2.

Financial Accounting
FINANCE AND FINANCIAL REPORTING
Accounting: the Language of Business
Generic representation of the activity of any business = a
‘cash pump’ cycle
Resources transformed into a value proposition (physically,
goods and services delivered to customers)
Customers exchange cash for these goods and services
Cash used for the acquisition of additional resources

2
 The generic business model is a
‘cash pump’ cycle
Resources obtained Cash received

Resources markets The BUSINESS

(potential suppliers) Transformation process Customers

Decisions and
actions

Cash outflows Value proposition and

(payments) goods delivered

Flow of cash: Arrows pointing left

Flow of resources, goods or services: Arrows pointing right

3
 Accounting describes – and is linked to –
every part of the activity of the firm
Resources obtained Cash received

Resources markets The BUSINESS

(potential suppliers) Transformation process Customers

Decisions and
actions

Cash outflows Value proposition and

(payments) goods delivered

ACCOUNTING
INFORMATION
4
Accounting: the Language of Business
Business creates an agency relationship that calls for
reporting
◦ Reporting to capital providers
◦ Reporting to business partners
◦ Reporting to superiors and peers

5
Flow of funds and flows of information (accounting
and reporting) between a business and its funds

6
Accounting: the Language of Business
Accounting is a living language
◦ Business relationships are affected by technology (e.g., Internet)
◦ New business issues
◦ The reality described by accounting is alive and evolving continuously
◦ The accounting language must be strong … and flexible (necessity of
principles)

7
Accounting: the Language of Business
Accounting is a language with some maneuvering room
◦ The accounting language describes a business activity
◦ Different ways of describing the same reality
◦ Choice of an accounting ‘solution’ (accounting ‘strategy’)
◦ Many examples in the financial press (change in accounting policies:
China Dangdang [revenue recognition], NTPC Ltd [depreciation], LAN
Airlines [adoption of IFRS]…)

8
Definition of accounting
Accounting
◦ To describe the life of a business entity
◦ Accounting information = decision-support tool for users
◦ Two key missions:
◦ facilitate value creation by supporting decision-making
◦ measure and report the amount of value created.
◦ Two sub-classes: financial accounting and managerial accounting

9
Accounting principles
The users must understand the meaning of the accounting
reports
Necessity of ‘rules of the game’
Rules = accounting principles
GAAP = Generally Accepted Accounting Principles
Different countries have different GAAPs: e.g. UK GAAP,
IFRS, US GAAP…
International rules also tend to converge
Four broad categories

10
Accounting principles
Substance
Basis of over form
valuation
Faithful
Unit of representation
measurement No offsetting Materiality

Objectivity Quality of
information
True and
fair view

Prudence Periodicity

Conservatism/ Matching
Prudence Accounting Going concern
period

Accrual
basis
Consistency

How to read this figure

Requirement Accounting
Objective
principle

11
Main objective: true and fair view
No officially recognized and generally accepted definition
True: financial statements do not falsify or dissimulate the
financial situation of the company at period-end, nor its
profits (or losses) for the period
Fair: accounts give accounting users complete and relevant
information for decision-making

12
Objectivity
Unit of measurement

Financial accounting records transactions expressed in

financial units
Some ‘non financial’ elements may be mentioned in the
notes (e.g., Environmental liability)

13
Objectivity
Basis of valuation and measurement
Different measurement bases can be employed:
◦ Historical cost
◦ Current (ore replacement) cost
◦ Realizable (settlement or liquidation) value
◦ Present value

14
Objectivity
No offsetting
Offsetting of opposite net effects of different transactions is
forbidden
Example: two bank accounts with opposite balances
Liability in favor of a supplier and receivable on the same
supplier

15
Quality of information
Substance over form
Transactions should be accounted for and presented in
accordance with their substance and economic reality and
not merely their legal form.
Examples: reporting for leased assets (see Chapter 12)

16
Quality of information
Faithful presentation
To be reliable, information must represent faithfully the
transactions and other events
Inherent difficulties:
◦ either in identifying the transaction and other events to be measured
◦ or in devising and applying measurement and presentation
techniques that can convey messages that communicate the full
complexity of those transactions and events

17
Quality of information
Materiality and aggregation
Information is material if its non-disclosure could influence
the economic decisions of users taken on the basis of the
financial statements

Each material item should be presented

separately in the financial statements

18
Prudence
Conservatism
Preparers of financial statements have to contend with
uncertainties that inevitably surround many events and
circumstances:
◦ collectability of doubtful receivables,
◦ probable useful life of plant and equipment,
◦ number of warranty claim that may occur...

