CHAPTER . BUSINESS ORGANIZATION AND TRENDS Expected, Learning Outcomes. After studying Chapter 4, you should be able to: 1. Explain the basic legal forms of business organizations such as, sole Proprietorship, partnership and corporation. 2. Know the advantages and disadvantages of adopting the a. Sole proprietorship b. Partnership ¢. Corporation ‘ form of business organization, 3. Determine the form of business organization most adaptable to an enterprise. : 4. Understand the important business trends such as * Increased globalization of business . Improving information technology ° Outsourcing and how they import a business firm's business ©Peration, oOo4CHAPTER 4 BUSINESS ORGANIZATION AND TRENDg THE ORGANIZATION OF THE BUSINESS FIRM The business firm is an entity designed to organize Taw materials, labor, and machines with the goal of producing goods and/or services. Firms 1. purchase productive resources from households and other firms, 2. transform them into a different commodity, and 3. sell the transformed product or service to consumers For business firms engaged in retail or trading activities, transforming purchased goods into a different commodity does not necessarily take place. Every society, no matter what type of economy it has, relies on business firms to Organize resources and transform them into products. In market economies, most firms choose their own price, output level, and methods of production. They get the benefits of sales revenues, but they also must pay the costs of the resources they use. Business firms can be organized in one of three ways: as a proprietorship, 8 Partnership, or a corporation. The structure chosen determines how the owners share the risks and liabilities of the firm and how they participate in making decisions. LEGAL FORMS OF BUSINESS ORGANIZATION PROPRIETORSHIP A sole proprietorship is a business owned by a single person who has complete control over business decisions. This individual owns all the firm’s assets and is responsible forall its liabilities, More businesses are sole proprietorship than any form of business organization. From a legal point of view, the owner of # Proprietorship #8 not separable from the business and is personally liable for all debts of the business. From an accounting prospective, however, the business !5 an entity separate from the owner (Proprietor). Therefore, the financial statements of the business present only those assets and liabilities pertaining to the business-2 Business Organization and Trends 39 owner cannot be paid salary or wages from the busi sen cants OS el 2 lhe business. Instead, the owner pusiness. The business itself of the business is reported supporting schedule, Among the advantages of a sole proprietorship are: 1, Ease of entry and exit Asole proprietorship requires no formal charter and is inexpensive to form and dissolve. 2. Full ownership and control ‘The owner has full control, reaps all profits and bears all losses. 3. Tax savings The entire income generated by the proprietorship passes directly to the owner. This may result in a tax advantage if the owner’s tax rate is less than the tax rate of a corporation. 4, Few government regulations . Asole proprietorship has the greatest freedom as compared with nay form of business organization. Major disadvantages of the proprietorship form include: 1. Unlimited liability The owner is personally liable or responsible for any and all business debts, Thus, the owner’s personal assets can be claimed by the creditors if the firm defaults on its obligations. Limitations in raising capital Fund-raising ability is limited. Resources may be limited to the assets of . owner and growth may depend on his or her ability to borrow money. * Lack of continuity . Pon death or retirement of the owner, the proprietorship ceases to exist.a 40 Chapter 4 Therefore, the proprietorship may be an ideal form of business OrBanizaton 2 fore, the pt ri 3 the following conditions exist: The anticipated risk is minimum and adequately covereg by insu ° ie. Trance, The owner is either unable or unwilling to maintain the . . Mecessany organizational documents and tax returns of more Complicateg business, * entities, © The business does not require extensive borrowing. PARTNERSHIP ip i i ich two or More persons A partnership is a legal arrangement in whic! wo cuighen capital or services to the business and divide the Profits oF losses may be derived therefrom, Partnership may operate under varying degrees of formality. For example, a formal Partnership may be established using a written ° Contract known as the Partnership agreement which is filed with the Securities ang Exchange Commission, Partnership may be either &eneral or limited. A general Partnership is one in which each partner has unlimited liability for the debts incurred by the business, General p; enter into contractual obl artners usually manage the firm and may may be divided in any wi igations onthe firm’s behalf. Profits and asset ownership ‘ay agreed upon by the Partners, A Timited Partnership is one Containing one or More general partners and one of more limited partners. The Personal liability