COMM1240 Running Flashcards

Financial Reporting

Disclose an organisations financial position and status to users outside the company to assist in making an informed decision

Incorporated Entities

Another word for corporations

Need for Financial Reporting

-       Reduce information asymmetry, ie when directors know more than shareholders

o   Directors can’t be held accountable, reduce confidence amongst shareholders

-       A solution to the agency problem

-       Allow comparability amongst companies

Aus Legal Regulation

-       Australia based of 2001 Corporations act, requires company to submit periodically

o   Statement of Financial Position (Balance Sheet)

o   Statement of Profit-Loss (Income)

o   Statement of Cash Flow

o   Statement of change in equity (Part of accounting equation)

o   Notes, ie accounting policies, and how estimates are made,  Ie if a company is projecting the cost of long service leave as parts of wages payable, they must show how such estimates are made

o   Auditors report, a neutral third party examines financial report for errors and manipulation

-       All corporations or legal entities must register with ASIC

Accounting Standards:

-       Financial reporting follows the Generally Accepted Accounting Standards, (which vary in each jurisdiction)

-       Aus accounting standards are set by the Australian Accounting Standards Board (AASB)

o   Based on International Financial Reporting Standards

-       The International Accounting Standards Board (IASB) is a body that develops, reviews, and withdraws international accounting standards

Advantages of Accounting Standards

Eliminate and reduce variations between companies in how they prepare accounts

When developing or reviewing accounting standards of particular focus, controversy, or debate

Oblige companies to produce more information than domestic laws desire -       Improves transparency, and reduces information asymmetry

Allow more flexibility -       These accounting standards are able to respond to change much easier than regulation is able to

Disadvantages of Standards

May not be appropriate to all companies, in all industries

Setting of standards may be bias, ie groups such as governments or certain industries

A lot of variation within rule for different items, hence negates any benifet of conformity

Some standards are to general, and hence are meaningless

Corporate Governance

Refers to the system of rules and practices in which a company is directed and controlled.

Goals of a Business

-       Within a business, there may be varying interests, from market share or sales, often short term conflicts with long term goals.

-       Main shareholder interest is the maximise value of owners equity, ie shares of the business or dividends

Board of Directors or Non Executive Directors:

-       Elected by the shareholders, protect shareholder interests

-       Goal to provide objective oversight, including monitoring the performance of executive directors

-       Ability to appoint and replace executive directors such as the CEO and CFO

Executive Directors

-       Involved in the day-to-day operations of a business, CEO and CFO

-       Elected by the board

Independence - Corporate Governance

-       That stakeholders should be free from conflicts that compromise their ability to make decisions

-       Directors, Board, Auditors are all separate stakeholders

Transparency - Corporate Governance

-       Publish financial statements

-       Disclose to shareholders their goals and significant events, such as any future expected payouts, lawsuits, or investment

Internal Controls - Corporate Governance

-       Policy and procedures put into place to ensure operations run effectively, efficiently and in adherence to the law, objectives include

o   Operational effectiveness and efficiency, ensuring resources are used efficiently

o   Reliable financial reporting, ensuring financial statements are accurate and not misstated

o   Compliance, ensuring all laws, regulation and internal policies are followed

Core Finance Decisions

1.     What real assets should the firm invest in? (Capital budgeting decisions)

2.     How should cash for the investment be raised? (Financing decision)

Real Assets

Physical tangible assets that have intrinsic value that are able to generate a return

Treasurer - Key Stakeholder

o   Manages cash flow and maintaining relationships with banks (ensures access to debt capital)

o   Goal is to maintain liquidity, and access capital at lowest cost possible

o   Manages financial risk, such as interest rate rises meaning less profit, or change in FOREX affecting export base

The Controller - Key Stakeholder

o   Known as head accountant

o   Manages internal financial reporting (preparing accurate financial statements) and internal auditing

o   Manages accounting risk, such as incorrect reporting to ensure historical accuracy

