BUSINESS FINANCE

Course Code: BUSFIN

Prepared by:

ANGEL V. RODRIGUEZ

Reviewed by:

LIZEL S. SOSMEÑA
SHS- OIC PRINCIPAL

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WEEK 5: STANDARDS in FINANCIAL REPORTING

Specific Objectives:
At the end of the chapter, the learners are able to:

• Distinguish between stockholders and stakeholders.

• Describe the different stakeholders who would be interested in reviewing
the financial statements prepared by a business organization.
• Show an understanding of the ethical issues in finance.
• Show an understanding of the following: Generally Accepted Accounting
Principles, International Accounting Standards, International Financial
Reporting Standards, and Philippine Financial Reporting Standards.

Motivation:

Pretend that you are working as a finance manager for a manufacturing firm.
Imagine the factory building, equipment, and people like a whole movie playing in
front of you. The story is going so well until your boss asks you to show him a
summary of results on how the company has fared in terms of financial performance
in the past six months. Essentially, he is asking you to give a mid-year review.

You can almost hear the boss shouting: “I want to know everything! I want to
know sales, expenses, cash on hand, cash on bank, accounts…everything!” You
freeze because it seems that the only word that you heard him say was “everything.”
Before you could say anything else, the scene gets more exciting. “I would like to
see the reports no later than tomorrow afternoon.”
For a real finance manager, the scene described above would neither be bad
nor exciting. Finance managers are ready for this kind of situation. Although it would
still take sometime to prepare the reports being asked for by the boss, these reports
are normally ready and just need to be updated. These reports are called financial
statements.

A financial statement is a record which gives the user a picture or description

of how an individual, a business, or an organization is in terms of financial health.
Financial statements are summarize all the financial activities within a specified
period of time. Financial statements are prepared either quarterly, semiannually, or
annually. The three most commonly prepared financial

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statements in organizations are the balance sheet, the income statement, and the
statement of cash flow. Each will be discussed in more detail in Module 3.

Before you proceed, here are some essential theories and principles that you
need learn. The succeeding section of this module will include a discussion on
stockholders, stakeholders, ethics, and the Generally Accepted Accounting Principles
or GAAP.

Stockholders vs. Stakeholders

Finance managers are not only accountable to stockholders. They also have to
almost always consider the perspective of stakeholders. Both stockholders and
stakeholders are all users of financial statements. A stockholder is a person who
bought shares of stocks a publicly traded corporation. Therefore, he or she is a part
owner of the business. On the other hand, a stakeholder is a person who is not
necessarily the owner of the business, but has an interest or stake on how the
business is performing or how it is managed. Stakeholders can either be internal or
external.

An internal stakeholder is someone who is directly involved in the business.

The stakeholders are as follows:

• Employees – They are interested in the way things are run in the organization—
from policies and procedure, hiring and retention, and perhaps most important
of all of their concerns, compensation and benefits. They are most interested
in whether the company is achieving financial goals and objectives as these
not only affect the way they are remunerated but are also determinants of the
stability of the business. For them a stable and sustainable business means
security of tenure. They ask for transparency in financial reporting from the
finance manager. The extent of transparency, however, is up to the discretion
of then management. In the case of unionized companies, the demand for
transparency when sharing financial information to employees is stronger.
• Stockholders – As defined earlier, stockholders are those who bought shares
of stocks of a publicly traded corporation. They are also entitled to dividends,
which are per share payments to stockholders out of the earnings or income
of a corporation for a specific period of time. Naturally they want to see the
organization hit sales and profitability targets. They want ensure sustainability.
Most importantly, they want to maximize their wealth which is reflected by the
earnings per share. Stockholders rely on the use of financial statements to
assess the risk and return trade-off in investing. The interest of stockholders
are at times in conflict with that of employees. Employees

