CONTEMPORARY ACCOUNTING 8TH EDITION BY BAZLEY Test bank

CONTEMPORARY ACCOUNTING  8TH EDITION BY BAZLEY  Test bank
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Chapter 10 Financing and business structures

TRUE/FALSE

1. The effect that the collapse of an airline has on the tourist industry is seen to be industry-specific and therefore a business risk.

ANS: T PTS: 1 AACSB: Knowledge, Analytical
TOP: Introduction

2. Working capital is represented by current assets less current liabilities for short-term working capital, whereas long-term working capital is total assets less total liabilities.

ANS: F PTS: 1 AACSB: Knowledge, Analytical
TOP: Short-term finance

3. Business risk is industry-specific, whereas financial risk is more firm-specific.

ANS: T PTS: 1 AACSB: Knowledge, Analytical
TOP: Introduction

4. Financing through creditors can result in opportunity costs where discounts are not taken up by the entity.

ANS: T PTS: 1 AACSB: Knowledge, Analytical
TOP: Short-term finance

5. Trade credit is widely used as a source of finance but the importance and use of trade credit varies from industry to industry and within industries.

ANS: T PTS: 1 AACSB: Knowledge, Analytical
TOP: Short-term finance

6. Financing through trade credit requires less security than financing through factoring.

ANS: T PTS: 1 AACSB: Knowledge, Analytical
TOP: Short-term finance

7. A bank overdraft is normally securitised over assets, either as a fixed charge over specific assets or as a floating charge over all assets; factoring is secured over specific assets being debtors; creditors generally require no security.

ANS: T PTS: 1 AACSB: Knowledge, Analytical
TOP: Short-term finance

8. Where an overdraft facility has been offered, the bank sees this as a semi-permanent source of finance, and prefers to see the account consistently overdrawn, as it will receive more fees through overdraft charges, thus reducing the risk of the finance.

ANS: F PTS: 1 AACSB: Knowledge, Analytical
TOP: Short-term finance

9. The purchase of an asset using loan finance and the leasing of an asset under a finance lease will both result in ownership of the asset being transferred at the time of acquisition/beginning of lease and not when all payments have been made.

ANS: F PTS: 1 AACSB: Knowledge, Analytical
TOP: Medium-term finance

10. Under a hire-purchase agreement, ownership of the asset remains with the financier until all payments have been received.

ANS: T PTS: 1 AACSB: Knowledge, Analytical
TOP: Medium-term finance

11. A major difference between accounting for an operating lease and a finance lease, in the books of the lessee, is that a finance lease will create an asset and a liability, whereas an operating lease will be treated as an expense.

ANS: T PTS: 1 AACSB: Knowledge, Analytical
TOP: Medium-term finance

12. AKP enterprises have negotiated a lease for a photocopier. The useful life of the asset is eight years. The lease is non-cancellable and provides that the term of the lease is over three years with the present value of the lease payments being 55% of the fair value. Title will not pass at the end of the lease period. Using the criteria in AASB 117, the lease would definitely constitute a finance lease.

ANS: F PTS: 1 AACSB: Knowledge, Analytical
TOP: Medium-term finance

13. A major discriminator between an operating lease and a finance lease is whether the risks and rewards of ownership have been substantially transferred to the lessee.

ANS: T PTS: 1 AACSB: Knowledge, Analytical
TOP: Medium-term finance

14. Debentures are essentially the same as a long-term loan except that debentures are particular to limited companies and have a fixed interest rate.

ANS: T PTS: 1 AACSB: Knowledge, Analytical
TOP: Long-term finance

15. An entity that can only raise equity finance through one owners contributions and retained profits is a sole proprietorship.

ANS: T PTS: 1 AACSB: Knowledge, Analytical
TOP: Long-term finance

16. Partnerships may have more ability to raise equity finance than sole proprietorships, as partnerships tend to have more people to contribute funds, but limited companies have a wider range of equity options than partnerships.

