Accounting Theory and Disclosure

Subcribe Us on YouTube 00:00:02 welcome to the Deep dive
00:00:32 Accounting scandals early 2000s
00:01:06 1936 okay with the formation of the committee on accounting procedure
00:01:36 Gap generally accepted accounting principles
00:02:11 future benefits yeah as employees earn them that must have been a big shock to the bottom line
00:02:45 Ripple effect you know far beyond just the balance sheet it makes you think about you know your own retirement planning
00:03:16 Financial Accounting Standards Board or fasb
00:03:46 Finance well understanding
00:04:17 Fasb Accounting Standards codification or ASC
00:04:47 Early 2000s that brought a wave of accounting scandals
00:05:20 how they uh pulled it off for so long and Enron wasn't alone right this era saw a string of similar scandals that really expose those vulnerabilities in the accounting system
00:05:53 Role of International Accounting Standards you know the rise of those multinational corporations in global trade has created this need for
00:06:23 International Accounting Standards board
00:06:54 Multinational corporations compare companies
00:07:28 Scott's insights
00:08:00 Gap explored those accounting scandals
00:08:31 Curious to see how it connects to accounting to markets
00:08:58 or EMH
00:09:36 Key challenges this idea of limits to Arbitrage
00:10:08 Complexity of financial reporting
00:10:40 Accounting information
00:11:11 Methods for valuing inventory like lifo fifo
00:11:44 Higher profits so it paints
00:12:21 lower taxable income
00:12:54 The cash coming in and going out of a business
00:13:27 The statement of cash flows
00:14:04 Financial performance
00:14:32 Inflows and outflows
00:15:07 Picture of a company's uh cash generating abilities transparency
00:15:39 Complexity of these financial instruments
00:16:11 Fair value measurement
00:16:41 Adjustments
00:17:13 Value measurements
00:17:46 The true economic value
00:18:22 A key challenge in accounting
00:18:50 Significant Investments
00:19:25 The systematic allocation of an asset's cost over its useful life
00:19:57 Depreciation it's uh you know a non-cash expense
00:20:29 Wear and tear obsolescence industry
00:21:05 Their accounting
00:21:39 Faithful representation you know company's position of their financial position
00:22:09 Assets future potential right or Market perception
00:22:48 Transfer it and it has to be probable that it'll uh generate future economic benefits
00:23:18 Property plant and Equipment exactly okay but
00:23:55 Balance sheet doesn't really reflect its worth right
00:24:25 amortization similar to depreciation right
00:24:58 If a patent has like a 20-year life you spread the cost exactly and amortization like depreciation is a uh non-cash expense
00:25:31 Assets fair value is lower than the carrying amount
00:26:07 Assets they need to be uh monitored oh yeah and reevaluated
00:26:38 Recognizing the value goes beyond
00:27:15 amortised like a patent it doesn't Goodwill
00:27:48 Why transparency and those clear disclosures they're so important
00:28:22 It is it really helps us make sense
00:28:53 Sustainability and the Reliability of those earnings
00:29:27 Earnings management
00:30:02 Equity represents ownership
00:30:36 Payments and the risk of default
00:31:10 Investors and creditors assess
00:31:42 Right the accounting treatment
00:32:12 Acquisitions and Reporting
00:32:45 Accountants they hold this position of trust t
00:33:20 The ethical responsibilities
00:33:56 happy accounting
00:00:02 welcome to the Deep dive today we're going deep into the world of accounting oh yeah you know all those debits credits and uh those fascinating uh Accounting Standards we've got some excerpts from an accounting textbook so yeah get ready for a journey it's funny you know so many people think accounting is just dry just number crunching right but uh it's really a history of how we try to understand you know financial decisions yeah and it's full of twists and turns believe me well just looking at these excerpts we've got some uh
00:00:32 interesting stuff here we've got uh the rise of us Gap that big shift in how companies account for those uh retiree benefits even the uh ongoing debate of historical cost versus current value yeah and uh of course we can't forget those accounting scandals early 2000s Enron anyone oh yeah so buckle up get ready this is going to challenge uh what you think you know about Finance yeah it makes you wonder yeah how many of those financial decisions big and small are uh influenced by these accounting
00:01:06 principles that those people don't even know about exactly so let's dive in let's go back way back to 1936 okay with the formation of the committee on accounting procedure or capap this was a major turning point uh for accounting standards in the US yeah the tap started out kind of small but things really took off after the SEC uh issued accounting series released enough four you know all of a sudden the capap had this you know this implicit Authority on best practices you know yeah yeah and their
00:01:36 work eventually gave us what we now know is Gap generally accepted accounting principles exactly and these pronouncements from the capap they weren't just theoretical right they had real world consequences take for example fasb statement number 106 dealing with other postretirement benefits or oprb this changed the game for how companies had to account for things like tyrey healthcare yeah before statement number 106 a lot of companies um they just use this pays you go approach you know for oprb so they'd only record the expense
