CGA-CANADA ACCOUNTING THEORY & CONTEMPORARY ISSUES [AT1] EXAMINATION March 2012 Time: 3 Hours

Marks

Note: All references to the Handbook refer to the CICA Handbook.

24

Question 1 Select the best answer for each of the following unrelated items. Answer each of these items in your examination booklet by giving the number of your choice. For example, if the best answer for item (a) is (1), write (a)(1) in your examination booklet. If more than one answer is given for an item, that item will not be marked. Incorrect answers will be marked as zero. Marks will not be awarded for explanations. Note: 2 marks each

a.

Economic consequences of new accounting standards are said to be consistent with efficient markets for which of the following reasons? 1) 2) 3) 4)

Because of the existence of securities markets anomalies Because there could be indirect cash flow effects of accounting standard changes Because accounting policy changes affect the amount of income tax payable Because accounting changes reflect a move from historical cost to fair value

b. Earnings management could be viewed as “opportunistic” or as an example of “efficient contracting,” depending on the goals of management. Which of the following settings reflects the efficient contracting aspect of earnings management? 1) Earnings management might help insolvent firms avoid immediate bankruptcy. 2) Earnings management might help credibly convey private information about the long-term earnings potential of the firm. 3) Earnings management is used to block communication from insiders to outside investors. 4) Earnings management is undertaken by manipulating discretionary accruals. c.

Jones (1991) found that a sample of U.S. firms reported negative discretionary accruals in the year of their application for U.S. government subsidies for victims of unfair foreign competition. Which of the following positive accounting theory (PAT) hypotheses is this finding consistent with? 1) 2) 3) 4)

Political cost hypothesis Bonus plan hypothesis Debt covenant hypothesis Both debt covenant and bonus plan hypotheses

d. In an agency situation, the first best contract between the principal and the agent will maximize the principal’s utility while maintaining the agent’s reservation utility under which of the following conditions? 1) 2) 3) 4)

The principal and the agent are working together for the first time. The principal and the agent are related. Securities markets are efficient. The principal can observe the agent’s chosen acts without cost to the principal. Continued...

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e.

One solution to the moral hazard problem relating to owner-manager conflicts is to link managerial compensation to performance measures that are correlated with managerial effort. If, however, the manager is paid only a fixed salary and no other form of compensation, which of the following will occur? 1) 2) 3) 4)

f.

An effort-averse manager will engage in insider trading. An effort-averse manager will exert minimal effort. A risk-averse manager will undertake earnings management activities. A risk-averse manager will want to bear compensation risk.

Which of the following best explains the reason that single person decision theory is important to accountants? 1) Decision makers’ prior beliefs about future firm performance are based mainly on non-financial information. 2) The information system helps investors calculate objective probabilities of future investment payoffs that are not conditional on financial statement information. 3) Financial statements provide information that is useful for many decisions. 4) Bayes’ theorem provides a method for rational investors to revise their state probabilities based on financial statement information.

g. One of the most useful concepts in financial accounting is relevance of financial information. Which statement best describes relevant financial information? 1) Relevant financial information faithfully represents without error what it intends to represent. 2) Relevant financial information gives investors information about a firm’s future economic prospects. 3) Relevant financial information faithfully represents without bias what it intends to represent. 4) Relevant financial information gives investors information about a firm’s past economic performance. h. In decision theory, which of the following describes the concept of rational decision making? 1) 2) 3) 4) i.

The act that provides the highest expected utility will be chosen. The act that provides the highest expected value will be chosen. The act that provides the lowest expected risk will be chosen. The act that provides the lowest systematic risk will be chosen.

Which of the following statements best explains the concept of due process in setting accounting standards? 1) The government must respect all of the legal rights that are owed to a person or corporation according to the law. 2) It is the manner in which an agent determines the expected utility of a given compensation system. 3) Major constituencies are represented in standard setting boards, super-majority voting, exposure drafts, and public meetings. 4) Standards are set in consultation with the constituencies affected by the standards.

j.