ANS: T PTS: 1 AACSB: Knowledge, Analytical
TOP: Long-term finance

17. In an entity that is highly geared, the effect of a decrease in profits or an increase in interest rates will have a greater negative impact on returns to shareholders than it will on an entity that is not so highly geared.

ANS: T PTS: 1 AACSB: Knowledge, Analytical
TOP: Long-term finance

18. A choice between debt finance and equity finance will result in a trade-off between risk and return.

ANS: T PTS: 1 AACSB: Knowledge, Analytical
TOP: Long-term finance

19. A factoring company is a finance company that specialises in providing a service for the collection of payments from debtors.

ANS: T PTS: 1 AACSB: Knowledge, Analytical
TOP: Short-term finance

20. The principal sources of revenue for a factoring company are the interest earned on the finance provided and the fees for managing the collection of debt.

ANS: T PTS: 1 AACSB: Knowledge, Analytical
TOP: Short-term finance

21. The sole source of equity finance for a company is contributed equity.

ANS: F PTS: 1 AACSB: Knowledge, Analytical
TOP: Long-term finance

22. The notion of substance over form may result in certain types of preference shares being classified as debt not equity.

ANS: T PTS: 1 AACSB: Knowledge, Analytical
TOP: Long-term finance

23. Classifying preference shares as debt not equity, would alter the gearing (leverage) of a company.

ANS: T PTS: 1 AACSB: Knowledge, Analytical
TOP: Long-term finance

24. The mix of debt finance and equity finance for a given entity is known as gearing.

ANS: T PTS: 1 AACSB: Knowledge, Analytical
TOP: Long-term finance

MULTIPLE CHOICE

1. Which of the following terms best describes a firm-specific risk that an entity faces, as opposed to an industry-specific risk?
A.
Investment risk
B.
Financial risk
C.
Market risk
D.
Business risk

ANS: B PTS: 1 AACSB: Knowledge, Analytical
TOP: Introduction

2. Working capital is:
A.
loan capital.
B.
total assets less total liabilities.
C.
current assets less current liabilities.
D.
quick assets less current liabilities.

ANS: C PTS: 1 AACSB: Knowledge, Analytical
TOP: Short-term finance

3. The term working capital is used to describe the:
A.
amount of equity (ownership) capital in the firm.
B.
portion of capital actively employed in generating revenues.
C.
amount of debt (borrowed) capital in the firm.
D.
cushion of current assets over current liabilities.

ANS: D PTS: 1 AACSB: Knowledge, Analytical
TOP: Short-term finance

4. Which of the following must be known in order to determine the firms total amount of working capital?

Current assets Current liabilities
A.
Yes Yes
B.
Yes No
C.
No Yes
D.
No No

ANS: A PTS: 1 AACSB: Knowledge, Analytical
TOP: Short-term finance

5. What is the total working capital for the following company?

Cash
$10,000
Debtors
$40,000
Creditors
$30,000
Land
$100,000
Equipment
$70,000
Long-term loan
$40,000

A.
$10,000
B.
$20,000
C.
$50,000
D.
$150,000

ANS: B PTS: 1 AACSB: Knowledge, Analytical
TOP: Short-term finance

6. Which of the following is not an example of short-term finance?
A.
Trade credit
B.
Factoring

C.
Finance lease
D.
Bank overdraft

ANS: C PTS: 1 AACSB: Knowledge, Analytical
TOP: Short-term finance

7. An example of a source of medium-term finance is:
A.
hire purchase.
B.
debentures.
C.
factoring.
D.
equity finance.

ANS: A PTS: 1 AACSB: Knowledge, Analytical
TOP: Medium-term finance

8. Which of the following is not a characteristic of a finance lease?
A.
It is generally non-cancellable.
B.
The lessee guarantees that the lessor will receive a specific residual value from the sale of the asset at the end of the lease term.
C.
It is like a rental agreement.
D.
The lessee has the right to use the leased asset.

