Chapter 2 – Conceptual Context

Issue of valuation (measurement) and the impact: USA reducing the price of firearm to sell more
firearm to Ukraine. Shows that accounting is both an enabler and infringer.

Conceptual framework that gives us a system of thought.

Recognised = included

Should there be an accounting fine in highly polluted cities for companies? To protect the
environment

E.g., A horse’s ass shows that concepts persist, and they impact practice – US rail tracks made a
specific distance due to how they were formed on old roads. 4 feet 8.5 inches comes from the
spacing needed by imperial roman chariots. Space shuttle has 2 rocket boosters which were shipped
by train to the factory, so they had to be designed by the width of a horse’s ass.

When rules change it has a significant effect on the economy. rulemaking and the impact on society
and as much as it has on individuals

Vested interests: political nature of process

Fair Value: amount at which asset exchanged between knowledgeable and willing parties in arms-
length transaction

Arm’s length transaction: commercial

Removes the historic basis which meant that you included something at how much it cost originally
e.g., building bought 10 years ago for 200,000 still valued at that. It used to continue to be used in
accounts. Fair value amount now asks what someone would be willing to pay us now and that
number is in the accounts. It is more current and up to date, but it is subject to manipulation.

Decision usefulness v. stewardship need to prioritise usefulness

Fair value caused huge losses as the value of its assets declined, caused RBS (Royal Bank of Scotland)
to become nationalised 12 months after paying 70 billion pounds to overtake a Dutch bank ABN
Amro. It shows how fair value can have negative impacts. Regulation of the financial industry had
loosened known as light touch regulation.

Overtook 26 companies in 8 years. Should have used the collapsing markets as a sign not to do the
deal. RBS shares dropped to 10p each. Observation that the board of the company failed in its
responsibilities.

Fair value can cause a company to be overvalued/inflated.

Encouraged lower wealth companies to chase companies.

1
AC4305 Week 2 Lecture 2: Chapter 3

Financial analysis: Extracting significant information from financial accounts

Why? To see performance

Who uses accounting info?

For what purpose? Control society/our future – AI challenges the future of financial analysis

Theory of financial analysis enables us to explain, predict, contextualises, legitimises

Can test accounting, is it the best source of info? What is relationship between accounting
information and the market?”

Classic (normative) theory:

 it is possible to be definitive as to how things work (objectivist view).

 Numbers can capture reality; it is possible to present a statement that we can put a number
on (economic/finance theory).
 Flaws: can’t assign a number to everything e.g. value of a person, caused this approach to
collapse.

Market based theories

 Perspective is away from the preparer of accounting info and now asks questions from the
perspective of the users. Asks the market their reality.
 The real issue is is it relevant to users and can they make sense of it.
 Testable: can ask the market can they make sense of it.

NOTE: Long–Term Capital Management (LCTM) shows the EMH also had problems.

Efficient market hypothesis (EMH)

 Focus on market/users NOT on the preparers

 Market as best captor of information – market is most efficient creator and user of
accounting info

 Share price as best measure of wealth – the market is adapting to share price e.g.; energy
companies have seen their shares move more dramatically due to the increase in the price
of energy

 Sources of information other than accounting

 All impounded immediately in share price – unlike accounting info this process is much more
immediate and doesn’t take months

 Stocks valued fairly in light of all available information – values fairly what is going on in the
company

2
Efficiency

 “Share price reflects fairly and immediately all available information”

 Efficiency?

o How does market react to information?

 Impact on;

o Accounting Regulators

o Accountants

o Investors, fund managers, analysts

Long–Term Capital Management (LCTM)

 EMH assumes rational investors – this is unrealistic

 LTCM (Hedge Fund) – major failure
o Highly leveraged – companies exploit the smallest differences in buying and selling
shares, borrowed heavily and encouraged investors to invest more
o Subject to little regulation – misreporting their performance on financial accounts
o Arbitrage trading
o Use mathematical and economic models to find opportunities
The best made models cannot protect against irrational behaviour.

3
Week 3 Lecture 1

Corporate Governance: Way businesses structured and controlled.

 CG varies across national boundaries:

o cultural reasons – e.g., comparison between Ireland (common law) and France
(bureaucratic approach - detailed codes for what needs to happen under certain
circumstances)

o social contexts – in China profits wasn’t an accepted term

o historical reasons – Companies formed under British empirical

o commercial focus

 CG regime impacts nature of accounting

o strong shareholding culture will require strong reporting culture e.g countries where
you have the stock exchange

 Importance reasserted by recent frauds etc.

Corporate Governance in Ireland &UK

 Anglo/American CG model common to English-speaking world

 Characterised by:

 gulf between directors and owners

 board of directors

 stock exchange as major source of finance

 Financial accounts seen as one means of bridging gulf between directors and owners (their
company)

Best Practice

 Frauds and Financial Crisis have led to model being questioned

 Flaws:

 too rigid – no flexibility, only one way of doing it, we could learn from the German
CG model

 open to abuse

 too focused on rights of investors – accounts not geared to all users e.g., employees,

 Accounting bodies, government proactive – companies now have to report on their carbon
footprint (part of CSR - Corporate Social Responsibility, how will that transaction affect a
company)

4
  Various reports address different aspects

 Best Practice reports and codes

Cadbury Report (possible exam q?)

First big response in an attempt to address the flaws in CG. Changed the rules about how companies
are structured and most importantly how they impact society. Changed the balance and how
companies behaved. Stopped asking companies to comply with 1000’s of rules. Assumes you are
applying with best practice or explain otherwise

 Commissioned by FRC, Stock Exchange etc.

 Chaired by Sir Adrian Cadbury

 Reviewed CG with specific reference to:

 responsibilities of directors – focused on how directors should behave

 nature of accounting information required

 audit committees – governance issue on checks in books

 relationship between owners, boards and auditors, etc.

