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Class 1: Corporate governance

What is corporate governance (CG)?


- Management = running business
- CG = Seeing that a company is run properly
- CG deals with the ways that suppliers of finance to corporations assure themselves of getting a ROI
- All companies need management AND governance
- Is not corporate financial management
- Is not corporate social responsibility or business ethics

Parties involved
- Shareholders: own company
- Directors: Guardians of company’s assets for shareholders
- Manager: Uses company’s assets

CG vs Mgmt

Why CG?
- Better access to external finance
- Lower costs of capital (interest rates on loans)
- Improved company performance – sustainability
- Higher firm valuation & share performance
- Reduced risk of corporate crisis & scandals

Why CG? Extended


- Effective management and distribution of wealth
o Ensure that enterprise creates max wealth and uses it sensibly for providing max benefits to
stakeholders and enhancing its capability to create wealth to maintain sustainability

- Discharge of social responsibility


o Ensure enterprise is acceptable to society

- Application of best mgmt. practices


o Ensure excellence in functioning of enterprise, optimum creation of sustainable wealth

- Compliance of law in letter & spirit


o Ensure value enhancement for stakeholders guaranteed by law for maintaining socio-economic balance

- Adherence to ethical standards


o To ensure integrity, transparency, independence and accountability in dealings with all stakeholders

CG Pillars
- Accountability
o Ensure mgmt. is accountable to the board
o Ensure board is accountable to shareholders
- Fairness
o Protect shareholders rights
o Treat all shareholders, including minorities, equitably
o Provide effective redress for violations

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- Transparency
o Ensure timely, accurate disclosure on all material matters incl. financial situation, performance,
ownership and corporate governance.
- Independence
o Procedures & structures are in place so as to minimize or avoid conflicts of interest
o Independent directors and advisers – free from outside influence

CG – Tool set
- Board of directors
o Good board practices include…
 Clearly defined rules/authorities
 Duties & responsibilities of directors understood
 Board is well structured
 Appropriate composition & mix of skills
 Appropriate board procedures
 Director remuneration (reward) in line with best practice
 Board self-evaluation and training conducted

- Transparent disclosure
o Financial info disclosed
o Non-financial info disclosed
o Financials prepared according to IFRS
o High quality annual report published

- Control environment
o Internal control procedures
o Risk mgmt. framework
o Internal audit function
o Independent audit committee established
o Management information systems established
o Independent external auditor conducts audit

- Large shareholders
o Can act as monitors
o Minority shareholders should have well-defined rights, a well-organised shareholder meetings, a policy
on related party transactions and a clearly defined and explicit dividend policy
o The legal environment = important

- Proxy fights
o Group of shareholders join forces and gather enough proxies to win a corporate vote
o Standard way to replace board members

- Financial structure
o Debt service limits inefficient management if bankruptcy is costly
- Hostile takeovers
o Allows one to capture large gain from taking over underperforming company
o 2 issues..
 Free rider problem: small shareholder doesn’t want to tender (offer for sale) their shares
 Competition from other bidders/incumbent management

- Agency conflict
o Issues between stockholder and debtholder or stockholder and management
o Two parties have different interests and asymmetric information. Principal cannot directly ensure that
agents are always acting in its (the principal’s) best interests.
o Incentives of two parties are not aligned

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Class 2: Measuring and reporting financial position (CH2)
Statement of financial position / balance sheet
- Financial position of firm on a particular date

- Assets (left) vs. Claims (right)


o Assets =
 1. Economic resource (right or future economic benefit)
 2. Under control of organization
 Capable of measurement in monetary term
o Claims
 Equity (claim of owner(s) against business
 Liabilities (claim of other parties eg. financial institutions)

Accounting equation

Assets = equity + liabilities

Extended : Assets = equity +/- profit (loss) + liabilities

Classification of assets (may vary according to nature of business)

- Current assets
o 1. Held for sale/consumption
o 2. Expected to be sold within year
o 3. Held principally for trading
o 4. Cash or near equivalents to cash
- Non-current assets

Classification of claims

- Current liabilities
o 1. Expected to be settled within the business’s normal operating cycle
o 2. Held principally for trading purposes
o 3. Due to be settled within a year after the statement of financial position date
o 4. No right to defer settlement beyond a year after the statement of financial position date

Equation for standard layout

Non-current assets + Current assets = Equity + non-current liabilities + current liabilities

Equation for non-standard layour

Non-current assets + current assets – current liabilities – non-current liabilities = equity

Accounting conventions that influence the statement of financial position

- Business entity convention = business & its owners are treated as being quite separate and distinct
- Historic cost convention = the value of assets on the balance sheet should be based on historic cost
- Prudence convention = caution should be exercised when preparing financial statements

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- Going concern convention = financial statements should be prepared on the assumption that a business will
continue operations for the foreseeable future
- Dual aspect convention = each transaction has two aspects, both of which will affect statement of financial
position

Money measurement

Key problems
- Goodwill & brands
- Human resources (eg. Waarde personeel)
- Monetary stability (inflatie ed.)

