Alaa Aliasrei ‫فيس‬ @Aliasrei ‫تلكرام‬ ‫عالء هحسن شحن‬

Solution Manual
to accompany

Contemporary Issues in
Accounting
Michaela Rankin, Patricia Stanton,
Susan McGowan, Kimberly Ferlauto
& Matt Tilling
PREPARED BY:

Patricia Stanton

John Wiley & Sons Australia, Ltd 2012

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CHAPTER 6

PRODUCTS OF THE FINANCIAL REPORTING PROCESS

6.1 Contemporary Issue Corporate accounting systems are out of date

1. Why do financial statements prepared under the IASB’s Conceptual Framework and
standards fail to meet the objective of financial reporting as outlined in the
Conceptual Framework? (K)

Financial statements are unable to achieve the objective of financial reporting because firms
do not report information that explains the main trends and factors that underlie their
development, performance, and position. Examples of such information include details about
the nature of the business, key resources, risks and relationships, and performance measures
and indicators.

2. Why do you think the author of the extract would expect readers of a marketing
journal would be interested in financial reporting? (J, AS)

Marketing focuses on the consumer and getting a “better deal” for them. Uses of financial
statements are consumers of the information; closing the gap in what is reported is a step in
getting a “better deal” for users. Additionally, the information that Management Commentary
should disclose specifically mentions customer measures (derived by marketers) as crucial
for assessing operating performance and, therefore, key information that should be reported
to investors.

3. What difficulties do you see in requiring the disclosed information to be ‘reliable and
comparable’ and ‘future oriented’? (J, AS)

Metrics about customer measures derived by marketing and other metrics related to key
resource would be reliable and comparable in the accounting sense. Other measures are more
subjective.

6.2 Contemporary Issue Be kind to shareholders: keep it short, sweet and

informative

1. Despite reiterating that the annual report is the single most important document a
company sends to its shareholders, the writer is critical of annual reports. Outline
those criticisms. (K)

 too long,
 providing information with too much corporate spin,
 providing information that is too diverse,
 providing information that is incomprehensible to the average person,

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 space wasted with superfluous photographs and over-the-top graphic design as if the
report has been hijacked by the public relations team and graphic artists, and
 too many statements that suggest that a good spin doctor has edited the report.

2. If annual reports are so important to shareholders, why are fewer people reading
them? (K)

Because of the factors listed in (1) and it may be also that many shareholders own shares in
both their own name and their superannuation fund, and have requested only one annual
report.

3. Why do you think the shareholder friendly report initiative will not be a ‘perfect
replacement’ for a concise report? (J, K)

The author states that the numerous required disclosures may defeat the initiative.

6.3 Contemporary Issue Standardised business language cuts operating

jargon confusion

1. What is XBRL? (K)

Extensible business reporting language, or XBRL, is a computer-based language that

converts business and financial data to a standardised form.

2. What are the advantages of XBRL as outlined in the extract? (K)

 Consistency
 Transparency
 Financial data easily accessible and interchangeable

3. Why will companies such as Edgar Online Inc. have to change their focus if they are
to survive widespread adoption of XBRL? (J, AS)

Companies such as Edgar Online Inc. Provide normalised data to analysts but XBRL is able
to do this without spending large amounts of expensive time converting data into a searchable
and analysable form. Their focus is likely to change to ways to make XBRL data more
marketable.

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Review questions

1. Why does accounting have regular reporting periods?

 Aids comparability and analysis

 Conventional
 Check on arithmetical accuracy
 Report to absentee owners
 Legal requirement

2. Consider the arguments for and against standardised reporting periods. Do you
agree that accounting periods should be more flexible? Give reasons for your answer.

There are several arguments given to support a more flexible approach to reporting periods.
For example, any standardised period cuts across many uncompleted transactions.
Standardisation may result in accountants apportioning unfinished operations and allocating
assets to an arbitrary accounting period of 12 months.

