Accounting for managers

An introduction to financial accounting

doc. dr. Aljoša Valentinčič

• Dr. Aljoša Valentinčič, Ph.D., MBA, B.Sc. (Econ.)• Assistant Professor of Finance and Financial Statement Analysis at

the Faculty of Economics and Research Fellow at Lancaster University

• Research: mainstream empirical accounting research• Member of EAA Standing Scientific Committee• Scientific coordinator of the INTACCT project – a 4-year, €2.4m EU-

funded investigation of economic consequences of the introduction of IFRS in the EU

• Member of Supervisory board of Triglav, d.d., largest Slovenian insurance company

• Office: RZ-204, phone 757, mail: aljosa.valentincic@ef.uni-lj.si . Feel free to drop in anytime.

Who am I?

Literature

• Sutton Tim (2004): Corporate financial accounting and reporting. 2nd. Edition. Harlow: Pearson Education Limited, 754 pgs.– Chapters: 2, 3, 4, 5, 8 (part), 10, 11, 12, 13, 14

• We will see how we progress and work accordingly• International Financial Accountings Standards Board:

International Financial Reporting Standards. Available free on-line from: http://ec.europa.eu/internal_market/accounting/ias_en.htm#adopted-commission

• Brigham Eugene & Co-authors (different years): Intermediate financial management. Any issue will do.

Congratulations for Your Choice!

• The data speak for themselves!• Never underestimate the importance of local knowledge, but

do not overestimate it either.

World stock exchanges market capitalization (in USD millions, end 2005)

Rest of the world;

44,451,996.1m; 99.982234%

Slovenia; 7,898.9m;

0.017766%

European stock exchanges market capitalization (in EUR million, september 2006)

Ljubljana; 8,421.56m; 0.079804%

Rest of Europe; 10,544,441.33m;

99.920196%

“Flavors” of accounting

• Paul Krugman: Flavors of Fraud, New York Times, 28.6.2002

• Assume you own a small kiosk that sells ice-cream…

– The business is not doing too good, so you start thinking about possible “strategies” to make it look better…

• Indeed, much MUCH better…

…and this is a cone

This is a scoop…

Enron and the Ice-Cream Kiosk

• Sign contracts with clients to buy 1 cone each day for the next 30 years (about 10,950 cones)

• Underestimate what it costs you to produce (or buy) a cone

• Profit is inflated… PLUS you “capitalise” profits for the next 30 years’ as this years’ gain

– in passing note that this is exactly what share prices do, taking into account:

• the size of “profit”, distribution through time, riskiness of the “profit”

• You sell overvalued shares of your ice-cream business to somebody else…– Pocket the money and do not worry about the other

guy…

WorldCom and the Ice-Cream Kiosk

• You hide your operating costs (sugar, milk, cream, chocholate, …) and you add them to the price of the fridge

– Fridge is usually and investment• you can use it in your business over a number of years• only when you use it does the machine wear out and generate

costs(*)

– Sugar, milk, cream, are consumed immediately and generate costs in the current income statement

• If they somehow “disappear”, you show high profits!

• If you have a lot of debt, you say it is because of investment that will generate future profits.

• You sell overvalued shares…

(*) This is the “classical” accounting view, generally does not hold any more – economic obsolescence must be taken into account, too.

Adelphia and the Ice-Cream Kiosk

• You begin to trade a lot of cones, and tell investors quantities matter, not profitability…– the logic being higher quantity leads to profits sooner or

latter• If they believe you, what do you do? • …

• Other “scandals” along similar lines– Parmalat also worth mentioning…

• We have introduced a great number of terms so far… – During the course we will deal with (some of) them!

• Note that many of the issues raised above are perfectly legitimate (and legal) and accountants have to deal with them every day – often, these issues are not simple at all!

What is Common to All These Stories?

• There is an economic transaction (e.g., someone buys an ice cream; buys/sells a share in the ice cream business, etc.)

– before that you have to “convince” people that something (a share, a cone, milk, fridge, …, a share, etc.) is worth paying money for• to convince you use financial statements – say profit

• Higher profits leads to higher share prices

– if you show your profits too high, then share prices are also too high

• (Changes in) Accounting data is strongly linked to (changes in) wealth of investors

Just as an Example – Basu(1997)…• Are (changes in) accounting data really strongly linked to

(changes in) wealth of investors?– if so, would you expect cash flows or accounting

earnings to be more important?

