Slides Financial Accounting MSB 2019

EMBA MSB, Financial Accounting 2019‐04‐25
MEDITERRANEAN SCHOOL OF BUSINESS
PROGRAM: Executive Master in Business Administration - EMBA

COURSE: ACT701 Financial Accounting
PROFESSOR: Cédric Lesage, MPhil, PhD
TERM: Spring 2019
Financial Accounting
CÉDRIC LESAGE, MPHIL, PHD
LAWRENCE S. BLOOMBERG CHAIR IN ACCOUNTANCY
CEDRIC.LESAGE@CONCORDIA.CA
EMBA MSB TUNIS
2-5 MAY 2019
Prof. Cédric Lesage
May 2019 1
Content
Financial Statements
◦ Session 1: Construction and interrelations
◦ Session 2: Quality of Financial Statements
◦ Session 3: Business Game
Financial Statement Analysis

◦ Session 4: Financial Equilibrium & Ratio Analysis
Reference Book
Stolowy H., Ding Y. Financial Accounting and Reporting. A Global Perspective,

Cengage Learning, 5th edition, 2017.
◦ User approach
◦ ‘a-national’ then ‘international’ approach
◦ Exercises with corrections
May 2019 2
Some rules…
S E S S I ON 1 : F I N AN C I A L S T A T E M E N TS
May 2019 3
Agenda
Session 1: Financial Statements
1. Introduction to financial accounting

2. Double entry principle and the balance sheet
3. Double entry principle and the income statement
4. Depreciation and dividends distribution
5. The accounting processus
6. Applications
7. Cash Flow Statement
8. Applications
9. Link between the Financial Statements
1. Introduction to financial accounting
May 2019 4
Introduction
Accounting: a language for business

◦ Describes operations made by the firm
◦ Booking entries
◦ Report syntheses to interested people to help them making good decisions
◦ Financial Statements
The problem
◦ Which rules (vocabulary and grammar) will make it possible to reach those objectives?
Luca Pacioli’s principles
Postulates:
1. In the accounting world, the business (or firm) is an entity in its own
right and that that entity is separate and distinct from the owners.
2. The financial world is a closed system. That is, money just doesn’t
just materialise from nowhere. If money is received by someone it
must have been given by someone else and vice versa.
May 2019 5
Luca Pacioli’s principles
Consequences: 4 concepts
1. The business or firm is an entity
2. The firm has a separate entity from the owner
3. Every transaction has two sides to it: a source and a destination
4. The profit from the firm’s activities belongs to the owners
25/04/2019
Application: Verdi (p. 43-45)
1. Creation of Verdi:
◦ Initial investment by shareholders: 150 CU
◦ (3/5: Stefania; 2/5 Stefano)
◦ Opening of a bank account for Verdi.
May 2019 6
2. Double entry principle and the Balance Sheet
Figure 2.1 Financial position

The financial position of a business is
defined by two equal ‘sides’
Assets Liabilities and shareholders’ equity

= =
What the entity owns (the resources with Obligations the entity has towards
which the firm will create future value
= third parties and shareholders
for customers for which these will =
exchange some of their own resources) Sources of financing of resources or assets
A balance sheet is a snapshot of the status of the financial

position of a business entity at a given point in time
May 2019 7
Components of the liabilities

Liabilities
o Obligations: Borrowed funds and
capital contributions
o Set of financing ressources
– Shareholders equity:
Liabilities Capital invested in the firm by the shareholders +
previous net income not distributed.
Current Net Income
– (Other) Liabilities:
Operations previously made by the firm that create
future obligations for the firm to pay cash, to deliver
goods or services.
Components of the assets

Assets
o Property and receivable rights
o Use of ressources
– Long term (or non-current) assets:

Assets Set of assets with a quite long utility life, that the firm
uses.
– Short term (or current) assets:

Set of assets components that are frequently
renewed.
May 2019 8
Double entry
Impacts the basic equation in at least two opposite ways that will
keep the equation balanced.
Assets = Liabilities + Equity
• Transactions can take place between assets, between

liabilities and shareholders’ equity, or can involve both
sides.
2. Verdi obtains a loan:

◦ Principal: 60 CU
3. Investment (computer, printer)

◦ Cost: 125 CU
◦ Check payment
May 2019 9

4. Sale of services:
◦ 14 May: contract for a public relation campaign for Sheila Burns (250
CU)
◦ Due payment: 31 July.
5. Receipt of cash from Sheila Burns:
◦ Amount: 180 CU
6. Payment for expenses:
◦ Salaries: 101 CU, by check
◦ Advertising: 85 CU, due within 60 days of receipt.
◦ Financial interest on the loan: 4 CU
7. Payment for the advertising
◦ Amount: 80 CU
8. Partial repayment of the principal of the loan
◦ Amount: 12 CU
3. Double entry and income statement
May 2019 10
The business equation revisited
Assets = Liabilities + Shareholders’ equity
= Liabilities Share
Assets + capital + Net income
= Liabilities Share
Assets + capital + Revenues - Expenses
Net income: definition
A movie recording the activity of the

firm during a period of time.
Two components:
Expenses Revenues
May 2019 11
Income Statement?
Remember…
4. Sale of services:
◦ 14 May: contract for a public relation campaign for Sheila Burns (250
CU)
◦ Due payment: 31 July.
5. Receipt of cash from Sheila Burns:

◦ Amount: 180 CU
6. Payment for expenses:

◦ Salaries: 101 CU, by check
◦ Advertising: 85 CU, due within 60 days of receipt.
◦ Financial interest on the loan: 4 CU
Figure 2.12 Links between the balance sheet and the

income statement
BALANCE SHEET
ASSETS = LIABILITIES + SHAREHOLDERS’ EQUITY
Share capital [Retained] earnings
INCOME STATEMENT
transferred to
(at the end of Expenses Revenues
the period)
Balance =
net income
(if profit;
otherwise it
would be on
the opposite
side)
May 2019 12
Some key points (1/2)
Both sides of the business equation must always be balanced with one another
Each transaction must be analyzed specifically to identify its possible impact on
shareholders’ equity
The result of a transaction that creates or consumes value is summarized in the
‘earnings’ account
What creates income?
◦ No income (impact on earnings) until transaction 4 (sale of services)
◦ First operation that affected the shareholders’ equity and therefore the
earnings
Some key points (2/2)
Net income is different from cash

