Enterprise economy (Economy of a firm)

1 semester
7 lectures
11 seminars
1 lesson = 1.11 points (pts)
Total attendance – 20 pts
Current and final control – 20 pts
20 pts for individual task (not compulsory)
40 pts for test (зачет) at the end of the module

Topic 1. Basics

We begin with a definition

A firm (company) is a business organization that sells goods/products or services to make a
profit.

Main aim is to make profit.

Difference between goods and services:

 Services are consumed at the moment they are provided
 Products may not be consumed at the moment they are provided

The main types of the organization are:

 Partnerships
 Sole trader business
 Limited Liability Company (LLC)
 Joint Stock Company

Partnerships
A partnership is a business arrangement in which several people work together, and share the
risks and profits.
In Britain and the US, partnerships do not have limited liability for debts, so the partners are
fully liable or responsible for any debts the business has.
Partnerships are not legal entities, so in case of a legal action, it is the individual partners and
not the partnership that is taken m court.
In most continental European countries there are various kinds of partnership which are legal
entities.
A sole trader business (индивидуальный предприниматель, ИП) - an enterprise owned and
operated by a single person - also has unlimited liability for debts (including Russia; but in
practice this “unlimited” liability is in fact limited due to several factors).

Limited Liability Company (LLC)

LLC has a separate legal existence from its owners (the shareholders). It can enter into
contracts, and can be sued or taken to court if it breaks a contract.
A company can (in theory) continue for ever, even if all the staff and owners change.
Most companies have limited liability, which means that the owners are not fully liable for the
business’s debts and other obligations.

1
The liability is limited to the value of the share capital: the amount of cash that the
shareholders have contributed to the company.
This limitation of liability encourages investors to risk their money to become part-owners of
companies, while leaving the management of these companies to senior managers (directors).

The managers run the company for its owners. There are standard procedures of corporate
governance - the way a company is run by the management for the shareholders, and how the
managers are accountable to them.
These include separating the job of chairman from that of managing director, and having
several non-executive directors on the board of directors who do not work full-time for the
company but can offer it expert advice. Non-executive directors are seen to be more objective
and less influenced by their opinions and beliefs. There is also an audit committee, containing
several non-executive directors, to which the auditors report.

Joint Stock Company

It is a business entity whose stock is owned jointly by the shareholders.
The shares (stocks) can be bought and sold by shareholders.
Shareholders are able to transfer their shares to others without any effects to the continued
existence of the company

The company is managed on behalf of the shareholders by a board of directors, elected at an

annual general meeting.

The shareholders also vote to accept or reject an annual report and audited set of accounts.
Individual shareholders can sometimes stand for directorships within the company if a vacancy
occurs, but that is uncommon.

The shareholders are usually liable for any of the company debts that extend beyond the
company's ability to pay up to the amount of them.

Russian companies try to copy Western standards in order to be attractive for Western
investors, but in practice so called ‘non-executive directors’ one way or another are affiliated
with the company.

In Russia, there are several main types of companies: Public Joint Stock Company (ПАО),
Nonpublic Joint Stock Company (НАО) and LLC (ООО).

Main pieces of legislation (in Russia):

 Joint-Stock Companies Act (Закон об акционерных обществах);
 LLC Act (Закон об ООО)
 the Civil Code (Гражданский кодекс);
 the Criminal Code;
 Accounting Act (Закон о бухучете);
 Bankruptcy Act (Закон о банкротстве)
 The Labor Code
 On Registration of Legal Entities and Sole Traders Act
 Legislation, regulating certain types of business activities
 Commercial Secrets Act (закон «О коммерческой тайне»)
 Competition Act (закон «О защите конкуренции»)

2
  Export Control Act (Закон «Об экспортном контроле»)
How to found a company?

When people found companies, they prepare Memorandum of Association /Charter.

Usually, this document states:
■ the company’s name;
■ the location of the company’s registered office (where to send official documents – e.g.
from tax service);
■ the company’s purpose – its aims/objectives;
■ the authorized share capital (the maximum share capital it can have).
■ the rights and duties of the shareholders and directors;
■ the relationships between shareholders and the company and its directors.

