GM 1404

Question 1

Inom parateserna indikerar på vilket kapitel kortet hör till.

Answer 1

Exempel: (Regulation) = Chapter 4

Question 2

Market Failure ? (Regulation)

Answer 2

Implies that there’re inefficient allocation of goods and services and that !!one party could become better off without any other party becoming worse off as an result!!

Question 3

4 market failures categories ? (Regulation)

Answer 3

Asymmetric information, public goods, externalities and market power (concentrated).

Question 4

Asymmetric information ? (Regulation)

Answer 4

Incomplete information could create opportunism. Regulation is needed to create more comparable information and reduce asymmetric information.

Question 5

Public goods and externalities? (Regulation)

Answer 5

Accounting could be seen as a public good. As one party will pay for it but everyone can later use and benefit from it.

Externalities = Could be negative or positive. In accounting there’s usually positive externalities because there are only the firm who will pay for creating the financial report but there will be a lot of users (who just benefit from it). Problem without regulation could thus be “underproduction of accounting” as firms try to minimise their costs creating them. But too much information could also be problematic, thus with regulation they try to achieve a “desirable” amount of accounting information.

Question 6

Market Power? (Regulation)

Answer 6

-Protect the consumer!

-Natural monopoly, high entry barriers, first-move advantages etc.

• Regulators would like to increase total output of the companies to maximise social welfare.

Question 7

Why regulate? Pros & Cons. (Regulation)

Answer 7

Pros:
Protects the consumers.
Lower the chances of new financial crisis.

Cons:
Could be more costly than private contracts.
Firms could become more risk averse.

Question 8

Principle based vs. Rule based (Regulation)

Answer 8

Same info as in the accounting class. Principle = more “up for discussion” and Rule = You have to follow this.

Question 9

State regulation pros & cons (Regulation)

Answer 9

Pros:

• Advantage of being clearly enforceable through the court system.

Cons:

• Could take a long time to change.

Question 10

Private standard setters, pros and cons? (Regulation)

Answer 10

Pros:

• More up to changes and can adapt quicker.

Cons:

• Feasibility of successful enforcement of this type of regulation is less evident. (Möjligheten att framgångsrikt verkställa denna typ av reglering är mindre uppenbar.)

Question 11

Anglo-American Group and Continental group (Regulation)

Answer 11

AAG = Canada, US and UK.
CG = Europe (ex UK)

Big difference is that AAG focuses on Equity investors and CG on creditors and banks.

See pic:

Question 12

Equity investors vs. Creditors? (Regulation)

Answer 12

Creditors has a lot more to loose (asymmetric economic exposure) as if the company goes bad, than they will lose all their leverage to the company. Equity investors has the choice of selling their part before it’s too late.

Question 13

Harmonisation? (Regulation)

Answer 13

More global from 90s encouraged harmonisation through out accounting. Listed firms from CG countries started to move towards AAG for higher harmonisation (because of the more cross-boarder investments happening in the world). Non-listed firms in CG countries remained the same.

Question 14

The qualitative characteristics of CF ? (CF)

Answer 14

See pic:

Question 15

(CF)
End the two sentences:
1. “Those who believe faithful representation should be prioritised over relevance…”

2. “Those who favor relevance are…”

Answer 15

1. “Tend to support historical costs as a basis for measurement”
2. “More open to fair value accounting”

Read the pic for more info.

Question 16

Matching principle ? (CF)

Answer 16

States that expenses should be matched to the revenues they help to generate.

Question 17

Prudence (Conservatism) ? (CF)

Answer 17

States that it’s better to overestimate liabilities and underestimate assets.

Have pros and cons.

Pro is that you could handle economic surprises better. May also benefit creditors because of their asymmetric exposure in contrast to equity investors.

Cons is for example that it’s harder for people to correctly value the company.

Question 18

Substance over form? (CF)

Answer 18

Refers to the idea that financial statements should reflect the economic substance rather than the legal form of events and conditions. IFRS 16 “Leasing” is a good example of this where lease agreements are accounted for in accordance with their economic substance rather than their legal form.

Question 19

True and fair view? (CF)

Answer 19

No stated definition of what is consider a true and fair view, but refers to the quality of being truthfully about underlying economic phenomena by being “accurate and comprehensive to within acceptable limit” (A cost-benefit analysis could be necessary to determine what these limits are).

Question 20

4 issues regarding accounting? (Structure of accounting issues = SOAI)

Answer 20

1. Definition of financial statement elements

2.Recognition and measurement: 4 styled Accrual situations (SAS)

3. Measurement bases
4. Disclosure

Question 21

Definition of financial statement elements ? (SOAI)

Answer 21

Assets, Liabilities, Income and Expenses.

Question 22

Recognition and measurement: 4 styled Accrual situations (SAS)? (SOAI)

Answer 22

1. Acquisition of resources
2. Future outflows of resources
3. Changes in value of existing items.
4. Revenue recognition

Question 23

Measurement bases ? (SOAI)

Answer 23

See picture:

Question 24

Disclosure? (SOAI)

Question 25

Definition of financial statement elements, assets and liabilities? (SOAI)

Answer 25

Assets = “Is a present economic resource controlled by the entity as a result of past events.” Defined as “rights” in CF 2018, not as “the asset”.

Liabilities = Is a present obligation of the entity to transfer an economic resource as a result of past events.

Both assets and liabilities are since 2018 not separated from the recognition criteria.

Question 26

Definition of financial statement elements, Equity ? (SOAI)

Answer 26

Refers to the money that belongs, after contractual and debts being deducted, to the equity holders (sometime referred as residual claimants).

Question 27

Definition of financial statement elements, Income and expenses ? (SOAI)

Answer 27

“Income is increases in assets or decreases in liabilities that result in increases in in equity, other than those relating to contributions from holders of equity claims”

“Expenses are decreases assets or increases in liabilities that result in decreases in equity, other than those realting to distributions to holder of equity shares”

Income and Expenses are linked to performance (important to remember!)

Question 28

“The longer the time-period between financial statement recognition and cash flow…?” (SOAI)

Answer 28

“The higher uncertainty”

Question 29

Historical cost ? (CF)
Current value ? (CF)

Answer 29

Historical costs is the price payed for an asset when it was required, or the consideration accepted at the time of taking on a liability.

