Revision Deck

Question 1

QUESTION 4
Warren Buffett, the legendary investor once remarked in his Chairman’s letter to the
shareholders of Berkshire Hathaway Inc.:
‘…If (employee share) options aren’t a form of compensation, what are they? If compensation
isn’t an expense, what is it? And, if expenses shouldn’t go into the calculation of earnings, where
in the world should they go?’

Required:
Critically evaluate the above statement in the context of accounting for employee share options.

Answer 1

Outline:
Students are expected to critically evaluate the arguments for and against expensing employee
share options (‘ESO’); e.g.:
Arguments for:
* ESO is a cost that should be matched against the benefits (in the form of incentivised
employees and their services) to which it relates.
* Cost of ESO can be reliably estimated.
* Disclosure in footnotes is not a substitute for recognition.
* Negative economic consequences can be managed

Arguments against:
* ESO does not meet the definition of expense in accordance with the Conceptual Framework
document.
* Double penalty on EPS: expensing ESO reduces profit whilst ESO if exercised, increases the
number of shares.
* Disclosure of ESO in the notes to the accounts will be sufficient.
* ESO transactions are similar to equity share issues in nature, and should be accounted for
accordingly.
* Negative economic consequences particularly on small start-ups.

Note:
Simple regurgitation of the points above does not guarantee good marks. Students are expected
to develop each argument fully and show signs of wider reading.

Question 2

Wider Reading for ESO

Answer 2

Warren Buffet sees ESO as a compulsory recognition as it evidences the health of a business.

Contradictory Entrepreneurs feel it takes away the opportunity to lure better management from well established businesses. Negatively effects their books.

Question 3

What are the differences between Equity and Acquisition Accounting? (Describe Acquisition Accounting)

Answer 3

Outline the main differences between acquisition accounting and equity accounting:

Acquisition accounting:

• Assets and liabilities of the acquiree are 100% consolidated on a line-by-line basis, with ownership interest in acquiree not owned by the acquirer shown as noncontrolling interest in the equity section.
• Revenue and expenses of the acquiree are 100% consolidated on a line-by-line basis, with profit attributable to NCI separately identified.
• Purchased goodwill is separately
  calculated and presented (if positive).
• Any impairments on the acquiree’s
  business are applied to goodwill.
• NCI exists whenever the acquiree is
  partially owned.
• Used in situations where the acquirer has control over the acquiree (e.g.
  subsidiaries).
• Intragroup transactions and indebtedness are eliminated upon consolidation.

Question 4

What are the differences between Equity and Acquisition Accounting? (Describe Equity Accounting)

Answer 4

Equity accounting

• Acquirer’s ownership interest in the
  acquiree’s net assets is consolidated into one line – ‘investment in associates’.
• Acquirer’s share of acquiree’s profit after tax is consolidated into one line – ‘share of profit of associates’.
• Purchased goodwill is subsumed within investment in associates.
• Any impairments on the acquiree’s
  business are applied to investment in
  associates.
• NCI is never present.
• Used in situations where the acquirer has significant influence over the acquiree (e.g. associates).
• Intragroup transactions and indebtedness are not cancelled upon consolidation.

Question 5

Discuss the Capital Maintenance Concept of Real Financial

Answer 5

Real Financial:

• The capital maintenance concept seeks to measure profit by ensuring that the resulting period end capital is at least as much as the opening (i.e. Ct ≥ Ct-1).
• Capital = the general purchasing power of shareholders’ interest.
• Use general retail price index (RPI) to
  represent general purchasing power.
• Use inflation-adjusted historical cost as measurement unit.
• Underpins Constant Purchasing Power (CPP) accounting.

Question 6

Discuss the Capital Maintenance Concept of Operating Capacity

Answer 6

Operating Capacity:

• The capital maintenance concept seeks to measure profit by ensuring that the resulting period end capital is at least as much as the opening (i.e. Ct ≥ Ct-1).
• Capital = the operating capacity of reporting entities.
• Use specific index to represent operating capacity.
• Use replacement cost as measurement unit.
• Underpins Current Cost Accounting (CCA).

Question 7

The current institutional arrangement of accounting standards setting shows that the regulated approach to financial reporting is better than the free market approach.

Required:
Critically evaluate the above statement with reference to the relevant academic literature.

Answer 7

Outline:

Students are expected to critically evaluate the pros and cons of the regulated approach and the free market approach to financial reporting. e.g.

