Marketing Strategy.doc

PART Aa) The aims of creative accounting in reducing gearing and increasing EPSDefinition Creative accounting is the deliberate manipulation of accounting rules to present an obsequious image of the firm. This involves dampening of fluctuations to some degree of earnings considered to be acceptable by users of financial reports (Amat et al., 1999). The technique is aimed at transforming somewhat dull figures in order to present accounts more attractive.Use of creative accounting in reducing gearing In order to reduce gearing, firms use off balance-sheet financing. According to ORegan (2006, p342), off balance-sheet financing is the process through which assets intimate to financing are kept off the balance sheet to reduce gearing. This is aimed at affecting the gearing of a firm. In other words, the approach refers to sourcing of funds for the business without reflecting the transactions on the balance sheet. The method has not only increased in application but also in terms of size and sophistication (ORegan, 2006). The main strategy is to reduce borrowings on the balance sheet so as to cut down the gearing ratio. In addition, the method may involve securing of borrowings for implementation of important projects or acquisition in future. Regardless of the manner in which one looks at it, it represents manipulation of the companys true financial position; thus, limiting the true and fair understanding of a companys state of affairs, and may lead to wrong investment decision making. There are no specific rules to off balance sheet financing technique. It owes nothing to company law or any particular rulesanything goes.Like any other borrowing techniques, off balance-sheet finance must be repaid eventually. The business must fulfil its financial commitments, be they on or off-balance sheet. By failing to fully disclose these facts, the business may find itself at the discretion of providers of such financing. Inasmuch as off balance-sheet technique may appear to mislead only the outsiders and act as a breather for the company, it is actually a double edged sword. It is understandable to use off balance-sheet technique to solve short-term financial problems in a tactful, subtle and self-effacing manner. Setting aside the moral issue, companies can use off balance-sheet technique to maintain their liquidity. There is no clear ways in which off balance sheet technique is used. Naser (1993) posits that there is a conspiracy of silence between providers and users of this type of financing. Use of creative accounting in increasing EPSEPS is one of the most robust measures of firms profitability and performance. It is a critical determinant of a companys future share price and forms part of investors decision on whether or not to invest in a firms stocks. Companies are able to manipulate EBIT, from which EPS is computed. The manipulation is effected through the use of various strategies as outlined below. The first approach to creative management to increase earnings is the manipulation of capitalisation of R&D expenditure. According to Huang (2004), managers cut their R&D expenditure to make up for their under-achieved earnings targets. When firms reduce R&D expenses, there is a direct increase in pre-tax profit. This makes earnings management to be an effective strategy in increasing earnings to avoid losses. Nonetheless, when firms amortise and capitalise R&D costs, R&D expenses in the current period becomes a combination of past expenses and current expenditures expensed. Other techniques such as managing accruals, for example, altering the percentage of current capitalised expenditures may be a more effective and less detrimental as compared to reduction in R&D. Furthermore, the choice between expensing and capitalising costs affect the general economy by impacting on firms real earnings and production and investment decisions. Both expensers and capitalisers manipulate R&D to manage earnings, though in different ways. The former manage R&D by reducing expenditures to meet targets; while the latter manage R&D expenditure to meet earnings targets, as opposed to managing transactions. A second method used to manage earnings is by changing of a companys depreciation policy. Management have all the discretion to choose their depreciation methods within the range of acceptable methods (Elliott et al., 2005). Changing of depreciation method is allowable if the new method is aimed at improving the manner in which the companys results and financial position are presented to shareholders. However, companys can change depreciation method given that it does not reflect change of accounting policy. According to Huang (2004), this allows them to adjust profits by changing the useful life of an asset or project. Thirdly, firms can try to reduce their expenses by either capitalising or deferring them to a future period. One of the effective strategies to defer costs is through closing stock. This reduces cost charges in a given year and pushes them to a better year. This may temporarily increase the companys stock value and also reduce the cost of sales for that year. As a result, the company will experience an increase in reported profits. O the other hand, this is just a deferral; inasmuch the company may succeed in reducing the cost of sales, this may exert too much pressure on end stock valuation.Another method used to increase earnings is through concealment of losses and liabilities. Concealment has a direct impact on inflating profits. This is made possible through the creation of an autonomous entity that takes care of the losses and/or liabilities as in the Enron scandal. Enron used this method to transfer liabilities to special purpose entities (SPEs) in order to better its financial performance.Another method of increasing earnings is thorough tampering with taxation. Firms use creative accounting to dampen of