Conservatism in the preparation of the financial

statements (caution in the exercise of judgment)

19
Prudence
Accrual basis
Accrual principle: recognizing or recording an event when it
occurs and not when the cash transaction it induces has
been completed

An entity should prepare its financial statements, except for

cash flow information, under the accrual basis of accounting

20
Periodicity
Accounting period

The yearly accounting period is generally some arbitrary

segmentation of the life cycle of any business

The measurement of income is carried in contiguous yet

clearly separated time slices

21
Periodicity
Going concern
Assumption: a business entity has a long life expectancy
Assumption: continuity when establishing the financial
statements (unless information on the contrary)

Valuation of assets and liabilities at their

historical costs rather than at their
liquidation value

22
Periodicity
Consistency of presentation
Comparability from period to period to be able to detect
trends and evolutions

The presentation and classification of items in

the financial statements should be retained from
one period to the next

23
Concepts of debit and credit
Concepts of increases and decreases can be confusing
By convention
◦ left-hand side of a T-account = debit side
◦ right-hand side = credit side

Assets = accounts with debit balances

Shareholders’ equity and liabilities = accounts with credit
balances

24
Basic rules for debit and credit

Assets or expenses
Debit Credit
Left Right
Increase Decrease

Shareholders’ equity, liabilities or revenues

Debit Credit
Left Right
Decrease Increase

25
 Basic business equation and
concepts of debit and credit
Assets = Shareholders’ equity + Liabilities
Debit Credit Debit Credit Debit Credit

Increases Decreases Decreases Increases Decreases Increases

(+) (-) (-) (+) (-) (+)

Net loss or Net profit

Expenses Revenues
Debit Credit Debit Credit

Increases Decreases Decreases Increases

(+) (-) (-) (+)

26
 Debit and credit from a bank’s
perspective

Accounting records of Verdi Company Accounting records of Bank of Venice

Cash at bank (Bank of Venice) Verdi Co.

D C D C
Debit: 150 Credit: 150

27
Accounting process
Description of the process

Structured multi-step progressive aggregation of elemental

data

Designed to be both exhaustive and efficient

28
Accounting process/
Accounting system
Stage Document Example:
prepared Establishing the capital of Verdi

Analysis of
supporting Cash 150
JOURNAL
documents Capital 150

Cash Capital
Posting to LEDGERS
and
accounts 150
GENERAL 150
LEDGER

Accounts Debit Credit

Control TRIAL Capital 150

BALANCE
…

Cash 150
…

Total 150 150

Synthesis FINANCIAL
STATEMENTS

29
Documents
Supporting document (source document)

Legal documents

Documents must be relevant

30
Verdi Co. journal
(1) Establishing capital payment
BS (A+) Cash at bank 150
BS (L+) Capital 150
(2) Borrowing from Bank of Venice
BS (A+) Cash at bank 60
BS (L+) Financial debt 60
(3) Purchasing equipment
BS (A+) Equipment 125
BS (A-) Cash at bank 125
(4) Sale to customer Sheila Burns
BS (A+) Accounts receivable 250
IS (R+) Service revenue 250
(5) Partial settlement of accounts receivable
by customer Burns
BS (A+) Cash at bank 180
BS (A-) Accounts receivable 180
(6) Payment of workers remuneration
IS (E+) Payroll expenses 101
BS (A-) Cash at bank 101
Payment of interest on debt (Bank of
Venice)
IS (E+) Interest expense 4
BS (A-) Cash at bank 4
Purchases of services
IS (E+) External expense 85
BS (L+) Accounts payable 85
(7) Partial settlement of accounts payable
BS (L-) Accounts payable 80
BS (A-) Cash at bank 80
(8) Partial reimbursement of debt principal
BS (L-) Financial debt 12
BS (A-) Cash at bank 12
31
1,047 1,047
Ledger
Data recorded in the journal integrally transcribed in the
ledger
Ledgers do not create data
Process of transferring entries from the journal to the
ledger = ‘posting’
Verdi Co.’s ledger in Table 3.5 (accounts are listed according
to their position in the financial statements)

32
 Verdi Co.’s ledger (1/2)
Assets Balance sheet Shareholders’ equity and liabilities
(On the last day of accounting period X1)

D Equipment C D Capital C
125 (3) 150 (1)

D balance = 125 C balance = 150

D Accounts receivable C D Financial debt C

250 (4) 180 (5) 12 (8) 60 (2)

