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2013 S1

a) What is the role of capital markets research? Explain the
underlying assumption of capital markets research as it
particularly relates to the usefulness of accounting information
for investor decision making purposes.
Capital market research explores the role of accounting and other
financial information in capital markets. Involves examining
statistical relations between financial information and share
The capital market research relies on the assumption that market
is EFFICIENT. If the market is not efficient, the statistical relations
between accounting/financial information and share prices are
likely to be distorted and the findings may not be reliable.
c) Define the efficient markets hypothesis (EMH) and explain three
forms of market efficiency.
Efficient market defined as a market that adjusts rapidly to
information into share prices when the information is released.
- Weak form: price reflect information about past price and
trading volumes.
- Semi-strong form: all PUBLICLY available information is rapidly
and fully impunded into share prices in an unbiased manner
when released
- Strong form: security prices reflect all information (public and
a) Explain the objective of fair value measurement in accordance
with AASB 13 Fair Value Measurement, paragraph 2
To estimate the price at which an ORDERLY transaction that
would take place between market participants at the
b) AASB 13 Fair Value Measurement, paragraph 16 prescribes that
if there is no active market there are three widely used valuation
techniques: (i) the market approach; (ii) the cost approach; and
(iii) the income approach. Explain what are meant by the cost
approach and income approach.
Cost approach: reflects the amount that would be required
currently to replace the service capacity of an asset (current
replacement cost).
Income approach: converts future amounts to a single current
amount. It is the current market expectation of future amounts.
d) Managers and accountants need to make judgements and

decisions in relation to the presentation of accounting

information in financial reports. One of these relates to the use of
fair value to measure the companys non-current assets e.g.,
property, plant and equipment (PPE). Outline the advantages and
disadvantages (criticisms) of using fair value measurement.
If there is active market
- Independent from management
- Determined by market forces
- Going concern (re-exit price)
Ignores the assumption made in accounting that the entity will
continue in business
- Subjectivity (revaluation techniques)
If there is no active market, fair value is measured using
valuation techniques which are based on predictions which
may not be correct.
Q3 Positive Accounting Theory
a) Define and explain positive accounting theory. Explain the
underlying concept of positive accounting theory.
Positive accounting theory: being concerned with explaining
accounting practice. It is designed to explain and predict which
firms will and which firms will not use a particular method.
Focuses on the relationship between various individuals, in
particular in a firm and how accounting methods are applied to
explain these relationships.
Positive accounting theory is based on the concepts of wealthmaximisation and individual self-interest. Individuals action is
driven by self-interest. Hence, individuals will do so to increase
their wealth.
b) Explain the role of accounting in agency relationships (agency
Accounting information can be used to minimize information
asymmetry between agent and the principal. Higher information
asymmetry leads to higher principals moral hazard and adverse
selection problems. Hence, it is expected that accounting
information can minimize principals moral hazard and adverse
selection problem and therefore minimize agency cost.
c) Explain the problems of adverse selection and moral hazard
(Akelof, 1976).
Adverse selection: investors are not able to make informed
investment decisions due to information gap.

Moral hazard: investors are not able to predict with certainty

insiders future actions regarding the firm due to an information
d) Explain the three costs of agency relationships documented in
Jensen and Meckling (1976) and provide 2 (two) examples of
each cost.
Monitoring cost:
e.g. auditing, internal control system, budget control,
performance review and incentive compensation system
Bonding costs:
e.g. preparing financial statements and contractual limitations on
the managers decision making power
Residual loss:
e.g. company resources or facilities are heavily used for personal
Q4 Agency Problems I and II
a) The journal article refers to Types I and II agency problems, which
often occur in family firms and non-family firms. What is meant by the
term 'agency problem and explain the difference between Types I and
II agency problems?
Agency problem: agency conflict between agent and principal due
to conflict of self-interest and they will act to increase their wealth.
Type I: In a firm that does not have high shareholding concentration
(HSC) or high family shareholding concentration. Small
shareholders cannot all represent themselves on the board of
directors and the size of their shareholding is insufficient to justify
the cost of monitoring managers. Small shareholders can align
themselves to appoint the board of directors to represent their
interests. Hence, conflicts of interest are more likely to arise
between the board of directors and shareholders.
Type II: In a firm that have HSC or HFSC, conflicts of interest are
more likely to occur between large shareholders or family
shareholders and other shareholders.
(b) The controlling families have incentives and the ability to extract
private benefits at the expense of non-controlling shareholders. Provide
2 (two) examples of how controlling families can appropriate firm
wealth at the expense of non-controlling shareholders and how these
problems can be minimised.