of a general Partner for the firm’s debt is unlimited while the personal liability of limited partners is limited to their investment. Limited Partners cannot be active in Management. Advantages of. 4 partnership include Among others the following: 1. Ease of formation er 4 partnership May require Telatively little effort and low start-up 2. Additional Source 8 Of capital A partnership has the fi Mancial resources of several individuals.Business Organization and Trends 41 3, Management base nership has a broad 4 id torship. ‘er management base or expertise than a sole 4, Tax implication A partnership like a proprietorship does not pay any income taxes, The income or loss of the business is distributed among the partners in accordance with the partnership and each partner reports his or her portion whether distributed or not on personal income tax return. Disadvantages of partnership are: 1. Untimited liability General partners have unlimited liability for the debts and litigations of the business. nv Lack of continuity A partnership may dissolve upon the withdrawal or death of a general * partner, depending on the provisions of the partnership. 3. Difficulty of transferring ownership It is difficult for a partner to liquidate or transfer ownership. It varies with conditions set forth in the partnership agreement. 5 4. Limitations in raising capital A partnership may have problems raising large amounts of capital because many sources of funds are available only to corporations. CoRPORATION ‘agrton is an artificial being created by law and is a legal entity separate and fro ‘tom its owners. This legal entity may own assets, borrow money and ae other business entities without directly involving the owners. In many im, liven owners who are also called shareholders do not directly manage the firm for a they’select managers designated as the Board of Directors to run the behaie em. The Board of Directors is authorized to act in the corporation’si Hi jon process is initial, a e Securities among 0 articles of i Incorporators Name of the corporation «Purpose of the corporation © Capital stock Authorized shares it will then issue its capital stock is evidenced by a stock certificate. The corporate bylaws the internal management of the company are d approved by the shareholders. These bylaws may be amended or extended from time to time by shareholder. ‘After the corporation is legally formed, Ownership of this stock which are rules that govern established by the board of directors an Advantages of a corporation are: 1. Limited liability sharcholiens are liable only to the extent of their investment in the es a pon. ite shareholders can only lease what they have invested in pes as ares, not any other personal assets, However, limited liability Pee al peopel, Government may pass through the corporate en a a aa taxes. Also, it is not uncommon for creditors 0 he cei are peccliers personally co-sign for credit extended to both the corporat ro default by the business, the creditors may s¥° areholders who have co-signed. 2. Unlimited life Corporations conti P nue to exist maxirnum legal life even after death of th i taxing | life of a cor ion i bere desired additional life dae ea z ne © ae a years. , ‘ase in transferring ownership Shareholders by selling than “2Sily sell thei . . ling their st. 1» eheir Ownership ji i yrations cremations, The ‘ttt affecting terest fr ost Co ae Ber financial base av’, °°, Sell stock provi egal form OF with # and the capital nee pees corporations for expansion.—w 5 4, Ability to raise capital Corporations can raise capital through the sale of securities such as bonds to investors who are lending money to the corporations and equity securities such as common stock to investors who are the owners. Business Organization and Trends 43 pisadvantages of a corporation include: 1. Time and cost of formation Registration of public companies with the SEC may be time-consuming and costly. 2. Regulation Corporations are subject to greater government regulations than other forms of business organizations. Shareholders can not just withdraw assets from the business. They can only receive corporate assets when dividends are declared and these amounts may be subject to limits imposed by law. 3. Taxes Corporations pay taxes on income they have earned. The complexity of the subject of taxation demands the advice of a qualified tax accountant. The need of large businesses for outside investors and creditors is such that, the corporate form will generally be the best for such firms. We focus on corporations in the chaptets ahead because of the importance of the corporate form not only locally but also in world economies. Also, a few financial management issues, such asdividend policy are unique to corporations. However. businesses of all types and sizes need financial management, so the majority of the subjects we discuss bear on any form of business. IMPORTANT BUSINESS TRENDS Four important business trends should be noted, namely: Increased globalization of business Ever improving information technology (IT) Corporate governance Outsourcing44 Chapter 4 Globalization of the