Chapter 3

Understanding Financial Statements

The Basic Financial Statements

- contains a useful information regarding the financial position of a
company, the success of its operations, the policies and strategies of
management, and insight into its future performance. The four financial
statements are:

1. The statement of financial position

- shows the financial position- assets, liabilities and owners’ equity of
the firm on a particular date such as the end of a quarter or a year.

2. The income or earnings statement

- represents the results of operations- revenues, expenses, net profit or
loss, for the accounting period.

3. The statements of changes in equity

- which summarizes the changes in a company’s equity for a period of
time (generally one year)

4. The cash flow statement

- provides information about the cash inflows and outflows from
operating, financing, and investing activities during an accounting period.

Conceptual Framework for the Preparation and Presentation of Financial

Statements

Financial reporting standards

- rules used by accountants for preparing financial statements
- allow for significant latitude in how certain transactions should be
accounted for, meaning that professional judgment is particularly
important

Qualitative Characteristics of Accounting Information

There are several costs of providing information, including:

1. costs of collecting, processing and disseminating
2. cost of auditing
3. costs associated with dangers of litigation and loss of competitive
advantage
4. costs to the user for analysis and interpretation

The Statement of Financial Position

- shows the financial condition or financial position of a company on a
particular date.
 - Is a summary of what the firm owns (assets) and what the firm owes to
outsiders (liabilities) and to internal owners (stockholders’ equity)

Current Assets
- includes cash or those assets expected to be converted into cash, used or
consumed within one year or one operating cycle whichever is longer.
- Operating cycle – is the time required to purchase or manufacture
inventory, sell the product, and collect the cash.
- Working capital or net working capital – used to designate the amount by
which current assets exceed current liabilities

Cash and Cash Equivalents

- cash – cash in any form – cash awaiting deposit or in a bank account
- cash equivalents – short-term and highly liquid investment that are
readily convertible to cash and so near their maturity that they present
insignificant risk of changes in value because of change in interest rates.
- Only highly liquid investments that are acquired three months before
maturity can qualify as cash equivalents

Marketable Securities
- are cash substitutes, cash that is not needed immediately in the business
and is temporarily invested to earn a return.
- These investments are in instruments with short-term maturities (less
than one year) to minimize the risk of interest rate fluctuations
- They may also be presented as Investment in Trading Securities

Accounts Receivable
- are customer balances outstanding on credit sales and are reported on
the statement of financial position at their net realizable value
- actual losses are written off against the allowance account, which is
adjusted at the end of each accounting period
- the analyst should be alert to changes in the allowance account – both
relative to the level of sales and to the amount of accounts receivable
outstanding – and to the justification for any variations from past
practices

Inventories
- are items held for sale or used in the manufacture of products that will be
sold.
- A retail company, lists only one type of inventory on the statement of
financial position: merchandise inventories purchased for resale to the
public
- A manufacturing firm would carry three different types of inventories:
raw materials or supplies, work-in process and finished goods
 - The accounting method chosen to value inventory and the associated
measurement of cost of goods sold have a considerable impact on a
company’s financial position and operating results
- Inventory cost-flow assumption – the amount of inventory reported on
the statement of financial position and the cost of goods sold expense in
the income statement
- The method used to value inventory will be shown either on the face of
the statement of financial position with the inventory account or more
commonly in the note to the financial statements relating to inventory

Property, Plant and Equipment

Fixed assets
- also called tangible, long-lived and capital assets
- those assets not consumed in annual business operations
- produce economic benefits for more than one year and they are
considered “tangible” because they have physical substance
- other than land, fixed assets “depreciated” over the period the time
that benefit the firm

Book value
- the difference between original cost and any accumulated
depreciation and any accumulated impairment losses to date

Other Noncurrent Assets

- such as property held for sale, the cash surrender value of life insurance
policies, and long-term advance payments
- additional category of noncurrent assets frequently encountered is
intangible assets such as goodwill recognized in business combination,
patents, trademarks, copyrights, brand names, and franchises

Goodwill
- most important for analytical purposes because of its potential
materiality on the statement of financial position of firms heavily
involved in acquisitions activity
- Goodwill arises when one company acquires another company for a
price in excess of the fair market value of the net identifiable assets
acquired
- The cost of goodwill is not amortized but entities are required to
assess it annually for possible impairment

Current Liabilities
- liabilities represent claims against assets and current liabilities are those
that must be satisfied in one year or one operating cycle
- includes accounts and notes payable, the current portion of long-term
debt, accrued liabilities and deferred taxes
 Accounts payable
- are short-term obligations that arise from credit extended by
suppliers for the purchase of goods and services

