Chapter 2-Fsa

2-7

Managers have discretion in financial reporting in most cases. This discretion may result from either of two sources. First, managers often have a choice between alternative generally accepted rules in accounting for certain transactions. Second, managers often have to make estimates of uncertain future outcomes. Each of these managerial judgments creates managerial discretion.

2.8 Monitoring and control mechanisms include SEC oversight, internal and external auditor review, corporate governance such as Board of Director subcommittees assembled to oversee the audit and financial reporting, and the omnipresent threat of litigation.

2-11

under the historical cost model, asset and liability values are determined on the basis of prices obtained from actual transactions that have occurred in the past. Under the fair value accounting model, asset and liability values are determined on the basis of their fair values (typically market prices) on the measurement date (i.e., approximately the date of the financial statements).

Under historical cost method, when asset (or liability) values subsequently change, continuing to record value at the historical cost—i.e., at the value at which the asset was originally purchased—impairs the usefulness of the financial statements, in particular the balance sheet. Because of this the historical cost model has come under a lot of criticism for various quarters, resulting in the move toward fair value accounting.

2-12

In accounting, conservatism states that when choosing between two solutions, the one that will be least likely to overstate assets and income should be selected. The two main advantages of conservatism are that (1) it naturally offsets the optimistic bias on the part of management to report higher income or higher net assets; and (2) it is important for credit analysis and debt contracting because creditors prefer financial statements that highlight downside risk....