00:02:11 you know when they actually paid it out right but this new standard forced them to switch to uh an acral basis which meant they had to acknowledge the full cost of those future benefits yeah as employees earn them that must have been a big shock to the bottom line for a lot of companies did this lead to any tough decisions absolutely did they consider cutting back on benefits or you know passing on the cost it was a financial bombshell for sure and um some companies yeah they did cut back on those retiree benefits
00:02:45 yeah and others looked for ways to uh to offset those increased expenses and it just highlights you know how these accounting standards they can have this Ribble effect you know far beyond just the balance sheet it makes you think about you know your own retirement planning right for sure like how these decisions can impact something like healthare benefits down the line yeah it's a good reminder that accounting isn't just about uh you know numbers on a page yeah it's about people's lives it's about their livelihood so as Gap
00:03:16 continued to evolve we see the Financial Accounting Standards Board or fasb stepping onto the scene they've been kind of calling the shots on those accounting pronouncements ever since shaping the way companies prepare uh their financials and these pronouncements they come in a few different uh varieties you know there's the statements of financial accounting standards or sfc's and those lay down The rules for you know specific accounting methods and procedures like the rules of the game for Gap exactly
00:03:46 then you have the statements of financial accounting Concepts or sfes and these are more uh like overarching principles guidelines they set that conceptual framework for Gap think of it like uh the Constitution that guides um you know the development of those specific rules so why do we care about all these pronouncements like what's the significance for someone trying to understand Finance well understanding these distinctions MH helps you navigate this complex world of Gap you know you could see how accounting standards are
00:04:17 created how they evolve and how they ultimately impact a company's you know financial reporting it's like peing behind the curtain right right you see how the sausage is made okay that makes sense and then there's the uh fasb Accounting Standards codification or ASC that's where all this guidance comes together right yeah that's right it's the official source for us Gap you know yeah bringing all those pronouncements together okay so we've traced this evolution of accounting standards and we see how they have uh these real world
00:04:47 impacts but uh the accounting world hasn't always been smooth sailing right right the early 2000s that brought a wave of accounting scandals that uh you know really shook confidence in the system oh yeah and Enron is a prime example absolutely they used uh special purpose entities or spes to manipulate their financial statements and obscure their debt levels right they Ed these sbes to you know keep massive debts off of their balance sheet they wanted to create this uh this illusion of financial strength yeah it's mindblowing
00:05:20 how they uh pulled it off for so long and Enron wasn't alone right this era saw a string of similar scandals that really expose those vulnerabilities in the accounting system yeah and these scandals weren't just about you know corporate greed right they also reflected that changing landscape of the global economy the rise of service Industries um increasingly complex financial instruments right created these new challenges you know so it raises a question could these scandals have been prevented that's the question
00:05:53 yeah is it possible to create a system that's truly resistant to manipulation especially as things get get even more complex it's tough there's no easy answers right it's not just about creating more rules it's about you know fostering a culture of ethical Behavior right you know professional skepticism commitment to transparency yeah and that brings us to the next chapter in our Deep dive the role of International Accounting Standards you know the rise of those multinational corporations in global trade has created this need for
00:06:23 more um you know Harmony yeah in those accounting practices you know worldwide that's where the International Accounting Standards bard ASB comes in yeah they're like the global fasb know what I was thinking working to create this common language for financial reporting you know across borders now the US uses Gap but there's been this uh discussion yeah about adopting iasb standards for us companies as well what's your take on this push for convergence it's a complex issue really valid arguments on both sides you know
00:06:54 supporters argue that it would simplify things you know for those multinational corporations make it easier MH for investors to compare companies uh you know across borders yeah but critics worry about the potential costs and complexities for you know businesses that are used to Gap it sounds like there's a lot at stake I want to uh explore this uh you know later on but before we move on there's this interesting uh figure in our source material an accounting theorist named Scott He argued that accounting has to
00:07:28 constantly adapt you know right to a changing environment yeah Scott's insights are crucial I think for understanding how accounting has evolved yeah he recognized that it can't be static you know it has to respond to these new economic um realities it's not just about crunching numbers it's about constantly re-evaluating and adapting exact to keep Pace with uh this rapidly changing landscape and that's what makes it so fascinating it's a dynamic field you know constantly evolving to reflect the complexities of the business world
