Introduction to Financial and

Managerial Accounting

September 2022

1
Introduction

2
 Purpose of Business

To sustainably create value for an organisation’s stakeholders

Stakeholders are individuals, groups or organisations that are affected/impacted by or

can affect/impact the organisation

3
What does a business do to create value?

• By delivering a value proposition that satisfies the needs of the

market.
• Selling that offer at a greater price than it costs.
• Costs including the cost of the capital needed to investment in
the capacity to produce the offer.

4
Who are the stakeholders of a business?
Employees
• Employees
• Management
• Competitors
• Customers
• Suppliers
• Governments
• Investors
• Shareholders
• The community

5
What do stakeholders need?
User group Informational Need - Value from the business
Employees Job security, salary negotiations
Management Understand performance and position
Competitors Assess competitiveness – margins, business model
Customers Financial Stability – continued service
Suppliers Credit worthiness – ability to pay
Governments Policy development, Taxes
Investors Risk – ability to repay plus interest
Shareholders Increase in value – dividends, profits
The community Impact of society and the environment

6
 Can accounting help with stakeholder
informational needs?

Accounting is the information system that records, measures

and reports on the financial transactions of the business entity
to decision makers

Financial transactions are actions that involve the inflow or outflow of cash in the
business
These are the impact of the activities undertaken by the business

7
 Types of Accounting
• Financial accounting – focused on external reporting,
principally to the providers of capital

• Managerial accounting – focus on internal reporting for

decision making

• Tax accounting – focus on planning and calculation of tax

payments

Financial accounting is backward looking – by definition it is reporting an current and

historic data
Managerial accounting – uses historic data and forecast data to model the future for
decision making

8
 Luca
Paciolo
1494 Summa Arithmetica

Benedetto Cotrugli, 1458 Marino Di Raphaeli, 1475

Modern accounting began with the emergence of double entry

bookkeeping in banks in 13th century Italy. It then spread to commerce and
slowly became the method used across the country. By the mid-15th
century, it had matured to the point that most Italian international
merchants, wholesale merchants, and Governments used the method,
along with some smaller merchants, monasteries, convents, palaces, and
households. This project presents an opportunity to make a major
contribution to the history of accounting in the period before the first
manual on this topic was published in 1494.

After its emergence, the method of bookkeeping by double entry was

characterised by regional variants, not just in how the entries were made,
but in the books used in the double entry system. It was only after Luca
Pacioli printed a manual in 1494 describing how to maintain account books
in double entry using the Venetian system that the accounting system and
the double entry method began a process of standardisation. Over the next
150 years, other manuals were printed following the same approach, both

9
in Italy and elsewhere and gradually the Venetian method described by
Pacioli became the international standard for books of account

However, very few examples exist of Venetian accounting before Pacioli’s

manual was printed. This raises doubts as to whether Pacioli’s Venetian
method was something he set down as a normative, or ideal description of
how account books should be kept rather than a description of actual
mercantile practice

Venetian merchants: Alvise Michiel (1470-1482), Soranzo Fraterna (1406-

1434) Andrea Barbarigo (1418-1449), and Jachomo Badoer (1436-1440). All
had variants in book-keeping methods

Bookkeeping manuals of Marino di Raphaeli (1475) and Luca Pacioli (1494).

Benedetto Cotrugli (Croatian: Benedikt "Beno" Kotruljević; 1416–1469) was

a Ragusan (Dubrovnik, Croatia) merchant, economist,
scientist, diplomat and humanist. – wrote Of Commerce and the perfect
merchant included appendices referring to double entry book-keeping
Marino de Raphaeli 1475

9
The primary purpose of financial accounting

To provide information about the reporting entity that is

useful to present and potential equity investors, lenders
and other creditors in their capacity as capital providers
[for the purposes of decision making]

10
 Providers of capital need to know

• has the firm generated attractive returns on the capital invested (and
will it continue) ?

• has the firm generated sufficient cash flows to pay obligations and
replenish its assets (will it be able to in the future) ?

has the firm generated profits and able to pay dividends

11
 Financial Statement and capital providers

Debt Investors

Financial Company
Statements Management

Equity Investors

In larger businesses ownership and management are separate, so management act as

agents to the principals or owners.
The financial statements act as a formal and standardised way to communicate the
performance and position of the business.

12
 Financial Statement and capital providers
Capital

Interest + Principal
Debt Investors

Financial Company
Statements Management

Equity Investors

Debt investors lend capital to companies that are able to repay the loan as well as pay
interest through the loan period. Debt holders have to evaluate risk in determining
whether to make such an investment.

Note there is another group of capital providers – suppliers. They too have to evaluate
the risk of supplying goods and services to the firm for which they do not require an
interest payment

13
 Financial Statement and capital providers
Loan Agreement
Capital

Interest + Principal
Debt Investors

Financial Company
Statements Management

Equity Investors

Debt investors lend capital to companies that are able to repay the loan as well as pay
interest through the loan period. Debt holders have to evaluate risk in determining
whether to make such an investment.
To minimise or contain future risk loan agreements often contain covenants. Below are a
selection of covenants, but note loan agreements are drafted with specific conditions
depending the situation.

