Management I: An Introduction to Financial Accounting Compulsory Module Bachelor Level Summer 2015 Prof. Dr. Barbara Schöndube-Pirchegger Lehrstuhl für Unternehmensrechnung und Controlling 1
Administrative Information Class Schedule Lecture Hours: Thursday, 13:15 15:45 Tutorial: Wednesday, 13:15 14:45 Grading: Final Exam 60 (60 min) Assignments? Total 60+? Lecturer contact Office: Vilfredo Pareto Gebäude (G 22), Room E 209 Office Hours: Thursday 11-12 a.m. or by appointment E-mail: barbara.schoendube@ww.uni-magdeburg.de Phone: 67 58728 Website: http://www.bwl1.ovgu.de/ Particular link to class website: 2
Textbook Basic Text: Tim Sutton (2004). Corporate Financial Accounting and Reporting 2 nd ed., Prentice Hall. Also of interest: Jane L. Reimers (2013), Financial Accounting, A Business Process Approach, 3 rd ed. Pearson International Edition Joel Demski, (2008), Managerial Uses of Accounting Information, Second Edition, Springer Available online via SpringerLink http://link.springer.com 3
Chapter 1: Introduction Purpose and Object of Financial Accounting What is Accounting? Accounting is the language of business Transactions are reflected in monetary terms Accounting information conveys information about the firm to internal and external parties The accounting system can be regarded as a library It stores financial data of a firm It is organized in some fashion The manager uses the library to gather information The manager s choices are reflected in the library 4
Why do we need Accounting? Take an economist s view for the moment A firm uses inputs to produce outputs This process is described by a production function Factor inputs, e.g. capital and labor, z 1, z 2 are used to produce output q Real live situation: Do we know what the production function of a firm looks like? Do we know the cost or profit function of a firm? 5
How does the accounting system work? Accounting involves two functions: Recording of transactions Transactions are business activities such as buying or selling goods, paying salaries Are to be measured in monetary terms Recording is also referred to as bookkeeping Preparation of financial statements and reports Regular interval reports Set up based on the recorded transactions Reports map financial consequences of business activities in an aggregated form 6
Stocks and flows in the library Stock variables relate to the situation of the company at a specific point in time Examples: stocks of goods, assets, liabilities Flow variables relate to the change of situation over a specific period of time Examples: expenses, income; change in value of a fixed asset, e.g. due to exchange rate changes Stocks are essentially reflected in the balance sheet Shows assets and liabilities present in a firm at the end of a financial year (point in time) Flows are added up to generate the income statement all revenues and expenses recorded within the period of a financial year are added up 7
Financial versus Management Accounting Financial Accounting: external focus Primary objectives Stewardship, reports on past performance Instrument to facilitate decisions for investors in the capital market Management Accounting: internal focus Primary objectives: Decision facilitating for the management Financial planning Instruments Cost accounting for decision making Control of management behavior Budgeting: goal setting and control of achievement Incentive system based on performance measures to be delivered by accounting 8
Contents of Financial Statements Minimum contents Balance Sheet Helps assess the company s financial strength Income Statement Helps measure the firm s financial performance Notes to the Accounts Provide additional information to entries to the balance sheet or income statement Further Contents Cash flow statement Helps to assess the firm s ability to survive Statement of changes in equity Segment report Environmental report 9
Financial Accounting: who is addressed? Investor orientation owners and potential acquirers of residual claims Shareholders Stakeholder orientation All parties that consider to or have committed resources to a relation with the reporting entity in exchange for future compensation Shareholders, creditors, suppliers, customers, government, public Tax authority orientation other interest groups could use the information to the detriment of investors Regulators, trade unions, competitors 10
Emphasize: Investor Orientation What would be objective of financial accounting? Providing information that investors find helpful in making economic decisions (Decision usefulness) What is useful information? Forward looking information Backward looking information Information that is Relevant, Relyable Comparable Alternatively: monitoring and disciplining role of accounting? 11
