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FINANCIAL STATEMENTS AND ACCOUNTING MECHANISMS

Financial disclosure has become a critical function for businesses. Today, firms are under pressure from various stakeholders (financial markets, the State, clients, employees, etc.) and are therefore engaged in information policies, in order to meet changing requirements. Thus, we can see that annual reports are providing a growing supply of information. It covers not only the needs of corporate governance, through the establishment of a management report and description of the principal organs of corporate control (for example, the structure of the Board and capital, the firm’s Audit committee, the salaries, etc.), but also those related to the firm’s environmental responsibility. Other documents and summary tables - the financial statements - also provide various business partners with a wide range of information about the nature and performance of the firm’s activity. They perform various functions. On the one hand, they can serve as evidence or control tools for monitoring the performance of contracts between the firm and its partners. On the other hand, they provide investors and other users with relevant information for economic decision making. Financial statements are therefore supposed to better reflect the economic situation of the company so that investors can properly evaluate the performance (section 1.1). In order to produce useful and relevant information, the preparation of financial statements is based on a number of principles, uses its own mechanisms of information processing (section 1.2) and allows a rigorous synthesis.

1.1 FINANCIAL STATEMENTS

The objective of financial statements is to inform all stakeholders about the business situation at a given date. We can identify several groups of regular users of financial statements. The current or potential owners of the company (shareholders for limited liability companies) are the first to be concerned by the financial statements. They are interested in the performance of the company in order to measure the profitability of their investment. On a long-term basis, it is also useful to know the evolution of business investments in order to evaluate if the company will be able to generate profits in the future, and therefore to distribute dividends. For similar reasons, the management team is also concerned by the information contained in the financial statements. Indeed, shareholders have delegated the management of their capital invested to them. Financial statements therefore provide a means for controlling the financial performance of the management team, by informing the owners of the quality of their decisions. In that matter, financial analysts are an important group of users. Their objective is to assess the company as a whole and to make recommendations on whether to invest in it or not. Many banks and other current and potential investors use the recommendations of these experts for decision-making purposes. Thus, the company must necessarily supply them with the most complete information possible. Although analysts do not exclusively base their decision on the financial statements, the latter represent a fundamental element of their analysis.

Other users of financial statements are the bankers, suppliers and other creditors who wish to know whether the company is - and will be - able to meet its financial commitments. This is related to both the reimbursement of debts and the payment of interest on loans. Moreover, the State, local authorities and social organizations refer to the accounting records to calculate the contributions and corporate taxes payable by the company. Finally, employees and their representatives also need information on the situation of the firm. It allows them to determine the outlooks on job security and define their social demands.

All these groups of users need information, in near real time, on the financial situation, performance and the status of the company’s cash account.

The financial situation consists in identifying the assets used by the company (lands, buildings, machinery, vehicles, inventory, receivables, and cash) and the financial resources, evaluating them and analyzing the evolution of their value over time.

The financial situation consists, at first, in identifying the assets used by the company (for example, lands, buildings, machinery, vehicles, inventory, receivables and cash), evaluating them and analyzing the evolution of their value over time. Meanwhile, the evolution of the financial resources, which enabled the acquisition of those assets, must also be carefully monitored. For instance, the more the company gets into debt, the more difficult it will be to reimburse its debts. Even a slight increase in debt can have significant consequences on the business, when a bank decides that it has crossed a particular risk threshold and, accordingly, increases the interest rate for all future loans.

The performance or the net income shows whether the activity of the firm as a whole is profitable, which is normally the main objective of the management team.

The performance or the net income shows whether the activity of the firm as a whole is profitable, which is normally the main objective of the management team. Here, profitability means that the money invested by the owners can make profits and thus increase their wealth. Entrusted by the owners to achieve this objective at any cost, the management of the company has to follow the change in income, using the financial statements, to ensure that the decisions are in accordance with the target fixed by the owners. If this is not the case, the regular monitoring of income enables corrective measures to be taken, before the situation of the company deteriorates.

The cash account includes cash, bank deposits and a number of other monetary elements which the company could liquidate within a very short span of time, usually in less than 3 months.