Which of the following is considered a part of positive accounting theory? 1) 2) 3) 4)

Income maximization Income smoothing Bonus plan hypothesis Prospect theory

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k. The criterion of usefulness of accounting numbers has implications for ethical behaviour by accountants. While it is likely that most people are inherently moral and ethical, which of the following rules and practices most encourages and enhances ethical behaviour by accountants? 1) Rules that require that goodwill assets are regularly tested for impairments 2) Rules that prohibit insider trading 3) Rules that allow firms freedom to choose whether or not to get their quarterly financial statements reviewed 4) Rules that require application of generally accepted accounting principles l)

Correct measurement of employee stock options (ESOs) have been the subject of debate ever since expensing of ESOs became mandatory in Canada. Which of the following causes the greatest problems with using the Black-Scholes model to value ESOs? 1) 2) 3) 4)

13

Share price variability Back dating of ESOs Unpredictability of the date of exercise of ESOs by option holders Intrinsic value of the ESO

Question 2 This question is based on the article entitled “Accounting Boards Issue Converged Fair-Value Standards,” which appeared in the CFO.com digital journal on May 12, 2011. The article quotes David Larsen, an accounting commentator and consultant, saying that the Financial Accounting Standards Board (FASB) of the U.S. and the International Accounting Standards Board (IASB) have both issued fair value accounting rules that are “almost word-for-word identical” and that “it is a big positive [for the argument] that convergence can be done.” Required 4

a.

3

b. The article states that the two standard-setting bodies are negotiating to ensure that all their respective accounting standards are as similar to one another as possible. Discuss which of the two theories of regulation this “convergence” effort is consistent with.

6

c.

(3) (3)

Discuss the benefits of convergence of U.S. GAAP and IASB accounting standards.

These converged fair value accounting rules prescribe additional disclosures by firms about the methods used to measure fair value assets that do not have an active market. For example, firms are now required to disclose parameters, such as weighted average cost of capital, if used for valuation of these assets. i)

For a firm that carries a significant amount of such assets (that is, assets that do not have an active market), discuss one potential cost of providing these additional disclosures. ii) Also discuss whether these additional disclosures have any effect on the operation of the managerial labour market.

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Question 3 This question is based on the article entitled “Bank Executive Compensation: Payback,” that appeared in the digital magazine CFO.com on November 21, 2008. In the wake of the most recent market downturn in the United States in 2007–2008, the currently high levels of U.S. bank managers’ pay was subject to criticism by many commentators. A number of banks proposed changes in the way top bank managers were compensated, especially in terms of how their bonuses are linked to net income. This article reported that UBS, a Switzerland-based bank, is contemplating the following bonus plan for its top managers: “From next year, cash payouts will be limited to one third of an executive’s entitlement [bonuses] in any one year; the rest will be rolled into one outstanding [accumulated] balance. The balance can go up or down depending on performance in any one year.” The accumulated balance is paid in equal instalments over the next two years. Assume that managers’ entitlement (bonuses) in any one year is a percentage (“k”) of the bank’s annual net income and that managers are risk averse and effort averse. Required 6

a.

4

b. Discuss the effect of this proposed UBS managerial annual cash payout plan on the propensity of managers to undertake accrual-based earnings management activities.

5

c.

11

Discuss the effects of this proposed UBS managerial annual cash payout plan on the value of k. In other words, explain whether managers would demand a higher value of k or a lower value of k in order to attain their reservation utility.

Discuss the effect of this proposed UBS managerial annual cash payout plan on the propensity of managers to undertake risky projects or safe (less risky) projects. Assume that UBS’s proposed bonus plan does not have a cap, but has a bogey.

Question 4 The collapse of firms like Enron and Worldcom are examples of the adverse effects of information asymmetry on securities markets. Following these and other financial reporting failures, investors realized that the shares of many firms were overpriced as a result of information asymmetry. It may seem strange that markets can be efficient and investors’ confidence can still collapse. However, these seemingly conflicting notions can be reconciled through the concept of fundamental value. Required 4

a.

Define the concept of fundamental value. Identify and explain how the concept of information asymmetry is related to fundamental value.

4

b. Explain the effect of information asymmetry on a firm’s perceived risk. Indicate whether it will increase or decrease risk. Explain whether increased information asymmetry will lead to higher or lower security prices.

3

c.

Briefly explain the role of financial reporting in an efficient market with information asymmetry.

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Question 5 This question is based on the article entitled “Ahold: Europe’s Enron,” which appeared in The Economist magazine dated February 27, 2003. The article describes the circumstances surrounding the financial irregularities of Ahold Inc., a European firm, that were disclosed to the financial press in early 2003. Required 4

a.

The article reports that on February 23, 2003, Ahold disclosed that it had overstated profits of the firm by $500 million. The market value of this firm plunged by 63% on the same day. Discuss why share prices of Ahold fell so sharply on the day of its announcement of overstated profits.

