Summary: Financial Accounting for Decision Makers

Deze samenvatting is gebaseerd op collegejaar 2012-2013.


Chapter 1: Introduction to accounting

Accounting is concerned with collecting, analyzing and communicating financial information. It is used to form a basis to prepare financial reports and the most fundamental element is that it is used to make more informed decisions.

Different user groups
Since there are different user groups of accounting information, it must be clear for the accountant for whom the information is prepared and for what purpose. The different user groups (seen in figure 1.1) have different interest in an organization and thus a conflict can occur between the user groups, especially over the distribution of the business’ wealth.
Figure 1.1

Usefulness of accounting
Accounting information provides us with an answer for questions about the financial position and performance of the business. Even though there are other sources of information about the company’s financial health (e.g. media announcements), there are no close substitutes for the financial statements’ information. Also, accounting can be used by a business to make an announcement concerning its profits, which can result in the investors’ decision whether to buy or sell shares.
Accounting can be seen as a service, but in order to be a useful one, accounting has 4 main characteristics:

  • Relevance: reports should be offered when decisions have to be made and include information that is important to the user.
  • Reliability: reports should not contain any errors or biases and it should show what is supposed to be shown.
  • Comparability: clear policies should be used so that reports can be evaluated and variations over time can be recognized.
  • Understandability: reports must be stated understandable for the user.

However, accounting information should not be provided if the expenses are greater than the benefit obtained by it. In contrast, accounting can be seen as an information system of a business. In order to be a valid information system, it has certain elements: it identifies, records, analyzes and reports the information.
Management accounting vs. financial accounting

Accounting can be divided into management accounting or financial accounting:

    • Management accounting
    • Financial accounting
    • For internal users

    • For external users

    • For a specific purpose

    • For a broad range of purposes

    • The reports are detailed

    • Reports provide a broad overview

    • Has no regulations

    • Has many regulations

    • Reports are produced yearly, half yearly or quarterly

    • Reports are produced as often as the managers like, can be daily weekly or monthly

    • The time orientation is both backwards and forwards

    • The time orientation is backwards

    • Focus on information which can be measured in monetary terms

    • Focus on both information which can be measured in monetary terms and non monetary terms

    • Quality is objective/verifiable

    • Quality is less objective/verifiable

Financial statements
The balance sheet presents information regarding the business’ wealth at a given point of time. The income statement, also known as the profit and loss account, provides information regarding the wealth created by a business in period of time. Another financial statement is the cash flow statement, which gives information concerning how cash is used and generated in a given period of time.

Even though financial reports can be used by investors to check the managers and their investment, managers can provide the users with misleading statements. Such sorts of scandals have major effects on the business environment and therefore the regulations concerning the financial statements are nowadays stricter.

Accounting is changing
Due to changes in the business environment over the past 25 years, accounting is changing. The business environment has become more competitive and turbulent, because of various causes (e.g. technology improvement, increase of global economy and pressure from owners for a higher return). The change in accounting is notable because these causes changed the needs of the users and therefore accounting information had to be modified. Financial accounting has developed a clearer framework and improved its principles. In addition, it has a more solid foundation with an international scope.
Management accounting has become more focused on satisfying the needs of customers and its focus is more external. Before the focus was more concentrated on gathering information within the firm, but nowadays it expanded by focusing on customers’ and rivals’ attitude. In addition, it has developed various methods to control costs.

Different kind of business ownerships

 

Sole proprietorship

Partnership

Limited company

Foundation

Easy to set up, without any formal procedures

Easy to set up, without any formal procedures

A framework of regulations and procedures are necessary

Ownership and size

One owner and quite small

At least 2 individuals and usually quite small

Owners are usually not daily involved in the business and size can be quite small but it can be very large

Liability

Unlimited for the owner.

No difference between the wealth of the proprietor and the firm

Unlimited for the owners.
No difference between the wealth of the partners and the firm

Limited up until the amount the investors invested

Accounting

For taxation authorities and in some cases to meet the demands of a particular user group

For taxation authorities and in some cases to meet the demands of a particular user group

At least annual financial reports made public (also for the Registrar of Companies), annual meeting of the owners to approve the reports, an independent firm inspecting the annual reports and records.

Organization of a business
Finance of a business can either come from the investors or the lenders. Investors can make a direct investment by buying shares or permitting past profit being invested in the business again. Additionally, businesses can borrow money from banks and/or suppliers supplying on credit.
In a large limited company, the investors are not engaged daily in the business. Instead, a board of directors, the most senior level of management, is assigned. A board of directors has a chairman (chosen by the directors) who is in charge of the board. Additionally, each board also has a CEO or managing director who is responsible for running the business on a daily base. The board has 3 important tasks:

  • Establish a strategy and overall direction for the business
  • Supervise and manage the activities of a business
  • Being in contact with owners and others related to the business

Objective of a business
Even though a business’ most important objective is to increase the owners’ wealth, the other objectives (e.g. meeting the needs of the other user groups) are not neglected. Meeting the needs of the other user groups are also necessary if the business wants to continue and be profitable on the long term. Due to the competitive atmosphere within a business and the power of the owners, managers can be replaced to be more responsive to the owners’ needs.

Risk vs. return
Risk is an important matter which has to be taken into account with financial decisions. Risk and return have the tendency to be related: the higher the risk, the higher the return.

Nonprofit organizations
Although nonprofit organizations do not exist for making profit, they also need to provide accounting information to make more informed decisions. They have the similar user groups as the profit striving organizations. These user groups use the accounting information to check whether it meet its objective and the appropriate manner of handling its wealth.

Chapter 2: Measuring and reporting financial position

An overview of the major financial statements

As mentioned earlier, there are 3 major financial statements: the cash flow statement, income statement and the balance sheet. The 3 financial statements are also known as the financial accounts of the business. The statements can be published either backward looking or forwards looking. If the statements are meant for external users, they are usually backward looking and if the statements are for internal users, they are published forwards looking.
Link between the 3 major financial statements
Link between the income statements and cash flow statements: both involve the measurement of wealth and/or cash flows during a particular period.

The balance sheet
The balance sheet presents the financial health of a firm at a given time and also referred as statement of financial position. The balance sheet of a firm shows the wealth of it at a given moment and the amount of wealth in each category. The balance sheet has two basic layouts: a vertical layout and a horizontal layout. A vertical layout, which has recently become the norm, lists the assets above the capital and liabilities. A horizontal layout, which can be seen in figure 2.1, presents the assets on one side and the claims on the other side. The assets and claims are listed in sequence of which asset or claim is furthest from cash, so the most easily converted into cash assets or claims are listed as last.

 

Balance sheet 31-12-2009

Assets

Claims

 

 

  1. Noncurrent assets/ Fixed assets

 

  1. Capital (Owner’s equity)

 

  • Tangible assets

  • Property

  • Plant/ Equipment

  • Vehicles/ Machines/tools

  • Fixtures and fittings

 

  • Opening balance (capital in beginning of the period)

  • Add profit(for the period)

  • Less drawings(for the period)

 

  • Intangible assets

  • Patents

  • Copyright

  • Trademarks

 

  • Reserves

 

 

 

 

 

  1. Current assets

 

  1. Noncurrent liabilities

 

  • Trade receivables

 

  • Long term borrowings

 

  • Inventory/work in progress

 

 

 

  • Cash/ bank account

 

 

 

 

 

  1. Current liabilities

 

 

 

  • Trade payables

 

 

 

  • Short term borrowings

 

Total assets

X

Total claims

X

Reviewed from figure 2.1:

  • The date of the balance sheet should be displayed in the heading, since the balance sheet shows the financial health at a given time. Therefore, the balance sheet is like a snapshot and presents only the information for that particular time, any time before or after the particular time can have major differences in the balance sheet.
  • Total assets = capital + liabilities [balance sheet equitation]
  • Total assets = total claims
  • Total assets = capital in the beginning of the year + profit (or – loss) for the period – drawings for the period +liabilities

Assets
An asset is a resource which is held by a business and it should possess all of the following characteristics:
 

  • A probable future benefit of monetary value should exist
  • The business must have an exclusive right over the resource
  • The benefit must arise from some past transaction or event, not in the future
  • The asset must be capable of measurement in monetary terms

Additionally, assets can be divided into either a noncurrent asset or a current asset. Noncurrent assets are also referred to as fixed assets and are held for the long time period (longer than one year). The classification whether an asset is a noncurrent or a current asset depends on the nature of the business. The nature of the business determines the purpose of the assets and can vary from business to business. For instance, if we have a computer store, computers would belong to their current assets (inventory) because in this business, computers are produced for resale. However, if a restaurant owns a computer, it does not belong to their current assets but to their noncurrent assets (equipment).
On the other hand, current assets are those assets that are hold for a short term, which have any of the following characteristics:

  • An assets that is either sold, used up or traded
  • The expectation is that these assets leave the business within one year
  • They are cash, nearly cash or short term investment

Within businesses that sell goods, there is a relationship between different current assets, which are mentioned in figure 2.1 (trade receivables, inventories and cash). Most goods are sold on credit within a company. When the customers pay their goods, bought on credit, the business receives an amount of cash. This cash can be used to buy inventories and the inventory will be sold on credit to customers again. An asset will remain to be an asset until the benefits are used up, sold or traded. A notable fact about assets is that it does not have to be a physical item (tangible asset) - it also can be an intangible asset, which is not a physical item. Examples of intangibles assets are patents and copyrights.
Tangible noncurrent assets are the actual tools used by the business to create wealth for a longer period than 1 year. Examples are property, plants and equipment. As all other items on the balance sheets, these are also valued by their historic value. However, these tools will be used or consumed and therefore the depreciation must be included in the balance sheet. The value with the adjustment of the depreciation is known as the carrying amount, net book value or written down value. On the other hand, an alternative is allowed: valuing the assets in fair values (which is the current market value). The fair value will provide the users of the accounting information with a more up-to-date figure. The frequency of revaluations should be high enough to make sure that the net book value of the revalued asset does not differ significantly from its fair value at the balance sheet date.

If an intangible noncurrent asset has an infinite useful life, it will not be affected by depreciation, but it will be annually tested so see if there has been a fall in the value. However, if the intangible noncurrent asset has a finite useful life, the depreciation will be deducted from its value.
Impairment of noncurrent assets occurs when the carrying amount of the asset is higher than the asset value that could be recovered from it through its continued use or sale. In these occasions, the asset has to be reduced to its recoverable amount. Also inventories run the face the risk of a drop in value, e.g. through damage. This loss must be shown in the balance sheet.

Claims
On the other hand we have the claims, which are divided into 2 types: the capital and the liabilities. A claim is an obligation on the part of the business to provide cash or some other form of benefit to an outside party. Normally, it arises when an outside party provides funds in the form of assets for use of the business.
The capital, also known as owners’ equity, represents the claim of the owner(s) against the business. Even though it seems strange that the owner(s) can have a claim against the business, in accounting the owner(s) and the business are separated, whatever type the business ownership is. Distinction between the business and the owner(s) means that all the funds of the owner(s) in the business will appear as a separate type of claim on the balance sheet. In limited companies there is even a distinction between each part of the owners’ equity, whether it was aroused by retained profit or by the part that is invested by the owner(s), usually by buying shares.

Liabilities are all the other claims from all other organizations and individuals, excluding the owner(s). Liabilities arise by past events and transactions, e.g. borrowing money from a bank. A liability will remain to be one until it is fully settled (e.g. paid back the loan). Liabilities can be further divided, whether it is a noncurrent liability or a current liability. Current liabilities meet any of the following characteristics:

  • They are to be settled within 1 year after the date of the balance sheet and within normal course of the operating cycle of the business
  • Their purpose is that they are held for trading
  • There is no right to postpone settlement for at least 1 year after the published date of the balance sheet

The noncurrent liabilities do not meet these characteristics and are due on a longer term than 1 year. However, a noncurrent liability can turn into a current liability. For example, a business has a loan of 18 months which is a noncurrent liability, but the year after it will appear under the type of current liability, assuming that the loan has not been paid off in the given period.
The division of liabilities gives the users of the balance sheet a better idea on how the capital of the business is raised, whether by long term or short term funds. If the business is financed mostly by long term funds, the financial risks associated with the business will increase because of the interest payments. The division of liabilities should also give the users a better impression about the capability of the business to meet its current liabilities by comparing the current assets (amount which is easily converted into cash or is already cash) with the current liabilities (claims that have to be met within the period of 1 year).

The relationship between claims and assets is that when a business wants to purchase assets, it has to raise the funds from an organization and or an individual (which will be shown on the claims side of the balance sheet).

Accounting conventions and the balance sheet
Accountings has a number of rules (or conventions), which have developed over time to solve the problems of accountants and users of the accounting information.

  • Business entity convention: for accounting, the owner(s) and the business are being treated as separated units and therefore the owner(s) is/are seen as a claimant of the business.
  • Historic cost entity convention: the assets’ value, shown on the balance sheet, is valued by its historic cost, also referred as the acquisition costs.
  • Prudence convention: this convention prevents too much optimism about the financial statements, since both actual losses and expected losses are recorded into the balance sheet. However, this is not the case for profits: profits are only recognized when they actually arise.
  • Going concern convention: this convention says that the financial statements should be made assuming that the business is going to continue its operations in the future. However, this assumption can only be made when it is true: if the business is in difficulties concerning financial matters, it may have to sell some of the noncurrent assets, whose market value will be lower than the balance sheet value, so this has to be counted in when a business has financial difficulties.
  • Dual aspect convention: each transaction regarding the balance sheet has 2 aspects, so that it will guarantee the equal left- and right side.

Money measurement

  • Goodwill and brands
    Some intangible assets are easily to measure in monetary terms, like patents and copyrights, but some intangible assets are difficult to measure. Examples are goodwill, which refers to the quality of the products, the employee skills and the customer relationship and brands, which is known as the image of the brand, the product quality. These assets are therefore excluded from the balance sheet. However, if the goodwill and brands are acquired through a transaction by taking over another firm, they can be valued as assets. The valuation of the goodwill and brands are based on the forecasted earnings from maintaining the assets.
  • Human resources
    Human resources are hard to measure in monetary terms and are therefore not included in the balance sheet. However, in some cases it is possible: for example in soccer clubs where the players are being valued and can be ‘sold’ to another club.
  • Monetary stability
    Using money to measure can cause some problems: the value of money will change over time (inflation). High rates of inflation causes the problem that the current value of the assets are much lower than the value shown in the balance sheet, which are valued by historic value.

Chapter 3: Measuring and reporting financial performance

The income statement
This statement, also referred as profit and loss account, has as main purpose to present how much profit (wealth) the business has made over a period of time. The period of time, when either the profit or loss is measured, is referred as the reporting period or financial period or accounting period. Whether the business is a limited company or a partnership, the principles for making an income statement are similar.
Information that is needed to prepare the income statement is the company’s revenue over a certain period of time. This is the economic benefit from the business’ common activities. The effect of revenue is that it either will increase the assets and/or it will reduce the liabilities. On the other hand, there is also the need to know the expenses of a business, which present the outflow of economic benefit from the ordinary activities of a business. The effect of expenses is the opposite of revenue, it will either in a decline in the assets’ value or it will increase the liabilities. Expenses are the effect of a business trying to generate revenue or generating revenue.
Basically, the income statement is the business’ revenue over a period of time minus the expenses in the same period of time, which will either provide a profit (positive amount) or loss (negative amount).

  • Profit (or loss) for the period = total revenue for the period minus expenses for the period.

Additionally, even though the balance sheet and the income statement are not replacements for each other, there is a relationship between the 2 statements. The difference between a balance sheet in the beginning of the period and at the end of the period is the change in wealth, shown in the income statement. With the balance sheets we could calculate the profit or loss over a period of time, but it is easier to provide an income statement.

  • Assets = capital + profit + liabilities
  • Assets = capital + (Revenue – expenses) + liabilities

Income statement layout

The layout of the income statement depends on the type of business it is, but in example 3.1, an income statement is shown:

Income statement for the year 2009

Revenue

  • Sales revenue

  • (Sales cost)

= Gross profit

Expenses

  • (Employees)

  • (Insurance)

  • (Gas/water/electricity)

  • Depreciation of machines/vehicles

= Operating profit

  • Received interest

  • (Paid interest)

 

= Net profit

Review from figure 3.1:

  • Items between brackets are the items that have to be deducted ( = cost)
  • Gross profit = sales revenue - cost
  • Operating profit = this is the profit generated from the regular activities of the business. This is the gross profit minus all the other expenses from the business operations, except the financing costs/revenue.
  • Net profit = also referred as the profit for the year, which is the operating profit minus the paid interest and plus the received interest. The net profit is the amount that will be added to capital of the balance sheet and it is the amount that is assigned to the owner(s) of the business.
  • Cost of sales: can be found in different ways. Sometimes the cost is identified when the sales is made or at the end of the accounting period. The accounting period can vary from a daily basis to a yearly basis. Normally, financial reports are published one time a year for the external users (sometimes quarterly or half yearly), but for internal users it can be on monthly, weekly, daily basis.

