Conceptual Questions for Final Flashcards by L Culbertson

What is adverse selection and what problem does adverse selection present to the market?

Adverse selection occurs when one party in a transaction has more information than the other. This can result in high-quality firms/goods leaving the market because they are indistinguishable from lower-quality firms/goods.

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How do market participants decide which firms to invest in (name four aspects)?

Financial Performance
Market position/competitive advantage
3.Management and Leadership
Growth Potential and Industry Trends

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What is information asymmetry? How is it mitigated?

When one party in a transaction has more or better information than the other. Accounts can mitigate it by making sufficient, high quality information avalible in a timely manner.

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How do stakeholders use corporate information?

Investors: Evaluate profitability, growth potential, and risks for investment decisions.
Lenders/Creditors: Assess financial health and ability to meet obligations.
Employees: Determine job security, career prospects, and company values.
Customers: Analyze product quality, ethical practices, and sustainability efforts.
Regulators: Ensure compliance with laws and regulations.
Suppliers: Assess financial reliability and partnership risks

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Why is it important for stakeholders that companies provide high-quality disclosures?

Informed Decision-Making: Ensures stakeholders have accurate and reliable data.
Trust and Transparency: Builds credibility and strengthens stakeholder relationships.
Market Efficiency: Reduces information asymmetry and improves resource allocation.
Risk Management: Helps stakeholders identify and assess potential risks.
Compliance and Accountability:

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What is the efficient market hypothesis (EMH)?

EMH suggests that financial markets fully and immediately reflect all available information in the prices of securities.

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What factors complicate EMH?

Behavioral Biases: Investor irrationality distorts market prices.
Information Asymmetry
Market Frictions: Transaction costs, taxes, and liquidity.
Market Anomalies: January effect or momentum.
Limits to Arbitrage: Risks, costs, or institutional constraints.

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What is a heuristic? What is its relation to decision making?

A heuristic is a mental shortcut or rule of thumb that simplifies problem-solving and decision-making.
Efficiency: Speeds up decisions
Simplification: Focuses on key aspects of a problem without analyzing all details
Risk of Bias: Can lead to errors or biases, as it trades accuracy for speed

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In the corporate environment, information asymmetry creates disadvantage. What parties are at a disadvantage and why?

Investors: leading to poor investment decisions
Employees: Incomplete knowledge strategy and finances affects job security and morale
Suppliers: Uncertainty can lead to unfavorable terms
Consumers: Lack of transparency about product quality or ethical practices leads to poor choices
Creditors/Lenders: increases the risk of lending to unstable companies

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Companies face advantages and disadvantages of disclosing firm-specific information. What are some of these advantages and disadvantages?

Pros: Reduce Information Asymmetry, Increase trust and Transparency, Attracts Investment

Cons: Competitive Disadvantage (disclosing sensitive info), Increased Scrutiny, Cost of Disclosure

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There are two sources of GAPP: primary and secondary. Give examples of each.

Primary sources include IFRS, and ASPE

Secondary would include thins like the CPA handbook, academic research and accounting textbooks

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What is regulatory capture?

Regulatory capture occurs when a regulatory agency is influenced or controlled by the industry it is supposed to regulate, leading to decisions that favor industry interests over the public good.

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What dimensions could we examine to determine if a board has been ‘captured’ in regards to regulatory capture?

-Board Composition & Industry Influence
-Decision-Making & Policy Outcomes
-Lobbying & Political Influence
-Financial & Resource Dependence
-Negative Public & Media Perception

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In general terms, what is the mandate of provincial securities commissions? What is the largest securities commission in Canada?

They regulate capital markets by enforcing securities laws, protecting investors, ensuring fair and efficient markets, and fostering public confidence in financial systems.
- The Ontario Securities Commission (OSC)

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What capitals are included in the International Integrated Reporting Framework (IIRF)? How are they interrelated? (6)

Financial Capital
Manufactured Capital
Intellectual Capital
Human Capital
Social & Relationship Capital – Stakeholder relationships, reputation, and trust.
Natural Capital – Environmental resources

changes in one can impact others

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How does IFRS define an economic entity? What difference does this make for corporate reporting?