4

b. This article sharply criticizes certain accounting accrual practices of Ahold. For example, the article states that, “Most firms that buy in bulk — including such admired retailers as Wal-Mart and Tesco — get discounts from suppliers if they meet sales targets. The issue is how those rebates are accounted for. The prudent practice is to wait until the targets are met. Failing firms, such as now-bankrupt Kmart, Fleming, a food distributor, and now Ahold, appear to have booked these payments before they were earned. Ahold may even have booked entire rebates as profit in the first year of multi-year agreements — or simply made them up.” Discuss how the iron law of accrual reversal makes this practice (of recognizing rebates in income before they are earned) unsustainable in the long run.

3

15

c.

The article reported that Ahold has been accused of keeping billions of dollars of debt off its balance sheet. Identify the effect, if any, of Ahold’s off-balance-sheet debt on its reported shareholders’ equity and net income. In other words, indicate whether these two items are understated, overstated, or remain the same, as a result of its off-balance-sheet debt.

Question 6 6 a. (2) i) Discuss the difference between “fair market value” and “value in use.” (2)

ii) Identify conditions under which these two sets of numbers are different and briefly explain why.

(2)

iii) Identify conditions under which these two sets of accounting numbers are equal to one other and also equal to historical cost accounting numbers.

9 (6)

(3)

b. i)

Discuss the difference in calculations involved in the ceiling tests under IFRS (IAS 36) and under U.S. GAAP (SFAS 144). Briefly explain which of the two rules is a more complete application of the measurement approach to decision usefulness.

ii) Explain under which of these two sets of ceiling test rules (that is, IAS 36 and SFAS 144) net income would likely be more volatile.

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Question 7 This question is related to an article entitled “Earnings management using classification shifting” by Sarah McVay, which appeared the October 2006 issue of The Accounting Review. This article examines the origins of the practice of “misclassifying core operating expenses (such as cost of goods sold) as special items” by several U.S. firms. Note that, by definition, special items are unusual or infrequent items. Required 2

a.

6

b. Briefly discuss the effects of the misclassification of core operating expenses as unusual or infrequent one-time special items on:

(2) (2) (2) 3

Identify the persistence of unusual or infrequent items in terms of Ramakrishnan and Thomas’ (1991) categorization of income statement items as either permanent, transitory, or price irrelevant items. Briefly discuss.

i) Net income in the year of misclassification. ii) Core earnings in the year of misclassification. iii) Core earnings in the year following the misclassification. c.

The article reported that the misclassification allowed firms to exceed financial analysts’ forecasts of firms’ earnings. Explain how. Note that financial analysts do not forecast a firm’s special (one-time) accounting items. END OF EXAMINATION

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ACCOUNTING THEORY & CONTEMPORARY ISSUES [AT1] EXAMINATION

AT1 Before starting to write the examination, make sure that it is complete and that there are no printing defects. This examination consists of 6 pages. There are 7 questions for a total of 100 marks.

READ THE QUESTIONS CAREFULLY AND ANSWER WHAT IS ASKED.

To assist you in answering the examination questions, CGA-Canada includes the following glossary of terms. Glossary of Assessment Terms Adapted from David Palmer, Study Guide: Developing Effective Study Methods (Vancouver: CGA-Canada, 1996). Copyright David Palmer. Calculate

Compare

Contrast

Criticize

Define

Describe Design

Determine

Diagram

Discuss

Evaluate

Mathematically determine the amount or number, showing formulas used and steps taken. (Also Compute). Examine qualities or characteristics that resemble each other. Emphasize similarities, although differences may be mentioned. Compare by observing differences. Stress the dissimilarities of qualities or characteristics. (Also Distinguish between) Express your own judgment concerning the topic or viewpoint in question. Discuss both pros and cons. Clearly state the meaning of the word or term. Relate the meaning specifically to the way it is used in the subject area under discussion. Perhaps also show how the item defined differs from items in other classes. Provide detail on the relevant characteristics, qualities, or events. Create an outcome (e.g., a plan or program) that incorporates the relevant issues and information. Calculate or formulate a response that considers the relevant qualitative and quantitative factors. Give a drawing, chart, plan or graphic answer. Usually you should label a diagram. In some cases, add a brief explanation or description. (Also Draw) This calls for the most complete and detailed answer. Examine and analyze carefully and present both pros and cons. To discuss briefly requires you to state in a few sentences the critical factors. This requires making an informed judgment. Your judgment must be shown to be based on knowledge and information about the subject. (Just stating your own ideas is not sufficient.) Cite authorities. Cite advantages and limitations.

