Assignment 2 — Session 2 (Winter)
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This assignment is based on Modules 1 through 7 and is due at the end of Module 7. It is worth 10% of your final course grade.
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Refer to the general instructions in Assignment 1.
Question 1 (20 marks)
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Empirical tests of the three hypotheses of positive accounting theory (PAT) are often based on the amount of discretionary accruals contained in net income.
Required
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a.
(4 marks)
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What are discretionary accruals? Why are they useful in testing the three PAT hypotheses?
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b.
(5 marks)
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The methodology designed by Jones (1991) (called the Jones Model) is usually used to estimate discretionary accruals. Outline in words how the Jones Model measures discretionary accruals.
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c.
(4 marks)
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For good corporate governance, contracts should be designed efficiently. A researcher finds, for a sample of firms, that the covenant slack in debt contracts (the difference between the critical value of a debt covenant ratio as specified in a debt contract and the value of that ratio on the borrower’s books on the date of the contract) is greater on average with greater variability over time of the debt covenant ratios. Is this finding evidence of efficient or opportunistic contracting? Explain your answer.
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d.
(7 marks)
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Discretionary accruals can be used opportunistically or efficiently. Conservative accounting can be regarded as a form of discretionary accruals because the firm chooses to report (that is, accrue) lower asset values and/or higher liability values. A researcher finds that firms with income escalator clauses in their debt contracts (an escalator clause increases the covenant level of net worth the firm is required to maintain under the contract by a percentage of reported net income) tend to use more conservative accounting than similar firms with no escalator clauses in their debt contracts. Is this finding consistent with efficient or opportunistic contracting? Explain your answer.
Question 2 (20 marks)
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Several accounting standards include ceiling tests (also called impairment tests).
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a.
(6 marks)
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What is a ceiling test? Identify two IASB accounting standards that contain a ceiling test and describe the test.
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b.
(6 marks)
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Ceiling tests are usually regarded in this course as one-sided examples of the measurement approach. However, they can also be regarded as examples of conservative accounting, as assets are written down but not written up. Ceiling tests are an example of conservative accounting. Why do bondholders favour ceiling tests? How do bondholders reward the firm for conservative accounting such as ceiling tests?
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c.
(4 marks)
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Explain briefly why auditors favour ceiling tests.
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d.
(4 marks)
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Outline the accounting for research and development (R&D) under IASB standards. Is this accounting conservative? Why? Explain why accountants account for R&D as they do.
Question 3 (22 marks)
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New Century Financial Corp., formed in 1995, was a large mortgage lender in the United States. Many of these mortgages were securitized and transferred to investors. New Century accounted for the proceeds of these securitizations as sales. However, New Century committed to buy back mortgages that became troubled within up to a year after transfer.
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New Century would retain some mortgages for itself (called retained interests), from which it would receive future cash flows. Also, the transfer agreements included the right to service the mortgages, for which New Century charged a fee. New Century valued these retained interests and servicing rights at current value, based on their discounted expected future cash flows. Thus, revenue from retained interests was recognized at the time of retention, and servicing revenue was recognized at the time of mortgage transfer. These policies required numerous estimates, and contrasted with a more conservative policy of recognizing revenues as cash flows from retained interests were received and servicing responsibilities rendered.
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The company’s share price increased dramatically, to a high of US$64 in 2004. Its reported net income reached $1.4 billion in 2005.
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However, New Century seriously underestimated the extent of its mortgage buybacks and resulting credit losses. Of $40 billion of mortgages granted in the first three quarters of 2006, it provided only $13.9 million for buybacks. Investor concerns about increasing buybacks rose in 2006 as the 2007-2008 market meltdowns approached. These buyback concerns added to concerns about early revenue recognition from retained interests and servicing. Also, the company failed to write down its retained interests as the current value of the underlying mortgages decreased.
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New Century was soon unable to borrow money to finance mortgage buybacks. Its shares lost 90% of their value, and the company was delisted from the New York Stock Exchange. In April 2007, it filed for bankruptcy protection.
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New Century’s auditor (KPMG) was drawn into the lawsuits that followed. KPMG denied liability, claiming that the provisions for buybacks were deemed adequate at the time, and blaming New Century’s failure on the market meltdowns of 2007-2008. In December 2009, the SEC filed civil fraud charges against three former executives of New Century, seeking damages and return of bonuses. Several other lawsuits followed. In November 2010, financial media reported final settlement of a class action lawsuit that included a payment of over $65 million by former company officers and directors, and a payment of $44.75 million by auditor KPMG.
Required
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a.
(4 marks)
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Use the concept of relevance to defend New Century’s policy of recognizing revenue as it securitized and sold mortgages. What was the policy’s major weakness?
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b.
(4 marks)
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Outline a more conservative accounting policy for New Century’s mortgage sale transactions. Consider both statement of financial position and net income effects of your policy.
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Hint: Read Theory in Practice 8.3, text page 314.
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c.
(6 marks)
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Use two characteristics of investor behaviour based on psychology to explain the rapid rise in New Century’s share price. Be sure to identify the specific behavioural characteristics you draw on in your answer.
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d.
(4 marks)
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Despite your answer in part (c), is the rapid rise in New Century’s share price necessarily inconsistent with (semi-strong) securities market efficiency? Explain.
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e.
(4 marks)
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Note that retained interests meet the definition of a financial instrument. How would these financial instruments be accounted for under IAS 39?
Question 4 (18 marks)
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Paul owns and operates a small, fast-growing business. He decides to hire a full-time manager. He will then take a year off to travel, and on his return will concentrate on the technical aspects of the business.
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Martha applies for the job. During her interview, Paul finds that Martha is risk averse, with utility for money equal to the square root of the dollar compensation received. She has reservation utility of 6 and is effort averse, with disutility of effort of 2 if she works hard (a1), and 1 if she does not work hard (a2).
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Paul’s business has, in previous years, earned net income before manager compensation of $800 75% of the time, and income of $0 25% of the time. Paul has taken courses in accounting and has always prepared the financial statements himself. Paul has always worked hard, and reckons that if he did not work hard net income would have been $800 only 20% of the time and $0 80% of the time. He expects this earnings pattern to continue into the future with a new manager. Paul realizes that he must motivate Martha to work hard, and offers her a one-year contract, with compensation based on a proportion of net income before manager compensation.
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Note: Take all calculations to two decimal places.
Required
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a.
(6 marks)
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What proportion of net income must Paul offer Martha so that she will accept the position and work hard? Show calculations.
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b.
(8 marks)
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Assuming that Martha accepts Paul’s offer from part (a), show calculations that verify she will in fact be motivated to work hard.
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c.
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