Course Code and Title: FINP1 – Financial Management

Lesson Number: 5
Topic: Understanding Financial Statements
Learning Objectives:
After studying Chapter 5, you should be able to:
1. Understand how business activities are reported through the financial statements.
2. Appreciate the general objectives of financial statements.
3. Enumerate and identify the need of various users that demand financial accounting
information.
4. Enumerate the sources of information about a business enterprises.
5. Understand the benefits and costs of supplying accounting information.
6. Identify the required financial statements and know how they are interconnected.
7. Know the nature and significance of the
a. Statement of Financial Position or Balance Sheet Statement
b. Statement of Comprehensive Income
c. Statement of Stockholder’s Equity, and
d. Statement of Cash Flows
Pre-assessment:

Write T if the statement is true and F if the statement is false.

T 1. To know the value of a company, it is important to understand the company’s business

activities.
F 2. Financial assets serve the needs of different users. STATEMENTS
T 3. Accounting information system involves application of accounting standards to produce
financial statements.
T 4. Financial system provides the insight on the business activities of the company under
analysis.
F 5. Financial planning provides information about the relative success of the strategic plans
which can be used to corrective action and make new operating, investing and financing
decisions. FINANCIAL STATEMENTS
 CHAPTER 5
UNDERSTANDING FINANCIAL STATEMENTS
INTRODUCTION
This chapter provides a framework and several tools to help us analyze companies and
value their securities. At this point, it is helpful to imagine yourself as a specific user of financial
statements. For example, assume that you are a manager deciding whether to acquire another
company or divest of a current division? Or imagine yourself as an equity or credit analyst
communicate an investment appraisal or credit risk report? This focused perspective will
enhance one's learning process and makes it relevant.
HOW BUSINESS ACTIVITIES ARE REPORTED
To be able to analyze a company effectively or infer its value, it is important that one
must understand the company's business activities. This can be accomplished through the
financial statements. Financial statements report on a company's performance and financial
condition and reveal executive management's privileged information and insights.
Financial statements serve the needs of different users. The operation of the accounting
information system involves application of accounting standards to produce financial statements
that provide the insight on the business activities of the company under analysis.
Accounting information should be used in the business context in which the information
is created. All companies without exception, plan business activities, finance those activities,
invest in those activities and then, engage in operating activities. Business firms conduct all
these activities while confronting business forces, including market constraints and competitive
pressures.
Financial statements also provide crucial input for strategic planning, as well as'
information about the relative success of those plans which can be used to corrective action and
make new operating, investing and financing decisions.
GENERAL OBJECTIVES OF FINANCIAL STATEMENTS
The important objectives of financial statements are:
1. Providing Information for Economic Decisions
The economic decisions that are taken by the users of financial statements require an
evaluation of the ability of an enterprise to generate cash and cash equivalents, and the
timing and certainty of their generation. This ability ultimately determines the capacity of
an enterprise to pay its employees and suppliers, meet interest payments, repay loans
and make distributions to its owners.
2. Providing Information About Financial Position
The financial position of an enterprise is affected by the economic resources such as:
a. Information about the economic resources controlled by the enterprise and its
capacity in the past to modify these resources is useful in predicting the ability of the
enterprise to generate cash and cash equivalents in the future.
b. Information about financial structure is useful in predicting future borrowing needs
and how future profits and cash flows will be distributed among those with an interest
in the enterprise.
 c. Information is useful in predicting how successful the enterprise is likely to be in
raising further finance.
d. Information about liquidity and solvency is useful in predicting the ability of the
enterprise to meet the financial commitments as fall due. Liquidity refers to the
availability of cash in the near future after taking account of financial commitments
and solvency refers to the availability of cash over the longer term to meet financial
commitments as they fall due.
3. Providing Information About Performance of an Enterprise
Another important objective of the financial statements is that, it provides information
about the performance and in particular its profitability, which is required in order to
assess potential changes in the economic resources that are likely to control the future.