Explain

In explanatory answers you must clarify the cause(s), or reasons(s). State the “how” and “why” of the subject. Give reasons for differences of opinions or of results. To explain briefly requires you to state the reasons simply, in a few words. Identify Distinguish and specify the important issues, factors, or items, usually based on an evaluation or analysis of a scenario. Illustrate Make clear by giving an example, e.g., a figure, diagram or concrete example. Interpret Translate, give examples of, solve, or comment on a subject, usually making a judgment on it. Justify Prove or give reasons for decisions or conclusions. List Present an itemized series or tabulation. Be concise. Point form is often acceptable. Outline This is an organized description. Give a general overview, stating main and supporting ideas. Use headings and sub-headings, usually in point form. Omit minor details. Prove Establish that something is true by citing evidence or giving clear logical reasons. Recommend Propose an appropriate solution or course of action based on an evaluation or analysis of a scenario. Relate Show how things are connected with each other or how one causes another, correlates with another, or is like another. Review Examine a subject critically, analyzing and commenting on the important statements to be made about it. State Clearly provide a position based on an evaluation, e.g., Agree/Disagree, Correct/Incorrect, Yes/No. (Also Indicate) Summarize Give the main points or facts in condensed form, like the summary of a chapter, omitting details and illustrations. Trace In narrative form, describe progress, development, or historical events from some point of origin

CGA-CANADA ACCOUNTING THEORY & CONTEMPORARY ISSUES [AT1] EXAMINATION March 2012 SUGGESTED SOLUTIONS Time: 3 Hours

Marks 24

Question 1 Note: 2 marks each

Sources/Explanations: a.

2) Topic 6.4 (Level 2) New accounting standards can have economic consequences if these new standards have indirect cash flow effects. For example, if a new accounting standard leads a firm to violate existing debt covenants, that can have economic consequences since violation of covenants can lead to cash flow effects if lender and borrower re-negotiate the debt. Option 1) is incorrect because one does not need market inefficiency to explain the economic consequences of new accounting standards. Option 3) is incorrect because income tax payable is determined by the tax code. Accounting changes can affect the income tax expense. Hence, these amounts are not necessarily the same. Option 4) is incorrect because not all accounting standard changes involve a move from historical to fair value accounting and, in any case, a reverse change can also have indirect cash flow effects.

b. 2) Topic 6.5 (Level 2) Conveying private inside information credibly to outsiders is an efficient contracting use of earnings management. If a firm delays bankruptcy it can either hurt or help the shareholders of the firm, depending on the circumstances of each case. Thus, option 1) is incorrect. If earnings management is used to block communication between managers and shareholders, that is not an efficient contracting use of earnings management. Thus, option 3) is incorrect. Using discretionary accruals to undertake earnings management might lead to either opportunistic or efficient contracting use of earnings management. Thus option 4) is not correct. c.

1) Topic 6.5 (Level 2) This action by managers of U.S. firms is consistent with the political cost hypothesis. These firms undertook earnings management to obtain relief from the government. While is it true that under certain circumstances, managers might want to report a lower level of earnings under the bonus plan hypotheses (for example, when earnings is less than bogey or more than the cap of the bonus plan) or under the debt covenants hypothesis (for example, smoothing earnings), in this case, political cost hypothesis is the best answer. All the other 3 options are incorrect.

d. 4) Topic 7.3 (Level 1) When the principal can observe the agent’s actions without cost, the first best contract between the principal and the agent can be achieved. For each managerial action the principal pays the agent a fixed sum large enough to meet the agent’s reservation utility. Since the agent is considered risk averse, this is good for him because he bears no risk and the principal can also maximize his own utility. Options 1) and 2) are incorrect because it does not matter whether the principal and the agent have worked together or are related. Option 3) is incorrect because the issue of securities markets efficiency is immaterial in this context.

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e.

2) Topic 7.3 (Level 1) When paid a fixed salary, the effort-averse manager will exert minimal effort because his disutility of effort is less when he shirks or puts in minimal effort. Hence, the manager will maximize expected utility when he shirks under these conditions. Options 1) and 3) are incorrect because it is not clear why an effort-averse or risk-averse manager will undertake insider trading or earnings management activities when paid a fixed salary. Option 4) is incorrect because it is the opposite; a risk-averse manager will not want to bear compensation risk.

f.

3) Topic 2.2 (Level 1) Single person decision theory’s support for the decision usefulness of financial statement information is important to accountants. Option 1) is incorrect because prior beliefs are based on financial as well as non-financial information. There are errors in option 2). The information system helps investors calculate subjective probabilities that are conditional on financial statement information. Option 4) correctly comments on Bayes theorem, which is a tool used in single person decision theory, not the reason it is important to accountants.

g. 2) Topic 1.7 (Level 1) Option 2) is an accurate description of the relevant accounting information. Options 1) and 3) are components of reliable financial information and are incorrect options. Option 4) refers to past performance rather than future and is not the correct answer. h. 1) Topic 2.4 (Level 2) A rational decision is an act that yields the highest expected utility, not the one with the highest expected value as in option 2). Both options 3) and 4) identify risk as the deciding factor. While a knowledge of the individual’s risk profile is required in the expected utility calculation, it is the resulting expected utility that will determine the choice. Therefore, option 1) is correct. i.

