ACCT 10001

Accounting Reports and Analysis

Tutorial 4: Liabilities, Equity

and WACC
Agenda

Exercise 1: Case study: Misclassification of

borrowings
Exercise 2: Case study: VW Emissions Scandal
Exercise 3: The debt-equity mix

2
Exercise 1 – Misclassification of borrowings
Background
• Centro Properties Group was a successful property manager of
regional shopping centres across Australia
• In 2006 its business expanded into the US
• The nature of its business meant that it incurred large amounts
of complex borrowings
• In its 2007 annual accounts Centro misclassified $billions of
borrowings as non-current liabilities that, in 2011, were ruled
should have been classified as current.

Discussion:
• Why is the classification of such significant borrowings
important? Are there potential agency issues?
Exercise 1 (continued)
The ensuing court case
• Centro’s directors argued that they could not be expected to
know that the liabilities in question were current liabilities within
the meaning of the relevant accounting standards because:
– There had been a recent change to the relevant accounting
standard and some ‘greyness’ in its interpretation
– The documentation relating to the borrowings was complex

Discussion:
• Is it reasonable for directors to claim ‘greyness’ and complexity
as grounds to explain the misclassification?
Exercise 1 (continued)
The outcome – a summary of the Court’s key findings:
• Directors should be expected to have a certain level of financial
literacy and understanding of basic accounting conventions
• Directors should undertake proper diligence to understand the
contents of the financial statements they are signing
• CA 2001 places on the Board and each director the specific task
of approving the financial statements and cannot delegate that
responsibility to others (i.e. directors cannot blame management
for any errors or misclassifications in the financial statements)

Regardless of whether or not they prepare them, directors take

ultimate responsibility for the financial statements they sign-off
as being true and fair and complying with CA 2001 and AASBs
Exercise 2 – The Volkswagen Emissions Scandal
Background
• In the latter part of 2015, it emerged that Volkswagen had
deliberately installed software that manipulated nitrogen oxide
output of its cars under regulatory test conditions that would
later emit levels well above legal limits under normal driving
conditions
• After the scandal broke, Volkswagen announced plans to spend
US$7.3b on rectifying the emissions issues, and planned to refit
some 11 million affected vehicles as part of a worldwide recall
campaign
• Several class actions commenced as did proceedings by
regulatory bodies for a range of breaches and violations of
environmental and safety standards as well as deceptive
practices
Exercise 2 (continued)
Subsequently
• Volkswagen announced in February 2016 that it would
postpone the release of its full-year results after admitting it
faced too much uncertainty over the financial impact of the
emissions scandal.

Discussion
Consider the likely impacts this scandal would have had on
Volkswagen’s financial statements and Note disclosures
Likely to recognise provisions for the recall costs (VW actually
set aside €6.7b for this) and disclose contingent liabilities based
on potential class actions and regulatory fines (analysts
estimated these would exceed €30b)
Exercise 3 – Weighted average cost of capital

The 30 June 2018 balance sheet of ARA Investments Ltd

reveals total liabilities of $56 million and net assets of $84
million.
The average rate charged by lenders is 6.25%.

Required:
What is the rate of return required by investors?
Who knows? What we do know is
that it will be higher than 6.25%
Exercise 3 (continued)
The analysis determines that the rate of return required by
investors is 12.5%

Required
Determine the WACC for ARA Investments Ltd
Weighting of debt = 56 / (56 + 84) = 40%
=> Weighting of equity = 60%
WACD = 40% x 6.25% = 2.5%
WACE = 60% x 12.5% = 7.5%
WACC = 10%
Exercise 3 (continued)
Assume that ARA Investments Ltd is exempt from income tax
and that its earnings before interest for the year ending 2018
was 11% of total assets.

Required
Discuss whether or not shareholders would be satisfied with
this result.
ROA of 11% > WACC of 10%
=> assuming the modelling is correct,
shareholders would be satisfied.
In fact, the actual return to shareholders
would be greater than what they required.
Exercise 3 (continued)
Assume that ARA Investments Ltd is exempt from income tax
and that its earnings before interest for the year ending 2018
was 8% of total assets.
The actual rate of return has no bearing on lenders –
Required lenders get their required rate regardless of profit
because interest must be paid.
Discuss whether or not lenders would be satisfied with this
result.
Does the fact ROA < WACC suggest ARA Investments made
a loss for the year?
Not necessarily – it means that the return
the shareholders actually received will be
less than what they required.
Exercise 3 (continued)
ARA Investments Ltd is considering expanding its operations
in the latter half of 2018 by acquiring a further $60 million in
assets. They are considering using debt at the existing
borrowing rate to finance entirely this capital investment.
Weighting of debt becomes 116 / (116 + 84) = 58%
Required => Weighting of equity = 42%
Advise ARA Investments Ltd whether
WACD =or58%
notxthis finance
6.25% = 3.625%
strategy is worthy. WACE = 42% x 12.5% = 5.25%
(Old WACC was 10%) New WACC = 8.875%
WACC is now lower => reduces ROA needed to satisfy
rates of return required by shareholders, BUT is a debt
ratio of 58% too high?
Before Next Tutorial
• Assessable Test Two
– Opens Friday 4 pm, Closes Sunday 4pm
• Review Lecture notes / readings
• Attempt non-assessable preparation quiz

NEXT TOPIC
• The Statement of Comprehensive Income
– Income and Expenses
– Profit and Other Comprehensive Income
© Copyright The University of Melbourne 2017