that should have been taken to the profit and loss statement will not go there so that reported profitability is higher for those companies with large quantities of financial instruments with declining market values will be higher than if the standard had not been changed.

3. Will companies with large holdings of dodgy financial instruments be motivated to disclose information about those instruments? Give reasons for your answer. (J)J Companies with dodgy financial instruments are likely to take advantage of the information asymmetry between themselves and external stakeholders to manipulate the financial performance of the company by not making any voluntary disclosures about their holdings.

Studies of impression management show that annual reports and other corporate communication media with shareholders and other stakeholders generally seek images that have positive expected values, while negatives are avoided.

4. What types of companies are likely to be impacted greatly by the changes to IAS39?

(K) K Banks, merchant banks, investment companies, superannuation companies and such.

5. How would the changes impact the truthfulness of financial reporting? (J, K)J K Depends on whether faithful representation is equivalent to truthfulness. The changes impact on the underlying substance of the financial reporting.

6. How do the changes impact on the comparability of financial statements? (J, K)J K The four choices should impact negatively on comparability, both of the balance sheet and the profit and loss statements.

7. Would you expect the ‘market’ to look through the changes? How can you empirically verify your answer? (J, K) Advocates of the EMH would argue that the market would be expected to see through the changes. To empirically support an answer, some research into the changes in share prices of

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Chapter 6: Products of the financial reporting process

companies with financial statements that employed the changes should verify whether the market looked through the changes. Students should be aware that other factors can complicate the results.

K 8. Argue whether the changes to IAS 39 represent a form of sanctioned earnings management. (J, K) Earnings management is defined as a ‘manager’s use of accounting discretion through accounting policy choices to portray a desired level of earnings in a particular reporting period’.

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Solution Manual to accompany

Contemporary Issues in Accounting Michaela Rankin, Patricia Stanton, Susan McGowan, Kimberly Ferlauto & Matt Tilling PREPARED BY:

Sue McGowan

John Wiley & Sons Australia, Ltd 2012

Chapter 7: Corporate governance

CHAPTER 7 CORPORATE GOVERNANCE Contemporary issues 7.1 Audit committees put risk management at the top of their agendas 1.

Traditionally, audit committees have primarily focused on managing financial reporting risk (i.e. risk of misstatements in financial statements) and reviewing aspects such as internal control systems. Do you believe the expansion of this committee’s role to consider business risk appropriate? (J, K)

There is no correct answer here and students may have different views. Points to make could include: • An essential part of any audit committee, even if focussing primarily on financial reporting issues, would include an assessment of risk as this would impact on issues such as going concern, impairment, values in financial statements etc, so the committee does need to understand the company’s risk profile.

• Given significance and importance of risk management (and failures associated with this in the global financial crisis) there is a need to manage and control risk. It could be argued that given its other functions, that necessarily require an understanding of this risk, that the audit committee is well placed to provide such control and oversight.

• Alternative views are: o This could overburden audit committees and impede its effectiveness. o It could be preferable to have a separate risk committee who can therefore concentrate on business risk The Institute of Chartered Accountants in Australia together with the UK Financial Reporting Council and the Institute of Chartered Accountants of Scotland, have recently published a paper “Walk the line: Discussions and insights with leading audit committee members” which provides insights from a series of interviews with audit committee chairmen of publicly listed companies about the role and challenges facing audit committees. This can be accessed from http://www.charteredaccountants.com.au/Industry-Topics/Audit-andassurance/Current-issues/Recent-audit-headlines/News-and-updates/Thoughtleadership-paper-reviews-the-role-of-the-audit-committee 2.

The extract notes a link between compensation structures within companies and risk management. Explain how these are related? (K, AS)

It should be understood, that compensation structures provide powerful signals about what an organisation values and rewards. As such they provide a way to direct employee behaviour. Hence compensation structures should consider how they will

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Solutions Manual to accompany Contemporary Issues in Accounting

be interpreted by employees and what actions they will encourage (and discourage). If compensation structures for example reward risk (for example, focusing on short term targets and not considering long term impacts) then these would be expected to increase the companies risk profile.

Students may think of some specific examples: • If a bank pays bonuses on the basis of loans granted but does take into account the risk associated with the loan (i.e. whether there is likely to be a default by the customer) this would seem to explicitly encourage granting of loans even where risk of default is high. (A compensation package to deter this could either have a ‘claw back’ provision – so if loan goes ‘bad’ bonus needs to be repaid, or have a large part of bonus paid at a later time when the likelihood of default can be more accurately assessed).

Contemporary issues 7.2 The individual must take responsibility for doing the

right thing 1.

This article discusses the issue of a code of conduct in corporate governance.

Discuss whether a code of conduct is important for corporate governance. (J, AS)

Every organisation has its own unique culture or value set. Most organisations don’t consciously try to create a certain culture. The culture of the organisation is typically created unconsciously, based on the values of the top management or the founders of an organisation.

The culture of an organisation is vital in corporate governance. A code of conduct is important in supporting this culture as it outlines explicitly expectations and responsibilities. It ‘sets the scene’ as to what is acceptable and what not is acceptable, actively can encourage and support either unethical or ethical behaviours. It also provides evidence of the value the company places on such behaviour.

However, as noted in the article, it is also important that the code is supported and that senior company members are committed and also adhere to the code.

For example, in the case of Enron (as noted in the text) the company was perceived to have ‘best practice’ in terms of codes of conduct and corporate governance yet in reality the culture and actual company practices were less than ethical.

Students may find it useful to look at some examples of codes of conduct. It is likely that their own university will have one. My own university has a code for staff (and also one for students) that outlines specific issues (such as respect for others, conflicts of interest, confidentially) but has a final guideline that staff should consider: If you would be ashamed if your conduct was reported in a University newsletter or a local newspaper read by friends and colleagues, you should question whether your behaviour is ethical.

2.

The article states that it is impossible to legislate for ethics. Do you agree with this? If this is the case, does this mean regulation is ineffective? (J, K, AS)

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Chapter 7: Corporate governance

Ethics relates to people and how they behave. If people are to act ethically they need to first, appreciate their actions and decisions involve ethical choices and second, be willing and able to then make the ‘right’ decision.

The fact that crimes are committed, and we have gaols full of prisoners, is clear evidence that legislation (law) itself does not prevent people from acting inappropriately.

However legislation can still have some impact by: • Although legislation tends to target clearer and more explicit examples of unethical behaviour it could be argued that this at least provides insight into societies expectations (and limits to acceptable behaviour).

• It could be argued to deter some of the worse abuses. Company directors can be subject to criminal actions and we saw with Enron imprisonment of directors.

• Legislation can also provide protection to whistle blowers An alternative view is that legislation can lead to a ‘rules based’ approach to ethical behaviour – where the perception is that as long as acts within bounds of legislation (i.e. to letter of the law) then that behaviour is acceptable.

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Solutions Manual to accompany Contemporary Issues in Accounting

Review questions 1.

Explain what is meant by corporate governance and why it is needed.

Corporate governance in very simple terms is ‘the system by which business corporations are directed and controlled’ (Cadbury, cited in Cowan, 2004, p. 15.).

The OECD’s definition expands on this: The corporate governance structure specifies the distribution of rights and responsibilities among the different participants in the organisation — such as the board, managers, shareholders and other stakeholders — and lays down the rules and procedures for decisionmaking. By doing this, it also provides the structure through which the company objectives are set, and the means of attaining those objectives and monitoring performance.

To have a good corporate governance system ensures that the corporation sets appropriate objectives, and then puts systems and structures in place to ensure those objectives which are set are met. It also provides a means for persons both within and outside the corporation to be able to control and monitor the activities of the corporation and its management.

With the increasing globalisation of business and competition for capital, companies that can provide assurances of good corporate governance will have a competitive edge in the market place and facilitate economic growth.

2.

‘Corporate governance is primarily focused on protecting the interests of shareholders.’ Discuss.

This would depend on what point-of-view you take: (a)

Traditional — the role of the corporation from a traditional view by Milton Friedman is that ‘corporate governance is to conduct the business in accordance with the owner or shareholders’ desire, which generally will be to make as much money as possible while conforming to the basic rules of the society embodied in law and local customs’.

(b)

Pluralist model — the responsibility of corporations goes beyond the narrow interests of shareholders and should be extended to a wider group of stakeholders.

(c)

Anglo-Saxon model — tends to focus on the problems caused by the relationship between managers and owners and often takes a control-orientated approach, concentrating on mechanisms to curb self-serving managerial decisions and actions.

In practice, shareholders are a key focus on most corporate government systems in large corporations. Whether the focus should be primarily on shareholders interest is of course debatable and this would make a good discussion question for the class. Of course, other entities (such as not-for-profit and public sector entities) should also

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Chapter 7: Corporate governance

practice good corporate governance and these entities would not have ‘traditional’ shareholders. Students may wish to consider whose interests would be of primary focus with such entities.

3.

What are risks of poor corporate governance and the advantages of good corporate governance?

Risks of poor corporate governance can be from: • a company making use of resources to benefit themselves. In some cases, it may

go as far to involve fraud. It is often more subtle in regard to false reporting because of the desire to maintain the value of benefits provided to corporate managers.

• corporations taking actions that shareholders may not consider desirable • corporations ‘hiding’ or providing ‘false’ information to shareholders to avoid

consequences • disparity between payments received by managers or corporations to their

performance.

Ultimately students should realise that such actions can risk the wealth of shareholders and other stakeholder groups (such as employees and customers), can increase costs to the corporation and even put at risk the continuation of the corporation itself.

Advantages of good corporate governance: • provides assurance that companies are properly managed • required for an efficient market • facilitates economic growth.

4.

Explain what is meant by the positive accounting theory and its relationship to corporate governance.

Positive accounting theory, using as its basis contracting theory, views the firm as a network of contracts or agreements. These contracts determine the relationships with and among the various parties involved. A key relationship is the agency contract.

An agency relationship by definition has two key parties: 1.

2.

a principal who delegates the authority to make decisions to the other party an agent who is the person given the authority to make decisions on behalf of the principal.

In this context the agent is the manager and the principals are the shareholders. Whilst the agent has a duty to act in the interests of the principals there is a common assumption in economic theory which is, if individuals are rational, they will act in

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their own best interests and this can lead to the agent making decisions to maximise their own wealth, rather than the principals.

Principals are also rational and will expect that the managers will not always act in the shareholders’ interests. This leads to three costs associated with this agency relationship: • monitoring costs. These are costs incurred by principles to measure, observe and control the agent’s behaviour.

• bonding costs. These are restrictions placed on an agent’s actions deriving from linking the agent’s interest to that of the principal • residual loss. This is the reduction in wealth of principals caused by their agent’s non-optimal behaviour.

This theory also identifies ways in which managers can act against shareholders’ interests known as ‘agency problems’, and that these problems can be reduced by linking management’s rewards to certain conditions. Students should refer to Figure 7.1, page 191, which provides an overview of the shareholder–manager relationship in agency theory. Chapter 5 also explains in more detail this theory.

Corporate governance is concerned with controlling and directing businesses and in the company context there is a often a clear separation of owners (shareholders) and managers. Hence an agency relationship exists. A number of the principles in corporate governance (and these are further reflected in more specific prescriptions/rules) are espoused to address the problems associated with the agency relationship as outlined in positive accounting theory.

For example the OECD principles of corporate governance specify that: • managers’ remuneration should be linked to shareholder interest and that a key responsibility of the Board is ‘aligning key executive and board remuneration with the longer term interests of the company and its shareholders’.

• the remuneration policy for executives and board members needs to be disclosed to shareholders.

5.

Identify the key areas addressed in corporate governance and provide examples of practices related to each of these areas. Explain how any individual practices identified help ensure good corporate governance.

Corporate governance involves ensuring that the decisions made by those managing the corporation are appropriate, and providing a means to monitor corporate activities and the decision making itself. It is primarily concerned with managing the relationship between the shareholders, the key managers of the corporation (this is usually the Board of Directors), other senior managers within the corporation, and other stakeholders. Many countries have developed suggested (and sometimes required) lists of rules or descriptions of the types of practices that should be included in corporate governance systems. However it is generally acknowledged that there is no ‘one’ system of corporate governance. The practices and procedures required or desired will be affected by: • The nature of the particular corporation and its activities. For example, in some

companies there are dominant shareholders whereas in others shareholding may be more widely spread, and

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Chapter 7: Corporate governance

• The environment in which the corporation operates

The text identifies three key areas to be addressed by any corporate governance system: 1. processes and methods to control and direct the actions of managers of the corporation to ensure make appropriate decisions – Specific examples of corporate governance requirements here are minimum standards of experience for directors; requirements that at least some of members of board of directors be independent.

2.

processes and procedures to ensure that stakeholders (such as shareholders) have the ability to protect their interests – Specific examples here would be voting rights and rights of shareholders to call meetings.

3.

to ensure that adequate information is provided to ensure transparency and meet accountability obligations of management.

– Specific examples here include requirements in relation to annual reports.

Students may also wish to consider how these areas are addressed in the summary of 3 codes of corporate governance in table 7.1).

6.

What is the rules-based approach to corporate governance and what are the advantages and disadvantages of this approach?

Rules-based approach identifies precise practices that are required or recommended to ensure good corporate governance. For example, there may be a rule that an audit or remuneration committee be established. The text provides some examples of specific rules.

The advantages of this approach are: • It provides at least a set of minimum corporate governance practices that must

be followed by all corporations, and • There is no uncertainties as to which practices are required. This also assists

with enforcement and with potential liability in terms of litigation.

The disadvantages of this approach are: • While this provides a minimum set of practices, it is likely that good corporate

governance requires practices beyond the minimum prescribed.

• It also can encourage a ‘check list’ (form over substance) approach to corporate

governance.

• The legislative backing of rules can result in the view that corporate governance

is about dealing with legal liability rather than about promoting the interests of shareholders and stakeholders (Bruce, 2004).

• It is generally accepted that there is no ‘one’ model of corporate governance. A

rules-based approach is essentially a ‘one size fits all’ approach and does not

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take into account the specific circumstances of the particular entity (e.g. such as distribution of shareholders, nature of environment).

7.

What is the principles-based approach to corporate governance and what are the advantages and disadvantages of this approach?

Principles-based approach is general principles or objectives of the corporate governance system which it should aim to achieve. For example, the general principle may be that the corporation should ensure that there is accurate and adequate disclosure of information. Rather than identifying the exact practices that may assist in helping meet this aim (such as directing specific times for rotation of auditors, certification of financial reports) this then places the responsibility on the managers to consider which practices are appropriate, given their circumstances.

The advantages of this approach are: • It arguably places a higher level of duty on directors to determine which

corporate governance practices are required, rather than simply accepting a minimum set of practices as being adequate.

• Its flexibility means that the corporate governance practices can be adapted for

the particular circumstances and environment of the entity The key disadvantages • It essentially leaves it to the directors to interpret these principles and decide

which corporate governance practices are needed and so relies on their honesty, integrity and commitment to good governance. If directors are competent and act in good faith then this is not a problem, however given that many of the corporate abuses that have renewed the interest in corporate governance practices usually stem from people not acting appropriately, this is problematic.

• It can lead to uncertainty about appropriate practices.

8.

Explain the problems identified from the global financial crisis in relation to risk management and how these relate to corporate governance.

The text outlines 4 problems with risk management.

1. a disjointed approach to risk management where risk was not managed or monitored at the entity level but at individual activity level so no effective understanding or oversight of risk for the corporation overall 2. information about risks not reaching the board or board members being able to understand or appreciate the risks involved 3. that the culture (pursuing growth in profits) encouraged risk taking 4. a ‘disconnect’ or ‘mismatch’ between company’s overall risk strategy and related procedures. For example, many remuneration packages provided incentives for high risk activities and short term outlooks.

A good corporate governance system ensures that the corporation sets appropriate objectives, and then puts systems and structures in place to ensure those objectives

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Chapter 7: Corporate governance

which are set are met. It also provides a means for persons both within and outside the corporation to be able to control and monitor the activities of the corporation and its management. A key role is to protect the interests of stakeholders (including shareholders). To do this it is essential that risk is understood, monitored and managed. However, historically most corporate governance models have not highlighted the importance of risk management.

In relation to the specific problems identified the following is noted: 1. Ultimate oversight and responsibility for risk management lies with the board.

Risks can be wide ranging and as the ASX code states may include “operational, environmental, sustainability, compliance, strategic, ethical conduct, reputation or brand, technological, product or service quality, human capital, financial reporting and market-related risks”. Hence it is important that the board considers the overall strategy. Managing these risks in isolation (at activity level) is not sufficient.

2. Cleary the board needs information about risks the company faces and how these are managed. Without sufficient information, and understanding of these, the board cannot perform its duties. It is claimed this was problematic given the complexity of the financial instruments associated with in the global financial crisis. The ASX code now recommends that management provide a report to the Board about the risk management systems implemented and their effectiveness.

3. Every organisation has its own unique culture or value set. Most organisations don’t consciously try to create a certain culture. The culture of the organisation is typically created unconsciously, based on the values of the top management and influenced by reward systems, management actions attitudes. A culture of growth needs to be balanced with consideration to the any attentive risks.

4. There needs to be a consistent approach to risk management and this needs to be reflected in the company’s procedures and practices. For example, any formal policies to reduce or control risk are likely to be s disregarded if compensation packages actually reward risk 9.

Explain the problems identified from the global financial crisis in relation to remuneration and how these relate to corporate governance.

The text outlines 2 problems identified in relation to remuneration: 1. a disconnect/mismatch between bonuses paid to executives and company performance. This was seen as particularly problematic given lack on information about these packages and any ability to curb/stop these bonuses.

There can be really 2 concerns here. First, often there is a perception that remuneration to some executives is excessive- how can these people warrant such huge payments. In good corporate governance directors/executives are supposed to act in the best interests of shareholders. Yet paying what seems unjustifiable amounts to themselves could be seen as a conflict of interest. Second, remuneration packages are supposed to be tied to company performance; this is what the Board and other executives are responsible for and hence what they are rewarded for. Yet despite poor

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or deteriorating company performance (even in some cases failure) many executives still received large (and increased) bonuses. How can this be justified?

2. compensation packages focused on short terms goals and encouraged excessive risk It should be understood, that compensation structures provide powerful signals about what an organisation values and rewards. As such they provide a way to direct employee behaviour. Hence compensation structures should consider how they will be interpreted by employees and what actions they will encourage (and discourage). If compensation structures for example reward risk (for example, focusing on short term targets and not considering long term impacts) then these would be expected to increase the companies risk profile.

Students may think of some specific examples: • If a bank pays bonuses on the basis of loans granted but does take into account the risk associated with the loan (i.e. whether there is likely to be a default by the customer) this would seem to explicitly encourage granting of loans even where risk of default is high. (A compensation package to deter this could either have a ‘claw back’ provision – so if loan goes ‘bad’ bonus needs to be repaid, or have a large part of bonus paid at a later time when the likelihood of default can be more accurately assessed).

‘Any corporate governance system is only as good as the people involved in it’. Discuss.

10.

As the text notes decisions in, and about, corporations are made by people. The quality of any corporate governance is ultimately affected by the people involved in it.

The following points could be discussed: • Competence — clearly, if individuals do not have the requisite expertise or

experience then this will adversely impact on decisions they make and reduce the quality of corporate governance.

• Integrity (ethics) of individuals. Whether or not individuals will act ethically is

affected by a number of factors. These include: –

the individual’s own moral code

–

the culture of the corporation and of peers. This is particularly important in relation to top management. In a number of corporations it is argued that either ethical or unethical behaviour permeates due to the stance taken by the ‘leaders’.

–

the consequences of the decision. For example, if asked to do something that is not ‘right’ by a manager and refusing could impact on employment/future promotion; how ‘wrong’ is the decision and will it have a significant impact on others; what is the likelihood of being caught and what are the consequences if found to be acting unethically).

• Does the quality of individuals become more or less important if you have rules-

based or principles-based corporate governance codes?

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Chapter 7: Corporate governance

–

There is no correct answer here. Rules-based allows companies to restrict practices to the specific rules and, hence, can argue that a form over substance approach can justify or defend unethical behaviour so long as rules are followed. Principles-based requires interpretations — presumably, if individuals do not act ethically there will be flexible interpretations of these. This is also obviously affected by enforcement and also legal issues (such as courts and what standards they consider when determining guilt and penalties for unethical behaviour).

• Does the quality of individuals become more or less important if you have

voluntary or legislated corporate governance codes?

–

This relates to the points made above. Again, if voluntary then relies more on individuals. However, legislated codes again can lead to the same problems as rules-based approach. The text notes the example in Hong Kong where codes are high but often not implemented.

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Application questions 7.1 Obtain the annual reports of a range of companies in the same industry and country and search for any disclosures in relation to corporate governance principles and practices. In relation to these disclosures: (a) Identify the key areas considered by these companies. (b) Are there any differences or similarities in corporate governance practices? (c) Do you believe you could judge or rank the relative standard of corporate governance of these companies based on the information provided? If not, what other information would you need to do so? (d) Which company would you rank has having the best (or worst) corporate governance from these disclosures? Explain how you have arrived at this decision. (e) Compare your rankings with those of other students. Identify and discuss the reason for any discrepancies between rankings (J, CT) No specific answers can be provided as this will depend on the companies considered.

Go online and download a couple of annual reports in the same industry, from 2007 to 2012 and see the differences. Discuss the following in class: (a)

What have you found out about the key areas?

(b)

Explain the differences and similarities in class, on your Blackboard or WebCT.

(c)

Discuss the judgement you have made.

(d)

Did you identify the best and worst cases or corporate governance?

7.2 Obtain the annual reports of a range of companies in the same industry in different countries and search for any disclosures in relation to corporate governance principles and practices. In relation to these disclosures: (a) Identify any differences or similarities in corporate governance practices. (b) Can you provide any reasons from the business and regulatory environments in the countries that would explain these differences? (J, AS) No specific answers can be provided as this will depend on the companies considered.

Again go online and download annual reports from various countries to discuss in class. It may also be useful to consider, identify and compare: •

country economic and business environmental factors

•

any specific corporate governance guidelines or requirements issued for companies in the specific countries considered, for example by local stock exchanges, as well as considering enforcement mechanisms.

In class, explain the differences or similarities in corporate governance practices.

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7. 3 Many small companies argue that corporate governance requirements are too costly and onerous and should be restricted to the large ‘top’ companies. (a) Do you think that corporate governance principles should apply to smaller companies? (J, K) The basic principles of corporate governance would appear to apply to all companies, even smaller and medium-size companies. As discussed in question 1, corporate governance in very simple terms is ‘the system by which business corporations are directed and controlled’ (Cadbury, cited in Cowan, 2004, p. 15.).

To have a good corporate governance system ensures that the corporation sets appropriate objectives and then puts systems and structures in place to ensure those objectives which are set are met. It also provides a means for persons both within and outside the corporation to be able to control and monitor the activities of the corporation and its management.

The basic principles would apply to all corporations, large or small. Although it could be argued that the mechanisms to achieve these would vary as these issues become more critical in larger companies with greater separation, and also in smaller companies cost efficiencies would need to be more carefully considered. (b) Are there any particular corporate governance practices or principles that you do not think should apply to smaller companies?

Students answers here may vary. It is suggested that the same principles apply but the practices may vary. For example, PCW have produced a toolkit for corporate governance in small and medium enterprises. This suggests that similar principles (as per ASX) apply however there may be reason for vary specific practices.

• This is link to tool kit http://www.himaa.org.au/Governance/toolkit_print.pdf (c) What would be the advantages of smaller companies complying with corporate governance principles?

Advantages of good corporate governance would also apply to smaller companies. In particular, for small companies these would include: • provides processes and assurance that companies are properly managed • managing risk and facilitating economic growth (including entering emerging

markets as investors need assurance that appropriate controls/systems are in place) . (d) What might be the consequences for smaller companies of not complying with corporate governance principles?

These were noted in question 3 above, that risks of poor corporate governance can be from:

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• a company making use of resources to benefit themselves. In some cases, it may go

as far as to involve fraud. It is often more subtle, false reporting because of the desire to maintain the value of benefits provided to corporate managers.

• corporations taking actions that shareholders may not consider desirable • corporations ‘hiding’ or providing ‘false’ information to shareholders to avoid

consequences Students may wish to consider the following: (a)

List the particular websites that address corporate governance for small companies.

(b)

Did you find any advantages to small companies having corporate governance requirements?

(c)

What were the consequences?

7.4

A friend cannot understand why executives and directors of companies are often paid bonuses and not simply paid a set salary. (a) Using principles from positive accounting theory, explain the reasons for, and nature of, bonus plans offered to directors and executives. (K)

Need to first explain agency theory which is a key principle in positive accounting theory. An agency relationship by definition has two key parties: 1. a principal who delegates the authority to make decisions to the other party 2. an agent who is the person given the authority to make decisions on behalf of the principal.