The cash account includes cash, bank deposits and a number of other monetary elements which the company could liquidate within a very short span of time, usually in less than 3 months. The objective here is different from the profit, that is to say it is not to maximize it.¹ However, it is important to have enough cash at all times, to meet financial deadlines, i.e. reimburse loans, pay the invoices of suppliers, salaries and taxes, etc. Failure to meet financial deadlines and the inability of the company to meet its commitments may result in insolvency, or even the outright liquidation of the company shortly afterwords. The analysis of the status and evolution of cash flow is therefore of high importance for the survival of the company.

Under the international accounting standards (IAS/IFRS), it is compulsory to publish at least one table dedicated to the analysis of each of these elements. Sections 1.1.1 to 1.1.3 explain the content and format of these tables, as well as the relationships between them.

1.1.1 Balance Sheet

Content

The balance sheet is the basic summary table, which presents the financial situation of a company at a given date.

The balance sheet is the basic summary table. It presents the financial situation of a company at a given date. It is measured by the difference between all assets of the company and all its liabilities (obligations to do, to pay) and represents the net value of what belongs to the owners, the shareholders’ equity. The balance sheet therefore presents three main elements: assets, liabilities (or obligations) of the company and its shareholders’ equity.

An asset is an item, a resource controlled by the firm from which future economic benefits are expected. It has a positive value for the company.

An asset is a resource (controlled by the firm) from which the company expects future economic benefits and has a positive value for it.² The future economic benefit is the potential of the asset to contribute directly or indirectly to cash flows for the benefit of the company. The assets of the balance sheet are primarily the properties of the company, i.e. what the company is at a given date in purely physical terms. It included lands, buildings, industrial equipment, furniture, inventory and cash. There are also intangible assets: either rights (patents or licenses, for example), or financial assets (equity investments, receivables, short-term investments or bank deposits).

A liability is an obligation to do or to pay. It has a negative value for the company.

Liabilities are obligations to do or to pay. They have a negative value for the company, since, at maturity, the company will have to reimburse them to third parties. It includes mainly bank loans and overdrafts, accounts payables and tax liabilities. We can add other liabilities whose exact timings or amounts are not known, but their existence is sure and certain, such as pension obligations, long-term product warranties or provisions for legal risks.

The shareholders’ equity is the difference between assets and liabilities. It represents the net value of the firm.

The difference between assets and liabilities results in the shareholders’ equity. It is the net value of a firm: it represents the value of what owners possess at the time of the establishment of the balance sheet. In normal circumstances, this value must at least include the subscribed capital. It is the initial input of owners, i.e. the capital invested at the creation of the company and the contributions made during each capital increase. Inasmuch as the profits over time are not fully paid as dividends, we should also find the part not distributed under equity reserves.

The net income is the balance between creation and consumption of wealth over a period (revenues - expenses).

The shareholders’ equity is also affected by each consumption (expense) or creation of wealth (revenue) in the company. The balance between creation and consumption of wealth over a period is the net income (Revenues - Expenses = net Income). If it is positive, the net creation of wealth returns to the owners and the value of their investment increases: this is known as a profit. If negative, it is the opposite: the value of the investment declines and is known as a loss. The net income is therefore the basic indicator of wealth creation for the company.

Format IAS 1 standard does not impose any compulsory detailed format of presentation. It rather indicates some principles to follow:

• The separate presentation of assets, liabilities and shareholders’ equity.

• The distinction between current and non-current assets and current and long-term liabilities. In practice, the threshold is usually of one year: elements with a residual maturity in the company of less than one year are considered to be current items, others as non-current.

• The distinction, among others, between:

• lands, buildings and equipments

• intangible assets, such as licenses, patents, software

• financial assets

• inventory

• receivables

• cash and equivalents

• accounts payables

• provisions for contingencies, i.e. those obligations whose exact timings and amounts are not yet known

• financial debts (especially bonds and bank loans)

• shareholders’ equity, including the initial input by the owner (equity capital), the non-distributed income (reserves) and the net income/loss of the accounting period.

• The possibility of a finer classification, if it improves the understanding of the financial situation of the company.