Chambers (cited by Luther) argued that the appropriate accounting period is determined
by the nature of the entity, so that it should reflect the earnings cycle of the reporting entity.
This view was supported by the American Institute of Certified Public Accountants in 1973
but has not been adopted.

Johnson & Kaplan argue that standardisation puts pressure on managers to produce profits
over short-term periods. Luther quotes several authors who argue that to overcome the
problems created by standardisation, annual accounts should have a cumulative component
because they are tentative and conjectural statements, the truth of which cannot be verified
until the reporting entity has run its entire course.

3. What are the perceived purposes of an annual report?

 Accountability of managers to absentee owners

 Provides information for decision making by non-management stakeholders
 Means of reporting corporate achievements
 Means of impression management, especially of positive images

4. Why are financial statements ‘highly valued’?

They are „highly valued‟ because financial statements have been attested to by a third party
(auditor) who is supposedly independent of management.

5. What do you understand by the term ‘fair presentation’? Give an example to

support your answer.

To understand the term „fair presentation‟ see chapter 2. The term means that the
representation should be free from bias. In this light it can be equated with “faithful

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representation” where the financial statements correspond to the actual events and transaction
that are being reported.

6. Financial reports have been criticised for their lack of completeness. In what ways
do financial reports fail the completeness test?

 Financial reports report on only those activities sanctioned by GAAP (including IASs).
 Reporting entities engage in activities that are not captured in the reporting process. For
example, social and environmental activities largely go unreported in financial reports.
 Reporting of Intangibles is restricted by accounting standards so that many intangibles are
not included in financial statements.

7. Defend the stand taken by accounting authorities in AASB138/IAS38 Intangible

Assets in relation to the treatment of intangible assets.

The stand by accounting authorities is based on three grounds:

 probability of the future benefits flowing to the reporting entity is too low
 lack of reliable measurement for intangibles
 the inability to separate many intangibles from their controlling entity.

8. Define ‘earnings management’. Do you consider it to be good or bad? Why?

Earnings management is defined as a „manager‟s use of accounting discretion through

accounting policy choices to portray a desired level of earnings in a particular reporting
period‟.
Whether it is considered good or bad will depend on the acceptance of the arguments of
Macintosh et al. 2000 or those of Parfet, 2000.

Because the measure of corporate success has become whether a corporation has reached its
earnings predictions, the temptation for management is to „manage‟ earnings to match
analysts‟ forecasts. In this process, as outlined by Macintosh et al., accounting earnings do
not reflect the outcomes of an enterprise‟s strategic decisions. Instead, analysts‟ predicted
earnings determine the strategy of an enterprise to satisfy the prediction. This means
management may take predictions about earnings as targets and select investments that are
likely to produce reported income equal to or exceeding the analysts‟ forecasts. Meanwhile,
the market incorporates analysts‟ earnings forecasts into share prices. In this way, share
prices, analysts‟ forecasts and reported income all relate to each other but not to „true‟ or
underlying income.

Parfet, a representative of preparers of financial reports, defends earnings management

by differentiating „bad‟ from „good‟ earnings management. The bad involves intervening to
hide true operating performance by creating artificial accounting entries or by stretching the
estimates required in preparing financial statements beyond reasonableness. This, he points
out, is the realm of hidden reserves, improper revenue (income) recognition and overly
aggressive or conservative accounting judgements.

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Good earnings management, on the other hand, involves management taking actions to
try to create stable financial performance by acceptable, voluntary business decisions in the
context of competition and market developments. The market tends to reward corporations
that achieve stable trends of growing income. Good earnings management involves spotting
the most beneficial use for the corporation‟s resources and quickly reacting to unforeseen
circumstances. Parfet declares earnings management not to be a bad thing but a reflection
of expectations and demands, both inside and outside a business, on the part of all
stakeholders in the capital market.

9. Why are annual reports so well regarded?

 Chief means of communication between management and non-management stakeholders

 Contain the audited financial statements
 The audited statements give credibility to the annual report.
 Annual reports also contain information not recognised in the financial statements,
information which is often complementary to the financials.
 Annual reports are the main source of voluntary disclosures by management.

