Financial reporting and Performance Measurement

The concept of value

Shareholder theory

Profitability is the social responsibility of the business to increase its profit. The objective for shareholders is the creation of value, prioritizing profitability over responsibility. Success can be measured by:

• Share price
• Dividends
• Economic profits

Stakeholder theory

Sustainability is the purpose of the firm, serving as a vehicle for coordinating stakeholder interests. The firm must give a fair reward to the obligation in time of the stakeholders (banks, collectivity, environment). Responsibility over profitability. Success can be measured by:

• Stakeholders satisfaction
• Seeing stakeholder management both as an end and a means

Profitability/sustainability conditions

Profitability is satisfactory if revenues minus cost is higher than the cost of capital multiplied for equity, KeR−C E × Ke, rewarding the investors who give up to invest in our company. Sustainability is satisfactory when the Cash-in flows plus liquidity are higher than cash-out flows: LIQ+CFin ≥ CFout. This indicates the ability to meet obligations, ensuring solvency in the long run and liquidity in the short run.

Firm purpose

• Maximise shareholder value by:
• Maximise future results
• Control risk

Firm aim

Value creation is the change in value due to company performance, aiming to achieve value, which is the sum of present values of future expected cash flow. The final aim of performance measurement is to support value creation.

Value creation = vt1-vt0 (the difference in the value of the firm during the period). If during the period the company distributes dividends, the value will be increased (value creation = vt1-vt0+dividend). If shareholders contribute to the value creation of the company (value creation = vt1-vt0 (+dividend) − deltaE).

Performance

• Measurable by either a number or expression
• The result of an action
• The ability or the potential to create results
• A judgment by comparison
• The comparison of the result with some benchmark

Performance is the sum of all processes that will lead managers to take appropriate actions in the present to create a performing organization in the future, e.g., one that is effective and efficient. Performance is a complex concept because indicators could be contradictory. Therefore, in order to manage it, it is important to have:

• Good understanding of the process
• Good understanding of the interaction with the environment

Performance measurement in the accounting perspective

1. Performance as a tool of financial management: use of financial resources to support the aim of the organizations. The main areas of the financial plan are:
   • Managing cash flow avoiding insolvency
   • Long term profitability
   • Attention to the balance sheet (asset purchase)
2. Performance as an overall business objective: The main focus on reporting for shareholders is:
   • Managing cash flow avoiding insolvency
   • Profit for shareholders:
   • Earning per share (EPS)
   • Price/earning ratio
   • CAPM
   • Economic Value Added (EVA)
   • Attention to the balance sheet (asset purchase)
3. Performance as a mechanism for motivating and control: balance between intrinsic motivation of employees (social identity, self-defined goals, etc.) and extrinsic motivation of employees (price incentives, bonus, etc.). A number of financial and non-financial indicators can be used:
   • Accounting performance measures (e.g., earnings, balance sheet)
   • Performance measures (balance scorecard, activity-based costing, residual income, economic value added)
   • Other performance drivers (short term profitability, market share, product leadership, personnel development)

Financial statement objectives

The objectives are to present the economic and financial position of a company to actual and potential stakeholders and to understand the numbers to better manage a business.

Financial statement analysis

This is the art of analyzing and interpreting financial statements. Thus, one may develop various analytical measures to portray meaningful relationships and extract information from raw financial data.

Accounting

1. Financial accounting: Provides information for both internal users (board of directors, department managers) and external parties (stakeholders, suppliers, banks, creditors, competitors, etc.). Financial accounting provides data about past performance (monetary data). It is regulated, and the type of information that it uses are only financial measurements. The nature of this information is objective, reliable, and consistent.
2. Management accounting: Provides information only for internal users (board of directors, department managers) or for internal decision-making (such as planning, implementation, control). Management accounting provides data related to how organizations are actually run (monetary and non-monetary data). It is not regulated. The type of information that it uses includes both financial measurements and operational and physical measurements. The nature of this information is more subjective and judgmental.

Financial accounting

Three primary financial statements:

1. Balance Sheet (or statement of financial position IAS1): Describes where the enterprise stands at a specific date. The statement of financial position is an inventory of assets, liabilities, and equity at the end of the month. The fundamental objective of the balance sheet is to determine the value of the net investment made by the firm’s owners (the shareholders) in their firm at a specific date.