Cash flow

Accounting earnings (before extraord. items)

???

Definition of Accounting

• Accounting is an information system that measures, processes, and communicates financial information about an enterprise.

Business Activities

(Transactions)Decision Makers

Data Information

Accounting

Measurement Processing Communication

Accomplished Accomplished Accomplishedby recording by storage and by reporting

of data preparation ofdata

What Is Being Measured?• What is measured? ⇒ business transactions

– These are economic events that affect the financial position of a business entity:• An exchange of value between two or more independent

parties (e.g., you purchase an ice cream or a fridge)• “Nonexchange” transactions:

– same effect as an exchange transaction (e.g., a machine burns down in a fire)

– no other (or “external”) parties involved– contrast this with the sale of this same machine!)

Communication Through Financial Statements (FS)

• FS are the primary means of communicating important accounting info to users; they represent the company in financial terms

– However, they are not perfect pictures of reality• Although recent moves towards fair values seems to want

to achieve precisely this…

• FS consist of (to start with) the Income Statement, Balance Sheet and Cash Flow Statement– There may be other supplementary/secondary

statements• In recent years, a lot of emphasis is put on the Statement of

changes in owners equity

Accounting Standards

• The International Accounting Standards Board (IASB), harmonize regulations, accounting standards around the world by establishing a set of international accounting standards that everybody agrees to– Standards – a common set of rules that determines

measurement, processing and communication

• Contrary to what accountants and politicians often claim– A single set of standards does not necessarily lead to

same financial statements• For this, the system of economic incentives is at least as

important (and probably more)– see more in Ball, Kothari and Robin (2001, JAE).

• Hence the need of an external assessment: INTACCT – “The European IFRS Revolution: Compliance, Consequences and Policy Lessons”

The Three Basic Financial Statements

• Income Statement → Profit– Shows the performance of a firm over a period of time

• Balance Sheet → Assets & Liabilities and Owners’ Equity– Shows the financial poEURion of a company at a given

date• Cash Flow Statement → Liquidity• (Foot)notes to financial statements are an essential part of

these statements!

• Very easy to draw a parallel with what a person earns, owns and how much money he or she has…

– though things are debatable…

The Purpose of the Balance Sheet

• BS shows the financial poEURion of a company on a given day

• Gives a listing of its resources and of its sources of capital

• Resources = Sources of capital

• In other words & simplified: it shows what the firm has and where it got the capital to finance these things from…

Assets

Liabilities

Owners' Equity

Components of the Balance Sheet

ASSETS:•Expected to provide future economic benefits to the firm

(economic benefit = receive cash or avoid paying cash!)

•Owned or controlled by the firm•The firm acquired it as a result of a past transaction or event

LIABILITIES:•LEGALLY: obligation of one entity to deliver money, goods, services•ACCOUNTING VIEW: irrevocability

Therefore:

•Present obligation of the firm to another party•Arises from past transaction or event•Involves sacrifice of assets of known or estimated amount

Liabilities – Some Examples

• Obligations may be expressed in terms of goods/services rather than cash

• Obligations are sometimes estimated:– Lufthansa: bonus miles programme

• €441.6m (2001) and €524 (2002)

– British Airways: unredeemed frequent flyer liabilities £111m (2002)

• By the way: • These have become huge. See Frequent-flyer economics

(The Economist, May 2nd 2002)• Another example: car manufacturers – warranties on new

cars– Renault: €509m (2001)

Owners’ Equity

Owners’ Equity

Contributed capital

(what the owners have paid in)

Earned capital

(what the company has earned for its owners

over time and not paid out as dividends)

• Owners’ equity: are the residual claims by owners of a business against the assets of the business

Note that in real-life statements this can change for different

reasons…

• Resources = Equities (claims against those resources)

Assets (A) = Liabilities (L) + Owners’ Equity (OE)

• Transactions cause balances of A, L, OE accounts to change daily (or many times within a day), but the equation always always balances– Yes, really always

• How?– Each transaction affects at least two accounts (it may affect more).

The effect of a transaction on assets is always the same as its effect on liabilities and owners’ equity.

• Owners’ Equity:= Share Capital (SC) + Retained Earnings (RE)

amount paid in amount generated from profit-by the owners producing activities and kept

for use within the firm= Assets (A) – Liabilities (L)

The Basic Accounting Equation

How do the Transactions Affect the Accounting Equation?

