Question & Answer

Explain the guidelines for credit rating agencies that resulted from the Financial Reform Act of 2010. (LO2)

Remuneration disclosure The ASX Corporate Governance Principles and Recommendations set out rules to deal with enhanced management performance and effectiveness and requires disclosure of the process for performance evaluation of the board, its committees and individual directors and key executives. However, the outcomes of individual evaluations are not required to be disclosed.   Required Why do you think such a recommendation is included in the guidelines? (LO5)

What two assumptions are central to the IASB conceptual framework?

Explain how the downgrading of bonds for a particular corporation affects the prices of those bonds, the return to investors who currently hold these bonds, and the potential return to other investors who may invest in the bonds in the near future. (LO2)

Cost function using account analysis and high-low method The Elder Clinic, a not-for-profit entity, provides limited medical services to low-income elderly patients. The manager’s summary report for the past four months of operations is reproduced here.     The clinic receives an operating subsidy from the city, but unfortunately, the operating loss that has been incurred through June $(79 392) is larger than anticipated. Part of the problem is the salary increase that went into effect in June, which had been overlooked when the budget was submitted to the city last year. To compound the problem, the cold winter months traditionally bring with them an increase in cold-related health problems. Thus, the clinic is likely to experience an increase in patient visits during July.   The clinic’s managers are considering an increase in patient fees to reduce losses. However, they are reluctant to raise fees because the patients have low incomes. They will raise fees only if it is necessary.   Required (a)          Use your judgement to classify costs as fixed, variable, or mixed. Explain how you classified each item. (b)          Create a cost function for the Elder Clinic. Use the high-low method to estimate the function for any mixed costs. (c)           Use the cost function to estimate July expenses based on a projection of 940 patient visits. (d)          List reasons why management of the Elder Clinic cannot know with certainty what the expenses will be during July. List as many reasons as you can. (e)           Describe the pros and cons of using your cost estimate from part (C) to decide whether to raise patient fees. (f)           The managers need your July cost estimate to decide whether to raise patient fees. Use the information you learned from parts (a) and (b)  to write a memo to the director of the Elder Clinic presenting your estimate of July costs. Provide the director with appropriate information for understanding your methodology and evaluating the reliability of your cost estimate.

The pension fund manager of Utterback (a U.S. firm) purchased German 20-year Treasury bonds instead of U.S. 20-year Treasury bonds. The coupon rate was 2 percentage points lower on the German bonds. Assume that the manager sold the bonds after five years. The yield over the five-year period was substantially more than the yield the manager would have received on the U.S. bonds over the same five-year period. Explain how the German bonds could have generated a higher yield than the U.S. bonds for the manager, even if the exchange rate was stable over this five-year period. (Assume that the price of either bond was initially equal to its respective par value). Be specific. (LO2, LO5)

Wayne Cooper has some questions regarding the theoretical framework in which GAAP is set. He knows that the FASB and other predecessor organizations have attempted to develop a conceptual framework for accounting theory formulation. Yet, Wayne’s supervisors have indicated that these theoretical frameworks have little value in the practical sense (i.e., in the real world). Wayne did notice that accounting rules seem to be established after the fact rather than before. He thought this indicated a lack of theory structure but never really questioned the process at school because he was too busy doing the homework. Wayne feels that some of his anxiety about accounting theory and accounting semantics could be alleviated by identifying the basic concepts and definitions accepted by the profession and considering them in light of his current work. By doing this, he hopes to develop an appropriate connection between theory and practice. Instructions (a) Help Wayne recognize the purpose of and benefit of a conceptual framework. (b) Identify any Statements of Financial Accounting Concepts issued by the FASB that may be helpful to Wayne in developing his theoretical background.

Indicate how well the percentage-of-sales method and the aging method accomplish the objectives of the allowance method of accounting for bad debts.

{Planning} Alan inherited $100,000 with the stipulation that he “invest it to financially benefit his family.”  Alan and Alice decided they would invest the inheritance to help them accomplish two financial goals: purchasing a Park City vacation home and saving for their son Cooper’s education.     Vacation Home Cooper’s Education Initial Investment $50,000 $50,000 Investment Horizon 5 years 18 years   Alan and Alice have a marginal income tax rate of 30 percent (capital gains rate of 15 percent), and have decided to investigate the following investment opportunities.      5 Years Annual After-Tax Rate of Return 18 Years Annual After-Tax Rate of Return Corporate bonds (ordinary interest taxed annually) 5.75%   4.75%   Dividend-paying stock (no appreciation and dividends are taxed at 15%)   3.50%     3.50%   Growth stock Future Value is $65,000   Future Value is $140,000   Municipal bond (tax-exempt) 3.20%   3.10%     Complete the two annual after-tax rates of return columns for each investment and provide investment recommendations for Alan and Alice.

