Ch1FinAccTheory

1 - 1Chapter 1 Introduction MBA AF 691-Financial Accounting Theory and Analysis SPRING 2023 Some Historical Perspective •Great depression*of 1930s -The stock market crash of 1929 -As a result, reinforcedhistorical cost accounting[I/S (income statement) based] -Lead to the creation of Securities Act of 1933 and 1934 and SEC (Securities and Exchange Commission) •Alternatives to historical cost accounting -Current value accounting: B/S (balance sheet) based •Value-in-use(intrinsic value; DCF value; very subjective) •Fair value(market value, exit price) -Mixed measurement model such as •Lower of cost or market for inventories •Impairment tests for PP&E (property, plant, and equipment) and acquisition goodwill *Major contributing factor: manipulation of financial reporting. 1 - 2 Collapse of the Stock Market Boom of Late 1990s / Early 2000s •Enron (using SPE to hide liabilities) •WorldCom -Capitalization of network maintenance costs → net income (NI) ↑ -Allowance for doubtful accounts ↓ → NI ↑ •Collapse of public confidence in capital markets •Effects on financial reporting -Increased regulation and corporate governance •Sarbanes-Oxley Act(2002). (ex.) creation of PCAOB, internalcontrol attestation, CEO/CFO certification, reform of corporate governance, audit committee -Tighten rules reoff-balance sheet entities such as SPE 1 - 3Market Meltdowns, 2007-2008 •Terminology -Securitization •One mortgage is broken into many securities and sold to many investors. -Financial instruments •Asset-backed securities (ABS) and MBS •Collateralized debt obligations (CDO) •Credit default swaps (CDS): insurance for fee. (ex) the fall of AIG -Liquidity risk •The risk of not being able to sell assets because of shortage of buyers •Liquidity pricing: value in use > market value -Counterparty risk •CDS issuers not able to meet obligations •(ex) GEICO not paying money for people experienced car accident.