Economic and Financial Accounting

Economic and financial analysis – 4ECTS Lesson 1A: Introduction to international accounting 1. Historical background The origins of accounting (Luca Pacioli, 15th centuries, worked for the Medici family and was the tutor of Leonardo da Vinci – he invented the double entry bookkeeping). What i...

Economic and financial analysis – 4ECTS Lesson 1A: Introduction to international accounting 1. Historical background The origins of accounting (Luca Pacioli, 15th centuries, worked for the Medici family and was the tutor of Leonardo da Vinci – he invented the double entry bookkeeping). What is accounting? Accounting exists to provide a service Accounting is a practical activity moving on changes in demand from users Accounting tends to be developed in different ways as a response to a particular environment Definition There’re several definitions, but Accounting Principles Board (US based institution) defines accounting as: a service activity, the function of which is to provide quantitative information, primarily financial in nature, about economic entities (one company or groups of companies) that is intended to be useful in making economic decisions, in making a resolved choice among alternative courses of action – 1970 A group of entities can be made even from two company (like holding, where there’s one that dominates the other) American Accounting Association defines accounting as: the process to identifying, measuring, and communicating information to permit informed judgments and decisions by users of the information – 1996 Identification – technical Measuring – attribution of a monetary value Communication – disclosure, very strong influenced by legislation, needs culture etc. Focus on definition of accounting It recognizes that accounting is a process It is concerned with economic information: while this is mainly financial, it also allows for non- financial information It is necessary to support informed judgments and decisions by the users Who are the users of economic information? Stakeholders (subjects that hold a stake, that have an interest in the company), they can be: - Internal (managers, employees et.) - External (suppliers, clients, prospective employees, state, tax authorities, shareholders) The goal of entities aimed at profit Make profits (or at least have more assets that liabilities) Create added value Give attention to shareholders vs. stakeholders Different roles of management’s duties in the circumstances (Bias: The managers can have the possibilities to chose one method or another within the law, to be more or less conservatives with the results – to pay less tax etc.) In any case, in a long-term perspective the goal of a company is to develop and remain a going concern. 1  Economic and financial analysis – 4ECTS What is a “going concern”? Means that the company will be strong and well alive in the future. A company that in this year generates losses is not necessarily going to close, but of course if it continuous to generate losses sooner or later will be liquidated. The financial accounting standards applies to companies that have living prospect even if they generate losses. Different users need different analyses Accounting can be divided into two things: Management accounting purposes are: - Budget control over revenues and costs, very important in this period of recession - Measure and improve productivity - Improve production process - Determine accurate product costs so that pricing decisions can be taken - Be able to face competition - Prepared for internal purposes - Needs to be kept secret for commercial reasons - No incentive to disguise the truth - No need of an external check - Estimates are acceptable - Used as a budgetary control over revenues and costs - Used to measure and improve productivity - Determine accurate product costs so that pricing decisions can be taken - No accounting principles for management accounting financial accounting Major differences between management and financial accounting Nature of reports produced Level of detail Regulations Reporting period (depending on legislation and on company laws) Time horizon Range and quality of information Financial accounting Must be audited externally, Based on accounting principles, Listed company – azienda quotata Formal and precise, estimates to be explained. what is an audit? An audit is a formal examination of a company’s financial records, typically conducted by an external certified consultant or an auditing firm. For: listed companies, audits are mandatory and must be performed by a certified audit firm. non-listed or smaller companies, audits may not be compulsory and can be conducted by individual certified professionals. Auditors are responsible for reviewing the company’s financial statements and verifying the accuracy of the numbers. In some countries, statutory auditors (a committee of 3 or 5 individuals) may also be involved. They not only check the financial records but also ensure compliance with legal requirements related to environmental, social, and other regulatory matters. While statutory auditors are external to the company, they are paid by the company for their services. 2  Economic and financial analysis – 4ECTS Terminology distinction Finance – what’s related to the financial sources Financial management – the management of the financial sources Financial accounting – the same as below but with accounting Accounting regulation and accounting profession Accounting may be regulated in different ways, for example by: The market, government, parliament Stock exchanges Accounting profession Committees of members from large enterprises The accounting profession The accounting profession is responsible for international and national accounting principle, as well as the audit profession. National accounting principles are called “LOCAL GAAP”, that is “Generally Accepted Accounting Principle.” Terminology Lesson 1B: International financial reporting standards (IFRS) overview Harmonization: why? harmonization means aligning accounting standards and practices Il processo serve per: (e sono anche le issue) across different countries. making it Comparison of financial accounting data easier for investors, companies, and Distribution of financial resources regulators to compare financial information from different countries. Regulation and controls Audit issues, especially in case of international groups International market of shares, bonds and other financial instruments International M&A market (merging and acquisition) International Accounting: the 4- cluster theory (David and Brierley, 1978) International accounting for the UK is kind of a tradition. Four clusters of accounting systems: 1. Roman-Germanic 2. Common-law 3. Socialist 4. Philosophical-religious 3  Economic and financial analysis – 4ECTS Roman-Germanic Latin speaking European countries because the legal system is the same. The Germanic system comes from the Latin roman law. The legal system of the Latin speakers and Germans belongs to western-continental Europe. It’s base on written laws. Common-law The United Kingdom and common-law countries had no written constitution. In those countries is important the professional practice it follows better the changing in the market. Socialist All the countries that belonged to the CCCP. This could also be a country where the rules of the state in the economic choice is very strong. The state is a very influence in the economy. This could be extended to other Scandinavian countries. Philosophical-religious in some countries the believes could influence the rules by which the companies must calculate the distribution or the calculation of interests (for examples). Nobes’ classification (1983) IMPORTANT TO REMEMBER Is a framework for categorizing different approaches to economic development based on a country’s institutional environment and economic characteristics. Classes: 1. Micro-fair-judgmental, commercially driven 2. Macro-uniform, Government-driven, tax dominated The three key categories in Nobe’s Classification are: 1. Market-Oriented Economies These economies rely on the market mechanism as the primary driver of economic activities. The allocation of resources, production decisions, and pricing are largely determined by the forces of supply and demand with minimal government intervention. Characteristics: Strong reliance on private ownership. Limited government intervention in pricing and production. Free-market competition promotes efficiency. Examples of countries: The United States, Western European countries. 2. Centralized (Command) Economies In centralized or command economies, the government plays a dominant role in decision-making processes. State control is prominent in determining production, distribution, and pricing, often through five-year plans or central directives. Characteristics: State ownership of land and enterprises. 4  Economic and financial analysis – 4ECTS Centralized decision-making regarding what and how much to produce. Government controls pricing, often disregarding market conditions. Examples of countries: Soviet Union (before its collapse), China Financial reporting for non-listed company Companies that are not listed on stock exchanges are still required to prepare financial statements according to national legislation. These regulations are often influenced by European Union (EU) directives, which outline governance and reporting standards for businesses across member states. The EU political authorities establish and approve these rules, aiming to harmonize financial reporting across the region to ensure transparency, comparability, and consistency in financial statements. Ex: “How to measure the value of an industrial building”. The directive said to member states that they could singularly choose between the historical cost of the buildings less its depreciation OR the FAIR VALUE, which is the MARKET VALUE. The fair value can be higher than the historical cost less the depreciation. However, the EU directive gave to the single member state the ability to choose. The Dutch State Autothirt left both choices to the professionals (extremely judgemental, not arbitrary). Similarly did the UK, (not as the Netherlands). Italy, which is a cold, Latin-speaking country, said that the building was to be measured based on the first method, that is the historical cost less the depreciation. EU-JP difference: 1) In France, the accounting local for French GAAP does depend on the EU, but the French public authority added requirements, and they required every limited liability French company to use specific/charts of accounts (list of the T accounts to be used in the double-entry bookkeeping). 