Free-market – Pros/Regulated – Cons:
* Free market arguments e.g. contractual incentives (e.g. Jensen & Meckling 1976), competitive capital markets (e.g. Ross 1979), signalling incentives, markets for managers and
corporate control, etc.
* Benston (1980): Regulation can be costly, lead to a loss of proprietary information, etc.
* Information overload
* Reduced flexibility
* Social benefits of regulation may not > social costs
* Recurrence of accounting scandals despite heavy regulation
* Lack of an acceptable criterion to select an optimum accounting standard (Demski 1973)
* “Nirvana” fallacy (e.g. Leftwich 1980)
* ‘Capture theory’/’Private Interest theory’ vs. ‘Public Interest’ theory of regulation.

Regulated – Pros/Free-market – Cons:
* Accounting information as a public good.
* Information asymmetry lead to over-supply of inferior info
* Costly for individuals to contract with firms
* Historical market failure e.g. GEC/AEI, opportunistic behaviour, earnings management, etc.
* Fairness of information access
* Recourse to private legal sanctions not always effective
* Public accountability
* Lack of comparability of financial statements without standards.

Question 8

Discuss the Nirvana fallacy.

Answer 8

• As a result of such an externality, for example, firms’ voluntary reporting and auditing may fall short of the social optimum, hampering the efficient allocation of resources (e.g., Coffee 1984) Argued that statements are a public good.
• To avoid the “nirvana fallacy” of deriving demand for regulation from comparing real-world market outcomes with hypothetical ideal outcomes, they call for a “comparative institution” approach to resolve the question of whether reporting and auditing mandates help or hurt resource allocation (e.g., Demsetz 1969; Leftwich 1980).

Question 9

Capture theory, what is it?

Answer 9

George Strigler (1971) that says a firm or an industry can benefit from the legislation if it captures the related regulatory body. In Public interest theory government find some firms or industries have issues that may harm the society. To protect social interest from those harms, government set regulatory body to regulate the behaviour of those firms and industries. The regulatory body could be officers, legislations or guiding principles. They monitor organisations to act good for the public. Capture theory agrees that regulations are introduced aim to benefit the public at first. But the aim will eventually fail because as time flews regulator are controlled by regulated party (firms or industries), and then regulator will protect the ‘regulated party’.

Question 10

Briefly discuss how and to what extent current purchasing power accounting can address the limitations of historical cost accounting.

Answer 10

Students are expected to discuss:

 the limitations of historical cost accounting (HCA) especially during inflation; e.g. profit overstatement and possibly over-distribution of dividends and over-payment of tax; unrealistic balance sheet values; inadequate depreciation charges; not recognising
holding gains of inventories and gains/losses on holding monetary items; distorting accounting ratios and performance trends; etc.

 how CPP accounting attempts to correct the effect of inflation by restating the financial statements on a common measurement unit based on the general retail price index, and
recognising the gains/losses of holding monetary items during inflation.

 how it maintains capital by declaring profit only when the purchasing power of shareholders has been preserved in real terms, and thereby prevent the over-distribution of dividends.

 how it allows more realistic accounting ratios and performance trends to be computed.

 how it cannot overcome all the weaknesses of HCA; e.g. the general rate of inflation (RPI) may not coincide with the specific inflation rates of individual assets – adjusting HC with
RPI may not therefore reflect the current value of the assets; although CPP maintains the purchasing power of shareholders, it may not necessarily maintain the operating capacity
of the business in physical terms; certain transactions remain unrecognised if not realised
e.g. internally generated intangible assets, etc.

Question 11

Motives behind corporate financial reporting strategies such as: accounting policy and disclosure
choice, lobbying activities on proposed accounting standards, etc. have been subjected to much debate in the literature. Discuss the factors that help motivate such strategies.

Answer 11

Students are expected to discuss various factors that help motivate corporate financial reporting
strategies, e.g.:

 Compliance with regulatory requirements
 Company characteristics and size
 Industry membership
 Profit-maximising/Tax minimising motives
 Economic consequences arguments / Positive accounting theory (political cost, debt covenant, and bonus plan hypotheses)
 Capital market pressure/incentives (meeting earnings benchmark, IPO, avoiding losses, etc.)

Question 12

Foster (1986) Financial Statement Analysis (Chapter 5);

Accounting Choice Discussion…

Answer 12

Foster:

Factors that mangement may consider when, making accounting method choices.

