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Accounting
The process of collecting, analyzing and communicating financial information about companies Financial accounting is concerned with the preparation of financial statements for decision makers
Information used by shareholders, lenders, suppliers, employees, customers, the government, investment analysts, community representatives etc. Needed to monitor contracts i.e. reduce principal-agent problems by measuring, monitoring agents performance
Incorporation either as
private limited company: Ltd public limited company: PLC
Management accounting is concerned with providing financial information internally, to managers to help them make informed business decisions
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Finance
The science of determining value and funds management In the company, corporate finance decisions are concerned with how managers can create value through investment decisions (capital allocation) financing decisions (capital structure: debt vs equity) how shareholders (as providers of capital) should be rewarded payout decisions (dividends, share repurchases)
Strategy
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Course outline
Accounting Introduction to financial reporting Key financial statements
Balance sheet, income statement, cash flow statement
Interpretation of accounts Creative accounting Finance Valuation of assets and Net Present Value Investment policy investment appraisal Financing policy capital structure Payout policy dividends, share repurchases
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We wont:
Be experts in any particular field Discuss at length what is within the syllabus and can easily be learnt from textbooks Discuss institutional/regulatory matters in great detail
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Main textbooks
Accounting
Atrill/McLaney: Accounting and Finance for Non-specialists, ed. Whittington: Elements of Accounting: An Introduction (both e-books available through the library) Parker: Understanding Company Financial Statements, 6th ed. 8th
This lecture
Objective of financial statements Key financial statements Balance sheet Income statement Cash flow statement
Finance
Ross/Westerfield/Jaffe: Corporate Finance, 10th ed., OR Ross/Westerfield/Jaffe/Jordan: Modern Financial Management, 8th ed., OR Brealey/Myers/Allen: Principles of Corporate Finance, 11th ed.
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Accounting is not a set of precise measurement rules that permit the exact measurement of profit/loss and firm value
It is full of choices that may mean a trade-off between relevance and reliability e.g. asset valuation: fair value or historical cost? Choices should reflect economic substance, not legal form They must be clearly stated in financial statements accounting policies
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Accounting choices
Battered banks are set to cushion the blow of further credit-related losses by exploiting a controversial accounting rule Under the rule, introduced in February 2007 after lobbying from banks, financial companies are allowed to use "mark to market" accounting on their own debt. In past months, the rule has helped banks including Lehman Brothers, Citigroup, Goldman Sachs, Morgan Stanley and Merrill Lynch to boost profits. Financial Times, 9 July 2008
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Operating expenses approx. US$7-9 billion But capitalized them and depreciated over long period
Capitalized: included in balance sheet as an asset rather than written off in income statement as an expense against revenue Depreciation: cost of using the asset is spread over the useful life of the assets
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Develops and issues both main standards (IAS/IFRS) and interpretations (IFRS Interpretations Committee)
Has embarked on harmonization of accounting standards globally
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Consolidated statements add companys subsidiaries over which control is exercised into aggregate figures Economic substance over legal form
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Profit/loss
Profit/loss
Cash flow
Cash flow
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Balance sheet
Shows, at the end of the fiscal year, the companys financial position Assets: the economic resources it controls Liabilities and equity: where its finance comes from
Assets Liabilitiesequity
It is a status report (a snapshot at a specific moment)
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Liabilities + Equity
Current liabilities
Short-term borrowings Trade payables Accrued liabilities (expenses, taxes etc)
Non-current liabilities
Long-term loans, bonds Pension liabilities Provisions
Shareholders equity
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Non-current (fixed) assets: held for the long-term operations of the business
Tangible assets property, plant & equipment (PP&E) Intangible assets e.g. patents, licences, goodwill Investments e.g. shares in/loans to other companies
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Non-current liabilities: due to outside parties but are not current liabilities
Long-term loans Pension liabilities current and past employees Provisions liability to pay in the future but amount or timing uncertain
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Income statement
Sets out the financial performance (results) of the companys operations during the fiscal year
Presents flow data (covering a period) Accomplishments
Less:
Efforts
Equals:
Performance
Links shareholders equity in last years and this years balance sheet Equity (t=1) = Equity (t=0) + profit/income (loss)
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Net profit/income
Net profit/income (loss):
The profit attributable to shareholders It is a residual the amount left over after deducting all expenses It represents the wealth generated by the company It can be used to pay dividends or repurchase shares retained for future investment to finance future growth (added to shareholders equity on the balance sheet as retained earnings)
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40 60 10 15 125 75
45 30 50 125 75
Administration buildings
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Depreciation
Capital investments in non-current assets (capital expenditures) CANNOT be recognized as an expense
so they are not tax-deductible
Depreciation
Importance:
capital expenditures are paid out of the companys net profit depreciation reduces the companys taxable profit and thus provides a tax shield!