2) In Japan Germany = Statutes 3) Sweden= Economic companies may influence the accounts. Nobes’ Updated Classification (1998) 5  Economic and financial analysis – 4ECTS Examples of NOBES’s CLASSIFICATION 1998 1) Finance Lease: a company may go to a bank and ask that bank to buy a piece of machinery that is to be used in my activities and then to rent it to me. The ownership is the bank’s until I pay it in full. However, my balance sheet will show me the value of the machinery as if it were mine and it’s the overall debt for that machinery. In Italy, this is PROHIBITED and the owner shall put the machinery of the balance sheet (in riferimento a Substance over form nel grafico). Why are there such difference? Providers of finance (investors vs. banks & families) Legal systems (common law vs. civil code) Taxation (single accounts vs. different accounts) Accounting profession (strength and size of professional bodies) Harmonization in the EU Directives – approvate dallo stato Regulations – come into force directly in all member states they don’t need the piece of local legislation IFRS adoption in consolidated accounts of listed companies, provided that such standards are endorsed by EC authorities. The central authorities of the EU issue directives to come into form single member states with a piece of local legislation. In the accounting world, accounting directives regulate the life and the functioning of NON-LISTED LIMITED LIABILITY COMPANIES. Regulations, instead, are also prepared by the EU central authorities but they come into form DIRECTLY, not needing a piece of local legislation. There was a regulation that enforced the use of IFRS for LISTED COMPANIES, but only for consolidated financial statements (a group of companies that must prepare two sets of financial statements: its own and subsidiaries). The IFRS adoption was made mandatory, as explained above. 6  Economic and financial analysis – 4ECTS EU Accounting and Auditing Directives The Directive 2013/34/EU replaced the IV and VII directives on single and consolidated financial statements! (Always for non-listed limited-liability companies.) Directives = accompanied by legal national law The Adoption of IFRS in the EU: the EC Regulation ** chiedere a Fra se tornano dubbi Enforced without the need to intermediate a piece of local law It’s important where the company is listed, not where it’s incorporated EC Regulation 1606/2002: IFRS mandatory in consolidated accounts of groups listed on any regulated market in the EU; options to extend the use of IFRS demanded to single Member States. EC Regulation 1606/2002: immediately enforced in all Member States (not a “directive”) FIRST FINANCIAL YEAR OF ENFORCEMENT: 2005 Example not need to be known by heart: The Italian Case: Many Options for Individual Companies and Holdings Legislative Decree 38 (Feb. 28, 2005) IFRS mandatory in consolidated accounts of non-listed banks (tiny, local) and insurance companies from 01.01.2005 to 31.12.2018; IFRS allowed, but not mandatory, since 01.01.2019 IFRS mandatory in separate accounts of listed companies and non-listed banks (2006; allowed since 2005) 1) Individual accounts (stand-alone company) Accounts = full set of 2) Separate accounts (of an Holding Company) public financial 3) Consolidated accounts (of all the companies of the group) statements - Each company prepare its own set of FS IFRS not allowed for separate and individual accounts of insurance companies (mandatory only for stand- alone listed insurance companies, since 2006) IFRS allowed for consolidated accounts of non-listed groups (2005) IFRS allowed for separate and individual accounts of entities included in consolidation area (2005, except insurance companies) IFRS allowed for stand-alone companies, since 2014 (art. 20, co.2, D.L. 24/6/2014, nr. 91, converted into Law 1/8/2014, nr. 116) IFRS not allowed for SMEs (art. 2435-bis Civil Code), also when included in IFRS consolidated accounts 7  Economic and financial analysis – 4ECTS If we assume that IFRS is international and different from Italian GAAP, imagine two Italian companies and one adopts the Italian law and one the IFRS as it’s allowed. What is normally based on individual or separate accounts? 1) Taxation: if we are both Italian but adopt different standards, the impact of taxation will be different. 2) The same will go for the dividend distribution (distribution of the net income by a company). If the calculation for the income is different, the dividends will be different. The same will apply in the case of twin companies. 3) If I’m Swiss and I’m listed in Frankfurter, I follow Frankfort All these things are called ACCOUNTING POLICY. IFRS is not allowed for SMEs (art. 2435-bis Civil Code), also when included in IFRS consolidated account. Political interest group policy problems whether to or not allow it. It is not the choice that makes you go against the law. TERMINOLOGY: 1. Individual accounts: Full set of public financial statements made public by a single legal entity (They can be prepared either by a stand-alone company or a company in a group different from the mother). 2. Separate accounts: Full set of public financial statements of a holding company 3. Consolidated accounts: Full set of public financial statements related to the group. So, the holding must prepare its separate account and the consolidated account. 4. Accounts: Means “Full set of public financial statements) 5. Endorsement: It means “to accept”. For that IFRS standard to come into force in the EU, it must be accepted officially by the EU. The adoption of IFRS in Italy: Separate and Individual Accounts IFRS are mandatory: Separate accounts of listed companies Separate and individual accounts of banks and other financial institutions (until 31th December 2018) Individual accounts of stand-alone listed insurance companies IFRS are allowed: Separate accounts of parent companies choosing IFRS for consolidation Individual accounts of all companies included in IFRS consolidated accounts Individual accounts of stand-alone non listed companies (since 2014: previously prohibited) Separate and individual accounts of banks and other financial institutions (since 1st January 2019) IFRS are not allowed: Separate accounts of insurance companies Individual accounts of non-listed insurance companies Individual accounts of SMEs (also when included in IFRS consolidation area) 8  Economic and financial analysis – 4ECTS The EC Regulation (and ‘European Standards’ vs. IFRS) What it exactly says: “Companies...shall (so must) prepare their consolidated accounts* in conformity with IAS adopted in accordance with the procedure laid out at Article 6(2) if, at their balance sheet date, their securities are admitted on a regulated market” 1. Member States can opt to extend this to separate or individual financial statements Adoption of IFRS Adoption of IFRS: endorsement process This image outlines the endorsement process within the European Union (EU) for international accounting standards, particularly the adoption of International Financial Reporting Standards (IFRS). EFRAG sends technical comments to the IASB (ED= exposure draft). The ones behind the EFRAG are the interest groups (banks, etc). At that point, the real endorsement program starts. When the IFRS standard is issued, the EFRAG revises it, then it’s translated and sent to ARC. Only if the ARC allows it, for those documents to become endorsed, the endorsement process is mandatory. Regulations = IMMEDIATELY BECOME LAW, DIRECTIVES DON’T More detailed not needed explanation of the image: Key Players in the Endorsement Process: 1. IASB (International Accounting Standards Board): The IASB is responsible for developing and issuing IFRS standards. It is an independent body that establishes these global standards for financial reporting. Consultation: As shown by the dashed line, the IASB interacts with various interest groups and stakeholders (including preparers, auditors, and users of financial statements) for feedback during the development of standards. 2. EFRAG (European Financial Reporting Advisory Group): EFRAG is the advisory body to the European Commission. Its role is to evaluate whether the IFRS issued by the IASB are conducive to the European public good, ensuring that the standards are technically sound and aligned with EU economic interests. Consultation: EFRAG consults with the IASB and gathers opinions from various interest groups before making recommendations to the European Commission. 3. Interest Groups: These include stakeholders from industries, financial institutions, auditors, and public interest groups that provide input during the consultation process. 4. European Commission: The European Commission is the central entity responsible for deciding whether IFRS standards should be endorsed and adopted in the EU. 9  Economic and financial analysis – 4ECTS Consultation & Decision Making: It works closely with the Accounting Regulatory Committee (ARC) in the decision-making process. 5. Accounting Regulatory Committee (ARC): The ARC is made up of representatives from the governments of EU member states. It plays a crucial role in approving IFRS standards by advising the European Commission. Once EFRAG provides its technical opinion, the ARC discusses and votes on whether the standards should be recommended to the European Commission. 6. Council & Parliament: Additional Decision-Making: In some cases (if there are legal or political concerns), the European Parliament and the Council may become involved in the decision-making process. This is the “additional decision-making” process (labelled 2 in the diagram) where, apart from the usual regulatory framework, political institutions may have a say before the standard is fully adopted. 