Current value has 3 different types:

1. Fair value = The market price of the item.
2. Value in use = Based on discounted future cash flows.
3. Current cost = The price in a hypothetical current transaction to acquire an asset or take on a liability.

Question 30

Entry price and exit price? (SOAI)

Answer 30

Entry price = is the price payed by the firm to acquire an asset or the amount received for taking on a liability.

Exit price = The price received upon disposal of an asset or the amount paid to settle a liability.

Question 31

Initial measurement and subsequent measurement? (SOAI)

Answer 31

IM = Occurs when an item is recognised in the financial statement.

SM = Fair value may change and the two measures can therefore diverge. Historical costs and fair value is only used in this kind of measurement.

Question 32

Current value are more difficult to estimate than historical value? True or False. (SOAI)

Answer 32

True. Historical value are based on transaction that has already occurred and is thus objectively verifiable.

Question 33

Problems with historical costs? 3 problems. (SOAI)

Answer 33

1. Deciding what’s included in historical costs when there are incidental costs (oförutsägbara kostnader).
2. Assets acquired as a package where cost must be determined for individual items.
3. Exchange transactions that do not involve cash.

Question 34

Timing? (SOAI)

Answer 34

Is a key factor for recognition of items in the financial statement.

Question 35

Measurement bases for different items in IFRS (picture only) - (SOAI)

Answer 35

See Pic:

Question 36

Fair value is defined as? (SOAI)

Answer 36

Market price.

Question 37

What about fair value in theory and practice? (SOAI)

Answer 37

Fair-value measurement is seen with scepticism and does according to CF not be used for measurements that involves high uncertainties. The use of fair-value is a concrete example of the trade off between relevance and faithful representation. See pic for what items that are used for fair-value measures and which who aren’t.

Question 38

Optimal contracts? (Incentives)

Answer 38

Align the interests of managers and shareholders, are often considered the most efficient alternative to direct monitoring by the owners and the board of directors. They could be incentive contracts that tie the manager’s pay to firm performance. An important question is, however, which measures of firm performance are relevant for the performance evaluation of managers.

Question 39

Incentive contracts? (Incentives)

Answer 39

• Bonus plans and profit-sharing.
• Net income is the main piler for achieving these rewards.

Question 40

Informativeness principle? (Incentives)

Answer 40

Any additional information that provides informative signal about the agent’s actions and efforts and allows for a more accurate judgement of his/her performance, is useful for improving the efficiency of compensation contracts.

Question 41

What is crucial when evaluating accounting performance measurements? (Incentives)

Answer 41

The quality of the accruals! As they are subject to both unintentional errors and deliberate bias, cause net income to be a noisy measure of performance in compensation contracts.

Question 42

Fair value accounting ? (incentives)

Answer 42

• fair value accounting is considered to be less conservative and more value relevant compared to historical cost accounting.
• The proponents of fair value accounting have empathised its role in enhancing the transparency and comparability of accounts, which can have a direct implication for the efficiency of contracts. Fair value-based reports may also enhance the stewardship role by directing managers toward the value of shareholders’ equity. However, there are also some drawbacks of using the fair value with respect to the stewardship role of accounting. Penman (2007) notes that managers should be rewarded for adding value (earnings) and not based on arbitrary changes in market prices. Earnings volatility due to fair value accounting can lead to noisy measurement of managerial performance and therefore be less attractive. Furthermore, fair value accounting increases the need for managers to exercise judgement and make estimates, which exposes shareholders to greater risks of expropriation.

Question 43

Market based performance measures ? (incentives)

Answer 43

• Based on stock price.
• Share-based compensation can incentive managers to undertake risky projects and increase the long-term value of the firm.
• The main benefit of using share price in compensation contracts is that unlike net income, share price can also reflect expected future benefits; that is, it is not deflated by conservative accounting policies. This implies that firms relying on future revenues to support current operations may prefer to use share price as a main driver of compensation contracts.
• Less likely to be exposed for opportunistic behaviour from managers (bias).

Question 44

opportunistic accounting choices ? (Incentives)

Answer 44

• Serve to maximize managers’ utility.
• Opportunistic choices of accounting procedures are also referred to as earnings management.

Question 45

Earnings management? (Incentives)

Answer 45

Occurs when 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 contractual outcomes that depend on reported accounting numbers.

Question 46

What is important to have in mind when accounting-based compensation contracts are used? (Incentives)

Answer 46

Opportunistic behaviour from managers (they want to maximise their own utility).

Question 47

Efficiency perspective and opportunistic perspective? (Incentives)

Answer 47

1) Efficiency perspective – suggests that discretionary accounting choices leads to efficient contracts

2) Opportunistic perspective – suggest that managers take advantage of the flexibility in accounting choices after knowing the nature of the contract, thereby reducing its efficiency.

*In other words, while performance based compensation plans may potentially mitigate conflicts of interest, the same contracts may encourage mangers to manipulate the accounting information for their own benefit and thus increase their pay.

Question 47

What are said more about bonus plans? (Incentives)

Answer 47

Bonus plans is more likely to lead to income-increasing accruals in earlier periods, since these lead to higher accounting earnings and therefore an increased amount of earnings-based bonuses in those periods.

Question 48

The political cost hypothesis and The litigation cost hypothesis?

Answer 48

-Firms that do not respond appropriately to political pressures face political costs, which may induce them to make opportunistic accounting choices in order to avoid such costs.

• The litigation cost hypothesis predicts that managers increase disclosures in the wake of controversial events or circumstances in order to avoid penalization.

Question 49

The big bath hypothesis (Incentives)

Answer 49

Predicts that if firm performance is poor at the time a new CEO is appointed, the new CEO may think it is advantageous to flush out losses feared to materialise soon enough anyway.

Question 50

Rule-based vs principle based standards ? (Incentives)

Answer 50

Rules-based standards also risk reducing the ability of financial statements to faithfully represent underlying economics. By contrast, management may convey private information to investors through its estimates and judgements, which has positive implications for capital markets. A trade-off many standard-setters (and investors) are willing to accept.

Question 51

Conclusion for accounting quality, in terms of incentives - two ways? (Incentives)

Answer 51

1) The quality – and thus usefulness – of accounting has implications for whether accounting numbers may serve as a basis for evaluating executives and thus constitute viable measures of performance in incentive plans.