10. Researchers speculate that management is motivated to disclose information

voluntarily either because it feels accountable or because it wishes to legitimise its
activities. Which do you think is the more likely reason and why?

“Accountable” invokes a responsibility or liability to be called to account whereas legitimacy

implies being in accordance with the values of society. The argument should be based on who
or what can call management to account and whether they would so. In relation to legitimacy,
scholars argue that an organisation‟s survival will be threatened if society perceives that it has
breached its social contract in which societal values are embedded. Management will be
“called to account" societal concerns.

11. Debate whether management should solely pursue profits.

The pursuit of profit is normally the concern of shareholders to whom management is

accountable in a broad sense. However, the sole pursuit of profits may cause harm such as in
the case of James Hardie. In that situation, the changes by management to their liability to
those harmed by asbestos potentially created great harm. Profits were being pursued to the
detriment of those harmed by the company‟s product. A notable case was the Ford Pinto
(USA) where even minor accidents ignited the car causing serious injury to those travelling in
the car. Ford has pursued profits rather than acknowledging a duty of care to those who
bought the vehicle.

12. What factors appear to instigate voluntary disclosure by management in annual

reports?

 Accounting standards prevent the recognition of many assets that contribute to the market
value of the reporting entity — voluntary disclosures make this information available.
 To improve corporate reputations

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 Concern for stakeholders — a concern wider than that for shareholders
 The philosophy that an entity has responsibilities beyond its legal responsibilities.
 Accountability
 To legitimise various aspects of a reporting entity
 To comply with community expectations, legal requirements and industry requirements
 Borrowing requirements require such disclosures
 To forestall regulations or actions by pressure groups
 To win reporting awards and/or to secure endorsements

13. Why should management explain poor performance in technical accounting terms?

Investors and other information users are assumed to be non-sophisticated users who are
unlikely to understand technical accounting terms and so, can be mislead in relation to the so-
called factors leading to a poor performance. The aim is to assign responsibility for the poor
performance to factors other than those in the control of management. In contrast, good
performances are reported in clear non-accounting terms, with responsibility for the
performance given to management.

14. Why do you think environmental disclosures are more researched than other social
disclosures?

Answers can be based on the reasons for disclosures:

Deegan lists ten reasons management might voluntarily disclose information in

annual reports:
1. to comply with legal requirements
2. because of economic rationality arguments
3. because of management‟s feeling that it is accountable to stakeholders
4. because of borrowing requirements
5. to comply with community expectations
6. to ward off threats to organisational legitimacy
7. to manage powerful stakeholders
8. to forestall regulations
9. to comply with industry requirements
10. to win reporting awards.

O‟Donovan‟s research suggests that management discloses environmental information

in annual reports to:
1. align management‟s values with social values
2. pre-empt attacks from pressure groups
3. improve corporate reputations
4. provide opportunities to lead debates
5. secure endorsements
6. demonstrate strong management principles
7. demonstrate social responsibilities

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15. Why is XBRL a ‘language’?

Language can be thought of as the communication of data, ideas, thoughts and feelings
through a system of arbitrary signals, such as voice sounds, gestures, or written symbols. As a
language, XBRL creates data is created by „tagging‟ financial information. The XBRL
tagging process converts the financial information contained within a document such as an
excel spreadsheet into a „document‟ or computer file with XBRL codes.

16. Debate whether XBRL is the likely future of financial reporting.

XBRL fulfils many of the desired conditions of financial reporting such as timeliness and
comparability as well as satisfying the reliance on electronics as a means of communication.

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Application questions
6.1 (a-j)

Answers will depend on the annual report chosen and its financial year. Students should be
encouraged to select an annual report from a non-listed entity so that comparisons can be
made with a listed company‟s annual report (case study 6.1).
Most answers can be supplied in tabular form.