D balance = 70 C balance = 48

D Cash C D Accounts payable C

150 (1) 125 (3) 80 (7) 85 (6)
60 (2) 101 (6)
180 (5) 4 (6) C balance = 5
390 80 (7)
12 (8)
322
D balance = 68

33
 Verdi Co.’s ledger (2/2)
Expenses Income statement Revenues
(For the accounting period X1)

D External expenses C D Sales C

85 (6) 250 (4)

D balance = 85 C balance = 250

D Payroll expense C
101 (6)

D balance = 101

D Interest expense C
4 (6)

D balance = 4

34
 Verdi Co. trial balance
Entries Balances
Accounts Debit Credit Debit Credit
Equipment 125 125
Balance Accounts receivable 250 180 70
sheet Cash 390 315 68
Capital 150 150
Financial debt 12 60 48
Accounts payable 80 85 5
External expenses 85 85
Income Payroll expenses 101 101
statement Interest expense 4 4
Sales 250 250
Total 1,047 1,047 453 453

35
Financial statements
Final stage of the accounting process

Operations undertaken specifically to establish the year-end

financial statements: ‘end-of-period entries’ (see Chapter 4)

36
The financial statements
Balance sheet/Statement of financial position
Income statement / P& L / Profit and loss account
Notes (to the financial statements)
Statement of cash flows / Cash flow statement
Statement of changes in equity

37
 A set of financial accounting users
Employees’ Work’s Labor
representatives council unions

Management
Internal users Employees

Shareholders

Users Customers
Potential Investors
investors
Competitors

Investment
analysts External users Tax
authorities

Creditors General public Government

Lenders Suppliers Regulatory

(banks) agencies
38
Introduction to the accounting process

Story of Costas, young merchant in Venice

His family has endowed him with 120 gold ducats
Costas invests 100 ducats in the venture
900 ducats lended by a banker
Table 1.2: ‘Wealth account’

39
 VM’s ‘Wealth account’ at step 1

Venture Costas owns Venture Costas owes

Cash in hand (100 + 900) 1,000 ducats Owed to banker 900 ducats
Total 1,000 ducats Total 900 ducats
‘Net worth’ of Venture Costas 100 ducats
(Conceptually, it is ‘owed’ by
VC to Costas, the individual
capitalist)

40
Costas story
1,000 ducats used to buy a ship, outfit it, staff it, load it with
cargo and merchandise
Change in cash
No change in ‘net worth’ (See Table 1.3)
List of all that the Venture owns

41
 ‘Wealth account’ after step 2
Venture Costas owns Venture Costas owes
Cash in hand (petty cash) 10 ducats Owed to banker 900 ducats
Cash in the hands of the captain 150 ducats
for sailors’ future wages and
operating expenses
Inventory of food and 330 ducats
consumable supplies on board
Inventory of merchandise to be 350 ducats
traded
Ship and equipment 160 ducats
Total book value of resources 1,000 ducats Total 900 ducats
‘Net worth’ of Venture Costas 100 ducats

42
Costas story
Costas sells one half of his ‘shares’ to a friend for 500 ducats
Personal wealth = 20 + 500 = 520 (not recorded) + 50% of
future net worth of VC
‘Premium’ = 500 - 50 (=100/2) = 450
Diversification of the risk and reduction of the potential
return
But no impact on the ‘net worth’ of the Venture
See table 1.4

43
 ‘Wealth account’ of VM after step 3

Venture Costas owns Venture Costas owes

Cash in hand 10 ducats Owed to banker 900 ducats
Cash given to the captain for wages 150 ducats
and operating expenses
Inventory of food and supplies 330 ducats
Inventory of merchandise to be 350 ducats
traded
Ship and equipment 160 ducats
Total book value of resources (1) 1,000 ducats Total owed to third parties (2) 900 ducats
‘Net worth’ of the venture (1) – (2) 100 ducats
Share of ‘net worth’ held by Costas 50%
Share held by friend 50%

44
Costas story
The claim held by the ‘share’ holders is not recorded in the
same way as the amount payable to the banker
4 years later, the expedition returns (3 ships)
Sale of merchandise: 10,008 ducats
Sale of the ships: 300 ducats

45
Costas story
Bonus granted to the crew: 1,000 ducats
Salary: 150 ducats
Interest paid to the banker: 418 ducats
Summary of the transactions: report of business activity or
‘income statement’
See table 1.5