 Championed ‘comply or explain’ culture

 Board: importance of efficient, diverse board, separate CEO and Chairman

 Executive Directors: service contracts to be limited to 3 years, disclosure of remuneration

 Non-Executive Directors: greater role, independence important

 Reporting and Controls: responsibility of board in relation to accounts, importance of

supplementary narrative info.

 Audit Committee: critical role in liaising with auditor, should comprise of 3 non-executive
directors, has emerged as critical element of CG regime

5
Week 3 Lecture 2: Guest

Greenbury Report

 CBI formed group to produce code in relation to directors’ remuneration

 Chaired by Sir Richard Greenbury

 Recommendations in respect of:

 remuneration committee – governance mechanism

Governance mechanism: a set of responses to conditions of uncertainty, dependence and

opportunism that exists in a business relationship

Refers to the structural relationship and operation mode between various elements.

 disclosure provisions

 remuneration policy

 service contracts and compensation

 Directors’ remuneration still source of controversy

The Wirecard Fraud – How one man fooled all of Germany (video)

What should the board of directors have been
doing?
What were the auditors up to? How can you
miss 1.9 billion dollars?
Common characteristics to these frauds :
strong charismatic individual at the top of the
company who can operate outside of the
board

Shares went from 100 to less than 2 euros per

share

Enron of Europe

Braun CEO -7% of the shares

Took out large loans on his share as collateral

Short selling

Operations were smaller than they appeared

– 250m gap in balance sheet

Involved in money laundering

Falsely increased money transactions by

sending money back and forth

Claimed they were using third parties, the

banks supposed to be holding this money in
the Philippines stated it didn’t exist (1.9bn)

6
Hampel Report

 Group formed to continue work of Cadbury

 Chaired by Sir Ronald Hampel

 Reiterated much of Cadbury & Greenbury

 Important in maintaining momentum

 Recommendations:

 different individuals as Chairman and CEO

 directors contracts not to exceed 1 year

 non-executives on remuneration committee

 training of directors

Turnbull Report

Emphasis’s internal control

 ICAEW set up group to pursue Cadbury ideas on internal control & risk

 Chaired by Sir Nigel Turnbull

 Assigns a strategic importance to control and risk in context of CG

– strategic = concern for the board of directors

Corporate response: embed controls – control is binary in function i.e., yes/no

Example of control: any expenditure over 100,000 has to be approved by CEO

 Shows directors how these areas are to be integrated into CG model

 In future may be seen as seminal report

 Focus on principles rather than rules

 Emphasis on:

 successful risk management adding value – controls in place

z internal control only possible if embedded in internal processes – is there an internal

audit function in the company, does it report to the audit committee

z role of board in reviewing and implementing

z key risks to be identified and managed

7
Corporate Response: the Risk Management Framework

1. identify the risks

2. determine the likelihood of the risks materialising
3. creating the steps of mitigation (to deal with the risks that might occur)

Higgs

 Focus on Non-Executive Directors (NEDs) – governance mechanism

 Reflects increasingly important role:

 Independent – express themselves at board meetings + challenge CEO’s

 Diverse

 Strategy, control and governance roles

 Higgs Report (2003) recommended:

 NEDs to comprise at least 50% of board – we now believe majority NEDs is best

 Separation of CEO and Chairman roles

 Ideally NEDs might serve two three-year terms

 Commended for avoiding excesses of SOX

Danger of Golden Circle: same people on every board, thinking of the same thing in every meeting

Smith

 Reflected increased importance of Audit Committee = governance mechanism

 Now seen as vital element of CG architecture

 Recommended that Audit Committee:

 Be comprised of at least 3 independent NEDs

 One member to have financial and banking experience

 Monitor and review integrity of financial statements, controls, etc. – good

governance to have the internal audit in place, include the creation of the risk
management framework. BEING TRANSPARENT

UK CORPORATE GOVERNANCE CODE JULY 2018 (Combined Code) - Not mandatory but carries a
significant Moral Authority

 Cadbury, Greenbury and Hampel formed basis of original Combined Code adopted by SE

 Supplemented by Turnbull, Higgs and Smith

8
  Code based on “Comply or Explain” approach

 Different to US – either obey the laws of the land or not

 Essentially ‘principles-based’

 Significantly impacts company disclosure, e.g. in Annual Report

Total Shareholder Value (TSV)

The inherent problem: ownership versus control leading to a clash between shareholder primacy
and director primacy.

 Prioritises shareholder agenda

 Emphasis on shareholder wealth (share price + dividends)

 Criticised as:

 Limited in perspective

 Short-term focus

 Open to abuse

 Key player in Global Financial Crisis

Stakeholder theory

Reminds corporations that they are corporate citizens i.e. pay taxes, adhere to laws

 Looks beyond investors and their needs

 Recognises a broader constituency, e.g.:

 employees

 environmentalists

 others including revenue, legislators, regulators (makes accounting rules), stock

market

 Challenges primacy of financial markets

 Champions greater transparency and accountability

 Potential for radical reform of CG model

Summary

Corporate behaviour and culture emerge as important ethical issues.

 CG a critical influence on nature, content and focus of the accounting process

9
  CG regime in UK part of Anglo-American scheme

 Characterised by investor emphasis

 Frauds, scandals were catalysts for change

 Cadbury, Greenbury, Hampel, Turnbull, Higgs & Smith

 “Comply or Explain”

 UK now world-leader in ‘best practice’

10
Week 4 Lecture 1 (Chapter 5)

Annual Report (can be dismissed as propaganda documents)

 Focus of text: ARs of EU Listed companies

 Principal means of communication - between companies and its stakeholders
 Produced annually by companies
 Increasing in size and importance
 Aimed primarily at shareholders
 Needs of other stakeholders being recognised
 Contains quantitative and qualitative info.
 Content controlled by statute, regulation, IFRS
 Narrative and financial elements, e.g.:
o financial statements and notes
o chairman’s, directors’, auditor’s reports
o Strategic Report – requires the company to disclose information that they would
prefer not to disclose for competitive reasons e.g., Ryanair don’t want to disclose
future intentions of Ryanair.
 Financial elements central
 Narrative elements increasing in range
 Supplemented by graphs, photos etc.

