UniversityofCambridge: Financial accounting and capital markets

On completion of this course, you will be able to:

• Apply and explain accruals and accruals accounting
• Model and explain financial sensitivities
• Appreciate the role of markets, and our place in them
• Understand and apply sustainable finance
• Integrate your learning and identify your next steps

**1. Cash flow versus Profit, Accruals & Accruals accounting **

An organisation’s sustainable cash flows and its accounting profits (or losses) are both supremely important, but they can be very different. For this reason, all larger organisations must publish both a cash flow statement and an income statement.

The reason for the difference is the accruals accounting principle. The accruals accounting principle is sometimes known as the matching principle. It means matching reported revenues, and the expenses incurred to earn those revenues, in the same accounting period. Even if the related cash flows took place in different accounting periods. Accordingly, financial reporting includes certain non-cash items and adjustments, in order to achieve the required matching. Examples include accruals for expenses incurred and committed, but not yet invoiced or paid. Changes in accruals are one example of a difference between cash flows and profits.

Applying accruals accounting is one of the more judgemental areas of financial reporting. The financial statements of larger organisations are externally audited, adding to their credibility. The organisation prepares the financial statements, and the auditors express an audit opinion on the fiancial statements, for an audit fee payable by the organisation.

**2. Capitalisation, Depreciation, Amortisation & Revaluation **

Other examples of differences between cash flows and profits include capitalisation, depreciation, amortisation and revaluation. Capital expenditure, or capitalised expenses, relate to an organisation’s larger assets that are expected to have a useful economic life of longer than a year. Examples include purchased plant and machinery, and transfer fees paid for professional sports team stars.

Accounting for this kind of expenditure spreads the accounting recognition of the total expense over the whole of the useful economic life of the asset. The accounting expense relating to tangible capital assets is known as deprecation. For intangible assets, it is known as amortisation. Accounting depreciation and amortisation are non-cash expenses.

The revaluation of long-term assets and liabilities is another example of a non-cash item in financial reporting. Depending on the nature of the revalued item, the revaluation may be reported as other comprehensive income or expense, rather than part of the profit or loss for the period.

**3. Financial modelling & Financial sensitivities **

A financial model is a simplified representation of a financial situation, using selected assumptions. Financial models are widely used in practice for valuation, and to support financial decisions and risk management. A model presents a financial calculation – or series of calculations – in a way that enables the user to understand it and to challenge it, especially about its assumptions. Well designed models also facilitate sensitivity analysis.

We will use Excel to illustrate financial modelling principles, but they apply generally, whatever modelling platform you or your colleagues are using. Key modelling principles include identifying and stating purposes, zoning workbooks into appropriate modules, workflow, visualisation and commentary. You will also appreciate the important differences between navigation, selection and editing.

Case study modelling applications will include the financial reporting and capital market concepts investigated throughout this course.

**4. Debt capital markets & Loan markets **

Capital is a source of finance for business operations, and also an investment for the capital provider. Borrowings and loans are liabilities for the borrower, and investment assets for the lender-investor. Creditworthy organisations can borrow money by issuing bonds. The bond is a promise by the issuer to repay the amount borrowed, plus interest, over a designated period of time. Issuers of bonds include a wide range of corporate and public sector entities, including central governments. Debt capital markets are the markets where bonds are traded.

The prices of bonds are inversely related to their current market yields. The yield is driven, in turn, by a number of factors including general market interest rates, and perceptions of the credit risk of the issuer. Credit rating agencies issue opinions on the credit risk of particular issues of bonds, as well as the general credit strength of certain issuers.

Loan markets relate to lending and borrowing documented in a loan agreement between a borrower and a lender, or a syndicate of lenders. Lenders include banks and other financial services organisations. Interest and capital repayments of loans and bonds are a legal contractual commitment of the borrower. Failure by the borrower to meet its obligations will generally be an event of default, giving additional enforcement rights to the lender. These lenders’ rights are a source of risk for borrowers, and a reason why adding debt to a financing structure increases risk for the borrower, at worst potentially leading to corporate failure for the over-borrowed company.

**5. Equity capital markets & Private equity **

The simplest, and most common, form of equity is ordinary shares, also known as common stock. Ordinary shares are a proportionate ownership interest in a company. Dividends on ordinary shares are a discretionary payment by the company, out of its profits (if any). This is key difference between equity capital and debt capital, debt servicing payments being contractual obligations. Shares and bonds are known collectively as securities. Other forms of security include intermediate ‘hybrid’ securities, which have some features of equity, and some features of debt instruments.

Equity is generally safer for the issuer compared with debt, but more expensive. Part of the cost of equity capital is the expectation, or requirement, of the equity investors for the company to grow its capital value. Equity capital markets are the markets where equity is issued and traded. Public companies, also known as listed companies, are those whose shares are quoted on a stock exchange, and which members of the public can invest in, generally through a broker.

Private equity deals with companies whose shares are not listed on exchange. Flotation, or an initial public offering, results in shares becoming listed on an exchange. Privatisation, or taking private, is the opposite process. Private companies have relatively fewer reporting obligations, but more limited access to new capital. Here as elsewhere, there is a trade off – and a strategic decision to make – to balance flexibility and cost. The balance point is likely to change over the life cycle of the business.