7. Companies: Once a standard has passed through the endorsement process, it is implemented by companies within the EU. All EU-listed companies must follow the endorsed IFRS when preparing their financial statements. Explanation to the image: 1. EFRAG Review European Financial Reporting Advisory Group (EFRAG) reviewing the IFRS (March to April) standards. EFRAG is responsible for advising the European Commission on whether the IFRS should be endorsed for use in the EU. 2. Translations Once the EFRAG review starts, the translation process begins. The IFRS (March to July) standards need to be translated into all official EU languages before further steps in the adoption process. 3. ARC Review Accounting Regulatory Committee (ARC) reviews the standards. The ARC Period (July to consists of representatives from each EU member state, and they September) evaluate whether the standards are in line with the legal framework and regulations of the EU. 4. EU Parliament the European Parliament may also get involved, especially in cases where (September to there are political implications or significant changes proposed by the October) IFRS standards. This step is critical as the Parliament plays a role in approving or influencing decisions. 5. Adoption official adoption of the IFRS standards into EU law. Once adopted, the standards become mandatory for all listed companies in the EU, which have to prepare their financial statements according to the IFRS. 10  Economic and financial analysis – 4ECTS CORPUS OF IFRS IAS/IFRS When the board of directors’ states that they will use IFRS for their financial statement, they are saying that they will use the whole thing. If the BOD is of an EU company, the corpus is endorsed. IAS was the precursor to IFRS and was issued by the International Accounting Standards Committee (IASC), while IFRS is issued by the International Accounting Standards Board (IASB). The primary difference lies in their status and adoption. IAS was the precursor to IFRS and was issued by the International Accounting Standards Committee (IASC). IFRS, on the other hand, succeeded IAS and was issued by the International Accounting Standards Board (IASB). IAS had limited global acceptance, while IFRS is widely adopted. Both are accepted by the EU. IAS up until 2011. How many Standards are currently issued? When we speak about the “corpus” we speak of all the 4 parts IFRS (IFRSs, IFRICs, SICs, IASs, differentiated from the titles) SIC is the oldest standard. 11  Economic and financial analysis – 4ECTS IFRS adoption across the world The concept of International Financial Reporting Standards has been in existence since mid 1990s. Since the universal common application of IFRS in mid 2000s nearly 200 different jurisdictions have adopted IFRS for their domestic financial reporting Each jurisdiction has different rules for the mandatory or voluntary application of IFRS, usually based on: o Whether companies are listed or unlisted; and o Whether consolidated or individual financial statements are being prepared It is more common that emerging country adopt IFRS than the older one. In the newer economies is more frequent to receive foreign investors coming from multinational groups. Most of the largest companies come from investments. There is also a problem with the accounting traditions, continental countries had problems in accepting the IFRS (2002). HISTORY- The IASB IASC formed in 1973, first standard published 1974 The 1980s: increasing membership and involvement of others The 1990s: agreements with IOSCO, increasing use of IASs, more convergence, worldwide support growing 1999-2001: restructuring agreed and implemented April 2001: new IASB takes over Legacy of IASC = 34 IASs, approx 30 Interpretations and a conceptual Framework document Convergence with US GAAP: SEC – Foreign Issuers What happens is that there are some US members in the IASB but, within the uS, they do not and cannot adopt the IFRS. à The US companies incorporated in the us and listed in the uS must adopt the US GAAP. However there’s a convergence process: Elimination of the requirement for foreign issuers to present a reconciliation of net income and equity from IFRS to US GAAP Applies to form 20-F filed on or after 4 March 2008 and relating to periods ending after 15 November 2007. If we are a NON-US company listed in US, and we prepare a financial statement IFRS we can present ourselves to a public financial market in the US without change the number. But the US company cannot, they must convert the financial statement. There is also another way to converge. The board in the US prepares the US GAAP and has an agreement with the ISB on some specific topics to prepare two different standards the contents of which are the same. They have a MOM on some topics. SEC timetable for application of IFRS in USA Potential early adoption by large multinational The SEC will make the ultimate decision on whether to finally adopt the IFRS. This SEC decision will be based on whether the IASB can transform itself and implement key changes, including obtaining independent funding 12  Economic and financial analysis – 4ECTS Large U.S. companies could switch to IFRS Mid-sized U.S. companies could switch to IFRS Small U.S. companies could switch to IFRS, but they did not Lesson 1C: IFRS adoption General requirements IAS1 sets out overall requirements for presenting financial statements, guidelines for their structure and minimum requirements for content: the nature and amount of economic resources (and claims) is useful because different types of resources affect a user’s assessment of the entity’s prospects for future cash flows differently. information about the variability and components of the return produced is useful in assessing the uncertainty of future cash flows. Objective of financial statements According to IAS1, the objective of general-purpose financial statements is "to provide information about the financial position, financial performance and cash flows of an entity that is useful to a wide range of users in making economic decisions". This is similar to the equivalent definition given in the IASB Conceptual Framework, (The foundation on which all the other standards stand). Conceptual Framework Document that stays above the IAS/IFRS and explains the basic principles on which the single standard of interpretation stands A complete set of financial statements comprises: 1. Statement of financial position (BALANCE SHEET, not only intangible but tangible assets as well). If we say NET financial position, it’s something else. Not required by IAS1. It’s the difference between all the financial liabilities less the financial assets. 2. Statement of profit or loss and comprehensive income (also called “income statement - revenues less expenses), a statement of changes in equity (total assets less total liabilities), and a statement of cash flows & notes (paragraph 10). The statement of comprehensive income is always made of two sections: income statement/other comprehensive income. 3. Financial statements must present fairly the financial position, financial performance, and cash flows of an entity (paragraph 15). 4. Complying with IFRSs (with additional disclosures) is presumed to result in a fair presentation. 5. Matching principles, expenses are included when they correspond to revenue examples, materiality decision For the sake of brevity, the statement of profit or loss and other comprehensive income may be referred to as the "statement of comprehensive income" 13  Economic and financial analysis – 4ECTS Examples: materiality decisions Is the error material? - Ex 1: Before its 20X8 FS approved for issue discovered depreciation expense for 20X8 overstated by CU150. Ignored the error (reported profit for 20X8 at CU600,000, ie understated by CU150). - Ex 2: Same as Ex 1, except had the error been corrected the entity would have breached a borrowing covenant on a significant long-term liability. General features (continued) Offsetting - not applicable unless required or permitted by IFRS Frequency of reporting - at least annually Comparative information - required unless IFRS specifies not - consider comparatives when changing the presentation or classifications of items Consistency of presentation - retain the presentation and classification of items unless IFRS requires a change or due to changes in an entity’s operations another alternative would be more appropriate. 14  Economic and financial analysis – 4ECTS Frequency of reporting Financial statements should normally be presented at least annually. An entity which presents financial statements for a period which is longer or shorter than one year should disclose: a) the reason for using a period that is longer or shorter than one year; b) the fact that the comparative amounts given for the previous period are not directly comparable with those given for the current period. Identification of the financial statements Name of the reporting entity Whether a single entity or a group Date at the end of the reporting period or the period covered Presentation currency used Level of rounding (e.g. $000 or $m) Statement of financial position formerly referred to in the standards as "balance sheet" current/non-current distinction information to be presented in the statement of financial position information that may be presented in the statement of financial position or in the notes Current and non-current assets An asset is a current asset if it satisfies any of the following criteria: (a) it is expected to be realized within the entity's normal operating cycle; (b) it is held for the purpose of being traded; (c) it is expected to be realized within 12 months after the reporting period; (d) it is cash or a cash equivalent as defined by IAS7. All other assets are non-current assets. A liability is a current liability if it satisfies any of the following criteria: (a) it is expected to be settled within the entity's normal operating cycle; (b) it is held for the purpose of being traded (c) it is due to be settled within 12 months after the reporting period; (d) the entity does not have the right to defer settlement for at least 12 months after the reporting period Information to be presented in the statement of financial position property, plant and equipment investment property intangible assets financial assets inventories trade receivables cash and cash equivalents trade payables provisions financial liabilities tax assets and liabilities equity capital and reserves 15  Economic and financial analysis – 4ECTS To be presented in the statement of financial position or in the notes Sub-classification of line items as appropriate to the entity's operations and/or as required by other international standards. (e.g. analysis of property, plant and equipment as required by IAS16) Analysis of equity capital and reserves. Statement of comprehensive income All items of income and expense recognized in an accounting period must be presented in either: (a) a single statement of comprehensive income, or (b) two separate statements, comprising: (ii) a statement showing the components of profit or loss, and (iii) a second statement beginning with the profit or loss for the period and showing the entity's "other comprehensive income". Information to be presented in the statement of comprehensive income revenue finance costs tax expense The first five items on this list may be profit or loss from discontinued operations presented in a separate statement of profit or loss for the period profit or loss. each class of other comprehensive income total comprehensive income for the period. 