• Compliance with Regulatory Mandates
• Du pont, on capitalisation of interest costs, as a result interest was included on PP&E lowering the interest on borrowing
• Choice of being privately owned to avoid regulatory bodies
• Consistency with the accounting model
• alternative methods such as matching costs with revenue, conservatism and objectivity.
• Changing from FIFO to LIFO (to achieve better revenue and cost matching)
• Presentation of Economic Reality or Truth
• used by management to explain an accounting change or criticising a mandated accounting method
• Early adoption of FASB statement 52., debate over the truthful representation of earnings within international corproations
• Comparability with other firms in the same industry
• Desire to achieve comparability with other firms in the industry is often cited as an important factor in accounting method choice. E.g. depreciation in real estate
• Management often perceives a mechanistic relationship between reported earnings and stock price
• Economic Consequences to the firm
• Accounting choice can influence market value of the firm’s equity and debt securities
  > Taxation expense influence
  > Data collection and Operating Cost Influence
  > Financing Cost Influence (bank lending)
  > Political and Regulatory Cost Influences (e.g. “a firm’s ability to pay taxes” can effect regulatory changes)
  > Wealth redistribution among claimants (effects the amount individual employees receive)

*Economic Consequences to Management
- Choice of pension plan etc.

Question 13

Financial Instruments (FA):

Discuss Debt Instruments and how they are accounted for…

Answer 13

Hold to collect = Amortised Cost

Hold to collect or sell = FVOCI

Hold to trade = FVPL

Not passed SPPI test = FVPL

Question 14

Financial Instruments (FA):

Discuss Derivative Instruments and how they are accounted for…

Answer 14

Never passing the SPPI test = FVPL

Question 15

Financial Instruments (FA):

Discuss Equity Instruments and how they are accounted for…

Answer 15

Not held for trading (elected to use FVOCI) = FVOCI

Not held for trading = FVPL

Held for trading = FVPL

Question 16

Financial Instruments (FA):

Discuss Hybrid Instruments and how they are accounted for…

Answer 16

Requires convertible loan notes -> FVPL (in the holders accounts)

The convertible bonds can be accounted for as compound (or hybrid) instruments in accordance with IAS 32. The fair value of the convertible bonds will be split into debt and equity, and then separately accounted for in the accounts. The debt element will be classified as ‘Other financial liabilities’ (since Kandinsky has no intention to repurchase them before maturity) and measured using the amortised cost method

Question 17

Table of consequential measurement for each form of Financial Assets.

Answer 17

• FVPL = FV -> change in FV in P&L and total income in the P&L (Finance Income)

SFP shows the total financial asset year on year.

• AC = FV + transaction costs -> AC in the P&L (interest income, effective rate in the P&L)

SFP shows the investment in debt “investment in corporate bond”

• FVOCI (equity) = FV + transaction costs -> change in FV in OCI and finance income in the P&L (Dividends)
• FVOCI (debt) = FV + transaction costs -> change in FV in OCI and interest income (effective rate) in P&L

SFP shows investment in corporate bond and Financial Asset revaluation reserve (gains/losses) in Equity

Question 18

Financial Instruments (FL):

Discuss the measurements of Financial Liabilties

Answer 18

FVPL = FV -> change in FV in SOCI (if it is related to the entity’s own credit rating, change in FV (if it is related to changes in market conditions). Then Finance costs (if any) in P&L

AC = FV - transaction costs -> AC schedule shows interest expense (effective rate) in the P&L

Question 19

Discuss the pros and cons of money financial capital maintenance

Answer 19

Critically review the strengths of the money financial capital maintenance concept (i.e. historical
cost accounting) – ease of use, reliability and verifiability and its

 Weaknesses especially during high levels of inflation:
o Profit overstatement and possibly over-distribution of dividends and over-payment of tax
o Unrealistic balance sheet values
o Inadequate depreciation charges
o Holding gains on inventories are not identified
o Holding gains/losses on monetary items are ignored
o Distorted accounting ratios and trends

Question 20

The history of accounting standard setting is littered with instances of political intervention by self-interested parties. With reference to academic literature, explain the factors that motivate certain self-interested parties to take pro-active actions to influence the decision making of standard setters. Discuss the appropriateness of these actions.

