Multiple Choice Questions

6.1. Historic cost accounting has been criticized as having a number of defects in times of rising prices. One of the main criticisms is that it fails to reflect the gain arising from borrowing in times of inflation. Which of the following statements best explains how companies gain from borrowing in times of inflation? A. The amount repayable under a loan does not increase over time as a result of inflation B. Interest rates are likely to be relatively low in times of inflation C. In times of inflation the likelihood that a company will default on a loan is significantly reduced D. Lenders are unlikely to require security for loans granted during periods of inflation Answer: A Explanation: Inflation helps companies to earn higher revenue utilizing same amount of resources while they have to pay the same amount of money as they stated during the signing of borrowing contract between the company and the creditor. 6.2. Some companies have chosen to incorporate the value of brands acquired on the balance sheet, without providing for annual amortization of these assets. Which of the following will not occur as a consequence of adopting such a policy? A. B. C. D. an improvement in net assets per share a reduction in the gearing ratio an improvement in return on capital employed an increase in shareholders funds

Answer: C Explanation: In reality adding the value of brands acquired increases the asset value though the value of brands acquired is intangible. It increases the value of the capital, and as a result return on capital employed reduces compared to other years. 6.3. Wellmax PLCs finance director wishes to report as high a figure for profit after tax as possible for the year-ended 30 September 2006. Which of the following decisions would she be unlikely to take, even if permitted by the companys auditors? A. revalue freehold land and buildings upwards to their current market value B. reduce the provision for bad debts C. to capitalize interest costs related to borrowings made to finance the construction of a new factory D. to increase the number of categories of overheads absorbed into the cost of production for the purposes of valuing closing stock Answer: D Explanation: In fact, increasing the number of categories of overheads absorbed into
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the cost of production is not going to change the overall value of closing stock as a result it not going to help to increase the profit after tax. 6.4. Which one of the following would be regarded as fraudulent? A. The absence of any provision for slow moving and obsolete stock B. The recognition of a proportion of the profit on a contract that has not been completed by the year-end C. The sale of goods to a customer close to the year-end, which the customer has not requested, on sale or return basis D. A change in the method for depreciating machinery from the reducing balance to the straight-line approach Answer: C Explanation: As customer has not requested the goods so it is obviously done by the executive to increase the net profit for the time being and perhaps to earn some extra bonus on sales. At the very beginning of next year the alleged executive might quit the job and the goods may return to company afterwards that is going to hamper companys financial state in both way. 6.5. Which of the following most closely explains what is meant by the term window dressing? A. Structuring transactions or making arrangements around the year-end so that the financial statements portray the business financial performance and/or position in a more favorable light B. Taking advantage of loopholes in accounting rules so that the financial statements portray the business financial performance and/or position in a more favorable light C. Deliberately falsifying accounting records so that the financial statements portray the business financial performance and/or position in a more favorable light D. Failing to prepare accounts which give a true and fair view Answer: A Explanation: Since window dressing involves dispatching goods at the end of the period knowing them to be defective so that they appear in the current years sales and accepting that they will be returned later in the next period.

6.6. Which of the following statements best describes the nature of creative accounting and window dressing? Legality Consistency with generally accepted
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accounting principles (GAAP) A. B. C. Window dressing is illegal Creative accounting is not illegal Window dressing is not illegal Creative accounting is illegal Window dressing is not illegal Creative accounting is not illegal Window dressing is not illegal Creative accounting is not illegal Answer: B Explanation: Since Creative accounting involves manipulating the accounting information and misrepresenting performance and position of the business, it absolutely illegal and contravenes GAAP principles. The window dressing is merely having some arrangement at the year end so that financial statement gives a favorable light to the financial position, thus though it is not illegal, but contravenes GAAP principle. 6.7 Which of the following are examples of window dressing rather than creative accounting? 1. A company changes its year-end to a date which coincides with a time of year when the companys inventory levels are at a seasonally low level 2. A company with a 31st December year-end persuading the bank to grant a 13 month short-term loan on 28th December rather than its standard 12 month loan. 3. A company with a 30 June year-end persuades a major customer to place an order on 29th June rather than 16th July as usual, and granting 2 months extra credit in return A. B. C. D. 1 and 2 only 2 and 3 only 1 and 3 only 1, 2 and 3 Window dressing contravenes GAAP Creative accounting contravenes GAAP Window dressing contravenes GAAP Creative accounting contravenes GAAP Window dressing contravenes GAAP Creative accounting does not contravene GAAP Window dressing does not contravene GAAP Creative accounting does not contravene GAAP

D.

