Financial Background:

A Review of
Accounting, Financial
Statements, and Taxes
Accounting Systems
and
Financial Statements
Accounting Systems and Financial Statement

➢ Virtually everything business enterprises do is recorded as a series of

money transactions within the structure of an accounting systems.

➢ The record and the system itself provide the framework most
managements use to control their business.

➢ Accounting systems produce several standards reports known as

“Financial Statements” that reflects business performance.
 Financial ● Are numerical representations
of a firm’s activities for an
Statements accounting period.
Nature of Financial Statements

❖ Financial statements are numerical representations of what it is

physically doing.
❖ The idea behind statements is to give a picture of what’s happening
within the company and between the company and the rest of the world
both physically and financially.
Nature of Financial Statements

● Recorded Facts
● Accounting Conventions
● Assumptions
● Personal Judgement
Nature of Financial Statements
● Recorded Facts

-Financial statements prepared on the basis of recorded facts.

-All the business transactions which are having financial character alone recorded in the
books of accounts (journals, ledger and other subsidiary books).

● Accounting Conventions

-guidelines used to help companies determine how to record certain business transactions
that have not yet been fully addressed by accounting standards.
 Nature of Financial Statements
● Assumptions

- assumptions are important because they form the building blocks on which financial
accounting measurements is based.

● Personal Judgement

- plays a vital role in the preparation of financial records and financial statements.
Management accounts may use their judgement in choosing the method of valuations
of closing inventory, in calculating the provisions for bad debt and in changing the
depreciation of fixed assets.
Is Income “Income”?

-Most people think of income as the money they’re paid, which, after payroll
withholding,is what they take home.

-The income statement is one of the traditional financial statements. It starts with the
dollar amount the company has sold,deducts cost, expenses, and taxes, and winds up with
the figure called net income (earnings after tax).

- Two major differences between net income and cash flowing into the company’s
pocket.
 ● Receiving a promise of later
Accounts payment rather than

Receivable immediate cash.

● Uncollected payments for
product sold.
 ● Deduction taken to account
for the decline in value of
Depreciation assets, such as machines
used in a business, over a
period of time.
● Used to offset the cost of
acquiring the asset.
Conclusion:

❏ Clearly these practices indicate hat accounting

income is conceptually different from paycheck
income and the financial statements are concerned
with more than just the flow of money in and out
of the business.
The three Financial Statements

1. Income statement
2. Balance sheet
3. Statement of Cash Flow
-the income statement and balance sheet is basic statement that
derived from the books of account.

-the statement of cash flows is developed from them.

 ● An accounting system is
organized set of rules by which
every transaction the firm
makes is recorded in a set of
The Accounting records.
● The records are collectively
System known as the company’s
“books”. Books used to be kept
in ledgers that looked like
books - hence the name.
 ● Books are separated into a
series of “accounts”. An
The Accounting account generally holds
records of transactions of a
System particular type or those
related to a particular part of
the business.
 Example:

Revenue account receives all the

The Accounting transactions involving the sale of
System product to customers, while Fixed
asset account receives records
related to the acquisition and
disposal of heavy machinery.
 Transactions- includes activities
like selling product, buying
The Accounting inventory and equipment, paying
wages, building product,
System borrowing money, paying taxes,
and paying dividends.
 ● Means that each entry has
Double Entry two equal parts called sides.
Each side of an entry is
System made to a different account.
Double Entry System Example
 ● At the end of each period all the
transactions occurring in the
Accounting period are totaled and
company’s books are brought up
Periods to date as of the last day of the
period.
and Closing ● Books are closed by updating

Books the period’s transactions in the

accounting system and creating
financial statements.
 ● It’s important to keep in mind
that last year’s financial
statements don’t say anything
Implications about what’s going on this
year or what will happen next
year. They refer only to the
past.
 ● There is a fundamental
difference between the two basic
financial statements. The income
statement reflects flows of
money over a period of time.
Stock and Flows The balance sheet represents
stocks of money at a point in
times.
● Revenue flow in while costs and
expenses flow out. The
difference is profit.
 INCOME
STATEMENT
INCOME ● An income statement shows
STATEMENT how much money a company
has earned during the
accounting period, commonly a
year.
Table 2-1 A Conventional Income Statement
Format
 ● Sales, also called revenue,
represents the total receipts
Sales from selling whatever it is the
company is in business to sell.
 ● Cost of goods sold and
Cost and expenses are subtracted from
sales to arrive at earnings
Expense before interest and taxes.
 ● COGS (usually just called Cost)
Cost of Goods represents spending on things