Positive/affirmative loan covenants are conditions that borrowers must fulfill in order
to keep receiving funds.
1) Required to report on cash flow and/or profit on a regular basis which is often more
regular than the annual accounts.
2) Maintain adequate insurances
3) Maintain the business in good standing in the country

Negative loan covenants define what borrowers can't do.

1) Limiting the total amount of indebtedness of the business and/or shareholders
2) Restriction on or forbidding distributions and/or dividends paid to shareholders
3) Restriction on or forbidding management fees paid to related parties
4) Prevention of a merger or acquisition without the lender’s permission
5) Prevention of investment in capital equipment, real estate, or other
businesses without the lender’s permission

14
6) Prevention of the sale of assets without the lender’s permission
7) Maintenance of a specific or targeted interest cover ratio

Financial Loan Covenants - Certain financial loan covenants may be used to restrict the
amount of credit the business can access from its line of credit.
1) Current Ratio (Current Assets divided by Current Liabilities)
2) Borrowing base calculation with a defined maximum percentage. The borrowing
base is the total of all eligible assets that could be used as collateral for accessing
additional lines of credits

Note there is another group of capital providers – suppliers. They too have to evaluate
the risk of supplying goods and services to the firm for which they do not require an
interest payment

14
 Financial Statement and capital providers
Loan Agreement Capital

Interest + Principal
Debt Investors

Financial Company
Statements Management

Equity Investors
Dividends

Dividend Policy Capital

The owners of the company are given a dividend as compensation for the equity
investment. Dividend policy is important in maintaining the share price. To decrease or
not pay dividends gives a negative signal to the market. This is not a cost of doing
business in the same way as paying debt investors in that it is a distribution of the firms
excess returns.

Businesses sometime return capital to shareholders in the form of share

repurchases/buybacks or make exceptional (one-off) dividends payments.

15
 Financial Statement and capital providers
Capital

Interest + Principal
Debt Investors

Financial Company
Statements Management

Equity Investors
Dividends
Capital
Attest

Audit fee
Independent
Auditors

Independent auditors are appointed by the company’s management to audit and sign-
off on the financial statements annually.

The auditors will test the systems in place for robustness and consistency. This will help
them understand that financial transactions are recorded consistently. They further
assess the way transaction are presented to ensure the are compliant with current laws
and applicable accounting standards.

E&Y (formally known as Ernst & Young) is preparing to split it’s audit business from it’s
management consulting business to prevent conflicts of interest.
In some jurisdictions financial regulators have insisted that auditors must be changed
after 5 years, this is to prevent auditors from being too close to the management and
not performing their duties correctly just to keep the business. E&Y failed to notice
Wirecard’s fraud.
Note auditors are not engaged to detect on fraud

16
Burberry

Page 221 Annual report 2021/22

17
 Reporting to Shareholders
Shareholders

Principal Committees

Independent
Board of Directors Audit Committee
Auditors

Nomination
Committee
Audit fee
Remuneration
Company Committee
Management

The board of directors represent (are agents of) the shareholders. The Board is
comprised of executive directors (directors that actively managing a part of the
business) and Non-executive directors (NED’s) that offer independent advice to the
Board.

Advising the Board are three main committees. The structure of governance differs
between companies and there may be other committees advising the Board.

The Audit committee - provide oversight of the financial reporting process, the
audit process, the company’s system of internal controls and compliance with
laws and regulations.
They appoint the auditors. They will oversee review significant accounting and
reporting issues and recent professional and regulatory pronouncements to
understand the potential impact on financial statements. They should be
assessing the completeness and accuracy of the financial reporting both external
and internal.

The Nomination committee that proposes new members to the Board, non-executives
(NED’s) or a new chairperson.

The Remuneration or Compensation committee that recommends the compensation

18
for the executive directors and senior management. As well as the Chairperson of the
Board

These committees should be independent, but may not be.

18
 Burberry

Page 168 Annual report 2021/22

19
 Principal Financial Statements

• Income Statement (also known as a Profit or Loss Statement or

a Statement of Financial Performance)

• Balance sheet (also known as a Statement of Financial Position)

• Statement of Cash Flows

IS: a statement covering a period of time – quarter, six months, full year and captures all
the activities associated with the value proposition – the revenue earned from the offer,
the cost of the offer, the delivery, selling and administration costs

BS: captures the capacity of the business – all the resources, both fixed capital and
working capital at a point in time which is the end date of the period covered by the IS
and CFS

SCF: shows the changes in the cash (bank) balances from the last period end to current
period end

Note – the Notes to the Financial Statements are an integral part of the financial
reporting and therefore fundamental in understanding the statements

