1

Financial Reporting, Our objectives

To identify and understand financial reportsTo understand primary financial models for planning & budgeting

2

Who uses accounting information?• Externally

• Taxpayers, citizens (existing and potential)• Creditors (existing and potential)• Regulators and other governmental units• Peers, Customers, Suppliers

• Internally• Managers, Employees• Cost Analysts (Internal Auditors)

3

External Financial Reporting

• Annual reports • City, departmental home pages• Securities and Exchange Commission

• A note on Transparency (fully and clearly revealing financial performance)

4

How is accounting information used• Performance measurement• Valuation• Operational control• Assessment of risk• Regulatory reporting• Contractual covenants

• debt restrictions, managerial compensation

• Individual investment decision analysis

5

Key Financial Statements

• Balance Sheet• Statement of Revenues and Expenses

(P&L)• Statement of Cash Flows• See City of Bryan, Texas Financial

Statements for 2005 in your packet

6

Balance sheet components• Assets

• Current (short-term)• Fixed (long-term)

• Liabilities• Short-term• Long-Term

• Fund Balances [net worth or net assets]• Assets = Liabilities + Fund Balances

7

Typical assets• Current assets

• Cash• Receivables

• Fixed assets• machinery and equipment; land

• Intangibles• Patents; Leases; Trademarks

8

Typical liabilities

• Current liabilities (due within 1 year)• accounts payable• Wages payable

• Long-term liabilities (not due within 1 year]• bonds payable• notes payable• long-term lease obligations

9

What does the balance sheet tell us about assets?• An estimate of the value of all assets• The type of assets held by an

organization• example: cash versus fixed assets

• The quality of assets held by a business• examples: age of assets, collectibility of

receivables

• The type of activities conducted by the entity

10

What does the balance sheet tell us about liabilities?• How much of the asset base is financed

by debt rather than by equity• How much of the debt is short term and

how much is long term• The types of debt an entity owes

• examples: accounts payable, bonds payable

• The types of creditors an entity owes• examples: banks, suppliers, institutions

11

Governmental accounting is often called “fund accounting”• Types of funds

• Governmental funds• Used to account for most resources

− Including those expended on public safety

• Proprietary funds• Used to account for activities that are operated as

businesses, e.g., a utility co.

• Trust and agency funds• Used to account for funds held on behalf of

others, e.g., a pension trust fund

12

Statement of Revenues & expenses (P&L)• Measures revenue

• Continuing operations• One-time gains/losses

• Measures expenses• From operations• Financing• One-time items

• Surplus/Deficit = revenue – expenses

13

Statement of Cash Flows

• Calculates cash flow (net amount in or out)• from operations

• should match income from the income statement if effect of accounting accruals are minimal

• from financing activities• cash obtained from issuing new securities• cash used to retire existing securities

• from investing activities• cash obtained from selling assets• cash used to buy assets

14

Cash flow analysis

• What questions do we try to answer in the analysis?• How strong is the entity’s internal cash flow

generation?• Can the entity meet its short-term

obligations?• Does the entity have free cash flow?• How much cash did the entity invest in its

growth & sustenance?• What is the quality of revenue streams?

15

To examine financial accounting information, let’s ask• How is accounting information different

from a checkbook?• Cash basis versus accrual basis accounting• Over the long run there is no difference--but

over the short run there is a difference

• Why is there a need for accrual-basis accounting?• Periodicity and long-lived assets

16

A note about accountants & accounting

• Accountants record transactions using accounting accruals rather than cash flows.• Depreciation• Income/expenses• Gains/losses

• Accountants must distinguish between costs that are incurred to purchase assets and those that are incurred for expenses

17

A note about accountants & accounting--continued• Accountants can’t measure some kinds

of assets, e.g., human capital, therefore these assets are not accounted for well

• Accountants use historical cost as the basis for measuring most assets

• Accountants are bound by more rules than the NFL and they’re twice as hard to follow (called GAAP)