Answer: B Explanation: Since window dressing involves having some transactions at the year end so that the sales and profit figures give a favorable number, the placement of order and granting 13 months loan before the year end clearly overstate the revenue figure. But the having inventory at low level does not comply to the overstatement of revenue.

6.8. Which of the following is not an example of a method used in the past by companies to achieve off-balance sheet financing? A. The sale of commodity stocks with an option to repurchase at a later date at a marginally higher price B. The holding of consignment stock which the company is effectively committed to purchasing C. The purchase of a non current asset via a leasing arrangement D. A guarantee given by the parent company for the loans of its subsidiaries Answer: A Explanation: As the contract is an option so company may not wish to repurchase it. By the mean time company does not have any responsibility according to the agreement. So it cannot be used as an off-balance sheet financing.

Exercise 1: Inflation accounting

What are the main defects of historic cost accounting in times of inflation? Ans: One of the most important conventions of Accounting is Historic Cost Convention. It holds that the value of asset shown on the statement of financial position should be based on their acquisition cost which is the historic cost. The other method to value the asset is based on measuring of current value. In todays world, Inflation has been the most persistent problem. This has meant that the value of money has declined in relation to other assets. In past years, high rates of ination have resulted in statements of nancial position which were prepared on a historic cost basis reecting gures for assets that were much lower than if current
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values were employed. Rates of ination have been relatively low in recent years and so the disparity between historic cost values and current values has been less pronounced. Nevertheless, it can still be signicant and has added fuel to the debate concerning how to measure asset values on the statement of nancial position. a) What are the main features of Current Purchasing Power accounting (CPP) and Current Cost Accounting (CCA)? Ans: The main features of Current Purchasing Power accounting (CPP) are: 1. It seeks to protect the general purchasing power of the owners investment, so that the owners would still have the same command over goods and services generally. 2. It is often commended for its reliability. 3. It abandons money as the unit of measurement. Instead, items are expressed in terms of pounds of current purchasing power. 4. If the CPP approach is adopted, it can only provide information in the form of supplementary reports. The conventional nancial statements, on which the CPP adjustments are based, will remain the centerpiece of nancial reporting. The main features of Current Cost Accounting (CCA) are: 1. It seeks to maintain the scale of business operations, so that the business can continue operating at the same level. 2. It is often commended for its relevance. 3. It continues to use money as the unit of measurement. (A consequence of using different measurement units is that the prot calculated under each approach cannot be easily compared.) 4. CCA nancial statements, on the other hand, could replace, rather than be supplementary to, the conventional nancial statements. Choosing between the two approaches will inevitably involve a value judgment as to whether it is the owners investment or the business entity that is of paramount importance. It could be argued that the two approaches are not mutually exclusive and that annual nancial reports could incorporate both. In other words, the business could produce CPP, CCA and historic cost nancial statements. This would provide users with a fuller picture. This, however, ignores, or at least underplays, the reporting costs involved and the problems likely to be created for less sophisticated users of nancial statements.

Exercise 2: Creative accounting and window dressing

a) Explain what is meant by creative accounting and window dressing. Ans: There are several accounting rules and independent checks, but still concerns prevail about the quality of published financial statement. This is because Directors seldom apply particular accounting policies or structure particular transactions in such a way that it portrays a financial condition that they want to show to public. This is
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not in line with the fair and true view. This misrepresentation of the performance and position of a business is referred to as creative accounting and it poses a major problem for accounting rule makers and for society generally. This misrepresentation often involved the overstatement of revenues and assets with inventory fraud featuring frequently assets were overstated by understating allowances for receivables, overstating the value of inventory and other tangible assets, and recording assets that did not exist. There is a frequent fraudulent phenomenon in business which is called window dressing. It involves dispatching goods at the end of the period knowing them to be defective so that they appear in the current years sales and accepting that they will be returned later in the next period. b) i) What are the three main motives for creative accounting? There are many motives behind engaging in creative accounting: One of the main motives of creative accounting is designed to overstate the revenue for a period. These methods often involve the early recognition of sales revenue or the reporting of sales transactions that have no real substance. Another main motive of creative accounting focuses on the activity to manipulate expenses. Those expenses that rely on directors estimates of the future or their choice of accounting policy are particularly vulnerable to manipulation. This method involves changing estimates about the future residual value of asset, changing accounting policies and incorrect capitalization of expenses. The other main motive of creative accounting is to conceal losses or liabilities. The nancial statements can look much healthier if these can somehow be eliminated. One way of doing this is to create a separate entity that will take over the losses or liabilities.
ii)

