Essay on Financial Accounting Theory

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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
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Gearing and interest coverage ratios are frequently used in debt covenant to reduce the risk exposure of the lenders. Gearing is the leverage that measures as the ratio of total liabilities total tangible assets. If the company takes excessive debt or loses tangible assets, its gearing might fall below the requiring ratio; the company is likely to breach the debt covenant. In terms of interest coverage number, the covenant requires that ratio of net profit, with interest and tax added back, to interest expense is at least a minimum number of times. In the case of Sigma Pharmaceutical, the reported loss of $389 million of profit might be the main reason for its breaching of the interest coverage ratio.

b. Explain the purpose of the debt covenant from a contracting theory perspective. Is the debt contract an efficient contract? Explain your answer.

From a contracting theory perspective, the purpose of the debt covenant is to reduce agency cost of debt. Under Positive accounting theory, borrowers would have divergent behaviours towards lenders, such as excessive dividend payments, claim dilution, asset substitution and underinvestment. Without safeguards, it is assume that lenders would ‘price protect’, that is requiring higher cost of interest to
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