Economic entity is an organization that has a legal entity separate from from its members and requires a company to consider who should record a transaction.

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Other comprehensive income items are defined by IFRS to include what 4 types of items?

-Changes in revaluation surplus
-Actuarial gains and losses- on defined benefit pension plans.
-Gains and losses from remeasuring available-for-sale financial assets.
-Effective portion of gains and losses on hedging instruments

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What is periodicity and how does periodicity affect the going concern assumption?

Periodicity is the division of a company’s life into specific time periods (e.g., months, quarters, or years) for financial reporting purposes.

The going concern assumption assumes the business will continue operating indefinitely.

Periodicity does not contradict this assumption but provides snapshots of financial performance within shorter time frames.

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At what point in time does historical cost equal fair value? What causes these two measurements to differ?

At the initial acquisition date.
Market fluctuations
Depreciation or amortization
Impairment
Revaluations
Time

What is the full disclosure principle? How can companies comply with full disclosure while maintaining accessible documents?

That companies should provide all necessary information in their financial statements that could influence the decisions of users.

-Use clear language
-summaries and highlights
-standardized reporting (IRFS)
-Prioritize materiality

What is a business model? What information does a business model include?

A business model describes how a company creates and captures value.

Includes: Value Proposition, target market, revenue streams, cost structure, key activities, resources, and partnerships, and, customer relationships.

High-quality earnings metrics are said to have confirmatory and predictive value. What does this mean? Discuss in the context of proforma earnings.

High-quality earnings metrics provide information that helps users confirm or correct their prior expectations about a company’s financial performance. Proforma earnings can lack quality if they exclude too many items or are manipulated to inflate performance, reducing their confirmatory and predictive value.

What are proforma earnings? What concerns do security commissions have about these earnings metrics, and what regulations are in place to mitigate potential manipulation?

-Potential to mislead investors
-Lack of standardization

Reporting Standards (IFRS)
Continuous Disclosure Obligations
Enforcement and Oversight

Why is management keen to avoid reporting losses, according to prospect theory?

Loss Aversion
Investor Perception
Executive Compensation
Debt Covenants
Reputation

What are common techniques management uses to increase income and avoid reporting a loss?

Revenue Recognition Manipulation Expense Deferral/Capitalization Cookie Jar Reserves Non-Recurring Adjustments Changing Accounting Policies Real Activities Manipulation Off-Balance Sheet Financing

What regulatory frameworks exist to prevent earnings manipulation?

GAAP/IFRS Standards Auditor Oversight CSA Guidelines

What is the significance of the "spike in small positive earnings" observed in studies?

This behavior aligns with prospect theory, where loss aversion drives managers to avoid reporting negative earnings. The spike highlights potential misleading financial reporting and the need for regulatory oversight.

What is big bath accounting?

exaggerating losses in a single period to make future periods appear more profitable

Why does management engage in big bath accounting?

Smoothing Future Earnings Meeting Performance Targets Masking Poor Performance Facilitating Restructuring Behavioral Factors Exceeding Low Expectations

What are the risks and regulations of big bath accounting?

Misleading Investors Regulatory Scrutiny Erosion of Trust GAAP/IFRS Standards Auditor Oversight

Where are non-GAAP earnings reported?

Management Discussion Analysis -Comments and discussion

Proforma earnings are sometimes called “earnings before the bad stuff”. Explain why.

Proforma earnings exclude expenses or losses that management deems non-recurring, non-operational, or unusual, such as restructuring costs, asset write-downs, or litigation expenses.

What types of companies have low/high accounts receivable? Is having high A/R good or bad?

Low A/R : retailers, restaurants High A/R : B2B, manufacturers -can lead to bad debt and strained cash flows -sales growth and customer relations

How can companies with high A/R reduce credit risk?

