Accounting Foundations

Topics

1. The relevance of accounting
2. Basic concepts
   1. Accounting events
   2. Accounting equation
   3. Revenue recognition
3. Financial Statements
4. FSA framework

1. The relevance of accounting

The objective of this course: understand how managerial decisions and economic events impact financial statements.

2. Basic concepts

2.1 Accounting events

Economic events and Accounting events.

What information is important to capture, process, aggregate, and report?

1. Purchasing merchandize or raw materials
2. Hiring employees
3. Contracting a loan
4. Selling goods or services
5. Returning goods to suppliers
6. Paying employees

2.2 Accounting Equation

\[Assets=Liability+Equity\]

• Definitions.
• Transactions (or economic events) modify assets, liabilities, and equity.
• However, always the accounting equation holds.
• This equation is the basis of double-entry accounting.

Extended Accounting Equation

\[Assets=Liability+ E_0+ Net Income- Withdrawals \]

• Net Income: Revenues - Expenses
  • Revenues increase Owner’s Equity, whereas Expenses decrease it.
• Owner’s Equity is not static.
• Business dynamic transactions impact the company’s financial position.

2.3 Revenue recognition

It is the second pillar in accounting. It is the process of recording revenue in the financial statements. When a company records revenues, it must also record related expenses. This is the matching principle:

1. Recognizing revenue when earned, regardless of when payment is received.
2. Expenses should be matched with revenues they helped to generate in the same period, even if payment occurs later.

Example Silvana eTravel SA

Let’s apply the accounting equation and matching principle to the transactions of the first month of a small company, Silvana eTravel SA.:

Transaction 1: Starting the business.

Silvana invested $30,000 of her own money to start the business.

She deposits $30,000 in a “Silvana eTravel SA” bank account.

Transaction 2: Buying an office.

Silvana purchases an office, paying $20,000 in cash. ​

Monthly Depreciation: $200​

Transaction 3: Buying an office supplies.

Silvana buys office supplies, agreeing to pay $500 within 30 days.​

The supplies will last until the end of the month.

Transaction 4: Earnings of Service Revenue

Silvana eTravel earns service revenue by providing travel services for clients. ​

She earns $5,500 in revenues and collects this amount in cash.​

The labor cost of providing the service was $600 and will be paid the first day of the next month.

Transaction 5: Revenue on account

Silvana eTravel performs services for clients who do not pay immediately. ​

Silvana receives clients’ promises to pay $3,000 within one month in return for her travel services.

The labor cost of the service was $200 and will be paid the first day of the next month.

Transaction 6: Paying expenses

During the same month, Silvana eTravel pays with cash:​

• Wharehouse rent, $1,100.​
• Utilities, $1600.​

Transaction 7: Long-term debt

Silvana borrows $5.000 using a Long term bank credit (3 years). The first month generates $35 on interest expenses, payable at the end of the year.

2.4 Accounts classification

Assets

Liabilities

Equity

3. Financial Statements

3.1 Aggregations

Each accounting event requires determining an amount affecting the respective accounts.

Some rules help us to define these amounts​.

• IFRS: International Financial Reporting Standards
• US GAAP: Generally Accepted Accounting Principles
• Local GAAP

Consistency across time and transactions is key!

3.2 Valuation basis

1. Historical Cost
2. Amortized cost
3. Net Realizable Value
4. Present Value of future payments
5. Fair Value

Recent example of opportunistic use of valuation methods:

“NRG Energy uses ‘accounting trick’ to make earnings look less volatile”

“As described by Weil, NRG (NRG) showed $992M of net derivative assets at year-end 2024, including $770M on contracts with frozen value.”

“The issue with this approach? For one thing, it potentially lets companies freeze unrealized gains that they believe are likely to turn into losses later,”

More about the case.

Financial Statements: Why?

After recording all transactions consistently according to established accounting rules, the next crucial step is to aggregate this data into a form that is useful for decision-making. This aggregation results in the creation of financial statements, which serve as a primary tool for conveying a company’s financial health and performance to various stakeholders.

Who uses financial statements, and why do they need them?

• Investors: To assess potential returns and risks, determine if the company is growing sustainably, and make informed decisions about buying, holding, or selling equity.
• Creditors: To evaluate the company’s ability to meet both short-term and long-term debt obligations, helping them make lending or credit extension decisions.
• Employees: to evaluate job security and performance compensation.
• Customers: To assess whether the company is a reliable long-term supplier, especially for critical goods or services.
• Suppliers: To determine if extending credit is safe.
• Governments and Regulators: To ensure compliance with tax laws and monitor economic policies.

3.3 Statement of Financial Position

The balance sheet shows the financial standing of the company on a specific date, presenting a clear picture of its resources, obligations, and net worth.

