📃 Accounting

Introduction

Apparently, the need to keep accounting was a key driver in the invention of writing and numbers.

Types of Accounting

  • Book keeping - raw data collection. Almost always double-entry bookkeeping
  • Financial accounting - Create reports about income statement, balance sheet, etc to see cash flows and profit and financial positiion of an entity.
  • Auditing - Independent checks
  • Management accounting - Internal use of accounting data to make decisions around prices, volumes of production, locations for expansion etc.

Deloitte, Ernst and Young, KPMG, PwC are apparently the big four.

Ownership

  • Individual / Sole Trader - Fully liable for tax, debt, profit etc.
  • Joint Owners / Partners - All partners are legally responsible for assets, tax etc.
  • LLP - partial protection for partners from some liabilities.
  • Company - full legal separation of owners from the business. Company has its own existence and ownership is determined by 'shares'. The 'shareholder' can transfer ownership by selling shares.

Multinational companies, e.g. Nokia have a single Parent company that pays taxes, transacts business etc and is viewed as a legal entity. It has multiple subsidiaries in different countries. Each S is a legal entity that pays taxes locally and reports dividends upstream to P.

International Evolution of Accounting

Serious accounting (double entry) started in Italy (Luca Pacioli published a book in 1494 that is the earlier surviving textbook describing it).

Spread to England eventually in 1800's.

After the Wall Street Crash of 1929, the SEC was formed and accountability became critical.

With globalization, accounting practices and reporting had to be similar for comparisons across countries to be valid.

US uses GAAP (Generally Accepted Accounting Principles). Australia, Brazil, Canada and the EU have an IASB (International Accounting Standards Board) that models the IFRS standards (International Financial Reporting Standards).

Question: What does India follow?

Answer: IFRS

The Fundamentals of Financial Accounting

A Balance Sheet is officially called Statement of Financial Position by the IFRS.

Good example here, on how initial investment, purchase of inventories, sale to customer and profit to owner etc are shown in balance sheet.

The equation

Assets0 = Equity0 + Liabilities0

Equity1 - Equity0 = Income0->1 - Expenses0->1

Assets1 = Equity1 + Liabilities1

I.e.

Assets1 = Expenses0->1 = Equity0 + Income0->1 + Liabilities1

Or

Assets - Liabilities = Equity = Net Assets

However, some costs end up as Assets (e.g. Land) or Expenses (e.g. wages), so it's not always clear which bucket to put a cost into. Here an asset is a resource which has remaining future benefits at the period end. An expense is a resource that is used up in that period.

So, for example, is money spent on Research and Advertising an Asset or an Expense?

Approach followed can be to measure Asset (resources with remaining future benefits at the period end), and call everything else an Expense.

Or measure all Expenses (everything used up in that period) and tag everything else as an Asset.

Or mix of both approaches.

Cash Flow

Some transactions involve cash flowing in or out but no profit (e.g. buying inventory), while others involve profit but no flow (e.g. selling inventory with later payment).

So we represent Operating and Investing and Financing as the 3 cash flows.

  • Operating == buying inventory, paying wages, selling stuff
  • Investing == buying property
  • Financing == owner investing his money, bank giving loan

Note Cash increasing does not imply profit (e.g. it could increase if we take a loan)

Similarly cash decreasing is also not necessarily bad (e.g. buying long lasting equipment)

Financial Reports of Listed Companies

Companies follow GAAP or IFRS and publish annual reports. Here we will see the audited financial statements.

They will provide:

  • Balance sheet
  • Income statement, in two parts
  • Statement of changes in equity
  • Cash flow statement

Assets

Definition: A resource controlled, as a result of a past transaction or event, when future benefit is expected.

i.e. a company does not 'control' or 'own' a road, so the road is not its asset.

It may lease some other company's and use it i.e. it controls it.

Staff are not treated as assets because they cannot be 'controlled'.

Assets can be :

  • Tangible: property, plant, equipment
  • Intangible: patents, licenses, software
  • Financial: cash, receivables, shares in other companies, government bonds.

And they can be:

  • Non-current e.g. property
  • Current e.g. this quarter's sales This helps assess future cash flows.

An asset is represented in the balance sheet in onese ways:

  • NRV: Net Realizable Value i.e. current selling price
  • FV: Fair Value i.e. market price now.
  • HC: Historical Cost i.e. original cost
  • DCF: Discounted Cash Flows i.e. worth to the business.

Apart from HC, rest are not easy to calculate or not relevant (FV is useless if there's no plan to sell the asset). So usually its represented on a cost basis i.e. market price of buying an inventory + taxes + transport + storage + labour and materials ==> cost of that inventory.

Depreciation of asset also needs to be considered.

Depreciation = (Cost - Residual Life) / Life

Liabilities

Definition: A present obligation, cause by a past event, expected to lead to future outflows.

E.g amounts owed to banks, tax authorities etc. Those that are present.

Therefore future wages are not liabilities.

Things that need to paid in the distant future are adjusted through discounting to differentiate from more urgent payments.

Interpreting numbers

Profit alone not enough e.g. measure their sales as well.

Also see their long term debt.

And liquidity i.e. can they meet current obligations with current assets.

Also how geared or leveraged are they, i.e. a heavily geated company is funded by a lot of debt and not equity capital. High gear == high risk. (since larger loans means more interest etc)

Earning per share (EPS) = profit after tax / Number of shares issued

Price earning (p/e) ratio : Market price per share / Earnings per share

i.e. expensiveness of the share i.e confidence level of investors. High p/e ratio => high confidence in the company.

Misleading accounts

  • Window dressing: temporary trans to improve numbers
  • Creative accounting: exploit loopholes, lack of clarity
  • Off-balance-sheet finance: incur obligations but don't show them

International Differences and Standardization

IFRS vs GAAP

Daimler-Benz and British Airways published earnings in both models and showed wildly different profit figures!

Regulation and Audit

Some stuff around the SEC, auditors, etc.

Statements are prepared by directors and auditors cannot prepare or change them, they only publish a review.

Stages of an audit: - Accepting and defining terms of engagement - Planning, risk assessment, level of materiality (i.e level of approximation that is acceptable) - Gathering evidence - Reporting to client and others

Internal Decision-making: Costs and Volumes

As a part of financial accounting, the following are produced: income statement, the balance sheet, the cash flow statement.

^ These are required by law.

But management accounting (focus of this and next chapter) is around internal documents: costing reports, break-even reports, budgets.

Accounting as Control

Stuff around internal Planning, Motivation (bonuseslegation (budget to each team), Communication, Control (analyze and iterate), Evaluation.

Come up with a balanced scorecard around 3 axes:

  • Keeping customers happy
  • Having good internal processes/objectives
  • Achieving learning/growth

Homework

Download and Understand a few financial reports. Compare 2 companies.

  • How leveraged is it? i.e. is money going to pay interest (i.e they've taken loans) or to pay owners
  • How much is it borrowing i.e. more borrowing -> more future growth

See satyam scan: initial disclosed reports and follow up reality.