ANS: C PTS: 1 AACSB: Knowledge, Analytical
TOP: Medium-term finance

9. The major accounting difference between a finance lease and an operating lease is that finance leases:
A.
involve larger amounts of funds.
B.
are for longer periods of time.
C.
involve the recognition of assets and liabilities.
D.
are cancellable.

ANS: C PTS: 1 AACSB: Knowledge, Analytical
TOP: Medium-term finance

10. When a firm leases a resource for most of its useful life and controls the resource as though it had been purchased, the lease is treated as:
A.
an operating lease.
B.
a finance lease.
C.
a primary lease.
D.
a producing lease.

ANS: B PTS: 1 AACSB: Knowledge, Analytical
TOP: Medium-term finance

11. If a lessee enters into a finance lease agreement, it will record:
A.
an asset only.
B.
a liability only.
C.
an asset and a liability.
D.
an expense only.

ANS: C PTS: 1 AACSB: Knowledge, Analytical
TOP: Medium-term finance

12. The Shifting Sands Company has negotiated to lease a piece of equipment. The equipment has a useful life of 10 years. The lease is non-cancellable but there is only a minor penalty if the lessee returns the equipment before the expiry of the lease. The lease terms provide that the lease is over five years and the present value of the minimum lease payments is 60% of the fair value of the asset at the commencement of the lease. Shifting Sands records the lease payments as an expense in the statement of comprehensive income. Based on this information, which of the following statements is correct?
A.
Assets and liabilities are understated as the lease should be a finance lease.
B.
Assets and liabilities are not affected as the lease is an operating lease.
C.
The non-cancellable nature of the lease determines that it should be a finance lease.
D.
There is insufficient information to determine whether the lease is a finance or an operating lease.

ANS: B PTS: 1 AACSB: Knowledge, Analytical
TOP: Medium-term finance

13. Raffles Ltd had retained profits of $10,000 on 1 January 20X7 and $30,000 on 31 December 20X7. If a profit of $60,000 was earned during the year, then the amount declared and/or paid in dividends during the period would be:
A.
$20,000.
B.
$30,000.
C.
$40,000.
D.
$50,000.

ANS: C PTS: 1 AACSB: Knowledge, Analytical
TOP: Long-term finance

14. FF Ltd declared and paid $150,000 in dividends during 20X7. Closing retained profits at 31/12/X7 was $860,000. What was opening retained profits at 1/1/X7, if FF Ltd made a loss of $180,000 for the year ended 31/12/X7?
A.
$530,000
B.
$860,000
C.
$890,000
D.
$1,190,000

ANS: D PTS: 1 AACSB: Knowledge, Analytical
TOP: Long-term finance

15. When a holder of preference shares has the right to receive all previously omitted dividends before ordinary shareholders receive any dividends, the preferred share is known as:
A.
participating preferred.
B.
cumulative preferred.
C.
compensating preferred.
D.
ex post rights preferred.

ANS: B PTS: 1 AACSB: Knowledge, Analytical
TOP: Long-term finance

16. A preference share is preferred because:
A.
it has a higher claim on dividends and assets than ordinary shares.
B.
it is preferred by shareholders as a potentially better investment.
C.
preferred shareholders have more voting rights than ordinary shareholders.
D.
it has a higher claim on assets in liquidation than creditors do.

ANS: A PTS: 1 AACSB: Knowledge, Analytical
TOP: Long-term finance

17. Which of the following statements is incorrect?
A.
Preference shares usually have a fixed dividend and rate higher than ordinary shares in a situation where a company goes into liquidation.
B.
A redeemable preference share with a fixed redemption date is classified as equity.
C.
A non-redeemable cumulative preference share gives the right to be paid current or accumulated dividends before ordinary shareholders.
D.
A non-redeemable cumulative preference is normally classified as equity.