Private and public companies

Private companies usually have ‘Limited’ or ‘Ltd’ at the end of their name. They are not allowed
to sell their stocks or shares on an open market (exchanges).
Most companies in the world are private.
As for Britain, the shares public limited companies (PLCs) are publicly traded on the London
Stock Exchange (LSE).
A stock exchange is a market where anyone can buy stocks and shares (via broker).
The US equivalent of a PLC is a company or corporation registered with the Securities and
Exchange Commission (SEC).
SEC-registered companies, also known as listed companies, have to make reports (i.e. every
three months and every year).
So, U can easily find basic facts about a company via form 10-K which is an annual report,
published at the web-site of SEC (sec.gov).
Among other the companies report on:
■ sales revenue (the money received by the company in that period from selling goods or
services);
■ gross profit (revenue less cost of sales);
■ net profit NP (gross profit less administrative expenses and tax).
NB: actually, there is no difference between net profit and net income.

Companies on the London Stock Exchange, known as quoted companies, have to produce a
half-yearly interim report which informs shareholders about the company’s progress. These
reports are not audited.
All companies with shareholders or stockholders have to send them an Annual Report (AR)
each financial year (FY).
This contains a review of the year’s activity, and an examination and explanation of the
company’s financial position and results. There are also financial statements and notes, and the
auditors’ report on the financial statements.

AGM
Public companies have to hold an Annual General Meeting (AGM), and most private ones do
too.
At the meeting the shareholders can question directors about the content of the Annual Report
and the financial statements, vote to accept or reject the dividend recommended by the
directors, and vote on replacements for retiring members of the board.

3
If there is a crisis or urgent need (misconduct by the directors, takeover/merger), the directors
or the shareholders can request to hold an Extraordinary General Meeting (EGM) to discuss the
situation.

Company valuation and measurement

Valuation – финансовая оценка компании
Investors in companies want to know how much the companies are worth, so companies
regularly have to publish the value of their assets and liabilities.
Companies also are to calculate their profits or losses: their managers need this information to
make decisions. So do shareholders (to invest in shares), bondholders (to invest in bonds), the
tax authorities and other regulators.
Companies can choose their accounting policies - their way of doing their accounts.
There are a range of methods of valuation - deciding how much something is worth - and
measurement - determining how big something is - that are accepted by law or by official
accounting standards.

In the US, there are Generally Accepted Accounting Principles (GAAP). In most of the rest of the
world there are International Financial Reporting Standards (IFRS), set by the International
Accounting Standards Board.

These standards are technical rules or conventions - accepted ways of doing things that are not
written down in a law.
Although businesses can choose among different accounting policies, they have to be
consistent, which means using the same methods every year, unless there is a good reason to
change the policy.
The policies also have to be disclosed or revealed to the shareholders. Usually, the Annual
Report contains a ‘Statement of Accounting Policies’ that mentions any changes that have
been made.
This enables shareholders to compare profits and values with those of previous years.

Areas in which the choice of policies can make a big difference to the final profit figure include
depreciation - reducing the value of assets in the company’s accounts, the valuation of stock or
inventory, and the making of provisions (amounts of money deducted from profits) for future
payments (e. g. for pensions).
As there is always more than one way of presenting accounts, the accounts of British
companies have to give a true and fair view of their financial situation.

Historical cost and inflation accounting

The aim of accounting standards is to provide shareholders with the
information that will allow them to make financial decisions. This is one reason why in
many countries accounting follows rhr hisroriral cost principle: companies record the
original purchase price of assets, and not their (estimated) current selling price or
replacement cost. This is more objective, and the current value is not important if the
business is a going concern - a successful company that will continue to do business - as
its assets are not going to Ix? sold, or do not currently need to be replaced.
However, some countries with regular high inflation, e.g. in South America, use inflation
accounting systems that take account of changing prices. One system used is replacement
cost accounting, which values all assets at their current replacement cost - the amount
that would have to be paid to replace them now.

4
Due diligence (DD)
DD – a comprehensive appraisal of a business, especially to establish its assets and liabilities
and evaluate its commercial potential.

