1. FINANCIAL ACCOUNTING Introduction Financial Statements

2. Financial Accounting - Introduction Today we want to:  Get to know each other  Discuss the nature of accounting  Revise the financial statements

3. 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

4. Financial Accounting - Introduction About myself…  Italian  Many interests/hobby  Professor of accounting

5. Financial Accounting - Introduction About you  Why are you doing an MBA?

6. 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

7. The book and its website  Very recent book  Plenty of supplementary material  http://www.mhhe.com/libby6e http://www.mhhe.com/libby6e Financial Accounting - Introduction

8. 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

9. A “simple” question  What is accounting?

10. A possible definition Can't you see? It all makes perfect sense Expressed in dollars and cents, Pounds, shillings and pence  (by R. Waters, “Amused to death”)  We wish it was true….. Financial Accounting - Introduction

11. 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

12. 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.

13. 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”)

14. 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)

15. From the video  Which accounting issues are brought up in the video? Double-entry mechanics Cash vs accrual Value of (intangible assets) Financial Accounting - Introduction

16. Financial statements: an introduction

17. 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

18. 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?

19. Financial Accounting - Introduction Financial statements: Example First 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

20. 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?

21. Financial Accounting - Introduction Day 1: Luca’s cash flow What cash movements took place on the first day of trading?

22. Financial Accounting - Introduction Day 1: Luca’s income statement How much wealth (profit) was generated by the enterprise on the first day of trading?

23. Financial Accounting - Introduction Day 1: Luca’s balance sheet What is the accumulated wealth at the end of the first day?

24. Financial Accounting - Introduction Financial statements: Example second day  On the second day of trading Luca sells the rest of his high school books for € 110.

25. 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?

26. Financial Accounting - Introduction Day 2: Luca’s cash flow What cash movements took place on the second day of trading?

27. Financial Accounting - Introduction Day 2: Luca’s income statement How much wealth (profit) was generated by the enterprise on the second day of trading?

28. Financial Accounting - Introduction Day 2: Luca’s balance sheet What is the accumulated wealth at the end of the second day?

29. 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!

30. Financial Accounting - Introduction B/S, I/S and CF statement Begin. day 1End of day 1End of day 2 I/S day 1 Wealth 300 Balance Sheet I/S day 1 Balance Sheet Wealth 350 Balance Sheet Wealth 360 Cash flow day 1 Cash flow day 2 Cash 0 Cash 250 Cash 360 Profit = 50Profit = 10 Cash increase = 250 Cash increase = 110 Cash flow logic Accrual logic Different!

31. 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 Framework In 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

32. 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

33. Balance sheet: an overall view

34. 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.

35. 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:

36. Financial Accounting - Introduction PUMA

37. Financial Accounting - Introduction Luca’s balance sheet Beginning of day 1 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

38. Financial Accounting - Introduction Luca’s balance sheet End of day 1  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)

39. Financial Accounting - Introduction Luca’s balance sheet End of day 2  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)

40. 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