Identify and explain at least three examples of how in the past each of the three main motives for creative accounting has been sought to be achieved.

Overstatement of revenue 1. Hollow swaps: telecoms companies sell useless fiber optic capacity to each other in order to generate revenues on their income statements. Example: Global Crossing. 2. Channel stuffing: a company floods the market with more products than its distributors can sell, artificially boosting its sales. SSL, the condom maker, shifted 60 million in excess inventories on to trade customers. Also known as trade loading. 3. Round tripping: also known as in-and-out trading. Used to notorious effect by Enron. Two or more traders buy and sell energy among themselves for the same price and at the same time. Inflates trading volumes and makes participants appear to be doing more business than they really are. Manipulation of Expense 1. One particularly notorious case of capitalizing expenses is alleged to have
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occurred in the financial statements of WorldCom (now renamed MCI). This company, which is a large US telecommunications business, is alleged to have overstated profits by treating certain operating expenses, such as basic network maintenance, as capital expenditure. This happened over a fifteenmonth period during 2001 and 2002. To correct for this over-statement, profits had to be reduced by a massive $3.8 billion. Concealment of losses or liabilities 1. Perhaps the most well-known case of concealment of losses and liabilities concerned the Enron Corporation. This was a large US energy business that used special purpose entities (SPEs) as a means of concealment. SPEs were used by Enron to rid itself of problem assets that were falling in value, such as its broadband operations. In addition, liabilities were transferred to these entities to help Enrons statement of financial position look healthier. The company had to keep its gearing ratios (the relationship between borrowing and equity) within particular limits to satisfy credit-rating agencies and SPEs were used to achieve this. The SPEs used for concealment purposes were not independent of the company and should have been consolidated in the statement of financial position of Enron, along with their losses and liabilities. When these, and other accounting irregularities, were discovered in 2001, here was a restatement of Enrons financial performance and position to reflect the consolidation of the SPEs, which had previously been omitted. As a result of this restatement, the company recognized $591 million in losses over the preceding four years and an additional $628 million worth of liabilities at the end of 2000. The company collapsed at the end of 2001 iii) For each example, explain the extent to which current IFRS accounting rules reduce the potential for such creative accounting.

The following procedures can be followed according to IFRS to reduce the potential for creative accounting: 1. There should be a focus on cash flow rather than income numbers. If there is a close attention to the cash flow, it becomes hardly impossible to hide numbers there. The two most common ways to alter financial statements is to either create fictitious revenue or to shift revenue or expenses to a different period than the one where they actually happened. By looking to cash flow and check statements, one can easily verify dates and compare numbers. 2. There should be more than one person in charge of the accounting. Rather than having a single person or even a couple working in a shared office, there should be a step system, in which financial statements are reviewed and processed by a series of different people in separate areas of the company. This will make it harder for somebody to change numbers without being caught later on in the process. 3. The investors and partners should never be capable of mixing company business with personal investments. Its easy to hype sales or revenues if a partner is investing his own money to buy shares or fund purchases that ultimately benefit the company. This is especially important if all the sales happened within a short period of time, before the company went up for sale or changed from private to be publicly listed.
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4. There should be an independent auditor to go over the statements after they have been tallied up by employees. Bringing an outsider into the mix is an almost fool-proof way of stopping creative accounting, as people inside the company would usually not risk being found out.

