Multiple Choice Questions

6.1. Historic cost accounting has been criticized as having a number of defects in times of rising prices. One of the main criticisms is that it fails to reflect the gain arising from borrowing in times of inflation. Which of the following statements best explains how companies gain from borrowing in times of inflation? A. The amount repayable under a loan does not increase over time as a result of inflation B. Interest rates are likely to be relatively low in times of inflation C. In times of inflation the likelihood that a company will default on a loan is significantly reduced D. Lenders are unlikely to require security for loans granted during periods of inflation Answer: A Explanation: Inflation helps companies to earn higher revenue utilizing same amount of resources while they have to pay the same amount of money as they stated during the signing of borrowing contract between the company and the creditor. 6.2. Some companies have chosen to incorporate the value of brands acquired on the balance sheet, without providing for annual amortization of these assets. Which of the following will not occur as a consequence of adopting such a policy? A. B. C. D. an improvement in net assets per share a reduction in the gearing ratio an improvement in return on capital employed an increase in shareholders’ funds

Answer: C Explanation: In reality adding the value of brands acquired increases the asset value though the value of brands acquired is intangible. It increases the value of the capital, and as a result return on capital employed reduces compared to other years. 6.3. Wellmax PLC’s finance director wishes to report as high a figure for profit after tax as possible for the year-ended 30 September 2006. Which of the following decisions would she be unlikely to take, even if permitted by the company’s auditors? A. revalue freehold land and buildings upwards to their current market value B. reduce the provision for bad debts C. to capitalize interest costs related to borrowings made to finance the construction of a new factory D. to increase the number of categories of overheads absorbed into the cost of production for the purposes of valuing closing stock Answer: D Explanation: In fact, increasing the number of categories of overheads absorbed into
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which the customer has not requested. The absence of any provision for slow moving and obsolete stock B. A change in the method for depreciating machinery from the reducing balance to the straight-line approach Answer: C Explanation: As customer has not requested the goods so it is obviously done by the executive to increase the net profit for the time being and perhaps to earn some extra bonus on sales. 6. Taking advantage of loopholes in accounting rules so that the financial statements portray the business’ financial performance and/or position in a more favorable light C. Which one of the following would be regarded as fraudulent? A.6.the cost of production is not going to change the overall value of closing stock as a result it not going to help to increase the profit after tax. Deliberately falsifying accounting records so that the financial statements portray the business’ financial performance and/or position in a more favorable light D.5. The sale of goods to a customer close to the year-end. Which of the following most closely explains what is meant by the term ‘window dressing’? A. Structuring transactions or making arrangements around the year-end so that the financial statements portray the business’ financial performance and/or position in a more favorable light B. 6.4. Failing to prepare accounts which give a true and fair view Answer: A Explanation: Since window dressing involves dispatching goods at the end of the period knowing them to be defective so that they appear in the current year’s sales and accepting that they will be returned later in the next period. Which of the following statements best describes the nature of creative accounting and window dressing? Legality Consistency with generally accepted 2 . The recognition of a proportion of the profit on a contract that has not been completed by the year-end C. 6. At the very beginning of next year the alleged executive might quit the job and the goods may return to company afterwards that is going to hamper company’s financial state in both way. on sale or return basis D.

it absolutely illegal and contravenes GAAP principles. thus though it is not illegal. Window dressing is illegal Creative accounting is not illegal Window dressing is not illegal Creative accounting is illegal Window dressing is not illegal Creative accounting is not illegal Window dressing is not illegal Creative accounting is not illegal Answer: B Explanation: Since Creative accounting involves manipulating the accounting information and misrepresenting performance and position of the business.accounting principles (GAAP) A. A company changes its year-end to a date which coincides with a time of year when the company’s inventory levels are at a seasonally low level 2. But the having inventory at low level does not comply to the overstatement of revenue. B. 2 and 3 Window dressing contravenes GAAP Creative accounting contravenes GAAP Window dressing contravenes GAAP Creative accounting contravenes GAAP Window dressing contravenes GAAP Creative accounting does not contravene GAAP Window dressing does not contravene GAAP Creative accounting does not contravene GAAP D. 6.7 Which of the following are examples of window dressing rather than creative accounting? 1. C. The window dressing is merely having some arrangement at the year end so that financial statement gives a favorable light to the financial position. 1 and 2 only 2 and 3 only 1 and 3 only 1. A company with a 31st December year-end persuading the bank to grant a 13 month short-term loan on 28th December rather than its standard 12 month loan. D. 3 . A company with a 30 June year-end persuades a major customer to place an order on 29th June rather than 16th July as usual. C. B. the placement of order and granting 13 months loan before the year end clearly overstate the revenue figure. but contravenes GAAP principle. and granting 2 months’ extra credit in return A. Answer: B Explanation: Since window dressing involves having some transactions at the year end so that the sales and profit figures give a favorable number. 3.