Chief Financial Officer - Key Stakeholder

o   Executive director, communicates with investors and shapes business long term strategy

o   Overall financial health and high (but fair and sustainable) stock evaluation

o   Conflict with the boards demands for high dividends (in the interest of shareholders), and re-invest cash into the company. Recall in the accounting equation, increase in retained earnings will increase cash or accounts receivable as part of assets

The Board of Directors - Key Stakeholder

o   Oversees the CFO and executive directors, and approves major financing decisions (ie issuing stocks or large loan)

o   As voted in by the shareholders, aim is to maximise shareholder wealth and returns

Investors - Key Stakeholder

-       Become owners of the company though buying shares

-       Returns come from dividends or capital gains

-       They bear higher risks, and are paid after lenders

-       Shareholders to maximise return may prefer higher returns, despite higher risks

Lenders

-       Receive a contractually fixed return with interest, not tied to the performance of the company

-       If company does default, lenders have a priority claim, over investors

Investors

-       Become owners of the company though buying shares

-       Returns come from dividends or capital gains

-       They bear higher risks, and are paid after lenders

-       Shareholders to maximise return may prefer higher returns, despite higher risks

Capital Markets

Where long term funds are raised and traded, such as shares, and corporate government bonds

Primary Market

Where newly issued share are traded

Secondary Market

Where existing securities are traded among investors

Role of Capital Markets

-       Provides information such as share and bond price to assess the performance of the financial managers and assist the financial managers in making decisions

-       Allow efficient allocation of capital into most efficient companies

-       Provides liquidity, as shares are able to be sold easily on the secondary market, investors can convert to cash quickly

Effects of Capital Market

-       Increase access to finance and allow firms to substitute debt finance

-       Allow firms to grow faster through more capital and assets, unlike debt finance, not having to pay back loans periodically, allow firms to deploy capital to more long term projects

-       Capital markets expose management to scrutiny from outside investor

o   Creates a principal agent problem, as managers may pursure their own interests other than maximising shareholder value

o   Investors, especially activist investors may increase pressure for short term results, rather than long term

Shareholder Wealth Maximisation

-       Means a company aims to increase the value of shareholder investments

-       Shareholder Wealth can come from two sources:

o   Capital Gains

§  Increase in value of their investment, such as share price

o   Dividends

§  Cash payments made to shareholder from company profits

Strategies to Maximise Shareholder Wealth

-       Board Pressure

o   Shareholders will apply pressure onto the board of directors, in turn discipline mangers

 

-       Compensation

o   By tying shareholder wealth to mangers compensation, such as through stock options, then managers will be more incentivised to serve shareholders’ interests

 

-       Reputational Damage

o   Poor performance by managers will damage their reputation and reduce their likelihood of future leadership positions

 

-       Takeover and Acquisition Threat

o   If a quoted company is underperforming, and its share price is falling, this makes it vulnerable to a hostile takeover

§  When an external party attempts to take control of a company without approval of board of directors

§  Done by either convincing current shareholders to vote out board, or by buying a controlling stake

o   Incumbent managers are then able to be easily replaced

§  Evident in the case of Elon Musk twitter takeover

Problems with Maximising Shareholder Wealth

-       Focused mainly on short term

-       Conflict with ESG goals, or ignore employee concerns

Agency Relationship

o   Stockholder and management relationship is called an agency relationship

o   The principal will hire an agent (does the task) to represent the principal’s interest, the differing objectives of both creates an agency problem.

Agency Cost

Refers to the cost of a conflict of interest between stockholders and managers

o   There are two types of agency cost

§  Direct agency cost, benifets management at the shareholders expense, ie the purchase of a corporate jet

§  An expense that arises from the need to monitor management actions, ie paying outside auditors to assess financial statements

o   Management seeks to inflate amount of control and corporate power, ie overpaying for a merger to increase size of company

Audits

-       Under the Corporations Act 2001, all public and large proprietary companies are required to undergo an external audit

-       An unbiased third party without a conflict of interest, in Australia this is commonly the Big 4 accounting firms