How to recognize revenue

Sometimes it is hard to recognize revenue because this can be done at different points. E.g. when goods are sold on credit, the revenue can be recognized when the order is placed or when the goods are delivered and accepted. Therefore recognizing revenue has the following criteria:

  • When revenue can be measured reliably
  • When the ownership and control is passed to the buyer (only for sales of goods)
  • When it is probable that the business received the economic benefit (e.g. when the buyer pays)

When these criteria are applied on products that are sold on credit, it can have the effect that the received sales are different from the sales shown on the income statement. Because of these criteria, it can be that revenue is recognized before receiving it. This effect is not applicable for goods that are sold for cash.
Long term contracts
Some businesses have long term contracts, which last more than one accounting period, e.g. construction contracts, which are usually longer than one accounting period. A possibility is that it will be broken down into stages and that every stage of completion can be measured reliably. Another example is a service. When it can be broken down into stages and every stage of completion can be measured reliably, the revenue will be recognized before the contract is completed. However sometimes it is not possible to break down a service into stages and in these cases the revenue will be recognized after the service is completed.

Recognizing expenses

The matching convention which is designed to provide us a guide when to recognize expenses. Expenses have to be recognized in the same accounting period as the associated revenue is accounted for. This can have the effect that an expense in a period reported in an income statement is not similar to the cash paid for that item during that period, either more or less.
The materiality convention expresses that immaterial amounts should only be considered when it is reasonable. This convention can mean that an expense does not have to be matched with the revenue related to it.

Profit, cash and accruals account

As was mentioned before, the revenue does not represent the exact amount of cash received and expenses as the actually paid amount of cash. The accruals convention deals with this by distinguishing liquidity and profit. Profit is a measure of achievement, or productive effort. The accruals accounting deals with the basis of the balance sheet and income statement which are based on the accruals convention.

Depreciation

The expense of depreciation which appears because noncurrent assets do not have a perpetual existence and will used up in the process, is relevant to both tangible and intangible noncurrent assets.

Before the calculations of the depreciation can be done, the following factors have to be known:

  • Cost of the asset: not only the cost for the asset itself, but also the installation cost, delivery cost and cost related to improvement & altering of the assets.
  • Use life of the asset: a tangible noncurrent assets has 2 types of ‘lives’: the economical life and the physical life. The economical life of an asset is determined by the result of technological development and demand changes, this is the time when the benefit of the asset is lower than the cost of the asset. The physical life of an asset is the time the asset is able to produce a good or a service. A longer physical life can be reached by either maintenance or improvements. It is possible that the physical life of an asset is much longer than the economical life, but the economical life of the asset is more important. This value is used for determining the expected useful life of the asset, in order to calculate the depreciation.
  • Residual value of the asset (also referred as the disposal value): this is the value that the asset is still worth after its economical life.

There are several methods for the allocation of depreciation:

  • Straight line method: this method divides the depreciated amount by the economical life of the asset. So in each period the same amount for depreciation is charged. The carrying amount (or written down value or net book value) is the machine cost minus the already paid depreciation. This is the value which presents the amount that still has to be paid off in the future years.
  • Reducing-balance method: this methods works with a fixed percentage of depreciation. This will lead to a high amount of depreciation charged in the beginning and lower charges in the later years. The fixed percentage can be calculated by the following formula:

P = (1- (R/C)^1/N) * 100%
P: percentage of depreciation
N: the useful life of the asset in years
R: the residual value of the asset
C: the cost of the asset

The method to be chosen for the assets depends on the pattern of the assets’ economical benefit. When the benefits are provided evenly over time (e.g. building) then the straight line method is appropriate, but when the benefits are declining over time, the reducing-balance method is chosen. When the pattern is unknown, normally the straight-line method is applied.

Inventory

The measurement of the inventory cost are important, since this will affect the calculations of profit and the remaining inventory, which is still held within the company and shown on the balance sheet. The two main assumptions for inventory are:

  • FIFO (first in, first out): the inventory which entered the business first is sold first
  • LIFO (last in, first out): the inventory which entered the business last is sold first.
  • AVCO (weighted average cost)

For both the inventory methods and the depreciation method the consistency convention is applied, which means that only one method should be applied.
Trade receivables

When a business sells goods or services on credit, the revenue can be recognized before the customer pays for the good or service. This will lead to an increase in sales revenue and the increase of the trade receivables. It can occur that there are bad debts, which are debts which will never be paid. These bad debts have to be written off, which affects the trade receivables (reducing it) and the expenses (increasing). The bad debt has to be written off in the same time period as when the sales were being made.

Sometimes this is not possible, therefore a proportion of the total trade receivables should be created under the name of ‘allowances for trade receivables’, which is shown as an expense in the income statement and this amount is deducted from the total trade receivables in the balance sheet.

Chapter 4: Accounting for limited companies (1)

Features of a limited company

  • Legal nature: a limited company (Ltd) is an artificial person, which means it has the same rights and obligations a person has. It is possible that a limited company is owned by one person, but normally it has many shareholders who have shares in the company. A limited company also has its own legal identity, which means that the ltd is separated from its owners.
  • Perpetual life: Normally, a limited company will continue to exist, even though all the owners of the company died. This is due to the fact that the shares can be passed on to someone else. Although entirety is granted, it is possible that shareholders or the courts can end this.
  • Limited liability: the company must take the duty to pay off its own debts and incur its own losses, but the shareholders are responsible up until the amount they invested, so their liability is limited.
  • Legal safeguard: different safeguards are present to protect individuals and companies which are doing business with a limited company. For example, shareholders might only withdraw their investment when they overcome certain restriction and companies have to publish financial statements regularly.
  • Public and private companies: a limited company can be either public or private. A public company can offer its shares to the general public, whereas the private one can not. The private limited company is usually smaller and the shares of a Ltd are often allocated amongst relatives.
  • Taxation: Because of the separation of the owners and the company, the company has to pay taxes over the profit/gains (the corporation taxes), which will be shown in the financial statements.
  • Transfer of ownership: Only the shares of a ‘listed’ company can be traded on Stock exchanges.

Managing a company

The senior level of management consists of a board of directors who are elected by the shareholders. Recently there are various discussions about the corporate governance, which is the way a company is directed and managed. The reason is that the managers who are the day to day controllers within the company do not always have the best interest for the owners of the company, who are not always involved in the daily routines.

Financing a company

  • Owners’ claim: also referred as equity, exists of 2 divisions, namely the shares and the reserves.
  • There are 2 types of shares: all the limited companies have ordinary shares (“equities”), but some companies have preference shares as well. Preference shares guarantee that if there is dividend available, the preference shareholders are the first one to receive this up until the maximum amount. This amount is usually a fixed percentage of the nominal value of the preference shares. The ordinary shareholders will receive the dividend after the preference shareholders have received their part of the dividend, which does not have a maximum amount.
  • Reserves are a part of the owners’ claim, which can be either profit or gains made by the company. There are 2 types of reserves: revenue reserves or capital reserves. Revenue reserves are the retained trading profits and gains on the removal of noncurrent assets of the company. Whereas the capital reserves can come from either issuing shares above the nominal value or the revaluing of noncurrent assets.
  • Shares can be either be split or consolidated. Splitting the shares means that the nominal value of the issued shares has declined, for example a share used to have a nominal value of €1.50, but after the split is has decreased to €0.75. This does not mean that the total nominal value of the shareholder decreased, but rather a decrease in the nominal value of a share and an increase of the number of shares (when the value is divided by 2, there have to be twice as many shares as before). Consolidating the shares means the opposite: an increase in the nominal value of a share and the decrease of the number of shares (e.g. 2 shares become 1 and the price doubles).
  • Bonus shares: these shares exist when a company wants to transfer reserves of any kind into share capital. This will mean that the reserves will decrease with the same value as the share capital increases and this amount will be distributed amongst the existing shareholders. A company creates these shares because it can give the shareholders more confidence, it gives the lenders confidence and it lowers the value of each share without reducing the shareholders’ wealth. 
  • Share capital jargon: Issued share capital (or allotted share capital) is the share capital that has been issued to shareholders. Occasionally, shareholders do not have to pay the full amount of the shares at the issued time because the company does not need the money yet. The called up share capital is the amount that has been ‘called’ by the company, which is the amount the company asked for. The paid up share capital is the capital that has been called and paid by the shareholders.

Raising share capital

After the first issue of shares to start a business, a business can make more issues to raise its share capital. This can be done by

  • Right issues: issues made to the existing shareholders
  • Public issues: issues for the general public
  • Private placing: issues for special individual, which are selected and asked whether they are interested or not.

Borrowings

  • Loan note issue: are slices of a loan which can be taken up by either individuals or companies. Loan note issues are also referred as loan stock or debentures. Debentures can be exchanged on a stock exchange, especially if the company is large. Loan notes holders do not have any rights like the shareholders do have; the loan notes holders are individuals or companies who lend money to the company.