high rates of inflation have resulted in statements of financial position which were prepared on a historic cost basis reflecting figures for assets that were much lower than if current 4 . Exercise 1: Inflation accounting What are the main defects of historic cost accounting in times of inflation? Ans: One of the most important conventions of Accounting is Historic Cost Convention. The other method to value the asset is based on measuring of current value. By the mean time company does not have any responsibility according to the agreement. The sale of commodity stocks with an option to repurchase at a later date at a marginally higher price B.8.6. Inflation has been the most persistent problem. The purchase of a non current asset via a leasing arrangement D. This has meant that the value of money has declined in relation to other assets. Which of the following is not an example of a method used in the past by companies to achieve ‘off-balance sheet financing’? A. In past years. In today’s world. The holding of consignment stock which the company is effectively committed to purchasing C. It holds that the value of asset shown on the statement of financial position should be based on their acquisition cost which is the historic cost. A guarantee given by the parent company for the loans of its subsidiaries Answer: A Explanation: As the contract is an option so company may not wish to repurchase it. So it cannot be used as an off-balance sheet financing.

items are expressed in terms of pounds of current purchasing power. the conventional financial statements. on the other hand. The main features of Current Cost Accounting (CCA) are: 1. The conventional financial statements. This is because Directors seldom apply particular accounting policies or structure particular transactions in such a way that it portrays a financial condition that they want to show to public. the business could produce CPP. This is 5 . It seeks to protect the general purchasing power of the owners’ investment. rather than be supplementary to. If the CPP approach is adopted. In other words. a) What are the main features of Current Purchasing Power accounting (CPP) and Current Cost Accounting (CCA)? Ans: The main features of Current Purchasing Power accounting (CPP) are: 1. It could be argued that the two approaches are not mutually exclusive and that annual financial reports could incorporate both. the reporting costs involved and the problems likely to be created for less sophisticated users of financial statements. or at least underplays. ignores. (A consequence of using different measurement units is that the profit calculated under each approach cannot be easily compared.) 4. 2. It seeks to maintain the scale of business operations. This. Rates of inflation have been relatively low in recent years and so the disparity between historic cost values and current values has been less pronounced. Instead. It continues to use money as the unit of measurement. CCA financial statements. it can still be significant and has added fuel to the debate concerning how to measure asset values on the statement of financial position. 3. Choosing between the two approaches will inevitably involve a value judgment as to whether it is the owners’ investment or the business entity that is of paramount importance. CCA and historic cost financial statements. will remain the centerpiece of financial reporting. It abandons money as the unit of measurement. could replace. It is often commended for its reliability. 3. This would provide users with a fuller picture. Nevertheless. however. but still concerns prevail about the quality of published financial statement. It is often commended for its relevance. so that the owners would still have the same command over goods and services generally. Exercise 2: Creative accounting and window dressing a) Explain what is meant by creative accounting and window dressing. 4. Ans: There are several accounting rules and independent checks. 2. it can only provide information in the form of supplementary reports.values were employed. so that the business can continue operating at the same level. on which the CPP adjustments are based.

