Finance with a review of accounting

Income statement and balance sheet

More realistic income statement and balance sheet
   Initial balance sheet (end of 2003)
   Income statement (2004)
   Final balance sheet (end of 2004)
First year of activity and subsequent years
Investments
The value of a firm
Balance sheet of a bank
A digression on "the value of things"
Exercises
List of proposed group presentation topics

More realistic income statement and balance sheet

Adjustments are made to apply as well as possible the matching rule
The first part of the lecture presented the techniques to go from the Trial balance to the Income Statement and the Balance Sheet, and it described the year-end adjustments in order not to forget any consumption of the year, and also to apply strictly the matching rule.

The example of part "a" was not very realistic
But the Income Statement and the Balance Sheet produced were not realistic, they were only the product of this quick presentation. (For instance, I did not include Salaries - you can, with the Mini_accounting.xls program -, because my point was only to show how to treat consumption expenditures. And the Balance Sheet does not have all the usual assets and liabilities met in a Balance Sheet, I just wanted to show how to treat assets and liabilities.)

Let's now look at more usual and realistic Income Statement and Balance Sheet.

Initial balance sheet

Example of initial BS
We start with the Balance Sheet at the beginning of an accounting period (it is the same as the end Balance Sheet of the preceding period). Here is a Balance Sheet at the beginning of 2004. It is the same as the Balance Sheet at the end of 2003.

Comments on the asset side:

The fixed assets are recorded at their historical value. Some cumulated depreciation appears in one lump account (it could also be split into various depreciation accounts). The net fixed assets is computed by subtracting the cumulated depreciation from the historical values (also called gross fixed assets).

The fixed assets include some intangibles: patents, goodwill, other things capitalised but with no material support.

A charge is said to be "capitalised" when it is not recorded in the IS but only in a capital account that appears in the BS.

The financial fixed assets are shares of other firms which the firm owns but which are not "consolidated" in these accounts.

Short term securities: a firm should not keep more cash (including sight bank account) than it needs for its current payments (salaries, etc.), because it is a waste of value. Cash does not produce interest. So one of the function of the financial officer of a firm is to place excess cash into short term securities, that remain fairly liquid (in case we suddenly need the cash), but yield interest. Usually, these are government bonds, or other safe and liquid values.

Comments on the liability side:

Corporations usually pay dividends which are part of their profit. The other part is called retained earnings. They accumulate in the account called "Cumulated retained earnings".

The sum of the Capital account and the Cumulated retained earnings account is called the Net worth of the firm (also the Equity).

The net worth: a first cut at the value of a firm
We touch here the problem of the value of the firm to someone who would buy it all (assets and liabilities). It is a vast question that we will meet again in this course. For the time being suffices to say that the accounting documents offer a first figure: the Net worth. Indeed, someone buying the assets and liabilities of the firm would become the owner of all the assets, but also have the current as well as long term liabilities to pay. So a logical price would be the difference between the total assets and the liabilities due to other people: it is the Net worth.

But the above reasoning has (some) validity only if the purchased firm has no interference with the other activities of the buyer.

The most meaningful approach is to say that the value of a firm, for a buyer, is the value of all the future extra cash flows the buyer will have, thanks to having bought the firm.

Classification of external liabilities
Other liabilities. There are two customary ways to classify the liabilities to outside agents: long term liabilities vs short term liabilities; and liabilities costing money (bonds, bank borrowings) vs "free" liabilities (trade creditors, state, dividends to be paid, etc.). Here, in a first approximation, we will consider that the two splits are the same.

"Money that costs money"
Long term liabilities cost money. We have to pay coupons on bonds, and we have to pay interest on bank borrowings (these costs will appear in the Income Statement).

"Money that does not cost money"
Short term liabilities do not cost money. They somehow come as "free financing". We buy a piece of machinery, say, 50 monetary units; until we pay the supplier, this piece of machinery is financed by the supplier. Some firms use a lot trade credit, but it is dangerous to have trade credit higher than current assets (more on this later).

Definitions:

the sum of the net worth and the long term liabilities is called the capital employed.
the difference between the capital employed and the net fixed assets is called the working capital.

The working capital is the part of the capital employed that does not finance fixed assets, but finances assets that turn quickly (part or all of the stocks, and possibly part of the debtors). This is why it is called working capital.

A graphical representation of the balance sheet.
(possible only if the Retained Earnings are positive)

Income statement

Example of IS between an initial BS and a final BS
Suppose the firm has the following Income statement for the year 2004.

Comments:

The COGS is 580. It is larger than the Purchases because we also reduced the stocks.