  • Withdrawing equity

Only the revenue reserves may be withdrawn by companies. When this amount is shown on the balance sheet, it is not the actually value. The actual value will usually have been decreased with one or more of the following items:

  • Corporation taxes

  • Paid out dividend

  • Trade losses or removal of noncurrent assets

The share capital and the capital reserves are the parts of the equity that can not be withdrawn. The large this part is, the better it is when the company is looking for lenders and other credit supplying individuals/companies.

There are some small differences in the income statement and balance sheet, regarding whether the company is a limited company or not.

Differences in the income statement

  • Profit before taxation: for a limited company this is not the complete profit of the year, whereas it is if the company was a sole proprietorship. This profit can be calculated by reducing the operating profit with the charges for interest (which can be either negative or positive)
  • Audit fee: if a limited company exceeds a particular size, it has to hire a individual firm or accountant to audit its financial statement, which brings an extra cost for the company with it.

Differences in the balance sheet

  • Taxation: A part of the taxation will be shown under liabilities. To be precise, 50% of the total amount which is shown on the income statement of the taxation has been paid by the company, but the other half will be paid after the balance sheet date. These paying arrangements are set down by law.
  • Other reserves: all other reserves that are not a part of the identified reserves, shown on the balance sheet. An example is the general reserves, which can be used for reinvestment into the company.

Dividends

Dividends can be paid out during the year, which will be referred as the interim dividend and the dividend that will be paid after the end of the year are referred as the final dividend. Unpaid dividend, which are sometimes declared by the directors during the year and are authorized, will be shown as a liability on the balance sheet.

Chapter 5: Accounting for limited companies (2)

Directors’ duty to account

Due to the fact that directors are appointed by the shareholders to run the business from day to day, they have some requirements:

  • Records of appropriate account have to be maintained
  • Publishing, for both internal and external users, and preparing financial statements and a directors’ report.

The need for accounting rules is required and there must be a kind of general framework and rules for accounting.

Due to the recent internationalizing companies, there is a need for an international harmonization of accounting rules, which can help users of the financial statements to compare the different statements of different companies with each other. The international set of rules for accounting is known as the international financial reporting standards and is developed by the international accounting standards board (IASB).

Presentation of financial statements
Regarding to IAS 1, financial statement should contain 4 items

  • Income statement
    The minimum required information, which have to be stated in the income statement are:

    • Revenue

    • Finance costs

    • Gains or losses on the assets sales or liabilities settlements, which arise from stopped operations

    • Expenses on taxes

    • Profit or loss

  • Balance sheet
    the minimum information that is required in a balance sheet are:

    • Property, plant and equipment

    • Investment property

    • Intangible assets

    • Financial assets

    • Inventories

    • Trade and other receivables

  • Cash and cash receivables

  • Provisions

  • Financial liabilities

  • Tax liabilities

  • Issued share capital and reserves

  • Statement with the equity changes

    • This statement informs the users about the changes in share capital and reserves during that period.

  • Cash flow statement

  • Helps the users of this statement to assess the ability of a company to generate cash and whether there is need for cash.

  • These extra notes helps the users with understanding the statements and normally will include the following notes in the statements

    • That the statements followed the rules of IFRS

    • a summary of the bases for measurement

    • extra information and explanation on particular items on the income statement, balance sheet, statement with equity changes and the cash flow statement,

    • other disclosures and objectives and policies of the management

  • Extra notes, with respect to accounting policies and other explanatory notes

The requirements offer a fair presentation of the financial health, position and performance and the cash in and outflows.

Auditors’ role

The shareholders have to elect a company or a specific auditor to check whether the financial statement provide a fair and true view. Therefore the auditor(s) have to examine the financial statements and the measurement and calculation where upon they are based. There is a relationship between the auditors, directors and shareholders. The shareholders elect the auditors and the directors. The directors prepare the financial statements and the auditors check whether the directors have provided a fair and true view about the business.

Directors’ report

Next to the financial statements, the directors are also required, by law, to prepare a directors’ report. This report extends beyond the information in the financial statements. It is also about non financial nature.

OFR Framework

  • the nature of the business
  • This is one of the 4 key elements and it includes the business’ environment it is operating in and it can be very broad. It also has a commentary on the products that are sold, the processes of the business, the structure of the business and the position regarding competitors. Sometimes a commentary on the macro environment is included (social, economic and legal environment)
  • business performance
  • This element includes the development and performance of the business now and in the future. Factors which are included are factors that have an effect on the performance and development.
  • This element includes an identification of resources that are not shown on the balance sheet, a description of the resources and the management of these resources and there should be a description of the threats and uncertainties the business is facing.
  • This element describes the cash flow, capital structure and liquidity of the business. Additionally, it also included the influences of different factors on the financial position of the business and those factors that are likely to have an effect in the future.
  • resources, risks and relationships
  • financial position

Creative accounting

Even though there are numbers of accounting rules and the auditors’ role, it is possible for directors to apply particular accounting policies so that they represent a ‘better’ picture of the financial position of the company, this is known as creative accounting. There are several methods:

  • Overstating revenue, for example by recognizing the revenue earlier then should be done.
  • Massaging expenses is the manipulation of expenses and especially the expenses that account on the forecast of the directors can be easily manipulated.
  • Concealing ‘bad news’, so that the financial health is stronger. An example is to create a separate entity that takes over the losses and liabilities.
  • Overstating the assets’ value by using higher values than the market value of the asset.

Checking for creative accounting, there are different methods to examine whether the business is representing itself better than it actually is. The checks include comparing the cash flows and the profit with each other, finding out which valuation method is used for assets and if the business used the same accounting policies as similar businesses.

In times of strong economic growth, the investors and auditors are less alert and therefore the chance to manipulate is easier. However, there are various stricter rules and actions taken by regulatory organizations to decrease the amount of creative accounting.

Chapter 6: Measuring and reporting cash flows

The cash flow statement

First it was not required for companies to make a cash flow statement besides the balance sheet and income statement. However, nowadays it is required because one can not assume in the long term that the company is profitable just because it has enough capital. Therefore, it is possible that profit, which is calculated by revenue minus expenses, has nothing or little to do with the cash in- and outflows. For example, when a noncurrent asset is depreciated: depreciation is an expense which will be shown on the balance sheet and which leads to a drop in the value of the asset. However, this does not have an effect on cash. To gain information about the movements of cash, the income statement is not suitable to use, but instead it is necessary to have a cash flow statement. Since 2005 it is required by the International Accounting Standard IAS 7 that companies create and publish a cash flow statement.

Importance of cash

On one side, cash can be seen as just an asset, like inventories and current assets, but on the other hand cash is really important for people and companies because in general it is accepted for payments of goods and services and for the payment of any claims against the business. Therefore cash in- and outflows are closely being analyzed by analysts to see whether a business is able to survive.

The main features of the cash flow statement

The cash flow statement summarizes all the cash receipts and payments of a business over a period and the net total of it is either the net increase or net decrease of the cash in the business over this period. Actually, the cash flow statement is an analysis of the cash in- and outflows of the business.

  • Cash and cash equivalents
  • According to IAS 7 cash is accessible to the business on demand, such as deposits in banks or comparable institutions and coins and banknotes. On the other hand, cash equivalents are short term investments, which are highly liquid, for which the converted cash amount is known and no significant risk of a change in the value. A cash equivalent is held for the goal that it meets the short term cash obligation.
  • Link between the financial statements
  • The 4 primary financial statements are the balance sheet, the cash flow statement, the statement of changes in equity and the income statement. As mentioned before, the balance sheet represents the assets (and cash) on one side and on the other side the claims (including the owners’ equity and liabilities) at a specific moment of time. On the other hand, the cash flow statement, the income statement and the statement of changes in equity show the change over a period of time. The income statement (from trading activities) and the statement of changes in equity (from non-trading activities) show the changes of the owners’ equity over a period of time. The cash flow statement shows the changes in cash (and cash equivalents)