Sold
that are closely associated with
the production of the product
or service being sold.
Cost of Goods Sold Example
 ● Sometimes called gross profit

Gross Margin margin, is simply sales revenue

less COGS.
 ● Expenses represent spending

Expense
on things that, although
necessary, aren't closely related
to production.
 ● Although not a separate line on
most income statement,
Depreciation depreciation is an important
item.
● Both cost and expense usually
include some depreciation.
 Interest and Earnings
Before Interest and Taxes
 ● If the firm is partially financed
with borrowed money (debt), it
has to pay interest on those
Interest ●
borrowings.
If a business is completely
financed with the owners'
money (equity), there's no
interest at all.
 ● If part of the financing is
borrowed, the firm is burdened
Interest with debt and the associated
interest payments.
● Leverage is the use of debt
financing
Earnings Before ● Operating Profit (EBIT) is a

Interest and business's profit before

consideration of financing
Taxes charges.
Earnings Before Tax
and Tax
Earnings Before ● Gross Margin less all all
expense, including interest,
Tax yields earnings before tax.
 ● The tax line on the Income
statement refers to income
taxes on the amount of
earnings before tax.
● Companies pay other taxes, but
Tax those appear as cost or
expense items farther up on
the Income statement.
● However, the statutory tax rate
applied to earnings before tax
doesn't always give the tax
shown on the statement.
 ● The tax figure also doesn't
necessarily reflect the tax
actually due, because some
items are treated differently for
Tax ●
tax and reporting purposes.
When the tax due is different
from the tax shown , most of
the difference is usually taken
to a deferred tax account on
the balance sheet.
 ● Net income, also called

Net Income
earnings, belongs to the
company's owners. It can either
be paid out as dividends or
retained in the business.
Retained ● Retained earnings become an

Earnings
addition to owner's equity on
the balance sheet.
● Retained earnings are those
not paid out as dividends.
BALANCE SHEET
BALANCE ● The balance sheet lists
everything a company owns

SHEET and everything it owes at a

moment in time.
● A balance sheet has two sides.
One lists all of the company's
assets, and the other lists all of
its liabilities and equity.
BALANCE ● The two sides must be equal
,or "balance" - hence the
SHEET balance sheet.
● The balance sheet is
sometimes called the
Statement of Financial
Position.
Table 2-2 A Conventional Balance Sheet
Format
Assets = Liabilities + Equity

Accounting Equation
 ● The ease with which an asset

Liquidity
becomes cash.
● Both assets and liabilities are
arranged in decreasing order of
liquidity.
Cash ● The most liquid asset.
 Account ● Next comes account receivable

Receivable
because one expects that, in
the normal course of business,
receivables will be collected in
cash within a few days.
 ● Next is inventory because it is
Inventory normally sold in short order,
generating cash or a
receivable.
 ● Are low on the list because
they would generally have to be
Fixed Assets sold on a used equipment
market to be turned into
money. Similar logic applies on
the liabilities side.
ASSETS
 ● money on bank checking
Cash accounts plus currency on
hand.
Accounts ● represent credit sales that have

Receivable
not yet been collected.
 ● also called allowance for
doubtful account.

● is designed to be an offset to
The Bad-Debt the trade receivable account.

Reserve ● This offset allows for the fact

that most businesses make
some credit sales that are
never paid.
 ● It should be written off if the

Writing off a
receivables is known to be
uncollectible.

Receivable ● It means reducing the balance

in accounts receivable by the
uncollected amount.
 ● Profit reductions caused by
uncollectible receivables are
distasteful, ao managements
Overstated sometimes postpone writing
off bad debts that should be
Receivables recognized.