16  Economic and financial analysis – 4ECTS Lesson 3: Avio group – Consolidated balance sheet pg. 176 NON-CURRENT ASSETS Depreciation Amortization Depletion Indefinite useful like we don’t amortize them (indefinite is different from saying that the life is infinite). We can have indefinite tangible life in current assets 1. Depreciation What is it? Depreciation is the process of spreading out the cost of a tangible asset (like buildings, machinery, or equipment) over its useful life. This helps a company show how much value the asset is losing each year as it wears out or becomes outdated. How it works in consolidated financial statements: In the consolidated financial statement, the parent company and its subsidiaries calculate depreciation on all their tangible assets. The total depreciation expense is combined and shown on the income statement as an expense, reducing the group’s overall profit. On the balance sheet, the accumulated depreciation reduces the value of the related assets. 2. Amortization What is it? Amortization is similar to depreciation, but it applies to intangible assets, like patents, trademarks, copyrights, or goodwill. The cost of these assets is spread out over time, based on their useful life. In certain case we can avoid the amortization if we have interest to renew the tangible assets. How it works in consolidated financial statements: Amortization expenses from intangible assets owned by both the parent company and its subsidiaries are combined and recorded in the income statement. Like depreciation, it reduces the group’s profit. On the balance sheet, the accumulated amortization is subtracted from the value of the intangible assets, lowering their reported value. 17  Economic and financial analysis – 4ECTS 3. Depletion What is it? Depletion is the process of allocating the cost of non-renewable natural resources (like oil, gas, minerals, or timber) over the period during which these resources are extracted and used. Depletion is different from impairment losses (which is pathologic). How it works in consolidated financial statements: For companies involved in resource extraction (like mining or oil companies), depletion shows how much of the natural resource was “used up” during the reporting period. This depletion expense is included in the income statement and reduces the group’s profits. On the balance sheet, the accumulated depletion is subtracted from the value of the natural resource asset (like oil reserves or mines). In Summary: Depreciation is for physical assets (buildings, machines) Amortization is for intangible assets (patents, copyrights) Depletion is for natural resources (oil, minerals) Goodwill Goodwill represents the excess amount paid by a parent company when acquiring a subsidiary over the fair value of its identifiable assets (like equipment or trademarks) and liabilities. It reflects things like the subsidiary’s brand reputation, customer loyalty, or skilled workforce, which are not listed as tangible assets and is never amortized. On the balance sheet: Goodwill is recorded as an intangible asset under the assets section. It represents the premium paid for the subsidiary’s intangible value. In the income statement: Goodwill is not amortized (like other intangibles), but it is tested annually for impairment. If the subsidiary’s value decreases, a goodwill impairment expense is recognized, reducing the value of goodwill on the balance sheet and the company’s profit. Right of use The right of use asset represents the value of an asset that a company is entitled to use under a lease agreement, even though the company doesn’t legally own it. Instead, the company pays installments (lease payments) over a specified period to gain the right to use the asset. The RoU asset is recognized on the balance sheet and reflects the benefits derived from the asset throughout the lease term. Investments Packaging of share. refer to financial assets such as shares, bonds, or other securities that a company acquires with the expectation of earning returns, like dividends, interest, or capital gains. These investments may include ownership stakes in other companies and are recorded on the balance sheet. They can be short-term (held for less than a year) or long-term (held for more than a year), depending on the company’s strategic goals. Investments and non-current financial assets are not amortized, must they must be tested to impairment losses. Investment property Are not depreciated and goes directly into the income statement. Investment property refers to real estate (such as land or buildings) that a company holds to earn rental income or for capital appreciation rather than for its own use or operations. Unlike other types of property, investment 18  Economic and financial analysis – 4ECTS properties are typically not depreciated if they are measured using the fair value model under accounting standards like IAS 40. Deferred tax assets Deferred tax assets represent amounts a company can use to reduce future taxable income. They arise from temporary differences between accounting income and taxable income, such as unused tax losses or tax credits. Although they are not real receivables (money the company is actually owed), they reduce the amount of taxes a company will need to pay in the future. Deferred tax assets are recorded on the balance sheet and are expected to be used against taxable income in upcoming periods, improving the company’s future cash flow. CURRENT ASSETS Advances to suppliers Advances to suppliers are prepayments made by a company to its suppliers for goods or services that will be received in the future. This type of payment creates a receivable on the company’s balance sheet, as it represents a claim to receive products or services in exchange for the cash already paid. Contract work-in-progress refers to costs incurred by a company for projects or contracts that are not yet completed. This includes expenses for labor, materials, and overhead related to ongoing construction or service contracts. It is recorded as a current asset on the balance sheet until the contract is finished, at which point the costs are recognized as revenue or transferred to completed project accounts. It helps companies track the value of work done on contracts before they are finalized. Cash and cash equivalents refer to a company’s most liquid assets, including actual cash on hand, demand deposits, and short- term investments that can be quickly converted to cash (typically within three months). This category includes items like bank accounts, money market funds, and Treasury bills. They are recorded as current assets on the balance sheet, providing a clear picture of the company’s liquidity and ability to meet short-term obligations. Are other items, asses, which are deemed to be equivalent to cash but they’re financially instruments readably salable on the market, and virtually free of risk. (bond issued by decently safe states etc. shares normally no, usually they’re public bonds) Tax receivable We can retake money from the state. 19  Economic and financial analysis – 4ECTS Other current assets – of which related parties Other current assets encompass various short-term assets that do not fit into standard categories like cash, accounts receivable, or inventory. can include prepaid expenses, advances to suppliers, and other receivables. The phrase “of which related parties” indicates that a portion of these assets is associated with transactions or balances involving related parties, such as: affiliates, subsidiaries, or entities controlled by the company. This disclosure helps provide transparency about potential conflicts of interest or financial relationships with these related entities on the balance sheet. Consolidated balance sheet pg. 177 Usually this part has a – sign because it’s on the credit side, but when you write down on the balance sheet it’s with the + sign. LIABILITIES Non-current liabilities are obligations that a company expects to settle or pay off in more than one year. This category includes long-term debts, deferred tax liabilities, and pension obligations. They represent the company’s long-term financial commitments. Non-current financial liabilities are long-term debts or obligations that a company has to pay in the future, typically beyond one year. This includes loans, bonds payable, and other forms of financing that are not due within the next 12 months. Non-current financial liabilities for leasing refer specifically to long-term lease obligations recognized under accounting standards. This includes the present value of lease payments for leased assets that the company will pay over the term of the lease beyond the next year. These liabilities reflect the company’s commitment to future lease payments for assets it uses but does not own. Employees Benefit Provision (à our TFR) Provision for risks and charges refers to a liability (with level of uncertainty) recognized on the balance sheet to cover future obligations or potential losses that a company anticipates but cannot precisely measure at present. 