MGTM11 - Financial Decision Making In A Multinational Corporation Lecture 1a Introduction to Management Accounting and Finance for Decision Making. Chapter 1: Accounting: the language of business Dr. Julia J. Nobari Email: julia.j.nobari@sunderland.ac.uk Welcome to lecture one (a) ‐ Introduction to Management Accounting and Finance for Decision Making. 1 Lecture 1a learning outcome • Definition of financial accounting • Types of companies • Users • Managerial accounting • Qualitative characteristics of accounting This week provides an introductions to both financial accounting and strategic management accounting. The first part of this course highlights aspects of financial reporting that are important to users of financial information for decision making. It covers the analyses of key financial statements and the frameworks of accounting regulation such as IAS. The second part to the course provides you with an introduction to strategic management information and cost management, managerial decision making and performance measurement. 2 ‘Cash pump’ cycle • Generic representation of the activity of any business = a ‘cash pump’ cycle The BUSINESS Transformation process Decisions and actions Cash received Customers Value proposition and goods delivered Cash outflows (payments) Resources markets (potential suppliers) Resources obtained Flow of cash: Arrows pointing left Flow of resources, goods or services: Arrows pointing right So, let’s start with the definition of business and generic business model. In any business resources transformed into a value proposition that can be physically, such as goods, or services that delivered to customers. Then customers exchange cash for these goods and services and this cash will be use for the acquisition of additional resources. This creates a dynamic action that calls business. This figure summarised a generic representation of the activity of any business that require many dynamic decisions making. 3 Therefore, business decisions involve how resources will be obtained, allocated to each skill set and unitized to serve customers. In profitable business, the money generated from customers should be greater than the money spends for resources. So, if sales exceed the resources consumed in creating the sales that is creates “profit.” The question here would be you as manager how you are going to allocate these resources to different product and services that are normally limited to time and money to maximising the profit? 3 Accounting describes and is linked to every part of the activity of the firm The BUSINESS Transformation process Decisions and actions Cash received Customers Value proposition and goods delivered Cash outflows (payments) Resources markets (potential suppliers) Resources obtained ACCOUNTING INFORMATION Your decision making depend to the type of activity and type of your organisation that you are working. Therefore, you need Accounting: a language for business that provide you a common language of communicating and to support your decision making. As Accounting records all flows through the ‘cash pump’ cycle of your business that is the life of your business. For more information, see Figure 1.2 in the textbook. 4 Figure 1.3 Flow of funds and flows of information (accounting and reporting) between a business and its funds Considering the complexity of all process behind the life of a business, there is a need for control. And this control creates an agency relationship that calls for reporting. Here accounting provide a tool for the control and reporting of how resources use to full fill the overall aim of a business that is maximizing a wealth. So, accounting enables us to reporting to capital providers, business partners, lender and many more stakeholders of the business. 5 Users of financial accounting Management Employees’ representatives Work’s council Labor unions Internal users Employees Suppliers Lenders (banks) General public Government Regulatory agencies Users Customers Competitors Tax authorities Investors External users Creditors Shareholders Potential investors Investment analysts Here summarized many users of financial accounting that each have different needs and expectations. And as you can see here there is no hierarchy of user. However, it is important to consider that any rank ordering would be subject to the context and culture specific. Textbook: See Fig. 1.4 and Table 1.1 for more information. 6 Table 1.1 Users and their different needs (1/4) Users Types of needs (not an exhaustive list) Accounting source- documents Accessible information (accounting and other) Delay to obtain information Management Information to plan, make strategic- and resource- allocation decisions and control Transaction documents, financial statements Total access, from source documents to financial statements Information is accessible on an ongoing basis. Its availability depends on the organization itself. Shareholders/ Investors Are concerned with the risk inherent in, and return provided by, their investments: ? Information to help them determine whether they should buy, hold or sell ? Information to assess the ability of the enterprise to pay dividends Financial statements Financial statements plus additional publicly available information about the successes of the firm in its markets and in its operations The date on which the financial statements must be made available before the general assembly is regulated in each and every country. The trend is towards earlier publication. Bankers, lenders Information to determine whether their loans, and the interest attached to them, will be paid when due Financial statements, both historical and pro forma (i.e., forecasts) Financial statements plus additional publicly and privately available information about the successes of the firm in its markets and in its operations A business will produce any additional ad hoc documents whenever it needs to raise funds from banks or on the market One of the key user of these information is management of a business. As they need to have an overview of their collective performance. As it describe in chapter one of the textbook, they are after all, the “ship’s captain” on the high seas. Also, shareholders of the business , whom to provide a capital essential to start the value creation cycle are demanding information to make sure they will be rewarded by either the dividends or interest. Therefore, they are using information about how efficiently the business is functioning and how likely the firm may perform in the future. 