UNIT III: UNDERSTANDING FINANCIAL STATEMENTS

A Detailed Report Presented to

The Faculty of the College in Business

Administration - Graduate School

University of the Cordilleras

In Partial Fulfillment

Of the Requirements for the Course

MSDM B003: MANAGERIAL ACCOUNTING

AND CONTROL i

Submitted by:

PURUGGANAN, ROMIE JON

CABALLERO, MARIA TERESA
TAMBUYAT, DANIELLE EVIA JASMIENE
UNIT 3. UNDERSTANDING FINANCIAL STATEMENTS

3.1 OVERVIEW OF THE BASIC FINANCIAL STATEMENT

3.2 THE BALANCE SHEET AND ITS COMPONENTS
3.3 THE STATEMENT OF RETAINED EARNINGS AND ITS COMPONENTS
3.4 THE STATEMENT OF CASH FLOWS AND ITS COMPONENTS

3.1 OVERVIEW OF THE BASIC FINANCIAL STATEMENT

DEFINITION

Financial statements are the means by which the information accumulated and
processed in financial terms is periodically communicated to the users. It is a
structured financial representation of the financial position and financial
performance of an entity in order to make sound business decisions.

COMPONENTS OF FINANCIAL STATEMENTS

A complete set of financial statements comprises the following components:

1. Statement of Financial Position

2. Statement of Profit and Loss and Other Comprehensive Income
3. Statement of Changes in Equity
4. Statement of Cash Flows
5. Notes to the Financial Statements (summary of significant accounting policies
and other explanatory information)

OBJECTIVE OF FINANCIAL STATEMENTS

The objectives of financial statements are to provide information about the

financial position, financial performance and cash flows of an entity that is
useful to a wide range of users in making economic decisions. It also shows the
managements stewardship of the resources entrusted to it.

To meet his objectives. Financial statements provide information about the

following:

1. Assets – resources controlled by the entity as a result of past transactions or

events from which future economic benefits are expected to flow to the entity.
2. Liabilities – present obligations of the entity arising from past transactions or
events, the settlement of which is expected to result in an outflow from the entity
of resources embodying economic benefits.
3. Equity – residual interest in the assets of the entity after deducting all of its
liabilities
4. Income and expenses including gains and losses
- INCOME is an increase in economic benefit during the accounting
period in the form of cash inflow or increase in asset or decrease in liability that
results in increase in equity.
- EXPENSE is decrease in economic benefit during the accounting period
in the form of an outflow or decrease in asset or increase in liability that results in
decrease in equity.
5. Contributions from and distributions to owners in their capacity as owners
- CONTRIBUTIONS FROM owners are increase in ownership interest resulting
from transfers from other owners
- DISTRIBUTIONS TO owners are decreases in ownership interest resulting
from transfers to owners.
6. Cash flows.
- CASH FLOWS are the cash receipts and payments arising from the
operating, investing and financing activities of the entity.

FINANCIAL POSITION

The financial position of an entity comprises its assets, liabilities and equity at a
particular moment in time. It pertains to the liquidity solvency and the need of
the entity for additional financing and is portrayed in the statement of financial
position.

FINANCIAL PERFORMANCE

The financial performance of an entity comprises its revenue, expenses and net
income or loss for a period of time. It is the level of income earned by the entity
through the efficient and effective uses of its resources as a result of operations
and is portrayed in the Statement of Profit and Loss and Other Comprehensive
Income.

USERS OF FINANCIAL STATEMENTS

User of financial information may be classified into two, Primary Users and Other
Users.

PRIMARY USERS include the existing and potential investors, lenders and other
creditors.

OTHER USERS include the employees, customers, governments and their

agencies, and the public.
3.2 THE BALANCE SHEET AND ITS COMPONENTS

BALANCE SHEET (STATEMENT OF FINANCIAL POSITION)

Balance sheet is a report on the financial position of a business enterprise at a

given point in time.

It comprises three main elements its assets, liabilities and equity.

ASSETS

Assets are the economic resources owned by the entity.