● This causes the receivables

balance to include amounts
that will never be collected.
Sample Problem

Writing Off a Large Uncollectible Receivables:

Good Guy Inc. has the following balances:

Gross accounts receivable ₱5,650

Bad-debt Reserve (290)

Net accounts receivable ₱5,360

Notice that the bad-debt reserve is approximately 5% of the gross receivables

balance, which is likely to represent normal losses of about 3% of sales plus a little
cushion for unexpected problems.
Last year, a customer approved for credit purchases up to only ₱100,000 placed an
order for product costing ₱435,000. Eager for the business, Goodguy’s president
accepted the order over the CFO’s objections. The customer has just gone out of
business without paying any part of the bill. Goodguy’s product is not recoverable.
What are the financial statement implications of writing off the bad debt? Assume
Goodguy’s direct cost of goods sold is 60% of sales revenue.
Solution:
Goodguy must reduce gross receivables by 435,000. Because of the double
entry accounting, the entry accomplishing that reduction must be offset with
opposing entries totaling the same amount If Goodguy starts by using the entire
bad-debt reserve to offset the loss, the balance sheet accounts will be:

Gross accounts receivable ₱5,215

Bad-debt Reserve 0

Net accounts receivable ₱5,215

That leaves (₱435,000 – ₱290,000 =) ₱145,000 to be charged to a bad debt
expense account impacting the income statement with a reduction in earnings
before tax (pretax profit).

But notice that now the firm has no reserve against normal bad-debt losses.
Reestablishing a 5% reserve will require additional charges to bad-debt expense
over the next few months totaling (₱5,215,000 x .05 = ) ₱260,750. Thus, the
total impact on the current income statement will be a reduction in pretax profit
of (₱145,000 + ₱250,750 =) ₱405,750.
Inventory ● is a product held for sale in the
normal course of business.
Work in Process ● contains the cost of raw

(WIP) materials and the cost of an

increasing amount of labor as
Inventories it moves toward becoming
finished product.
 ● Inventory reserve account is

The Inventory
created for items predicted that
will not be able to sold because

Reserve Items can be damaged,

become spoiled, get stolen and
become obsolete.
 ● If inventory discovered to be
missing, damaged, or obsolete,
the balance sheet inventory

Writing Off Bad

account must be reduced to
reflect the loss.

Inventory ● If the loss is large, part of the

reduction may have to be offset
directly to an expense account,
resulting in a reduction in profit.
 Cause:

Overstated
● Managements usually try to
avoid reducing recorded

Inventory
profits. Thus, they are prone to
accept any rationalization to
the effect that the inventory is
holding its original value.
 In receivables and inventories:

● can be a significant problem to

users of financial statements.

In assets:

Overstatements ● The firm value is less than it is

being held out to be.

*Can also be mean that the

company is not managed
effectively.
 ● It is a long-lived assets. Many
things can be in this category,
the predominant item is usually

Fixed Assets fixed assets, which can be also

called property, plant, and
equipment (PPE).
● A fixed assets is something
that has a useful life of at least
one year.
 ● The first three assets on out
balance are called current

Current Assets ●
assets.
The term “current” means that
in the normal course of
business, these items can be
expected to become cash
within one year.
 ● Depreciation is an artificial
accounting device that spreads
the cost of an asset over its
estimated useful life regardless
Depreciation of how it is acquired or paid
for.
● According to Matching
Principle, recognition of asset’s
cost should match its service
life
Financial Statement
Presentation
 ● It is the entry posting
Accumulated depreciation expense to the
income statement posts the

Depreciation same amount to a balance

sheet account.
● It is carried as an offset to the
value of an asset, so at any
time the value of the asset is
the difference between its
original cost and its
accumulated depreciation
Table 2-3 Fixed Assets Depreciation

Suppose a firm buys a truck for $10,000 and decides to depreciate

it over a useful life of four years at $2,500 each year. During the same
period, each year’s balance sheet will carry three numbers related to
the asset: its gross value, its accumulated depreciation, and its net
value.
Table 2-3 Fixed Assets Depreciation
 ● Net book value is not market

Disposing of a value. The asset may be salable

on the used of equipment

Used Asset market for an amount that’s

more or less than its NBV at any
time. It’s important to
understand the accounting
treatment if that occurs.
Example 2-2 Concept Connection