4) Topic 1.1 (Level 2) Standards are set in consultation with major constituencies — usually investors and managers. Option 1) is a general legal definition of due process and is therefore not the best answer for the purposes of this question. Option 2) makes a false association between due process and expected utility. Option 3) is a list of several devices used to attain due process, but does not explain the concept.

j.

3) Topic 6.4 (Level 1) Bonus plan hypothesis is one of the hypotheses that comprises positive accounting theory (PAT). Income maximization and income smoothing are patterns of earnings management rather than PAT hypotheses. Thus, options 1) and 2) are wrong. Prospect theory is not a part of PAT and hence option 4) is wrong.

k. 4) Topic 2.8 (Level 2) Rules requiring the application of GAAP foster greater ethical behaviour because GAAP provides a set of rules, the violation of which might attract adverse comments from auditors and other stakeholders. Insider trading rules foster ethical behaviour by all insiders, not necessarily accountants, and hence option 2) is incorrect. Option 1) is not correct because it is a subset of GAAP. The choice of whether or not to review interim statements might provide an opportunity for managers to signal quality if they choose to review them, but there could be other reasons for not choosing to review and thus option 3) is not the correct answer.

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l.

3) Topic 6.2 (Level 1) The Black-Scholes (BS) model assumes options will be held to maturity whereas ESOs tend to be exercised early. This is the biggest problem with using the BS model for ESO valuation. Share price variability can be estimated from historical share price data. Thus, option 1) is incorrect. Intrinsic value is the difference between share price and exercise price on the grant date and is not relevant for BS models. Thus, option 4) is incorrect. Back dating does not have anything to do with BS and thus option 2) is incorrect.

13 4

Question 2 a. Source: Topic 10.2 (Level 2) IFRS and U.S. GAAP are the two major sets of accounting standards that are being used by all major economies in the world. U.S. firms use accounting standards enacted by the FASB and most of the rest of the major economies of the world use IFRS enacted by the IASB. Convergence of the two sets of rules would have a number of benefits. Financial statements would become more comparable, and since financial statements form the major set of information about firms, convergence will lead to more cross border share trading as investors are able to better understand and interpret financial statement information regardless of geographical location of the firm. Enhanced trading would lower the cost of capital and increase the flow of capital and investments across jurisdictions.

3

b. Source: Topic 10.2 (Level 2) The article notes that the two standard-setting bodies are negotiating to achieve convergence in accounting standards. Convergence negotiations reflect compromises made by each body as they try to achieve consensus. Compromises are necessary to satisfy the varying demands of different national and international interest groups that the two bodies represent. This process is an example of the interest group theory of regulation rather than the public interest theory of regulation, under which standards will be set to maximize social welfare rather than meeting the different demands of different constituencies or interest groups.

6 (3)

c. i)

Source: Topic 9.1 (Level 2) There are at least two important potential costs of enhanced disclosure. First, increased disclosure requirements might have proprietary costs, which if released might affect the competitive position of the firm leading to negative future cash flows. The second cost arises from the loss of ability to signal information if previously voluntary disclosures become mandatory. Third, there can also be costs of paying for a specialist or out-of-pocket costs of doing the work. Note: Any one cost is good enough for full marks.

(3)

ii) Source: Topic 9.2 (Level 1) More disclosures will enhance transparency in the managerial labour market since information about managerial performance will be known to the market participants through increased firm level disclosures. This will increase the efficiency of the managerial labour market and the value of managerial reputation will be correctly reflected in the managers’ reservation utility.

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Question 3 a. Source: Topic 7.3 (Level 2) The bonus plan where only one third of the annual bonus entitlement is paid out in cash, with the rest accumulated in a deferred account to be paid in instalments in the future, will reduce the fluctuation and standard deviation of the cash flow (bonus) stream and reduce the riskiness of the bonus stream. This will reduce compensation risk and will tend to reduce the value of k that the manager demands in order to attain his or her reservation utility. On the other hand, the cash payouts are less also, because only one third of the bonus entitlement is paid out immediately and the rest in future instalments. Thus it will cause managers to demand a higher value of k in order to reach their reservation utility. The net effect of this plan on k is uncertain. Note: Either compensation risk effects or cash payout effects need to be mentioned in order to get full marks.