The form of the cash flow statement

  • Layout The layout of the cash flow statement can be seen in figure 6.1. As can be reviewed form the figure, the statement separates cash flows from different types of activities (from operating, investing and financing activities). The total of the statement is either a net increase or a net decrease in cash and cash equivalents over the period.
  • Operating activities The cash flow from operating activities is either the cash inflow or outflow from the trading activities, after paying taxes and the financing costs. This is the total of cash receipts from cash sales minus the paid inventories, cost for rent, wages costs interest costs (of the borrowings, corporation tax and dividends paid). It is important that only the received and paid amounts of cash for that period are included in the cash flow statement. This also the case for the payments of tax and dividends: only the paid amounts are included in the cash flow statement. The law regulated that a business has to pay half of the previous year’s tax and half of this year’s tax. The operating activities of a company are the normal day to day activities of a company.
  • Investing activities The cash flow from investing activities is either a cash inflow or outflow which is acquired through either cash payments for additional noncurrent assets or from the removal of noncurrent assets. These noncurrent assets can buildings and machines, but it also can be shares in another business bought by the company. Additionally, these cash flows can also come from investment receipts outside the business (either making new investments and or disposing existing investments), e.g. dividends from shares that the business owns in another business.
  • Financing activities Cash flow from financing activities is related to the long term financing of the business, which is the cash flow acquired through raising or paying back long term finance. It is also possible to include the dividends payment in this category as another option (can be included in the operating activities as well).
  • Net increase/ decrease in cash and cash equivalents The total of the statement is either an increase or decrease of the business’ cash and cash equivalents which depends on the various activities, whether they are negative or positive.
  • Normal direction of the cash flows Usually, the cash flows from operating activities are positive and help the cash and cash equivalents of a business to increase. Investing activities are on the other hand, usually negative since the noncurrent assets wear out or become outdated and a business usually buys assets. However a company can sell its assets, which increases the cash flow, but usually this is much lower than the amount spend on new assets. The cash flow of financing activities depends on how the business operates, but is usually positive.

Cash flow statement

Cash flows from operating activities

(plus or minus) Cash flow from investing activities

(plus or minus) Cash flow from financing activities

= net increase/decrease in cash and cash equivalents over the period

Preparation of the cash flow statement

The information which is required for the cash flow of operating activities can be acquired through 2 methods: the direct method and the indirect method.

  • Direct method: this method analyzes the cash records of the business and identifies the payments and receipts which are related to the day to day activities of the business.

  • Indirect method: this method is used more often because it is less complicated. It is based on the income statement and the balance sheet - however, the profit for the year is not the same as the cash inflow for that period. So the information from the balance sheet and income statement has to be adjusted to be useful for the cash flow statement. The total of cash flow of the operating activities can be calculated by taking the profit before taxation adding the depreciation and the paid interest for that profit. Also, adjusting this by the movements in inventories, trade receivables and trade payables and deducting payments in that period for taxation, interest on borrowings and dividends, it ends up being the net cash from operating activities.

Indirect method for the cash flow of operating activities

Profit before taxation

plus depreciation

plus interest expenses to the profit

plus inventory (if there is a decrease in the inventory) or minus inventory (if the inventory increased)

plus trade receivables (if there is a decrease in the trade receivables) or minus trade receivables (if the receivables increased)

plus trade payables (increase)or minus trade payables (decrease)

minus interest, taxation and dividend paid.

= net cash flow from operating activities

What does the cash flow statement tell us?

  • In which ways the business generated cash during the period and on what it was spend
  • By analyzing previous cash flow statements it is possible to see the financing and investing trends of the business and the business’ behavior could be predicted

Chapter 7: Analyzing and interpreting financial statements (1)

Financial ratios

A ratio is a measurement that relates one figure of the financial statement to another one. Also, a ratio can be related to a resource of the business (e.g. operating profit per employee). Ratios are often used by businesses because the ratio can be used to compare a business’ financial position to another business’ position or to compare the performance over a period of time.

Ratios are also used by people who are interested in the business and its performance because by evaluating various ratios, it is possible to have a representation of the business’ financial position and health. Even though the ratios can be used to show the strengths and weaknesses of the business, it does not inform us how these strengths and weaknesses are developed. Therefore, the ratios have the intention to arise questions rather than providing the answer for our questions. Another drawback is that the interpretation of financial ratios is hard.

There are various forms of a ratio: it can be presented as a percentage or as a proportion, which solely depends on the needs of the users. Also, even though there various ratios possible, only a small number of ratios are really useful and provide us with a significant between the two figures. In general, there is no standard list of ratios and standard way to calculate a ratio. However, the calculations should be constant for a business to make comparison possible.

Classifications of the financial ratios

The classification of the financial ratios depends on the related area of the financial performance or position and there are 5 main areas:

  1. Profitability: ratios belonging to this category provide an overview about the success of a business to generate wealth. Profitability ratios show the relation between profit made (or other values supporting the profit e.g. sales revenue) and other figures of the financial statements or a business resource. The most common profitability ratios are:

    • ROSF (return on ordinary shareholders’ funds)
      This is a ratio between the net profit for the period available to the owners and the owners’ average stake in the business during that same period. For the ordinary shares capital, we should take the average ordinary shares capital, which is calculated by taking the ordinary shares capital at the beginning of the year and at the end of the year and then dividing this by 2. If the beginning shares capital is not available then only the year end capital is taken. In general, the higher this ratio the better, taken into consideration that this is not attained at the expense of potential returns in the future.
      Profit for the year (net profit) - Preference Dividend
      ----------------------------------------  * 100
      Ordinary Shares Capital + Reserves

  • ROCE (return on capital employed)
    This ratio compares the operating profit generated during a period with the average long term capital invested in the business during the same period, so it is actually a measurement between the output (operating profit) and the inputs (invested capital). Also, for this ratio the average capital employed (share capital + reserves + noncurrent liabilities) should be used, if this information is available.
    Operating Profit
    ---------------------------------------- * 100
    Share Capital + Reserves + Noncurrent liabilities

  • Operating profit margin
    This ratio compares the operating profit for the period with the sales revenue during the same period. This ratio is seen as the most appropriate measure of operational performance, because this ratio is not influenced by the financing ways of the business. The outcome of this ratio can vary between the different business types.
    Operating Profit
    ------------- * 100
    Sales Revenue

  • Gross profit margin
    This ratio relates the gross profit of a business during a period to the sales revenue for that period. The gross profit is the profit after deducting the cost of sales of the sales revenue. This measurement therefore shows the profitability of a business in buying/producing and selling goods/services before any other expenses are taken into consideration.
    Gross Profit
    ------------- * 100
    Sales Revenue

  • Efficiency: these ratios are also known as the activity ratios and reflect the efficiency of various resources within the business. Different efficiency ratios are:

    • Average inventories turnover period
      This ratio measures the average days the inventory stays within the business. For this ratio, the average inventories held is used and it can be calculated by using the inventory a the beginning and ending of the year and divide this by 2. The lower this ratio, the more it is preferred by the business since holding inventories is costly.
      Average Inventories held
      -------------------- * 365
      Cost of Sales

    • Average settlement period for trade receivables
      This ratio calculates the average days the credit customers take to pay the amounts they need to pay to the business. The business prefers a lower ratio, since these amounts could be used for other purposes, which are more profitable.
      Trade recievables
      ----------------- * 365
      Credit Sales Revenue

  • Average settlement period for trade payables
    This ratio measures the average number of days the business takes to pay its suppliers of goods and services on credit. The business prefers a higher amount of days because it is seen as a free source of finance for the business. However, taken into consideration that if a business waits too long this could result in a loss of goodwill of the suppliers.
    Trade Payables
    ------------ * 365
    Credit Payables

  • Sales revenue to capital employed
    This ratio is also known as the asset turnover ratio and it measures how effectively the business uses its asset to generate the sales revenue. A higher asset turnover ratio shows that the assets are being used more effectively in the generation of sales revenue. On the other hand, when this ratio is too high, it suggests that the business is overtrading, which means that the business does not have enough assets to sustain the sales revenue level. Also in this measurement, the average is taken for the denominator.
    Sales revenue
    -----------------------------------------
    Share Capital + Reserves + Noncurrent liabilities
    Sales revenue per employee
    Sales Revenue
    ------------------
    Number of Employees

  • This ratio shows a relation between the sales revenue generated and a specific resource, which is labor. It shows the productivity of the employees. A business would prefer a higher outcome, since this shows that the workforce is being used efficiently.

  • Liquidity: liquidity ratios are a useful measure whether the business is able to meet its short term obligations. The following liquidity ratios are commonly used:

    • Current ratio
      This ratio compares the current assets with the current liabilities. The ‘preferable’ amount of this ratio is 2:1, but it depends on the type of business the company is operating in. A higher current ratio is preferred over a lower one, but when the ratio is too high, it shows that the business has a lot of funds are cash or other high liquid assets and therefore can not be used more productively.
      Current Assets
      ------------------
      Current liabilities

  • Acid test ratio
    This ratio is almost the same as the previous ratio, but this one does not take inventories into consideration, regarding the current assets. This is done because not for all the businesses inventories can be easily converted into cash. The minimum level of this ratio is 1:1; however, it depends on the type of business the company is operating in.
    Current Assets - Inventory
    ---------------------
    Current Liabilities

  • Cash generated from operations to maturing obligations
    This ratio compares the cash generated from operations to the current liabilities of the business. This ratio indicates the capability of the business to meet its long term obligations. This ratio is preferred to be higher, since this shows a better liquidity of the business.
    Cash Generated From Operations
    ---------------------------
    Current Liabilities

  • OCC: operating cash cycle
    The OCC is the amount of days between paying for the goods and receiving the cash from the sale of those goods. When the OCC increases, this increases the financing requirements needed and the financials risks. The OCC can be calculated by adding the average settlement period for trade receivables and the average inventories holding period and then subtracting the average payment period for the trade payables.

