LECTURE ONE:

DEFINITION OF FINANCIAL MANAGEMENT AND ACCOUNTING

Financial Management is a discipline concerned with the generation and allocation of scarce
resources (usually funds) to the most efficient user within the firm (the competing projects)
through a market pricing system (the required rate of return).

A firm requires resources in form of funds raised from investors. The funds must be allocated
within the organization to projects which will yield the highest return.

SCOPE OF FINANCE FUNCTIONS

The functions of Financial Manager can broadly be divided into two: The Routine functions
and the Managerial Functions.

1. Managerial Finance Functions

Require skillful planning, control and execution of financial activities. There are four important
managerial finance functions. These are:

(a) Investment of Long-term asset-mix decisions

These decisions (also referred to as capital budgeting decisions) relates to the allocation of funds
among investment projects. They refer to the firm's decision to commit current funds to the
purchase of fixed assets in expectation of future cash inflows from these projects. Investment
proposals are evaluated in terms of both risk and expected return.

Investment decisions also relates to recommitting funds when an old asset becomes less
productive. This is referred to as replacement decision.

(b) Financing decisions

Financing decision refers to the decision on the sources of funds to finance investment projects.
The finance manager must decide the proportion of equity and debt. The mix of debt and
equity affects the firm's cost of financing as well as the financial risk. This will further be
discussed under the risk return trade-off.

(c) Division of earnings decision

The finance manager must decide whether the firm should distribute all profits to the
shareholder, retain them, or distribute a portion and retain a portion. The earnings must also be
distributed to other providers of funds such as preference shareholder, and debt providers of
funds such as preference shareholders and debt providers. The firm's divided policy may
influence the determination of the value of the firm and therefore the finance manager must
decide the optimum dividend - payout ratio so as to maximize the value of the firm.

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(d) Liquidity decision

The firm's liquidity refers to its ability to meet its current obligations as and when they fall due.
It can also be referred as current assets management. Investment in current assets affects the
firm's liquidity, profitability and risk. The more current assets a firm has, the more liquid it is.
This implies that the firm has a lower risk of becoming insolvent but since current assets are
non-earning assets the profitability of the firm will be low. The converse will hold true.

The finance manager should develop sound techniques of managing current assets to ensure
that neither insufficient nor unnecessary funds are invested in current assets.

2. Routine functions

For the effective execution of the managerial finance functions, routine functions have to be
performed. These decisions concern procedures and systems and involve a lot of paper work
and time. In most cases these decisions are delegated to junior staff in the organization. Some
of the important routine functions are:

(a) Supervision of cash receipts and payments

(b) Safeguarding of cash balance

(c) Custody and safeguarding of important documents

(d) Record keeping and reporting

OBJECTIVES OF A BUSINESS ENTITY

Any business firm would have certain objectives which it aims at achieving. The major goals of
a firm are:

• Profit maximization

• Shareholders' wealth maximization

• Social responsibility

• Business Ethics

• Growth

(a) Profit maximization

Traditionally, this was considered to be the major goal of the firm. Profit maximization refers to
achieving the highest possible profits during the year. This could be achieved by either
increasing sales revenue or by reducing expenses. Note that:

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Profit = Revenue – Expenses

The sales revenue can be increased by either increasing the sales volume or the selling price. It
should be noted however, that maximizing sales revenue may at the same time result to
increasing the firm's expenses.

The pricing mechanism will however, help the firm to determine which goods and services to
provide so as to maximize profits of the firm.

The profit maximization goal has been criticized because of the following:

(a) It ignores time value of money

(b) It ignores risk and uncertainties

(c) it is vague

(d) it ignores other participants in the firm rather than the shareholders

(b) Shareholders' wealth maximization

Shareholders' wealth maximization refers to maximization of the net present value of every
decision made in the firm. Net present value is equal to the difference between the present
value of benefits received from a decision and the present value of the cost of the decision.
(Note this will be discussed further in Lesson 2).

A financial action with a positive net present value will maximize the wealth of the
shareholders, while a decision with a negative net present value will reduce the wealth of the
shareholders. Under this goal, a firm will only take those decisions that result in a positive net
present value.

(c) Social responsibility

The firm must decide whether to operate strictly in their shareholders' best interests or be
responsible to their employers, their customers, and the community in which they operate. The
firm may be involved in activities which do not directly benefit the shareholders, but which will
improve the business environment. This has a long term advantage to the firm and therefore in
the long term the shareholders wealth may be maximized.

