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123 Cards in this Set
- Front
- Back
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What were the two incentive problems in uncovering Bernard Madoff? |
1) Information Production 2) Information Revelation |
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What were the two reasons the SEC had difficulty producing information? |
1) Limited Budget while flooded with cases. 2) Riskier bigger vs. safe smaller cases. |
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Why is it difficult for competitors to produce information? |
Resource intensive |
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Why is it difficult for the auditor to produce information? |
They aren't sophisticated enough. |
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Why is it difficult for the clients to produce information? |
Justified silence because they are trade secrets. |
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What are the two reasons it is difficult for the SEC to reveal information? |
1) Different groups responsible within the SEC. 2) Repercussions from public failure. |
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What are the two reasons the competitors found it difficult to reveal information? |
1) Fear of losing trading profits. 2) Risk of reverse litigation. |
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Why was it difficult for the auditor to reveal information in the Madoff case? |
Family connection. |
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Why didn't the clients reveal information in the Madoff case? |
Undermines their own position |
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Why does accounting look the way it does? |
There is a difference in information between insiders and outsiders of a firm which could cause a conflict of interest making insiders take advantage of outsiders. Outsiders created an accounting system to help solve this problem, "conservatism". |
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Why do we need accounting? |
The market won't deliver the best quantity and quality of information for society - externalities. Also reduces transaction costs between firm and market. |
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Why does the firm exist? |
Solution to market shortcomings (high transaction costs) |
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Who tries to solve the market failure when there are too many firms? |
The regulator. |
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What are the three measurements of value in the "Theory of Value"? |
1) Value-in-use. 2) Value-in-exchange. 3) Cost-of-production. |
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What is a pro and con for value-in-use? |
More relevant but subjective. |
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What does the value-in-exchange provide? |
When it is not expensive to use market, value-in-exchange is objective and provides a floor for value-in-use. |
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What is a pro and con of cost-of-production? |
Is least relevant but it is objective. |
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What is the central trade-off in accounting? |
Relevance vs reliability |
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What is the goal of accounting? |
Mitigate firm insider-outsider conflict. |
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What are the four means to achieving the goal of accounting? |
1) Accounting by transaction. 2) Historical Cost. 3) Prudent Value Recognition. 4) Conservatism. |
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What is the dual role of accounting? |
1) Institution of the individual firm. 2) Regulation across all firms. |
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How does accounting support that the firm is a solution to market shortcomings? |
Reduces transaction costs between firm and market. |
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Why would you not want to ask for cheat sheets in an exam? |
Arms Race: - Individual student incentive to produce cheat sheet at private cost with no private benefit. - Everyone in class is worse off. |
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What is the caveat to the firm solving market shortcomings? |
Firms' interaction creates market failure. |
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How does the market failure from firms' interaction get solved? |
Accounting standards regulate market for information among firms. |
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What are the two fundamental problems in information asymmetry? |
1) Imperfect interest alignment of firm stakeholders. 2) Information advantage of firm insiders over outsiders. |
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What is the definition of adverse selection? |
(Hidden information) When one party knows more than another in a trade and the parties have imperfectly aligned interests. |
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What are 3 market solutions to adverse selection? |
1) Accounting 2) Private Contracts (eg warranties) 3) Third-party information certifier (eg analysts) |
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What are the two regulatory solutions to adverse selection? |
1) Accounting 2) Third-party information intermediary (eg credit rating agency) |
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What is the definition of moral hazard? |
(Hidden action) One party cannot observe the future actions of another in a (long-term) trade and parties have imperfectly aligned interests. |
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What are the two outcomes that come from moral hazard in insurance? |
1) Unattainable best outcome: insurance company fully insures us and we take the most care possible. 2) Actual 2nd best outcome: we are partially insured and we take less care than we otherwise would. |
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What are the two outcomes that come from moral hazard in employment? |
1) Unattainable best outcome: Manage is paid fixed salary only, yet works as hard as he can. 2) Actual second best outcome: Manager's pay is partially sensitive to performance and manager works less hard than the maximum. |
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What are the two imperfect solutions to information asymmetries? |