Narrative Content (first half of the report)

 Should supplement financial statements

 Required by statute:
 Directors’ Report: Impact of Combined Code extensive
 Includes sections: trading activity, developments during period, directors
(especially remuneration), employees, corporate governance, Directors’
responsibilities for financial statements
 Auditor’s Report
 Auditor conducts “independent review”
 Report (ISA 700):
 Opinion on ‘true and fair’ [or “fair presentation”]
 Report may be unqualified (good as the auditor is sufficiently confident) or
modified (ISA 705)
 Modified opinion significant for any company - may lead to drop in share price
 Must also comment on: internal controls, compliance with Governance Code,
any other area of AR showing inconsistencies
 Audit report content changing significantly
 New style audit reports a response to audit failures
 ISA 700 + Governance Code now require:
 Greater insight into conduct of audit
 Focus on risks, materiality and audit scope
 Companies must also report on how audit committee interacted with auditors -
Reflects growing role of audit committee
 Strategic Report (CA06)

11
  This type of report recommended by Cadbury
 Equivalent of US Management’s Discussion & Analysis
 Replaces Operating & Financial Review (OFR)
 Commentary by directors on strategy/plans/risks
 Historical assessment, but with future perspective
 FRC: Guidance on the Strategic Report:
 Insight into business model
 Describe risks and future prospects
 Analysis of past performance

 Not required by statute: Most interesting because it is not controlled, disclose some key insights
which wouldn’t have been disclosed otherwise.
 Chairman’s statement: Personal perspective, Comments on macro contexts, Usually
refers to: significant events, overall results, performance, future prospects, Danger of
management ‘spin’
 Chief Executive’s report,
 Other, e.g., historical summaries.

Other Elements

 Some ARs now include report by CEO

 allows CEO to communicate with users
 supplements other elements
 Historical summaries
 not required by statute
 usually summarise 5-year performance
 often tabular/graphical presentation
 Visual (graphs/photos) commonly used

Financial

Tesco PLC - See especially pp. 116 & 118 in the annual report (will be given in the exam – will be
asked to calculate some ratios and analyse). Asked to analyse the performance of Tesco under
several headings which will be covered in Tutorials.

 Fraud resulting from internal accounting – under pressure they decided to be creative and to
include earlier than should have been the case income of the company = aggressive revenue
recognition.
 Revenue Recognition
 Inflated profits (£250m) that should not have been shown until 2016
 Whistle-blower
 Governance
o Auditors – at fault
o Board – serious deficiencies in leadership with many being replaced after this event
 Reaction of Stakeholders - not just shareholders who lost money due to drop in share price.
Real hit on suppliers as they couldn’t trust Tesco’s pricing policy. Many customers stopped
shopping there.

12
Week 4 Lecture 2

• Accounting often a key element in enabling or uncovering frauds

13
• Frauds tell us much about how accounting works (or is exploited!)

• Enron shows complex accounting structures can be used

• Phar Mor shows how simple stock valuation methods can hide $m

• Wirecard shows how poor auditing can assist

• Toshiba shows how cost-cutting can be manipulated

• Role of other actors as support for accounting is key:

• Auditors

• Board of Directors

• Management

WorldCom

• AT&T breakup 1983

• Rents out existing infrastructure – ‘line costs’

• Bernie Ebbers – got 25 years in prison (conspiracy)

• Strong cost-control culture = how you account for expenses and stock internally,
manipulation of these items directly impacts profits.

• WorldCom grew by acquiring others e.g., Sprint

• Trading margins contracted

• Accounting numbers ‘changed’ e.g., inserting incorrect numbers – didn’t provide an

explanation

• Expenses began to be shown as Assets – this increased profits e.g., WorldCom incurred
salaries costs in one of its companies instead of putting it in the income statement they
put in in the Balance Sheet

• $3.8b in fraudulent transactions

Notes:

The accounting team were asked to come up with accounting entries to show profits which did not
match reality. They were under pressure to do this as the company is chasing profits because its
share price relies on those profits = earnings management/profits manipulation.

Pre-paid capacity

Pension funds typically lose the most when these events occur apart from employees losing jobs, the
may also lose their jobs.

Toshiba

• Incentive structures

14
 • Profits manipulated to ensure share price rises

• ‘Earnings management’ – financial analysts working for large investment banks, analyse
companies to see what’s going on and how its acting, as they come more familiar, they
try to project profits, companies then try to chase the profits set by analysts as
reasonable expectations, if they don’t reach it the shares lose value.

• Short-termism

• Profits of $1.2b ‘created’ over time – uncovered in 2015 - to achieve these targets by analysts
they pretended to make profits that they never made.

• Major projects had fabricated numbers

• Overstated inventory (stock) numbers i.e. product that 10e was revalued at 15e so that it would
be valued at 15e in the accounts and not 10 the price it was actually sold for.

• What about Board

• What about Auditors?

Week 5 Lecture 1 – Chapter 6

Annual Report: Financial

15
Annual Report photographs of a business and its performance overtime.

They want us to arrive to a positive conclusion.

Consolidation

 Most large plc’s are ‘business combinations’

 i.e., various companies under one parent:

 wholly owned subsidiaries (entirely owned by the parent)

 partly owned subsidiaries (companies that they have invested in)

 associates (sometimes in/out of the picture)

 These require consolidated (group) accounts

 Consolidated accounts of EU listed companies the focus of this module e.g., Tesco plc

 Consolidated (Group) accounts comprise accounts of parent and:

 wholly owned subsidiaries: incorporate fully

 partly owned: incorporate partially

E.g., Enron which had a parent company called Enron and at the end they over 3,000 subsidiaries,
Tesco would be much simpler.