The separation of ownership and control means that managers can act in their own interests which may be contrary to the interests of shareholders. Managers have variety of ways of reducing wealth to shareholders for the benefit of themselves.

These problems include risk aversion, dividend retention and horizon. Given these specific difficulties (the problems discussed below) to alleviate these problems managers remuneration is not simply paid as salary but by a bonus linked to variables that try to reduce these problems. The problems are: i

the risk aversion problem — managers prefer less risk than shareholders because their human capital is tied to the firm. Shareholders are more diversified because their human capital is not tied to the firm. Managers can reduce their own risk by investing in low risk investments rather than maximising the value of the firm through higher risk projects.

A bonus plan that relates managers’ salaries to profit may encourage less risk aversion.

ii the dividend retention problem — managers prefer to pay out less of the company’s earnings in dividends in order to pay for their own salaries and perquisites (big offices, expensive business trips).

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Relating a part of mangers’ remuneration to profit and requiring that a minimum dividend payout ratio be maintained can help. iii the horizon problem—managers are only interested in cash flows for the period they remain with the firm whilst shareholders have a long term interest in the firm’s cash flows.

Principals may relate part of managerial compensation to share prices, particularly for managers whose tenure is nearing completion.

Bonus schemes can reduce these problems by tying manager’s remuneration to some index of the firm’s performance, which has a high correlation with the value of the firm (share prices, earnings). This ties managerial compensation to performance.

Remuneration can also be tied to dividend payout ratios or to options or share bonus schemes Hence, this explains why is it preferable to pay managers a bonus (linked to appropriate variables/targets) rather than a set salary.

It may be interesting to examine details of remuneration packages of directors etc (often these are disclosed in annual reports or available on the companies web page as a separate remuneration report) and see how these principles are reflected in the packages. (b) Because share-based payments to employees (including directors) are now required to be recognised as expenses, would this reduce the need to use shares or share options as part of a manager’s remuneration package?

Theoretically, as the rationale for share options as part of a manager’s remuneration is to reduce the potential problems that arise due to the agency relationship between mangers and shareholders the fact that these are recognised as expense should not reduce the need for these to be part of the package for managers. The need (i.e. to reduce potential agency problems) still exists regardless of whether or not these are recognised as expenses or not.

However recognition as expenses (which involves measuring the value of these options which previously was ‘undisclosed’) can lead to more scrutiny of this component. It may be that this increased visibility of the value of these options leads people to question the awarding of these to managers. In recent years this scrutiny has increased as value is made more transparent- and also increased questioning of the basis for the awarding of these options (for example, if share price or performance has fallen then many argue that managers should not receive bonuses and there needs to be a clearer link between management performance and bonuses awarded).

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7.5

Obtain the annual report for a listed company and examine the remuneration packages provided for executives. (J, AS)

Note: these are disclosed in annual reports (or available on the companies web page as a separate remuneration report) and see how these principles are reflected in the packages.

A suggested example is the 2010 annual report for AMP — this includes details of the remuneration package and related benchmarks. You can access this from links from http://www.amp.com.au/ or the 2011 annual report for Crown Ltd which includes details of the amounts of potential cash bonuses. You can access this from links from http://www.crownlimited.com.

(a) Identify the key components of the remuneration packages for directors and executives. Do the principles of agency theory provide a rationale for each of these components?

Relate the key components of the remuneration packages identified to the three problems of agency theory identified. These problems include risk aversion, dividend retention and horizon and are discussed in the answer to 7.4.

You may wish to consider the following: • Are the benchmarks/targets for obtaining these bonuses clear?

• Are these reasonable for rewarding performance? For example, if linked to the

share price of the company do they take into account general share price movements for similar companies? If they do not, then they may be penalising or rewarding managers for market factors rather than their own performance.

• Are there any components that do not ‘fit’ with the principles of the

shareholder/manager agency relationship? If so, why do you think these components are included? (b) Would these packages provide incentives for these executives to manipulate accounting figures?

You will need to consider the following: • If any of the bonuses are linked directly to accounting numbers (such as profit)

then there may be incentives to manipulate to increase bonuses • If linked to non-accounting numbers (such as dividends or share price) then you

would need to consider market efficiency? For example, if the market would increase share price if profit increases via changes in accounting profit (i.e. the market is not efficient) then this would also create incentives to manipulate accounting figures. (c) How much information is provided about any bonuses paid? Is this information sufficient to allow shareholders to determine if these packages are reasonable?

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This will depend on the reports that you have found. You will probably find that in many cases there is limited information (in particular about benchmarks — often generic information about benchmarks is included rather than specifics). This makes it difficult for shareholders to consider however there could be legitimate coemptive reasons for not disclosing this information.

7.6

In many countries in Asia it is claimed that concentration of ownership/control by families of companies causes particular difficulties with corporate governance. For example, Hong Kong billionaire Richard Li owns 75 per cent of Singapore-listed Pacific Century Regional Developments. (J, K) (a) Examine corporate governance guidelines and identify specific recommendations for practice aimed at protecting minority investors.

This will vary depending on the guidelines examined. For example: • The ASX principles of best practice do not seem to specifically refer to minority

shareholders. However general principles regarding shareholders and requirements of independent board members may assist. Link to ASX if this needed is http://www.asx.com.au/governance/corporate-governance.htm • The OECD principles do refer to minority shareholder interests in a number of

specific instances. http://www.oecd.org/dataoecd/32/18/31557724.pdf • The Chinese code has many references to minority shareholders http://www.ecgi.org/codes/documents/code_en.pdf • The Pakistan Corporate Governance guide for family- owned campiness also specifically identifies the need to respect and protect minority shareholders http://www.cipe.org/regional/southasia/pdf/CG_Guide_Pakistan_08.pdf (b) Would these suggested practices be effective where there is a higher concentration of family control in a company?

There is no correct answer here. However, should consider issues such as: • Even where codes specifically address issue of minority shareholders how can it

be ensured that rights considered given influence that any dominant shareholders will have.

• Given that investment is choice and minority shareholders would know of

limitations to their power/influence when investing does this justify should corporate governance be focused on majority concerns.

Students may also wish to go online and download information on Pacific Century Regional Developments and consider the specific circumstances of the company.

7.7

Each year various bodies give corporate governance awards. Examples are, in Malaysia, an annual award is made by Malaysian Business, sponsored by

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the Chartered Institute of Management Accountants (CIMA), and with The Australasian Reporting Awards (Inc.), an independent not-for-profit organisation makes annual awards. (K, SM) (a) Locate the criteria on which these awards are based and compare these for different awards.

For example, the Australasian Reporting Awards and criteria for corporate governance awards states that “These Awards seek to recognise the quality and completeness of disclosure and reporting of corporate governance practices in the annual reports of business entities in the public and private sectors.” for private sector entities states. Review the criteria section at http://www.arawards.com.au/

(b) Are there any significant differences between the criteria?

This will depend on awards criteria reviewed. (c) In what areas of corporate governance reporting did winning companies outperform other companies?

This will depend on information available. For example, the Australasian Reporting Awards identifies companies that have been ranked as gold, silver or bronze and specifies what the differences are in being awarded this rating. So it may be useful to look at reports for companies in these different rankings to identify any differences.

For example, one difference between gold and silver is that gold requires ‘full’ disclosure whereas silver requires ‘adequate’ disclosure. (d) Does the wining of an award for reporting necessarily mean that these companies have best corporate governance practices?

Students should consider: • How would you tell if a company did not follow these practices that they have

claimed?

• How likely it is that companies who do not have good corporate governance

practices would disclose this fact? It may be what is not disclosed that is important.

(Remember: Enron was perceived as one of the best but fell short in practice)

7.8

Australian companies listed on the ASX must report on their corporate governance practices on the basis of ‘comply or explain’. That is, they are not required to comply with all of the specific corporate governance practices detailed by the ASX but if they choose not to comply, they must identify which guidelines have not been ignored and provide a reason for their lack of compliance. (K, SM) (a) Examine the corporate governance disclosures of some Australian listed companies and identify any instances where best practice recommendations of the ASX have not been met.

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Examples are in questions 7.9 and 7.10. Students should be able to find own examples. (b) Do you believe that the noncompliance in these instances is justified?

See responses to questions 7.9 and 7.10. Responses will depend on the nature of noncompliance and also circumstances and reasons given by particular company for noncompliance. (c) What are the advantages of having a ‘comply or explain’ requirement rather than requiring all companies to comply with all best practice recommendations?

The advantages is that this allows specific circumstances of a company to be considered when determining appropriate corporate governance practices (so for example, does not impose a ‘one size fits all’ approach regardless of the size of the company). This is consistent with the principles-based approach to corporate governance. While this allows flexibility, the fact that the need to disclose and justify non-compliance also allows shareholders and other stakeholders to clearly identify any instances of non-compliance and also requires management to consider this (it could be argued as need to disclose if do not comply then management need to explicitly consider whether or not non-compliance is justified as will be open to scrutiny).

7.9

In the 2009 annual report of Boral Ltd (an Australia-listed company), the corporate governance disclosures include the following note: The Board has considered establishing a nomination committee and decided in view of the relatively small number of Directors that such a Committee would not be a more efficient mechanism that the full Board for detailed selection and appointment practices. The full Board performs the functions that would otherwise be carried out by a Nomination Committee. (J, K)

(a) Examine the ASX corporate governance principles and identify the best practice recommendations in relation to nomination committees.

• ASX

Corporate Governance Principles can be http://www.asx.com.au/governance/corporate-governance.htm

found

at

The ASX recommendations for a nomination committee are related to Principle 2; Structure the Board to add value. The specific recommendation for the nomination committee is 2.4. This indicates that for smaller companies a separate, formal committee may not realise desired efficiencies.

The recommendation includes: • A charter establishing roles and responsibilities • Composition of at least 3 with majority independent and chaired by independent director

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• •

Responsibilities include making recommendations about required competencies of directors, succession plans, appointments and process for evaluation of performance Selection and appointment process and re-election of directors (b) What potential governance problems are these recommendations designed to meet?

Students should see that given the role of the Board of Directors is it essential that those on the board are the ‘best’ people for this role. Also the responsibility to ensure that the composition of the Board is of the right level of expertise, experience and independence to ensure that it can meet its obligations, lies with the Board itself, a nomination committee assists in this by specialising in the recruitment (so ensuring that the company is able to recruit the ‘best’ people for these positions) and also should assist in ensuring a balance of executive and non-executive directors (o to avoid potential dominance. bias and protect shareholders interests).

If the nomination of Board members is undertaken without a nominations committee this means that the Board itself is deciding on members without input or review from any others. Firstly, the Board itself may not have the time or expertise to search and recruit the best people (especially given their other duties). Also it is difficult for the Board to consider itself and its members objectively. Historically, in particular the recruitment of non-executive directors by the chairman of the Board, has been seen as often compromised at least in terms of independence — clearly, if appointed by the Board itself, new directors may feel under an obligation to support the people who have appointed them. Students should recognise that a key risk in the Board making appointments without a nomination committee is that the existing Board may choose members who will agree with their own views and not be willing to challenge or provide objective advice/criticism. (c) Is Boral’s deviation from these best practice recommendations justified?

Boral website is boral.com.au. Information about these best practice recommendations can be found on the website: Boral 2009 annual report relating to Board appointments and nomination committee and the annual directors review.

Boral site is http://www.boral.com/

Boral have justified their non-establishment of a nomination committee on the basis of efficiency in light of the small number of Board members (this was 6 but was increased in 2007 to 8). The ASX guidelines do state that for smaller boards a nomination committee may not be efficient. Also, Boral notes that they do use an external consultant in the process of identifying and assessing potential candidates.

This could alleviate some of issues of not having a nomination committee. Students may arrive at different views as to whether deviations from best practice guidelines are acceptable.

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(d) In March 2010 (see 2010 annual report), Boral did introduce a Nomination Committee (as part of the Remuneration Committee) although it is noted that the number of directors remained the same.

What reason can you think of for this change, given Boral’s previously stated reason for not complying with this best practice recommendation previously? (J, K) The 2010 Boral annual report states: In March 2010, the Board decided that it would be desirable to have a committee to assist the board with its nomination responsibilities. Accordingly, the responsibilities of the Remuneration Committee were expanded to encompass nomination responsibilities, and the Remuneration Committee was reconstituted as the Remuneration and Nomination Committee. In addition to responsibilities relating to remuneration, the Committee now has responsibility for making recommendations to the Board on matters such as succession plans for the Board, suitable candidates for appointment to the Board, Board induction and Board evaluation procedures. P34

It should be noted that in 2010 although the number of directors remained the same (at 8) there was a change in 2 directors. Also a comparison of the 2009 and 2012 annual reports reveals that more information is provided about this corporate governance area in the 2010 annual report and it is also apparent that a review of company policy in this area was undertaken. For example: The 2009 Annual report stated: The Directors believe that limits on tenure may cause loss of experience and expertise that are important contributors to the efficient working of the Board. As a consequence, the Board does not support arbitrary limits on tenure and regards nominations for reelection as not being automatic but based on the individual performance of Directors and the needs of the Company. (p 33).

The 2010 Annual report stated: The Directors have adopted a policy that the tenure of Non-Executive Directors should generally be no longer than nine years. A Non-Executive Director may continue to hold office after a nine year term only if the Director is re-elected by shareholders at each subsequent Annual General Meeting. It is expected that this would be recommended by the Board in exceptional circumstances only.(p 35).

There is no correct answer to why Boral has changed this practice. Possible reasons/motivations could include: • The changes in 2 new directors may have motivated the board to review this policy. They may have decided that the task was more appropriately and efficiently handled by a committee.

• Increased scrutiny (or expected) on corporate governance practices following the global financial crisis. In particular in Australia the changes relating to shareholders voting and rights in relation to directors remuneration could have prompted company to undertaken these changes.

• It is also likely that the company overall would be under increased scrutiny due to its performance. As company operating in the building industry, the company has been adversely affected by the global financial crisis (particularly the impact

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on US property market) and also by a downturn in the Australian building industry. Given the impacts on profits/earnings etc this would be expected to bring more scrutiny on directors’ performance/abilities etc.

7.10 In the 2010 Annual report of Biota Ltd (an Australia-listed company), the corporate governance note disclosed an audit committee composed of two directors (chaired by an independent nonexecutive director and supported by one other nonexecutive director). (J, K) (a) Examine the ASX corporate governance principles and identify the best practice recommendations in relation to audit committees.

The ASX practices are outlined below in principle 4. Recommendations include: • Establishing an audit committee • Structure of this committee • A formal charter • Disclosures (b) What potential governance problems are these recommendations designed to meet?

Students should recognise that the audit committee recommendations relate to Principle 4 So the establishment of an audit committee is seen as essential to safeguard the integrity of the financial reporting. The outline of the audit report above indicates the problems that this is trying to alleviate. The audit committee is trying to ensure that the financial information is not compromised (i.e. for example, it aims to ensure that the selection and appointment of the auditor who checks the reports is independent, that the financial information provided to shareholders is adequate, and that the internal control systems and management processes underlying financial reports are adequate). This committee also assists in tyring to ensure that reporting is not unduly influenced by management. (c) Does Biota’s audit committee meet these guidelines and if not, is any deviation from these best practice recommendations justified?

Information about the company’s ASX Corporate Governance Council Guidelines can be found in the 2010 Biota annual report (www.biota.com.au) Obtain the annual report for Biota and answer the questions.

Clearly Boral has not met the minimum three membership requirements as recommended by the ASX, although both members are non-executive independent directors.

It states (p. 12) that “The Board is of the view that the composition of the Audit and Risk Committee and the skills and experience of its members are sufficient to enable the Committee to discharge its responsibilities with the charter. All other non-

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executive directors are able to attend meetings at the discretion of the Committee Chair as observers.”

Biota could argue that have reduced membership on basis that it is a smaller company with only 7 directors. Also 6 of the 7 board members are independent, including the Board Chairman, and it is noted that “The Board Chairman attends most meetings as an ex officio member of the committee.” The fact that is chaired and supported by non-executive directors could be argued to alleviate any concerns, as well. Also the fact that auditor has policy of rotation also may alleviate concerns.

Students may arrive at different views as to whether deviations from best practice guidelines are acceptable.

7.11 At times there are problems (and subsequent investigations) with corporate governance, which include deficiencies in financial reporting. (J, K, AS) (a) Search the website of regulatory authorities (such as the Australian Securities and Investment Commission or the Securities and Exchange Commission in the United States) and identify a case that has been investigated that involves issues of corporate governance.

The ASIC annual report provides a summary of major cases and the media centre often provides summaries of cases considered or investigated (access from http://www.asic.gov.au).

The ‘key matters’ section at http://www.asic.gov.au/asic/ASIC.NSF/byHeadline/Media%20centre has information on major investigations/cases.

For example in the 2010/11 annual report: http://www.asic.gov.au/asic/asic.nsf/byheadline/Westpoint+bulletin?openDocument • has details re breaches of duties by directors

Students will find other cases. For example, on the SEC (US) http://www.sec.gov/ site: For example http://www.sec.gov/news/press/2012/2012-21.htm discusses a case of accounting fraud. (b) Briefly discuss the corporate governance issues and what part financial reporting played in these.

This will depend on the cases found by students. It may be useful to look at the annual reports of companies involved in investigations and consider their corporate governance disclosures (and practices). (c) Suggest what procedures or practices would prevent these abuses occurring.

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Gain, this will depend on the cases found by students. It may be useful to consider the nature of cases and problems: e.g. did these require collusion (i.e. involvement of more than one person); how were problems detected (this may give hint of how could be prevented and whether corporate governance processes could have assisted); what corporate governance disclosures did these entities make (do these indicate systems acceptable).

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Case Study Questions Case Study 7.1 Critical questions of governance 1. This article discusses the issue of corporate governance in family dominated businesses. Go to the Center for International Private Enterprise website, www.cipe.org, and locate the Pakistan Institute of Corporate Governance document ‘The Corporate Governance Guide: Family Owned Companies’.

This guide includes four principles. Do you think these principles would address the types of problems identified in the extract? (J, AS) The 4 principles outlined in this guide are: 1. Duty of Loyalty Directors are supposed to act honestly. The duty of loyalty requires directors to act honestly and in the best interests of the institution and its shareholders as a whole.

2. Family Governance Ownership and exercise of rights of all shareholders, including minority shareholders, should be respected and protected by forming a functional family council.

3. Employees & Other Stakeholders The board of directors should appreciate the role of the employees, especially key management, in the success of the company and should ensure that employees are treated with fairness and equity and without discrimination.

4. Ethics, Disclosure, and Transparency The organization should be governed in an ethical and transparent manner under effective accountability mechanisms.

Student may have different views whether these principles would be effective. The principles themselves are broad and so it would be assumed that if adhered to these should be effective in addressing the types of problems identified in the extract. For example, the extract identifies: • Trying to use company cash to acquire other family members businesses • Threat by chairman to employee leaving company • The CEO’s wife giving (presumably) non-company work for employee to do • Employees misusing information from previous employee The extract also notes that some of these could have been avoided by good corporate governance practices (such a clarifying roles, and internal controls that prevent employees who have left from accessing information).

2. Do you think regulation would be effective in dealing with the types of problems identified? (J, K) Again students may have different views.

Legislation could possibly target some types of problems: for example, in Australia we have employment legislation and anti-discrimination legislation that may deter some of these actions; there could be specific legislation re mis-use of company information. Corporation legislation could provide ‘rights’ to minority shareholders in particular cases (e.g. where related party transactions.

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However the role of legislation is necessarily limited. You need to consider enforcement. This includes not only will it be enforced but how this will be enforced and whether parties will act to have these enforced. In these situations we have unequal power relationships – for example, employees who wish to keep their jobs (or job prospects at the very least) may be reluctant to act, even if there is legislation.

Legislation cannot cover every scenario, and you cannot legislate for what people think.

3. The article argues that the larger issue relates to culture and ethics. Do you agree? How critical is the CEO in this? (K, AS) Corporate culture and ethics are important. Many articles and books have been written in recent years about culture in organisations, usually referred to as ‘Corporate Culture’. The dictionary defines culture as ‘the act of developing intellectual and moral faculties, especially through education’. This writing will use a slightly different definition of culture: ‘the moral, social, and behavioural norms of an organisation based on the beliefs, attitudes, and priorities of its members’. The terms ‘advanced culture’ or ‘primitive culture’ could apply to the first definition, but not the latter.

Every organisation has its own unique culture or value set. Most organisations don’t consciously try to create a certain culture. The culture of the organisation is typically created unconsciously, based on the values of the top management or the founders of an organisation. Hence the CEO is critical in this. The culture of an organisation is vital in corporate governance. It ‘sets the scene’ as to what is acceptable and what not is acceptable, actively can encourage and support either unethical or ethical behaviours.

Case Study 7.2 Reining in executive pay 1.

This article discusses the recent changes to address alleged excessive executive remuneration. Identify the main features of the reforms and how these could be effective. (K, AS)

The article discusses changes in the US under the Financial Reform Act. These are aimed at improving accountability and transparency.

The main features as described in the article are: • Increased rights of shareholders: e.g. providing shareholders with rights to vote (although non-binding) on executive compensation and also to ability (under certain conditions) to nominate potential board members.

• Increased disclosure: e.g. of executive pay and how relates to actual financial performance of the company; ratio of CEO compensation to median workers pay • Increased control i.e. board compensation committee must be independent Effectiveness of these reforms is interrelated. For example, adequate disclosure is required if shareholders are to be able to make an informed vote on whether or not to

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approve the compensation package. The type of information disclosed (such as how relates to actual performance and relationship to ‘median’ pay) would presumably ‘highlight’ more clearly any disparities or incongruities. It could be argued that as the shareholders vote is non-binding, this could be simply ignored; however companies (and directors) would presumably wish to avoid the situation where shareholders vote against their packages, particularly if there are provisions to allow these same shareholders to nominate their own board candidates.

(Further details of reforms can be found in actual legislation but students are not expected to consider beyond article).

Although not asked in the question it may be useful to consider the Australian situation where there is now a ‘two- strike’ rule, where if more than 25% of shareholders vote no to the company’s remuneration report at 2 consecutive annual general meetings then there is a possible ‘spill’ of the Board.

2. The article argues that the effectiveness of the reforms is based on the assumptions that shareholders will act. Is this assumption reasonable? What are the barriers to effective share holder control? (K) Students may note the following as barriers to effective shareholder control: •

•

• •

3.

Willingness to act. It could be argued that shareholders with diverse portfolios are less ‘concerned’ about specific companies, than their overall portfolios.

They can manage risk by diversification and holding a range of shares/investments. In such cases they may be reluctant to intervene/take action. This has also been claimed to apply to some institutional shareholders who take a passive approach. Any ‘action’ here is likely to be restricted to changing their portfolio of shares (e.g. selling shares) rather than actively acting to challenge or question company management.

Diversity and fragmentation of shareholders. In many companies there are numerous minority shareholders. To take effective action such shareholders would need to ‘combine’. This is difficult. In many cases few minority shareholders even attend annual meetings etc. Further, many of these shareholders may lack sophisticated business expertise.

Cost of action. This also relates to discussion above. Taking action involves costs- be these time, money. For minority shareholders (or investors with diversified portfolios) the costs are likely to outweigh any potential benefits.

Lack of information. Most shareholders rely on the information provided to them by the company. If this is deficient then the effectiveness of any action can be impeded.

The article argues that other ‘incentives’ — such as taxation laws and denying contracts — should be implemented. Do you think such measures would improve corporate governance practices? (J, K)

The ‘incentives’ raised in the article are essentially economic incentives. Such incentives are used to promote or deter certain actions. The incentives mentioned in the article are:

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• •

Setting a limit to tax deductions for executive pay Applying conditions on executive pay to be awarded government contacts

If such incentives were introduced this effectively places a potential ‘real’ economic cost on companies (for example, if tax deductions limited for executive pay then any amounts over the limited cost the company ‘more’ as no deductions would be allowed).

Students could argue regarding possible effectiveness: •

•

•

In practice it is likely that such ‘incentives’ agree to and implemented, would only be applied to extreme cases. Therefore their effectiveness is only limited to a few companies. Also incentives such as those related to government contracts would also only impact those companies involved in such contracts.

Would these costs be material to a particular company- and therefore be an effective control/deterrent? For large companies, even though executive pay may appear disproportionate, these costs are usually minimal in the overall company’s costs.

