FINANCIAL ACCOUNTING

Introduction

Financial Statements

Financial Accounting - Introduction

Today we want to:

Get to know each otherDiscuss the nature of accountingRevise the financial statements

Financial Accounting - Introduction

Getting to know each other

A little bit about myself A little bit about you What is the purpose of this

course

Financial Accounting - Introduction

About myself… Italian Many interests/hobby

Professor of accounting

Financial Accounting - Introduction

About you

Why are you doing an MBA?

Financial Accounting - Introduction

About the course

You are not going to become a professional accountant!

But, I hope, you will be able to Understand accounting issues Deal with accountants and accounting

information Use accounting information to make

decisions

The book and its website

Very recent book Plenty of supplementary material  http://www.mhhe.com/libby6e

Financial Accounting - Introduction

Practicalities

The PDA Store– Annual report to be handed in after session 14

Quizzes– Voluntary– They can HELP you– They can NOT HURT you

Feedback

Financial Accounting - Introduction

Financial Accounting - Introduction

A “simple” question

What is accounting?

A possible definition

Can't you see?It all makes perfect senseExpressed in dollars and cents,Pounds, shillings and pence

(by R. Waters, “Amused to death”) We wish it was true…..

Financial Accounting - Introduction

Financial Accounting - Introduction

McKinsey’s typology of jobs “Transformational”: extracting raw materials or

converting them into finished goods– traditional– declining

“Transactional”: interactions that can easily be scripted or automated

“Tacit”: complex interactions requiring a high level of judgment – Fastest increasing category

Talent: the ability to solve complex problems or invent new solutions (The Economist, October 7th 2006)– The most looked after ability for tacit jobs

Financial Accounting - Introduction

Our challenge for this course

Approach accounting as a “tacit” job Learn how to use your “talent” to make

the best use of the accounting system in business life

Accounting can be “fun”! Accounting as the transformation of raw

data into information.

Financial Accounting - Introduction

From “The Economist”

Accounting precision is an elusive goal. A company’s earnings measured under American accounting rules, for example, can be twice as high as under British rules, without any bending at at all.” (9th of March 2002, “A survey on Management”)

Financial Accounting - Introduction

Learning from the masters…

The mechanic of accounting is the double-entry system of recording transactions

Double-entry was systematized by an Italian monk: Fra Pacioli at the end of the 15th century.

Let us learn from him the basics of the system…….(video)

From the video

Which accounting issues are brought up in the video?

Double-entry mechanicsCash vs accrualValue of (intangible assets)

Financial Accounting - Introduction

Financial statements:

an introduction

Financial Accounting - Introduction

Financial statements The objective of general purpose financial

statements is to provide information about the financial position, performance and cash flows of an enterprise that is useful to a wide range of users in making economic decisions.

They provide information about and enterprise's:– Assets– Liabilities– Equity– Income and expenses– Cash flows

Financial Accounting - Introduction

Information provided by financial statements

What cash movements took place over a particular period?

Balance sheet (B/S)

Income statement (I/S)

Cash flow statement

How much wealth was generated by the enterprise over a particular period?

What is the accumulated wealth of the enterprise at the end of a particular period?

Financial Accounting - Introduction

Financial statements: ExampleFirst day

Luca decides to sell his high school books

Luca begins his enterprise with € 300 worth of books

On the first day of trading, he sells 2/3 of the books for € 250

Financial Accounting - Introduction

Example: first day

What cash movements took place on the first day of trading?

How much wealth (profit) was generated by the enterprise on the first day of trading?

What is the accumulated wealth at the end of the first day?

Financial Accounting - Introduction

Day 1: Luca’s cash flow

What cash movements took placeon the first day of trading?

Opening balance (cash introduced) € 0Proceeds from the sale of books € 250Closing balance € 250

Financial Accounting - Introduction

Day 1: Luca’s income statement

How much wealth (profit) wasgenerated by the enterprise on the

first day of trading?

Sales € 250Cost of sales (2/3 of € 300) € 200Profit € 50

Financial Accounting - Introduction

Day 1: Luca’s balance sheet

What is the accumulatedwealth at the end of the first day?

Cash (closing balance) € 250Books left for resale (i.e. inventory) € 100Total enterprise wealth € 350

Financial Accounting - Introduction

Financial statements: Examplesecond day

On the second day of trading Luca sells the rest of his high school books for € 110.

Financial Accounting - Introduction

Example 1: second day

What cash movements took place on the second day of trading?

How much wealth (profit) was generated by the enterprise on the second day of trading?

What is the accumulated wealth at the end of the second day?

Financial Accounting - Introduction

Day 2: Luca’s cash flow

What cash movements took placeon the second day of trading?