7 Table 1.1 Users and their different needs (2/4) Users Types of needs (not an exhaustive list) Accounting source- documents Accessible information (accounting and other) Delay to obtain information Suppliers and other trade creditors Information to determine whether amounts owed to them will be paid when due. Trade creditors are likely to be interested in an enterprise over a shorter period than lenders unless they are dependent upon the continuation of the enterprise as a major customer. Information to determine whether the studied firm offers a better business opportunity in the future and therefore to decide if any preferential treatments should be offered to this particular firm. Financial statements In theory these users have no particular claim on financial information beyond the published financial statements, but by benchmarking and comparative analysis plus an organized intelligence watch, they can interpret financial information in a detailed manner Case by case Customers Information about the going concern nature of an enterprise, especially when they have a long-term involvement with, or are dependent on, the enterprise. Customers are especially interested in evaluating the viability of the firm as an ongoing supplier for service after sales and/or for future orders. Financial statements Just like suppliers, customers will ask information directly and cross-reference it to be able to have leading signals indicating possible opportunities or problems Case by case Here the list continue with rest of the stakeholders and where and how they using accounting information. Such as suppliers and customers. 8 Table 1.1 Users and their different needs (3/4) Users Types of needs (not an exhaustive list) Accounti ng source- document s Accessible information (accounting and other) Delay to obtain information Competitors To compare relative performance Financial statements Competitive analysis will be the output of large databases of financial statements, cross-referenced with business intelligence and a good understanding of the economic sector Case by case, as a function of the amount of resources dedicated to information gathering Employees Information about the stability and profitability of their employers. Information to assess the ability of the enterprise to provide remuneration, retirement benefits and employment opportunities. Financial statements Access is regulated through legislation in every country Case by case, moderated by local legislation As well as competitors and employees. 9 Table 1.1 Users and their different needs (4/4) Users Types of needs (not an exhaustive list) Accounting source- documents Accessible information (accounting and other) Delay to obtain information Government, regulatory agencies, tax authorities Are interested in resource allocation and, therefore, want to know about the activities of enterprises. Also use information in decisions to stimulate the economy, to determine taxation policies and assessments. Also use some or all the information in the calculation of national economic statistics. Financial statements, often recast in a pre-defined tax-based format possibly following different rules On a recurring basis the tax- formatted financial statements plus, in the case of a tax audit, access to all source documents Each country has specific rules. For example, in the UK, most companies are required to pay corporation tax nine months and a day after the end of an accounting period General public Enterprises affect members of the public individually and collectively. For example, enterprises may make a substantial contribution to the local economy in many ways, including the number of people they employ and their patronage of local suppliers. Financial statements may assist the public by providing information about the trends and recent developments in the prosperity of the enterprise and the range of its activities. Financial statements Regulated access Case by case And government as well as general public. 10 Types of companies • Merchandising company • Sells goods in same form as acquired • Merchandising inventory • Manufacturing company • Converts raw materials into finished goods • Materials inventory, work in process inventory, finished goods inventory • Service company • Provides intangible services • Supplies, parts inventory, jobs in progress In this respect it is important to identify a primary capital provider in the business depend to the type of the entity In general, there are three type of organisations: merchandise, that they buy and sells goods, manufacture organisation that convert raw material into finish goods and sells, and finally service provides companies that providing intangible services. 11 Definition of financial accounting • Accounting • To describe the life of a business entity • Accounting information = decision ‐ support tool for users • Two key missions: • facilitate value creation by supporting decision ‐ making • measure and report the amount of value created • Two sub ‐ classes: • Financial accounting and • Managerial accounting So far, we discuss whom are user of business information, and here clarify what type of information should be accessible for each users. Financial accounting reflects the economic activity of the business. Its purpose is to allow users to understand its situation. It contains quantifying information in money term. As well as non ‐ financial information in the shapers on the notes to the financial reporting. Financial accounting has two sub sections: financial accounting and managerial accounting that facilities value creations by providing supporting information for decision making. For majority of business, the financial accounting information must be file 12 publicly in the shapes of financial statements and annual report that is accessible by all stakeholders (users). However, managerial accounting provides confidential information only and only to the management of a business. Managerial accounting deals with the informational needs of decision makers inside the business. It, therefore, deals with complex issues such as detailed product cost, or business process cost analyses, or the diffusion of information inside the business to create a mobilization of the energies of all members pf personnel and staff. 