Midterm Exam Review Comm 311

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23 Oct 2014
Comm 311 Financial Accounting Midterm Exam Review
October 2014
Chapter 1/Week 1
-The demand for accounting info arises because people like investors need to make
decisions under uncertainty about the future i.e. future growth and dividends
-Firms have incentive to supply the information because it reduces information
asymmetry (it is a costly signal)
GAAP – Generally accepted accounting principles – broad principles and conventions
of general application as well as rules and procedures that determine accepted accounting
Information – evidence that can potentially affect an individual’s decisions
Information asymmetry – a condition in which some people have more information
than others. Includes two types:
1. Adverse Selection – a type of info asymmetry whereby one party to a contract has
an information advantage over another party
i.e. You are buying a car and are willing to pay between 2-4k for it –
would the midpoint (3k) be a good start? The sellers of the cars have more
information than you do and those sellers who know their car to be higher than
average quality will not accept your offer of $3000, only those sellers who have
below average cars would accept your offer, meaning you will always overpay if
you offer 3k. As you go lower you face the same problem of always overpaying
until you lower to the lowest price in the range, $2k, meaning you will be buying
the worst possible car in the group. If the sellers think through this process
beforehand they don’t put their cars on the market at all, and as a result the used
cars available on the market are all ‘lemons’
Costly signal – communication of information that is otherwise unverifiable by
means of an action that is costly to the sender, arises because unverifiable
disclosures are cheap talk and cannot be believed (example of costly signal is a
used car dealer providing a guarantee against defects for a year)
Cheap talk – communication of unverifiable information by means that are
virtually costless i.e. ‘this car is a bargain
2. Moral hazard: A type of info asymmetry whereby one party to a contract cannot
observe some actions relating to the fulfillment of the contractual terms by the
other party
i.e. knowing that you have insurance and would not be liable to pay
damages if you unintentionally injure someone or get into a crash you are likely to
drive a bit faster and less carefully since you don’t bear the consequences of
accidents. Called moral hazard since the provision of insurance encourages less
care and effort, and therefore higher risk. There are ways to mitigate the cost of
moral hazard like having a deductible
-moral hazard involves information about one party’s actions that is not available to the
other party (hidden actions), and involves info about what happens in the future, whereas
adverse selection concerns no actions other than whether the parties choose to reveal
information that they possess (hidden info from the past and present)
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-a firm’s management needs to provide credible evidence to investors so that its shares
are not priced as ‘lemons’
-a claim by the CEO that the firm is just underpriced is just cheap talk, financial
statement done by independent auditors add credibility, or costly signals like payments of
Agency problem – arises from the inability of the principals to monitor the agents to
ensure that they make decisions in the best interest of the principals
-with moral hazard, we are concerned with the future actions of management; if the
executives are paid on a fixed salary basis, short of being fired they would be largely
insured against bad performance, and wouldn’t be motivated to strive for good
performance. To mitigate this moral hazard problem, accounting reports can be used to
provide info to owners about the firm’s performance as an indirect indicator of
management performance, and incentive pay can link compensation to performance
measures and mitigate moral hazard
Positive accounting theory – a theory for understanding managers motivations,
accounting choices, and reactions to accounting standards
Earnings management – managers efforts to bias reported accounting info in one way
or another.
Why do managers want to bias earnings upward?
Pay more for the firm’s shares
For financing – lower interest rate, more $$
Meet its contractual obligations such as debt covenants
Meet regulatory requirements such as capital requirements
Provide a stronger bargaining position in merger negotiations
Obtain higher compensation
Why do managers want to bias earnings downward?
reduce additional taxes or regulations
increase the likelihood of receiving gov’t subsidies and trade protection
Take a big bath in a bad year resulting in higher future compensation and higher
stock price
Improve the firm’s bargaining position relative to employee unions
Efficient securities market (semi strong form) – a market in which the price of
securities traded in the market at all times properly reflects all information that is publicly
known about those securities. A market that is strong form efficient has prices that reflect
all info, whether publicly or privately known. Efficient market theory has several
important implications for accounting:
a) Security prices react quickly to accounting information
b) Accounting information competes with other sources of information
c) It is important to distinguish new information from what has already been
reflected in prices
d) Using only publicly available information, it is difficult to earn abnormal profits
e) It is possible to earn abnormal profits using info that is not publicly available
f) Accounting reports and standards can assume that users have a reasonable level of
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g) Efficient market theory influences legal doctrine (misleading statements are
Chapter 2/Week 2
Components of the IFRS Conceptual Framework:
1. Users and their needsexisting and potential investors, lenders, and other
2. Objectives of financial reportingafter identifying the users (target market( we
must think about the information needs. The objective of financial reporting is to
aid investment and lending decisions (IFRS). It also provides information on the
amount, timing, and uncertainty of cash flows and on the entity’s resources,
claims, and performance. According to ASPE the objective is to make resource
allocation decisions and/or assess management stewardship.
3. Qualitative characteristicsthe desirable characteristics of financial reports that
help to meet users’ information needs. The framework enumerates six qualitative
characteristics, categorized as either fundamental or enhancing characteristics:
a. Fundamental qualitative characteristicsthe characteristics that must be
present for information to be useful for decision making
i. Relevance – the ability to influence user’s economic decisions.
Information that is able to provide feedback about past
performance (has confirmatory value) or helps make predictions
about future performance (has predictive value)
a. Materiality – whether the omission or misstatement of a
particular piece of information about a reporting entity
would influence users economic decision. If an item has so
little relevance that it would not change decisions, then it is
immaterial. Should be assessed on the basis of a class of
items or transactions rather than on an item to item or
transaction to transaction basis (i.e. even though each item
is immaterial for its maker, a company cannot omit
inventories from balance sheet since all of them together
are material)
ii. Representational faithfulness – the extent to which financial
information reflects the underlying transactions, resources, and
claims of an enterprise. Includes three attributes:
a. Completeness – the inclusion of all material items in the
financial statements
b. Neutrality – the extent to which information is free from
c. Freedom from error – the extent to which information is
absent of errors or omissions
b. Enhancing qualitative characteristicsthe characteristics that affect the
information’s degree of usefulness. Includes:
i. Understandability – the ease with which users are able to
comprehend financial reports
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