-       Auditors report informs if the financial statements give a true and fair view in accordance with accounting standards

Divergent Objectives

Different Shareholders have varying objectives

Group	What They Want
Customers	Low Prices
Workers	High salary and compensation
Suppliers	Timely payment and fair pricing
Managers	High salary and compensation
Shareholders	Capital gains and dividends
Board	Appease the shareholders
Government	Taxation revenue and regulation

Ethical Responsibilities

Why Ethical Businesses:

-       Follow legal regulations, meaning won’t be penalised or under scrutiny by governments

-       Being socially responsible is attractive to customers, socially conscious investors, attracts a wider pool of workers, and better allow firms to meet ESG goals

 

Conflict of Ethical Responsibilities:

-       Managers may face a conflict between ethical responsibilities and shareholder returns

-       Short term profits may come at the expensive of ethical responsibilities

-       However long term performance may be benefited by positive public opinion

 

Friedman Doctrine

-       The sole social responsibility of a business is to increase its profits within the bounds of the law

Taxation

-       A compulsory unrequited payment to government.

-       Unrequited as benefits provided are not proportion to taxes paid

o   Ie low income orders receive far more than they gain

Purpose of Taxation

-       Raise revenue for government

-       Correct market failure or acts as a disincentive

Administration of Tax in Australia

-       Federally – Australian Taxation Office (ATO)

-       State – Office of State Revenue (OSR)

Self Reporting System

-       Taxpayers bear responsibility for providing tax returns

-       Will face penalties if done incorrectly

Individual Income

-       Main sources of income involve employment and investment

-       Income can be derived from sole trader, trusts, partnerships classed as individual income

Capital Gains

-       Capital gains refers to profit received when assets are sold

-       For individual classed as personal income

o   In Aus there is a 50% capital gains discount if assets held onto for more than a year, only 50% of that taxable gain will be added to income (note this only applies to individuals)

Calculating Individual Incomes

-       Tax Deductions can include

o   Work related expenses (that haven’t been re-imbursed by employer)

Sole Trader Taxation

-       An individual conducting business in their own name

-       Not legally different, especially taxation, from their owner

Partnerships Taxation

-       Two or more people conducting business together

-       Any income is classed as personal income

-       Treated as a conduit

o   Conduit is an entity that passes income to its owners and beneficiaries

o   Partnerships itself must still file tax return, showing income, and who income is flowing to

Trust

-       A legal relationship where a trustee manages assets on behalf of a beneficiaries

-       Treated as a conduit, income flows to individual taxpayers and taxed at the individual tax rate

Company and Corporations

-       A separate legal entity from shareholders and managers, and corporation must file their own returns

-       Businesses with turnover below $50 Million are subject to a 25% tax rate

-       Businesses with turnover above $50 Million are subject to a 30% tax rate

Company income Tax Deductions

-       Deductions reduction off income

o   Incurred in borrowing money, ie interest payments

o   ‘Bad Debt’, money owed to the company becomes unrecoverable

o   Depreciation, strict guidelines on method and effective life

o   Incurred in gaining or producing assessable income

o   Losses from previous years, will only apply if passes a similar business test

Tax Minimisation

-       Use deductions and tax credit to reduce the amount of tax paid within the boundaries of the law

Tax Avoidance

-       Legal, however goes against the ‘spirt of the law’ such as exploiting loopholes to reduce tax paid

-       Case Study

o   In 2012 it was uncovered that Starbucks in the UK paid zero tax in its first 15 years of operations, through royalty payments to other Starbucks subsidiaries

o   Negative public reaction, with boycotts of the brand, with a voluntary £10 in tax over 2 years

Tax Avoidance

-       Illegal, involves deliberately misrepresenting or concealing information to reduce tax paid

Classical - Different systems of company taxation

-       Income is subject to double taxation

o   Once at company level

Modified Classical System - Different systems of company taxation

-       Dividends taxed at a preferential rate compared to other income

Full Imputation - Different systems of company taxation

-       Tax credit given to shareholders for tax on profits already paid

o   In Australia, main example is franking credits

Partial Imputation - Different systems of company taxation

-       A partial tax credit given to shareholders for tax on profits already paid

Partial Inclusion - Different systems of company taxation

-       A portion of the dividends received are included as taxable income for shareholders

Split Rate System - Different systems of company taxation

-       Company is taxed at different tax rates depending on if they retain the income, or pay it out to shareholders

o   Retained profit taxed at higher rate

No dividend tax - Different systems of company taxation

-       Dividends aren’t taxed at all for shareholders.