Group Structures

Scenario 1 shows us that P plc owns 100% of S1 plc -> wholly owned subsidiary i.e. included in P plc
consolidated accounts.

Scenario 2 shows us that P plc owns 51% of S2 plc -> partially owned i.e. included

Note: If a company owns more than 50% it will be included in the accounts.

Scenario 3 shows us that P plc owns 5% -> not included in consolidated accounts

16
Format of Financial Statements

 Impact of EU Directives on presentation

 IAS 1, Presentation of Financial Statements, the principal standard for large plcs – created by
IASB which has a number of principles.

 Overall principles:

 “Fair presentation” [NB: “True & Fair”] – fair is typically established by case law

 Compliance with IFRS must be stated

 Offsetting generally not allowed

 Each material class of item to be presented

 Basic accounting concepts continue

Financial Statements in Annual Report

 Financial statements are core of AR

 Controlled by statute, standards, etc.

 Under IAS 1 financial statements include:

 Statement of Financial Position (Balance Sheet)

 Income Statement (Profit and Loss Account) – looks at the income of the company to try
and calculate the profit of the company

 Cash Flow Statement – tells us what’s actually going on in a company, cash that goes in
and out, a lot of frauds have been uncovered from these

 Statement of Changes in Equity – looks at changes in the relationships between the

company and its owners (won’t be studying)

 Notes to the accounts – largest section in AR, provide more detail on items included in
the first three items

Ratio Q3

Statement of Financial Position (Balance Sheet)

 Format not rigid

17
  Subject to minimum disclosure provisions

 Assets and Liabilities must be divided between “current” and “non-current” – only requirement
under IAS1

 Current means short term

 Non-current means medium/long term

 “Current” if:

 Realisable within normal operating cycle, or

 Held primarily for trading purposes, or

 In form of cash (or a ‘cash equivalent’ item), or

 Expected to be realised with 12 months

Equity – money owed to the owners

See Tesco 2022

 Presents Group results for 2022

 i.e., Tesco + subsidiaries etc

 Shows overall performance/position of Group

 See financial statements pp 116+118

 Group Balance Sheet p118 will be given in exam to do calculations/ratios, significance of the
results?

 Group Income Statement

18
The idea of trends is very important – discloses significant information to us

Intangible Assets

 IAS 38: ‘identifiable non-monetary assets without physical substance’

 e.g.: intellectual capital (knowledge a business has), customer loyalty, brands, software
etc

 To qualify, asset must be:

 ‘identifiable’ – separable

 ‘controlled’ – rights to future economic benefits

 Classify as

 ‘Indefinite’ life: subject to impairment tests

 ‘Finite’ life: can be valued using fair value and amortised

 Internally generated intangibles with demonstrable feasibility may now be recognised

Used to account for 15% now account for 70% in relevant importance in a company’s assets

Week 5 Lecture 2 – Chapter 6

Income Statement (IS) – P/L

 IAS 1 imposes certain minimum required headings:

19
  Revenue

 Finance costs

 Share of profits from associates and joint ventures

 Tax expense

 Allocation of profit

 Disclose dividends recognised as distributions – significant issue (dividends: monies a company

pays back to its owners on an annual basis – way a company retains its owners over time)

 ‘Fair Presentation’ may require additional items

 Where material, items to be disclosed separately – default is to reduce disclosure

 Expenses can be analysed by:

 Nature: materials, staff costs, etc., or

 Function: cost of sales, administration, etc

Note: the key is to disclose everything clearly.

 Choice will impact IS structure

 IFRS 5 requires that results of Discontinued Operations be shown on face of IS (Discontinued

company: company that they sell off)

Cash Flow Statements (CFS)

 CFS allows an assessment of ability to generate and apply cash (or cash equivalents)

 Reflects critical role of cash in commercial life

 IAS 7 requires presentation under three headings:

 Operating – principal trading activity

 Investing – e.g. acquisitions, dividends received

 Financing – cash movements relating to Equity or borrowings

 Additional information disclosed by way of notes

Notes to Financial Statements

 Integral part of reporting process

 Cross-referenced to primary statement

 Stock/Debtors/Creditors

 Bank Loans etc

20
 Disclose:

 Basis of preparation

 Additional information, often in narrative form

 Typically, AR has separate section dealing with Accounting Policies (IAS 8)

 Outlines policies, judgements, etc, used

Summary

 Financial statement presentation heavily regulated

 Increasing emphasis on greater disclosure and supplementary information in notes

 Continuing change likely in future due to:

 changing reporting culture

 new technologies and media

 Fair value represents significant change

ENRON – energy + broadband

Kenneth Lay

2 employees gambled and transferred money into their own accounts

Skilling (CEO) introduced mark to market to Enron.

Graded employees 1-5 and those graded 5 were fired, ranked on capacity to generate money for the
company this made employees exploit accounting rules to show as high a profit as possible.

Mark to market – aggressive accounting style: companies gather in profits that they haven’t yet
earned and to show them as profit immediately e.g., profits for next 10 years(5bn) could be included
now even if it isn’t received in the next 10 years/falls through. It had been lobbied for by the energy
companies in the USA and were given this concession by the accounting board. Proves accounting is
political. Meaning company is worth more on paper.

When they arrived at plant discovered it wasn’t connected to energy grid – unable to produce
anything as no electricity. Still allowed show 5nb profit in accounts.

Whistle-blowers – people w key company info

Started trading futures on the weather.

Company collapsed 20 years ago, and they are still finding subsidiaries.

Week 6 Lecture 1 – Guest Lecture

List of indicators at Co with problems

21
 Generating negative cash flow – found in operating activities

 Significant losses – is this a continuation/trend?

