For the purposes of this assignment, you will assume questions one and two are set in 2019. You will also assume that AASB 15 is operational. When dealing with revenues and incomes, you will not consider other accounting rules, unless AASB 15 specifically directs you to do so.
You will assume all other accounting rules currently issued are unchanged in 2019. That is, you do not have to worry about proposed changes or recent changes to rules, such as IFRS 16, the new accounting standard on leases. Your company’s financial year ends on December 31 in all questions.
Question 1 (30 marks)
You are an internal auditor at a company which produces household appliances, such as irons and microwave ovens. The last couple of years have been very hard for the company and the board of directors sacked the Chief Executive Officer (CEO) in May 2018. The new CEO took over in August 2018, sacked most of the remaining senior managers and brought in his own team. The new CEO promised to turn the company around.
When Al, the new CEO, took over, he indicated that he would close down all the production lines based in Adelaide. This represents about 30 percent of all the company’s production lines. All inventory from these product lines would be disposed of via liquidation sales. This announcement was made in the national media in November 2018. At that time, the carrying amount of this inventory was $3.5m and its estimated NRV was $1m. Due to a variety of reasons, none of these liquidation sales took place in 2018. In addition, Al demanded another $2m write down on inventory product lines that would be retained. The $2m write down raised some questions, as this inventory had been selling well all year and there were no indications of problems with expected demand levels or pricing of these items. Al said it was important to be conservative, as he did not want to be accused of overstating an important asset class.
As part of the same announcement in November 2018, Al stated that closing the production lines was an element of a restructure of the company. Relevant staff were notified in November 2018 that their employment with the company would cease in January 2019. This component of the restructuring is estimated to cost $25m. The company recognised this in the annual report for the year ended 2018.
In addition, the senior managers decided to restructure the company by removing many mid-level managers in 2019 and 2020. This was not announced publicly by December 31 2018, as the details were still being worked out. However, Al demanded the company recognise a provision of $10m in 2018 for these expected redundancies.
Finally, Al required the company to record a provision of $1.5m in 2018 for some environmental damage that occurred in 2016 when company staff spilled some chemicals onto the ground, which killed some trees and poisoned a pond on the company’s property. However, the chemicals did not have a long term effect and the spill did not breach any laws. The company has not indicated publicly that it will repair the damage and it does not have a history of doing this. This is the first time the impact of the spill was reflected in the company’s books.
a) Prepare the journal entries for the year ended 31/12/2018 according to Al’s wishes.
b) Analyse whether these journal entries comply with relevant accounting rules. You must justify your answers with reference to the specific rules (AASB XXX, para y). If you think there is ambiguity, identify the different treatments, and the specific issues giving rise to this ambiguity. (12 marks)
c) Your manager has a feeling Al is playing a dirty game with the accounting figures. However, Al has made a number of statements saying that he prefers to be conservative, in order to protect the shareholders from unpleasant surprises. Discuss whether you think Al is doing the right thing, by being conservative, or whether he is playing a dirty game. You must justify your response by referring to the accounting rules and the conceptual framework. Your manager suggests a good way to address this issue would be to prepare some journal entries, based on feasible scenarios, for what might happen in 2019 and 2020. (10 marks)
Question 2 (30 marks)
This question also relates to Al and the same company. In August 2019, Kelly Ltd contacted the company and made the following proposal. Kelly said that it wanted to ensure supply of its inventory from the company, particularly for the Christmas sales season, so it wanted to place a large order in September 2019 (7,000 units with a total cost to Kelly of $486,000). These units had cost the company $130,000 to make). However, Kelly does not have adequate storage to hold all the extra inventory, so it asked if the company could hold this inventory for Kelly and deliver it when needed. Kelly was happy to pay $40,000 for this. The company agreed to this, a contract was signed and Kelly received an invoice in late August 2019. Kelly will pay for the storage as the inventory leaves the company’s warehouse. This inventory was placed in a locked section of the company’s warehouse, with a sign on the door indicating this was Kelly’s inventory and was not to be delivered to other customers. By the end of 2019, 80% of this inventory had been delivered to Kelly and paid for. Kelly had also paid for 80% of the expected storage costs. Kelly will pay for the remaining inventory and storage costs in January 2020.
