Question 2: Accounting Analysis Flashcards
What are the three ways accounting reflects what happened in the underlying business?
1) Accrual accounting
2) Accounting standards
3) Delegating financial reporting to managers
How does accrual accounting enable the financial statements to reflect actual performance
1) Unlike cash accounting, accrual accounting records the records the benefits and costs associated with economic activities when they occur, rather than the mere transition of cash
2) Enables the full economic consequences of transactions within a given period to be reflected in the statements
3) Enables managers to reflect inside information within the statements
How do accounting standards enable accounting to reflect the underlying performance?
1) Accounting standards implemented by the AASB in Australia LIMIT POTENTIAL DISTORTIONS that management can introduce into reported numbers, while still reflecting the underlying performance
2) Accounting conventions ensure that managers use their accounting flexibility to summarise their knowledge of the business activities for non-self serving purposes
How does delegating financial reporting to managers enable the underlying performance to be reflected?
1) Corporate managers can CHOOSE ACCOUNTING POLICIES AND DISCLOSURES that make it easier for users of financial reports to truly understand the economic performance
2) While accounting standards provided minimum reporting requirements, managers can also voluntarily add ADDITIONAL DISCLOSURES to provide transparency regarding the firms activities
How does auditing improve accounting?
Ensures that accounting rules and conventions are consistently applied over time and that their accounting estimates are reasonable & improves the overall quality of accounting data
What are the three reasons why accounting doesn’t work properly?
1) Accrual accounting
2) Noise from accounting standards
3) Motivations behind the management reporting strategy
Why does accrual accounting mean accounting doesn’t work?
1) Managers cannot perfectly predict the consequence of future transactions and FORECAST ERRORS are a source of noise in accounting
2) Extent of error depends on the complexity of transactions, predictability of the firms environment and unseen economy-wide changes
How does noise from accounting standards and rules impact accounting quality?
1) Difficult to reduce management discretion without reducing the information content of accounting data
2) The extent to which it impacts quality Is dependent on how well uniform accounting standards capture the nature of a firms transaction
How do corporate managers introduce noise and bias into the FS?
Due to a variety of incentives to achieve either their own objectives or the objectives of the firm as a whole
What are some of the reasons why certain accounting choices may be made?
1) Debt covenants: If close to being in breach- management may select accounting policies that reduce the potential breach
2) Management compensation: Choose policies that maximise personal compensation and job security
3) Corporate control contests: Accounting numbers are used extensively in the debate and therefore mgt may use accounting numbers to improve their own future prospects
4) Tax considerations: accounting choices may be made to reduce taxation implications (For example, in the US, the choice of inventory method may result in tax deductions)
5) Regulatory considerations: Managers may make accounting decisions to influence regulatory outcomes
6) Stakeholder considerations: Make decisions to influence the stakeholders perception of the firm
7) Competitive considerations: Competition may determine disclosure decisions (for example, breakdown of performance of various segments of the business)