The financial statements can look much healthier if these can somehow be eliminated. One way of doing this is to create a ‘separate’ entity that will take over the losses or liabilities. Also known as ‘trade loading’. One particularly notorious case of capitalizing expenses is alleged to have 6 . shifted £60 million in excess inventories on to trade customers. Round tripping: also known as ‘in-and-out trading’. ii) Identify and explain at least three examples of how in the past each of the three main motives for creative accounting has been sought to be achieved. SSL. • Another main motive of creative accounting focuses on the activity to manipulate expenses. Example: Global Crossing. Used to notorious effect by Enron. It involves dispatching goods at the end of the period knowing them to be defective so that they appear in the current year’s sales and accepting that they will be returned later in the next period. There is a frequent fraudulent phenomenon in business which is called window dressing. Manipulation of Expense 1. 3. • The other main motive of creative accounting is to conceal losses or liabilities. overstating the value of inventory and other tangible assets. Channel stuffing: a company floods the market with more products than its distributors can sell. b) i) What are the three main motives for creative accounting? There are many motives behind engaging in creative accounting: • One of the main motives of creative accounting is designed to overstate the revenue for a period. This misrepresentation often involved the overstatement of revenues and assets with inventory fraud featuring frequently – assets were overstated by understating allowances for receivables.not in line with the fair and true view. 2. Inflates trading volumes and makes participants appear to be doing more business than they really are. This misrepresentation of the performance and position of a business is referred to as creative accounting and it poses a major problem for accounting rule makers and for society generally. These methods often involve the early recognition of sales revenue or the reporting of sales transactions that have no real substance. Hollow swaps: telecoms companies sell useless fiber optic capacity to each other in order to generate revenues on their income statements. This method involves changing estimates about the future residual value of asset. Those expenses that rely on directors’ estimates of the future or their choice of accounting policy are particularly vulnerable to manipulation. changing accounting policies and incorrect ‘capitalization’ of expenses. artificially boosting its sales. the condom maker. Overstatement of revenue 1. Two or more traders buy and sell energy among themselves for the same price and at the same time. and recording assets that did not exist.

When these. This company. is alleged to have overstated profits by treating certain operating expenses. and other accounting irregularities. 7 . It’s easy to hype sales or revenues if a partner is investing his own money to buy shares or fund purchases that ultimately benefit the company. In addition. such as basic network maintenance. The investors and partners should never be capable of mixing company business with personal investments. in which financial statements are reviewed and processed by a series of different people in separate areas of the company. As a result of this restatement. This will make it harder for somebody to change numbers without being caught later on in the process. If there is a close attention to the cash flow. There should be a focus on cash flow rather than income numbers. To correct for this over-statement. SPEs were used by Enron to rid itself of problem assets that were falling in value. before the company went up for sale or changed from private to be publicly listed.occurred in the financial statements of WorldCom (now renamed MCI). Perhaps the most well-known case of concealment of losses and liabilities concerned the Enron Corporation. This happened over a fifteenmonth period during 2001 and 2002.8 billion. explain the extent to which current IFRS accounting rules reduce the potential for such creative accounting. The following procedures can be followed according to IFRS to reduce the potential for creative accounting: 1. The two most common ways to alter financial statements is to either create fictitious revenue or to shift revenue or expenses to a different period than the one where they actually happened. were discovered in 2001. here was a restatement of Enron’s financial performance and position to reflect the consolidation of the SPEs. as capital expenditure. liabilities were transferred to these entities to help Enron’s statement of financial position look healthier. 3. there should be a step system. The SPEs used for concealment purposes were not independent of the company and should have been consolidated in the statement of financial position of Enron. Rather than having a single person or even a couple working in a shared office. one can easily verify dates and compare numbers. which is a large US telecommunications business. which had previously been omitted. By looking to cash flow and check statements. such as its broadband operations. Concealment of losses or liabilities 1. The company collapsed at the end of 2001 iii) For each example. This was a large US energy business that used ‘special purpose entities’ (SPEs) as a means of concealment. profits had to be reduced by a massive $3. There should be more than one person in charge of the accounting. it becomes hardly impossible to hide numbers there. along with their losses and liabilities. The company had to keep its gearing ratios (the relationship between borrowing and equity) within particular limits to satisfy credit-rating agencies and SPEs were used to achieve this. the company recognized $591 million in losses over the preceding four years and an additional $628 million worth of liabilities at the end of 2000. This is especially important if all the sales happened within a short period of time. 2.

A new managing director has recently taken over. He therefore believes that the accounts for the yearended 31st December 2010 should show the highest profit possible. and he believes that all the ‘bad news’ should be taken in the 2010 accounts (so that the performance of the company under his reign can look all the more impressive). 2010 was a difficult trading year and the finance director is concerned that the company will fail to achieve a £55m profit forecast which stock market analysts are expecting.the managing director 8 . Exercise 3: Quick Buck plc Quick Buck plc is a manufacturer of washing machines. Required: You are required to deal with each of the following 4 accounting issues facing Quick Buck plc from one of three perspectives: . The issues are set out below. There should be an independent auditor to go over the statements after they have been tallied up by employees.the auditors . as people inside the company would usually not risk being found out. the company accountant. however. The draft accounts show a pre-tax profit of £50m. Bill Bodgitt. has prepared the draft financial statements.the finance director . which show a pre-tax profit of £50m.4. Bringing an outsider into the mix is an almost fool-proof way of stopping creative accounting. but is having a little difficulty with some of the more subjective issues that have arisen.

