Midterm Solution Key - Commerce 353 Intermediate Financial...

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Unformatted text preview: Commerce 353 Intermediate Financial Accounting I 2011 – Term 2 Professor Jenny Zhang Midterm Exam ______________________________________________________________________________ Time: 90 minutes (7:00pm – 8:30pm) Maximum Marks: 60 *** Please answer all questions in the space provided. *** This is a closed book exam − only pens/pencils and calculators are permitted. A dictionary is permissible with prior approval of the instructor. For essay questions, clear and logical point form is acceptable. ______________________________________________________________________________ ††† Please Think before you write! ††† ______________________________________________________________________________ Question # 1 2 3 4 5 6 Total Max Marks 10 10 8 8 10 14 60 A Obtained Section: 201 202 203 (circle) Student ID#: _____________ Name: ________________ Question 1: Multiple choice (2 marks each; 10 marks total; suggested time – 10 minutes) Select the letter of the best answer and write your answers in the boxes at the bottom of the page. a. Positive accounting theory (PAT) forms an important component of financial accounting theory. Which of the following statements appropriately describes PAT? A. PAT is concerned with which accounting policy choices managers should make. B. PAT is concerned with specifying managerial accounting policy choice so that it is logically consistent with underlying decision theories. C. PAT is concerned with achieving diversification of accounting policies used in the firm. D. PAT is concerned with predicting managers’ accounting policy choices and how managers will respond to proposed new accounting standards. b. Agency theory suggests that to motivate managers to act in the best interests of owners, managers should share some risk of uncertain payoff, but the risk should not be excessive. If the risk is excessive, which of the following would be true? A. Managers will undertake risky projects. B. Managers will collude with their competitors to increase the prices of products. C. Managers will expect higher levels of compensation. D. Managers will adopt income-increasing accounting methods. c. Which of the following statements reflects the concept of earnings quality (EQ)? A. B. C. D. A company has high EQ if the reported income is close to the amount of operating cash flows. A company has low EQ if the reported income is close to the amount of operating cash flows. A company has high EQ if the financial statements are prepared unbiasedly. A company has low EQ if the financial statements are prepared conservatively. d. The lower-of-cost-or-market (LCM) rule requires that when the market value of the investment falls below its carrying value, the investment is written down to market value. Once an asset is written down, it may not be written up again. How is the LCM rule justified? A. In terms of relevancy B. As consistent with the financial capital maintenance assumption C. Benefits should exceed costs D. In terms of prudence e. ABC Inc., a car manufacturer, has had some ongoing litigation proceedings (started on Oct. 1st, 2010) concerning the safety of its cars in Canada. The financials for the year 2010 (ended on Dec. 31st, 2010) have not been issued at this date. The litigations proceedings have finally concluded on Feb. 5th, 2011 and ABC is required to pay $100 million in damages to customers in Canada. Which of the following statement is correct: A. ABC Inc. should disclose a $100 million loss in the footnotes to the 2010 annual reports and recognize this loss in the first quarterly report of 2011. B. ABC Inc. should recognize a $100 million liability in the 2010 annual reports. C. No adjustment is required for 2010 annual reports as ABC Inc. has not paid $100 million to the customers. D. None of the above. Place the letters for your answers in the appropriate box below: Question: 1 2 3 Answer: D C C 2 4 5 D B Section: 201 202 203 (circle) Student ID#: _____________ Name: ________________ Question 2 (10 marks) Below is an excerpt of an article in Wall Street Journal. Bristol-Myers on Monday released its restatement of results going back several years. The company said as much as $2.75 billion in sales and $900 million in profit had been booked improperly from 1999 through 2001. The overselling to wholesalers (recording revenue when products are shipped to the wholesalers) -- known as "channel stuffing"-- accelerated through this period, culminating with $1.44 billion in improper sales revenue in 2001. The channel-stuffing generally took place at the end of each quarter to meet quarterly sales targets, according to the restatement. Directors at Bristol-Myers Squibb Co. announced yesterday that Chief Executive Peter Dolan will leave the company. Required: Discuss the relevant accounting issues in this article (hint: information asymmetry, positive accounting theory). • • There is information asymmetry between managers and investors (shareholders and debtholders). Mangers of Bristol-Myers committed fraud to meet quarterly