Financial Accounting

1. Financial Accounting Dr.Pietro Andrea Podda , PhD

2. Introduction • Accounting is the science that studies the collection, recording, interpretation and transmission of financial information • Accounting is divided into two main types: financial (directed to external users) and managerial (for internal use)

3. Users of Financial Accounting • Here below is a list of the main users of Financial Accounting information (categories overlap): • A)Investors (equity, bonds) • B) Banks (lenders) • C) Employees • D) Government (Tax authorities) • E) Competitors • F)Suppliers • G) Customers • H) Investment Analysts • I) Owners (shareholders)

4. How to provide Financial Accounting information • FinancialAccounting data are incorporated in specificdocumentsreleased by economicentities. These documents are calledFinancialStatementsand are five: • a) Balance Sheet- itrepresents a pictureofthefinancialassets, liabilitiesandequitiesof a companyat a given moment oftime • b) IncomeStatement- itdeliversinformationabouttransactionsoccurredduring a specific period oftime • c) StatementofEquity- itinformsaboutchanges in thecompositionofequityduring a specific period • d) Cash FlowsStatement-itdealswithmovementsof cash during a specific period • e) Notes-complementary information

5. Qualitative Requirements Financial Accounting Information must meet • FinancialAccountingInformation should bereportedwhenit has thefollowingcharacteristics: • a) Relevance- itcan influence decisions • b) Reliable- itis not affected by significanterrorsorbias • c) Comparability- itallowstheidentificationofchanges\differencesfrom data related to previousyearsorfrom data released by competitors • d) Understandability- anaverage-knowledgeable user, broadlyfamiliarwith financialissues, shouldbeable to readfinancialstatements • Overall, informationwillbeprovidedwhenthebenefitsofitsproduction are not overcome by costs

6. Importance of Financial Accounting and Risks • Theneed to findaccurateFinancialAccountingInformationisofparamountimportance in a globaleconomycharacterised by internationaltransactions • UnfortunatelyAccountingis not a “Precise Science” and there are many possibilities to “manipulate” financial statements

7. Typesofcompanies • Sole propietorship-Oneowner. No distinctionbetweentheownerandthecompany as foraccountingpurposes • Parterships- Fewowners. Distinctionbetweentheownerandthecompany as foraccountingpurposes • Limited company- Many owners. Distinctionbetweentheownerandthecompany as foraccountingpurposes

8. The Balance Sheet • Purpose: to representthefinancialpositionofthecompanyat a given moment oftime (thisiswhyitisalsocalledStatementofFinancialPosition). ItpresentstheAssetsofthe business on theonesideandtheClaimsagainstthe business on theother • AnAssetis a resourceoverwhichthe business has control , capable to bemeasured in monetarytermsandfromwhich a futureeconomicbenefitisexpected. Assets are dividedintotwomaintypes: tangible (theycanbeviewedandtouched) andintangible

9. The Balance Sheet: Claims • A Claimisanobligation on the business to transfer financialresources to otherparties. Claimsmaybeoftwotypes: • A) Equity- thecapitalprovided by theowners to the business. Ownerscanwithdrawtheirinvestment, atcertainconditions, fromthecompany • B) Liabilities-anobligation on the business to transfer a resource to partiesotherthantheownersacting in theirposition as owners. A liabilityinvolvestheexpectedoutflowsofresourcesfromthecompany on the basis of past transactions, withthecompanyhaving no right to refuse/avoidthe transfer

10. The Balance Sheet: theEquations • THE FOLLOWING EQUATIONS REPRESENT THE RELATIONSHIP BETWEEN THE TWO SIDES OF THE BALANCE SHEET • ASSETS= LIABILITIES+EQUITY • HENCE • LIABILITIES= ASSETS-EQUITY • EQUITY= ASSETS-LIABILITIES

11. Currentand Non CurrentAssets • A furtherclassificationofAssetsisthatbetweenCurrentand Non CurrentAssets. CurrentAssetsmeetanyofthefollowingcharacteristics: • A) they are heldforsaleorconsumption in thenormalcourseof a business operating´cycle • B) they are expected to be sold withinthenextyear • C) they are heldprimarilyfortrading • D) they are cash ornear-cash (i.e. short-term investments) • Assets not meeting anyoftherequirementsabove are called Non CurrentAssets

