Chapter 1

Question 1

What is the purpose of financial reporting?

Answer 1

Provide useful financial information to investors and managers for decision-making

Question 2

Who are the two primary users of financial reports?

Answer 2

Investors and managers

Question 3

Why is consistency in financial reporting important?

Answer 3

It ensures comparability across firms and time periods, aiding in decision-making

Question 4

What is the role of accounting standard setters?

Answer 4

Develop rules and guidelines that ensure transparency and consistency in financial reporting

Question 5

What is information asymmetry?

Answer 5

a situation where one party has more or better information than another

Question 6

What are the two types of information asymmetry?

Answer 6

Adverse selection
Moral hazard

Question 7

What is adverse selection?

Answer 7

When managers have better information than investors and may manipulate financial disclosures

Managers within companies have inside information, leaving the potential for investors to receive bias information in financial documents that don’t tell the full story

Question 8

What is moral hazard?

Answer 8

When managers take actions that are unobservable to investors, leading to potential misalignment of interests

Question 9

What is the question that arises from moral hazard?

Answer 9

How to motivate and evaluate managers performances

Question 10

What is the question that arises from adverse selection?

Answer 10

What is useful information to the investor? Who determines what is useful and sufficient disclosure?

Question 11

How does information asymmetry affect capital markets?

Answer 11

It can lead to poor investment decisions and misallocation of resources

Question 12

What is historical cost accounting?

Answer 12

Recording assets at their original purchase price

Question 13

Why is historical cost accounting considered reliable?

Answer 13

It is based on actual transactions and is verifiable

Question 14

What is fair value accounting?

Answer 14

Recording assets at their current market value

Question 15

Why is fair value accounting considered more relevant?

Answer 15

It reflects the current economic value of an asset, provided up-to-date information

Question 16

What is the mixed measurement model?

Answer 16

A combination of historical cost and fair value measurement used in modern accounting

Question 17

What are some common criticisms of fair value accounting?

Answer 17

It can introduce volatility and relies on subjective estimates, reducing reliability

Question 18

How did the 1929 stock market crash impact accounting standards?

Answer 18

It reinforced the use of historical cost accounting to prevent manipulationWhat

Question 19

What was one major consequence of the Enron scandal (2001)?

Answer 19

The introduction of the Sarbanes-Oxley Act (2002) to improve corporate governance

Question 20

What role did accounting play in the 2008 financial crisis?

Answer 20

The use of off-balance-sheet financing and complex financial instruments reduced transparency

Question 21

What regulatory actions were taken after the 2008 financial crisis?

Answer 21

New accounting standards on fair value, consolidation, and increased disclosure requirements

Question 22

What is the efficient contracting view of financial reporting?

Answer 22

Financial reporting is shaped by contractual needs, such as debt and compensation contracts

Question 23

What does securitization mean?

Answer 23

Pooling of contractual debt (ex: mortgages) and selling their related cash flows to third party investors

Also called asset backed securities (ABS)

Question 24

How do debt contracts influence financial reporting?

Answer 24

Lenders require conservative accounting to protect against risk

Question 25

What is the role of financial reporting in manager compensation contracts?

Answer 25

It helps measure performance-based pay and aligns manager incentives with shareholder interests

Question 26

How does conservatism benefit contracting?

Answer 26

It prevents managers from overstating profits and protects creditors

Question 27

Why is ethics important in accounting?

Answer 27

Ethical behaviour ensures financial statements are honest, accurate, and reliable

Question 28

What was the ethical issue in the Enron scandal?

Answer 28

The company used fraudulent financial reporting to inflate earnings and hide debt

Question 29

What is an auditor's ethical responsibility?

Answer 29

To provide independent and unbiased assurance on financial statements

Question 30

How does professional judgement impact ethical behaviour in accounting?

Answer 30

Accountants must apply standards fairly and avoid misleading financial reports

Question 31

What is a rules-based accounting system?

Answer 31

A system with strict, detailed accounting rules (example: US GAAP)

Question 32

What is a principle based accounting system?

Answer 32

A system that focuses on broad accounting principles with professional judgement (example: IFRS)

Question 33

Is IFRS a rules-based accounting system or a principle based accounting system?

Answer 33

Principle based accounting system

Question 34

Is US GAAP a rules-based accounting system or a principle based accounting system?

Answer 34

Rule-based accounting system

Question 35

What is a disadvantage of rules-based accounting?

Answer 35

It can encourage 'loophole' accounting, where companies follow the rules but mislead investors

Question 36

Why do many regulators prefer principles-based accounting?

Answer 36

It allows for flexibility and better representation of economic reality

Question 37

What role did accounting standards play in the 2007-2008 market meltdown?

Answer 37

Fair value accounting was criticized for amplifying losses during the crisis

Question 38

What were some financial instruments that contributed to the 2008 crisis?

Answer 38

Collateralized debt obligations (CDOs) and credit default swaps (CDS)

Question 39

How did regulators respond to the financial crisis?

Answer 39

They introduced stricter disclosure rules and new fair value measurement guidelines

Question 40

What is the relationship between corporate governance and accounting?

Answer 40

Strong governance ensures financial transparency and reduces fraud risk

Question 41

What is the fundamental problem in financial accounting theory?

Answer 41

Balancing the needs of investors (decision-useful information) and managers (performance measurement)

Question 42

What type of information do investors prioritize?

Answer 42

Future firm performance indicators, often from current value accounting

Question 43

What type of information do managers prioritize?

Answer 43

Performance evaluation measures, often from historical cost accounting

Question 44

How does regulation attempt to solve this problem?

Answer 44

By setting standards that balance relevance (for investors) and reliability (for contracts)