20
What are the fundamental activities of a
business?

• Financing activities – raises financial capital from owners and

creditors

• Investing activities – invests in capacity/resources needed to

do business

• Operating activities – engagement with the customer; the

generation and use of resources

21
Business activities are described in the financial statements

Income Balance
Statement Sheet

Operating Investing Financing

Activity Activity Activity

Revenues & Assets Liabilities &

Expenses Equity

22
 Financial Statements
Example: Example:
31 December 31 December
2020 2021

Income Statement for the period (2021)

Statement of Cash Flows for the period (2021)

Opening Closing
Balance Balance
sheet sheet

The balance sheet is a snap shot of the company at a point in time

The income statement and the statement of cash flows capture the flows (cash or profit)
throughout the period

23
 How does accounting view the business?
Key concepts
• Entity

• Monetary units

• Periodic

• Historical cost (reliable or relevant)

24

Entity – reporting should be separate from other organisations. In the case of groups
each company has its own set of accounts which can then be consolidated.
Monetary – transactions are recorded in currency units, the functional currency is that
of where the company operates and the reporting currency is normally where the
company is based and reports. This means that some currencies will be translated into
the reporting currency.
Periodicity – companies are obligated to report at least once a year. Companies listed on
a stock exchange will have report more often. In Europe companies prepare an interim
report (an unaudited 6 month report – first half of the year) and an annual report
(audited); in the US companies will file unaudited reports every quarter (10Q) and a full
year audited report (10K)
Historic costs – financial transactions are recorded at the time and therefore are historic
in nature. This means the values recorded are reliable, because they can be traced to the
original purchase. However, over time these values are less relevant to decision makers.
There are provisions within international financial reporting standards that the original
values recorded can revalued to fair values, current values or value in use.
This uses a revaluation account which is included in the equity section of the balance
sheet. Since any change in assets or liabilities impacts shareholders.

24
 Fundamental assumptions:

Accrual assumption – what is it?

Going concern – why is it important?

25

An accrual is the recording of a financial transaction before the cash has been received
or paid.
Accruals are made in order to calculate the performance, it is important to include all
revenues and expenses in the accounts
- Matching concept

Going concern – the ability of a company to settle obligations as they fall due in the
foreseeable future. The foreseeable future is not defined, but one could use to the end
of the next accounting period.
If a company is not a going concern then it will have to liquidate assets in order to pay
debts. This inevitably will mean the selling of assets at a lower value than the company
has them recorded.
A company may become not a going concern because of various factors such as the
collapse of a market or a downturn in the economy

25
Source of financial accounting rules

• Legislation

• Accounting standards

• Stock exchange regulations

26
Accounting standards
Recognition/Derecognition:
- when an item is regarded as an asset, liability, equity, revenue or expense

Measurement:
- historic cost [original transaction price less impairment charges]
- current value [fair value, value-in-use and current cost]

Disclosure:
- the IASB Conceptual framework guides the general presentation [income
statement versus other comprehensive income] and minimum level of
disclosure – hence the importance of the notes in the annual report

27
 Financial Reporting Standards
Covers the issues of recognising, measuring and reporting the
financial transactions of international businesses.

• every country has it’s own generally accepted accounting

principles (GAAP)

• IASB has developed a series of international standards known as

International Financial Reporting Standards (IFRS)

In the European Union we have EFRAG, European Financial Reporting Advisory Group
that ratifies the use of IFRS

28
Why have international standards?

World’s financial markets are borderless

To assess the risks and returns of their various investment

opportunities, investors and lenders need financial
information that is relevant, reliable and comparable across
borders.

29
 Business models
• the transformation of input capitals
through business activities to create
outputs which are measured by
outcomes

Examples of the six capitals:

Financial capital: lines of credit, cash reserves, ability to access finance, collateral assets
etc
Manufactured capital: anything man made – buildings, plant, machinery, ICT, inventory
etc
Human capital: talented people capable of collaborating to create value
Intellectual capital: knowledge, patents, franchises, licences etc
Relationship capital: networks of customers, suppliers, collaborators etc
Natural capital: use or access to land, air, water. Eg water ways or canals for
transportation or water for cooling or irrigation

As managers we measure the outcomes: for example

Financial – Operating cashflow, free cash flows
Manufactured – number of stores, inventory levels, number of delivery vehicle
Human capital – training courses, cross training, transfers, promotions, new hires
Intellectual – new patents, new franchise agreements
Relationships – active customers, net promotor scores, churn rates
Natural – energy/water use, polluting events, de-carbonisation programme, recycling

30
How Illy describes its business model

31
Business models

We are a technology platform that uses a massive

network, leading technology, operational excellence
and product expertise to power movement from point
A to point B…We connect consumers (“riders”) with
independent providers of ride services (“ride drivers”)
for ridesharing services and connect consumers
(“eaters”) with restaurants…

32
Which company?

33