short-term fluctuations in tax expenditure. By reducing the tax bill, this adds to the profits of a company; thus, increasing the companys earnings per share. The responses of U.K. and U.S. legislatorsAccording to Dean and Clarke (2004), accounting standards require “true and fair” presentation of financial reports. This has been the hallmark of UK-based accounting. In the United States, accounting standards are more of prescriptive in nature. Thus, the IASB and the IFRS used in the U.K. are more of a principles-based regime as opposed to a rule-based regime in the U.S. Nonetheless, US standards are significantly more comprehensive that U.K.s standards or IFRS. Since the collapse of Enron, Authorities in the US have taken measures to protect investors. The actions are aimed at improving a companys financial health. The authorities are aimed at ensuring that rules and standards are regularly revisited to tighten up enforcement and monitoring of accounting practices for both firms and auditors. In addition, disciplinary measures are taken if any anomaly is identified to maintain discipline (Robert, 2002).b) Regulatory Discussioni) The impairment of tangible and intangible assets in the light of IAS 36 Impairment of Assets. The Standard outlines the requirements for accounting and presenting the impairment of non-financial assets. This includes the treatment of impairment; the determination of any impairment losses and related disclosures. Application of the IAS 36 is open to varied interpretation. Recent global economic developments have pushed impairment into the spotlight. This has forced companies to reassess their assumptions and methods applied on recognition of impairment. As stated earlier, IAS 36 covers impairment of tangible and intangible assets under the IFRS. The standard requires that an asset should be carried at a value not exceeding its recoverable amount. All entities are required to test all assets that show the potential of being impaired, as soon as there are any indications of impairment. This should be conducted at least once a year for goodwill and intangible assets with indefinite useful lives. Key requirements of IAS 36An entity is obligated to assess, whether or not there is an indication of the non-financial asset will be impaired. In case there indeed the asset will be impaired; the firm should determine the recoverable amount of the asset or the cash generating unit. Goodwill and intangible assets that have indefinite useful lives and those intangibles not in use in the current financial year should be assessed for impairment at least once every year. This is irrespective of whether or not there is an indication of impairment. In addition, a non-financial asset is deemed to be impaired if the recoverable amount is less than its carrying amount. IAS 36 defines the recoverable amount of an asset as the higher of value in use and fair value less its disposal costs. The standard requires that any impairment loss to be declared in income statement as an expense. In case the asset is classified as a re-valued asset, as per IAS 16 and IAS 38, impairment loss is charged against any gains on the asset in the previous period. Entities are required to extensively disclose their impairment test and any of the recognised impairment losses. For impairment losses recognised in the previous reporting period, firms are required to reverse it if there are changes in the estimates used in determining the recoverable amount of the asset. It is important for management, notably the finance department to plan early and make use of the right skills and techniques such as forecasting and modelling methods. The selection of the most appropriate approach varies across firms, but the bottom line is that the assumptions must be based on facts. This requires adequate knowledge of the industry and firm level operational aspects. Some firms require full involvement of the senior executive who provide the required support, input and critically evaluate results. In summary, management need to use any resources that they can get their hands on because impairment is all about comprehensive business assessment and is not a mere accounting exercise. ii) The importance of basic and diluted earnings per share (EPS) figures to current and potential investors in the light of IAS33: Earnings Per Share The purpose of any earnings measure is to give the most accurate meaning, and comparability of one company to another. Earnings show attribution of profits to the equity shares. The focus of the IAS 33 is on ensuring that there is consistency in the calculation of the denominator the number of shares. Even if EPS is negative, disclosure is still mandatory. EPS is usually computed in the context of a firms ordinary shares. Earnings attributable to ordinary shareholders are as a result computed by subtracting earnings to shareholders from net income of more senior equity instruments. All listed companies are required to disclose both basic and diluted earnings per share in their income statements. Furthermore, companies that file or intend to file financial statements with an exchange rate or other bodies for the purposes of issuance of ordinary shares is also required to declare EPS. Basic EPS is computed by dividing a firms profit or loss for the financial year by the outstanding sharesincluding adjustments for rights and bonus issues. On the other hand, diluted EPS is computed by dividing the profit or loss by the adjusted weighted average number of ordinary shares that include dilutive potential ordinary shares. The later include financial instruments and contracts that may lead to are related to the issued ordinary shares such as convertible bonds and options. Computation of both basic and diluted EPS is important for investors because they represent the continuing and total operations of a company. Part BTransaction aAccording to IAS16 property, plant