• An increase in one asset and decrease in another• An increase in one liability and decrease in another• An increase in one OE account and a decrease in another OE

account• An increase in an asset, an increase in liability• An increase in an asset, an increase in OE account• An increase in liability, a decrease in OE account

• More combinations involving more than two “accounts” are possible, but always:– the change on the left-hand side must equal the change on the

right-hand side!

A = L + OE

Example: Sonček, d.o.o.

• Janko and Metka want to open a shop in Piran:– On 2nd January they form Sonček, d.o.o, investing 20.000 EUR

of their savings– On 3rd Jan. they lease shop premises for 3 months and pay

6.000 EUR– On 4th Jan. they buy equipment (shop fixtures, cash register,

shop sign) for 10.000 EUR in cash; the equipment is expected to last for several years

– Same day they borrow 12.000 EUR from a bank for 3 months– On 5th Jan. they buy merchandise worth 35.000 EUR of which

24.000 is acquired on credit and the rest paid immediately in cash

– On 6th they return some of the defective merchandise worth 5.000 EUR

– On 7th they find they have excess shop fixtures of 1.000 EUR; they exchange them with a nearby shop for merchandise of same value

• We will record these accounting events into a spreadsheet

1. On 2nd January they form Sonček, d.o.o, investing 20.000 EUR of their savings

• Financial statement impact (in 1.000s EUR):

• Left-hand side: cash is always an asset (+20.000)• Right-hand side: we need +20.000. Could the 20K be a

liability? – Is it a present obligation? No.– Does it involve any sacrifice? No.– Therefore: it has to be part of OE.

• Record this into a spreadsheet:

A = L + OE

= +Cash +20 = Contributed Capital +20

Assets Liabilities Owners' Equity

2. On 3rd Jan. they lease shop premises for 3 months and pay 6.000 EUR immediately

• Financial statement impact (in 1.000 EUR):

• What is this thing called “Prepaid rent”?!?– expected to provide future economic benefits to the firm

• No? Yes? What?

– owned or controlled by the firm

– the firm acquired it as a result of a past transaction or event

= +Prepaid rent +6Cash -6Net effect 0 = 0 + 0

Assets Liabilities Owners' Equity

3. On 4th Jan. they buy equipment (shop fixtures, cash register, shop sign) for 10.000 EUR in cash; the equipment is expected to last for several years

• Financial statement impact (in 1.000 EUR):

• What (if any) is the difference between the asset “Cash” and the asset “Equipment”?– in accounting terms?– from the point of view of an owner?– what if we were only using the so-called “cash

accounting”?

= +Equipment +10Cash -10Net effect 0 = 0 + 0

Assets Liabilities Owners' Equity

4. Same day they borrow 12.000 EUR from a bank for 3 months

• Financial statement impact (in 1.000 EUR):

• After Janko and Metka have take the loan:– Present obligation of the firm to another party– Arises from past transaction or event– Involves sacrifice of assets of known or estimated

amount– The transaction is irrevocable!

• The loan is thus a liability…

= +Cash +12 = +12 Bank loan

Assets Liabilities Owners' Equity

Summary of Transactions up to 4th Jan.

• BS shows the financial poEURion of a company on a given day

• Gives a listing of its resources and of its sources of capitalresources = sources of capital

Account1. Initial

investment2. Shop rental

3. Equip. purchase

4. Bank loanBALANCE

4.1.ASSETS:Cash +20 -6 -10 +12 16MerchandisePrepaid rent +6 6Shop equip. +10 10

TOTAL ASSETS +20 +12 32

LIABILITIES:Accounts payableBank loan +12 12

OWNERS' EQUITY:Contributed capital +20 20

TOTAL LIAB & OE +20 +12 32

5. On 5th Jan. they buy merchandise worth 35.000 EUR of which 24.000 is acquired on credit and the rest paid immediately in cash

• Financial statement impact (in 1.000 EUR):

• Note: more than 2 accounts are affected, but the accounting equation still holds!

= ++24 +24

Net effect of:Inventory +35 +24 Accounts payableCash -11

Assets Liabilities Owners' Equity

6. On 6th they return some of the defective merchandise worth 5.000 EUR

• Financial statement impact (in 1.000 EUR):

• Is there a another possibility?– What would happen had Sonček already fully paid for the

goods?

– But: Is this likely?!?