1. clearer credit policies 2. several payment options 3. stricter collections

Why might management exchange assets with a related company? How is this management bias dealt with in IFRS?

Balance Sheet Manipulation and Hiding Losses or Overstating Profits If assets are exchanged, they must be recorded at fair value, not an arbitrary management-determined price. If fair value cannot be determined, the asset is recorded at the carrying amount of the asset given up.

Name 3 indicators of impairment (i.e. how do we know an asset or CGU is impaired?)

1. changes in tech market, economic, or legal environment that adversely affects entity 2. Market rates of return have increased with a negative effect on assets value in use and recoverable amount 3. Evidence of obsolescence or physical damage of the asset

With reference to the recognition criteria for capitalization, describe the treatment of R&D under IFRS and the rationale driving this accounting treatment.

Matching Principle – Capitalizing development costs aligns expenses with future revenues they help generate. Conservatism – Research costs are expensed because of their uncertain future benefits. Financial Statement Reliability – Prevents overstatement of assets by ensuring only viable projects are capitalized.

IFRS permits the use of cost and revaluation models for intangible assets. In what situations is the cost model more appropriate and why? Give an example of when the revaluation model may be appropriate.

When no active market exists, Many intangible assets are unique and have no observable market price. An example could be internally generated software intended to be used by the company that generated it

What is the difference between accumulating and non-accumulating rights to benefits? How are these accounted for in IFRS (show journal entries to exemplify)?

Accumulating Rights – Benefits that can be carried forward if unused Non-Accumulating Rights – Benefits that expire if unused Accumulating: Y1-Dr. Employee Benefits Expense Cr. Provision for Employee Benefits Y2-Dr. Provision for Employee Benefits Cr. Salaries & Wages Payable Non-Accumulating: Dr. Employee Benefits Expense Cr. Salaries & Wages Payable Dr. Salaries & Wages Payable Cr. Cash

What is the difference between a legal and constructive obligation? Give an example of a constructive obligation and its accounting.

Legal obligations are enforceable by law (e.g., contracts, regulations). Constructive obligations arise from a company’s behavior and past practices, creating a valid expectation. Constructive obligations must be recognized as a liability if the outflow of resources is probable and can be measured reliably. Dr. Employee Benefits Expense $100,000 Cr. Provision for Bonuses $100,000 Next year Dr. Provision for Bonuses $100,000 Cr. Cash $100,000

What is the recognition criteria for provisions (ASPE: contingent loss) under IFRS and ASPE? Why is ASPE not as onerous?

IFRS: Present Obligation – Legal or constructive obligation exists. Probable Outflow (>50%) Reliable Estimate – Can be reasonably measured ASPE: Likely Obligation (~70%) Reasonably Measurable – Can estimate loss amount - Focuses on legal (not constructive) obligations

Preferred shares are described as a hybrid of debt and equity. Explain this statement with reference to the features of pref shares that were discussed in class.

Because of the some of the features that pref shares have like non-voting and them being redeemability and convertibility, fixed dividend payments, priority over common stocks, and cumulative payments they can seem more like debt than equity.

Common shareholders are entitled to the residual value in the company. Explain what this statement means.

Common shareholders have a claim on the company's remaining assets and earnings after all other obligations have been settled. They are last in line in terms of profits.

Dividends and repurchases of shares are both methods of returning cash to shareholders. What factors does management weigh in deciding whether to increase dividends versus repurchasing shares?

Companies with stable, predictable earnings often increase dividends to reward shareholders. Companies with excess cash, undervalued stock, or uncertain future earnings may opt for share repurchases for flexibility and tax efficiency.

From a shareholder’s perspective, what are the perceived benefits and drawbacks to a company increasing their debt (i.e. more debt)?

Pros: Higher returns (leverage effect) Tax advantages Avoid Dilution (decreases EPS) Cons: More financial risk (more interest) Reduced flexibility (bank does not care about unexpected costs)