Intermediate Accounting Volume 1, 13th Canadian Edition by Donald E. Kieso Test bank
Moral hazard refers to hidden actions, and occurs as a result of human nature. People or companies may shirk their responsibilities if they think they can get away with it, e.g., not disclose negative information since they know it may be detrimental to their share price. This is a form of management bias.
Difficulty: Easy
Learning Objective: Understand the financial reporting environment.
Section Reference: Financial Statements and Financial Reporting
CPA: Communication
CPA: Financial Reporting
CPA: Strategy & Governance
Bloomcode: Knowledge
AACSB: Communication
Ex. 1-62 Maintaining competitive advantage
In the most efficient and effective marketplace possible, all stakeholders would have equal access to all relevant information. However, a company may believe that complete disclosure may hurt its competitive advantage or position. Offer an example of a circumstance where this may be the case. What do you think the company should do?
Solution 1-62
An example where disclosure may hurt the company’s competitive advantage or position would be a legal battle. If the company were in the middle of a lawsuit, the company would want to be careful about how much information was disclosed because it might affect the outcome of the lawsuit. This is an ethical dilemma. The company must weigh the costs and benefits of sharing information. If the financial impact of the lawsuit is expected to be material, they should, at minimum, disclose its existence in the notes to the financial statements. If the amount and timing of any financial impact are sufficiently known and certain, an accrual of these amounts may be necessary.
Difficulty: Hard
Learning Objective: Understand the financial reporting environment.
Section Reference: Financial Statements and Financial Reporting
CPA: Communication
CPA: Professional & Ethical Behaviour
CPA: Strategy & Governance
Bloomcode: Evaluation
AACSB: Communication
Ex. 1-63 Management bias in financial statement presentation
There are many reasons why management may present biased information in the financial statements. Identify and explain at least three (3) such motivations.
Solution 1-63
Possible motivations for management bias include:
1. Evaluation of management performance – If the company has not performed at the level expected by investors, there may be incentive by management to try and present the financial information in a way that is more favourable than the actual results.
2. Compensation structures – Renumeration either bonuses or stock options that are tied directly to net income.
3. Access to capital markets and meeting financial analyst expectations – Desire to meet the financial analysts’ expectations for performance, since this may directly affect cost of capital or share prices.
4. Contractual obligations – Lending agreement covenants that have specific requirements related to liquidity or solvency.
Difficulty: Easy
Learning Objective: Understand the financial reporting environment.
Section Reference: Financial Statements and Financial Reporting
CPA: Communication
CPA: Professional & Ethical Behaviour
CPA: Strategy & Governance
Bloomcode: Comprehension
AACSB: Communication
Ex. 1-64 Financial versus managerial accounting
Distinguish between financial and managerial accounting.
Solution 1-64
Financial accounting (financial reporting) is the process that culminates in the preparation of financial reports that cover all of the enterprise’s business activities and that are used by both internal and external parties. Users of these financial reports include investors, creditors, and others.
In contrast, managerial accounting is the process of identifying, measuring, analyzing, and communicating financial information to internal decision-makers. This information may take varied forms, such as cost-benefit analyses and forecasts that management uses to plan, evaluate, and control an organization’s operations.
Difficulty: Easy
Learning Objective: Understand the financial reporting environment.
Section Reference: Financial Statements and Financial Reporting
CPA: Financial Reporting
Bloomcode: Knowledge
AACSB: Communication
Ex. 1-65 Role of securities commissions and stock exchanges
Explain the role of securities commissions and stock exchanges in financial reporting.