20  Economic and financial analysis – 4ECTS These provisions are created for risks that may arise from legal claims, warranty costs, or restructuring costs. Provision for charges are provision for warranty, we sell our finished products but in the contract we must repair or do services to that product. Example: If a company is facing a lawsuit, it might estimate the potential costs and create a provision of $500,000 to cover expected legal fees or settlements. This amount is recorded as a liability on the balance sheet until the outcome of the lawsuit is determined. Other Non-Current Liabilities are long-term obligations that do not fit into standard categories like loans or leases. This category can include various financial commitments that a company is obligated to pay after one year. Current Financial Liabilities are short-term debts or obligations that a company needs to settle within one year. This includes loans, lines of credit, or other financial obligations that are due soon. Example: A company might have a bank loan that requires repayment of $100,000 in the next six months. This amount would be classified as a current financial liability. Current Financial Liabilities for Leasing represent the portion of lease obligations that are due within the next year. This includes lease payments for leased assets that the company needs to pay in the upcoming 12 months. Example: If a company has a lease agreement for office space and has $20,000 in lease payments due over the next year, this amount is recorded as a current financial liability for leasing. Current Portion of Non-Current Financial Payables refers to the amount of long-term debt or financial obligations that is due to be paid within the next year. It essentially represents the short-term part of long-term loans. Example: If a company has a long-term loan of $500,000, with $50,000 due for repayment in the coming year, that $50,000 would be listed as the current portion of non-current financial payables. Provisions for Risks and Charges are liabilities set aside for future obligations or potential losses that a company anticipates but cannot precisely measure yet. These provisions prepare the company for possible financial impacts. Example: If a company expects to face warranty claims and estimates that it will cost $30,000 to cover those claims, it would record this amount as a provision for risks and charges on its balance sheet. 21  Economic and financial analysis – 4ECTS Trade Payables are amounts a company owes to its suppliers for goods or services received but not yet paid for. This is part of normal business operations. Example: If a company buys $15,000 worth of raw materials on credit, this amount will be recorded as trade payables until the company pays its supplier. Advances from Clients for Contract Work-in-Progress are payments received from clients before the company has completed the work. This amount is recognized as a liability until the services or goods are delivered. Example: If a company is working on a construction project and receives $50,000 upfront from a client, this amount would be recorded as an advance from the client until the project is completed. Current Income Tax Payables are amounts owed to tax authorities for income taxes that a company has incurred but not yet paid. This liability reflects the company’s tax obligations for the current financial period. Example: If a company estimates it owes $25,000 in income taxes for the year but has not yet paid, this amount would be recorded as current income tax payables. Other Current Liabilities are miscellaneous short-term obligations that do not fall into the standard categories listed above. This may include various accrued expenses and deferred revenues. Example: If a company has accrued vacation pay for employees amounting to $10,000 that is due to be paid within the year, this amount would be classified under other current liabilities. EQUITY Share capital represents the total value of shares issued by a company to its shareholders in exchange for funds. It reflects the equity stake that shareholders have in the company. Example: If a company issues 1,000 shares at a nominal value of $1 each, the share capital would be $1,000. Share Premium Reserve (or additional paid-in capital) is the amount received from shareholders above the nominal value of the shares issued. It represents the extra amount investors are willing to pay for the shares beyond their par value. Example: If a company issues shares with a nominal value of $1 for $5 each, the share capital is $1,000 (1,000 shares), and the share premium reserve would be $4,000 (the extra $4 per share times 1,000 shares). 22  Economic and financial analysis – 4ECTS Other Reserves include various types of equity reserves that may be created for specific purposes, such as revaluation surpluses, foreign currency translation adjustments, or other comprehensive income items. They help track changes in equity that are not part of retained earnings. Among other reserves could be revaluation assets. Example: If a company has a reserve of $10,000 from foreign currency translation adjustments due to investments in foreign subsidiaries, this amount would be classified under other reserves. Revaluation method: we start with the historical cost of the land, but then the current value goes up we can take with us the revaluation. It goes directly to the revaluation reserves, not to the income statement. Retained Earnings represent the accumulation of net profits that a company has earned over time and retained in the business instead of distributing them as dividends. This amount reflects the company’s ability to reinvest in operations or pay off debts. Example: If a company has generated total profits of $100,000 over its lifetime and paid out $40,000 in dividends, the retained earnings would be $60,000. Image à The 10% total is not holding shareholder’s but the subsidiaries (firm A) shareholder. ISFRS ask the holding and the subs to add the 100% assets and liabilities each. Group Net Profit refers to the total profit earned by the entire group of companies (including the parent company and its subsidiaries) during a specific financial period. This figure reflects the overall profitability of the consolidated entity. Example: If the parent company has a profit of $200,000 and its subsidiaries contribute an additional $50,000, the group net profit would be $250,000. Total Group Equity is the total net assets of the consolidated group, representing the shareholders’ total claim on the assets of the parent company and its subsidiaries. It is calculated as the sum of share capital, share premium reserve, retained earnings, other reserves, and group net profit. Example: If a company has share capital of $1,000, share premium reserve of $4,000, retained earnings of $60,000, and other reserves of $10,000, the total group equity would be $75,000. Equity attributable to non-controlling interests represents the portion of equity in subsidiaries that is not owned by the parent company. This is applicable when the parent does not own 100% of a subsidiary, meaning there are other shareholders. Example: If a subsidiary has total equity of $1,000,000 and the parent owns 80%, the equity attributable to non-controlling interests (the 20% owned by others) would be $200,000. 23  Economic and financial analysis – 4ECTS Total Net Equity is the total amount of equity held by the shareholders of the parent company, which includes the equity attributable to non-controlling interests. It summarizes the total equity of the consolidated entity. Example: If total group equity is $75,000 and equity attributable to non-controlling interests is $200,000, the total net equity would be $75,000 plus $200,000, totaling $275,000. Avio Case: STATEMENT OF CHANGES IN CONSOLIDATED EQUITY NOTE!!! We are required to know what STATEMENT OF CHANGES IN CONSOLIDATED EQUITY (what it represents and what it shows) and is but not specifically each item. The Statement of Changes in Consolidated Equity is a financial report that shows how the equity section of a company’s balance sheet has changed over a specific period. It outlines the movements in shareholders’ equity, including: Share capital: Any new shares issued or bought back. Share premium reserve: Changes from issuing shares above their nominal value. Retained earnings: Adjustments from net profits earned or dividends paid to shareholders. Other reserves: Changes due to revaluations, foreign currency translations, or other comprehensive income items. Equity attributable to non-controlling interests: Changes in the ownership stake of minority shareholders in subsidiaries. This statement helps stakeholders understand how various factors affect the company’s overall equity, reflecting the company’s financial health and the performance of its investments over time. Note: equity at 31/12/2021 is the opening balance for the year 2022 24  Economic and financial analysis – 4ECTS Treasury share (or treasury stock) are shares that a company has issued and later repurchased from its shareholders but has not retired. These shares are held by the company itself and are not considered when calculating earnings per share or dividends because they are not outstanding shares. Actuarial gain/(losses) reserves refer to adjustments made to the company’s balance sheet related to its pension and other post- employment benefit plans. These gains or losses occur due to changes in actuarial assumptions (like life expectancy, discount rates, or employee turnover) or the actual returns on plan assets differing from expected returns. They are recorded in other comprehensive income and can affect the company’s overall equity. Stock grant reserve is an equity account that reflects the total value of stock options or shares that a company has granted to employees or executives as part of their compensation packages but has not yet issued. This reserve recognizes the company’s obligation to issue shares in the future and is usually adjusted based on the vesting of the stock grants. Translation reserve is a component of equity that captures the effects of converting the financial statements of foreign subsidiaries into the reporting currency of the parent company. It arises from changes in exchange rates and is recorded in other comprehensive income. This reserve helps reflect the company’s net investment in foreign operations and adjusts for currency fluctuations over time. Avio Case: CONSOLIDATED INCOME STATEMENT A consolidated income statement is a financial report that summarizes the revenues, expenses, and profits of a parent company and its subsidiaries as a single entity over a specific period, typically a quarter or a year. It combines the financial results of the parent and all its controlled subsidiaries, eliminating any intercompany transactions to avoid double counting. The statement of comprehensive income, is made of 2 parts: 1. Income Statement 2. OCI – Other Comprehensive Income 1. Income Statement: This section summarizes the company’s revenues, expenses, and resulting net profit or loss for a specific period. It provides a detailed view of operational performance, showing how much the company earned and spent. 