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(d) Business Ethics

Related to the issue of social responsibility is the question of business ethics. Ethics are defined
as the "standards of conduct or moral behaviour". It can be thought of as the company's
attitude toward its stakeholders, that is, its employees, customers, suppliers, community in
general, creditors, and shareholders. High standards of ethical behaviour demand that a firm
treat each of these constituents in a fair and honest manner. A firm's commitment to business
ethics can be measured by the tendency of the firm and its employees to adhere to laws and
regulations relating to:

i. Product safety and quality

ii. Fair employment practices

iii. Fair marketing and selling practices

iv. The use of confidential information for personal gain

v. Illegal political involvement

vi. bribery or illegal payments to obtain business

(e) Growth

This is a major objective of small companies which may even invest in projects with negative
NPV so as to increase their size and enjoy economies of scale in the future.

AGENCY THEORY

An agency relationship may be defined as a contract under which one or more people (the
principals) hire another person (the agent) to perform some services on their behalf, and
delegate some decision making authority to that agent. Within the financial management
framework, agency relationship exist between:

(a) Shareholders and Managers

(b) Debtholders and Shareholders

a) Shareholders versus Managers

A Limited Liability company is owned by the shareholders but in most cases is managed by a
board of directors appointed by the shareholders. This is because:

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i) There are very many shareholders who cannot effectively manage the firm all at the
same time.

ii) Shareholders may lack the skills required to manage the firm.

iii) Shareholders may lack the required time.

Conflict of interest usually occur between managers and shareholders in the following ways:

i) Managers may not work hard to maximize shareholders wealth if they perceive that
they will not share in the benefit of their labour.

ii) Managers may award themselves huge salaries and other benefits more than what a
shareholder would consider reasonable

iii) Managers may maximize leisure time at the expense of working hard.

iv) Manager may undertake projects with different risks than what shareholders would
consider reasonable.

v) Manager may undertake projects that improve their image at the expense of
profitability.

vi) Where management buy out is threatened. ‘Management buy out’ occurs where
management of companies buy the shares not owned by them and therefore make the company
a private one.

Solutions to this Conflict

In general, to ensure that managers act to the best interest of shareholders, the firm will:

(a) Incur Agency Costs in the form of:

i) Monitoring expenses such as audit fee;

ii) Expenditures to structure the organization so that the possibility of undesirable

management behaviour would be limited. (This is the cost of internal control)

iii) Opportunity cost associated with loss of profitable opportunities resulting from
structure not permit manager to take action on a timely basis as would be the case if manager
were also owners. This is the cost of delaying decision.

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(b) The Shareholder may offer the management profit-based remuneration. This
remuneration includes:

i) An offer of shares so that managers become owners.

ii) Share options: (Option to buy shares at a fixed price at a future date).

iii) Profit-based salaries e.g. bonus

(c) Threat of firing: Shareholders have the power to appoint and dismiss managers which is
exercised at every Annual General Meeting (AGM). The threat of firing therefore motivates
managers to make good decisions.

(d) Threat of Acquisition or Takeover: If managers do not make good decisions then the
value of the company would decrease making it easier to be acquired especially if the predator
(acquiring) company beliefs that the firm can be turned round.

b) Debt holders versus Shareholders

A second agency problem arises because of potential conflict between stockholders and
creditors. Creditors lend funds to the firm at rates that are based on:

i. Riskiness of the firm's existing assets

ii. Expectations concerning the riskiness of future assets additions

iii. The firm's existing capital structure

iv. Expectations concerning future capital structure changes.

These are the factors that determine the riskiness of the firm's cashflows and hence the safety of
its debt issue. Shareholders (acting through management) may make decisions which will
cause the firm's risk to change. This will affect the value of debt. The firm may increase the
level of debt to boost profits. This will reduce the value of old debt because it increases the risk
of the firm.

Creditors will protect themselves against the above problems through:

a. Insisting on restrictive covenants to be incorporated in the debt contract. These

covenants may restrict:

• The company’s asset base

• The company’s ability to acquire additional debts

• The company’s ability to pay future dividend and management remuneration.

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• The management ability to make future decision (control related covenants)

b. if creditors perceive that shareholders are trying to take advantage of them in unethical
ways, they will either refuse to deal further with the firm or else will require a much higher
than normal rate of interest to compensate for the risks of such possible exploitations.

It therefore follows that shareholders wealth maximization require fair play with creditors. This
is because shareholder’s wealth depends on continued access to capital markets which depends
on fair play by shareholders as far as creditor's interests are concerned.