DD is aimed at minimizing of corporate risks while conducting business activities and to check
potential contractors and partners (e. g. for fraud etc.).

Sources of DD-information. They can be classified:

 Open (Google, open databases etc.)
 Closed (special databases)
Standard preliminary file about contractor may contain the following items:
 registration data (address, phone numbers, subsidiaries etc.);
 shareholders and beneficiaries names;
 corporate history (including credit reputation);
 current business activities and their indicators (including assets, liabilities, market
position);
 business reputation (law and regulators actions, public image, charitable activities etc.)
 the executive (including the formal and informal contacts, business experience) and
corporate structure (formal and informal);
 security organization (contacts with enforcement authorities, security service
(own/outsourcing));
 corporate strategy;
 main rivals and partners.
Basic corporate information can be found via open sources. To make search, U need to know
only TIN or Primary State Registration Number (ОГРН).
Usually, companies publish on their web-sites such documents as Charter, registration
certificates, licenses, financial accounts (IFRS, RAS etc.), company details (taxpayer
identification number etc.).
Next source is web-site of Unified State Register of Legal Entities (ЕГРЮЛ). Here, U can find
information about form of legal entity's incorporation (public/nonpublic etc.), address, size of
registered capital, data about founding shareholders, facts of not reporting to tax authorities,
debts for tax etc.
Just only via data of Russian Tax Service web-site U are able to make a preliminary conclusion
about your potential partner or contractor and find aspects, which need further detailing.
Federal Agency for State Registration, Cadastre, and Cartography (Rosreestr) can also be
considered as an important source of data, but the access is not free.
Request would allow to get data from Unified State Register of Real Estate Rights and
Transactions (Единый государственный реестр прав на недвижимое имущество и сделок с
ним, ЕГРП).
This source can be used to find data about buildings, belonging to a company.

Fedresurs.ru is operated by Interfax web-site, which represents Unified Federal Register of

Legally Valid Data (Единый федеральный реестр юридически значимых сведений). Free
search would allow U only to find out whether a company is incumbent or not. U can also learn
whether a company is bankrupt or not.

5
Fssprus.ru is web-site of Federal Bailiff Service where U can find information about executory
processes, relating not only to companies, but to individuals as well.
Search request returns the following data, including: company name, form of legal entity's
incorporation, legal address, proceeding counting number, case for proceeding termination
Web-site of Russian Federal Antitrust Service fas.gov.ru contains the register of malevolent
suppliers for state contracts (rnp.fas.gov.ru). Solutions.fas.gov.ru gives access to regulatory
legal acts and other pieces of legislation.

Pravosudie system (sudrf.ru) allows U to get data about legal actions. Search request returns
information about the case, decision and text of the certain document.
Kad.arbitr.ru provides information about arbitration cases. Again, U need to only TIN.
Actually, companies use other tools to find out more detailed information about contractors.
There are several relevant systems: SPARK, Seldon.Basis, Integrum, Skrin.ru etc.
They are based on official data of Federal Tax Service, Russian Statistical Agency and other
bodies, but they provide more detailed information. Also, they have their own services and
scoring systems, which can calculate risk level for the certain contractor.

For example SPARK provides its own assessment of various risk factors, and allows to download
list of companies given certain criteria (e. g. revenue), to search through ‘black lists’, to analyze
credit risks, to search for affiliation, to look through corporate credit history, to look through
financial accounts etc.
According to SPARK, there are several alarm signs:
 recent date of company registration;
 minimal size of registered capital;
 fact of unpaid debt and/or proceeding in execution;
 false registration address and/or phantom (bogus boss);
 inclusion into ‘black lists’;
 revolving-door management teams;
 old/no financial data.
Russian corporate practice shows that often false/bogus registration address seems to be
sufficient criteria to reject a company as potential contractor.
Also, SPARK can provide data for Ukrainian, Belorussian, Kyrgyz and Kazakh companies and
legal entities.
NB: it’s not easy to find data about non-public companies as since 1.07.2015 they are not
obliged to publish any information, according to the law.
Scan-interfax.ru allows U to conduct analysis of media environment and to monitor positive or
negative media coverage of a company activity.
Express analysis allows to conduct certain kinds of analysis: liquidity analysis, financial
solvency analysis, credit capacity analysis etc.
Other systems on the market have familiar functions.
The main problem is that received data must be check due to errors or mistakes, which
inevitably exist in official and unofficial databases. Also, it should be noted that financial
accounting analysis may be based upon outdated information due to reporting process. So, this
implies importance of media monitoring (kommersant.ru or vedomosti.ru) to spot negative
trends early.

