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Accounting & Finance

Judge Business School


Instructor: Dr. Peter Szilagyi Office: 11/12 Trumpington Street Phone: 01223 764 026 Email: p.szilagyi@jbs.cam.ac.uk

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What is a limited company?


A corporation separate from the persons who own it or manage it
a separate legal entity with its own privileges and liabilities

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

Liability of members (the shareholders) is limited to the amount invested


vs. sole proprietorships and partnerships (unincorporated businesses), where owner is liable with personal assets

Incorporation either as
private limited company: Ltd public limited company: PLC

Company life is perpetual at least in principle


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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)

Accounting & finance are central to capital markets and business


Capital markets
Economics International business Operations

Accounting & finance


Marketing

Corporate governance and ethics


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Strategy

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Course outline
Accounting Introduction to financial reporting Key financial statements
Balance sheet, income statement, cash flow statement

Scope of the course


We will:
Discuss the basics of understanding company financial statements and making crucial finance decisions Be able to appreciate usefulness/limitations of the basics

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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Objective of financial statements


The objective of financial statements is to provide information about the financial position, performance and changes in financial position of an entity that is useful to a wide range of users in making economic decisions.
IASB, Framework for the Preparation and Presentation of Financial Statements, paragraph 12

Accounting as a service function


To be useful, accounting information should be
Relevant ability to influence decisions Reliable free from significant error or bias Comparable to evaluate performance over time Understandable as clear as possible

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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Accounting choices WorldCom


Largest bankruptcy filing in US history until 2008 Bernard Ebbers former CEO
Convicted in 2005 for nine counts of conspiracy, securities fraud and false regulatory filings 25-year prison sentence

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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Coping with accounting choices


International Financial Reporting Standards (IFRS)
Called International Accounting Standards (IAS) until 2001 Set of global accounting and reporting standards, issued by the International Accounting Standards Board (IASB) Used as a basis for national accounting regulation (usually called GAAP Generally Accepted Accounting Principles/Practice), or as a benchmark for its development Used in at least 113 countries; EU regulation came into effect in 2005 No full compliance of US GAAP yet, but the IASB and the US Financial Accounting Standards Board (FASB) are working together to achieve convergence

International Accounting Standards Board (IASB)


A private sector body based in London Succeeded the International Accounting Standards Committee (IASC) in 2001 Has no responsibility to any governmental organization

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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Annual financial statements


Single public source of economic company data
Prime external communication tool and of interest to the companys many stakeholders (shareholders, lenders etc.) Needed to monitor contracts (directors bonuses, borrowing covenants) Starting point for tax assessment

Annual financial statements


Structure: Key financial statements (i) Balance sheet (ii) Income (profit and loss) statement (iii) Cash flow statement Notes to the accounts Statement of changes in equity Audit report

Subject to independent audit (if listed/large companies)


Verification to provide reasonable assurance statements are presented fairly and/or give a true and fair view

Consolidated statements add companys subsidiaries over which control is exercised into aggregate figures Economic substance over legal form

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Key financial statements


Balance sheet
Shows the companys financial position at the end of the fiscal year: the economic resources (assets) it controls and where its finance comes from (liabilities and equity) It is a status report (a snapshot at a specific moment)

Key financial statements


Balance sheet 31 Dec 2011 Balance sheet 31 Dec 2012 Balance sheet 31 Dec 2013

Profit/loss

Profit/loss

Income statement and cash flow statement


Set out the financial performance of the companys operations during the fiscal year Measure flows of wealth (profit) and cash respectively Present flow data (covering a period)

Income statement 2012

Income statement 2013

Cash flow

Cash flow

Cash flow statement 2012


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Cash flow statement 2013

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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

Balance sheet format


It can be presented in two basic formats:
Horizontal balance sheet Vertical balance sheet

Companies report vertical balance sheets in practice, BUT


US: items listed in order of liquidity (nearness to cash) (i) current assets, (ii) non-current assets (i) current liabilities, (ii) non-current liabilities, (iii) equity UK: (i) assets listed in reverse order of liquidity, then (ii) liabilities are shown as a deduction from assets in order of liquidity, with current liabilities first deducted from current assets
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Assets Liabilitiesequity
It is a status report (a snapshot at a specific moment)

