MBA Intensive Seminars 2004

1. MBA Intensive Seminars 2004 FMA Revision notes MBA INTENSIVE SEMINARS 2004

2. Definition Accounting is the process of • identifying, • measuring • and communicating • financial information about an entity • to permit informed judgments and decisions • by users of the information. MBA INTENSIVE SEMINARS 2004

3. The Accounting Equation Assets minus Liabilities equals Equity A - L = E Assets equals Liabilities plus Equity A = L + E Equity Capital Ownership claim Shareholders’ funds MBA INTENSIVE SEMINARS 2004

4. Power of Accounting “Accounting provides a very selective but powerful representation of the corporate identity..” “The detailed language of assets, liabilities, costs, profits provide a range of corporate imagery and vocabulary …….” “Accounting provides the categories through which organisational participants perceive both themselves and the organisation.” Mike Powers MBA INTENSIVE SEMINARS 2004

5. Creative Accounting? “Things may exist independently of our accounts, but they have no human existence until they become accountable. They may not exist, but they take on human significance by becoming accountable..” “Accounts define reality and at the same time they are that reality….” “Accounts do not more or less accurately describe things. Instead they establish what is accountable in the setting in which they occur” “Whether they are ACCURATE OR INACCURATE by some other standards, accounts define reality for a situation in the sense that people act on the basis of what is accountable in the situation of their action.” Ruth Hines MBA INTENSIVE SEMINARS 2004

6. You will discover That accounting is subjective, partial and potentially misleading Accountants use language / numbers in a highly technical way Accounts are a highly stylised story, representation, description of organisational events Differences between the ‘Accounting World’ and the ‘Organisational World’ Problematic nature of accounting numbers MBA INTENSIVE SEMINARS 2004

7. And there’s more…. The tribe of accountants takes many forms and lives within all organisations No such thing as a correct ‘cost’, ‘value’, ‘profit’..it all depends on context The value of accounting in managing organisations MBA INTENSIVE SEMINARS 2004

8. Roles of Accounting Improve problem solving / decision making Manage risks Trust, Assurance Educational - learn about organisations Language of business Construct, define, measure success/failure MBA INTENSIVE SEMINARS 2004

9. Roles of Accountants Assisting the internal management of organisations Complying with external financial reporting, controls and with taxation regulations Expert consultants on financial and organisational performance MBA INTENSIVE SEMINARS 2004

10. Financial Accounting Accounting concepts Profit and Cash distinction Financial statements Organisational impact MBA INTENSIVE SEMINARS 2004

11. Hierarchy of Accounting Qualities Decision Makers and their characteristics Benefits > Costs Understandability Decision-Usefulness Relevance Reliability Predictive value Timeliness Verifiability Representational Faithfulness Comparability & consistency Feedback Value Neutrality Materiality MBA INTENSIVE SEMINARS 2004

12. Transactions Buy materials on credit from suppliers Sell goods or services on credit to customers Pay suppliers Receive cash MBA INTENSIVE SEMINARS 2004

13. When is profit reported? When goods or services are sold NOT when cash is paid or received MBA INTENSIVE SEMINARS 2004

14. Example: Antiques dealer Buy 10 chairs for cash $200 each Sell 6 chairs on credit $300 each Profit 6 x $100 each = $600 Cash flow = minus $2,000 MBA INTENSIVE SEMINARS 2004

15. Profit, not cash Matching Concept – match revenues received with the costs incurred to generate them Goods received but not paid for –Creditors (Payables) Goods or services supplied but no cash yet - Debtors (Receivables) Prudence concept – providing for known / probable losses – e.g. Doubtful debts, Depreciation of fixed assets MBA INTENSIVE SEMINARS 2004

16. Profit, not cashcontd Customers pay in advance for services extending beyond the accounting period Company agrees with supplier to buy materials at fixed price for 5 years Home currency euros, borrow in dollars Increase in valuation of fixed assets MBA INTENSIVE SEMINARS 2004

17. Change over a period start Assets - Liabilities = Equity During the period Profit/loss end Assets - Liabilities = Equity MBA INTENSIVE SEMINARS 2004

18. Contents of annual report Financial highlights Company overview Chairman’s statement Chief Executive’s review Audit report Financial statements Notes to the accounts MBA INTENSIVE SEMINARS 2004

19. The main financial statements Balance Sheet 1 AS AT Balance Sheet 2 AS AT Balance Sheet 3 AS AT 31 Dec Year 1 31 Dec Year 2 31 Dec Year 3 Profit and Loss Account For period Profit and Loss Account For period Cash Flow Report Cash Flow Report MBA INTENSIVE SEMINARS 2004

20. Fixed assets Current assets Liabilities Shareholders’ funds Balance sheet horizontal MBA INTENSIVE SEMINARS 2004

21. Balance sheet vertical MBA INTENSIVE SEMINARS 2004

22. Profit and loss account MBA INTENSIVE SEMINARS 2004

23. Cash flow statement Operating cash flows plus Investing cash flows plus Financing cash flows Equals change in cash and bank loans MBA INTENSIVE SEMINARS 2004

24. Creative accounting What do we want to create? Less profit? More profit? Fewer assets? More assets? More liabilities? Fewer liabilities? MBA INTENSIVE SEMINARS 2004

25. Creative Accounting Practices Income smoothing – move profit from one year to another Changing accounting policies, particularly depreciation, asset valuations Overstating costs, particularly in regulated industries Making expenses into Assets - ‘capitalisation’ MBA INTENSIVE SEMINARS 2004

