CASE 1:OZZIE MINERAL L.T.D
1) a)The management’s Arguments
The management’s argument that the equipment should be written down in value because the downturn in copper industry was temporal, was not ethical. This is because most non-current assets are subjected to wear and tear. According to GAAP the principle of valuation was modified to create financial reports to appear more conservative than the historical basis by stipulating a downward adjustment of assets there is potential of the selling value going way below the initial cost. The yearly devaluing of non-current assets through obsolescence reduces the value of its initial cost. The management’s argument was therefore illogical since the equipment can not revalue back to its initial cost due to the above mentioned reason. It is therefore prudent for the equipment to be written down to the $7 million where apportion of its expected life is expensed to depreciation. If the equipment is not downturned then its residual value might end up being very low or zero in case the mine closes permanently. The general effort is to project financial statements on the most traditional basis feasible such that the company’s financial statements’ net worth represents the true value of the company. Similarly, the historical cost principle stipulates that assets and expenses are recorded in the books of accounts at their real costs which are objective and verifiable. This system gives a world wide, dependable and easy method of recording assets and expenses. It is therefore not right for the management to assume that the cost of the equipment will go back to the original price considering the available conditions of depreciation. It is henceforth recommended for the management to use the GAAP principle of valuation and the historical cost principle in the valuation of the equipment to accurately ascertain the real cost of it to avoid violation of the accounting standards of IAS 16 where the principle issues in the realisation of the assets are estimation of their subsequent amount and the depreciation costs and the impairment losses to be realised commensurate to them. The equipment will therefore have to be downturned for this standard to be obeyed.
Question B) The agency problems between management and shareholders
Management should make decisions that maximise the share price of shareholders’ investment. The share price can only rise up if the market is proficient. Assuming the market is efficient then the investments of the shareholders will be more profitable and more stable. The managers are the agencies of the shareholders and therefore they should act in the interests of the shareholders. However, managers may not act in the interests of the shareholders by acting in their own interests which are different from those of the shareholders. These agency problems come up due to separation of ownership and management in a firm. The managers run the organization as if they are the owners yet the ownership is to the shareholders.
In this case the managers consume excess perquisites by wasting the firms’ money on corporate parties and lavish offices. The managers increase the size of the firm needlessly while the top level management increase their pay in relation to the firms’ size. At the same time the managers invest in zero NPV projects just to increase size of the firm and improve on their prestige. At times, they may involve themselves in projects that are not meaningful (Buchholz, and Rosenthal, 2002) exposing the firm in non-systematic risks through over diversifying of the firm. The motive behind these actions is majorly for greedy of power and prestige in the eyes of the public and their personal lives. The managers want to live lavishly without considering the welfare of the owners of the business. Sometimes there is excess accounts manipulation where there managers modify the financial statements to reflect profitability in the company by failing to disclose all the information related to the firm. As in the case study mentioned the management’s way of valuing the equipment is deceitful to the shareholders to convince them not to write down the equipment for own material gain. Similarly, with recent scandal of Enron and WorldCom in U.S. (Robins 2006) it clearly reflects management greediness in over diversifying and accounts manipulation to increase their prestige and high image.
Bebchuk and Fried, (2003, p. 3- 22), focuses on an instant where ownership and management are disconnected. The managers usually acquire a significant level of authority especially in a publicly traded firm. They may use their tracts to gain their personal comfort in various methods. For instance, they may be involved in territory making. They may refuse to disburse the excess income when the company does not have investment openings that are beneficial. The managers may also establish themselves in their positions making it hard to throw them out when their performance goes down the scale. Under the executive compensation the managers take the principal approach where they dictate the pay they should receive which imposes a considerable cost on the shareholders investments (The Financial Times 2011). The compensation structure might be commanded by the market forces which motivate value maximization and hence manipulate the power of the managers. The executives may control the ability of the managers to gain more on their side but the managers always have a way of obtaining arrangements that are in their favour. Moreover, by use of power and camouflage the managers use compensation consultants, loans to executives; attractive farewell kits the managers are able to manipulate their compensations (Khurana&Nohria 2008). In such organization high managerial power and pay the performance is usually below per. Such power is achieved when the board of directors is fragile, the outside shareholders are small in number or there are less corporate shareholders and that there is more use of antitakeover bids. The shareholders in turn suffer in a number of ways; they receive peanuts in dividends payment due to reduced shareholder value which in turn scares them from further investments into the company.
Ways in which shareholders can contain the agency problem
The shareholders have wider methods of solving the agency problems which include;threat of takeovers, use of share options as incentives, use of institutional investors and use of reliable board of directors (Peters et al 2011 P. 429-445). By threat of takeovers, the shareholders through the board of directors give an option of selling off their shares to other shareholders if the management is unable to deliver in their performance. This method is normally considered to be the best because managers are normally frightened by the idea that the firm will change ownership hence the management is likely to be changed by the new shareholders. However, some management officials and executives might use antitakeoverdefences to scare away the investors for a possible takeover. Resistance of the managers through the anti take overs raises questions in the minds of the probable investors as to the stability of the firm hence they may take time to reconsider their stand (Frederick, 2002).