Answer 20

• Standard setting ≈ regulation on accounting by private institutions (e.g. FRC, FASB, IASB).
• Accounting standards stipulate how economic transactions are recognised, measured and disclosed in financial statements (or not in some cases). They have direct effects on how corporate financial performance and position are reflected and perceived by the financial
  statement users.
• Whilst there is empirical evidence to suggest that the accounting information market is fairly efficient and that market participants can see through the reported numbers, there remains the
  contention that accounting standards can still have unintended economic consequences (i.e. the impact of accounting reports on the decision-making behaviour of business, government, unions, investors and creditors (Zeff 1978)).
• Businesses and companies are shown to take pro-active actions to lobby for accounting standards that are deemed favourable to them (or against undesirable standards) and thus
  rendering the standard setting process a political one (e.g. Gerboth (1973), Watts (1977), Zeff (2002), Georgiou (2004), etc.).
• Closely relates to the notion that standard setting is a political process is the different theories of regulation e.g. public interest theory, capture theory and private interest theory. These
  theories explain the rationale behind regulation and to what extent it can be influenced by self interested parties.
• Accounting standards that have been heavily contested include e.g.
  o Proposed accounting standard on employee stock options (SFAS 123) led to strong
  opposition by many US companies which resulted in FASB withdrawing the proposal;
  o IFRS 39 – EU carve out following political lobbying by French banks; government intervention on financial assets reclassification rules during the 2007/08 financial crisis;
  o FRS 17 – led to the demise of many defined benefit schemes;
  o See also Zeff (2002) for others.
• The factors that motivate companies to undertake corporate lobbying behaviour have been
  subjected to extensive theorising and empirical testing. Notable factors include:
  o The Bonus plan, Debt covenant and Political cost hypotheses of the Positive accounting theory (Watts and Zimmerman 1990, Holthausen and Leftwich 1983). Efficient vs
  opportunistic versions of PAT.
  o Valuation effects and accounting-based contracting effects (see Allee et al. 2008).
• The appropriateness of these actions is debatable (and to a certain extent depending on one’s
  value and perspective, so no definite answer). Recall that there are two versions of PAT:
  Efficient contracting vs opportunistic gaming so it could be argued both ways.

Question 21

Cash Flow Statement differences

Answer 21

Cash flow = cash receipts and cash payments whereas profit = revenue – expenses.
* Cash flow is computed on the basis of cash accounting whereas profit is based on accrual
accounting.
* Cash accounting = account for transactions when receipts and payments take place. Accrual accounting = accounting is done when transactions occur (e.g. revenue earned, expenses incurred).
* Cash accounting ignores matching principles whereas accrual accounting requires cost to be matched against revenue when the relationship can be established or justifiably assumed. E.g. the periodic allocation of depreciation/amortisation to the income
statement.
* Useful information provided by CFS e.g.
o It helps users to predict future cash flows of an entity.
o It reports how managers have got cash and how they used cash to run the business.
o It helps to determine the ability of an entity to pay dividends and interest.
o It shows the relationship of profitability to cash-generating ability – thus the quality of
profit earned.
o It provides useful information e.g. liquidity, viability, and adaptability.
o CF is not easily manipulated and not affected by estimations/ assumptions and by accounting policies.
* However, timing of CF can be manipulated by management (e.g. delay of capital expenditure, etc.). CFS does not consider matching; hence does not reveal the profitability of the business.

Question 22

IFRS 10 definition of control

Answer 22

IFRS 10 definition of control:
* Three key elements:
o Power over investee;
o Exposure, or rights to variable returns from involvement with the investee; and
o Ability to use power over the investee to affect the amount of the investor’s returns.

• Students are expected to briefly explain each of the elements above; e.g.
• Power
  o Power means the ability to direct the relevant activities of the investee;
  o Relevant activities are activities of the investee that significantly affect the investee’s returns
  (e.g. selling and purchasing of goods or services, managing financial assets, etc.)
  o Power arises from substantive rights as opposed to protective rights; sources of power can
  include: voting rights, contractual rights, or special relationships.
• Variable returns:
  o Variable returns are returns that are not fixed and have the potential to vary as a result of
  the performance of an investee. Variable returns can be only positive, only negative or both
  positive and negative.
  o Examples include: dividends, changes in value of an investment, servicing and
  management fees, etc.
• Ability to use power:
  o A clear link between the existence of power and the ability to extract variable returns.
  o Need to consider if the investor has the current ability to direct the relevant activities
  (decision-making rights) on its own account (in other words, as principal); or on behalf of
  other investors that have delegated their power to it (in other words, as agent). Only the
  former counts.

Question 23

Strengths and weaknesses of CPP Accounting

Answer 23

Strengths:
* Like HCA, CPP is transaction-based and hence figures can be easily verifiable.
* Its measurement unit – RPI (which is independently constructed by the government) is well understood by the majority of the public. This also facilitates time-series comparison
of accounts since they are of the same measurement basis.
* It takes owner’s purchasing power into consideration and hence prevents payment of a dividend out of real capital.
* It recognises that inflation induces loss (gains) of holding monetary assets (liabilities) and accounts for such item in profit calculations.