1) Private Contracts 2) Accounting |
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Why is a private contract an imperfect solution to information asymmetries? |
Imposes cost (risk from trade) on informed party and improves incentives (to sell/work), thereby reveals info and reduces trade cost. |
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What is an example of a private contract that solves adverse selection? |
Warranties. |
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What is an example of a private contract that solves moral hazard? |
Deductibles/ bonuses |
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What is an example of accounting solving moral hazard? |
Accounting profit reliably measures output of managerial effort. |
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What is an example of accounting solving adverse selection? |
Asset value reveals quality of product offered for sale by company. |
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Is having an informational advantage always beneficial for the informed party? |
No! outcome depends on reaction of other parties. |
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What is the feedback effect? |
Not only can accounting improve the firm by fixing market shortcomings, but the accounting can change the firm in attempt to improve it. |
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Why is accounting conservative? |
To reduce impact of incentive of insiders to lie to outsiders. |
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What is the two step measurement process in accounting? |
1) Is it a genuine transaction? 2) What are the characteristics of this transaction? |
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Which characteristics do we ask for in accounting? |
The characteristics that are harder to manipulate and then treat them with a grain of salt. |
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What are the three aspects of accrual accounting? |
1) Recognition - existence of transaction. 2) Measurement - value exchanged in transaction. 3) Classification (aggregation) - business purpose of transaction/activity. |
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What is the binary outcome when a firm spends $100 today? |
Is it an asset or an expense? |
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What is the binary outcome when a firm receives $100 today? |
Is it revenue or a liability? |
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When there is a change in estimate such as depreciation rate, what update needs to be made? |
Prospective Update. |
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When there is a change in accounting policy or a correction of errors, what update needs to be made? |
Retrospective change with restatement. |
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What is the goal of a balance sheet? |
Snapshot of a firm's business model/risks. |
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What is the logic behind a balance sheet? |
"no such thing as a free lunch" in a transaction. |
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What is the method used to create a balance sheet? |
Double-entry bookkeeping. |
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What are the assets of a firm? |
Recognized resources of the firm with a source of 'certain' future benefits. |
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What are the liabilities and equity of a firm? |
The recognized claims on assets of the firm. |
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What three things are required in order for an asset to be recognized? |
1) It embodies a probable future benefit. 2) The accounting entity can control the benefit. 3) The transaction/event producing the benefit has occurred. |
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What three things are required in order for a liability to be recognized? |
1) it embodies a future specific sacrifice of economic benefits. 2) The entity has little discretion to avoid the sacrifices. 3) The event causing the obligation has already occurred. |
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What is Stockholders' Equity? |
The residual claim on a firm's assets. |
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What are the four types of shareholders' equity? |
1) Contributed capital (assets contributed to the firm by owners) 2) Retained Earnings (cumulative, undistributed earnings) 3) Reserves (other gains or losses not in R/E) 4) Non-controlling interest (in subsidiaries) |
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What is the logic behind double-entry bookkeeping? |
Every transaction has two effects: an outflow and inflow) and the two sides of a fair transaction must balance otherwise you create something out of nothing (a free lunch) |
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What is a debit? |
Inflow from a transaction. |
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What is a credit? |
Outflow from a transaction |
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What is the main reason we go through the effort of creating journal entries? |
To ask specific questions of the manager to ensure he isn't fabrication information. |
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When do accountants recognize expenses? |
1) Related revenues are recognized (matching principle) eg COGS 2) Incurred (i.e. when assets are consumed), if difficult to match with revenues (expensing rule) eg Period costs 3) Event triggered - downward revaluation of assets (loss recognition rule) eg impairment |
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What is the net income formula in accrual accounting? |
Net income = Recognized revenues - matched expenses |
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What are revenues in accrual accounting? |
Inflows of benefits from selling goods/services |
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What are expenses in accrual accounting? |
Outflows of benefits used up in generating revenues. |
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What is the retained earnings formula in accrual accounting? |
R/E: BB + NI - Dividends = EB |
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When can accountants recognize revenue? |
