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Understanding Australian Accounting Standards

Janice Loftus, Ken Leo, Ruth Picker, Victoria Wise, Kerry Clark

By Janice Loftus

John Wiley & Sons Australia, Ltd 2013

Understanding Australian Accounting Standards 1st Edition Loftus Solutions Manual Visit TestBankDeal.com to get complete for all chapters

Chapter 2: Application of Accounting Theory

© John Wiley and Sons Australia Ltd 2013 2.1 Comprehension Questions

• Describe the four components of an accounting policy. Illustrate your answer with examples.

Accounting policies the following involve four components:

Definition – which element(s) of financial statements is recognised, e.g. recognising expenditure on building improvements as an asset; Recognition – when the item is to be recognised, e.g., recognising cost of goods sold as an expense when goods are delivered to the customer; Measurement: how should it be measured, e.g., whether to measure an asset at cost or fair value, how to measure depreciation; and Disclosure: how information should be presented and disclosed, such as whether to disclose the useful life of an asset.

• Differentiate normative accounting theory from positive accounting theory. Provide an example

of each

A normative theory prescribes what should be done based on a specific goal or objective. The outcome of a normative theory is derived from logical development based upon a stated objective; e.g., the Conceptual Framework prescribes principles, such as recognition criteria for elements of financial statements, based upon an explicit objective of financial reporting. In contrast, the role of a positive theory is to describe, explains or predict. For example, agency theory is a positive theory because it is used to explain why managers prefer accounting policies that increase profit in certain situations, such as when there is a bonus plan linked to accounting profit.

• What is the difference between the deductive an inductive processes of developing a theory?

Developing a theory using inductive reasoning commences with observing definable activities and actions, which form the basis for inferring the principles that conform to the observations. The theorist would then attempt to infer higher-level assumptions and objectives.Developing a theory using deductive reasoning commences with setting objectives, which may be based on assumptions. For example, an objective of providing information that is useful for decision making involves assumptions about the users of financial statements and their information needs for decision making. Principles, (e.g., information should be faithfully represented) are derived logically from both the objectives and the assumptions. Definitions and observable actions are, in turn, derived from the principles.Thus, under inductive reasoning, observations of practice lead the development of principles. However, under deductive reasoning, the objectives and principles lead to the actions prescribed by the theory.

• What is an agency relationship? Explain how monitoring costs, bonding costs and residual loss

arise in agency relationships.

An agency relationship occurs when one party, who is referred to as the principal, employs another party, the agent, to undertake some activity on their behalf. Costs incurred by the principal to observe, evaluate and control the agent’s behaviour are referred to as monitoring costs. Examples of monitoring activities incurred by shareholders to monitor management include having the financial statements audited. Bonding costs are those costs incurred by the agent to provide assurance to the principal that they are acting in the principal’s best interests. The time and effort expended in producing and providing quarterly accounting reports to lenders is an example of bonding costs. Residual loss is the reduction in value of the firm that results from the separation of ownership of control, when the marginal cost exceeds the expected benefit of additional monitoring and bonding.

• Why would managers interests differ from those of shareholders?

Agency theory assumes that parties, such as manager and shareholders, will act in their own interests.Accordingly, given separation of ownership and control managers are expected to act in their own interests through excessive consumption of perquisites and avoidance of effort. The interests of managers and shareholders can also diverge because managers have shorter horizons in evaluating decisions, are more risk aversion and prefer dividend retention.

Solutions Manual to Understanding Australian Accounting Standards © John Wiley and Sons Australia Ltd 2013 2.2

• Explain the following agency problems that can arise in the relationship between owners and

managers

• the horizon problem
• risk aversion
• dividend retention

a) Shareholders are concerned with the long term growth and value of the firm, which reflects the

market’s expectations of the present value of the future cash flows. However, management’s interest in the cash flow potential may be limited to the period over which they expect to be employed by the firm. This horizon problem is exacerbated by approaching retirement. Managers generally adopt a shorter horizon than shareholders when evaluating proposed actions or investments, e.g., delaying research and development expenditure may increase short-term profitability but have adverse long-term consequences.

b) Managers are generally more risk averse than shareholders because managers are less able to diversify

risk. Shareholders typically spread their investment (and hence, their risk) across a range of securities and other assets. Their liability is limited to the unpaid capital on their shares. Shareholders may also receive income from sources, such as employment, that are independent of the company. Managers, however, have less diversifiable ‘human’ capital invested in the company. Their management compensation (remuneration) is likely to be their primary source of income.

c) Managers’ prefer to maintain a greater level of funds within the company through dividend retention.

This helps managers to expand the size of the business they control (empire building) and to pay their own salaries and benefits. Shareholders, on the other hand, may have a preference for increased dividends.

• Outline the four agency problems that can arise in the relationship between lenders and

managers.