The order in which items are listed on the balance sheet is not random
May 2019 13
Profit appropriation
Three possibilities:
◦ Distribute the profit entirely to the shareholders
as dividends
◦ Distribute the profit partially to the

shareholders as dividends and the balance is
a reserve
◦ Not distribute profit at all (shareholders reinvest

their claim in its entirety in the business)
+
1. Profit appropriation:
◦ Dividends distributed: 3 CU
◦ Transfer to retained earnings?
Hypothesis: no income tax
May 2019 14

Documents Registration
Classification Grouping
5. The production process of accounting information
Documents
Supporting document (source document)
Legal documents
Documents must be relevant
May 2019 15
Journal
Day-to-day chronological register of accounting information found in the

source documents of all allowable transactions
Double-entry principle
Journal entries for the eight transactions of Verdi Co. (see Chapter 2) are shown
in Table 3.4
Assets = Liabilities + Shareholders’ equity
= Liabilities Share
Assets + capital + Net income
= Liabilities Share
Assets + capital + Revenues - Expenses
Share
Assets + Expenses = Liabilities + capital + Revenues
May 2019 16
Left = “debit”
 of assets or expenses,  of liabilities, capital or
revenues
Right = “credit”
 of assets or expenses,  of liabilities, capital or
revenues
Ledger
Data recorded in the journal integrally transcribed in the ledger

Ledgers do not create data
Process of transferring entries from the journal to the ledger = ‘posting’
Verdi Co.’s ledger in Table 3.5 (accounts are listed according to their position in
the financial statements)
May 2019 17
Trial balance
List of the debit and credit footings for each account in the ledger
To check that the sum of all the debit balances is equal to the sum of all the
credit balances
Format of the trial balance varies from one company (or software) to another
See developments in Appendix 3.2
Figure 3.8 Accounting process/

Accounting system
Stage Document Example:
prepared Establishing the capital of Verdi
Analysis of
supporting Cash 150
JOURNAL
documents Capital 150
Cash Capital
Posting to LEDGERS
and
accounts 150
GENERAL 150
LEDGER
Accounts Debit Credit
Control TRIAL Capital 150

BALANCE
…
Cash 150
…
Total 150 150

Synthesis FINANCIAL
STATEMENTS
May 2019 18
6. Applications
Application
Assignment 2.3 : “Busoni”, p. 81
May 2019 19
Notion of depreciation
Fixed assets gradually lose value
‘Consumption’ of the fixed asset
Consumption = ‘Depreciation expense’ since it reflects the gradual loss of value

of these assets
Ressources comsumption and Inventories
Beginning Inventory
+ Purchases of resources
= Available resources to be consumed
- Resources consumed
= Ending Inventory
May 2019 20
Two methods to obtain the consumption of

resources and inventory
• Method 1: Purchases recorded as inventory in the

balance sheet
= “Perpetual inventory system”
• Method 2: Purchases recorded as expense in the

income statement
= “Periodic inventory system”
Application
Assignment 2.4: “Corelli”, p. 81-82
May 2019 21
7. Cash Flow Statement
Figure 3.1 Example of an operating cycle
Purchases of raw materials
CASH
Inventory of raw materials
Collection of receivables
Transformation of raw
materials
Receivables
Inventory of finished
products
Sales
May 2019 22
Statement of cash flows
Required financial statement by IFRS

Limited vision given by the balance sheet (financial position at beginning and
end of year) and the income statement (activity during the year)
Necessity to understand the evolution of cash during the year
Table 3.1 Illustrative statement of cash flows

Cash flows from operating activities
Cash received from customers 80
Cash paid to suppliers and employees -30
Net cash from operating activities (1) 50
Cash flows from investing activities
Purchase of property, plant and equipment -15
Proceeds from sale of equipment 5
Net cash used in investing activities (2) -10
Cash flows from financing activities
Proceeds from issuance of share capital 35
Proceeds from long-term borrowings 10
Dividends paid -20
Net cash from financing activities (3) 25
Net increase in cash and cash equivalents (4)=(1)+(2)+(3) 65
Cash and cash equivalents at beginning of year (5) 5
Cash and cash equivalents at end of year (6) 70
Change in cash (7)=(6)-(5) 65
Control (4)=(7)
May 2019 23
Application
Assignment: Verdi’s Cash Flow Statement?
8. Applications
May 2019 24
Application
Assignment 3.3 : “Schubert”, p.110-111

Use the template provided in class
Cash basis vs. Accrual Basis
Cash basis:
◦ Recognition of revenues/expenses when received/paid.
◦ Problems?
Accrual Basis
◦ Recognition of revenues when sold and related costs at the same time.
May 2019 25
Cash basis vs. Accrual Basis

TOW Inc.
Time 1 2 3 4 5 6 7
Sales 10 20 40 80 160 320 640
Expenses 8 16 32 64 128 256 512
Net Income 2 4 8 16 32 64 128
Beg. Cash 0 0 ‐8 ‐14 ‐26 ‐50 ‐98
Inflows 0 0 10 20 40 80 160
Outflows 0 8 16 32 64 128 256
Ending Cash 0 ‐8 ‐14 ‐26 ‐50 ‐98 ‐194
Time 1 2 3 4 5 6 7
Sales 10 20 40 80 160 320 640
Expenses 11 22 44 88 176 352 704
Net Income ‐1 ‐2 ‐4 ‐8 ‐16 ‐32 ‐64
Beg. Cash 0 10 30 59 117 233 465
Inflows 10 20 40 80 160 320 640
Outflows 0 0 11 22 44 88 176
Ending Cash 10 30 59 117 233 465 929
Figure 14.1 Reporting cash flows from

operating activities
Cash flow from operating activities
Direct method Indirect method
Reports major classes of Step 1: Adds non-cash items

gross cash receipts and (and items related to other
payments activities) back to net income
Step 2: Adjusts this amount
for changes in inventories,
receivables and payables
‘True’ direct method ‘Semi-direct’ method

Determining cash flows from the Adjusting accrued revenues and
accounting records of the company expenses for changes in inventories,
receivables and payables
May 2019 26
9. Financial Reporting
Transition: from the 15th century to the

19th
Pacioli’s work spread throughout Europe, (translated into English
in 1543)
England: Early 18th century:
◦ New financial concept: Joint stock company (permanent existence,
limited liability of shareholders, transferability of shares)
1) separation btw. ownership and management
 need for the owner to get information about the manager’s work
2) creation of a stock market
need for potential investors to get information about the firms
1) + 2): joint interest for the firm to get trustworthy financial information
development of a) an auditing profession; and 2) government
regulation
25/04/2019 1 - 54
May 2019 27
Financial Reporting= to account for
Managing a firm creates an agency relationship that requires the manager to

“account for” their management:
◦ Towards the resources providers (shareholders, bankers, etc.)