Controlling shareholders can appoint their family members or

friends as the members of board of directors although they are
not competent with huge salary and remuneration package.
Controlling shareholders via their appointed board of directors
can manage accounting earnings. E.g. to hide adverse effects of

related party transactions or to rise family members position in

- Majority of board members should be independent.
- CEO not family member of friend of controlling shareholders
- The presence of an independent audit committee
(c) Ali, Chen and Radhakrishnan (2007) state that family firms face
less severe Type I agency problems and more severe Type II agency
problems (p. 281). Provide plausible reasons why family firms face
more severe Type II agency problems and less severe Type I agency

Family firm face less severe Type I problem because of their

ability to directly monitor the managers. This enables family firms
to compensate management accounting to accounting
performance measures. Thus, the financial report would be less
likely to be manipulated.
On the other hand, family firms face more Type II agency
problems because of their significant stock ownership and control
over the firms board of directors. Family firms boards tend to be
less independent and are consists of majority family members.
Hence, family shareholders are likely to have conflict interest
with non-controlling shareholders.
Q5 Off-balance Sheet Debt Financing/ cost of debt
(a) Describe one transaction-structuring technique firms have used
to keep debt off the balance sheet and one incentive for doing so;
a. trust preferred securities
b. synthetic leases
c. special purpose entities
1. bonus contracts
2. to avoid debt covenant violation
3. capital adequacy requirements
(b) Discuss the accounting techniques identified in Sweeney (1994)
that firms use to try to avoid debt covenant violation; and
The techniques are categorised into voluntary and mandatory
accounting changes.
Voluntary accounting changes:
Default firms adopt income-increasing voluntary accounting
changes. For example, changes to pension accounting assumptions,
inventory valuation methods and depreciation methods.
Mandatory accounting changes:

Default firms adopted income-increasing accounting standards

relative to control sample. Similarly, they delayed the adoption of
income-decreasing accounting standards compare to control sample.
(c) Debt contracts may permit or prohibit accounting changes
(whether voluntary or mandatory) from impacting on debt covenant
compliance calculations. Discuss the role that permitting
accounting changes to influence compliance calculations has on the
cost of debt, and the reasons behind this.
Beatty stated that debt contracts that do not permit voluntary
accounting changes have lower interest rate spread. There are two
reason: firstly, lenders trying to price protect against borrowers
manipulation by adopt income-increasing voluntary accounting
changes to avoid violation. Secondly, borrowers are willing to pay
higher cost of debt for the flexibility.
Beatty also stated that debt contracts that do NOT permit
mandatory accounting changes have lower interest rate spread.
There are also two reason. Firstly, lenders price protect to cover the
costs of monitoring and investigating violations caused by
mandatory accounting changes. Secondly, borrowers are willing to
pay higher cost of debt due to additional record keeping cost
associated with excluding mandatory accounting changes.

Q6 Earnings Quality
(a) Explain one technique academic research uses to measure
earnings management; and
Jones model, Modified- Jones model, Earnings smoothing metrics
and managing earnings towards positive targets.
(b) What is meant by the term value relevance? Explain why
accounting information prepared in accordance with international
accounting standards is considered value relevant.
Value relevance refers to the incorporation of information into stock
prices. Due to the fact that accounting numbers generated by IAS are
considered of higher quality than others, such accounting information
is considered more informative and will be incorporated into stock
prices accordingly. Investor will rely more on such information in
making their investment decisions.