sales targets. They oversold to their wholesaler and recognized revenue before products were sold to the customer, which is not allowed by GAAP. (2 marks) These frauds make it impossible for investors to evaluate the company’s true performance. Bristol-Myers’s shares are likely overpriced prior to the discovery of the frauds. Financial reporting in this case is associated with low quality and low decision usefulness. (3 marks) • As predicted by positive accounting theory, managers have incentives to manage earnings to maximize their own utility. More specifically, bonus plan hypothesis says that managers have incentive to choose accounting policies that maximize their compensation. Debt covenant hypothesis predicts that firms want to minimize the cost of debt, include the costs from default. • In the Bristol-Myers case, the bonuses of executives could be linked to firm performance (Bonus Plan Hypothesis). Therefore, they have incentive to “stuff the channel” and overstate sales revenue to meet earnings target. Bristol-Myers’s debt covenants may also be linked to its performance such as interest coverage ratio, so managers want to manipulate earnings to prevent the firm from going into financial distress (Debt Covenant Hypothesis). [2.5 marks for applying bonus plan hypothesis and debt covenant hypothesis, respectively] 3 Section: 201 202 203 (circle) Student ID#: _____________ Name: ________________ Question 3 Financial accounting theory (8 marks; suggested time – 8 minutes) Presented below is an excerpt from a recent speech given by SEC commissioner J. Carter Beese. “I believe investors will be far better off if the value of stock options is reported in a footnote rather than on the face of the income statement. FASB’s proposal to require expensing of stock options is making it more difficult for young firms to attract venture capital. The fact that these firms will have to report a large amount of expense on the income statement makes them appear less profitable. FASB’s proposal provides incentives for companies to stay private longer, so that they are able to use options more freely to attract and retain key employees, and they avoid the earnings hit that going public will entail. As domestic venture capital deals become less profitable, investors will start to look overseas for alternative investment opportunities.” Required: You are a believer of market efficiency. Do you agree with Mr. Beese’s remark? Why? Under EMH, all publicly available information is reflected in stock price. (2 marks) Investors are sophisticated enough to “see through” accounting numbers. Hence whether stock options are expensed or disclosed in the footnotes should not matter. (2 marks) How we account for certain transaction does not affect the underlying economics of a firm. Whether the stock option are expensed or disclosed does not affect future cash flows / future prospects of the companies. Therefore, the future cash flows and risks of a firm should not be different under these two different approaches. (2 marks) Investors should be able to undo these different accounting policies. Thus after the new rule (expensing stock options) takes place, holding everything else constant, firms’ valuations should not change. That is, as a young firm goes public, it will fetch the same stock price even if it has to subtract stock option expense from net income and report lower net income as a result. Venture capitalists will be as likely to invest in young firms after the new rule as before. (2 marks) 4 Section: 201 202 203 (circle) Student ID#: _____________ Name: ________________ Question 4 Financial accounting theory (8 marks; suggested time – 8 minutes) Accounting standards in Canada currently require intangible assets to be recorded at purchase cost if they have been purchased from a market transaction. Costs incurred on internally generated intangibles cannot be capitalized in most cases. Enterprises must expense costs incurred to create a patented invention, to build up a brand or trademark, or to improve customer loyalty. In other words, many intangible assets are not recognized as assets on the balance sheet, or they are recognized at a nominal value of $1. When Canada begins to apply IFRS beginning January 1, 2011, Canadian companies will have the option of using the cost basis as they have in the past, or the revaluation basis. The revaluation basis reports intangible assets at their estimated current value. While the revaluation option will be available, companies can also choose to continue using the historical cost basis. Required: Apply the concepts of information asymmetry, earnings management, relevance, and reliability in this context. Info asymmetry: Insiders have better information about the value of intangibles, which are difficult to value. The current value of intangible assets could be useful information that would be otherwise unavailable to investors. The additional information could alleviate uncertainty regarding future cash flows, reducing investors’ perception of risk surrounding the company’s operations. The reduced risk could increase stock price. (3 marks) Relevance