Ac.F 311 FINANCIAL ACCOUNTING II

QUESTION 1

ANSWER ALL PARTS OF THIS QUESTION

a)  Amiram et al. (2018) start their definition of financial reporting fraud with: “[…] fraud is a combination of multiple elements. The most basic of these are that

(i) there must be a misrepresentation in the form of a misstatement,                misreporting, or omission; (ii) that misrepresentation must be material; (iii) the person making the misrepresentation must have done so with some fault in    the sense that the material misrepresentation was committed negligently,       recklessly, or with knowledge of its falsity […]” [Amiram, D., Bozanic, Z., Cox,

J. D., Dupont, Q., Karpoff, J. M. and Sloan, R. (2018). Financial reporting fraud and other forms of misconduct: A multidisciplinary review of the      literature, Review of Accounting Studies 23(2): p. 733]

REQUIRED:

i)    Rephrase the above definition in your own words.

[3 marks]

ii)   Explain how financial reporting fraud is related to earnings       management. To do so, first set out a definition of earnings     management and then explain its relation to financial reporting fraud.

[6 marks]

Maximum word limit for part a) = 405 words

b)  The below figure is Figure 3 from Burgstahler and Dichev [Burgstahler, D. and Dichev, I. (1997). Earnings management to avoid earnings decreases and      losses, Journal of Accounting and Economics 24(1): p. 109]. Earnings are       computed as annual net income over beginning-of-the-year market value.

REQUIRED:

i)    Describe the figure.

[2 marks]

ii)   Explain why this figure can be considered evidence that supports the existence of earnings management in practice.

[4 marks]

iii)  Explain the objective that likely underlies the earnings management activities illustrated in the figure.

[4 marks]

Maximum word limit for part b) = 450 words

c)  A rational expectations model for earnings management could be based on the following assumptions:

1.  The value of the firm is  and normally distributed with mean  and variance  .

2.  The manager observes the signal  =  +  , where  is normally distributed (0, ) and independent of  .

3.   Market participants know that the manager observes  .

4.  The manager reports  =  +   with earnings management component  .

5.  The manager is risk-neutral with a utility function  =  −   , where  is the market price and 0  <   < 1 .

6.  Market participants know about the incentive structure of the manager and set the market price based on all available information:  = [|] .

In equilibrium, action choices of both players, i.e., manager and market      participants, are mutual best responses. Market participants set the market price according to the following linear function:

() =  + 

With the following coefficients in equilibrium:

 =  − ( + ) and  =

Finally, the manager engages in equilibrium in earnings management according to the following function:

  =

REQUIRED:

i)   Discuss whether assumptions 1, 2 and 4 are plausible in a real- world setting.

[6 marks]

ii)   Provide an interpretation of the equilibrium pricing function. To do so, first reformulate the equilibrium function by using the above    expressions and rearranging terms. Then explain how market      participants set the market price of the firm.

[ 10 marks]

Maximum word limit for part c) = 720 words

d)  “In these models, the inability to undo the earnings management is due to       asymmetric information; typically, the manager knows some things which        others do not. Therefore, an additional condition which must be met for           earnings management to exist in an analytic model is that the asymmetry in    information persists; one assumption that permits this persistence is a form of blocked communication that cannot be eliminated by changing the contractual arrangements.”

[Schipper, K. (1989). Commentary on earnings management, Accounting Horizons 3(4): p. 95-96]

REQUIRED:

Schipper (1989) emphasizes the importance of the assumption of blocked     communication in analytical models. Explain whether this assumption is likely to be fulfilled in a real-world setting. You can, but do not have to, refer to        arguments from Schipper (1989).

[ 15 marks]

Maximum word limit for part d) = 675 words

Total for Question 1: 50 marks

QUESTION 2

ANSWER ALL PARTS OF THIS QUESTION

a)  Financial accounting regulation has three components: written rules, their implementation and enforcement.

REQUIRED:

i)   Explain why financial accounting is usually regulated and not left to market forces.

[6 marks]

ii)   Explain the terms ‘written rules,’ ‘ implementation’ and ‘enforcement’ by means of an example. You will not receive marks if you                reproduce examples discussed in the lecture (recordings) and/or     workshop.