4

b. Source: Topic 7.3 (Level 2) The propensity of managers to undertake earnings management activities is likely to be less. Since managers are paid only a third of the entitlement, any increase in the amount of compensation cash payout as a result of earnings management activities will be restricted to a smaller amount (one-third only) in the first year. Thus, the immediate benefit of earnings management is less. In subsequent years, when accruals reverse, this will likely negatively affect subsequent years’ incomes and will reduce the deferred and accumulated amount and hence the instalments. These two effects will tend to reduce incentives to undertake earnings management activities. Note: Both current smaller effect and the potential accrual reversal effects need to be mentioned in order to get full marks. Give 3 marks if only “smaller” effect or only “reversal” effect is mentioned.

5

c.

Source: Topic 8.3 (Level 1) Managers will get a reduced cash bonus (one third), which will encourage managers to undertake risky projects. By undertaking risky projects, managers can expect to benefit from upside risk since UBS’s bonus plan has no cap. The downside risk is reduced because of the existence of the bogey.

11

Question 4 Source: Topic 3.5 (Level 1) 4

a.

The fundamental value of a share is the value it would have in an efficient market if there is no inside information. That is, all information about the share is publicly known. If there is no information asymmetry, share price would equal the firm’s fundamental value. Under more realistic conditions, however, all information is not publicly known. Thus, in presence of private information, share prices will not equal fundamental value.

4

b. The effect of information asymmetry is to increase the estimation risk of investors. If a firm is perceived to be affected by information asymmetry and hence subject to increased estimation risk, this will decrease demand for the security and will lead to a fall in its prices.

3

c.

Financial reporting can be used as a device to control the adverse selection problem and estimation risk, thereby improving the working of the securities markets. Financial reporting is a method of converting inside information and thereby reducing the difference between the efficient market price of a firm and its fundamental value. Due to the direct and indirect costs of disclosure, it is obvious that the gap between share prices and fundamental value will remain, but it ought to be reduced to an acceptable level. Continued...

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Question 5 a. Source: Topic 9.2 (Level 1) The big drop in share prices of Ahold reflects the effects of lack of adequate disclosure and the consequent loss of investor confidence in the financial statements of the company. While full disclosure by firms has the effect of lowering the cost of capital by increasing share price, lack of disclosure has the opposite effect. Alternatively, investors revised downwards estimates of Ahold’s earnings persistence. This resulted in lower share prices. Note: Either disclosure or persistence is worth full marks.

4

b. Source: Topic 8.7 (Level 1) Once rebates of yet to be realized target sales are recognized in net income, there is no room for recognizing more rebates when sales targets are actually met. If, in fact, targets are not met for some reason, the rebates that have been recognized have to be reversed with negative consequences on net income. This puts an upper limit on the amount of rebates that can be recognized ahead of time. Thus, the iron law of reversal of accruals makes this practice unsustainable.

3

c.

Source: Topic 8.1 (Level 1) This is an example of an extreme form of earnings management. If some of the debt owed by Ahold is not shown in the balance sheet, assuming that assets are shown correctly on the balance sheet, the shareholders’ equity will be overstated because shareholders’ equity reflects net assets, namely assets minus liabilities. The interest expense corresponding to the off-balance-sheet debt will also not be recognized in the income statement, leading to the reported net income being overstated.

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Question 6 a. Source: Topic 5.1 (Level 1)

(2)

i)

(2)

ii) They are equal under ideal conditions when no arbitrage conditions will ensure that market values of assets and liabilities are equal to the present values of future cash flows. However, the two sets of numbers will not be equal when properly working markets do not exist for the asset/liability, or when the market for the assets/liabilities is not perfect.

(2)

iii) Fair value will equal value in use and historical cost numbers under ideal conditions and if present value accounting is used.

9

Fair market value reflects a system of measurement based on market values of assets and liabilities. Value in use reflects a measurement system based on the discounted present value of future cash flows.

b. Source: Topic 5.4 (Level 2)

(6)

i)

Under IAS 36, the ceiling test is based on the tests of impairment. An asset is considered impaired if its book value is greater than its realizable value, where realizable value equals the greater of the fair value less cost to sell the asset, and the value in use amount. The difference in the two numbers is impairment, which can be reversed if the recoverable amount increases. Under SFAS 144, the ceiling test is based on the following impairment test. An asset is considered impaired if book value is greater than the undiscounted present value of its future cash flow. Once the asset is considered impaired, the impairment amount is equal to the excess of book value over the value of the best and highest use of the asset. This amount is either the market price of the asset or, if that is not available, the discounted expected present value of the asset. No reversals are permitted under SFAS 144. IAS 36 is a more complete application of the measurement approach. The use of undiscounted future cash flows in SFAS 144 and the inability to reverse impairments makes it a weaker example of the measurement approach.