and reliability (1 mark for relevance, 3marks for reliability (1.5 for estimation erro and 1.5 for bias): This difference these two approaches is also closely related to the trade-off between relevance and reliability we often see in financial reporting. The revaluation basis., i.e., recognizing intangible assets on the balance sheet potentially increases relevance but decreases reliability. The information about certain internally generated intangible assets such as brand name and trademark is useful for predicting firms’ future performance, because these brand names or trademarks can probably bring future economic benefits to a firm. For example, the brand name of “Apple” is associated with high quality products. Customers around the world are willing to pay high price premium for a product under this brand name, so such information is relevant. Therefore At the same time, however, such information is associated with low reliability. Whether a brand name can bring ‘probable’ future cash flow is subjective to manager’s discretion. Such estimates are inherently noisy (estimation error). Furthermore, managers can use their discretion to bias the estimates, so that their companies can report higher intangible assets (and thus less expenses) than they actually have; investors can be misled and overestimate these companies’ value. (bias) Therefore, whether the information is useful depends on management’s motivations for providing the information. If the figures are prepared unbiasedly to aid investors’ decisions, they would provide relevant information. Earnings management, Conservatism/prudence (1 mark): • The current Canadian accounting standard on internally generated intangible assets is also consistent the conservatism/prudence principle. Because mangers naturally have incentives to overstate assets, conservatism helps alleviate such incentives and reduce potential upward bias in financial reporting. 5 Section: 201 202 203 (circle) Student ID#: _____________ Name: ________________ Question 5 Frameworks for financial reporting (10 marks; suggested time – 10 minutes) Reliability is one of the desirable characteristics of financial reports that help to meet users’ information needs. The IFRS framework enumerates five attributes of reliability: faithful representation, substance over form, neutrality, prudence, and completeness. Required: a. Briefly explain in your own words what neutrality and prudence mean, respectively. In your opinion, do they conflict with each other? Why? (5 marks) Neutrality refers to the extent to which information is free from bias. (1 mark) Prudence is the inclusion of a degree of caution in making estimates under uncertainty so as to avoid overstating performance and financial position. (1 mark) It appears that prudence causes downward bias in financial reporting, which creates conflicts with neutrality. However, we know managers have upward bias in financial reporting. For example, more often than not, managers have bonus plan based on earnings and/or the firms have restrictive debt covenants which specify a certain level of debt to equity ratio or requires a firm to maintain a certain interest coverage ratio. Managers will have incentives to inflate earnings and assets, and to understate liabilities and expenses. Prudence in this case will help counterbalance the upward bias in financial statements caused by those incentives. Therefore, prudence is consistent with the idea of neutrality. (3 marks) 6 Section: 201 202 203 (circle) Student ID#: _____________ Name: ________________ b. What does substance over form mean? Give one example where substance over form is applied. (5 marks. Hint: we have seen two examples in class: I gave one example in class when I explained substance over form, the other is in the Exxon case.) Substance over form suggests that financial information should be recorded/ presented according to the economic substance of the transaction rather than its legal form. (1 mark) Example (4 marks for 1) or 2), 2 marks for 3): 1) Computer Associates exchanged its inventory (computer software) with another firm at the end of the year and both recorded sales revenue. The SEC applied substance over form: although the legal form of the transaction is a sale, the financial position for both firms remain the same as before this transaction: the same inventory and the same amount of cash, the economic substance is nothing changed. Therefore, these two firms were not allowed to book revenue. 2) In Exxon’s case, Exxon did not directly retire its bond outstanding. Instead, Exxon bought government bonds and put it in a trust. These government bonds will generate exactly the cash needed to pay interest and principal back to Exxon’s bondholders. The legal relationship between Exxon and its bondholder did not end. However, the economic substance is Exxon no longer needs to come up with cash to pay its bondholder. Their relationship has been extinguished. Therefore, according to “substance over form”, Exxon was able to recognize gains from retiring the bonds although they did not make a direct repurchase. 