Firm i basis and with good reason: invest: 1 tions operate on a global basis g esting prac aaa ats be highly profitable. Decisions to build plants and Produce goods abroad are also motivated by the attraction of low-cost labor and the transfer of highly efficient technology that gives competitive price advantages b foreign operations. ‘As domestic demand reaches maturity, the search for new markets leads corporation to invest and sell abroad. The trend to develop a Presence abroad is also motivated by a desire to hedge against risks. Because economic activity differs from one country to the next, diversification abroad tends to dampen the overall fluctuations of sales and earnings, thus reducing the risk exposure of a corporation. Fortunately, the advent of new financial instruments, including financial derivatives, such as futures and swap agreements, provides managers with new tools for hedging and minimizing foreign risks. Competition is intensified with the emergence of foreign industrial power, like Japan, South Korea and China because of the opportunities for local firms to import lower priced goods for sale in the domestic market. This not only saves the domestic firm the need to invest in new capacity, but it also allows to share in the technological advances of that country. See A oF the 5 rn will continue to provide highly profitable-opportunites ‘irms, but thi: . oe : ., ail hoe vb Rovement requires careful decision making and highly Ever-lmproving information Technology (IT) Improvenients in (7 are 5] "8 spurring globalizati ing financial mana, as it re zation, and they are changing finé elsewhere, Fhims are ie ved in North America, Europe, Southeast Asia Bvesswork out of finanae ne Massive data and using them takes much of Corporation is considering decisions, For example, when Double-Drage” remuly from thousands of bi tential site for a new mall, it can draw hist 2 lowers the risk Of investing inn Stores to redic ed site. Th ey Skee ict results at the propos_— _ | Business Organization and Trends_45 corporate Governance jg trend relates to the way the top managers operate and interface with Keholders. At the same time, the Securities and Exchange Commission (SEC) which has, jurisdiction over the shareholders and the information that must be given has made it easier to activist shareholders to changes the way things are done vein firm. Some years ago, the corporation's chairman of the board of directors yas almost always also the chief executive officer, and this person decides who would be elected to the board and therefore would have complete control of the firm’s operations. That made it impossible for shareholders to replace a poor management team. Currently, investors who control huge pools of capital (hedge funds and private equity groups or venture capitalists) are constantly looking for underperforming. firms and they quickly take control and replace manager. Most firms today have strong written codes of ethical behavior and companies also conduct training programs to ensure that employees understand proper behavior in different situations. When conflicts arise involving profits and’ ethics, ethical consideration are so obviously important that they dominate. Outsourcing Outsourcing occurs when domestic firms invest and produce gtods in foreign countries or when these firms choose to rely on imports rather than byild domestic plans and produce these goods domestically. Low labor-cost:countries, like China, open up new investment opportunities for corporations from the United States, Europe and Middle-East. Growing competitive pressures are forcing domestic firms to invest abroad or to import cheap foreign products. one maior factor responsible for outsourcing is the ease with which technology il peace ‘abroad. China, India and other Asian countriés including the That a can claim technological parity while enjoying low costs of production. ly Outsourcing is such ani attractive investment option.LL ™ ‘When evaluatin} i rporate manager is forced Juating the merits of outsourcing a corp central decisions. i a plant overseas. duce domestically or move ie Fe rdoser tacit goods to take advantage of low tabor and other P ae or shift to more capital-intensive and technologically advanced cos I rations. . : 3 pace abroad in order to gain access to new rapidly growing foreign markets. Outsourcing relieves managers from having to purchase raw materials or to hedge against the risk that the prices of these raw materials will increase. An outsourcing firm does not have to incur the high costs of pension plans, health benefits, Pollution control, and worker safety. Some risks such as technological obsolescence and unforeseen changes in de: outsourcing. These and other advantages mak aaa how to work with probability models will help a manager to evaluate the oe aor of Outsourcing compared to domestic investments. Also, given ai me yo pare among countries, Outsourcing will continue to pay an Bee ne . dente’ decision making, However, when USA President b 5 . A Countries such as China, tee nC Ea cea ee Sparked among these Nations, anada and others, trade wars are said to haveyr Business Organtzétion and Trends 47 REVIEW QUESTIONS AND PROBLEMS Questions What are the three basic forms of business ownership? What are the ‘advantages and disadvantages of each? Between the three basic forms of business ownership, describe the ability _ of each form to access capital. Explain how the founder of a business can eventually lose control of the firm. How can the founder ensure this will not happen? Who owns a corporation? Describe the process whereby the owners control the firm’s management. What is the main reason that an agency relationship exists in the corporate form of organization? In this context, what kinds of problems can arise? In what way can statistics be used to help managers succeed? 