Suppose the truck in table 2-3 is sold after three years for $4,000 paid
immediately in cash,

a. What revenue and profit would the firm recognize on that

transaction?
b. What ash flow would be generated if the firm’s tax rate is 30%?
Example 2-2 Concept Connection
SOLUTION:

The revenue from the sale is simply the price received, $4,000. The
cost takes a little more thinking. The truck was originally purchased for
$10,000, but three-fourths of that amount has already been recognized as
cost/expense on the income statement through the depreciation entries
on the left side of the Table 2-3. After three years, those total $7,500, so
only $2,500 of the truck’s original cost remains to be recognized. That
amount is conveniently available on the balance sheet as the truck’s
third-year NBV. Hence we have the following:
Example 2-2 Concept Connection

a. Profit

Revenue $4,000
Cost (NBV) 2,500
Profit Contribution to EBT $1,500
Example 2-2 Concept Connection

a.
Example 2-2 Concept Connection
b.
Accounting Cash Flow

Revenue $4,000 $4,000

Cost (NBV) 2,500
Profit Contribution to EBT 1,500
Tax (30%) 450 450
Contribution to net income $1,050
Cash Flow $3,550
Example 2-2 Concept Connection

b.
 ● Depreciation runs over the
estimated useful life of an asset.

The Life Estimate However, it’s quite common for

things to last beyond their
estimated lives. Assets still in
use beyond their life estimates
are said to be fully depreciated.
Tax Depreciation and Tax Books
The government provides many incentives to
business through the tax system. One of the
most prominent involves depreciation, which is a
tax-deductible expense.
Tax-deductible ● It is any expense that is
considered “ordinary, necessary,

Expense
and reasonable” and that helps a
business to generate income.
● Deductibility implies that higher
depreciation in a given year
results in lower tax in that year,
because taxable profit is lower.
● Accelerated Depreciation
recognizes more of an asset’s
cost in the early years of its life.
 ● Depreciation is a financial
Depreciation fiction; it doesn’t represent a
current flow of money even
Is a Noncash though it’s treated as a cost or
an expense. It has nothing to
Expense do with how an asset is
acquired or paid for.
● It is simply an ongoing charge
to the carrying amount of a
fixed asset, designed to reduce
the recorded cost of the asset
over its useful life.
Total Assets ● It is the sum of all current and
long-term assets held by a
company
LIABILITIES
 LIABILITIES
It represents what the company owes to
outsiders
 ● It arise when firms buy from
vendors on credit (called trade
Accounts credit)

Payable
● In most companies, the bulk of
accounts payable arises from
the purchase of inventory.
● When a credit sale is made, the
seller records receivable and
the buyer records a payable
 ● The length of time allowed until
payment is due.
● Common terms involve

Terms of Sale
payment within 30 days and
include a discount.
● Trade credit is generally free in
that no interest is charged if
the full amount is paid within
the allowed time.
 ● Conditions in which the firm
has liabilities that are not
reflected on the balance sheet.
Understated -For example, its possible to

Payables receive goods from a vendor,

use it, and simply not recognize
the transaction financially.
Eventually, the vendor will
demand payment and the issue
will be raised but may take a
while
 ● They are an accounting device

Accruals
used to recognize expenses
and liabilities associated with
transactions that are not
entirely complete.
Payroll Accrual
 ● There are accruals for for any
number of things. For example,
suppose a company is billed in
arrears for property tax at the end
of government fiscal year in June.

Other Accruals
If the firm closes its books at the
end of December, it owes the local
government for 6 months of
property tax even though it has
received no bill and won’t until
June. A property tax accrual
properly reflects this expense and
liability in the meantime.
 ● Defined as items requiring

Current payment in one year; hence,

payables and accruals are
Liabilities ●
classified as currents.
Other current liabilities include
notes payable, short-term
loans, and any long-term debt
that’s within a year
 ● Current liabilities are
collectively referred to as gross
working capital while the
difference between current
assets and current liabilities is

Working Capital ●
known as net working capital.
Net working capital represents
the amount of money a firm
needs to carry on its routine
day-to-day activities.

Net working capital = current

assets - current liabilities
 ● Common practice to refer to it
simply as debt, especially if

Long-term debt
there isn’t much short-term
debts.
● Long-term debt usually
consists of bonds and
long-term loans
 ● A business that is financed
with debt.

