Appunti di Environmental accounting

Environmental accounting

Double entry bookkeeping method

The double-entry bookkeeping method allows us to collect, transform, and analyze data to disclose the financial performance of companies. We can report financial transactions of a firm, and each transaction must be recorded in a book called ledger and be summed up both in the balance sheet (financial position statement) and the income statement (or profit and loss statement). At the end of the accounting period, the company has to report a positive result called profit or a negative one called loss.

The book has two sides (debit and credit sides), then there are other two parts in which are reported:

• Main elements of the balance sheet (all the financial positions):
  • Assets (like machinery, trademarks, etc.)
  • Liabilities (like debts, external sources of financing)
  • Equity (internal sources of financing)
• Main elements of the income statement:
  • Revenues (or incomes)
  • Expenses

We have to register a financial positive variation on the debit side and a negative variation on the credit side (i.e., an asset on the debit side, the decreasing on the credit if a company wants to use external sources of money they use liabilities (long and short terms), increase in liability means increase in assets). The vice versa holds when we are registering an economic (profit and loss) variation: an increase of a revenue must be noted on the credit side and the vice versa for expenses. The accounting equation is A = L + E (asset = liability + equity).

In order to collect a financial transaction, we have to record at least two entries for each financial transaction. This method is used as a test to keep the accounting equation on balance (the algebraic sum of debit and credits must be equal to 0 for each financial transaction of a company), when talking about the balance sheet. For the income statement, the result of the algebraic sum is a final number indicating the profits or debts (be it positive or negative).

After knowing this method, we have to know how to recognize info in each financial statement and how we can use them to disclose performances of a company, in order to make decisions. We also have to understand differences among the main accounting principles and international financial reporting standards.

Main sources of financial resources

Each company needs money to start its business and to compete against the main players' competitors. So, which are the main sources of financial resources? They can come from two different types of investors:

• Stockholders (or shareholders):
  • Their money is noted in the balance sheet under the voice "equity" (money of the owners of the company). Also called risk money because if a person invests money directly on the equity of a company, they can lose everything if the company fails in the market. Of course, they want a potential return on their investment, and they can gain back money from three different ways:
    • Dividends: IFF a company has a profit at the end of the accounting period, they can share the dividends with the stockholders.
    • Long position investment: if they buy shares of a company at a lower price, and after a certain period of time, this price increases, they can gain a higher price by selling their shares.
    • Short position investment: they can also use an external party to sell shares immediately on the market, repurchase them at a lower price, and gain from this financial operation.
• Creditors (bank, suppliers, etc.):
  • They are represented by whoever can lend money to the firm, and their gain is called interest. The interest rate is related to the time period (longer the period, higher the rate) and the risk of a company (higher is the risk, higher is the interest rate that company has to pay to creditors). This is not considered risky capital because after selling assets to the company, they can obtain partially or entirely the amount of their initial investment plus the interest rate (common revenue for creditors).

Differences between private and public companies

We have to recognize differences between private and public companies. Shares of the private ones are sold with private negotiation/deals with buyers. The last ones are publicly traded on stock markets (i.e., Piazza Affari, Wall Street, etc.), and people can buy shares of these companies using financial platforms almost immediately. We already saw also that there are different types of investors, and they are all interested in potential return.

The accounting system

Definition: "The accounting system is the ability of the company to collect information from all business units inside the company itself, to analyze them using accounting principles, and to report the info for external or internal decision makers."

All these information can be reported in:

• Financial accounting report: periodic financial statements (quarterly, semester, yearly) very useful to external decision makers in order to assess the company's financial performance, to rationally evaluate and to decide to lend their money (for creditors) or to invest directly in the equity part becoming owners of the company (investors).
• Managerial accounting report: budget plans and continuous performance reports useful to internal decision makers (aka managers) to run the company and to make decisions related to the core business of firms and companies. They have to decide the best strategic decision to run daily operations of the company (providing managerial accounting reports with budget and planning).