2. OCI (Other Comprehensive Income): This section includes revenues, expenses, gains, and losses that are not recognized in the income statement but impact the company’s overall equity. Common items in OCI include unrealized gains and losses on available-for-sale securities, foreign currency translation adjustments, and actuarial gains or losses from pension plans. 25  Economic and financial analysis – 4ECTS Revenues à the values of what we sold change in inventory of finished products, in progress, and semi-finished refers to the increase or decrease in the value of goods held in inventory during a specific period. It reflects how much inventory has been produced, sold, or purchased compared to the previous period, impacting the cost of goods sold and ultimately the net profit. Other operating income consists of revenue generated from activities not directly related to the primary business operations. This may include income from leasing equipment, royalties, or gains from the sale of assets. It provides insights into additional ways the company generates income beyond its core business. Consumption of raw materials represents the total cost of raw materials we used in production during the production process in a specific period. This figure indicates how much the company has spent on materials to create finished goods, impacting the overall cost of goods sold. These are not related to the depletion. Service costs refer to expenses incurred for services consumed during the period, such as outsourced services, maintenance, utilities, or consultancy fees. These costs are essential for the company’s operations but do not directly relate to the production of goods. Personnel expenses encompass all costs related to employees, including salaries, wages, bonuses, benefits, and payroll taxes. This category reflects the company’s investment in its workforce and is a significant component of overall operating expenses. 26  Economic and financial analysis – 4ECTS Amortization & depreciation are accounting methods used to allocate the cost of tangible and intangible assets over their useful lives: Amortization applies to intangible assets (like patents or trademarks), spreading their cost over the period they are expected to provide value. Depreciation applies to tangible assets (like machinery or buildings), reflecting the reduction in value as the asset ages and is used. Both expenses reduce the company’s taxable income and are essential for accurately reporting asset values on the balance sheet. Effect valuation of investments under equity method – operating income/(charges) This is something that goes into the IS, some qualified shares are evaluated by this. The effect valuation of investments under the equity method refers to the accounting treatment for investments in other companies where the investor has significant influence, typically defined as owning 20% to 50% of the investee’s voting shares. Under this method, the investor recognizes its share of the investee’s profits or losses as operating income or charges in its own income statement. Cost capitalized for internal work refers to the expenses incurred by a company for producing or developing its own assets rather than acquiring them from external sources. These costs are added to the balance sheet as capital assets instead of being expensed in the income statement during the period they are incurred. EBIT - Earnings Before Interest and Taxes Definition: Is a MARGIN, not a ration, it’s a measure of a company’s profitability that focuses on its operating performance. It represents the earnings generated from core business operations without considering interest expenses or income tax expenses. EBIT is useful for comparing profitability across companies and industries, as it removes the effects of financing and tax strategies. Under EBIT we can find: Financial Income refers to earnings generated from non-operating activities, primarily related to investments and other financial assets. This includes: - Interest Income: Earnings from interest on loans or deposits (or bonds) - Dividend Income: Earnings received from owning shares in other companies. (passive loans) - Gains on Investments: Profits realized from the sale of financial assets, such as stocks or bonds. Financial charges Financial charges (or interest expenses) represent the costs associated with borrowing funds or other financial obligations. This includes: - Interest Expense: The cost incurred from loans, bonds, or other debt instruments. - Bank Fees and Charges: Costs related to maintaining bank accounts or other financing arrangements. 27  Economic and financial analysis – 4ECTS Net Financial Income/(Charges) refers to the difference between financial income earned and financial charges incurred during a specific period. This metric indicates the overall impact of financial activities on a company’s earnings. Financial Income: Earnings from investments, such as interest and dividends. Financial Charges: Costs associated with debt, such as interest expenses. Investment Income/(Charges) specifically refers to the income or losses derived from investments in financial assets, such as stocks, bonds, and other securities. It is a broader term that may encompass net financial income but focuses more on the returns generated from investments rather than debt-related charges. Investment Income: Includes dividends, interest, and gains from the sale of investments. Investment Charges: Losses from investments or costs related to managing investment portfolios. Profit Before Taxes (also known as Earnings Before Tax or EBT) is the amount of profit a company has earned before deducting income tax expenses. It reflects the company’s operational performance, including all income and expenses, but before tax liabilities. Net Profit (or Net Income) is the final profit of a company after all expenses, including operating expenses, interest, taxes, and any other charges, have been deducted from total revenue. It represents the company’s overall profitability and is a key indicator of financial health. Summary Net Financial Income/(Charges) reflects the net impact of financial activities on earnings Investment Income/(Charges) focuses specifically on returns and losses from investments. Profit Before Taxes measures profitability before tax liabilities. Net Profit indicates the final profitability after all expenses, providing a comprehensive 28  Economic and financial analysis – 4ECTS Basic earnings/(losses) per share Earning divided by number of the shareholders (of the mother). Outstanding share: This refers to the total number of shares that are currently held by shareholders, excluding any shares held in the company’s treasury (treasury shares). Diluted earnings/(losses) per share is a financial metric that reflects the potential decrease in earnings per share that would occur if all convertible securities, such as stock options, convertible bonds, and other equity instruments, were exercised or converted into common shares. This measure provides a more conservative estimate of earnings available to each share of common stock compared to Basic EPS. Avio Case: CONSOLIDATED COMPREHENSIVE STATEMENT Those items are non-monetary Actuarial Gains/(Losses) refer to the changes in the value of pension plan assets and obligations due to adjustments in actuarial assumptions, such as changes in life expectancy, interest rates, or market conditions. Actuarial Gains/(Losses) Reserve is an accounting entry that captures the cumulative effect of actuarial gains and losses over time. This reserve is part of a company’s equity in the financial statements and is typically categorized under Other Comprehensive Income (OCI). Total Other Comprehensive Income Items, Net of Tax Effect (B) captures gains and losses that impact equity but are not reflected in the income statement for the period. 29  Economic and financial analysis – 4ECTS Comprehensive Income/Loss for the Year (A + B) provides a holistic view of a company’s financial performance by summing net income and total other comprehensive income, reflecting all changes in equity during the reporting period except those arising from owner transactions. This measure is crucial for investors and stakeholders seeking a complete understanding of a company’s financial health. Lesson 4A: How to prepare a cash flow statement – IAS7 pg. 132 accounting full notes to 144 Usefulness of the Statement of Cash Flows The statement of cash flows is one of the five main statements according to IAS1 and it provides users of financial statements information to assess: 1. Entity’s ability to generate future cash flows. 2. Entity’s ability to pay dividends and obligations (Entity obligation – in juridical sense, to pay dividend and debts) 3. Reasons for the difference between net income and net cash provided (used) by operating activities. 