[4 marks]

iii)  Explain which component(s) of financial accounting regulation is (are) addressed by IFRS harmonization.

[2 marks]

iv) Discuss two potential reasons for differences in financial accounting regulation that we observe in practice.

[5 marks]

Maximum word limit for part a) = 765 words

b)  “Facilitating comparability of financial statements is an important element of    the Accounting Consensus […] Consider two companies: Company A that       spends $1 million on R&D and manages to get a patent of doubtful value; and Company B that also spends $1 million on R&D and manages to develop a     patent whose market value is estimated by the firm to be $10 million. Consider two possible standards: X that allows firms to capitalize that part of the R&D    cost that does not exceed the firm’s estimate of the value of the R&D; and Y    that requires the firm to treat all R&D outlays as expense when incurred.

Under Standard X […], to the user of the statements the two companies could look the same when their underlying states are entirely different […] Under      Standard Y, both firms must expense the $1 million outlay against the current period income, and their balance sheets and income statement for the year     would be identical (other things being the same) when, in fact, their underlying economic situations are quite different.”

[Sunder, S. (2009). IFRS and the accounting consensus, Accounting Horizons 23(1): p. 104-105]

REQUIRED:

i)   Sunder (2009) uses the above example to demonstrate that          comparability is often not achieved through accounting standards. Explain why his example is appropriate when comparability is       defined in line with the Conceptual Framework of the IASB.

[5 marks]

ii)   Discuss which of the remaining enhancing qualitative                  characteristic(s), as defined in the Conceptual Framework of the IASB, might favour an accounting rule such as Standard Y, as   opposed to Standard X, in the above example.

[5 marks]

iii)  Discuss which of the fundamental qualitative characteristic(s), as   defined in the Conceptual Framework of the IASB, might favour an accounting rule such as Standard Y, as opposed to Standard X, in the above example.

[8 marks]

Maximum word limit for part b) = 810 words

c)  Zeff and Nobes [Zeff, S. A. and Nobes, C. W.(2010). Commentary: Has          Australia (or any other jurisdiction) ‘adopted’ IFRS?, Australian Accounting     Review 20(2): 178-184] conclude that firm compliance with IFRS as issued by the IASB varies greatly across countries that supposedly adopted IFRS.

REQUIRED:

Discuss different reasons for the variation in firm compliance with IFRS. You can, but do not have to, refer to arguments from Zeff and Nobes (2010). You can use examples to illustrate your points.

[15 marks]

Maximum word limit for part c) = 675 words

Total for Question 2: 50 marks

QUESTION 3

ANSWER ALL PARTS OF THIS QUESTION

JUP plc operates in a variety of industries. JUP plc use the pound (£) as its functional currency. Set out below are draft extracts from JUP plc’s financial statements for the year ended 31 March 2021:

Extract from the statement of comprehensive income for the year ended

31 March 2021

Revenue

Cost of sales

Gross profit

Administrative expenses

Finance costs

Profit before tax

Income tax

Profit for the year

Other comprehensive income

Total comprehensive income

Statement of financial position for the year

£000

60,900

(31,700) 

29,200

(20,800)

(2,500) 

5,900

(1,200) 

4,700

-

4,700

ended 31 March 2021

Property plant and equipment

Loan to Gamma plc (Note 1)

Other assets

Total assets

Share capital

Retained earnings

Other reserves

Non-current liabilities

Net defined pension liability at 1 April 2020 (Note 2) Current liabilities

Total equity and liabilities

£000

24,000

14,625

24,375

The following notes relate to unresolved financial reporting issues:

Note 1 – Loan to Gamma plc

On 31 March 2020, JUP plc made a secured loan of £15,000,000 to a supplier,         Gamma plc. The loan has an annual interest rate of 8% and is repayable in full on 31 March 2023. The loan objective is achieved by collecting contractual cash flows.

On 31 March 2020, the loan had a low credit risk and the probability of default in the next 12 months was 2.5%. An impairment of £375,000 was recognised.