Corporate Deductions - Different systems of company taxation

• Deduct value of dividends, thus reducing taxable income and overall tax paid.

Legal Requirement for Financial Reports

-       Under the Corporations Act 2001, all public and large proprietary companies must produce financial statements

o   Must have them audited externally

o   Submit to ASIC, and are publicly available

Accountability and Financial Report

-       Ensures transparency for shareholders, and to hold the board accountable

o   Allows shareholders to make informed decisions

-       Provides evidence of performance

-       Reduce information asymmetry (directors knowing more than shareholders)

Some users who benefit from Financial Reporting

o   Potential owners, decide whether to buy shares in company

o   Managers, whose compensation is in line with company performance

o   Regulators to determine if companies are following the law

o   Financial Analyst used for making projections

o   Competitors, in attempting to understand organisations operations and future decisions. This is why managers may be reluctant to disclose information to share holders

o   Customers, especially if they hold long term contracts with companies, ie with Metricon Collapse

Main users who benefit from Financial Reporting

 

o   Equity Investors, investors who have a share in the business, and entitlted to a share of the profits, usually paid last

o   Loan Creditors, such as banks. Financial statements can give an indicator on the companies liabilities, and assets, and hence allow determination of risk

o   Employees, are interested in ability of organisation to pay wages, and unions may be looking at the ability of business to offer pay increases, ie profitability

o   Business Contracts, suppliers who are often paid after the good or service is rendered. If a business has high levels of liabilities, this could be a problem

Financial Reporting for Access to Capital

Some banks or investors will insist of corporations disclosing financial information. Financial information allows investors to assess risk

-       Debt Capital (Loans)

-       Equity Capital (Shares or stake in company)

Value of Financial Reporting for Enviro, Social and Eco sustainability

ESG Refers To

Environmental:

o   Carbon emissions, pollution, rubbish

 

Social Impact:

o   Labour practices, community impact (ie a giant factory next to schools)

 

Economic Sustainability:

o   Long term viability of the business, reducing risk

 

Appeasing Socially Conscious Investors

-       Some investors may be concerned about social impact, hence will only invest in firms that align with their goals

-       This allows firms greater access to capital

 

Long Term Benefits

-       Short term profit maximisation can deplete resources in the long run, or worsen long term consumer sentiment

 

Regulation and Government

-       May appease governments, allowing for preferential legislation and advantageous tax rules

 

Incentive for Other Firms

-       Will incentivise other corporations to reduce their impact, reduces long term risk across the industry

 

Market Signalling

Sustainable reporting can indicate strong corporate governance, and the business is in a strong financial position

Alternatives to Traditional Financial Reporting(ASK FOR HELP)

(ASK FOR HELP)

Cost - Accounting Concept

-       Non current assets generally appear in the statement of financial position at the original cost less depreciation to date

-       For example, if buy an asset for $100, then depreciate by $20, the cost would be $80

Money Measurement - Accounting Concepts

-       Statements restrict to themselves to matters which can be measured objectively in monetary terms

-       Ie goodwill cannot be measured

Business Entity

-       Affairs of the business are kept separate form those of the owners

-       Ie the owners personal home investments cannot interfere with a business

Accrual - Accounting Concepts

-       Transaction recognised when good or service is rendered, not when cash is received

Going Concern - Accounting Concepts

-       Company will continue operating into the foreseeable future

o   If company isn’t expected to survive for 12 months, will be issued with going concern warning