Accounting assumptions and principles

Assumptions

6
When writing accounts and financial statements, accountants have to follow a number of
assumptions, principles and conventions. An assumption is something that is generally
accepted as being true. The following are the main assumptions used by accountants:
■ The separate entity or business entity assumption is that a business is an accounting unit
separate from its owners, creditors and managers, and their assets. These people can all
change, but the business continues as before.
■ The time-period assumption states that the economic life of the business can be divided into
(artificial) time periods such as the financial year, or a quarter of it.
■ The continuity or going concern assumption says that a business will continue into the future
■ The unit-of-measure assumption is that all financial transactions are in a currency.
Companies with subsidiaries - that is, other companies that they own - in different countries
have to convert their results into one currency in consolidated financial statements (for the
whole group of companies).
Principles
The following are the most important accounting principles
■ The full-disclosure principle states that financial reporting must include all significant
information: anything that makes a difference to the users of financial statements.
■ The principle of materiality, however, says that very small and unimportant amounts do not
need to be shown.
■ The principle of conservatism is that where different accounting methods are possible, you
choose the one that is least likely to overstate or over-estimate assets or income.
■ The objectivity principle says that accounts should be based on facts and nor on personal
opinions or feelings. Accounts, therefore, should be verifiable: it should be possible for internal
and external auditors to show that they are true.
■ The revenue recognition principle is that revenue is recognized in the accounting period in
which it is earned. This means the revenue is recorded when a service is provided or goods
delivered, not when they are paid for.
■ The matching principle, which is related to revenue recognition, states that each cost or
expense related to revenue earned must be recorded in the same accounting period as the
revenue it helped to earn.
Assets

An asset is a resource of economic value that a company has with the expectation that it will
provide future benefit.
A company’s assets are usually divided into current assets like cash and stock or inventory,
which will be used or converted into cash in less than a year, and fixed assets such as buildings
and equipment, which will continue to be used by the business for many years.
The key feature of fixed assets wear is that they are wear out - become unusable, or become
obsolete - out of date, and eventually have little or no value.
So, fixed assets need to be depreciated: their value on a balance sheet is reduced each year by
a charge against profits on the profit and loss account.
Usually, part of the cost of the asset is deducted from the profits each year.

In the West, the most common system of depreciation for fixed assets is the straight-line
method, which means charging equal annual amounts against profit during the lifetime of the
asset (e.g. deducting 10% of the cost of an asset’s value from profits every year for 10 years).
Many continental European countries allow accelerated depreciation: businesses can deduct
the whole cost of an asset in a short time. Accelerated depreciation is considered as a way to
encourage investments. For example, if a company deducts the entire cost of an asset in a

7
single year, it reduces its profits, and therefore the amount of tax it has to pay. Consequently
new assets, including huge buildings, can be valued at zero on balance sheets.

In Russia, there are several ways how to calculate depreciation.

Straight-line – depreciation is charged in equal amounts for the whole term.
Debased (уменьшаемый остаток) – each year depreciation is charged on residual cost of an
asset (not initial).
Based on natural indicators – e. g. machine hour.
In Russia, the concrete term is determined by Tax Code and Decree of the Russian
Government (Постановление Правительства РФ от 01.01.2002 N 1 в ред. от 06.07.2015).
According to Russian law, depreciation term is calculated in months.
There are 10 groups
1) 1-2 years; 2) 2-3 years; 3) 3-5 years; 4) 5-7 years; 5) 7-10 years; 6) 10-15 years
7) 15-20 years; 8) 20-25 years; 9) 25-30 years; 10) 30 yrs and more

NB: BrE: fixed assets (FA); AmE: property, plant and equipment (PPE).
Assets such as buildings, land, machinery and vehicles are grouped together under fixed assets.
British companies occasionally revalue (calculate a new value for) fixed assets like land and
buildings in their balance sheets. The revaluation is at either current replacement cost - how
much it would cost to buy new ones, or at net realizable value (NRV) – how much they could be
sold for.