00:08:00 so we've covered the history of Gap explored those accounting scandals and touched on this push for international convergence where do we uh head to Next in our accounting Adventure well next we'll dive into how accounting research really shapes our understanding of this field we'll explore different uh you know research methods and influential theories like the efficient market hypothesis the efficient market hypothesis which has had a big impact on accounting practice you know I've heard of it but I've never fully grasped it so
00:08:31 I'm really curious to see how it connects to accounting it's a fascinating concept you know yeah challenges some of our assumptions about how markets work you know how information is reflected in stock prices get ready for some thought-provoking insights so uh before the break we were talking about the efficient market hypothesis and how it uh shaped accounting research so can you tell us a little bit more about this Theory and how it connects to accounting practice the efficient market hypothesis
00:08:58 or EMH basically says that uh stock prices they already reflect all the available information okay so in theory that means you can't consistently beat the market right yeah because any new information it gets priced in like that so if the market is really efficient then what role does accounting even play right I mean wouldn't all that financial information be irrelevant if the market already knows everything that's a good question and the EMH it's been really influential but uh it's not without its
00:09:36 uh you know critics right one of the key challenges is this idea of limits to Arbitrage limits to Arbitrage which suggests that um even if there are uh mispricings in the market it's not always that easy for investors to exploit them because well there are things like you know trading costs Short Selling constraints even just uh you know lack of awareness of that mispricing so there could be valuable information hidden in those financial statements exct that the market hasn't fully digested exactly
00:10:08 that makes sense especially with you know the complexity of financial reporting and that's where the skilled uh you know analysts and investors come in they sift through those numbers they try to find those mispricings and then they make those uh investment decisions you know based on their analysis so accounting plays this crucial role in providing the raw material so to speak absolutely for that kind of analysis absolutely and the EMH yeah even with those limitations has really um you know shaped how we think about the value of
00:10:40 accounting information yeah it really emphasizes the importance of you know timely and accurate and transparent right reporting you know to ensure that markets can function efficiently I'm starting to see how accounting and finance are intertwined right it's not just about you know crunching the numbers it's about how they're you know inter interpreted how they're used exactly the real world in the real world right so let's talk about um inventory valuation okay you've got um some excerpts there that uh you know
00:11:11 highlight these different methods for valuing inventory like lifo fifo weighted average and uh from what I've read these choices can really impact uh a company's financials huge can you kind of walk us through those uh different methods of course and explain why it even matters so let's start with fifo first in first out first in first out basically assumes that the oldest inventory is sold first okay so in a period of rising prices like we have now this means the cost of goods sold will be lower resulting in well you know
00:11:44 higher profits so it paints this uh more optimistic picture right it can during you know inflationary time there another hand yeah you have lifo Lio last in first out last in first out and that assumes that the new newest inventory is sold first okay so in you know those same Rising prices that's going to lead to a higher cost of goods sold and lower profits that seems uh a little counterintuitive yeah why would a company choose a method that makes their profits look lower it's about taxes ah you know using lifo can result in uh
00:12:21 lower taxable income during those inflationary periods potentially saving the company money on taxes so it's a a strategic decision absolutely right they're balancing the financial reporting with tax optimization exactly companies really have to uh you know weigh those tradeoffs yeah between those different methods you know and choose the one that best uh aligns with their uh financial goals now Switching gears a little bit um let's talk about the statement of cash flows it seems pretty straightforward you know just tracking
00:12:54 the cash coming in and going out of a business yeah but uh are there any nuances I should be aware of yeah the statement of cash flows it really is about tracking the cash but it's more than just looking at you know the bank balance okay it really categorizes those cash flows into three main activities yeah operating investing and financing so it gives you a more complete picture exactly of a company's uh you know Financial Health you got it so it's not just about how much cash a company has it's where it's coming from and where
00:13:27 it's uh you know exactly and the statement of cash flows can reveal a company's um you know ability to generate cash from its core operations right you know invest in its future growth manage its uh financing activities for example a company could be profitable on paper but struggle to generate cash right that would be a a red flag big red flag could be you know underlying problems with their business model yeah or um their ability to collect you know pay so the statement of cash flows provides this different lens