Unfortunately. However.454 c) Managing Director (Million ₤) 8 (2) 9 Book Value at the end of December 31. no depreciation charge with respect to these machines has been made for 2010. 2010 Depreciation for the year 2010 (50% of Current BV) [Assuming Economic Life is 3 years as stated] Current Book Value at December 31. 2010 5. and therefore the machines are currently shown at a Net Book Value of £8m. Non-current assets – repair and maintenance equipment On 1st January 2009 the company spent £12m acquiring 500 special machines for repairing and maintaining the company’s products. The technical manager believes the equipment will last for a further 10 years. In the draft accounts.546) [Assuming Economic Life time is further 10 years as stated by Technical Manager] Current Book Value at December 31. The machines were originally expected to have a useful economic life of 3 years and a zero residual value. Requirement: At what value should the company’s repair and maintenance equipment be shown in the balance sheet? Answer: a) Auditors Book Value at the end of December 31. however. 2010 b) Finance Director Book Value at the end of December 31. 2010 6 Depreciation for the year 2010 [{100/(10+1)%} of Current BV] (0. 2010 Write off (Lost 125 machines) (Million ₤) 8 (2) (Million ₤) 8 (2) 6 (3) 3 New Book Value at the end of December 31. 2010 Write off (Lost 125 machines) New Book Value at the end of December 31. the machines are in near perfect condition. partly because when the company’s washing machines break down they are normally beyond repair. 2010 Write off (Lost 125 machines) .1. a recent non-current asset audit could only account for 375 of these machines.

Auditors have identified only 375 of the machines as the non current assets. As depreciation for the year 2009 has already been accounted for. 2010 = ₤ 6 million. Inventory Included within the company’s inventory is £10m relating to 100. c. 2010 Value of Inventory at the end of December 31.the ‘C5’ model. the current book value of those machines as of December 31. 2. the total economic life will be 11 years (as the year 2010 has already passed). So. depreciation charged for the year 2010 = ₤6 million/11 = ₤ 0. So. 2010 Depreciation for the year 2010 (50% of Current BV) [Assuming Economic Life is 3 years as stated] Current Book Value at December 31.₤ 0. they have 3/4th of the machines intact. Moreover.000 units of an old line of washing machines that was popular in the 1990’s but much less so today . The selling price of these models is £125 per unit. depreciation expense for the year 2010 is = 50% X ₤ 6 million = ₤ 3 million So. Requirement: At what value should the inventory of C5’s be shown in the balance sheet? Answer: a) Auditors Value of Inventory at the end of December 31. So. from the perspective of the finance director the current book value of this asset is ₤ 5.₤ 3 million = ₤ 3 million b. 2010 6 (3) 3 Notes: a. The book value of the machines from the perspective of Managing Director will be same as that of the Auditor.546 million. These machines have a value of 3/4 X ₤ 8 million = ₤ 6 million. The marketing director believes they could all be sold relatively quickly if priced at £50 each. These are currently selling at a rate of around 10.000 units per year. So.454 million (= ₤ 6 million. No provision has been made with respect to this stock.546 million) at the year end. ultimately at the year end. As a result. there is a loss of 125 machines. depreciation has been charged considering a total life time of 3 years. 2010 (Million ₤) 10 10 10 .New Book Value at the end of December 31. The technical manager believes the equipment will last for a further 10 years.

