ACCT90013 THEORY OF FINANCIAL ACCOUNTING

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Mock Examination - Semester 1 2023

ACCT90013

THEORY OF FINANCIAL ACCOUNTING

QUESTION 1 (20 MARKS): INFORMATION PROBLEMS, MEASUREMENT, AND EXECUTIVE COMPENSATION

Stefan Marsalek is the CEO of Graz Skiorts (GS), an operator ofbudget ski resorts in Austria. Nearing the end of fiscal year 2022, Marsalek is concerned that this year’s net income is not going to be high enough for him to meet the target to receive his bonus under GS’s executive compensation plan (which is based on net income).

As such, he is considering selling some of GS’s Russian-made ski lift equipment. This equipment is specialised to the low-quality ski runs that GS has, so is worth more to GS than to a potential buyer.

Marsalek estimates that the value in use of the equipment is $45 million, but that a buyer would pay $36 million (this is fair value at the end of fiscal year 2022). Fair value at the end of fiscal year 2021 had been $34 million.

GS uses the cost model to value the equipment on its financial statements, with the carrying amount of the equipment being $20 million at the end of fiscal year 2022. If GS sells the equipment, the resulting gain on selling the equipment would be enough for Marsalek to hit the target for his bonus

at the end of fiscal year 2022.

Ignore taxes in this problem.

(a) What information asymmetry problem is presented in the case above and what incentives arise due to the firm’s measurement policy? Do GS’  shareholders want  Stefan Marsalek to  sell the

equipment? Explain.                                                                                                               (5 marks)

Answer:

This case constitutes a moral hazard problem between Marsalek and the shareholders (1 mark)   under which Marsalek sells assets that are valuable to the firm in order to realized unrecognized fair value gains, i.e., gains trading (1 marks). Importantly, Marsalek’s action of selling the          equipment is unlikely to be observed by the shareholders beforehand (1 mark), and shareholders want Marsalek to keep the equipment, as value in use exceeds fair value (2 marks). That is,        Marsalek’s decision to sell the equipment to receive his own bonus is value-destroying for the   shareholders.

(b) Suppose that instead of the cost model, GS has used the revaluation model to account for the equipment. Under the revaluation model, fair value gains on equipment are recognised as other comprehensive income and realized gains when selling the equipment are recognised in net income. Suppose the bonus target is based on the net income number. Would using the revaluation model to measure the equipment address the information  asymmetry problem identified in question  (a)?

Explain.                                                                                                                                  (5 marks)

Answer:

If using the revaluation model, selling the equipment would still increase the reported net income and not selling the equipment would not. (2 marks)

Hence, the revaluation model would not help. (2 marks)

The manager still has incentive to sell the equipment to increase net income and thus his bonus. (1 mark)

(c) Suppose the bonus target is based on comprehensive income instead of net income. Would using the revaluation model address the information asymmetry problem identified in question (a)? Explain. (4 marks)

Answer:

The revaluation model would help. (1 mark)

Regardless of whether the manager sells the equipment the fair value gain is recognised in comprehensive income and thus increases his bonus. (2 marks)

Thus the manager has no incentive to sell the equipment. (1 mark)

(d) Discuss two options when designing Marsalek’s incentive contract other than the one outlined in

(c) that might help alleviate the issue at hand.                                                                       (6 marks)

Answer:

Any feasible option presented is awarded 3 marks. Examples for feasible options include the following:

1.   Marsalek could be endowed with restricted share awards or stock options with long    vesting conditions. This will lengthen Marsalek’s decision horizon, compelling him to not make decisions that harm firm value.

2. The contract can include additional metrics that would weaken the incentive to sell. For instance, non-GAAP metrics could be designed that would only focus on the core          operating performance and would exclude gains from selling operating assets.

QUESTION 2 (12 MARKS): STANDARD SETTING

In the early 2000s, the Canadian government and accounting standard setting bodies contemplated to abandon their domestic accounting standards and instead either adopt US GAAP or IFRS. While IFRS is adopted by more than 100 countries worldwide, US GAAP is only practiced in the US. However, the US has the largest economy and the largest capital markets worldwide, and the US was Canada’s largest trading partner with a 8,900 kilometre shared border. Ultimately, Canada fully adopted IFRS in 2011.