A. CURRENT ASSETS – are those that can be reasonably expected to be

sold, consumed or exhausted within one year of an enterprise’s normal
operations. Examples are;
a. Cash,
b. Cash and Cash Equivalent,
c. Trade and Receivables,
d. Inventories
e. Prepaid Expense

B. NON-CURRENT ASSETS – are those that cannot be used within an entities

normal operation or those that cannot be used within a year or that can be
utilized in more than one year. Examples are:
a. Property, Plant and Equipment
b. Long-term Investments
c. Intangible Assets
d. Other assets that do not fall under current assets or anything long term.

LIABILITIES

Liabilities are debts and obligations of the enterprise from lenders and other
creditors.

A. CURRENT LIABILITIES - are liabilities that are payable within one year or
within an enterprises normal operating cycle. Examples are;
a. Trade and other payables
b. Short-term borrowings
c. Current portion of long-term debt
d. Current tax liability
B. NON-CURRENT LIABILITIES – are long-term obligations that are held longer than
one year or that cannot be classified as current liabilities.
EQUITY
Equity is the residual interest of owners in the net assets of an enterprise
measured by the excess of asset over liabilities (Asset less Liabilities equal Equity)

STRUCTURE
A balance sheet shall present current and non-current assets including
current and non-current liabilities as a separate classification. It shall present all
assets and liabilities in the order of liquidity and must be faithfully represented.

A balance sheet heading specifically identifies at four significant items related

to the statement;
a. Name of the entity
b. Title of the statement
c. Specific date of the statement
d. Unit of monetary measure or currency

BAÑAGA FOREX TRADING, Inc.

BALANCE SHEET
December 31, 2020
ASSETS LIABILITIES
Current Assets Current Liabilities
₱ Trade and other ₱
Cash 10,500,000.00 Payables 500,000.00
Accounts ₱ Current portion of bonds ₱
Receivable 1,000,000.00 payable 100,000.00
₱ ₱
Inventories 200,000.00 Total Current Liabiliies 600,000.00
₱
Total Current Asset 11,700,000.00 Non-current Liabilities
Bonds payable ₱
Non-current Assets remaining portion 900,000.00
Plant Property ₱ Total Non-current ₱
Equipment 10,000,000.00 Liabilities 900,000.00
Total Non-current ₱ ₱
Asset 10,000,000.00 TOTAL LIABILITIES 1,500,000.00
₱
TOTAL ASSET 21,700,000.00 EQUITY
₱
Retained Earnings 20,200,000.00
₱
Total Equity 20,200,000.00
TOTAL LIABILITIES AND ₱
EQUITY 21,700,000.00
3.3.1 THE STATEMENT OF RETAINED EARNINGS AND ITS COMPONENTS

Retained earnings, otherwise known as accumulated profits, represent the

cumulative balance of periodic net income or loss, dividend distributions, prior
period errors, changes in accounting policy, and other capital adjustments.

An accumulated loss account or deficit happens when the retained earnings

account has a debit balance. In effect, this account decreases the
shareholders’ equity of a corporation.

There are two (2) kinds of retained earnings:

•Unappropriated retained earnings - These represent the portion which is free

and can be declared as dividends to shareholders.

•Appropriated retained earnings - These represent the portion which has been
restricted and therefore not available for dividend declaration.

The following options broadly cover some of the possibilities on how the surplus
money allocated to retained earnings and not paid out as dividends can be
utilized:

business operations expansion

launch a new product/variant
any possible merger, acquisition, or partnership
share buybacks
repay any outstanding loan (debt)

PROFORMA STATEMENT:
COMPONENTS:

Prior Period Adjustments

These are made in the financial statements to correct the incomes or expenses
arisen in the current year as a result of omissions or errors in the preparation of
financial statements of one or more periods in the past.

Mathematical mistakes
Misinterpretation of facts and figures
Failure to accrue or defer certain expenses or revenues
Oversights
Fraud or misuse of facts existed at the time financial statements were prepared
Mistakes in applying accounting policies

Comprehensive Income / Loss

Is Statement of Comprehensive Income and Income Statement same?

The statement of comprehensive income is a financial statement that

summarizes both standard net income and other comprehensive income (OCI).
The net income is the result obtained by preparing an income statement.
Whereas, other comprehensive income consists of all unrealized gains and losses
on assets that are not reflected in the income statement.

