Financial Reporting,

1
Financial Reporting,
Our objectives To identify and understand
financial reports To understand primary financial
models for planning budgeting
2
Who uses accounting information?

• Externally
• Taxpayers, citizens (existing and potential)
• Creditors (existing and potential)
• Regulators and other governmental units
• Peers, Customers, Suppliers
• Internally
• Managers, Employees
• Cost Analysts (Internal Auditors)

3
External Financial Reporting

• Annual reports
• City, departmental home pages
• Securities and Exchange Commission
• A note on Transparency (fully and clearly
  revealing financial performance)

4
How is accounting information used

• Performance measurement
• Valuation
• Operational control
• Assessment of risk
• Regulatory reporting
• Contractual covenants
• debt restrictions, managerial compensation
• Individual investment decision analysis

5
Key Financial Statements

• Balance Sheet
• Statement of Revenues and Expenses (PL)
• Statement of Cash Flows
• See City of Bryan, Texas Financial Statements for
  2005 in your packet

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Balance sheet components

• Assets
• Current (short-term)
• Fixed (long-term)
• Liabilities
• Short-term
• Long-Term
• Fund Balances net worth or net assets
• Assets Liabilities Fund Balances

7
Typical assets

• Current assets
• Cash
• Receivables
• Fixed assets
• machinery and equipment land
• Intangibles
• Patents Leases Trademarks

8
Typical liabilities

• Current liabilities (due within 1 year)
• accounts payable
• Wages payable
• Long-term liabilities (not due within 1 year
• bonds payable
• notes payable
• long-term lease obligations

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What does the balance sheet tell us about assets?

• An estimate of the value of all assets
• The type of assets held by an organization
• example cash versus fixed assets
• The quality of assets held by a business
• examples age of assets, collectibility of
  receivables
• The type of activities conducted by the entity

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What does the balance sheet tell us about
liabilities?

• How much of the asset base is financed by debt
  rather than by equity
• How much of the debt is short term and how much
  is long term
• The types of debt an entity owes
• examples accounts payable, bonds payable
• The types of creditors an entity owes
• examples banks, suppliers, institutions

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Governmental accounting is often called fund
accounting

• Types of funds
• Governmental funds
• Used to account for most resources
• Including those expended on public safety
• Proprietary funds
• Used to account for activities that are operated
  as businesses, e.g., a utility co.
• Trust and agency funds
• Used to account for funds held on behalf of
  others, e.g., a pension trust fund

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Statement of Revenues expenses (PL)

• Measures revenue
• Continuing operations
• One-time gains/losses
• Measures expenses
• From operations
• Financing
• One-time items
• Surplus/Deficit revenue expenses

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Statement of Cash Flows

• Calculates cash flow (net amount in or out)
• from operations
• should match income from the income statement if
  effect of accounting accruals are minimal
• from financing activities
• cash obtained from issuing new securities
• cash used to retire existing securities
• from investing activities
• cash obtained from selling assets
• cash used to buy assets

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Cash flow analysis

• What questions do we try to answer in the
  analysis?
• How strong is the entitys internal cash flow
  generation?
• Can the entity meet its short-term obligations?
• Does the entity have free cash flow?
• How much cash did the entity invest in its growth
  sustenance?
• What is the quality of revenue streams?

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To examine financial accounting information,
lets ask

• How is accounting information different from a
  checkbook?
• Cash basis versus accrual basis accounting
• Over the long run there is no difference--but
  over the short run there is a difference
• Why is there a need for accrual-basis accounting?
• Periodicity and long-lived assets

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A note about accountants accounting

• Accountants record transactions using accounting
  accruals rather than cash flows.
• Depreciation
• Income/expenses
• Gains/losses
• Accountants must distinguish between costs that
  are incurred to purchase assets and those that
  are incurred for expenses

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A note about accountants accounting--continued

• Accountants cant measure some kinds of assets,
  e.g., human capital, therefore these assets are
  not accounted for well
• Accountants use historical cost as the basis for
  measuring most assets
• Accountants are bound by more rules than the NFL
  and theyre twice as hard to follow (called GAAP)

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Internal Financial Planning Reporting