(a) In your own words, discuss two benefits of full IFRS adoption for Canadian firms, where your

answer should include one benefit each related to capital markets and supply chains.         (6 marks)

Answer (3 marks each):

1. Capital markets: When fully adopting IFRS, firms become more internationally comparable to similar firms overseas that also implement IFRS. This facilitates investment into Canadian  firms by foreign investors as investors are enabled to understand the fundamentals of the firms better.

2. Supply chains: Financial reporting information is also used in supply chains, and customers and suppliers (B2B) that practice the same set of standards likely facilitates contracting across borders.

(b) Speculate on why Canada chose to adopt IFRS instead of US GAAP. Explicitly state any

assumptions you might impose in your discussion.                                                               (6 marks)

Answer: Any feasible answer will be awarded marks. The following suggestions provide some guidance:

• Canada, while presumably heavily integrated with the US economy due to its                 geographical proximity, likely opted to adopt IFRS as a response to the globalization of markets and the benefits that come with widely adopted accounting standards.

• US investors are likely also familiar with IFRS because several stock exchanges permit foreign listed companies to apply IFRS instead of US GAAP. Hence Canadian firms    might not be at a disadvantage when seeking US capital.

QUESTION 3 (20 MARKS): ASSET RECOGNITION AND EQUITY VALUATION

Consider two similarly sized companies, Zweek Limited and Yark Limited. Both are part of the information technology industry, both are growth firms, and both rely heavily on intangible assets. Further both 2021 financial reports suggest a similar ROA of 22 percent. However, a main difference is that Zweek naturally grew over time through investment, whereas Yark heavily engaged in mergers and acquisitions.

(a) Discuss, in your own words, how the shortcomings of current accounting standards, introducing the issue of nonrecognition of intangible assets, influences the interpretation of the ROAs and thus the comparability of the two firms. Further provide a statement on whether you think Zweek or Yark

is fundamentally more profitable.                                                                                         (10 marks)

Answer:

Since Zweek organically grew and invested in intangible assets (but had to record them as      operating expenses), whereas Yark undertook M&A and thus recognized intangibles through recording goodwill, Zweek likely suffers from a larger nonrecognition bias than Yark. That is the assets of Zweek are more understated as compared to Yark’s. (4 marks)

Since both are growth firms, this implies that Zweek must have increasingly invested in R&D and other intangibles. Assuming that margins on these investments are stable, this implies that Zweek’s reported net income is likely more understated than Yark’s. (3 marks)

Except for very young firms, the denominator effect is typically dominant so that Zweek’s ROA is overstated as compared to Yark’s. Therefore, Yark is the more profitable company. (3 marks)

(b) You are an analyst who values Zweek by applying a relative valuation approach using Yark as a benchmark. Discuss how the nonrecognition issue Zweek suffers from impact the valuation using (i)

the P/E ratio, (ii) the P/B ratio, and (iii) Enterprise Value/EBITDA as multiples.                (4 marks)

Answer:

In Zweek’s case, its net income, EBITDA, and the book value of equity are understated relative to Yark (2 marks). This implies that, while the multiples are unbiased, the multiplicator (net      income, EBITDA, BV of equity) is too low, implying a too low equity value for Zweek.(2 marks)

(c) Discuss one specific way to address the nonrecognition issue in the context of a relative valuation of Zweek. Further specify the assumptions under which such a model-guided approach to investing can lead to a profitable investment decision and whether these assumptions are fulfilled in this case. (6 marks)

Answer:

For growth firms such as Zweek with presumably a not too long history it will be sufficient to account for the intangibles at cost. (2 marks)

The fundamental assumptions underlying any relative valuation are that markets are inefficient for valued firms and efficient for benchmark firms. This might indeed be the case in the given scenario since 

2023-05-29