ANS: B PTS: 1 AACSB: Knowledge, Analytical
TOP: Long-term finance

18. Which of the following statements is incorrect?
A.
A redeemable preference share that is redeemable by the holder is classified as equity if it is not probable that redemption will occur.
B.
A redeemable preference share with a fixed redemption date is classified as debt.
C.
Sole proprietorships, partnerships and limited companies can all raise equity finance from owners contributions but only limited companies can issue ordinary shares.
D.
A company distributes profits in the form of dividends, which is a reduction in retained profits, whereas distributions of profits by partnerships and sole proprietors are reductions in owners equity.

ANS: A PTS: 1 AACSB: Knowledge, Analytical
TOP: Long-term finance

The following information applies to questions 19 and 20. Kucinta Manufacturing Company started operations with the following capital:

Partners contribution of cash
$25,000
Cash obtained from a group of creditors
$15,000
Loan obtained from the local bank
$5000

19. What is the amount of equity financing for this partnership?
A.
$30,000
B.
$25,000
C.
$45,000
D.
$20,000

ANS: B PTS: 1 AACSB: Knowledge, Analytical
TOP: Long-term finance

20. What is the amount of debt financing for this partnership?
A.
$5000
B.
$45,000
C.
$20,000
D.
$15,000

ANS: C PTS: 1 AACSB: Knowledge, Analytical
TOP: Long-term finance

21. When a company obtains financial resources from owners, it is termed:
A.
debt.
B.
operating.
C.
equity.
D.
risk-free.

ANS: C PTS: 1 AACSB: Knowledge, Analytical
TOP: Long-term finance

22. The following amounts of capital were obtained to start operations of Yuppie Manufacturing at the beginning of 20X8:

Owners contribution of cash
$80,000
Owners contribution of machinery & equipment
46,000
Loan from the owner
18,000

$144,000

What is the amount of equity financing for this firm?
A.
$18,000
B.
$62,000
C.
$98,000
D.
$126,000

ANS: D PTS: 1 AACSB: Knowledge, Analytical
TOP: Long-term finance

23. Deep Lake Lodging Company was established at the beginning of 20X7 with the following capital:

Partners cash contributions
$46,000
Cash obtained from a group of creditors
30,000
Loan obtained from the local bank
10,000
Total
$86,000

What is the amount of equity financing for this firm?
A.
$10,000
B.
$40,000
C.
$46,000
D.
$76,000

ANS: C PTS: 1 AACSB: Knowledge, Analytical
TOP: Long-term finance

24. Which of the following provide resources to an organisation in exchange for future returns?

Owners Creditors
A.
No Yes
B.
No No
C.
Yes Yes
D.
Yes No

ANS: C PTS: 1 AACSB: Knowledge, Analytical
TOP: Chapter 10

25. Which type of shares has a higher claim on dividends and assets than ordinary shares?
A.
Voting
B.
Preference
C.
Senior
D.
Favoured

ANS: B PTS: 1 AACSB: Knowledge, Analytical
TOP: Long-term finance

26. Which of the following represent capital that has been earned by the profitable operation of a company?

Paid-in capital Retained profits
A.
Yes Yes
B.
Yes No
C.
No Yes
D.
No No

ANS: C PTS: 1 AACSB: Knowledge, Analytical
TOP: Long-term finance

27. Retained profits can best be described as:
A.
cash receipts minus expenses after adjustments.
B.
net profit minus expenses after adjustments.
C.
undistributed profits.
D.
net profit minus cash disbursements after adjustments.

ANS: C PTS: 1 AACSB: Knowledge, Analytical
TOP: Long-term finance

28. The term retained profits:
A.
is representative of the cash that the corporation has available to pay dividends as of the balance sheet date.
B.
is found among the assets on the balance sheet of any profitable corporation.
C.
refers to an item whose value is always as large as, or larger than, that of cash on the balance sheet.
D.
refers to an account balance found on the balance sheet of a corporation that has paid dividends of lesser amount than profits since the beginning of the corporation.

