Ch10 sm god7e - accounting theory PDF

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Solutions Manualto accompanyAccounting Theory 7eBYAnn TarcaChapter 10ExpensesChapter 10: Expenses John Wiley & Sons Australia, Ltd 2010Chapter 10: ExpensesCase Study 10 Accounting for frequent flyer points: fact or fiction?1. Describe the accounting process used to account for frequent flye...

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Solutions Manual to accompany

Accounting Theory 7e

BY

Ann Tarca Chapter 10 Expenses

Chapter 10: Expenses

 John Wiley & Sons Australia, Ltd 2010

© John Wiley and Sons Australia, Ltd 2010

10.2

Solution Manual to accompany Accounting Theory 7e

Chapter 10 - Expenses CASE STUDIES Case study 10.1 Emissions trading: recognising the cost of pollutants

1.

What are emission allowances? Do they meet the IASB Framework definition of assets or expenses?

Emissions allowances are credits or allowances that a company receives from a regulatory agency that represent the right to emit a specified amount of pollution. Emission allowances are created as part of an emissions trading program. An emission allowance is an asset because it represents a future economic benefit. When the emission allowance is used up, it becomes an expense or consumption of future economic benefits. A company with surplus credits can sell them, giving rise to an inflow of future economic benefits or revenue while a company with insufficient credits will need to purchase them, giving rise to an outflow of future economic benefits and therefore an expense. 2.

How do businesses obtain emission allowances?

Emission allowances are issued by the regulatory agency responsible for the emission trading program. A number of allowances are given, based on political and economic considerations. Companies can buy, sell or hold their allowances so allowances can also be purchased from other companies which have surplus credits. 3.

How are emission allowances accounted for in the USA?

Emission allowances are accounted for on an accrual basis. When issued by the regulatory agency, the allowances have a zero cost basis for the receiving entity. Allowances purchased in the market place are recorded as inventory, using lower of cost or market valuation. When allowances are consumed, inventory is reduced and an expense recognised. Sales of allowances give rise to gains and losses, which are recognised in income. 4.

Why are the IASB and FASB involved in setting guidelines for accounting for emission trading?

The standard setters have proposed that the emission rights be measured at fair value (at balance date) with gains and losses on remeasurement recognised in income in the period in which they accrue. The standard setters are involved in setting guidelines to ensure comparability and consistency in the way in which companies account for emission allowances. The boards aim to ensure that all assets, liabilities, revenues and expenses are recognised in the period to which they relate. Emission trading can gives rise to assets, liabilities, expenses and revenue (as per the IASB Framework) so these transactions should be recognised in the accounts. The standard setters have active projects on their agendas to ensure that suitable guidance for emission trading is issued in the future.

© John Wiley and Sons Australia, Ltd 2010

10.3

Chapter 10: Expenses

Case Study 10.2 Accounting for frequent flyer points: fact or fiction?

1.

Describe the accounting process used to account for frequent flyer points prior to the adoption of IFRS. How was the matching principle breached by this practice?

Revenue was recorded when points were sold. An expense (the cost of the FF seat) was not recorded at the same time. This was recorded later when travel occurred. The matching principle was breached by early recognition of revenue, without a corresponding increase in expense (‘cost of goods sold’ or cost of ticket given away). 2.

How could companies benefit from this accounting practice? Consider both the short and long term.

In the short term, the accounting policy of recognising revenue immediately while deferring the FF expense to a later period allows a company to report more revenue and greater profit. However, in the long term there is no benefit as earnings will be reduced by the expense in later years. Presumably companies are concerned about looking good in the short term. Perhaps they are hoping business will improve, so that the deferred expense has relatively lesser impact when it is recognised in the later period. 3.

Why was Qantas keen to correct the errors reported in the AFR article?

As a major listed company, Qantas would not want to be seen as breaching accounting standards or Corporations Law requirements. Such an action would be viewed badly in the market place. It suggests the company does not employ competent accountants, or does not obey the law. It may imply the company has engaged in earnings management. Such action would raise questions about the corporate governance practices of the company, which could have adverse effects on its reputation. Qantas would seek to protect its reputation as it makes use of public finance and depends on support of investors. It would want to avoid negative publicity arising from inaccurate reporting. 4.

Explain the difference between the cost/provision and the deferred revenue approaches.

Under the cost/provision approach Qantas recorded an expense at the time of the award, thus effectively reducing the revenue recognised in relation to the associated ticket sale. In addition, liabilities were increased by the value of the seat to be given up in the future. The deferred revenue approach will require Qantas to separate the value of the ticket sold into two parts: revenue relating to the current service (the airline seat) and revenue relating to the future award. Only the current service revenue is recognised and future revenue is allocated to a liability account (deferred revenue) to be settled when the award is exercised.

© John Wiley and Sons Australia, Ltd 2010

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Solution Manual to accompany Accounting Theory 7e

5.

What impact do you expect adopting the deferred revenue approach to have on Qantas’s financial statements?

