353 Theory Flashcards

Who demands financial accounting information?

Investors, lenders, and other creditors (outside decision-makers).

Who supplies financial accounting information?

Management (insiders who prepare and release reports).

What is information asymmetry?

One party has more or better information than another.

Define adverse selection.

Hidden information: one party knows relevant facts that the other does not.

Define moral hazard.

Hidden action: the principal cannot easily monitor what an agent actually does.

In a corporation, who is the principal and who is the agent?

Shareholders are principals; management is the agent.

What is the agency problem?

Managers may pursue their own interests instead of maximizing shareholder value.

How might incentive compensation reduce moral hazard?

Aligns managers' payoff with shareholders' interests, but does not eliminate moral hazard.

What is the 'lemons' problem?

Investors cannot distinguish good from bad firms and discount prices, deterring high-quality sellers.

Why does costly signalling help reduce adverse selection?

A credible, verifiable signal helps distinguish higher-quality firms from lower-quality ones. (Paying dividends is an example)

Give two examples of accounting-related signalling.

Audited financial statements and dividends.

Why is 'cheap talk' an ineffective signal?

Unverifiable claims can be copied by low-quality firms.

How may nondisclosure be interpreted by investors?

If investors know management holds information, they may fear the worst.

What is earnings management?

Managers use accounting choices or estimates to bias reported results toward incentives.

What does positive accounting theory try to explain?

Why managers choose accounting policies based on incentives such as compensation or debt covenants.

Give three incentives for income-increasing earnings management.

Bonuses, avoiding debt covenant violations, and making share prices or financing prospects look stronger.

What is a 'big bath' strategy?

Taking a large loss in an already-bad year to improve apparent results in future years.

What is the key distinction between strong and semi-strong market efficiency?

Strong includes public and private information; semi-strong includes public information.

Under semi-strong efficiency, what happens after important public bad news?

Security prices should adjust rapidly downward if the news reduces expected value.

What is channel stuffing?

Pushing unusually large sales to distributors to accelerate revenue or meet targets.

Which theoretical issues can channel stuffing illustrate?

Information asymmetry, moral hazard, agency incentives, and earnings management.

What does high earnings quality primarily imply in the practice exam?

Unbiased reporting that faithfully reflects underlying economics.

Why is flexibility in accounting standards a trade-off?

It can improve relevance but creates room for estimation bias and manipulation.

Human capital contracts: how do they allocate risk?

Students pay a share of future income; investors bear more earnings risk.

Human capital contracts: name one moral hazard problem.

Students may work less or underreport income because investors cannot fully monitor effort.

Human capital contracts: name one adverse selection concern.

High-earning students may prefer ordinary loans, leaving riskier students in income-share contracts.

What is the purpose of the conceptual framework?

Support consistent standards and decisions about new accounting issues.

Who are the primary users under IFRS's general-purpose reporting objective?

Existing and potential investors, lenders, and other creditors.

What do primary users want to assess?

The amount, timing, and uncertainty of future cash flows.

What are the two fundamental qualitative characteristics?

Relevance and faithful representation.

What gives information relevance?

Predictive value, confirmatory value, or materiality.

Define predictive value.

Information helps users predict future outcomes or cash flows.

Define confirmatory value.

Information helps confirm or revise prior expectations.

Define materiality.

The threshold where omitting, misstating, or obscuring financial information could reasonably influence the economic decisions of primary users; determines which accounts require specific internal controls and audit testing.

What are the three features of faithful representation?

Completeness, neutrality, and freedom from error.

What is neutrality in accounting information?

Information is free from bias toward a desired outcome.

What does freedom from error mean?

No errors or omissions in the process of describing and measuring the item.

Name the four enhancing characteristics.

Comparability, verifiability, timeliness, and understandability.

Define comparability.

Users can identify similarities and differences across firms or periods.

Define verifiability.

Independent knowledgeable observers could reach similar conclusions.

Define timeliness.

Information is available soon enough to affect decisions.

Define understandability.

Information is clearly classified and presented so informed users can comprehend it.

Define an asset under the course's framework.

A resource controlled from a past event expected to yield future economic benefits.

Define a liability under the course's framework.

A present obligation from a past event expected to require an economic outflow.

What are the five elements of financial statements?

Assets, liabilities, equity, income, and expenses.

Which statements show stocks versus flows?

Financial position is a point-in-time stock; income and expenses cover a period.

What is recognition?

Deciding whether and when an item enters financial statement line items.

What is measurement?

Determining the dollar amount assigned to a recognized item.