Balanced scorecard perspectives, performance objectives, and measures Perspectives, performance objectives and potential performance measures for the balanced scorecard at Holiday Resorts are as follows: Perspectives (i)         Financial (ii)        Customer (iii)       Internal business (iv)       Learning and growth   Performance objectives A.      Reduce housekeeping costs B.      Improve the quality of and results from advertising campaigns C.      Decrease vacancy rate during the off-season D.      Increase number of return customers E.      Increase overall profits F.      Increase the use of Internet-based reservations G.     Retain high-quality employees H.      Increase the number of activities available to customers I.       Improve the quality of stay for holiday makers J.       Provide employee training in quality customer service K.     Reduce error rate in reservations   Potential performance measures 1.       Operating margin 2.       Customer complaint rate 3.       Survey customers at check-in about how they first heard about the resorts 4.       Housekeeping cost per room 5.       Number of employee hours spent in training 6.       Error rate in reservation process 7.       Percentage of reservations made using the website 8.       Customer surveys about satisfaction and quality 9.       Employee turnover rates 10.     Number of activities per resort that are available to customers 11.     Percentage and number of return customers 12.     Number of hours of employee training offered 13.     Vacancy rates 14.     Customer focus groups inquiring about quality and potential success of advertising 15.     Number of suggestions that improve quality of service   Required (a)     For each perspective (i–iv), identify at least one appropriate performance objective (A–K). (b)     For each performance objective (A–K), identify at least one appropriate performance measure (1–15). (c)     Explain the links between the measures.

The Financial Accounting Standards Board (FASB) has developed a conceptual framework for financial accounting and reporting. The FASB has issued eight Statements of Financial Accounting Concepts. These statements are intended to set forth the objective and fundamentals that will be the basis for developing financial accounting and reporting standards. The objective identifies the goals and purposes of financial reporting. The fundamentals are the underlying concepts of financial accounting that guide the selection of transactions, events, and circumstances to be accounted for; their recognition and measurement; and the means of summarizing and communicating them to interested parties. The purpose of the statement on qualitative characteristics is to examine the characteristics that make accounting information useful. These characteristics or qualities of information are the ingredients that make information useful and the qualities to be sought when accounting choices are made. Instructions (a) Identify and discuss the benefits that can be expected to be derived from the FASB’s conceptual framework study. (b) What is the most important quality for accounting information as identified in the conceptual framework? Explain why it is the most important. (c) Statement of Financial Accounting Concepts No. 8 describes a number of key characteristics or qualities for accounting information. Briefly discuss the importance of any three of these qualities for financial reporting purposes.

Vedula Advertising Agency was founded by Murali Vedula in January 2009. Presented on the next page are both the adjusted and unadjusted trial balances as of December 31, 2014.   Instructions (a) Journalize the annual adjusting entries that were made. (b) Prepare an income statement and a retained earnings statement for the year ended December 31, and a classified balance sheet at December 31. (c) Identify which accounts should be closed on December 31. (d) If the note has been outstanding 10 months, what is the annual interest rate on that note? (e) If the company paid $10,500 in salaries and wages in 2014, what was the balance in Salaries and Wages Payable on December 31, 2013?

Midwest Enterprises made the following entry on December 31, 2014. Interest Expense 10,000 Interest Payable 10,000 (To record interest expense due on loan from Anaheim National Bank) What entry would Anaheim National Bank make regarding its outstanding loan to Midwest Enterprises? Explain why this must be the case.

Assume that the price of a good falls. How will an ‘efficient’ level of consumption be restored?

On July 31, 2014, Amsterdam Company engaged Minsk Tooling Company to construct a special-purpose piece of factory machinery. Construction was begun immediately and was completed on November 1, 2014. To help finance construction, on July 31 Amsterdam issued a $300,000, 3-year, 12% note payable at Netherlands National Bank, on which interest is payable each July 31. $200,000 of the proceeds of the note was paid to Minsk on July 31. The remainder of the proceeds was temporarily invested in short-term marketable securities (trading securities) at 10% until November 1. On November 1, Amsterdam made a final $100,000 payment to Minsk. Other than the note to Netherlands, Amsterdam’s only outstanding liability at December 31, 2014, is a $30,000, 8%, 6-year note payable, dated January 1, 2011, on which interest is payable each December 31. Instructions (a) Calculate the interest revenue, weighted-average accumulated expenditures, avoidable interest, and total interest cost to be capitalized during 2014. (Round all computations to the nearest dollar.) (b) Prepare the journal entries needed on the books of Amsterdam Company at each of the following dates. (1) July 31, 2014. (2) November 1, 2014. (3) December 31, 2014.

