CIA3003: Final Exam Semester, 20192010

Question 1

(a) Normative theories

• Recommend/prescribe what should happen. Accounting theorist attempt to establish
'norms' for 'best accounting practice' E.g. Conceptual Framework
• Concerned with developing an ideal approach to measure and report, then provide
prescription of what should happen
• Normative theories are deductive in nature (based on logical argument) sought to
develop new methods of accounting

Positive theories
• Provide framework for explaining the practises that were being observed
• Seek to predict and explain particular phenomena
• Decision-usefulness orientation- focus shifted from the principles of accounting to the
outcome of the accounting process.
• Begin with assumption(s), and through logical deduction enable prediction(s) to be
made : .
• Is based on 'rational economic person' assumption
( o individuals motivated by self-interest tied to wealth maximisation
o challenges the view that accountants will be 'objective'

(1 mark for point and relevant explanation)

(5 Marks)

(b) Arguments for Conceptual Framework:

Technical benefits:
1. Improve the practice of accounting and to provide a basis for answers to specific
accounting questions and problems.
2. It is stated that the Conceptual Framework does this in two ways:
By providing a basis and guidance for those who set the specific
accounting rules.
1. Establish precise definitions that facilitate discussion of
accounting issues and enhance accountability.
By helping individuals involved in preparing or auditing or using financial
statements.
Political benefits:
3. Prevent political interference in setting accounting standards.
Accounting information has significant real-world affects.
Standard setters can argue the theoretical correctness of their decisions
by referring to the principles of Conceptual Framework
Professional benefits:
4. Protect the professional status of accounting and accountants
Profession has a unique body of knowledge, maintain status as a
profession

Arguments against Conceptual Framework:

It is ambiguous:
the principles are too vague
too much room for alternative Interpretations.
 It is descriptiv e not prescriptive:
the Conceptual Framework simply describes current accounting practise
should be prescriptive (normative) and try to improve practice.
The concept of faithful representation is inappropriate as considered to
misunderstand the nature of accounting .
Realist view:
Financial statements are representationally faithful and provide an
objective picture of an entity's resources and obligations .
Is there one correct figure for profit? Eg: differ due to use of cost or
revaluation for an asset.
(1 marks for point and relevant explanation)
(10 Marks)
(Tota/: 15 marks)

Question 2

Historical cost:
Dominant measurement approach.
Traditional historical cost essentially requires items to be recorded at the amount at
( which they were purchased they were received. Transactions are based on the past.
Less relevant, as it is not necessarily reflective of the value of benefits (present and
future) .
What an entity paid for item in past is not reflective of value/benefit of item
now and in the future
• . ~Produces information which is more faithfully represented .
More neutral as there is very little or no estimation involved.
Values can be traced back to transaction documentation
Information produced is generally understandable ,
However historical costs but may less comparable.
Different items are purchased on different dates and in different year
Purchasing power of money changes, amounts paid in different years cannot
really be compared
Two entities, one with older assets, one with newer assets, is it appropriate to
compare net assets?
Fair value:
Arguments for fair value:
Information produced using fair value as the measurement base is argued to be
more relevant as reflects what items are worth now rather than what they were worth
C when purchased.
Neutral depiction as fair values are primarily determined using objective market
prices.
The quoted market price for an item is an objective method for determining the fair
value of an item and is more faithfully represented.
However, if no active market, forming a theoretical estimate of the current
market value involves assumptions and professional judgements.
Information produced using fair value is viewed as being more understandable
User perspective easy to understand as fa ir value equivalent to market value
of item
More comparable (arguably).
All values are current and measured on same date
However, due to variation which can exist in the valuation techniques
adopted to measure fair value, information is less comparable
 Arguments against fair value:
Amount of subjectivity and judgement involved in forming estimations of
market value in the absence of an objective market price.
Less faithfully represented due to the subjective nature of the valuation
process.
The most controversial measurement approach due to the subjective nature
of estimates involved in determining fair value when no active market exists
for an item

Current cost:
Information is more relevant than the use of historical cost as it reflects what would
be paid for same item today
Faithfully represented information due to the use of actual current cost.
However, current cost is more complex(less understandable) that other
measurement approaches
In reality, unlikely to buy an equivalent item, as item may be no longer be
available and technology is constantly changing
Values may be more comparable in the sense that costs should always reflect the
amount to be paid now to receive same future economic benefit,
However, due to to the variability which exists in terms of how an entity may
chose to achieve the same economic benefits, it may be less comparable .