ANS: D PTS: 1 AACSB: Knowledge, Analytical
TOP: Long-term finance

29. Wilmington Fisheries had a Retained Profits account balance on 1 January 20X2 of $12,000. During 20X2, the firm had net profit of $7200 and paid a $3600 cash dividend. What is the 31 December 20X2 Retained Profits balance?
A.
$12,200
B.
$15,600
C.
$19,600
D.
$21,200

ANS: B PTS: 1 AACSB: Knowledge, Analytical
TOP: Long-term finance

30. Dividends on ordinary shares are:
A.
expensed when paid.
B.
expensed when incurred.
C.
expensed at year end.
D.
a reduction of retained profits.

ANS: D PTS: 1 AACSB: Knowledge, Analytical
TOP: Long-term finance

31. Blue Nose Cold Storage Company was incorporated on 1 January 20X5. Since then, the following shares have been issued:

Preference shares, 5%, $25
8000 shares
Ordinary shares, $20
10,000 shares

On 31 December 20X7, the company declared and paid a total of $50,000 in dividends. This was the first dividend declared by the firm. That is, until this date no dividends had been declared or paid during the first two years of operations. If the preference shares are cumulative, what is the most that will be available out of the $50,000 dividend for payment to the ordinary shareholders?
A.
$20,000
B.
$30,000
C.
$40,000
D.
$50,000

ANS: A PTS: 1 AACSB: Knowledge, Analytical
TOP: Long-term finance

32. Identify the correct statement below.
A.
Bank overdrafts are classified as long-term loans in Australia.
B.
Commitments are disclosed on the statement of comprehensive income because they affect net profit but not cash flow.
C.
Finance leases are accounted for as if the leased items had been purchased.
D.
The expense associated with operating leases is reported on the cash flow statement under the category of investing activities.

ANS: C PTS: 1 AACSB: Knowledge, Analytical
TOP: Chapter 10

33. A shareholder makes an investment in a company. The net effect of this contribution is an increase in:
A.
share capital only.
B.
both assets and share capital.
C.
both assets and liabilities.
D.
both liabilities and share capital.

ANS: B PTS: 1 AACSB: Knowledge, Analytical
TOP: Long-term finance

34. Davis Computer Company has total liabilities of $50,000, total assets of $280,000 and paid-up capital of $120,000. What is the amount of retained earnings and/or reserves?
A.
$20,000
B.
$110,000
C.
$140,000
D.
$160,000

ANS: B PTS: 1 AACSB: Knowledge, Analytical
TOP: Long-term finance

35. The sources of equity finance for a company are:
A.
contributed equity.
B.
retained profits.
C.
general reserves.
D.
all of the above.

ANS: D PTS: 1 AACSB: Knowledge, Analytical
TOP: Long-term finance

36. Where preference shares are redeemable at the discretion of the issuer, and shareholders have not been advised of the companys intention to redeem the shares:
A.
meet the definition of a liability.
B.
represent debt.
C.
are recognised as equity.
D.
are recognised as a financial liability.

ANS: C PTS: 1 AACSB: Knowledge, Analytical
TOP: Long-term finance

SHORT ANSWER

1. Describe the nature and importance of working capital to a business entity.

ANS:
Working capital is represented by the excess of currents assets over current liabilities; and is the basis of funding the day-to-day operations of an entity. Thus, it is an important determinant of solvency.

PTS: 1 AACSB: Knowledge, Analytical
TOP: Short-term finance

2. Describe the nature of trade credit, factoring and bank overdrafts as sources of short-term finance.

ANS:
Trade credit refers to the short-term funding of goods (services) by the suppliers of the goods (services). The period of time involved and amount of credit depends on a number of factors, including the terms of trade of the industry, the creditworthiness of the business and its importance to the supplier.

Factoring refers to the realisation of accounts receivable prior to the due date through a third-party factoring entity who assumes responsibility for collecting the accounts receivable when they accrue. The factoring entity charges interest for the service, based on the finance provided, and a fee for managing the collection of the receivables.

A bank overdraft is a financing facility that may be drawn upon, up to a certain amount, to meet the needs of the borrower as and when required. Interest is only charged when the facility is used.

