Financial Reporting: Ideal Market Conditions, Convertible Bond, Fair Value Accounting, Intangibles a

Ideal Market Conditions and Single Measurement Basis in Financial Reporting

Question 1

a) Given that in reality, ideal conditions of markets are unlikely to hold, critically appraise whether a single measurement basis in financial reporting is appropriate. Discuss the concept of ideal market condition as part of your answer.

b) Alley Ltd operates under ideal conditions of uncertainty. On January 1, 2020, Alley Ltd acquired an asset to be used in its operations. Its cash flows depend on the demand conditions. The machinery will last three years, at which time its salvage value will be £200. Alley Ltd financed the asset purchase by issuing ordinary shares. In 2020, net cash flows will be £2100 if the demand conditionsare favourable and £700 if they are unfavourable. In 2021, cash flows will be £1600 if the economic conditions are favourable, and £600 if they areunfavourable. In 2022, cash flows will be £2000 if the economic conditions are favourable, and £700 if they are unfavourable. Cash flows are received at yearend. In the first and second years (2020 and 2021), the probability that the economic conditions are favourable is 0.3 and 0.7 that they are unfavourable. Inthe third year (2022), the probability that the economic conditions are favourableis 0.4 and 0.6 that they are unfavourable. The interest rate in the economy is 9% in all three years. Alley Ltd pays a dividend of £200 at the end of 2020. In 2020, the demand condition is favourable. Demand conditions for 2021 and 2022 are not yet known. Prepare a statement of financial position (balance sheet) as at the end of 2020 and a statement of income for 2020.

Question 2

a) Money Ltd issued £3,000,000 of 6% convertible bond at par on 1st January 2019. Interest is payable in on 31 December each year and the bond has a three-year term. Each £3,000 bond can be converted at any time up to maturity for 1200 of £1 ordinary shares. If the conversion option is not taken up, they will be redeemed at par. The prevailing market interest rate for similar debt without conversion options is 8%. The company prepares financial statement to 31 December each year.

Calculate the separate components of the financial instrument on initial recognition;

Prepare an amortised cost table for the life of the financial liability;

Prepare the ledger account for the financial liability;

Prepare the relevant financial statement extracts for years 2019, and 2020;

Prepare the accounting entries on redemption if (a) the conversion is taken up; (b) the conversion option is not taken up.

Critics have blamed fair value accounting for amplifying the subprime crisis and for causing the 2007/08 financial meltdown. Critically appraise whether you agree/disagree with this statement.

Question 3

1. a) Drawing on prior earnings management literature, critically appraise managerial incentives in manipulating reported earnings.
2. b) ‘Not all earnings management activities are bad’ Using extant literature, evaluate whether you agree/disagree with this statement.

Question 4

‘The inadequate accounting treatment of internally generated intangibles leads to a misallocation of resources’. Using relevant academic literature, critically evaluate this statement.

Question 5

Critically appraise the benefits of international financial reporting convergence undertaken by IASB from the perspective of investors. Define the term ‘financial reporting convergence’ as part of your answer