Business Economics - Appunti per Esame

Communicating of relevant information

Financial statements are documents that provide some specific rules for economics business (mandato). Internal documents, reports.

Decision making

Accounting information is designed to meet the needs of both internal and external users when making decisions concerning a business entity.

Internal users

Managers and employees of a business entity use the information to:

• Make decisions concerning operations
• Evaluate business success
• Expand operations in new markets
• Evaluate alternatives in the use of scarce (costly) resources

External users

Stakeholders are parties outside the entity who have a stake (interest) in the performance of the entity and use accounting information to make decisions about the entity. (investors, suppliers, governments – taxes + know impact of activities on economics, like the number of employers).

Typical information requirements of external users

• Investors: Information to determine the future profitability of an entity, dividend policy, growth prospects
• Banks: Information to determine whether the entity is able to repay a loan
• Customers: Information concerning the entity’s ability to provide goods and services
• Suppliers: Information concerning the entity’s ability to pay for purchases
• Employees: Information concerning job security, salaries, and career opportunities
• Community and interest groups: Information concerning social and environmental aspects
• Government authorities: Information to determine the amount of tax

Massimiliano Guerini, Dipartimento di Ingegneria Gestionale

Financial accounting

It's the preparation and presentation of the financial statements to allow users to make decisions about the entity. Financial statements are a set of annual reports directed towards the information needs of a wide range of users, mainly external users:

• Statement of cash flows
• Balance Sheet (Statement of Financial Position)
• Income Statement (Profit & Loss Statement)
• Statement of Changes in Equity (changes in the ownership)

NB: It's regulated by rules. Why? - Transparency towards external stakeholders, - Globalization and increased complexity.

Management accounting

It provides information for internal users. Basically, it is related to monthly/weekly reports for internal audiences. It considers various parts of the entity rather than the overall entity, and it is not regulated by rules.

The main activities include:

• Formulating plans, forecasts, and budgets
• Providing information to be used in monitoring and control within the different parts of an entity

We are going to talk about plans, forecasts, and budgets + providing information to be used in monitoring and control within the different parts of an entity. You also have to estimate the risk.

Financial accounting vs. Management accounting

Management accounting concerns the needs of internal users, while financial accounting focuses on reports for external users.

International standards:

• GAAP: Generally accepted accounting principles - A set of rules and practices, having substantial authoritative support that guide financial reporting.
• IFRSs: International Financial Reporting Standards
• IASB: International Accounting Standards Board

Massimiliano Guerini, Dipartimento di Ingegneria Gestionale

Financial statements

Key characteristics

The conceptual framework sets out the key concepts that underline the preparation and presentation of financial statements for reporting entities.

Objective

The objective of financial reports is to provide information about the financial position, performance, and cash flows of an entity that is useful to a wide range of users in making economic decisions. (“Income statements”)

Qualitative characteristics

• Relevance
• Faithful representation (ex: Parmalat’s case)
• Comparability
• Verifiability
• Timeliness
• Understandability

Definition and recognition of elements

• Assets: A resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity (a resource: like PC; to get it you need help from outside, like a bank)
• Liabilities: A present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources.
• Equity: The residual interest in the assets of the entity after all its liabilities have been deducted.
• Income: Inflows or other enhancements of assets, or decreases in liabilities that result in an increase in equity other than those relating to contributions by equity participants.
• Expenses: Decreases in economic benefits in the form of outflows or depletions of assets or incurrence of liabilities that result in a decrease in equity other than those relating to distributions from equity participants.

Limitation of financial accounting information

• Time Lag in the distribution of information to users (ritardo)
• Historical information based on Past Data
• Subjectivity of information refers to the choices involved in the inclusion of items to be reported and accounting policies to adopt.
• Costs of providing information:
• Information costs, costs involved in gathering, summarizing, and producing info contained in financial report.
• Release of competitive information: Information in the financial report could be used by competitors.

Business goals and sustainability

Primary goal of a business entity

Maximizing profits (shareholder value) - A business entity should compensate owners/shareholders with a competitive financial return on investment and the protection of the entity’s assets. Management decision-making is primarily concerned with increasing the ability to distribute dividends to shareholders.