• The presentation of values for at least one comparative year, which allows the reader to compare current values with those of the previous accounting period.

Figure 1.1 Balance sheet structure: Anglo-Saxon format.

For the actual presentation of the balance sheet, several alternatives are generally used. The choice depends mainly on the accounting tradition of the country in which the company operates (e.g. UK, France, Germany, etc.).

The Anglo-Saxon tradition presents the balance sheet in a list format, which has for resultant the shareholders’ equity at the bottom of the table. This balance sheet first indicates the assets, from which it deducts the obligations or liabilities. This leads to a balance (Net Assets), which represents the net value of the firm, and corresponds to the value of the shareholders’ equity (see Figure 1.1).

In the consolidated balance sheet³ of BP (British Petroleum) at 12/31/2008 (see Figure 1.2), the amount of Non-Current Assets of $161,854m is clearly distinguished from that of the Current Assets of $66,384m. The total assets are therefore of $228,238m. After deduction of Liabilities of $136,129m, the Net Assets amount to $92,109m. This represents the total Equity presented on the bottom line. In the UK, Current Assets and Current Liabilities are generally grouped together, as is the case in this example where they amount to $69,793m. We can thus easily calculate an indicator that measures the Net Current Liabilities of $3,409m (69,793 − 66,384). Bonds maturing in the short term are thus more than covered by liquid assets in the same time frame. This is an important indicator of financial stability in the short term.

Figure 1.2 Extract of the BP annual report 2007, values in millions of dollars.

According to French tradition, which is also that of most countries of continental Europe, goods and assets possessed by the company are presented in the Assets section, on one side of the balance sheet, and obligations and equity are grouped under the Liabilities section, on the other side of the balance sheet. The Liabilities therefore represent all funds invested in the company, whether on a limited (debt and provisions) or unlimited period (equity). The Assets represent the form in which financial resources are invested and employed in the business. Of course, it is not always possible to create a direct link between a given resource and a specific application. But originally, any asset had to be financed in one way or another and there was therefore a liability of corresponding value. That is why Total Assets and Total Liabilities are always for the same amount (see Figure 1.3).

Figure 1.3 Balance sheet structure, French format.

In the French balance sheets, the term Liability covers two different meanings, which can be confusing. In the meaning mentioned above, Liability refers to all the financial resources available to the entity. But Liabilities can also designate the obligations of the entity to third parties, whether they are current or non-current. For this reason, the concept does not include equity. These two meanings can be used simultaneously by the same entity in the same balance sheet, as illustrated by the annual balance sheet of Lafarge Group in 2007 (see Figure 1.4).

In Figure 1.4, we can easily identify the basic structure of the balance sheet: Assets at the top and Liabilities below. The two major categories of Assets are Non-current Assets (€21,490m) and Current Assets (€6,818m), giving Total Assets of €28,308m at 12/31/2007. The liability is structured into three sections: first, equity, here called Shareholders’ equity (€12,077m), then non-current obligations under the designation Non-current Liabilities (€10,720m) and current obligations, under the heading Current Liabilities (€5,51 1m). The bottom line of the balance sheet entitled Total Liabilities includes both current and non-current liabilities and shareholders’ equity (€28,208m).

Like that of BP in the previous example, this presentation enables one to observe easily, for example, whether the values achievable in the short term (€6,818m) are sufficient to cover short-term obligations (€5,511m). The situation of Lafarge seems entirely satisfactory, since there is a surplus (€1,307m).

Figure 1.4 Extract of the Lafarge, Balance Sheet, annual report, 2007.

The current/non-current approach goes as far as to separate, a priori, within a single homogeneous element, the short-term and the long-term parts. Thus, in the balance sheet of Lafarge, we find in both Non-Current and Current Liabilities, the line Financial Liabilities, which essentially refers to the financial debt of the group. The part of this debt that matures within one year is allocated to Current Liabilities (€1,762m) and the part that matures in more than one year to Non-Current Liabilities (€8,347m). Reading financial statements therefore requires great vigilance. Most terms are not mandatory and companies can choose others.