46
 Report on the activity of the Venture
Costas for the 4 years of its activity
Revenues
Revenue from the sale of merchandise 10,008
Revenue from the sale of the ships (100 + 75 +125) 300
Total revenues 10,308
Expenses
Wages and expenses (as planned) -150
Bonus paid to the captain and crew -1,000
Consumption of initial inventory of ‘food and supplies’ -330
Consumption of the initial inventory of ‘merchandise to be traded’ -350
Interest expense paid to banker -418
Consumption of the original ship (depreciation) -60
Cancellation of the net book value of the original ship after wear and -100
tear due to its sale
Consumption of the two additional ships (these were captured and 0
therefore have no cost)
Total expenses -2,408
Income 7,900

47
Costas story
In the activity report:
◦ Positive elements = revenues
◦ Negative elements = expenses

Determination of the ending cash balance (see table 1.6)

Determination of the ‘wealth account’ (see table 1.7)

48
Ending cash balance
Beginning cash balance (1) 0
Receipts
Capital contribution by Costas 100
Amount received from the banker 900
Sales of merchandise 10,008
Sale of ships 300
Total cash receipts (2) 11,308
Payments or disbursements
Different payments (cash for wages [150], food [330], -990
inventory of merchandise [350], acquisition of the ship
[160])
Payment of bonus to captain and crew -1,000
Interest expense paid -418
Total cash payments (3) -2,408
Ending cash balance (4)=(1)+(2)+(3) 8,900
Cash flow generated during the period (5)=(2)+(3) 8,900

49
Statement of cash flows
Beginning cash balance (1) 0
Cash flows from operations
Sales of merchandise 10,008
Different payments (cash for wages, food and inventory) -830
(excluding the ship)
Payment of bonus to captain and crew -1,000
Interest expense -418
Total cash from operations (operating cash flows) (2) 7,760
Cash flows from investing
Acquisition of one ship -160
Sale of 3 ships (a divestment) 300
Total cash from investing (investing cash flows) (3) 140
Cash flows from financing
Capital contribution by Costas 100
Amount received from the banker 900
Total cash from financing (financing cash flows) (4) 1,000
Cash flow generated during the period (5) =[(2)+(3)+(4)] 8,900
Ending cash balance (1)+(5) 8,900
50
 ‘Wealth account’ after step 4
(return of the expedition)

Venture Costas owns Venture Costas owes

Cash in hand (see Tables 1.6 8,900 ducats Owed to banker 900 ducats
and 1.7)
Total resources (1) 8,900 ducats Total owed to third parties (2) 900 ducats
Net ‘‘worth’ of the venture (1) – 8,900 – 900 =
(2) 8,000 ducats
Percentage of the net worth 50%
owned by Costas himself
Percentage of the net worth 50%
owned by the shareholder friend

51
Costas story

Increase of ‘net worth’ : 8,000 - 100 = 7,900

Increase = profit
In this story, profit  cash flow
It is usual. It often happens in real life (see the Statement of
cash flows in Chapter 3)

52
Costas story (conclusion)
Record the financial position (‘wealth account’ or ‘balance
sheet’)
Prepare a document about the value creation (‘income
statement’)
Prepare a document showing the evolution of cash
(‘statement of cash flows’)
Profit (in the income statement) = Increase of net worth (in
the balance sheet)

53
 Useful information
Fundamental characteristics of useful information

Relevance Faithful representation

Predictive Confirmatory Materiality Completeness Neutrality Free from

value value error

Comparability Verifiability Timeliness Understandability

Enhancement of usefulness

54
Statement of financial position or
Balance sheet
Set of two lists:
◦ resources (assets)
◦ obligations (liabilities to creditors and shareholders’ equity)

Statement of financial position (Balance sheet) represented

by an equation

55
Balance sheet equation

Resources (or assets) = obligations to third

parties (liabilities) plus equity
(shareholders’ claims)

or

Assets minus liabilities = Net assets =

Shareholders’ equity (or net worth)

56
 Financial position
The financial position of a business is
defined by two equal ‘sides’

Assets Liabilities and shareholders’ equity

= =
What the entity owns (the resources with Obligations the entity has towards
which the firm will create future value
= third parties and shareholders
for customers for which these will =
exchange some of their own resources) Sources of financing of resources or assets

A balance sheet is a snapshot of the status of the

financial position of a business entity at a given point in
time
57
 Statement of financial position
(Balance sheet)
Continental European presentation in thousands of Currency
Units [CU]