and equipment, only the direct costs of preparing an asset for use capitalised. Under the IAS 37 provisions, contingent liabilities and contingent assets, Epsilon has a constructive responsibility to provide for the entire cost of rectification of $6 million. However given that the materiality of the effect of discounting, IAS 37 requires that such provision be discounted at its present value. The transaction is as follows:Provision at 1 January 2010 (in 000) = 6,000 x 0.4632 = 2,779. An increase in the provision is recorded as finance cost in the income statement. At 31 December 2012, the finance cost will be 8%*2,779 = 222, while the provision will be 2,779 + 222= 3,001. The initial provision is entered as a debit entry to PPE because it is a cost incurred to gain an economic benefit. Therefore, the total cost, depreciation and carrying amount are computed as: Total cost = 25,000 + 2,779 = 27,779 Depreciation = 10% * 27,779 = 2,778Carrying amount = 27,779 2,778 = 25,001 Transaction bFor this development project, only costs incurred after the feasibility and other project conditions have been met are capitalised, in this case 5.4 million. All previous costs should be expensed in the income statement, including those incurred earlier in the same accounting period. Amortisation of the capitalised project cost commences when the process is starts to bear commercial benefits. An annual charge would be 540,000 (5.4 million/10). The charge in the year ended 31 December 2012 is 135,000 = (540,000 x 3/12). Transaction cProperty lease should be treated as the whole amount. Under IAS 17 Leases if possible, the assistant should divide property leases into land and buildings elements for the purposes of evaluating their correct accounting treatment.Given that the company will vacate the premise at the expiry of the lease, the land element is regarded as an operating lease; thus, rental rent is expensed in the income statement. Given that the land element is 50%, a rental expense of 250,000 (50% *500,000) is charged on the income statement.The building element is treated as a financial lease. Therefore, the company should debit 2.5m (50%*5 m) to PPE and credit it as a finance lease. Depreciation is computed as (2.5m* 0.02) = 50,000 and debited to the income statement as well as the finance cost of (8%*2.5m) = 200,000. On the balance sheet, the current liability is 54,000 (250,000 2,450,000* 8%), while the closing liability is 2,450,000= (2,500,000 + 200,000 250,000). Transaction dUnder IAS 39-Financial instruments: recognition and measurement, the shares are regarded as financial assets. A gain of 1,200 (1,000 x (320 200) is recognised in other comprehensive income in previous periods. When the shares are sold in the current period, a gain of 720 (1,200 * 0.6) becomes realised. The realised gain should be reclassified as part of the gain on sale of the shares, this is 960 = 720+ (600* (360 320). The unsold shares are treated as financial assets and valued at their fair value. This is computed as (400 x 350) = 1,400. The gain on re-measurement of 120 = (400* (350 320) is recognised in the comprehensive income statement for the year. For equity, the closing balance associated with the investment will be 600 = (400 x (350 200). Part CPart A: Financial Ratio AnalysisLiquidity RatiosBrealey et al. (2008) argue that it is important for a firm to maintain adequate liquidity; liquidity impacts directly on daily activities. Company As current ratio is 1.7, while that of B is 1.5. Both companies have current ratios above 1, implying that current assets exceed current liabilities and that the company can meet their liquidity requirements. The quick ratio for company A is 1.1 while that of company B is 0.8. This implies that company A has a strong liquidity position, while company B heavily relies on inventories to meet short-term liquidity obligations. Elliot and Elliot (2012) argue that overreliance on inventories can make a firm to be vulnerable to liquidity shortages if there is a significant decrease in demand for the companys goods. Thus, a quick ratio above 1 guarantees that there is sufficient liquidity to take advantage of any available opportunities. Activity RatiosFrom the record, accounts receivables days stood at 80 days for company A and 120 days for company B. This shows that company A is more efficient in collecting receivables than company B. Inventory turnover was 4.80 and 3.80 times for company A and company B respectively. The ratios show that company A is able to turnover inventories faster than company B. Company b is turning over inventories less times; this may imply lower demand for the companys goods as compared to company A. Similarly, accounts payable days is 60 days for company A and 90 days for company B. In addition, it takes company two month to settle payables while company B requires three months. The high accounts payables days may reflect the companys challenges with settling creditors on time. This may prove to be detrimental for the company given that the company may be losing out on discount offers on timely payments, a factor that may be enjoyed by company A. Profitability RatiosCompany A has a lower gross profit margin than Company B. However, operating profit margin is higher (10%) than that of company B (7%). Similarly, company A has a better return on capital employed (12%) than company B (8%). This shows Company As resilience in maintaining a good return on the capital employed. The same patter appears for return on equity; this stood at 14% and 12% respectively. Company A has a good indication of profitability than company B, the high return on equity can be attributed to an increase in net income (Atrill and McLaney, 2011). Debt and Financial Risk RatiosThe percentage of total debt to total assets is 40% for company A and 50% for company B. This shows that company B has a higher level of debt relativ