Information about variability of performance is important and useful in predicting the
capacity of the enterprise to generate cash from its existing resource base, and in
forming judgment about the effectiveness which the enterprise might employ additional
resources.
4. Providing Information about Changes in Financial Position
The financial statements provide information concerning changes in the financial position
of an enterprise, which is useful in order to assess its investing, financing and operating
activities during the reporting period. This information is useful in providing the user with
a basis to assess the ability of the enterprise to generate cash and cash equivalents,
and the needs of the enterprise to utilize those cash flows.
DEMAND FOR FINANCIAL ACCOUNTING INFORMATION
Decision makers and other stakeholders demand information on the company's past and
prospective returns and risks to facilitate efficient contracting and risk sharing.
The broad classes of users that demand financial accounting information include the following:
1. Managers and Employees
For their own and prospective earnings, potential managers and employees need
accounting information on the financial condition, profitability and prospects of their
companies as well as comparative financial information on competing companies and
business opportunities. Management uses financial statements to raise financing for the
company, to meet disclosure requirement and to serve as a basis for executive
remuneration and bonuses, for wage negotiations and to meet disclosure requirements.
2. Investors and Analysts
Financial statements are used by these parties to decide whether to buy or sell equity
shares. Expectations about future profitability and the ability to generate cash influence
the price of securities and a company's ability to borrow money at favorable terms. Other
information intermediaries such as, financial press writers and investment analysts are
interested in predicting companies' future performance.
3. Creditors and Suppliers
Banks and other lenders need financial accounting information to help determine loan
terms, loan amounts, interest rates and required collateral. Suppliers demand financial
data to establish credit terms and to determine their long-term commitment to supply-
chain relations. Both creditors and suppliers use information to monitor and adjust their
contractual requirements and environment with a business firm.
 4. Shareholders and Directors
Financial accounting information are needed by owners and directors of the company to
assess its profitability and risks, to evaluate managerial performance and to help make
leadership decisions.
5. Regulatory and Tax Agencies
The SEC, BIR, BSP and other legal institutions I demand financial accounting
information to monitor the business firms' compliance with laws, for public protection,
price setting and for setting tax and other regulatory policies.
6. Customers and Potential Strategic Partners
Customers both current and potential, need accounting information to evaluate a
company's ability to provide products and services as agreed and to assess the
company's reliability and staying power. Potential Strategic partners would wish to
estimate the firm's profitability to assess the fairness of returns on mutual transactions
and strategic alliances.
7. Other decision makers
Financial accounting information are required for varied purposes by other parties from
assessing damages for environmental abuses to making policy decisions involving
economic, social, taxation and other initiatives.
SOURCES OF INFORMATION ABOUT BUSINESS ENTERPRISE
In general, the quantity and quality of accounting information that companies supply are
determined by manager's assessment of the benefits and costs of disclosure. In the Philippines,
publicly listed companies must file financial accounting information with the Securities and
Exchange Commission (SEC). These are;
1. The audited annual report that includes the four financial statements (Statement of
Financial Position [traditionally known as the Balance Sheet Statement], Statement of
Comprehensive Income, Statement of Stockholders' Equity, and Statement of Cash
Flow) with explanatory notes and the management's discussion and analysis of financial
results.
2. The unaudited quarterly or interim reports that include summary version of the four
financial statements and limited additional disclosure.
All other registered corporations and partnerships are likewise required to file annually
audited financial statements with accompanying explanatory notes with the SEC.
BENEFITS OF DISCLOSURE
The advantages of supplying accounting information extend to a company's capital,
labor, input and output markets. Companies compete in these markets. For instance, debt and
equity financing are sourced from capital markets and the better a company's prospects, the
lower will be its cost of capital as reflected in higher stock prices or lower interest rate. The
same is true for a company's recruitment efforts in labor markets and its ability to establish and
maintain superior supplier customer relations in the input and output markets.
 The company's ability to disclose reliable (audited) accounting information about its
products, processes and other business activities enable them to better compete in capital,
labor, input and output markets.