However, companies can recognize depreciation: that assets are used up in the process of generating revenue
(i) The company makes capital investments in non-current assets (capital expenditures) (ii) The assets loss of value is recognized as an operating expense (depreciation) also recognized on the balance sheet, because the value of the assets will now be reduced!
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Depreciation methods
Straight-line method: asset depreciated evenly over its useful life
Cost of machine Estimated useful life Estimated residual value
Depreciation chargeperyear
Depreciation methods
Reducing-balance method: applies a fixed percentage of depreciation to the written-down value (WDV)
e.g. if depreciation charge=50% of WDV Cost of machine Year 1 depreciation charge Written-down value Year 2 depreciation charge Residual value 40050% 20050% 400 -200 200 -100 100
NOTE: Balance sheet recognizes depreciation by showing the assets written-down (net book) value
Year 1 Year 2
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NOTE: Balance sheet recognizes depreciation by showing the assets written-down (net book) value
Year 1 Year 2
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Depreciation example
Sainsbury:
Tangible assets Depreciation is calculated to write down the cost of the assets to their residual values, on a straight-line method on the following bases: Freehold buildings and leasehold properties 50 years, or the lease term if shorter Fixtures, equipment and vehicles 3 to 15 years Freehold land is not depreciated Land and buildings under construction and non-current assets held for sale are not depreciated.
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Depreciation example
Sainsbury:
Intangible assets Pharmacy licences are carried at cost less accumulated amortization and any impairment loss and amortised on a straight-line basis over their useful economic life of 15 years. Externally acquired computer software and software licences are capitalised and amortised on a straight-line basis over their useful economic lives of 3-5 years. Goodwill is tested for impairment annually () and is carried at cost less accumulated impairment losses.
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Inventories
Inventories (or stock) are goods and materials that a company holds for the ultimate purpose of resale Companies must determine
(i) the cost of the inventories sold during the period (the cost of sales on income statement) (ii) the cost of the inventories remaining (on balance sheet)
Inventories method
In inventory costing three methods are recognized: (i) First in, first out (FIFO) earliest inventories sold first (ii) Last in, first out (LIFO) latest inventories sold first (iii)Weighted average cost (AVCO) weights are the quantities of each batch of inventories purchases The benchmark treatment in international accounting standards is either FIFO or AVCO, LIFO is unacceptable
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Inventories example
Sainsbury:
Inventories are valued at the lower of cost and net realizable value. Inventories at warehouses are valued on a first-in, firstout basis. Inventories at retail outlets are valued at calculated average cost prices. Cost includes all direct expenditure and other appropriate attributable costs incurred in bringing inventories to their present location and condition.
Impairment of assets
An asset is impaired when its market value falls below its carrying amount and is not expected to recover
this means that the asset's market value is less than its book value, and the future cash flows to be generated from the asset are less than the net difference between the market value and the book value it becomes necessary to write down the value of the asset in the books by income statement: recognizing the value loss as an expense balance sheet: reducing the value of the asset
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Note: balance in the companys bank current account is actual cash, s.t. an overdraft is negative cash!
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Exercise 1
Jack Smith started a business as an antique dealer on 1 August 2013. The following transactions were made during his first two weeks of trading: 1. Started the business with 5,000 in cash as opening capital. 2. Bought an Edwardian desk for 500 cash. 3. Bought five Art Deco table lamps for 200 each, on account from Jacques Shiraz. 4. Sold the desk for 750 cash. 5. Sold four table lamps for 300 each on account to his Uncle George. 6. Paid rent of 250 cash. 7. Considered expanding his business into eBay. 8. Earned 50 for writing a magazine article about the antiques industry, but had not yet been paid for it. 9. Paid Jacques Shiraz 500 in partial settlement. 10.Received 1200 from Uncle George in full settlement of the amount due. 11.Bought a van for use in the business for 4000 cash. 12.Received a telephone bill for 150 but had not paid it yet.
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NON-CURRENT LIABILITIES EQUITY Opening balance Profit and loss Gross profit Less operating expenses
Receivables
5. 8. 10.
2. 3. 4. 5.
Inventories
1. 4. 5. 6. 8. 12.
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CASH FLOW FROM INVESTING ACTIVITIES Non-current asset purchase Equity issuance Increase/decrease in cash Cash at start of period Cash at end of period
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11. 1.
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Summary
Balance sheet: shows the companys financial position assets = liabilities + equity Income and cash flow statements: set out the financial performance of a companys operations
link the balance sheet at the beginning of the period with the balance sheet at the end
Depreciation, inventories costing and impairment affect both the balance sheet and the income statement Reading: Atrill/McLaney chapters 1-3, 5
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