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Discipline of Accounting, UTS Business School (TUTORIAL QUESTIONS (WITH SOLUTIONS)
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In-class questions are marked thus: E15.17.
Discipline of Accounting, UTS Business School In-class questions for each week Note: Reference styles are as follows: D1-4 Whittred Zimmer Taylor and Wells, chapter 1, Discussion question 1-4 CQ1: x,y,z Loftus et al chapter 1, Comprehension Question x, y, and z CS1.1 Loftus et al chapter 1, Case Study 1 E1.1 Loftus et al chapter 1, Exercise 1
1. Introduction – material for tutorial in Week 2 Preparation: Additional Questions AQ1-AQ4 (below) Ch.1: (p.28) CQ1: 4,6,9,11,12; Ch.1: (p.30) E1.5; Ch.1: (p.29) CS1.1(d); Ch.2: (p.49) CQ2: 6,7,8; Ch.2: (p.52) E2. In-class discussion : Ch.1: (p.30) E1.4, Ch.1: (p.31) E1.13; Ch.2: (p.29) CS2. Additional Questions AQ1) What are the three functions of accounting? AQ2) What are the agency costs of debt, as discussed in WZTW Chapter 1? AQ3) What are the agency costs of equity, as discussed in WZTW Chapter 1? AQ4) If income-increasing accounting techniques result in lower income in the following year(s), why do management use them? SOLUTION TO AQ AQ1 The three functions of accounting are decision-making, contracting and stewardship SOLUTION TO AQ AQ2 The agency costs of debt are: Management will use the debt to increase dividend payments to shareholders Management will borrow additional funds, thus diluting the claim of the existing debtholders Management will use the funds for a purpose other than that stated (asset substitution) Management will not invest in a positive NPV project as all (or most) of the cashflows will flow to the debtholders (under investment) SOLUTION TO AQ AQ3 The agency costs of equity are: Management will consume additional resources not required in the performance of their employment (perquisite consumption)
standard may be modified to the extent necessary to take account of the Australian legal or institutional environment and, in particular, to ensure that any disclosure and transparency provisions in the standard are appropriate to the Australian legal or institutional environment. This is often reflected in modifications to standards for application by not-for-profit entities in Australia. SOLUTION TO CQ1. 6. What is the difference between Australian Accounting Standards and IFRSs? While IFRSs are developed for application by profit-seeking entities, Australian Accounting Standards are also applied by not-for-profit entities in the public and private sectors. Accordingly Australian Accounting Standards may include additional or different requirements or exemptions for not-for-profit entities. Australian Accounting Standards also cover additional matters, such as disclosure requirements (typically in a separate standard) on matters not covered by IFRSs. The difference introduced by the AASB can be easily identified in the texts. For example, paragraphs added by the AASB are prefixed with “Aus” while paragraphs deleted by the AASB are indicated as “deleted by the AASB”. SOLUTION TO CQ1.
9. Outline the fundamental qualitative characteristics of financial reporting information to be included in general purpose financial statements. The fundamental qualitative characteristics of financial information are relevance and faithful representation. Paragraphs QC6 to QC11 of the Conceptual Framework elaborate on the qualitative characteristic of elevance. Information is relevant if: - it is capable of making a difference in the decisions made by the capital providers as users of financial information - it has predictive value, confirmatory value or both. Predictive value occurs where the information is useful as an input into the users’ decision models and affects their expectations about the future. Confirmatory value arises where the information provides feedback that confirms or changes past or present expectations based on previous evaluations. - it is capable of making a difference whether the users use it or not. It is not necessary that the information has actually made a difference in the past or will make a difference in the future.
Paragraphs QC12 to QC16 of the Conceptual Framework elaborate on the fundamental qualitative characteristic of faithful representation. Information is faithfully represented if: complete. A complete depiction includes all information necessary for a user to understand the phenomenon being depicted, including all necessary descriptions and explanations. (QC13) neutral A neutral depiction is without bias in the selection or presentation of financial information. (QC14) free from error. Free from error means there are no errors or omissions in the description of the phenomenon, and the process used to produce the reported information has been selected and applied with no errors in the process. (QC15) SOLUTION TO CQ1.
11. Discuss the essential characteristics of an asset as described in the conceptual framework. Discussion of essential characteristics of asset: resource must contain future economic benefits control, requiring a capacity to benefit from the asset in the pursuit of the entity’s objectives, and an ability to deny or regulate the access of others to those benefits. past event, giving rise to the entity’s control over future economic benefits. Physical form and the right of ownership are not essential to the existence of an asset. For example, property held on a lease is an asset if the entity controls the benefits that are expected to flow to the entity even though there is no legal ownership. SOLUTION TO CQ1. 12. Discuss the essential characteristics of a liability as described in the conceptual framework. A liability is defined in the current conceptual framework as ‘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
standards themselves would suffer from the same problem if there were no framework. The conceptual framework provides guidance and direction to the standard setters, and therefore will lead to consistency among the standards. But it is a set of concepts. It provides a boundary for the exercise of judgement by the standard setter and the interpretive body. **Case study
SOLUTION TO CS1.1(d) Visit the AASB website (www.aasb.gov.au) and find out the following: (d) Why are there differences in the numbering systems for current accounting standards (e.g. AASB x, AASB xxx and AASB xxxx)?** (d)Different numbering systems for standards: See Pronouncements for information, plus section 1.7.4 in the text. AASB x represent those standards adopted by the AASB from the IFRSs of the IASB. AASB xxx represent those standards adopted by the AASB from the IASs of the IASB and its predecessor the IASC. AASB xxxx represent those standards issued exclusively by the AASB for companies in the Australian context. In addition, the AAS standards consist of standards issued by the AASB for special organisations e.g. superannuation plans, government. (The numbering system is also set out in tabular format at the For Students link; go to About, then AASB and select For Students).