People and companies are very inventive. It is possible (if not likely) that if such incentives were introduced companies may ‘structure’ arrangements to avoid any such limitations. We see examples in relation to the law or even accounting standards where there can be the claim that the companies are following the ‘letter’ of the law but not the spirit’. If companies can avoid any limitations by such arrangements then this would impede effectiveness.

Case Study 7.3 Limits to governance; Corporate reforms often have unintended consequences 1.

This article discusses the increased use of regulation in corporate governance issues arguing that this may produce ‘unintended consequences’. Can you identify any unintended consequences that could occur? (K, AS)

The basic issue here is that in trying to ‘fix’ one problem, other problems can arise that were not expected or intended. The article mentions: • Change in tax laws to reduce excessive employee remuneration led to a shift way from salary packages to stock options as a means of rewarding employees/executives. As these points often required certain conditions to be met (such as particular share price or earnings) to vest this encouraged actions to realise these options (and resulted in changing attitude towards risk). Also if tried to short term hurdles/targets then encourages a short term focus.

• The rationale for having independent directors is outlined in response to question 2 in relation to this case. However the article suggests given that the independent directors will necessarily not have as detailed knowledge of the specific business/company this can result in those executive directors in practice having more influence/power. Particularly for complex issues (and it was noted in relation to the financial crisis that the complex financial instruments were not understood by a number of independent directors) this would negate the benefits of having an independent director to effectively review, monitor performance or make independent judgment. As the article

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•

2.

suggests, if the board has a large number of independent directors then the information advantage that the CEO has could result in real authority being concentrated in the CEO. The article also notes that regulation itself can hamper good corporate governance. For example, if regulation regarding compensation deters a company from hiring the ‘best’ person due; or if requirements for a certain number of independent directors means that board overall has less knowledge or expertise than required to effectively manage. In other words, the focus is on meeting, for example, legislative requirements rather than engaging in good corporate governance practices.

The focus of reforms on the need for sufficient independent directors is discussed in this article. What is the underlying rationale for inclusion of independent directors? Should independence override concerns of competence and expertise? (J, K)

The underlying rationales for independent directors include: • As independent they can monitor and review performance of management, presumably without conflicts of interest.

• Can enhance confidence in board as seen as by public as exercising independent judgement • Can add expertise that other board members may not possess • Increase diversity of board. Arguably this leads to more balanced decisions.

Clearly independence should not override concerns of competence and expertise. A director could be entirely independent yet if they do not have the expertise required then they will not be able to effectively undertake their role.

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Solution Manual to accompany

Contemporary Issues in Accounting Michaela Rankin, Patricia Stanton, Susan McGowan, Kimberly Ferlauto & Matt Tilling PREPARED BY:

Patricia Stanton

John Wiley & Sons Australia, Ltd 2012

Chapter 8: Capital market research and accounting

CHAPTER 8 CAPITAL MARKET RESEARCH AND ACCOUNTING Contemporary Issue 8.1 Economists and the global financial crisis 1. Who was John Maynard Keynes? (K) John Maynard Keynes was a British economist who influenced the theory and practice of macroeconomics (Keynesian economics), as well as the economic policies of governments.

Refining the existing work on the causes of business cycles, he advocated the use of both fiscal and monetary policies and measures to mitigate the adverse effects of economic recessions and/or depressions.

2. To what does the author attribute the causes of the global financial crisis? (K) The author attributes the causes to two dimension, one microeconomic and the other macroeconomic. The microeconomic refers to “the epoch of privatisation, public-private partnerships and market-mimicking arrangements of many different types, all based on the assertion that ‘state failure’ was invariable a more serious problem than market failure”. The macroeconomic dimension has two parts. “The first was a belief in the underlying stability of the (private) capitalist economy, if it was not disturbed (‘shocked’) by mistaken government intervention. The second was a belief in the efficiency of financial markets, which therefore required only the lightest of government regulation, if any at all”.

3.

3. How did the efficient market hypothesis contribute to the crisis? (J, K) Belief in the EMH lead to much deregulation of national and international financial transactions, deregulation which encouraged “foolhardy behaviour on a massive scale by large corporate players in financial markets and in discouraging any serious attempt at governmental regulation”.

Contemporary Issue 8.2 Mathematical models 1. If mathematical models were abandoned, what could replace them? (J) Models would probably be expressed in verbal terms with accompanying diagrams or flowcharts - a back to the future solution.

2. Discuss whether mathematical models are better to be partly right rather than totally wrong. (J) Discussion should include the realisation that no model is likely to be completely accurate, that there is a need to test models before they are put into use, and that users of the model should understand what has been simplified in the model and the ramifications of that simplification.

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Solution manual to accompany: Contemporary Issues in Accounting

3. Should decision makers be more mathematically literate so that they understand the limitations of the models they use or should the models be extensively tested before use? (J) Both alternatives could be defended.

Contemporary Issue 8.3 Road to wealth may lie in marching out of step 1. Why should the price you paid for a share be irrelevant to your decision to hold it, or to sell that share? (J) Because what you paid for a share is in the past. As the author notes, “there is nothing you can do to change it, so you should ignore it”. Economists call it a ‘sunk cost’ and so it is ‘irrelevant information’. The only thing you can hope to do is to influence the future, so the future is what a buyer of a share should focus on, particularly the question, “do I know of any other share (or other investment) that offers a better prospect of gain than the share I’ve got my money in now?”

J 2. What is meant by the phrase that ‘people are loss averse’? (J, K) The phrase, ‘loss averse’, refers to the finding that people are highly reluctant to crystallise a paper loss by selling up but are willing to take more risks to avoid losses than to realise gains.

3. Explain ‘anchoring’. How does anchoring contradict the efficient market hypothesis?

(K, AS) Anchoring is the obsession with the price paid for something such as shares - decisions are made based on this single figure that should have little bearing on the decision whether to hold or sell those shares.

Anchoring contradicts the EMH because when analysts are faced with new information that contradicts their forecast, they tend to dismiss that information as a short-term phenomenon whereas the EMH holds that all new information is almost instantly incorporated into the market and reflected in share prices.

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Review Questions 1. Explain what is meant by an ‘efficient market’.

An efficient market is one in which share prices reflect fully all available information.

2. Distinguish an event study from an association study.

An event study examines the changes in the level or variability of share prices or trading volume around the time when information is released. This information is assumed to be information new to the market if share prices or trading volume reacts to this information. In contrast, an association study aims to see how quickly accounting measures capture changes in the information reflected in share prices over a given period.

3. Explain why accounting earnings do not capture all the information contained in share prices.

Accounting earnings do not capture all the information contained in share prices because they are calculated using the conservative principles of revenue realisation and expense matching which do not recognise all the events that are incorporated into share prices. Additionally, these principles result in bad news being disclosed in a more timely manner than good news, reflecting the less stringent accounting recognition criteria for bad news.

4. Explain how accounting’s recognition and realisation principles affect the relationship between earnings and share prices.

Accounting’s recognition and realisation principles are conservative and backward looking so that they do not allow the recognition of all events that investors use to make predictions about future performances of the reporting entity.

5. What is meant by the term ‘post-earnings announcement drift’? What implications does this phenomenon have for the efficient market hypothesis?

‘Post earnings announcement drift’ refers to the evidence that stock markets underreact to earnings information — there is not an instantaneous, complete reaction to value-relevant information but rather a gradual adjustment to the information. This gradual adjustment contradicts the EMH which assumes that markets react instantaneously and completely to all value-relevant information.

6. In what ways are the finance definition of ‘relevance’ and the conceptual framework definition provided in chapter 2 similar?

According to the finance literature, an item of information is relevant if it has the ability to make a difference to the decisions of users of that information so that these users modify their expectations about future payoffs or associated risk. Accounting definitions of relevance refer to information which influences the economic decisions of users by helping them either

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Solution manual to accompany: Contemporary Issues in Accounting

predict or confirm their past evaluations or past events. In both definitions, users are expected to modify their beliefs based on the information.

7. When is an accounting number said to be ‘value relevant’?

An accounting number is assumed to be value relevant only if the amount reflects information relevant to investors in valuing an entity, and if the amount is measured reliably enough to be reflected in share prices.

8. Explain why earnings are not good measures of value relevance.

Accounting earnings capture only those events that pass the criteria for recognition. Investors are assumed to focus on all events that affect future cash flows of an entity. Additionally, accounting earnings can be negative which tells investors little about the future cash flow generating ability of the reporting entity.

9. International accounting standards are conservative in their treatment of intangibles. Will this conservative treatment conflict with investors’ perceptions of the value of intangibles to a firm?

Accounting’s conservative treatment of intangibles (largely they are expensed) conflicts with investors’ perceptions of the value of intangibles to an entity. The costs of intangible assets have been shown to be relevant to investors, but investors perceive the expenditures as capital acquisitions, in contrast to the accounting treatment of expensing such expenditures.

10. Summarise the main findings of the value relevance literature in relation to accounting.

• • • • • •

The relationship between accounting earnings and share returns is weak.

Accounting earnings do not capture all the information incorporated into share prices.

Evidence on decomposed earnings and share prices is contradictory.

Investors seem to value fair value accounting more than historical amounts.

Consolidation improves the value relevance of earnings.

There is information content in earnings announcements.

11. What principles are blamed for financial statements being poor indicators of value?

How do these principles inhibit valuation?

Revenue recognition and expense matching are blamed for financial statements being poor indicators of value. These principles inhibit valuation because they favour the recognition of bad news over good news.

12. Read the section on earnings management in chapter 6. How does that view of earnings management differ from the view held in the finance literature? Why would investors react positively to earnings management?

When managers use accounting choices to bias disclosures, the choice is called earnings management. Earnings management doesn’t affect cash flows, therefore, investors, who are assumed by the EMH to see through opportunistic accounting choices, will not alter their

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assessments of associated share prices. However, investors may react positively to earnings management because they are unable or unwilling to unravel the effects of earnings management. Investors have been shown to react positively to ‘big bath’ accounting because it allows improved performances in subsequent periods.

13. What is prospect theory? What are the implications of prospect theory for finance?

Prospect theory is based on the simple idea that the pain associated with a given amount of loss is greater than the pleasure derived from an equivalent gain so that investors attach more importance to avoiding a loss than deriving a gain. Researchers finding evidence of market inefficiency draw on prospect theory for support in arguing that investors are not rational.

Because rationality is one of the assumptions of many of the models used in finance, those models will not predict accurately if investors do not act rationally.

14. In the literature on which this chapter is based, the notions of the efficient market hypothesis and the CAPM are referred to as a ‘paradigm’. Findings that conflict with these hypotheses are called ‘anomalies’. Find definitions of these terms. How do they explain the progress of knowledge in the finance discipline?

In these circumstances, a paradigm is usually defined as a set of concepts, principles, ideas and such shared by a community of scholars. An anomaly is a deviation from the commonly accepted tenets of a paradigm. An increase in the number of anomalies weakens faith in the paradigm. At some point, another paradigm may replace the existing one. It is akin to evolutionary principles — a better explanation will replace a weaker one.

In the finance discipline, if anomalies reach a critical point where the EMH is no longer seen to offer a satisfactory explanation, then another explanation will take its place — an explanation which is accepted by a greater number of scholars than those still accepting the EMH. 15. Behavioural finance, in contrast to mainstream finance, focuses on what aspects of capital markets?

Behavioural finance focuses on decision making under uncertainty and, unlike mainstream finance, on the decision makers, using the cornerstones of cognitive psychology and the limits to arbitrage. The limits to arbitrage suggest that low-frequency market evidence does not support market efficiency and the rationality of investors.

16. What does cognitive psychology tell us about investors?

Cognitive psychology tells us that: • • • • •

investors are not rational they make systematic errors in the way they think investors use heuristics to make decision making easier investors, especially male investors, are overconfident about their abilities they place too much reliance on recent experience

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Solution manual to accompany: Contemporary Issues in Accounting

• investors are influenced by the way information is presented, so that good image and high

awareness associated with a particular company results in a lower perception of risk • investors avoid realising paper losses but seek to realise paper gains • investors’ evaluation of returns is distorted by the size of the anchor they use as a starting

point for the evaluation • investors’ emotions affect their risk-return perceptions and investment behaviour.

17. Does cognitive psychology supply explanations of why investors have flocked to subscribe in high-profile companies such as Woolworths or Telstra?

Companies such as Woolworths and Telstra have high brand awareness within the Australian market. Cognitive psychology suggests that the brand and image awareness of these companies will result in investors perceiving them as a lower risk investment than other less high profile companies.

18. Evaluate whether behavioural finance is able to explain the main anomalies of efficient markets.

Student evaluations will depend on the evidence used by the student to support their position.

19. What are heuristics? How can they lead to poor decision making?

Heuristics are the rules of thumb used by decision makers to make decision making easier.

Affect heuristics suggest that positive emotional associations with a particular company will result in that company being a lower perceived investment risk. Other heuristics relate to an investor’s past experience — they place too much weight on that experience so that they place too little weight on long term experiences. Other heuristics separate decisions that should be combined.

20. How would you evaluate large amounts of research findings that are based on associations, without much theoretical underpinning? O 6 Answers to this question depend on the standpoint taken. For example, the use to which the associations are put will determine how these research findings are evaluated. If the findings are reasonable predictors of future events, then they may be valued by those using them as predictors.

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Application Questions: 8.1

Marcus Padley, a stockbroker, made the following statements in an article in the Sydney Morning Herald. (J, K, AS, CT) I love ‘The Warren Buffet Way’. In fact, one of my first clients introduced himself by saying, ‘I am Fred and I’d like to invest the Warren Buffet Way’. Well whoopee do!

What shall we do? Get the annual reports of the top 200 companies. Analyse the accounts of each, assess ‘value’ and then go to the stock market and find out that ‘wow, I’m right and the whole market is wrong’ and the share price is trading below the true ‘value’. Then purchase the shares and wait for that value to inevitably emerge.

In fact most Warren Buffett-based approaches are terrible at timing, which in reality is about the only thing that really matters. In an increasingly impatient market it is not just about ‘what’, it is becoming all about ‘when’. Investors who sat through the 54.5per cent fall in the market in the financial crises need to earn 113% to get their money back. That’s 13 years of compounding average annual returns. Not caring about ‘when’ just cost us 13 years.

(a) Critically evaluate the two statements made by Marcus Padley in the context of capital market research. J In relation to the first statement, a critical evaluation should take into account that • EMH says that share prices reflect all available information – the client is assessing available information • The accounts in the annual reports are based on accounting principles which do not capture all the information relevant to share prices, particularly information about intangibles which make up a high proportion of the assets held by many listed firms • Earnings management may distort the accounts.

In relation to the second statement, a critical evaluation should focus on behavioural finance – investors do not sell early enough. Behavioural finance says that investors will try to avoid the loss by holding onto their shares hoping for a rise in the market.

8.2

In December 2008, OZ Minerals wrote down its assets by $201 million. In its 2010 accounts it reversed this impairment charge, recording an increase of $141.1 million to net profit. The impairment reversal was a non-cash adjustment — it did form part of OZ Minerals’ operating earnings. As a result, the market was reported to have found the reversal of historic interest only. However, after the announcement of its 2010 earnings, OZ Minerals’ share price outperformed the broader mining market, rising by over 3%. (J, AS) (a) If the reversal was of ‘historic interest only’, how can the share price reaction be explained?

Intuitively, the increase in net profit should result in an increase in the share price as an increase in net profit is good news; good news is expected to increase share price. The impairment reversal may have been part of earnings management. The EMH suggests that investors should see through cosmetic earnings management but behavioural theory suggests otherwise. Investors decisions are multifaceted, easily changed and seek satisfactory solutions rather than optimal ones. Perhaps the 2010 earnings announcement was “satisfactory”.

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Solution manual to accompany: Contemporary Issues in Accounting

8.3

In September 2008, the Seven Network revealed it had incurred losses on its strategy to ‘park’ hundreds of millions of dollars in listed securities which were the result of the sale of half of its TV and magazine interests to a private equity firm, a strategy which the company had not revealed to the market. Seven’s share price closed at its lowest level since January 2005. (J, K) (a) What is a ‘private equity firm’?

A private equity firm is an investment manager that makes investments in the equity of companies through a variety of investment strategies including leveraged buyouts and venture capital. It raises funds that will be invested in accordance with one or more specific investment strategies and will receive periodic management fees as well as a share in the profits earned from each of its managed funds. One of their well known strategies is to acquire a controlling position in a company and then look to maximize the value of that investment. (b) Why do you think the share price fell? J Probably due to investors finding out about the transaction whether by insiders who publish investor news sheets, or though disclosure by non-Seven media. (c) Was it a response to the lack of disclosure? J Debatable, but probably to the fact that the Seven Network revealed the losses. (d) Was it a response to the losses incurred by the strategy? J Intuitively, that is a possibility, although post earnings announcement drift suggests that because the announcement was of losses, the fall in the share price should have been delayed.

8.4

Talking to the financial press about the David Jones 2010 earnings from its department store business, its CEO acknowledged that it had been a tough time for the company due to the departure of its former CEO after sexual harassment claims against the former CEO. The current CEO said the company should be judged on two indicators: sales and share price. He distinguished between the man (the former CEO) and the David Jones’ 170-year old brand. David Jones’ shares rose 2%. (a) Do you agree that a company such as David Jones should be judged on sales and share price? (J)

Answers will depend on the point of view adopted. Shareholders who want dividends and capital gains would favour sales and share price. Stakeholders would be wider in their views, judging a company from a corporate citizenship perspective. (b) Why is the distinction between the ‘man’ and the ‘brand’ important? (AS) The brand is longer lasting. CEO life expectancies are short especially if they do not deliver on what the Board of Directors want.

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(c) If brands are so important to a company’s share price, why are internally generated brands not recognised under accounting rules? (AS) Accounting standard setters are conservative in relation to intangibles such as brands. See the chapter on special reporting issues.

8.5 The behaviour of the former CEO of David Jones apparently did not impact the company’s share price. However, according to a study by two American economists, the transgressions of Tiger Woods were responsible for wiping up to $US12 million off the value of his sponsors (Gatorade, Nike, Gillette, Electronic Arts). Gatorade and Nike were the worst hit of his sponsors. (a) How can this apparent contraction between the impact of the David Jones’ CEO and Tiger Woods be explained? J Tiger Woods was promoted as the personification of the ideals that were built into the brands of companies such as Gatorade and Nike. When he was shown not to incorporate those ideals, the share price was punished for those companies probably for using him as their brand image. The DJ’s CEO did not feature in advertisements for the store and its owning company.

The media also suggested that the Board’s decisive move to remove him as CEO reflected well on shareholders, hence the lack of punishment of the share price. (b) What does the impact on sponsors’ shares say about the adage that ‘any publicity is good publicity’? J In this case, the adage did not apply.

8.6 Read accounting standard AASB133/IAS33 Earnings per Share and answer the following questions. (a) How is earnings per share calculated? (K) EPS is calculated by dividing profit or loss attributable to ordinary equity holders of the parent entity (the numerator) by the weighted average number of shares outstanding (the denominator) during the period. (b) What are some of the allocations, predictions and wild guesses that go into the calculation of net income? (K) • • • •

Definitions of income, revenue, and expenses which exclude certain transactions Recognition criteria which excludes further transactions Allocations of revenues and expenses to prior or future periods Depreciation calculations (c) In light of the allocations, predictions and guesses, how reliable do you think the earnings per share are as a summary of a firm’s activities for a period? (J, AS)J A

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Solution manual to accompany: Contemporary Issues in Accounting

Students should address the meanings of “reliable” both from a dictionary meaning and the accounting meaning. Answers will depend on how well the student can support their argument.

8.7

For the 2010 financial year, Phoslock Water Solutions had: • • •

Revenues from ordinary activities up by 79%.

Earnings before depreciation, amortisation, tax and interest improved by 40%.

Net loss for the period improved by 33% over the previous year’s loss.

(a) What would you intuitively expect to be the market reaction? (J) Intuitively the share price should have risen. (b) Over the following two weeks, the company’s share price fell by a third. The directors could not offer a business reason for the fall. Can you suggest a reason(s) for the fall? Explain your reasoning. (J, AS) Answers should be assessed by the student’s argument behind their explanation.

8.8A Geoffrey Hill, a private share consultant, made the following statements.

Comment on each statement, noting that some might require some research on your part. (a) First statement: The trouble with all of this overseas money flowing into our market and pushing it to new levels is that overseas investors have different views on what ‘value’ means. The sheer weight of money obviously increases share prices but the institutions investing for overseas investors have scant regard to the level of risk that they are adding to everyone’s portfolios.

(i) What do you understand by ‘value’ in the context of this statement? (SM)S Different answers are to be expected.

M (ii) What is a portfolio? What role does risk play in the composition of a portfolio? (K) A portfolio is a number of different shares selected to achieve a particular purpose such as the minimisation of risk associated with share ownership. By diversifying the shares in the portfolio, risk is average across the shares. However, portfolios can contain only low risk ‘blue chip’ shares.

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(b) Second statement: We have become accustomed to low oil prices, over the past 20 years. This has created a disincentive not to develop alternative energy supplies due to economics.

But it is a different story now with the oil price near $US50 a barrel. Pacific Hydro operates hydro and wind farms in Australia, Chile, Fiji and the Philippines. As new projects come on line, the economics and profit become stronger. It is trading on a P/E of 16 and dividend yield of 1.4 per cent. There is no value here for the Chartist’s Portfolio so we will not be investing.

(i) What is a ‘Chartist’?

A chartist is a share market analyst who plots the price trends of shares on charts to deduce trends which will give an indication of what the markets will do in the future. Identified trends are used for buy and sell decisions relating to those shares. (ii) What makes his or her share purchasing decisions distinctive? K Chartists believe that all significant information about a company’s performance is already reflected in its share price, and so the study of price movements will provide the key to investment decisions. Other tools used by investment analysts are not used in their decision making.

8.9 The listed investor, Djerriwarrh, had a solid year in 2009, but not according to IAS rules. Its net operating profit rose by 21.1% despite holding nearly 29% of its portfolio in bank shares. Because of AASB139/IAS39 Financial Instruments: Recognition and Measurement, it had to report a pre-tax ‘impairment’ charge of $70.9 million and a net charge of $49.7million pushing its results to a loss of $14.1 million. Shares in the Djerriwarrh portfolio qualified for the charge, shares that were not even remotely close to going broke but were impacted by the global financial crisis share market rout. The problem is that as share prices recover, impairment charges already taken against earnings cannot be reversed. (a) Does the accounting impairment rule, as it stood in 2009, make sense? (J) No, it did not as the companies in which Djerriwarrh had shares (AMP, Brambles and AIG) were not likely to go broke. The rule did not envisage a share market crisis of the size of that generated by the GFC. The rule also did not make sense in that reversals in the share price (future gains) had to by-pass the profit and loss (income) statement, being taken to the balance sheet as adjustments to reserves. (b) What changes were made to AASB139/IAS39 Financial Instruments: Recognition and Measurement as a result of the unforeseen consequences such as that suffered by Djerriwarrh? (K) The main change was to allow companies like Djerriwarrh to book changes in the value of their shares against balance sheet reserves.

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Solution manual to accompany: Contemporary Issues in Accounting

(c) As a result of the changes, will investment companies that book impairment losses to the balance sheet be able to report dividend income as income? (K)S CTLO 7 No, they are no longer able to report dividend income as income!

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Case Study Questions Case Study 1 Who needs credit ratings? They should be optional 1.

What is the function of a credit rating agency? (K)

A credit rating agency is a company that assigns credit ratings for issuers (companies, governments, banks and such) of certain types of debt obligations as well as the debt instruments themselves. Issuers are organisations issuing debt-like securities that can be traded on a secondary market. A credit rating for an issuer should take into consideration the issuer's ability to pay back a loan. The credit rating affects the interest rate applied to the particular security being issued.

2.

Why have these agencies prospered? (J)

As noted in the case study, these agencies have prospered because “government regulators, through the Basel II bank regulations to take one example, have in effect required all companies and countries to have credit ratings that indicate how likely a particular entity is to default... The world’s largest rating agencies, which enjoy regulatory clout, Standard & Poor’s, Moody’s and Fitch, have grown fat and powerful on the back of these mandates”.

3.

Why do credit ratings ‘underpin the world’s financial system’? (K)

As noted in the case study, for regulators, ratings are a simple and cheap way to monitor and compare the riskiness of financial institutions. The popularity of ratings as a simple and cheap way to monitor financial institutions mean that they now underpin the world’s financial system so that ratings now critically influence the composition of every bank’s balance sheet.

K 4. Can you offer reasons why credit rating agencies would have valued US sub-prime mortgages as AAA? (J, K) Because the issuers of the sub-prime mortgages would have paid the credit rating agencies for the rating. The complex nature of the sub-prime mortgages would have helped also to mask the risk associated with them.