2) The quality of accounting is partially determined by executive incentives to make opportunistic accounting choices (that benefit the executives)

Question 52

Read only from the incentive chapter:

Answer 52

Ironically, the plans used for incentivizing executives to act in the shareholders’ interest may likewise provide incentives to manipulate the accounts – since these are used as basis of measurement in those plans.
If accounting is so important for contractual efficiency, one might ask why standard-setters and shareholders allow managers to exercise discretion and judgement. After all, opportunistic managers can misuse accruals to overestimate earnings and thus increase their compensation. Further, accounting choices may be made to avoid penalization from political and market forces. This leads us back to the rationales for principles-based accounting and the idea that only by allowing managers to convey their private information can faithful representation and relevance – and thus usefulness – be achieved. Nevertheless, in the presences of incentives, restrictions on accounting manipulations (and real decisions) are needed. This is where additional internal governance mechanisms and enforcement by external authorities come into the picture.

Question 53

Enforcement & Monitoring? (EMI)

Answer 53

Enforcement - the act of ensuring that rules, laws, standards or directives are adhered to or followed in the way intended.

Monitoring – the act of overseeing a firm’s activities with the intention of detecting deficiencies in a timely manner, so that preventive or corrective measures can be introduced.

Question 54

Two institutional environment? (EMI)

Answer 54

Country-level enforcement:
Accounting enforcement is defined as the activities undertaken by independent bodies (monitoring, reviewing, educating and sanctioning) to promote firms’ compliance with accounting standards in their statuary financial statements. The idea behind this is that with stricter enforcement, one expects the usefulness of financial reports to increase. The need for enforcement is primary derived from the significant discretion given to managers in applying accounting standards. Interpretation and implementation guidance from external enforcers, along with continuous reviews and monitoring within firms, may help facilitate compliance.
The importance of country-level enforcement is becoming increasingly recognised where studies have concluded that there are capital market benefits of adopting IFRS (such as increased liquidity). However, these benefits are only fully understood by also considering countries’ legal and institutional settings and enforcement.

The legal environment:

One aspect of the institutional environment often referred to in the accounting literature is the legal tradition. As we saw in chapter 4, a distinction is made between code law and common law countries (Angelo-American countries). Common law countries show a greater extent of legal protection of investor rights, including voter rights and protection against appropriation by management. So, what implications does this have for accounting outcomes and accounting quality? Whilst increased corporate transparency may encourage widespread ownership, this also creates a demand for transparency. In order to reduce information asymmetry and agency costs, firms with higher ownership dispersion (ägarespridning) must maintain a high quality in their disclosures and reported earnings.
In code law countries, shareholders often hold a large block of stock and voting rights. They also appoint their representatives to sit on the board and thus get inside information. Thus, decreasing the need of high-quality reporting.

Question 55

Corporate governance ? (EMI)

Answer 55

(Definition: “Corporate Governance refers to the set of mechanisms that influence the decisions made by managers when there is separation of ownership and control”)

To summarize, the optimal combination of governance mechanisms in a firm depends on the unique situation of that firm. We continue this section with threeimportant firm-specific governance mechanisms: ownership structure, board of directors and auditing.

Question 56

3 parts within corporate governance? (EMI)

Answer 56

Ownership structure (Dispersed or concentrated), Board of directors, Auditors.

Question 57

Conclusion of the chapter (EMI)

Answer 57

Greater transparency and higher-quality earnings enable compensation committees to better evaluate managers’ performance and design more efficient compensation contracts. Other governance mechanisms, such as auditors and other forms of enforcement of accounting standards, should be in place to ensure high-quality accounting. In shaping and being shaped by other governance mechanisms, accounting is considered one of the essential components of this complex equilibrium process.

Question 58

Which of the 4 SAS relates to assets? (Assets)

Answer 58

The first (SAS 1: Acquisition of resource) and the third: (SAS 3: Changes in value of existing items)

Question 59

Three types of assets? (Assets)

Answer 59

Tangible, intangible and financial.

Question 60

Important for tangible and intangible assets (value reducing )? (Assets)

Answer 60

Amortisation or Depreciation.

Question 61

Three measurement models for assets? (assets)

Answer 61

Cost model – implies that the value is equal to its cost less any accumulated depreciation and impairment losses. This is asymmetric in the sense that unrealized gains from increases in value are not recognized while losses are recognized through impairment.

Revaluation model – requires systematic and periodic revaluations to fair value when there is a material difference between fair value and book value. The depreciation amount is adjusted based on the revalued amount. Although the revaluation model may seem more symmetric than the cost model, it is not entirely so. Gains are recognized on the balance sheet but not in the income statement. Losses on the other hand, are recognised in the income statement. Consequently, both the cost model and revaluation model reflect conservatism in accounting.

Fair value model – assets are measured at fair value at each balance sheet date and all gains and losses are recognized in the income statement (it is thus a symmetric model). No depreciation is carried out.

Question 62

Depreciation models? (Assets)

Answer 62

1. Straight-Line
2. Accelerated methods
3. Decelerated methods
4. Methods based on actual physical usage

Which model to use is fully up for judgements, but it’s important that you use a method that makes the depreciation faithful and reliable.

Question 63

Which model are intangible assets measured? (Assets)

Answer 63

With respect to SAS 3, intangible assets are measured with the cost model. The revaluation model is possible, but very restrictive, while fair value cannot be used for intangible assets.

Question 64

Intangible assets can be acquired in three separate ways? (Assets)

Answer 64

1) Separate external acquisition

Takes place, the purchase price should be a reasonable approximation of the expected future economic benefits. More specifically, the probability criterion considered fulfilled, since the price indicates that there is a probability of future benefits, and the reliability criterion is often considered fulfilled, as the purchase price, representing the cost, is settled with monetary assets.

2) External acquisition as part of a business combination

If an acquisition takes place as part of a business combination, both criteria are always considered to be met. As above, the acquisition itself indicates a probability of future economic benefits. Although the estimates used for measuring an intangible asset’s fair value may require a significant degree of judgement and thus contain a considerable amount of uncertainty, IASB believes that users would still benefit from the separate recognition of the intangible assets as opposed to recognising the full amount as goodwill. This is a clear example of when the relevance of information is considered high enough to justify any measurement errors that reduces faithful representation.

3) Generated internally

there is no apparent transaction on which the measurement could be based. Even if it is possible to identify the costs associated with R&D, the asset is believed to always fail the first recognition criterion, that is future economic benefits cannot be determined with sufficient probability.

