MiF Financial Accounting and

Analysis: Introduction

Session 1

www.london.edu

Today: an introduction
• Five themes
• The fundamental equations of accounting
• Financial reporting output
• Balance sheet
• Income statement
• Notes and other output
• Recording transactions: basic procedure and examples
• Exercise: constructing financials from the ground up

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Theme 1: on uses and users
• The goal is to identify, measure, and communicate useful
information
• How efficiently is the firm operating?
• Does it have sufficient financing?
• Are managers doing a good job?
• Different users (boards, managers, investors, creditors…) differ in
how they want items measured
• Example 1: What is AOCI?
• Example 2: The payoff structure of debt, and the payoff structure of
equity.

Theme 2: on shades of gray

• The hardest truth: things have to be on or off the financials.
• The gray area is at both the intensive margin and the extensive
margin:
• Intensive margin: how much is a receivable overdue by 90 days worth?
• Extensive margin: should a company’s brand be recorded as an asset?
• The point: financial accounting does not have to be the way it is

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Theme 2: on shades of gray

Theme 3: on the “rules”

• Accounting is not physics: there are “rules”, but they are
dictated by other accountants, not divined
• Financial Accounting Standards Board (FASB) in the US – Generally
Accepted Accounting Principles (GAAP)
• International Accounting Standards Board (IASB) in London –
International Financial Reporting Standards (IFRS)
• And many, many others…
• And there are other important factors, other than standards:
• Regulatory oversight, such as auditing and disclosure requirements
• Personal relationships and expertise
• Managers’ incentives

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Theme 3: on the “rules”
B: Distribution of Total Assets for DE Private Firms
3000
2250 Reporting dates Jan 1 2010 through Dec 31 2011
Frequency

1500
750

60 70 80 90 100 110 120 130 140

Percentage of Threshold
SD statistic = 7.98***

Theme 4: on malfunction

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Theme 5: on misconceptions
• Popular perceptions, which inform common practices in
valuation and other areas of finance, are often wrong:
• Example 1: “How assets and liabilities come to be doesn’t matter. All
that matters is what they’re worth now.”
• Example 2: “EBITDA is a consistently-defined metric for measuring
performance.”

Fundamental equations of accounting

• Assets = Liabilities + Shareholders’ Equity
• What the firm has (its resources) and how the firm is financed
• Identity maintained with any transaction – consider taking out a loan,
paying a dividend, or buying equipment with cash
• Debits = Credits
• Debits are on the left, and credits are on the right
• Convention to simplify bookkeeping that is basically the first equation in
disguise

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More on debits = credits

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Financial reporting output

• Financial statements
• Balance sheet
• Income statement / Profit and loss account
• Statement of comprehensive income
• Statement of shareholders’ equity
• Cash flow statement
• Notes to the financial statements
• Other mandated and voluntary disclosures
• Managers’ discussion and analysis / Directors’ report
• Voluntary forecasts and “non-GAAP” figures
• Etc.

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Balance sheet
• Snapshot in time of the financial position of the firm, presented
in the format of one of the fundamental equations of accounting:
Assets = Liabilities + Shareholder’s Equity
• Both assets and liabilities are:
• Ordered in either ascending (IFRS) or descending (US GAAP) order of
liquidity
• Categorized broadly as current or noncurrent
• The key challenge is to make it both reliable and complete; this
is a trade-off largely determined by how we define the elements
of the balance sheet

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Balance sheet – assets

• A rough definition: Rights to probable future economic benefits
• Conditions for an asset to be recognized (put on the balance sheet):
1. Own or control the right to obtain the benefit of the item
2. Right to use the item as a result of a past transaction or exchange
3. Future benefit reliably measurable

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Which of the following are assets?
• Accounts receivable (trade debtors in UK)
• Inventories (stocks in UK)
• Marketing expenditures
• Customer promises to buy products (“executory contracts”)
• Reputation
• Brand name
• Patents
• Customer list

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How assets arise matters!

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Balance sheet – liabilities
• A rough definition: Obligations of the entity to transfer economic
benefits
• Conditions for a liability to be recognized:
1. Item represents a present obligation (not an intent)
2. Obligation a result of a past transaction or exchange
3. Firm has little or no discretion to avoid obligation
4. Future transfer of benefits reliably measurable

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Which of the following are liabilities?

• Long-term bond payable
• Receipt of payment in advance of providing service
• Damages the company must pay if it loses a pending lawsuit
(assume a 40% chance of losing the lawsuit, and the amount is
reasonably estimable)
• Estimates of product warranties
• Income taxes payable in future periods in respect of taxable
temporary differences

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Balance sheet – shareholders’ equity
• Shareholders’ equity is a residual interest, which is a claim on all
assets not required to meet the firm’s liabilities—payoff structure is
like a call option
• Several components:
• Share capital and share premium: owners’ investments
• Retained earnings: company profits that it has not yet paid out
• Accumulated other comprehensive income: the accumulation of gains and
losses that do not “hit” the income statement
• Others…

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Income statement
• Financial performance of the business over a particular period
(a measure of flow, whereas the balance sheet is a measure of
stock)
• Exact format differs by company and country, but the basic
structure is generally similar:
• Start with “net” sales
• Deduct a variety of operating and non-operating expenses (or income)
• End with net income (or comprehensive income, if also deducting items
in other comprehensive income)