PTS: 1 AACSB: Knowledge, Analytical, Communication
TOP: Short-term finance

3. Describe the nature and major sources of equity finance.

ANS:
Equity finance is long-term permanent finance associated with the ownership of a business entity. The two major sources of the finance are contributed equity and retained profits.

PTS: 1 AACSB: Knowledge, Analytical
TOP: Long-term finance

4. Distinguish between an operating lease and a finance lease and describe how the separate classes of lease are accounted for in the books of the lessee.

ANS:
An operating lease is a strict rental agreement. A finance lease, on the other hand, arises where leasing is used as a means of financing the acquisition of the asset concerned. Where a lease is classified as an operating lease, the lease instalments are simply treated as expenses to the lessee. However, where a finance lease is involved, the lessee is required to recognise, at the inception of the lease, an asset and liability equal to the present value of the minimum lease payments*; all future lease instalments are separated between interest and principal; and the leased asset is amortised.

* Note: AASB 117 Leases, provides for the measurement of the asset (liability) at the fair value of the asset, or, if lower, the PV of the minimum lease payments, each determined at the inception of the lease.

PTS: 1 AACSB: Knowledge, Analytical, Communication
TOP: Medium-term finance

5. Explain the concept of leverage. Why is this concept important for management?

ANS:
Leverage is the practice of using borrowed funds and amounts received from preferred shareholders in an attempt to earn an overall return that is higher than the cost of these funds. This is important because the total return should be larger than the cost.

PTS: 1 AACSB: Knowledge, Analytical
TOP: Financing structures and financial risk

6. Why do companies manage their working capital?

ANS:
Companies manage their working capital because they want to keep an appropriate amount on hand. This means that they want to have enough on hand to finance their day-to-day operations plus have a reserve on hand for the unexpected. If a company has too little working capital it risks not having enough liquidity. If a company has too much working capital the company risks not putting its assets to their best use, resulting in decreased profitability.

PTS: 1 AACSB: Knowledge, Analytical, Communication
TOP: Short-term finance

PROBLEM

1. On 1 January 20X3, the Harglo Construction Company leased a bulldozer from ASIS Sales Corporation. The lease meets the criteria for classification as a finance (capital) lease and requires Harglo to make annual payments of $30,000 at the end of each of the next 10 years with the first payment due on 31 December 20X3. The present value of the lease payments is $200,000 based on an interest rate of 8%.

How would the lessee record:

(a)
The inception of the lease on 1 January 1 20X3?

(b)
The first lease payment on 31 December 20X3?

(c)
Depreciation on the bulldozer for 20X3, assuming the straight-line method is used over the life of the lease, and zero residual value?

ANS:
(a)
Increase Leased Property by $200,000 and increase Obligation Capital Lease by $200,000 to record acquisition of bulldozer under lease from AIS Sales Corporation.

(b)
Increase Interest Expense by (8% $200,000) $16,000, decrease Capital Lease Obligation by $14,000, and decrease Cash by $30,000 to record lease payment for bulldozer.

(c)
Increase Amortisation Expense by [($200,000 0)/10] $2000 and increase Accumulated Amortisation: Leased Property by $20,000 to record annual amortisation on leased bulldozer.

PTS: 1 AACSB: Knowledge, Analytical
TOP: Medium-term finance

2. On 1 March 20X3, the Red Dour Inn Company purchased a motel for $1,000,000, paying 25% in cash and financing the remainder with a 20-year, 12% mortgage that requires monthly payments of $8258.14.

How would the Red Dour Inn record:

(a)
The acquisition of the building on 1 March 20X3?
(b)
The first mortgage payment on 1 April 20X3?
(c)
The second mortgage payment on 1 May 20X3?

