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Study Guide

BU457- Final Exam Guide - Comprehensive Notes for the exam ( 129 pages long!)


Department
Business
Course Code
BU457
Professor
Bixia Xu
Study Guide
Final

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WLU
BU457
FINAL EXAM
STUDY GUIDE

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Introduction to Financial Accounting Theory
Conservative Accounting
o Conservatism: requiring of higher standard of verification to record gains
than to record losses, resulting in persistent understatement of assets,
earnings, and shareholder’s equity relative to their current values
o Unrealized losses from declines in value are recognized when they
take place, but gains from increases in value are not recognized until
they are realized
Note on Ethical Behaviour
o Ethical behavior by accountants and auditors are required, since numerous
accountants designed, were involved in, or at least knew about the various
reporting irregularities
o It seems that conforming to GAAP is not sufficient to prevent financial
reporting failures
o By ethical behavior, this means that accountants must behave with integrity
and independence in putting the public interest ahead of the employer’s and
client’s interests, should these conflict
o In effect, in the longer run, self-interested behavior and ethical behavior
merge
Rule-Based Versus Principles-Based Accounting Standards
o Rule-based standards attempt to lay down detailed rules for how to account
o Principles-based standards lay down general principles only, and rely on
auditor professional judgment to ensure that application of the standards is
not misleading
The Complexity of Information in Financial Accounting and Reporting
Environment of accounting is both very complex and challenging
o Complex because the product of accounting is information, and
absence of perfect or true accounting concepts and standards
o Individuals will not be unanimous in their reaction to even the same
information
o In affecting decisions it also affects the working of markets, such as
securities markets and managerial labour markets
The Role of Accounting Research
There are two complementary ways to view the role of research
o Consider its effects on accounting practice
o Improving our understanding of the accounting environment
The Importance of Information Asymmetry
Information asymmetry: some parties to business transactions may have
an information advantage over others
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There are 2 types of information asymmetry
o Adverse selection: type of information asymmetry whereby one or
more parties to a business transaction, or potential transaction, have
an information advantage over other parties
Occurs because some persons will know more about the
current condition and future prospects of the firm than outside
investors
This can be adverse to the interest of ordinary investors, since
it reduces their ability to make good investment decisions
o Moral hazard: type of information asymmetry whereby one or more
parties to a business transaction, or potential transaction, can observe
their actions in fulfillment of the transaction but other parties cannot
Accounting net income can be viewed as a measure of
managerial performance
This helps control moral hazard in two complementary ways
Net income can serve as an input into executive
compensation contracts to motivate manager
performance
Net income can inform the managerial labour market,
so that a manager who shirks will suffer a decline in
income, reputation, and market value in the longer run
The Fundamental Problem of Financial Accounting Theory
The most useful measure of net income to inform investors, that is, to control
adverse selection, need not be the same as the best measure to motivate
manager performance, that is, to control moral hazard
Providing it is reasonably reliable, current value accounting enables better
investment decisions and better-operating capital markets
This is because it provides up-to-date information about assets and liabilities,
hence of future firm performance, and reduces the ability of insiders to take
advantage of changes in asset and liability values
Stewardship role of accounting is providing information that is highly
informative about management’s performance in running the firm, since this
enables efficient compensation contracts and better working of managerial
labour markets
From a managerial perspective, a less volatile and more conservative income
measure, such as one based on historical cost, or at least a measure that
excludes certain unrealized gains and losses, may better fulfill a role of
motivating and evaluating managers
Given that there is only one bottom line, the fundamental problem of
financial accounting theory is how to design and implement concepts and
standards that best combine the investor-informing and manager
performance-evaluating roles for accounting information
The proposed format includes a separate income statement section for other
comprehensive income
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