Types of Efficiency

Efficient market hypothesis can be explained in 3 ways:

a) Allocative Efficiency

A market is allocatively efficient if it directs savings towards the most efficient productive
enterprise or project. In this situation, the most efficient enterprises will find it easier to raise
funds and economic prosperity for the whole economy should result.

b) Operational Efficiency

This concept relates to the cost, to the borrower and lender, of doing business in a particular
market. The greater the transaction cost, the greater the cost of using financial market and
therefore the lower the operational efficiency. Transaction cost is kept as low as possible where
there is open competition between broker and other market participants. For a market to be
operationally efficient, therefore, we need to have enough market markers who are able to play
continuously.

c) Information Efficiency

This reflects the extent to which the information regarding the future prospect of a security is
reflected in its current price. If all known (public information) is reflected in the security price,
then investing in securities becomes a fair game. All investors have the same chances mainly
because all the information that can be known is already reflected in share prices. Information
efficiency is important in financial management because it means that the effect of management
decision will quickly and accurately be reflected in security prices. Efficient market hypothesis
relates to information processing efficiency. It argues that stock markets are efficient such that
information is reflected in share prices accurately and rapidly.

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Forms of Efficiency

Informational efficiency is usually broken down into 3 different levels (forms):

a. Weak form level of efficiency

This level states that share prices fully reflect information in historic share price movement and
patterns (past information/historic information). If this hypothesis is correct, then, it should be
possible to predict future share price movement from historical patterns. E.g. If the company’s
shares have increased steadily over the past few months to the current price of Shs.30, then this
price will already fully reflect the information about the company’s growth and therefore the
next change in share prices could either be upward, downward or constant with equal
probability.

b) Semi-Strong form level of Efficiency

This level states that share prices reflects all available public information. (past and present
information). If the market has achieved this level, then fundamental analysis will not enable
investors to earn consistently higher than average returns. Fundamental analysis involves the
study of company’s accounts to determine its theoretical value and thereby find any
undervalued share. Fundamental theory states that every share in the market has an intrinsic
value, which is equal to the present value of cash flows expected from the security.

c) Strong form level of Efficiency

This level states that price reflects all the available public and private information (past, present
and future information). If the hypothesis is correct, then, the mere publication of information
that was previously confidential should not have impact on share prices. This implies that
insider trading is impossible. It follows therefore, that in order to maximize shareholders’
wealth, managers should concentrate on maximizing the NPV of each investment.

Definition of Accounting

Accounting is defined as a process of identifying, recording, classifying, summarizing,

reporting and keeping of financial information. This process entails the following;

Identifying: This concerns looking or observing transactions which are of financial nature, so
as to record them in the books of account. The information to be identified may include sales
transactions, purchases transactions, expenses transactions etc.

Recording: The information identified is recorded in a systematically manner (according to the

time) of occurrence within the organisation. This is with reference to timing of date, period etc.

Classifying: The financial information is then grouped into similar categories. The categories
can include expenses, capital expenditures, assets, liabilities etc.

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Summarizing: The financial transactions in an organisation are quick enormous. As such it is
necessary that once they are recorded, they should be summarized in order to bring out
meaningful information to the users.

Reporting: The information summarized above is then reported to the stakeholders for use to
make various decisions. Reporting is done when financial statements such as statement of
financial performance, statement of financial position, statement of changes in equity, statement
of cash flows and others are generated and published.

Keeping: The financial information used for recording is then kept safely for future reference
or comparison

Stakeholders of Financial Information

Stakeholders are users of financial information. They are organisations or individuals who are
affected by the information generated by an organisation. The stakeholders are divided into two
categories as follows;

a) Internal Stakeholders
b) External stakeholders

Internal Stakeholders

These are the stakeholders who are directly affected by the activities of an organisation. The
stakeholders in this category include;

i. The Management: These are the people who are entrusted with stewardship management of
an enterprise. They manage the organisation by putting the capital of that organisation for the
best interest of the capital providers (Owners).

ii. The Owner (s): These are the individuals/organisations who provide equity for starting up
an organisation. They are interested in seeing the organization improve in terms of profitability
(profit maximisation) and wealth (shareholders wealth maximisation)

iii. The Employees: These are the people who work for an organisation. They perfume duties
assigned to them by the management.