NB: In companies, profits are allocated to shareholders via a dividend, or kept within the company as retained earnings.

Sustainability

“Sustainable development is development that meets the needs of the present without compromising the ability of future generations to meet their own needs” (Brundtland, 1987). Sustainable development meets the needs of the present without compromising the ability of future generations to meet their own needs. This implies working for the good of all stakeholder groups, not just maximizing shareholder wealth.

Entities need to account for:

• Resources used (labour, material, energy)
• Output produced (services, carbon emission, waste, ...)

Macro drivers of sustainability

• Competition for resources: Population is continuously growing but resources are scarce.
• Climate changes: We have a fossil-fuel-based economy.
• Globalization and connectivity: The increases in connectivity can actually be dangerous for business entities because everybody in a few minutes could know information about business. Less time to both build reputation and destroy it.

Stakeholders theory

The purpose of a business entity is to work for the good of all stakeholder groups, not just to maximize shareholder wealth.

Legitimacy theory

Society allows the entity to operate (maximizing shareholders value) as long as the entity agrees to act in a socially acceptable manner.

Corporate social responsibility (CSR)

CSR refers to the responsibility an entity has to all stakeholders, including society and the physical environment in which it operates. Why? Managers are motivated by the desire to do the right thing. At the end, entities act in a socially responsible manner because there is ultimately some benefit to their profits:

• Avoiding interference from governments or other groups
• Building reputation/brand

Business entities are not only related to economic performance, but also environmental and social performance. This approach is called triple bottom line:

• I. Economic performance
• II. Environmental performance
• III. Social performance

In addition to required financial reporting, entities are voluntarily reporting on their sustainability practices.

Business structures

Business structure

It's a type of business entity that is legally recognized in a given jurisdiction, so there are some rights and some mobilizing. Choosing a correct business structure is very important!

Basic forms of business structure

• Sole trader
• Partnership
• Company
• Trust (Anglo-Saxon countries)

The first three could be so different in all countries.

Business structures differ in terms of:

• Ownership structure, how many owners and what type
• Owner liability, so the responsibility that the owner has concerning the operation of the business entities
• Funding opportunities
• Decision making responsibility, owner and manager could be delegated by others
• Taxation

Sole trader (impresa individuale)

It’s an individual who controls and manages a business, just one owner that is the “big boss”, but it’s possible to hire employees. The business is not a separate legal entity, basically the idea is that the owner and the business entities are considered the same, they have the same implication, taxes are calculated with the consideration of the earnings of the owner. The owner is liable for all the business debts.

Advantages

• Quick, inexpensive, and easy to establish
• Inexpensive to wind down
• Flexible reporting (no accounting standards)
• Owner has total autonomy over business decisions
• Owner claims all the profits of the business and all the after-tax gains if the business is sold

Disadvantages

• Marco is the owner of Marco’s, a small bar in the city center. During the first year of operation, the business was very successful.
• One day, a customer approaches the counter to order a coffee and, unfortunately, slips on a recently washed area of the floor.
• The customer spends three weeks in hospital and decides to begin proceedings against Marco’s;
• Marco has insurance to cover such incidents, but the insurance does not cover all the costs;
• Limited by skill, time, and investment of owner; Marco needs to mortgage his house to the bank in order to obtain a loan.
• Restrictive structure due to non-legal status of the entity
• NB: Unlimited liability, the main disadvantage because the owner has full responsibility for business debts. If the business is unable to meet a financial obligation, the owner’s personal assets can be seized to satisfy the debts.

Partnership (società di persone)

It’s an association between two or more persons who carry on a business as partners and share profits or losses.