In addition, the owners might decide to give incentives to the existing managers commensurate to their performance using share options. The owners might give the managers an opportunity to own part of the firm if they reach a particular level of share price level. As such the managers will work towards share price maximisation knowing very well they might become part of the owners. When one owns something he or she is unable to misuse it given the power understanding the benefits accrued to it. The share holders might also employ the use of institutional shareholders where other organization buys interests in the firm to become part of the owners (Vurro and Perrini 2011 p. 459-474). As a result there is high level of evaluation and monitoring which reduces the chances of selfish serving of managers’personal interests. Finally, the shareholders may use reliable members of the board to closely monitor the actions of the shareholders. The board members will scrutinize and question the management if suspected of not serving owners interests. The management can not make any decisions without the approval of the board of directors a phenomenon will impel them to be responsible of their own actions
Question 2 a) Case study 2
Treatment of Warranty expense/ liability in the Complex’s financial statements
A warranty liability represents an obligation of the Complex Computers L.T.D to repair or replace the defective computers within the one year period predetermined. This commitment meets the possible and reasonably estimated measure of a contingent liability. The reporting and treatment of the contingent liabilities is found under the International Accounting Standards Number 37. The commitment creates an expense that should be matched against the income in the present period of the income statement. Warranty liabilities and warranty expenses must be recorded and reported at the moment the item is sold. The amount can then be estimated if it is possible that the customers can make claims regarding the warranty. According to the financial accounting standard board statement of financial accounting standards number five, accounting for contingencies.Since the company sold 100 computers for $1250, the total sales realised were $ 125 000. The warranty claims will amount to 2% of the sales which comes to (.02*125000 = $ 2500) for the whole year. The warranty expense amounts to a total of $ 17 000, $ 10 0000 in cost of repairs and $ 7 000 in labour. Since labour was provided under the warranty coverage, the warranty liability will be reduced (FASB 2011). Therefore, the warranty expense for $ 17 000 will be debited by the accountant while crediting estimated warranty payable by the same amount as at 30th June 20X3. The accountant will credit the warranty claim of $ 2 500 and debit by the same amount the capital account as at 30 th June 20X3 when the computers are sold (Averkamp 2011).
Under the International Accounting Standards number thirty seven, contingent liabilities are uncertain in nature and so they are not recognised but are disclosed where an inflow of economic gain is possible (Deloitte, 2005). When the recognition of income is practically right positive, then the related asset is not a contingent asset and its realisation is suitable (International Accounting Standard number 37, 31-35).
There may be difficulties in the operation of the firm when it applies warranty liability and warranty expenses especially when the firm is at its growth stage. The possible challenge of the Complex Computer L.T.D in relation to the warranty liability and warranty expenses is that the firm might not be able to control the increase in the overhead and personnel costs. The firm’s costs exceed the revenues. The annual payroll is $187 500 for the five employees, the company made a repair of $ 10 000 in parts and $ 7000 in labour and its provision on warranty amounts to $ 2500 which is 2% of the total sales revenue. The total costs incurred in the business for the year is $ 207 000. The total amount of sales revenue realised is $125 000 assuming all the 100 computers were sold. The total cost of running the business surpasses the total revenue acquired by the company by almost double the amount. It is therefore very difficulty for the company to sustain the labour force and the warranty arrangement for the business for the next trading period. The company has to pay off its expenses or finance its operation using finance companies or insurance companies (McDermott 2011) and have extra funds to rejuvenate the business. Consequently, the firm should do away with some of its employees and the cost related to the warranty liabilities and warranty expenses for it to be perpetual (Gimblet 2011) or else the company faces the risk of extinct in its business operation.
Why Old and loyal employees can not be treated as assets
To respond to this question one needs to understand the meaning of the term asset and liabilities. Assets are possessions managed by the entity as a result of past events from which the economic benefits in future are anticipated to flow to the entity. They have the following features; they are recognized in the financial statements when it is possible that the future economic benefits will arise. These items are controlled by the entity and that they arise out of a past event. These items are acquired at a cost or value which can be measured reliably. The items classified as assets are tangible in nature and can be seen or felt. Besides, these items are exchangeable at a cost commensurate to their historical cost and that they have legal enforcement on them. Assets are held principally for trading or held for sale or consumption in the normal course of the operation of the entity.
On the other hand, liabilities are present obligations of the business arising from the events in the past occurrence, the completion of which is expected to end in an outflow of resources from the entity’s economic benefits. Therefore, employees whether they are loyal or have stayed for long in the organization can not be classified as assets because the timing of the benefit related to its existence. The employees benefit does not rise in future but rather the benefit has already been given by the employees so they can be only be classified as liabilities. The benefit is in the current period because at the end of the month or week they are given wages and salaries.
The employees can neither be classified as current assets nor non-current assets because for them to be categorised as current assets their benefits should be expected to be realised within an operating period or they should be held for consumption or they should be held majorly for trading within a period of twelve months after the end of the last financial period. Basing on this, we can not term employees as current assets and neither should the owner of complex computers wonder why the old and loyal employees not be treated as assets. Moreover, the employees can not be categorised as non-current assets due to the fact that they have stayed in the firm for a longer period of time. Non-current assets as known are property, plant or equipment or long term investments in a firm. The owner can not classify the employees as non-current assets because their benefits are not realised in future just like investments neither are they property, plant or equipment. Consequently, it will only be prudent to classify the employees as liabilities since expenses are incurred in paying for their salaries and wages (IAS 19, 2005 Amendments). The reconciliation for the provision should have an opening balance and the possible additions and the amounts charged on the provision plus a closing balance. A prior trading period is not required as for the case of Complex Computer L.T.D.
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