12. Currentand Non CurrentLiabilities • AlsoLiabilitiesmaybeclassifiedintoCurrentand Non Current. CurrentLiabilitiesmeetanyofthefollowingrequirements: • A) expected to besettledwithinthenormalcourseofthe business operatingcycle • B) due to besettledwithin 12 months • C) primarilyheldfortradingpurposes • D) No right to deferpaymentbeyond 12 months • Non currentLiabilities are identifiedthrough a residualmechanism

13. Balance Sheet Layout • Therecanbe many forms. The most important are vertical (Assetsfollowed by Claims) andHorizontal (Assets on theleftside, Claims on therightside). Items are presentedaccording to thefollowingcriteria: thelowertheliquidity, theearliertheitemispresented

14. Accountingconventions • Business entity convention-as foraccountingpurposes, the entity andtheowner are separateentities • Prudenceconvention- not to overstatethevalueofassets, not to understatethatofclaims • Goingconcern- itispresumedthe business willcontinue to operate • Dualentry- eachtransactionaffectstwopostsofthe Balance Sheet

15. Goodwill versus IntangibleAssets • Goodwill isthat part ofthevalueof a companywhichcannotbevalueddirectly. Goodwill is not separablefromthe rest oftheAssetsandcannotbemeasureddirectly • Internallygenerated goodwill cannotbereported. Howeveranacquirerof a companyisallowed to report thevalueof goodwill oftheacquiree • Itisdifficultnowadays to establish a clearseparating line between goodwill andintangibleassets. In any case examplesofcomponentsof goodwill canbethemotivationofworkforce, itscapacity to findnewclients, thecustomer portfolio of a company

16. Reporting Assets: HistoricCostsandLossofvalue • Assetscanbereportedattheirhistoriccosts. ThelossofvalueoccurredaftertheacquisitionoftheAssetisalsotakenintoaccountandsubtractedfromthehistoriccost • As forfinite-lifeAssets (itisalreadyknownwhentheywill not beusefulanylonger), lossofvalueiscalledDepreciation (tangibleAssets) orAmortisation (intangibleones). Thelossofvaluecanbeplannedaccording to a preciseschedule • As forinfinite-lifeAssets (itis not knownwhentheywillcease to beuseful) lossofvaluecannotbeplannedorscheduled. Indeed, itisassessedeachyear (Impairment)

17. Reporting Assets: Fair Value • Anotherwayof reporting thevalueofAssetsisthroughthe Fair Valuemethod. The Fair Valueisthepricewhichisconsideredwouldbepaid in a transactioninvolvingtwowilling, independent andknowledgeablepartiesexchanging a good/servicesimilar to theonewhosevaluemustbereported • In comparisonwithHistoricCostmethod, the Fair Valuemethodoffers a more realistic idea ofthevalueofanAsset. However, there are not perfectmethodsforcalculatingthe Fair Valueofanitem

18. Income statement • This particular financial statement provides information about the flows of transactions occurred during a given period • Revenues and Expenses are recorded. Revenues are economic benefits arising from the ordinary activities of the business, whereas expenses are economic outflows. When the former exceeds the latter, then the company reports a profit. Gross profits measure just the difference between the revenue from goods sold and their cost, whereas the operating profit subtracts operating expenses from the gross profit. In turn, net profit is given by the residual obtained when interest and loan net expenses are deducted from the operating profit • Revenues and expenses are recognised on the basis of the principle of Accrual. On the basis of this, revenues and expenses are recognised whenever the ownership and control of the good is transferred. Services are normally recognised when rendered

19. Income statement • Challenges arise because sometimes certain items are produced within a long period of time. Hence the generating revenues and expenses may be recognised across various accounting periods • Goods and services are recognised on the basis of Accrual rule, independently from the actual flow of cash • Overall, revenue is recognised when it can be measured reliably and there is an expected economic benefit accruing to the company

20. Methods of depreciating assets • Assets with an economic finite life may be depreciated acccording to two main methods: • Straight-line method: in this case the amount of depreciation is the same over the whole economic life of the asset • Reducing balance method: in this case the percentual amount on the basis of which the amount of depreciation is calculated is the same each year. However, the amount itself varies. There is a formula useful to calculate the percentage needed.