  • Financial gearing: These ratios show the relationship between the owners’ equity (or capital) and the borrowed amounts, which are contributed by others in the form of loans. The reason why a business borrows is because that either the owners do not have enough funds or it can used to increase the returns to owners, when the returns of the funds are higher than the interest costs of the funds. Another benefit of borrowing is that interest expenses are tax deductible.

    • Gearing ratio
      This ratio compares the long term liabilities with the long-term structure of the business (where again, the average is taken)
      Long Term (noncurrent) liabilities
      ------------------------------------------------- * 100
      Share Capital + Reserves + Long Term (Noncurrent) Liabilities

    • Interest cover ratio
      This ratio measures the operating profit available to the interest payable. The lower this ratio, the higher the risk for the lenders that the interest payments are not being met and the greater the risk that the shareholders will make a change to recover this.
      Operating Profit
      ---------------
      Interest Payable

  1. Investment: investment ratios present the gains of an investment in the business, regarding the returns and performances of shares from a point of view of the external users (e.g. shareholders). Investment ratios will be discussed in chapter 8.

Different user groups have different needs regarding the financial information about a business. Shareholders are likely to be interested in the investment, profitability and gearing ratios. Providers of long term funds are usually interested in the profitability and gearing ratios, whereas the short term lenders are interested in the liquidity ratios.

Link between profitability and efficiency

The ROCE ratio can also be calculated by multiplying the operating profit margin ratio by the sales revenue to capital employed. Therefore it can be concluded that the overall return on capital funds provided within the business are established by both profitability of sales and the efficiency of the capital use.

The need for comparison

Interpretation and evaluation of the information provided by the ratio is only possible if we have a benchmark for this ratio. There are 3 possibilities to use as a benchmark:

  • Past periods By comparing the same ratio from different periods, it is possible to identify trends and whether the performance of the business is improved or weakened. On the other hand, it is possible that comparison is not possible due to changes in trading conditions. Also, a ratio improvement may seem satisfying at first, but compared to the ratios of similar businesses it isn’t.
  • Similar businesses Due to the competitive environment nowadays, it is important to take the ratios of the competitors into account since survival of the business can depend on the performance of the competitors. However, it is hard to acquire these financial statements because it is not obligated for all businesses to publish the statements.
  • Planned performanc This is likely to be the most important benchmark for the managers, since this informs them about the level of achievement, regarding the planned performance. This is only possible if the planned performance are based on realistic statements. Normally, when the planned performances are being developed, the business already takes its own past periods and similar businesses into account.

Chapter 8: Analyzing and interpreting financial statement (2)

Investment ratios

As was mentioned before, these ratios consider the business performance, from the point of view of shareholders. The following investment ratios are used widely and are made to assist investors to measure the returns on their investment.

  • Dividend payout ratio
    This ratio calculates the percentage of earnings paid out in dividend to the shareholders. For the shareholders who have ordinary shares, the earnings for the year available for dividends will be the net profit (after taxation) minus the dividends related to preference shares.
    Dividends Announced for the year
    ----------------------------------- * 100
    Earnings for the year available for dividends
    There is an alternative for this ratio called Dividend cover ratio, which expresses by how many times the earnings available for dividend covers the actual dividend.
    Earnings for the year available for dividend
    -------------------------------------
    Dividend announced for the year

  • Dividend yield ratio
    This ratio links the cash return from a share to its current market value. This could assist investors to assess the return on their shares in the business.
    Divident per share / (1-t)
    ----------------------- * 100
    Market value per share

Where t is the rate of income tax.

  • EPS (Earnings per share)

This ratio links the earnings available to the ordinary shareholders with the number of ordinary shares in issue. The earnings which are available for the ordinary shareholders are the net profit after taxation minus the dividend for the preference shareholders. EPS is seen by investment analysts as an essential measure of share performance.
Earnings available to ordinary stakeholders
-----------------------------------
Number of ordinary shares in issue

  • Operating cash flow per share

This ratio relates the cash generated from operations (minus the dividend for preference shareholders) to the number of ordinary shares in issue. This due to the fact that it is argued that on short term, the generated cash from operations offers a better picture, whether the business is able to pay out the dividends.

Cash generated from operations - preference dividend
---------------------------------------------
Number of ordinary shares in issu

  • Price/earnings ratio

This ratio links the market value of a share to the earnings per share. A higher P/E ratio reflects the optimism of the market, regarding the growth of the business.

Market value per share
------------------
Earnings per share

Financial ratios and the problem of overtrading

Overtrading can occur in many businesses, e.g. as a new business is expanding and it is not able to meet the increase demands of their customers or as a business is not able to raise funds, either by themselves or by investors. Overtrading can be described as the operating level of a company, which can not be supported by the finance committed to it. It has to be dealt with since it causes liquidity problems and it can have make the company exceed its borrowing limits and/or slow down the progress of paying back the trade payables and lenders which will consequently affect the managers as they have to find cash to pay the payments.
Businesses can deal with overtrading by matching the finance available with the level of operations. In some cases, this could mean that the company will be losing sales and profits, but on the long term it will be able to survive.
Effect on the financial ratios
The current ratio, average inventories turnover period and average settlement period for trade receivables will be lower when overtrading exists in companies. The current ratio will be lower, because the company has a lack of liquidity. The average inventory turnover period will be lower, due to the lower inventory level, which is caused by the lack of financial resources to buy them. To improve their cash flow, the company will be chasing its credit customers and therefore the average settlement period for trade receivables will be lower. On the other hand, the average settlement period for trade payables will be higher because the business is trying to postpone payments to its suppliers.

Trend analysis
Some large businesses will publish their key ratios covering more years, so users will be able to detect trends. Another possibility is to plot key ratios of different competitors in a graph to detect trends.

Common-size financial statements
These statements are normal financial statements, but presented in terms of a base figure. This will make comparison of the statements easier and the difference and trends are more obviously detected.

  • Vertical analysis
    This approach sets one main figure of the statement as the base figure and expresses the other figures of the statement as a percentage of the base figure. The most popular base figures being used are: sales revenue of an income statement, total long term funds of the balance sheet and the cash flow from operating activities of the cash flow statement. By using other accounting periods of the business as a benchmark, it is easy to compare the different periods with each other and detect trends and differences. It is also possible to compare different businesses with each other, either from the same industry or not. The problem with this approach is that it does not show the different values of the base figure.

  • Horizontal analysis
    This analysis uses a base year, which is normally the latest or earliest year, and sets all the figures of the statement of the base year on 100. The following or previous years will express the figures as a percentage change of the base year. E.g. 2005 is the base year and the inventories increased with 5% in 2006, this will be shown in the common-size income statement as inventory on 105. The problem with this approach is that comparison within the same year is rather difficult.

  • Using ratios to predict financial failure
    In the recent years, there is a better developed and systematic approach to use the ratios to predict future behavior of the business. Researchers are nowadays especially interested whether it is able to predict financial failure with ratios.

    • Using single ratios
      Approaches to use single ratios to predict the financial failure of companies, by focusing on the fact whether the individual ratio is a good or bad predictor of the failure. The analysis of Beaver focused on a specific ratio of a number of companies that failed and examined this particular ratio over a couple of years before the company failed. They wanted to see whether there was a trend detectable and this could be have been an early warning sign for the company and if the ratio was good or bad predictor. Beaver compared the ratio of the companies that failed with company that didn’t fail. Another researcher, Zmijewski found that a company that failed has some characteristics e.g. lower rates of return, higher levels of gearing, lower levels of coverage for their fixed interest and more variable returns on shares. The approaches adopted by these researchers are known as the univariate analysis, since they focus on one particular ratio at a time. A drawback of this approach is that it can give conflicting signals.

    • Using combinations of ratios
      Another approach is to use a combination of ratios, instead of using a single ratio. Multiple discriminate analysis (MDA) is a statistical technique and sets a border, known as the discriminate function, between the companies that do fail or do not fail. From this approach we calculate e.g. 2 different ratios, plot these in the diagram, both for the failed businesses and the non-failed businesses and try to see where the boundary is. The boundary can be shown as:

Z = a + (b * Ratio on the Y-axes) + (c * Ratio on the X-axes)
a = constant

b and c = are the weights of the ratios

z= total score
The researcher Altman developed a model called the Z score model, which was based on 5 financial ratios.