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 demand higher compensation and benefits which are expenses to the company
while stockholders want to maximize profits, either by decreasing expenses or
increasing income.
• Top Management – Although members of the top management team are
employees as well, it is best to separate the discussion on this stockholder
group to put things in proper perspective. They share the same concerns with
the other employees but from the financial management perspective, they are
most concerned with the quality of financial data that are made available to
them. They use these financial data for analysis and decision-making.
Members of top management, especially the president, are accountable to the
board of directors.
• Department Managers – the extent to which the department managers rely on
financial statements differ from that of the members of top management. On
this level, the analysis of financial statements is on the operational level. Some
examples of analysis on the operational level are labor efficiency and its effect
on direct labor cost in production, percentage of reject in relation to overall
output, return on marketing investment, sales per market segment, and
training costs vs. turnover rate.
• Brand of Directors – This is a group of individuals who were elected by the
stockholders to represent them. The board of directors normally consist of
highly qualified [people in the field or industry. They are tasked to ensure then
financial well-being of the company through the creation of policies. Some of
the policies that are created by the board of directors are on dividends and on
compensation of the members of the top management.
• Labor Unions – A labor union is an organization of employees whose mission
is represent the employees in negotiation with employers. Labor union leaders
and members review financial statements for them to gain an understanding
of the firm’s capacity to give the demands of employees. Some of the most
common issues addressed during negotiations are compensation and benefits,
working conditions, overtime compensation, holidays, vacation, and work
hours. The result of the negotiation between a labor union and an employer is
a collective bargaining agreement. A collective bargaining agreement
(CBA) is a contract between the employer and stipulated in the said document
is the procedure for the labor dispute resolution. A CBA is legally enforceable,
normally for one year, and the parties have to comply with the stipulations.
Some CBAs are enforceable for more than one year. A new CBA supersedes
the old one. An employee cannot be compelled to join a labor union. In the
same token, union busting, or any attempt to stop the formation of a labor
union is also illegal.

An external stakeholder is someone who is not directly involved in the business

but in one way or another has a stake on how the business is managed or hos it
is performing. The following are external stakeholders.:

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 • Customers – They are the most important external stakeholders. They are
the lifeblood of the business. Companies across industries, regardless of
size, devote a considerable amount of resources for customer acquisition
and retention., making sure that their needs and demands are satisfied.
Finance managers need an understanding of customer demands for proper
budget allocation on activities that are geared toward maintaining customer
relations. Customers like dealing with firms that possess a reputation of
financial stability and are ethical in the way they source and spend funds.
• Suppliers - The relationship between suppliers and business organization
has evolved overtime, from being merely supplier-customer top a more
sustainable partnership. Traditionally, suppliers simply sell goods to
business customers and get paid within the terms of the sales. Nowadays,
finance managers in collaboration with the marketing officers, seek
marketing support from suppliers in the form of free products for
giveaways, event sponsorship, printing of marketing materials, and even
research and development for new products or the improvement of existing
ones. From the perspective of the supplier, its is good to see the firm
prosper under the premise that the firm will order more. An established
relationship between suppliers and firms also means better payment terms.
Problems are also easily remedied when they arise because processes on
both ends are streamlined. Due to the aid of technology, the purchasing
systems of firms are even linked with that of their suppliers. Asa result,
order processing has become faster and more cost efficient.
• Government – The stake of the government is simple. Representative or
officers of government agencies, in the case of the Philippines, the Bureau
of Internal Revenue (BIR), review the financial statements of firms to
determine payment of income taxes or the applicability of certain
exemptions. Government agencies also want to make sure that firms
comply with licensing requirements and regulatory standards and that they
pay the right taxes in timely manner. It is imperative for the finance
manager to be updated with the changes on the laws that cover licenses,
reporting standards, and taxes. In the past decade, the BIR has been very
aggressive in terms of their dealings with businesses with fall short on the
payment of the right amount of taxes.
• Competitors – Competing firms within an industry monitor one another’s
activities and overall performance: product offerings, pricing strategies,
investments made, relationships with external stakeholders, and
movement of prices of stocks for publicly traded corporations. Along with
the other managers in an organization , the finance manager must conduct
activities—within the bounds of the law, of course—that are geared toward
competitive intelligence, or the firm’s ability to monitor, within the bounds
of both ethical and legal standards, the activities of its competitors. Such

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 information should be leveraged by the firm through policy making and the
creation of strategies aimed at gaining competitive advantage.
• Financial Institutions – Financial institutions review the financial statements
to see if another firm applying for a loan is creditworthy. Using a scoring
system of creditworthiness, a loan application is assessed based on the
borrower’s ability to pay the loan or the probability of default.
• Potential Investors – Similar to stockholders, potential investors review
financial statements in order to assess the potential return if they invest in
a business versus then risks associated with such investment. For instance,
several years of profitability would mean that the company is stable and
that the risk factor is low.

Ethical Issues in Finance

Just like any other field in business, finance operates in an environment

surrounded by ethical issues. Finance managers are expected to adhere to high
ethical standards. Ethics is defined as a set of rules or norms on what is right or
wrong, good or bad thinking, behavior, or judgment. In any discipline, the basic
steps for an ethical decision model are as follows, as stated in Business and
Personal Finance:

1. Determine the ethical issue.

2. Identify the actions for handling the situation.
3. Identify the people affected by the situation.
4. Analyze how the situation affects the people involved.
5. Decide which actions to take.

