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Chapter Summaries for 1st Midterm.docx

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Midterm Review (Highlights of each chapter) Chapter 1: Introduction (Adverse selection and moral hazard) - Conservative accounting: anticipate no profits, anticipate all losses - Ideal conditions: future cash flows and probabilities are known - Information asymmetry o Adverse selection: some parties may have an information advantage over others before the transaction occurs  If quality cannot be assessed, buyer is willing to pay at most a price that reflects the average quality but seller of good items will not want to sell at the price for average quality  Investors will not buy bad securities so the market will not function well o Moral hazard: parties can observe their actions in fulfillment of the transaction but other parties cannot after the transaction occurs  Incentive to behave differently once an agreement is made  Sarbanes-OxleyAct made it illegal for a registered public accounting firm to provide non audit services to a client at the same time as an impermissible audit (Public CompanyAccounting Oversight Board) - Rational investor: model of how an investor may use new information to revise beliefs about future firm performance - Decision usefulness: use theory of rational investor o Information: form does not matter o Measurement: accountants taking responsibility for incorporating measurements - Efficient securities market: share prices fully reflect all publicly available information - Behavioural theories: efficient contracts to motivate manager performance and achieve good corporate governance Chapter 2: Accounting Under Ideal Conditions (Relevancy and reliability) - Ideal conditions under certainty: future firm cash flows and interest rates are publicly known with certainty o Information on F/S are entirely irrelevant o Dividend irrelevancy as long as investors can invest at the same rate of return o Information is reliable, and the B/S provides all information - Ideal conditions under uncertainty o State of nature (good or bad outcome) o State probabilities (objective and publicly known, realizations of good or bad outcome are independent) o Abnormal earnings is the difference between expected and actual cash flows  First calculate expected PV of future cash flows - Oil & gas accounting o Full cost method: all exploration costs are capitalized o Successful efforts: only exploration costs of successful wells are capitalized o FASB/SEC mandated SE method in 1977 but in 1979 SEC went against FASB allowing firms to choose either method o Reserve Recognition Accounting: application of PV accounting when ideal conditions do not exist  Discounted at mandated rate of 10%  Revenue recognized as reserves are proved Midterm Review (Highlights of each chapter)  Critiques of RRAinclude: problems with relevance, estimates needed, estimates are subject to error and bias - Relevant information: information about future firm performance - Reliable information: complete, free from material error/bias - Relevance vs. Reliability trade-off o Historical: I/S shows past performance as is the best predictor for future performance (therefore more relevant) o Current: B/S shows current assets/liabilities (therefore more reliable) o Trade-offs include timing of revenue recognition, recognition lag, and matching principle for expenses o Mixed measurement model consists of current value measurement forA/R,A/P, financial instruments and post-retirement benefits  Historical cost for inventory, PPE, purchased goodwill - Accountants are not needed if true net income existed (judgment is therefore required) Chapter 3: The Decision Usefulness Approach to Financial Reporting (Information affecting investors decisions and risk) - Categorize users into broad constituents and understand the decision needs of each constituent - Investors need information to help them assess securities’expected returns and the riskiness of these returns - Single-person decision theory: individual must make a decision under conditions of uncertainty - Information system: conditional probabilities linking current financial information and future firm performance o Gives information about the reliability/relevance trade-off and conservatism - The rational decision theory model: formalized procedure to make the best decision from a set of alternatives and incorporate new information to revise former subjective assessments under conditions under uncertainty (Bayes’theorem) o The rational, risk-averse investor and portfolio diversification  Mod
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