◦ Towards the business partners (clients, providers)
◦ Towards the employees and the public institutions (State, etc.)
See Fig. 1.4 and Table 1.1
Figure 1.4 A set of financial accounting users

Employees’ Work’s Labor
representatives council unions
Management
Internal users Employees
Shareholders
Users Customers
Potential Investors
investors
Competitors
Investment
analysts External users Tax
authorities
Creditors General public Government
Lenders Suppliers Regulatory

(banks) agencies
May 2019 28
Financial vs. Managerial Accounting
Financial Accounting Managerial Accounting

•Classify, record, analyze and interpret •Collect, record and analyze internal
accounting data accounting data
•OBJECTIVE •OBJECTIVE
• Financial situation • Information about costs
• Results and dividends • Decisions about product development
57
International Regulation
IAS 1 “Presentation of financial statements”

Revised in december 2003 and september 2007
List of the Financial Statements (§ 10) :
◦ 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
◦ An example: Renault
Transparent 58
May 2019 29
Table 2.1 Statement of financial position

(Balance sheet) (continental European presentation in
[kCU])
The list of obligations and resources can be structured either in

increasing or decreasing order of liquidity.
Assets Shareholders’ equity and liabilities
Land and equipment 200 Shareholders’ equity 400
Inventories 150
Accounts receivable 100
Cash 50 Liabilities 100
Total 500 Total 500
Emphasis on the long-term potential of the firm

(Balance sheet) (North American presentation - in
thousands in [kCU])
Assets Lia bilities and shareholders’ equity

Cash 50 Liabilities 100
Inventories 150
Land and equipment 200 Shareholders’ equity 400
Total 500 Total 500
Emphasis on the short-term survival of the firm
May 2019 30

(Balance sheet) (British presentation - in [kCU])
Land and equipment 200

Inventories 150
Cash 50
Minus Liabilities -100
= Net assets 400
Shareholders’ equity 400
Emphasis on the net worth of the firm
Illustration
Illustration: Renault
May 2019 31
S E S S I ON 2 : E A R N I NG S Q UA L I T Y
Program
Session 2: Earnings quality
1. Accounting principles
2. Application of some principles
3. Earnings management: optimization or manipulation?
May 2019 32
1. Accounting principles
1930 Great Depression: stock market

crash
May 2019 33
1930 Great Depression: regulation
Consequences
◦ 1934: Creation of the US Securities and Exchange Commission (SEC) by the Securities Act.
◦ Main objective: protecting investors by means of a disclosure-based structure
◦ Creation of an accounting profession (AICPA), to which standard setting is delegated.
◦ Creation of a conceptual framework
◦ The users must understand the meaning of the accounting reports
◦ Necessity of ‘rules of the game’: Rules = accounting principles
◦ Importance of “conservative accounting”
Figure 4.1 Accounting principles

Substance
Basis of over form
valuation
Faithful
Unit of representation
measurement No offsetting Materiality
Objectivity Quality of
information
True and
fair view
Prudence Periodicity
Conservatism/ Matching
Prudence Accounting Going concern
period
Accrual
basis
Consistency
How to read this figure
Requirement Accounting
Objective
principle
May 2019 34
Main objective: true and fair view
No officially recognized and generally accepted definition

◦ True: financial statements do not falsify or dissimulate the financial situation of the
company at period-end, nor its profits (or losses) for the period
◦ Fair: accounts give accounting users complete and relevant information for decision-
making
We also speak about:

◦ Reliability
◦ Relevance
2. Applications of some principles
May 2019 35
Accrual Principle: definition
Sales and expenses are taken account of in the accounting period in which
they occur (and are included in the income statement for that period), whether
or not cash was received or paid out.
Fundamental accounting concept which recognizes the time lag between
sales and purchases on one hand, and collection and payment of cash on the
other.
Permits meaningful comparisons based on the actual operations of the business
undisturbed by the timing of payments.
Conservatism principle
Definition
◦ A revenue should be booked only if realized, while an expense should be accounted
for as soon as its realization is probable, even eventual.
◦ All potential losses existing at the fiscal year-end should be booked, while potential
gains will not.
◦ Conservatism principle should be applied in such a way that current uncertainties

should not be transferred to future fiscal years.
May 2019 36
Conservatism principle
Application to Schubert
We assume that the forecast has been realized

• X2 Actual F/S = X2 Forecast
We are now in January X3, finalizing the X2 F/S

• Transaction 1: One of your client has not paid yet his receivable (€30,000), due at
30/11/X2. After investigation, your estimation of the risk that your client does not pay is
around 40%.
• Transaction 2: A worker has been injured when working on in your warehouse the
3/10/X2 . He is suing you for non compliance of the regulation on safe working
conditions, and he has just started the procedure. Your lawyer assesses a potential
cost of € 10,000, including indemnities and legal costs associated to the coming
lawsuit.
What do you do?
Matching Principle: definition
This principle requires a company to match expenses with related revenues in

order to report a company's profitability during a specified time interval.
Ideally, the matching is based on a cause and effect relationship: sales causes
the cost of goods sold expense and the sales commissions expense.
◦ If no cause and effect relationship exists, accountants will show an expense in the
accounting period when a cost is used up or has expired.
◦ If a cost cannot be linked to revenues or to an accounting period, the expense will be
recorded immediately. An example of this is Advertising Expense and Research and
Development Expense.
May 2019 37
Matching Principle
Application to Schubert
• Transaction 3: Statistics show a return rate to the After-sales service of about 5% of the
sales, covered by a warranty program.
What do you do?
Figure 4.2 Main categories of end-of-period entries