Exercise 3: Quick Buck plc

Quick Buck plc is a manufacturer of washing machines. The draft accounts show a pre-tax profit of 50m. 2010 was a difficult trading year and the finance director is concerned that the company will fail to achieve a 55m profit forecast which stock market analysts are expecting. He therefore believes that the accounts for the yearended 31st December 2010 should show the highest profit possible. A new managing director has recently taken over, however, and he believes that all the bad news should be taken in the 2010 accounts (so that the performance of the company under his reign can look all the more impressive). Bill Bodgitt, the company accountant, has prepared the draft financial statements, which show a pre-tax profit of 50m, but is having a little difficulty with some of the more subjective issues that have arisen. The issues are set out below. Required: You are required to deal with each of the following 4 accounting issues facing Quick Buck plc from one of three perspectives: - the auditors - the finance director - the managing director

1. Non-current assets repair and maintenance equipment

On 1st January 2009 the company spent 12m acquiring 500 special machines for repairing and maintaining the companys products. The machines were originally expected to have a useful economic life of 3 years and a zero residual value. However, partly because when the companys washing machines break down they are normally beyond repair, the machines are in near perfect condition. The technical manager believes the equipment will last for a further 10 years. Unfortunately, however, a recent non-current asset audit could only account for 375 of these machines. In the draft accounts, no depreciation charge with respect to these machines has been made for 2010, and therefore the machines are currently shown at a Net Book Value of 8m. Requirement: At what value should the companys repair and maintenance equipment be shown in the balance sheet?

Answer: a) Auditors Book Value at the end of December 31, 2010 Write off (Lost 125 machines) New Book Value at the end of December 31, 2010 Depreciation for the year 2010 (50% of Current BV) [Assuming Economic Life is 3 years as stated] Current Book Value at December 31, 2010 b) Finance Director Book Value at the end of December 31, 2010 Write off (Lost 125 machines) (Million ) 8 (2) (Million ) 8 (2) 6 (3) 3

New Book Value at the end of December 31, 2010 6 Depreciation for the year 2010 [{100/(10+1)%} of Current BV] (0.546) [Assuming Economic Life time is further 10 years as stated by Technical Manager] Current Book Value at December 31, 2010 5.454
c)

Managing Director (Million ) 8 (2)

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Book Value at the end of December 31, 2010 Write off (Lost 125 machines)

New Book Value at the end of December 31, 2010 Depreciation for the year 2010 (50% of Current BV) [Assuming Economic Life is 3 years as stated] Current Book Value at December 31, 2010

6 (3) 3

Notes: a. Auditors have identified only 375 of the machines as the non current assets. So, there is a loss of 125 machines. So, ultimately at the year end, they have 3/4th of the machines intact. These machines have a value of 3/4 X 8 million = 6 million. Moreover, depreciation has been charged considering a total life time of 3 years. As depreciation for the year 2009 has already been accounted for, depreciation expense for the year 2010 is = 50% X 6 million = 3 million So, the current book value of those machines as of December 31, 2010 = 6 million- 3 million = 3 million b. The technical manager believes the equipment will last for a further 10 years. So, the total economic life will be 11 years (as the year 2010 has already passed). So, depreciation charged for the year 2010 = 6 million/11 = 0.546 million. As a result, from the perspective of the finance director the current book value of this asset is 5.454 million (= 6 million- 0.546 million) at the year end. c. The book value of the machines from the perspective of Managing Director will be same as that of the Auditor.

2. Inventory
Included within the companys inventory is 10m relating to 100,000 units of an old line of washing machines that was popular in the 1990s but much less so today - the C5 model. The selling price of these models is 125 per unit. These are currently selling at a rate of around 10,000 units per year. The marketing director believes they could all be sold relatively quickly if priced at 50 each. No provision has been made with respect to this stock. Requirement: At what value should the inventory of C5s be shown in the balance sheet? Answer: a) Auditors Value of Inventory at the end of December 31, 2010 Value of Inventory at the end of December 31, 2010 (Million ) 10 10
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b) Finance Director Value of Inventory at the end of December 31, 2010 Value of Inventory at the end of December 31, 2010
c)

(Million ) 10 10 (Million ) 10 (5) 5

Managing Director

Value of Inventory at the end of December 31, 2010 Write off due to revaluation (Lost 50% value) New Value of Inventory at the end of December 31, 2010

Notes:
a.