Most large companies have a formally written document called Code of

Ethics. This document is communicated to all employees from different levels
within the organization. Employees, managers, and nonmanagers alike, are
expected to follow then guidelines enumerated therein. They rea also
encouraged to behave ethically at all times.

The discussion on the internal and external stakeholders already shows the
importance of the information given by finance managers. Financial information
needs to be accurate and must be delivered to its users in a timely manner.
Otherwise, such information will lose relevance. That is why in the conduct of their
profession, finance managers are expected to adhere to high ethical standards.
Finance managers are often confronted with ethical issues. These issues present a
dilemma for decision-making. Below are some of the issues.

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 • Full Disclosure and Transparency- Finance managers face the dilemma of full
disclosure and transparency while still maintaining confidentiality. It is
imperative for them to safeguard highly classified financial records because if
they fall to the wrong hands (a competitor, for instance) the organization’s
position in the industry could be compromised.
• Professional Duty vs. Company Demands – Finance managers and
practitioners are sometimes torn between meeting company standards and
adhering to ethical standards. Quotas, targets, and other financial metrics put
pressure on employees. When people fear the negative consequences of not
meeting standards set by the organization, they are often tempted to ignore
ethical standards.
• Individual Judgment vs. Demands for Clients – Finance professionals are
sometimes confronted with demands from certain clients which are unethical
nature. For instance, a client asking for insurance settlement that is higher
than what is actually due, a client asking an accountant to hide revenues and
pad expenses in the income statement , and a financial advisor being asked
by his or her client to indulge financial information about a competing firm in
exchange for generous monetary gift.
• Misrepresentation – Decision makers rely on data analyzed and prepared by
finance professionals. It is imperative that finance professionals present all
material facts. A piece of information is considered material if knowledge of
such would have changed or affected the decision made. There is
misrepresentation if a financial advisor chooses not to inform his or her client
that the board of directors of a corporation is considering the sales of a
business unit to another company. This piece of information may affect the
client’s decision in the purchase of that company’s stocks had it been made
known to him or her.
• Conflict of Interest – As earlier discussed, a finance professional is resource
person for individuals and organizations alike. As a resource person, there
must be no conflict of interest. Conflict of interest arises when someone has a
self-serving interest, which makes him or her an unreliable source. For
instance, the CFO of a firm is married to a major investor of a competing firm.
This setup presents a conflict of interest as the CFO may discuss classified
financial information with his or her spouse.

The Generally Accepted Accounting Principles

Finance managers follow the Generally Accepted Accounting Principles (GAAP)

in the preparation, analysis, and reporting of financial statements to the intended
users. According to Investopedia, the GAAP is a standard practice for businesses in
presenting financial statements to maintain the continuity of information and
uniformity of presentation across international borders.

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 The GAAP maybe summarized as follows:

Qualitative characteristics are the qualities attributes that make financial

accounting information useful to the users. The fundamental qualitative
characteristics are relevant and faithful representation. The finance manager is
tasked to ensure that all information included in financial reporting is useful to the
users in making economic decisions. Information is relevant when, if made available
to the users, it will impact his or her decisions. In addition, information is relevant
when it has both confirmatory and predictive value. Information has predictive value
when it can aid forecasting decisions. On the other hand, it has confirmatory value if
it can help explain historical records on past transactions.

Below is a complete list of the qualitative characteristics of financial statements:

1. Materiality is a practical rule in accounting which dictates the strict adherence

to GAAP is not required when the items are not significant enough to affect the
evaluation decision and fairness of the financial statements. Materiality is also
known as the Doctrine of Convenience. The concept of materiality is relative
to the size of the firm. Information is considered material if its omission or
misstatement might influence the economic decision that the users will make
based on the financial information provided.
2. Faithful representation is the standard which means that there should be
proper accounting for all transactions. The amount that should be reflected on
record should be the actual amount involved in the transaction that took place.
Faithful representation has three characteristics: completeness, neutrality, and
error free. Completeness means relevant information should be complete and
presented in a way that facilitates correct understanding. Neutrality means
that the financial statements should be prepared in such a way that it does not
favor one party to the detriment of another party. Error-free means there are
no errors or omissions in the document.
3. Substance over form means its is necessary that pieces of information are
accounted for in accordance with their economic substance and reality and not
merely their legal form. Consequently, the economic substance of the
transaction shall prevail over the legal form should there be a conflict between
substance and form.
4. Conservatism means that when decision makers have to choose between
alternatives, the alternative that has the least effect on equity should be
chosen. In the other words, if an error is to happen, it is it is preferred that it
be an understatement rather than overstatement. In ever simpler parlance, if
a finance professional is in doubt on how to record a particular transaction, he
or she must record a loss and not record any gain. However, conservatism
should not be mistaken with fraud. Recording of a sale amounting to P1 000
000 for only P500 000 is not conservatism but fraud.

