Financial reporting and Performance Measurement

THE CONCEPT OF VALUE

1. Shareholder theory: PROFITABILITY the social responsibility of the

business is to increase its profit

Objective for shareholder is the creation of value

Profitability over responsibility

Success can be measured by:

Share price

 Dividends

 Economic profits



2. Stakeholder theory SUSTAINAILITY the purpose of the firm is to

serve 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

 See stakeholder management both as an end and a means



Profitability/sustainability conditions

1. Profitability is satisfactory if revenues minus cost is higher than the cost

is the alternative

>

of capital multiplied for equity. , Ke

R−C E × Ke

reward the investors give up to invest in our company

2. Sustainability is satisfactory when the Cash-in flows plus liquidity are

higher than cash-out flowsà Sustainability is the

LIQ+CFin ≥CFout .

ability to meet the obligation, so to be solvent, in the long run

solidity liquidity.

called and in the short run, called

FIRM PURPOSE:

Maximise shareholder value by:

1. Maximise future results

2. Control risk

FIRM AIM:

Value creation ( = the change in value due to company performance ) to

achieve value ( =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 distribute dividend, the value will be

 increased ( value creation= vt1-vt0+dividend)

If during the period shareholder contribute in some way to the value

 creation of the company ( value creation= vt1-vt0 (+dividend) – deltaE)

PERFORMANCE:

1. Measurable by either a number or expression

2. The result of an action

3. The ability or the potential to create result

4. A judgment by comparison

5. The comparison of the result with some benchmark

FINAL DEFINITION of PERFORMANCE : Performance is the sum of all

processes that will lead the managers to take appropriate actions in

the present that will 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 a :

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 are:

Managing cash flow avoinding insolvency

 Profit for shareholders:

 1) Earning per share (EPS)

2) Price/earning ratio

3) CAPM

4) 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 (es. Earnings, balance sheet

 etc)

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:

To present the economic and financial position of a company to actual

1. and potential stakeholder

To understand the number, and use the understanding to better manage

2. a business

FINANCIAL STATEMENT ANALYSIS:

Is the art of analyzing and interpreting financial statements. Thus, one may

develop various analytical measures to portraits meaningful relationship and

extract information from raw financial data.

ACCOUNTING:

1. FINANCIAL ACCOUNTING: provide information for both internal users

( board of directors, department managers) and external parties

( stakeholders, suppliers, banck, creditors,competitors..). The financial

accounting provide data about PAST performance (monetary data) .

it is regulated and the type of information that it uses are only

financial measurement. The nature of this informations is

obljective, reliable and consistent

2. MANAGEMENT ACCOUNTING: provide information only for internal users

( Board of directors, department managers) and or internal decision

making ( such as planning, implementation, control) . internal The

management accounting provide data related to how organizations are

ACTUALLY run (monetary and non monetary data) it is not

regulated. The type of info that it uses are both financial

measurement but also operational and physical measurement.

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 (investiment of shareholders detto anche

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 statement are prepared in accordance with Generally Accepted

Accounting principles and IFRS. They provide information to monitor

performance in terms of

Profitability : ability to sell product and generate profit

 Solidity : ability to pay long term and short term debts

 Liquidity : ability to pay debts and collect credits



PERFORMANCE:

3. PROFITABILITY : condition of a fair profitabilityREVENUES-COST>

is the alternative

Ke*E ( value creation). r = PROFIT/ CAPITAL Ke

reward the investors give up to invest in our company

WE SEE THE PROFITABILITY FROM THE INCOME STATEMENT AND THE

BALANCE SHEET ( FUNCTIONAL/ OPERATING MODEL)

1. SOLVENCY) :It is a survival condition, and a pre condition to value

creation. Ability to pay long term obligation: LIQUIDITY+CFin >=

CFout

A company must be liquid in a short period and solid in the

medium-long period

In order to value the solvency we need the balance sheet (FINANCIAL

REFORMULATION) and the cash flow statement.

Solvency analysis can be referred to short term or long term:

solidity

Referring to the long termà (as the precondition to survive,

commitment to pay obligations in the long run). Here profitability and

solvency tend to converge. Here the situation is driven by

profitability. 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 transaction

referring to the past there are the precondition 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

on the long run).

We have to consider that in the financial statement we have only a few of cash

inflows and out flows and they depend on past transaction, we miss the future

effect on inflows and outflows of future transaction. I can state my financial

equilibrium based on the financial statement, but I miss my future

business effects [balance sheet gives us signal but not complete

answers]. The more we go on in time the more the effect of past

transaction will lower, and the effect of future transaction will be

higher. The financial statement helps us to tell if there are the precondition of

value creation liquidity

Referring to the short term à (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. (ex.

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 STATEMENT ( 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:

1. A distinction between the operating and financing aspects of the business

2. 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 statemnte

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)

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 viceversa, 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 , present current and non current distinction.

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 realised 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 op. cycle (surplus assets)ex.

Financial Assets or Liabilities, Bond, 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 ossia data di scadenza)

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, plan 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 ( es. intellectual proprieties,copyrights ,

 goodwill, patents, trademarks, derivative financial instrument 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

 partecipations, bonds, loans, securities held as fixed assets, financial

assets at fair value… )

N.B it is useful to indicate the accumulated depreciaton and the non-



available goods ( vedi tabella)

2. Current assets:

Liquidity (that is distinguished in deferred liquidity and immediate

 cash) e short-term financial investiments ( definiti come

marketable security, ad esempio I certificate di deposito,

commercial paper ) cash and cash equivalent



Trade receivable e other receivable

 Inventories ( such as raw materials, product and service so they

 could be tangible or intangible)

Pre-paid expenses ( FANNO PARTE DELL’INVENTORY E POSSONO

 ESSERE CURRENT E NON CURRENT) (payments made by the firm

for good or service it will receive after the date of the balance

sheet, es. 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 recog-

nized (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 ( differite)

 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 ossia ratei passivi ( 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 earning



Liabilities that are unearned are called government grants that are reduction of

fixed assets

DIFFERENZA FRA 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 in-flow of money,

financial debts are costly due to the remuneration to the lender (interests).

Trade debts are the exactly opposite, when we write down a trade

debt we do not have any in-flow of money, it represent a time for paying

for something that I’m using today, they do not generate interests so

they’re not costly.

PRE-PAID EXPENSES when the company what to use a service that is paid in

advanced (eg 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 month, non-current if later)

UN-EARNED REVENUES when a client pays for the entire service and at the end

of the years the company still has to deliver a part of the service LIABILITIES

(non-monetary debts, quindi commercial debts??) (current if next 12

month, 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 service already provided

ACCRUED EXPENSES When we start using a service at the end of the years the

service is still going on but we will pay the entire service when it’s finished, the

amount represents the value of the part of the service already used. (debits

liabilities

N.B. GOVERNMENT GRANTS



They can be consider unearned revenues. But They are treated as

 a REDUCTION OF FIXED ASSETS

Commercial debts that are not certain become provisions (incerti

 in tempo)

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

trans- formed into finished goods. The cycle