Notes payable
- are short-term obligations in the form of promissory notes to
suppliers or financial institutions

Current Maturities of Long-term Debt

- when a firm has bonds, mortgages, or other forms of long-term debt
outstanding, the portion of the principal that will be repaid during
the upcoming year is classified as a current liability
- the note lists the amount of long-term debt outstanding, less the
portion due currently

Accrued Liabilities
- result from the recognition of an expense in the accounting records
prior to the actual payment of cash

Noncurrent Liabilities
- obligations with maturities beyond one year are designated on the
statement of financial position as noncurrent liabilities
- this category can include: bonded indebtedness, long-term notes payable,
mortgages, obligations under leases, pension liabilities, long –term
warranties and deferred income taxes

Deferred tax liabilities

- are the amounts of income taxes payable in future periods in respect
of taxable temporary differences

Equity
- the ownership interests in the company organized as a corporation are
represented in the final section of the statement of financial position,
stockholders’ equity or shareholders’ equity.
- Ownership equity is the residual interest in assets that remain after
deducting liabilities

Share Capital
- the amount listed under the share capital account is based on the par or
stated value of the shares issued. The par or stated value usually bears no
relationship to actual market price but rather is a floor price below which
the stock cannot be sold initially.
Additional Paid-In Capital
- the account reflects the amount by which the original sales price of the
stock shares exceeded par value as well as from other sources such as
donated capital, treasury stock transactions, etc

Retained Earnings
- the sum of every peso a company has earned since its inception, less any
payments made to shareholders in the form of cash or stock dividends.
- Are funds company has elected to reinvest in the operations of the
business rather than pay out to stockholders in dividends.
- Retained earnings should not be confused with cash or other financial
resources currently or prospectively available to satisfy financial
obligations. Rather, the retained earnings account is the measurement of
all undistributed earnings

Other Equity Accounts

- include preferred stock, foreign currency translation effects, treasury
stock, and the accumulation of unrealized gains or losses on investments
in debt and equity securities that are classified as noncurrent investments

THE INCOME STATEMENTS

The income statement comes in two basic formats and with considerable
variation in detail presented.
 The earnings statement in a multiple-step format – provides several
intermediate profit measures – gross profit, operating profit and earnings
before income tax – prior to the amount of net earnings for the period.
 The single-step version of the income statement groups all items of
revenue, then deducts all categories of expense to arrive at a figure for
net income.
 Discontinuing operations occur when a firm sells a major operation of its
business. The results of continuing operations are shown separately from
the operating results of the discontinued portion of the business. Any gain
or loss on the disposal is also disclosed separately
Net Sales
- total sales revenue for each year is shown net of returns and allowances
- a sales return is a cancellation of a sale
- sales allowance is a deduction from the original sales invoice price
- the remainder of the income statement reveals management’s ability to
translate sales peso into profits

Cost of Goods Sold

- the first expense deduction from sales is the cost to the seller of the
products sold to customers
- Venetian, Inc uses the LIFO (“last in, first out”) method, which means that
the last purchases made during the year have been charged to expense
- Cost of goods sold percentage – the relationship between cost of goods
sold and net sales, is an important one for profit determination because
cost of goods sold is the largest expense item for many firms

Gross Profit
- difference between net sales and cost of goods sold
- first step of profit measurement on the multiple-step income statement
and is a key analytical tool in assessing a firm’s operating performance
- the gross profit figure indicates how much profit the firm is generating
after deducting the cost of products sold

Operating Expenses
- include selling and administrative, advertising, lease payments,
depreciation and repairs and maintenance among others
  Selling and administrative expenses
- are expenses that relate to the sale of products or services and to the
management of the business
- they include salaries, rent, insurance, utilities, supplies and
sometimes depreciation and advertising expense

 Advertising costs
- should be a major expense in the budgets of companies for which
marketing is an important element of success

 Lease payments
- include the costs of rentals of leased facilities for retail outlets

 Depreciation and Amortization

- depreciation is used to allocate the cost of tangible fixed assets such
as buildings, machinery, equipment, furniture, and fixtures and
motor vehicles
- amortizations is the term applied to the cost expiration of intangible
assets such as patents, copyrights, trademarks, licenses, franchises
and goodwill
- the cost of acquiring and developing natural resources – oil and gas,
other minerals and standing timber – is allocated through depletion
- depreciation expense is calculated principally by the straight-line
method based upon estimated useful lives for buildings. Estimated
useful lives of leasehold improvements represent the remaining term
of the lease in effect at the time the improvements are made. Other
methods may be used such as sum-of-years’ digits, declining balance
method, etc

 Repairs and maintenance

- are the annual cost of repairing and maintaining the property, plant,
and equipment
- expenditures should correspond to the level of investment in capital
equipment and to the age and condition of the company’s fixed
assets.