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 5. Understandability means that if financial information is to be useful, it will
have to be comprehensive, reported in a form that is understandable from the
perspective of the users. It should be noted, though, that financial statements
cannot realistically be understandable to everyone. Financial reports are
prepared for users who have reasonable knowledge of business and economic
activities and who review and analyze information diligently.
6. Comparability means that information about a reporting entity is more
useful if it can be compared with similar information about other entities and
with similar information about the same entity for another period or another
date. Comparability may be made within an entity or across entities, with
comparable information presenting both similarities and dissimilarities.
Comparability within an entity—also known as horizontal comparability or
intracomparability—is the quality of information that allows comparisons
within a single entity from one accounting period to the next. On the other
hand, comparability across entities—also known as intercomparability or
dimensional comparability—is the quality of information that allows
comparisons between two or more entities engaged in the same industry. For
financial information to be of value to the users, such as information should
be compared with similar information either within the organization or from
another entity.
7. Consistency means that accounting methods and principles used by the firm
should be uniform from one accounting period to another. It does not mean,
however, that the firm cannot change accounting methods. If such a change
will result to improved financial reporting processes, then the firm should
proceed with making the change, provided that the firm makes the change
known to users. It is not a good business practice if a firm refuses to change
its accounting methods if there are better options or alternatives.
8. Verifiability means that the other users of financial statements, all
knowledgeable but independent from one another, are able to arrive at a
consensus that a financial record is a faithful representation. Financial
information is verifiable when there is enough evidence so that two different
users of a financial report, for instance, will arrive at the same conclusion.
Verification can be direct or indirect. Direct verification means verifying an
amount or other representation through direct observation. On the other
hand, indirect verification means checking the inputs against a model,
formula, or other technique and recalculating the inputs using the same
methodology.
9. Timeliness means that financial information should be made available to the
users in a timely manner. Delays in reporting diminish the relevance of
financial information. As a rule of thumb in financial reporting, the older the
information, the less useful it is.
10.Cost constraint means that the benefit gained by the firm from the
information should outweigh the cost associated with obtaining information.

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 Sample Case

Case 1 below will illustrate some of the ethical issues that may be faced by a
professional practicing accounting or finance. It will also give you the opportunity
to test your understanding of some of the important concepts discussed in this
module. Read the given case and then answer the questions that follow.

Mary graduated with academic distinction and passed the board examination six months after
graduation. She is now a Certified Public Accountant (CPA). She is currently employed by a company that is
engaged in the manufacture of gift boxes, gift wrapping paper, ribbons, and other similar items. She gets a good
salary but she is still living from paycheck to paycheck. Moreover, she is sending her younger sibling to college.

One weekend, she s out that her friend’s company is looking for someone who can take care of their
accounting books. Mary was excited because she now has the opportunity to earn extra money. She asked
about her friend’s company: Wrap It Up!

Mary’s friend explained that Wrap It Up! Is engaged in the manufacture of paper, plastic, and boxes.
Mary explained to her friend that she is hesitant to even consider her friend’s offer because of a possible conflict
of interest. Mary believes that it is inappropriate for her to do accounting work for another company with a
similar line of business with that of her current employer. Her friend stated that it should be fine because
although the two companies are very similar, they are not direct competitors. The two parted ways after their
brief chat.

Mary pondered on her friend’s offer. She believes there will be conflict of interest if she takes up the
offer. Though she remains open to the possibility of accepting it considering her friend’s assurance that Wrap It
Up! Is not a direct competitor of her current employer. Moreover, she knows that the extra work will help her
out in her finances.

1. In your opinion, is it appropriate for Mary to accept her friend’s offer? Justify your answer.
2. Will there, indeed, be any conflict of interest if Mary accepts her friend’s offer? Explain your answer.
3. If you were in Mary’s situation, would you accept your former classmate’s offer or not? Explain your
answer.

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