Limitations:
* Since it is based on HCA, some of the shortcomings associated with HCA are still applicable to CPP model (e.g. treatment of financial instruments).
* The general rate of inflation (RPI) may not coincide with the inflation rates of individual assets – adjusting HC with RPI may not therefore reflect the replacement value of the
assets.
* Although CPP maintains the purchasing power of shareholders, it may not necessarily maintain the operating capacity of the business in physical terms.

Question 24

Briefly compare and contrast defined contribution and defined benefit pension schemes in terms of their nature and accounting.

Answer 24

• Both defined contribution (DC) and defined benefit (DB) pension schemes are remuneration arrangements that aim to provide employees with payments after they have retired from their employment.
• Pension payments are usually funded by employers via independent third parties (pension companies) which regularly collect pension contributions and invest them in assets.
• With DC, the contributions made into the scheme are usually fixed. The amount of benefits an employee will eventually receive will depend upon the investment performance of the fund’s
  assets. Thus in such plans the actuarial and investment risks rest with the employee.
• The accounting treatment of such plans is also straightforward. The cost of the plan to the employer is charged to the income statement on an annual basis and (normally) there is no
  further long term liability. This treatment applies the matching concept in that the cost of the post-retirement benefits (i.e. employer’s contribution payable under the scheme) is charged to
  the period in which the employer received the benefits from its employee.

The difference between contribution due and contribution paid is treated as either prepayment or accrual
accordingly.

• With DB, the amount of benefits an employee will eventually receive is pre-specified in the pension agreement, and is usually a function of the employee’s final salary. As such, the employer is contractually bound to deliver such benefits to the employees; i.e. the actuarial and investment risks therefore rest with the employer.
• Given the uncertainty of the future, the amount of the eventual liability and the investment performance of the plan assets is hard to predict. Hence, it is common to rely on actuaries who
  will advise on the funding arrangement.
• Accounting for DB is more complicated because of its nature, the uncertainty involved, and the volatilities of both pension obligation and plan assets’ performance. In particular, the net
  funding status of the DB scheme needs to be recognised in the balance sheet, whilst the costs (e.g. current and past service costs, interest expense) and the return on plan assets need to be recognised in the income statement. In addition, remeasurements of plan assets and benefit obligation are taken to the statement of other comprehensive income.

Question 25

How do you account for employee stock options (ESO)

Answer 25

Example Answer:

Accounting for employee share options is governed by IFRS 2 Share based payment.
* Jazz PLC’s runs a typical equity-settled ESO scheme that carries a vesting period of five years.
* IFRS 2 requires that the total cost of ESO to be spread over the vesting period, with the annual ESO expense charged to the statement of profit or loss.
* Total cost of ESO is computed as: FV of ESO at grant date * Expected number of ESO to be vested.
* The ‘Expected number of ESO to be vested’ has to be estimated on a rolling basis using the latest available information about employee turnover.
* In the case of Jazz PLC, the total cost of ESO at 31 December 20X2 can be computed as follows:
FV of ESO at grant date * Expected number of ESO to be vested = Total
cost…
£1.25 600 employees – 25 left – 113 expected to leave during
the vesting period = 462 * 500 options each = 231,000
= £288,750
* The cost is spread over the vesting period of 5 years; hence the 20X2 charge is £288,750/5 =£57,750.
* The 20X2 accounting effect of the ESO is thus:
DR ESO expense (in SP/L) 57,750
CR Equity (in SFP) 57,750

Question 26

What are the profitability ratios?

Answer 26

• Gross Profit Margin = (gross profit/sales) x 100%
• Profit before interest and tax Margin = (PBIT/sales) x 100%
• Return on capital employed = (PBIT/(Equity + Debt) x 100%
• Return on Equity = (PAT, NCI & Pref Dividends/Equity (excluding NCI)) x 100%

Question 27

What are the efficiency ratios?

Answer 27

• Asset Turnover = Sales / Capital Employed (total assets - current liabilities)
• Inventory Holding Period = (Inventory / Cost of Sales) x 365
• Trade Receivables Collection Period = (Receivables / Revenue) x 365
• Trade Payables payment period = (Payables / Cost of Sales) x 365

Question 28

What are the liquidity ratios?

Answer 28

• Current Ratio = (Current Assets / Current Liabilities)
• Quick Ratio = (Current Assets - Inventory/ Current Liabilities)

Question 29

What are the solvency ratios?

Answer 29

• Gearing = (Debt / Equity + Debt) x 100%
• Interest Cover = (PBIT / Finance Cost)