K 5. Why does the author have a low opinion of credit ratings? (J, K) Because “the agencies rarely disagree with each other, they are paid exclusively by borrowers who hanker for higher ratings, their regulatory sinecure protects them from any competition, and as mere opinions, they cannot be held legally accountable for stuffing up”.

6. J K 6. What is meant by ‘moral hazard’? (K) Moral hazard as a special case of information asymmetry in that it refers to a situation in which one party in a transaction has more information than another. Moral hazard occurs when the party with more information about its actions or intentions has a tendency or incentive to behave inappropriately from the perspective of the party with less information.

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7.

Explain the statement that the finance sector is ‘replete with moral hazard and chock full of malign incentives’. (J, K)

Need to explain that moral hazard is information asymmetry – the borrower knows more about their ability to repay a loan than the lender, and therefore has incentives to deceive the lender in order to gain the loan.

8. Can you suggest why making credit ratings optional would ‘cure these perversions’?

(J, K) Because the finance sector would have incentives to make risk assessments rather than pay a credit rating agency to do it for them.

K 9. Research the following: (a) The author is a research fellow of the Centre for Independent Studies. Is this Centre ‘independent’? (J, K) The Centre’s website proudly states that the CIS is actively engaged in supporting a market economy and a free society under limited government where individuals can prosper and fully develop their talents. (b) How have ratings been used to regulate the investment decisions of local government? (J, K) The NSW Local Government Act restricted the investment decisions of local government to securities which were rated AAA (the highest rating assigned by the rating agencies). (c) How have the ratings resulted in large investment losses for many NSW local governments? (J, K) Many NSW councils claim they were misled by representatives of the ratings agencies who said that the products, CDOs and other credit derivatives, were rated AAA. According to newspaper reports of the action taken by NSW local governments against the rating agencies, not only did the raters and vendors know of the extreme risk of the products the councils were buying but they did not properly disclose the risks to the councils. They were fundamentally misled”. With the Global Financial Crisis, councils lost millions on the purchase prices of these AAA rated “investments”.

Case Study 2 Women take more risks when investing: survey 1.

What do you understand by a ‘life cycle theory of investing’? Does the research by BT and UWA support this theory? (J, K, AS)

The life cycle theory of investing posits that persons choose planning horizons which shorten as individuals get older. During their lifetime, individuals will also reassess their portfolios, the time between reassessments being determined by their wealth and the ways in which they hold that wealth. At each stage in their lifetime, individuals must determine the mix of

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consumption, wealth tied up in risky assets and the amounts they wish to spend on leisure purchases.

As an individual ages, the amount of their wealth tied up in human capital declines, the amount that is investment in risky assets also declines as their flexibility to work longer, change jobs etc decreases. In the case study, this is reflected in younger individuals holding more growth (riskier) assets than older individuals.

2.

How does being wealthy affect investment choices? (J)

The theory suggests that wealthier individuals are prepared to take more risks — the more wealthy an individual is, the greater the holding of risky assets.

3.

What other factors seem to affect investment activity? (K)

Age and gender 4.

How do the findings by BT and UWA differ from the findings and predictions of behavioural finance? (J, AS)

• In contrast to the predictions of behavioural finance, the BT, UWA respondents did not

hold on to their losing investments and sell their winning investments; • Female investors were more prepared to invest in risky assets than their male counterparts.

5.

In what ways do the BT and UWA findings confirm or deny the predictions and findings of behavioural finance? (J, AS)

Many of the cornerstones of behavioural finance are neither confirmed or denied by the BT, UWA findings. Those which are contradicted are those relating to buy/sell strategies and investment behaviour linked to gender.

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Solution Manual to accompany

Contemporary Issues in Accounting Michaela Rankin, Patricia Stanton, Susan McGowan, Kimberly Ferlauto & Matt Tilling PREPARED BY:

Michaela Rankin

John Wiley & Sons Australia, Ltd 2012

Chapter 9: Earnings management

CHAPTER 9 EARNINGS MANAGEMENT Contemporary Issue 9.1: Considering earnings quality in investment decisions 1.

Explain the three criteria usually considered important in assessing earnings quality. (K)

The three criteria considered important in assessing earnings quality are: Trend in profit results: This related to consistency over a significant time period.

Assessing trends requires analysis of how much profits vary from year to year. If profits are increasingly steadily over time the company is assumed to be a more attractive investment than a company with volatile earnings.

Operating/non-operating mix: It is important to assess whether profits are generated from operations or whether they are related to abnormal items. Abnormal items are generally non-recurring, and a company should be attempting to generate most of its profits from normal operations.

Earnings base: the more diversified the sources of earnings are, the more attractive an entity is likely to be. If a company earns profits across a range of geographic regions and markets it is less likely to be at risk if one of those markets fails.

2.

Outline two advantages to a company from having high quality earnings. (J)

High quality earnings provides information to analysts and shareholders about the quality of management of the company, and meets their expectations and predictions.

As pointed out in the article, the better the quality of earnings, ‘the more consistently the company should be able to deliver solid results’.

Quality of earnings is likely to lead to a more accurate future earnings forecast. As such it can affect company share price.

3.

Given the information you have already addressed in this chapter, what are some methods companies could use to ensure they present consistent profits?

(J)

Entities can use a number of methods to present consistent profits. These include: Accounting policy choice – where managers have flexibility in making accounting choices, they can chose policies that manage timing differences and the amounts of expense recognition and asset valuation, for example.

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Solution manual to accompany: Contemporary Issues in Accounting

Accrual accounting – companies will manage accruals to generate consistent revenue and earnings growth.

Income smoothing – managing fluctuations in income by shifting earnings from peak periods to less successful periods. This is also related to accrual management.

Real activities management – managing operational decisions rather than accounting policies and accruals. This can relate to discretionary spending on research and development or advertising, offering price discounts to maximize sales towards the end of an accounting period etc.

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9.2

Chapter 9: Earnings management

Review questions 1.

Define what is meant by ‘earnings’ and outline why it is important to shareholders.

Earnings is another name for net income or profit. Earnings are important to shareholders as a measure of entity performance, as they indicate the extent to which the entity has engaged in activities that add value to it. They are used by shareholders to assess managers’ performance, and to assist in predicting future cash flows and assess risk.

2.

Explain what is meant by earnings management.

Earnings management has been defined in a number of ways including: to ‘managers use judgement in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company, or to influence the contractual outcomes that depend on reported accounting numbers’ from Healy and Wahlen (1999), or the more conservative definition by McKee (2005) as ‘reasonable and legal management decision making and reporting intended to achieve stable and predictable financial results’. The above definitions differ on whether normal financial decisions are part of the definition, or whether the purpose of earnings management is to mislead.

3.

Is earnings management always bad? Explain your answer.

No, earnings management is not always bad. Ronen and Yaari (2008) classify some earnings management decisions as ‘white’, referring to beneficial earnings management that enhances the transparency of financial reports. It can signal longterm value to stakeholders.

4.

How can accounting policy choice be considered earnings management?

Explain your answer.

Accounting policy choices are made within a framework of applicable accounting standards. Standards provide flexibility to management in making accounting choices.

These can include valuation of inventory, straight-line or accelerated depreciation etc.

A choice between different accounting methods will lead to different timing of expenses, the amount of expenses that are recognized and recognition of expenses. As such accounting methods can be used to manage asset values and earnings.

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Solution manual to accompany: Contemporary Issues in Accounting

5.

What is income smoothing and how is it commonly used to manage earnings?

Income smoothing moderates year-to-year fluctuations in income by shifting earnings from peak years to less successful periods. It relies on accrual accounting practices such as early recognition of sales revenues, variations in bad debts and delaying asset impairments. It is commonly used in earnings management to present consistent firm value over time and continuous growth – evidence of high quality earnings.

6.

Why and in what circumstances would a management team consider engaging in big bath accounting?

Big bath accounting refers to large losses reported against income. Management might consider using big bath accounting when there is a change in the management team, with the need to write-off assets or operational units that were under-performing under the previous management team. They are also used when restructuring operations, when there is a need to restructure debt, with significant asset impairment or disposal of operating units.

7.

Provide two reasons why entities might engage in earnings management.

There are two main reasons for engaging in earnings management: (1)

(2)

8.

Earnings are managed for the benefit of the entity, including to meet analysts’ and shareholder expectations and predictions, and to maximize the value of the entity, to convey private information or to avoid violating restrictive debt covenants; To meet short-term goals which lead to maximizing managerial remuneration and bonuses.

How is earnings management related to entity valuation?

A number of methods are used to value an entity including which rely on using current values to forecast future value. One of the following are commonly used: book value, operating cash flow and net income. Share prices are more highly aligned with net income than with operating cash flow, so income, or earnings, is commonly used to determine entity value. As this is very important to analysts and shareholders it leads to managers ensuring earnings are smooth, with little volatility. Earnings volatility can be an indication of the increased chance of insolvency. They want to send a message to shareholders that the firm is a strong investment.

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Chapter 9: Earnings management

9.

What is ‘earnings quality’ and how is it related to earnings management?

Earnings quality relates to how closely current earnings are aligned with future earnings. Current earnings, which are highly correlated to future earnings, are said to have high earnings quality and lead to a more accurate future earnings forecast. This leads to more confidence in the entity, and greater demand for shares.

Because of this, managers have incentives to manage earnings to limit volatility – ensure smooth earnings and to improve earnings quality.

10. Explain why managers who receive a cash bonus as part of their remuneration might wish to manage earnings.

Managerial bonuses are generally tied to a range of firm performance measures, including earnings. Agency theory assumes managers are self-interested and wish to maximize any financial rewards. As such, they will manage earnings, including income smoothing, accruals management and accounting policy choices to maximize earnings, and consequently their bonus.

11. Why is corporate governance important for evaluating corporate earnings management?

The board of directors is responsible for approving plans strategies and investment decisions made by the management team. How the board functions – corporate governance – is essential to the overall operation and future of the company. The constitution of the board, including their expertise and independence are important in determining how likely it is that managers are able to manage earnings. Strong governance means a balance between corporate performance and an appropriate level of monitoring. When the board fails in this role, and is seen to merely ‘rubber stamp’ managerial decisions, it is more likely that inappropriate earnings management can result.

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9.5

Solution manual to accompany: Contemporary Issues in Accounting

Application questions 9.1 Table 9.1 presents examples of some common accounting decisions, and how companies following a conservative, moderate, aggressive or fraudulent strategy might use these to manage earnings. Prepare a similar table and complete it in relation to the following accounting decisions: (a) Revenue recognition from services (b) Intangible assets (c) Impairment of non-current assets (d) Revaluation of non-current assets (K, J) Conservative Services are prepaid and performed in full Regularly impair, do not revalue even in an active market

Moderate Services prepaid and partially performed Slow to record impairment losses

Impairment of non-current assets

Conservative impairment policy used

Revaluation of non-current assets

Use cost basis of accounting

Slow to record Non-current impairment assets are losses impaired but no impairment loss recorded Record Revalue nonrevaluations current assets annually using when no generous change in fair valuations value

Revenue recognition from services Intangible assets

Aggressive Services are agreed to but not yet performed Revalue intangibles even when no active market

Fraud Fraudulent scheme

Overstate intangibles where nonexistent intangibles are recognised Fictitious noncurrent assets recorded to bolster asset balances Upwardly Revalue impaired noncurrent assets estimates to meet earnings targets

9.2 Examine the 2010 annual report of Qantas Airways Ltd, available at www.qantas.com.au. Review the corporate governance statement and evaluate how successful you think the board structure is likely to be in limiting earnings management. In particular, consider the board size, independence, and committees in place. Prepare a report of your findings.

(K, J, CT) The corporate governance statement starts on page 20 of the annual report. This details committees, and how the company meets the ASX good corporate governance recommendations. Other information that is useful to the completion of a report on .

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Chapter 9: Earnings management

Qantas governance strategies that are likely to limit earnings management is found on pages 10-11 of the annual report – details of the board of directors, their experience and qualifications.

A report should include the following information: The Qantas board is a large board, with 10 members. Nine of these members are independent non-executive directors (the only non-independent executive director is the CEO Alan Joyce). A large, independent board is less likely to merely ‘rubber stamp’ decisions of the executives and the CEO so is more likely to limit the use of earnings management.

The committee most relevant to earnings management is the audit committee. The audit committee of the Qantas board is comprised of four independent directors. The CEO is not a member of the board. All members are financially literate. A review of their qualifications on pages 10 and 11 indicate that the chair is a fellow of the Institute of Chartered Accountants and is a CPA. He previously held the role of senior partner of Ernst and Young, which is likely to indicate he is well versed in appropriate accounting methods, use of accruals and income smoothing techniques.

All other members have experience in finance or banking roles, meaning they are also in a position to be critical of any aggressive earnings management techniques management use.

Other relevant corporate governance strategies relate to executive remuneration. The remuneration report is developed by the remuneration committee, and the report is disclosed in the financial reports of the company. It is important that it includes a range of both short term and long term performance targets, and they are not all linked to metrics that executives can ‘manage’ – such as earnings.

9.3 Outline the three methods discussed in this chapter that entities can use to manage earnings. Discuss the circumstances in which entities are likely to use each method. (K) The three methods entities can use to manage earnings include: Accounting policy choice – where managers have flexibility in making accounting choices, they can chose policies that manage timing differences and the amounts of expense recognition and asset valuation, for example. Entities may choose to alter change accounting policies at a time when they change an accounting estimate (for example extending the useful life of an asset) or changing the use pattern of an asset (eg. changing form straight line to reducing balance depreciation). If a company changes accounting policies they will need to provide the auditor with documentation to justify the decision. As such, it is more costly than accrual accounting or income smoothing.

Accrual accounting – Accrual accounting techniques generally have no direct cash flow consequences. They can include recalculating impairment of accounts receivables (provisioning for bad debts), delaying asset impairment, adjusting inventory valuations, amending depreciation and amortization estimates, including expected useful life and residual values. Companies will manage accruals to generate consistent revenue and earnings growth.

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Solution manual to accompany: Contemporary Issues in Accounting

Income smoothing – relates to managing fluctuations in income by shifting earnings from peak periods to less successful periods. This is also related to accrual management. It can include such activities as early recognition of sales revenues, variations in bad debts or warranty provisions, or delaying asset impairments. Income smoothing is used to present the appearance of constant growth, and limit volatility in earnings. companies will manage accruals to generate consistent revenue and earnings growth.

9.4 You have recently been appointed as a researcher for a firm of share analysts. As one of your first roles you are required to prepare a report for your manager to outline common techniques used to manage or manipulate earnings. From your prior accounting knowledge you would have gained an understanding of techniques you can use to examine entity performance and profitability, including trend analysis. Document what strategies you might use as an analyst to detect earnings management using accounting information. (K, J, CT) There is a range of techniques analysts can use to examine financial data to detect earnings management. A number of these are outlined in Contemporary Issue 9.1.

These can include: Examine trend in profit results – the analyst should be able to determine if profits are consistent, and growing gradually over time, or if they vary significantly from one year to the next. Analysts can also access half yearly, and sometimes quarterly data that can assist in this assessment. Is the company subject to seasonal variations? Are they meeting forecasts on a half yearly basis?

Operating/non-operating mix – analysts need to determine which part of the business is generating profits. If earnings are being generated through non-recurring items such as gain on sale of fixed assets, rather than current operations, it may indicate a problem with meeting earnings forecasts and continued increases in earnings.

Earnings base – analysts should examine from where the company sources earnings.

If they are spread across a number of operations or sectors there is a higher likelihood of longer-term success than if the company relies on only one operation, or even one major customer.

Analysts should also look at the change in debt arrangements in place, and leverage ratios. This may give an indication of earnings management being used to avoid breaches of covenants etc. Similarly, executive compensation arrangements and performance hurdles managers are required to meet to obtain bonuses are going to provide an indication of the extent to which earnings management is likely, if they are heavily based on earnings targets.

9.5 Obtain the Remuneration Report for a publicly listed company. Examine the compensation contract for the Chief Executive Officer (CEO). Document the range of remuneration components used in the CEO pay arrangements and what performance targets are used to determine both cash and equity payments. What earnings management techniques would the management

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Chapter 9: Earnings management

team be likely to use in these circumstances to maximise their short-term and long-term remuneration? Explain your answer. (K, J) A range of remuneration components and performance targets are used in the remuneration contract of CEOs. As an example, in the 2011 financial report of David Jones Ltd: The remuneration of the CEO consists of fixed pay, short term incentives and long term incentives. Page 39 of the annual report indicates that fixed pay constitutes 39%, short term incentives are 19% and long term incentives are 42%.

The table on page 45 indicates the range of performance targets that the CEO and other executives need to meet to receive short term bonuses. These include: net profit after tax, capital expenditure, and costs.

Long term incentives are based on: net profit after tax and total shareholder return.

Given both short term and long term incentives are linked to earnings/profits there are incentives for the executive team to manage earnings to maximize these performance measures. This can include use of accruals and income smoothing. Real earnings management through, for instance, managing costs are also likely to be used.

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Solution manual to accompany: Contemporary Issues in Accounting

Case Study Questions Case study 9.1: The ethics of earnings management 1.

Why would the NZSO wish to smooth income?

The NZSO would wish to smooth income because it needs to assure government (which provides grants) and sponsors that it is using the funds provided to it on an annual basis, and does not have a significant surplus over the medium term. This is important to ensure the continued support of these bodies for the NZSO. It is also important that the NZSO does not show large deficits in any year, as this can mean the management of the body will be questioned.

2.

Were the earnings management techniques the NZSO used ethical? Explain your answer.

The earnings management techniques were not used to mislead users, by presenting financial data that was entirely inaccurate. The difficulty with having the end of the financial year finishing in the middle of a concert season means the total costs and income for the entire season are going to be spread over two financial periods. The NZSO is not using methods to hide costs or overstate profits, they are merely using methods to smooth out costs and income over the medium term in order to ensure there are no periods with a large surplus followed by another with a large deficit. As such it would appear the management techniques are ethical.

3.

What factors would you consider when determining whether such a decision was ethical?

Some of the factors you would consider are: • Are the decisions designed to mislead stakeholders?

• Is the management of the NZSO using funds for alternative purposes?

• Do costs and income align over the medium term – e.g. over two or three reporting periods?

• What are the reasons behind the decision to smooth income?

Case study 9.2: Mastering corporate governance: when earnings management becomes cooking the books 1.

What earnings management techniques are outlined in the above article?

The article refers to both legitimate and less than legitimate techniques to manage earnings. These include: looking for loopholes in generally accepted accounting .

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Chapter 9: Earnings management

principles, earnings smoothing, accounting estimates and other discretionary judgments.

2.

What role can the audit committee play in detecting and/or limiting earnings management?

The audit committee needs to overview the policies used in measuring and reporting transactions, and ensure the methods used reflect a ‘true and fair view’ of the underlying transactions. They need to, identify and use their judgment to examine whether earnings management techniques are appropriate given the circumstances, whether they are legitimate, or whether they in fact obscure the true financial position of the company.

3.

What relationship does the audit committee have with the external auditors in ensuring earnings management is within acceptable limits?

The audit committee appoints the external auditors and ensures they are independent.

The external auditors will examine the policy and processes the audit committee uses to assure the truth and fairness of the financial information they are auditing. The audit committee represents the company in any dealings with the external auditors, and need to be in a position to answer any of their questions and provide justification for any earnings management techniques used.

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9.11

Solution Manual to accompany

Contemporary Issues in Accounting Michaela Rankin, Patricia Stanton, Susan McGowan, Kimberly Ferlauto & Matt Tilling PREPARED BY:

Matthew Tilling

John Wiley & Sons Australia, Ltd 2012

Chapter 10: Fair value accounting

CHAPTER 10 FAIR VALUE ACCOUNTING

Contemporary Issue 10.1 How to conjure up billions

1.

What is the relationship between liabilities and the recording of goodwill? (K)K

GM recorded some of its liabilities at amounts that exceeded fair value, primarily related to employee benefits. The difference between those liabilities’ carrying amounts and fair values gave rise to goodwill as the identifiable net assets were reduced creating a difference with equity value that was ‘filled’ with goodwill. The bigger the difference, the more goodwill GM booked. In other instances, GM said it recorded certain tax assets at less than their fair value, which also resulted in goodwill.

On the liabilities side, for example, GM said the fair values were lower than the carrying amounts on its balance sheet because it used higher discount rates to calculate the fair value figures. The higher discount rates took GM’s risk of default into account, driving fair values lower.

2.

Explain how GM can argue that because it has a higher risk of default the fair value of the liabilities would be lower than their carrying amount. (J, K)

This is a direct result of the requirement that liabilities be carried at their market value.

Remember that the IASB in the Basis for Conclusions paragraph BC88–BC89 to IFRS 13 states that “the fair value of a liability equals the fair value of a properly defined corresponding asset”. Someone holding GMs debt would reduce its value to account for a higher default risk. This translates into a lower liability value, as the companies on credit risk must be included in the calculation.

JK 3. Discuss what would be most relevant to the users of GM’s financial statements with regards to the valuation of the liabilities. (J, K, AS) This is an interesting issue. Surely the expected amount to be paid is most relevant. In fact it could be argued that by taking into account the entity’s own credit risk the principles of going concern have been violated.

Contemporary Issue 10.2 Serial floats and patent porkies 1.

Describe the three acceptable valuation techniques and how they could be used the fair value of the patent in this scenario. (K) a)

The market approach is based on the ability to identify a market for an identical or comparable asset or liability.

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10.1

Solution manual to accompany: Contemporary Issues in Accounting

This would require a similar patent to be identified and then a market price established. In reality it is very unlikely that a similar enough patent will be found as patents by their nature are meant to be unique. Also there is not a well-established or active market. b) The income approach is based on converting future cash flows or income and expense into a single present value.

This would require the use of cash flow budgets and significant estimates of future performance. c)

2.

The cost approach is based on an estimate of the cost of replacing the ‘service capacity’ of the asset under consideration.

This would focus simply on the cost incurred to date in securing and developing the patent.

Provide examples of the inputs you could use to establish the fair value of the patent and to what level those inputs would be assigned. (J, K, AS)

There are a range of potential inputs to any model employed to value a patent. The majority, other than costs, are going rely heavily on unobservable assumptions and are therefore going to be level 3 inputs.

3.

Given that the valuation of the patent did involve a sales transaction would this indicate that the market approach was the appropriate one to use in this case?

What weight can be placed on the ‘independent valuation’? (J, K)

It would appear that the sale was not a market transaction as it involved related parties and therefore does not represent a market approach, therefore it is not appropriate to use in this case. The independent valuation is worrying, though it is difficult to tell from the article whether it was the patent that was valued or the transaction. IT could be perfectly true that 24 million was “paid” for the patent and this is what has been verified. It is also possible that the “transactions” are not inappropriate, the question is the recording in the accounts.

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10.2

Chapter 10: Fair value accounting

Review Questions 1. Why has the IASB decided to release a standard on ‘fair value’, given that it is a general term, rather than a specific accounting issue?

Because it is seen as such a key concept in accounting and is used across so many standards the IASB clearly feels it is important to crystallise all the relevant material in a single standard. It will be interesting to see how this standard integrates with the Conceptual Framework as the measurement concepts are developed and expanded in the coming months and years.

2. What alternative measures are used in the accounting to value items? Provide specific examples.

As discussed in Chapter 4 Measurement accounting uses a mix measurement model.

Traditionally historic cost has been the predominant measure in accounting. It focuses on the actual amount paid for an item though adjustments may be made over time to account for changes in the asset. This approach is used for many items including intangibles, property plant and equipment, and inventory.

Current replacement cost is the amount that would be paid at the current time to purchase an identical item. It can be used to measure inventory when current cost represents net realisable value.

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. It can be used to measure property plant and equipment under the revaluation model.

Present value is the present discounted value of the future net cash flows associated with the item. It can be used to measure the value of biological assets.

3. What are the main arguments against the old definition (i.e. the one presented in Appendix A of AASB 3) of fair value?

IFRS 3/AASB 3Business Combinations Appendix A defined fair value as: The amount for which an asset could be exchanged, or a liability settled between knowledgeable, willing parties in an arms-length transaction.

The use of the word ‘exchanged’ is problematic. In this hypothetical transaction, is the asset being measured from the point of view of the buyer or the seller?

Applying the definition to liabilities is a little confusing. First, what do we mean by settle a liability. In reality, a liability isn’t settled with knowledgeable and willing parties, but rather a creditor who has a right to receive the money.

The definition does not make it clear on which date this exchange should be valued.

What does it mean to be a ‘willing’ party? An organisation may be in distress and in urgent need of cash and therefore willing to sell an asset at a deep discount for rapid reimbursement.

