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Chapter 1
Fundamentals of Financial Accounting Theory
I. Problems
P1-1. Suggested solution:
People need to make decisions under uncertainty, which creates the demand for information to
reduce that uncertainty, allowing them to make better decisions. However, if everyone had
access to the same information at the same time, no one would be able to supply any information
useful to anyone else (since they already have it). Thus, an asymmetric distribution of
information is necessary for the supply of information from those who have relatively more of it
to those who have relatively less.
P1-2. Suggested solution:
An IPO is a sale of a part of the entrepreneur’s company to other investors. Inherently, there is
uncertainty about the future success of this company and the value of the company’s shares in
the future. Potential investors demand information to reduce this uncertainty. If the entrepreneur
is able to supply information that reduces the potential investor’s perceptions of uncertainty, she
is likely to be able to obtain a higher stock price in the IPO. The entrepreneur has intimate
knowledge of her company’s operations, which is likely to be far superior to the information
available to potential buyers of the IPO shares—there is information asymmetry between the
entrepreneur and potential investors.
P1-3. Suggested solution:
A borrowing/lending transaction involves an advance of funds from the bank to the company in
exchange for promises of future repayment from the company to the bank. There is, of course,
uncertainty regarding the ability of the company to repay the bank in the future. The
corporation’s management has better information about the company’s prospects in comparison
to bank staff. To reduce this information asymmetry, the bank demands information such as
audited financial statements. The corporation is willing to supply this information in order to
obtain the most favourable borrowing terms (e.g., a low interest rate).
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,Full download please contact or qidiantiku.com
P1-4. Suggested solution:
Adverse selection Moral hazard
Hidden action or information? Hidden information Hidden action
Information about past, present, or future? Past and present Future
Associated with the market for “lemons” or Insurance
Market for lemons
insurance deductibles? deductibles
Mitigation of information asymmetry involves
Full disclosure Risk sharing
risk sharing or full disclosure?
Most closely associated with investment Investment Compliance with
decisions or compliance with contractual terms? decisions contractual terms
Creates demand for provision of relevant or Relevant
Reliable information
reliable information? information
P1-5. Suggested solution:
The managers within companies have an information advantage over outside investors. This
adverse selection causes investors to be sceptical of investing in the company, unless
management provides information to alleviate that scepticism. If management withholds
information, investors will rationally price the company as a “lemon.” To avoid this negative
outcome, management’s best response is to voluntarily provide information to investors.
P1-6. Suggested solution:
Signalling must be costly to be credible because a costless signal can be sent by anyone. A signal
that can be sent by anyone has no value because such “cheap talk” does not help differentiate one
party from another. Thus, the signal should not believed—it is not credible.
Since signalling must be costly to be credible, a company that can credibly communicate
information through other more cost-effective means would avoid costly signalling. Therefore, if
there are no other cost-effective means to communicate a particular type of information, the
company could choose to use costly signalling. For example, to credibly indicate management’s
belief in the sustainability of the company’s cash flows, the company can commit to a higher
level of dividend payments to shareholders.
P1-7. Suggested solution:
The separation of ownership and management creates a moral hazard by allowing management
to take responsibility for the resources of shareholders, and the shareholders cannot monitor
management. Shareholders would like to see high returns on their investment, but this can only
be expected if management works hard to create value. Managers incur the cost of hard work,
but they do not obtain the benefits of that hard work in the absence of incentive pay.
Accounting information helps to alleviate this moral hazard in two ways. Accounting
reports provide measures of performance that shareholders can use to evaluate/monitor
management. Second, the accounting performance measures can be used as a basis for rewarding
management. Incentive pay linking management compensation to value creation helps to align
the interests of management with those of shareholders.
Full download please contact or qidiantiku.com
, Full download please contact or qidiantiku.com
P1-8. Suggested solution:
Moral hazard arises in a lending context because the bank loses control of funds that it advances
to the borrowing enterprise. The bank is justifiably worried that the borrower will misspend the
funds and not repay the loan and interest. This scepticism causes banks to be reluctant in lending
and to charge high interest rates to cover potential losses from unpaid loans.