Question 65

The reliability criterion ? (Assets)

Answer 65

Refers to the fact that information should be faithfully represented, financial reports should, however, also be relevant.

Question 66

Why does IAS 38 (Intangible assets) only in rare cases allow the revaluation model? (Assets)

Answer 66

The reason is that the revaluation model requires fair value of the asset to be determined by reference to an active market, presumably as fair value estimates made on the basis of internal valuation models would not encourage faithfully represented information.

Question 67

Issues with impairments? (Assets)

Answer 67

Impairment test needed?
Write-down needed?
Fair value or value in use?
Discount rate?

Question 68

Value of goodwill (issues)? (Assets)

Answer 68

Cash-generating units?
Fair value or value in use?
Discount rate?

Question 69

IAS 36 requires impairment tests when? (Assets)

Answer 69

There are indicators that an impairment has occurred. These indicators could be falling market values for the asset, physical damage, changing market conditions brough on by legal or technological changes related to the asset, as well as changes within the firm that can have an adverse effect on its ability to extract full potential from the asset.

Intangible assets with an indefinite useful life are subject to impairment testing at least annually!

Impairment testing involves calculating the asset’s recoverable amount, which is defined by IAS 36 as the highest of realizable value and value in use.

Question 70

Inventories? (Assets)

Answer 70

The transfer of the asset to the income statement in the form of an expense occurs when inventory is sold (i.e., realized). It is then included in cost of goods sold. An issue in the measurement of realized inventory is what assumption to make regarding which particular piece of inventory are sold when there is a large number of similar items acquired at different times and at different prices. Based on IAS 2, the assumption can either be first-in-first-out, or average costing. US GAAP also allows for last-in-first-out.

Question 71

Lessor or a lessee? (Assets)

Answer 71

Lessor: Owns the leased asset.

Lessee: “Rents”.

Question 72

Main issue regarding leasing? (Assets)

Answer 72

Main issue of leasing is whether the lessor or the lessee should recognise the asset on the balance sheet.

Question 73

Three common views that are adopted regarding lease agreements? (Assets)

Answer 73

1) A lease is a rental agreement: The lessor recognise the asset on their balance sheet. (Operating lease)

2) A lease is a rental agreement or a transfer of the underlying assets, depending on the conditions of the contract: The lessee recognise the asset on their balance sheet if the lease agreement is more like a sale, i.e. the economic life for the asset is the same length as the leasing agreement. Also called “financial lease”. Operating lease is the opposite when the lessee don’t have the asset for it’s entire economic life, thus the asset will be recognise in the balance sheet for the lessor.

3) Focus is placed on the transfer of rights to use the asset, rather on the asset itself. So even if the lease agreement only lasts for a limited part of the asset’s economic life, the right to use the asset is still recognised as an asset by the lessee. This is the view IFRS 16 Leases has adopted.

Question 74

Two important concepts within lease accounting? (Assets)

Answer 74

Comparability and Conceptual consistency.

Question 75

IFRS 16 and leasing - the lessee perspective (Read only)

Answer 75

IFRS 16 defines assets as the right to use a resource, in agreement with the view taken in the conceptual framework. Since all lease agreements create a right to use a resource for lessees, it follows that all lease agreements should be recognised as assets (with corresponding liabilities) on the balance sheet. There still are some exceptions, for example short term leases. The issuance of this standard was preceded by substantial debate ranging from the excessive costs of applying the standard, to the decline of the leasing industry. Although the standard may have had some potentially negative consequences on the firms’ financial ratios, the overall benefits have been determined to exceed the costs. First, the change of financial ratios may actually make financial statements better reflect the underlying economics, as all lease agreements create financial liabilities for lessees, and with the new standard such as liabilities are reflected in the balance sheet. Second, IFRS 16 turns a binary classification of lease agreement into judgement on continuous scale. A continuous outcome reduces the effect of managerial judgement on financial statement outcomes, while increasing faithful representation and comparability. Finally, an issue arising in the implementation of IFRS 16 for lessees is how to distinguish between the right to use an asset and a service contract. There is a general tendency that the service component in lease agreements is becoming more important. For example, a firm can either lease a copy machine or they can make an agreement with a copy machine supplier to pay for a service of making copies. In the former case, an asset and liability are recognised in the lessee’s balance sheet. In the latter case, only service fees are recognised.

**Lessors still follow the same logic as in IAS 17 and continues to classify leases in operating and financial leases. This because aligning lessor and lessee accounting was difficult and additionally, there was a general agreement that for lessors, lease accounting was not problematic

Question 76

What are the two main reason behind the larger focus on financial instruments the last few decades? (Assets)

Answer 76

1) The complexity of financial instruments and markets have increased greatly.

2) Financial instruments are important in banks and insurance companies, which in turn has a great governmental interest. Since the crisis in 2007-2008, IASB’s work can be summarized into the three themes measurement, entity issues, and disclosure.

Question 77

Definition of financial assets? (Assets)

Answer 77

Cash, Contractual rights to receive cash (or other financial assets) in the future, & Equity instruments in other firms.

Investments in financial assets are nearly always recognized as assets on the balance sheet.

Question 78

The main issue relating to the measurement of financial assets and three measurement models used ? (Assets)

Answer 78

When unrealized gains and losses should be recognized in financial statements.

In IFRS, there are three measurement models used for financial assets:

1. Fair value through profit and loss (FVPL)
2. Fair value through other comprehensive income (FVOCI)
3. Historic (amortized) cost

Question 79

Difference between FVOCI and FVPL regarding recognition? (Assets)

Answer 79

For FVOCI, there are two possibilities:
1) gains and losses are recognized as in profit and loss (income statement) when they are realized.
2) gains and losses are recognised in OCI are never recognised in the income statement. These two methods are called recycling and not recycling of OCI.

Using fair value is seen as relevant when either, 1) the changes in fair value are likely to be realized in the firm’s cash flows, or 2) changes in value are used internally to assess performance. Meanwhile fair value should only be used when faithful representation is obtainable. In other words, fair value should not be used when there is too much uncertainty in its measurement.

Question 80

Financial assets differs from the other assets how, 3 answers? (Assets)

Answer 80

1) fair value is often relevant
2) it is easier to obtain a reliable measure of fair value
3) financial assets are not used in combination with other assets, so their stand-alone fair value is a good reflection of the value to the firm.