A Purchases account is used only for Trading firms
When we have a Purchase account, we are dealing with a trading firm. For manufacturing firms some refinements must be made to account for the manufacturing process:

There are three types of stocks: Raw materials, Work in process, and Finished goods to be sold.
A manufacturing account is prepared, from certain accounts of the Trial balance, prior to the Income Statement.
The manufacturing account computes a "Total cost of goods produced" (TCOGP).
The TCOGP is the equivalent of the "Purchases" of a trading firm.
Then the Income Statement is prepared as before, and TCOGP is adjusted, as before, with variation of stocks of Finished goods.

The "gross operating result"
Before depreciation, financial costs and taxes, the firm is able to produce a result of 170 (this figure does not appear above; it is the sum of 80 + 90). It is sometimes called the "gross operating result". It is an important measurement of the firm's capacity to produce value. It will compared with the means used to produce this value.

Any acccounting measure must be compared to another one -> ratios
Obviously it is a more impressive performance to produce such an operating result with capital employed around 500, than if it were around 1000! This observation will lead us to study performance ratios. If I tell you "Firm F generated a gross operating result of 1 million euros", you have no way to know whether the firm is efficient or not, until I give you the figure for the Capital Employed (= Net Worth + "Money that costs money")

The financial costs are the yearly cost of having 50 in bonds and 100 borrowed from a bank.

For simplicity I assumed the taxes are 25% of the result after financial costs and taxes.

Finally, again for the sake of simplicity, I assumed the firm distributes no dividends. (Microsoft did not distribute any dividends from its introduction in the stock market, in 1986, until recently.)

Sometimes we use a more casual presentation for the IS and the BS
A comment on the more casual presentation of an IS: a single column, and no + or - signs; the reader is supposed to know what is added and what is subtracted.

Balance sheet (end of 2004)

Example of BS at the end of a period.
There are some consistency constraints between the initial BS, the IS and the final BS
Let's see what the new balance sheet, at the end of the accounting period, could be:

Comments on the asset side:

Investments in fixed assets
The gross fixed assets increased by 100 (50 in machinery, 25 in buildings, and 25 transportation). These expenditures are called "Investments in fixed assets". At the same time, the yearly depreciation for 2004 was 80, so the cumulated depreciation is now 280, and the net fixed assets are 220. (We assume there were no divestments of assets.)

Other items of the asset side
The firm did not change its position in financial assets.

The stocks went down. The closing stocks are now 50, compared to 130 for the opening stocks.

Client paper went up from 200 to 270. There are some ratios to check to see whether this is acceptable, or a bad sign. At any rate, it must be financed one way or another. (The suppliers, on the liability side went up from 80 to 100.) Somehow we may say that the delta client was financed by stocks.

Short term securities and bank & cash. The firm increased these two accounts, altogether, by 80. It chose to invest 50 into more short term securities, and keep the rest as cash (and bank) which increased by 30.

Comments on the liability side:

The capital account did not move.

The evolution of the (cumulated) retained earings
The retained earnings increased by 60, that is the entire profit of the year, since it distributed no dividends.

Other items of the liability side
The L.T. liabilities did not move.

S.T. liabilities changed, they increased by 30 (20 in suppliers, and 10 in other creditors).

Comment on the cash:

We see that the cash increase (30) is less than the profit (60).

In fact, a part of the cash went into short term securities. If we hadn't invested into S.T. securities, our cash position would have increased by 80.

At any rate, there is no direct link between profit and cash.

The role of the cash flow statement: an analysis of the evolution of the cash balance
Analysing the origins of the cash movements is done in the cash flow statement, an important document of the accounting system. The cash flow statement shows whether the cash movements come from healthy causes, or have causes that we should worry about.

A look at a few BS of firms on Yahoo Finance. Look for instance at the BS and IS of Amazon over several years.

First year of activity and subsequent years:

The first year of activity is a bit special: the BS starts empty.
Remember that accounting establishes on a regular basis "the final documents at the end of a period of activity". The most customary situation is to take the calendar year as the period of activity. So there is a first year of activity, then a second one, a third one, etc.

At the very beginning of a firm, the accounting system is empty; all the accounts are empty. The first two accounts to receive entries are the capital account and the cash account. Then, as the operations unfold, and the transactions take place the accounts fill up.

In the first Trial balance, there is nothing coming from previous years...
At the end of the first year, we proceed to a first "synthesis": we establish the Trial Balance, make some adjustments and prepare the Income Statement and Balance Sheet for the first year.

The Income Statement is some sort of a "movie" of what happened during the year;
the Balance Sheet is a "snapshot" of the firm at the end of the year.
In theory a Balance Sheet can be established at any date t, but since it is rather time consuming to prepare, it is done only once a year.
It takes a few months to complete, and the Balance Sheet, and the Income Statement, of year_n are usually finalised not before March or April of year_n+1.
Likewise, in theory, an Income Statement can be established between any two dates t₁ and t₂.
There is no such thing as an Income Statement for date t.
When we talk about "the IS at date t" we usually mean "the Income Statement over the past 12 months ending at t".
And, like for the Balance Sheet, to prepare an IS is time consuming, so we don't compute IS frequently; usually only once a year.