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Case Study Questions

Case study 6.1 Reading the annual report: ten issues to consider

1. Obtain a copy of an annual report issued by a listed company. (K)K

2. Follow the suggestions of the corporate regulator, and analyse the annual report:

(a) Examine the figures in the financial statements to get an overall impression of the
financial performance of the company.

Calculation of the commonly used financial ratios would be helpful in answering this
question.

(b) Note which figures you think are important to an understanding of the financial
performance of the company you have chosen.

The calculated ratios especially those relating to liquidity, profitability, debt, cash flows and
operating performance should be helpful.

(c) Read what management has to say about these figures in the front half of the
report.

Care should be taken to align the numbers reported in the financial statements and those
reported in the front half of the annual report. Management discussion can enlighten the
reported numbers; it can also obfuscate them. Impression management has been identified as
a tool used in annual reports. Positive images will be promoted; negative images will be
avoided. This strategy has been shown to be applied to the figures reported in the front half,
especially where those figures are reported graphically. Students should be aware that the
figures may reflect earnings management and realise that earnings management is difficult to
detect from a public document such as the annual report.

(d) Return to the financial report and examine the figures again, taking into account
what management has said in the front half. Has your assessment changed in any
way? How? (J, K, AS, CT)

Students should be guided by the questions identified by ASIC especially those relating to the
year‟s highlights and the comparison with the previous annual report if it is available.

3. Write a short assessment of the company as a potential investment. (J, K, AS, CT)

The assessment should include the key areas identified by the regulator: operational and
strategic activities of the company, the financial results and the future strategic directions and
performance. The 10 questions identified in the case study should give the assessment its
structure.

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Case study 6.2 The impact of the global financial crisis on IAS 39 Financial
Instruments: Recognition and Measurement

1. Suppose you are a company holding large quantities of financial instruments the
market value of which had declined markedly since purchase. How would you
classify those instruments and why? (J, AS)

The changes to IAS 39 created incentives for those holders of large quantities of financial
instruments with large impairment charges to classify the financial instruments as assets
“held to maturity” or as “loans and receivables”.

2. Compared to the pre-change IAS39, what are the likely impacts of the changes to
IAS 39 on balance sheet values of companies holding large amounts of financial
instruments? (K, AS)

Impairment charges that should have been taken to the profit and loss statement will not go
there so that reported profitability is higher for those companies with large quantities of
financial instruments with declining market values will be higher than if the standard had not
been changed.
3. Will companies with large holdings of dodgy financial instruments be motivated to
disclose information about those instruments? Give reasons for your answer. (J)J

Companies with dodgy financial instruments are likely to take advantage of the information
asymmetry between themselves and external stakeholders to manipulate the financial
performance of the company by not making any voluntary disclosures about their holdings.
Studies of impression management show that annual reports and other corporate
communication media with shareholders and other stakeholders generally seek images that
have positive expected values, while negatives are avoided.

4. What types of companies are likely to be impacted greatly by the changes to IAS39?
(K)
K
Banks, merchant banks, investment companies, superannuation companies and such.

5. How would the changes impact the truthfulness of financial reporting? (J, K)J K

Depends on whether faithful representation is equivalent to truthfulness. The changes impact

on the underlying substance of the financial reporting.

6. How do the changes impact on the comparability of financial statements? (J, K)J K

The four choices should impact negatively on comparability, both of the balance sheet and
the profit and loss statements.

7. Would you expect the ‘market’ to look through the changes? How can you
empirically verify your answer? (J, K)

Advocates of the EMH would argue that the market would be expected to see through the
changes. To empirically support an answer, some research into the changes in share prices of

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companies with financial statements that employed the changes should verify whether the
market looked through the changes. Students should be aware that other factors can
complicate the results.
K
8. Argue whether the changes to IAS 39 represent a form of sanctioned earnings
management. (J, K)

Earnings management is defined as a „manager‟s use of accounting discretion through

accounting policy choices to portray a desired level of earnings in a particular reporting
period‟.

© John Wiley and Sons Australia, Ltd 2012 6.11