Types of business activities

We can differentiate three types of business activities:

• Financing activities: They are related to the ability of the company to collect money from internal/external sources of financing and have effects mainly on the liability part of the balance sheet. i.e., borrowing money from banks will improve liabilities in the balance sheet causing an effect on the asset part of the sheet increasing of L+E we’ll have an increase of A. On the other hand, if we repay money to banks, we’ll have a decrease in L causing a decrease in A (like Allbank account). This kind of activities have multiple interactions and effects on the balance sheet and on the cash flow statement in which we map the increase or decrease of cash. Financing activities don’t have an impact on the income statement, just an indirect effect (we’ll have to pay interest rates if we borrow money).
• Investing activities: They are related to the purchase/selling of assets of the company (generally long-term assets which are tangible) and have effects on the assets part of the balance sheet. If we invest money in purchasing new equipment or machinery, we are improving A creating a debt (simultaneously a decrease in bank account or increase of L) and a decrease on the cash flow statement because we have to pay our investment (outflows of money). If we sell an old A on the market, we’ll have an increase in cash flow. They do not have any effect on the income statement BUT we have an indirect effect through depreciation (tangible assets) or amortization (intangible asset) which is done in order to spread the initial investment of the new asset over its lifetime (we cannot report the entire amount of an investment only in the first income statement period, but we must spread it over a certain period of time). For the accrual principle, revenues and expenses must be recorded in the accounting period in the day they really occur even if the cash is not already received or paid of operating activities from the financial cycle. Another indirect effect could be the gain/loss on disposal of assets.
• Operating activities: They are related to the core business of the companies (selling goods to customers) and have effects on the income statement. We record both inflows and outflows i.e. expenses (paying raw material, salaries, energy, and third-party services like rent) and also different types of revenues. We have also effects on the financial statement since revenues generally generate an inflow of cash reported in the cash flow statement and an increase of the bank/cash account in A part of the balance sheet VS if we have expenses, we have an outflow of cash and also an effect in L part with an increase of commercial debts called payables (or a decrease of A).

Importance of financial accounting

Financial accounting is important because decision makers rely on financial info to invest money in firms and companies and to make rational decisions for investors, creditors, and managers within the firm (marketing, credit, supply chain, and human resources generally these four functions are considered the main operation inside a company); accounting is considered a complementary function to all operations inside the company (they all need info to make decisions).

Main financial statements

The financial accounting reports are made up by four main financial statements:

• Balance sheet: reports financial positions (amount of A, L, stockholder’s E) of an accounting entity at a certain point in time (picture of financial position at a point in time NOT a flow!).
• Income statement: reports revenues less expenses during the accounting period in order to obtain a profit or a loss.
• Statement of stockholder’s equity: reports all the changes in the stockholder’s equity account, including change in retained earnings balance caused by net income and dividends, during the reporting period (if at the end of the accounting period in our statement we have a profit we can reinvest it totally or partially in business process and we have to report it in this statement this not distributed profit increases the retained earnings, increasing the equity of the company). Ending retained earnings amount is: beginning retained earnings amount + profits – dividends. NB: this is not reported in the international financial reporting standards but goes under the voice “equity” in the balance sheet.
• Statement of cash flow: we report inflows and outflows of accounting period in the categories of operating, investing, and financing activities.

Notes to financial statement at the end of the main financial statement, notes in which we explain the values reported in the main financial statement (which method we use to evaluate depreciations, amortizations, etc.). It’s very useful to understand the business strategy of the company’s manager.

The four basic financial statements can be prepared at any point in time (end of the year, quarterly like companies publicly traded on the American stock market, monthly). The structure of the heading can be composed of: name of the company, title of the statement, and the specific date and the unit of measure (i.e., millions of euros, thousands of euros, etc.).

Importance of the cash flow statement

NB: the vast majority of firms fail on the market for liquidity problems, and analyzing the statement of cash flow is important for all companies. Anyways, especially for small and medium firms, it’s quite complex to keep account of all the movement in the cash account (they need to know exactly for each financial transaction the movement in cash). Generally, this statement is not mandatory (only for publicly traded companies); on the contrary, the balance sheet and the income statement are mandatory for all firms.

In the balance sheet, we have a picture of the financial position of the company (we have both internal and external sources of financing and the asset in which are reported all the previous sources). In the income statement, we have revenue and expenses related to the core business of the company during the accounting period at the end of which we have to calculate a profit or a debt. NB: this is the most important financial statement since it reports the profitability of the company, the ability to generate value for shareholders but also for the entire set of stakeholders!

We can calculate the profitability using some measures of the income statement and also combining some elements of it with some others of the balance sheet in order to calculate some important indicators i.e., the potential gain of the shareholder calculated by profit/total amount of equity (it doesn’t mean they receive these monies because they get it by the dividend). Or we can use profit/total assets to understand the ability of a company to repair all kinds of investments (broader indicator of the profitability of the company and also industries sector in which the company is involved higher the profitability higher the capacity to attract new entrants and increase the competitiveness; companies should think strategically how to improve entry barriers in order to obstacle new entries in the industry).