 Difficulty servicing debt – e.g., CRH have over $10bn in debt

 Large overdraft

 Net current liabilities – give away sign to problem in a business

 Irritated creditors

 Reduced dividends – if company pays dividend every year, shareholders begin to expect this. If
it’s lower than last year may indicate a problem

Approaches to Analysis

 Mass of data requires techniques to be used

 Different user requirements
 Goal of process is ‘informed decision-making’
 Challenges are how to:
o contextualise
o compare
 Fundamental Analysis / Technical Analysis

Fundamental Analysis

Liquidity, Profitability, Solvency (look for final exam)

 Focus on business fundamentals

 Macro- and Micro- issues
o economy
o competitors
o financial performance
 Principal techniques:
o common-size statements -> what do the income statement, cashflow statement,
balance sheet -> must have these 3 by law -> what are the profits by a % of sales e.g.,
Tesco single digit, IBM double digit
o ratios (percentages, etc.)

Common-size Statements

 Provide a common base -> same worldwide revenue – expenses = operating profit ->
 enables us to compare industries
 e.g., express all as % of sales
 Enables comparison:
o cross-sectional
o segmental

22
 o temporal
 May remove size as explanatory variable
 Tesco post in Feb to include Christmas sales as share price usually increases
o Account for the year

Ratios – what do the numbers say, how well is management managing

 Reduce information to common form

 Enable inter-firm comparison
 Categories:
o liquidity
o activity
o financing
o profitability
o investment

Use of Ratios

 Ratios only one part (Calculation) of process

 Overall process can be summarised as OCAID:

o Observation: assessment of available information

o Calculation: reduction to other forms e.g. ratios

o Analysis: initial contextualization

o Interpretation: identification/evaluation of significance

o Decision-making: goal of FIA

 Art/Skill

o Matching principle

o Going concern basis (continue in the future)

Ratios: Issues/Problems

 Ratios only a means to an end

 Perpetuate problems in accounting data
 Assumptions not always sustainable
 Benchmarking a useful technique
 Statistical issues:
o negative numbers
o small numbers
o numerator/denominator

23
Want to be able to know have some of the assets been impaired.

Leverage/Gearing the size of the debt in financing assets

Week 6 Lecture 2 – Chapter 8

Cash

 Importance of cash

24
 ‘Cash is King’
 Liquidity: ‘availability of cash in short term’
o Capacity of firm to generate cash
 Activity: ‘efficient management of funds’
o Efficiency of cash generation
 Liquidity and activity linked

To survive: Having cash or access to it WHEN you NEED it

Activity

 Quantifies trading activity in a way that recognises link with cash-generation

 Measures management efficiency
 Focus on management of short-term assets/liabilities
 i.e., Working Capital management
o Debtors
o Stock also called Inventory
o Creditors
1. Implications for cashflow
2. The management of these 3 areas show the competence of managers

Debtors – trade receivables (owe you money)

 Debtors: ‘claims to future cash’

 Trade Debtors: ‘amounts due in respect of credit sales
 Debtor’s days: time taken to pay by credit customers
o (Trade Debtors / Credit Turnover) x 365
o Firms will want to reduce this, i.e., ensure payment is received more quickly

Week 7 Lecture 1 – Chapter 9

Financing

 “Manner in which an entity funds activities”

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 Long-term focus

 Financial structures of firms vary e.g., retail sector is common -> lot of short-term funding
sources i.e., sell regularly, large quantities meaning large amount of cash coming but they must
have enough funding for building. Different to company in property -> more concerned in long
term-funding. e.g., Ryanair trying to use short-term loans -> funding would be too costly, and
they would be bankrupt

 Financial stability a critical consideration

o often directly related to funding structure

o excessive “external” funding problematic

 Range of long-term sources

 Equity v. Debt

Equity

 Typically, ‘money invested by shareholders’ i.e., owners

 Equity/Capital section of B/S (see also Chapter 6)

o issued/authorized

o issued share -> shares that the company has made available in the market

o Authorized -> the maximum number of shares that a company can issue.

o value

o nominal/issue price -> price at which shares are made available -> figure in BS

o market price -> as traders trade the shares the value fluctuates

 Dividends

 Ordinary = risk-takers – variable dividend

 Preference: regular payment, fixed dividend

Reserves

Making profits every year but chooses to retain its profits and not pay a dividend -> typically do it as
they need to keep investing in the company

 Arise from retention of profits or events such as issue of shares at a premium

o Distributable - retained profits -> could give back to shareholders

o Non-distributable - share premium -> profits the company can’t give back
typically for legal reasons

 Usually attached to equity interest

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 Because ‘owed to owners’

Debt

 Form of funding
 External – does not grant ownership rights e.g., loan from bank
o fixed v. variable cost
 Security usually required
o fixed / floating
 Normally paid before shareholders so considered more secure

e.g., company that has most of its funding provided by its owners is fairly much in control of that
dynamic. Relationship between company and providers of debt are very different.

Types of Debt

 Bank loans and overdrafts

 Debentures – long-term secured loans
 Debenture stock – convertible to equity
 Leases – “finance” or “operating” (see Chapter 12)
 Bonds
o Increasingly important source of funding
o “Issued” by companies and purchased on market
o Covenant restrictions
 Securitization – sales of future inflows
 Derivatives

Week 7 Lecture 2

Types of Debt

 Bank loans and overdrafts

 Debentures – long-term secured loans
 Debenture stock – convertible to equity

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 Leases – “finance” or “operating” (see Chapter 12)
 Bonds
o Increasingly important source of funding
o “Issued” by companies and purchased on market
o Covenant restrictions
 Securitization – sales of future inflows
 Derivatives

Ratios

 Variety of ways of classifying funding:

o internal/external

o fixed cost/variable cost

o long-term/short-term

 Gearing: (note treatment of preference shares) ->

o debt/equity

o high/low

 High gearing ->high proportion of debt compared to equity

 Debt to total assets

 WACC: reflects mix of funding types/structures -> not examined (Weighted Average Cost of
Capital)

o Useful industry/sector benchmark

 Interest cover: PBIT/interest expense -> the degree of comfort we have in anticipating whether
our profits cover the cost of our debt (interest)

Example (O’Regan p323)

Ordinary Share Capital 1,000,000

Preference Share Capital 900,000

Retained Earnings 2,000,000

Fixed cost 5-year bank loan 100,000

Variable-cost 1 year overdraft 300,000

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Current Liabilities 200,000

Funding Profile

Shows how funding impacts the capacity of the company to develop into both the short and long
term

1. Gearing: Debt v Equity

1,000,000:3,000,000 = 1:3 (33% = low)
(Pref + 5yr: Ord + RE)
2. Short Term v Long Term
500,000:4,000,000 = 1.8
(OD + CL: Ord+Pref+RE+5yr)
3. Fixed cost v Variable Cost
1,000,000:3,300,000
(Pref + 5yr: Ord+RE+OD)

Carillion – UK Construction Company

Mismatch didn’t have the right type of debt/funding to progress into the future.