Type of entries Examples Root principles
Unexpired costs Accounting period

Adjusting entries Unearned revenues Matching
Unrecorded expenses Accrual basis
Unrecorded revenues
Depreciation,
Change in value of Historical cost
amortization, depletion
fixed assets Conservatism
Provisions for
depreciation (impairment)
Valuation allowances
End-of- Change in value of /provisions for Historical cost
period current assets depreciation (accounts Conservatism
entries receivable, inventories,
short-term investments)
Change in value of Historical cost

liabilities Provisions (e.g., risks) Conservatism
Correction of errors (Internal and external)

Other entries and auditing
adjustments Ending inventory
(periodic system) Accounting period,
Closing entries Matching
Accounting period
May 2019 38
3. Earnings management: optimization or manipulation?
What Is Earnings Management?
Earnings management is the choice by a manager of accounting policies

(accruals), or real actions, that affect earnings so as to achieve some specific
reported earnings objective
Here, we concentrate on role of accruals in earnings management
78
May 2019 39
Definitions
Operating Income =
Accruals + Operating Cash-Flows
Accruals =
Discretionary Accruals + Non Discretionary Accruals
Figure 14.4 Where are the accruals?

Net income
±
Non-cash items
(+ Depreciation expense
+ Amortization expense
+ Depletion expense
+ Provision expense [valuation allowance] Potential
- Reversal of provision [valuation allowance]) cash flow
±
Profit or loss on sale of fixed assets
(- Gain on sale
+ Loss on sale)
±
Changes in inventories, receivables and payables
=
Cash flows from operating activities
May 2019 40
Definitions
Manipulations qualified according to different motivations:

◦ Earnings management
◦ Level of the earnings
◦ Income smoothing
◦ Changes in the earnings
◦ Big bath accounting
◦ In periods of restructuring: “clear the decks”
◦ Motivations?
◦ Windows dressing
◦ Creative Accounting
The “Iron Law”: Accruals reverse
Illustration:
◦ A manager increases reported earnings by $1,300 this year. This was done by reducing
the accrual for:
◦ credit losses: $500
◦ warranty costs expense: $800
◦ both below the expected amount.
◦ Why (other things being equal) next year’s earnings will be lowered by $1300?
May 2019 41
The Good Side of Earnings Management

Investor-based arguments for good earnings
management
◦ To credibly communicate inside information to investors
◦ Blocked communication may inhibit direct disclosure of earnings
expectations
◦ Discretionary accrual management as a way to credibly reveal
management’s inside information about earnings expectations
◦ Manager foolish to report more earnings than can be maintained
◦ Manage reported earnings to an amount management expects will persist
Earnings Management at General Electric (1)

Net Income
25000
20000
15000
10000
5000
0
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
May 2019 42
Earnings Management at General Electric (2)

In 2008:
o GE reports lower earnings for quarter ended March 31, 2008
o Share price falls by 13%
o Why did share price fall?
The Bad Side of Earnings Management

Moral hazard (Contracting Perspective)
o Opportunistic Earnings Management (Positive Accounting Theory)
Ex: Abuse of Provisions (Hanna (1999), see also Nortel)

• Investors and analysts look to core earnings, ignoring provisions for extraordinary and
non-recurring items
• Implies manager not penalized for non-core provisions, such as writedowns,
provisions for restructuring
• But current non-core provisions increase core earnings in future years, through lower
amortization and absorption of future costs
• As a result, managers tempted to “overdose” on non-core provisions, thereby putting
earnings “in the bank”
also called cookie jar accounting
May 2019 43
Evidence of Earnings Management for

Bonus Purposes
A contractual motivation: Bonus plan hypothesis: to manage cash bonus
Sunbeam Corp. Earnings Management
1400
1200
1000
800
M USD
600
400
200
0
-200
Q1 1997 1997 Q1 1998
Sales 253.5 1200 244.5
Net Income 6.9 109.4 -44.6
Stock Price 40 53 22
May 2019 44
Sunbeam Corp Earnings Management
Other Earnings Management Motivations

Other contractual motivations
◦ Debt covenant hypothesis: to manage debt covenants
◦ Implicit contracts
◦ E.g., credit enhancement role leading up to 2007-2008 meltdowns
Political cost hypothesis

◦ To lower political “heat”
To meet investors’ earnings expectations

◦ Strong negative share price reaction if expectations not met
◦ Damage to manager reputation if expectations not met
Initial public offerings

◦ To increase proceeds of new share issues
May 2019 45
Transparent 91
Transparent 92
May 2019 46
Control of the earnings quality

External control:
◦ Legal auditors
◦ Banks, creditors
◦ Investors (in particular institutional investors)
Internal control:
◦ Internal auditors
◦ Audit Committee
◦ Board Committee
A good Corporate Governance increases the quality of the Financial

Statements
S E S S I ON 3 : B A C H B US I N E S S G A M E
May 2019 47
Application
3.5 Bach Company p.111-117
SE SSI ON 4 : FI N ANCIAL STATE ME NT AN ALYSIS
May 2019 48
Program
Session 4: Financial Statement Analysis
1. Introduction
2. The rules of financial equilibrium
3. Ratio Analysis
4. Introduction to the DuPont’s system
5. Analysis of the sales profitability
6. Conditions of use of ratios
7. Second-level analysis
8. Application
1. Introduction
May 2019 49
Financial Analysis
Objective
◦ To express a comprehensive diagnosis on the financial situation of the firm
◦ To assess its current and future performances
◦ To assess its ability to sustainability finance its activity
Principles
◦ Financial Analysis leads to a financial diagnosis
◦ Financial Analysis must provide operational proposals
◦ Financial Analysis raise mostly non financial problems
Sources of information about companies
Annual report to shareholders

Business newspapers and magazines – Specialized magazines (see Appendix
18.2)
Databases and statistics publications
Financial statements filed with tax or judicial authorities (see Appendix 18.3)
May 2019 50
The big questions
Is the firm profitable?

◦ To maintain its productive capital
◦ To permit the reimbursement of its debts
◦ To generate a sufficient remuneration of the capital invested by the shareholders
Is the firm solvent?