Companies in countries which use historical cost accounting (recording only the original
purchase price of assets) do not usually record an estimated market value (the price at which
something could be sold today). The conservatism and objectivity principles support this.
Balance Sheet (BS)

Usually, company law in Britain, in the US, and other countries require firms to publish annual
balance sheets: statements for shareholders and creditors.
The balance sheet is an official document that summarizes a company's assets, liabilities and
shareholders' equity at a specific point in time
It has two halves.
The totals of both halves are always the same, so they balance.
One half shows a business’s assets, which are things owned by the company, such as factories
and machines, that will bring economic benefits.
The other half shows the company’s liabilities, and its capital (or shareholders’ equity).
Liabilities are obligations to pay other organizations or people: money that the company owes,
or will owe at a future date.
Usually, these include loans, taxes that will soon have to be paid, future pension payments to
employees (in the West), and bills from suppliers (companies which provide raw materials or
parts).
If the suppliers have given the buyer a period of time before they have to pay for the goods,
this is known as granting credit.
Since assets are shown as debits (as the cash or capital account was debited to purchase them),
and the total must correspond with the total sum of the credits - that is the liabilities and
capital - assets equal liabilities plus capital (or A = L + C).
American and continental European companies usually put assets on the left and capital and
liabilities on the right.
8
Also a vertical format is used, with assets at the top, and liabilities and capital below.

Shareholders’ equity consists of all the money belonging to shareholders. Part of this is share
capital - the money the company raised by selling its shares. But shareholders’ equity also
includes retained earnings (нераспределенная прибыль): profits from previous years that
have not been distributed (paid out to shareholders as dividends).
Shareholders’ equity is the same as the company’s net assets, or assets minus liabilities.
A balance sheet does not show how much money a company has spent or received during a
year. So, balance sheet can be compared with snapshot on a certain date.
This information is given in other financial statements: the profit and loss account and the cash
flow statement.

To repeat: in accounting, assets are generally divided into fixed and current assets. Fixed assets
(or non-current assets) and investments, such as buildings and equipment, will continue to be
used by the business for a long time.
Current assets are things that will probably be used by the business in the near future. They
include cash (money available to spend immediately), debtors/ accounts receivable (money,
owed by companies or people), and stock.

If a company thinks a debt will not be paid, it has to anticipate the loss - take action in
preparation for the loss happening, according to the conservatism principle. It will write off the
sum as a bad debt, and make provisions by charging a corresponding amount against profits
(deducting the amount of the debt from the year’s profits).

Manufacturing companies generally have a stock of raw materials, work-in-progress (partially

manufactured products) and products ready for sale.
There are various ways of valuing stock or inventory, but generally they are valued at the lower
of cost or market, which means whichever figure is lower: their cost - the purchase price plus
the value of any work done on the items - or the current market price. This is another example
of conservatism: even if the stock is expected to be sold at a profit, you should not anticipate
profits.

Assets can also be classified as tangible and intangible. Tangible assets are assets with a
physical existence (things you can touch) such as property, plant and equipment.
Tangible assets are generally recorded at their historical cost minus less accumulated
depreciation charges - the amount of their cost that has already been deducted from profits.
This gives their net book value.

Intangible assets include brand names (legally protected names for a company’s products,
patents) exclusive rights to produce a particular new product for a fixed period, and trademarks
(names or symbols that are put on products and cannot be used by other companies).
Networks of contacts, loyal customers, reputation, trained staff or ‘human capital’, and skilled
management can also be considered as intangible assets.
As it is difficult to give an accurate value for any of these things, companies normally only
record tangible assets. For this reason, a going concern should be worth more on the stock
exchange than simply its net worth or net assets: assets minus liabilities. If a company buys
another one at above its net worth (because of its intangible assets) the difference in price is
recorded under assets in the balance sheet as goodwill.