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Balance sheet format horizontal


Assets Current assets
Cash and cash equivalents Trade receivables Inventories Prepaid liabilities (expenses, taxes etc)

Balance sheet Walmart

Liabilities + Equity

Current liabilities
Short-term borrowings Trade payables Accrued liabilities (expenses, taxes etc)

Non-current liabilities
Long-term loans, bonds Pension liabilities Provisions

Non-current (fixed) assets


Tangible assets Intangible assets Investments
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Shareholders equity
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Balance sheet Walmart

Balance sheet Sainsbury

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Balance sheet Sainsbury

Balance sheet items assets


Current assets: constantly changing during the accounting period or realizable within one year
Cash and cash equivalents Trade receivables due from customers Inventories (stock) Prepaid liabilities expenses, taxes etc

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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Balance sheet items liabilities


Current liabilities: due for settlement in the short term
Short-term borrowings from banks, financial markets (incl. long-term loans due within one year) Trade payables due to suppliers Accrued liabilities expenses, taxes etc

Balance sheet items equity


Equity is the residual (remaining) claim of shareholders
Shareholders are the most junior class of investors: they can only claim whatever is left after all liabilities have been paid If liabilities exceeds assets, negative equity exists

Accounts listed under shareholders equity can include:


Share capital - nominal/par value of shares issued Preferred shares - if any, has properties of both debt & equity Capital surplus /share premium - excess funds from shares sold over nominal value Treasury shares - shares bought back (no voting or dividend rights; cancelled shares go into capital redemption reserve) Stock options - issued to management and employees Retained earnings - net profit not distributed to shareholders

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:

Income statement format


Revenue/sales less cost of sales = Gross profit/income (loss) less additional operating expenses of supporting the business (distribution, administration) = Operating profit/income (loss) less financing costs (income) = Profit/income (loss) before taxes less taxes = Net profit/income (loss) [Earnings before Interest and Taxes (EBIT) operating profit, but EBIT also includes non-operating profit e.g. from investments]
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Revenues Expenses Profit/income (or loss)

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)

Income statement Walmart

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Income statement Sainsbury

Ref: Statement of changes of equity 4th statement required by IFRS

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Classification of operating expenses


Revenue Nature Raw materials Salaries, wages Depreciation Other costs Total Operating profit 200 Revenue Function Cost of sales Distribution costs Admin expenses Total Operating profit 200

Classification of operating expenses


Function: Cost of sales Distribution costs Input costs: Salaries and wages Depreciation Factory employees Production site Sales agents Cars Administrative expenses Accountants

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!

To calculate a depreciation charge for a period, we need


(i) (ii) (iii) (iv) Cost (or fair value) of the asset Useful life of the asset Residual value of the asset Depreciation method Straight-line method Reducing-balance method

The depreciation of intangible assets is known as amortization

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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

400 2 years 100


400 100 150 2

NOTE: Balance sheet recognizes depreciation by showing the assets written-down (net book) value
Year 1 Year 2
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250 (asset sold for 100)

NOTE: Balance sheet recognizes depreciation by showing the assets written-down (net book) value
Year 1 Year 2
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200 (asset sold for 100)

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

In a period of changing prices, inventory costing can be a problem


Which inventory costing method? Prudence convention requires current assets incl. inventories to be valued at the lower of cost and net realizable value

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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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Impairment bad receivables


Many businesses sell goods on credit. The dual aspect of a credit sale:
increasing revenue (on income statement) increasing receivables by amount of credit sale (on balance sheet)

Bad receivables example


Sainsbury:

Bad receivables must be written off by


increasing expenses expense known as impairment of receivables (on income statement) reducing receivables (on balance sheet) Net receivables = Gross receivables less allowance for bad receivables
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Bad debts example