1» Why do firms seek global exposure? . What kind of different decisions are faced by a global firm? .. What are some of the advantages of outsourcing? What are some of the problems it créates for the firm? . If a company’s board of directors wants management to maximize shareholder wealth, should the CEO’s compensation be set as affixed peso amount, or should the compensation depend on how well the firm performs? If it is to be based on performance, how should performance be Measured? Would it be easier to measure performance by the growth rate in reported profits or the growth rate in the stock’s intrinsic value? Which Would be the better performance measure? Why? ! What. are some actions that sharéholders can take to ensure that Management's and shareholders’ interests are aligned?t=_——~"~>S—s—sWK$=s— nt u undertake? Why? Bid am. omen’ Ne .> Forms of Business Organization _49 pultiple Choice Questions ib One of the major disadvantages ofa sole proprietorship is that there is unlimited liability to the owner. b. _ the simplicity of decision making. c. low organizational costs. d. low operating costs. iP The partnership form of organization a. _ avoids the double taxation of earnings and dividends found in the corporate form of organization. b. _ usually provides limited liability to the partners. c. has unlimited life. d. simplifies decision making. A corporation is a. owned by stockholders who enjoy the privilege of limited liability. . . . _ easily divisible between owners. c. a separate legal entity with. perpetual life. d. all of the above.UNIT I Evaluating Operating and Financial Performance — Chapter 5 Understanding Financial Statements 6 Assessment of the Firm’s Operating Efficiency and Finantcial Position Through Financial Statements Analysis 7 Cash Flow Analysis 8 Operating and Financial LeverageCHAPTER UNDERSTANDING FINANCIAL STATEMENTS Expected, Learning Outcomes 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 needs of various users that demand financial accounting information. 4. Enumerate the sources of information about a business enterprise. 5. Understand the benefits and costs of supplying accounting information. e 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 Stockholdefs' Equity, and d. Statement of Cash Flows O04CHAPTER 5 UNDERSTANDING FI NANCIAL 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 2 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 — how do you assess and 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 t0 produce financial statements that provide the insi F svities of insight on thi tivities o! the company under analysis, ight ie business ac! Accounting information should be information is created, All companies Sinance those activities, invest in th used in the business context in which the s without exception, plan business activities, Ose activities and then, engage in operating II these activities while confronting business forces, includin; ig mi and competitive pressures. larket constraints Financial statem: ‘i information Ramee poe crucial input for strategic planning, as well % corrective action and nals pee Success of those plans which can be used new operating, investing and financing decisions.£ ee Understanding Financial Statements 53 f eNERAL OBJECTIVES OF FINANCIAL STATEMENTS ‘The im| I. ny portant objectives of financial statements are: 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.” . 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. = . 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. Information is useful in predicting how successful the enterprise is likely to be in raising further finance. 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. ¢$4_ Chapter 5 nnn —— 3. Providing Information About Performance of an Enterprise Another important objective of the financial statements is that, it tov) information about the performance and in particular its Profitability, Which s potential changes in the economic resouy Information about Variability op i sired in order to a ai likely to control the future. | t performance is important and us ul in predicting the capacity of the enterprise to generate cash flows from its existing resource base, ang in forming judgment about the effectiveness with which the enterprise might employ additional resources. 