1) The firm has performed all, or most of, the services it is expected to provide AND 2) the firm has received assets whose value can be measured with reasonable precision (ideally cash or cash equivalent like receivables) |
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In franchising, when are rent and royalties recognized? |
In the period earned. |
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In franchising, when are the initial fees upon opening of a restaurant recognized? |
Upon opening of the restaurant. |
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When does revenue get recognized in consignment sales? |
When the right of return expires. |
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When do installment sales get recognized? |
In proportion to payments received. |
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What is the key difference in recognizing revenue between installment sales and franchise-like transactions? |
There is an inseparability of product in installment sales. |
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What is it possible to recognized revenue at point of production? |
Possible if risk and rewards of ownership transfer prior to delivery. eg minerals sold on forward contracts for future delivery at a pre-determined price |
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What are the two types of construction contracts? |
1) Fixed-price contracts 2) Cost-plus contracts |
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Where does moral hazard come from in fixed-price contracts? |
Seller may shirk quality |
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Where does moral hazard come from in cost-plus contracts? |
Seller has no incentive to lower costs |
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What two ways is revenue recognized for Fixed-price contracts? |
Percentage of completion OR cost recovery |
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How is revenue recognized for cost-plus contracts? |
Cash accounting |
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What two reasons make it difficult to measure the percentage of completion? |
1) Engineering estimates may not be the same percentage of completion as economic value. 2) Percentage of the budgeted costs incurred (cost-to-cost approach) -- budget may be underestimated because manager may want credit earlier. |
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What is the logic behind the percentage of completion method? |
Reward managers for work successfully undertaken. |
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How does the cost recovery method of recognizing revenue work? |
Revenues and expenses are recognized as cash collected, but in equal amounts until all costs are recovered. Only give the firm a profit when all costs have been covered by incoming cash flows. |
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Out of % completion, installment, and cost recovery, rank the uncertainty of completing the project. |
% completion: low uncertainty Installment: medium uncertainty Cost Recovery: high uncertainty |
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For % of completion, what are the five phases in the accounting cycle? |
1) incur cost on project. 2) Bill the client 3) Receive payments 4) Year-end adjustments 5) Complete the project. |
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What is the JE for Incurring a cost in % completion? |
Dr. CIP (WIP) - A Cr. Cash or A/P - A or L |
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What is the JE for billing in % completion? |
Dr. A/R - A Cr. Billing on CIP - CA |
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What is the JE for receiving payments in % completion? |
Dr. Cash - A Cr. A/R - A |
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What is the JE for a period end adjustment in % completion? |
Dr. Construction Expense - E Dr. CIP (WIP) - A (profit) Cr. Revenue - R |
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What is the JE for completing the project in % completion? |
Dr. Billing on CIP - CA Cr. CIP - A |
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What is the relationship between risk and the extent of moral hazard? |
Inverse relationship. Eg insurance: if someone has full insurance, they have no risk, meaning their moral hazard is high. |
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What is a way a seller can overcome the issue of adverse selection for buyers? |
Use a costly signal such as a guarantee against defects for a year. |
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What are two ways that accounting information can help solve adverse selection? |
1) Firm can hire independent auditors to attest to the financial statements' compliance with accounting standards. 2) Firm can use costly signalling such as the payment of dividends. |
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How can accounting information mitigate moral hazard? |
Reports can be used to provide information to owners about the firm's performance as an indirect indicator of management performance and use incentive pay. |
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What is positive accounting theory? |
A theory for understanding managers' motivations, accounting choices, and reactions to accounting standards |
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What are the two fundamental qualitative characteristics of financial reporting? |
Relevance and representational faithfulness. |
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What are the four enhancing qualitative characteristics? |
Understandability, comparability, verifiability, and timeliness. |
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What is materiality? |
Whether the omission or misstatement of a particular piece of information about a reporting entity would influence users' economic decisions. |
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What are the three attributes of representational faithfulness? |
1) Completeness 2) Neutrality 3) Freedom from error |
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What is an asset? |
A resource controlled by an entity as a result of past events from which future economic benefits are expected to flow to the entity. |
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What is a liability? |
A present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of economic resources embodying economic benefits. |
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What is "going concern"? |