Q7 Executive Compensation
(a) Explain the roles of the remuneration committee and
compensation consultants in setting CEO pay levels;

The remuneration committee makes the final recommendation on

the remuneration of executives, which is put to the board of directors
for ratification.
The committee may draw upon the services of a compensation
consultant who advises on the level and components of the
compensation package of the executives
(b) Provide two (2) examples of how compensation consultants
independence may be impaired in setting CEO pay levels; and
1. they have not been hired directly by the remuneration
committee, but rather have been hired by the CEO to advise on the
executive remuneration
2. they have been hired by the CEO to provide other service to the
(c) Amstrong, Ittner and Larcker (2012) find that firms with weaker
governance are more likely to use compensation consultants and have
higher CEO pay than firms with stronger governance. Discuss why firms
with weaker governance are more likely to employ compensation
consultants and have higher CEO pay.
One potential approach is through the use of compensation
consultants. A wide range of business leaders, academics and
politicians charge that CEOs of companies with weak governance use
compensation consultants to design and justify excessive pay package.
Q8 accounting for income tax
(a) Describe one risk and one benefit firms face when engaging in
tax aggressive behaviour;
Risk: increase IRS scrutiny
Benefit: improving the after-tax position of the firm through tax
(b) Given the proprietary nature of tax return data, how do
academics measure a firms tax aggressiveness? Provide an example of
such a measure; and
Academic often construct tax aggressiveness proxies using
financial statement numbers. One example is a firms effective tax
rate, another is to calculate their book-tax differences.
(c) Hutchens and Rego (2012) find that more tax aggressive firms
have a higher cost of equity. Discuss a plausible explanation of this
Investors perceive the risks of tax aggressiveness to out weight the
benefits and is detrimental to firm value.

2013 S2
Q1 Capital Markets research

a) Explain two plausible reasons why earnings announcements of

large firms are more likely to have less effect on share prices
than those of small firms
Large firms have more resources and higher visibility than
small firms. Hence, large firms are more likely to have more
information disclosed to public than small firms therefore
reduces information gap between large firms and investors. In
addition, analysts are more likely to follow large firms because
larger and more investors are more likely to invest in large
firms than small firms. This increases earnings forecast
accuracy of large firms that lead to less earning surprise for
large firms relative to small firms at the earnings
announcement date. On the other hand, small firms have
higher information asymmetry than large firms which leads to
more earnings surprise at announcement date.
b) Discuss one plausible reason why particular accounting
information may not affect share prices and provide a specific
example to support.
Although particular accounting information does not affect
share price, we cannot conclude that particular accounting
information has no value. Investors might have anticipated
particular accounting information prior to the announcement
e.g. a company announced that it has achieved earning
target. Since earning target has been in public domain and it
has been impounded in the current share price. The
announcement of earnings is not a surprise to investors and
would not affect firms share price.
Q2 Fair value measurement
a) Explain what is meant by the market approach.
A valuation technique that uses prices and other relevant
information generated by market transactions involving
identical or comparable assets, liabilities or a group of
assets and liabilities such as a business.
b) Outline the disadvantage of using the income approach to
Subjectivity: future cash flows and discount rate are based on
the managers predictions therefore they can be easily
managed by the managers to suit their interest.

c) Explain what are meant by market participants in accordance

with AASB13
Buyers and sellers in the principal market for the asset or
d) Outline four specific characteristic of market participants as
per AASB 13
1. they are INDIPENDENT of each other
understanding about the asset or liability and the transaction
using all available information, including information that
might be obtained through due diligence efforts that are usual
and customary.
3. they are ABLE to entered into a transaction for the asset or
4. they are WILLING to enter into a transaction for the asset or
Q3 Positive accounting theory and value relevance
a) Which type of agency problem? Explain what are the
difference between agency problem types I and II.
Type II
Type I: In a firm that does not have high shareholding
concentration, small shareholders cannot all represent
themselves on the board of directors and the size of their
shareholding is insufficient to justify the costs of monitoring
Small shareholders can align themselves to appoint the board
of directors to represent their interest. Conflicts of interest are
more likely to arise between the BOARD OF DIRECTORS and
Type II: in a firm that does have HSC or HFSC, conflicts of
interest are more likely to occur between LARGE/FAMILY
b) Explain what are meant by the opportunism and efficiency
hypotheses? Provide one plausible incentive that may
motivate managers to manage earning upwardly
Opportunism Hypothesis: managers act in their own best
interest to maximize their wealth at the expense of some
other parties.
Efficiency Hypothesis: managers act in the best interest of the
firm to maximize the value of the firm.
Managers manage earning upwardly to meet earnings target
in order to maximize their bonus payment or increase share
c) Explain results in table three and outline the reason.