Although the deferred revenue method is different to that previously used by Qantas and different accounts are used, the net effect on Qantas’s accounts is the same. The amount of net revenue is the same and a liability is recognised in relation to the future award. For Qantas IFRIC 13 will not affect net revenue or total liabilities.

© John Wiley and Sons Australia, Ltd 2010

10.5

Chapter 10: Expenses

THEORY IN ACTION Theory in Action 10.1 Options deal dwarfs salary of ANZ chief 1.

Since 2005, IFRS 2 (AASB 2) requires companies to record an expense in relation to stock options plans. Explain the requirements of IFRS 2 (AASB 2) and how they differ to previous requirements. (Students will need to consult additional resources. See the list at the end of this chapter).

Prior to the application of IFRS 2 Share-based Payment many companies did not include an expense in relation to the cost of providing employee remuneration via stock options. Some managers did not support the recognition of an expense, which would reduce earnings. Under IFRS 2 (AASB 2) companies are required to account for equity-settled and cashsettled share-based payment transactions as well as transactions where an entity receives goods and services and the transaction can be settled with cash, equity instruments or other assets (para 2). For equity-based transactions, the entity measures goods or services received (and the corresponding increase in equity) directly at their fair values. If the entity cannot estimate reliably the fair value of goods or services received, then their value is measured indirectly by reference to the fair value of the equity instruments granted (para 10). Fair value is to be based on market prices at grant date (para 16). If market prices are not available, the fair value is to be estimated using a valuation technique, to reflect measurement based on an arms’ length transaction between knowledgeable and willing parties. The valuation technique used should reflect generally accepted practice for valuing financial instruments and should incorporate factors and assumptions used by knowledgeable and will market participants (para 17). 2.

Provide an overview of the advantages and disadvantages of the requirements of IFRS 2 (AASB 2).

Standard setters argue that including the cost of share-based payments improves the relevance, reliability and comparability of financial statements. The information helps users of financial reports to better understand the company’s financial expenditure and commitments. Recognising share based payments, and provided associated disclosures, improves the information set with which investors work and thus assists them in analysing and evaluating companies. The information has the potential to enable users to make better resource allocation decisions. Some commentators argue that recognition of share based payments introduces volatility and subjectivity into the accounts. The argument is that since the expense is based on fair value measurement (actual or estimated market prices, which can be volatile) it may introduce volatility into reported earnings. Standard setters argue that volatility is an economic phenomenon and should be captured. However, some managers oppose fair value measurement which they claim introduces volatility because they consider it makes the analysts’ prediction task more difficult and complicates the communication process between managers and analysts. Whether IFRS 2 leads to increased volatility is an empirical question still under investigation. The second argument relates to subjectivity of measurement. Option pricing methods currently in use include the Black-Scholes-Merton model and the binomial valuation model.

© John Wiley and Sons Australia, Ltd 2010

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Solution Manual to accompany Accounting Theory 7e

Obviously these models are based on assumptions, which may vary from reality. Intentional or unintentional error may result. They are also subject to managerial incentives, i.e. managers can influence model inputs and therefore the resulting valuation. There is US evidence of managers controlling valuation inputs to achieve desired option valuations (e.g. Google company in 2007). 3.

The article states that certain executives gain much more on options plans than is shown in their company’s accounts. For example, the ANZ CEO gained $19.7m cashing in options, but his pay was shown as $7.2m in the 2006 annual report. Given that IFRS 2 requires the recording of an expense for share based payments, explain how this could occur.

As explained in part (1) IFRS 2 requires that options be valued at grant date and that an expense reflecting this value be included in the accounts over the life of the option. Therefore the expense recognised in the accounts is the value at grant date (e.g. at t = 0) not the value when the options are exercised (e.g. t = 3, if options vest in three years). The value at grant date can be less than the value when the option is exercised because the value at grant date is an estimation which can prove to be incorrect. For example, if share prices rise more than predicted the estimated value will be less than actual value and the amount for stock options expense will be less than the amount received by the employees when they exercise the options. 4.

In light of your answer to question 3, do you consider that the requirements of IFRS 2 should be changed? Why or why not?

It is not necessary to change the requirements of IFRS 2. The difference explained in (3) above arises due to the use of estimation models. Estimation is inevitable in relation to valuing options in many cases so it is not a weakness of the standard which leads to the discrepancy between value at grant date and exercise date. If the difference results from the technique used, it is not a weakness of the standard per se. Of course, the standard could require different techniques, however, it recommends ‘current best practice’ so a change in recommendations is not required. The matter can be resolved by disclosure. Indeed, the information quoted in the article relies on existing disclosures which occur in two places: the value of options at grant date as shown in the financial statements and the value of options at exercise date as shown in the remuneration report included in the annual report. Therefore stakeholders can see the amount of remuneration received via options. Perhaps the writer is concerned about the ability of readers to locate the information and understand the difference between value at grant date and exercise date. Writers of accounting standards assume reasonable ability among people using financial reports. On this basis, standards setters or regulators would claim that in this case the information is transparent and it is therefore up to users to make use of the information provided as they see fit.