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 pau aud Prospective returns and risks to facilitate efficient contracting and risk- sharing. { The broad classes of users that demand fi the following: i inancial accounting information include Managers and Employees For their own well-bein employees heed accor Profitability and Pros; financial information nt 1g and prospective earnings, potential managers and unting information on the financial condition, Pects of their companies as well as comparative Manageme Uses finer n competing companies and business opportuni to meet disclosure arin ements to raise diene conn Femineration and bag tuirement and to serve as a basis for exec 0 requirements, nuses, for wage negotiations and to meet disclos> Understanding Financial Statements 55 Investors and Analysts Financial statements are.used by these Parties to deci sell equity shares. Expectations about future Pears rah o 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. . 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. |. 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. . Regulatory and Tax Agencies The SEC, BIR, BSP and other legal institutions demand financial accounting information to monitor the business firms’ conipliance with laws, for public protection, price setting and for setting tax and other Tegulatory policies. 3 » 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 to assess the company’s reliability and staying power. Potential tegic partners would wish to estimate the firm’s profitability to assess \ faimess of, returns on mutual transactions and strategic alliances.56 Chapter 5 7. Other decision makers Financial accounting information are required for varied purposes 4 parties from assessing damages for environmental abuses to making Poli 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 éstablish and maintain superior supplier customer relations in the input and output markets. a mle eas ely to disclose reliable (audited) accounting information about its Products, processes and other business activities enable them to better com in capital, labor, input and output markets.a {srs OF DISCLOSURE Understanding Financial Statements 517 ‘he preparation and dissemination costs of supplying accounting information can substantial, and the possibility for information to Produce competitive isadvantages is high. Companies are apprehensive that disclosures of their activities such as product or segment Successes OF failures, strategic initiatives, technological or systems iqovations could harm their competitive advantages. Companies also face sible 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 serutiny. CONSTRAINTS ON RELEVANT AND RELIABLE INFORMATION |. 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 © economic decision making needs of users. * Balance Between Benefit and Cost Heri between benefit and cost is a pervasive constraint rather than exceed ae characteristic. The benefits derived from information should owe, © Cost of providing it. The evaluation of benefits and costs is, t, substantially a judgmental process.58 Chapter 5 3; Balance Between Qualitative Characteristics a balancing or trade-off between qualitative characteristiog é Generally, the aim is to achieve an appropriate balance among the characteristics in order to meet the objective of Financia statements, The relative importance of the characteristics in different casey is a matter of professional judgment. In practice, often necessary. 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 a! 4 ‘Stocktbotdere ine Saran of Comprehensive Income, Statement © juit pear ty and the Statement of Cash Flows report on performance 0” The three statements in the mi cial ue ¢ middle of Fis 1 lit f financl Position from the beginning to the end of ee a oeUnderstanding Financial Statements _59 Statement of ‘Cash Flows Statement of Financial Position Statement of Financial Position Statement of Stockholders’ Equity (beginning-of- period) (end-of- period) Statement of Comprehensive Income Figure 5-1. Financial Statement Links across Time 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. ORANGE INC. Retained Earnings Reconciliation For the Year Ended September 30, 20X4 (pesos in millions) Retained earnings, September 30, 2013 5.607 Add: Net income 3.496 Less; Dividends (0) Other adjustments (.002) Retained earnings, September 30, 2014 9.101 Figure 5-2, Retained Earnings Reconciliation60 Chapter 5 . . ith stockholders (e.g., stock issuances, ur nt te gn stole ly eu inee and dividend payme wee statement, thus, measures the change in Company y, alg for the period. The a ‘ordance with financial reporting standards, Thi, is ng as measured in = value as measured by the market. Of course, ajj Vale Se aS find their way into the income statement. So, from along. ia perspective, the income statement does measure pes - company Value, This is why stock prices react to reported income and to analysts ©xPectations about future income. in 0X3- ith assets of P17.205 mill Orange Inc. begins the fiscal year 20X3-20X4 witl illion, eeeuisiaa of at for P6.392 million and noncash assets for 10.813 million, These investments are financed with P7.221 million from honowners and P9.934 ‘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 