COSTS OF DISCLOSURE
The preparation and dissemination costs of supplying accounting information can be
substantial, and the possibility for information to produce competitive disadvantages is high.
Companies are apprehensive that disclosures of their activities such as product or
segment successes or failures, strategic initiatives, technological or systems innovations could
harm their competitive advantages. Companies also face possible lawsuits when disclosures
create expectations that eventually are not met. Disclosure costs including political costs are
high for highly visible companies such as large telecommunication conglomerates (e.g. PLDT
and Digitel), oil companies and software companies because they are favorite targets of public
scrutiny.
CONSTRAINTS ON RELEVANT AND RELIABLE INFORMATION
1. Timeliness
If there is undue delay in the reporting of information, it may lose its relevance.
Management may need to balance the relative merits of timely reporting and the
provision of reliable information. To provide information on a timely basis, it may often be
necessary to report before all aspects of a transaction or other event are known, thus
impairing reliability. Conversely, if reporting is delayed until all aspects are known, the
information may be highly reliable but of little use to users who have had to make
decisions in the interim. In achieving a balance between relevance and reliability, the
overriding consideration is how best to satisfy the economic decision making needs of
users.
2. Balance Between Benefit and Cost
The balance between benefit and cost is a pervasive constraint rather than a qualitative
characteristic. The benefits derived from information should exceed the cost of providing
it. The evaluation of benefits and costs is, however, substantially a judgmental process.
3. Between Qualitative Characteristics
In practice, a balancing or trade-oil' between qualitative characteristics is often
necessary. Generally, the aim is to achieve an appropriate balance among the
characteristics in order to meet the objective of financial statements. The relative
importance of the characteristics in cases is a matter of professional judgement.
4. True Fair View or Fair Presentation
Financial statements are frequently described as showing a true and fair view of the
financial position, performance and changes in financial position of an enterprise.
Although, this framework does not deal directly with such concepts. the applications of
the principal qualitative characteristics and of appropriate accounting standards,
normally results in financial statements that convey what is generally understood as a
true and fair view of such information.
FINANCIAL STATEMENTS
Business activities are periodically reported by companies using four financial
statements: the Statement of Financial Position, Statement of Comprehensive Income,
Statement of Stockholders' Equity and the Statement of Cash Flows.
Figure 5-1 shows how these statements are interconnected across time. A Statement of
Financial Position reports on a company's financial position at a point in time. The Statement of
Comprehensive Income, Statement of Stockholders' Equity and the Statement of Cash Flows
report on performance over a period of time.
The three statements in the middle of Figure 5-1 link the statement of financial position
from the beginning to the end of a period.

