C30HY exam May 2020

Suggested solutions

a) Drawing on the literature, compare, contrast and critically discuss the usefulness of financial
information and general narrative reporting within the annual reports.
In their answers, students are expected to discuss some of the following aspects:
1. Suggested sources of literature:
a) Campbell et al (2008) (paper on reading list) report evidence against narrative reporting, i.e.
information conveyed using narrative reporting do not have informative value. Chairman statement
was found to be less useful than the Chief Executive’s review because the latter was believed to
contain more information about the future.
b) Evidence in favour of narrative reporting - Coram et al. (2011) (paper on reading list) examine
whether enhanced disclosures of non-financial performance indicators have influence on financial
analysts’ decision processes. Financial analysts pay considerable attention to non-financial
performance indicators but usage depended on the trend - direction of financial information. Financial
information received greater attention when the trend was negative whereas non-financial
performance indicators received greater attention when the trend was positive.
c) Use of narrative reporting for predicting bankruptcy - Smith et al. (2000) (paper on reading list) found
that firm’s discretionary narrative disclosures measured its financial risk of bankruptcy. Content
analysis of the Chairman’s statement in the UK sample of annual reports showed that the statements
were closely associated with financial performance and these unaudited disclosures contained
important information.
2. Financial information vs. narrative reporting
I. Financial information
a. Objective
b. Measurable
II. Narrative reporting
a. Subjective
b. Describes the most important non-financial information in an annual report to provide a broad
meaningful picture of the business / market position / performance / strategy / future prospects
3. Students should also use and refer to other relevant sources of literature.

b) Critically discuss debates in the accounting literature on the competitive advantages and
disadvantages of intellectual capital disclosure.
In their answers, students are expected to discuss some of the following aspects:
 Intellectual capital disclosure is based on (determined by) various theories.
 Difficulties with choosing relevant metrics for constituents – might be as few or as many as preparers
wish.
 No limitations imposed on combining generic and unique metrics; a wide range of choices in terms of
measurement and analysis.
 Too many opportunities to be inventive (the lack of common definitive language) that results in unusual
and strange elements of intellectual capital (for example, “rookie ratio” – number of employees with less
than 2 years service).
 Intellectual capital is impossible to incorporate into the statement of financial position.
 Several available scoreboard frameworks (references to CIMA reports, Bontis (2001) and Holmen
(2005) - papers on reading list).

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  Kaplan and Norton’s original framework (balanced scorecard) that suggests four generic perspectives
(customer, internal business process, learning and growth (people/innovation) and financial).
 Skandia AFS reporting framework developed by Edvinsson (1997) (paper on reading list):
 visualising intellectual capital (1995)
 value creating processes (1996)
 The Skandia Navigator reporting framework (developed from Scandia AFS) suggests four sets of
information (historical – financial; current – operational; future – renewal and external – environment)
and requires to identify strategically critical indicators.
 Narrative reporting frameworks based on fewer numbers but more reflection (for example, Operating
and Financial Review, Strategic Report (UK), Management Commentary (IFRS).
 Students should also use and refer to other relevant sources of literature.

c) Critically discuss debates in the accounting literature on the role of Fair Value Accounting in the
2007-2008 financial crisis.
In their answers, students are expected to discuss some of the following aspects:
• According to the IFRS, fair value is the ‘amount for which an asset could be exchanged, or a liability settled,
between knowledgeable, willing parties, in an arm’s length transaction’.
• Under US GAAP and IFRS, fair value is most frequently used for financial assets and liabilities.
• Distinction between inputs: quoted prices in active markets must be used as fair value when available. In
the absence of such prices, an entity should use valuation techniques and all relevant market information
that is available so that valuation techniques maximise the use of observable inputs.
• Proponents of fair value accounting: fair value reflects current market conditions based on timely
information and leading to an increase in transparency.
• Opponents of fair value accounting: fair value is irrelevant and potentially misleading for assets that are held
for a long period. In addition, fair value is not reliable.
• The problem of litigation risk: deviations from market prices under fair value accounting standards require
substantial judgment.
• In times of financial recession, fair value accounting might exacerbate the crisis by creating downward
spiral. As a result, observed market prices drop significantly below the fundamental values of assets. Thus,
fair value accounting is pro-cyclical - exacerbates swings in the financial system – and can provoke
contagion in the financial markets.
• However, the concern about banks’ ability to engage in ‘gains trading’ (selectively selling financial
instruments with unrealised gains and keeping those with losses) was a major reason for introducing fair
value accounting for financial instruments.
• Managers have an information advantage over the gatekeepers. Therefore, it is difficult to write fair value
accounting standards that provide the flexibility when it is needed and constrain managers’ behaviour when
it is not needed.
• Fair value accounting imposes a tradeoff between relevance and reliability, transparency and financial
stability.
• Students should also use and refer to other relevant sources of literature.

d) With reference to the literature, reflect on and critically discuss the following statement on earnings
management:
“It seems many managers are convinced that if a practice is not explicitly prohibited or is only a slight
deviation from rules, it is an ethical practice regardless of who might be affected either by the practice
or the information that flows from it” (Bruns et al., 1990: 22).
Bruns, W. J., Merchant, K. A. (1990) The dangerous morality of managing earnings. Management
Accounting, 72(2), 22-25.
In their answers, students are expected to discuss some of the following aspects:

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 According to Schipper (1989 - paper on reading list), earnings management is purposeful intervention in the
external financial reporting process with the intent of obtaining some private gain (as opposed to merely
facilitating the neutral operation of the process).
 Managers use judgment in financial reporting and in structuring transactions to alter financial reports to either
mislead some stakeholders about the underlying economic performance of the company or to influence the
contractual outcomes (such as debt covenants and other conditions affecting interest and other finance
charges) that depend on reported accounting numbers (Healy & Wahlen, 1999 – paper on reading list). For
example, booking premature revenue/ making unsupportable reduction in bad debt expense provisions.
 Typical areas of earnings management are revenue recognition (receivables, deferred and accelerated
revenues, contract judgment), expense recognition (capitalisation, depreciation, deferring, non-recurring), off-
balance sheet accounting (joint ventures, Special Purpose Entities, non-consolidated debt) and goodwill (high
acquisition premium, switch from amortisation to impairment test, use of management discretion).
 In addition to attempts to maximize managerial remuneration (for example, change in CEO – “Big Bath
Accounting”), managers also need to meet analysts’ and shareholders’ expectations. Valuation models
suggest that volatility of earnings might affect their values - higher risk leads to lower values.
 For Graham et al. (2006 – paper on reading list), earnings management is promoted by currently dominating
short-termism in financial reporting (e.g., rules based vs principles-based accounting standards, quarterly
EPS guidance and quarterly reporting, ex-post settlement of accruals estimates).
 Students should also use and refer to other relevant sources of literature.

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