General instructions

General instructions

A. If this is your first time using the Online Learning Environment, check out the Course Orientation and the quick tutorials in the Support Centre. You
will find general assignment FAQs in your Assignment Submission/Group Work area.

B. Prepare your answers to these assignment questions in Word and save them as one Word document on your hard drive. For the recommended format and
filename, see the Assignment Submission/Group Work/FAQ area. If this assignment Word file requires you to paste Accpac.RTF reports, Excel.xls sections, or
other files, you are strongly advised to refer to How To/Use Software/Excel and/or How To/Use Software/Word, to ensure you successfully submit your
completed assignment.

C. When your file is complete and you are ready to submit it for marking, select your Assignment Submission/Group Work area. For help, refer to the quick
tutorial “Submit assignments.”

Follow these steps to ensure that your marker receives your assignment:

• Select the Grade Centre link.
• Select the exclamation mark (!).

· In the section “Your work,” select the file. If you can view the unmarked assignment, it is okay. If you are unable to view the assignment, contact your
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D. For Excel or Accpac data files, you must download and unzip the data files for the course. See the instructions on the Data files page under the Course
Modules tab, and click on the session 2 data files link.

E. For questions involving mathematical calculations, you must show your calculations to receive maximum marks. For questions with computer components,
follow the given procedure.

F. Adopt a consistent approach to rounding in your calculations. Here are some general guidelines:

· Round all currency numbers to two decimals.

For $ million, you may omit decimals. For example, $18,824.68 × 542 = $10,202,976.56. You may round this to $10,202,977.

If the unit is in thousands of dollars, calculate it as $18.82 (thousand) × 542 = $10,200.44 (thousand).

If you are asked to state the result of the multiplication in $ million, you would respond $10.20 million.

· Round all other numbers to a minimum of four decimal places (unless otherwise directed in the question). For example, if a share is trading at a price
per share of $27.25 and has earnings per share of $3.89, then the stock has a price-earnings ratio of $27.25 ÷ $3.89 = 7.0051 and an earnings-price ratio
of $3.89 ÷ $27.25 = 0.1428 or 14.28%.

When in doubt, err on the side of greater accuracy.

Question 1 (17 marks)

HiSpeed Ltd. plans to manufacture cross-country skiing equipment. Its cash flows are highly dependent on the weather in early winter. HiSpeed operates
under ideal conditions of uncertainty. On August 1, 2014, the beginning of its first year in business, HiSpeed acquires equipment to be used in its
operations. The equipment will last two years, at which time its salvage value will be zero. The company finances the equipment purchase by issuing common
shares.

HiSpeed’s annual net cash flows will be $800 if the weather is snowy and $300 if it is not snowy. Assume that cash flows are received at year end. In each
year, the objective probability that the weather is snowy is 0.7 and 0.3 that it is not snowy. The interest rate in the economy is 3% in both years.

HiSpeed will pay a dividend of $50 at the end of each year of operation.

Required

a. (9 marks)

In 2014, the weather is snowy. Prepare a statement of financial position as at July 31, 2015, the end of HiSpeed’s first year of operations, and an income
statement for the year.

b. (2 marks)

What timing of revenue recognition is implicit in the income statement you have prepared in part (a)? When ideal conditions do not hold, is this timing of
revenue recognition relevant? Is it reliable? Explain.

c. (6 marks)

Assume that HiSpeed paid the present value you calculated in part (a) for its equipment. Calculate HiSpeed’s net income for the year ended July 31, 2015 on
a historical cost basis, assuming that equipment is depreciated on a straight-line basis. Under the more realistic assumption that ideal conditions do not
hold, which measure of net income is most relevant? Which is most reliable? Why?

Question 2 (18 marks)

Prem has $2,000 that he wishes to invest for one year. He has narrowed his choices down to one of the following two actions:

i: Buy bonds of X Ltd., a company that has a very high debt-to-equity ratio. These bonds pay 8% interest, unless X defaults, in which case Prem will
receive no interest but will recover his principal. (a1)

ii: Buy Canada Savings Bonds, paying 3% interest. (a2)

Prem assesses the prior probability of X Ltd. defaulting as 0.40. His utility for money is given by the square root of the amount of his net payoff. That
is, if he buys the Canada Savings Bonds, his net payoff is $60, yielding utility of v60 = 7.75, and so on. Prem is a rational decision maker.

Required

a. (4 marks)

Based on his prior probability calculations, which action should Prem take? Show your calculations.

b. (9 marks)

Before making a final decision, Prem decides he needs more information. He obtains X Ltd.’s current financial statements and examines its
times-interest-earned ratio. This ratio can be either high or low. Upon calculating the ratio, Prem observes that it is low. On the basis of his prior
experience in bond investments, Prem knows the following conditional probabilities:

Debt-to-Equity Ratio

Future State

Low

High

ND (no default)

0.50

0.50

D (default)

0.05

0.95

Which action should Prem take based on this new information? Show your calculations; take each step to two decimal places.

c. (5 marks)

An accounting standard (IAS 16) allows X Ltd. to value its property, plant, and equipment at fair value. The company plans to adopt this option, since it
will reduce its debt-to-equity ratio.

Evaluate (in words — no calculations required) the likely impact of this adoption on the main diagonal probabilities of the information system in part (b).

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Question 3 (15 marks)

Efficient securities market theory has long been under attack from behavioural finance, which draws on behavioural theories of investor behaviour to
explain why security prices do not always behave as the economic theories of rational investing and market efficiency predict. These attacks have increased
since the 2007-2008 security market meltdowns.

Required

a. (4 marks)

Explain why prospect theory predicts that security prices will differ from their prices under efficient security markets theory.

b. (4 marks)

Describe two accounting-related efficient securities market anomalies and, for each, explain why it is an anomaly.

c. (3 marks)

The efficient securities market anomalies suggest that investors underreact to the full information content of financial statements. Choose one behavioural
theory that predicts this underreaction and explain why it predicts underreaction.

d. (4 marks)

Should accountants be concerned that the importance of financial reporting may decline if behaviourally biased investors do not use all the information in
the financial statements? Explain.

50

ASSIGNMENT 2 — SESSION 2 (WINTER)

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.

Refer to the general instructions in Assignment 1.

Question 1 (20 marks)

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

a. (4 marks)

What are discretionary accruals? Why are they useful in testing the three PAT hypotheses?

b. (5 marks)

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.

c. (4 marks)

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.

d. (7 marks)

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)

Several accounting standards include ceiling tests (also called impairment tests).

Required

a. (6 marks)

What is a ceiling test? Identify two IASB accounting standards that contain a ceiling test and describe the test.

b. (6 marks)

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?

c. (4 marks)

Explain briefly why auditors favour ceiling tests.

d. (4 marks)

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)

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.

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.

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.

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.

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.

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

a. (4 marks)

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?

b. (4 marks)

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