-       Assets are able to be depreciated over its useful life

o   If your business is going to close in 3 months, then spreading out depreciation over 3 years is not adequate

Prudence - Accounting Concepts

-       Managers should give a fair picture of companies finance

-       Should account for likely losses, debt, or payout early

-       Don’t recognise uncertain gains

o   One example is if the company is suing another company

Consistency - Accounting Concepts

-       Accounting policies should be applied consistently from year to year

o   Ie method for estimating future cost of long service leave

-       Allows for comparability across multiple years and prevents manipulation

Matching Concept - Accounting Concepts

-       Looks at relationship between expenses and revenue

o   Links what expenses caused the revenue

o   Moving from inventory to cost of goods sold

Dual Aspect Account - Matching Concept

-       Every transaction will have two effects on the accounting equation, ensuring it always balances

Materiality - Accounting Statement

-       An item is material if its omission could influence the decision taken by users of a financial statement

o   Ie, a company doesn’t disclose a multi million ongoing lawsuit, this is a liability that hasn’t been recorded

Purpose of a Statement of Financial Position

 Also known as balance sheet, provides a snapshot assets, liabilities, equity at a given point in time.
This gives an indication of:

• Solvency (Wether a company can repay its debt over time), by testing wether assets exceed liabilities

• Liquidity (How quickly a company can convert its assets to cash), sorted by different sections on the balance sheet
  

Purpose of a Statement of Financial Performance

Shows performance of a company over a period

Purpose of a Cash Flow Statement

• Provides details of movements in an entities cash balance over a specific period of time

• Records an expense when it leaves an account, unlike accrual accounting

Purpose of Notes to the Account

o   Provides context to the financial accounts

o   Breaks down the depreciation of certain PPE, ie what technique was used

o   Pending lawsuits, expected contract in the long term

Construction of a Cash Flow Statement

-       Categorised into:

  Operation Activities

·      Net Income

·      Adjustments (from depreciation and amortisation)

·      Changes in working capital (AR and AP)

Investing Activities

·      Capital Expenditure (ie buying PPE, will cause to be negative)

·      Proceeds from investments and capital gainss

  Financing Activities

·      Debt issuance (repaying and debt servicing)

·      Equity raising (dividends and buybacks)

Income Statement Structure

Revenue

-       Cost of Goods Sold

 

=Gross Profit

-       Distribution Cost

-       Administrative Expenses

-       Other operating expenses

 

=Operating Profit

-       Finance Income

-       -Finance costs

=Profit before Tax

-       -Tax expense

 

=Yearly Profit

Income Statement Elements

Purpose:

-       Shows financial performance of business over period of time

-       How effectively is an entity at generating profit

-       Shows the revenues earned and expenses incurred over a period

 

Displays financial performance derived from business operations over a period

o   Reports revenue and expenses

 

Sales Revenue

-       Revenue derived from the core components of the business with sale of goods or services

COGS

-       Cost of directly producing and selling the goods, including material cost, direct labour and manufacturing overhead

 

Finance Income

-       The money a company earns from its financial assets and investments, outside its core business operations. For example interest a bakery earns from its savings.

 

Finance Cost

-       Cost of borrowing and servicing debt

 

-       Prepared using accrual accounting, must be consistent

o   Recognise the transaction when good or service has been rendered

-       Instead of a balance sheet which shows at a moment in time, the income statement records over a specific time

Balance Sheet Elements

-       Tells the financial position of a company at a point in time

o   Usually measured at end of year or quarter

-       Companies set of financial resources and obligations at a point in time

-       Shows the resources (assets), and how they are financed using either debt or equity

o   For debt, if corporation fails to pay for debt, then there is an obligation to pay given amount back with interest. For investors, they know there is a legal obligation for companies to pay a fixed amount

o   Equity has no obligation to pay back, but may dilute profits as the financial ratio, earnings per share will decrease

-       Elements Include:

o   Assets

§  Resources that will be used by entity to generate output

§  Cash, property, inventory, accounts receivable, patents

§  Must be measurable

o   Liabilities

§  A list of debts and financial obligations, with legal consequences

§  What the company owes

§  This must be paid back first

o   Shareholders Equity

§  Any remainder after liabilities are paid, and then sold

Basic Equation:

Assets=Liabilities + Equity

Balance Sheet Structure

Assets

Current Assets
            Inventory

            Trade Receivable

            Cash

=Total Current Assets

Non Current Assets

            Property Plants and Equipment

            Intangibles

=Total Non Current Assets
=Total Assets

Depreciation

-       Shows the cost of using non current assets, it measures the amount of capital stock that has been used up over a year, due to:

o   Wear and tear (physical assets)

o   Passage of time

o   Obsolesce

Purpose of Depreciation

-       Allow comparability among financial statements

-       Shows realistic value of assets

-       Prevents profits from being overstated, and makes more consistent year to year

o   ie if one year company buys a whole fleet of trucks, then they can spread cost of depreciation over a couple years, as an expense

Contra Asset Accounts

-       Opposite balance to the normal asset account, ie decreases the book value of assets

-       Each asset has its own account, and represents the total depreciation of the asset

-       Contra accounts used to show initial value of assets, and improves transparency in financial reporting

Straight Line Depreciation

(Purchase Amount - Salvage Value)/(Useful Life)

Shareholder Equity Formula

Equity=Share Capital + Retained Profits + Reserves

Share Capital

-       The money shareholders invest directly into a company in exchange for shares

-       All the money spent buying shares on the primary market
 

Retained Earnings

-       Accumulated value of the profits from company that haven’t been paid out as dividends

-       Includes profits from previous years

Other Reserves

-       Parts from equity that arise from specific accounting adjustments, and don’t fit into share capital or retained earnings

-       Ie increase in value of assets, for example a house increasing from $1 Million to $1.3 Million, this will be recorded in other reserves

Purpose of Financial Statement Analysis

-       Process of analysing and interpretating accounting numbers

-       Helps stakeholders interpret the financial statements and evaluate an entities financial position

Financial statements include the Balance Sheet, Income Statement and Cash Flow Statement

Purpose of Ratio Analysis

-       Ratios need to be considered in the context of industry averages, past records, abnormal situations

o   To Combat, users of information should be informed of other information, and affairs relating the company such as recent investments or geopolitical event


-       Ratios are reliant on information from the balance sheet and income statement,

o   Past information can’t be used to predict future outcomes

o   Information may be incorrect, or not comparable between organisations

o   To combat users should be informed, and information should be reputable, and correct

Intracompany Analysis

-       Comparing the performance of a company with itself from the past

-       Compare against previous year’s performance, projections, expected performance

Inter company Analysis

-       Comparing between companies, most relevant when comparing against industries

Types of Ratio Analysis

-       Vertical Analysis

-       Percentage Change

-       Horizontal Analysis

-       Ratio Analysis

o   Profitability Ratio

o   Liquidity Ratio

o   Financial Structure Ratio

o   Activity Ratio

o   Market Value Ratio

Vertical Analysis

-       Expresses a component of the financial statement over another component (base figure).

o   For income statement, this is most often revenue/sales

o   For balance sheet, this is most often

Horizontal Analysis and Percentage Change Analysis

-       A technique to express how much a value has shifted over two time periods

• (Y2-Y1)/(Y1)

Du Pont Analysis

Decomposes the formula for return on equity into its component drivers, so are able to see how different components affect ROE. Informs how much of a change in ROE can be attributed to each factor.

ROE=(Profit Margin)(Total Asset Turnover)(Leverage)

(Net Income)/(Shareholder Equity)
=(Net Income/Sales Revenue)*(Sales Revenue/Assets)*(Assets/Shareholder Equity)

Return on Equity

-       How effectively a company uses shareholder equity to generate income

ROE = (Net Income)/(Shareholder Equity)

Profit Margin

-       Measures company operating efficiency, shows the amount of net income generated from sales

-       Impacted by changes in price or operating expenses
PM = (Net Income)/(Sales Revenue)