(3)

11

ii) IAS 36 and SFAS 144 both require that impairments are recognized in net income. Since IAS 36 allows reversals of the impaired amount and SFAS 144 does not, net income is likely to be more volatile under IAS 36.

Question 7 Source: Topic 4.4 (Level 1) 2

a.

6 (2)

b.

Unusual and infrequent items could be either transitory or price irrelevant depending on the nature of the item.

i)

There is no change in net income when there is a misclassification of a core operating expense as a special item.

(2)

ii) Core earnings will be inflated in the year of misclassification, a portion of the core expenses having been misclassified as special one-time items. This reduces total core expenses and enhances core earnings.

(2)

iii) Core earnings will revert back to their normal levels if there is no misclassification in the following year. There is no effect of the misclassification in the year following the year of misclassification.

3

c.

The misclassification will enhance the core earnings, and since analysts typically forecast core earnings before special infrequent items, this could cause reported net income to exceed analysts’ forecasts of earnings. END OF SOLUTIONS

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CGA-CANADA ACCOUNTING THEORY & CONTEMPORARY ISSUES [AT1] EXAMINATION March 2012 EXAMINER’S COMMENTS

General Comments Some students did very well on this examination, while others seemed poorly prepared. For example, in Question 7, many students reversed the subsequent write-up provisions of IAS 36 and SFAS 144. Also, in Question 6, there was some confusion between fair value and value-in-use. For a professional accountant, errors like these are not acceptable. Those students that did not do well should notice that many of the questions asked students to “discuss.” This requires a complete and thorough answer (see the glossary of assessment terms on the examination). If possible, students should consider both sides of the issue in question.

Specific Comments Question 1 Multiple choice (Levels 1 and 2) Performance on this question was satisfactory. Question 2 Standards convergence (Levels 1 and 2) Performance on this question was unsatisfactory. a.

Most students were aware of the benefits of standards convergence. However, in part (b), some students were completely unaware of the two theories of regulation (Level 1). Others had some awareness, but incorrectly concluded that the public interest theory was correct. The use of the word “negotiating” in the question indicated that the interest group theory applies.

c.

i)

Most students did not mention the cost that arises since regulation prevents signalling. That is, a cost of the improved disclosure regulations is that a firm that may wish to signal its commitment to quality reporting cannot do so because every firm must adopt the improvements. However, it was not necessary to discuss this particular cost, since the question asked for only one.

c.

ii) Many students had difficulty with the concept of reservation utility. Most answers correctly stated that better disclosures would improve the operation of the managerial labour market. However, the question asked students to discuss. A complete answer would go on to point out that improved market operation would enable the market to better evaluate the manager’s ability and effort, so that each manager’s reservation utility would better reflect that manager’s own reputation and market value.

Continued... AT1M12

©CGA-Canada, 2012

Question 3 Bonus plans (Levels 1 and 2) Performance on this question was unsatisfactory. a.

There are two effects of the bonus deferral scheme on managers’ expected utility of compensation. One is that utility is reduced by deferring two-thirds of the bonus, since its receipt is pushed into the future — the present value of a dollar to be received tomorrow is less than the present value of a dollar received today. This would cause the affected managers to demand a higher bonus percentage. The second effect is on risk. Changes in risk will also affect expected utility of compensation for a risk-averse manager. Most students mentioned only the risk effect. Indeed, many students felt that compensation risk would increase, since the bonus may change in the future. However, a careful reading of the quote from the UBS bonus plan suggests that once awarded, the total bonus awarded for that year would not change. Thus, risk of future bonus payments would decrease to the extent that receiving a bonus over three years rather than one year would reduce the variance of annual bonus payments over time, working against managers demanding a higher bonus percentage. However, marks were still awarded if there was a good discussion of the effects of increased risk.

b.

This part was reasonably well answered by most students. However, there are at least two reasons why earnings management would be reduced. One is that the effect of earnings management on manager compensation is spread out over 3 years. Thus two-thirds of the benefits to the manager from earnings management are deferred, reducing the incentive to manage earnings. The second effect arises from accrual reversal. Reversal of any income-increasing earnings management accruals in the current year will reduce the bonus pool in future years, further reducing the earnings management incentives. Many students identified only the accrual reversal effect.

c.