6. Explain the following agency problems that can arise in the relationship between owners and managers: a) the horizon problem b) risk aversion c) dividend retention a) Shareholders are concerned with the long term growth and value of the firm, which reflects the market’s expectations of the present value of the future cash flows. However, management’s interest in the cash flow potential may be limited to the period over which they expect to be employed by the firm. This horizon problem may be exacerbated if the manager is approaching retirement. Managers generally adopt a shorter horizon than shareholders when evaluating proposed actions or investments, e.g., management’s preference for delaying research and development expenditure may increase short-term profitability but may also have adverse long-term consequences, such as missed opportunities for innovation and new product development. b) Managers are generally more risk averse than shareholders because managers are less able to diversify risk. Shareholders typically spread their investment (and hence, their risk) across a range of securities and other assets. Their liability is limited to the unpaid capital on their shares. Shareholders may also receive income from sources, such as employment, that are independent of the company. Managers, however, have less diversifiable ‘human capital’ invested in the company. Their management compensation (remuneration) is likely to be their primary source of income. c) Managers prefer to maintain a greater level of funds within the company through dividend retention. This helps managers to expand the size of the business they control (empire building) and to pay their own salaries and benefits. Shareholders may have preference for increased dividend. In particular, this would occur where the retention of dividends results in lower returns because the firm has insufficient investment opportunities. Under such circumstances funds would be held in low return investments, such as cash and cash equivalents, or perhaps invested in negative net present value projects.
8. What is a debt covenant and why is it used in a lending agreement? Debt covenants are restrictions or undertakings imposed in debt contracts. Debt covenants reduce the risk to the lender, resulting in lower interest costs being imposed on the borrower. Some debt covenants use accounting numbers. For example, a debt covenant may restrict leverage to a maximum of 60 per cent of total assets. By agreeing to debt covenants, managers may be able to borrow funds at lower rates of interest. Debt contracts will often restrict investment opportunities of the firm, including mergers and takeovers, to protect themselves against the additional risk arising from asset substitution. Establishing a maximum ratio of debt to tangible assets can also mitigate asset substitution by restricting investment in intangible assets. Restricting higher priority debt is a common method of reducing the risk of claim dilution. SOLUTION TO E2. Exercise 2. Leases and efficient market hypothesis Accounting standard setters are debating changes to the requirements for accounting for leases. Currently, if a lease is classified as a finance lease, the leased asset and a corresponding lease liability are recognised in the statement of financial position of the lessee. However, if a lease is classified as an operating lease, a lease asset and a lease liability are not recognised by the lessee. Instead, lease payments are recognised as expenses as incurred and lease commitments are disclosed in the notes to the financial statements. The following statement has been made in relation to the proposed changes to accounting for leases: If the efficient market hypothesis is correct, management would be indifferent between classifying the lease as a finance lease or as an operating lease. Required Critically evaluate this statement.
