Financial Accounting Theory Essay

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QUESTION 1
a. Outline the objective and the principles of a theory that prescribes fair value accounting.

Fair value accounting is to measure selected assets at fair value. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. The objective of fair value accounting is linked with the objective of ‘decision usefulness’ of general purpose financial reporting. That is, to provide relevant information that is representationally faithful for users.
IASB’s (and FASB’s) accounting standard on fair value measurement establishes a ‘fair value hierarchy’ in which the highest attainable level of inputs must be used to establish the fair value of an …show more content…
Debt covenant is an efficient contract in that it reduces the manager’s ability to adversely affect the wealth of debtholders, and it reports earlier ‘technical default’ if the covenant is breached, therefor reduce the risk exposure of the debtholders.

c. What are three possible consequences of Sigma Pharmaceuticals breaching its debt covenant?

It depends on the terms of the debt contract. The debtholder might demand immediate repayment of the loan, seize particular asset over which it has security. Alternatively, the debtholder could agree to renegotiate the terms of the contract and not enforce the conditions of the breach.

d. Is it possible for managers to exercise opportunistic behaviour given the debt contract? Explain your answer.

Under PAT, debt contracts are initially put in place as a mechanism to reduce the agency costs of debt from an efficiency perspective. However, from an opportunistic perspective, it is predicted that management with a subsequent incentive to manipulate accounting numbers. It would be too costly, and for practical purpose impossible, to write ‘complete’ contracts stipulating all accounting methods that management must use. Therefore, management will always have some discretionary ability, which may enable it to loosen the effect of debtholder-negotiated restrictions. For
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