12 The Financial Statements • Balance sheet/Statement of financial position • Income statement / P& L / Profit and loss account • Notes (to the financial statements) • Statement of cash flows / Cash flow statement • Statement of changes in equity So, financial statement as one of the key outputs of the financial accounting process is includes number of documents, such as: • Balance sheet/Statement of financial position • Income statement / P& L / Profit and loss account • Notes (to the financial statements) • Statement of cash flows / Cash flow statement • Statement of changes in equity In the next 4 weeks you are going to investigate each of these statements under the international 13 accounting standard and reporting and critically evaluate how they can help the decision making. 13 • Differences Between Management Accounting and Financial Accounting • Statutory requirement for limited companies to produce annual financial accounts, whereas there it is optional for management accounting. • Financial accounting reports describe the whole of the business, whereas management accounting focuses on reporting information for different parts of the business. • Financial accounting reports must be prepared in accordance with generally accepted accounting principles (e.g., the International Financial Reporting Standards Board). • Financial accounting reports historical information, whereas management accounting places greater emphasis on reporting estimated future costs and revenues. • Management accounting reports are produced at more frequent intervals. The first difference is that management accounting is presented to a company’s internal community, while financial accounting is prepared for an external audience. Even though financial accounting is of great importance to current and potential investors, management accounting is necessary for managers to make current and future financial decisions for their business. The second difference is that financial accounting is exact and must follow to international financial reporting standard (IFRS) or Generally Accepted Accounting Principles (GAAP), while management accounting can be based off a guess or estimate since most managers do not have time to get exact numbers by the time a decision needs to be made. The third 14 difference is time Period: Financial accounting is concerned with the financial results that a business has already achieved, so it has a historical orientation. Managerial accounting may address budgets and forecasts, and so can have a future orientation. The fourth difference is the timing: Financial accounting requires that financial statements be issued following the end of an accounting period. Managerial accounting may issue reports much more frequently, since the information it provides is of most relevance if managers can see it right away. There is other differences that summaries in the next two slides. 14 Table 1.9 Differences between managerial and financial accounting (1/2) Managerial accounting Financial accounting Purpose Understand how value is created in detail so as to assist internal decisions Measure the performance of the firm as a whole and report it to relevant decision-makers Principal users of the output Managers and decision-makers at all levels inside the firm and within responsibility delegation Senior management of the firm, but, originally, intended mainly for external users who look at the firm as a whole: investors, banks, customers, personnel, etc. Regulatory context None in most industries (government contract costing is regulated in most countries), but focus on continuous progress in a philosophy of balancing costs and benefits Financial accounting information is a social good and is therefore regulated at least by the bodies regulating financial markets, by tax authorities and by the profession itself in a spirit of giving a true and fair view of the situation of the firm. Although the cost benefit approach is not mentioned in regulations, it is common sense to expect that managers should never produce data or information at a cost that exceeds its expected benefits from ‘better’ decision-making Behavioral implications Aimed at mobilizing energies inside the firm by the distribution of the appropriate information after ad hoc analyses Does not attempt to influence behavior and, even on the contrary, tries to be as fair as possible to all parties involved Here is the summary of the main different between managerial accounting and financial accounting. 15 Table 1.9 Differences between managerial and financial accounting (2/2) Managerial accounting Financial accounting Time frame Oriented to ward anticipation (based on fine modeling of internal and market-linked business processes) and analysis of deviatio ns between anticipated and observed results An objective record of what was actually realized, thus mainly oriented toward s the past (compariso n of periods allows extrapolation) Time horizon Flexible and continuous. Information is collected on any time period deemed interesting to the decision-maker Financial statements must be made available at predetermined fixed intervals Orientation Detailed units of analysis such as: business processes, functions, knowledge sets, customer markets, customer types, products, resources markets, etc. A process of systematic aggregation of records of discrete, simple and elemental events to create categories of like transactions and create, in fine , financial statements that give a synthetic view of the situatio n of the firm on a given date Fineness Accent is placed on interactions and on the operatio n of business models: can be a finely partitioned as needed Aggregate and ex post facto vision Frontiers Defined by the usefulness of the data: importance of commercial, strategic, behavioral, economic aspects in decision- making aspects. It is totally normal in managerial accounting to extend the analysis beyond the legal borders of the entity Often defined and constrained by the regulatory and legal context, financial accounting records transactions within the legal (or otherwise specified) perimeter of the entity and between the legal entity and third parties And the rest of the differences. 16