Chapter 1 Flashcards
What is the purpose of financial reporting?
Provide useful financial information to investors and managers for decision-making
Who are the two primary users of financial reports?
Investors and managers
Why is consistency in financial reporting important?
It ensures comparability across firms and time periods, aiding in decision-making
What is the role of accounting standard setters?
Develop rules and guidelines that ensure transparency and consistency in financial reporting
What is information asymmetry?
a situation where one party has more or better information than another
What are the two types of information asymmetry?
Adverse selection
Moral hazard
What is adverse selection?
When managers have better information than investors and may manipulate financial disclosures
Managers within companies have inside information, leaving the potential for investors to receive bias information in financial documents that don’t tell the full story
What is moral hazard?
When managers take actions that are unobservable to investors, leading to potential misalignment of interests
What is the question that arises from moral hazard?
How to motivate and evaluate managers performances
What is the question that arises from adverse selection?
What is useful information to the investor? Who determines what is useful and sufficient disclosure?
How does information asymmetry affect capital markets?
It can lead to poor investment decisions and misallocation of resources
What is historical cost accounting?
Recording assets at their original purchase price
Why is historical cost accounting considered reliable?
It is based on actual transactions and is verifiable
What is fair value accounting?
Recording assets at their current market value
Why is fair value accounting considered more relevant?
It reflects the current economic value of an asset, provided up-to-date information
What is the mixed measurement model?
A combination of historical cost and fair value measurement used in modern accounting
What are some common criticisms of fair value accounting?
It can introduce volatility and relies on subjective estimates, reducing reliability
How did the 1929 stock market crash impact accounting standards?
It reinforced the use of historical cost accounting to prevent manipulationWhat
What was one major consequence of the Enron scandal (2001)?
The introduction of the Sarbanes-Oxley Act (2002) to improve corporate governance
What role did accounting play in the 2008 financial crisis?
The use of off-balance-sheet financing and complex financial instruments reduced transparency
What regulatory actions were taken after the 2008 financial crisis?
New accounting standards on fair value, consolidation, and increased disclosure requirements
What is the efficient contracting view of financial reporting?
Financial reporting is shaped by contractual needs, such as debt and compensation contracts
What does securitization mean?
Pooling of contractual debt (ex: mortgages) and selling their related cash flows to third party investors
Also called asset backed securities (ABS)
How do debt contracts influence financial reporting?
Lenders require conservative accounting to protect against risk
What is the role of financial reporting in manager compensation contracts?
It helps measure performance-based pay and aligns manager incentives with shareholder interests
How does conservatism benefit contracting?
It prevents managers from overstating profits and protects creditors
Why is ethics important in accounting?
Ethical behaviour ensures financial statements are honest, accurate, and reliable
What was the ethical issue in the Enron scandal?
The company used fraudulent financial reporting to inflate earnings and hide debt
What is an auditor’s ethical responsibility?
To provide independent and unbiased assurance on financial statements
How does professional judgement impact ethical behaviour in accounting?
Accountants must apply standards fairly and avoid misleading financial reports
What is a rules-based accounting system?
A system with strict, detailed accounting rules (example: US GAAP)
What is a principle based accounting system?
A system that focuses on broad accounting principles with professional judgement (example: IFRS)
Is IFRS a rules-based accounting system or a principle based accounting system?
Principle based accounting system
Is US GAAP a rules-based accounting system or a principle based accounting system?
Rule-based accounting system
What is a disadvantage of rules-based accounting?
It can encourage ‘loophole’ accounting, where companies follow the rules but mislead investors
Why do many regulators prefer principles-based accounting?
It allows for flexibility and better representation of economic reality
What role did accounting standards play in the 2007-2008 market meltdown?
Fair value accounting was criticized for amplifying losses during the crisis
What were some financial instruments that contributed to the 2008 crisis?
Collateralized debt obligations (CDOs) and credit default swaps (CDS)
How did regulators respond to the financial crisis?
They introduced stricter disclosure rules and new fair value measurement guidelines
What is the relationship between corporate governance and accounting?
Strong governance ensures financial transparency and reduces fraud risk
What is the fundamental problem in financial accounting theory?
Balancing the needs of investors (decision-useful information) and managers (performance measurement)
What type of information do investors prioritize?
Future firm performance indicators, often from current value accounting
What type of information do managers prioritize?
Performance evaluation measures, often from historical cost accounting
How does regulation attempt to solve this problem?
By setting standards that balance relevance (for investors) and reliability (for contracts)