ANS:
(a)
Increase Motel by $1,000,000.00, decrease Cash by (1,000,000 25%) $250 000.00, and increase Mortgage Payable by $750,000.00 to record purchase of motel with $250,000 cash payment and a 20-year, 12% mortgage.
(b)
Increase Interest Expense by ($750,000 1%) $7500.00, decrease Mortgage Payable by ($8258.14 $7500.00) $758.14, and decrease Cash by $8258.14 to record monthly mortgage payment.
(c)
Increase Interest Expense by [($750,000 $758.14) 1%] $7492.42, decrease Mortgage Payable by ($8258.14 $7492.42) $765.72, and decrease Cash by $8258.14 to record monthly mortgage payment.

PTS: 1 AACSB: Knowledge, Analytical
TOP: Long-term finance 1

CASE

1. The following is an excerpt from a 2002 press release by the US corporation, Pacific Gas and Electric (PG&E).

Accounting for PG&E NEG Synthetic Leases

The Corporation announced on Feb. 21 that it was initiating a thorough review of the accounting treatment of several synthetic leases used to finance power plant development at the PG&E NEG (National Energy Group). The review confirmed that payments to the independent equity owners during construction reduced the investors equity below the minimum requirement to maintain these leases off balance sheet. As a result, the Corporations statements now include these financings on balance sheet. The change in accounting treatment resulted in no restatement of prior year earnings, a less than $1 million impact on earnings for the fourth quarter 2001, an increase in total assets and liabilities of $118 million in 1999, $861 million in 2000, and $1.058 billion in 2001.

Additional information
Synthetic leases involve the use of a special purpose entity (SPE) who holds title to the asset(s) (in this instance, power plants) and raises the debt to finance the assets. The assets are then leased to a single lessee here, PG&E. The accounting objective of synthetic leases is to finance the acquisition of an asset and at the same time keep the corresponding debt off the balance sheet of the acquiring company. The SPE typically leases the property to the lessee at rates below those of a traditional lease. Prior to 31 January 2003, the presumption in favour of consolidating an SPE could be avoided if the following two conditions were met:
(i)
there was an minimum acceptable outside equity investment in the SPE. The SEC determined, minimum acceptable outside equity investment was 3% of total capital; and
(ii)
the independent owner had control over the SPE. Control was defined as a majority voting interest.

The independent equity owner in the case of PG&E was an independent third-party lessor.

Required:
Discuss the accounting and ethical issues involved in the case.

ANS:
The issues that may be discussed include the following:

Accounting issues:

broadly, the accounting issues concern the strategy of keeping debt off balance sheet, and the consequences of doing so for the various stakeholders involved.

Favourable financial consequences for shareholders of PG&E include: the cost savings associated with the reduced leasing fees which is obviously acceptable to the independent equity holder; the reduced cost of capital that might ensue from PG&Es lower leverage level; avoidance of any adverse economic consequences that might ensue from existing debt contracts in the event that the debt was brought on balance sheet.

With respect to the issue of consolidation, the practice was within USGAAP at the time, subject to the consolidation conditions being met.

The implications of the synthetic lease arrangement, per se, for the decision-usefulness criterion of general purpose reporting by PG&E. The decision usefulness criterion is underpinned by the first principles substance over form, relevance and reliability. From the perspective of the decision-usefulness basis for consolidation and accounting for leases, these principles were defined, in this instance, by regulation.

The issue of transparency (disclosure) for all concerned.

Ethical issues:

Debtholders: off balance sheet financing may hold adverse consequences for debtholders, where transparency does not prevail. Adverse consequences for debtholders favour shareholders. This issue may elicit discussion concerning the question of whether managements first duty is to shareholders; and the broader issue of self-interest as a fundamental attribute of market economies/capitalism.

Evaluating PG&E managements actions in terms of good and bad consequences reflects a utilitarian approach to ethics.

The actions of management may be evaluated from a deontological perspective.

A lack of transparency prevailed when the leases were left off balance sheet i.e., when conditions for doing so no longer prevailed? This raises the question of the role of the external auditor in this matter.

PTS: 1 AACSB: Knowledge, Analytical, Ethics
TOP: Medium-term finance

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Once the order is placed, the order will be delivered to your email less than 24 hours, mostly within 4 hours. 

If you have questions, you can contact us here