• Liquidity Position: The split between current and non-current assets and liabilities shows the company’s ability to meet short-term obligations.
• Capital Allocation: The types of assets owned and the composition of liabilities vs. equity reveal how effectively resources are being utilized and how risky the financing structure is.
• Owner’s Equity: Provides insight into the accumulated profits, contributed capital, and overall value attributable to shareholders.

3.4 Statement of Comprehensive Income

Companies are required to present comprehensive income, which includes both profit or loss and other comprehensive income (OCI).

The Income Statement shows the company’s financial performance, detailing revenues, expenses, and profit or loss for the period.

• However, some gains and losses do not go directly to profit or loss but instead are recognized in Other Comprehensive Income (OCI).

In practice, companies may choose to present this information either as a single statement combining both profit or loss and OCI or as two separate statements—one for the profit or loss and another for comprehensive income.

3.5 Cash Flow Statement

The matching principle means that cash inflows and outflows differ from revenues and expenses. The Cash Flow Statement shows actual cash movement.

Components:

1. Operating activities: Cash from core business operations.
2. Investing activities: Cash from buying/selling long-term assets.
3. Financing activities: Cash from issuing/repaying debt or equity, and paying dividends.

3.6 Statement of Changes in Equity

Shows changes in Equity over a specific period, focusing on the main components: Common Stock and Retained Earnings.

Components:

1. Beginning balance of equity accounts
2. Share Capital: + capital increase; - capital decrease
3. Retained Earnings: + net income; - net loss; - dividends
4. Ending balance of equity accounts

Why could other stakeholders be interested in this statement?

• Creditors check if the company is reinvesting enough. Each dollar paid as a dividend is a dollar that cannot be paid later on to credits.​

• External investors also see if the company is increasing its capital base. It indicates that current shareholders see growth opportunities that need to be financed.​

3.7 Dependencies across Financial reports

Some examples

1. Cash payments to reduce Trade payables will be reflected in the Balance sheet and Cash Flow Statement.​
2. Recognizing non-current assets depreciation will be reflected in the Balance sheet and Income Statement.​
3. Profits of the year will be reflected in the Balance Sheet, Income Statement, and Statement of Changes in Equity.​

3.8 Notes to the Financial Statements

They reveal important information about the company’s financial position and performance that would be difficult to discern from the financial statements.

Elements:

1. Basis of preparation: IFRS, US GAAP, etc.
2. Summary of significant accounting policies: valuation, depreciation, etc.
3. Management’ assumptions and estimates: useful life, etc.
4. Risk characteristics: credit, liquidity, market, etc.
5. Contingent liabilities: legal disputes, etc.
6. Related party transactions: transactions with owners, managers, etc.

3.9 Management’s Discussion and Analysis (MD&A)

It is a section of the annual report that provides management’s interpretation of the company’s recent performance.​

• Issues related to current and future operations/performance
• Favorable/unfavorable trends
• Important events and uncertainties
• Explanations of unusual or infrequent events
• Price changes

It is mainly forward-looking information.​

4. FSA framework

Let’s study a general framework for financial statement analysis (FSA).

• How is the company growing? Type of assets, funding.​
• Do the company needs to change our liquidity/solvency policy?​
• Are the managers using our assets efficiently?​
• What is driving our profits/losses?​

4.1 Steps

1. Macro-economic factors:
2. Industry factors:
   1. Industry growth
   2. Industry structure: competition, barriers to entry, etc.
   3. New products or technologies
3. Company factors:
   1. Business model
   2. Long-term plans
   3. Who?

4.2 Analysis and Metrics

After analyzing the previous steps, we can analyze the company’s financial statements.​

1. Comparison across time:​
   • How is the company doing relative to previous years?​
   • What has internally and externally changed?​
2. Comparison within industry peers:​
   • What explains cross-sectional differences?​
   • Different shocks​, efficiencies, innovation, or new products.

4.3 Areas of Financial Statement Analysis:

1. Credit (Risk) Analysis:
   1. Liquidity
   2. Solvency
2. Profitability Analysis:
   1. Return on investment
   2. Operating performance
   3. Asset utilization
3. Valuation: estimate the intrinsic value of a company (stock).

Common rules

• Balance sheet items: Ratios are calculated using average values.​
• Income statement items: Ratios are calculated using year-end values.​
• Cash flow statement items: Ratios are calculated using year-end values.​

Check the Formula Sheet for the most common ratios.

A very naive approach is to analyze the statement “as they are reported” without adjusting them.

However, in this course, we will dig deep and learn how to measure them correctly:

• Topic 2: Adjustments to represent real financing activity
• Topic 3: Adjustments to represent real investing activity
• Topic 4: Adjustments to represent real operating activity

Questions

Check my website for an updated version of this presentation:

https://www.marceloortizm.com/