The info was in the report, but they had to go through too much info to find.

Summary

 Large, growing range of sources of finance

 Important for firms to be able to quantify and categorize these sources
 Can be classified depending on focus/purpose:
o external/internal
o fixed/variable cost
o long-term/short-term
 Gearing an important measure of stability

Increasing use of complex financial instruments

Week 8 Lecture 1 – Chapter 10 Profitability and Return on Investment

Group Project

1. Executive summary

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2. NB Financial Analysis
3. Interpretation
4. Governance
5. Future prospects
6. Conclusion/recommendations
7. Appendix (link to annual report, include calculations of the ratios used in financial section) -> not
included in word count of 3,500 -4,500 words.

Profitability and Return on Investment

 Investments are made with a view to:

o earnings
o capital appreciation
 Investors will assess investment under:

1. profitability

2. return on investment

3. payout policy => reference to dividends => ratios have been developed as a mean of assessing
the quality of these earnings.

 Ratios, etc. developed to assess these

o As with all FA, context is key when interpreting i.e., compare with closest
competitor/previous performance/overall sector activity => importance of trends.

Profitability

 Critical for long-term viability - profits are increases in value that result from investments.

 Gross Profit (Margin) rate: expresses gross profits as a function of overall revenue => useful as it
looks at that core activity of the business which is its core trading activity e.g., pubs as a sector
are expected to have a gross profit rate of 45% which you can compare against.

o (Gross Profit / Revenue) x 100%

o focus on trading activity

 Operating Profit rate: gross profit - expenses

o (Operating Profit / Revenue) x 100%

 Net Profit rate: further refinement of profit as we deduct more expenses, reflects the increasing
deductions we are making as we deal with more expense types.

o (Profit before Tax / Revenue) x 100%

 Operating/Net/EBIT (Earnings before interest and Tax) /PBIT (Profits before Interest and Tax)
interchangeable!

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Profitability Example

Company A:

Revenue €10m

Gross Profit € 3m

Net/Operating Profit € 1m

Gross Profit ratio = 30% (3m/10m)

Net/Operating Profit ratio = 10% (1m/10m)

Earnings Per Share: must be provided by law

 Widely used and closely regulated -> included in Tesco Statement

 EPS = Earnings / Equity shares in issue

 Must be provided at end of Income Statement

 e.g., Company A has earnings (Profits) of €20m with four million shares in issue (able to buy +
sell):

o EPS = €20m/4m = €5 -> for each share out in the market it has earned €5

 Calculation of denominator (equity shares in issue) complicated by: difficult to compare to last
years

o new issues -> If a company keeps issuing shares it’s difficult to choose which number to
include

o share options -> Option to particular people to buy shares at a discount

Market Ratios

The higher the ratio shows that the company is doing/projected to do well, market is positive about
the prospects of the company.

Anything under 10 – not good

Above 10 and growing is positive (varies by sector)

BS doesn’t show current market value

 Price/Earnings Ratio (PER)

o relationship between earnings and market price
o important benchmark - industry averages available
o = market price per share / EPS
 e.g., A plc has EPS of 5; Market Price per share = €40

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 o PER = €40/5 = 8

 Widely used by investors:

o Higher PER = expectation of EPS growth

Payouts

 Investors invest to earn a return

 Total Shareholder Return (TSR): the value to them of the appreciation in the value of a share and
also some dividends they may receive
o = Share price appreciation + Dividends
 Increasingly companies also engaged in Share Buybacks – highly monitored
o Involves company acquiring own shares in market
o Benefits for both shareholder and company
 Occasionally used to favourably impact ratios
o Attractive to companies with cash surplus

Dividend Policy – Exam Question: illustrate with examples

 Dividends: distribution of profit to shareholders – annual return based on investment

 Company dividend policy depends on:
o previous policy
o availability of profits and cash
o market expectations
 Dividend Yield
o (Dividend per share/Market Price per share) x 100%
 Dividend Cover: capacity of the company to pay dividends
o Profit after Tax less Pref Dividend / Ordinary Dividend
 Dividend Payout
o Ordinary Dividend/ Profit after Tax less Pref Dividend

Summary

 Businesses must generate returns

o profits
o capital appreciation
 Ratios developed to assess earnings/return
o relate earnings to investment being assessed
 Profitability ratios assess success of firm in generating profits
 Earnings ratios assess performance of firm from perspective of investors

Week 8 Lecture 2 – Chapter 13 Creative Accounting

 Common and serious problem for accounting -> impact on quality of accounting info that
becomes available.