The evaluation of this statement commences with an explanation of the claim made, and then considers both its strengths and weaknesses. This evaluation argues that there is some merit in the statement but it reflects a misunderstanding of the implications of an efficient market and ignores other reasons why management might prefer to classify a lease as a finance lease. The author (of the statement) asserts that managers would have no preference for classifying a lease as either operating or financing if the market is efficient. The classification of a lease as either operating or financing has implications for its effect on financial statements. Specifically, when a lease is classified as a finance lease, the leased asset and a corresponding lease liability for the present value of the minimum lease payments are recognised in the statement of financial position. Conversely, when a lease is classified as an operating lease, lease rental is expensed as incurred and the leased asset and corresponding liability are not recognised on the statement of financial position. Market efficiency suggests that the share price would impound all information disclosed about the lease, irrespective of whether it is in the financial statements or in the notes. Although the statement is not specific, the implied form of market efficiency is the semi- strong form in which share prices respond in a rapid and unbiased manner to new publicly available information. Information included in general purpose financial reporting is publicly available, irrespective of whether disclosure is in the financial statement, or the notes to the financial statements. Thus, if the effect on the share price is the same irrespective of whether the lease is classified as a finance lease or an operating lease, management might be expected to be indifferent between the alternative lease classifications and their implications for financial statements. The claim in the statement and the above argument contain some assumptions, including that managers believe the market to be efficient and act on that belief. Market efficiency does not rely on market participants believing in it. Management might still make choices on a mistaken belief in inefficiency; that some managers act as if the market is not efficient, does not mean it is not efficient. Indeed, market efficiency may be
(b) Does the conceptual framework lead to measuring the building at $15 000 000? Or at $9 800 000? Or at some other amount? (a) Is the fair value relevant to stakeholders’ decisions? Whether the stakeholders care about the fair value of the building should be considered. Relevance Information in financial statements is relevant when it influences the economic decisions of users. It can do that both by (a) helping them evaluate past, present, or future events relating to an enterprise and by (b) confirming or correcting past evaluations they have made. Materiality is a component of relevance. Information is material if its omission or misstatement could influence the economic decisions of users. Timeliness is another component of relevance. To be useful, information must be provided to users within the time period in which it is most likely to bear on their decisions. Faithful representation Information in financial statements is a faithful representation if it is complete, neutral and free from material error and bias and can be depended upon by users to represent events and transactions faithfully. Information is not a faithful representation when it is purposely designed to influence users’ decisions in a particular direction. There is sometimes a trade-off between relevance and faithful representation — and judgement is required to provide the appropriate balance. Faithful representation is affected by the use of estimates and by uncertainties associated with items recognised and measured in financial statements. These uncertainties are dealt with, in part, by disclosure and, in part, by exercising prudence in preparing financial statements. Prudence is the inclusion of a degree of caution in the exercise of the judgements needed in making the estimates
required under conditions of uncertainty, such that assets or income are not overstated and liabilities or expenses are not understated. However, prudence can only be exercised within the context of the other qualitative characteristics in the conceptual framework, particularly relevance and the faithful representation of transactions in financial statements. Prudence does not justify deliberate overstatement of liabilities or expenses or deliberate understatement of assets or income, because the financial statements would not be neutral and, therefore, not have the quality of reliability. Analysis The fair value of the property is relevant to the investors in the enterprise. The enterprise — and therefore its owners — are better off because the value of the property has gone up. Better off means that their wealth increased. Is the fair value reported by the appraiser reliable? Certainly, appraisals involve judgements, and different valuation methods and different assumptions can generate different valuations. The objectivity and other qualifications of the appraiser should be considered. The conceptual framework acknowledges that accounting information can be reliable even if it is not precise. The appraiser acknowledged that there is a potential for error of plus or minus 10%. That does not mean that the value information is not reliable. (b) The conceptual framework does not include concepts or principles for selecting which measurement basis should be used for particular elements of financial statements or in particular circumstances. The qualitative characteristics do provide some guidance, particularly the characteristics of relevance and faithful representation. **Exercise
SOLUTION TO E1.13 (in-class) [p.31) Definition and recognition criteria Glenelg Accounting Services has just invoiced one of its clients $3600 for accounting services provided to the client. Explain how Glenelg Accounting Services should**
Total liabilities (including a long term debt agreement) 5 000 60 Shareholders’ equity 3 400 40 Profit (includes depreciation expense of $100,000) 1 200 14 Tony was puzzled by the senior managers’ response: ‘You don’t understand our business. What might look like an improvement for your financial statements, looks like devastating economic consequences for us.’ Additional information
**- Managers receive a bonus, subject to profit exceeding 10% of total assets.
Preparation: Ch.15: (p.499-500) CQ15: 1,6; Ch.15: (p.500)E15.1, Ch.15: (p.501) E15. Additional Questions AQ5-AQ10 (below) In-class discussion: Additional Question AQ11 (below) Additional Questions AQ5) How does the AASB framework define: a. Income b. Revenues c. Expenses d. Losses AQ6) Identify and discuss two potential reasons why management would manipulate profit in the following directions: a. Upwards b. Downwards AQ7) According to AASB 118 Revenue : a. When is revenue recognised for the sale of goods? b. When is revenue recognised for the rendering of services? c. How much revenue is recognised when it is allowable to do so? AQ8) In each of the following cases, state at which point you would expect revenue to be recognised, consistent with AASB 118 Revenue : a. Airlines receive cash for passenger and freight fares before the provision of air services. In fact, air transportation may take place several months after the purchase date of the tickets, and the journey may conclude months after it has commenced. Only after the flight on a defined sector has concluded can the airline have full claim to the fare because only then does the client lose the right to a refund of the ticketed amount. b. A major transportation company provides ‘long haul’ freight services under contracts that imply that clients agree to pay for the freight when the goods are loaded onto the truck. Although there is a valid claim against the client once the goods are loaded, invoices are usually not processed until the service has been
provided. c. Stamps are produced and then sold across the counter to customers by Australia Post. After the sale, it is legally possible for customers to return stamps for cash, subject to a 10% discount on the face value, but experience has shown that stamps are rarely cashed in. d. A merchant bank makes a prior agreement with its clients that a non-utilisation fee will be charged for credit facilities granted to a client but unused during the year. The charge cannot be levied until the end of the year, when it is established that the facility was unutilised. e. An electrical supply commission repairs damaged equipment and power lines and charges the costs to the persons responsible for the damage. Often it takes some time to locate the persons responsible.