Some examples of these unrealized gains or losses are:

Gains or losses from pension and other retirement programs

Adjustments made to foreign currency transactions
Gains or losses from derivative instruments
Unrealized gains or losses from debt securities
Unrealized gains or losses from available-for-sale securities
Dividends

Dividends are economic resources distributed by the company to its

shareholders. It may be in the form of cash, shares (stocks), or other properties.
These dividends are the products of the company’s effort in achieving superior
performance for a particular period.

Important Dates in Dividends Distribution

•Date of declaration - It is the announcement of the board of directors (BOD) to

distribute dividends to its shareholder.

•Date of record - On this date, the corporation prepares the list of shareholders
who are entitled to receive dividends. No entry is required on this date

Treasury stock, also known as treasury shares or reacquired stock, refers to

previously outstanding stock that is bought back from stockholders by the issuing
company. The result is that the total number of outstanding shares on the open
market decreases. These shares are issued but no longer outstanding and are
not included in the distribution of dividends or the calculation of earnings per
share (EPS).

Rationale Behind Share Repurchases

There are several reasons why companies reacquire issued and outstanding
shares from the investors.

1. For reselling
Treasury stock is often a form of reserved stock set aside to raise funds or pay for
future investments. Companies may use treasury stock to pay for an investment
or acquisition of competing businesses. These shares can also be reissued to
existing shareholders to reduce dilution from incentive compensation plans for
employees.

2. For controlling interest

The repurchase action lowers the number of outstanding shares, therefore,
increasing the value of the remaining shareholders’ interest in the company. The
reacquisition of stock can also prevent hostile takeovers when the company’s
management does not want the acquisition deal to push through.

3. Undervaluation
When the market is not performing well, the company’s stock may be
undervalued – buying back the shares will usually boost the share price and
benefit the remaining shareholders.
4. Retiring of shares
When treasury stocks are retired, they can no longer be sold and are taken out
of the market circulation. In turn, the share count is permanently reduced, which
causes the remaining shares present in circulation to represent a larger
percentage of shareholder ownership, including dividends and profits.

5. For improving financial ratios

If there is a sound motive for the buyback of stocks, the improvement of
financial ratios may just be an after-effect of such good management decisions.
This results in an increase in the return on assets (ROA) ratio and return on equity
(ROE) ratio. This then illustrates positive company market performance.

Benefits of a Statement of Retained Earnings

The purpose of releasing a statement of retained earnings is to improve market

and investor confidence in the organization. It is used as a marker to help
analyze the health of a firm. Retained earnings do not represent surplus funds.
Instead, the retained earnings are redirected, often as a reinvestment within the
organization.

The retained earnings for a capital-intensive industry or a company in a growth

period will generally be higher than some less-intensive or stable companies. This
is due to the larger amount being redirected toward asset development. For
example, a technology-based business may have higher asset development
needs than a simple t-shirt manufacturer, as a result of the differences in the
emphasis on new product development.

While a t-shirt can remain essentially unchanged for a long period of time, a
computer or smartphone requires more regular advancement to stay
competitive within the market. Hence, the technology company will likely have
higher retained earnings than the t-shirt manufacturer.

The Retention Ratio

One piece of financial data that can be gleaned from the statement of
retained earnings is the retention ratio. The retention ratio (or plowback ratio) is
the proportion of earnings kept back in the business as retained earnings. The
retention ratio refers to the percentage of net income that is retained to grow
the business, rather than being paid out as dividends. It is the opposite of the
payout ratio, which measures the percentage of profit paid out to shareholders
as dividends.

The retention ratio helps investors determine how much money a company is
keeping to reinvest in the company's operation. If a company pays all of its
retained earnings out as dividends or does not reinvest back into the business,
earnings growth might suffer. Also, a company that is not using its retained
earnings effectively have an increased likelihood of taking on additional debt or
issuing new equity shares to finance growth.

As a result, the retention ratio helps investors determine a company's

reinvestment rate. However, companies that hoard too much profit might not
be using their cash effectively and might be better off had the money been
invested in new equipment, technology, or expanding product lines. New
companies typically don't pay dividends since they're still growing and need the
capital to finance growth. However, established companies usually pay a
portion of their retained earnings out as dividends while also reinvesting a
portion back into the company.
3.4.1 Understanding the Cash Flow Statement

The statement of cash flows, or the cash flow statement, is a financial

statement that summarizes the amount of cash and cash equivalents entering
and leaving a company. The cash flow statement (CFS) measures how well a
company manages its cash position, meaning how well the company
generates cash to pay its debt obligations and fund its operating expenses. The
cash flow statement complements the balance sheet and income
statement and is a mandatory part of a company’s financial reports since 1987.