Define historical cost.

Amount paid to acquire an item.

Define current cost.

Amount it would cost to replace an item today.

Define realizable value.

Amount an asset could be sold for.

Define settlement value.

Amount needed to settle a liability.

Define present value.

Discounted amount of future cash flows.

Fair value versus historical cost: primary trade-off?

Fair value may be more relevant; historical cost is often easier to verify.

What makes fair values of intangibles vulnerable?

Subjective estimates can be difficult to verify and open to management bias.

Under semi-strong EMH, does mere revaluation create value?

No, if it reveals no new information and future cash flows and risk stay unchanged.

When might an intangible revaluation affect market price?

When the valuation supplies new information beyond investors' expectations.

Google price index: primary strength in the review?

Timely and potentially relevant near-real-time information.

Google price index: key representational weakness?

Online-only sample may be incomplete or biased and less comparable to official measures.

Cash basis versus accrual basis?

Cash basis records cash movements; accrual records transactions when they occur.

What is the main benefit of accrual accounting?

More timely and complete performance reporting despite payment timing.

What is an accrual accounting drawback?

Estimates introduce uncertainty and possible earnings management.

What is the cut-off date?

The reporting-period end that separates transactions between periods.

What is an adjusting subsequent event?

New evidence about a condition that existed on the balance sheet date.

What is a non-adjusting subsequent event?

An event caused by a condition arising after year-end.

How do you treat an adjusting subsequent event?

Adjust the year-end financial statements.

How do you treat a material non-adjusting event?

Do not adjust; disclose it if material.

What is a correction of an accounting error?

Fixing a mistake in prior-period accounting or reporting.

How is a prior-period error treated?

Retrospectively: restate the affected prior-period amounts.

What is an accounting policy change?

Switching a method, e.g., FIFO to weighted average, not due to a new estimate.

How is an accounting policy change treated in the review?

Retrospectively, with comparative restatement.

What is a change in accounting estimate?

A revised judgment from new information, such as useful life or bad debt rate.

How is a change in estimate treated?

Prospectively: apply to current and future periods.

FOB shipping point: when does control normally transfer?

When goods are shipped under the stated arrangement.

FOB destination: when does control normally transfer?

When goods arrive at the customer-designated destination.

What two questions does revenue recognition answer?

How much revenue and when to recognize it.

When is revenue recognized?

When or as control passes and a performance obligation is satisfied.

Does receiving cash always mean revenue has been earned?

No; cash paid before performance creates deferred revenue.

Why is deferred revenue a liability?

The seller still owes goods or services to the customer.

Name the five revenue recognition steps.

Identify contract; identify obligations; determine price; allocate price; recognize as satisfied.

What are the contract identification criteria in the review?

Approval, identifiable rights and terms, commercial substance, probable collection.

What is commercial substance?

Contract changes expected risk, timing, or amount of future cash flows.

What is a performance obligation?

A promise to transfer a distinct good or service.

What does inherently distinct mean?

Customer can benefit from the item alone or with readily available resources.

What does contextually distinct mean?

The promise is separately identifiable within the contract.

What is transaction price?

Consideration expected in exchange for promised goods or services.

Relative stand-alone price allocation formula?

Total transaction price × individual stand-alone price / sum of stand-alone prices.

If a distinct lesson is advertised as 'free', should it receive an allocation?

Yes, if it is a separate performance obligation.

What happens to the allocated amount for a future lesson?

Deferred revenue until the lesson is provided.

Three estimation methods for missing stand-alone selling prices?

Adjusted market, expected cost plus margin, and eligible residual approach.

Name some indicators that control transferred.

Right to payment, legal title, possession, risks/rewards, customer acceptance.

Expected returns: revenue recognized equals?

Consideration expected to be retained after returns.

Expected returns: refund liability measurement?

Expected refunds at selling price.

Expected returns: right-to-recover asset measurement?

Cost of inventory expected to be returned, adjusted as appropriate.

Noncash consideration is measured at what?

Fair value of the consideration if reliably measurable; otherwise seller's SSP.

How should a significant financing component be reported?

Separate cash selling price as sales and time value as interest revenue.

Is discount on notes receivable an expense?

No, it is a contra-asset initially and amortizes into interest revenue.

What is an assurance-type warranty?

Promise product meets specifications; record warranty expense/liability.

Assurance warranty: separate performance obligation?

No; estimate expense and warranty liability at sale.

What is a service-type warranty?

Additional future service; separate performance obligation with deferred revenue.