4. Identify and discuss the objectives of the fair value standard.

The fair value standard has the following objectives:

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10.3

Solution manual to accompany: Contemporary Issues in Accounting

(a) to establish a single source of guidance for all fair value measurements required or permitted by IFRSs to reduce complexity and improve consistency in their application; (b) to clarify the definition of fair value and related guidance in order to communicate the measurement objective more clearly; and (c) to enhance disclosures about fair value to enable users of financial statements to assess the extent to which fair value is used and to inform them about the inputs used to derive those fair values.

These certainly appear to justify the need for an authoritative standard on fair value. The first is focussed on accounting information producers, while the second is focussed on users. The third objective is the most significant in some ways. While the IASB stated they did not want to significantly change accounting practice around fair value simply clarify, the enhanced disclosure has brought with it significant additional requirements for reporting entities and accountants.

5. What is the new definition of fair value? Explain the key parts to this definition.

The definition of fair value in paragraph 9 of IFRS 13 Fair Value Measurement is: The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

Key parts of this definition are: Price - it is based on an exchange value.

Would – it can be a hypothetical transaction.

Received to sell – it is an exit price Paid to transfer – again an exit price.

Orderly transaction – Market has time to operate and no duress.

Market participants – Arms-length transaction Measurement date – the date the transaction would be assumed to occur.

6. Why has the IASB chosen to use exit price as the primary measure of fair value?

The use of an exit price offers a number of advantages. First, it is current. It allows users to focus on a value today, not some historic price that may or may not be relevant under today’s conditions. Second, it is specific. It focuses on the asset or liability at hand, rather than the price to purchase a generic equivalent item. Third, it has a level of independence by introducing, if only hypothetically, an external party into the transaction. The value is based on its estimate of value, not the price the entity was, or is, prepared to pay for the item.

7. Assuming an entity does not want to sell an asset, how is exit price useful to the users of that entity’s financial statements?

Exit price is seen to capture more than just the price of an asset but more intrinsically its value in use. As discussed in the text we can put up an economic rationalist argument that ultimately concludes that the exit price must closely approximate the expected future benefit contained in the asset. The same logic can also be applied to liabilities.

The point where a sale will occur is therefore constrained by the minimum the current owner will accept and the maximum the potential buyer will pay and both are determined with

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Chapter 10: Fair value accounting

reference to the expected future benefit to be received from the asset. There may be some difference in opinion or potential benefit or risk tolerance based on access to skills or markets, but in a reasonably efficient market these differences will not be significant.

Therefore, the sales price of an asset can be taken as a fair estimate of its future value, or the expected future economic benefit to be realised, which is a fundamental part of the definition of an asset.

And this expected future economic benefit is also assumed to be useful information to the users of the entity’s financial statements.

8. The existence of a market is very important to determining fair value. What factors would indicate an appropriate market exists?

Appendix B to the standard, which contains the application guidance, devotes considerable discussion to how to identify when a market is not to be considered active, and therefore not amendable to an orderly transaction and so not an appropriate basis for assigning a fair value.

Based on the factors identified in paragraph B37 we can conclude an active market DOES exist when: (a) There are sufficient recent transactions. (b) Price quotations are developed using current information. (c) Price quotations don not vary substantially either over time. (d) There exist Indices that are highly correlated with the fair values of the asset or liability. (e) There are low implied liquidity risk premiums, yields or performance indicators (such as delinquency rates or loss severities) for observed transactions or quoted prices. (f) There is a narrow bid-ask spread or at least a steady bid-ask spread. (g) There is a market for new issues (i.e. a primary market) for the asset or liability or similar assets or liabilities. (h) Information is publicly available.

9. If it is determined that markets for the item under consideration are inactive, does that mean they cannot be fair valued? Discuss.

Under IFRS 13, if it is determined that the market is not active, then an entity may determine that significant adjustments are needed to quoted prices to accurately reflect estimated fair value, or in fact market prices may not be used at all. Instead, an alternative valuation technique (or techniques) may be used if deemed appropriate. The standard does not describe a method for making these adjustments should they be deemed necessary.

This creates some interesting issues.

So the obvious answer is yes, you can still fair value. But is it still a fair value in accordance with the definition if it is not based on market valuations? Probably not. A number of respondents to the exposure draft suggest that if a market does not form the basis of the valuation then it should not be called a ‘fair value’ but something else. The IASB decided this would be too confusing and did not introduce a separate terminology.

Second, does this create a dangerous precedent that may encourage accountants to declare a falling market (which is often accompanied by some of the indications of an ‘inactive’ market as described in paragraph B37) to be inactive. They can then make adjustments up to artificially increase the value of an asset?

10.

While fair values are based on market prices, the standard also states that fair values are based on the specific item being valued. What does this mean

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Solution manual to accompany: Contemporary Issues in Accounting

when considering the valuation of a share in company? A large piece of mining equipment?

The valuation of a share in a company should be a relatively straight forward undertaking.

Assuming the share is publically traded, and we are talking about a common class of share, there is a market and each share in the market is identical (having the same rights). So no adjustment should need to be taken to account for the fact it is a ‘different’ share that we are valuing.

The mining equipment will need adjustment. Even if there is an active market for the mining equipment we are fair valuing because each individual piece of equipment will have specific characteristics that will impact on the amount buyers are willing to pay. This could be condition, age, location, use based. So even in an active market consideration will need to be given to the value attached to the specific item being valued.

11. What are the limitations on determining the highest and best use for an asset when establishing fair value?

Paragraph 28 of IFRS 13 imposes three limitations to keep the estimates realistic and focused on the specific asset to be valued: (1) the use must be physically possible, taking into account, for example, the location or condition of the asset; (2) it must be legally permissible, considering for example zoning regulations; and (3) it must be financially feasible, meaning that even if physically and legally possible, it would be fiscally sensible to put the asset to the nominated best use.

12. Identify and discuss the hierarchy for fair valuing liabilities.

The standard sets out a hierarchy for valuing liabilities and equity. In the first instance, if there is an active market for the debt or equity, then this market will provide a fair value for the debt or equity. When public prices aren’t available for the debt or equity, according to paragraph 37 of IFRS 13 the entity should, where possible, ‘measure the fair value of the liability or equity instrument from the perspective of a market participant that holds the identical item as an asset at the measurement date’. Should no corresponding asset exist for a liability or equity then the entity needs to use a valuation technique based on the assumptions that would be used by market participants.

The first level is most consistent with the fair value ideal, but relatively uncommon for liabilities. The second level is interesting from an economic theory perspective. Also note that this is not the case under the leases standard for many types of finance lease, where often the lease liability does not equal the lease asset (note of course leases are excluded from the fair value standard). The third level is the most contentious and has the potential to significantly impact on firms that have liabilities for restoration.

13. Describe the valuation techniques that can be used to fair value an asset, which method is preferred?

Paragraph 62 states that there are three widely used techniques that can be used to fair value an asset and that the entity ‘shall use valuation techniques consistent with one or more of those approaches to measure fair value’. The techniques are outlined in some detail in Appendix B to IFRS 13.

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Chapter 10: Fair value accounting

The market approach is based on the ability to identify a market for an identical or comparable asset or liability. This approach is theoretically most directly related to the intention of the standard. Depending on the nature of the market, adjustments may need to be made to take existing transactions and best approximate the price that would be relevant to the specific item under consideration.

The income approach is based on converting future cash flows or income and expense into a single present value. Usually this would mean using discounted cash flow models, but could alternatively use much more complex models such as a Black–Scholes– Mertons options pricing approach.

The cost approach is based on an estimate of the cost of replacing the ‘service capacity’ of the asset under consideration. This is what is known as the current replacement cost in accounting theory. The cost is calculated not based on a new asset, rather an asset that would substitute to derive comparable benefit, taking into account the ‘obsolescence’ of the current asset.

The technique chosen is a matter for professional judgment however, paragraph 67 of IFRS 13 requires that the accountant maximise relevant observable inputs and minimise unobservable inputs. In practice this would mean that the market approach is most likely to be preferred. However, this also means that where a market is inactive, as previously discussed, alternative valuation methods are available to an entity.

14. Describe the 3 levels of inputs that can be used in valuing an item under AASB 13/IFRS 13. How is the valuation level ultimately determined?

Appendix A of IFRS 13 defines inputs as: The assumptions that market participants would use when pricing the asset or liability, including assumptions about risk, such as the following: the risk inherent in a particular valuation technique used to measure fair value (such as a pricing model); and the risk inherent in the inputs to the valuation technique.

Inputs may be observable or unobservable. Observable inputs are split into two levels, those that do not need to be adjusted, that is, they are based on active markets for identical assets or liabilities, these inputs are termed Level 1 inputs. Other observable inputs require adjustment to reflect quantitative or qualitative differences between the item under consideration and the market observed, these inputs are termed Level 2 inputs. Level 3 inputs are based on unobservable inputs that require estimation and inference by the entity.

In establishing the fair value of an item the entity will most likely have to use a range of inputs. Paragraph 73 of IFRS 13 is clear: The fair value measurement is categorised in its entirety in the same level of the fair value hierarchy as the lowest level input that is significant to the entire measurement.

‘Significant’ requires professional judgement to interpret.

15. What information must be disclosed when an item in the balance sheet is measured at fair value? How are the disclosures different depending on the level of input?

The principles for disclosure are set out in paragraph 91 of IFRS 13:

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Solution manual to accompany: Contemporary Issues in Accounting

An entity shall disclose information that helps users of its financial statements assess both of the following: (a) for assets and liabilities that are measured at fair value on a recurring or nonrecurring basis in the statement of financial position after initial recognition, the valuation techniques and inputs used to develop those measurements. (b) for recurring fair value measurements using significant unobservable inputs (Level-3), the effect of the measurements on profit or loss or other comprehensive income for the period.

The actual disclosures required are comprehensive, as indicated in paragraph 93 of IFRS 13, and are outlined in the text. As the level of measurement moves from level 1 through to level 3 the amount and nature of the disclosure becomes increasingly comprehensive.

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Chapter 10: Fair value accounting

Application questions 10.1 In light of the Conceptual Framework for Financial Reporting what are the broad arguments for and against the use of fair value and modified historic cost in accounting? [J,K] The argument over which is better, modified historic cost or fair value has traditionally formed around the terms relevance and reliability. Historic cost is argued to be more reliable while fair value has been argued to be more relevant. Generally the concept of prudence has been called upon to support reliability and therefore historic cost. The recent rewriting of the conceptual framework, which has exchanged reliability for faithful representation, coupled with the preferencing of relevance have signalled a shift towards fair value. The framework also emphasises that faithful representation requires a lack of bias, both positive or negative, invalidating arguments in favour of prudence.

10.2 The fair valuing of liabilities has proved problematic for the IASB. Discuss the old definition and contrast with new definition. Have the problems been satisfactorily dealt with, are there other issues to consider? [K,J] The old definition focused on the “settlement of a liability”. The concept of settlement was difficult to define and could be very specific to the firm and tended to lead to a focus on future events. The new definition shifts the focus to a market, what would it cost to pay someone else to take the liability off the firm’s hands. This creates a focus on the current condition and terms of the liability and introduces the market into its valuation. It has solved many of the associated confusion, but is still problematic. It may be that the current organisation is uniquely positioned or advantaged in settling the liability and therefore could argue that a market valuation will lead to an over estimate of the eventual cost. Also some liabilities are difficult to shift and therefore very difficult to secure an appropriate market valuation.

10.3 As noted in the chapter, potential valuation bases were considered when deciding how to measure fair value. Describe each and, where appropriate, give examples of how these are already used in accounting. [K] • • • • • • • •

Past entry price Unmodified historic cost. Generally used for inventory valuation.

Past exit price Immediate resale value when purchased.

Modified past amount Modified historic cost. Often used for plant and equipment.

Current entry price Current purchase price.

Current exit price Current selling price. Basis for fair value.

Current equilibrium price The intersection of entry and exit price. An economic ideal.

Value in use Discounted value of future cash flows. Probably the most useful measure of value, sometimes used to achieve a fair value.

Future entry price Value asset could be purchased for in the future.

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Solution manual to accompany: Contemporary Issues in Accounting

•

Future exit price.

Value asset could be sold for in the future.

10.4 Paragraph 16 of AASB 13/IFRS 13 indicates that fair value should be based on the principal or most advantageous market for an item. What do these terms mean and how does this relate to the value of the item to the entity itself? [K] The Principal Market is the market with the greatest volume and level of activity for the asset or liability. The Most Advantageous Market is the market that maximises the amount that would be received to sell the asset or minimises the amount that would be paid to transfer the liability, after taking into account transaction costs and transport costs. It has been argued that because they do not relate to the current use of the asset they provide an inappropriate basis on which to value an asset or liability. However the IASB argues that an entity should be aware of these markets and that they would sell the item into them if their current use did not entail at least an equivalent amount of value.

Hence these markets are indicative of the base value of an item to the entity and therefore provide useful information.

10.5 XYZ Ltd owns a land based drilling rig. It is in near perfect condition and unmodified. The company wishes to establish a fair value for the rig and identified two markets where near identical rigs are being actively traded. In Market A, the price that would be received is $27 000, there will be a commission payable to a selling agent of 10% and it will cost $3,000 to transport the rig to that market. In Market B, the price that would be received is $26 000, there are no commissions to pay and the costs to transport the asset to that market are $3000. What fair value would be placed on the asset based on this information? Show workings and explain. [K, AS] Transaction costs are the incremental direct costs to sell an asset or transfer a liability, while transport costs are the costs necessarily incurred to transfer an asset to its most advantageous market. The measurement of fair value requires both costs to be taken into consideration in the determination of the most advantageous market. However, only transport costs are used in the calculation of the fair value number.

Most advantageous market Market A: $27 000 – 2700 – 3000 = $21 300 Market B: $26 000 – 3000 = $230 000 Therefore Market B is the most advantageous and the fair value of the asset is $23,000 as this only takes into account transportation costs. If there had been commissions or other transaction costs these would have been excluded once the most advantageous market was identified.

10.6

An entity wants to fair value some of its motor vehicle asset, which consist of approximately 20 motor vehicles of various, but common, commuter type cars.

How would the entity go about fair valuing those motor vehicles and what factors would it need to consider? [J, K, AS]

The decision to fair value must be applied at the class level. So if some motor vehicles are to be valued, then all motor vehicles must be fair valued unless it is possible to argue that there are distinct groups of motor vehicles with very difference uses within the organisation. Having established which vehicles are to be fair valued a process would have to be undertaken. Given these are common, commuter type cars it would seem that a market based approach is most appropriate. Appropriate adjustments would need to be made based on market factors that participants would consider in

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Chapter 10: Fair value accounting

valuing the assets. Presumable make and model of the vehicle, kilometres driven, condition of the vehicles.

10.7

The concept of highest and best use to value an asset has been criticised by a number of respondents to the fair value exposure draft. They argued that it may not reflect the actual use of the asset by the entity and therefore provides a misleading valuation for the asset under consideration. Why did the IASB proposed this definition and how is it justified in situations where the use is clearly different. [J, K]

The arguments used by the IASB assume a relatively efficient market and economic rationalism. The efficient market argument assumes the entity is reasonable aware of the value the asset has to them, and the value they could get from other markets. Economic rationalism assumes that the entity will take options that maximise profit and return to shareholders. Therefore entities with assets would sell the item into the most advantageous or principal market if their current use did not entail at least an equivalent amount of value. Hence these markets are indicative of the base value of an item to the entity and therefore provide useful information.

10.8

10 years ago your organisation bought a block of land on the Perth foreshore for $500 000. Over the next two years an apartment block was constructed on the site at a cost of $5 000 000. The apartments are currently owned by your organisation and sublet to tenants on a variety of leases not longer than five years. You want to establish the fair value of the property using AASB 13/IFRS 13. You have ascertained the following information for your assessment: [J, K, AS] I.

Two separate expert valuations have been received. One valuer said the property was worth around $9 000 000 ($1 000 000 for the land and $8 000 000 for the building). The other valuer said it was worth $6 000 000 ($750 000 land value and $5 250 000 building value). Both valuers acknowledge that valuing the building in the current economic climate is difficult as there have been few sales of comparable buildings recently. They have used their experience of prior markets to estimate the values.

II.

The current cost of replacing the building has been established as $7 500 000, determined based on the current design with today’s construction costs, including labour, materials and overhead.

III.

Present value of future cash flows: Average net cash inflows over next 20 years is estimated to be $650 000 per year, based on projected cash flows from rent, tax savings and expenditures.

It is assumed after 20 years the building will need to be replaced, and the land will be worth $1 000 000. The current borrowing rate for the entity is 12%.

IV.

Depreciation is currently being charged on a straight-line basis using the same assumptions presented in part III.

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Solution manual to accompany: Contemporary Issues in Accounting

(a) Discuss each of the above four values as a basis for establishing fair value. In accordance with AASB 13/IFRS 13 which methodology do you believe is most appropriate? What additional information would you like to obtain to make a better estimate?

Valuation A is superficially based on a market valuation. While this is ideal any many circumstances, the evidence here would strongly suggest there is an inactive market. And therefore significant adjustments may need to be made to the valuations. Using this valuation would quickly introduce a number of level 3 inputs. In addition the significant variations in value presented would suggest that this just simply isn’t an appropriate base. One thing that is clear from the standard, simply collecting a number of valuations and averaging them is not an appropriate approach.

Valuation B is a cost approach. This may be appropriate in this situation. Adjustments may need to be made to account for the current condition of the building, and a way still needs to be found to value the land. But this may introduce the least number of unobservable inputs.

Valuation C is an income approach. In an ideal world the income approach gives the most relevant information about the value of an asset. However in the real world it often relies on the most number of assumptions and is subject to the potential for significant manipulation.

In this case, given the time frames involved and the associated uncertainties of the building rental market it would seem unlikely that this provides an appropriately reliable basis for valuation. The figures given appear insufficiently detailed and considered. Is it likely that the net cash inflow will remain steady for 20 years? How was the value for the land established?

Substantial though would need to be put into the appropriate discount rate, accounting for a range of factors specific to the project.

Valuation D is not a fair value but simply and application of the modified historic cost which is an acceptable alternative to fair value.

Given the limited information available the most appropriate approach to fair value the asset would appear to be based on approach B current replacement cost. It is possible that with further refinement an appropriate income approach could be established, but it would require significant additional work and possibly a number of level 3 inputs.

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Chapter 10: Fair value accounting

Case Study questions Case study 1 Former FDIC Chief: fair value caused the crisis 1. A number of observers suggest that fair valuing of CDOs under the old definition caused the global financial crisis of 2008. What do you think of this argument? [J, AS] 2. What indications were there that the market was not working properly? [J, AS] 3. Under AASB 13/IFRS 13, how would these financial instruments been valued? [J, AS]

There has also been significant academic research on this question and a review of the literature will turn up more recent discussion. However in short there are two camps, as so often seems to be the case. One side tends to argue that failure to use fair value allowed the CDOs to be carried at an inflated price for too long that actually made the crisis worse.

Proponents of this view argue that this is exactly why fair value should be used. Opponents of fair value argue that because market values had to be used, and this was especially true under previous applications of the fair value rule to financial instruments, when a market goes ‘toxic’ that is trades falls to below rational expectations, these values are required to be used in the financial statements even though the holder does not intend to sell. CDOs had a market value of zero and therefore had to be recorded as such even though the holders believed there was intrinsic value in the instruments. The market panicked confusing market value with actual value and this lead to the potential for a ‘run on the bank’.

There were clear indications that the market had gone toxic, liquidity had left the market, trade volumes were non-existent and the market values that were present were substantially below a rational valuation of the instruments.

Under IFRS 13 adjustments can be made to market prices when there is clear indication that the market is not working properly.

This addresses some of the concerns raised by users about the implementation of fair value.

However it raises other concerns. It is acknowledged that not only do there exist times when markets are toxic but also when they are irrational exuberant. The new standards allows financial report prepares to uncritically accept and use inflated market prices and then potentially turn around and argue, when prices are falling, that the market has become inactive and therefore attempt to avoid recording declines in value.

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Solution manual to accompany: Contemporary Issues in Accounting

Case study 2 Required 1. Identify the three valuation techniques that could have been used for establishing fair value and discuss their appropriateness in this situation. [K] 2. There are two present value approaches outlined in AASB 13/ IFRS 13. How are they different and how would it have changed your approach to establishing fair value in this case study? [J, K] 3. Calculate the expected present value of the liability in accordance with AASB 13/IFRS 13. [AS] 4. How would your value have differed if you had simply calculated the valuation based on the entities expected discounted cash flow? [J, AS] 5. How is this difference in valuation, which has caused concern in the mining industry, justified by the IASB? [J, K] 6. What is non-performance risk and why is it included in the calculation? [K] 1.

The standard states that there are 3 widely used techniques and that the entity must “use valuation techniques consistent with one or more of those approaches to measure fair value”. The techniques are then outlined in some detail in Appendix B to IFRS 13.

2.

The market approach is based on the ability to identify a market for an identical or comparable asset or liability. This approach is theoretically most directly related to the intention of the standard. Depending on the nature of the market, adjustments may need to be made to take existing transactions and best approximate the price that would be relevant to the specific item under consideration.

The income approach is based on converting future cash flows or income and expense into a single present value. Usually this would mean discounted cash flow models familiar from finance, but could alternatively be much more complex models such as a Black-ScholesMertons options pricing approach.

The cost approach is based on an estimate of the cost of replacing the “service capacity” of the asset under consideration. This is what is known as the current replacement cost in accounting theory.

3.

Expected “Settlement Value” (Old definition):

Expected Labour Costs in 10 Years: Overhead: Total: Inflation factor (4% for 10 years) Expected Cash Flow Discount Rate: Present Value = =

$250 000 (weighted average) $200 000 $450 000 1.4802 $666 090 5% $666 090/ (1 + 0.05)^10 $408 921

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Chapter 10: Fair value accounting

Expected Exchange Value (Current definition): Expected Labour Costs in 10 Years: Overhead: Contractors Mark Up Total: Inflation factor (4% for 10 years) Expected Cash Flow

$250 000 (weighted average) $200 000 $90 000 $540 000 1.4802 $799 308

Market Risk Premium (add 5%)

$39 965

Risk Adjusted Expected Cash Flow

$839 273

Discount Rate:

8.5% (includes non-performance risk)

Present Value = =

$839 273/ (1 + 0.085)^10 $371 198

4.

The technique chosen is clearly a matter for professional judgment and will depend on the circumstances and information available to the accountant attempting to make the valuation. However the standard, in paragraph 67, requires that the accountant maximise relevant observable inputs and minimise unobservable inputs. In practice this would mean that the market approach is most likely to be preferred. However this also means that where a market is inactive, as previously discussed, alternative valuation methods are available to an entity.

5.

In this case the only option available that makes sense is an income approach.

6.

Non-performance risk The risk that an entity will not fulfil an obligation. Nonperformance risk includes, but may not be limited to, the entity’s own credit risk.

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Additional Readings Gwilliam, D., & Jackson, R. H. G. (2008). Fair value in financial reporting: Problems and pitfalls in practice A case study analysis of the use of fair valuation at Enron. Accounting Forum, 93947600(02), 240-259.

Rayman, R. (2007). Fair value accounting and the present value fallacy: The need for an alternative conceptual framework. The British Accounting Review, 39(3), 211-225.

Retrieved from http://www.sciencedirect.com/science/article/B6WC3-4P0NC171/2/3ee78d96a90a3b01e5e797a70d663b4e Ronen, J. (2008). To Fair Value or Not to Fair Value: A Broader Perspective. Abacus, 44(2), 181-208. doi:doi:10.1111/j.1467-6281.2008.00257.x Whittington, G. (2008). Fair Value and the IASB/FASB Conceptual Framework Project: An Alternative View. Abacus, 44(2), 139-168. doi:doi:10.1111/j.1467-6281.2008.00255.x

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Solution Manual to accompany

Contemporary Issues in Accounting Michaela Rankin, Patricia Stanton, Susan McGowan, Kimberly Ferlauto & Matt Tilling PREPARED BY:

Michaela Rankin

John Wiley & Sons Australia, Ltd 2012

Chapter 11: Sustainability and Environmental Accounting

CHAPTER 11 SUSTAINABILITY AND ENVIRONENTAL ACCOUNTING Contemporary Issue 11.1: Perfect timing for world’s first: Carbon Neutral Winery 1. Outline the potential costs and benefits of making moves towards carbon neutrality. (J) Costs would include putting a system in place to measure greenhouse gas emissions before they can be managed and mitigated; changing practices and training of staff to mitigate emissions; the cost of changing agricultural practices; changing transport used; costs of certification etc.