4. Cash investing and financing transactions during the period. Usefulness and Format There are no exceptions, according to IAS7, for the preparation and presentation of cash flows statement. In EU, the cash flow statement is mandatory only for larger companies. According to IAS7, cash comprises “cash on hand and demand deposits (bank current accounts)”. Bank current accounts can also be negative, so they are part of cash also when they have a negative balance. Therefore, bank overdrafts can exist and are generally repayable on demand and considered as an integral part of an entity’s cash management: we may have a negative cash. This is not possible according to other standards such as US GAAP, in which bank overdrafts are considered liabilities. IAS7 states that statement of cash flow must show the net of cash and cash equivalents. Cash equivalents are: “short-term, highly liquid investments that are readily convertible to known amounts of cash and are subject to an insignificant risk of changes in value”. An investment will usually not qualify as a cash equivalent unless it has a maturity date which is no more than three months after the date of acquisition. E.g: Short-term listed bonds issued by a triple A state is considered as cash. Shares are not included in the definition of cash equivalents unless the case of preference shares acquired within a short period of their maturity and with a specified redemption date. IAS7 requires that the statement of cash flows should report cash flows classified by: 30  Economic and financial analysis – 4ECTS ❖ Operating activities, related to the items of i/s, are “the principal revenue-producing activities of the entity” and other activities that are not investing or financing activities; ❖ Investing activities comprehend the “acquisition and disposal of long-term assets and other investments not included in cash equivalents”. They show both changes in investments and long-term assets the word “investments” means financial long-term assets (packages of share that we normally buy in order to hold them in medium to long term) when we purchase or sell long-term financial assets or long-term bonds, we are in this field à investing activities. (important for the exam!). ❖ Financing activities are “activities that result in changes in the size and composition of the contributed equity and borrowings of the entity”. They show changes in long-term liabilities and stockholders’ equity. Cash inflows and cash outflows, those are related to our need of finance. Cash inflows for financial activities, come to our bank when we ask for money. When we give them back is cash outflows. Or when we issue bonds, it’s a cash inflow. Changes in Long-Term Liabilities and Stockholders’ Equity Classification of Cash Flows Suppliers for inventory à what we purchased 31  Economic and financial analysis – 4ECTS Significant non-cash activities The loans we make to third parties are investing activities and not in financing activities. Sale of common stock (ordinary share in Uk) means issuing new shares for cash. We may have also significant (something is significant when it influences the decisions of the third parties about our company) noncash activities: Those are out the Cash Flow Statement, we must list in a separate schedule at the bottom any significant non-cash activities happened during a period (year) [– important for the exam, asked inside]: 1. Direct issuance of common stock to purchase assets. the company issues shares (common stock) to buy an asset, like property or equipment, instead of paying cash. This affects the equity (ownership) of the company and adds the purchased asset to its balance sheet, but no cash is exchanged. 2. Conversion of bonds into common stock. When bondholders convert their bonds into common stock, they give up their debt claims for ownership (equity) in the company. This changes the company’s debt structure and equity balance without involving cash. 3. Direct issuance of debt to purchase assets. we issue bonds and give them directly to the former of the assets. 4. Exchanges of plant assets This occurs when a company swaps one physical asset (like machinery or equipment) for another, without cash payment. It results in a change in the types of assets on the company’s balance sheet but doesn’t involve any cash movement. Companies report noncash activities in either a: separate schedule (bottom of the statement) or separate note to the financial statements. In any way the disclosure is mandatory NB! Format of the Statement of Cash Flows The difference between the two re the following: - direct method à easier to be understood from third parties - indirect method à most used by companies 32  Economic and financial analysis – 4ECTS Format of the Statement of Cash Flows In preparing the statement of cash flows we need three sources of information: 1. Comparative balance sheets. If it is the first year of activity, we must provide also the b/s of previous year that will have all values equal to zero; 2. Current income statement. We do not need the OCI section because it contains revaluations and write downs which are non-monetary values therefore, they do not give rise to cash flows; 3. Additional information from notes to the account. The three main steps in preparing the statement of cash flows are: 1. Determine net cash provided/used by operating activities by converting net income from an accrual basis to a cash basis. 2. Analyze changes in noncurrent asset and liability accounts and record as investing and financing activities or disclose as noncash transactions. 3. Compare the net change in cash on the statement of cash flows with the change in the cash account reported on the b/s to make sure the amounts agree. In terms of operating activity, we must choose between two methods of disclosure: direct method or indirect method. ❖ With the direct method, major classes of gross cash receipts and gross cash payments arising from operating activities are disclosed individually and then are aggregated to give the total amount of cash generated from operations. A statement of cash flows prepared using the direct method might typically disclose: i. Cash receipts from customers; ii. Cash paid to suppliers of goods and services; iii. Cash paid to employees. 33  Economic and financial analysis – 4ECTS ❖ With the indirect method, we start from profit or loss before taxation, and then adjust so as to calculate the total amount of cash generated from operations. This because the purpose of indirect method is to transform the i/s related to the accrual basis of accounting, into a i/s related to cash basis, in order to create a cash flow statement for operating activities which contemplates only cash flows related to the cash movements. Common adjustments to income (loss) before taxation are: Add back noncash expenses such as depreciation, amortization, depletion expense, impairment losses and revaluation gains in i/s (for instance in IAS40 or financial instruments measured at FVTPL unless they are sold), since they are noncash, they haven’t generated and will not generate any cash flows in the future. Interest payable is also added back. Deduct gains on disposal of assets and add losses on disposal of assets. The actual sale proceeds of such assets are shown later as cash inflows in investing activities; Changes in noncash current asset and current liability accounts: increases in current assets must be subtracted since have a negative meaning in terms of cash flows as they represent a lack of cash received. E.g. increase in receivables. Decreases in current assets must be added back since have a positive meaning in terms of cash flows as they represent extra cash available. E.g. decrease of trade receivables; increases in current liabilities must be added back since have a positive meaning in terms of cash flows as it means we haven’t paid an amount yet and we have extra cash available. E.g. increase in trade payables. Decreases in current liabilities must be subtracted since have a negative meaning in terms of cash flows as it means we have already paid to settle part of a liability and have less cash available. The direct and indirect method will, of course, give the same total amount of cash generated by operations during the period. The choice is completely free, but it must be kept consistently over time. Companies favor the indirect method for two reasons: Easier and less costly to prepare; Focuses on differences between net income and net cash flow from operating activities. 34  Economic and financial analysis – 4ECTS Indirect method: question: define which of those items are monetary/operating or non-monetary etc. 35  Economic and financial analysis – 4ECTS Preparing the Statement of Cash Flows: Indirect Method Determine net cash provided/used by operating activities by converting net income from accrual basis to cash basis. Common adjustments to Net Income (Loss): Add back noncash expenses (depreciation, amortization, or depletion expense). Deduct gains and add losses. Changes in noncash current asset and current liability accounts. Step 1: Operating activities Depreciation expense Although depreciation expense reduces net income, it does not reduce cash. The company must add it back to net income. Loss on Disposal of Plant Assets (minusvalenza) perdita su dismissione di un’attività immobilizzata (come un macchinario o un impianto) si verifica quando un’azienda vende o elimina un bene a un prezzo inferiore al suo valore contabile residuo. Il valore contabile è quanto il bene vale ancora per l’azienda, dopo aver considerato il costo iniziale e la quota di ammortamento accumulata nel tempo. Companies report as a source of cash in the investing activities section the actual amount of cash received from the sale. Any loss on sale is added to net income in the operating section. Any gain on sale is deducted from net income in the operating section. In the current example, we are making the simplifying hypothesis that all the current assets and liabilities are short term and that they do refer all to operating activities and not to financing or investing activities of the company. In the case of b/s, the classification by destination or time is absolutely relevant for operating activities section of cash flows statements: in fact, not all current items of b/s classified according to time are operating activities. Changes to non-cash current asset accounts When the Accounts Receivable balance decreases, cash receipts are higher than revenue earned under the accrual basis. 