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Apple’s income statement – circa 2005

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Recording transactions
• Need three things: Account, amount, and direction
• Account
• Accounts receivable, inventory, bonds payable…
• If you don’t know the name, be descriptive!
• Accounts are “permanent” or “temporary” – all accounts are permanent
except the dividends account and income statement accounts (will come
back to this shortly)
• Amount – either given or calculated
• Direction – up or down (technically, debit or credit)

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 Sample transaction worksheets
Transaction Assets Liabilities Shareholder's Equity
Asset a/c 1 Asset a/c 2 Asset a/c 3 Liab. a/c 1 Liab. a/c 2 Equity a/c 1 P&L effect Retained earnings
Opening balances:

Date Transaction

Transfer of retained
profit

Closing balances

Transaction Assets Liabilities Shareholder's Equity

Fixed assets Inventories Cash Bonds payable Accounts payable Share capital P&L effect Retained earnings
Opening balances:

30-Jun-14 Raise equity X X

05-Sep-14 Issue bonds X X

Transfer of retained
profit

Closing balances

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Example 1
Suppose that a company buys a machine costing £100,000 on credit.
This transaction has two effects:

• Assets increase by £100,000

• Liabilities increase by £100,000
Transaction Assets Liabilities Shareholder's Equity
Fixed Assets Accounts payable

Purchase of machine 100,000 100,000 0

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 Example 2
Suppose that a company previously sold goods worth £50,000 to a
customer who has yet to pay. When the customer subsequently pays,
the transaction has two effects:
• Assets increase by £50,000
• Assets fall by £50,000
Transaction Assets Liabilities Shareholder's Equity
Cash Accounts receivable

Customer payment 50,000 (50,000)

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Example 3
A company receives a telephone bill for £1,000. Two effects:
• Liabilities increase by £1,000
• Shareholders’ funds decrease by £1,000

Transaction Assets Liabilities Shareholder's Equity

Accounts payable Profit & loss effect

Telephone bill 1,000 (1,000)

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 Creating financials from the transaction
worksheet
• Fill out the transaction worksheet to reflect all transactions and
other relevant events
• Do the closing process:
• Intuition: you don’t want to show this year’s sales or expenses on the
income statement next year
• All temporary accounts need to be “closed” (i.e., zeroed out) to retained
earnings
• Use the ending balances of all accounts to construct the balance
sheet
• Use the amounts in the P&L effect column to construct the
income statement

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Transaction worksheet for a firm’s 2017

Transaction # Assets Liabilities Shareholder's Equity
Fixed assets Inventories Cash Bank loan Accounts payable Share capital P&L effect Retained earnings

Initial capital 1
Bank loan 2
Purchase of shop 3
Purchase of books 4
8
Sales 5
9
Cost of sales 5
9
Electricity bill 6
Interest 7
Salary 10
Payment to creditors 11

Transfer of retained
profit

Closing balances

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 Transaction worksheet for a firm’s 2017
Transaction # Assets Liabilities Shareholder's Equity
Fixed assets Inventories Cash Bank loan Accounts payable Share capital P&L effect Retained earnings

Initial capital 1 20,000 20,000

Bank loan 2 20,000 20,000
Purchase of shop 3 20,000 (20,000)
Purchase of books 4 10,000 10,000
8 30,000 30,000
Sales 5 10,000 10,000
9 35,000 35,000
Cost of sales 5 (5,000) (5,000)
9 (20,000) (20,000)
Electricity bill 6 (2,000) (2,000)
Interest 7 (3,000) (3,000)
Salary 10 (10,000) (10,000)
Payment to creditors 11 (25,000) (25,000)

Transfer of retained (5,000) 5,000

profit

Closing balances 20,000 15,000 25,000 20,000 15,000 20,000 0 5,000

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Balance Sheet as of 31 Dec 2017

Assets Liabilities & Sh. Equity

Cash 15,000 Accounts payable 15,000

Inventories 25,000
Current assets 40,000 Current liabilities 15,000

Shop 20,000 Bank loan 20,000

Fixed assets 20,000 Fixed liabilities 20,000

Share capital 20,000

Retained Profit 5,000
Sh. Equity 25,000

Total assets 60,000 Total liab. & sh. eq. 60,000

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 Transaction worksheet for a firm’s 2017
Transaction # Assets Liabilities Shareholder's Equity
Fixed assets Inventories Cash Bank loan Accounts payable Share capital P&L effect Retained earnings

Initial capital 1 20,000 20,000

Bank loan 2 20,000 20,000
Purchase of shop 3 20,000 (20,000)
Purchase of books 4 10,000 10,000
8 30,000 30,000
Sales 5 10,000 10,000
9 35,000 35,000
Cost of sales 5 (5,000) (5,000)
9 (20,000) (20,000)
Electricity bill 6 (2,000) (2,000)
Interest 7 (3,000) (3,000)
Salary 10 (10,000) (10,000)
Payment to creditors 11 (25,000) (25,000)

Transfer of retained (5,000) 5,000

profit

Closing balances 20,000 15,000 25,000 20,000 15,000 20,000 0 5,000

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Income Statement for the year ended 31

Dec 2017

Sales 45,000
Cost of Sales (25,000)
Gross profit 20,000

Administrative expenses (12,000)

Profit before interest 8,000

Interest expense (3,000)

Net profit 5,000

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