Developing a reward system Synergy Ltd’s incentive plan is based on a shared bonus pool. Return on investment (ROI) is used as the main performance metric and is calculated as: Operating profit before tax ÷ Assets at gross book value   Receipt of the incentive is dependent on the achievement of annual ROI targets. These targets were set in consultation with division managers. Moreover, the senior management team is rewarded on the basis of organisational ROI. The amount of bonus received by managers is determined as follows. The bonus pool is determined as:   $100 000 + 10% of increases in annual combined ROI   The bonus pool is shared 15 per cent to senior management (shared equally among 10 managers on the basis of organisational ROI), 50 per cent to divisional managers (shared among three managers according to divisional ROI) and 35 per cent to managers within the divisions (shared among 12 mangers according to divisional ROI). The bonus payment is in the form of cash. While some members of the management team have expressed concerns about the use of ROI as the key performance metric, the CEO is intent on keeping things simple and believes that ROI is a good summary measure on which to base senior management and divisional manager rewards. One of the senior managers, Sonia Lee, has become persistent in her objections to the current bonus scheme. She feels the scheme needs to reflect shareholder interests with suitable measures at each level of the company that reflect managers’ span of control and the right mix of incentives.   Required You have been asked to advise the board of Synergy Ltd on a possible new incentive plan that addresses the concerns of Sonia Lee. Prepare a report outlining the detail of your incentive plan. Make sure you explain how your plan addresses Sonia’s concerns.             (LO2 and 4)

What enables banks safely to engage in both maturity transformation and risk transformation?

Graber Corporation runs a long-haul trucking business. Graber incurs the following expenses: replacement tires, oil changes, and a transmission overhaul. Which of these expenditures may be deducted currently and which must be capitalized? Explain.

Discuss why an incentive package might include individual, divisional and        corporate-level performance targets.

Oscar, Felix, and Marv are all one-third partners in the capital and profits of Eastside General Partnership. In addition to their normal share of the partnership’s annual income, Oscar and Felix receive annual guaranteed payments of $7,000 to compensate them for additional services they provide. Eastside’s income statement for the current year reflects the following revenues and expenses: Sales revenue $ 420,000 Dividend income 5,700 Short-term capital gains 2,800 Cost of goods sold (210,000) Employee wages (115,000) Depreciation expense (28,000) Guaranteed payments (14,000) Miscellaneous expenses (9,500) Overall net income $ 52,000 In addition, Eastside owed creditors $120,000 at the beginning of the year but managed to pay down its liabilities to $90,000 by the end of the year. All partnership liabilities are allocated equally among the partners. Finally, Oscar, Felix and Marv had a tax basis of $80,000 in their interests at the beginning of the year. a. What tax basis do the partners have in their partnership interests at the end of the year? b. Assume the partners began the year with a tax basis of $10,000 and all the liabilities were paid off on the last day of the year. How much gain will the partners recognize when the liabilities are paid off? What tax basis do the partners have in their partnership interests at the end of the year?

What are postretirement benefits other than pensions?

Using the information in BE5-14, determine Martinez’s free cash flow, assuming that it reported net cash provided by operating activities of $400,000.

Why is austenitic stainless steel called by that name?

Merck & Co., Inc. and Johnson & Johnson are two leading producers of health-care products. Each has considerable assets, and each expends considerable funds each year toward the development of new products. The development of a new health-care product is often very expensive, and risky. New products frequently must undergo considerable testing before approval for distribution to the public. For example, it took Johnson & Johnson 4 years and $200 million to develop its 1-DAY ACUVUE contact lenses. Below are some basic data compiled from the financial statements of these two companies.   Instructions (a) What kinds of intangible assets might a health-care products company have? Does the composition of these intangibles matter to investors—that is, would it be perceived differently if all of Merck’s intangibles were goodwill than if all of its intangibles were patents? (b) Suppose the president of Merck has come to you for advice. He has noted that by eliminating research and development expenditures the company could have reported $4 billion more in net income. He is frustrated because much of the research never results in a product, or the products take years to develop. He says shareholders are eager for higher returns, so he is considering eliminating research and development expenditures for at least a couple of years. What would you advise? (c) The notes to Merck’s financial statements note that Merck has goodwill of $1.1 billion. Where does recorded goodwill come from? Is it necessarily a good thing to have a lot of goodwill on a company’s books?

Assume that you maintain bonds and money market securities in your portfolio, and you suddenly believe that long-term interest rates will rise substantially tomorrow (even though the market does not share the same view), while short-term interest rates will remain the same. a. How would you rebalance your portfolio between bonds and money market securities?  b. If other market participants suddenly recognize that long-term interest rates will rise tomorrow and they respond in the same manner as you do, explain how the demand for these securities (bonds and money market securities), the supply of these securities for sale, and the prices and yields of these securities will be affected. c. Assume that the yield curve is flat today. Explain how the slope of the yield curve will change tomorrow in response to the market activity. (LO2)