Beginning of second year: all the capital accounts start with some content; the revenue accounts start anew
After year one, the second year begins. At the beginning of the second year, all the Revenues accounts have been set anew, and are empty. Whereas the Capital accounts of the Balance Sheet begin with initial balances, namely the figures in the Balance Sheet at the end of the first year.

The bottom line adds cumulatively into the BS profit and loss line (except if there are some dividends)
In particular, at the end of the second year, the bottom line of the Income Statement of the second year will be added to the P&L of the first year into the account called "Cumulated profit and loss" on the liability side of the Balance Sheet.

Closing stock of year_n-1 becomes the opening stock of year_n
Also, simply enough, what was the closing stock of year_n-1 becomes the opening stock of year_n. Of course the opening stock of the first year is zero.

Investments

Expenditures for tools which will be used over several years
Investments are expenditures which are not consumed during the year, unlike revenue expenditures which directly contribute to the "creation" of the sales.

Why make investments?
Investments are made with a view toward developing the production means of the firm, in order to be able to create even more value in the future.

Investments require money
They must be financed, like everything else. It will be a central topic of this course to study when an investment has good prospects and should be made, and when it is a bad one.

We will also see the various ways to finance investments. In the end the money always comes either from the shareholders, or from bondholders, or from banks.

Example of financial securities
The stocks, the bonds, and the borrowings are themselves securities, with a value. They are traded on primary markets and on secondary markets. We shall see all this.

The value of a firm

A firm is a "value creating machine" (I use this expression not to use the more informal "money making machine", but the idea is exactly the same).

As such, it has a value.

The balance sheet gives a first cut (a very first cut) at evaluating the value of a firm. Technically, the net worth is the value of the firm in its books (net worth = total assets minus liabilities to external agents).

But this figure may be far away from what a buyer might be willing to pay. Many other factors are to be taken into account.

Essentially, the modern way to analyse the value of a firm is to consider the stream of net cash flows it can produce for its owner (the dividends) of for a possible buyer (extra cash flows), and use some simple formula from this stream of CF (cash flows).

For certain possible buyers of a firm, it can create huge extra cash flows with no relation to the small size of the acquired firm. This is the reason why eBay, in October 2005, purchased the small firm Skype, for the fantastic sum of $2,6 billions. And in October 2006 Google purchased the small firm YouTube for $1,65 billions.

We shall study how to compute the value of a series of future cash flows.

There are cases where a buyer will buy all the assets of the firm without buying the firm itself - the legal entity. In that case, the value arriving in the books of the buyer, is the total assets of the acquisition, plus a possible goodwill (an extra value compared to the total assets value of the acquired firm - this the case of eBay buying Sype). The legal structure of the target firm may be kept by its current owner because there are situations where the liabilities provide tax shelters. This is outside the scope of this course on value creation.

Balance sheet of a bank

Balance sheets of commercial banks are different from the balance sheets of industrial and commercial firms, although the same accounting rules and techniques (journal, posting, double-entry, etc.) strictly apply.

The liability side of the balance sheet of a commercial bank, is made of three sources of funds: the initial capital (plus retained earnings), possible borrowings from other banks and from the money markets, deposits from clients like firms as well as you and me.

The asset side is made of various financial assets from most liquid (listed at the bottom) to least liquid (listed at the top). The most liquid assets are cash, and reserves at the central bank. Then a commercial bank holds all sorts of loans made to firms, to cities, possibly to governments (even foreign governments), and of course to private individuals (in particular to finance their housing).

There are strict rules, in each developed country, as to the amount of reserves a commercial bank must keep. There are also guidelines like the Cooke ratios to see if a bank (in particular a foreign bank from a country with lax regulations) is healthy or not.

The final unexpected aspect of a commercial bank is that it can create money: it can lend you money by opening a deposit account for you, and crediting it, and on the other side (on the asset side) registering a debit in a loan account to your name.

In France, some years ago, about 15% of the money in circulation consisted of banknotes and coins, and the other 85% was in the form of bank deposits. (Percentage today in the euro zone to be checked, probably not much different.)

All the above explanations apply to commercial banks. A central bank, in charge of issuing the bank notes, is somewhat different: on the liability side appear a record of the bank notes printed, and deposits by commercial banks ; on the asset sides we have money created for or lent to the State, and various reserves in foreign currencies, precious metals and other values (some bonds resulting from open market operations, etc.)