Question 81

Difficulties with hedge accounting? (Assets)

Answer 81

From a standard-setters perspective, there is a trade-off between allowing firms to reflect their own unique hedging arrangement while preventing firms from using hedge accounting when economic hedging doesn’t exist. If no regulation is set, there is a high risk of manipulation of financial statements through too much freedom in measuring financial instruments. If requirements are too strict, however, it may prevent firms from using effective hedging arrangements, making firms economically worse of.

Question 82

Financial liabilities? (LE)

Answer 82

• Always recognised in the balance sheet.
• The main issue instead relates to whether or not unrealized changes in value should be recognized. In other words, the question is whether to use historic cost (amortized) or current value.

Question 83

Provisions? (LE)

Answer 83

-Estimates of future outflows due to product warranties or sales returns (routine)

• Lawsuits or environmental remediation. (High uncertainty)

-Employee Benefits such as pension funds etc.

-Another example of provisions is restructuring reserves. An obligation that is considered to exist if there is an explicit plan for the restructuring and those affected been notified. There is some evidence that firms use this form of provision opportunistically to improve future earnings and additionally separate out the provision expenses from ordinary operations by labelling them extraordinary.

Question 84

Once a provision is recognised? (LE)

Answer 84

The question becomes whether to show unrealized gains and losses due to changes in value. IAS 37 states that all changes in value should be recognised immediately to reflect the up-to-date value of the provision. This is relevant as it relates to future payment, so any changes in value are expected to be realized.

Question 85

Two basic view of provisions? (LE)

Answer 85

1. Balance sheet view - which is embraced in IAS 37 states that a provision is recognised as soon as future outflow of resources cannot be avoided. This means conservatism in that a liability is recognised as soon as it is probable. Neutral accounting, on the other hand, would make the best possible estimate of expected future outflow, and recognise the provision earlier.
2. Income statement view - is that provisions are recognised to correctly measure all expenses required to generate certain revenues (matching principle). To the extent that obligating events take place, they do so within the course of a firm’s revenue-generating operations. Where the fact that cash outflows may not occur until a much later date is no reason to neglect the expense in current period, along with a provision.

Question 86

Different types of provision and problems: (Read Only)

Answer 86

• Provisions based on statistical calculations and past experience
  -Decommissioning costs as provisions
• Lawsuits (higher uncertainity)
• Discount-rates?

Provisions based on statistical calculations and past experience:
A type of provisions that is generally easy for management to account for. Based on past experiences, firms are able to perform statistical calculations of expected costs and make provisions for them when they record revenues from sales. Firms cover these expected costs and make provisions for them when they record revenues from sales. Firms cover these costs by promising customer warranties, to boost sales by reducing customers’ risk.

Provisions for lawsuits:
Difficult to for see as they are one-time events. Whenever a lawsuit is filed against a firm, there is a risk of future payments being required to settle the case. Sometimes risks are deemed small, which would make it a contingent liability, but sometimes it must be recognised. Because of the unique circumstances, it means management must use their judgement in making reliable estimates. If management has incentives to postpone expenses to later periods, by failing to recognise a provision in a timely manner, this may give them leeway to manage earnings and reduce the representational faithfulness of the accounts.

Decommissioning costs as provisions:
Decommissioning is the act of dismantling and removing major facilities, such as nuclear power plants, at the end of their useful lives. (This has a long explanation of the standards)

Discount rate when calculating provisions:
Estimating discount rates is not only potentially difficult but choices and judgements can have a large effect – especially when long-term provisions are concerned. According to IAS 37 a discount rate should reflect “current market assessments of the time value of money and the risks with specific to the liability”, something that may not be specific enough. Although some firms voluntarily disclose the discount rate, there are no formal requirements regarding this.

Question 87

managerial judgement, includes all chapters for the balance sheet?

Answer 87

Measurments, choice of measurement models and determining e.g., Fair-Value is all exposed for managerial judgement. Could be good and bad.

1) Management wants to recognize expenses early – this is the case when it is beneficial to show a clear positive trend (big bath).

2) Management could have incentives to hide liabilities – that is, even if the recognition of a provision is warranted, management uses its discretion to avoid recognition, for example in order to improve debt-to-equity.

Question 88

Employee benefits 4 categories? (LE)

Answer 88

1) Short-term benefits,
2) Post-employment benefits
3) Other long-term benefits
4) Termination benefits.

When it comes to post-employment benefits, one must distinguish between defined benefit plans and defined contribution plans. Where the former guarantees payment of certain amount at settlement data, and in the latter the firm only promises to make an agreed-upon fixed payment during the employees’ active work period.

Question 89

What affect the size of equity ? (LE)

Answer 89

Both net income and OCI affect the size of equity, and thus the balance sheet. However, in terms of firm performance, the two give different signals.

Question 90

Five steps for revenue recognition ? (IS)

Answer 90

1) Identify the contract with a customer
2) Identify performance obligations
3) Determine the transaction price
4) Allocate the transaction price to performance obligations
5) Recognize revenue as performance obligations are satisfied

Question 91

Issue between IFRS 15 (contracting) and IFRS 16 (leasing)?

Answer 91

There is a scope issue between IFRS 15 and IFRS 16 leases, where depending on if it is a service or lease contract, different standards are applied.

Question 92

Share-based payment? (IS)

Answer 92

Common types of share-based compensation are stock options and restricted stocks. In stock option plans, employees are granted options allowing them to acquire shares in the company in the future. Such plans entail a cost for participants in the plan that is equal to the exercise price of the acquired options. Restricted stock is usually contingent on a certain amount of time elapsing, or a certain performance target being achieved, before the stock can be traded.

Question 93

Controversy with share-based payment? (IS)

Answer 93

The main conceptual argument against seeing it as an expense is that it constitutes an owner transaction, where the CF definition of an expense excludes these transactions. However, the belief that share-based payments do not constitute an expense has been disregarded by two primary reasons
1) There is an “opportunity” or economic cost of granting equity instruments to employees. This is derived from the fact that the company would receive a higher amount if they would have issued the shares to the market. Employees would not be interested in share-based compensation if they did not receive a discount
2) Because the firm either has to buy back shares or issue new ones this will have a dilutive effect on the capital structure of the firm. Which will lead to a cost for the shareholders
Granted that share-based competition is a cost for the shareholders in terms of value, it calls for recognition in the financial statements

Question 94

In accordance with IFRS 2 equity instruments should be measured at? (IS)

Answer 94

Fair Value - works for public firms but for private it becomes more difficult.