In September 2019 Al decided to adopt the Kelly transaction, as it offered a way to increase sales and profits of the company. A senior sales manager contacted Lee Ltd., a major customer and made the following offer. If Lee increased its orders by 5 percent above the number of units purchased for the October – December quarter in the previous year, it would receive a 10 percent discount on the purchase price. Further, the company would hold on to the stock for Lee and deliver it when asked to. Al thought this would be attractive to Lee, as it would reduce its storage costs. If Lee did not accept this offer, it would be excluded from future special offers, such as discounts. You are advised that in the relevant quarter of the previous year, Lee bought 10,000 units of inventory. This many items currently cost the company $200,000 to make and have a gross selling price of $695,000. Al estimated that Lee will pay the company $50,000 to store the inventory. In September 2019 Lee indicated it would accept these terms, and increased its order for the October – December quarter by 5 percent, but that it was not happy with the threat. An invoice was issued to Lee by the end of September.
Al ordered that the Kelly transaction and the Lee transactions be recorded as sales in August and September 2019. The company uses the perpetual inventory system. You can ignore GST.
a) Prepare the journal entries that would have been passed in August and September, when Al ordered the transactions to be recorded, and the adjusting entries at December 31 2019 (assume all changes in the original entries happened at December 31 2019). (10 marks)
b) Prepare the journal entries that should have been passed in August, September, and December 31. You must justify your answer with reference to specific accounting rules (AASB XXX, para y, or something similar). If you think the journal entries in (a) are appropriate, you must state this and justify your answer. (20 marks)
Question 3 (40 marks)
Discuss whether there are theoretical explanations which would predict or would not predict Al’s behaviour in the two previous questions. (15 marks)
What implications, if any, arise in relation to the standard setting process? (25 marks)
You must conduct a literature review to address parts (a) and (b) of this question. You need to cite at least 8 relevant published studies. Please note, you must link the findings of the articles, and other literature, to the material presented in this assignment. If you just tell me what the articles said, without linking them to Al’s behaviour in the questions above, you can expect a very low score for this question (much less than 30%).
Marks will be awarded for the quality of your literature review, your ability to link the literature review to the questions asked, and your written communication skills.
Please use these references as below and with footnotes references
Leo, K., Knapp, J., McGowan S., and J. Sweeting (2015). Company Accounting, 10th Edition, John Wiley & Sons, Milton. This is our main book
You may also wish to consult the following:
The Accounting Handbook (2016).
Deegan, C. (2014). Financial Accounting Theory, 4th Ed., McGraw-Hill, North Ryde.
Gaffikin, M. (2008). Accounting Theory: Research, Regulation and Accounting Practice, Pearson Education, Sydney.
Deegan, C. (2012) Australian Financial Accounting. 7th Edition, McGraw Hill, North Ryde.
These are available from the university bookshop and in the library.
There is relevant research in this area that we will draw upon in the unit. The main journal databases for accounting (and these can be accessed through the library as well) include:
On ScienceDirect, you have access to major accounting journals including Accounting, Organizations and Society, Critical Perspectives on Accounting, the British Accounting Review and others. Use the advanced search function.
On Emerald, there are a number of accounting journals, but the most useful for this unit is Accounting, Auditing and Accountability Journal.
You can also access these through the library website.
Other leading accounting journals include: The Accounting Review, Journal of Accounting Research, Contemporary Accounting Review, Journal of Accounting and Economics.
Erickson, M., M. Hanlon, and E. Maydew. 2004. How much will firms pay for earnings that do not exist? Evidence of taxes paid on allegedly fraudulent earnings. The Accounting Review 79 (2):387-408.
Heron, R. A., and E. Lie. 2007. Does Backdating Explain the Stock Price Pattern Around Executive Stock Option Grants? Journal of Financial Economics 83:271-295.
Jensen, M. C., Meckling, W.H. 1976. Theory of the firm: managerial behavior, agency costs and ownership structure. Journal of Financial Economics 3:305-360.
Mills, L., and K. Newberry. 2005. Firms’ off-balance-sheet and hybrid debt financing: evidence from their book-tax reporting differences. Journal of Accounting Research 43:251-282.
Watts, R. L., J. L. Zimmerman. 1978. Towards a Positive Theory of the Determination of Accounting Standards. The Accounting Review LIII (1):112-134.
———. 1979. The Demand and Supply of Accounting Theories: The Market for Excuses. The Accounting Review LIV (2):273-305.
———. 1990. Positive Accounting Theory: A Ten Year Perspective. The Accounting Review 65 (1):131-156.
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