Cash Flow Definitions

• Cash Flow – Inflows and outflows of cash and cash equivalent

• Cash Balance – Cash on hand and demand deposits (cash
balance on the balance sheet)
• Cash Equivalents – Cash equivalents include cash held as bank
deposits, short-term investments, and any very easily cash-
convertible assets – includes overdrafts and cash equivalents with
short-term maturities (less than three months)

4.2 How to Use a Cash Flow Statement

• Cash from operating activities can be compared to the company’s

net income to determine the quality of earnings. If cash from
operating activities is higher than net income, earnings are said to
be of “high” quality”.
• This statement is useful to investors because, under the notion that
cash is king, it allows investors to get an overall sense of the
company’s cash inflows and outflows and obtain a general
understanding of its overall performance. It allows investors to
understand how a company's operations are running, where its
money is coming from, and how money is being spent. The CFS The
CFS is important since it helps investors determine whether a
company is on a solid financial footing.
• Creditors, on the other hand, can use the CFS to determine how
much cash is available (referred to as liquidity) for the company to
fund its operating expenses and pay its debts. If the company is
funding losses from operations or financing investments by raising
money (debt or equity) it will quickly become clear on the
statement of cash flows.
4.3 Difference of Cash Flow Statement from Income Statement

Cash Flow Statement Income Statement

The cash flow statement is linked to
the income statement by net profit or
net loss, which is usually the first line
item of a cash flow statement, used
to calculate cash flow from
operations.
Shows the exact amount of a
company's cash inflows and outflows
over a period of time.
Cash Flow Statement is strictly for cash
transactions only.
Income statement follows accrual
accounting, whereas a cash flow
statement does not. Thus, entries in it
are recorded only when money
exchanges hands.
Income statement also records non-
cash revenues and expenses.

The income statement and the cash flow statement are two out of the three
components of a financial statement, the other being the balance sheet.
Though they both differ in the types of information they show, the income
statement reflecting a business's performance via its revenues, expenses, and
profits, and the cash flow statement reflecting how that profit or loss flows
throughout the company, they are both inseparably linked. The cash flow
statement cannot exist without the income statement, as it begins with the net
income or loss derived from the income statement, and goes onto show how
well a company manages its cash position.

Cash Flow vs Profit

Cash Flow Profit

Cash flow can be positive or negative.
Positive cash flow indicates that a
company has more money moving into
it than out of it. Negative cash
flow indicates that a company has more
money moving out of it than into it.
Profit is typically defined as the balance
that remains when all of a business’s
operating expenses are subtracted from
its revenues.
It’s what's left when the books are
balanced and expenses are subtracted
from proceeds.
Profit can either be distributed to the
owners and shareholders of the
company, often in the form of dividend
 payments, or reinvested back into the
company.

It gives the investors an idea about the

ability of a company to meet its future
obligations.

For example, if an income statement shows a net profit of $100, it does not
really mean that the company has increased its cash repository by $100
because income statement also reports non-cash transactions. But the bottom
figure of $100 in a cash flow statement certainly means that the company has
increased its cash deposits by $100 during the previous accounting period.

It's important to note that the CFS is distinct from the income statement
and balance sheet because it does not include the amount of future incoming
and outgoing cash that has been recorded on credit. Therefore, cash is not the
same as net income, which on the income statement and balance sheet
includes cash sales and sales made on credit.

4.4 Components of a Cash Flow Statement

The main components of the cash flow statement are:

1. Cash from operating activities
2. Cash from investing activities
3. Cash from financing activities
4. Disclosure of noncash activities is sometimes included when prepared
under the Generally Accepted Accounting Principle (GAAP).