◦ To assess its liquidity risk
◦ To understand the cash needs arising from its operating cycle
◦ To understand its financial balance
2. The rules of financial equilirium
May 2019 51
First rule
The firm is an
economic entity
that
Obtains ressources …and convert them

(from its in assets needed for
shareholders, its activity, also of
debtholders, or variable durations.
other parties) for
variable
durations…
1rst rule of financial equilibrium:

To finance long term assets by
sustainable resources
Second rule
Firm A Firm B
Net Equities Second rule:

Net Equities o Balance internal and external
ressources for long term ressources
Contingent
Liabilities
Contingent Debt ratio:
Liabilities
Long and Long term ressources/ Net Equities < 0.5
Medium Long and
Term Debts Medium
Term Debts
May 2019 52
Table 15.4 Statement of financial structure (Cash

equation)
Shareholders’ equity and long-term (financial) liabilities (long-

term capital or LTC)
- Net fixed (non-current) assets, i.e., net of accumulated depreciation
(FA)
= Working capital or WC
Current assets (except cash) (CA)

- Current liabilities (except bank overdrafts) (CL)
= Working capital need or Financing need arising from the
operating cycle or WCN
Positive cash (i.e., cash and cash equivalents) (PC)

- Bank overdrafts (BO)
= Net cash (NC)
working capital - working capital need = net cash
Application
2.7 Stora Enso
May 2019 53
Statement of financial structure – Case 1
WCN
>0 WC
>0
NC> 0
WC
WCN >0
>0
NC< 0
May 2019 54
WC
>0
NC
>0
WCN
<0
WC
<0
WCN
NC <0
>0
May 2019 55
WCN
<0
WC
<0
NC
<0
WC
<0
NC
<0
WCN
>0
May 2019 56
3. Ratio Analysis
Ratio analysis
Widely used analytical technique for interpreting financial statements
Caution should be exercised
Necessity to verify the coherence of the quantities that are related
May 2019 57
Figure 18.1 Ratio comparisons
Three possible types of ratios, according to the basis of

their comparisons.
Three types of comparisons
Time-series comparisons Cross-sectional comparisons Rules of thumb

(Longitudinal analysis) (Inter company benchmarks) (Experiential benchmarks)
Common-size (or vertical) analysis
Preparation of common-sized financial statements, i.e., a balance sheet

presented in percentage of a base figure (indexed as 100)
Base =
◦ Single-step => Total assets
◦ Multiple-step balancing with equity = > Equity
◦ Multiple-step balancing with long-term funding => Long-term funding
May 2019 58
Table 16.3 Procter and Gamble - Consolidated

Statement of Earnings (1/3)
In percentage of net sales 2011 2010 2009 20 08 200 7

Net sales 100.0% 100.0% 100.0% 100.0% 100.0%
Cost of products sold 49.4% 48.0% 50.4% 49.5% 47.7%
Selling, general and administrative expense 31.5% 31.7% 29.5% 30.3% 32.3%
Operating income 19.2% 20.3% 20.0% 20.2% 20.0%
Interest expense 1.0% 1.2% 1.8% 1.9% 1.7%
Other non-operating income/(expense), net 0.2% 0.0% 0.5% 0.5% 0.8%
Earnings before income taxes 18.4% 19.1% 18.8% 18.8% 19.1%
Income taxes from continuing operations 4.1% 5.2% 4.9% 4.5% 5.6%
Net earnings from continuing operations 14.3% 13.9% 13.9% 14.2% 13.4%
Net earnings from discontinued operations 0.0% 2.3% 3.6% 1.0% 0.4%
Net earnings 14.3% 16.1% 17.5% 15.2% 13.8%
Table 15.1 Procter and Gamble - Consolidated balance

sheets (2/3)
in millions of USD Balance sheets Common-size balance sheets

Years ended June 30 2011 2010 2009 2008 2011 2010 2009 2008
CURRENT ASSETS
Cash and cash equivalents 2,768.0 2,879.0 4,781.0 3,313.0 2.0% 2.2% 3.5% 2.3%
Investment securities - - - 228.0 - - - 0.2%
Accounts receivable 6,275.0 5,335.0 5,836.0 6,761.0 4.5% 4.2% 4.3% 4.7%
Inventories 0.0% 0.0% 0.0% 0.0%
Materials and supplies 2,153.0 1,692.0 1,557.0 2,262.0 1.6% 1.3% 1.2% 1.6%
Work in process 717.0 604.0 672.0 765.0 0.5% 0.5% 0.5% 0.5%
Finished goods 4,509.0 4,088.0 4,651.0 5,389.0 3.3% 3.2% 3.4% 3.7%
Total inventories 7,379.0 6,384.0 6,880.0 8,416.0 5.3% 5.0% 5.1% 5.8%
Deferred income taxes 1,140.0 990.0 1,209.0 2,012.0 0.8% 0.8% 0.9% 1.4%
Prepaid expenses and other current assets 4,408.0 3,194.0 3,199.0 3,785.0 3.2% 2.5% 2.4% 2.6%
Total current assets 21,970.0 18,782.0 21,905.0 24,515.0 15.9% 14.7% 16.2% 17.0%
PROPERTY, PLANT AND EQUIPMENT
Buildings 7,753.0 6,868.0 6,724.0 7,052.0 5.6% 5.4% 5.0% 4.9%
Machinery and equipment 32,820.0 29,294.0 29,042.0 30,145.0 23.7% 22.9% 21.5% 20.9%
Land 934.0 850.0 885.0 889.0 0.7% 0.7% 0.7% 0.6%
Total property, plant and equipment 41,507.0 37,012.0 36,651.0 38,086.0 30.0% 28.9% 27.2% 26.5%
Accumulated depreciation (20,214.0) (17,768.0) (17,189.0) (17,446.0) (14.6%) (13.9%) (12.7%) (12.1%)
Total property, plant an d equipment 21,293.0 19,244.0 19,462.0 20,640.0 15.4% 15.0% 14.4% 14.3%
GOODWILL AND OTHER
INTANGIBLE ASSETS
Goodwill 57,562.0 54,012.0 56,512.0 59,767.0 41.6% 42.1% 41.9% 41.5%
Trademarks and other intangible assets, net 32,620.0 31,636.0 32,606.0 34,233.0 23.6% 24.7% 24.2% 23.8%
Net goodwill and other intangible assets 90,182.0 85,648.0 89,118.0 94,000.0 65.2% 66.8% 66.1% 65.3%
OTHER NONCURRENT ASS ETS 4,909.0 4,498.0 4,348.0 4,837.0 3.5% 3.5% 3.2% 3.4%
TOTAL ASSETS 138,354.0 128,172.0 134,833.0 143,992.0 100.0% 100.0% 100.0% 100.0%
May 2019 59
Table 15.1 Procter and Gamble - Consolidated