   Assets = Liabilities + Equity (investment of shareholders also known as net asset value)

2. Income Statement (or statement of comprehensive income IAS 1): Depicts the revenue and expenses for a designated period of time. The principal objective of the income statement is to measure the net profit (or loss) generated by the firm’s activities during a period of time referred to as the accounting period (usually a year). The income statement has information about the firm’s activities that resulted in increases and decreases in the value of the owners’ investment in the firm during a period of time.

   Revenues - Expenses = Net Income

3. Statement of Cash Flow (IAS 7): Depicts the ways cash has changed during a designated period of time.
4. Statement of changes in equity (statement of comprehensive income?)
5. Notes

The financial statements are prepared in accordance with Generally Accepted Accounting Principles and IFRS. They provide information to monitor performance in terms of:

• Profitability: Ability to sell products and generate profit
• Solidity: Ability to pay long-term and short-term debts
• Liquidity: Ability to pay debts and collect credits

Performance

Profitability: Condition of a fair profitability where revenues minus cost is greater than the alternative Ke*E (value creation). r = Profit/Capital Ke, rewarding the investors who give up to invest in our company. We see the profitability from the income statement and the balance sheet (functional/operating model).

Solvency: It is a survival condition and a precondition to value creation. Ability to pay long-term obligations: Liquidity + CFin ≥ CFout. A company must be liquid in a short period and solid in the medium-long period. In order to value solvency, we need the balance sheet (financial reformulation) and the cash flow statement.

Solvency analysis can be referred to as short-term or long-term: Solidity: Referring to the long term (as the precondition to survive, commitment to pay obligations in the long run). Here profitability and solvency tend to converge. If in the long term we have profitability problems, sooner or later we are going to also face solvency problems. In conclusion, in the long term, profitability and solvency must be verified continuously, otherwise, the firm is in default. Solidity depends mostly on future cash flows, rather than the running business. What the financial analysis is willing to state is if considering the transactions referring to the past there are the preconditions to meet the payment obligation in the future and so the precondition of value creation (if the financial structure of the company will have the precondition to be solvent in the long run).

We have to consider that in the financial statement we have only a few cash inflows and outflows and they depend on past transactions, we miss the future effect on inflows and outflows of future transactions. I can state my financial equilibrium based on the financial statement, but I miss my future business effects [balance sheet gives us signals but not complete answers]. The more we go on in time the more the effect of past transactions will lower, and the effect of future transactions will be higher. The financial statement helps us to tell if there are preconditions for value creation.

Liquidity: Referring to the short term (commitment to pay in the short run). In the short run profitability and solvency can diverge. We can have a company with high profitability but low solvency and vice versa (e.g., Start-up). On the contrary, some other firms can have huge liquid financing in the short run but with low profitability; the firm is not sustainable over time.

Reformulating financial statements

Useful to make projections about the future of the firm:

• We discuss the template for reformulating financial statements in a way that makes them ready for analysis.
• Financial statement analysis requires:
• A distinction between the operating and financing aspects of the business
• A reformulation of the financial statements into a form that makes this distinction clear
• A sharper picture of the business is drawn with reformulated financial statements.

Solvency

1. Balance sheet riclassificato in current and non-current (financial model)
2. Cash flow statement

Profitability

1. Income statement
2. Balance sheet (functional model)

From the balance sheet, you can study the precondition of the solvency to be verified.

IAS 1 prescribes the format of the financial statement (all of three)

1. Balance Sheet (or statement of financial position): The balance sheet is the basis for evaluating capital structure, solvency, efficiency, and liquidity. IAS 1 does not prescribe the format of the statement of financial position (assets can be presented current then non-current or vice versa, as well as for liabilities).

   Assets = Liabilities + Equity

   Current / non-current distinction

   The balance sheet presented according to the financial reporting standard and the IAS1 presents current and non-current distinctions.

   Current/ non-current assets criteria: "Turnover speed" toward liquidity (time to sell the good). An asset shall be classified as current when it satisfies any of the following criteria:

   • It is expected to be realized in, or is intended for sale or consumption in, the entity's normal operating cycle.
   • It is held primarily for the purpose of being traded.
   • It is expected to be realized within 12 months after the reporting date.

   All other assets shall be classified as non-current.

   For the assets that don't come from the operating cycle (surplus assets) → e.g., financial assets or liabilities, bonds, loans, participation, the criteria is the 12 months or my intention to sell the assets within or beyond the 12 months.

