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Management I:

An Introduction toFinancial Accounting

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Contact Information:

Office: Vilfredo-Pareto-Building (G22), Room E-209

Office hours: Thursdays 11-12 a.m., or by appointment

Email: barbara.schoendube@ovgu.de

Phone: 0391 – 67 18 728

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Class Schedule:Lectures on Wednesday, 9:15 – 11:45Tutorials on Tuesday, 9:15 – 10:45First Tutorial on April 24.04.

Course website:http://www.bwl1.ovgu.de/en/teaching/content/current_lectures/financial_accounting-p-131.htmlnotes and exercises

Grading scheme: Final Exam 100Assignments ?Total 100+?

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Basic text:

Tim Sutton (2004). “Corporate Financial Accounting and Reporting“ 2nd ed., Prentice Hall.

Also of interest:Jane L. Reimers (2008), “Financial Accounting, A Business Process Approach”, 2nd ed. Pearson International EditionAugustine Benedict/Barry Elliott (2008) “Financial Accounting, An Introduction”, Prentice Hall

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Chapter 1: Introduction

Purpose and Object of Financial Accounting

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What is Accounting?“Accounting is the Language of Business”

Sound understanding of accounting is essential for all business people

Financial Accounting: external focus• Primary objectives

Stewardship, reports on past performanceInstrument to facilitate decisions for investors in the capital market

Management Accounting: internal focus• Primary objectives:

Decision facilitating for the management• Financial planning Instruments• Cost accounting for decision making

Control of management behavior• Budgeting: goal setting and control of achievement• Incentive system based on performance measures to be

delivered by accounting

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What is Accounting?

Accounting involves two functions:

Recording of transactions• Transactions are business activities such as buying or selling

goods, paying salaries• Are to be measured in monetary terms• Recording is also referred to as bookkeeping

Preparation of financial statements and reports• Regular interval reports• Set up based on the recorded transactions• Reports map financial consequences of business activities in

an aggregated form

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Contents of Financial Statements

Minimum contentsBalance Sheet• Helps assess the company’s financial strength

Income Statement• Helps measure the firm’s financial performance

Notes to the Accounts• Provide additional information to entries to the balance sheet

or income statement

Further Contents Cash flow statement• Helps to assess the firm’s ability to survive

Statement of changes in equitySegment reportEnvironmental report

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Stocks and Flows

Stock variablesrelate to the situation of the company at a specific point in timeExamples: stocks of goods, assets, liabilities

Flow variablesrelate to the change of situation over a specific period of timeExamples: expenses, income; change in value of a fixed asset, e.g. due to exchange rate changes

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Financial Accounting: who is addressed?

Investor orientationowners and potential acquirers of residual claims• shareholders

Stakeholder orientation All parties that consider to or have committed resources to a relation with the reporting entity in exchange for future compensation• Shareholders, creditors• Suppliers, customers, government, public

Tax authority orientationother interest groups could use the information to the detriment of investors

• regulators• trade unions• competitors

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Objectives of Financial ReportingAccording to investor orientation:

Providing information that investors find helpful in making economic decisions

What is useful information?Forward looking informationBackward looking information

Information that is • Relevant,• Relyable• Comparable

Alternatively: monitoring and disciplining role of accounting?

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Desirable characteristics of AccountingRelevance

Timelymaterial

Reliabilityunbiased, neutral, comprehensive, objective

Comparablebetween entitiesover time (consistency principle)

transaction cost-efficientcost of information should not exceed its valueinfluence on cost of capital• unreliable and scarce information may lead to market

failure (accounting scandals)

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Decision Usefulness according to IASB Framework (revised 2010) include:Primary qualitative characteristics:

RelevanceInformation is relevant if it has the potential to influence a decision • by changing expectations or predictions• by feedback on the performance of past decision rules • by enhancing assessment of risk, esp. default risk

Faithful representation• This includes that information must be complete, neutral and free from

errorsFurther qualitative characteristics include:

Comparability• Absolute performance difficult to assess. Investment decisions depend on

expected relative performance. So accounting information is more useful if similar facts can be compared over different

periods and companies.

VerifiabilityTimelinessUnderstandability

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Who is required to prepare financial statements?

An Accounting EntityIn this class we typically think of an accounting entity as either• A company

or• A group of companies under common control

• Also possible:Individual traders, Partnershipsnon for profit organizations (e.g. Charities, government agencies)

Requirement to set up financial statements does not necessarily imply an requirement to publish them

• Accounting entities may be required to set up financial statements in order to ensure a decent information basis for business decisions

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Who is required to publish Financial Accounting Information?

