Answer:

Sales reps’ decisions to falsify documents and overstating product quantities are seemingly unobservable and thus private information by the respective rep. The sales rep uses their     information advantage to profit from commissions, establishing a moral hazard problem. (4 marks)

Further management learned about this practice but did not act in a timely manner. Now it     depends on whether there was any benefit to be gained from negligence. Since under current revenue recognition practices revenues are recorded when control over products changes to    customers, the overstated orders imply that too many products are shipped and delivered, at   which point revenues are recognized. This implies that revenues and thus profits were likely  overstated at the end of a financial year and, given that management is compensated based on profits (assumption), this also gives rise to an adverse selection problem because overstated   financial information misleads investors and investors anticipate such issues and may be less inclined to, e.g., participate in an SEO due to their information disadvantage. (6 marks)

Answer: (3 marks each)

1.   Change compensation practices: Questrix may adjust its compensation of sales reps by only paying commission if GPs do not return any product.

2. Introduce adequate oversight and controls: Firm may hire additional staff which confirms internally submitted orders with GPs.

Answer:

The sales team’s compensation is only linked to their sales commission. It can impose high compensation risk to them because: (5 marks)

1.   There are no bounds in commission, especially no base salary to maintain a certain level of compensation. In a bad year with no or low sales, the compensation to a sales rep       could be very low or even zero.

2. There is no consistency between years, which means the compensation to a sales rep      fluctuates with sales. The sales are often affected by factors out of the sales rep’s control (e.g., product quality, market sentiment, industry-level, macro-economy level factors).

To lower the sales rep’s compensation risk, the compensation package could have the following adjustments: (5 marks)

Set a bogey and/or cap in a sales target to reduce ex ante risk, because they impose bounds

on the sales rep’s commission.

Add a base salary to the package.

Use of relative performance evaluation reduces risk because the common risk faced by all

firms in the comparison group is filtered out. Thus, a sales rep may be compensated even if sales outcomes are poor, if his/her performance was not as poor as the industry average.

    Engage a compensation advisor to assess the sales team’s compensation because with industry

expertise the advisor is likely to consider exceptional or unexpected circumstances.

Answer:

First, standard setters consider a relevance-reliability tradeoff in that they evaluate whether a new accounting standard improves investors’ decision making, while at the same time          considering enforceability/verifiability issues in the implementation of the new standard. (4 marks)

Second, they consider the costs arising from firms implementing the new standard into their accounting systems, and further the costs arising from investors having to change their        valuation models. (3 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)

With the exception of 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)