Present value:
Y alues are more relevant as _users _are interested in the value or net worth of an-
entity
Present value provides an estimate of he present value of future cash flows
expected to be derived from an item
Due to the estimation involved, assumptions and judgement the approach lacks
faithful representation and neutral depiction.
Less understandable as approach involves complex estimations and formulas .
Comparable (arguably) as amounts are discounted to the present day and in current
dollars.
(1 mark each for discussion on impact of different measurement choices on relevance,
faithful representation , understandability and comparability for any 3 measurement bases
above.)

(Tota/: 12 marks)
C Question 3

No, earnings management is not always unethical. There are many definitions of earnings
management. The definitions will differ on whether normal financial decisions are part of
earnings management or the purpose is to mislead. Earnings management can range from
conservative, which is within the bounds of IFRS to fraud which is illegal. Ronen and Yaari
(2008) classify some earnings management decisions as 'white' , referring to beneficial
earnings management that enhances the transparency of financial reports. It can signal long-
term value to stakeholders.

(Discussion on whether ethical- Max 3 Marks)

3
 Entity valuation
Research by Dechow (1994) indicates that share prices are more aligned
with net income than with operating cash flows
Net income/earnings is commonly used to determine entity value
An entity's value is effectively the present value of future income discounted
at a risk adjusted discount rate
Companies with more volatile patterns of earnings are likely to
have a higher risk measure, therefore likely to have lower entity
value
Managers are more likely to engage in income smoothing to reduce
volatility and therefore risk of investment.
However, many managers may also take a short-term perspective and focus
on delivering earnings and meeting targets.
Long-term value maximising decisions may not be considered .

Managerial compensation and earnings management

Management makes the key decisions about strategy, investments, budgets,
operations, business strategy and acquisitions.
Although managers are appointed to operate the business for the benefit of
l shareholders, agency theory argues their objectives do not necessarily
always align.
The remuneration package for senior managers relates payment to various
performance measures.
Some common performance me_asures that directly_ relate to__ earn ings
include:
accounting returns
sales revenue
• net interest income
Prior research suggest that managers will manage earnings in such a way
that they maximise their bonus.
If earnings are so low that they are unlikely to meet their
targets, they are likely to engage in big bath write-offs.
Entities that adopt a long-term bonus plan in addition to a short-term plan are
able mitigate earnings management
Changes in CEO and earnings management:
Earnings management is particularly evident around the time a CEO
changes.
(_ Outgoing CEOs are likely to manage earnings up in final year to increase
opportunities or reduce appearance of poor performance.
Incoming CEOs are more likely to take an earnings bath in the first year and
then the following year show large earnings increases.
To avoid violating restrictive debt covenants/ corporate distress
Default on a debt agreement can be associated with corporate distress.
Entities that are financially distressed and facing debt covenant violations are
likely to use earnings management to avoid the costly breach of debt
covenants.

- Max 3 marks each per reason why companies employ earnings management (when
managers have incentives to use them, what techniques are used)

(Tota/: 15 marks)
 Question 4
Arguably, conventional financial accounting practices discourage us from
embracing
sustainable business practices. There are a number of reasons for this,
including the
following .

The objective of general purpose financial reporting, as noted in the IASB

Conceptual
Framework for Financial Reporting, is to provide information to present and
potential
investors, lenders and other creditors to assist them in their resource
allocation
decisions. Other stakeholders who are making decisions unrelated to the
allocation of
resources are not directly considered.