Benefits would include an increase in sales, particularly to customers specifically interested in the origin of their products; increasing marketing opportunities to different retailers, such as supermarkets signing up to a food miles program; energy savings, and therefore reduction in energy costs.

2. The ‘food miles’ movement is increasing in strength in the United Kingdom, with some major retailers, for example Tesco, asking suppliers to label products with their carbon footprint. Evaluate what impact this move could have on the New Zealand wine industry. (J) New Zealand wineries that embrace the carbon neutral concept and seek certification are likely to increase their market share in the United Kingdom, as they are meeting their requirements for labeling. They are likely to take market share from wineries in other countries, which are not considering these moves. It is likely to act as a marketing opportunity and increase the industry’s exposure to different markets and customers.

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Solution manual to accompany: Contemporary Issues in Accounting

Review questions 1. Explain the meaning of sustainability and outline why corporations might consider it in their business operations.

Sustainability, or sustainable development, is concerned with development that meets the needs of the present without compromising the ability of future generations to meet their own needs. It refers to three main areas – economic development, environmental development and social development.

Corporations might consider their effect on sustainability as they are in control of the majority of the earth’s resources so any moves towards sustainability cannot occur without the support of business. Figure 11.1 presents reasons that BHP Billiton embraces sustainable development. These include: to reduce business risk and enhance business opportunities; to gain an maintain their ‘licence to operate’ – which is also referred to as a social contract; to improve operational performance and efficiency; improved attraction and retention of its workforce; maintain security of operations; enhanced brand recognition and reputation and to enhance their ability to strategically plan for the longer-term.

2. Explain the difference between eco-justice and eco-efficiency, and explain how both might relate to business activities.

Eco-justice considers the ability to meet the needs of the current inhabitants, including strategies to alleviate poverty, access to basic water, food and shelter. It also takes a long-term focus where it recognizes that consumption of resources today needs to consider the effect this will have on the quality of life of future inhabitants. These two aspects of eco-justice are referred to as intragenerational equity and intergenerational equity respectively. Eco-efficiency, on the other hand, focuses on how efficiently resources are used to minimize the impact on the environment.

Some businesses are larger than some governments. As such, they have a great deal of power over resources. Given businesses control the majority of the world’s resources, entities can put systems in place to contribute to the efficient use of these resources to meet eco-efficiency demands. They also have control over the extent to which resources are depleted to avoid eco-justice considerations relating to intergenerational equity. Many businesses operate globally, so are in a position to be able to assist to alleviate poverty, and ensure their employees in developing countries, and their communities have access to food, clean water and shelter.

3. What reasons can an entity provide for adopting sustainable development?

There are a number of reasons that businesses can provide for adopting sustainable development. A good discussion is provided in Figure 11.1, which presents reasons that BHP Billiton embraces sustainable development. These include: to reduce business risk and enhance business opportunities; to gain an maintain their ‘licence to

© John Wiley and Sons Australia, Ltd

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Chapter 11: Sustainability and Environmental Accounting

operate’ – which is also referred to as a social contract; to improve operational performance and efficiency; improved attraction and retention of its workforce; maintain security of operations; enhanced brand recognition and reputation and to enhance their ability to strategically plan for the longer-term.

4. Identify what information entities are likely to provide if they use triple bottom line reporting.

Triple bottom line reporting is also referred to as environmental, social and governance reporting and sustainability reporting. Companies are likely to provide information about their financial performance, their environmental performance and their social performance.

5. Explain the difference between sustainability reporting and traditional financial reporting.

Traditional financial reporting focuses on recognising the financial effects of an entity’s transactions. It follows generally accepted accounting principles and accounting standards and is audited by an external auditor. The financial report is limited to transactions that have a financial impact. Sustainability reporting however goes beyond this. It includes reporting on the environmental activities and of the entity as well as its social impacts. These are combined with financial information.

6. What benefits should entities expect from preparing sustainability reports?

The following benefits can be gained from preparing sustainability reports: • Embedding sound corporate governance and ethics systems throughout the organisation • Improved management of risk through enhanced management systems and performance monitoring • Formalising and enhancing communication with key stakeholders • Attracting and retaining competent staff • Ability to benchmark performance with other entities.

7. What is international integrated reporting and how does it differ from the current financial reporting system we have?

Integrated reporting is designed to improve sustainability reporting and integrate it more closely with financial and governance reporting. It is designed to bring together financial, environmental, social and governance information in a clear, concise, consistent and comparable format. It differs from our current financial reporting system as it goes beyond the financial impact of activities, and a general disclosure of

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Solution manual to accompany: Contemporary Issues in Accounting

governance to include a framework to integrate environmental and social reporting together in an integrated way.

8. What is the Global Reporting Initiative, and what is its purpose?

The Global Reporting Initiative was launched in 1997 as an initiative to develop a globally accepted reporting framework to enhance the quality of sustainability reporting. It provides a framework of principles and performance indicators that organisations can use to measure and report their social and environmental performance. Its purpose is to enhance the transparency, comparability and clarity of sustainability reports.

9. Identify four corporate stakeholders and explain how they affect a business’s operations.

Table 11.3 provides examples of a range of stakeholders. These can include: Shareholders – provide funds to the entity. Their support is essential for continued success of the entity, as their support affects share price and corporate value.

Customers – major users of the entity’s products and services. A continued and growing supply of customers is essential to the continued success of the entity.

Fund investors – like shareholders, they buy shares in the company and support companies for which they see opportunities for growth in value.

Community groups – may supply labour to the entity, but need to support the entity’s operations if the entity and community are to exist harmoniously.

Media – can impact the views of other stakeholders by voicing concerns and making other groups aware of the businesses operations and activities Government and regulators – monitor mandatory reporting, impose taxes and charges and uphold legislation that the entity needs to follow.

10. For the four corporate stakeholders you have identified above, document how an organisation might engage with them about sustainability issues.

Entities can engage with these stakeholders in the following ways: Shareholders – direct emails, provide information in annual reports and stand-alone sustainability reports, website.

Customers – directly through email and other written communication. The media and the corporate website would also be useful.

Fund investors – direct communication through email, phone, meetings with fund managers, and through providing sustainability information in written form, for example the sustainability report.

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Chapter 11: Sustainability and Environmental Accounting

Community groups – can use the media, company website, attending community meetings, and through local government Media – media releases, direct communication through email, phone and by providing copies of sustainability reports.

Government and regulators – direct reporting to show are compliant with regulations, email and phone.

11. Identify how ethical investment can affect corporate decision making regarding sustainable business operations.

Ethical investment and the growth in ethical funds pose an increasing influence on entities’ corporate sustainability performance and reporting. Increasing demands for social and environmental performance information means that companies are seeking to satisfy their needs to attract funds and support. Being listed on a sustainability index such as one of the Dow Jones Sustainability Indexes means companies can also attract investment and support from fund managers and small investors who are driven in their investment choice by ethical, social and/or environmental considerations.

12. Explain what an environmental management system is and how it can be used to improve environmental performance.

An environmental management system (EMS)is a system that organisations implement to measure, record and manage their environmental performance. It is useful to assist in improving environmental performance because it allows entities to measure and record their performance, set benchmarks or key performance indicators, and put in place mechanisms to meet these benchmarks. It is often said you can’t control what you can’t measure. An EMS allows an entity to measure its environmental outputs in order to look towards controlling and reducing them, thus improving performance.

13. Explain how emissions trading schemes are likely to affect financial reporting.

An emissions trading schemes is a system designed to control emissions by allowing participants to trade excess emissions permits. This is likely to affect financial reporting because it will require companies to measure and report emissions permits it holds, through grants from government and those it purchases. There are also likely to be financial implications from the trade of permits. While there are currently no financial reporting guidelines around the operation of an emissions trading scheme it is likely that emissions permits are likely to be reported as either financial instruments or intangible assets, and both are used in jurisdictions which currently have an emissions trading scheme in place.

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Solution manual to accompany: Contemporary Issues in Accounting

Application questions 11.1 There are currently no formal accounting standards for the reporting of social and environmental activities. Evaluate what issues this has for preparation of financial reports. (J, K) Given there are currently no formal accounting standards for the reporting of social and environmental activities this means that these activities are not going to be included in the transactions reflected in the financial statements. For example, an entity’s impact on the environment, in terms of pollution is not costed and included as an expense. While entities are required to account for the present value of future cleanup costs of contaminated sites, they do not have to account for the ongoing impact of this contamination on the environment. Similarly, entities are not currently required to account for any social cost which does not have a direct financial impact..

While some disclosures are required concerning employee benefits, 11.2 In this chapter a range of stakeholders have been identified that managers should consider when determining their sustainability performance and reporting. Determine how managers should engage with each one of these stakeholders and document what sustainability issues they would be likely to discuss during this engagement process. (J, K) Shareholders – direct emails, provide information in annual reports and stand-alone sustainability reports, website. The entity would be likely to discuss their sustainable business activities and how these will add to firm value. This might also include how it is addressing legislation on carbon emissions.

Customers – directly through email and other written communication. The media and the corporate website would also be useful. Customers may be interested in the source of products, with some actively seeking green or fair trade products. Consequently entities will communicate the environmental credentials of products including the extent to which they are sourced from sustainable sources.

Fund investors – direct communication through email, phone, meetings with fund managers and through providing sustainability information in written form, for example the sustainability report. Some investors search out socially responsible companies to invest in. Entities will report their social and environmental activities to attract ethical fund investors. Managers will also discuss how the entity is addressing issues such as carbon emissions disclosure and reduction requirements.

Community groups – can use the media, company website, attending community meetings, and through local government. Entities will discuss facilities and services provided to local community groups, and issues such as job creation, health, and emissions information relating to the local environment.

Media – media releases, direct communication through email, phone and by providing copies of sustainability reports. Given the media acts as a voice that sets the agenda relating to many issues an entity will wish to advise any positive social and environmental activities.

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Government and regulators – direct reporting to show are compliant with regulations, email and phone. The entity will discuss the potential impacts of legislative changes relating to social and/or environmental activities.

11.3 Obtain the 2011 Sustainability Report for Toyota Ltd. Prepare a report that addresses the following issues:(J, K, CT) The 2011 Sustainability Report for Toyota Ltd is presented for the first time online. (a) Document Toyota’s vision and mission statement, and articulate how these might relate to sustainability, if at all.

Our vision Most respected and admired company.

Our mission We deliver outstanding automotive products and services to our customers, and enrich our community, partners and environment.

Our four core values Customer first Respect for people International focus Continuous improvement and innovation.

While the vision does not specifically relate to sustainability, the mission and core values do. In Toyota Ltd’s mission they discuss enriching the community and environment. This will lead to organizational strategies to address these sustainability issues. In addition one of the company’s four core values is respect for people, implying a social focus beyond a profit motive.

The company also has a separate environment vision and action plan. (b) Outline Toyota’s stakeholders and explain how they have engaged each of these stakeholder groups.

In its sustainability report under ‘Stakeholder Engagement’ the following table highlights stakeholders groups the company engages with and how: Stakeholder Group Employees

Customers

Key Issues

Response and Engagement in 2010/11

Employee satisfaction and job security

Working at Toyota, communication broadcasts and employment programs

Career and professional development

Learning and development programs via Toyota Institute Australia. Read about our Employees

Customer service

Customer satisfaction surveys

Product quality

Interaction via dealerships

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Solution manual to accompany: Contemporary Issues in Accounting

Customer Experience Program Business partners dealers

Business partners suppliers

Community

Government

Effects of Great East Japan Earthquake and natural disasters in Australia

Dealer support during natural disasters

Environmental impacts

Dealer Environmental Risk Audit Program and Toyota Environmental Dealership Program

Ongoing development

Dealer training

Effects of Great East Japan Earthquake and natural disasters in Australia

Annual Supplier conference

Self-reliance

Supplier Development Programs

Contribution to local community

Local and national community partnerships

Ongoing viability of Australian automotive market

Regular interaction on key issues such as production of next generation engine at Altona plant

Community sponsorships

Written submissions including NPI, EEO and NGERS Toyota Motor Corporation

Efficient operations

Regular liaison on operating issues including product quality, sales and marketing

The company also discusses a Community Liaison Committee under its Altona Environmental Improvement Plan and a Stakeholder Engagement Survey. (c) Outline governance mechanisms in place on the Board of Directors to address sustainability.

Under the ‘Governance’ section of the report the company reports that the board has an Environment Committee and a Health and Safety Committee. Both of these would address sustainability issues. (d) Articulate how Toyota Ltd links sustainability to its risk management systems.

Toyota Ltd does not disclose information in its 2011 report on how it links sustainability to its risk management system. A perusal of the 2010 report, however, discussed the Enterprise Risk Management process that is used to develop a risk profile for each business unit, which is then used for planning yearly objectives. The organization was in the process of integrating the risk management process into other business planning and management systems at that time.

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(e) Outline any guidance Toyota Ltd used in implementing environmental and social performance and reporting systems.

The company has gained ISO14001 certification for its environmental management system so has used the guidance of the quality system in its implementation. The company also uses the Global Reporting Index (GRI) to develop and present its sustainability report. It has been assessed by the GRI as meeting level A. 11.4 You are the accountant of a company that is considering expanding its operations to a country in the developing world. You are to prepare a report to the CEO outlining what issues the company should consider from a sustainability perspective when making this decision. (J, CT) There are a range of issues the CEO needs to consider from a sustainability perspective. These include but are not limited to: • • • • •

Environmental impacts of the activities Access to resources using sustainable transport methods Depletion of resources to the detriment of the local community Providing appropriate wages and facilities for employees. It is likely that the company will need to provide additional support in the form of shelter, food and water to employees and their families Government regulations

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Solution manual to accompany: Contemporary Issues in Accounting

Case Study Questions Case study 11.1: Turning the heat on 1. Outline how climate change is likely to affect Sewell’s business operations in developing countries. (J, K) Climate change affects developing countries arguably more than in developed countries for a number of reasons. Poor infrastructure is one major factor, as is a lack of resources. A lack of government regulation over business and infrastructure development means emissions are not measured or controlled. Developing countries seeking investment from foreign organisations are likely to not pay attention to the systems put in place to minimize emissions.

2. Evaluate the social issues likely to impact on a business operating in a developing country. (J, K) Limited education is likely to affect the skills of potential employees. Employees are also likely in many cases to be malnourished and lack transportation to get to work.

This is also likely to lead to higher levels of illness amongst employees than would be the case in developed countries. Businesses are likely to have to consider supporting staff and their families through the provision of basic needs such as food, water and shelter. They are also likely to need to build infrastructure to support the local community as well as the business.

3. Evaluate what role accountants can play in addressing climate change in a business environment. (J, K) To manage climate change and carbon emissions entities need to be able to measure their outputs. Accountants work with the major information systems of the organization and so are in a position to contribute to the development of an information system that can measure and record emissions as a first step to managing and reducing them. They can also attempt to measure the cost to the business of incurring these emissions, particularly when an emissions trading scheme is used.

Case study 11.2: Dutch group seeks to tie executive bonuses to social responsibility 1. The company that employs you is a manufacturing firm. It is considering following the lead of DSM and developing some performance indicators to tie executive bonuses to environmental performance. Outline what some of these might be. (J, K) A company wishing to tie executive bonuses to environmental performance could consider the following indicators, amongst others: • • • •

Energy usage and savings Greenhouse gas emissions Reduction in waste Product development that minimizes environmental impacts

© John Wiley and Sons Australia, Ltd

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Chapter 11: Sustainability and Environmental Accounting

2. Document measures of performance relating to social issues, such as employee and consumer relations that should also be considered. Explain your answer.

(J,K) Measures of performance relating to social issues could consider: • • • • •

Employee injury rates Employee satisfaction Investments in community activities Stakeholder management indicators Consumer complaints

Case study 11.3: Super funds set to track down carbon footprints 1. Identify why you would expect the finance sector, and investment funds in particular, to have an interest in climate change. (J, K) Climate change and greenhouse gas emissions are becoming an increasing area of risk and associated costs for corporations. How companies manage these risks is important to the finance sector, and investment funds in particular as investors are likely to wear the cost of significant changes an entity needs to make to reduce its carbon emissions in the future. This will lead to ongoing reduction in income and firm value.

2. Outline potential sources of information that superannuation funds could use to gather data about a company’s sustainability operations. (J, K) Superannuation fund managers could contact the company directly in the first instance. They can rely on publicly available information such as the annual report, sustainability report or the corporate website. They could also seek access to government data from the National Pollutant Inventory. Superannuation fund investor could also become signatories to the Carbon Disclosure Project and access information about carbon emissions about the top 200 Australian and top 50 New Zealand companies, together with firms from a large number of other countries. They could also seek information about how a company compares to those listed on an index such as the Dow Jones Sustainability Indexes.

3. Outline methods superannuation funds could use to encourage companies to take a more active role in managing climate change. (J, K) Superannuation funds could take a number of different approaches. This can include lobbying the company to seek a change in their performance, or join the CDP and seek change through this group. They could raise the issue of climate change at general meetings. They could also choose to boycott investment in companies that do not put in place mechanisms to manage climate change.

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Solution Manual to accompany

Contemporary Issues in Accounting Michaela Rankin, Patricia Stanton, Susan McGowan, Kimberly Ferlauto & Matt Tilling PREPARED BY:

Michaela Rankin

John Wiley & Sons Australia, Ltd 2012

Chapter 12: International accounting

CHAPTER 12 INTERNATIONAL ACCOUNTING

Contemporary Issue 12.1: Adopting IFRS in Asian countries vital 1.

Outline the benefits of adoption of IFRSs in Sri Lanka. (J, K) Benefits of IFRS adoption in Sri Lanka include the following: • • • •

2.

A commonly understood financial reporting framework; Support foreign investment through provision of comparable and credible financial information; Enhanced business environment; Promote access to finance.

What are the challenges expected to be faced by the country in adopting IFRSs from 2011? (J) Challenges might include: • • • •

An inconsistency with legal, environmental or political systems, where IFRSs are designed to meet the needs of a western society based on a strong capital market; May be the need to educate local accountants on IFRSs; Need to educate investors and other users on the differences from local GAAP; Enforcement of accounting rules will need to be considered.

Contemporary Issue 12.2:

1.

Survey finds multinationals facing new tax challenges

How can multinationals use transfer pricing to minimize their taxation burden? (K) Transfer pricing relates to the pricing of goods and services transferred between members of a corporate family. At an international level transferring goods and services internally may mean that the entity is not impacted by a range of taxed such as goods and services taxes and sales taxes in countries where they may need resources. Entities may be able to transfer goods and services to other entities in the corporate group which operate in countries with more lenient tax practices and rules.

2.

Why do you think taxation authorities would get involved in transfer pricing? (J, K) Taxation authorities are likely to wish to get involved, as the more MNEs transfer goods internally to other corporate members internationally to avoid paying taxes it means the governments are going to miss out on potential revenue sources gained from sales in the country of origin.

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Solution manual to accompany: Contemporary Issues in Accounting

Review questions 1.

Outline and differentiate the various definitions of international accounting.

International accounting, or international financial reporting, refers to a description or comparison of accounting in different countries and the accounting dimensions of international transactions. International financial reporting can be defined at three levels – universal or world accounting; company level standards and practices; and comparative accounting. Universal accounting relates to standards, guidelines and rules issued by supranational organisations such as the International Federation of Accountants.

Company level accounting, on the other hand, focuses on accounting processes required to account for a range of international transactions at the corporate level.

These might include accounting for foreign investments or transactions, and parent-foreign subsidiary consolidations. It is the definition with the narrowest focus.

Comparative accounting studies the rules, standards and guidelines that exist in different countries and a comparison between these. It considers the diversity of accounting practices across the globe.

2.

Explain the environmental factors that lead to national differences in accounting.

There are a range of environmental factors that can influence accounting on an international level. They can generally be classified as ‘cultural’ attributes, and can include such factors as: • •

• • •

3.

The taxation system – can affect accounting practice in countries where financial reports are used to determine an entity’s tax liabilities, such as Japan, France and Germany; Sources of finance – these may differ across countries where some rely on banks as major sources of finance, in others equity markets and shareholders provide funds for corporate operations, and in others entities can be owned primarily by families or government; The political system – the accounting system may reflect political philosophies or objectives; Economic growth and development and the nature of the economic system – whether the economy is primarily industrial or agricultural will affect they nature of the accounting system in place; The legal system – common law or codified Roman (or civil) law can impact the extent to which accounting rules and regulations are codified in legislation.

What are the two main legal systems operating worldwide? How might these affect accounting?

The two main legal systems operating across the world are referred to as common law and codified Roman law, otherwise referred to as code law or civil law.

Common law, which originated in England, relies on a limited amount of statute

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Chapter 12: International accounting

law, which is interpreted by the courts. Civil law, on the other hand, was developed in non-English speaking countries and originated in Europe. These countries tend to rely more heavily on statute law, without the extent of court interpretation found in common law. Common law countries are likely to have non-legislative organisations developing accounting standards. The accounting profession is likely to have less of an influence in civil law countries.

4.

Countries that rely on capital markets for finance, as opposed to banks and governments, are likely to expect greater levels of public disclosure in their accounting systems. Evaluate this argument and provide examples.

Where entities operate in countries that rely more on capital markets and external investors for finance, rather than banks or government, there is going to be higher levels of information asymmetry between investors and the entity. Banks and government are in a position to demand specific information from an entity so there is less likely to be onerous public disclosure requirements as there is not the same need to reduce information asymmetry between external users and the entity.

5.

Outline and discuss three cultural aspects that can differ across countries.

How do these cultural differences relate to differences in accounting systems?

Hofstede identified a total of five cultural dimensions on which countries can differ. These include: a. Individualism versus collectivism – individualism relates to a preference for a loosely knit social framework, while collectivism refers to a preference for a tightly knit social framework. In an individualist society there is a preference for self-regulation rather than compliance with prescriptive legal requirements. This leads to the development of strong professional organisations. In collectivist societies statutory control is stronger, so professional bodies are less prevalent and they do not have the same level of input to accounting standard development. b. Power distance –refers to the extent to which members of society view power entities as distributed unequally. Where entities prefer an unequal distribution of power they have a preference for uniformity of accounting requirements also. c. Uncertainty avoidance – refers to how comfortable members of society are with uncertainty and ambiguity. In countries where there is a preference for high uncertainty avoidance there would also bee a preference for accounting systems that avoid any ambiguity, meaning a rules-based approach to accounting regulation rather than a principlesbased approach. d. Masculinity versus femininity – masculinity refers to a preference for assertiveness, achievement and material success, while societies with feminine traits have a preference for caring for the weak and nurturing.

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Solution manual to accompany: Contemporary Issues in Accounting

e. Long-term versus short-term orientation – long-term focus on social and status obligations, a thrifty approach to resources etc. A short-term orientation engenders social pressure to overspend and is concerned with appearances.

6.

What does accounting harmonisation mean? Differentiate harmonisation from convergence or adoption.

Accounting harmonisation implies reconciling different points of view and reducing diversity, while allowing countries to have different sets of accounting standards.

Convergence or adoption is a process that takes place over time, and implies the adoption of one set of standards across the globe. This can also be referred to as standardisation.

7.

Explain the benefits of global adoption of IFRSs. Many countries, and developing nations in particular, do not have well codified accounting standards. Adoption of IFRSs is a cost effective way to institute a comprehensive system of accounting standards. Adoption of IFRSs would also enhance the operation and globalisation of capital markets.

8.

What are advantages of having one set of accounting standards worldwide?

Financial statements would be more comparable, making it easier for investors to evaluate a range of investment opportunities, thus leading to reduced risk to investors. Adoption of IFRSs would also reduce the cost of financial statement preparation by MNEs or those seeking to cross-list on multiple exchanges around the world, and would increase the ability of MNEs to access less expensive capital in other countries.

9.

What are the limitations of global adoption of IFRSs? It may be difficult to achieve international comparability of accounting practices through IFRS adoption due to differences in business, financial and accounting culture from one country to another. The costs involved in overcoming the sometimes vast difference in legal and political systems across the globe may be too great. Religion can also be a factor that impacts on accounting practices in some jurisdictions, leading to difficulties in applying IFRS which can conflict with the purpose of financial reporting in countries, such as Islamic countries, where religion and culture can play a significant role in business operations.

10. Outline the key challenges of US GAAP and IFRS convergence.

There are a number of key challenges to US GAAP and IFRS convergence. One is the different underlying philosophies of the two standards. While the IASB standards are ‘principles-based’ the FASB has taken a ‘rules-based’ approach to standard setting. The support of the US government and a number of business constituents is going to be essential to any changes to the US GAAP regime.

There have been delays in the agenda due to the large number of draft standards which have been produced over a short period of time.