Cash Flow from Operating Activities

The operating activities on the CFS include any sources and uses of cash
from business activities. In other words, it reflects how much cash is generated
from a company's products or services. Generally, changes made in cash,
accounts receivable, depreciation, inventory, and accounts payable are
reflected in cash from operations.
These operating activities might include:

• Receipts from sales of goods and services

• Interest payments
• Income tax payments
• Payments made to suppliers of goods and services used in production
• Salary and wage payments to employees
• Rent payments
 • Any other type of operating expenses

In the case of a trading portfolio or an investment company, receipts from

the sale of loans, debt, or equity instruments are also included. When preparing
a cash flow statement under the indirect method, depreciation, amortization,
deferred tax, gains or losses associated with a noncurrent asset, and dividends
or revenue received from certain investing activities are also included. However,
purchases or sales of long-term assets are not included in operating activities.

This includes cash arising out of the core business the company is in. The
difference between the revenue generated out of the sales of the products and
the cost will be cash flow from operating activities. For example, purchases or
sales of a product, increase or decrease in current assets and current liabilities,
depreciation, expenses relating to trading, administrative, selling expenses, etc.

Cash Flow from Investing Activities

This section of the cash shows the investment a company makes. It

includes cash spent in capital expenditures or the cash raised out of a sale of
long-term assets or any other form of investment. Includes the acquisition and
disposal of non-current assets and other investments not included in cash
equivalents. Investing cash flows typically include the cash flows associated with
buying or selling property, plant, equipment (PP&E), other non-current assets,
and other financial assets.
Cash spent on PP&E is called Capital Expenditures (CapEx)

Investing activities include any sources and uses of cash from a

company's investments. A purchase or sale of an asset, loans made to vendors
or received from customers, or any payments related to a merger or acquisition
is included in this category. In short, changes in equipment, assets, or
investments relate to cash from investing.
Usually, cash changes from investing are a "cash out" item, because cash is used
to buy new equipment, buildings, or short-term assets such as marketable
securities. However, when a company divests an asset, the transaction is
considered "cash in" for calculating cash from investing.

Cash Flow from Financing Activities

• A company will look to expand its business from time to time. To finance
this, the company will either raise equity or debt. This comprises of cash
from financing activities.
• Cash flow from financing activities are activities that result in changes in
the size and composition of the equity capital or borrowings of the entity.
 • Cash from financing activities includes cash flows associated with
borrowing and repaying bank loans, and issuing and buying back shares.
Payment of dividends, payments for stock repurchases, and the
repayment of debt principal (loans) are included in this category.
• Changes in cash from financing are "cash in" when capital is raised, and
they're "cash out" when dividends are paid. Thus, if a company issues a
bond to the public, the company receives cash financing; however,
when interest is paid to bondholders, the company is reducing its cash.

HOW TO PREPARE A CASH FLOW STATEMENT

The operation section of the Statement of cash flows can be shown through
either the direct method or the indirect method. With either method, the
investing and financing sections are identical; the only difference is in the
operating section. The direct method shows the major classes of gross cash
receipts and gross cash payments. The indirect method, on the other hand,
starts with the net income and adjusts the profit/loss by the effects of the
transactions. In the end, cash flows from the operating section will give the same
result whether under the direct or indirect approach, however, the presentation
will differ. The International Accounting Standards Board (IASB) favors the direct
method of reporting because it provides more useful information than the
indirect method. However, it is believed that greater than 90% of public
companies use the indirect method.

Cash flow is calculated by making certain adjustments to net income by adding

or subtracting differences in revenue, expenses, and credit transactions
(appearing on the balance sheet and income statement) resulting from
transactions that occur from one period to the next.

How Cash Flow Is Calculated?

PROFIT P
DEPRECIATION D
AMORTIZATION A
IMPAIRMENT EXPENSE I
CHANGE IN WORKING CAPITAL ΔWC
CHANGE IN PROVISIONS ΔP
INTEREST TAX (I)
TAX (T)
OPERATING CASH FLOW OFC

• These adjustments are made because non-cash items are calculated into
net income (income statement) and total assets and liabilities (balance
 sheet). Because not all transactions involve actual cash items, many items
have to be re-evaluated when calculating cash flow from operations.
• Cash flow from operations for a time period can be determined using
either the direct or indirect method.
• As a result, there are two methods of calculating cash flow: the Direct
Method and the Indirect Method.