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 Highlighted by recent frauds: Enron, Wildcard, etc
 ‘Use and abuse of accounting techniques and principles to create financial statements that do
not give a true and fair view’
o emphasises intentional aspect
o both techniques and principles manipulated
o correct context of ‘true and fair’ [or ‘fair presentation’]
o both active and passive aspects
 Governance context

Accounting Manipulation

A plc & B plc have following balance sheets, and both are seeking loan of 50:

A plc B plc

Assets 100 200

Bank Loan nil 100

Capital 100 100

A plc more favourably viewed as ‘low-geared’

Debt: Equity ratio A = 0% (0:100); B = 100% (100:100)

Temptation exists for B plc to hide existing loan

This would be ‘creative accounting’

Example of Kraft Heinz

 Seeking operational efficiencies to increase profits

 Initial focus on reducing costs
 Merger synergies gradually ceased
 Pressure from senior management
 Incentivise creative accounting as aggressive revenue recognition -> initially exceeded analyses
estimates

Earnings Management

 Earnings management culture

 Analysts make future estimates using accounts
o Analysts’ expectations drive profits agenda
 Short-term focus on share price
o Significant role in global financial crisis
 Various techniques used by firms
 May impact long-term viability
 Aggressive accounting culture

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Creative Accounting Practices

 Off-balance sheet financing

 Exploiting complexities of financial instruments
o Derivatives, hedging etc
 Fair values
o Subjective nature
o Increased volatility
 Cash flow manipulation
 Revenue Recognition
o Aggressive practices relating to revenue
o IAS 18
o IFRS 15 (convergence project IASB/FASB)

Role of Ethics

 Creative accounting persists

o Accounting, governance and regulatory aspects
 Ultimately an ethical/moral issue
 Accounting bodies proactive in this area
o considerable corpus of ethical guidelines
o self-regulation sufficient?
 Cultural change in attitude required

Whistleblowing

 Regulators seeking to protect those who alert authorities to fraud, malpractice, etc
 Irish Protected Disclosures Act 2021 (2022)
o Identifies corporate culture as critical
o Focus on protecting whistle blower
o Use of ‘prescribed persons’ as conduit
o Office of Protected Disclosures + Commissioner
 EU Whistleblowing Directive 2019
 Comparison with US approach

Summary

 Creative accounting a significant and continuing problem for accounting

 Some progress made in eradicating more common abuses
 Ethical challenges
 Whistle blowers

Could/should creative accounting be eradicated entirely?

Week 9 Lecture 1 – Chapter 14 Corporate Social Responsibility (Reporting) -CSR

Issues not normally part of accounting template

Responsibility – ethical

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 Recent developments and contexts
o globalization
o ‘green’ agenda -> environmental impulses, should have a view to our engagement with
the environment
o stakeholder theory -> reports to individuals/entities/employees other than owners
o social responsibility -> companies understood as corporate citizens have both rights and
responsibilities
 Financial reporting responding
 ‘Attitude not techniques’
o Seeks qualitative as well as quantitative expression -> numbers don’t suffice
o Addresses issues such as environmental impact
 Some pioneer companies, e.g., Prudential, BT

 Broader responsibilities/possibilities of reporting function

o e.g., wider range of users (Shareholder/Stakeholder)

 investors

 employees

 community

 customers, etc

 Takes emphasis off numbers and puts it onto ‘qualitative’ information

 Companies as ‘corporate citizens’

 Regulatory environment is critical

o National/International (UN Global Compact)

 Potent force for positive action

o e.g., oil companies / political action

o Role of ‘citizen power’

 Resistance from some, e.g., some MNEs

 Power struggle between business and others?

 Part of broader social agenda

 Narrative disclosures likely to increase

o Range of reports will expand

Triple Bottom Line (TBL)

 TBL is one response to information demands of CSR

35
 Measures performance under:

o Financial;

o Social; and

o Environmental

 Reflects limitations of traditional model

E.g., Shell must disclose; how much they contribute to political lobbying each year, degree they have
degraded areas, carbon emissions.

Limited in the way it displays info as q’s are conservative.

Sustainability & Environmental accounting

 Sub-set of CSR

o Area of most significant impact on accounting

 Response to ‘green agenda’

 Environmental Reports now produced by many large companies

o e.g., Shell

o genuine or propaganda? E.g., Unilever grow financial profits as they engage with this
particular agenda.

 Increased disclosures:

o contingent liabilities for environmental damage -> companies might have to include a
charge against profits for their cleanup costs of activities in the future e.g., airlines being
charged due to damage to environment. Tax on the company reflecting their impact on
society.

o Carbon emissions

Sustainability – Exam Q

 Sustainability: ‘capacity to sustain service without diminishing critical capital’

o Ensuring that what happens this year (activity/performance) does not compromise
future years,

 Central and key concept

 One accounting response distinguishes between:

o Capital: Man-made / Natural

o Man-made -> what we create - clothes, buildings

o Natural:

36
  Critical -> water, air, natural resources such as metals, ground earth-based
resources, -> air provided by nature; exists apart from our engagement with it

 Non-critical -> self-replicate e.g., trees

 This imposes notion of ‘social costs’ on business

o businesses ‘charged’ for use of critical resources

o most businesses would be making losses if charged

 See Tesco Annual Report 2022

UNILEVER

 Paul Polson impact he had on the company which turned around their impact on the
environment

37
 Long-term perspective
 Earnings Management Culture
 ULSP (Sustainable Living Plan)
o Reduce costs
o Mitigate risks
o Drive growth of brands
 Annual Report

Supply Chain Management

Getting produces from field to fork

 Area of considerable focus

 One point at which interests of developed and developing world may converge

o Significant political pressure for change

o Results in largest MNEs becoming proactive

 Political roles:

o UN/ILO (International Labour Organisation)

o Regulatory bodies

o Accountants -> determine using our language what is profitable or not

Circular Economy

Fashion industry

– combating inefficiencies - over production - they are produced initially with the idea of being
recycled - mass market

Sustainability Finance

 Environmental Social Governance (ESG)

 ESG Funds – Reporting/Disclosure
 Greenwashing
 Invest to advance SDGs
 Growing regulation
 How do we invest and what is the impact of our investments?

What can Accounting do?