• Budgets
• Operating budget (to manage revenues, expenses)
• Capital budget (to manage assets, liabilities)
• Pro-forma financial statements
• Role of budgets financial plans
• Specify sources uses of financial resources
• Identify financial constraints
• Set financial expectations
• Establish benchmark for actual performance
  (control role)

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Preparing an expense budget

• Requires
• Assumptions about cost behavior
• Costs are classified as fixed, variable, or mixed
• Assumptions about service volume
• Other assumptions
• E.g., inflation rate
• Expectations about changes in specific costs
• Go to budgeting exercise for Local City, Texas

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Graphically, we can show
Total Cost
TotalCost
Volume
Volume
Variable Cost
Fixed Cost
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Budgets Financial Responsibility

• Budgets and accountability will align with
  organizational chart
• Most boxes on the organizational chart have
  responsibility for spending and/or generating
  revenues
• See Organizational chart for City of Bryan

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How do we know whether an organization (or its
parts) is performing well?

• We need to measure the performance of our
  organization (whole and segments)
• We need to compare the performance measurements
  to some meaningful benchmark
• Problems with accounting measurement and
  reporting models
• Measure physical things reasonably well
• Do not measure intangible things well
• Including human capital

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What benchmarks are typically used?

• Expectations about
• cost levels
• revenue levels
• Peers or Competitors performance
• Contract specifications
• Industry average performance
• Historical performance

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Quick exercise

• Suppose at the end of 2006, we observed that
  Local City had spent 15,575,000 for professional
  salaries. What could we conclude from this
  information?

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The capital budget is our plan for acquiring
long-lived assets

• Is a key tool to gain evolutionary improvements
  in
• Efficiency
• Effectiveness
• Quality
• safety

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The capital budget results from analysis of
alternative capital expenditures using

• Investment justification criteria such as
• Payback
• Net present value (NPV)

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The payback method

• Measures the amount of time it takes to recoup
  the initial investment outlay associated with a
  capital project.
• This method ignores the time value of money and
  ignores cash flows occurring after the payback
  period.

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Payback method illustrated

• Suppose your city is considering installing
  additional public bus routes. The initial cost
  would be 800,000, and the new net revenues would
  be as follows
• Year 1 150,000 Year 4 200,000
• Year 2 300,000 Year 5 150,000
• Year 3 300,000 Year 6 100,000
• What is the payback period?

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Net present value method (NPV)

• Considers the time value of money
• Is calculated as the present value of cash
  inflows less the present value of cash outflows.
• Requires the use of a calculator or tables for
  discount factors
• Only projects with a positive NPV are considered
  financially acceptable

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Assume for the bus route illustration, that the
cost of capital is 8. Calculate the NPV.

• Amount disc factor Present V.
• Year 0 (800,000) 1.0000 (800,000)
• Year 1
• Year 2
• Year 3
• Year 4
• Year 5
• Year 6

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What if?

• You dont know the cost of capital?
• You arent certain about the cash flows?
• You arent certain about the life of the project?
• You cant quantify some relevant information?
• Then, do sensitivity analysis.
• Go to next Local City Exercise

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What do we mean by the term management control?

• Controls are used to improve the odds that the
  results achieved align with the plan budgets.
• Controls steer the organization.

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The budget is used as a control

• When actual financial results are compared to the
  budget, and
• Positive and negative reinforcement are given to
  those who caused favorable or unfavorable
  deviations (variances) from the budget.

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The Use of Financial Information to Support
Decision Making

• Our objectives
• Apply basic financial concepts to decision making
• Apply basic models to support financial decisions

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The Models of Financial Decision Making

• General decision making model
• Volume management model
• Quality management model

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General decision making model

• Costs versus benefits
• Objective is to find decision alternative that
  maximizes the extent to which benefits exceed
  costs
• Must consider only relevant costs
• Must consider only relevant benefits

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Many decisions are focused on cost management
strategies

• Generic cost management strategies include
• Cost avoidance
• Cost containment
• Cost reduction

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Typical, short-term decisions

• Insource/outsource activities
• Choosing most effective use of resources
• Improving efficiency

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Relevance exercise

• Suppose you are considering submitting a proposal
  to replace a copy machine in your office. Here
  is the information you have gathered.
• New machine
  Old machine
• Cost
  5,000 10,000
• Salvage value
  1,500
• Remaining life
  3 years 3 years
• Variable cost per copy .01
  .04
• Further assume that you make 150,000 copies each
  year. Should your request for a new copy machine
  be approved?