2.960 million from P6392 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). : lend information to update the a updated retai A € statement of financial position using” peskies ane 2ccount along with the remaining pce of fina stockholden equity aan balance, Third, it Prepares the stateme : I b si information from the cash account. and other atoment tea Irces,Understanding Financial Statements 61 Statement of Financial Position September 30, 20X4 & 20X3 (pesos in millions) 20X4 20X3 Assets Cash 9352 P 6392 Noncash assets 15.995 10.813 Total assets 925.347 P17.205 Liabilities and Owners’ equity Total liabilities P10.815 P 7.221 Owners’ equity Contributed capital 5.368 4.355 Retained earnings 9.101 Other stockholders’ equity 063 fies and Owners’ equity _ 25.347 Statement of Cash Flows Statement of Comprehensive Income forthe Year Ended September 30, 20X4 For the Year Ended September 30, 20X4 (pesos in millions) (pesos in millions) Operating cash flows P 5.470 Revenues 24.006 Investing cash flows (3.249) Expenses 20.510 Financing cash flows -2B9 ‘Net earnings Netchange in cash P2960 (Césh balance, Sep. 30, 20X3 6.392 Cash balance, Sep. 30, 20X4 P9.352 Statement of Stockholders’ Equity For the Year Ended September 30, 20X4 (pesos in millions) Contributed capital, Sep. 30, 20X3 4.355 Stock issuance 1.013 Coritributed capital, Sep. 30, 20X4 Retained earnings, Sep. 30. 20X3 5.607 Mims 3.496 Less: Dividends 0 Less: Other adjustments (.002) Retained earnings, Sep. 30,20X4 P9.101 Other stockholders” equity, Sep. 30, 20X3 P .022 Other changes in equity 2041 Other stockholders’ equity, Sep. 30, 20X4 _P hi leure S-3, Articulation of Orange Inc. Financial Statements62_Chapter 5 STATEMENT OF FINA! ‘nancial Position reports a company’s financial position at a nq. A Statement of Financi (assets) namely, what the company owns ang FR inti " rces. in time, the company’s resou! the sources of asset financing. There are two ways a company can finance : assets: 1. Owner financing. 2, Nonowner financing. It can also raise money from banks or othe, creditors and suppliers. c This means that both owners and nonowners hold claims on company assets, Owner claims on assets are referred to as Equity, and nonowner 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). NCIAL POSITION It can raise money from shareholders, Blue Company a Statement of Financial Position ae December 31, 20X4 point in time | (pesos in millions) Cash P 88.658 Total Noncash assets 457.662 resources }—> Total assets Financing }+> Liabilities and Owners’ equity = Total liabilities P 299.518 Nonowner Owners’ Equity claim on, Contributed capital 53.920 Tesources: Retained earings 144.306 Other equity* 48.576 [> _ Total Owners’ equity » 246.80: Total liabilities and owners’ equity 546,320 ° Figure 5-4. Statement of Financial Position —_—— statement tit ; ; : Statement includes es BeBin with word consolidated: This means tha the the parent Company owns. For Blu ee and one or more subsidiaries, companies comprehensive income and minority imeeene” Oe CAuity includes accumulated otherUnderstanding Financial Statements 63 tivities nvesting Act f financial position is organized like th i i fs giatement o ‘ e accounting equation. Inyestin, ivities are represented by the company’s assets. These assets are Meanie re gombination of nonowner financing (liabilities) and owner financing (equity). Financing Activities Assets must be paid for, and funding is provided by a combination of owner and nonowner financing. Owner (or equity) financing includes resources contributed to the company by its owners along with any profit retained by the company. Nonowner (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 nonowner financing? If. nonowner 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 4ssets and liabilities at fair values be more informative? What problems _ might fair-value reporting cause? i 4 at the Blue Company Statement of Financial Position summarized in Figure ink about these questions.64_Chapter 5 Working Capital assets are often called working capital because these assets “turn Cee et then replaced throughout the year. that is, they are used and Net’ working capital is the difference between current assets minus Curen, liabilities while net operating working capita is the difference between assets and non-interest bearing current liabilities. rey 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 an 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 = 236.490 million; expenses = P210.064 million; and net income 26.426 million. Net income reflects the profit (also called earnings) to owners for that specific period. Blue Company Statement of Comiprehensive Income For Year Ended December 31, 20X4 (pesos in millions) Goods or services Revenues 236.490 <—| Provided to Expenses 210.064 Net Income (loss) 26.42 ; Other comprehensive income as Coss incurred to Total ~ ee aot 0. 26.426 Figure 5-5, Statement of Comprehensive Income Manufacturing and merchandisi i i i ition! expense account, called ¢: sof ae gompanies cal nani eae Ost Fi nt of comprehensive income fo #1 Beads sold (or cos escles nn Se ta