1.1.2 Income Statement (or Profit and Loss Account)

One of the two areas of the balance sheet that deserves a very special attention is the change in equity between two fiscal periods. They may increase or decrease as a result of specific operations, such as increases or reductions of capital. The issuance of new shares is an example of a capital increase in a public company. The net income has also an impact on the change in equity. It reflects the amount of net creation or consumption of wealth of the company by its activity or other events between two fiscal periods. It measures the economic performance of the company. All users of financial statements need maximum information on the composition of the result. The second summary table, the profit and loss account (or income statement), gives details about the different elements of expenses and revenues.

A revenue is an operation that increases the wealth of the company.

An expense is a consumption of resources that impoverishes the company.

According to their call to make the connection between two balance sheets, therefore between two closing dates, the values in the income statement represent only the flows recorded over the period. A transaction that increases the wealth of the company is called a revenue and the consumption of resources that impoverishes the company is an expense. For example, the revenue that is generally the most important, i.e. the turnover, is not the turnover of the closing date, but the one achieved during the period to which the income statement refers. It is the same for all other revenues and expenses.

The exact content of the income statement is not completely detailed. In all cases, according to the IAS 1 standard, the requirements are to include:

• Financial expenses, representing the cost of financing the entity.

• Revenues from ordinary activities, that is to say, sales and all other revenues that the entity realized in the framework of its activity.

• Income tax.

• Net income of the accounting period.

• Net earnings per share in two variants.⁴

Thus, in the income statement, there is no requirement to give the details of expenses related to the activity. However, the standard strongly recommends that details be provided for one of the following classifications:

• The classification of expenses according to their nature. On these grounds, we distinguish in particular:

• consumption of raw materials and other inventory items;

• wages and salaries (i.e. employee costs);

• depreciation and amortization of the value of different goods during the period.

• The classification of expenses by function. In this sense, we distinguish:

• cost of sales, corresponding to the production cost of goods sold or acquisition cost of goods sold;

• administrative expenses of the entity;

• distribution expenses;

• research and development expenses, if the entity has the corresponding activity.

Both patterns lead necessarily to the same net income. The difference lies in the allotment of expenses. For example, employee costs in an industrial company are divided between employees in production, administration and commercial services. In an income statement with a classification of expenses by nature, all these costs are grouped into one item, listed as wages and salaries. However, in an income statement with a classification of expenses by function, such costs are spread over several items: wages of production staff are included in cost of goods sold; those of administrative staff in administrative expenses; and those of commercial staff in distribution expenses.

The income statement of British Petroleum (see Figure 1.5) is an example of a classification of expenses according to their function in the company. The flexibility of the IAS 1 standard allows the Group to bring together certain items, to detail others and select the most appropriate designations to a specific economic situation.

For example, distribution and administrative expenses are grouped on one line ($15,412m). The group also discloses two intermediate result: the "Profit before interest and taxation. . . and Profit for the year".

For the income statement, like the balance sheet, entities may also choose between a single list presentation and a presentation in two columns. Most entities that prepare their accounts according to IFRS standards choose the first presentation. It consists in starting from sales and other ordinary income, and deducting expenses related to business activity. Other expenses are then subtracted, then the financial result and, finally, the tax on profits. The net income of the period is obtained by adding and subtracting different elements listed in Figure 1.5.

The second presentation is similar to that of the balance sheet, opposing assets and liabilities of the entity: it consists in putting side by side the expenses and revenues in two separate columns. It is rarely used today.

1.1.3 Cash-Flow Statement

The Cash flow statement details all the operations that generated cash flows during the fiscal period.

Figure 1.5 Income statement 2008, British Petroleum.

It is indeed important to compare the cash position at the date of the balance sheet with that of the previous closing period. But the mere comparison of balances is not enough, because many reasons can explain changes in the balance. The aim of the Cash flow statement is to detail all the transactions that generated cash flows during the financial year and thus create a link between the amount of the opening and closing cash balances. As in the income statement, all the values of the cash flow statement are flows for a period and do not represent the operations performed only at the closing date. In the cash-flow statement, the flows are classified into three categories:

• Cash flows from operating activities. They are related to transactions in connection with the creation of sales or other ordinary income, and not to flows of investment or financing. They are mostly all flows related to the current activity (cost of sales, administrative and distribution expenses).