Key features

• Enable sharing of ideas, skills, and resources
• Easy and cheap to establish
• Some partnerships have a written agreement, others don’t

Partnership agreement

Should include details of:

• The name
• The contributions of cash and other assets to the partnership made by each partner

It’s important to decide the methods of sharing profits or losses, it includes:

• Sharing according to each partner’s capital contribution
• Splitting profits or losses equally between the partners
• Sharing them based on salary requirements

Advantages

There’s some similarity with sole trader:

• Relatively easy and simple to set up
• Informal business structure
• Ability to share capital, skills, talents, knowledge, and workload between two or more people

Disadvantages

• Unlimited liability, again as sole trader
• There are partners that are responsible for business risk and others that have no responsibility.
• Mutual agency (very big disadvantage): Each partner typically is an agent for the business, so each partner can make decisions for all the partners. They have the legal authority to make business decisions; but if the decision is bad, all the other partners have to share the consequences. So choose the right partner.
• Disputes arise from profit sharing and decision-making issues
• Changing ownership is difficult, if one partner withdraws then a new partnership agreement is needed

Company (società di capitali)

It’s a business structure that has a separate legal identity from its owners and is taxed on its taxable income. It is recognized as a legal identity.

Key features

• Owners of a company are known as shareholders.
• Independent legal entity
• Shareholders have limited liability, for the purchase price of their shares only, so there are no company debts
• A company has unlimited life, not dissolved when owners die or change

Proprietary (or private) company

These companies cannot offer their shares to the public. Shares of these businesses are less liquid and the values are difficult to determine. This is a common form of business structure adopted by small and medium-sized enterprises (SMEs).

Public company

It’s a company whose ownership is dispersed among the general public in many shares, which are freely traded. The shares of a public company are often traded on a stock exchange (listed public company):

• The act of being listed allows the market to determine the value of the company through daily trading
• Listed companies have better opportunities for fundraising

This is the common form of business structure adopted by large multinational companies.

NB: You have to be very transparent and declare everything, if you aren’t able to do this you will have a lot of problems with the law.

Advantages

• Limited liability for shareholders
• Corporate tax rate is usually lower than the top personal tax rate
• Business expansion networks made easier due to legal structure
• Can raise additional capital through public share offerings

Disadvantages

• More time consuming and costly to set up
• Must comply with complex company rules and other legal requirements
• If a company is listed, it will have:
• To bear the cost of initial public offerings (IPOs)
• Increased disclosure of information
• Potential loss of control – hostile takeovers
• Separation of ownership and control
• In public companies, shareholders have little to say in day-to-day operations
• Managers act on behalf of shareholders: Shareholders elect a board of directors, which is the highest authority in the management of the company; Voting rights depend on the number of shares.
• Agency costs: Directors should act in the interest of shareholders, but this is not always the case; Shareholders need to set up mechanisms to ensure that managers make decisions that align with shareholders’ objectives

Trust

Legal entity created by a party (the trustor) through which a second party (the trustee) holds the right to manage the trustor’s assets or property for the benefit of a third party. Typical in some Anglo-Saxon countries.

We have three agents:

• Trustor, parent
• Trustee, investment professor, he doesn’t own the assets, he has to manage the money for the welfare of another person, the beneficiary, who is going to receive the money that has been invested. He has to manage for the benefit of the beneficiary.
• Beneficiary, son. Once the beneficiary is deemed able to manage the funds, the beneficiary will receive possession of the trust.

NB: Different business structures mean different business reports. Accounting entity concept, business transactions are recorded separately from personal transactions involving the owner(s).

Business structures summary

Massimiliano Guerini, Dipartimento di Ingegneria Gestionale

Examples

I. Marco and Francesca wish to start an internet business, marketing cosmetics. They consider the business risky, and they are concerned about the legal issues (for example, their personal liabilities) for this business once they start trading. They could enter into a partnership or a proprietary company. A partnership would suit them as they are probably bringing into the entity individual skills and knowledge about cosmetics and the internet. However, they have stated that they are concerned regarding their personal liabilities so therefore a proprietary company would mean the entity would be incorporated as a separate legal entity which would ultimately result in Marco and Francesca only being held responsible to the extent of their capital contributions.

II. Lisa has just started a business (jewelry making) by herself, with the help of $10,000 inherited from a rich aunt. She wishes to employ her husband as the bookkeeper. Lisa appears to be the sole contributor of capital for his home maintenance business. Therefore, the sole trader form seems to be the appropriate form of business. Even though her husband will work as a bookkeeper, Lisa appears to be not only the sole contributor of capital but also the sole decision maker (she has the skills for crafting jewels, the husband hasn’t).

III. Paul, Ingrid, and Adam studied commerce together at the university. The three have maintained their friendship over the years.