Limitations of ratio analysis
As ratios are beneficial by the means that they offer a quick method to analyze the financial health of a company. However, there are some limitations and problems:

  • Quality of financial statements
    As ratios are based on the financial statements and the analysis of ratios therefore are based on the statements, it all depends on the quality of the financial statements. Also, creative accounting is a major issue concerning the quality of the financial statements.

  • Inflation
    Inflation can be a problem in most Western countries since it can distort the results of the financial statements. Inflation influences the difference in the current and balance sheet values of assets. This means that comparison between different periods or different companies will be more difficult. Inflation also distorts the profitability ratios, since the expenses are based on historic costs rather than the current costs, which will lead to an understatement of the expenses and an overstatement of profit.

  • The restricted vision of ratios
    Ratios do not provide the full information and therefore it is important not to rely too much on ratios. Ratios are relative measures, but it is also needed to look at the absolute numbers of the company.

  • The basis for comparison
    To make ratios useful, they need a ‘benchmark’ to compare with, but it is sometimes difficult to find this benchmark (through different financing methods, years ends and accounting policies)

  • Balance sheet ratios
    Some ratios of the balance sheet could be misleading, since the balance sheet is only a picture of the business at a particular moment.

Chapter 9: Reporting the financial results of groups of companies

Groups
Groups are established when a parent company can exercise control over a subsidiary by owning more than 50% of shares. They are created by the parent company which sets up a new company or takes over an existing one. Usually, parent companies are required to produce one financial statement for the whole group and treat all assets, liabilities and cash flows as their own.

The different financial statements which have to be created by the parent company have to be in accordance to special rules:

  • Group statements of financial position/ balance sheet

Group statements of financial position are created by adding up assets and liabilities of the subsidiaries and setting the equity of each subsidiary in the subsidiary’s balance sheet against the “investment in subsidiary” figure in the parent’s balance sheet. It is possible that the equity of the subsidiary does not equal the investment, e.g. in case of goodwill arising on consolidation which means that more or less was paid for the shares than their fair value. “Goodwill arising on consolidation” represents the value of the ability of the subsidiary to generate profits as a result of an established workforce and valuable cost and sales synergies.
Another reason could be that the parent company does not own all shares of the subsidiary which leads to minority interests reflecting the fact that the parent’s shareholders do not supply all of the equity finance to fund the group’s net assets.
Thirdly, there will be a difference between equity and investment if the subsidiary made profits or losses since the parent acquired or establish it (which happens all the time in reality).
There is positive and negative goodwill: through positive goodwill, more was paid for the subsidiary than the fair value. Negative goodwill means that not enough was paid which should be credited to the income statement. In general, the entire value of goodwill may be shown on the balance sheet.
It is important to notice that financial flows between parents and subsidiaries should NOT be included in the balance sheet.

  • Group income statement
    The group income statement is created by adding all revenues and expenses within the group up. As in the balance sheet, internal trading is not mentioned on the group income statement.
    One special characteristic is that it has to be shown how much of the profit belongs to the subsidiary’s shareholders by deducting the minority shareholders’ share from the total profit.

  • Group statement of comprehensive income
    As the group income statement, the statement of comprehensive income is created by adding up all items. It must distinguish between non-controlling interests income and income which belongs to the shareholders of the parent company.

  • Group statement of cash flows

The statement of cash flows is created by adding up all cash flows within the group, but not the internal cash flows.

Associate companies

In an associate company, the investing company (not parent in this case) does not have a controlling interest but is able to exert influence in some other way, e.g. by placing a representative in the board of directors. However, the investing company has to include its associate company in all financial statements. The share of profits of the associate company is included in the income statement as well as taxes and interest payments related to the associate. In the balance sheet, the investment made in the associate will appear; however, dividends received from this investment will not be included.

Chapter 10: Increasing the scope of financial reporting

 

Development in financial reporting
Firstly, financial reports did not follow any regulations and were only prepared to inform investors about the financial situation of the company. However, this led to abuses and financial reporting regulations were introduced by the government, e.g. the need for an independent audit. Those regulations have become stricter during the past 150 years and in the future, governments want to introduce better rules rather than just more rules.

There are several different kinds of financial reports and statements apart from the basic ones:

  • Segmental reports
    Segmental reports are created to help users achieving a better understanding of financial health by disaggregating information on the financial statements. The IASB (International Accounting Standards Board) defines the operating segment by using the “management approach” while the IFRS 8 (International Financial Reporting Standard 8) wants each segment to be included. Those different regulations can make it rather difficult the compare segmental reports of different businesses.
  • Business review
    A business review is a report that is supposed to provide a balanced and comprehensive analysis of the development and performance of the business. The directors are required to set it out on the principal risks. In the UK, the Accounting Standards Board has issued a Reporting Standard that provides useful guidelines when producing a business review.

  • Interim financial statements
    Interim financial statements are either supplements to the annual financial statements or separate financial statements. It aims to smooth out annual expenses between interim periods in order to enhance the ability of interim statements to help users to predict annual profits. For this, the integral method of interim profit measurement is used. Another method is the discrete method of interim profit measurement which confirms past predictions and predicts the future at the same time. In both cases, the usual accounting policies as used in all financial statements are used. According to the International Accounting Standard 34, the discrete method should be favoured but only if tax is included. It also sets the minimum requirements for interim reports which consist of condensed financial statements and explanatory notes.

  • Value added statements
    The definition of value added is total outputs – total inputs. The value-added statement consists of two parts:

    • A calculation of the value added

    • A description of how the value added was applied

Within a capitalist economy, the value added has only limited usefulness as a measure of wealth creation.

Inflation accounting and reporting

Since inflation might lead to an overstatement of profit and undermines the portrayal of financial position (obscuring erosion of equity, understatement of asset values, failure to show gains and losses on holding monetary items), it has to be included while preparing a financial statement. One approach is the CCP (Current purchasing power) which focuses on the purchasing power of the owners’ investments. The second approach, CCA (Current cost of accounting) focuses on maintaining a business’ scale of operations.

Chapter 11: Governing a company

Corporate governance

As in most large companies, the owners are not the ones who are in charge of the day to day activities of the company. In these situations, the interest of the different groups can conflict with each other, e.g. the directors of the company spend their time pursuing their own interest instead of pursuing the interests of the shareholders. At first this may seem to only have a negative effect on the shareholders, but in the long run it will be a problem for the whole society: the investors decrease their investment, the company receives lower amounts of funds to spend on investments which can affect the performance and financial health of the company. This leads to the need of a framework of rules to control and monitor the behavior of the directors, which are based upon 3 guiding principles:

  • Disclosure
    This is related to good corporate governance and it also provides some benefits for the investors. The investors are able to receive information, to make buy-and-sell decisions and this again will be reflected in the value of the company. If the management if performing badly, this will be show in the market value as well, with a decrease in the stock price, which can lead to a change in management by the shareholders.

  • Accountability
    This is related to the fact that the roles and tasks of the various directors are defined and known, so that an adequate monitoring process is possible. There are even some requirements by law: the annual financial statements of some large businesses are being audited.

  • Fairness
    To keep it fair for everyone, there are some restrictions made by law for directors to buy and sell shares of the company in some situations, e.g. before the announcement of the annual results.

Strengthening the framework of rules

In the recent years, the number of rules has increased to strengthen the weakness in corporate governance, due to the increase in creative accounting. On the other hand, some people believe that the institutional shareholders should be more active in the matters of corporate governance. Institutional shareholders are institutions as banks, insurance and pension funds, who own large parts of the shares of a business.

The board of directors

The board of directors is in control of the day to day activities within the company and manages the company on behalf of the shareholders and satisfying the shareholders’ interests. The board is led by the chairman; for listed companies there is an extra requirement: the board also includes executive and non-executive directors.

  • Chairman
    Is the senior director, who is elected by the other directors and is the person who chairs the board meetings.

  • Executive directors
    These directors have a double function: he or she is a member of the board and makes key decisions at the level of the board. And on the other hand he/she is responsible for his/her own department, which acts on the decisions made by the board. Examples of an executive director: CEO, CFO.