• Cash flows from investing activities. These are the cash flows related to a movement in non-current assets. Especially, there are the expenditures related to investments (intangible, tangible and financial), including land, buildings, furniture and financial assets. These flows also take into account all operations related to the disposal of non-current assets. These flows are usually not important when it comes to sales of assets at the end of their useful life, such as machinery at the end of its technological life. However, they can be quite significant when the entity disposes of land or financial investments whose value has probably increased significantly since their acquisition.

• Cash flows from financing activities. These are all flows associated with movements in equity contributions by the owners or in financial debt. They are mainly increases or reductions of capital, payment of dividends to shareholders, and receipt or repayment of financial loans.

Figure 1.6 Cash flow statement 2008, Birtish Petroleum.

The presentation of the cash flow statement is standardized by the IAS 7. Figure 1.6 shows, for the Britsh Petroleum Group, the three main sections: operating (here called operating activity), investing and financing activities.

The cash flow statement for British Petroleum at 12/31/2008 shows as basic information, relatively low in the table, that cash increased by $4,635m during 2008, reaching a level of $8,197m. This value of $8,197m corresponds to that shown in the balance sheet at 12/31/2008 in the line Cash and cash equivalent in the current assets of the balance sheet of the entity.

The increase of $4,635m is divided mainly into three parts:

• An increase of $38,095m related to operating activities. The current activity of the entity is generating cash flow and thus helps to finance at least part of the financial needs elsewhere.

• A cash outflow of $22,767m related to investment operations, mainly due to capital expenditure.

• A cash outflow of $10,509m related to financing activities. This amount is the balance of large movements due to the repayment of loans and the repurchase of shares.

British Petroleum has thus chosen to finance about half of its investments by current flows generated by the activity.

Without the cash flow statement, the analysis of the increase in cash of $4,635m (130% compared to the beginning of the period) would have been much more complicated or even impossible.

1.1.4 Distinction between Income and Cash

The analysis of the income statement and the cash-flow statement of British Petroleum shows that income and cash do not measure the same thing. The net income is a performance measure based on the commitments of the company, while cash flows reflect the cash receipts and disbursements. Thus, although during 2008 the financial performance (the profit) of the BP Group is $21,666m, the changes in its cash show an increase of $4,635m (Figure 1.6).

It is therefore imperative for the understanding of the accounting system to distinguish these two concepts, and that is the goal of Application 1.1. Starting with a statement of cash flows, it introduces, step-by-step information that is necessary to determine the net income of the Rafo Company for the same period. The first three steps are devoted to the calculation and analysis of the change in cash:

1. Status of cash during the year 2008

2. Calculating the change in cash due to only operating activities

3. Analysis of variation in cash.

The following steps add the missing information in order to determine the corresponding revenue or expense, and thus the operating profit:

4.The sales

5.The purchases

6.The consumptions

7.The amortizations.

An eighth step is to determine the net income of the period and analyze it in comparison with the change in cash. This concludes that these two indicators each measure a different aspect of the business situation and are bound together by a common starting point: the balance sheet.

APPLICATION 1.1

Cash Position

M. Ferrara and his partners are owners of the candy shop Rafo, which produces and sells mint and caramel candies. During the night of 12/31/2008 to 01/01/2009 a fire destroys almost all the accounting documents. Only some limited backup data is left. However, a report with 2008 cash inflows and outflows is still available.

Transaction of 2008 (in thousand Euros)

On 01/01/2008, Rafo had €5,000,000 on its bank account.

What is the Cash Position at the end of the Fiscal Year 2008? The cash position for 2008 corresponds to the initial cash position plus the sum of cash inflows minus the sum of cash outflows related to the fiscal year.

Cash Generated by the Operating Activity The objective is to analyze whether the main and recurring business is able to generate enough cash to enable the company to meet its obligations. It can therefore avoid the repeated use of external financing (loans, shares issuance) or even an insolvency situation when new funds are not available (when the current assets can no longer cover outstanding liabilities).

