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Explain the term 'lobbying'.
Provide 2 examples of how a company can lobby when they are concerned about proposed changes to an accounting standard.
- Lobbying is the action by those affected by accounting standards to place pressure on the standard setters to effect change in order to achieve a favourable outcome.
- Interms of the standard setting process, views can be expressed and considered through:
- Providing feedback on exposure drafts
- Writing submissions to standard setters either directly-
- Or through related bodies such as accounting professional bodies.
Explain the horizon problem that exists between owners/shareholders and managers.
Propose 2 remuneration mechanisms that can assist in reducing the problem
- Horizon problem exists because managers and owners having differing time horizons in relation to the entity.
- Shareholders have an interest in the long term growth and value of the entity as the share value of the entity today reflects the present value of the expected future cash flows over the long term.
- Shareholders prefer managers to undertake long term projects to ensure future growth of the firm.
- Managers on the other hand, interested in the cash flow potential only as long as they expect to be employed by the entity.
- Managers tend to focus on maximising short term profitability to show evidence of effective management.
- Linking bonuses to share price movement or giving managers shares and options can mitigate the horizon problem, as managers are motivated to take long term projects.
What is a 'derivative financial instrument'?
Provide an example to illustrate your answer.
Identify two key aspects of a derivative financial instrument
- Derivative financial instrument: instrument that creates rights and obligations with effect of transferring one or more of the financial risks inherent in an underlying primary financial instrument.
- Eg: share option, currency swap, forward contract
- Key aspects of derivatives:
- Derivatives are contracts between buyers and sellers.
- A derivative financial instrument derives its value from the value of some other financial asset or variable.
- The price of a derivative rises and falls in accordance with the value of the underlying asset.
- Sometimes no money is exchanged at the beginning of the contract.
- Derivatives are designed to offer a return that mirrors the payoff offered by the instruments on which they are based.
Why is a firm's earnings quality important to shareholders?
- Earnings quality affects shareholders' ability to assess stewardship (managerial accountability) and a firm's future prospects.
- Earnings quality reflects how current earnings map into future earnings. It indicates the persistence of future cash flows- and hence returns to shareholders.
- Distorted earnings cause adverse selection and impair shareholders' resource allocation decision.
Managers can use different methods to manage earnings including accrual and real earnings management. Contrast accrual earnings management with real earnings management
Accrual earnings management:
- Allows entities to delay or accelerate recognition of income and expense and enables entity to temporarily adjust profit figures.
- No direct cash flow influence.
- Real earnings management:
- Change the timing or structuring of an operation, investment, and⁄ or financing transaction in an effort to influence the output of the accounting system.
- Direct cash flow consequences.
Can reduce entity value because actions taken in the current period to increase earnings can have negative effects on cash flows in later periods.
Cannot be regulated- auditors and regulators cannot question a firm’s real business decisions.
Discuss the factors a manager or accountant might consider when making various expensing and capitalisation choices
- Whether research and development expenditure is likely to lead to future economic benefits.
- take into account what the management team want the bottom line profit or net assets to be.
- It can affect executive bonus payments (0.5%) and likelihood of defaulting on loans (0.5%).
What is normative accounting theory? What role does it play in accounting practice and financial reporting?
- Normative accounting theories (NATs) are prescriptive since they provide recommendation and guidance in accounting practice and financial reporting which may or may not be adopted by practitioners in the field.
- NATs attempt to explain what accounting "should be" rather than what accounting "is".
- Not based on real world observations and are therefore more subjective/value-laden.
An example to NATs is the Conceptual Framework. The Conceptual Framework prescribes the objectives of financial reports and the qualitative characteristics of accounting information. The Conceptual Framework suggests relevance and faithful representation as two fundamental qualitative characteristics of information, this is subjective and one can challenge that other notion such as comparability should take precedence.
Ethical/normative branch of stakeholder theory
Financial reporting should provide information to all stakeholders for decision making. All stakeholders ought to be treated fairly and equally in financial reporting regardless of their power.
What is the underlying assumption of positive accounting theory? Discuss how this assumptions explains managerial decision making in financial reporting
- “Rational economic person” is the underlying assumption of positive accounting theory
- This assumption views that all individuals (be it shareholders, debtholders or managers) are self-interested and rational parties who aim to maximize their own wealth.
- For instance, self-interested managers have the incentives to maximize a company’s profit through creative accounting or capitalising rather than expensing an item in order to receive greater remuneration.
Explain the market approach and provide an example of an asset and a liability that is commonly measured using this approach
The market approach uses prices and other relevant information generated by market transactions involving identical or comparable items, for example quoted market prices.
- It would be more preferred because if an active market exists, the prices are determined in a more objective manner (level 1 input) (1%) than other approaches by reducing opportunistic or erroneous managerial assumptions, so are more easily verifiable. This would increase the reliability/faithful representation of information. (1%)
- Eg. shares, treasury notes
Accounting standard setting is subject to political pressure. Discuss
- Accounting standards determine the recognition and measurement of accounting elements, which influences a firm’s reported financial performance and position thus there are economic consequences and wealth transfer.
- Lobbying and equity in standard setting: Therefore, it often attracts lobbying from powerful vested interests who are influenced by accounting standards.
Define economically recoverable reserves as per EE
Economically recoverable reserves refers to the estimated quantity of product in an area of interest that can be expected to be profitably extracted, processed and sold under current and foreseeable economic conditions
Why are investors concerned about the disclosures of economically recoverable reserves?
- Importance of ERR disclosures:
- Reserve disclosures reflect revenue of mining firms, investors will rely on such information to revise their expectations about those firms' future profitability and cash flows.
- Reserve estimations involve complex assumptions and estimates that affect the quality of information useful for decision making.
Discuss factors discussed in the article that are found to have an impact on the disclosure of economically recoverable reserves
Effective corporate governance
: Ensure reserve-related risks are identified, assessed, addressed and monitored to achieve organizational goals.
: Disclose more information about ERR to comply
with the regulation and listing rules in different jurisdictions so
they can raise additional capital
and increase investment/business profile internationally
Reserves in foreign jurisdictions
: Disclose more information about ERR to comply with legal, financial and operational requirements
of the jurisdiction in which it operates.
Pledging of reserves in debt covenants:
Disclose more information about ERR so that lenders can evaluate ERR
which is pledged as security against borrowings
- Leverage: Disclose more information about ERR to reduce monitoring costs and assure stakeholders that cash used to exploit reserves will generate future economic benefits to discharge debt obligation.
- External (big 4) auditor: Auditors, particularly Big 4 auditors with reputational capital, require managers to disclose more information of ERR to assess the appropriateness of assumptions and estimations
Outline how this study contributes to accounting policy and financial reporting practice
The study contributes to a better understanding of the extent and rationale behind the reserves disclosure practices of Australian resource firms.
The study highlights that monitoring and contracting mechanisms enhance disclosures of forward looking information about reserves in the annual report.