= +Inventory -5 = -5 Accounts payable

Assets Liabilities Owners' Equity

= +Inventory -5Cash +5Net effect 0 = 0 + 0

Assets Liabilities Owners' Equity

What Else Can Happen?• Factories (shops) hate to give cash back. More likely, they

will acknowledge an obligation to replace faulty goods:

– Note: the factory’s obligation is Sonček’s claim – “Accounts receivables”

• Another frequently used possibility from real life is to exchange faulty goods with other goods:

• Are there any differences between these cases? – In the first case (previous slide), Sonček, d.o.o., is a

smaller firm than in the other three cases!

= +Inventory -5"Accounts receivable" +5Net effect 0 = 0 + 0

Assets Liabilities Owners' Equity

= +Inventory -5Inventory II. +5Net effect 0 = 0 + 0

Assets Liabilities Owners' Equity

7. On 7th they find they have excess shop fixtures of 1.000 EUR; they exchange them with a nearby shop for merchandise of same value

• Financial statement impact (in 1.000 EUR):

= +Equipment -1Inventory +1Net effect 0 = 0 + 0

Assets Liabilities Owners' Equity

Summary of Transactions between 4th and 7th January• Where do we start?

– Or, alternatively, where is the history of Sonček, d.o.o., stored?

– History of Sonček is stored in the balance sheet• we do not need to know all the individual transactions, just

their cumulative effects from day 1 onwards

AccountBALANCE

4.1.5. Purchase of inventory

6. Return of goods

7. Inventory for equip.

BALANCE 7.1.

ASSETS:Cash 16 -11 5Merchandise +35 -5 +1 31Prepaid rent 6 6Shop equip. 10 -1 9

TOTAL ASSETS 32 +24 -5 51

LIABILITIES:Accounts payable +24 -5 19Bank loan 12 12

OWNERS' EQUITY:Contributed capital 20 20

TOTAL LIAB & OE 32 +24 -5 51

Balance Sheet - Presentational Example

Current assets

Cash 5

Merchandise

inventory 31

Prepaid rent 6

42

Fixed assets

Shop equipment 9

TOTAL ASSETS 51

Current liabilities

Bank loan 12

Accounts payable 19

31

Owners’ equity

Contributed capital 20

TOTAL EQUITIES 51

Balance sheet of Sonček, d.o.o, on 7 th Jan. Year 1

Classification of Assets

• Arbitrary delimiter current/fixed: duration of 1 year or more for fixed assets.– Remember WorldCom’s wires??

Assets

Short term assets

(current assets)

Long term assets

(fixed assets)

Cash

Short-term investments

Inventory

Receivables

Tangible

Intangible

Financial (Investment)

Accruals & defferrals, etc.

Assets – Novartis, 2003

• All “typical groups” of assets are present here…

Classification of Liabilities

• Note: on purpose this terminology is an annoying combination of British-English and American-English– So is the terminology in IFRSs…

Liabilities

Current liabilities

(Short-term liabilities)Long-term liabilities

Accounts payable

Loans payable

Accrued expenses

Deferred taxes

Long-term debt

Provisions

Capitalised lease obligations

…

…

Cadbury Schweppes, 2005 (1)

• Remember the net asset form of the accounting eqaution?

Cadbury Schweppes, 2005 (2)(Footnote 19 to Balance sheet)

Cadbury Schweppes, 2005 (3)

• Sometimes very detailed information is provided voluntarily– Why would firms do it?

• Cadbury Schweppes is probably an example of an excellent report

(Footnote 19 to Balance sheet, continued)

Liabilities – Is it Always Clear What They Are?

Owner’s Equity – An Example

Changes in Equity?

Additional Web Resources

• Some nice webcasts: http://webcast.ey.com/thoughtcenter/default.aspx?action=listarchived

• Key International Financial Reporting Standards

http://www.iasplus.com/dttpubs/pocket2005.pdf• News about IFRSs:

http://www.iasplus.com/index.htm • IASB and FASB

http://www.iasb.org and http://www.fasb.org .• A podcast webEURe with accounting podcasts

http://www.podcastingnews.com/details/feeds.feedburner.com/bestaccountingpractices/view.htm

• INTACCT project: http://www.intacct-research.org .

Where Are We Going?

• Introduction / Balance sheet• Income statement and link with balance

sheet• Recording process

• Accrual basis of accounting