Leverage ● Using borrowed money can

enhance the return on an
entrepreneur’s own investment
EQUITY
 EQUITY
Represents fund supplied to business by their owners. These
funds are in two forms: direct investments and retained
earnings.
 ● One is entitled common stock
The and represents arbitrary

Representation
amount called par value of
each share times the number

of Direct
of shares outstanding.
● The other account is called

Investments by paid in excess and represents

the amount paid for the stock

its Owners over its par value.

 ● Earnings paid out are said to be

Retained distributed; those kept in

business are retained.
Earnings ● The account shows all earnings
ever retained by the company
just as the stock accounts
show all money ever invested
directly by owners.
 ● It is a security issued by some
firms that is effectively a cross
between debt and common

Preferred Stock
equity.
● It is classified as equity and is
included in equity section of
balance sheet. Total equity is
the sum of common and
preferred equity.
 ● The sum of long-term debt and
Total Capital ●
equity is total capital.
Generally used to support
long-term assets.
 ● It is the sum of the right side of
Total Liabilities the balance sheet reflects

and Equity
where all of the company’s
funds have come from and the
obligation it has to outsiders
and owners as a result pf those
advances.
TAX ENVIRONMENT
 The Tax Environment

Tax Authorities
- Taxes(a) are imposed by various government authorities.

Three common taxing authorities (US)

● Federal - Central government.
● State - Organized political community under central government.
● Local (cities and counties) - Units of government in a State.

(a) Tax is a compulsory financial charge or some other type of levy imposed on taxpayer (an individual or legal
entity) by a governmental organization in order to fund government spending and various public expenditures.
 Tax Bases
- It is the items that is taxed, usually income, wealth, and consumption.
Three (3) common tax bases
Income Tax Wealth Tax Consumption Tax

➢ The taxpayer pays a ➢ Also called valorem ➢ It is based on the amounts of

fraction of income in a taxes. certain goods we use.
➢ Sales tax is paid by end users
designated time period ➢ It is based on the value of
of the product on its
(taxable year) to the certain types of assets. purchase price. It is imposed
taxing authority. ➢ The most common by local and state
wealth tax is levied by governments.
cities and counties on the ➢ Federal government also
value of real estate. impose its consumption
taxes called excise taxes(a).

(a) Excise tax is a consumption taxes impose on certain items such as alcohol, tobacco, and gasoline.
Income Taxes: Total Effective Tax Rate
- Total effective tax rate (TETR) is the combined rate to which the taxpayer is
subject. It is not simply the sum of federal and state rates, because state tax
is deductible from income in the calculation of federal tax.

ILLUSTRATION
Suppose a taxpayer is
subject to 30% federal
tax and a 10% state tax
on income of $100. He or
she would pay as
follows;
Progessive Tax Systems, Marginal and Average Rates
- The U.S. federal income tax systems is progressive. In a progressive tax
system, a taxpayer’s tax rate increases as income increases.

➢ A progressive system might be one ILLUSTRATION

which everyone earning less than Taxpayer earnings $25,000 would calculate taxes
$20,000 pays 20% rate, but those as follows;
earn over $20,000 pay 30% on
earning over $20,000.
➢ Notice that taxpayers with income
over $20,000 don’t pay the higher
rate on their entire income, but only
on the amount over $20,000.

● Progressive tax system is characterized by the higher tax rates on incrementally higher income.
 Progressive taxation system in the Philippines

● The higher the income earned, the higher the tax rate & fixed tax due charged to a taxpayer.
 Distribution of Chapters
Ma Luz Anne Go Marilet Tagum

❏ Accounting Systems and Financial ❏ Assets (Part 1)

Statements Cash to Overstatements

*The nature of financial statements Precious Cablao

❏ Assets (Part 2)
* Accounting System
Fixed Assets to Total Assets
Ruffa Mae Vargas
Cristina Lourdes De Castro
❏ Income Statement
❏ Liabilities
* Presentation ❏ Equity
Jetrho Lenin Buera
❏ Balance Sheet
❏ Tax Environment
* Presentation ❏ Income Tax Calculations