00:14:04 I guess for which to view uh you know a company's financial performance exactly it's an essential tool for investors yeah you know looking to assess a company's um liquidity solvency it's Financial flexibility now I understand there are two main methods for preparing the statement of cash flows the direct and the indirect method so what's the difference the key difference is really how they present those cash flows from operating activities the direct method actually lists those um you know cash
00:14:32 inflows and outflows so it gives you a more you know granular view okay the indirect method starts with um net income yeah and then adjusts for those uh noncash items so the direct method is more transparent but uh more complex right whereas the indirect method is simpler but might you know obscure some of those details you got it while the indirect method is um you know more commonly used there's this push for more adoption of the uh direct method yeah because it really offers that um you know clearer
00:15:07 picture of a company's uh cash generating abilities transparency you know that seems to be this recurring theme in accounting you know the more transparent the reporting the better equipped investors are to make decisions it's crucial builds trust and confidence so now um let's dive deeper into those fair value measurements okay that we uh you know touched upon earlier fair value I'm intrigued by it because it seems to be popping up you know everywhere it happens its use has really expanded in recent years driven by you know the
00:15:39 complexity of these financial instruments yeah and this need for uh more relevant information so fair value it's all about determining uh the current market price right yeah basically like what would this be worth if I sold it today exactly it's a market base measurement so it reflects that price yeah that would be received you you know to sell an asset or paid to transfer you know a liability in an orderly transaction between Market participants but as we said before determining that fair value it can be
00:16:11 tricky especially for you know those assets that aren't actively traded right which is why the fasb they've established this hierarchy for fair value measurement it ranks the quality and the reliability of the information used so it's a like a tiered system where some inputs are you know more more reliable than others so you got level one inputs those are the most reliable based on you know readily observable market prices mhm think you know like actively traded stocks or bonds okay then you have level two
00:16:41 inputs this is still observable you know but they might not be for identical assets so you might need some adjustments okay and then there's level three those are the least reliable often based on unobservable inputs yeah and a company's own you know judgments so as we move down the hierarchy that that subjectivity it increases increases and the potential for you know manipulation or bias it grows yeah grows and that's why transparency and clear disclosure are essential when it comes to those fair
00:17:13 value measurements okay so uh all this talk about fair value those market prices to raise this question how do companies account for assets that they've um you know built themselves right a factory or a piece of equipment yeah well for those self-constructed assets companies typically capitalize those costs incurred right to build the asset okay things like materials labor overhead yeah aligned with the historical cost principle so they're adding up all those expenses right that went into creating
00:17:46 the asset and they're recording that as uh the initial value on the balance sheet exactly so uh it gives you a reliable uh measure although it might not always reflect uh you know the true economic value if the market value ends up being higher it seems like there's this constant tension in accounting between objectivity and relevance yeah right historical costs yeah it's objective but it may not reflect that uh you know current value fair value is potentially more relevant but uh can be subjective yeah
00:18:22 you've hit the nail on the head that tension is uh you know a key challenge in accounting yeah and something that uh you know standard Setters and practitioners they're grappling with all the time okay so we've explored uh you know fair value measurements and how they relate to those different asset types now I want to dive into those long-term assets specifically um property plant and Equipment okay those are some of the biggest items right huge on a balance sheet yeah these assets also known as PPN yeah they represent
00:18:50 you know significant Investments for companies yeah and they play a uh crucial role in you know generating revenue and profits so how do companies account for these uh long-term assets well accounting for PPN M it involves several key principles yeah recognition measurement and depreciation okay so recognition that's uh you know when a company decides to record an asset on the balance sheet and for PPN an asset must be probable of providing you know future economic benefits yeah and its costs can
00:19:25 be reliably measured and then you have measurement which which involves determining that uh initial value of the asset which you know under historical cost includes all those costs necessary to um get it ready for use so it's not just the purchase price right it's any costs related to you know acquiring and preparing it exactly for use and then there's depreciation depreciation which is uh you know the systematic allocation of an asset's cost over its useful life okay because we're recognizing that it's
00:19:57 uh diminishing you know over time so like spreading the cost of the asset over the period it's expected to be used exactly and depreciation it's uh you know a non-cash expense yeah meaning there's no actual outflow of cash it's a way of um matching the cost of the asset with the revenue it helps generate but how do companies determine that uh you know useful life that's a good ques