The list of obligations and resources can be structured either in

increasing or decreasing order of liquidity.
Assets Shareholders’ equity and liabilities
Land and equipment 200 Shareholders’ equity 400
Inventories 150
Accounts receivable 100
Cash 50 Liabilities 100
Total 500 Total 500
Emphasis on the long-term potential of the firm

58
Statement of financial position
(Balance sheet)
North American presentation - in thousands of CU

Assets Liabilities and shareholders’ equity

Cash 50 Liabilities 100
Accounts receivable 100
Inventories 150
Land and equipment 200 Shareholders’ equity 400
Total 500 Total 500

Emphasis on the short-term survival of the firm

59
Statement of financial position
(Balance sheet)
British presentation - in thousands of CU

Land and equipment 200

Inventories 150
Accounts receivable 100
Cash 50
Minus Liabilities -100
= Net assets 400
Shareholders’ equity 400

Emphasis on the net worth of the firm

60
Double entry accounting and the balance
sheet equation

Assets = Liabilities + Shareholders’ equity

or
Assets - Liabilities = Shareholders’ equity

Double entry accounting:

Impacts the basic equation in at least two opposite ways
that will keep the equation balanced
Transactions can take place between assets, between
liabilities and shareholders’ equity, or can involve both sides

61
Main categories of assets
Assets

Non-current assets Current assets

Tangible assets (see Inventories (see

chapter 7) chapter 9)

Intangible assets Receivables (see

(see chapter 8) chapter 10)

Financial assets (see Cash (see

chapter 10) chapter 10)

62
Net income

Net income (period t)

=
Shareholders’ equity (at the end of period t)
minus
Shareholders’ equity (at the beginning of period t)
(all things being otherwise equal)

63
 Transaction 1
• Initial investment by shareholders
• Creation of the company
• Capital contribution of 150
• Deposit on the bank account

Assets = Liabilities + Shareholders’ equity (SE)

Cash Financial debt Share capital Details of SE transaction:
Transaction (1) + 150 + 150 Initial investment

150 150

64
 Transaction 2
• Verdi obtains a 60 currency units loan
• Liability recorded
• Increase in cash
Assets = Liabilities + Shareholders’ equity (SE)
Cash Financial debt Share capital
Beginning balance 150 150
Transaction (2) + 60 + 60
Ending balance 210 = 60 + 150

210 210

65
 Transaction 3
• Purchase of equipment in exchange for liquidity
(125)
• Fixed asset recorded
• Decrease in cash
Assets = Liabilities + Shareholders’ equity
(SE)
Cash + Equipment Financial debt Share capital
Beginning balance 210 60 150
Transaction (3) - 125 + 125
Ending balance 85 + 125 = 60 + 150

210 210

66
 Transaction 4
• Services rendered (sold) for 250 on credit
• Revenue recorded
• Increase in assets (accounts receivable)

Assets = Liabilities + Shareholders’ equity (SE)

Cash + Accounts + Equipment Financial Share + Earnings Detail of SE
receivable debt capital transaction:
Beginning balance 85 125 60 150
Transaction (4) 250 250 Service
revenue
Ending balance 85 + 250 + 125 = 60 + 150 + 250

460 460

67
 Transaction 5
• Receipt of cash in partial settlement of the account
receivable (180)
• Decrease in accounts receivable
• Increase in cash

Assets = Liabilities + Shareholders’ equity (SE)

Cash + Accounts + Equipment Financial Share capital + Earnings
receivable debt
Beginning balance 85 250 125 60 150 250
Transaction (5) 180 - 180
Ending balance 265 + 70 + 125 = 60 + 150 + 250

460 460

68
 Transaction 6
• Expenses in cash (salaries, 101 and interest, 4) and on
account (external expense, 85)
• Expenses recorded
• Decrease in cash
• Increase in liabilities
Assets = Liabilities + Shareholders’ equity (SE)
Cash + Accounts + Equipment Accounts + Financial Share + Earnings Detail of SE
receivable payable debt capital transaction:
Beginning 265 70 125 60 150 250
balance
Transaction (6) - 101 - 101 Salaries expense
-4 -4 Interest expense
85 - 85 External expense
Ending. balance 160 + 70 + 125 = 85 + 60 + 150 + 60

355
355

69
 Transaction 7
• Partial settlement of accounts payable (80)
• Decrease in liabilities
• Decrease in cash
Assets = Liabilities + Shareholders’ equity (SE)
Cash + Accounts + Equipment Accounts + Financial Share + Earnings
receivable payable debt capital
Beginning balance 160 + 70 + 125 = 85 + 60 + 150 + 60
Transaction (7) - 80 - 80
Ending balance 80 + 70 + 125 = 5 + 60 + 150 + 60