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Chapter 12: International accounting

11. What is transfer pricing and how does it affect the operation of MNEs? Transfer pricing relates to the pricing of goods and services transferred between members of a corporate family. At an international level transferring goods and services internally may mean that the entity is not impacted by a range of taxed such as goods and services taxes and sales taxes in countries where they may need resources. Entities may be able to transfer goods and services to other entities in the corporate group which operate in countries with more lenient tax practices and rules

Application questions 12.1

Visit the website of the IASB and FASB and read the documents relating to US GAAP and IASB convergence. Prepare a summary of the process to date, and the timelines for future convergence. (K) This summary has been prepared as at April 2012.

2002 – both signed the Norwalk Agreement –g aimed at removing any differences between IFRSs and US GAAP 2006 – bodies issued a Memorandum of Understanding (MoU) which included milestones and priorities to be completed by 2008 2007 – the SEC in the US permits foreign entities listed on US securities exchanges to use IFRS in preparing financial reports, with no need to also present comparative reports in accordance with US GAAP 2008 – the MoU is updated with priorities outlined to 2011 2011 – progress report issued, which confirms that the bodies are giving priority to three main projects on their MoU – revenue recognition, leasing and financial instruments. Priority is also being given to insurance contracts.

The following projects have been completed: • • • • • • • • • • •

Share-based payments Segment reporting Non-monetary assets Inventory Fair value option Accounting changes Borrowing costs Non-controlling interests Business combinations Research costs derecognition

Work on the priority projects is to be completed over the next few years

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Solution manual to accompany: Contemporary Issues in Accounting

12.2

The New York Stock Exchange (NYSE) is the largest exchange in the U.S. Visit the website of the NYSE, www.nyse.com, and determine the number of foreign companies listed on it. Choose ten of these companies and analyse their latest financial reports, available from the companies’ websites. Document how the companies have addressed the difference, if any, between their reporting requirements for United States purposes and those for their home jurisdiction. Why would foreign companies have gone to the effort of listing their shares on the NYSE and the expense of preparing separate financial statements in some cases? (J, SM)

12.3

Find the financial report available on the websites of one domestic company, and one foreign company that operates in the same industry and complete the following: (J, K, AS, SM) For the purposes of demonstration only, the following points relate to Qantas Ltd and Emirates Ltd, a company listed in the United Arab Emirates.

(a) Document what accounting principles the foreign and domestic companies used to prepare their financial report.

The financial statements of Qantas comply with Australian accounting standards, and also with IFRSs. The financial statements of Emirates are prepared in accordance with IFRSs. (b) Document any differences between the formats of the report or the accounting principles used between your two companies.

The accounting principles are the same. There are no fundamental differences in the formats of the reports of both companies. (c) Document any differences in the directors’ report for each company.

Emirates does not provide a directors report in its financial report. This means there is no presentation of information concerning corporate governance, including the roles of directors, meetings attended, how the company adheres to a code of corporate governance principles and directors’ and executives’ remuneration. These issues are all addressed in the Qantas report. (d) Prepare a table which outlines the similarities and differences you have observed.

Accounting rules

Both use IFRSs. Qantas reports also comply with Australian accounting standards issued by the AASB

Format

The format of all financial reports is the same for both companies

Directors report

Emirates does not include a directors report. There is no discussion of the role of directors, and

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Chapter 12: International accounting

corporate governance practices or directors’ and executives’ remuneration in the Emirates annual report. These are all included in the Qantas report

12.4

Form small teams and have each team select two countries from different cultural areas. Identify and compare each country’s environmental, cultural and accounting values. (J, K, CT) An example of two countries could include, but is not limited to: Australia, and China. For the purposes of illustration these countries will be compared.

Australia is a western democratically run country, while China is an eastern country where there is an extensive amount of control by the government. This has impacted on accounting and business operations in a number of ways.

Until relatively recently China was not open to foreign investment, and most entities were government controlled or owned. This is now changing, with an increase in foreign and private ownership. This has not changed to the extent of Australia, however, where there is an active capital market with many entities being owned by shareholders who buy and sell shares on the stock exchange.

Australia has a common law system while the legal system is China is a code law system.

If you refer to page 346-47 of the text Hofstede’s cultural dimensions are discussed. China tends towards collectivism while Australia tends towards individualism. China has a large power distance, while Australia’s is smaller.

In Australia, society is happy to tolerate uncertainty, while in China it tends towards strong uncertainty avoidance.

In terms of Gray’s accounting dimensions, Australia tends towards professionalism, while China favours statutory control. The countries also differ on uniformity versus flexibility, with China favouring more uniformity.

Finally, in China there is a high degree of secrecy while in Australia transparency is favoured.

12.5

Visit the website of the Australian Stock Exchange, www.asx.com.au.

Select a large company that is listed on the securities exchange that also has operations in different countries – a MNE. You may need to refer to the company website or annual report for this information. Access the latest annual report and evaluate the impact of operating across countries on the company’s financial reporting requirements (J, K, SM)

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Solution manual to accompany: Contemporary Issues in Accounting

Case Study Questions Case study 12.1: US accounting switch to aid multinationals 1.

Outline some reasons the US regulators are likely to accept financial reports prepared under IFRSs rather than US GAAP for listing purposes.

(J, K) There has been evidence that IFRSs were better at uncovering problems during the GFC, thus are likely to be reliable. The US regulators have signed an agreement to move towards convergence, so have changed some US standards to align with IRFSs. In this case there is alignment between the two types of standards. If the standard setters in the US are looking at IFRSs as quality standards that are informing their own accounting standard setting then they need to be seen to be embracing IFRS. The US regulators are keen to attract foreign investment, and accepting financial reports based on IFRSs is one way to encourage this.

2.

What would you perceive to be negative aspects of convergence between the FASB and IASB? Explain your answer. (J, K) The standards are formulated using two different underlying philosophies – US GAAP are rules based while IFRS are principles based. Convergence will likely mean substantial changes to IFRS to reflect a greater emphasis on rules rather than principles, which will not necessarily align with the needs of users in other countries.

3.

How do you think the agreement to accept IFRSs will impact on US companies? (J, K) US companies which operate internationally will likely not be affected by this requirement as they may also be using IFRS to prepare reports in other countries. They will need to look closely at how their financial procedures compare with competitors which use IFRS as there are likely to be differences in accounting methods. For instance, in the US, LIFO is commonly used for inventory accounting, while it is not permitted under IFRS. Accounting for research and development will also be different. In the US all R&D must be expensed, while under IFRS it can be capitalized if certain criteria are met.

Case study 12.2: Making the most of IFRS 1.

Outline the arguments both for and against full adoption rather than harmonization with IFRSs. (J, K) Arguments in favour of full adoption: Financial statements would be more comparable, making it easier for investors to evaluate a range of investment opportunities, thus leading to reduced risk to investors. Adoption of IFRSs would also reduce the cost of financial statement preparation by MNEs or those seeking to cross-list on multiple exchanges around the world, and would

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Chapter 12: International accounting

increase the ability of MNEs to access less expensive capital in other countries.

Arguments against full adoption: It may be difficult to achieve international comparability of accounting practices through IFRS adoption due to differences in business, financial and accounting culture from one country to another. The costs involved in overcoming the sometimes vast difference in legal and political systems across the globe may be too great. Religion can also be a factor that impacts on accounting practices in some jurisdictions, leading to difficulties in applying IFRS which can conflict with the purpose of financial reporting in countries, such as Islamic countries, where religion and culture can play a significant role in business operations. Adoption instead of convergence would result in countries giving up significant control of the standard setting process.

2.

What are the benefits to India of convergence? (J, K) The benefit to India of convergence is the ability to attract foreign investment where investors are able to understand the financial reports. Reporting costs for companies operating internationally will be reduced. At the same time, convergence rather than adoption ensures the Indian standard setters maintain control of the standard setting process, and are able to incorporate those standards that reflect the business environment and culture in the country.

3.

As an investor looking to invest in the Indian market, what do you see as the obstacles to investment? (J, K) The fact that the Indian government is considering convergence rather than adoption of IFRS means that an investor will need to look closely at the financial reports to recognize the differences in financial reporting practices when comparing potential investments in other countries. Investors would perceive greater risk of investing in Indian firms as the financial reports will not align fully with those of alternative investment opportunities in other nations.

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12.9

Solution Manual to accompany

Contemporary Issues in Accounting Michaela Rankin, Patricia Stanton, Susan McGowan, Kimberly Ferlauto & Matt Tilling PREPARED BY:

Michaela Rankin

John Wiley & Sons Australia, Ltd 2012

Chapter 13: Corporate Failure

CHAPTER 13 CORPORATE FAILURE

Contemporary Issue 13.1: Not open and shut 1.

Discuss how trade barriers may have contributed to the failure of the RedGroup. (J, K, AS)

The RedGroup have blamed the collapse of the company partly on import barriers which protect local publishers. This means that when the company imports books they are subject to import duties which leads to the need to increase the retail price of books in the stores. This could have contributed to failure of the company as it means the entity is less competitive on price than online bookstores, with many consumers moving away from traditional bookstore shopping to purchase books online as a result of more competitive prices.

2.

From the previous discussion, what other issues can the retail sector face which might lead to corporate distress? (J, K, AS)

Increased competition from online bookstores, which have lower overheads and other costs could have lead to corporate distress. Bookstores in Australia are also subject to goods and services taxes, whereas stores operating internationally may be able to avoid these if they are selling online and delivering to Australia. The expansion of electronic books is also likely to have impacted on the book retail sector.

3.

Outline some ways the sector could change its operations to sustain and compete in a global market where the internet dominates. (J, K, AS)

Local retailers could expand their online presence to enable them to compete. This could mean moving warehousing offshore to countries where costs of products are lower, which would enable retailers to offer books at lower prices, and enable the company to avoid import taxes.

Contemporary Issue 13.2: Penalties, enforcement key to real reforms 1.

The article highlights regulatory changes in the United States as a result of the GFC. Research the main outcomes from this legislation and document how this is anticipated to improve governance in the finance sector. (K, SM)

The stated aim of the legislation is: ‘To promote the financial stability of the United States by improving accountability and transparency in the financial system, to end "too big to fail", to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes.’ DoddFrank Wall Street Reform and Consumer Protection Act.

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Solution manual to accompany: Contemporary Issues in Accounting

Some of the major outcomes of the legislation include: Two new agencies were created to monitoring systematic risk and clarify oversight of bank entities.

Additional rules governing liquidation or bankruptcy of financial institutions were outlined.

Reporting requirements of hedge funds have been expanded.

A separate body has been set up to monitor the insurance sector Regulations increased accountability of swaps and credit derivatives, which were resulted in failure of some entities during the crisis. These must now all be traded centrally.

Improvements to regulation of credit rating agencies and the asset-backed securitization process were also included.

All of these reforms are anticipated to improve governance by expanding on regulatory oversight, and the requirements for reporting by financial institutions. They are designed to reduce systematic risk in the sector.

2.

Outline the arguments both in favour of and against increasing regulation, given the extent of regulation already in the market. (K, SM)

Arguments against increasing regulation include: there was already a broad range of regulations and governance measures in place to limit risk in the sector, yet it did not prevent the GFC. Companies that are going to ‘push the boundaries’ with respect to rules or commit fraud are likely to always do so, no matter what additional regulation is put in place.

Arguments in favour of increasing regulation include: it will encourage entities to focus on risk taking and governance mechanisms and put in place policies to improve governance in this regard. Strong penalties are expected to deter any adverse behaviour.

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Chapter 13: Corporate Failure

Review questions 1. What is corporate failure?

Corporate failure can mean a range of things. It has been defined as a company filing for bankruptcy; delisting for a range of reasons; or liquidation. It could also include the appointment of a receiver or administrator to assist the entity to trade out of financial difficulties.

2. Articulate what is meant by bankruptcy and insolvency. In doing so, highlight the similarities and differences.

Bankruptcy and insolvency are similar terms which may mean different things in different jurisdictions. For instance, in the US ‘bankruptcy’ refers to failure of a corporation, while this is referred to as insolvency in Australia, with ‘bankruptcy’ relating to individuals. As such, both terms are similar in that they refer to corporate failure, and are often used interchangeably.

3. What are four common causes of corporate failure?

Common causes of corporate failure can include any of the following: a. Poor strategic decisions – failing to understand relevant business drivers leading to poor business strategic decisions b. Greed or the desire for power – leading to growth in the business that is unsustainable c. Overexpansion and ill-judged acquisitions – where costs can exceed benefits d. Dominant CEOs – who are not adequately managed or scrutinized by the board e. Failure of internal controls – may lead to failure to identify and manage operational risks f. Ineffective boards – where they do not operate independently of management 4. What external factors can influence corporate failure?

External factors that can influence corporate failure include: changes in technology, recession, competitors’ actions, deregulation, changes in import protection in an industry or interest rate changes.

5. What internal factors can influence corporate failure?

Internal factors the can influence corporate failure include: weak strategy, financial mis-management, or dysfunctional culture.

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Solution manual to accompany: Contemporary Issues in Accounting

6. Researchers and professionals have highlighted the importance of cash flow in avoiding corporate failure. Explain why this factor is important.

There needs to be enough cash to pay staff and creditors, pay GST obligations, and other operating expenses. If a business cannot make these basic payments they are not going to be able to operate at the level to make sales. This will lead to staff leaving, suppliers refusing to provide stock, or demanding immediate payment where the business previously operated on more extended credit terms.

7. What direct costs can result from corporate failure?

Direct costs that can result from failure include: expenses to hire lawyers and accountants, restructuring advisors or a range of insolvency practitioners. Additional interest on holding debt that cannot be discharged due to a lack of cash flow, or refinancing debt if covenants have been violated are also direct costs of insolvency.

8. What indirect costs can result from corporate failure?

Indirect costs that can result from failure are difficult to identify. They can relate to reputation and opportunity costs. For example, some entities might suffer lost sales and profit as a result of customers choosing to avoid dealing with a company that is in receivership or is attempting to trade out of insolvency. Key employees or managers may also leave the organization. Lost opportunities can also arise because management focus on survival of the entity and are not focused on longer-term opportunities.

9. Discuss what financial indicators can be used by analysts to assist in predicting whether companies might be at risk of distress or failure.

Analysts use a range of financial indicators, or ratios, to predict corporate failure. One of the most common models in this regard is the Altman Z-Score. Altman included five rations in his final model: working capital/total assets; retained earnings/total assets; earnings before interest and tax/total assets; market value of equity/book value of total liabilities; sales/total assets. Others stress the importance of cash flows.

10. What factors should investors look for to assess the likelihood of corporate failure? Explain how each might be related to the likelihood of corporate failure.

Factors investors should look for to assess the likelihood of corporate failure include: • • • • •

Poor cash flow, or no cash flow forecasts – inability to pay debts is one of the first signs of insolvency Disorganized internal accounting procedures – a business cannot control what it cannot measure Incomplete financial records – may be a sign that the business is attempting to cover up difficulties Absence of budgets and corporate plans – no longer-term strategy might indicate a lack of direction and difficulties in managing for the shortterm Continued loss-making activity – will be difficulties operating into the future

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Chapter 13: Corporate Failure

• • • • • •

Accumulating debt and excess liabilities over assets – may be difficulties with cash flow going forward Default on loan or interest payments – will have higher costs of debt and may not be able to borrow further funds to finance operations Increased monitoring by financier – additional cost of debt and reporting requirements Outstanding creditors of more than 90 days – indicative of cash flow problems Installment arrangements entered into – indicative of cash flow problems Loss of key management personnel – loss of confidence in the future direction of the business

11. Corporate governance has been highlighted as an important factor in alleviating the risk of corporate failure. Evaluate which aspects of corporate governance are likely to guard against corporate failure.

Strong corporate governance that is likely to guard against failure will have the following characteristics: • • • • • •

Boards are active in setting and approving the strategic direction of the company Boards are effective in overseeing risk and setting an appropriate risk level for the entity Boards consist of independent directors, with audit, compensation and nomination committees made up completely from independent directors Directors own an equity stake in the company Director quality - At least one of the independent directors should have expertise in the entity’s core business, attend the majority of meetings and limit the number of boards they sit on Boards should meet regularly without management present

12. What is the global financial crisis (GFC)?

The global financial crisis (GFC) has been referred to as the worst financial crisis since the Great Depression in the 1920s. It commenced with a downturn in the US housing market, which created a liquidity shortfall in the banking system. This resulted in the collapse of a number of large financial institutions, a downturn in stock markets and the government bailout of banks in a number of countries.

13. How did the GFC start?

The GFC is said to have started in the US housing sector. Leading up to the financial crisis there was a substantial increase in housing prices, with historically low interest rates. This created an environment which promoted borrowing, with lending standards relaxing and subprime mortgages increasingly being used. House prices started to decline towards the end of 2006, with significant defaults and foreclosures on mortgages following in early 2007. This coincided with an increase in interest rates and saw a number of financial companies filing for bankruptcy.

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Solution manual to accompany: Contemporary Issues in Accounting

14. Articulate the relationship between the housing sector and the finance sector.

The housing sector and the finance sector are closely linked. The finance sector provides the funds for housing development and purchases, and hold mortgages over property as security on loans. In addition, research has shown that the end of major asset bubbles can also have a significant effect on other markets, such as the stock market.

15. How was the housing sector so integral to the development of the GFC? The health of the housing sector is thought to be a critical indicator of the health of the economy in any company. The GFC was thought to have commenced with the increasing house prices – known as an asset bubble, and low interest rates.

Borrowings increased and subprime mortgages were offered where funds were leant to parties with limited ability to repay. When the housing price bubble burst and house prices declined there was limited opportunity to repay mortgages and this resulted in an increase in default, and a reduction in cash flows to banks.

16. Why have Australian financial institutions been able to avoid the worst of the GFC? The Australian financial sector was protected to a certain extent as a result of strong prudential regulation of capital requirements. Further, government intervention to encourage spending served to ensure Australia avoided a technical recession.

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Chapter 13: Corporate Failure

Application questions 13.1 Identify a delisted Australian company from the following website: www.delisted.com.au. Access the financial reports for the previous five years. Work in teams to determine and calculate a range of financial ratios which you could use to assess the evidence of financial distress that might have been evident to investors in the five years leading up to failure. (J, CT, SM) As a result of browsing the above website you should have been able to identify a large number of companies. One of these is A.B.C. Learning Centres Ltd, which collapsed in 2008. A search of the internet will provide access to annual reports on a number of websites. Alternatively they may be available through a range of databases normally held by university libraries, such as Aspect Huntley FinAnalysis or Connect 4. Share prices to calculate market value of equity can be downloaded from FinAnalysis if this is available to you under the ‘Charts and Prices’ tab.

You could calculate the ratios used in the Altman’s Z-Score, in addition to a cash flow ratio such as operating cash flow ratio (cash flow from operations/total liabilities).

For A.B.C. Learning these ratios for five years are as follows (note sales/TA has not been calculated as the firm was a service provider): Ratio

2007

2006

2005

2004

2003

Working capital/TA

-26.11%

5.69%

3.21%

4.12%

1.28%

Retained earnings/TA

4.24%

4.29%

4.68%

7.85%

9.14%

EBIT/TA

7.13%

6.65%

6.40%

10.43%

12.12%

Market value of equity/Book value of TL

1.32:1

5.88:1

2.89:1

5.67:1

4.45:1

CFO/TL

9.55%

20.8%

14.60%

17.81%

16.60%

13.2 You are interested in investing in shares in an Australian company but are worried the company might be in financial distress. Prepare a list of factors you might look at in deciding whether it might be considered to be a sound investment, or indicate potential distress. (J, K) This chapter highlights a range of factors that can be useful to assess an entity as a potential for investment, or to indicate potential distress. These include, but are not limited to: •

A range of financial ratios as reflected in the Altman Z-Score

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Solution manual to accompany: Contemporary Issues in Accounting

• • • • • •

Cash flow forecasts Budgets, corporate plans and strategies Evidence of continuing loss-making activities Ratio of liabilities to assets Any evidence of default on loans or interest payments Corporate governance quality reflected in board independence, board effectiveness and involvement in developing the strategic direction of the entity, share ownership by directors etc.

13.3 Access the Australian Prudential Regulation Authority (APRA) website.

Document what rules and regulations it has in place to oversee governance of deposit institutions. Identify any proposals it is examining that may affect future governance requirements. (J, K) APRA has in place CPS 510 Governance, which sets rules and regulations for governance of deposit taking institutions. This prudential guideline is effective from 1 July 2012 and replaces APS 510.

• • • • • • • •

The key requirements include: Specific requirements relating to board size and composition The requirement for the chairperson to be an independent director An audit committee Policies regarding board performance The establishment of a remuneration committee A remuneration policy A dedicated internal audit function

Proposed changes are identified in letters to deposit taking institutions. As a result of Basel Committee on Banking Supervision Pillar 3 disclosure requirements for remuneration being issued, there is anticipated to be changes to remuneration disclosure requirements – which are outlined in CPS 510. Consultation is to take place in the first half of 2012.

Case study 13.1: ABC Learning ‘reliant’ on debt to cover cash shortfalls 1.

Outline the importance of cash flow to ensuring the ongoing operation of a company. (J, K)

Cash flow is essential to the ongoing operation of a company. Cash is needed to pay staff, pay GST obligations, debtors and other operational expenses. These expenses must be paid regularly and failure to do so will mean a business runs the risk of failure.

2.

Discuss the corporate governance and board mechanisms that could have served to limit the chances of corporate failure in the case of ABC Learning.

(J, K)

The board appears to not have paid adequate attention to strategy upon the acquisition of other companies. The board did not appear to effectively oversee risk levels. There was a lack of independence on the board. The board appeared not to question

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Chapter 13: Corporate Failure

executives with regards to budget, cash flow and the source of cash to fund day-today operations.

Case study 13.2: Company failures soar by 40 pc 1.

Discuss how the GFC could have affected business health in New Zealand.

(J, K)

The GFC contributed to a recession in New Zealand, which led to increased unemployment, and declining orders and sales. As a result, businesses had problems with cash flow, and difficulties paying debt. The end result was an increase in liquidation or receivership in the country.

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13.9

Solutions Manual to accompany

Contemporary Issues in Accounting Michaela Rankin, Patricia Stanton, Susan McGowan, Kimberly Ferlauto & Matt Tilling PREPARED BY:

Patricia Stanton

John Wiley & Sons Australia, Ltd 2012

Chapter 14: Special reporting issues

CHAPTER 14 SPECIAL REPORTING ISSUES

Contemporary Issue 14.1 The Myth of ‘Conservative Accounting’ 1. Define ‘conservative’ as the term is used by the author. (J) J Underestimate earnings and the value of assets.

2. What is the ‘myth’ that is exposed by the author? (J, AS) The myth is that the mismeasurement of profitability and assets due to the expensing of investment in intangibles results in conservative accounting.

3. Who would be harmed by the failure to capitalise intangible assets? (J, AS) All who have an interest in the financial statements.

Contemporary Issue 14.2 How do you value an asset like the Rosetta Stone?

1. How does the author summarise the requirements of the British standard and its associated statement of recommended practice (SORP) in relation to heritage assets?

The author summarises the requirements as “if you know the cost of a heritage asset or can value it, do so. If you can’t, provide further explanation in the accounts so people at least understand the nature of the asset.”

This is because the standard requires extra information such as the extent of access permitted to heritage assets, valuation when the donated service is provided by an individual as part of their trade or profession, the contribution of volunteers, and the value to the entity of any gift.

2. Why is valuing a heritage object such as the Rosetta Stone difficult?

The Rosetta Stone is a unique asset, therefore, there is no active market (as defined by the IASB) for it. How do you value its economic benefits such as an understanding of Egyptian hieroglyphs?

3. How does convergence with IFRSs complicate valuing heritage assets? (J, K) The IFRS uses a principle of ‘fair value’. This principle is manageable when applied to freehold property donated but to heritage assets such as the Rosetta Stone?

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Solution manual to accompany: Contemporary Issues in Accounting

Contemporary Issue 14.3 The sum of us 1. Why would Te Papa resort to valuing its collections ‘in bulk’?

Because Archives [New Zealand] was faced with the task of valuing 77 km of records. To cost each individual signature would not have been cost effective.

2. How could the price per metre be derived, and defended?

One defence relates to the uniqueness that comes with age – valuing older documents more highly than recent ones, especially where the signees may still be alive. The amount assigned per kilometre of shelving could have been derived by sampling document and ascertaining their individual value and then averaging the value over the kilometre.

3. Do you regard the use of benchmarks of similar items a defensible method of obtaining a value for infrequently traded items? (J) Obtaining market value for assets is a form of benchmarking as the value of any asset at any point in time cannot be ascertained until it is sold.