Question 95

Government grants problematics ? (IS)

Answer 95

A firms receives resources from government without having to give up anything.

There are two views on how to recognize government grants:
1) It is seen as income and should therefore be reported in the income statement
2) It is seen as financing and should not be recognised in the income statement

Question 96

Foreign currency problematics ? (IS)

Answer 96

Currency exchange rates fluctuate, and assets and liabilities change value in the reporting currency, gains and losses ensue.

IAS 21 requires for foreign currency:

• Transactions are measured at the current exchange rate when the transaction is recognized in the financial statements
• Monetary items (item value will not change in the future) on the balance sheet are translated at the current exchange rate on the balance sheet
• Non-monetary items (item value will change in the future) measured at historical cost are translated at the historic exchange rate
• Non-monetary items measured at fair value are translated at the exchange rate on the date of the measurement

Question 97

Foreign currency translation for group accounting and consolidation (measure)?

Answer 97

1) The current method = implies that both assets and liabilities in the foreign subsidiary are translated at the current exchange rate.

2) The monetary/non-monetary method = implies that monetary items are translated at current rate and non-monetary at historical rate.

There is a difference between the two in recognizing gains and losses, where the first method uses OCI, and the other in the income statement.

Question 98

Income taxes problematics? (IS)

Answer 98

Current tax = the tax payable to authorities for the period. Determined by the authorities and therefore does not represent a measurement in accounting.

Deferred tax = is an accounting adjustment intended to provide a better reflection of the tax expense in relation to accounting income and it involves several measurement issues. The use of deferred tax is an interesting example of the trade-off between relevance and reliability (faithful). A relevant measure of deferred tax liability should probably consider both the probability of payment and the effect of discounting.

Question 99

Main issue concerning revenues ? (IS)

Answer 99

The timing of revenue recognition. (SAS4)

Question 100

An area which has been subject to changes for the last decades in group accounting? (GA)

Answer 100

The non-controlling interest or minoirty interest.

Question 101

Structured entities? (GA)

Answer 101

legal entities where “normal” scope requirements are difficult to apply. Structured entities are often set up to handle very a specific type of transaction. Examples are CDO’s and other securitizations. These entities often have very restrictive articles of association, sometimes referred to being managed on “autopilot”.

Question 102

Levels of control ? (GA)

Answer 102

1) Control – over 50% of voting power

2) Significant influence – between 20-50% of voting power, these are called associates

3) Joint control – two or more investors has joint control. An investment over which multiple parties have joint control is called a joint arrangement

4) Holdings with no real influence – under 20% of voting power

Question 103

The equity method? (GA)

Answer 103

The one required by IFRS.

The equity method if sometimes referred to “one line consolidation”, where the investor recognized its share in the equity as an asset on in the balance sheet and share of net income in the income statement.

Question 104

Joint venture and joint operation ? (GA)

Answer 104

JV = The investors have an interest in the equity of the joint arrangement; that is, the joint venture is a separate legal entity where the investors are residual claimants. This makes it logical to use the equity method

JO = The investors have a direct interest in the individual assets of the joint arrangement. This means that joint operations are accounted for using proportional consolidation.

Question 105

Business combinations ? (GA)

Answer 105

Often referred to as M&A.

1) Determine who the acquirer is
2) Determine the transaction price
3) Allocate the transaction price to assets (including goodwill) and liabilities
4) Determine the subsequent measurement of assets and liabilities in the acquiree.

Question 106

Goodwill accounting? (GA)

Answer 106

There are three main alternatives:
1) Immediate elimination against equity

2) Amortization over the expected useful life

3) Measured at historical cost with no amortization, instead, periodic impairment testing is performed

All three alternatives are problematic, but in different ways. Immediate elimination can result in a great decrease in equity, something that is not desirable. Amortization requires an amortization period to be decided and goodwill has no apparent useful life. Additionally, research suggests that this amortization has little relevance for financial statement users. Using impairment testing has the disadvantage that it is based on judgement and uncertainty.

*One reason why goodwill has been so controversial is that it is commonly believed to affect real firm behaviour through managerial incentives. The incentives come from different effects on earnings after the transaction. The three methods differ in terms of impact on earnings, since they differ in how goodwill is recognised as an expense. When goodwill is eliminated immediately, there is never an expense, so earnings after the transaction is high. Also return on equity skyrockets. Amortization results in systematic recognition of expenses and lower earnings. An effect that becomes stronger in shorter amortization periods. In the last method, there is no systematic expense and leads to higher earnings. Instead, expenses are concentrated in a few time periods, when impairment is recognized.

Currently, the measurement of goodwill is at historical cost, with no amortization but annual impairment testing. However, this has been debated for both conceptual and practical reasons. Standard-setters argue that goodwill has no apparent decline in value over time, which is why there is weak conceptual motivation for amortization.

Question 107

Ownership vs entity with NCI ? (GA)

Answer 107

1) According to the owner perspective – only the proportion acquired by the parent company is remeasured at fair value and the proportion owned by the NCI is measured at the acquiree’s (subsidiary’s) reported value. (IFRS 3 adopts this perspective)

2) According to the entity perspective – 100% of the subsidiary is remeasured at fair value.

Question 108

Step-wize acquisition ? (GA)

Answer 108

is when different parts of a subsidiary are acquired at different times. There are two different ways of accounting this.

1) Account for each transaction and then add up – which is consistent with remeasurement of a proportion of the acquiree’s assets and liabilities

2) Focus on when control is obtained - and remeasure 100% of assets and liabilities at that time

Question 109

Two different considerations regarding the level of standardization from standard-setters? (PFD)

Answer 109

A low level of standardization allows to properly reflect a firms own specific situation. Whereas a high level of standardization facilitates users’ comparisons between different firms. A trade-off similar to principle-based versus rule-based standards.

Question 110

Two main ways in which the change (of a standard for example) can be reflected in financial statements? (PFD)

Answer 110

Retrospective application - Preparing financial statements as if the new policy/estimate had always been applied. Which usually also involves presenting comparable information concerning prior periods in accordance with the new policy/estimate. From a user perspective this is more likely to be useful.

Prospective application - Applying the new policy/estimate only on transactions occurring after the change and no previous transactions are remeasured.