The assumption that the reporting entity will continue operating into the foreseeable future. |
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What is the subsequent-events period? |
The period between the cut-off date and the date when the company authorizes its financial statements for issuance. |
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What criteria makes an asset current? |
If it will be realized (sold or used) within a year or during the operating cycle, whichever is longer. |
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What are the six steps in the accounting cycle? |
1) Journalizing 2) Posting 3) Adjustments 4) Preparing financial statements 5) Journalizing closing entries 6) Posting of closing entries |
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When does cash accounting sufficiently meet information demands? |
When enterprises have finite and short lives because all cash cycles close when the entity dissolves. |
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Why does accrual accounting better satisfy the demand for information than cash accounting? |
It provides additional information on cash cycles that are not yet complete at the reporting date. |
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What are the five steps in the IFRS standard for revenue recognition? |
1) Identify the contract with the customer. 2) Identify the performance obligations. 3) Determine the transaction price. 4) Allocate the transaction price to performance obligations. 5) Recognize revenue in accordance with performance. |
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What motivated Exxon's retirement of the debt? |
The early recognition of a profit, and a reduction of debt. |
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Why is an early recognition of profit valuable? |
Compensation is tied directly to short-term profit, which allows for the extraction of real resources from the firm in the short term when the ability to do so in the future is risky/uncertain and the parties whose interests are contractually linked to profit are protected from such risk through limited liability. |
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What was the benefit of lowering the debt in the Exxon case? |
The firm becomes less risky (lower risk of default), which lowers the cost of debt financing (an example of a reduction in a transaction cost). |
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Why did Exxon opt to use in-substance defeasance rather than an outright repurchase or redemption? |
They would boost their profit more as a result of preferential tax treatment. |
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In the Exxon case, what is the journal entry for issuance of new exxon debt to raise funding for gov't bond purchase? |
Dr. Cash - A 312 Cr. Bonds Payable - L 312 |
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In the Exxon case, what is the journal entry for the gov't bond purchase? |
Dr. Investment - A 312 Cr. Cash - A 312 |
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In the Exxon case, what is the journal entry for the transfer into the trust? |
Dr. Bonds Payable - L 515 Dr. Transaction Fee - E 5 Dr. Income Tax - E αT*198 Cr. Investment - A 312 Cr. Gain on Transfer - R 203 Cr Cash - A 5 Cr. Income Tax Liability - L αT198 |
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In the Exxon case, what is the overall transaction for the journal entry for in-substance defeasance? |
Dr. Bonds Payable - L 203 Dr. Transaction Fee - E 5 Dr. Income Tax - E αT*198 Cr. Gain on transfer of debt - R 203 Cr. Cash - A 5 Cr. Income Tax liability - L αT*198 |
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If Exxon were to directly repurchase their debt, what what the journal entry be for the issuance of new Exxon debt for repurchase? |
Dr. Cash - A 290 Cr. Bonds Payable - L 290 |
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If Exxon were to directly repurchase their debt, how did the number 290 become the price of the exxon debt? |
The details are not crucial, but the essence is that Exxon debt is cheaper (requires a higher return) than gov't debt because it is riskier. |
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If Exxon were to directly repurchase their debt, what would be the journal entry for repurchasing the old Exxon debt? |
Dr. Bonds Payable - L 515 Dr. Income Tax expense - E αR * 225 Cr. Cash - A 290 Cr. Gain on debt retirement - R 225 Cr. Income tax liability - L αR 225 |
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If Exxon were to directly repurchase their debt, what would be the overall transaction journal entry? |
Dr. Bonds Payable - L 225 Dr. Income Tax expense - E αR * 225 Cr. Gain on debt retirement - R 225 Cr. Income Tax Liability αR * 225 |
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What does the comparison between the in-substance defeasance and the direct repurchase of Exxon's old debt reveal? |
In-substance defeasance lowers (financing) debt less (203<225) but likely boosts current profit more ( 1 − (αT*198) > 1 − αR* 225) due to a preferential tax treatment αT ≪ αR. A more favorable tax treatment combined with a stronger preference for higher profit than lower debt. |
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What was the final result for the old debt holders in the Exxon case? |
They benefitted as the contracted cash flows remain the same but will be less risky as a result of the transaction (gov't bond risk instead of overall Exxon risk). |
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What was the final result for top management of Exxon in the Exxon case? |
Likely benefited with a higher compensation from their compensation being linked to profit. |
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What was the final result for equity holders in the Exxon case? |
- Could have benefitted from potentially higher current compensation (dividends) at the potential expense of future dividends. (earnings management) - Cost may be incurred on the share price possibly decreasing as a result of potential shareholders thinking that top management diverted their time away form real long-term value creating activities. |
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What was the final result for the US government in the Exxon case? |
Likely a loser in the transaction because they forewent higher tax revenue. |