The accountants' notion of materiality also tends to preclude the reporting

of social
and environmental information.

As highlighted in Gray, Owen and Adams (1996), another issue that arises
in financial
accounting is that reporting entities frequently discount liabilities, particula
rly those
that will not be settled for many years, to their present value. This tends
to make
future expenditure less significant in the present period. This has particula
r relevance
( to future 'clean-up costs' and remediation costs. Discounting liabilities
can tend to
make them immaterial in the current period and therefore not presente
d in the
balance sheet - that is, discounting can effectively make the liabilities 'disappe
ar'.

Financial accounting adopts the 'entity assumption', which requires the

organisation
to be treated as__an _entity _distinct from its owners, other organisations
and other
stakeholders. If a transaction or event does not directly impact upon the
entity, the
transaction or event is to be ignored for accounting purposes. This means
that the
externalities caused by reporting entities will typically be ignored, thereby
meaning
that performance measures (such as profitability) are incomplete from
a broader
societal (as opposed to a 'discrete entity') perspective .

In financial accounting and reporting , expenses are defined in such

a way as to
exclude the recognition of any impacts on resources that are not controlle
d by the
entity (such as the environment), unless fines or other cash flows result.
For example,
under the International Accounting Standards Board's conceptual framew
ork (as
discussed in chapter 6) , expenses for financial reporting purposes are defined
as:

C . . . decreases in economic benefits during the accounting period in the

form of outflows or depletions of assets or incurrences of liabilities that
result in decreases in equity, other than those relating to distributions
to
equity participants. (Paragraph 4.25b)

An understanding of expenses therefore requires an understanding of

assets. Assets
are defined as resources 'controlled by the entity as a result of past events
,and from
which future economic benefits are expected to flow to the entity'
(paragraph 4a,
emphasis added). The recognition of assets therefore relies upon control,
and hence
environmental resources such as air and water, which are shared and
therefore not
controlled by the organisation, cannot be considered as 'assets' of that
organisation.
Thus their use, or abuse, is not considered as an expense .

There is also the issue of 'measurability'. For an item to be recorde

d for financial
accounting purposes it must be measurable with reasonable accuracy.
As paragraph

5
 4.38 of the IASB Conceptual Framework for Financial Reporting states:

An item that meets the definition of an element should be recognised if:

(a) it is probable that any future economic benefit associated with the
item will flow to or from the entity; and
(b) the item has a cost or value that can be measured with reliability.

Trying to place a value on the externalities caused by an entity often relies on

various estimates and 'guesstimates', thereby typically precluding their recognition
from the financial accounts on the basis of the potential inaccuracy of the
measurement.

General purpose financial reporting also requires us to break the life of the
organisation (which could be deemed to be indefinite) into smaller periods, such as
yearly (or quarterly, or half-yearly) periods. We are then required to calculate the
profit for each period. Focusing on yearly periods can act to discourage the managers
of the organisation from taking a longer term perspective (particularly, perhaps, if they
are paid bonuses that are linked to annual profits). By contrast, a consideration of
sustainability would require us to take a longer term focus.

Taken together, the above limitations of financial accounting do tend to indicate that
financial accounting practices do not provide an 'ideal' vehicle to encourage
corporations to embrace sustainable business practices.

(1 mark for point and releval']t expl~nation) _

(Total: 10 marks)

Question 5
Those managing a company may use the resources to benefit themselves (rather
than shareholders).
WorldCom-CEO granted board money to settle personal business activities
Corporations may take actions that shareholders may not consider desirable.
Mitsubishi in Japan failed to inform customers of potential safety problems in
their vehicles
Corporations may hide or provide false information to shareholders to avoid
consequences.
Enron failed to inform level of debt, Worldcom recorded expenses as assets
to improve profit
Disparity ('mismatch') has been perceived between the payments received by the
managers of corporations and their performance.
Directors receiving massive payments and benefits even when corporate
performance is poor

Max 2 marks for point and relevant explanation

(Total: 8 marks)