Sample/practice exam 2019, answers PDF

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QUESTION ONE (5 Marks) Q1(a) What is the crucial aspect of signalling that would make the signalling work? (2 marks) Q1(b) Give three examples of managerial signalling. (3marks)

Solution: Crucial aspect of a signal: Must be less costly for high types to signal (i.e., it must be costly to the signaler if untrue) Q1(b) Give three examples of managerial signalling. Solution: (3 marks = 1+1+1)       

Grant of executive stock options Adoption of conservative accounting Report excess positive accruals A high-quality, good-news forecast The proportion of equity retained at IPO Retain a high-quality auditor Debt financing

QUESTION TWO Identify on what basis each of the following assets or liabilities should be measured: (i) Investment in a trading portfolio of shares listed on ASX stock exchange (1 mark) (ii) Bonds that are debt Solution: Investment in share = Fair Value Through Profit & Loss (FVTPL) Bond Debt = Amortized Cost QUESTION THREE In August 2016 ABC Ltd reported a record earning of $15 per share. BHP Ltd reported earnings per share of $12. The prior year’s earning per share of ABC Ltd and BHP Ltd was $10 and $18 respectively. The analysts earning expectation of earning per share immediately prior to the earnings announcement for ABC Ltd and BHP Ltd was $15 and $9 respectively. Which company would have the greatest security price response to its earnings announcement in August 2016 and why? ( 2 marks) Solution BHP because it is had the greater amount of unexpected earnings ($3 versus $0 dollars).

QUESTION FOUR (5 Marks) Discuss how assigning an item to recognition or disclosure may affect its use by investors? (5 marks) Solution: •

If the market is fully efficient and all information fully disclosed then recognition versus disclosure may not matter. (2 marks)

BUT (3 marks) • If the market is inefficient and/or costs of information processing is high, then recognized amounts may be valued differently by investors than information disclosed • The literature has shown that investors react differently to the same information presented in different forms, such as note disclosure versus income statement recognition. • The act of recognition may be more informative than disclosure, because the information may become more reliable/precise because, for example, of auditor verification of such estimates. • The act of recognition may reveal the differential level of precision of recognized amounts versus disclosed amounts.

QUESTION FIVE (8 marks) Describe the three conditions necessary for the market to be inefficient.

(8 marks)

Solution: Market inefficiency theory rests on the following three assumptions/characteristics 1. Investors exhibit information processing biases that cause them to over- and under-react. (3 marks) 2. Individual investors’ errors/biases in processing information must be correlated across investors so that they are not averaged out. (3 marks) 3. Limited arbitrage: Existence of rational investors should not be sufficient to make markets efficient. (2 marks)

QUESTION SIX (8 marks) Q6(a) What measurement methods are available under AASB 116 to measure the value of property, plant and equipment? (2 mark) Solution Cost or fair value

Q6(b) Assume that you are the CFO of a listed public company. What measurement method would you choose to measure the value of property, plant and equipment? Outline three arguments for and three arguments against your choice.

(6 marks)

Solution Arguments for HC  Past transactions (past performance) is an important input into the prediction of future cash flows (from the valuation perspective)  Past transactions and events are important for holding management accountable (from the efficient contracting perspective)  More reliable as HC is based on occurred external party transaction Arguments against HC  HC may not match current revenue with current operating costs  Revenue recognition lag (since revenue is not recognition until receipt of cash is probable)  Problem with P&L in times of rising prices  No recognition in balance sheet of the current value of assets and liabilities  Aggregation of different measurement units (the 'additivity' problem) Arguments for FV  Relevance. Current fair values may provide more relevant information for forecasting the future  Opportunity costs Fair value in the balance sheet provides information to measure a firm’s opportunity costs from selling the firms assets and using in an alternate investment  No ‘Additivity’ problem. The measurement scales of all assets and liabilities are the same  Comparability

QUESTION SEVEN (10 marks) Q7(a) What are three key characteristics of intangible assets according to AASB 138/IAS 38 para 8? (3 marks) Solution   

Identifiable Non-monetary in nature Without physical substance

Q7(b) Explain what is meant by ‘identifiability’ in the definition of an intangible asset. (3 marks)

Solution An asset meets the identifiability criterion in the definition of an intangible asset when it: (a) is separable, i.e. is capable of being separated or divided from the entity and sold, transferred, licensed, rented or exchanged, either individually or together with a related contract, asset or liability (exclusion examples include goodwill, staff morale); or (b) arises from contractual or other legal rights, regardless of whether those rights are transferable or separable from the entity or from other rights

and obligations. (is included to allow such assets as water rights, where these were allocated by a government but if not used were unable to be onsold and so were not separable, to be classified as intangible assets). QUESTION EIGHT (6 marks) Q8(a). Define public good.

(1 mark)

Q8(b). Define externalities problem. (1 mark) Q8(c). Define free rider problem.

(1 mark)

Q8(d). Explain how the public good nature of information, externalities problem, and free rider problem together may lead to market failure in private information production. (3 marks)

Q12(a). Define public good. (1 marks) Solution A pubic good is a good such that consumption by one person does not destroy it for use by another. Q12(b). Define externalities problem. (1 marks) Solution Externalities problem is an action taken by a firm that imposes costs or benefits on other firms or individuals for which the entity creating the externality is not charged or does not receive revenue Q12(c). Define free rider problem. (1 marks) Solution Free rider problem is the receipt by a firm or individual of a benefit from an externality Q12(d). Explain how the public good nature of information, externalities problem, and free rider problem together may lead to market failure in private information production. (3 marks) -11-

Solution Information has characteristics of a public good. An investor can use the information in an annual report without eliminating its usefulness to other investors. Hence, investors perceive annual reports as free. Consequently, suppliers of public goods may have trouble charging for these products, which gives rise to externalities problem. However, firms’ annual reports are not “free.” Production of annual report is costly. Other, more significant, costs include the possible disclosure of valuable information to competitors. Then, investors can “free ride” on this information. Since all investors will realize this, no none has an incentive to pay. As a result, it is difficult for the firm to charge for producing information, in which case it produces less information than is socially desirable....