Desirable characteristics of accounting identified in textbooks Relevance Timely material Reliability unbiased, neutral, comprehensive, objective Comparable between entities over time (consistency principle) Transaction cost-efficient cost of information should not exceed its value influence on cost of capital unreliable and scarce information may lead to market failure (accounting scandals) 12
Decision Usefulness as reflected in IASB Framework (revised 2010): Primary qualitative characteristics of financial statements: Relevance Information is relevant if it has the potential to influence a decision by changing expectations or predictions by feedback on the performance of past decision rules by enhancing assessment of risk, esp. default risk Faithful representation This includes that information must be complete, neutral and free from errors Further qualitative characteristics include: Comparability Absolute performance difficult to assess. Investment decisions depend on expected relative performance. So accounting information is more useful if similar facts can be compared over different periods and companies. Verifiability Timeliness Understandability 13
What limits disclosure? 1. Cost-Benefit trade-off concerns all the qualitative characteristics and conventions obviously, benefits of providing information should exceed cost Cost recording, collecting and processing data auditing competitors learn about your organization Benefits better management and mgmt. control allocation of resources forecasting economic growth disseminating reports possibly litigation cost time and effort to read/analyze reports access to capital markets tax assessment Benefits are much harder to quantify than most of the costs. 14
Who is required to prepare financial statements? An Accounting Entity In this class we typically think of an accounting entity as either A company A group of companies under common control Also possible: Individual traders, Partnerships non for profit organizations (e.g. Charities, government agencies) Requirement to set up financial statements does not necessarily imply an requirement to publish them Accounting entities may be required to set up financial statements in order to ensure a decent information basis for business decisions 15
Who is required to publish Financial Accounting Information? General idea: accounting entities should be required to publish financial accounting information whenever there is a sufficient need for such information from outside the firm Investors Stakeholders Financial accounting information is more valuable the more information asymmetry with respect to relevant information is present Investors: Separation of ownership and control Stakeholders: creditors, suppliers, and customers may need some information, too Requirements to publish accounts differ in different countries Sole traders are in some countries not required to publish accounts Specific accounting rules for non for profit organizations 16
Accounting Entity versus Legal Entity A group consists of at least two individual companies each being a legal entity If the companies are under common control the group is an accounting entity Each individual company is an accounting entity, too In most countries companies belonging to a group are required to publish financial statements For each single company belonging to the group For the group as a whole Problematic aspect with regard to groups: What does common control mean? 17
Accounting Regulation Germany Regulation in codified law: Handelsgesetzbuch (HGB) = commercial code German Accounting Standards Committee (Deutsches Rechnungslegungs Standards Committee (DRSC)), 1998 DSR (Deutscher Standardisierungsrat) DPR (Deutsche Prüfstelle für Rechnungswesen) BAFin (Bundesanstalt für Finanzdienstleistungen) The United States US-GAAP (generally accepted accounting principles); numerous detailed regulations FASB (Financial Accounting Standards Board) established in 1973; private-sector body SEC (Securities and Exchange Commission) established in 1934; federal agency 18
Accounting in Europe IASC (International Accounting Standards Committee) Was founded in 1973; privately-funded accounting standard setter (based in London) Since 2001 IASB (International Accounting Standards Board) Sets International Accounting Standards (IAS), now IFRS (International Financial Reporting Standards) http://www.iasb.org.uk/ European Union authorities influence regulations of member states by rulings that have to be translated into the law of the individual member states. Since 2005 companies listed in member states are required to publish group accounts following International Financial Reporting Standards as far as endorsed by the European Union 19
Structure of this lecture Part 1: Foundations Balance Sheet Income Statement Accounting Records Accrual Adjustments Annual Report and accounts Cash Flow Statement Part 2: Accounting treatment of specific items Tangible and intangible assets Inventories Receivables and revenue recognition Liabilities Owner s equity 20