General idea: accounting entities should be required to publish financial accounting information whenever there is a sufficient need for such information from outside the firm

InvestorsStakeholders

Financial accounting information is more valuable the more information asymmetry with respect to relevant information is present

Investors: Separation of ownership and control Stakeholders: creditors, suppliers, and customers may need some information, too

Requirements to publish accounts differ in different countries• Sole traders are in some countries not required to publish accounts

Specific accounting rules for non for profit organizations

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What limits disclosure?

1. Cost-Benefittrade-off concerns all the qualitative characteristics and conventionsobviously, benefits of providing information should exceed cost

Cost• recording, collecting and processing data • disseminating reports• auditing • possibly litigation cost• competitors learn about your organization • time and effort to read/analyze

reports

Benefits• better management and mgmt. control • access to capital markets• allocation of resources • tax assessment• forecasting economic growth

Benefits are much harder to quantify than most of the costs.

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Accounting Entity versus Legal Entity

A group consists of at least two individual companies each being a legal entityIf the companies are under common control the group is an accounting entityEach individual company is an accounting entity, too

In most countries companies belonging to a group are required to publish financial statements • For each single company belonging to the group• For the group as a whole

Problematic aspect with regard to groups:What does common control mean?

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Accounting RegulationGermany

Regulation in codified law: Handelsgesetzbuch (HGB)= commercial code

German Accounting Standards Committee (DeutschesRechnungslegungs Standards Committee (DRSC)), 1998DSR (Deutscher Standardisierungsrat)

DPR (Deutsche Prüfstelle für Rechnungswesen)BAFin (Bundesanstalt für Finanzdienstleistungen)

The United StatesUS-GAAP (generally accepted accounting principles); numerous detailed regulationsFASB (Financial Accounting Standards Board) established in 1973; private-sector bodySEC (Securities and Exchange Commission) established in 1934; federal agency

on the web: http://www.drsc.dehttp://www.fasb.org/http://www.sec.gov/

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Accounting in Europe

IASC (International Accounting Standards Committee)

founded in 1973; privately-funded accounting standard setter (based in London)Since 2001 IASB (International Accounting Standards Board)Sets International Accounting Standards (IAS), now IFRS (International Financial Reporting Standards) http://www.iasb.org.uk/

European Union authorities influence regulations of member states by rulings that have to be translated into the law of the individual member states.

Since 2005 companies listed in member states are required to publish group accounts following International Accounting standards as far as endorsed by the European Union

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What is decent disclosure?

In the U.S., the issue was addressed by the SEC in 1998: „The Plain English Handbook“

Statement of Arthur Levitt, then chairman of the SEC:

We need to acknowledge that disclosure is not disclosure if it doesn't communicate. The proposed rule [i.e. the handbook] requires prospectuses to ... [be] ... in plain English. It asks issuers to use the hallmarks of plain English ... active voice, short sentences, everyday language, tables, and no legal or business jargon. Our eventual goal is to purge the entire document of words that, in the famous phrase of George Orwell, fall upon the facts like soft snow, blurring the outlines and covering up all details.“

[Reuters, February 25, 1997. „SEC to help investors understand mutual funds.“]

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Full disclosure principle – Case studyPorsche AG vs. Deutsche Börse on interim reporting in 2001

sports car manufacturer Porsche got thrown out of the MDax, the German Midcap-Index listing 70 companies, for its reluctance to issue quarterly reports... as the Deutsche Börse AG sees it: "Porsche and Spar are being taken out of the MDAX because the two companies do not publish quarterly reports, which Deutsche Börse requires in the interest of transparency for investors." (press release, 7 August 2001)

... as Porsche sees it: "We feel that quarterly reports are first and foremost a plan to drum up business for Deutsche Börse AG and the banks. … Porsche has always … informed investors … - and this not just every three months. It is therefore not surprising that Porsche, even without ever having submitted quarterly reports, received the Investor Relations Award this May as the MDAX-listed company with the best information sharing policy. … " (press release, 18 July 2001)Who has a point? Do both have a point?

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Structure of this lecture

Part 1: FoundationsBalance SheetIncome StatementAccounting RecordsAccrual AdjustmentsAnnual Report and accountsCash Flow Statement

Part 2: Accounting treatment of specific itemsTangible and intangible assetsInventoriesReceivables and revenue recognitionLiabilitiesOwner‘s equity