Uses of the statement of financial position


- Shows how the business is financed and how funds are deployed
- Can provide a basis for assessing the value of business
- Relationships between assets and claims can be assessed
- Performance can be better assessed

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Class 3: Measuring and reporting financial performance
The income statement (aka profit & loss account)

- Measures and reports how much profit a business has generated over a period

Profit (or loss) = Total revenue in period – Total expenses incurred in generating that revenue

- Revenue = Measure of inflow of economic benefits (eg. sales of goods, interests received)
- Expense = Measure of outflow of economic benefits (eg. COGS, insurance expense)

Relationship income statement. & balance sheet (statement of financial pos)

Assets = Equity + (Sales revenue – expenses) + liabilities

COGS

- Cost of goods sold during period


- Is not the cost of goods that were bought
- COGS = opening invent + goods bought – closing inventory

Recognition of revenue

Basic criteria to be met before revenue is recognized:


- The amount of revenue can be measured reliably
- It is probable that the economic benefits will be received
Additional criterion is to be applied where the revenue comes from the sale of goods:
- Ownership and control of the items should pass to the buyer

Recognition of expenses

- Matching convention: expenses should be matched to revenue that they help generate
o Expense reported in income statement  cash paid for that item during period

Accounting conventions and the income statement

Materiality convention
- Subject to treatment of accruals and prepayments
- If amounts involved are trivial (not meaningful), we should consider only what is expedient (useful)
o Usually this means treating an item as an expense in the period in which it is first recorded rather than
strictly matching it to the revenue to which it relates
- Example: $2 worth of equipment left at end of year. Processing It isn’t worth time and effort since its effect is
negligible on the measurement of profit or financial position. Result; treat as expense of current period and
ignore following period
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Accruals convention
- Profit is the excess of revenue over expense, NOT excess of cash receipts over cash payments.
- Says that profit is NOT a measure of cash generated, rather of achievement.

Depreciation

= portion of the cost of a non-current asset that has been depleted in generating the revenue recognized during a
particular period

Four factors have to be considered to calculate depreciation charge for a period:


1. The cost of the asset (fair value = selling price that could be obtained in an orderly transaction under market conditions)
2. Useful life (economic) of asset
3. Residual (disposal) value
4. Depreciation methods

Depreciation method: Straight line


= depreciate evenly over useful life

Annual depreciation charge = (total cost – residual value) / useful life

Carrying amount = net book value = total cost – accumulated depreciation

Depreciation method: Reducing-balance

Annual depreciation charge = P x net book value at beginning of period

Depreciation method: Double declining balance (DDB)

- Similar to reducing-balance method


- Ignores residual value
- Main difference = fixed depreciation percentage = 2 x depreciation percentage straight line method

Annual depreciation charge = 2 x straight line methods depreciation % x net book value at beginning period

Inventory costing methods

- FIFO: First in, first out


- LIFO: Last in, first out
- AVCO: Weighted average cost = inventories go into a ‘pool’ with average cost
o Total cost / total inventory

Bad debts written off

Bad debt = customer won’t pay for good bought on credit

In this case..
- Reduce trade receivables
- Increase expenses ‘bad debts written off’

Matching convention: at end of reporting period, try to estimate amount of bad debts
- allowance for trade receivables
o expense on income statement and deducted from total trade receivables on balance

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Uses and usefulness of the income statement

- Helps in providing information on…


o How effective the business has been in generating wealth
o How the profit was derived

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Lesson 4: Accounting for limited companies (Ch 4)
Limited company
- Can be very small or very large
- Liability of owner is limited
- Unlimited number of owners possible
- Some obligations, including…
o Documents of incorporation
o Annual financial reports
o Annual meeting of owners
o Audit

Main features:

Two main forms of limited company

Public Limited Company (plc)


- Can offer its shares for sale to the general public
Private limited company (Ltd)
- Cannot offer its shares for sale to the general public
- Tend to be smaller companies with few major shareholders (ie. family company)

Role of stock exchange

- Primary market: Enable companies to raise new finance


- Secondary market: Enable investors to sell their securities (incl. shares and loan notes)

Equity (the owner’s claim)

Types of share capital

- Ordinary shares (equity):


o Shareholder = primary risk taker as they share in profits only after other claims are satisfied
- Preference shares:
o Shares that guarantee that shareholders will receive the first part of the dividends when they are paid.
Up to a maximum value.