   Current/non-current liabilities criteria: Speed of maturity (expiry date). A liability is classified as current when it satisfies any of the following criteria:

   • It is expected to be settled in the entity's normal operating cycle (i.e., may be more than 12 months).
   • It is held primarily for the purpose of being traded.
   • It is due to be settled within 12 months after the reporting date.
   1. Equity → without expiry date
   2. Non-current liabilities → medium-long term expiry date
   3. Current liabilities → short term expiry date

The reformulation of the balance sheet (or statement of financial position) – Financial methods

Assets:

1. Non-current/fixed assets:
   • Tangible fixed assets (building, property, plant, and equipment). Non-financial tangible assets are generally reported at their historical cost, which is the price the firm paid for them. As time passes, the value of these assets is expected to decrease. To account for this loss of value, their purchase price, reported in the balance sheet as the gross value of fixed assets, is systematically reduced (or written down) over their expected useful life. This periodic and systematic value-reduction process is called depreciation. Several methods are used to determine the annual depreciation charge. The most commonly used is the straight-line depreciation method. When this method is used, the firm's assets are depreciated by an equal amount each year. According to the less frequently used accelerated depreciation method, the depreciation charge is higher in the early years of the asset’s life and lower in the later years.
   • Intangible fixed assets (e.g., intellectual properties, copyrights, goodwill, patents, trademarks, derivative financial instruments, etc.). Intangible assets are recorded at cost. As in the case of tangible assets, their value is usually gradually reduced as time passes. This cost-reduction process, called amortization, follows the same principles as depreciation for tangible assets.
   • Financial fixed assets (shareholder interest in other company participations, bonds, loans, securities held as fixed assets, financial assets at fair value).
2. Current assets:
   • Liquidity (distinguished in deferred liquidity and immediate cash) and short-term financial investments (defined as marketable security, e.g., certificates of deposit, commercial paper) cash and cash equivalent.
   • Trade receivable and other receivable.
   • Inventories (such as raw materials, product, and services; they could be tangible or intangible).
   • Pre-paid expenses (included in inventory and can be current or non-current) (payments made by the firm for goods or services it will receive after the date of the balance sheet, e.g., Assurance policy). The way prepaid expenses are accounted for illustrates a key accounting principle, known as the matching principle. This principle says that expenses are recognized (in the income statement) not when they are paid but during the period when they effectively contribute to the firm’s revenues. Expenses prepaid by the firm must be carried in its balance sheet as an asset until they become a recognized expense in its (future) income statement.
   • Derivative instruments measured at fair value.

Liabilities:

1. Non-current liabilities:
   • Long-term financial debt.
   • Long-term trade payable (commercial debts).
   • Pension liabilities.
   • Deferred taxes liabilities.
   • Provisions for risks and changes.
   • Provisions for employee benefits (Fondi per rischi e oneri).
2. Current liabilities:
   • Short-term financial debt.
   • Current portion of long-term debt.
   • Short-term trade and tax payable (commercial debts).
   • Tax liabilities.
   • Accrued expenses (wages and taxes payable). They arise from the lag between the date at which these expenses have been incurred and the date at which they are paid.
   • Unearned revenues (non-monetary debts).
3. Equity
   • Retained earnings.

Liabilities that are unearned are called government grants that are a reduction of fixed assets.

Difference between financial debt and commercial debt

Financial debts derive from money that we borrow, so on the other side, there is a lender. When we write down a new financial debt, there is an inflow of money; financial debts are costly due to the remuneration to the lender (interests). Trade debts are the exact opposite; when we write down a trade debt, we do not have any inflow of money. It represents a time for paying for something that we’re using today; they do not generate interests, so they’re not costly.

Pre-paid expenses

When the company wants to use a service that is paid in advance (e.g., insurance that ends after a year), it represents the value of the service that we still have to use after the end of the accounting period → Inventory area (current if next 12 months, non-current if later).

Un-earned revenues

When a client pays for the entire service and at the end of the year the company still has to deliver a part of the service → Liabilities (non-monetary debts, hence commercial debts?) (current if next 12 months, non-current if later).

Accrued revenues (credits → assets)

The company starts to deliver a service but the client hasn’t paid yet for the service; he will pay at the end of the service. The amount represents the value of the service already provided.

Accrued expenses

When we start using a service at the end of the year, the service is still going on but we will pay for the entire service when it’s finished. The amount represents the value of the part of the service already used (debits → liabilities).

Note: Government grants can be considered unearned revenues but are treated as a reduction of fixed assets. Commercial debts that are not certain become provisions (uncertain in time).

Operating cycle and cash conversion cycle

The cycle starts on the right side with procurement, the act of acquiring raw materials. It is followed by production, during which the raw materials are transformed into finished goods.