© John Wiley and Sons Australia, Ltd 2010

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Chapter 10: Expenses

Theory in Action 10.2 Share option plans worthless 1.

Outline the difference between an option plan and a performance rights plan.

A share option plan grants employees the right to receive company shares in the future subject to certain conditions being met. Share options may be granted at reduced cost, minimal cost or no cost to employees. When vesting conditions are met, employees have the choice of exercising their options and obtaining company shares. Vesting conditions typically include the share price reaching a particular target and the employee remaining with the company for a particular period (e.g. three years). Instead of increases in share price, performance rights plans use the company’s performance relative to its peers as the benchmark for exercising options. The article states that the performance hurdle usually involves comparing a company’s total shareholder return against a group of similar companies. If the company achieves the performance hurdle (a certain shareholder return compared to its peers) then executives can exercise their options and obtain shares at a favourable price. 2.

The article states that almost three quarters of employee share option plans issued by the top 50 ASX firms are now worthless. Explain how options can be worthless when companies have billions of dollars of assets.

Share option plans are ‘in the money’ when the value of the share is greater than the cost of the option. In this situation, a wealth maximising individual will exercise the option and obtain the shares. If options are granted at a discount to share price, then as long as the share price rises they are ‘in the money’ and have value for the employee. By January 2009, share prices had declined dramatically as part of the global financial crises which took hold of markets from October 2008. The value of option plans is linked to share price (not to the value of the company’s assets) so the fall in share prices rendered options worthless because the cost of exercising the option was greater than the value of the share obtained when the option was exercised. Options became ‘out of the money’ and had no value to the holder. 3.

What does an environment of falling share prices reveal about the effectiveness of incentive plans as motivational tools?

Share option plans were introduced as a way of incentivising employees and aligning their interests with those of shareholders. If employees are able to increase their company’s share price to meet the conditions of the option plan, then shareholder wealth increases but so too does the value of employee options and consequently the employees’ wealth. Share option plans were popular prior to the tech stock crash in April 2001. Options permitted firms to compensate employees without an outflow of cash and without a remuneration expense being recorded (because of accounting standards in force at the time) which would have reduced earnings. However, when stock prices crashed after April 2001, in some cases options became worthless. Consequently, companies adopted performance rights plans. They were set up with different performance hurdles which were not as sensitive to overall movements in the share price. As we can see by observing markets, share prices move in response to many factors and in many circumstances these factors are outside the control of individual managers (e.g. share prices move in response to the weather and terrorist acts). Therefore it is in the

© John Wiley and Sons Australia, Ltd 2010

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Solution Manual to accompany Accounting Theory 7e

managers’ interests to link their remuneration to factors over which they have relatively more control. Instead of requiring a certain level of increase in share price (difficult to achieve when the market falls) the test for exercising the options is based on comparing the performance of the company to that of other similar companies. Thus employees benefit when their firm outperforms others but the award of options is not affected by overall market movements (which affect all firms). This situation shows that option plans can still be used to motivate employees in times of falling prices if they are set up in an appropriate way. It also shows that the principles of incentive plans do not change, but the way plans are set up evolve as market conditions change.

© John Wiley and Sons Australia, Ltd 2010

10.9

Chapter 10: Expenses

Theory in Action 10.3 Loophole lets bank rewrite the calendar 1.

Outline the events which led to Société Générale recording a 2008 loss in the company’s 2007 accounts. How did the bank justify its action?

In 2008 the French bank suffered an enormous loss due to the unauthorised trading activity of employee Jérôme Kerviel. The loss occurred in January 2008 but since the 2007 accounts had not been finalised the bank decided to include the loss in 2007. The bank offset the 2008 loss against the 2007 profit to give a result of a net loss of Euro 4.9 billion. In the annual report the bank stated that applying IAS 39 Financial Instruments: Recognition and Disclosure and IAS 10 Events after Balance Sheet date would have been inconsistent with a ‘fair presentation’ of its results. The article states that the bank does not elaborate on why this would be so. Therefore, readers are left to draw their own conclusions. One view is that the event was not a positive one for the bank (either in terms of financial performance or corporate image) or for the banking sector in general or the French securities market. Therefore management included the loss in 2007 (despite it having occurred in the 2008 financial year) possibly because the managers (or major investors or the French banking/company regulator) wanted to ‘get it out of the way’ i.e. it wanted to take the loss, make the disclosure, and move on. 2.

On what grounds has the bank’s approach been criticised?

The bank’s action has been criticised for several reasons. First, the loss had not occurred at the end of 2007. If Kerveil’s actions had been discovered in 2007, the loss would not have been incurred as his positions were profitable in that year. Second, the bank made use of the ‘carve out’ related to IAS 39,which was itself controversial. For many parties, the use of the ‘carve out’ is not best practice. In addition, the company did not disclose what results would have been if the carve out had not been used, thus their reporting was not transparent for investors. 3.

Evaluate the role of the auditors in this situation.

The role of the auditors is to attest that the financial statements provide a fair presentation of the company’s position and performance in compliance with accounting standards. On the face of the situation, it s...