Management I: Financial Accounting

Management I:

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Contact Information:

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Office: Vilfredo-Pareto-Building (G22),

Room E-209

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

appointment

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Email:

[email protected]

Class Schedule:

Lectures on Wednesday, 11:15 – 13:30

Tutorials on Tuesday, 9:15 – 10:45

Course website:

z http://www.uni-magdeburg.de/bwl1/

Πnotes and exercises

z Grading scheme:

Final Exam 100 Assignments ?

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Basic text:

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Tim Sutton (2004). “

Corporate Financial Accounting

and Reporting

“ 2

_{ed., Prentice Hall.}

Also of interest:

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Jane L. Reimers (2008), “

Financial Accounting, A

Business Process Approach

”, 2

_{ed. Pearson}

Chapter 1: Introduction

Purpose and Object of Financial

Accounting

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What is Accounting?

z “Accounting is the Language of Business”

ΠSound understanding of accounting is essential for all business people

ΠFinancial Accounting: external focus

• Primary objectives

ΠStewardship, reports on past performance

ΠInstrument to facilitate decisions for investors in the capital market

ΠManagement Accounting: internal focus

• Primary objectives:

ΠDecision facilitating for the management

• Financial planning Instruments

• Cost accounting for decision making

ΠControl of management behavior

• Budgeting: goal setting and control of achievement

• Incentive system based on performance measures to be delivered by accounting

Financial Accounting: who is addressed?

Investor orientation

Πowners and potential acquirers of residual claims

• shareholders

Πparties that consider to or have committed resources to a relation with the reporting entity in exchange for future compensation

• creditors

• suppliers / customers (maybe)

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Tax authority orientation

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other interest groups could use the information to

the detriment of investors

• regulators

• trade unions

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Contents of Financial Statements

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Financial Accounting is

the process of summarising

financial data ...and publishing it in the form of annual

reports for the benefit of people outside the organisation

Annual accounts typically comprise:

ΠBalance sheet

ΠIncome statement (profit and loss account)

ΠCash flow statement

ΠNotes to the accounts

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Numbers in the statements come from the accounting

records (bookkeeping system) of the accounting entity

Contents of Financial Statements

Balance Sheet

Œ Helps assess the company’s financial strength

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Income Statement

Œ Helps measure the firm’s financial performance

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Cash flow statement

Œ Helps to assess the firm’s ability to survive

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Stock variables

Πrelate to the situation of the company at a specific point in time

ΠExamples: stocks of goods, assets, liabilities

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Flow variables

Πrelate to the change of situation over a specific period of time

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Objectives of Financial Reporting

According to investor orientation:

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Providing information that investors find helpful in

making economic decisions

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What is useful information?

ΠForward looking information

ΠBackward looking information

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Information that is

• Reliable

• Comparable

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Alternatively: monitoring and disciplining role of

Desirable characteristics of Accounting

Relevant

Πtimely

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Reliable

Πunbiased, neutral, comprehensive, objective

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Comparable

Πbetween entities

Πover time (consistency principle)

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transaction cost-efficient

Πcost of information should not exceed its value

Πinfluence on cost of capital

• unreliable and scarce information may lead to market failure (accounting scandals)

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Decision Usefulness according to IFRS Framework

include:

Œ Information 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

ΠInformation relevance depends on timely availability.

z Reliability

ΠFour dimensions of reliability

1. Verifiability

2. Representational faithfulness

3. Neutrality

4. Prudence

z Comparability

ΠAbsolute 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.

z Consistency

Œ Consistency: using the same accounting procedures over several periods. • Changes in accounting procedures must be indicated and explained.

Accounting Entities

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Who is required to prepare financial statements?

ΠSpecific rules apply in different countries

• Various business organizations

• Non for profit organizations

ΠE.g. Charities, government agencies

z Since we focus on investor-oriented accounting we restrict ourselves to companies and groups

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Legal Forms of Business Organization

1.

sole proprietorship / sole trader

z liable with personal resources

z if business is sold, a new proprietorship is established

2.

partnership

z not a separate legal entity

z unlimited liability of at least one partner

z any change in participation requires new partnership

3.

corporation (also private limited company)

z separate legal entity

z risk of ownership limited to investment in the company

z shares can be sold to others without an effect on the identity of the corporation

Source: US Bureau of Census (1992); IfM Bonn (1997)

Legal forms of business organization

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Regulation

z Germany, Austria

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

Œ DPR (Deutsche Prüfstelle für Rechnungswesen)

Œ BAFin (Bundesanstalt für Finanzdienstleistungen)

Πtax accounting rules influence financial accounting

ΠGerman Accounting Standards Committee (Deutsches Rechnungslegungs Standards Committee (DRSC)), 1998

z The United States

ΠUS-GAAP (generally accepted accounting principles); numerous detailed regulations

ΠFASB (Financial Accounting Standards Board) established in 1973; private-sector body

ΠSEC (Securities and Exchange Commission) established in 1934; federal agency

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

Accounting in Europe

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IASC (International Accounting Standards Board)

Πfounded in 1973; privately-funded accounting standard setter (based in London)

ΠSets International Accounting Standards (IAS), now IFRS (International Financial Reporting Standards)

Πhttp://www.iasb.org.uk/

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

ΠSince 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?

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

z Statement of Arthur Levitt, then chairman of the SEC:

z 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.“]

What is decent disclosure?

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information must not be hidden in obscure prose

Example 1:

Œ What you read : „We are well-positioned for future growth“

ΠWhat happened? By every measure of corporate

performance, the company dropped to or near the bottom of its industry.

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Example 2:

Œ What you read: „With perseverance, the company‘s

extraordinary performance in generating added value will be recognized in the market place.“

Œ What happened? The company‘s stock price has languished for years while major market indexes skyrocketed.

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Full disclosure principle – Case study

Porsche AG vs. Deutsche Börse on interim reporting in 2001

z sports car manufacturer Porsche got thrown out of the MDax, the German Midcap-Index listing 70 companies, for its

reluctance to issue quarterly reports

z ... 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)

z ... 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)

What limits disclosure?

1.

Cost-Benefit

Πtrade-off concerns all the qualitative characteristics and conventions

Πobviously, 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