LINKAGE OF FINANCIAL STATEMENTS

The four financial statements are linked with each other and linked across time. This
linkage is also known as articulation. The succeeding section demonstrates the articulation of
financial statements using Orange Inc.
The statement of financial position and statement of comprehensive income are linked
via retained earnings. Retained earnings are updated each period and reflect cumulative
income that has not yet been distributed to shareholders. Figure 5-2 shows Orange Inc. retained
earnings reconciliation for 20X4.
 In the absence of transactions with stockholders (e.g., stock issuances, repurchases and
dividend payments), the change in stockholders' equity equals income or loss for the period.
The income statement, thus, measures the change in company value as measured In
accordance with financial reporting standards. This is not necessarily company value as
measured by the market. Of course, all value relevant items eventually find their way into the
income statement. So, from a long term perspective, the income statement does measure
change in company value. This is why stock prices react to reported income and to analysts'
expectations about future income.
Orange Inc. begins the fiscal year 20X3-20X4 with assets of P17.205 million, consisting
of cash for P6.392 million and noncash assets for PI 0.813 million. These investments are
financed with P7.221 million from non-owners and P9.984 million from shareholders. The owner
financing consists of contributed capital of P4.355 million, retained earnings of P5.607 million
and other stockholders' equity of P22 million.
Figure 5-3 shows statement of financial position at the beginning and end of Orange Inc.
The statement of cash flows explains how operating, investing and financing activities increase
the cash balance by P2.960 million from P6.392 million at the beginning of the year to P9.352
million at year-end.
Orange Inc.'s P3.496 million net income reported on the income statement is also
carried over to the statement of shareholders' equity. The net income explains nearly all of the
change in retained earnings reported in the statement of shareholders' equity because Orange
Inc. paid no dividends in that year (other adjustments reduced retained earnings by P.002
million).
There is an order to financial statement preparation. First, a company prepares its
income statement using the statement of comprehensive income accounts. It then uses the net
income number and dividend information to update the retained earnings account. Second, it
prepares the statement of financial position using the updated retained earnings account along
with the remaining statement of financial position accounts from the trial balance. Third, it
prepares the statement of stockholders' equity. Fourth, it prepares the statement of cash flows
using information from the cash accounts and other sources.
STATEMENT OF FINANCIAL POSITION
A Statement of Financial Position reports a company's financial position at a point in time, the
company’s resources (assets) namely, what the company owns and also the sources of asset
financing. There are two ways a company can finance its assets:
1. Owner financing. It can raise money from shareholders.
 2. Non-owner financing. It can also raise money from banks or other creditors and
suppliers.
This means that both owners and non-owners hold claims on company assets. Owner
claims on assets are referred to as Equity, and non-owner claims are referred to as Liabilities
(or debt). Since all financing must be invested in something, we obtain the following basic
relation: (investing = financing). This equality is called the accounting equation which follows:
(assets = liabilities + owners' equity).

*Financial statement titles sometimes begin with word consolidated. This means that the financial
statement includes a parent company and one or more subsidiaries, companies that the parent
company owns. For Blue Company, other equity includes accumulated other comprehensive
income and minority interests.

Investing Activities
Statement of financial position is organized like the accounting equation. Investing
activities are represented by the company's assets. These assets are financed by a combination
of non-owner financing (liabilities) and owner financing (equity).
Financing Activities
Assets must be paid for, and funding is provided by a combination of owner and non-
owner financing. Owner (or equity) financing includes resources contributed to the company by
its owners along with any profit retained by the company. Non-owner (creditor or debt) financing
is borrowed money. We distinguish between these two financing sources for a reason: borrowed
money entails a legal obligation to repay amounts owed, and failure to do so can result in
severe consequences for the borrower. Equity financing entails no such obligation for
repayment.
 Some questions that a reader of the Statement of Financial Position of Blue Company
might have at this early stage are:

 Blue Company reports P88.658 million of cash on its 20X4 statement of financial
position, which is 16% of total assets. Many investment-type companies such as Blue
Company and high-tech companies such as Cisco Systems carry high levels of cash.
Why is that? Is there a cost to holding too much cash? Is it costly to carry too little cash?
 The relative proportion of short-term and long-term assets is largely dictated by
companies' business models. Why is this the case? Why is the composition of assets on
statement of financial position for companies in the same industry similar? By what
degree can a company's asset composition safely deviate from industry norms?
 What are the trade-offs in financing a company by owner versus non-owner financing? If
non-owner financing is less costly, why don't we see companies financed entirely with
borrowed money?
 How do shareholders influence the strategic direction of a company? How can long-term
creditors influence strategic direction?
 Most assets and liabilities are reported on the statement of financial position at their
acquisition price, called historical cost. Would reporting assets and liabilities at fair
values be more informative? What problems might fair-value reporting cause?
Review the Blue Company Statement of Financial Position summarized in Figure 5-4 and
think about these questions.
Working Capital
Current assets are often called working capital because these assets “turn over”, that is, they
are
they are used and then replaced throughout the year.
Net working capital is the difference between current assets minus current liabilities
while net operating working capital is the difference between current assets and non-interest
bearing current liabilities.
STATEMENT OF COMPREHENSIVE INCOME
The statement of comprehensive income reports on a company's performance over a
period of time and lists amounts for revenues (also called sales), expenses and other
comprehensive income. Revenues less expenses yield the bottom-line net income amount.
Figure 5-5 shows the Blue Company Statement of Comprehensive Income. Refer to its income
statement to verify the following: revenues P236.490 million; expenses = P210.064 million; and
net income P26.426 million. Net income reflects the profit (also called earnings) to owners for
that specific period.
 Manufacturing and merchandising companies typically include an additional expense
account, called cost of goods sold (or cost of sales), in the statement of comprehensive income
following revenues. It is also common to report a subtotal called gross profit (or gross margin),
which is revenues less cost of goods sold. The company's remaining expenses are then
reported below gross profit. This income statement layout follows:

Operating Activities
Operating activities use company resources to produce, promote and sell its products
and services. These activities extend from input markets involving suppliers of materials and
labor to a company's output markets involving customers of products and services. Input
markets generate most expenses (or costs) such as inventory, salaries, materials and logistics.
Output markets generate revenues (or sales) to customers. Output markets also generate some
expenses such a marketing and distributing products and services to customers. Net income
arise when revenues exceed expenses. A loss occurs when expenses exceed revenues.
Differences exist in the relative profitability of companies across industries. Although
effective management can increase the profitability of a company, business models play a large
part in determining company profitability.
The following questions might be considered regarding the Statement of Comprehensive
Income.

 Assume that a company sells a product to a customer who promises to pay in 30 days.
Should the seller recognize the sale when it is made or when cash is collected?
 When a company purchases a long-term asset such as a building, its cost is reported on
the statement of financial position as an asset. Should a company, instead record the
cost of that building as an expense when it is acquired? If not, how should a company
report the cost of that asset over the course of its useful life?
  Manufacturers and merchandisers report the cost of a product as an expense the
product sale is recorded. How might we measure the costs of a product that is old by a
merchandiser? By a manufacturer?
 If an asset, such as building, increases in value that increase is not reported as income
until the building is sold, if ever. What concerns arise if we record increases in asset
values as part of income, when measurement of that increase is based on appraised
values?
 Employees commonly earn wages that are yet to be paid at the end of a particular
period. Should their wages be recognized as an expense in the' period that the work is
performed, or when the wages are paid?
 Companies are not allowed to report profit on transactions relating to their own stock.
That is, they don't report income when Stock is sold, nor do they report an expense
when dividends are paid to shareholders. Why is this the case
Review the Blue Company Statement of Comprehensive Income summarized in Figure 5-5 and
think about these questions.
The statement of stockholders' equity reports on changes in key types of equity over a
period of time. For each type of equity, the statement reports the beginning balance, a summary
of the activity in the account during the year and the ending balance.

Contributed capital represents the cash that the company received from the sale of stock
to stockholders (also called shareholders), less any funds expended for the repurchase of stock.
Retained earnings (also called earned capital or reinvested capital) represent the cumulative
total amount of income that the company has earned and that has been retained in the business
and not distributed to shareholders in the form of dividends. The change in retained earnings
links consecutive statement of financial position via the income statement: Ending retained
earnings = Beginning retained earnings + Net income – Dividends. For Blue Company, its
recent year's retained earnings increases from PI 17.824 million to PI 44.306 million. This
increase of P26.482 million is explained by net income of 106.426 million, no payment of
dividends and PO.056 million related to a mandated accounting change.
STATEMENT OF CASH FLOWS
 The statement of cash flows reports the change (either an increase or decrease) in a
company's cash balance over a period of time. The statement reports on cash inflows and
outflows from operating, investing and financing activities over a period of time.

Consider the following questions regarding the Statement of Cash flows:

 What is the usefulness of the statement of cash flows? Do the statement of financial
position and income statement provide sufficient cash flow information?
 What types of information are disclosed in the statement of cash flows and why are they
important?
 What kinds of activities are reported in each of the operating, investing and financing
sections of the statement of cash flows? How is this information useful?
 Is it important for a company to report net cash inflows (positive amounts) relating to
operating activities over the longer term? What are the implications if operating cash
flows are negative for an extended period of time?
 Why is it important to know the composition of a company's investment activities? What
kind of information might we look for? Are positive investing cash flows favorable?
 Is it important to know the source of a company's financing activities? What questions
might that information help us answer?
 How might the composition of operating, investing and financing cash flows change over
a company's life cycle?
 Is the bottom line increase in cash flow the key number? Why or why not?

