Chapter 1:

A Framework for
Business
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 Key Concepts in Chapter 1
• Financial statements are an important source
of information to the capital markets and
business analysts.
• Analysing financial statements addresses a
number of issues of interest to external
stakeholders and company insiders.
 Learning Outcomes
be able to:

1. Evaluate the role of financial reporting in capital

markets.
2. Explain how business activities are processed and
reported in financial statements.
3. Discuss business analysis using information from
financial statements and other sources.
 The Role of Financial Reporting
in Capital Markets
• Financial reporting provide much-needed
information to capital market participants
– Financial intermediaries depend upon the
information in financial statements to evaluate
investment opportunities.
– Information intermediaries assure the quality of
financial statement representations.
– Relevant and reliable financial information is
essential for the functioning of capital markets.
LO 1
Markets
How Capital Markets
Function
LO 1
Connecting Finance with Business Ideas
Financial reporting connects finance with business ideas
 Ideally, finance/capital should flow to the most
promising and profitable business ideas and strategies
 Equally, poor prospects or business ideas should not
be able to attract capital (or require a significant
premium)

But how would those with funds be able to judge or

evaluate ideas without credible financial reporting?
LO 1
Lemons

A lemon is a bad (financially unsound)

investment prospect.
 If investors can’t distinguish good prospects from
lemons, they will value all in the same way (i.e. use
an average)
Consequently
 Good ideas will be undervalued (shares under-
priced), causing entrepreneurs to leave the market
 Lemons will be overvalued (shares over-priced)
 From Business Activities to
Financial Statements

• Financial statements measure and summarise

the economic consequences of business
activities.
• Accounting systems facilitate information
quality.
– The role of accrual accounting
– The need for generally accepted accounting
principles (GAAP)
– Auditing and the quality of financial information.
 From
Business
Activities to
Financial
Statements
LO 2
Aggregation of Transactions
Consider the following factors
1. Volume of transactions
 Need to group and summarise
2. Accounting period
 Need to allocate transactions to “correct” periods,
considering cut-offs
3. Confidentiality of events and transactions
 commercial confidence, proprietary knowledge
etc.
LO 2
Accrual Accounting
Includes Cash Transactions, plus
1. Estimates e.g. depreciation, doubtful debts, obsolete
inventory, leave, warranties
2. Timing Differences
a) Prepaid Expenses
b) Unpaid Expenses
c) Unearned Income
d) Credit Sales and other Accrued Income
Necessitated by the accounting period
LO 2
Accounting Standards [Mandatory]
The Good/Upside
Providing information that is useful for economic
decision making i.e. relevant and reliable
International Financial Reporting Standards (IFRS) are
designed to improve quality of reporting through
1. Comparability over time and across organisations
2. Countering managers’ incentives to distort
financial reports for their own gain
LO 2
Accounting Standards [Mandatory]
The Bad/Downside

Consider some potential trade-offs

1. Uniformity vs flexibility
 There may be genuine business differences
 IFRS may permit multiple treatments e.g.
Inventory, Depreciation
2. Beating the system (substance over form)
 e.g. lease transactions
LO 2
Managers’ Reporting Strategy
Mandatory reporting requirements establish minimum
reporting requirements.
Managers may also use voluntary disclosure, which
provides discretion over:
1. Timing
2. Quantity
3. Content e.g. social and environmental
performance
4. Medium e.g. print, TV, website, face to face
LO 2
Auditing
Provides independent assurance/verification of financial
disclosures
 Improves quality of reporting
 Improves confidence of users (reduces risk)

Consider
 Threat of litigation may cause auditors to be more
rigid and less flexible
 Auditors also have an influence in the standard
setting process (circular)
LO 3
Information Asymmetry
Managers know a lot more about their own businesses
than outside users.
 Effective FSA attempt to obtain/distil managers’
inside information from publicly available sources
Financial analysts
 Interpret financial statements, using their
knowledge of the firm’s industry and competitive
strategies
 Are more objective than managers in evaluating
economic consequences of operating and investing
decisions.
Financial Statements to Business
Analysis
 Financial Statements and
Business Analysis
• Business intermediaries use financial
statements to accomplish four key objectives:
– Business strategy analysis
– Accounting analysis
– Financial analysis
– Prospective analysis.
Business
Strategy
Analysis
LO 3
Business Strategy Analysis
Generate performance expectations by analyzing the
industry and the firm’s competitive strategy
1. Identify key profit drivers (or success factors) and
business risks
2. Assess the firm’s profit potential at a qualitative
level (sustainable/increasing/decreasing).
3. Use this to forecast future performance
LO 3
Accounting Analysis
Evaluate accounting quality by assessing accounting
policies and accounting estimates
1. To what extent do the policies and estimates capture
the underlying economic reality?
 Requires industry-specific knowledge
2. Undo any distortions to create “unbiased”
accounting data
 Especially when comparing firms e.g.
depreciation policy
3. This improves reliability of data and resulting
conclusions
LO 3
Financial Analysis
Evaluate performance using historical (and current) data
1. Ratio Analysis
 Profitability
 Efficiency
 Financial Leverage
2. Cash Flow Analysis
 Liquidity and financial flexibility
LO 3
Prospective Analysis
Forecasting a firm’s future

1. Preparing financial statement forecasts

2. Performing business valuation
 Concluding Comments
• Financial statements are a source of widely
available data on publicly traded corporations.
• Accrual accounting attempts to accurately
reflect expectations of economic
performance, but requires careful analysis.
• This chapter has outlined a useful framework
for business analysis using financial
statements.