275
275

70
 Transaction 8
• Repayment of the financial debt (12)
• Decrease in liabilities
• Decrease in cash
Assets = Liabilities + Shareholders’ equity (SE)
Cash + Accounts + Equipment Accounts + Financial Share + Retained
receivable payable debt capital earnings
Beginning balance 80 + 70 + 125 = 5 + 60 + 150 + 60
Transaction (8) - 12 - 12
Ending balance 68 + 70 + 125 = 5 + 48 + 150 + 60

263
263

71
 Summary table
Assets = Liabilities + Shareholders’ equity (SE)
Transaction Cash + Accounts + Equipment = Accounts + Financial + Share + Earnings Detail of SE
receivable payable debt capital transaction:
(1) + 150 + 150 Initial investment
(2) + 60 + 60
(3) - 125 + 125
(4) + 250 + 250 Service revenue
(5) + 180 - 180
(6) - 101 - 101 Salaries expense
(6) -4 -4 Interest expense
(6) 85 - 85 External expense
(7) - 80 - 80
(8) - 12 - 12
Ending 68 + 70 + 125 = 5 + 48 + 150 + 60
balance

263 263

72
 Statement of financial position (Balance sheet)
on 31 December X1 (increasing order of
liquidity)

Assets Equity and liabilities

Fixed assets Shareholders’ equity 210
Equipment 125 Capital 150
Earnings (net income) 60

Current assets Liabilities

Accounts receivable 70 Financial debt 48
Cash at bank 68 Accounts payable 5
Total assets 263 Total equity and liabilities 263

73
Some key points (1/2)
Both sides of the business equation must always be
balanced with one another
Each transaction must be analyzed specifically to identify its
possible impact on shareholders’ equity
The result of a transaction that creates or consumes value is
summarized in the ‘earnings’ account
What creates income?
◦ No income (impact on earnings) until transaction 4 (sale of services)
◦ First operation that affected the shareholders’ equity and therefore
the earnings

74
Some key points (2/2)
Net income is different from cash
Net income (+ 60) is different from the cash flow (+ 68)
◦ Some transactions only have an impact on the bank’s cash balance
and not on earnings (capital, debt, equipment)
◦ Credit phenomenon (customers and suppliers)
◦ See table 2.6

The order in which items are listed on the balance sheet is

not random

75
Statement of comprehensive income
(Income statement)

The income statement is like the ‘film’ of the ‘activity’ of the

business during a given period
◦ Activity
◦ During a given period

Accrual principle (accrual accounting)

76
 Links between the balance sheet
and the income statement
BALANCE SHEET

ASSETS = LIABILITIES + SHAREHOLDERS’ EQUITY

Share capital [Retained] earnings

INCOME STATEMENT

transferred to
(at the end of Expenses Revenues
the period)
Balance =
net income
(if profit;
otherwise it
would be on
the opposite
side)

77
Elements of the income statement
Revenues
Expenses
Income or ‘Bottom line’

Revenues - expenses = Income (profit or loss)

78
 Income statement of Verdi
Company
Total revenues 250
Sales 250

Total expenses 190

Services and supplies consumed 85
Personnel expenses 101
Interest expenses 4
Income (revenues - expenses) + 60

Vertical format (by nature)

79
 Income statement

Expenses Revenues
Purchases consumed and external 85 Sales 250
expenses
Personnel expenses 101
Interest expenses 4
Profit 60
Total 250 Total 250

Horizontal format (by nature)

80
 Income statement for period X1 (vertical
format [by function])

Sales 250
Cost of sales [personnel expense related to the Disc Jockey] -56
Gross margin 194
Selling expenses (advertising campaign) -85
General and administrative expenses [personnel expense -45
related to the accountant]
Operating profit 64
Interest expense -4
Profit before tax 60

81
Notion of depreciation
Fixed assets gradually lose value

‘Consumption’ of the fixed asset

Consumption = ‘Depreciation expense’ since it reflects the

gradual loss of value of these assets

82
Recording the depreciation
Verdi illustration: 125 depreciated over 5 years

Balance sheet 31/12/X1 Income statement X1

Assets Equity and liabilities Expenses Revenues

Equipment Share capital External expenses Sales

125 150 85
250
Salaries expense
Accumulated depreciation Debt
101
25
48
Accounts receivable Depreciation expense Opening
balances
are shown
70 25 in italics
Accounts payable Interest expense
Cash
5
4
68