balance sheets (3/3)
CURRENT
LIABILITIES
Accounts payable 8,022.0 7,251.0 5,980.0 6,775.0 5.8% 5.7% 4.4% 4.7%
Accrued and other 9,290.0 8,559.0 8,601.0 10,154.0 6.7% 6.7% 6.4% 7.1%
liabilities
Taxes payable - - - 945.0 - - - 0.7%
Debt due within one year 9,981.0 8,472.0 16,320.0 13,084.0 7.2% 6.6% 12.1% 9.1%
Total current liabilities 27,293.0 24,282.0 30,901.0 30,958.0 19.7% 18.9% 22.9% 21.5%
Long term debt 22,033.0 21,360.0 20,652.0 23,581.0 15.9% 16.7% 15.3% 16.4%
Deferred income taxes 11,070.0 10,902.0 10,752.0 11,805.0 8.0% 8.5% 8.0% 8.2%
Other noncurrent liabilities 9,957.0 10,189.0 9,146.0 8,154.0 7.2% 7.9% 6.8% 5.7%
TOTAL LIABILITIES 70,353.0 66,733.0 71,451.0 74,498.0 50.8% 52.1% 53.0% 51.7%
SHAREHOLDERS’ 68,001.0 61,439.0 63,382.0 69,494.0 49.2% 47.9% 47.0% 48.3%
EQUITY
TOTAL LIABILITIES 138,354.0 128,172.0 134,833.0 143,992.0 100.0% 100.0% 100.0% 100.0%
AND
SHAREHOLDERS’
EQUITY
4. Introduction to the DuPont’s system
May 2019 60
DuPont’s system
Created by managers at DuPont de Nemours in the 20ies.

Still widely used today
Starting point:
◦ A first key ratio that is then decomposed into three ratios (first-level analysis)…,
◦ …that are on their turn decomposed into other ratios (second-level analysis) that
enables to refine the diagnosis.
Advantages
◦ Simple and easy to remember
◦ All ratios come from the first key-ratio.
◦ Facilitates a systematic analysis approach
◦ Prevents from missing elements that could be proven to be crucial.
◦ Highlights the relationships between various ratios
◦ Increases the value of the diagnosis.
Starting point: ROE

ROE: Return on Equity
Measures the profitability from the

shareholders’ perspective.
ROE = = How much profit is generated by one

Net Income unit of shareholder’s equity?
/ (Average Equities)
May 2019 61
StoraEnso ROE
2012 2011 2010 2009 2008 2007 2006
Net income (23) 490.4 342.2 769.3 -878.2 -674.7 -212.4 589.2
Equity year 2 (21) 5,876.0 5,959.8 6,254.7 5,182.5 5,650.5 7,665.5 8,020.6
Equity year 1 (25)=(21) year 1 5,959.8 6,254.7 5,182.5 5,650.5 7,665.5 8,020.6 7,313.7
Average Equity (26)=[(21)+(25)]/2 5,917.9 6,107.3 5,718.6 5,416.5 6,658.0 7,843.1 7,667.2
Return on equity
(27)=(23)/(26) 8.3% 5.6% 13.5% -16.2% -10.1% -2.7% 7.7%
(ROE) (in %)
First level analysis
ROE
ROA
Net Average Assets/
Income/Average Average net equities
assets
Net profit margin

Assets turn-over Financial leverage
(RoS)
Sales/Average assets (1+financial leverage)
Net income/ Sales
May 2019 62
StoraEnso ROA
2012 2011 2010 2009 2008 2007 2006

Net income (23) 490.4 342.2 769.3 -878.2 -674.7 -212.4 589.2
Assets year 2 (33) 13,693.6 12,999.1 13,036.7 11,593.2 12,240.8 15,310.8 17,382.1
Assets year 1 (34) 12,999.1 13,036.7 11,593.2 12,240.8 15,310.8 17,382.1 17,830.7
(35)=
Average assets [(33)+(34)]/2 13,346.4 13,017.9 12,315.0 11,917.0 13,775.8 16,346.5 17,606.4
Return on (36)=
3.7% 2.6% 6.2% -7.4% -4.9% -1.3% 3.3%
assets (in %) (23)/(35)
StoraEnso Return on Sales
2012 2011 2010 2009 2008 2007 2006
Net income (23) 490.4 342.2 769.3 -878.2 -674.7 -212.4 589.2
Sales (9) 10,814.8 10,964.9 10,296.9 8,945.1 11,028.8 11,848.5 11,460.4
Return on sales (24)=(23) 4.5% 3.1% 7.5% -9.8% -6.1% -1.8% 5.1%
(in %) /(9)
May 2019 63
StoraEnso Asset Turn-Over
2012 2011 2010 2009 2008 2007 2006

Sales (9) 10,814.80 10,964.90 10,296.90 8,945.10 11,028.80 11,848.50 11,460.40
Assets year 2 (33) 13,693.6 12,999.1 13,036.7 11,593.2 12,240.8 15,310.8 17,382.1
Assets year 1 (34) 12,999.1 13,036.7 11,593.2 12,240.8 15,310.8 17,382.1 17,830.7
Average assets (35)= 13,346.4 13,017.9 12,315.0 11,917.0 13,775.8 16,346.5 17,606.4
[(33)+(34)]/2
Asset Turn-Over (36)= 81.0% 84.2% 83.6% 75.1% 80.1% 72.5% 65.1%
(in %) (23)/(35)
Application
3.2 Identification of industry segments p.108
May 2019 64
5. Analysis of the sales profitability
Analysis of sales profitability
Net profit margin (or Return on sales)