Generally speaking, the movements in operating cash must only include:

• operations related to the reporting period;

• operating activities strictly speaking, excluding financial transactions and investing operations.

APPLICATION 1.2

Which Cash Amount was Generated by 2008 Operating Activities?

Some transactions are not related to the operating activities of Rafo (purchase, transformation, packaging, sale):

• The sale of bonds (transaction 3). This operation is related to non-current financial assets - considering that the securities were not held for speculative reasons. This cash flow is related to the investing activity.

• Transactions 12, 13 and 14 are related to equity (dividends) or long-term debt (debt, financial charges). Those cash flows are related to the financing activity.

• The modernization of the packaging chain (transaction 15). This operation will have an impact on future periods (unlike salaries, this investment will generate economic benefits even after 12/31/2008). This expense represents an investment over 10 years into a non current asset. Therefore the cash flow must be related to the investing activity.

The cash flows generated by operating activities are as follows:

Cash inflows

Cash outflows

Analysis of Change in Cash There should be several comparisons: with previous years, with forecasts for 2008, with comparable companies, etc. However, in principle, the business of a company must be widely profitable in cash.

• Otherwise, other specific sources of finance (loans, etc.) must be anticipated. They include constraints (especially payment of dividends and interest on loans).

• It is the cash generated by the operating activities that enables a company to invest (direct payment or indirect financing via loan repayments).

APPLICATION 1.3

Analysis of Cash Flows

Rafo’s positions are as follows:

The investment into the packaging chain is entirely financed by the sale of securities and does not necessitate any debt contracting or other financial resources.

The cash surplus from the operating activity is used, on the one hand, to pay the interests from the debt and to repay debt, and, on the other, to pay a dividend to the shareholders who invested capital in the company.

Determination of the Operating Profit The universal convention for the recognition of net income is to recognize revenues and expenses when they are realized and not when cash is received or paid. The criteria used for the recognition is the transfer of risks and benefits associated with the ownership of property (see Chapter 2). In practice, that is usually the date of delivery for goods or the completion date for services, and this causes a lag between the cash flow date and that of recognition of income. Whenever a seller grants a settlement period (i.e. sale on credit) - for example, the product is registered for sale prior to payment - the good is therefore delivered to the buyer. The risks and benefits are thus transferred to the latter (the buyer) long before that client receives and pays the corresponding invoice. To determine the net income from cash flows, we must have all the elements related to the time lag of cash.

Regarding sales, at least part of the receipts of year N corresponds to sales during the previous year. Conversely, some of the sales in period N are still to be cash collected (credit sales), because the company provides terms of payments, and that should be taken into account when determining the profit made on sales of N. We must therefore know the amount of receivables at 01/01/N and 12/31/N (see Application 1.4). The amount of receivables at January 1 corresponds to sales made last year and must be deducted from the cash receipts of the period N to get the result. The amount of receivables at December 31 is added to the amount obtained because it corresponds to sales of N; however the cash receipt for that transaction has still not occurred. Thus:

Salesn = Cash receiptn + (Receivablesn − Receivablesn−1)

APPLICATION 1.4

Operating Activity (1): Determination of Sales

Let’s presume that the accounts receivable were 50,000 on 01/01/2008 and 40,000 on 12/31/2008. The 2008 sales are computed as follows:

The reasoning is similar for purchases of raw materials (see Application 1.5). The company probably has settlement deadlines that must be considered. This time, we must take into account liabilities towards suppliers, which correspond, at the beginning of the year, to purchases made during the previous period and are only paid during the current period. They should therefore be deducted from the disbursements of the period. However, we must add the amount of payables at the end of the period, as they reflect the purchases of the period N for which payment has not yet been made. Thus:

Purchasesn = Cash disbursmentsn + (Payablesn − Payablesn−1)

APPLICATION 1.5

Operating Activity (2): Determination of Purchases

On 01/01/2008 the accounts payable were 19,000 and on 12/31/2008 they were 13,000. The purchases of 2008 are computed as follows:

This amount corresponds to all the goods and services purchased in 2008.