Chapter 2: The balance sheet a snapshot of assets and liabilities of the enterprise Fundamental Structure: Resources Sources of Capital Assets Liabilities Residual Claims = Asset: Resource owned or controlled by the accounting entity expected to provide future economic benefits to the accounting entity ownership or control acquired in a past transaction Liability:= obligation to settle a past transaction by transferring resources to an outside party Residual claims= Owners equity 21
The basic accounting equation Note that the following equation always holds: Assets = Liabilities + Owner s Equity The effect of a transaction on the left hand side of the balance sheet always equals the one on the right hand side Examples: An increase in one asset and a decrease in another asset An increase in an asset and an increase in a liability An increase in an asset and an increase in owners equity An increase in a liability and a decrease in owners equity Each transaction affects at least two accounts 22
Line items on the balance sheet Assets... economic resources owned (or controlled) by a business as a result of past transactions that are expected to yield future economic benefits and eventually result in cash inflows to the business enterprise. Examples: property, plant, cash, copyrights, patents, investments Liabilities... claims of those to whom money is owed, i.e. liabilities are existing debts and obligations Examples: loans payable to a bank, salaries payable to employees Owner s Equity... residual interest in the assets of a business enterprise after deducting its liabilities; also referred to as residual equity or net assets 23
Classification of assets Assets current (to be converted within operating cycle) cash and marketable securities receivables inventories prepayments and accrued income fixed property, plant and equipment long-term financial investments intangible assets 24
Classification of liabilities and shareholders equity Liabilities current short-term debt and current portion of long-term debt payables accrued expenses and deferred income long-term long-term debt provisions for contingencies and charges other long-term liabilities Equity Common Stocks at par value additional paid-in capital (= capital surplus, share premium) Reserves accumulated other comprehensive income / loss retained earnings net income for the year 25
Explanations, assets by examples inventories: merchandise, raw materials, purchased parts, goods in process, finished goods prepayments and accrued income prepaid rent, interest earned but not yet received long-term financial investments intangible assets long-term loans given, investments in shares of other companies as far as not consolidated patents, trade marks, exclusive rights, software 26
Explanations, liabilities short-term debt and current portion of long-term debt provisions for contingencies debt due within a short period, usually one year potential liabilities, provision for imminent risks e.g. litigation risks, risks from commitment whose costs are expected to exceed revenue provisions for taking back used products, recovery and cleaning up, dismantling nuclear power plants waste disposal recultivation of open pit mines,... charges obligation to pay money in the future, usually attached to an asset owned by the entity 27
Explanations, equity Reserves equity in excess of par value of shares legal or statutory reserves law or statute may prescribe to accumulate a certain volume of profits not distributable revaluation reserves accumulated other comprehensive income / loss cumulative profits due to revaluation of assets, e.g. due to exchange rate changes some changes in asset or liability values not due to transactions with the outside world are not reported in the income statement ( Dirty surplus accounting) 28
Conceptual Explanations Accruals accrued revenues an asset! accrued expenses a liability! Deferrals deferred revenues a liability! deferred expenses an asset! a revenue that has been earned (= recognized) but not yet occurred as an addition to assets or a reduction of liabilities such as for instance a receivable an expense that has become economically unavoidable but not yet occurred as an addition to liabilities or a reduction of assets the money is at the entity s disposal before the revenue is realized an expense has been paid for before the resource consumption occurred e.g. prepaid rent, prepaid interest 29
Understanding the basic accounting equation The story : Angie has a degree in political science and economics, and decides to start her own business Vote-Consult. Some time ago she received 8.000 from a very good friend, money that she now uses to invest in her enterprise. During the first days of her new enterprise s life the following transactions occurred (in chronological order): 1. Angie deposits 8.000 in a bank account in the name of Vote- Consult. 2. She purchases computers and other office equipment for 4.000. 3. Angie buys office supply for 500 on credit. 4. She pays 300 of the total amount she spent on supplies. 5. She pays the remaining 200 out of her personal pocket. 30