Activity:
Write T if the statement is true and F if the statement is false.
T 1. Economic decisions that are taken by the users of financial statement require an
evaluation of the ability of an enterprise to generate cash and cash equivalents and the timing
and certainty of their generation.
 T 2. The financial statements provide information concerning changes in the financial
position of an enterprise, which is useful to assess its investing, financing, and operating
activities during the reporting period.
T 3. Regulatory and Tax Agencies uses financial accounting information to monitor the
business firms’ compliance with laws and regulations.
F 4. Disclosures are not needed in a publicly listed entities like telecommunication
companies, oil companies, and manufacturing firms.
F 5. Automation is the linkage of the four financial statements with each other and across
time.

Reinforcement:
Choose the letter of the correct answer:
1. The following are general objectives of financial statements except for one:
a. Providing information for social decisions
b. Providing information about an entity’s financial position
c. Providing information about the performance of an enterprise
d. Providing information about changes in financial decision.
2. The following are the broad classes the demand financial accounting information, except
for one:
a. Managers and Employees
b. Investors and Analysts
c. Bystanders loitering around the company
d. Shareholders and Directors
3. Statement 1: SEC, BIR, BSP and other institutions demand financial accounting
information for compliance with laws and regulations in the Philippines.
Statement 2: Customers don’t see the demand of a company’s accounting information.
a. Statement 1 is True, Statement 2 is False
b. Statement 1 is False, Statement 2 is True
c. Both statements are True
d. Both statements are False
4. Statement 1: The unaudited quarterly or interim reports doesn’t need to be submitted by
publicly listed companies to the Securities and Exchange Commission (SEC).
Statement 2: The audited annual report needs to have explanatory notes and analysis of
financial results upon submission to SEC for publicly listed companies.
a. Statement 1 is True, Statement 2 is False
b. Statement 1 is False, Statement 2 is True
c. Both statements are True
d. Both statements are False
5. The following are constraints on relevant and reliable information, except for one:
a. Timeliness
b. Balance Between Benefit and Cost
c. Between Qualitative Characteristics
d. Unfair Presentation
6. The following are the types of financial statements are typically used in periodical
reporting, except for one:
a. Statement of Assets, Liabilities and Net worth
 b. Statement of Comprehensive Income
c. Statement of Stockholders’ Equity
d. Statement of Cash Flows
7. Statement 1: The statement of financial position and statement of comprehensive
income are linked via the Retrain Earnings account.
Statement 2: Both owners and non-owners can hold claims on company assets,
provided that the company allowed it to do so.
a. Statement 1 is True, Statement 2 is False
b. Statement 1 is False, Statement 2 is True
c. Both statements are True
d. Both statements are False
8. Statement 1: Assets must be paid for, and funding can be provided by a combination of
owner and non-owner financing.
Statement 2: Equity financing includes resources contributed through bank financing or
borrowings.
a. Statement 1 is True, Statement 2 is False
b. Statement 1 is False, Statement 2 is True
c. Both statements are True
d. Both statements are False
9. Statement 1: Current Assets are often called working capital because these assets “turn
under”.
Statement 2: Net working capital is the difference of non-current assets minus current
liabilities.
a. Statement 1 is True, Statement 2 is False
b. Statement 1 is False, Statement 2 is True
c. Both statements are True
d. Both statements are False
10. Statement 1: Operating activities use company resources to produce, promote and sell
its products or services.
Statement 2: The statement of cash flows reports the change in a company’s cash
balance over a period of time.
a. Statement 1 is True, Statement 2 is False
b. Statement 1 is False, Statement 2 is True
c. Both statements are True
d. Both statements are False