 Accounting challenged by new agenda

 Variety of options

o do nothing

o show cost of critical capital consumed as an ‘expense’

o incorporate more narrative reports

38
 o include financial charge/provision

 Integrated Reporting (IR) - don’t need to know

o Principles-based framework

o Could dramatically change reporting

Summary

 Because it is a social issue it is also political

 Accounting is a social science and can respond to social/political agendas

 Social and environmental concerns are now of central importance to users of ARs

 How should accounting respond?

o do nothing

o be more proactive and imaginative

 CSR also likely to be advanced in overall governance context

Lecture 10 Week 1 - Preparation/Presentation of Final Accounts

See Chapter 6, pp. 205-212; 231-234, Worked examples in Tutorials Weeks 11 & 12

39
 Three primary statements:
o Comprehensive Income Statement – IS (Profit & Loss Account)
o Balance Sheet – B/S (SoFP)
o Cashflow Statement (not required)
 Prepare in accordance with IAS 1, Presentation of Financial Statements
 Principal issue is presentation, with some additional calculations
 Lecture approach will be to progress through this topic step-by-step
o Covered by worked examples in lectures (W10) and in tutorials (W11 & 12)
o IF YOU CAN DO TUTORIAL EXAMPLES, YOU CAN DO EXAM QUESTION

 Typically, you will be provided with information in the form of

o Trial Balance (a list of accounting balances)

o Adjusting items listed after Trial Balance (TB)

Task 1: Learn HOW TO CLASSIFY each TB item: Income/Expense/Asset/Liability

Task 2: Accounting Principles:

o Items listed in Trial Balance have one effect: (i.e., entered once in final accounts)

o Items listed after Trial Balance (Post-Trial) have two effects: (i.e., entered twice in final
accounts)

Exam: Provided with Trial Balance + Adjusting items. Required to prepare B/S + IS by applying the
two principles above in accordance with IAS1

40
41
1. Depreciation (see example in Text, pp.211-2)

• Value ‘consumed’ in generating Revenue

• Straight Line/ Reducing Balance

• 20% Straight Line = 20% of Cost

• i.e. 20% x €250,000,000

• = €50,000,000

2. For presentation purposes, you are asked to group some items together under ‘Distribution
Costs’

Distribution Costs:

Delivery Costs 117,822

Carriage Outwards 67,119

184,941

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Summary

 There are only about 20 items in any Trial Balance

 There are only about 5 or 6 Post Trial Balance Adjustments – Depreciation, Debenture Interest,
Stock at year end, Dividends, Accruals for Auditors Remuneration and/or Corporation Tax
 Focus is on presentation: Apply 2 basic principles, Address any additional presentation
requirements
 Prepare IS and B/S

43
 Week 10 Lecture 2 – Chapter 15

International Accounting

 International context of accounting now a central feature

 Various catalysts:
o globalization
o international trade/MNEs/financial markets
o technology
 IASB and FASB now envisaging possibility of a single global accounting regime
o harmonization/convergence
 FASB
o US Based
o GAAP (Generally Accepted Accounting Practices)
o Rules Based
 IASB
o EU based
o IFRS
o Principles Based

Accounting Blocs

 For historical, commercial, social, and cultural reasons accounting practice varies
 However, possible to identify 4 blocs:
o Anglo-American
o Continental European
o Islamic -> as a scheme it doesn’t allow certain practices such as charging of interest,
subordinate to the Anglo-American system as others are.
o Marxist e.g., China -> doesn’t recognise assets, ownership, property rights, profit ->
unsuitable to modern world
 Significant variations between, within these

Continental European Accounting

 Common origin in Italian double-entry (middle-ages)

 Governance cultures:
o less emphasis on stock market
o small family-based businesses predominate
o less developed accounting profession
o legalistic accounting perspective
 Result is that financial reporting function less developed than Anglo-American model
 Unique aspects of German & French systems

Skipped slides 7-14

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Harmonization & convergence

IASB and FASB have seen a possibility to try and converge and become one single unique accounting
scheme

 Greater awareness of international issues:

o stronger financial markets/globalization/MNEs
 Standardization: “uniform reporting rules”
o too ambitious/inappropriate?
 Harmonization: “reduction of reporting differences” – INCREMENTAL AND GRADUAL
EVOLUTION OF A COMMON SYSTEM, gradual reduction of reporting differences and hence
would build up over time.
o attainable goal?
 Convergence – gradual and common aspirations, that wouldn’t be as ambitious i.e., how to deal
with the differences between the systems
o FASB/IASB: equivalence road map
o SEC making concessions on US GAAP reconciliations
o Mixed results: leasing, revenue recognition
o FASB conceded much of the agenda to IASB i.e., FASB system doing more
moving/changes than the IASB
o ALLOWS EACH TO RECOGNISE THE VALIDITY OF THE OTHER in doing that the US
was making much bigger concessions then it normally does.
o Mixed results -> leasing context the 2 bodies were able to produce a
common/converged standard that could be used by both. Unfortunately, it was
followed by a revenue recognition which died when the interests of US business and
EU businesses were different.
 Many of the world’s capital markets now require IFRS
 154 countries use IASB scheme but US do not plan on joining and they still use FASB
 Remaining major capital markets without an IFRS mandate are:

o US, with no current plans to change -> bifurcated

o Japan, where voluntary adoption is permitted but not required (250+ plcs now
adopting)

o China, which has committed to adopt IFRS at some undefined future date

FASB still resisting single global regime

Summary

 Different accounting cultures exist

 Anglo-American / Continental European
o significant common origins
o important differences
o Anglo-American seen as more mature
o EU anxious to retain European aspect
 Convergence “project” results mixed

45
Week 11 Lecture 1

Socio Political Nature of Accounting

Accounting responds to power

It can change

It can be misused

-> needs to be regulated -> otherwise the people with money/power can decide what happens

Accounting is socio political and so powerful that it must be regulated

Is providing targets for a company helpful?

How can accounting be used to hold people accountable?

Money paid to employees (wages) decrease profits

Money paid to owners (dividends) do not decrease profits -> owners are taking a risk -> not an
expense

decrease cost by outsou

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