June 2022 Flashcards
Explain the role and objectives of external audit?
(1) External audit is a common approach used on behalf of shareholders (principal) to monitor the directors’ (agents’) activities and take corrective action where necessary. External audit fees, therefore, are an agency cost.
(1) The key objective of an external audit is to protect the interests of shareholders by independently reporting the state of a company’s finances.
The auditors should:
- (1) ensure that the Board receives accurate and reliable information, and
- (1) assess the appropriateness of the accounting principles.
(1) An audit results in an audit opinion about whether the financial statements give a “true and fair” view of the company’s financial situation and operations for the period.
Describe the differences between a “principles-based” and a “rules-based” financial reporting system.
(1) Principles-based system, e.g. IFRS, uses an underlying set of principles (a “conceptual framework”) within which standards are developed.
(1) Therefore, the principles provide the theoretical basis for determining which events should be accountable for, how they should be measured and how they should be communicated to users.
(1) Where there is not such a framework, then rules must be designed to cover every eventuality, and this means there will be a rules-based system (such as some national Generally Accepted Accounting Principles (GAAPs)).
(1) Therefore, in a rules-based system the exercise of judgement is minimised.
(1) This could be preferred by auditors, who may fear litigation. However, this may lead to a large volume of regulatory measures, which do not always detect or prevent financial irregularities.
Explain, using an example, what is meant by the “accruals basis of accounting”.
(1) The accruals basis of accounting is one of the overriding concepts for financial statements. International Accounting Standard 1 (IAS 1) requires financial statements, except for cash flow information, to be prepared using the accruals basis of accounting.
(1) The accruals concept requires transactions to be accounted for in the period when income is earned or expenses are incurred, (1) not when they are received or paid in cash.
(1) For example, a company delivers goods to one of its clients in November and raises an invoice to the client. The client settles the invoice in the following January. Under the accruals accounting concept, the company must record the revenue in November, as that is when the income is earned.
(1) However, the cash payment from the client is not received until the following January, at which point the cash would be recognised in the cash flow statement.
Outline the factors which companies and shareholders should be aware of when a company issues new shares by a rights issue.
(1) A rights issue offers existing shareholders the right to buy new shares in proportion to their existing shareholding.
(1) Therefore, a rights issue enables shareholders to retain their existing share of voting rights.
(1) Usually, the price at which the new shares issued by a rights issue is at a discount to the current share value (i.e., less than the current share price in the market).
(1) This bypasses the pricing problem for shares issues since the shares are offered to existing shareholders at an attractive price.
(1) Shareholders also have an option to sell their rights on the stock market.
(1) Note, however, that quoted and unquoted companies can make rights issues.
(1) With a rights issue for a quoted company, because more shares are issued to the market, the share price is diluted and is likely to fall.
(1) Dilution occurs because a rights offering spreads a company’s net profit over a larger number of shares.
(1) Thus, the company’s earnings per share (EPS) decreases as the allocated earnings result in share dilution.
Explain what factors would constitute a “significant influence” by a company over an associate company, according to IAS 28 (Investments in Associates and Joint Ventures).
(1) An entity over which the investor has significant influence, and which is neither a subsidiary nor a joint venture, is called an associated.
(1) The key criterion here is significant influence.
(1) This is defined as the “power to participate in the financial and operating policy decisions of the investee, but not to control or have joint control over those policies.”
(1) Significant influence is presumed with an equity shareholding of between 20% and 50%.
In IAS 28 significant influence can be evidenced in one or more of the following ways:
- (1) Representation on the BoD (or equivalent or the investee)
- (1) Participation in the investee’s policy-making process
- (1) Material transactions between investor and investee
- (1) Interchange of management personnel; or
- (1) Provision of technical information
