Chapter 3 Flashcards
What does “decision usefulness” mean in financial accounting?
It refers to how well financial information helps users make informed economic decisions
Who are the main users of financial statements?
Investors, lenders, managers, unions, standard setters, and governments
What is the main decision problem for investors?
Determining whether to buy, sell, or hold securities based on future firm performance
How does financial information improve decision-making?
It helps users predict future cash flows and assess risk
What happens when accounting operates in non-ideal conditions?
It becomes difficult to balance relevance and reliability
Why is valuation based on future cash flows problematic?
Because future cash flows are uncertain, reducing reliability
What are some challenges in income measurement?
Changes in market value or present value are unreliable
Historical cost ignores certain value changes
Income depends on accounting choices (example: revenue recognition, amortization…)
What is decision theory in accounting?
A framework used to understand how users make rational decisions under uncertainty
Why is decision theory important for accountants?
It helps accountants identify the most useful financial information for decision-makers
What is Single-Person Decision Theory (SPDT)?
A model that explains how individuals make decisions to maximize their utility
What factors determine a person’s utility in SPDT?
Wealth and risk
How do investors use financial statements in Single-Person Decision Theory (SPDT)?
They update their beliefs about future firm performance based on accounting information
How do financial statements function as an information system?
They provide a link between a firm’s economic events and investors’ decision-making
What is information in decision theory?
Any evidence that affects an individual’s decision-making process
What happens if financial statements contain low-quality information?
Investors may make poor investment decisions, leading to market inefficiencies
How does risk affect decision usefulness?
Higher risk means financial information is even more valuable in helping investors reduce uncertainty
Why do risk-averse investors need high-quality financial information?
To reduce uncertainty and make better investment decisions
Why can’t financial information always be both relevant and reliable?
Because relevant information is often less reliable (like fair value), and reliable information can be less relevant (like historical costs)
What are examples of relevant but unreliable information?
Fair value estimates, future cash flow projections
What are examples of reliable but less relevant information?
Historical cost data, amortization schedules
What do diagonal elements in an information system represent?
The connection between financial statements and true economic performance
What do off-diagonal elements in an information system represent?
Noise (errors or misleading information that weakens financial reporting quality)
What is the main objective of accounting standard setters?
To provide financial information that is useful to investors, lenders, and other creditors
What assumptions do standard setters make about investors?
That they are risk-averse and need information about future cash flows
What are the key desirable characteristics of useful financial information?
Relevance
Reliability (faithful representation)
Timeliness
Comparability
Verifiability
Understandability
What is the Management Discussion & Analysis (MD&A) section?
A narrative report where management explains financial performance and risks
What kind of information is included in MD&A?
Company performance
Liquidity needs
Risks and uncertainties
Future expectations
Is MD&A more focused on relevance or reliability?
Relevance because it contains forward-looking information
What is MD&A still considered somewhat reliable?
It must be approved by the board
Companies must update forward-looking information if errors arise
What accounting tradeoff must accountants consider?
Balancing relevance and reliability while maintaining comparability, timeliness, and verifiability
