Accounting for managers

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Accounting for managers

• An introduction to financial accounting
• doc. dr. Aljoa Valentincic

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Who am I?

• Dr. Aljoa Valentincic, 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_at_ef.uni-lj.si . Feel free to
  drop in anytime.

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

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Congratulations for Your Choice!

• The data speak for themselves!
• Never underestimate the importance of local
  knowledge, but do not overestimate it either.

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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

This is a scoop
and this is a cone
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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

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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.
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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!

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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

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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)
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Definition of Accounting

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

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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!)

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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

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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

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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

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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

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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

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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)

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Owners Equity

• 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
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The Basic Accounting Equation

• 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)
  

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How do the Transactions Affect the Accounting
Equation?
A L OE

• 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!

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Example Soncek, d.o.o.

• Janko and Metka want to open a shop in Piran
• On 2nd January they form Soncek, 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

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1. On 2nd January they form Soncek, 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
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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

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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?

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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

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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 capital
• resources sources of capital

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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!

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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 Soncek already fully paid
  for the goods?
• But Is this likely?!?

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What Else Can Happen?

• Factories (shops) hate to give cash back. More
  likely, they will acknowledge an obligation to
  replace faulty goods
• Note the factorys obligation is Sonceks 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), Soncek,
  d.o.o., is a smaller firm than in the other three
  cases!

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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)

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Summary of Transactions between 4th and 7th
January

• Where do we start?
• Or, alternatively, where is the history of
  Soncek, d.o.o., stored?
• History of Soncek is stored in the balance sheet
• we do not need to know all the individual
  transactions, just their cumulative effects from
  day 1 onwards

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Balance Sheet - Presentational Example
Balance sheet of Soncek, d.o.o, on 7th Jan. Year 1

• 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

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Classification of Assets

• Arbitrary delimiter current/fixed duration of 1
  year or more for fixed assets.
• Remember WorldComs wires??

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Assets Novartis, 2003

• All typical groups of assets are present here

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Classification of Liabilities

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

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Cadbury Schweppes, 2005 (1)

• Remember the net asset form of the accounting
  eqaution?

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Cadbury Schweppes, 2005 (2)
(Footnote 19 to Balance sheet)
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Cadbury Schweppes, 2005 (3)
(Footnote 19 to Balance sheet, continued)

• Sometimes very detailed information is provided
  voluntarily
• Why would firms do it?
• Cadbury Schweppes is probably an example of an
  excellent report

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Liabilities Is it Always Clear What They Are?
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Owners Equity An Example
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Changes in Equity?
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Additional Web Resources

• Some nice webcasts http//webcast.ey.com/thoughtc
  enter/default.aspx?actionlistarchived
• 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.feedbu
  rner.com/bestaccountingpractices/view.htm
• INTACCT project http//www.intacct-research.org
  .

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Where Are We Going?

• Introduction / Balance sheet
• Income statement and link with balance sheet
• Recording process
• Accrual basis of accounting