26. Off-balance sheet financing , e.g leasing, Sale and buyback, special purpose vehicles Recognising profits that aren’t really there – foreign exchange rates affecting values of assets and loans Corporate takeovers – ACCOUNTING MINEFIELD adjusting policies, fair values, goodwill, brands, reorganisation costs……... MBA INTENSIVE SEMINARS 2004

27. Corporate crime / fraud Directors are responsible for preventing crime and fraud They are required to have a system of internal controls Who controls executive directors for honesty/? Audit committees, Non-executive Directors, Supervisory Board MBA INTENSIVE SEMINARS 2004

28. Corporate crime/ fraudcontd. Creating fictitious contracts Fictitious Assets, inaccurate valuations Omitting Liabilities, misleading valuations Raid the employees’ pension fund MBA INTENSIVE SEMINARS 2004

29. Analysis andInterpretation of Financial Statements MBA INTENSIVE SEMINARS 2004

30. First Steps BC (before calculation) • Why are you analysing accounts? • Who are you interpreting for? • When are you interpreting? • What are you intending to interpret? • Limitations of Financial Accounts MBA INTENSIVE SEMINARS 2004

31. Always bear in mind • Preparers of accounts know how people will interpret their accounts • Be cynical – assume the accounts are the best possible picture • Analysis only as good as original data – • Never just use accounts – check from many different sources • Accounting terms are different from general understandings MBA INTENSIVE SEMINARS 2004

32. However…. • Accounts are main source of systematically produced regulated information • Good as it gets • Usually reliable – 3rd party verified • Follow the same basic rules • Most of the information is there (in the small print) • You can never eliminate the risk of fraud / criminal misrepresentation MBA INTENSIVE SEMINARS 2004

33. Analyse Accounts to determine Is the company: • Growing? • Profitable? • Managing its assets effectively? • Sufficiently liquid? • Financed properly? • Able to meet its financial obligations? • Viewed favourably by financial markets? MBA INTENSIVE SEMINARS 2004

34. Financial ratios • Quick and simple check on financial health • Small number of ratios gives a picture of the business. Easy to calculate, harder to interpret. • Provide a starting point for further investigation. MBA INTENSIVE SEMINARS 2004

35. Key areas for analysis • Profitability • Liquidity • Asset management • Debt management (financial structure) • Market value MBA INTENSIVE SEMINARS 2004

36. Success in making profit Return on capital employed profit sales Profit _____ x _______ = __________ sales total assets total assets profitability x efficiency = ROCE MBA INTENSIVE SEMINARS 2004

37. Managing liquidity • Can we pay the bills as they fall due? • Can we pay the wages of employees? • Buy stock (inventory) on credit • Sell on credit = accounts receivable • Pay suppliers = accounts payable • Ideally, match cash flows in and out MBA INTENSIVE SEMINARS 2004

38. Asset management • Use fixed assets to earn sales revenue • Manage working capital • stocks (inventory) • debtors (accounts receivable) • creditors (accounts payable) • working capital cycle MBA INTENSIVE SEMINARS 2004

39. Financial structure • Is it a good idea to borrow? • Creates greater risk - interest payments and capital repayments • Benefits to shareholders when profits are rising • Risks to shareholders when profits are falling MBA INTENSIVE SEMINARS 2004

40. Advantages of ratios • Comparisons are relative to other figures • Compare businesses of different size • Gives picture of company strategy • Financial and trading performance • Compare with industry averages • Simple summary of complex information MBA INTENSIVE SEMINARS 2004

41. Reasons for using ratios • Gives summary statistics • Helps identify industry benchmarks • Input to formal decision model • Standardise for size MBA INTENSIVE SEMINARS 2004

42. Applications of analysis • Predictions of corporate earnings • Construct projected financial statements • Predict corporate failure • Indicators of financial distress e.g. Altman’s models, combination of ratios MBA INTENSIVE SEMINARS 2004

43. Problems with ratio analysis • No agreement on definitions or specific set of ratios • Accounting estimation • Data not available • Timing of data does not match • Differing accounting policies • Negative numbers and small divisors MBA INTENSIVE SEMINARS 2004

44. Limitations of ratio analysis • Diverts attention from the underlying information • May not give sufficient attention to the notes to the accounts • Accounting policies may affect comparison • Industry differences MBA INTENSIVE SEMINARS 2004

45. Creative accounting Could involve: • Inflating reported profits and EPS • Accounting for losses via balance sheet reserves and all profits through P & L • Reporting profits without generating equivalent cash • Reporting lower borrowings MBA INTENSIVE SEMINARS 2004

46. Survival Tips for Accounting Jungle • Read the accounts backwards • Read the accounting policies and compare • Screen accounts using filters – e.g. high profit low tax, changing depreciation policies • Cash is King (or Queen) • Assess risk: If in doubt, keep out (or get out) MBA INTENSIVE SEMINARS 2004

47. Return on Capital Employed Profit before interest and taxation x 100 Shareholders’ funds plus long term debt • Often called ‘Operating profit’ Assets minus Liabilities = Equity • Total assets minus current liabilities equals Shareholders’ funds plus long term loans MBA INTENSIVE SEMINARS 2004

48. Return on Capital Employed Top line questions • What increases/ decreases profit? • Sales? Operating Costs? Bottom line questions • Recent increases in assets may not yet have created profit • Is there any debt ‘off balance sheet’? MBA INTENSIVE SEMINARS 2004

49. Return on Shareholders Funds (also called Return on Equity) Net profit after taxes x 100 Shareholders’ funds MBA INTENSIVE SEMINARS 2004

50. Return on Shareholders Funds Top line questions • What increases/ decreases profit? • Sales? Operating Costs? • Interest charges? Taxes? Bottom line questions • Is the company high/ low geared? MBA INTENSIVE SEMINARS 2004