2010 should be ₤ 10 million which is equal to the book value. b. This is why the new Managing Director will consider the value of inventories according to the current selling price. Value of closing inventory should be recorded as per the book value. the cost of inventories shall comprise all costs of purchase. c. The aged-receivables analysis reveals: Within 1 month 1 – 2 months 2 – 3 months 4 – 6 months 6 – 12 months £20m £10m £13m £12m £10m 11 . So. 2010 Write off due to revaluation (Lost 50% value) New Value of Inventory at the end of December 31. costs of conversion and other costs incurred in bringing the inventories to their present location and condition.b) Finance Director Value of Inventory at the end of December 31. 2010 Notes: a. So. 2010 will be ₤ 5 million. The finance director will also evaluate the inventories according to the book value. 3. from the auditors’ point of view the value of inventory at the end of December 31. The new Managing Director will not agree to suffer a loss with the valued stock. 2010 c) (Million ₤) 10 10 (Million ₤) 10 (5) 5 Managing Director Value of Inventory at the end of December 31. There is no relationship of selling price with the valuation of inventory. Receivables The company is owed £70m by receivables at the year-end. the new value of inventory at the end of December 31. According to IAS. the company might undergo a loss of 50% under his reign. 2010 Value of Inventory at the end of December 31. If he doesn’t do so.

which went into liquidation on 5th January 2011. 2010 c) Managing Director Value of Receivables at the end of December 31.2 months category’). 2010 b) Finance Director Value of Receivables at the end of December 31. so he will not want to 12 b. ‘The Honest Nick Leasing Company’.Over 12 months £5m Quick Buck normally offers 2 months’ credit to its customers. During 2010. Brian Damage. the older receivables have proved more difficult to clear. . No provision for bad debts has been made in arriving at the ‘draft profit’ for 2010. Requirement: At what value should the company’s receivables be shown in the balance sheet? a) Auditors Value of Receivables at the end of December 31. so total receivables will be = ₤ 70 million – ₤ 5 million = ₤ 65 million The finance director will want to maximize profit. Although Brian has made some progress with the receivables under 1-year old. the auditor will consider any credit beyond 12 months as bad debt. the company recruited a new credit controller. 2010 (Million) 70 (40) 30 (Million) 70 70 (Million) 70 (5) 65 Notes: a. 2010 Write off of Receivables not recovered for 12 months or over Value of Receivables at the end of December 31. 2010 Write off of Receivables not recovered for over 2 months New Value of Inventory at the end of December 31. (£2m is included in the ‘6 – 12 months category’ and £1m in the ‘1. As the company has a policy of extending credit for 2 months. The company is owed £3m by a major customer. 2010 Value of Receivables at the end of December 31.

No payments had been made with respect to this campaign during 2010 and no entry has been made in arriving at the ‘draft profit’ for the year. The new Managing Director will not agree to risk suffering a loss with the receivables. billboard and media advertising campaign. 2010 b) Finance Director Total cost of the campaign ‘Up-front’ cost of production Accrual advertising cost as of December 31. the company began a major television. The total cost of the campaign will be £8m (£2m of which is the ‘up-front’ cost of production). the new value of receivables at the end of December 31. if any. So the new Managing Director will want to consider any receivables due over 2 months as bad debt to avoid probable loss. according to the new Managing Director. c. Advertising accrual In December 2010.declare any receivable as bad debt. This relates to a 4-month campaign from December 2010 to March 2011 inclusive. So. Requirement: What accrual. 2010 c) Managing Director Total cost of the campaign (Million) 8 (Million) 8 2 2 (Million) 8 2 6/4=1.5 3. and calculate the receivables as ₤70 million. 2010 Accrual advertising cost as of December 31. 2010 will be = ₤ 70 million – ₤ 40 million = ₤ 30 million 4.5 13 . should be created with respect to the company’s advertising campaign? a) Auditors Total cost of the campaign ‘Up-front’ cost of production Monthly cost for December.

the auditor will calculate the accrued cost = ₤2 million + ₤6 million/4 = ₤3. He will propose to consider all the expenses accrued in this year. ₤2 million is upfront cost of production. and the rest will be accrued in the future. So. From the total cost of ₤8 million.Accrual advertising cost as of December 31. The new Managing Director will want to consider any cost accrued in this fiscal year if possible.5 million Finance Director 5. So.5 million The finance director will want to maximize profit. 2010 8 Notes: a. and the rest (₤6 million) is for running the campaign for 4 months. according to the new Managing Director. c. the accrued cost = ₤2 million. b. so he will argue that only the upfront cost of production has been accrued.454 million 10 million 70 million 2 million Managing Director 3 million 5 million 30 million 8 million 14 . So. according to the finance director. the accrued cost = ₤8 million. Summary of Decisions Auditor NBV of repair and maintenance equipment Value of C5 inventory Receivables (net of provision) Advertising accrual 3 million 10 million 65 million 3. so this cost is equally distributed over 4 months.

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