83
 Balance sheet after depreciation

Assets Balance sheet as of 31 December X1 Equity and liabilities

Equipment Gross value 125 100 Shareholders’ equity
- Acc. depreciation 25 Capital 150
Accounts receivable 70 Earnings 35
Cash 68 Liabilities
Debt 48
Accounts payable 5
Total assets 238 Total liabilities 238

84
 Horizontal income statement [by
nature] after depreciation

Expenses Income statement for the period ending Revenues

31 December X1
External expenses (services 85 Sales 250
purchased from third parties and
consumed)
Personnel expense 101
Depreciation expense 25
Interest expense 4
Income (Profit) before tax 35
250 250

85
Vertical income statement [by nature] for
the period ending 31 December X1

Revenues
Sales 250
Total revenues 250
Expenses
External expenses consumed 85
Personnel expense 101
Depreciation expense 25
Interest expense 4
Total expenses 215
Income (Profit) before tax 35
(Revenues - Expenses)

86
 Vertical income statement [by function]
for the period ending 31 December X1

Sales 250
. Salaries expense (Disc Jockey) -56
. Depreciation expense (technical equipment) -20
Cost of sales (or cost of goods sold) -76
Gross margin 174
Selling expenses (advertising campaign) -85
. Salaries expense (accountant) -45
. Depreciation expense (administrative equipment) -5
General and administrative expenses -50
Operating profit 39
Interest expense -4
Profit before tax 35

87
 Closing of the income statement
and identification of the earnings
Balance sheet 31/12/X1 Income statement X1

Assets Equity and liabilities Expenses Revenues

Equipment Share capital External expenses

Sales
150
125 85
85
[Retained] Earnings Salaries expense 250
Accumulated depreciation 250
35 101
25 101
Debt
Depreciation expense Opening
Accounts receivable
48 balances
25 are shown
70 25 in italics
Accounts payable Interest expense
Cash
4
5 4
68

88
Profit appropriation
Three possibilities:
◦ Distribute the profit entirely to the shareholders as dividends
◦ Distribute the profit partially to the shareholders as dividends and
the balance is a reserve
◦ Not distribute profit at all (shareholders reinvest their claim in its
entirety in the business)

89
Example of an operating cycle
Purchases of raw materials

CASH

Inventory of raw materials

Collection of receivables
Transformation of raw
materials
Receivables

Inventory of finished
products

Sales

90
Statement of cash flows
Required financial statement in certain countries
Limited vision given by the balance sheet (financial position
at beginning and end of year) and the income statement
(activity during the year)
Necessity to understand the evolution of cash during the
year

91
Illustrative statement of cash flows
Cash flows from operating activities
Cash received from customers 80
Cash paid to suppliers and employees -30
Net cash from operating activities (1) 50
Cash flows from investing activities
Purchase of property, plant and equipment -15
Proceeds from sale of equipment 5
Net cash used in investing activities (2) -10
Cash flows from financing activities
Proceeds from issuance of share capital 35
Proceeds from long-term borrowings 10
Dividends paid -20
Net cash from financing activities (3) 25
Net increase in cash and cash equivalents (4)=(1)+(2)+(3) 65
Cash and cash equivalents at beginning of year (5) 5
Cash and cash equivalents at end of year (6) 70
Change in cash (7)=(6)-(5) 65
Control (4)=(7)

92
Link between statement of financial position /
balance sheet, income statement and statement of
cash flows (simplified approach)
BALANCE SHEET

ASSETS = LIABILITIES + SHAREHOLDERS’ EQUITY

Cash Other assets Share capital [Retained] earnings

INCOME STATEMENT
STATEMENT OF
CASH FLOWS transferred to
(end of Expenses Revenues
period)
Beginning transferred to Balance =
cash balance (beginning of period) net income
(if profit;
otherwise it
Operating would be on
cash flows the opposite
side)
Investing
cash flows

Financing
cash flows

Ending cash transferred to

balance (end of period)

93
Business combinations: principles and
methods
Acquisition of shares
Acquisition of the shares of a company which is dissolved
Two companies merge to become a third entity
Acquisition of assets

94
Usefulness of consolidated financial
statements (1/3)
If the parent company is a ‘pure’ holding company (1/2)
◦ Income statement very ‘simple’
◦ No ‘traditional’ items such as ‘sales revenue’, ‘cost of goods sold’ or
‘purchases’
◦ Revenues = ‘management fees’ and ‘investment income’
◦ Expenses = mainly administrative expenses

