Teacher’s Summary:
In this comprehensive conversation, Tanya provides insightful and thorough responses to Ann’s questions on earnings management, financial reporting, and the use of various financial instruments. Tanya demonstrates a clear understanding of complex accounting concepts and effectively explains how companies might engage in earnings management, the potential use of available-for-sale investments for such purposes, and the impact of these practices on financial statements. She also explains the benefits and challenges of using the matrix format for financial reporting.
Tanya’s responses are well-structured, articulate, and supported by references to academic literature and practical examples. Her ability to explain technical terms in an accessible manner and to provide relevant examples enhances the overall quality of the discussion.
I would grade this conversation as an A for its depth, clarity, and insightful analysis.
QUESTION 1
Ann: What is your understanding of earnings management?
Tanya: Healy and Wahlen (1999), explained that, “Earnings Management” occurs when managers use judgement in financial reporting and in structuring
transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of a company or to influence contractual outcomes that depend on reported accounting numbers.
Earnings management typically involves false increases/decreases of profit and revenue figures through aggressive accounting tactics. As profit is not very volatile due to earnings management we can look to accruals; the more accruals a company has, the more likely they are to be managing earnings.
It can be quiet easy for management to find loopholes in the standards to enable them to manipulate earnings to the desired level. Managers would practice such behaviour to benefit themselves for example, a personal bonus scheme or even to follow market expectations.
There are four main ways managers can manage earnings
1) Unsuitable revenue recognition
2) Inappropriate accruals and estimates of liabilities
3) Excessive provisions and generous reserve accounting
4) Intentional minor breaches of financial reporting requirements that aggregate to a material breach.
For example managers can estimate future economic events such as choosing LIFO instead of weighted average.
Ultimately, earnings managements misinform stakeholders about the fundamental economic performance of the firm.
QUESTION 2
Ann: Do you think available-for-sale investments can be used for earnings management?
Tanya: Available-for-sale investments could potentially be used for earnings management. Firstly, the firm could involve themselves in selective timing. Meaning that they could sell the asset when in a period of high profit so the unrealised losses will become realised and profit will only decrease a little. The firm may also show a lack of effort to determine fair value, thereby increasing investments. Finally another point to be noted would be the risk of improper accounting for impairment losses (Sullu, M 2006).
QUESTION 3
Ann: Do you think any other items in TVC’s financial report could be used for the purpose of earnings management?
Tanya: I believe items relating to Foreign currency and held-for-trading investments to be two other items which could potentially be used for earnings management. Selective timing of these two items allows managers to manipulate the figures on the companies’ financial statements by either selling in periods of high profit or visa versa.
QUESTION 4
A) Ann: What are available-for-sale investments reported as?
Tanya: Available-for-sale investments are reported as their Fair Value. I found this from Note (1B) Investments, from the financial statements.
B) Ann: What profit/loss is reported for the year from available-for-sale investments in the profit statement?
Tanya: A profit of $15 millions was reported.
C) Ann: How much profit/loss is reported for the year from available-for-sale investments in total income and expense for the year?
Tanya: A loss of $35 million was reported in this instance.
D) Ann: How do you think those figures will impact on the current and future profits?
Tanya: Profit for the current year will be $15 million extra, however if the company chooses to sell the available-for-sale investments then the unrealised losses will be realised and profit will decline by $15 million.
E) Ann: What was the amount of available-for-sale investments last year then?
Tanya: Last years figure was $45 million for available-for-sale investments.
QUESTION 5
Ann: Do you think the firm’s executives have engaged in earnings managements?
Tanya: I believe the firm could have engaged in earnings management but it is quiet hard to determine from the information given. It is hard to gauge when available-for-sale investments were sold, and in not knowing this decide if the firm engaged in earnings management. We would also need to look at such information as other accruals, when revenue was recognised and check both provision and reserves to see if managers may have had the chance to manage earnings.
QUESTION 6
Ann: What do you think about David’s comment that performance should be based on change in equity or profit? Or do you think it should be some other measure?
Tanya: I believe that performance should be based on both equity and profit. It is important to look at both statements as they give users a variety of different information. The equity statement holds most of the information stakeholders would need to make informed decisions. However one can see the profit figure is used to derive the end figure for changes in equity, so it would help stakeholders to see how the company came up with the final profit figure. The more information provided helps with the transparency issue so many companies face.
PART B
QUESTION 1
Ann: (Distributes Exhibit 4) What is your understanding of the reconciliation?
Tanya: The reconciliation helps us see values that were not included in the income statement before, however these figures have come from changes in equity.
In addition to this, we can see that a total of $62 million was profit from the companies current operations, their core product, being manufacturing. However on closer inspection of the reconciliation we can see that total income recognized in equity was $172 million. This figure indicates that $110 million of profit was not to do with their core product (manufacturing), but secondary income, such as foreign currency.
Ann: Do you think it’s important for TVC to disclose this?
Tanya: Yes, I think the firm should disclose such reconciliation. As I mention previously it breaks total income up into two sections, letting stakeholders see how much of the actual profit was from core operations and how much of the total income recognized in equity was from secondary sources.
QUESTION 2
Ann: (Distributes Exhibit 6) Do the figures change using the matrix format income statement compared to Part A question 4?
Tanya:
A) Is still reported at fair value same as before.
B) Has changed to a loss of $35 million reported in profit.
C) Has remained the same at $35 million loss reported in total income and expense.
D) Current and future profits will both change using the matrix format. A loss of $35 million will be recorded for the current year, and depending on whether the company sells available-for-sale investments the future year could also see a loss of $35 million.
E) Remains unchanged at $45 million also.
Overall Ann, I found it easier to find the figures in the matrix format rather that looking through different pages to try and find the figures in Part A. However I find it interesting and unusual that question B differs between the two formats.
QUESTION 3
Ann: I don’t really know anything about the matrix format, what is it about?
Tanya: The matrix format combines data from the IAS 1 income statement and statement of changes in equity into one statement. It allows users to see items before and after remeasurements by having three columns,
1) Items before remeasurements
2) Items after remeasurements
3) A final column being the totals of the previous two.
If a company were to report their income statement in a matrix format it would provide for a more accurate format. This is because items become more transparent. Firstly because all information regarding to income now appears on one page, this includes both realized and unrealized. Secondly because of the structure of the matrix format remeasurement is now easier to find (Tarca, A et al 2007).
Ann: Oh, ok, well who would benefit most if we changed to this approach?
Tanya: It would benefit stakeholders most, as mentioned previously it’s easier to read and decipher between realized and unrealized items. External users will now be able to be quicker and more accurate at finding information in the statements (Tarca, A et al 2007).
Ann: Should the matrix format replace the old system?
Tanya: no I don’t think it should completely replace the old system, I just think it should be a supplement for IAS 1 financial reports.
QUESTION 4
Ann: hmmm, I see what you mean, but I’m still not too sure about the matrix format.
Tanya: So you are still a little confused on the matrix format then? Well I know its made the financial data simpler to read for you but I think the problem you’re faced with is whether or not it’s helping you in your primary decision of offering PB a new contract. I think the matrix format lets us see more clearly the possibility of earnings management. We can gauge more closely what’s happening with available-for-sale investments and other potential items. I think the matrix format has helped make things a little more transparent but not 100% in confirming what you should do about the PB, I think to make that decision we still need more information.