Operating Profit
- also called EBIT or earnings before interest and taxes
- is the second profit determination and measures the overall performance
of the company’s operations: sales revenue less the expenses associated
with generating sales
Other Income (Expense)
- includes revenues and costs other than from operations, such as dividend
and interest income, interest expense, gains (losses) from investments
and gains (losses) from the sale of fixed assets

Earnings Before Income Taxes

- is the profit recognized before the deduction of income tax expense

Net Earnings
- or “the bottom line” represents the firm’s profit after consideration of all
revenue and expense reported during the accounting period

Earnings Per Ordinary Share

- is the net earnings for the period divided by the average number of
ordinary shares outstanding

THE STATEMENT OF CHANGES IN EQUITY

An enterprise should present as a separate component of financial
statements, along with the traditional financial statement, a statement showing:

a. the net profit or loss for the period

b. items of income (including gain) and expense (including loss)
which are recognized in equity, as required by this standard, and
the total of these items;
c. the cumulative effect of changes in accounting policy and the
correction of fundamental errors
d. capital transactions and distribution with/to owners of the
enterprise
e. the balance of accumulated profit or loss at the beginning of the
period and at the statement of financial position date, and the
movements for the period; and
f. a reconciliation between the carrying amounts of each class of
equity capital, share premium and each reserve at the beginning
and the end of the period, separately disclosing each movement
THE CASH FLOW STATEMENT
The cash flow statement provides information about cash inflows and
outflows during an accounting period segregated according to operating activities,
investing activities, and financing activities

An enterprise should report cash flows from operating activities using either:
1. the direct method, whereby major classes of gross cash receipts and gross
cash payments are disclosed; or
2. the indirect method, whereby net income or loss is adjusted for the
effects of transactions of a non-cash nature, any deferrals or accruals of
 past or future operating cash receipts or payments and items of income
or expense associated with investing or financing cash flows

The illustrative cash flow statement presents cash flows from operations using the
direct method
Cash Flows From Operating Activities
- these include cash effects of transactions and other events that enter into
the determination of income such as delivery or production of goods for
sale, providing services, operating expenses and other income expenses
- operating activities are principal revenue-producing activities of an
enterprise and include delivering or producing goods for sale and
providing services

Cash Flows From Investing Activities

- these include cash effects of transactions involving acquiring and selling
or otherwise disposing of:
a) securities that are not cash equivalents and
b) productive assets that are expected to benefit for long periods of
time and lending and collecting on loans

- investing activities – include the acquisition and disposition of property,

plant and equipment and other long-term assets and debt and equity
instruments of other enterprises that are not considered cash equivalents
or held for dealing or trading purposes
- investing activities also include:
1. cash advances and collections and loans made to other parties
2. cash payments and receipts for future contracts, formal contracts,
option contracts and swap contracts except when the contracts are
held for dealing and trading purposes or the payments or receipts
are classified as financing activities

Cash Flows From Financing Activities

- include cash effects of transactions involving borrowing from creditors
and repaying the principal and obtaining resources from owners and
providing them with a return on the investment
- financing activities – include obtaining resources from and returning
resources to owners as well as obtaining resources through borrowings
and repayments of the amounts borrowed

Challenges and Obstacles Confronting the User of Financial Statements

1. volume of information
2. complexity of the accounting rules
3. variations in the quality of financial reporting
4. impact of inflation of financial statement data
5. omission or difficult to find financial information

Volume of Information
The user of a firm’s annual report usually encounters a great quantity of
information that encompasses the required information such as:
  financial statements
 notes to the financial statements
 the auditor’s report
 summary of key financial data
 high and low stock prices
 management’s discussion and analysis of operations
 effect of foreign currency translation
 segmented data

Auditor’s report – related to the financial statements and notes is the report
of an independent auditor

Quality of Financial Reporting

1. Management can make choices with respect to accounting policies
and make estimations in the application of these policies
2. Management can exercise discretion regarding the timing of the
expense and revenue recognition
3. Many of the expenditures made by a business firm are discretionary
4. Existence of nonrecurring and non-operating items
5. Missing and difficult to find information
 Examples are:
 Intangibles as employee relations with management
 The morale and efficiency of employees
 The reputation of the firm with its customers
 Its prestige in the community
 The effectiveness of management
 Potential exposure to change in regulation

Impact of Inflation
- during a period of inflation, distortions occur in the valuation of assets
and determination of net income.
- For example, the effect of inflation on the statement of financial position
property, plant and equipment accounts for many firms which do not use
revalued amount would result to understatement of the asset account
and understatement of depreciation expense