21. Allocating the cost of sales • In case of goods of the same type which are bought at different prices, the costs of sales may be allocated according to three methods: • FIFO (First in, first out)- the first goods to be bought are considered the first to be sold • LIFO (Last in, first out)- the last goods to be bought are considered the first to be sold • AVCO (Average cost method)- the costs of goods sold are calculated as a weighted average of the total of goods purchased

22. Cash-Flow Statement • The Cash Flow Statement is a summary of the cash receipt and payment during a given time. It contains a picture of cash and cash-equivalents • Cash is notes and coins in the hands of a company, as well as bank deposits accessible on demand. Cash-equivalents are short-term (3 months maximum), highly liquid investments with an insignificant risk. Cash-equivalents are held to meet short-term cash committments • Cash is divided into three categories: operating, investing and financing

23. How to deal with Bad Debts • Not all trade receivables are always paid back by debtors. Some of them are left unpaid (Bad debts) • Each year a company must write bad debts off and report an estimate of those receivables which are probably going to be written off in the future • If it results that the company has over(under)stated the extent of future bad debts, then it must adjust the financial statements of future years. For example, if the future amount of bad debts was overstated, then the company will report the residual in Revenue

24. Cash-Flow Statement • Operating Cash indicates receipts and payments related to the main activity of the reporting entity. It equals the cash receipt from the sale of goods/services minus the cash paid to buy inventories, pay workers, rent and so on. Also taxes actually paid are counted • Investing Cash is cash related to the investments of the company to buy additional non current assets or to the disposal of non current assets. It includes also investments in other entities (acquisitions), receipt of dividends for shares in other companies, payment for loans to other companies • Financing cash indicates the long-term financing of the company. It includes bank borrowing, cash collected through the issue of shares and bonds

25. Cash-Flow Statement • The Operating Cash Flow statement may be prepared following two methods:Direct and Indirect Method • The Direct Method starts from the books kept by the company and calculates all cash movements

26. Cash-Flow Statement: The Indirect Method • The Indirect Method is used to draw the Cash-Flow from the Income Statement and the Balance Sheet. It starts from the operating profit, it adds the depreciation of assets, + (-) the decrease (increase) in inventories, + (-) decrease (increase) in trade receivables, + (-) increase (decrease) in trade payables, less interest paid *, less taxation. The result is the Net Cash Flows from operating activities • * Interest paid may appear also in other parts of the Cash-Flow Statement

27. Financialindicators • Financialindicators (orfinancialratios) provide a measureofthe performance of a company, howwellthecompany has done • These financialratios are offivetypeswhichmeasure: • A) Profitability, thecapacityof a company to generateprofits • B) Efficiency, theefficient use ofspecificresources • C) Liquidity, theavailabilityofliquidresources • D) Gearing, thelevelofdebts

28. Financialindicators 2 • E) Investment, thereturn to shareholders • In orderfinancial ratio to beinterpreted, wemusthavesome sort ofbenchmark (term ofcomparison). Thisis, usually, the past of a company, equivalentratiosofcompetitorsortheplannedratios

29. Indicatorsof profitability • Return on ordinaryshareholderFunds (ROSF)- Numerator (N) : profit fortheyearlessany preference dividend paid , Denominator (D): OrdinaryShareCapital+ Reserves • Return on CapitalEmployed (ROCE)-N: OperatingProft, D: ShareCapital+Reserves+Non CurrentLiabilites • Opeating Profit Margin: N: Operating Profit, D: SalesRevenue • Gross Profit Margin: N: Gross Profit, D: SalesRevenue

30. IndicatorsofEfficiency • AverageInventoryTurnover Period-N: AverageInventoryHeld, D: CostsofSale ALL MULTIPLIED BY 365 • Average Settlement Period forTradeReceivables-N: TradeReceivables, D: CreditSalesRevenue ALL MULTIPLIED BY 365 • Average Settlement Period forTradePayables -N: TradePayables, D: CreditPurchases ALL MULTIPLIED BY 365 • Salesrevenue to CapitalEmployed - N: SaleRevenue, D: Equity+Non CurrentLiabilities • Sales per employee