Altering the nominal value of shares to make shares more marketable

- Share splits
o Splitting the price of a share, but doubling the amount so nominal value stay the same
- Share consolidation
o Reducing the number of shares and increasing their nominal value per share to compensate

Bonus shares
- Issue extra shares by using reserves of any kind and turning them into share capital
o Decrease reserves by $50k, increase share capital by $50k

Sources of long-term finance for a Ltd. Company

- Share issues
- Retained profits
- Long-term borrowings

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Raising share capital

Common issue methods


- Rights issues: issue made to existing shareholders in proportion to their existing share holdings
- Public issues: Issues made to the general investing public
- Private placings: Issues made to selected individuals that are asked if they are interested in picking up new shares

Withdrawing equity

- Not available for withdrawal:


o Share capital (nominal/par value)
o Capital reserves

- Available for withdrawal


o Revenue reserves (Paying dividends, share repurchase)

Accounting for groups of companies

Two reported items on financial statements that indicate group statements


- Goodwill arising on consolidation
o Occurs when parent acquires subsidiary from previous owners and pays more for it than the individual
assets appear to be worth. Appears as an intangible non-current asset on the group statement.
- Non-controlling interests (NCI)
o Interests or claims of outside shareholders (aka minority interests) – financed parts of company outside
of the parent company.
 Total share 60 mill. 15 mill owned by outside shareholders -> (shares owned/total shares) x
equity

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Class 5: Measuring and reporting cash flows (ch 6)

Definition of cash and cash equivalents

Cash = notes and coins in hand and depostits in banks and similar
institutions that are accessible to business on demand

Cash equivalent = short-term, highly liquid investments that can be readily


convertible to known amounts of cash (ie. stocks)

Relationship between balance sheet, income statement and cash flow


statement

- Balance sheet
o relationship between assets and claims at particular point
in time
- Income statement
o Explains how, over a period of two statements, equity
figure from first statement has altered as a result of
trading operations
- Cash flow statement
o Looks at changes over the reporting period. Explains the
alteration in the cash (and cash equivalent) balances between the first and second statement.

Standard presentation for statement of cash flows

- Cash flows from operating activities


o Cash in- and outflows arising from normal day-to-day trading
activities
- Cash flows from investing activities
o Cash in- and outflows relating to acquisition/disposal of non-
current assets
o Cash inflows arising from financial investments
- Cash flows from financing activities
o Cash in- and outflows related to the long-term financing of
the business

Deducting net cash flows from operating activities

Two approaches…
- Direct method
o Involves analysis of cash records for that period, identifying all
payments / receipts relating to operating activities. Hardly used.
- Indirect method
o Popular method. Figure for profit for the period will be linked to the net cash flows from operating
activities. Income statement has to be made anyway; information from it can be used as a starting
point to deduce cash flows from op. act.

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Net cash flows from investment activities

Cash inflows from investment activities


- Disposal of non-current assets
o Important; loss/gain on disposal
 Impact on operating profit, but no cash movement
- Interest received
- Dividend received

Cash outflows from investment activities


- Purchase of non-current assets

Net cash flows from financing activities

Cash inflows from financing activities


- Issue of new loan
- Issue of new shares (not bonus shares)

Cash outflows from financing activities


- Paying back loan (loan redemption)
- Repurchase of shares

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Class 6: Analyzing and interpreting financial statements (Ch 7)
Categories

- Profitability: Evaluate profitability of business


- Efficiency: assess business resource management effectiveness
- Liquidity: assess ability of business to meet ST financial obligations
- Financial gearing: assess extent to which a business is financed from borrowings
- Investment: assess return on shareholder’s investment

Ratios benchmarks

Ratio’s may be compared with…


- Past periods
- Similar businesses
- Planned performance

The effect of financial gearing

Financial gearing = financing a business by borrowing rather than


by owner’s equity.

Extent to which a company is geared is important in assessing risk;


borrowing is costly and can be significant financial burden,
increases risk of becoming insolvent

A circular movement in the large wheel (operating profit) leads to a relatively large circular movement in the small wheel
(returns to ordinary shareholders

Limitations of ratio’s
- Quality of financial statements
- Inflation
- Restricted view of ratios
- The basis for comparison
- Statement of financial position ratios

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