Question 111

Mandatory Disclosure ? (PFD)

Answer 111

From a user perspective, high-quality information is needed for improved decision making, and from the preparer perspective, disclosure is needed to improve firm transparency and mitigate adverse selection.

Due to potential market failures (asymmetric information, negative externalities etc), leaving the provision of information to the free market can be suboptimal, meaning that mandatory disclosures are necessary i.e., it is unlikely that board members, especially independent directors with more to gain from successful monitoring, would be willing to rely on voluntary disclosures made by managers. Instead, they are expected to require public (mandatory) disclosures that are typically audited and carry higher credibility compared to voluntary disclosures.

Question 112

Commitment effect for incentives? (PFD)

Answer 112

Mandatory disclosures have been shown to serve as an important mechanism to ensure a commitment to providing credible information that voluntary disclosures cannot fully substitute. It has been observed that even when holding the disclosed information constant, market liquidity has gone down for a sample of firms subject to deregulation of disclosure. That is, when the disclosure of a set of information items became voluntary rather than mandatory, adverse market effects were found even for firms that voluntarily disclosed the information

Question 113

Problems identified with incentives? (PFD)

Answer 113

From a communication perspective, three main problems with disclosures in practice were identified:
- There is a lack of relevant information
- There is too much irrelevant information
- The notes are not organized well enough to constitute effective communication.

Question 114

Conclusion of chapter 15 and disclosure? 3 parts.

Answer 114

The “how” to disclose FI is more important than the “what”. In order to achieve comparability over time, standard-setters must consider how best to achieve it

One major issue facing standard setters (ex-ante) as well as preparers (ex post) is whether an item should be recognized in the primary financial statements or merely disclosed in the notes.

Finally, standard-setters must decide on which disclosures should be mandatory as opposed to voluntary, and how these mandatory disclosures should be regulated. The IASB has identified a number of problems with current disclosure requirements and highlighted weaknesses in current disclosure practises. In essence, firm communication has been criticized by academics and standard setters as being ineffective and containing too much irrelevant information and too little relevant information. To some extent, this can be attributed to over-regulation, a part of which is the result of specific disclosure requirements appearing in response to current events.

Question 115

Positive accounting theory? (PAT)

Answer 115

Wants to enhance the scientific approach for accounting (descriptive). “What is” are more important than “what ought to be”. Accounting theory must remain value-free in order to be scientific. PAT believes that everyone is utility maximisers.

Question 116

Conceptual framework - qualitative characteristics?

Answer 116

All will lead to decision usefulness (see pic):

Relevance has two be of predictive value and confirmatory value for enhancing decision making and forecasts.

Faithful representation should be free from errors, neutral and completeness which will help to accurat

Question 117

Trade-offs between stewardship roles and valuation?

Answer 117

The stewardship role focus on historical feedback to the investors as they evaluate managers performance, whereas valuation of accounting focusing on future orientation (as investors aim to estimate values based on predictions of future firm performance).

Example: Fair value accounting may be advantageous from a valuation perspective since fair values are generally considered more contemporary and informative of current market conditions and thus more value-relevant. Meanwhile the stewardship role implies that accounting measures should first and foremost be reliable measures that are less influenced managerial judgements. Accounting that are based more on historical events are more useful in that case.

Question 118

Economic (capital market perspective)?

Answer 118

Central to this perspective is that accounting has economic consequences for all capital markets participants as well as the economy as a whole.

Definition: “Useful (and consequently high-quality) accounting is that which provides users with such information to let them make informed decisions with respect to the decisions models they employ.” - Users in this case could be investor or creditor.

Question 119

Matching principle?

Answer 119

States that expanses should be matched to the revenues they help to generate. E.g., should expenses be matched to correct period.

Question 120

Earnings quality three dimensions? (EQ)

Answer 120

• Accounting standard followed
• Accounting policy or method chosen
• Judgements made

Question 121

How do you measure earnings quality?

Answer 121

Through Relevance, Faithfully representing, Comparability and so forth but do not have any direct measures and proxies are therefore used.

Question 122

Two main proxies used in measure of earnings quality? (EQ)

Answer 122

In terms of proxies there are two common classifications:

1) Earnings properties.

2) External indicators of earnings quality.

Question 123

Earnings properties? (EQ)

Answer 123

The two components of earnings are accruals and cashflows. In the long run earnings and levered free cash flows from operations will be equal to each other. But in the short run they will differ by accruals. (Earnings = Operating cash flows + Accruals)

Question 124

Earnings persistence? (EQ)

Answer 124

Is a measure of how earnings from one year are carried forward into the next, that is, it’s a measure of how sustainable earnings are, or in yet other terms, to what extent that are recurring. EP are useful for DCF equity valuation models used by investors.

• Downsides (with respect to the equity market): High-accrual firms will be over-valued compared to low-accruals firms. Arbitrage opportunities? Accruals anomaly - Short low accruals portfolios and long high accruals portfolios because this will yield positive abnormal returns.

Question 125

Earnings smoothness? (EQ)

Answer 125

Smooth earnings are a result of applying accrual accounting to improve decision usefulness. Income smoothing is the shifting of revenue and expenses among different reporting periods in order to present the false impression that a business has steady earnings. Management typically engages in income smoothing to increase earnings in periods that would otherwise have unusually low earnings. This might seem desirable; however, smoothing earnings tend to imply undesirable, unwarranted or abnormal smoothness brought about artificially.

Difference between ES and EP is that EP behave earnings over time and ES has to to with how earnings relate to an external benchmark.

3 categorises: Natural smoothness, Real or artificial.

NS = Income generation in certain industries such as cash only businesses and real estate and construction businesses.

RS= Achieved though operating decisions and the timing of these.

AS= May orientate in classification changes or timing alterations.

Question 126

Abnormal accruals? (EQ)

Answer 126

(Also called low quality accruals!!) Accruals that do not reflect performance, either due to measurement errors or intentional distortions.

High quality accruals = Fundamental performance. High quality earnings that do not reverse. Using income-increasing accruals to boost profits in one period must result in income-decreasing accruals in future periods.

In regard to above: you cannot only have good periods of inflows, the reality will eventually catch up. The question in regard to accruals are though how long time this takes.

Question 127

Earnings timeliness? (EQ)

Answer 127

Reflects the extent to which current earnings capture the information impounded in current stock returns.