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Relevance exercise 2

• Suppose you are an Aggie football fan and that
  you just purchased a ticket to the t.u. game for
  80.
• Further suppose that as the football season
  evolves demand for the ticket increases and in
  October you have an opportunity to sell your
  ticket for 200.
• Which costs are relevant in the decision to
  sell or keep your ticket?

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Relevant costs

• Include
• Costs that vary across decision choices
• Incremental costs
• Differential costs
• Opportunity costs
• Exclude
• Sunk costs

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There are many ways to categorize costs in
decision making

• These cost categories are useful for applying
  cost management tools concepts
• Fixed versus variable (behavior)
• Relevant versus irrelevant
• Controllable versus noncontrollable
• e.g., fuel usage versus fuel price
• Direct versus indirect

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Insource/outsource exercise

• Assume the cost to process a job application in
  house for NYPD is described by the following
  equation
• Total annual cost 25,000 12 per
  application
• Alternatively, the processing can be outsourced
  to an independent firm at a cost of 25 per
  application.
• What would you do if the annual demand for this
  service is estimated to be 1,000 applications?
  10,000 applications?
• At what volume level would you be indifferent
  between insource/outsource?
• Why is volume an important element in this
  decision?

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Volume Management Model

• Cost/Volume/Profit (CVP) analysis is a method of
  exploring the relationships among volume and
  costs
• And, in some settings revenue
• CVP analysis depends on an understanding of cost
  behavior i.e., fixed and variable
• Breakeven is a particular focal point in CVP
  analysis

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CVP illustrated

• Suppose we want to develop a citizens police
  academy to generate support for law enforcement
  among residents. The cost of the academy is
  estimated to be 100,000 plus 200 per
  participant.
• If we charge participants 500 per person, how
  many participants do we need to break even?
• How many participants do we need to generate
  10,000 of net profit?

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Graphic illustration of CVP analysis
Total Revenues

Total Costs
Breakeven
of participants
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Example continued

• If we anticipate we will be unable to generate
  enough interest to reach the breakeven level of
  participation, what strategies should we consider
  before we abandon the idea?

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Another exercise

• Consider the difference in accounting for (or
  justifying) buying a copy machine versus
  purchasing a training course aimed at improving
  employee safety.
• Why is justification of the training much more
  difficult?

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Cost drivers

• Ultimately, the key to understanding how to
  manage a cost is understanding what causes the
  cost to be incurred
• Direct costs
• Costs that are caused by, and easily traced to, a
  specific activity
• Indirect costs
• More difficult to understand causality
• There has been significant growth recently in
  indirect costslargely because of technology costs

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Controlling costs with cost drivers

• Costs are managed by managing the cost driver
• The more obvious the cause/effect relatinship
  between the cost and cost driver, the more
  successful cost control efforts will be.
• For example, what would you logically expect to
  be the driver of fringe benefit costs?
• Is this a controllable cost?

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Quality management model

• Objective is to obtain the highest quality of
  service at minimum cost. Requires minimizing the
  sum of the following costs
• Prevention costs incurred to prevent quality
  problems
• Appraisal costs incurred to find quality
  problems
• Internal failure costs to correct quality
  problems when such problems are discovered
  internally
• External failure costs to correct quality
  problems when such problems are discovered by
  customers

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Quality costs
Prevention appraisal

Internal and External failure
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Quality exercise

• Where should the quality management budget be
  spent in the following settings? Why?
• Neurosurgeon
• Tire manufacturer
• Lawn maintenance service
• Automobile Repair Shop
• Police Force

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Quality exercise 2

• Suppose your department holds the view that
  better screening in the employee hiring process
  would reduce employee turnover, and its
  associated costs. Further, you have developed a
  new employee screening process and have estimated
  that such a process would have a first year cost
  of X to implement. How could you use the
  quality cost model to promote implementation of
  the new screening process?
• Now, lets try the comprehensive short exercises
  that follow.