CHAPTER 5

UNDERSTANDING FINANCIAL STATEMENT

INTRODUCTION

Financial statements are tools that managers use to help them in their decision-making
considering financial implications. First-level supervisors, like foremen; middle level managers,
like product managers; and high-level managers, like company presidents make decisions with
financial implications. The decision to increase the salary of employees has financial implications
because it requires financing or funding in the long run. The decision to purchase land or any other
asset implies the need for financing. The decision to grant overtime to employees also requires
funding. The decision to increase sales will increase revenue but will also require increased
funding for purchases or manufacturing. The decision to borrow money from a bank will provide
funding, but will involve interest cost. The decision to sell some of the unused or idle machinery
will be a source of funds. The decision whether to lease or to buy has financial implications as
well and can affect profitability and wealth maximization. Financial statements are the key source
of information for most financial decision-making purposes. For these reasons, the information
contained in the financial statements is of utmost importance to financial managers.
This chapter will discuss the different financial statements, their purposes, and how they
are prepared. A detailed discussion of retained earnings and accumulated profits of a business is
provided so the students will learn to appreciate them. In addition, the chapter will introduce the
students to the concept of sinking fund and appropriation of cash for any appropriation made for
retained earnings.

INTENDED LEARNING OUTCOMES

At the end of the chapter the students should be able to:

1. Discuss the purpose of the different financial statements
2. Illustrate how to prepare the different financial statements
3. Explain the importance of retained earnings to a business enterprise
4. Understand and discuss the importance of appropriation of retained earnings
5. Appreciate the importance of setting aside cash for appropriation of retained earnings.

DISCUSSION

FINANCIAL STATEMENTS:
DEFINITION
• the product of financial accounting
• show the results of operation, financial condition, changes in owner's equity, and
sources and uses of cash.

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BASIC TYPES OF FINANCIAL STATEMENTS
1. Income statements
2. Balance sheet or statement of financial position 3. Statement of changes in owner’s/
partners’/ stockholders’ equity

INCOME STATEMENT
• It shows the results of operations— profit or loss.
• The income statement for a trading firm and a manufacturing firm is called a multi-step income
statement because it is more complicated than the income statement for a service firm.

Income Statement: SERVICE FIRM

(Details the revenues and expenses of the service firm; called a single-step income statement)

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Income Statement: TRADING CORPORATION
(Shows the sales, cost of sales, operating expenses, and the other income and other expense
accounts)

MATIBAY MERCHANDISING Income Statement

For the Year Ended June 30. 201 B

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 MATIBAY MERCHANDISING
Income Statement
For the Year Ended June 30. 201 B

MATIBAY MERCHANDISING
Income Statement
For the Year Ended June 30, 201B

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PRODUCT COSTS vs PERIOD COSTS
1. Product Costs (manufacturing cost)
1.1 Direct materials (variable) - materials directly incorporated in the product.
1.2 Direct labor (variable) - labor/ payment to workers who directly worked on the products,
like the cutters and sewers for garments.
1.3 Manufacturing/factory overhead (variable and fixed) - all costs of producing a product
other than direct materials and direct labor.
2. Period Costs (fixed or variable)
2.1 Selling expenses - associated with marketing the product.
2.2 Administrative expenses — expenses other than selling which include office salaries,
office supplies, depreciation for office equipment, etc.

BALANCE SHEET
➢ Shows the financial condition or position of a business firm
➢ Details the assets, liabilities, and owner(s)' equity of the business
➢ The balance sheet can be in:
1. account form - assets are shown on the left side and the liabilities and owner(s)'
equity on the right side, just like the t-account.
2. report form - the liabilities and owner(s)' equity are reported after the assets.

RM MANUFACTURING COMPANY
Balance Sheet
December 31, 201C

ASSETS

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MARKET VALUE vs BOOK VALUE
1. Market Value - current replacement costs; value that assets will command in the open market.
2. Book Value — acquisition costs or historical costs shown in the balance sheet; for those with
contra-accounts like accounts receivable and the fixed assets, the book value is the acquisition
cost less the balance in the contra-account.

For example:
Accounts Receivable P30, 000
Allowance for Bad Debts (3, 000)
Net book value P 27,000

STATEMENT OF CHANGES IN OWNERS' EQUITY

1. For a sole proprietorship, the Statement of Changes in Owner's Equity details the original or the
beginning investment or capital, any additional investment(s), withdrawal(s) by the owner, and the
profit/ loss of the business.
2. For a partnership, a Schedule of Division of Profit/ Loss is first prepared to determine the share
of the partners in the profit/ loss of the business which is either added (if profit) or deducted (if
loss) to the partners.
capital account. Other than this, it follows the format for sole proprietorship.
3.For a corporation, a Statement of Retained Earnings is first prepared. It starts with the capital
stock, additional paid-in capital stock, and the retained earnings.

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STATEMENT OF RETAINED EARNINGS
▪ Retained Earnings — the account that shows the accumulated profits/ losses of a business.
▪ The Statement of Retained Earnings shows the changes in the retained earnings account,
which include:
1. Beginning retained earnings account balance;
2. Profit/ loss earned or incurred during the year;
3. Dividends paid to stockholders; and
4. Appropriations of retained earnings added, increased, or reduced.

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CASH FLOW STATEMENT
1. It is sometimes called the funds flow statement, or he statement of sources and uses of cash, or
statements of
sources or uses of funds.
2. A simple cash flow statement lists cash receipts and disbursement
3. A complex cash flow statement shows net cash flows from:
3.1 operating activities - all operation-related earning activities of the firm;
3.2 investing activities - all activities related to non-current assets— buying and selling them;
and
3.3 financing activities - involve obtaining resources from owners and paying them dividends,
and from creditors and repaying them.

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