◦ First driver of the profitability
◦ How much benefit is generated by each unit of sales
◦ Ideally, that ratio should be as high as possible
◦ One can analyze all components of this ratio (Analysis of sales, of the margin,
of the EBIT, EBITDA, etc.)
May 2019 65
Analysis of Sales Profitability StoraEnso

2012 2011 2010 2009 2008 2007 2006
Sales (in value) 10,815 10,965 10,297 8,945 11,029 11,849 11,460
Change in Sales -1.4% 6.5% 15.1% -18.9% -6.9% 3.4% 1.0%
Changes in inventories of FG and WiP -0.1% 0.3% 0.6% -2.2% -0.7% 0.7% -0.1%
Materials and services -64.4% -63.8% -62.7% -61.1% -61.8% -59.5% -55.6%
Freight and sales commissions -9.3% -9.3% -9.8% -9.3% -10.2% -9.6% -10.4%
COGS 73.8% 72.8% 71.8% 72.6% 72.7% 68.4% 66.1%
Personnel expenses -12.6% -12.7% -13.4% -15.1% -15.1% -14.5% -15.1%
Other operating income 2.0% 1.9% 1.5% 1.9% 1.1% 0.7% 3.1%
Other operating expenses* -5.4% -5.3% -4.7% -9.4% -7.0% -6.4% -7.4%
Share of results in equity accounted 1.0% 1.1% 0.7% 1.2% 0.1% 2.9% 0.8%
investments
EBITDA 11.3% 12.1% 12.3% 6.1% 6.3% 14.4% 15.3%
Depreciation, amortization and -4.9% -5.2% -2.7% -12.9% -12.9% -12.9% -9.1%
impairment
EBIT 6.4% 6.9% 9.6% -6.8% -6.6% 1.5% 6.2%
Financial income 1.2% 0.4% 0.9% 2.3% 3.2% 1.4% 2.4%
Financial expense -3.1% -3.5% -1.9% -5.5% -4.8% -2.7% -2.5%
Profit/(Loss) before Tax 4.5% 3.8% 8.6% -9.9% -8.1% 0.2% 6.1%
Income tax 0.1% -0.7% -1.1% 0.1% 1.9% -0.1% -0.1%
Net Profit/(Loss) from Continuing 4.5% 3.1% 7.5% -9.8% -6.2% 0.1% 6.0%
Operations
Net Profit/(Loss) 4.5% 3.1% 7.5% -9.8% -6.1% -1.8% 5.1%
6. Analysis of the asset efficiency
May 2019 66
Analysis of asset turn-over
Assets turnover
◦ Second driver of profitability
◦ Measures the efficiency of the asset management
◦ How much sales is generated by each unit invested in the firm’s assets.
◦ An important link between both main financial statements (income statement
and balance sheet)
Ideally, that ratio should be as high as possible, as it means that the ratio would
be used at their maximum
One distinguishes between:
◦ Short term efficiency
◦ Long term efficiency
StoraEnso
Short Term Asset Management Efficiency
2012 2011 2010 2009 2008 2007 2006

Sales (1) 10,814.80 10,964.90 10,296.90 8,945.10 11,028.80 11,848.50 11,460.40
Average Receivable (2) 1,671.4 1,638.2 1,492.2 1,472.9 1,823.2 2,109.9 2,171.4
Average Inventory (3) 1,493.1 1,501.7 1,378.1 1,487.6 1,843.1 2,006.1 2,085.0
Average Trade
(4) 1,738.5 1,784.7 1,699.1 1,644.0 1,906.4 2,149.5 2,276.4
Payable
Average Operating (5)=
Working Capital (2)+(3)- 1,426.1 1,355.2 1,171.2 1,316.5 1,759.9 1,966.5 1,980.0
Need (4)
Operating WCN in (6)=(5)/
48 45 42 54 58 61 63
days of sales (1)*365
May 2019 67
StoraEnso
Short Term Asset Management Efficiency
2012 2011 2010 2009 2008 2007 2006

Sales (1) 10,814.80 10,964.90 10,296.90 8,945.10 11,028.80 11,848.50 11,460.40
Average (2) 1,671.4 1,638.2 1,492.2 1,472.9 1,823.2 2,109.9 2,171.4
Receivable
(3)=(2)/(1)
DSO *365 56.4 54.5 52.9 60.1 60.3 65.0 69.2
COGS (4) 7,976.6 7,985.7 7,397.5 6,498.4 8,020.9 8,104.4 7,579.4
Average Inventories (5) 1,493.1 1,501.7 1,378.1 1,487.6 1,843.1 2,006.1 2,085.0
(6)=(5)/(4)
DIO *365 68.3 68.6 68.0 83.6 83.9 90.3 100.4
Average Trade (7) 1,738.5 1,784.7 1,699.1 1,644.0 1,906.4 2,149.5 2,276.4
Payable
(8)=(7)/(4)
DPO *365 79.5 81.6 83.8 92.3 86.8 96.8 109.6
(CCC) =
Cash Conversion DSO + DIO
45.2 41.6 37.1 51.3 57.5 58.5 59.9
Cycle – DPO
StoraEnso
Long Term Asset Management Efficiency
2012 2011 2010 2009 2008 2007 2006

Sales (1) 10,814.80 10,964.90 10,296.90 8,945.10 11,028.80 11,848.50 11,460.40
PPE Year 2 (2) 5,048.7 4,942.5 5,066.9 4,700.2 5,413.7 6,476.7 9,153.6
PPE Year 1 (3) 4,942.5 5,066.9 4,700.2 5,413.7 6,476.7 9,153.6 9,936.8
(4)=((3)+(2
Average PPE ))/2 4,995.6 5,004.7 4,883.6 5,057.0 5,945.2 7,815.2 9,545.2
Fixed Assets turn-over (5)=(4)/(1) 2.16 2.19 2.11 1.77 1.86 1.52 1.20
Depreciation (6) -531.6 -572.6 -282.7 -1,152.9 -1,422.4 -1,529.6 -1,043.8
Remaining years of (7)=(4)/(6)
-9.4 -8.7 -17.3 -4.4 -4.2 -5.1 -9.1
life of PPE
May 2019 68
6. Analysis of the financial leverage
Analysis of solvency
Financial leverage
◦ Informs about the proportion of assets that are financed by its owners.
◦ Measures the level of debt (an increase of the ratio= a higher indebtedness)
◦ The higher the leverage, the higher the ROE (ceteris paribus)
◦ Cautious:
1. a higher leverage also means higher financial expenses and then a
decrease of the net margin.
2. A higher levelrage also means a higher financial risk = liquidity issue!
May 2019 69
StoraEnso Financial Leverage
2012 2011 2010 2009 2008 2007 2006

