Financial Accounting Issues

Question 1

Q1 what are the potential methods of earnings management? Are you able to identify examples for each of the methods?

Answer 1

• Accounting policy choice:
  o most common form of earnings management.
  o strategic choices of accounting policy.
  o E.g., selecting favourable depreciation policies.
  o Any other examples from your knowledge?
• Accrual accounting:
  o allows entities to delay or accelerate recognition of income and expenses.
  o enables entity to temporarily adjust profit figures.
  o Examples (accrued revenue) …….?
• Income smoothing:
  o ‘Smoothing moderates year-to-year fluctuations in income by shifting earnings from peak years to less successful periods.’
  o Shareholders prefer to invest in an entity that exhibits consistent growth patterns, rather than one that has uncertain and changing earnings patterns.
  o Any example?

Question 2

Q2 What are the potential methods of Real activities management? Are you able to identify examples for each of the methods?

Answer 2

Managing earnings by managing operational decisions, not just accounting policies, or accruals.
Examples include:
* accelerating sales
* reducing expenditures
* altering shipment schedules and delaying research and development and maintenance expenditures.

Real activities management can reduce entity value because actions taken in the current period to increase earnings can have negative effects on cash flows in later periods.

Question 3

What is the definition of corporate governance?

Answer 3

Corporate governance is defined by the Organisation for Economic Co‐operation and Development (OECD) as: ‘A structure which specifies the distribution of rights and responsibilities among the different participants in the organisation and which lays down the rules and procedures for decision-making’.

Cadbury Report, 1992, para. 2.5: ‘Corporate governance is the system by which companies are directed and controlled’.

Question 4

Q4 What are the benefits of having a good corporate governance system?

Answer 4

• Increasing globalization of business and competition for capital.
• companies that can provide assurances that the company is being appropriately managed can gain a competitive edge.
• Reducing perceived risks to investors can reduce the cost of capital.
• Expanding company shareholdings to a broader base, combined with more organised and active shareholders lobby groups, is placing more scrutiny on company management.

Question 5

Q5 What are the models of corporate governance?

Answer 5

• The Anglo-Saxon (also called Anglo-American) model:

o Traditional view of the role of the corporation.
o is characterized by large, listed companies with dispersed ownership.
o The managerial team operates on behalf of shareholders, and this is the classic setting where agency theory applies. Ensures that the interests of shareholders are met.
o Financial reporting is a ‘governance mechanism’ useful to reduce information asymmetries between investors and managers.

• The German & Japanese models

o Emphasise multiple stakeholders.
o There are two different classes of owners: one class is highly concentrated and stable (banks or State); the other one is represented more of investors with short-term interests (shareholders).
o There is a separation between the goal-setting (Supervisory Board) and the execution (Management Board).
o Financial reporting is also used by major shareholders (as banks) for contracting and evaluation purposes.

• The continental European model

o More focused on employees
o Large, listed companies are run by run by founding families or the State.
o Financial reporting is therefore useful to reduce the asymmetry between major owners and minority investors (rather than the classical owner-manager dichotomy.