Theory

Question 1 (25 marks) Several accounting standards include ceiling tests (also called impairment tests). a. What is a ceiling test? Identify two IASB accounting standards that contain a ceiling test and describe the test. (7 marks) b. 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? (6 marks) c. Explain briefly why auditors favour ceiling tests. (6 marks) d. 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. (6 marks) Question 2 (25 marks) Most firms hedge at least some of their risks. Hedging can take two basic forms—namely, natural hedging and hedging by means of derivative instruments. The use of derivatives as hedges has expanded greatly in recent years. Generally, under accounting standards (IAS 39 and related U.S. standards), derivative instruments are fair-valued with any unrealized gain or loss included in net income. However, hedge accounting provides some exceptions to this rule. Required: a. A firm has a large amount of long-term debt (valued on a cost basis) and decides to set up a natural hedge of this debt. However, a natural hedge can lead to excess net income volatility— that is, net income volatility greater than the actual volatility of the firm’s operations. Explain how this can happen. (5 marks) b. Suggest two ways that the excess net income volatility arising in part (a) can be prevented. (6 marks) c. IAS 39 identifies two basic types of hedge. Describe each type. For each type, explain how IAS 39 controls excess net income volatility arising from entering into the hedge. (8 marks) d. Use the bonus plan hypothesis of positive accounting theory to explain why a firm manager dislikes excess net income volatility. Are the policies to control excess net income volatility you described in parts (a) and (b) unethical? Explain why or why not. (6 marks)