I

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Chapter 14: Special reporting issues

Review Questions 1.

What are the distinctive features of an intangible asset?

• • • • • •

2.

largely knowledge assets which cannot be verified merely by visual inspection not separate, saleable, or discrete items well-defined property rights often do not extend to intangibles difficult to measure reliably often difficult to write fully specified contracts.

Which of the features of an intangible asset are irrelevant to the Conceptual Framework definition of an asset?

Using the Conceptual Framework definition of an asset, none of the above features precludes an intangible item from being identified as an asset.

3. What are the distinctive features of a heritage asset?

Heritage assets are tangible examples of the cultural or natural environments that a particular community is desirous of preserving with the UK ASB’s approach (FRS 30, para.2) being typical, because it stresses the contribution of the asset to knowledge and culture.

4. Which of the features of a heritage asset are irrelevant to the Conceptual Framework definition of an asset?

Assess each individually: Does the asset possess a reliable measurement attribute and is future realisation of the benefit more likely than less likely?Could the benefit be described as financial or economic, or is it more like service potential?

5. What impact has the accounting standard AASB138/IAS38 Intangible Assets had on the balance sheet?

Because IAS38 defines an intangible asset as “an identifiable non-monetary asset without physical substance” (para 8) it sets up barriers to the recognition of many assets in the financial statements, particularly balance sheets.

6. Justify the recognition (and associated valuation) of heritage assets on their controlling entity’s balance sheet.

Recognition is justified by proponents (chiefly, regulators) through economic rationalism, that is, accountability of asset managers for the assets under their control is best satisfied by financial recognition. This process, in turn, requires valuation in dollar terms. Opponents deny the validity of these arguments.

7. What is your understanding of the term ‘economic’ in the Conceptual Framework definition of an asset?

The answer should include at least the following: • the value for which someone is willing to pay;

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Solution manual to accompany: Contemporary Issues in Accounting

• •

8.

the potential to contribute directly or indirectly to the flow of cash and cash equivalents to the entity; in relation to not-for-profit entities, their ability to meet their objectives of providing needed services to beneficiaries.

Explain whether the definition of an asset would be less problematic if the definition included the term ‘financial’ instead of ‘economic’?

Answers should indicate that ‘economic’ transactions or benefits do not necessarily involve monetary exchanges whereas ‘financial’ refers to monetary exchanges or benefits.

9

Name the generally accepted intangible assets that are recognised on a balance sheet.

Cash, investments, goodwill 10. How does ‘recognition’ differ from ‘disclosure’?

Recognition refers to the process of incorporating in the financial statements an item that meets the definition of an element and satisfies the criteria for recognition. Disclosure refers to the inclusion of the item elsewhere, often in the Notes to the financial statements.

11. What are the implications of disclosing information about an asset rather than recognising it?

• The item does not contribute to assessments of the future earning capacity of the entity • Leads to differences between market value and book value 12. What do you think accounting standard setters should do in relation to (a) intangible assets?

Perhaps they should remove the inconsistencies in treatment; for example, an internally generated intangible is not recognised but if the same intangible is purchased, then it is recognised. If standard setters are confident that their guiding conceptual framework passes the relevance and reliability tests needed elsewhere, then they should allow the capitalisation of all those assets that pass the definition and recognition tests. Cash has been capitalisation since bookkeeping evolved. Pre harmonisation, Australia capitalised many intangibles and “the sky did not fall in”. Something has to be done as intangibles are the assets of the future. (b) heritage assets?

Heritage assets are widely variant in their scope. They range from the natural environment and archaeological artefacts that have no legitimate market, to other items, such as artworks, that have a ready market. There is no one approach that covers all these groups. The standard setters could tailor treatments idiosyncratically to the particular class of asset. For example, with national parks, which are essentially held in trust, they could adopt the American federal model and ascribe no dollar value but report on the condition of the asset and expenditure on it.

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Chapter 14: Special reporting issues

Justify your position Justification should be logical using the definition and recognition tests as well as findings from scholarly research.

13. Why do you think there was widespread opposition to the recognition of heritage assets?

• • • •

Uncertainty as to whether heritage assets satisfied the recognition criteria Costs of valuing heritage assets Was not apparent that recognition was useful for decision making Valuation implied that the assets were for sale

14. Why is the element of ‘control’ problematic for the recognition of heritage assets?

It is extremely problematic whether public sector and/or not-for-profit entities have the requisite degree of control over the heritage assets they manage, or for which they are custodians. For instance, it is arguable whether access to the benefits of many heritage assets is excludable — for example, national parks. Additionally, many environmental assets are technically owned by the States but ‘are subject to varying degrees of control by the [Commonwealth] government’. In some cases, this amounts to joint control, which, in accounting parlance, is not control at all. In other cases, effective control is vested (by deed or grant) in another funded or sponsored instrumentality or local community voluntary organisation.

15. How is the presence or absence of a market vital to the justifications advanced for the treatment of intangible and heritage assets? Evaluate these justifications.

The Conceptual Framework does not define any differences between assets. It does not specify that tangibility, separability, ownership and existence of markets for the asset are relevant in the decision about whether to record and report an asset although reliability is a necessary condition for recognition. IAS38/AASB138 contends that control is difficult to demonstrate in the absence of legal rights enforceable in a court of law as well as allow for the reliable measurement of the item which forms part of the recognition test. By the very nature of heritage assets, in most cases there is not a ready market or, alternatively, management is prevented, in the community interest, from selling them.

With control comes the ability to buy, sell, or withhold from a market, characteristics that are argued to indicate the notion of an asset. IAS38/AASB138 argues that it is ‘uncommon’ for an active market to exist for intangible assets because each asset is unique. It is extremely problematic whether public sector and/or not-for-profit entities have the requisite degree of control over the heritage assets they manage, or for which they are custodians.

16. How would you conceive the problem of what is an asset so that standard setters do not have to release further information to clarify whether an item is, or is not, an asset?

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Solution manual to accompany: Contemporary Issues in Accounting

A start would be to examine what a definition is trying to do: a description made up of a generic term identifying the broad category to which the “asset” belongs and a modifying word or phrase which specifies it distinctive or essential components, thus restricting the definition to include on the appropriate referents and so distinguishing from it similar senses and words.

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Chapter 14: Special reporting issues

Application Questions 14.1 Obtain a copy of your university’s annual report. (a) What intangibles does it report? (b) Does it capitalise intellectual capital? (c) Does it disclose information about its most valuable intangible, its intellectual capital? (d) Does it recognise or disclose any information about any heritage assets it may control? (J, K, AS) Students should apply the definitions of intangibles and heritage assets to identify whether the university reports any of these assets, and should identify where they were reported (recognition v disclosure). Voluntary disclosures should also be identified. The concept of control should be consulted as well as visual identification of likely heritage assets.

14.2

Read the following passage: The immediate expensing of practically all internally generated intangible investments in the United States, a questionable procedure given the substantial future benefits of many such investments, is often justified by the conservatism principle. Conservative accounting procedures, goes the argument, counter managers’ prevalent optimism, and are appropriate given the generally high level of uncertainty associated with the outcome of intangible investments.

However, no accounting procedure consistently applied can be conservative (or aggressive) forever. Over the lifetime of the enterprise, if reported earnings under a conservative accounting rule are understated (relative to a less conservative rule) during certain periods, they have to be overstated in other periods, given that conservative/aggressive accounting procedures essentially shift earnings from one period to another.51

(a) What is the ‘conservatism principle’?

Generally the principle refers to the recognition of losses as soon as they are apparent and the recognition of gains only when realised. (b) How is it applied to intangibles?

By the immediate expensing of practically all internally generated intangible investments (c) Why do the authors believe that expensing of intangibles is ‘questionable’?

If reported earnings under a conservative accounting rule are understated (relative to a less conservative rule) during certain periods, they have to be overstated in other periods (d) Why can’t accounting procedures generated by the conservatism principle be conservative forever? (J, K) Over the lifetime of the enterprise, conservative accounting procedures essentially shift earnings from one period to another.

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Solution manual to accompany: Contemporary Issues in Accounting

14.3

The following passage was taken from the article ‘R&D reporting biases and their consequences’.

We find evidence consistent with investor fixation on the reported profitability measures. Thus, the stocks of conservatively reporting firms appear to be undervalued, while the stocks of aggressively reporting firms appear to be overvalued, and these misvaluations appear to be corrected when the reporting bias reverses from conservative to aggressive, or vice versa. In addition, the misvaluations are significant for both ROE and earnings momentum profitability indicators. The misvaluation evidence we detect is consistent with well-established behavioral finance findings and, in particular, with the heuristic of representativeness that makes investors view patterns in reported data as representative about future patterns and thus overreact. The social relevance of systematic mispricing of securities is that it leads to misallocation of resources in both the real and capital markets.52

(a) What do the authors mean by ‘investor fixation’?

That investors rely only on reported profitability measures. (b) How does investor fixation on profitability lead to misvaluations of stocks?

Reporting of profitability is biased according to whether conservative to aggressive principles are being used, and investors fail to see behind the reported numbers.

(c) Explain the heuristic of ‘representativeness’? (J, K) The representativeness heuristic judges the probability of a hypothesis by considering how much the hypothesis resembles available data so that investors view patterns in reported data as representative about future patterns and thus overreact.

14.4 Jim Peterson made the following comments about PricewaterhouseCoopers’ announcement that they officially abandoned their ‘perfectly serviceable name in favour of the three-letter vernacular’ (i.e. PwC): When the accounting profession’s very survival rests on the ability to sell a basic core product — assurance on financial information — the essence of that delivery is the maintenance of confidence among issuers and users in consistent, solid and predictable quality service. That has been more than challenge enough, in difficult times for the profession. But its messages can and should be pretty stolid. A slightly boring orthodoxy is not a bad thing . . . We may of course expect defensive messages from the branding types at PwC, justifying what must be massive expenditure for this effort, along the lines of ‘we wanted to shake things up’ and ‘we have an exciting new set of messages’. Trouble is, they don’t, and the world of assurance users doesn’t want it.53

(a) Would PwC be able to recognise the expenditure on its new ‘three-letter vernacular’ on its balance sheet? Justify your answer.

Its ‘three-letter’ vernacular is a brand, both a brand name and a logo. IAS 38 offers the argument that expenditure on internally generated brands, mastheads, publishing titles,

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Chapter 14: Special reporting issues

customer lists and such cannot be recognised because expenditure on them cannot be distinguished from expenditure that develops the business as a whole. The argument for PwC is whether it is “internally generated” or because it was commissioned, whether it was purchased. If it can be argued that it was purchased, then the expenditure can be capitalised. (b) How could PwC defend the ‘massive expenditure’ on its new brand?

By elaborating on the expected future economic benefits. (c) What message does the spending send in relation to expected future economic benefits?

That PwC expects the future economic benefits to exceed the cost of developing the logo. (d) If you were PwC’s auditor, would you allow the expenditure to be capitalised? Why? (J, K) The logical answer would examine the definition of an asset, and if the expenditure passes the definition, then to see if the expenditure passes the recognition test(s) that any probable future economic benefits will accrue to the entity and that it has a cost or value that can be measured reliably.

14.5

In their article on ‘Intangibles and the OFR’, Vivien Beattie and Sarah Jane Thomson included the following graph:

(a) What does a market-to-book ratio tell you about how complete a company’s financial statements are?

The ratio is a rough guide of how incomplete a company’s financial statements are. (b) What does a market-to-book ratio of less than 1.0 mean?

That the company’s market value is less than its book value.

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Solution manual to accompany: Contemporary Issues in Accounting

(c) The authors report that GlaxoSmithKline, a leading pharmaceutical manufacturing and research company had the highest ratio. Where would you expect media companies to be positioned on the chart? Why? (J, K) Because media companies are knowledge intensive, thus high in intangibles that cannot be recognised under current accounting standards, their ratios should be high, possibly as high as the research companies.

14.6

Australian government departments were formally encouraged (under AAS29 Financial Reporting by Government Departments) to value their heritage assets by their ‘written-down current cost’ determined by reference to current market prices for the future economic benefits embodied in the asset or an estimate of those market prices.

(a) What difficulties do you envisage in applying this requirement to: (i) A ruined abbey?

What is the nature of the asset you are valuing and what is the meaning or relevance of the term future economic benefits when applied to it? Is its value related to the innate cultural or historic quality, its restored valuation, its present condition, or the value of the land on which it sits as an alternative use? (ii) A dinosaur skeleton?

Similar to above with the additional caveat that managers of museums, in particular, are resistant to inclusion of collection assets on balance sheets because it renders them capable of being realised for short term financial gain when that was not the asset’s original or primary purpose. (iii) A steam locomotive? (J, K) This is a cross-over type asset, having both potential commercial possibilities and cultural and industrial heritage characteristics. A survey of rail heritage custodians revealed that most believe there is a market for steam locomotives, so ostensibly there would be no problem in establishing a financial valuation. However, this likely does not capture or preserve the innate heritage quality of the asset which would seem defeat the purpose of the exercise.

14.7

The following information was reported in the New Zealand Sunday Star-Times newspaper: For a decade, Treasury has required institutions like Archives New Zealand, Te Papa and the National Library to tot up the value of their treasures. Archives’ holdings are currently estimated to be worth $524m, including the $20m for the 1835 declaration of independence of northern chiefs, and $10m for the women’s suffrage petition that led to New Zealand becoming the first country in the world to give women the vote, Te Papa’s treasures have been valued at $526m, while the rate books and manuscripts at National Library have been valued at

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Chapter 14: Special reporting issues

$671m. [Rodney Wilson] has concerns that publishing the value of Auckland Museum’s collections would give strength to museum sceptics. ‘It raises political issues, the sort of stupid comment you sometimes hear in local body politics, well if they’ve got all that money let them sell something’ he says. 55

(a) What is the danger envisaged by the valuation of heritage assets?

Less sophisticated users of the financial statements of the entity holding the heritage assets may well argue that the valuation represents funds and so the assets should be sold to cover the expenses of the entity. (b) Does a sale of a Maori feather cloak in the United States indicate a market for such items along the lines of IAS38/AASB138 Intangible Assets?

An active market (AASB138) is one in which all the following conditions exist: • The items traded within the market are homogeneous • Willing buyers and sellers can normally be found at any time • Prices are available to the public. (c) Can items from indigenous cultures be considered an ‘active market’ in terms of the definition of an active market in AASB 13/IFRS13 Fair Value Measurement? (J, K) An active market (IFRS13) is a market in which transactions for the asset/liability take place with sufficient frequency and volume to provide pricing information on an ongoing basis.

14.8

The article cited above goes on to say: Putting a value on the nation’s treasures has made no difference to funding the three organisations, but it has made the crown look wealthier. The assets make up more than $1.7b of the crown’s $72b of assets in the latest financial year.

But you won’t find the Americans rushing to have the Declaration of Independence valued. New Zealand, followed soon after by Australia, is so far alone in requiring its public institutions to view its heritage assets with a gimlet eye . . . New accounting standards from the Institute of Chartered Accountants . . . require beancounters in local governments and trusts to start accounting for heritage assets just like any other item of property, plant and equipment.

The edict covers everything from public monuments erected by local authorities to the butterfly specimens in regional museums.56

(a) Who or what is the ‘crown’ to which the article refers?

The New Zealand government (b) Has valuing heritage assets made the crown actually wealthier? Why? The crown is not wealthier in terms of disposable income or assets held for sale. The wealth is accounting paper based.

(c) Why do you think New Zealand and Australia were alone in valuing their heritage assets?

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Solution manual to accompany: Contemporary Issues in Accounting

Because of the philosophy of the standard setters that standards have the quality of “one-sizefits-all”. (d) How can their stance on heritage assets be justified in terms of the Conceptual Framework? (J, K) • •

14.9

Balance sheet focus All assets to be recognised

More from the article in the Sunday Star-Times newspaper: [T]here is revolt among the country’s big regional museums, who say they don’t need a dollar sign on a balance sheet to recognise an item of immense value. [Three museums] are all refusing to comply with the new accounting standards . . . The country’s biggest regional museum is the Auckland War Memorial Museum . . . It is preparing to publish its annual accounts . . . in a form that makes accountants everywhere blanch — with a caveat attached to the accounts . . . the caveat will be mildly worded, explaining that the museum refuses to comply with the new rules. ‘It’s not a good look, but it’s a bad look that we’re prepared to live with. Somebody has to fly the flag of common sense.

It’s dogma. They’ve come up with something which in accounting terms makes a lot of sense to them. But it makes no sense in many places out in the market place’.57

(a) Would you expect an audit qualification for the financial statements in response to the caveat attached to the accounts? Justify your answer.

An audit report in part attests to compliance with accounting standards. If the museum refuses to comply then there must be an audit qualification. (b) Why do you agree (disagree) with the museum manager that ‘Somebody has to common sense’?

Points to consider could include: • There is an arguable case that financial valuation of collections in entities such as a war museum is a waste of resources and potentially trivialises the human sacrifice embodied in the lifeless artefacts.

• Alternatively, the case for commonsense could/should have been argued before the regulations came into effect. If the argument of the museums did not prevail, then they have a responsibility to comply with the law. Citizens, including corporate entities, have no mandate to comply with only the regulations that suit them. (c) What alternative measure or measures could be taken to ‘recognise’ the value of items in the museums? (J, K) An alternative is the structured, qualitative disclosure about all classes of heritage assets, including a mission statement, number of physical units, their condition and maintenance, acquisitions and disposals.

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Chapter 14: Special reporting issues

14.10 Read the following article from Business Wire on Interbrand’s methodology for valuing brands: Brands create value, both for consumers who use their preferred brands and for the companies that own the brands. For more than 25 years, Interbrand . . . has been evaluating exactly how much brands are worth. Now its brand valuation methods have been certified according to International Standards Organization (ISO) 10668:2010, making Interbrand the first brand consultancy in the world to achieve ISO 10668 certification [which] is the international norm that sets minimum standard requirements for the procedures and methods used to determine the monetary value of brands. It defines a coherent and reliable approach for brand valuation that takes into consideration financial, legal and behavioural science aspects.58

(a)

Argue whether the ‘reliable’ approach of brand valuation by Interbrand would satisfy the reliability part of the recognition test for assets.

See chapter on the conceptual framework. Estimates of the cost or value does not necessarily mean that a measure is unreliable. (b)

Debate whether the awarding of the ISO Standard will impact the accounting for internally generated intangible assets. (J, K, AS)

Auditors must sign off the accounts. In deciding whether an intangible will be recognised in the accounts requires the intangible to pass the definition test and then the recognition test.

The Standard would most likely impact auditor’s decision as to whether the future economic benefits have been measured reliably. However, the nature of the intangible must be taken into account as the accounting standard does not allow certain intangibles to be recognised.

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Solution manual to accompany: Contemporary Issues in Accounting

Case Study Questions Case study 14.1 Fund managers, intangibles and private disclosure Questions 1. What is meant by ‘intellectual capital’? (K) Outside scholarly literature, intellectual capital often refers to intangibles, as the associated meaning is the difference between the physical and financial assets and the market value of an entity. In the scholarly literature, intellectual capital is divided into three categories: i) human capital, and in particular, the knowledge that a worker takes home with him; ii) structural capital – the infrastructure that enables human capital to function; and iii) relational capital – customers and networks and such.

2. Why do you think, intellectual capital has been the only named intangible by the author? (J, K) Because it is being used in the non-scholarly manner.

K 3. The fund managers are being informed in a private way. Argue whether this advantage should be treated as insider information. (J, K) Insider trading is commonly defined as trading on information obtained by individuals with potential access to non-public information about a company. Arguably, informing fund managers of information not publicly available constitutes insider information if the fund manager trades on that information.

JK 4. Who benefits from this inside information? (K) The fund managers and indirectly, their clients.

5. Argue the case whether the market benefits that fund managers gain in this way should be regulated. (J, K) Arguments should revolve around the issue of what constitutes insider trading – trading on information that is not publicly available.

K 6. Identify any ways this private disclosure process could be used to improve the public disclosure process via financial reporting. (K, AS) Markets rely on information. More information should increase the efficiency of the market.

Information is being made available when the fund managers release this information to their clients thus benefiting the market. However, private information is usually only private because financial reporting does not include this information. Full disclosure would reduce private information.

K AS

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Chapter 14: Special reporting issues

7. Undertake research to ascertain the governance of fund managers; who or what governs fund managers. (J, K, AS) Fund managers are subject to the Government’s Corporate Law Economic Reform Program, The regulations mean that comparable financial products are subject to the same rules; that providers of financial services must be licensed; and that financial markets are each subject to a single licensing regime. ASIC is the governing body.

8. Who governs those who govern the fund managers? (K) The Commonwealth Government.

Case study 14.2 Kakadu: mining versus intangible values 1. In one sentence summarise the debate that is the focus of this article. (K) Whether mining would jeopardise the integrity of the key values for which Kakadu was listed on the World Heritage List.

2. Prepare a list of: (a) the tangible assets of Kakadu; • sandstone plateau and escarpment • savanna woodlands and open forests • rivers and billabongs • flood plains, mangroves and mudflats • mammals, reptiles and birds • rock carvings and paintings • minerals (b) the intangible assets of Kakadu; and • Mirrar dreaming • Natural beauty • Cultural values (c) the heritage assets of Kakadu. (J) • • •

rock carvings and paintings unspoiled landscape cultural values

3. Which of the assets identified would pass the Conceptual Framework definition of an asset? Justify your answer. (J, K) Consider the main groups of asset at Kakadu arising from the lists and assess them by reference to the Framework definition attributes:

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Solution manual to accompany: Contemporary Issues in Accounting

• • • • •

Natural environmental (including flora) - future economic benefit embodied? controlled by managing entity? Additionally, pass the recognition test(s) of reliable measurement and probable realisation of the benefit?

Fauna – as above Aboriginal artefacts – as above Minerals – would seem to have normal potential commercial value and therefore an asset under the Framework Abstract Values – no place in financial accounting

4. Of those assets identified in (3), which would pass the Conceptual Framework recognition test? Give reasons for your answer. (J, K) • • • • •

Natural environmental (including flora) – Do they pass the recognition test(s) of reliable measurement and probable realisation of the benefit?

Fauna – as above Aboriginal artefacts – as above Minerals –because of their potential commercial value minerals would probably pass the reliable measurement and probable realisation of the benefit Abstract Values – no place in financial accounting

5. On what grounds did you identify some of Kakadu’s assets as heritage assets? (J, K, AS) Heritage assets typically embody the following characteristics: •

ASB (UK) FRS 30: “A tangible asset with historical, artistic, scientific, technological, geophysical or environmental qualities that is held and maintained principally for its contribution to knowledge and culture”

•

ASB (South Africa) GRAP 103: “assets that have a cultural, environmental, historical, natural, scientific, technological or artistic significance and are held indefinitely for the benefit of present and future generations”

AS 6. When decisions have to be made, for example as in the use of Kakadu, how has the inability to value intangible and heritage assets reliably disadvantaged the case for their preservation? (J, K, CT) Decision making has evolved to a cost-benefit analysis. Assessing cost of something is relatively easy compared to the assessment of benefits especially intangibles and heritage assets. Benefits are commonly understated. The adage says, “you never know what you have got until its gone”.

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Chapter 14: Special reporting issues

7. Which of the unique geological formations, plants, animals and minerals of Kakadu would (J, K, AS) (a) pass the active market test of IFRS13 Fair Value Measurement?

AASB 13 Appendix A defines an “active market”: A market in which transactions for the asset or liability take place with sufficient frequency and volume to provide pricing information on an ongoing basis.

(b) satisfy the capitalisation provisions of FRS30 Heritage Assets?

Relevant FRS 30 Provisions: “Recognition and Measurement 18 An entity should report heritage assets as tangible fixed assets and recognise and measure these assets in accordance with FRS 15 ‘Tangible fixed assets’**, …

21 Valuations may be made by any method that is appropriate and relevant.

22 There is no requirement for valuations to be carried out or verified by external valuers, nor is there any prescribed minimum period between valuations. However, where heritage assets are reported at valuation, the carrying amount should be reviewed with sufficient frequency to ensure the valuations remain current.” ** equivalent to AASB 116 Property, Plant and Equipment

8. How do you weigh up the benefits of mining against more intangible values? (J, K, CT) Heritage assets are preserved when one or all of the following conditions are met: ⬧ value to the community exceeds the opportunity cost in alternative commercial use ⬧ they are irreplaceable and held in perpetuity ⬧ they are used for community rather than commercial purposes Therefore, if the tangible economic value of mining to the community at large is greater than the intrinsic value of a national park, then mining will prevail. However, the assessment should also consider other potentially negative impacts of mining activities, for example, to the supply of fresh drinking water.

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