18

Internal Financial Planning & Reporting

• Budgets• Operating budget (to manage revenues, expenses)• Capital budget (to manage assets, liabilities)• Pro-forma financial statements

• Role of budgets & financial plans• Specify sources & uses of financial resources• Identify financial constraints• Set financial expectations• Establish benchmark for actual performance (control

role)

19

Preparing an expense budget• Requires

• Assumptions about cost behavior• Costs are classified as fixed, variable, or mixed

• Assumptions about service volume• Other assumptions

• E.g., inflation rate• Expectations about changes in specific costs

• Go to budgeting exercise for Local City, Texas

20

Graphically, we can show

TotalCost

TotalCost

Volume Volume

Variable Cost Fixed Cost

21

Budgets &Financial Responsibility

• Budgets and accountability will align with organizational chart• Most boxes on the organizational

chart have responsibility for spending and/or generating revenues• See Organizational chart for City of Bryan

22

How do we know whether an organization (or its parts) is performing well?• We need to measure the performance

of our organization (whole and segments)

• We need to compare the performance measurements to some meaningful benchmark

• Problems with accounting measurement and reporting models• Measure physical things reasonably well• Do not measure intangible things well

• Including human capital

23

What benchmarks are typically used?

• Expectations about• cost levels• revenue levels

• Peer’s or Competitor’s performance

• Contract specifications• Industry average performance• Historical performance

24

Quick exercise

Suppose at the end of 2006, we observed that Local City had spent $15,575,000 for professional salaries. What could we conclude from this information?

25

The capital budget is our plan for acquiring long-lived assets

• Is a key tool to gain evolutionary improvements in• Efficiency• Effectiveness• Quality• safety

26

The capital budget results from analysis of alternative capital expenditures using

• Investment justification criteria such as• Payback• Net present value (NPV)

27

The payback method

• Measures the amount of time it takes to recoup the initial investment outlay associated with a capital project.• This method ignores the time value of

money and ignores cash flows occurring after the payback period.

28

Payback method illustratedSuppose your city is considering installing

additional public bus routes. The initial cost would be $800,000, and the new net revenues would be as follows:

Year 1 $150,000 Year 4 $200,000Year 2 $300,000 Year 5 $150,000Year 3 $300,000 Year 6 $100,000What is the payback period?

29

Net present value method (NPV)• Considers the time value of money• Is calculated as the present value of

cash inflows less the present value of cash outflows.

• Requires the use of a calculator or tables for “discount factors”

• Only projects with a positive NPV are considered financially acceptable

30

Assume for the bus route illustration, that the cost of capital is 8%. Calculate the NPV. Amount disc factor Present V.Year 0 $(800,000) 1.0000 $(800,000)Year 1Year 2Year 3Year 4Year 5Year 6

31

What if?

• You don’t know the cost of capital?• You aren’t certain about the cash flows?• You aren’t certain about the life of the

project?• You can’t quantify some relevant

information?• Then, do sensitivity analysis.• Go to next Local City Exercise

32

What do we mean by the term “management control?”

Controls are used to improve the odds that the results achieved align with the plan & budgets.

Controls steer the organization.

33

The budget is used as a control

• When actual financial results are compared to the budget, and• Positive and negative reinforcement

are given to those who caused favorable or unfavorable deviations (variances) from the budget.

34

The Use of Financial Information to Support Decision Making

Our objectivesApply basic financial concepts to decision makingApply basic models to support financial decisions

35

The Models of Financial Decision Making

• General decision making model

• Volume management model

• Quality management model

36

General decision making model

• Costs versus benefits• Objective is to find decision

alternative that maximizes the extent to which benefits exceed costs

− Must consider only relevant costs− Must consider only relevant benefits

37

Many decisions are focused on cost management strategies

• Generic cost management strategies include• Cost avoidance• Cost containment• Cost reduction

38

Typical, short-term decisions

• Insource/outsource activities• Choosing most effective use of

resources• Improving efficiency

39

Relevance exercise

• Suppose you are considering submitting a proposal to replace a copy machine in your office. Here is the information you have gathered.