Sustainability and financial statements

Statement of stockholder’s equity (only for US) in which we have to map all the changes in the equity part made up by common stock and the retained earnings. We can use profit also by reinvesting it in the equity part to improve internal sources of financing and investing in new assets which implies improving social or environmental performances. The three main pillars of sustainability (economic & financial, social, and environmental performances) are extremely correlated because first of all, we need higher profitability to invest in new technologies in order to improve environmental performances that will generate new value giving birth to a virtuous cycle BUT first of all, we need money to invest! If firms don’t have a huge amount of profitability, it's really hard to improve all the business processes.

Cash flow statement is not mandatory (see above) but it’s hard to have an internal analytic financial function in order to analyze all the flows of the company (they cannot fully disclose their financial information if they need to borrow money externally, they need to pay higher interest rates). It is also important for another type of analysis: if a company has a new project in the market, it can be evaluated by using the cash flows to analyze the suitability of the new project and to compare the efficiency and productivity of different projects looking at the trends over 10/20/30 years in the cash flow (all the inflow and all the outflows divided into the three different activities), actualizing the flows and comparing the net present value of different projects in order to choose the most efficient one with the higher internal rate of return.

Main elements of the balance sheet

The main elements of the balance sheet:

• Liabilities (we disclose them in order of maturity)
  • Accounts payable is the commercial debts of a company with suppliers (raw materials, components, etc.) considered a short-term debt since we pay back our suppliers in 30/60/90 days and we don’t generally have to pay interests.
  • Accrued expenses following the accrual principle, all the revenues and expenses must be recorded in the accounting period in the day in which they really occur whether or not the cash has already been received/paid (mismatch between the operating cycle and the financial cycle with change in cash we can pay in advance, in the middle, or after). At the end of the accounting period, we have this fake account (like amortization/depreciation). This is considered a short-term liability.
  • Notes payable related to long-term liabilities like loans (written promises to repay a loan/debt in a certain period of time, generally over 1 year) and they include interests to be paid, included in the notes.
  • Taxes payable all the debts with government.
  • Unearned revenue
  • Bonds payable another external source of financing similar to the bank loan (generally a long-term liability) but they can be issued by firms we generally have three actors: the bank, a financial broker (like investment bank that sells bonds to the market to private individuals or institutions) and the company. The firm has to pay back the full amount of money and the interests (several types of bonds).
• Stockholder’s equity
  • Common stock number of shares issued by a company multiplied by their value (amount invested in the business by stockholders).
  • Retained earnings we can use profits to reinvest them to improve the equity part and use this higher equity in reinvesting in new assets (ability of the company to use their profits to increase their capital). In other words, the past earnings not distributed to stockholders.
• Assets (we disclose them in order of liquidity = ability of an asset to be transformed into cash)
  • Cash most liquid asset by definition in our balance sheet.
  • Short-term investment
  • Accounts receivable when a company has a commercial credit with customers, we receive a payment in 30/60/90 days without interests.
  • Accrued revenue
  • Notes receivable
  • Inventory goods (final products) that we have in stock to be sold immediately in the market.
  • Supplies or materials or semi-finished materials that can be used immediately in the production processes.
  • Prepaid expenses (we have to pay in advance for the use of a service i.e., insurance).
  • Long-term investment: tangible (i.e., land), intangible (i.e., trademarks) or financial assets (i.e., purchased shares of another company we want to control another company or to merge with it) and this are the main elements.
  • Equipment
  • Buildings
  • Land
  • Intangibles (only when the company buys them on the market like a patent or a copyright from an inventor, or a trademark/goodwill of another company)

Analysis of a balance sheet

Let’s see some of these voices in detail: When you have to analyze a balance sheet, we find accrued expenses, accrued revenue, and unearned revenues and prepaid expenses. They have not a huge impact on the financial performance since they’re written at the end of the accounting period to adjust/integrate some amount of money to balance the accounting equation assets and matching with the accrual principle all the financial transactions (we can have a mismatch between operating and financial cycles).

Let’s start with the prepaid expense: we assume we purchased an insurance policy for 1 year of $1200, we start the coverage period on 1/7/20 and we end it on 1/7/21. On the 31/12, we have to end the accounting period and prepare all the documents: if we pay in advance, at the beginning we report the operation using the do