Accounting information can be valuable in alleviating this moral hazard by allowing the
bank to monitor the performance of the borrower using the accounting reports (e.g., is the
company profitable, how much assets does it have, how much cash flow is it generating?). Part
of the monitoring is in the form of covenants that require the company to comply with various
financial ratios computed using accounting reports. By alleviating the extent of moral hazard,
accounting information allow banks to be less sceptical of borrowers and thereby lower the
interest rates that they charge and increase their lending activity.
P1-9. Suggested solution:
An agency problem (moral hazard) arises when shareholders hire a manager to run the business
for them, as the shareholders cannot directly observe management’s actions in administering the
resources entrusted to him.
Some would suggest that the shareholders’ motivation for investing is solely to maximize their
returns while the employee’s (management) motivation for working is to do as little as possible
to earn the agreed upon salary. While this is likely an extreme case it remains that shareholders
are normally interested in earning high returns whereas the manager may be reluctant to work
hard to create those returns unless there is an incentive to do so.
There are various ways to mitigate this problem, including:
Linking the manager’s pay to value creation by paying a bonus for achieving stipulated
financial targets such as net income, return on equity, and sales growth.
Granting the manager a partial ownership interest in the company through direct
shareholdings or a stock option plan so as to align the manager’s interests with that of the
owners.
Using accounting reports to monitor the company’s performance as a proxy (indirect
measure) of the manager’s performance.
P1-10. Suggested solution:
This is a case of adverse selection, because the information is not affected by the actions of the
person who has the information—we cannot change time. There is only hidden information, not
hidden actions. (Using a fake or borrowed piece of identification is fraudulent and the insurance
would be voided.)
P1-11. Suggested solution:
All three situations are most likely cases of moral hazard as they involve hidden actions, rather
than hidden information. An outcome of moral hazard is that parties may take on risks because
the negative consequences of those risks will be borne by someone else.
Full download please contact or qidiantiku.com
Chapter 1
Fundamentals of Financial Accounting Theory
I. Problems
P1-1. Suggested solution:
People need to make decisions under uncertainty, which creates the demand for information to
reduce that uncertainty, allowing them to make better decisions. However, if everyone had
access to the same information at the same time, no one would be able to supply any information
useful to anyone else (since they already have it). Thus, an asymmetric distribution of
information is necessary for the supply of information from those who have relatively more of it
to those who have relatively less.
P1-2. Suggested solution:
An IPO is a sale of a part of the entrepreneur’s company to other investors. Inherently, there is
uncertainty about the future success of this company and the value of the company’s shares in
the future. Potential investors demand information to reduce this uncertainty. If the entrepreneur
is able to supply information that reduces the potential investor’s perceptions of uncertainty, she
is likely to be able to obtain a higher stock price in the IPO. The entrepreneur has intimate
knowledge of her company’s operations, which is likely to be far superior to the information
available to potential buyers of the IPO shares—there is information asymmetry between the
entrepreneur and potential investors.
P1-3. Suggested solution:
A borrowing/lending transaction involves an advance of funds from the bank to the company in
exchange for promises of future repayment from the company to the bank. There is, of course,
uncertainty regarding the ability of the company to repay the bank in the future. The
corporation’s management has better information about the company’s prospects in comparison
to bank staff. To reduce this information asymmetry, the bank demands information such as
audited financial statements. The corporation is willing to supply this information in order to
obtain the most favourable borrowing terms (e.g., a low interest rate).
Full download please contact or qidiantiku.com
,Full download please contact or qidiantiku.com
P1-4. Suggested solution:
Adverse selection Moral hazard
Hidden action or information? Hidden information Hidden action
Information about past, present, or future? Past and present Future
Associated with the market for “lemons” or Insurance
Market for lemons
insurance deductibles? deductibles
Mitigation of information asymmetry involves
Full disclosure Risk sharing
risk sharing or full disclosure?