95
Usefulness of consolidated financial
statements (2/3)
If the parent company is a ‘pure’ holding company (2/2)
◦ The balance sheet also unusual
◦ No significant amounts under accounts receivable, accounts payable,
and inventories
◦ Value of tangible and intangible assets is often low
◦ High amount of financial investments

96
Usefulness of consolidated financial
statements (3/3)
If the parent company is a ‘mixed’ holding company
◦ More informative content
◦ Far from giving a true and fair view of the performance potential of
the group and of its risks, assets and obligations
◦ Importance of financial investments, investment income and
management fees

97
Nature of relations between the parent
company and group entities
Nature of the relation(s) existing between the parent
company and the different group entities

How the financial statements of each of the individual

group entities will be taken into account in the
consolidation process

98
Control (IAS 27, revised 2003: § 13, until
2012)
Ownership > one half of the voting power
Ownership  one half of the voting power:
◦ Power > one half of the voting rights by virtue of an agreement with other investors;
◦ Power to govern the financial and operating policies of the entity under a statute or
an agreement;
◦ Power to appoint or remove the majority of the members of the board of directors
or equivalent governing body and control of the entity is by that board or body; or
◦ Power to cast the majority of votes at meetings of the board of directors or
equivalent governing body (…).

99
Control (IFRS 10, 2011, from 2013)
Three cumulative conditions:
◦ Power over the investee (§ 10–14)
◦ Ability to direct the relevant activities
◦ Rights (voting rights)
◦ Contractual arrangements (see Appendix B)
◦ Exposure, or rights, to variable returns from its involvement with the
investee (§ 15–16); and:
◦ The ability to use its power over the investee to affect the amount of
the investor’s returns (§ 17-18)

100
Significant influence
(IAS 28, revised 2003: §§ 6-7, until 2012
IAS 28, 2011: §§ 5-9, from 2013)
Ownership  20% of the voting power of the investee
Evidence of significant influence:
◦ Representation on the board of directors or equivalent governing body of the
investee;
◦ Participation in policy-making processes (…);
◦ Material transactions between the investor and the investee;
◦ Interchange of managerial personnel; or
◦ Provision of essential technical information

101
Joint control (IAS 31, revised 2003:
§ 7 – until 2012
IFRS 11, IAS 28, 2011 – from 2013)
Joint ventures take on many different forms and structures
All joint ventures result from a contractual arrangement
between two or more economic entities in which joint
control is established

102
Percentage of control and percentage of
interest (1/2)
Percentage of control (percentage of vote, or of voting
rights) = degree of dependency in which a parent company
holds its subsidiaries or associates
Proportion of total voting rights held by the parent in its
related company
Percentage used to determine the consolidation method

103
Percentage of control and percentage of
interest (2/2)
Percentage of interest (called percentage of ownership or of
stake) = claim held by the parent company over the
shareholders’ equity (including net income) of its
subsidiaries or associates
Percentage used in the process of consolidation of accounts
and calculations to define majority and minority interests

104
 Percentages of interest and control may
differ from percentages of interest

30% C1 40%
P C2

43%

• Percentage of control = 43% (and not 83%)

• Percentage of interest = 55% [43% + (30 %
 40%)]

105
 Consolidation methods (from
2013)
Type of Type of Consolidation
relation company method
Consolidation (or ‘full consolidation’
Control Subsidiary or ‘global consolidation’ or ‘global
integration’)

Significant Associate
influence
Equity method
Joint venturer

Joint control

Joint operator Specific method based on inclusion

of assets and liabilities

Three main types of relationships two methods

106
Consolidation process
Step 1: identify the companies to be consolidated
Step 2: pre-consolidation
Step 3: consolidation entries and operations
Step 4: preparation of the consolidated financial statements

107
Foreign currency translations
All accounts must be expressed in the same currency
Unique currency (‘reporting currency’) = generally the
parent’s currency
Foreign exchange rates affect the translation of financial
statements, established originally in foreign currencies

108
Legal mergers
Two different forms of ‘legal mergers’ between two
companies:
◦ The assets and liabilities of one company (the merged company) are
transferred to the other company (the merging company) and the
former (merged) company is dissolved, or
◦ The assets and liabilities of both companies are transferred to a new
company and both original companies are dissolved

109
Legal mergers: Major accounting issues
Determination of the value of each business
Determination of the rate of exchange of shares
Determination of the number of shares to issue
Determination of the merger premium
Accounting entries for recording for the merger so as to be
able to produce a relevant new balance sheet

110