Management I: Financial Accounting 1
Contact Information: Office: Vilfredo-Pareto-Building (G22), Room E-209 Office hours: Thursdays 11-12 a.m., or by appointment Email: barbara.schoendube@ww.uni-magdeburg.de Phone: 0391 67 18 728 2
Class Schedule: Lectures on Wednesday, 11:15 13:30 Tutorials on Tuesday, 9:15 10:45 Course website: http://www.uni-magdeburg.de/bwl1/ notes and exercises Grading scheme: Final Exam 100 Assignments? Total 100+? 3
Basic text: Tim Sutton (2004). Corporate Financial Accounting and Reporting 2 nd ed., Prentice Hall. Also of interest: Jane L. Reimers (2008), Financial Accounting, A Business Process Approach, 2 nd ed. Pearson International Edition 4
Chapter 1: Introduction Purpose and Object of Financial Accounting 5
What is Accounting? Accounting is the Language of Business Sound understanding of accounting is essential for all business people 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 6
Financial Accounting: who is addressed? Investor orientation owners and potential acquirers of residual claims shareholders parties that consider to or have committed resources to a relation with the reporting entity in exchange for future compensation creditors suppliers / customers (maybe) Tax authority orientation other interest groups could use the information to the detriment of investors regulators trade unions competitors 7
Contents of Financial Statements Financial Accounting is the process of summarising financial data...and publishing it in the form of annual reports for the benefit of people outside the organisation Annual accounts typically comprise: Balance sheet Income statement (profit and loss account) Cash flow statement Notes to the accounts Numbers in the statements come from the accounting records (bookkeeping system) of the accounting entity 8
Contents of Financial Statements Balance Sheet Helps assess the company s financial strength Income Statement Helps measure the firm s financial performance Cash flow statement Helps to assess the firm s ability to survive 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 9
Objectives of Financial Reporting According to investor orientation: Providing information that investors find helpful in making economic decisions What is useful information? Forward looking information Backward looking information Information that is Relevant, Reliable Comparable Alternatively: monitoring and disciplining role of accounting? 10
Desirable characteristics of Accounting Relevant timely Reliable 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) 11
Decision Usefulness according to IFRS Framework include: 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 Information relevance depends on timely availability. Reliability Four dimensions of reliability 1. Verifiability 2. Representational faithfulness 3. Neutrality 4. Prudence 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. Consistency Consistency: using the same accounting procedures over several periods. Changes in accounting procedures must be indicated and explained. 12
Accounting Entities Who is required to prepare financial statements? Specific rules apply in different countries Various business organizations Non for profit organizations E.g. Charities, government agencies Since we focus on investor-oriented accounting we restrict ourselves to companies and groups 13
Legal Forms of Business Organization 1. sole proprietorship / sole trader liable with personal resources if business is sold, a new proprietorship is established 2. partnership not a separate legal entity unlimited liability of at least one partner any change in participation requires new partnership 3. corporation (also private limited company) separate legal entity risk of ownership limited to investment in the company shares can be sold to others without an effect on the identity of the corporation Common property: separate accounting entity 14
Legal forms of business organization *) e.g. cooperatives Source: US Bureau of Census (1992); IfM Bonn (1997) Remark: German data apply only to small and medium-sized businesses, and partnerships include limited-liability partnerships. 15
Regulation Germany, Austria Regulation in codified law: Handelsgesetzbuch (HGB) = commercial code DPR (Deutsche Prüfstelle für Rechnungswesen) BAFin (Bundesanstalt für Finanzdienstleistungen) tax accounting rules influence financial accounting German Accounting Standards Committee (Deutsches Rechnungslegungs Standards Committee (DRSC)), 1998 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 on the web: http://www.drsc.de http://www.fasb.org/ http://www.sec.gov/ 16
Accounting in Europe IASC (International Accounting Standards Board) founded in 1973; privately-funded accounting standard setter (based in London) 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 Accounting standards as far as endorsed by the European Union 17
What is decent disclosure? In the U.S., the issue was addressed by the SEC in 1998: The Plain English Handbook Statement of Arthur Levitt, then chairman of the SEC: We need to acknowledge that disclosure is not disclosure if it doesn't communicate. The proposed rule [i.e. the handbook] requires prospectuses to... [be]... in plain English. It asks issuers to use the hallmarks of plain English... active voice, short sentences, everyday language, tables, and no legal or business jargon. Our eventual goal is to purge the entire document of words that, in the famous phrase of George Orwell, fall upon the facts like soft snow, blurring the outlines and covering up all details. [Reuters, February 25, 1997. SEC to help investors understand mutual funds. ] 18
What is decent disclosure? information must not be hidden in obscure prose Example 1: What you read : We are well-positioned for future growth What happened? By every measure of corporate performance, the company dropped to or near the bottom of its industry. Example 2: What you read: With perseverance, the company s extraordinary performance in generating added value will be recognized in the market place. What happened? The company s stock price has languished for years while major market indexes skyrocketed. 19
Full disclosure principle Case study Porsche AG vs. Deutsche Börse on interim reporting in 2001 sports car manufacturer Porsche got thrown out of the MDax, the German Midcap-Index listing 70 companies, for its reluctance to issue quarterly reports... as the Deutsche Börse AG sees it: "Porsche and Spar are being taken out of the MDAX because the two companies do not publish quarterly reports, which Deutsche Börse requires in the interest of transparency for investors." (press release, 7 August 2001)... as Porsche sees it: "We feel that quarterly reports are first and foremost a plan to drum up business for Deutsche Börse AG and the banks. Porsche has always informed investors - and this not just every three months. It is therefore not surprising that Porsche, even without ever having submitted quarterly reports, received the Investor Relations Award this May as the MDAX-listed company with the best information sharing policy. " (press release, 18 July 2001) Who has a point? Do both have a point? 20
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 disseminating reports possibly litigation cost time and effort to read/analyze reports Benefits better management and mgmt. control allocation of resources forecasting economic growth access to capital markets tax assessment Benefits are much harder to quantify than most of the costs. 21