Defaults on loans by cash-strapped customers and delinquent credit card debts sent Bank of America tumbling to a $1bn (610m) quarterly loss, offering a blunt reminder that finance on the US high street is lagging behind a revival in prosperity on Wall Street. Much of the shortfall arose at Bank of America's 6,000 highstreet branches. The bank's losses for failed loans came to almost $10bn and it added a further $11.7bn to its reserves to cover anticipated future defaults. Bad debts push Bank of America to $1bn loss Guardian, 16 October 2009
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Cash flow statement


Shows the cash receipts and payments over the accounting period, and their impact on the companys cash position critical because no business can operate without cash! presents flow data (covering a period) also includes cash equivalents
highly liquid investments that are readily convertible and subject to an insignificant risk of value changes e.g. bank deposit account

Note: balance in the companys bank current account is actual cash, s.t. an overdraft is negative cash!
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Cash flow statement format


Cash flows from operating activities +/Cash flows from investing activities +/Cash flows from financing activities = Net increase (decrease) in cash

Cash flow statement Sainsbury

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Deducing operating cash flows


Cash flows from operating activities can be calculated
Directly: analyzing all cash records of the company very time-consuming Indirectly: using items in the income statement e.g. (i) take operating profit (ii) add back depreciation (non-cash item) (iii) deduct taxes (not yet included) (iv) adjust for movements in receivables and payables (i) take net profit (ii) add back depreciation and interest payments (iii) adjust for movements in receivables and payables
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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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Exercise 1 balance sheet


Current assets Current liabilities Cash Payables Receivables Inventories Non-current assets Equity Tangibles Current assets Current liabilities Cash Payables Receivables Inventories Non-current assets Equity Tangibles Current assets Current liabilities Cash Payables Receivables Inventories Non-current assets Equity Tangibles Page 57 Current assets Current liabilities Cash Payables Receivables Inventories Non-current assets Equity Tangibles Current assets Current liabilities Cash Payables Receivables Inventories Non-current assets Equity Tangibles Current assets Current liabilities Cash Payables Receivables Inventories Non-current assets Equity Tangibles

Exercise 1 balance sheet


Current assets Current liabilities Cash Payables Receivables Inventories Non-current assets Equity Tangibles Current assets Current liabilities Cash Payables Receivables Inventories Non-current assets Equity Tangibles Current assets Current liabilities Cash Payables Receivables Inventories Non-current assets Equity Tangibles Page 58 Current assets Current liabilities Cash Payables Receivables Inventories Non-current assets Equity Tangibles Current assets Current liabilities Cash Payables Receivables Inventories Non-current assets Equity Tangibles Current assets Current liabilities Cash Payables Receivables Inventories Non-current assets Equity Tangibles

Exercise 1 balance sheet


CURRENT ASSETS Cash 1. 2. 4. 6. 9. 10. 11.

CURRENT LIABILITIES Payables 3. 9.


Accrued expenses 12.

Exercise 1 income statement


Sales 4. 5. 8. 4. 5. Less cost of sales 6. 12. Operating profit
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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.

NON-CURRENT ASSETS Tangibles 11. Page 59 ASSETS

LIABILITIES AND EQUITY

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Exercise 1 cash flows statement


CASH FLOW FROM OPERATING ACTIVITIES Inventory purchase Sale Rent payment Trade creditor payment Trade debtor receipt 2. 4. 6. 9. 10.

Tesco vs Sainsbury in 2012


Tesco's Christmas numbers were always going to be bad, but not this bad. In the UK, same-store sales excl. VAT and petrol fell 2.3%. [..] Tesco's expected earnings could fall by one-tenth. [] The company has expanded too quickly and has lost business to rivals which have invested more in promotions. [] The "space race" among supermarkets was always unsustainable. [] The grocer now trades at about 9 times expected earnings - a discount of about a fifth to its UK peers. Financial Times, 12 January 2012 Two Tesco executives sold 350,000 of shares in the days leading up to the dramatic profit warning that wiped 18% off the companys value in two days.
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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.

CASH FLOW FROM FINANCING ACTIVITIES

The Times, 14 January 2012

Sainsbury vs Tesco in 2012

Sainsbury vs Tesco in 2013?

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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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