Most closely associated with investment Investment Compliance with
decisions or compliance with contractual terms? decisions contractual terms
Creates demand for provision of relevant or Relevant
Reliable information
reliable information? information
P1-5. Suggested solution:
The managers within companies have an information advantage over outside investors. This
adverse selection causes investors to be sceptical of investing in the company, unless
management provides information to alleviate that scepticism. If management withholds
information, investors will rationally price the company as a “lemon.” To avoid this negative
outcome, management’s best response is to voluntarily provide information to investors.
P1-6. Suggested solution:
Signalling must be costly to be credible because a costless signal can be sent by anyone. A signal
that can be sent by anyone has no value because such “cheap talk” does not help differentiate one
party from another. Thus, the signal should not believed—it is not credible.
Since signalling must be costly to be credible, a company that can credibly communicate
information through other more cost-effective means would avoid costly signalling. Therefore, if
there are no other cost-effective means to communicate a particular type of information, the
company could choose to use costly signalling. For example, to credibly indicate management’s
belief in the sustainability of the company’s cash flows, the company can commit to a higher
level of dividend payments to shareholders.
P1-7. Suggested solution:
The separation of ownership and management creates a moral hazard by allowing management
to take responsibility for the resources of shareholders, and the shareholders cannot monitor
management. Shareholders would like to see high returns on their investment, but this can only
be expected if management works hard to create value. Managers incur the cost of hard work,
but they do not obtain the benefits of that hard work in the absence of incentive pay.
Accounting information helps to alleviate this moral hazard in two ways. Accounting
reports provide measures of performance that shareholders can use to evaluate/monitor
management. Second, the accounting performance measures can be used as a basis for rewarding
management. Incentive pay linking management compensation to value creation helps to align
the interests of management with those of shareholders.
Full download please contact or qidiantiku.com
, Full download please contact or qidiantiku.com
P1-8. Suggested solution:
Moral hazard arises in a lending context because the bank loses control of funds that it advances
to the borrowing enterprise. The bank is justifiably worried that the borrower will misspend the
funds and not repay the loan and interest. This scepticism causes banks to be reluctant in lending
and to charge high interest rates to cover potential losses from unpaid loans.
Accounting information can be valuable in alleviating this moral hazard by allowing the
bank to monitor the performance of the borrower using the accounting reports (e.g., is the
company profitable, how much assets does it have, how much cash flow is it generating?). Part
of the monitoring is in the form of covenants that require the company to comply with various
financial ratios computed using accounting reports. By alleviating the extent of moral hazard,
accounting information allow banks to be less sceptical of borrowers and thereby lower the
interest rates that they charge and increase their lending activity.
P1-9. Suggested solution:
An agency problem (moral hazard) arises when shareholders hire a manager to run the business
for them, as the shareholders cannot directly observe management’s actions in administering the
resources entrusted to him.
Some would suggest that the shareholders’ motivation for investing is solely to maximize their
returns while the employee’s (management) motivation for working is to do as little as possible
to earn the agreed upon salary. While this is likely an extreme case it remains that shareholders
are normally interested in earning high returns whereas the manager may be reluctant to work
hard to create those returns unless there is an incentive to do so.
There are various ways to mitigate this problem, including:
Linking the manager’s pay to value creation by paying a bonus for achieving stipulated
financial targets such as net income, return on equity, and sales growth.
Granting the manager a partial ownership interest in the company through direct
shareholdings or a stock option plan so as to align the manager’s interests with that of the
owners.
Using accounting reports to monitor the company’s performance as a proxy (indirect
measure) of the manager’s performance.
P1-10. Suggested solution:
This is a case of adverse selection, because the information is not affected by the actions of the
person who has the information—we cannot change time. There is only hidden information, not
hidden actions. (Using a fake or borrowed piece of identification is fraudulent and the insurance
would be voided.)
P1-11. Suggested solution:
All three situations are most likely cases of moral hazard as they involve hidden actions, rather
than hidden information. An outcome of moral hazard is that parties may take on risks because
the negative consequences of those risks will be borne by someone else.
Full download please contact or qidiantiku.com
