Lecture 3

Question 1

An asset:

Answer 1

An asset is an economic resource controlled as a result of past events

Question 2

An economic resource:

Answer 2

An economic resource is a right with the potential to produce economic benefits

Question 3

Asset distortions arise from ambiguities about whether:

Answer 3

• The firm owns/controls the economic resource.
  Some transactions make it difficult to assess the ownership of an asset or companies structure transactions to dilute (economic) ownership
  Example: when financial statements include all ‘controlled’ subsidiaries of the parent company
• Future economic benefits can be measured with reasonable certainty.
  With certain expenditures, it is uncertain whether or not they entail future benefits – that is, whether they are assets or expenses
• Value estimates are appropriate
  Distortions may also arise from uncertainty about an asset’s value. This applies to both historical cost and current (‘fair’) value estimates

Question 4

How to correct the adjustment of the including of subsidiaries of the parent company?

Answer 4

Parent Company
Assets 90 Equity 50
Subsidiary 10 Liabilities 50

Subsidiary
Assets 50 Equity 10
Liabilities 40
So the consolidated financial statement if the following:

Consolidated
Assets 140 Equity 50
Liabilities 90

Question 5

What determines whether a company needs to be consolidated?

Answer 5

The control, but when are you in control of the firm.

Question 6

How to create structures intended to avoid consolidation?

Answer 6

Special purpose entities/vehicles’ (SPE/SPV) are used by companies to:
Shift earnings to tax havens
Isolate financial statements from particular risks (e.g., construction companies)

Question 7

What is the key example of the uncertainty of economic benefits?

Answer 7

Accounting for research and development leads to an understatement of assets.
Research expenditures: Expenses / included in the income statement.
Development costs: Assets / recognized on the balance sheet.
Distinction is based on technical feasibility, marketability, etc.

Question 8

When are development costs capitalized?

Answer 8

In the pharmaceutical industry, development expenses are in most cases capitalized only once a patent has been obtained.

Question 9

An analyst thinks that the research expenses of Bayer AG should be reported as assets, rather than in the income statement (as required).
What would the financial statements of the company look like, if the expenses were capitalized?

If capitalized, the useful life of the research asset would be two years.
Assume that Bayer AG spends on its research evenly throughout the year.
Same result as if all expenses were incurred in the middle of the year (‘mid-year convention’).
That means that we record amortization as of 1 July each year

Answer 9

In 2017, Bayer recorded research expenses of €4.5bn, and in 2018 of €5.2bn. If capitalized, Bayer would have made the following journal entries:

Journal entries for 2017 expenditures:
1 july 2017:
Debet: Research asset 4.5bn
Credit: Cash 4.5bn
31 december 2017:
Debet: Amortization expense 1.13bn (= 4.5/2/2)
Credit: Research Asset 1.13bn
31 december 2018:
Debet: Amortization expense 2.25 bn
Credit: Research Asset 2.25bn
30 juni 2019
Debet: Amortization expense 1.13bn
Credit: Research asset 1.13bn
Journal entries for 2018 expenditures:
1 july 2018
Debet: Research asset 5.2 bn
Credit: Cash 5.2bn
31 december 2018
Debet: Amortization expense 1.3bn (=5.2/2/2)
Credit: Research asset 1.3bn
31 december 2019
Debet: Amortization expense 2.6bn
Credit: Research asset 2.6bn
30 juni 2020
Debet: Amortization expense 1.3bn
Credit: Research asset 1.3bn

Question 10

With these journal entries. As of 31 December 2018, balance sheet and income statement would be adjusted as follows (ignoring tax effects):

Answer 10

Adjustments 31 December 2018
(Billions) Assets Liabilities
Balance sheet
Research Asset +5.03
Shareholders’ Equity +5.03
Income statement Debit Credit
Research Expenses -5.2
Amortization expenses +3.55
Net profit +1.65

Question 11

Try to practice slide 10-14, 20, 21 of lecture 3 with journal entries of R&D

Answer 11

Ja doe dan

Question 12

liability

Answer 12

a present obligation to transfer an economic resource as a result of past events.

Question 13

Distortions may also arise from uncertainty about an asset’s value. This applies to both historical cost and current (‘fair’) value estimates, but why?

Answer 13

For historical cost assets:
Useful life (and residual value) needs to be estimated, affecting depreciation expense and asset values. [→ see example in tutorial ]
Possibly, write-downs (‘impairments’) may be needed, requiring further estimates.

For current (‘fair’) value assets:
For actively traded financial instruments is fair valuation straightforward.
Real estate property may require somewhat more estimates.
Following acquisitions, intangible assets (brands, customer lists, etc.) are measured at their current values, requiring even more estimates

Question 14

SUMMARY
What is important to keep in mind while making adjustments?

Answer 14

many accounting adjustments will be estimates and there for Adjusting financial statements remains a subjective task, but is essential for the subsequent steps of financial statement analysis

Question 14

Distortions may arise from ambiguities about whether:

Answer 14

• An obligation has been incurred.
• The proper measurement of an obligation.

Question 15

Typically, companies aim to understate liabilities to (2):

Answer 15

to overstate earnings or
to overstate the strength of financial position.
- not setting provisions