3101AFE Workshop 6 solutions PDF

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3101AFE Accounting Theory and Practice WORKSHOP 6 Deegan Topic 7: Positive accounting theory QUESTION 1: Explain the efficiency perspective and the opportunistic perspective of positive accounting theory. Why is one ex ante and the other ex post? The efficiency perspective takes the view that contractual arrangements will be designed to reduce future conflicts of interest (and associated agency costs) between individuals involved in the operations of an organisation. Well-designed contracts are expected to reduce future transaction costs. By reducing future transaction costs, well-designed contracts can have the effect of increasing the value of an organisation. Because the contractual arrangements are implemented in advance to reduce future agency conflicts, they are described as occurring ex ante (before the fact). The opportunistic perspective relies upon the assumption that individuals are always motivated by their own self-interest so once they enter into a contractual arrangement they will use any flexibility within the contract to maximize their own utility (i.e. wealth). Because it is not practical to write ‘complete’ contracts, there will always be some degree of flexibility in most agreements. Because the opportunistic behaviours occur after contracts have been negotiated, the actions are described as occurring ex post (after the fact). QUESTION 2: If a company pays its senior managers under accounting-based bonus plans would the managers, or the shareholders (or both), prefer the use of conservative accounting methods? Explain the reasons for your answer. Conservative accounting methods tend to delay the recognition of revenue and gains, accelerate the recognition of expenses and losses, and report lower net assets in the balance sheet. For example, measuring assets at the lower of cost and recoverable amount is a conservative accounting method due to the asymmetric treatment of gains and losses. Compare this to measuring an asset at fair value where gains and losses are measured symmetrically. Under the bonus hypothesis, managers maximize profits to obtain their highest bonus. Accordingly, managers would be expected to oppose conservative accounting methods as they provide little opportunity to manage earnings upwards. By contrast, shareholders not directly involved in the management of an organisation prefer conservative accounting methods because conservative accounting methods reduce the opportunities for managers to manage earnings, particularly on the upside. This reduces the risk that investors will pay too much for shares (adverse selection) and reduces the risk managers will make decisions not in the interests of shareholders because they do not bear the wealth effects of their actions (moral hazard).

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QUESTION 3: If a large company subject to a high degree of political scrutiny has a choice between expensing and capitalizing an item of expenditure, what does the political cost hypothesis of Positive Accounting Theory predict will be the preferred choice? Explain your answer. Watts and Zimmerman’s (1990, p.139) political cost hypothesis predicts large firms are more likely to make accounting choices that reduce reported profits. Size is a proxy variable for political attention: that is, the larger the organization, the more likely it is assumed to be subject to political scrutiny. If we assume that an entity is subject to a high degree of political scrutiny, and if we assume that high profits will attract unwanted political attention, the entity would expense an item of expenditure rather than capitalizing it.

QUESTION 4: Read Accounting Headline 7.8. Babcock and Brown had negotiated an agreement with lenders that its market capitalization would not fall below an agreed amount of $7.50 per share. However, the share price dipped below this agreed amount, meaning that the lenders could demand repayment of the funds if they choose to invoke their right to do so. From a PAT theory perspective, why would Babcock have agreed to this market capitalization requirement rather than other types of covenants, such as a restriction on the organization’s total liabilities to total tangible assets? Further, why would the banks have negotiated to have this market capitalization agreement included within the debt agreement? (Question 7.29 from Deegan) From a PAT perspective, an organisation would negotiate the terms of its debt contract with lenders in order to attract funds at the lowest cost. Presumably, Babcock believed by agreeing to this particular debt covenant, they have obtained their debt funding at the lowest cost. From Babcock’s perspective, accepting this debt covenant is risky as share price is not solely within managements’ control. However, PAT assumes all actors are rational and it is of note that when Babcock negotiated the restriction there was a very small likelihood the minimum market capitalisation requirement would be violated. Babcock shares fell from $34.63 to $5.25 in twelve months! From the lender’s perspective, an advantage of this covenant is that it is not directly under the control of management and it would be difficult for management to manipulate compared to covenants based upon accounting numbers (although there would be additional debt covenants in the contract that do use accounting numbers). The extra layer of protection for the lender reduces their risk and adds to the expectation that accepting such a covenant led to a lower cost of debt for Babcock.

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QUESTION 5: Read Accounting Headline 7.11 and answer the following questions: (a) Why could the new accounting standard trigger debt covenants, creating a technical default? (b) Do you think the likelihood this new accounting standard will be released would already be influencing lease companies? (c) Do you think lenders would prefer that more leases be recognised and disclosed on borrower balance sheets, or be kept off balance sheet? Firstly, Accounting Headline 7.11 shows that not everything that is written in newspapers is correct. For example, the article states that finance leases transfer ownership of the asset from the lessor to the lessee at the end of the lease term. This is not correct. Some finance leases transfer ownership, but some do not. The transfer of ownership is not the basis for differentiating between an operating and finance lease, as the article asserts. Nevertheless, the article is correct in that the new accounting standard will require many leases that were previously operating leases to be recognized on the balance sheet. Including previously unrecognized leases in the balance sheet will mean both assets and liabilities will increase and this will have implications for companies. (a) A common debt covenant is the debt to asset ratio (or debt to equity ratio). If a reporting entity has assets of $10 million, liabilities of $6 million, and equity of $4 million, its debt to assets ratio is 60 per cent. However, if it were to recognize previously unrecognized leased assets and liabilities with a value of $3 million, assets will increase to $13 million, liabilities will increase to $9 million, and equity will remain unchanged. The debt to asset ratio is now 69%, which could cause a technical default. (b) Once an accounting standard is probable, companies plan for the change. In this case, leasing companies will structure new products and companies might wait before entering into new lease arrangements. (c) Lenders wish to minimize repayment risk. Accordingly, lenders prefer conservative accounting treatments, including the recognition of debt in the balance sheet. This leads to earlier activation of default and increased likelihood of repayment.

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