On 1 March 2021, a credit rating agency indicated that Gamma plc was experiencing financial difficulty and its credit rating was lowered as there was a significant              increase in credit risk. The expected credit losses over the remaining life of the loan  were estimated at £2,000,000.

No adjustments have been made in the financial statements for the year ended 31 March 2021 to reflect the information received from the credit rating agency on 1

March 2021.

Note 2 – Pension schemes

Pension Scheme A

JUP plc operates a defined benefit pension scheme for its directors and senior         management. JUP plc calls this pension scheme – Pension Scheme A. On 1 April   2020, JUP plc had a net pension liability of £11 million in respect of the Pension       Scheme A. This balance represents the difference between the fair value of the       pension scheme assets of £18 million, and the present value of the pension scheme obligations of £29 million.

The following information has been provided by the pension fund actuary for Pension

Scheme A:

The trustees of the Pension Scheme A made an offer to its pensioners to exchange future pension increases for a higher current pension, which would then remain       constant. On 1 March 2021, this offer was accepted by the pensioners and this       resulted in a past service gain of £2 million.

The present value of the scheme liabilities at 31 March 2021 is £27.2 million, which includes the impact of the offer and its acceptance. The fair value of the scheme    assets at the same date is estimated to be £22 million.

The pension fund actuary has provided the following information:

£000

Current service cost                                                                 700

Benefits paid to pensioners                                                  1,800

The yield on high-quality corporate bonds is 3% pa.

Pension Scheme B

On 1 April 2020, JUP plc started a new pension scheme which is open to all its       employees. JUP calls this pension scheme – Pension Scheme B. This scheme is a separately constituted retirement benefit plan for its employees who are not             members of Pension Scheme A. JUP plc and the employees both pay contributions into the plan. Contributing to the scheme entitles the employees to the right to a      specific portion of the plan assets which can be used to buy an annuity on the         employee’s retirement. The employees have no right or recourse to the employer if the level of funding for their retirement is not met.

Pension contributions for Pension Scheme A and Pension Scheme B

On 31 March 2021, JUP plc paid pension contributions which are included in

administrative expenses, comprising of:

£000 800 650

1,450

Other than recording the cash payment for the contributions, no adjustments have  been made in the financial statements for the year ended 31 March 2021 in respect of either Pension Scheme A or Pension Scheme B.

REQUIRED:

a)  Set out and explain the correct financial reporting treatment in the JUP plc financial statements for the year ended 31 March 2021 for:

•   the loan to Gamma plc (Note 1); and

•   the Pension Scheme A and B (Note 2).

Show all journal entries required to correct the financial statements for the year ended 31 March 2021.

(20 marks)

b)  Prepare, including your adjustments above, a revised statement of            comprehensive income and a revised statement of financial position at 31 March 2021 for JUP plc.

(15 marks)

c)  Evaluate the difference between the financial reporting for Pension Scheme A and Pension Scheme B. You should refer to relevant financial reporting          standards, accounting concepts and academic articles.

(15 marks)

Maximum word limit for part a) and c) = 1,575 words

Total for Question 3: 50 marks

Ignore any adjustments for current and deferred taxation

External Revenue

£m

Internal  Revenue

£m

Profit/(loss)

£m

Assets

£m

Liabilities

£m

Chemicals

Vaccines - manufacturing Vaccines - retail

Cosmetics

Hair care

Body care

Evac plc uses the six business areas in its internal accounts to report to the chief operating decision maker.

For the purpose of reporting to the chief operating decision maker, Evac plc excludes head office administration costs of £5 million and net interest of £1.6 million from the figure for profit as reported in the statement of profit or loss. These costs are not        included in the above table

Head office assets of £150 million and liabilities of £175 million are also not included in the above table.

Evac plc’s assets are all located in the UK. 50% of its external revenue is in respect of customers in the UK, 15% in Europe and 35% in the US.

REQUIRED:

a)        Identify and explain which of the six business areas are reportable operating      segments for Evac plc under IFRS 8 Operating Segments for the year ended 31 March 2021.

(20 marks)

b)        Prepare a note showing the disclosure of Evac plc’s segments suitable for publication for the year ended 31 March 2021.

(15 marks)