3) A business can have the legal form of a single corporation, a group of two or more corporations such as parent-subsidiary group, a trust, or a partnership. Applying substance over form results in the same accounting treatment for these different legal forms of organizing a business. I am asking for an example that will results in different treatment when economic substance is considered and when legal form suggests. 1) And 2) are examples where you will have different presentation on FS when economic substance is applied instead of just focusing on the legal forms. 3) is too general. 7 Section: 201 202 203 (circle) Student ID#: _____________ Name: ________________ 4) Question 6 Accrual accounting (10 marks; suggested time – 10 minutes) Part a: Determine the effects of the accounting changes on the relevant assets, liability, equity and comprehensive income in the year 2009 and 2010, respectively. a. The accountant omitted 25% of the warehouse when counting the inventory on Dec. 31st, 2009. Inventory reported in 2009 was $75,000. b. The company had been using the straight line depreciation method. In fiscal 2010, management decided to switch to the double declining balance method. This change increases depreciation expense by $20,000 on Dec.31, 2009 and $35,000 on Dec. 31, 2010. c. In 2010, the company changes the allowance for doubtful accounts from 3% of sales to 2%. Sales revenue for 2010 was 500,000. Required: For each of the four issues described above, using the following table, identify (i) the type of accounting change; (ii) the treatment required; and (iii) the effect of the accounting change on the 2009 and 2010 financial statements. For (iii), identify both the direction (↑ ↓) and the amount of the effect relative to the amount without the accounting change. Type of acctg change (1 mark for getting entire column right, take 0.5 pt for each wrong) Treatment (1 mark for getting entire column right, take 0.5 pt for each wrong) a. Correction of error Retrospective ↑25K b. c. Effects in year 2009 Income Assets /Liabilities Equity Income ↑25K ↑25K 0 0 ↓25K Change in Retrospective ↓20K acctg policy ↓20K ↓20K ↓55K ↓55K ↓35K Change in estimates 0 0 ↑5K ↑5K ↑5K Prospective Assets /Liabilities Equity Effects in year 2010 0 Note: some students will put “error” in the first cell, which is wrong. 1 mark for getting the entire first (second) column right. Take 0.5 mark away for each cell that is wrong. All other cells are 0.5 mark each, except the ones in green. The green ones are worth 0.5 mark in total. For the green ones, if one cell wrong, take all 0.5 away. 8 Section: 201 202 203 (circle) Student ID#: _____________ Name: ________________ Part b. Structure of financial statements and articulation (4 marks; suggested time – 5 minutes) The following presents summarized financial statements for Whiskey Golf Ltd., in $000’s. Statement of Financial Position as at Dec. 31 2010 2009 2010 2009 Cash $ 180 $ 250 Accounts payable $ 740 $1,400 Accounts receivable (net) 2,500 2,000 Current portion of long‐term debt 300 300 Inventories 1,800 1,500 Prepaid expenses 300 210 Current liabilities 1,040 1,700 Current assets 4,780 3,960 Long‐term debt 900 1,200 Total liabilities 1,940 2,900 Land 500 500 Plant and equipment (net) 3,500 3,820 Preferred shares 800 800 Intangible assets 20 20 Common shares 2,000 2,000 Goodwill 800 800 Retained earnings 4,860 3,400 Long‐term assets 4,820 5,140 Total equity 8,560 7,400 Total assets $9,600 $9,100 Total liabilities and equity $9,600 $9,100 Cash flow statements for years ended Dec. 31 Statement of Comprehensive Income for yrs ended Dec. 31 2010 2009 2010 2009 Revenue $7,500 $7,000 Cash flow from operating activities 880 700 Cost of goods sold (4,900) (4,800) Cash flow from discontinued (530) 0 Interest expense (400) (400) operations Earnings before tax 2,200 1,800 Cash flow from investing activities 100 (400) Income taxes 660 540 Cash flow from financing activities (380) (300) Income before discontinued operations 1,540 1,260 Net change in cash 70 0 Loss on discontinued operations (600) 0 Net income $940 $1,260 Additional information: 2010 2009 $ 80 Dividends on preferred shares $ 80 Required: (1) What does it mean by financial statements are “articulated”? (1 mark) All four major financial statements are connected. (2) Identify three substantive errors in the above financial statements. There are no addition errors. Assume the all required disclosures have been made in the notes of the financial statements. The company did not have any transactions involving “other comprehensive income.” (3 marks, 1 mark each. Need to be specific) Cash flow statement ($0 net change) does not articulate with the change in cash on the statement of financial position ($70 decline). Net income ($940) and dividends (-$80) do not articulate with the change in retained earnings (+$1460) A statement of changes in equity is required. 9 ...
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This note was uploaded on 02/21/2011 for the course COMM 353 taught by Professor Jennyzhang during the Winter '10 term at The University of British Columbia.

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