What happens to the balance sheet? 1. Angie deposits 8.000 in a bank account in the name of Vote-Consult. [Extension of both assets and liabilities side] 2. She purchases computers and other office equipment for 4.000. [Exchange of assets] 3. Angie buys computer paper and office supply for 500 on credit. [Extension of both assets and liabilities side] 4. She pays 300 of the total amount she spent on supplies. [Contraction of both sides] 5. She pays the remaining 200 out of her personal pocket. [Exchange on the liabilities side] 31
Valuation: general aspects Asset values on the balance sheet do not represent expected future economic benefits; they are valued either at cost (at the value of resources due or given in exchange for acquiring them) or at market (at current market price, if available) expected future benefits usually will be greater than asset values on the balance sheet If future benefits are estimated to be below cost or market the asset has to be depreciated accordingly Liabilities are valued at the amount (known or estimated) of assets to be given up to settle them Note that valuation of assets and liabilities is asymmetric! prudence or conservatism principle 32
What affects owner s equity? the owner may put money (assets) into the business owner s investment, or take them out of the business owner s withdrawals operating the business entails revenues and expenses INCREASES owner s investment revenues owner s equity DECREASES owner s withdrawals expenses 33
Chapter 3: The Income Statement Income: Increase in an entity s net assets Resulting from an entity s operations Over a period of time Fundamental balance sheet equation: Assets = Liabilities + Equity Net Assets = Assets Liabilities => Net Assets = Equity Assets = Liabilities + Owner's Equity (profits) (losses) 34
Income Income results only from entity operations Capital transactions with owners Gains or losses from changes in exchange rates when group accounts are concerned are not operations Such transactions do not affect income but equity Income is generated over a period of time The period between two balance sheet dates The income statement provides detailed information about how income was generated It adds up revenues and deducts expenses Income is the bottom line of the income statement 35
Income statement Balance sheet and income statement are interrelated 36
Revenues and Expenses Revenues gross increase in owner s equity resulting from operating the business with the objective of generating profits usually results in an increase in an asset Examples: sales; fees, commissions; interest; dividends; rents Expenses cost of assets consumed or services used resulting from business activities and are, in general, actual or expected cash outflows Examples: salaries, wages; interest on loans; insurance premiums; cost of providing fringe benefits to employees; decrease in inventory Revenues > Expenses Net profit Revenues < Expenses Net loss 37
Some Terminology Cash Inflow Cash Outflow Revenue Expense Do not mix up the terms! Revenue is not necessarily a cash inflow and an expense is not necessarily a cash outflow. 38
Angie s business story continued transactions (in chronological order): 6. Invited speech at a regional conference, 1000, remitted to the bank account This is a revenue: Accounts affected: Bank; Revenues; Amount: 1.000 7. First rent and utility payment due, charged to bank account, 500. This is an expense: Accounts affected: Cost of office space; Bank 8. Prepayment received for a series of invited speeches, 4.500. This is not yet a revenue, this is unearned revenue Accounts affected: Bank; Unearned revenue. 9. Personal expenses (haircut, groceries, etc.), 400, paid using the EC card. This is a withdrawal Accounts affected: Owner s equity; Bank. 39
Income Statement Format (funcional basis) Net Revenue Cost of goods sold (by product category) Gross margin Operating expenses Operating Income (EBIT) + Financial, Investment & other revenue Financial expenses expenses from investments and other Income before Taxes Income taxes Income after Tax + Extraordinary Items Net income 40
Income Statement Format (natural basis) Sales Revenue +/ Change in product inventory Period expenses (by type) Net income 41
Explanations of income statement items Net revenue = gross revenue discounts returns Cost of goods sold = cost of goods available for sale ending product inventory Cost of goods available for sale = beginning product inventory + cost of goods manufactured Cost of goods manufactured = direct materials + direct labor + allocated production overhead cost ending product inventory (finished and work in process) value to be determined according to an inventory valuation method, e.g. LIFO, weighted average cost 42