Four agency problems that can arise between lenders and managers include: excessive dividend payments to owners; asset substitution; claim dilution; and underinvestment.Management may pay excessive dividend, which can leave the company with insufficient funds to service the debt. To reduce this problem managers and lenders agree to covenants that restrain dividend policy and restrict dividend payouts as a function of profits.Asset substitution refers to management investing in riskier assets after the loan has been arranged, e.g., borrow money to invest in local production facilities but actually spending it on overseas investments with additional foreign currency risk. Managers may use the debt finance to invest in alternative, higher risk assets in the likelihood that it will lead to higher returns to shareholders. Lenders bear the risk of this strategy as they are subject to the increased risk of default, but do not share in any benefit in the form of higher returns if the investment project becomes more successful.Claim dilution arises when firms take on debt of an equal or higher priority. For example, after obtaining an unsecured loan, management might obtain additional loan funds by offer floating charge over its working capital to another lender. This reduces the assets available to unsecured creditors in the event of default.Lastly, underinvestment can arise if the borrower is struggling to repay the principal and interest components of debt. Extra cash flows that might be generated by additional projects would go to repaying the debt rather than increasing shareholder wealth because creditors rank above shareholders in order of payments.Thus any funds generated by these projects would go towards debt rather than equity if the company were liquidated. Managers, acting on behalf of owners, may lack incentive to undertake projects that could lead to increased funds being available to lenders.

• What is a debt covenant and why are they used in lending agreements?

Debt covenants are restrictions or undertakings imposed in debt contracts. Debt covenants reduce the risk to the lender, resulting in lower interest costs being imposed on the borrower. Some debt covenants use accounting numbers. For example, a debt covenant may restrict leverage to 60 per cent of total assets. By agreeing to debt covenants, managers may be able to borrow funds at lower rates of interest.Debt contracts will often restrict investment opportunities of the firm, including mergers and takeovers, to protect themselves against the additional risk arising from asset substitution. Establishing a minimum ratio of debt to tangible assets can also mitigate asset substitution by restricting investment in intangible assets.Restricting higher priority debt is a common method of reducing the risk of claim dilution.

• Why would managers agree to enter into lending agreements that incorporate covenants?

Chapter 2: Application of Accounting Theory

© John Wiley and Sons Australia Ltd 2013 2.3

Lenders expect to be compensated for risk. Debt covenants reduce the risk to the lender and thus result in lower interest costs being imposed on the borrower. As a result of agreeing to debt covenants, managers may also be able to borrow more funds and/or for longer periods.

• How does accounting information reduce agency problems in relationships between

management and shareholders?

Accounting information is used in contracts that are designed to agency problems in the relationship between shareholders and management. For example, a bonus may be calculated as a percentage of profit. Accounting information is also used to monitor performance. For example, performance indicators, such as return on shareholders’ equity, are used in determining whether a manager has met performance targets.

• How does accounting information reduce agency problems in relationships between

management and debtholders?

Accounting information is used in debt covenants to reduce the risk to the lender. For example, a debt covenant may restrict leverage to 60 per cent of total assets, thus reducing the lender’s risk of claim dilution. Debt covenants may also restrict dividend payouts as a function of profits, again using accounting information.

• What are the factors a manager might consider in making various expensing-capitalisation

choices?

While accounting standards play a very important role in determining accounting treatment, this does not remove the need for professional judgement in the application of accounting principles. According to agency theory, the application of judgement in accounting policy choice may be influenced by incentives arising from the economic consequences, particularly in relation to the outcomes for contracting parties. In deciding whether to account for an item expenditure (e.g., cost of maintenance which also enhances the efficiency of the asset) as an asset or an expense, management may consider the effect of the alternative accounting treatments on their remuneration, the firm’s proximity to debt covenants, and the political visibility of the firm.

• Linking managerial remuneration to firm performance motivates managers to act in the

interests of shareholders. However, it also burdens managers with greater risks than they may like. How do organisations balance these two considerations in management remuneration plans?

Management compensation packages typically comprise fixed salary and at-risk components. The at-risk remuneration refers to that part of a manager’s income which is subject to meeting or maintaining performance targets. Also, some remuneration schemes link at-risk remuneration to performance over a longer period, which reduces the risk borne by management for intermittent fluctuations in performance over a period of several years. Benchmarking against other firms or the industry can also be used in compensation arrangements to reduce the manager’s exposure to industry-wide risks.

• Bonus plans are used to reduce agency problems between managers and shareholders. Discuss

two (2) of these problems specific to the relationship between shareholders and managers and identify how bonus plans can be used to reduce the agency problems you have identified. In your answer you should provide examples of specific components that may be included in a bonus plan to address the issues identified.

While all three problems that can arise in the shareholder-manager agency relation are considered in this solution, students need only address two of them in answering the question.Managers generally adopt a shorter horizon than that of shareholders in making decisions about various courses of action the company may take. The horizon problem can be reduced by linking management rewards to the company’s performance over a longer period, for example, through share-based remuneration, such as shares or executive share options. Paying a portion of managerial remuneration as shares provides management with an incentive to focus on long-term performance because it is likely to affect their own wealth.Managers’ prefer to maintain a greater level of funds within the company, thus increasing their power and prestige, whereas may have a preference for increased dividends. The dividend retention problem can be mitigated by aligning the interest of managers with those of the firm through the use of incentive-based