Value of closing inventory should be recorded as per the book value. There is no relationship of selling price with the valuation of inventory. According to IAS, the cost of inventories shall comprise all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition. So, from the auditors point of view the value of inventory at the end of December 31, 2010 should be 10 million which is equal to the book value.

b. The finance director will also evaluate the inventories according to the book value.
c.

The new Managing Director will not agree to suffer a loss with the valued stock. If he doesnt do so, the company might undergo a loss of 50% under his reign. This is why the new Managing Director will consider the value of inventories according to the current selling price. So, the new value of inventory at the end of December 31, 2010 will be 5 million.

3. Receivables
The company is owed 70m by receivables at the year-end. The aged-receivables analysis reveals: Within 1 month 1 2 months 2 3 months 4 6 months 6 12 months 20m 10m 13m 12m 10m
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Over 12 months

5m

Quick Buck normally offers 2 months credit to its customers. The company is owed 3m by a major customer, The Honest Nick Leasing Company, which went into liquidation on 5th January 2011. (2m is included in the 6 12 months category and 1m in the 1- 2 months category). During 2010, the company recruited a new credit controller, Brian Damage. Although Brian has made some progress with the receivables under 1-year old, the older receivables have proved more difficult to clear. No provision for bad debts has been made in arriving at the draft profit for 2010.

Requirement: At what value should the companys receivables be shown in the balance sheet? a) Auditors Value of Receivables at the end of December 31, 2010 Write off of Receivables not recovered for 12 months or over Value of Receivables at the end of December 31, 2010 b) Finance Director Value of Receivables at the end of December 31, 2010 Value of Receivables at the end of December 31, 2010 c) Managing Director Value of Receivables at the end of December 31, 2010 Write off of Receivables not recovered for over 2 months New Value of Inventory at the end of December 31, 2010 (Million) 70 (40) 30 (Million) 70 70 (Million) 70 (5) 65

Notes:
a.

As the company has a policy of extending credit for 2 months, the auditor will consider any credit beyond 12 months as bad debt, so total receivables will be = 70 million 5 million = 65 million The finance director will want to maximize profit, so he will not want to
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b.

declare any receivable as bad debt, and calculate the receivables as 70 million.
c.

The new Managing Director will not agree to risk suffering a loss with the receivables. So the new Managing Director will want to consider any receivables due over 2 months as bad debt to avoid probable loss. So, according to the new Managing Director, the new value of receivables at the end of December 31, 2010 will be = 70 million 40 million = 30 million

4. Advertising accrual In December 2010, the company began a major television, billboard and media advertising campaign. The total cost of the campaign will be 8m (2m of which is the up-front cost of production). This relates to a 4-month campaign from December 2010 to March 2011 inclusive. No payments had been made with respect to this campaign during 2010 and no entry has been made in arriving at the draft profit for the year. Requirement: What accrual, if any, should be created with respect to the companys advertising campaign? a) Auditors Total cost of the campaign Up-front cost of production Monthly cost for December, 2010 Accrual advertising cost as of December 31, 2010 b) Finance Director Total cost of the campaign Up-front cost of production Accrual advertising cost as of December 31, 2010 c) Managing Director Total cost of the campaign (Million) 8 (Million) 8 2 2 (Million) 8 2 6/4=1.5 3.5

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Accrual advertising cost as of December 31, 2010

Notes:
a.

From the total cost of 8 million, 2 million is upfront cost of production, and the rest (6 million) is for running the campaign for 4 months, so this cost is equally distributed over 4 months. So, the auditor will calculate the accrued cost = 2 million + 6 million/4 = 3.5 million The finance director will want to maximize profit, so he will argue that only the upfront cost of production has been accrued, and the rest will be accrued in the future. So, according to the finance director, the accrued cost = 2 million. The new Managing Director will want to consider any cost accrued in this fiscal year if possible. He will propose to consider all the expenses accrued in this year. So, according to the new Managing Director, the accrued cost = 8 million.

b.

c.

Summary of Decisions Auditor NBV of repair and maintenance equipment Value of C5 inventory Receivables (net of provision) Advertising accrual 3 million 10 million 65 million 3.5 million Finance Director 5.454 million 10 million 70 million 2 million Managing Director 3 million 5 million 30 million 8 million

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