Opening balance (from day 1) € 250Proceeds from sale of books € 110Closing balance € 360

Financial Accounting - Introduction

Day 2: Luca’s income statement

How much wealth (profit) wasgenerated by the enterprise on the

second day of trading?

Sales € 110Cost of sales (1/3 of 300) € 100Profit € 10

Financial Accounting - Introduction

Day 2: Luca’s balance sheet

What is the accumulated wealthat the end of the second day?

Cash (closing balance) € 360Books left for resale € 0Total enterprise wealth € 360

Financial Accounting - Introduction

Balance sheet and income statement What is the initial wealth of the enterprise (Luca)?

All the high school books = € 300

What is the final wealth of the enterprise (Luca)?The cash accumulated = € 360

What is the wealth generated in the two days? Two ways of answering

– Final wealth – initial wealth = € 360 - € 300 = € 60– Income day 1 + Income day 2 = € 50 + € 10 = €60– They are the same!– This is not a coincidence!

Financial Accounting - Introduction

B/S, I/S and CF statement

Begin. day 1 End of day 1 End of day 2

I/S day 1Wealth

300

BalanceSheet

I/S day 1

BalanceSheet

Wealth

350

BalanceSheet

Wealth

360

Cash flow day 1

Cash flowday 2

Cash

0

Cash

250

Cash

360

Profit = 50 Profit = 10

Cash increase = 250 Cash increase = 110

Cash flow logic

Accrual logic

Different!

Financial Accounting - Introduction

Remember the accrual principle?The effects of transactions and other events are

recognised when they occur (and not as cash or its equivalent is received or paid) and they are recorded in the accounting books and reported in the financial statements of the periods to which they relate.

IASB FrameworkIn this example, cost is recognised (both in day 1 and day 2) even if no cash outflow takes place.

In accounting terms we are using inventory valued at fair value

Financial Accounting - Introduction

Cash flow vs Accrual (accounting) Accounting focuses on the economic effects

of transactions, not on the cash flow Classic examples where cash flow and

accrual logic do not coincide– Purchase of long lived pieces of equipment

(fixed assets)– Sale of goods and/or services on credit– Purchase of goods and/or services on credit

Balance sheet:

an overall view

Financial Accounting - Introduction

Purpose of a balance sheet To set out the financial position of an enterprise at

a given date, i.e. to report the ASSETS and

CLAIMS of an enterprise.

It is a status report rather than a flow report. The balance sheet has two counterbalancing

sections:– the left side lists assets which represent the resources of

an enterprise;– the right side lists liabilities and owners’ equity which

represent claims against those resources. Because the B/S shows the financial status at a

particular point in time, it is always dated.

Financial Accounting - Introduction

The balance sheet equation

Assets = Liabilities + Owners’ equity

Economic resources (future economic benefits) that are controlled by an enterprise and whose cost (or fair value) can be objectively measured

Present obligations of the enterprise arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits

Amount of finance owners have provided to the enterprise

The left and right sides of a balance sheet are always kept in balance:

Financial Accounting - Introduction

PUMA

Financial Accounting - Introduction

Luca’s balance sheetBeginning of day 1

Assets Liabilities + EquityHigh school books 300 Equity 300Total 300 Total Equity 300

When Luca start his business there is no cash movement

However he has decided to put his books on sale

This initial economic fact is registered by the accounting system in the balance sheet

Financial Accounting - Introduction

Luca’s balance sheetEnd of day 1

Assets Liabilities + EquityHigh school books 100 Equity 300Cash 250 Profit 50Total 350 Total Equity 350

Notice that Equity at the end (350) – Equity at the beginning (300) = Profit (50)

The books sold are eliminated from the B/S (300 – 200 = 100)

The cash received is included in the B/S (250) The profit gained (50) is re-invested in the business

and increases Luca’s wealth (equity)

Financial Accounting - Introduction

Luca’s balance sheetEnd of day 2Assets Liabilities + EquityHigh school books 0 Equity 300Cash 360 Profit 60Total 360 Total 360

The books sold are eliminated from the B/S (100 – 100 = 100)

Notice that Equity at the end (360) – Equity at the beginning (350) = Profit (10)

The cash received (110) is included in the B/S and added to the existing cash (250) to give the final value (360)

The profit gained (10) is re-invested in the business added to the existing (50) and increases Luca’s wealth (equity)

Financial Accounting - Introduction

Summing up Three main financial statements

– Balance sheet– Income Statement– Cash Flow statement

Accounting does not follow the cash logic, it follows the accrual logic

The balance sheet equation– Assets = Liabilities + Equity

How to prepare a very simple balance sheet