External Stakeholders

These are the stakeholders who do not directly affect the operations of an organisation. The
stakeholders include;

i. Investors: These are the individuals or organisations that commit funds for a return. They are
interested in seeing that the organisation give them high returns for their investments

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ii. Suppliers: These are the stakeholders who supply to an organisation goods for sale or use on
cash or credit (creditors). They are interested on the liquidity of an organisation so as to
determine whether the organisation can make prompt payment to them

iii. Customers: These are the stakeholders who buy goods or services from an organisation.
They are also known as debtors when they buy the goods on credit. They are interested on
being charged fairly low prices, being given quality products etc.

iv. Competitors: These are the firms that deal in similar products or services. They are
interested in strategy bench marking

v. Financial Institutions: These are the institutions that are responsible regulating the industry
of operation like the capital markets authority or banking institutions the provide capital. They
are interested in ensuring that the organisation complies with set rules and regulations for
practice.

Difference between Financial Accounting and Financial Management Accounting

Financial accounting is closely linked to cost accounting or management accounting.

However, the following are notable key difference:

i. Financial accounting is a regulatory/mandatory requirement as oppose to management

accounting which is a management requirement

ii. Financial accounting is done periodically i.e. after every one year end (periodicity concept)
while management accounting is done regularly i.e. daily/weekly/monthly reports can be
required by management for decision making purpose

iii. In some cases financial accounting is taken to be used by external stakeholders while
management accounting is taken to be used by the internal stakeholders

Conceptual Framework of Financial Management

A conceptual framework of accounting is a coherent system that describes the nature purpose of
accounting and how certain transactions are treated in Financial Management. It has the
following advantages;

i. Assist in development of coherent set of standards built upon same foundation

ii. Assist in resolution of new and emerging issues of accounting

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iii. Assist in quick resolution of practical problems in accounting by reference to the basic theory

iv. It is a guide for the development of future financial accounting standards

v. It assists users of financial reports in interpreting information contained in the financial

statements prepared through consistency

A. Elements of financial Statements

The elements of financial statement include the assets, liabilities, capital, revenue, expenses,
and net profit/net loss.

Assets

The assets are economic resources owned by an organisation as a result of past transaction
which are to be used to confer future economic benefit (s) to the organisation.

Characteristics of assets ASS

Classification of assets

Fixed Assets: They are to be used for a long period of time in an organisation. They include
land, buildings, motor vehicles, equipment, plants and machinery, furniture e.t.c

Current Assets: They are to be used for a short period of time (less than one year). They include
stock, debtors, bank balance, and cash in hand e.t.c

Tangible assets: They are assets with physical existence e.g the fixed assets

Intangible assets: They are assets without physical existence e.g good will

Fictitious assets: They are capital expenses converted to assets e.g preliminary expenses

Liabilities

These are economic obligations arising to an entity as a result of past transaction which will
involve future settlement by the resources of an organisation

Characteristics of Liabilities ASS

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Categories of liabilities

Long term liabilities: They are liabilities which take a long time to settle within an organisation
e.g. long term loan

Current liabilities: They are liabilities which take a short period to settle in an organisation e.g.
creditors

Contingent liabilities: They are liabilities accrue to an organisation following a condition e.g.
court cases

B. Qualitative Characteristics of Financial Information

These are the attributes that make financial information useful to its stakeholders. They
include:

i. Understand ability: Financial information generated should be easily understood by the

users. This is usually facilitated by including foot notes to the financial statements

ii. Reliability: information is said to be reliable when it has predictive value. The users can use it
to predict future performance of an entity

iii. Relevance: Information is relevant when users can depend on it to make a given decision.
Relevance is important as much as there is timeliness (time value)

iv. Materiality: information is material when it error/omission can affect decision making

v. Comparability: Information generated should be easily compared with other similar entities

LIMITATIONS OF ACCOUNTING INFORMATION ASS

FINANCIAL MANAGEMENT ACCOUNTING CONCEPTS

This level contains the underlying assumptions used in accounting. The accounting concepts
include;

i. Business Entity Concept: Accountants hold a business as an entity separate from

its owners. This is regardless of whether it is a sole proprietorship or a limited company

ii. Duality Concept: This requires that every transaction has to be recorded twice in the
accounts. It forms the basis for double entry system

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 iii. Accrual/Matching Concept: This requires that revenues and costs must be recognized as
they are earned/incurred. The two must therefore be matched together in the profit and loss
account relating to their period

iv. Going Concern Concept: This implies that business will continue to be in operation into
foreseeable future and that there is no intention to end operations in the near future

v. Materiality Concept: This concept states that an item is material if its omission or
misstatement will affect decision making ability by the financial information users

vi. Consistency Concept: this concept requires that similar items should be accorded similar
treatment and treated similarly in the different financial period

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