Explain one plausible reason why agency costs may be lower

when manager is also a shareholder.
The result support that agency costs are lower when manager
is a shareholder. The proxy of agency costs is an expense
ratio. It means that higher expense ratio leads to higher
agency costs. The variable is 1 if the manager is also a
shareholder and zero otherwise. The coefficient is significantly
negative means that the dummy variable is negatively
associated with lower expense ratio.
(ii) if the manager is also a shareholder, it is more likely that
there is no agency conflict between manager and shareholder
in particular when the manager own 100% of the firm.
Q4 Earnings quality and value relevance
a) Explain what is meant by accruals quality
Accruals quality as the metric that best reflects the ability of
current earning to reflect future cash flows.
b) Outline two examples for each type of discretionary accrual
Operational discretionary accruals
1. In the last month of the end of financial year, the company
has many outstanding sales contracts, managers can use their
operational discretion to expedite the delivery of goods or
services. Hence, more revenues and profits can be recognized
in the current financial year.
2. managers induce customers to buy more goods or services
by providing luxury credit terms (longer credit terms)
Long-term investment discretionary accruals
1. managers use flexibility in the goodwill rule to determine
the recoverable amount of goodwill to either increase or
decrease goodwill impairment loss
2. managers also use their discretion to increase or decrease
depreciation expenses of non-current assets by changing
estimates of the useful life or delaying the write off of NCA.
c) What is meant by noise trading
Noise trading a non-information based trading. E.g. trading
due to liquidity or rebalancing of portfolio.
Q5 Off-balance sheet debt financing/ cost of debt
a) Explain what is meant by off-balance sheet debt financing and
describe two incentives of its use.
Off-balance sheet financing refers to obtaining cash, goods or
services without a formal borrowing arrangement which
requires recognizing a liability on the face of the balance
It makes the company tohave more credit worthiness

To reduce debt-equity ratio

It allows borrowers to level up without recognizing liabilities on
their balance sheet.
b) Explain what is a debt-covenant
Resrictions that are imposed on a borrower by a lender that
granted the loan. The restrictions may specify that a borrower
must achieve certain level of sales or profits or may maintain
certain level of debt to assets ratio or debt-equity ratio or limit
the borrowers ability to take on other debts. Breaching debt
covenants can cause severe consequences to borrowers. E.g.
lender can demand the borrower to pay the loan immediately
or impose heavy penalty.
Describe one accounting technique that can be used by
managers to avoid breaching accounting-based debt
Managers may select accounting choices/techniques to satisfy
accounting-based restrictions stated in debt agreements. For
example, if the accounting based covenants are related to
profit, managers can upwardly manage earnings via
discretionary accruals.
c) Explain why lenders may offer lower interest rates if debt
covenants restrict borrowing firms from implementing
voluntary accounting charges otherwise allowed by
accounting standards.
The restriction imposed by lenders on borrowing firms for not
implementing voluntary accounting changes can reduce
managers opportunism to manage earnings. Hence, it
reduces lenders moral hazard problem therefore decrease
contracting costs. This enables lenders to lower the interest
Q6 Cost of equity capital and accounting information/ international
accounting standards
a) Explain why more information disclosed by a listed firm increases
the firms stock liquidity and consequently affects its cost equity.
Information is linked to the cost of capital through stock liquidity.
Providing more information will reduce information asymmetry.
confidences and induce them to buy the firms shares. More
investors to buy the firms share will increase stock liquidity
which in turn reduces transaction costs, therefore reduce cost of
b) Explain why accounting information prepared in accordance with
IFRS may lower a firms cost equity
IASs improve the quality of accounting information. This reduces

information asymmetry between firms and investors as well as

between investors. Since investors would face lower uncertainty
they would demand a lower rate of return
Q7 Executive compensation
a) Explain the role of executive compensation consultants in
advising on chief executive officer pay packages
b) Finding suggest CEO pay is higher in companies where the
consultant provides other services. Discuss the plausible reason
for those findings
c) Explain how a company can reduce those potential conflicts of
interest faced by executive compensation consultants.