36  Economic and financial analysis – 4ECTS Company adds to net income the amount of the decrease in accounts receivable. When the inventory balance increases, the cost of merchandise purchased exceeds the cost of goods sold. Cost of goods sold does not reflect cash payments made for merchandise. The company deducts from net income this inventory increase. When the Prepaid Expenses balance increases, cash paid for expenses is higher than expenses reported on an accrual basis. The company deducts the decrease from net income to arrive at net cash provided by operating activities. If prepaid expenses decrease, reported expenses are higher than the expenses paid. 37  Economic and financial analysis – 4ECTS Changes to non-cash current liability accounts When Accounts Payable increases, the company received more in goods than it actually paid for. The increase is added to net income to determine net cash provided by operating activities. When Income Taxes Payable decreases, the income tax expense reported on the income statement was less than the amount of taxes paid during the period. The decrease is subtracted from net income to determine net cash provided by operating activities. Summary of conversion to net cash provided by operating activities – INDIRECT METHOD Step 2: investing and financing activities Company purchased land of $110,000 by exchanging bonds for land. This is a significant noncash investing and financing activity that merits disclosure in a separate schedule. 38  Economic and financial analysis – 4ECTS From the additional information, the company acquired an office building for $120,000 cash. This is a cash outflow reported in the investing section. The additional information explains that the equipment increase resulted from two transactions: (1) a purchase of equipment of $25,000, and (2) the sale for $4,000 of equipment costing $8,000. The increase in common stock resulted from the issuance of new shares. Financing activities are related to the issuing of common stocks +20.000 and distribution of cash dividend -29.000. Retained earnings increased $116,000 during the year. This increase can be explained by two factors: (1) Net income of $145,000 increased retained earnings, and (2) Dividends of $29,000 decreased retained earnings. 39  Economic and financial analysis – 4ECTS According to IAS7, after each section is mandatory to shown the subtotals and at the end of the cash flow statements is mandatory to compare the net change in cash on the statement of cash flows with the change in the cash account reported on the b/s to make sure the amounts agree. So, the statement of cash flows with indirect method is: The amounts in cash b/s agree with the result we achieved in statement of cash flows. Step 3: Net Change in cash Compare the net change in cash on the Statement of Cash Flows with the change in the cash account reported on the Balance Sheet to make sure the amounts agree. Direct method The section related to the operating activities is disclosed in a more detailed way. The direct method does not start from net income or loss since it does not imply transformation of the statements: it takes directly all the cash inflows and outflows. The net cash provided by operating activities is the difference between cash receipts and cash payments. Cash receipts can result from sales of goods and services to customers or from receipts of interests and dividends on loans and investments. Cash payments can result from payments to suppliers, employees, for operating expense, for interests, or taxes. Cash receipts from customers: for computer services, accounts receivable decreased $10,000. Accounts receivable initial balance is 30.000, and end balance is 20.000, in between we generate sales revenue for 507.000, therefore during the year we received 517.000. 40  Economic and financial analysis – 4ECTS Cash payments to suppliers: in 2014, Computer Services Company’s inventory increased $5,000 and cash payments to suppliers were $139,000. We need to check the interaction between cost of goods sold, inventory items of b/s and account payable: Cash payments for operating expenses: 111.000 according to the accrual basis of accounting, but we must check the pre-paid expenses which increased 4.000. This means we prepaid 4000$ more than what was accrued as expense in the year. So, cash payments for operating expenses are $115,000 (111.000 + 4.000), since we concretely paid that amount in the year. Insurance policies are typical pre-paid expenses. E.g. insurance policy that cost 120$ and that must be paid in advance on 1 November. How much is the cost for the insurance if it lasts 12 months? à The accrual is 20$ only but we concretely paid 120$ (20 + 100 of prepaid expense). Cash payments for interests: in 2014, Computer Services’ had interest expense of $42,000. 41  Economic and financial analysis – 4ECTS Cash payments for income taxes: cash payments for income taxes were $49,000. Investing and Financing activities: increase in equipment: (1) equipment purchased for $25,000, and (2) equipment sold for $4,000, cost $8,000, book value $7,000. Increase in Land: land increased $110,000. The company purchased land of $110,000 by issuing bonds → Significant noncash investing and financing transaction. Increase in Building. Acquired building for $120,000 cash → Investing transaction. Increase in Bonds Payable. Bonds Payable increased $110,000. The company acquired land by exchanging bonds for land → Significant noncash investing and financing transaction. Increase in Common Stock. Increase in Common Stock of $20,000. Increase resulted from the issuance of new shares of stock → Financing transaction. Increase in Retained Earnings. The $116,000 net increase in Retained Earnings resulted from net income of $145,000 and the declaration and payment of a cash dividend of $29,000 → financing transaction (cash dividend). So, the statement of cash flows with direct method is: 42  Economic and financial analysis – 4ECTS Also in the case of direct method is mandatory to compare the net change in cash on the statement of cash flows with the change in the cash account reported on the b/s to make sure the amounts agree. Specific disclosure requirements According to IAS7, we must respect some specific disclosure requirements. As regards interests and dividends: Separate disclosure for each category; Interest paid and interest and dividends received may be classified as operating cash flows or interest paid and interest and dividends received may be classified as financing cash flows and investing cash flows respectively; Dividends paid may be classified as operating or financing cash flows. As regards taxes on income: Separate disclosure; Classification as cash flows from operating activities unless specific identification with financing and investing activities. As regards changes in ownership interests in subsidiaries and other businesses: Separate disclosure; Classification as investing activities. Specific disclosures are required, especially the amount of cash and cash equivalents in the subsidiaries or other businesses over which control is obtained or lost. Cash flows arising from changes in ownership interests in a subsidiary that do not result in a loss of control shall be classified as cash flows from financing activities. Exercise A – Cash Flow Statement: Indirect Method à other sheet SUMMARY: OF ALL ITEMS PER CATEGORIES OF ACTIVITIES AND WHERE TO FIND THEM 1. Operating Activities Operating activities include the main revenue-generating activities of the company and adjustments for non-cash items. They can be presented using either the direct or indirect method. Direct Method: Shows actual cash inflows and outflows. Cash receipts from found in sales revenue or accounts receivable Add customers Cash payments to suppliers found in cost of goods sold, operating Subtract and employees expenses, or accounts payable Interest received à if treated as operating under IAS 7 Add Interest paid à if treated as operating Subtract Dividends received à if treated as operating Add Income taxes paid Subtract 43  Economic and financial analysis – 4ECTS Indirect Method: Starts with net income and adjusts for non-cash and non-operating items. Net Income – Start here (from the Income Statement) Adjustments for non-cash items: Depreciation and Add amortization Impairment losses Add Gains on sale of assets e.g., equipment or investments, from the Subtract Income Statement Losses on sale of assets Add Changes in working capital (balance sheet items): Increase in accounts receivable Subtract Decrease in accounts receivable Add Increase in inventory Subtract Decrease in inventory Add Increase in accounts payable Add Decrease in accounts payable Subtract 2. Investing Activities Investing activities include purchases and sales of long-term assets and investments, which can be found on the balance sheet. Purchase of property, plant, from balance sheet and notes Subtract and equipment (PPE) - Proceeds from sale of (sale of warehouse) Add PPE Purchase of intangible assets e.g., patents, licenses Subtract - Proceeds from sale of Add intangibles Purchase of investments e.g., stocks, bonds, long-term investments Subtract Proceeds from sale or Add maturity of investments Cash advances and loans to Subtract other parties Collections on loans Add (principal only) 44  Economic and financial analysis – 4ECTS 3. Financing Activities Financing activities reflect changes in the company’s capital structure and can be found in equity and debt sections on the balance sheet. Proceeds from issuing equity common or preferred stock Add Proceeds from issuing debt e.g., bonds, loans Add Repayment of debt principal only Subtract Payment of dividends from retained earnings or cash flow notes Subtract Purchase of treasury shares stock buybacks Subtract Proceeds from reissuing Add treasury shares OPERATING ACTIVITIES + Net income add + Depreciation charge add + Depreciation expense add + Loss on disposal on long – term 3. Long-term investments that had a cost of add investments €18,000 were sold for €14,000 à in this case is €4000 + Increase in trade payables add Account payables - Decrease in trade payables Subtract - Increase in trade receivable Subtract Account receivables + Decrease in trade receivable Add - Increase in inventory Subtract Inventory + Decrease in inventory Subtract + Decrease in prepaid expenses add Pre