9
 Liabilities
Liabilities are amounts of money that a company owes
They are generally divided into two types
 long-term (more than 12 months);
 current (less than 12 months).
Long-term liabilities or non-current liabilities may include bonds.
Current liabilities are expected to be paid within a year of the dare of the balance sheet.
They include:
■ creditors - largely suppliers of goods or services to the business who are not paid at time of
purchase;
■ planned dividends;
■ deferred taxes - money that will have to be paid as tax in the future, although the payment
does not have to be made now;
Accrued expenses (начисленные обязательства)
These are expenses that have been built up during the accounting year but will not be paid until
the following year, after the date of the balance sheet. So accrued expenses are charged
against income (that is, deducted from profits) even though the bills have not yet been received
or the cash paid.

Accrued expenses could include taxes and utility bills (electricity, water etc.)

Shareholders' equity on the balance sheet

Shareholders’ equity is recorded on the same part of the balance sheet as liabilities, because it
is money belonging to the shareholders and not the company.

Shareholders’ equity includes:

■ the original share capital (money from stocks or shares issued by the company)

■ share premium: money made if the company sells shares at above their face value (the value
written on them)

■ retained earnings: profits from previous years that have not been distributed to shareholders

■ reserves: funds set aside from share capital and earnings, retained for emergencies or other
future needs.

The profit and loss (P&L) account

Companies’ annual reports contain a profit and loss account.

This is a financial statement which shows the difference between the revenues and expenses of
a period.

Non-profit (or not-for-profit) organizations such as charities, public universities and museums
generally produce an income and expenditure account. If they have more income than
expenditure this is called a surplus rather than a profit.

At the top of these statements is total sales revenue: the total amount of money received
during a specific period.

Next is the cost of sales, also known as cost of goods sold (COGS): the costs associated with
making the products that have been sold (raw materials, labour, factory expenses etc.).
10
The difference between the sales revenue and the cost of sales is gross profit (earnings).

There are many other costs or expenses that have to be deducted from gross profit, such as
rent, electricity, office salaries etc. These are often grouped together as selling, general and
administrative expenses (SG&A).

The statement also usually shows EBITDA (earnings before interest, tax, depreciation and
amortization) and EBIT (earnings before interest and tax).

We should remember that depreciation and amortization expenses can vary depending on
which system a company uses.

It is one of important indicators of a company's financial performance as it indicates the ability

of a company to service debt. It is also used as a proxy for the earning potential of a business.

EBITDA can be used to analyze and compare profitability between companies and industries
because it eliminates the effects of financing and accounting decisions.

Actually, EBITDA can be compared to operational cash flow. So, some major metrics are
associated with EBITDA (ebitda).

Some ratios (коэффициенты, мультипликаторы)

EBITDA to sales ratio (EBITDA margin, рентабельность по ebitda) is a financial metric used to
assess a company's operating profitability by comparing its revenue with earnings.

It shows the percentage of a company's earnings remaining after operating expenses

High value means a company is able to keep its earnings at a good level. So, business seems to
be sustainable and robust.

Usually, it is used for comparing similar-sized companies within the same industry.

Also adjusted EBITDA is used. It normalizes income and expenses since different companies
may treat each type of income and expense differently

After all the expenses and deductions is the net profit (loss), often called the bottom line. This
profit can he distributed as dividends (unless the company has to cover past losses), or
transferred to reserves.

NB: BrE: net profit; AmE: net income

BrE: profit and loss account; AmE: income statement

Sales Revenue

Cost of Sales

Gross Profit

Selling, General and

11
 Administrative Expenses

Earnings before Interest, Tax,

Depreciation and Amortization

Depreciation and Amortization

Earnings before Interest and Tax

Interest expenses

Income Tax

Net Profit

The cash flow (CF) statement

Companies also produce a cash flow statement (отчет о движении денежных средств, ДДС).
This gives details of cash flows - money coming into and leaving the business, relating to:

■ operations - day-to-day activities

■ investing - buying or selling property, plant and equipment

■ financing - issuing or repaying debt, or issuing shares.

The cash flow statement shows how effectively a company generates and manages cash.

12