New machine Old machine

Cost $5,000 $10,000 Salvage value 1,500 Remaining life 3 years 3 years Variable cost per copy $.01 $.04

Further assume that you make 150,000 copies each year. Should your request for a new copy machine be approved?

40

Relevance exercise #2

• Suppose you are an Aggie football fan and that you just purchased a ticket to the t.u. game for $80.

• Further suppose that as the football season evolves demand for the ticket increases and in October you have an opportunity to sell your ticket for $200.

• Which costs are “relevant” in the decision to sell or keep your ticket?

41

Relevant costs

• Include• Costs that vary across decision

choices• Incremental costs• Differential costs• Opportunity costs

• Exclude• Sunk costs

42

There are many ways to categorize costs in decision making

• These cost categories are useful for applying cost management tools & concepts• Fixed versus variable (behavior)• Relevant versus irrelevant• Controllable versus noncontrollable

• e.g., fuel usage versus fuel price• Direct versus indirect

43

Insource/outsource exercise

Assume the cost to process a job application “in house” for NYPD is described by the following equation:

Total annual cost = $25,000 + $12 per applicationAlternatively, the processing can be outsourced to an

independent firm at a cost of $25 per application. What would you do if the annual demand for this service is

estimated to be 1,000 applications? 10,000 applications?

At what volume level would you be indifferent between insource/outsource?

Why is volume an important element in this decision?

44

Volume Management Model• Cost/Volume/Profit (CVP) analysis is a

method of exploring the relationships among volume and costs• And, in some settings revenue

• CVP analysis depends on an understanding of cost behavior; i.e., fixed and variable

• Breakeven is a particular focal point in CVP analysis

45

CVP illustrated

Suppose we want to develop a “citizen’s police academy” to generate support for law enforcement among residents. The cost of the academy is estimated to be $100,000 plus $200 per participant.

If we charge participants $500 per person, how many participants do we need to break even? How many participants do we need to generate $10,000 of net profit?

46

Graphic illustration of CVP analysis

Total Revenues

Total Costs

Breakeven

# of participants

$

47

Example continued

If we anticipate we will be unable to generate enough interest to reach the breakeven level of participation, what strategies should we consider before we abandon the idea?

48

Another exercise

• Consider the difference in accounting for (or justifying) buying a copy machine versus purchasing a training course aimed at improving employee safety.

Why is justification of the training much more difficult?

49

Cost drivers

• Ultimately, the key to understanding how to manage a cost is understanding what causes the cost to be incurred• Direct costs

• Costs that are caused by, and easily traced to, a specific activity

• Indirect costs• More difficult to understand causality• There has been significant growth recently in

indirect costs…largely because of technology costs

50

Controlling costs with cost drivers• Costs are managed by managing the

cost driver• The more obvious the cause/effect

relatinship between the cost and cost driver, the more successful cost control efforts will be.

• For example, what would you logically expect to be the driver of “fringe benefit costs?”

Is this a controllable cost?

51

Quality management model

• Objective is to obtain the highest quality of service at minimum cost. Requires minimizing the sum of the following costs:• Prevention: costs incurred to prevent quality

problems• Appraisal: costs incurred to find quality problems• Internal failure: costs to correct quality problems

when such problems are discovered internally• External failure: costs to correct quality problems

when such problems are discovered by customers

52

Quality costs

$Prevention &appraisal

Internal and

External failure

53

Quality exercise

• Where should the quality management budget be spent in the following settings? Why?• Neurosurgeon• Tire manufacturer• Lawn maintenance service• Automobile Repair Shop• Police Force

54

Quality exercise #2

Suppose your department holds the view that better screening in the employee hiring process would reduce employee turnover, and its associated costs. Further, you have developed a new employee screening process and have estimated that such a process would have a first year cost of $X to implement. How could you use the quality cost model to promote implementation of the new screening process?

Now, let’s try the comprehensive short exercises that follow.