  • Non-executive directors
    These directors only have a function within the board and are not working for the company. Usually, the non-executives have business experience gained from the past and they are also active in other companies as directors. The Combined code distinguishes a non-executive and an independent non-executive director. A non-executive director is independent if he or she didn’t work for the company within the previous 5 years. The main reason why a company has non-executive directors is because the company needs particular persons who are able to bring a non subjective approach. According to the Combined Code, the large companies which are listed must have at least 50% of their board being non-executive directors, excluding the chairman. The chairman should be a non-executive at the appointing point. For the companies which are smaller but are listed, there should be a minimum of 2 non-executives in the board. Even though the executive directors are more in depth involved in the company, both the executive and non-executive directors have the same obligations towards the company’s shareholders.

The Combined Code

The Combined Code was established in 1998 as a combination of The Code of Best Practice on Corporate Governance and a separate code of practice (which was about the directors’ salary and conditions). It was modified in 2003 because of the suggestions made by the Higgs Report which made suggestions about the role of the chairman and the role of the other directors, especially of the non-executive directors. The Combined Code is linked to the London Stock Exchange in the sense that listed companies need to meet the requirements of the Code or they have to specify why they do not. If a listed company can not accomplish this, it is possible that the company will be deleted from the list. Through this framework, the shareholders have more information about the company’s affairs, which leads to better checks of the power of the board. On the other hand, when the rules are too strict this could discourage the entrepreneurial mind of directors.

The task of the board

  1. Decide on the strategic direction of the company
    The strategic direction of a company can be decided by the board, but it is also possible for the board to develop an executive committee. The board will be setting the strategic aims and further it is the responsibility of the executive committee, which includes the CEO and other executives. If the committee made a plan, it has to be approved by the board.

  2. Exercise control
    The control which the board is exercising is usually executed by different board committees which is composed of different board members. The committees must report their various developments and their results to the full board. It is also possible for committees to have the same directors. The sections where the board has to exercise control are:

    1. The Executive committee implement the strategic plan

    2. The Audit committee assures reliable financial statements

    3. Risk management committee has the task to evaluate and manage the risk. (It is also possible that the audit committee fulfill this task)

    4. Nomination and remuneration committee has the duty to offer a formal and transparent procedure regarding the way directors are nominated and remunerated

    5. A committee has to check the performance of the board of directors as a whole and also the performance of the individual directors.

  3. Maintain external relations
    The board has as main purpose to meet the needs of the company and the shareholders. Therefore, the board needs to create and maintain a good relationship with the shareholders. This is done by having informal meetings between the board and the shareholders, where both groups express their opinion

Chairing the board

The expectations of the chairman include:

  • Frequently holding meetings, where problems and issues are being discussed and can be dealt with
  • The agenda of the board shows the key issues and problems the company is facing
  • Informing the directors on time with relevant and reliable information which can help them to deal with the problems and issues
  • Giving the directors enough time during the meetings to discuss the issues and problems
  • Providing all the directors the opportunity to give their opinion at the meetings
  • Guiding the discussions during the meetings so that they stay focused on the key issues and problems

Relationship between the chairman and CEO

As the chairman leads the board of directors and the CEO leads the management team, it is stated in the Combined Code that both roles shouldn’t be occupied by the same person. However, in real life this does exist. On the other hand, the separation of the 2 roles can bring problems as well. There is not always a good relationship between the CEO and chairman, which can lead to conflicts.

Role of the non-executive directors

Since the strengthening of the corpora governance standards, the image of the non-executive directors has changed. Nowadays the role of these directors is seen as valuable. As they are or have been executive directors of another company, they can offer useful ideas. Also, because the non executive directors are not involved in the daily operations of the company, they can provide an independent point of view. Their experience and skills can also help with identifying the weaknesses and to give ideas to improve these weaknesses. The role of the non-executive directors in a committee, to exercise control over a particular area, is really important e.g. Audit committee. Another important role of these directors is that they are sometimes the channel between the shareholders and the board. In addition, their reputation is usually good in their particular field, which has a positive effect on the profile of the company.

  • Role conflict
    As the different roles of the non- executive directors also includes monitoring, this can lead to conflicts between non-executive and executive directors

  • Relations with the executive directors
    The executive directors can dislike the presence of the non-executive directors because:

    • The non-executive directors are monitoring the behavior of the executive directors

    • As the non-executive directors are not involved in the day to day running of the business, they do not completely understand the business

    • Executive directors think that the non-executive directors do not devote enough time and energy to carry out their tasks

    • The non-executive directors may think that the executive directors are acting unhelpful because they refuse to provide the non-executives with the key information and reports, they do not succeed in providing the non-executives with the important information on time or they are having informal meetings about important issues without the non-executives

  • Maintaining independence
    The non-executives should maintain an independence voice, even under the increase burdens on them and under the influence of the executive directors.

The audit process

  • External audit
    The external audit is required for most large businesses. External audit has to do with preparing the annual financial statements and publishing them. The external auditors are chosen by and report to the shareholders. Usually, they are independent accountants and they check the financial statements prepared by the directors. These accountants also have to provide the shareholders with their own opinion about the financial statements, whether it provides a true and fair view of the financial health of the company or not.

  • Internal audit
    Even though there is no legal requirement to have an internal audit, most large companies do have it. Their main purpose is to provide the directors with support regarding the financial reporting systems and the company’s control, whether it is reliable or not.

  • Audit committees
    The audit committee is required by the Combined Code and is regarded as essential to good corporate governance.

  • The role of the audit committee
    The main role and responsibilities of the audit committee are set by the Combined Code and are as follow:

    • To control the integrity of the financial statements

    • To examine to internal controls of the company

    • To give advice about the selection and removal of the external auditor

    • To control and examine whether the external auditor is independent, objective and effective.

    • To set up and apply policies regarding the supply of non-audit services by the external auditor

  • Fulfilling the role
    The audit committee will receive its terms of reference, which describes the role and responsibilities of the committee, and it will also receive resources to carry out these responsibilities.
    The committee should have regular meetings and it should have clear lines of communications to be more effective. The internal auditors should help the committee with reporting the effectiveness of internal control and risk management process.

Assessing board performance

The evaluation of the board performance can be done by an external party or by the board members itself, which is preferred by the members.
Areas which could be evaluated are e.g. company objectives, board structure and roles, meetings, composition of the board, and the development of the board.

Remunerating directors

The remuneration of directors is hard but it is essential to the success of the company

  • Remuneration policy
    In the Combined Code it is stated that remuneration should be linked to performance and the level of directors’ remuneration should interest and motivate individuals of the right quality. The package of remuneration consists of 2 major elements, the fixed element and the variable element. The fixed element is the base salary and the variable element is the part that is based on the performance of the individual.

  • Tenure and service contracts
    The provisions concerning the re-election of the directors are made because they keep them focused and to renew the board over time.

  • Remuneration committee
    The remuneration committee, which consist only of independent non-executive directors has the task of setting the payments and benefits for the executive director and chairperson.

  • Reporting directors’ remuneration
    It is required by law that the UK listed companies make a directors’ remuneration report, approved by the shareholders, on annual basis. This report describes the remuneration of each director and also specifies the salary, fees, expense allowances, compensation for loss of office, number of shares and retirement benefits in details.

Total shareholder return

TSR is a widely used performance target. The total return from a share is made up of 2 parts, namely the increase/decrease in share value over a period of time + the dividends paid out during that particular period. It can be calculated by the following formula:
Paid Dividend per share + (share value - nominal value)
--------------------------------------------- * 100
Nominal value
Economic value added

EVA is another performance target and is based on the economic profit which has been around for various years. It shows whether the returns generated are more than the returns needed from investors.
NOPAT - (R * C)
NOPAT stands for the Net Operating Profit After Tax
R stands for returns required by inventors, which is the weighted average costs for capital
C stands for the capital invested,

Directors’ share option

A way to reward long-term performance is through the granting of directors’ share option. This means that the director can purchase equity shares in the company at a settled price. These options will only be exercised if the shares’ market value is higher than the option price. However, the director is not able to trade these shares anymore and will be forfeited if the director quits his job at the company. Recently there is a discussion about this option, whether it is an appropriate mean to reward directors.

Deciding on a target

Usually companies will not rely on one particular target, but instead uses a range of targets, so that the various areas of performance are covered.

The rise of shareholder activism

The development of a framework of rules for the management has improved corporate governance, but it is also vital that the shareholders are more active with checking and monitoring the behavior of the directors.

Nowadays the most important investors are the institutions, but this does not indicate that individuals are investing less in the large companies. The individuals invest through an institution.

Recently, the institutions have a more active role in corporate finance. Because of the high amount of shares of the company, it is hard for the institution to sell its shares if a company performs poorly. In addition, the competitive pressure means they have to outperform and this will mean that they are less tolerant with bad performances of the company.

Shareholders activism can take different forms: the simplest form of it is that the shareholder becomes more active in voting and to a more complex form, which is intervening in the affairs of the company.

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