Non-current
5,300.4 4,253.1 4,212.9 3,791.3 3,815.1 4,452.7 6,021.6
Liabilities*
Current Liabilities 2,517.2 2,786.2 2,569.1 2,619.4 2,775.2 3,192.6 3,339.9
Liabilities year 2 7,817.6 7,039.3 6,782.0 6,410.7 6,590.3 7,645.3 9,361.5
Liabilities year 1 7,039.3 6,782.0 6,410.7 6,590.3 7,645.3 9,361.5 10,517.0
Average Liabilities 7,428.5 6,910.7 6,596.4 6,500.5 7,117.8 8,503.4 9,939.3

(36)=(23)/
Equity year 2 5,876.0 5,959.8 6,254.7 5,182.5 5,650.5 7,665.5 8,020.6
(35)
(25)=(21)
Equity year 1 5,959.8 6,254.7 5,182.5 5,650.5 7,665.5 8,020.6 7,313.7
year 1
(26)=[(21)
Average Equity 5,917.9 6,107.3 5,718.6 5,416.5 6,658.0 7,843.1 7,667.2
+(25)]/2
Financial Leverage (27)=(23)/
125.5% 113.2% 115.3% 120.0% 106.9% 108.4% 129.6%
(in %) (26)
StoraEnso Long term Debt Ratio
2012 2011 2010 2009 2008 2007 2006

Long-term liabilities (20) 5,300.4 4,253.1 4,212.9 3,791.3 3,815.1 4,452.7 6,021.6
Equity (21) 5,876.0 5,959.8 6,254.7 5,182.5 5,650.5 7,665.5 8,020.6
Long-term debt to (22)=(20)/(21) 0.90 0.71 0.67 0.73 0.68 0.58 0.75
equity ratio
May 2019 70
StoraEnso Liquidity Ratio
2012 2011 2010 2009 2008 2007 2006

Current assets (1) 5,311.1 4,609.8 4,494.1 3,758.2 3,968.7 5,288.5 5,037.2
(including Cash)
Current liabilities (2) 2,517.2 2,786.2 2,569.1 2,619.4 2,775.2 3,192.6 3,339.9
Current ratio (3)=(1)/(2) 2.11 1.65 1.75 1.43 1.43 1.66 1.51
Cash and cash (4) 1,849.9 1,138.8 1,110.9 890.4 415.8 970.7 609.0
equivalents
Cash ratio (5)=(4)/(2) 0.73 0.41 0.43 0.34 0.15 0.30 0.18
EBIT (6) 689.0 759.3 986.2 -607.6 -726.6 176.9 708.4
Financial expenses (7) 335.5 381.3 192.5 488.5 523.9 318.6 289.0
Interest Coverage (8)=(6)/(7) 2.1 2.0 5.1 -1.2 -1.4 0.6 2.5
ratio
7. Conditions of use of ratio analysis
May 2019 71
Conditions of use of ratio analysis (1/3)
Base the analysis on comparisons

Avoid computing seemingly different ratios, which in reality have the same
informational content
Even in case of ‘named’ ratios, provide the definition of the ratio
Avoid information overload created by too many ratios
Be aware of the limits of ratios due to the timing of the financial statements
Be aware of the limits of the ratios due to the quality of financial statements
Be aware of the difficulty of interpreting negative ratios (loss, negative cash,
negative equity)
Do not look for a standardized list of universally applicable ratios
May 2019 72
Ratios defined in a given country should only be applied to financial statements

of another country with great caution
Never overestimate the explanatory power of ratios: judgment is necessary
8. Application
May 2019 73
Application
18.4 “South Petrol and North Petrol”
May 2019 74

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EMBA MSB, Financial Accounting 2019‐04‐25

MEDITERRANEAN SCHOOL OF BUSINESS

PROGRAM: Executive Master in Business Administration - EMBA

CÉDRIC LESAGE, MPHIL, PHD

LAWRENCE S. BLOOMBERG CHAIR IN ACCOUNTANCY

EMBA MSB TUNIS

2-5 MAY 2019

Financial Statement Analysis

Stolowy H., Ding Y. Financial Accounting and Reporting. A Global Perspective,

Session 1: Financial Statements

1. Introduction to financial accounting

Session 1: Financial Statements

1. Introduction to financial accounting

Accounting: a language for business

Luca Pacioli’s principles

Luca Pacioli’s principles

Application: Verdi (p. 43-45)

Session 1: Financial Statements

2. Double entry principle and the Balance Sheet

Figure 2.1 Financial position

Assets Liabilities and shareholders’ equity

A balance sheet is a snapshot of the status of the financial

Components of the liabilities

Components of the assets

– Long term (or non-current) assets:

– Short term (or current) assets:

Assets = Liabilities + Equity

• Transactions can take place between assets, between

Application: Verdi (p. 43-45)

2. Verdi obtains a loan:

3. Investment (computer, printer)

Application: Verdi (p. 45-51)

Session 1: Financial Statements

3. Double entry and income statement

The business equation revisited

Assets = Liabilities + Shareholders’ equity

Net income: definition

A movie recording the activity of the

Application: Verdi (p. 45-51)

5. Receipt of cash from Sheila Burns:

6. Payment for expenses:

Figure 2.12 Links between the balance sheet and the

ASSETS = LIABILITIES + SHAREHOLDERS’ EQUITY

Share capital [Retained] earnings

Some key points (1/2)

Some key points (2/2)

Net income is different from cash

◦ Distribute the profit partially to the

◦ Not distribute profit at all (shareholders reinvest

Application: Verdi (p. 59-64)

Hypothesis: no income tax

Session 1: Financial Statements

5. The production process of accounting information

Supporting document (source document)

Documents must be relevant

Day-to-day chronological register of accounting information found in the

The business equation revisited

Assets = Liabilities + Shareholders’ equity