Depreciation expense reduces profit but does not impact cash flow (it is a non-
cash expense). Hence, it is added back. Similarly, if the starting point profit is
above interest and tax in the income statement, then interest and tax cash flows
will need to be deducted if they are to be treated as operating cash flows.

There is no specific guidance on which profit amount should be used in the

reconciliation. Different companies use operating profit, profit before tax, profit
after tax, or net income. Clearly, the exact starting point for the reconciliation
will determine the exact adjustments made to get down to an operating cash
flow number

Direct Cash Flow Method

What Is the Direct Method?

• The direct method is also known as the Income Statement Method.

• Uses actual cash inflows and outflows from the company's operations,
instead of modifying the operating section from Accrual Accounting to a
cash basis. Accrual accounting recognizes revenue when it is earned
versus when the payment is received from a customer.
• Measures only the cash that's been received, which is typically from
customers and the cash payments or outflows, such as to suppliers. The
inflows and outflows are netted to arrive at the cash flow.
• The cash flow direct method determines changes in cash receipts and
payments, which are reported in the cash flow from the operations
section.
• The direct method for the statement of cash flows provides more detail
about the operating cash flow accounts, although it's time-consuming.
• The cash flow statement's direct method takes the actual cash inflows
and outflows to determine the changes in cash over the period
Example of the Statement of Cash Flows Direct Method
Lowry Locomotion constructs the following statement of cash flows using the
direct method:
Lowry Locomotion Statement of Cash Flowsfor the year ended 12/31/x1
Cash flows from operating activities

Cash receipts from customers $45,800,000

Cash paid to suppliers (29,800,000)

Cash paid to employees (11,200,000)

Cash generated from operations 4,800,000

Interest paid (310,000)

Income taxes paid (1,700,000)

Net cash from operating activities $2,790,000

Cash flows from investing activities

Purchase of property, plant, and (580,000)

equipment

Proceeds from sale of equipment 110,000

Net cash used in investing activities (470,000)

Cash flows from financing activities

Proceeds from issuance of common 1,000,000

stock

Proceeds from issuance of long-term 500,000

debt

Principal payments under capital lease (10,000)

obligation

Dividends paid (450,000)

Net cash used in financing activities 1,040,000

Net increase in cash and cash 3,360,000

equivalents

Cash and cash equivalents at beginning 1,640,000

of period

Cash and cash equivalents at end of $5,000,000

period
Indirect Cash Flow Method

What Is the Indirect Method?

• The indirect method takes the net income generated in a period and
adds or subtracts changes in the asset and liability accounts to determine
the implied cash flow.
• The indirect method uses increases and decreases in balance sheet line
items to modify the operating section of the cash flow statement from
the accrual method to the cash method of accounting.
• With the indirect method, cash flow from operating activities is calculated
by first taking the net income off of a company's income
statement. Because a company’s income statement is prepared on an
accrual basis, revenue is only recognized when it is earned and not when
it is received.
• The indirect method is more commonly used in practice, especially
among larger firms. With the indirect method, cash flow from operating
activities is calculated by first taking the net income off of a company's
income statement.
• The indirect method presents the statement of cash flows beginning
with net income or loss, with subsequent additions to or deductions from
that amount for non-cash revenue and expense items, resulting in cash
flow from operating activities. Net income is not an accurate
representation of net cash flow from operating activities, so it becomes
necessary to adjust earnings before interest and taxes (EBIT) for items that
affect net income, even though no actual cash has yet been received or
paid against them.
• The indirect method also makes adjustments to add back non-operating
activities that do not affect a company's operating cash flow.

For example, depreciation is not really a cash expense; it is an amount that is

deducted from the total value of an asset that has previously been accounted
for. That is why it is added back into net earnings for calculating cash flow.
Example of the Statement of Cash Flows Indirect Method
Phantom Books following statement of cash flows using the indirect method:

Direct Method vs Indirect Method

Direct Method
In the Direct Method, all individuals
instances of cash that are received or
paid out are tallied up and total is the
resulting cash flow.
Indirect Method
In the indirect method, the
accounting line items such as net
income, depreciation, etc. are used
to arrive at cash flow.
In financial modeling, the cash flow
statement is always produced via the
indirect method.
Below is a comparison of the Direct Method vs the Indirect Method.
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