Downsides?

• Might suffer from prudence and thus make it hard to evaluate

Question 128

Target beating? (EQ)

Answer 128

Earnings that just meet or beat a target is a type of property of earnings that has been used as a warning sign of low-quality earnings. Targets that can either been set by the firm itself or by external parties, such as analysts.

• Investors are seemingly pleased when a firms beats their target - which reflects the stock price.

Question 129

The role of Discretion? (Incentives)

Answer 129

Even though there’s always a risk for opportunistic behavior from managers, disallowing judgements (i.e., Principle-based standard settings) is not an alternative because of the risks such as manipulation of activates in companies and managers hiding private information through its estimates and judgements for investors. Also to have a accounting system that dictates every single transcation will become too costly and “ohanterligt”.

Question 129

Jones model (Accruals)? (EQ)

Answer 129

-Function of the change in revenues and property.

• Discretionary accruals: If a firms experiences an increase in its total accruals but no corresponding increase in the change in revenues or its PP&E, this must be due to discretionary accruals.

Question 130

Dechow and Dichev model? (EQ)

Answer 130

Focusing on short-term accruals and thus the change in working capital.

Cons: Does not capture long-term accruals such as goodwill impairments or PP&E.

Question 131

Value relevance ? (EQ)

Answer 131

A high correlation between book values and market measures is referred to as an earnings or book values having (high) value relevance.

(Also earnings quality is previously categorized as e.g., stock returns covary “samvariation” with accounting numbers)

Main criticism = Is that earnings-return relationship is a noisy measure that fails to distinguish the accounting system from fundamental performance or other institutional factors. It’s especially problematic in studies doing country comparisons.

Question 132

What if the book value and market value are close to each other? (EQ)

Answer 132

Low growth opportunities.

Question 133

All earnings quality measures has strengths and weaknesses. The best approach is?

Answer 133

To consider their appropriateness in a given research setting and to use several measures and compare and contrast the results.

Question 134

Intermediaries’ evaluation of earnings ? (EQ)

Answer 134

The final category of earnings quality indicators are analysts’ reports, internal & external audit reports, and statements from external enforces such as the SEC. Where analysts’ reports forecasting ability and thus, the usefulness, and issuance from the SEC typically indicates serious negligence or fraudulent behaviour.

Question 135

Asset recognition criteria?

Answer 135

“An asset is recognised in the balance sheet when it is probable that the future economic benefits will flow to the entity and the asset has a cost or value that can be measured reliably”

Question 136

Liabilities recognition criteria?

Answer 136

A liability is recognised in the balance sheet when it is probable that an outflow of resources embodying economic benefits will result from the settlement of a present obligation and the amount at which the settlement will take place can be measured reliably.

Question 137

Disclosure Quality, 4 main categories ?

Answer 137

Analyst rankings - rankings (ESG for example)
Textural attributes - VDn ordbajsar i rapporten för att dölja misstag.
Index-based measures
Earnings Quality - (Earnings properties External indicators of earnings quality).

Question 138

Stewardship role vs. Valuation role of accounting?

Answer 138

Stewardship role want accounting to be of high quality in terms contracting relationships. (Faithful representation)

Valuation role of accounting will instead focus on relevance and to use the financial statement for high quality forecasts. This is “better” for investors.

Question 139

Provisions and the % ?

Answer 139

If a managers is 50% + sure of future outflow then it has to be recognized in the balance sheet. (“Probable chance”)

Between 25-50% - Has to be placed in notes. (“Contingent liability”)

0 % - approx. 25 % - Too much uncertainty and up for judgements. (“Remote” and does not recognize in the notes or balance sheet)

OBS! This is an area which are influenced a lot by managerial judgements.

Question 140

CEO Letter ? (Incentives)

Answer 140

• Voluntary narrative disclosure (not audited or regulated in any accounting standard)
• The part most shareholders prefer to read, but it’s widely believed not to contain any sustains information that would help investors in their decision-makings.
• Strategic communication tool.

Question 141

Determinants of disclosure (reasons for disclosure in regard to capital market incentives)?
5 parts.

Answer 141

Performance - Generally predicts a positive relationship between performance and disclosure.

Financing needs - Firms with greater financing needs are believed to have incentives to increase disclosure in order to reduce information asymmetry between managers and capital providers. (Maybe contradictory signalling desperation from the firm?)

Globalisation - Disclosure reduces the great information asymmetry between global firms and thus enhance cross-boarder capital providers etc.

Ownership structure - Many shareholders and with individual small holdings will enhance the incentives to be more transparent. But if the ownership structure are more concentrated then it’s the opposite because don’t have need to disclose as much (family organisation for example).

Proprietary costs (costs of preparing, disseminating, auditing information, cost deriving from disclosing information which may be used by competitors and other parties in a way that is harmful for the reporting company) - Could incentives for reduce disclosure because of the risk from exposing yourself for other companies.

Question 142

IFRS vs. most local GAAP in terms of disclosure quality?

Answer 142

Higher quality in IFRS for decision makings.
Better enforcements in IFRS compared to local gaaps.
Higher transparency
Cost of capital is in general lower in IFRS.
Less uncertainity regarding future cash flows.
Stocks in IFRS firms enjoy greater liquidity.

Question 143

Boilerplates (incentives)?

Answer 143

Standardized phrases in a financial report for example.

Question 144

Entrenchment problem? (Corporate Governance)

Answer 144

Problem within a concentrated ownership structure due to conflict of interest between controlling shareholders and other (minority) shareholders (Principle to principle conflict).

Question 145

Board of directors ? (Corporate Governance)

Answer 145

Board independence and Board diversity are important to be able to challenge and monitor the decisions of managers.

Question 146

Recognition vs. Disclosure?

Answer 146

Recognition is the process of recognizing the transactions and events that have taken place and determining how they should be reflected in the financial statements, while disclosure is the process of providing additional information about those transactions and events to help users understand the financial statements.

Question 147

Legal or constructive obligation ?

Answer 147

• A constructive obligation arises from the entity’s actions, through which it has indicated to others that it will accept certain responsibilities, and as a result has created an expectation that it will discharge those responsibilities.
• A legal liability is a commitment imposed on a party as the result of a contract or civil action. A legal liability may be covered by insurance. It may also be voided by the legal structure of a business; thus, the legal liabilities of a corporation do not extend to its shareholders