Most students missed the main point here, namely that there is a high degree of upside risk but little downside risk when the bonus plan includes a bogey but not a cap. Thus, the manager has an incentive to engage in risky projects since there is everything to gain but little to lose. In this regard, the upside risk effect of a bonus with a bogey but no cap is much like that of a stock option.

Question 4 Information asymmetry and fundamental value(Level 1) Performance on this question was satisfactory. a.

Well answered by most students.

b.

Most students realized that investors will perceive higher firm risk due to information asymmetry. The best answers were more precise, identifying estimation risk as the specific risk involved. That is, a source of estimation risk is investor uncertainty about the ethics and honesty of management. Increased concern about adverse selection thus implies increased estimation risk. Risk-averse investors respond to increased estimation risk by bidding share price down.

c.

Well answered by most students. Most answers recognized that financial reporting can reduce the threat of adverse selection, decreasing estimation risk and thereby moving efficient market share price closer to fundamental value. Some students, however, stated that financial reporting could increase both relevance and reliability. Since these two qualities have to be traded off, this statement is incorrect.

The best answers also pointed out that the costs of removing all adverse selection and estimation risk would be prohibitive, so that some gap between efficient market price and fundamental value will remain.

Continued... AT1M12

©CGA-Canada, 2012

Question 5 Financial irregularities (Level 1) Performance on this question was satisfactory. a.

Well answered by most students.

b.

Well answered by most students. However, several answers were vague and incomplete. Most realized that accrual reversal was the root source of the unsustainability of Ahold’s policy. There are two reasons for this. One is that even if the sales targets were met, accrual reversal would require larger and larger rebate accruals each year if increases in reported earnings were to be maintained. The other is that if sales targets were not met, it would be necessary to reverse some of the bonus accruals later when it became apparent that targets were not met. Many answers were a mix of these effects.

c.

Generally well answered.

Question 6 Fair value vs. value-in-use; IAS 36 and SFAS 144 (Levels 1 and 2) Overall performance on this question was unsatisfactory. a.

i)

a.

ii) and iii) Most students realized that the answers here depended on the lack or presence of ideal conditions. Many students, however, restricted their answer to ideal conditions of certainty. Ideal conditions of uncertainty also produce the same results. The only difference is that under ideal conditions of uncertainty, market values and expected value-in-use are equal. This requires that the probabilities of future cash flows are publicly known and objective. This is an assumption of ideal conditions under uncertainty.

b. i)

b

Well answered by some students. However, some students appeared to have little or no understanding of the meaning of the terms fair value and value-in-use. This is surprising given the recent attention to these terms as a result of the 2007-2008 market meltdowns, when managers of financial institutions demanded some relief from fair value accounting and greater use of value-inuse (Topic 1.2). The lack of knowledge of these simple definitions resulted in an inability to answer well the rest of part (a).

This question required knowledge of IAS 36 and SFAS 144. Most students did have a reasonable knowledge of them. Where there were problems, they usually arose from not remembering that SFAS 144 requires a 2-step process of first estimating undiscounted present value and them applying the ceiling test if undiscounted present value is less than book value. IAS 36 requires a direct comparison of current value and book value, and a ceiling test writedown if current value is less.

ii) Many students correctly realized that IAS 36 is closer to full fair value accounting because it allows subsequent writeup if current value improves, whereas SFAS 144 does not. Thus, IAS 36 tends to produce more volatile earnings. The main problem was that many students thought that SFAS 144 allowed subsequent writeup but IAS 36 did not, which is backwards.

Continued... AT1M12

©CGA-Canada, 2012

Question 7 Earnings management and special items (Level 1) Performance on this question was satisfactory. a.

Most students correctly identified unusual and infrequent items as transitory under the Ramakrishnan and Thomas categorization. Very few, however, recognized that some such items could be price irrelevant. While not required as part of the answer, an example would be a writeoff or writedown of organization costs.

b. i)

Most students correctly concluded that net income would not be affected. The reason, of course, is that unusual or infrequent items go “above the line.”

b. ii) Most students correctly concluded that core earnings would be overstated. b. iii) A number of students concluded incorrectly that next year’s core earnings would also be misstated. Since the earnings management in this question involved only misclassification, not discretionary accruals, there is no accrual reversal here. Not realizing this could result from not reading the question carefully enough. c.

AT1M12

Correctly answered by most students.

©CGA-Canada, 2012

AT1 March 2012 (Past Examination)

Mar 1, 2012 - 3) A risk-averse manager will undertake earnings management activities. ... is a big positive [for the argument] that convergence can be done.” Required. 4 ..... price variability can be estimated from historical share price data.

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