13 Lesson 2 REVIEW OF FINANCIAL STATEMENTS. Financial statements are written records that convey the business activities and the financial performance of a company. Financial statements are often audited by government agencies, accountants, firms, etc, to ensure accuracy and for tax, financing, or investing purposes. Financial statements include: Statement of Financial Position (Balance Sheet), Statementof Profit or Loss (Income Statement), Statement of Changes in Equity, Cash flow statement and Notes to financial Statements, Annual Financial Stateme: Constituents of A ts al Financia statements > WallstretMojo. This lesson covers the following topics: = The major financial statements * The information contained in the financial statements ‘The purpose, format, components, and presentation of the financial statements Rok effective financial decision making At the end of the lesson, the student shall be able to: = Enumerate the basic financial statements. = Identify and discuss the information contained in the financial statements. = Describe the purpose, format, components, and presentation of the financial statements. = Discuss the role of financial statements in decision making Financial Statements represent a formal record of the financial activities of an entity. These are reports that quantify the financial strength, performance and liquidity of a company. These are used by investors, market analyst and creditors to evaluate a company’s financial health and earings potential.14 ‘The four basic financial statements are Statement of Financial Position- also known as the Balance Sheet, shows the financial position of an entity at a given date. It is comprised of the following three elements: - Assets: Something a business owns or controls (e.g. cash, inventory, plant and machinery, etc) - Liabilities: Something a business owes to someone (e.g. creditors, bank loans, etc) - Equity: What the business owes to its owners. This represents the amount of capital that remains in the business afer its assets are used to pay off its outstanding liabilities. Equity therefore represents the difference between the assets and liabilities. Income Statement. also known as the Profit and Loss Statement, reports the ‘company's financial performance in terms of net profit or loss over a specified Period. Income Statement is composed of the following two elements: Income: What the business has earned over a period (e.g. sales revenue, dividend income, etc) - Expense: The cost incurred by the business over a period (e.g. salaries and ‘wages, depreciation, rental charges, etc) Net profit or loss is arrived by deducting expenses from income. Statement of Changes in Equity- summarizes the changes in a company’s equity for a period of time (generally one year). This is also known as the Statement of Retained Eamings, details the movement in owners’ equity over a period. The movement in owners’ equity is derived from the following components: - Net Profit or loss during the period as reported in the income statement ~ Share capital issued or repaid during the period Dividend payments Gains or losses recognized directly in equity (e.g. revaluation surpluses) ~ Effects of a change in accounting policy or correction of accounting error Cash Flow Statement - presents the movement in cash and bank balances over a period. The movement in cash flows is classified into the following segments: Operating Activities: Represents the cash flow from primary activities of a business, ~ Investing Activities: Represents cash flow from the purchase and sale of assets other than inventories (e.g. purchase of a factory plant) - Financing Activities: Represents cash flow generated or spent on raising and repaying share capital and debt together with the payments of interest and dividends,15 Financial Statements reflect the effects of business transactions and events on the entity. The different types of financial statements are not isolated from one another but are closely related to one another as is illustrated in the following diagram, Ea Sa pereeres Seppe! eee Cer) Balance Sheet, or Statement of Financial Position, is directly related to the income statement, cash flow statement and statement of changes in equity Assets, liabilities and equity balances reported in the Balance Sheet at the period end consist of. = Balances at the start of the period; = The increase (or decrease) in net assets as a result of the net profit (orloss) reported in the income statement; = The increase (or decrease) in net assets as a result of the net gains (or losses) recognized outside the income statement and directly in the statement of changes in equity (e.g. revaluation surplus); = The increase in net assets and equity arising from the issue of share capital as reported in the statement of changes in equity; = The decrease in net assets and equity arising from the payment of dividends as presented in the statement of changes in equity; = The change in composition of balances arising from inter balance sheet transactions not included above (e.g. purchase of fixed assets, receipt of bank loan, etc). * Accruals and Prepayments + Receivables and Payables16 Income Statement, or Profit and Loss Statement, is directly linked to balance sheet, cash flow statement and statement of changes in equity, The increase or decrease in net assets of an entity arising from the profit or loss reported in the income statement is incorporated in the balances reported in the balance sheet at the period end. The profit and loss recognized in income statement is included in the cash flow statement under the segment of cash flows from operation after adjustment of non-cash transactions. Net profit or loss during the year is also presented in the statement of changes in equity Statement of Changes in Equity is directly related to balance sheet and income statement. Statement of changes in equity shows the movement in equity reserves as reported in the entity's balance sheet at the start of the period and the end of the period. The statement therefore includes the change in equity reserves arising from share capital issues and redemptions, the payments of dividends, net profit or loss reported in the income statement along with any gains or losses recognized directly in equity (e.g. revaluation surplus), Statement of Cash Flows is primarily linked to balance sheet as it explains the effects of change in cash and cash equivalents balance at the beginning and end of the reporting period in terms of the cash flow impact of changes in the components of balance sheet including assets, liabilities and equity reserves, Cash flow statement therefore reflects the increase or decrease in cash flow arising from: = Change in share capital reserves arising from share capital issues and redemption; ‘Change in retained earnings as a result of net profit or loss recognized in the income statement (after adjusting non-cash items) and dividend payments; = Change in long term loans due to receipt or repayment of loans; = Working capital changes as reflected in the increase or decrease in net current assets recognized in the balance sheet; = Change in non-current assets due to receipts and payments upon the acquisitions and disposals of assets (i.e. investing activities) ‘The objective of financial statements is to provide information about the financial position, performance and changes in financial position of an enterprise that is useful to a wide range of users in making economic decisions (IASB Framework).7 Financial Statements provide useful information to a wide range of users: Managers require Financial Statements to manage the affairs of the company by assessing its financial performance and position and taking important business decisions. Shareholders use Financial Statements to assess the risk and retum of their investment in the company and take investment decisions based on their analysis. Prospective Investors need Financial Statements to assess the viability of investing in a company. Investors may predict future dividends based on the profits disclosed in the Financial Statements. Furthermore, risks associated with the investment may be gauged from the Financial Statements. For instance, fluctuating profits indicate higher risk. Therefore, Financial Statements provide a basis for the investment decisions of potential investors, Financial Institutions (e.g. banks) use Financial Statements to decide whether to grant a loan or credit toa business. Financial institutions assess the financial health of a business to determine the probability of a bad loan. Any decision to lend must be supported by a sufficient asset base and liquidity Suppliers need Financial Statements to assess the credit worthiness of a business and ascertain whether to supply goods on credit. Suppliers need to know if they will be repaid. Terms of credit are set according to the assessment of their customers’ financial heatth. Customers use Financial Statements to assess whether a supplier has the resources to ensure the steady supply of goods in the future. This is especially vital where a customer is dependent on a supplier for a specialized component. Employees use Financial Statements for assessing the company's profitability and its consequence on their future remuneration and job security. Competitors compare their performance with rival companies to learn and develop strategies to improve their competitiveness. General Public may be interested in the effects of a company on the economy, environment and the local community. Governments require Financial Statements to determine the correctness of tax declared in the tax returns. Government also keeps track of economic progress through analysis of Financial Statements of businesses from different sectors of the ‘economy,18 Lesson 2.4 Limitations of Accounting & Financial Reporting Accountancy assists users of financial statements to make better financial decisions. It is important however to realize the limitations of accounting and financial reporting when forming those decisions. Different accounting policies and frameworks Accounting frameworks such as IFRS allow the preparers of financial statements to use accounting policies that most appropriately reflect the circumstances of their entities. Whereas a degree of flexibility is important in order to present reliable information of a particular entity, the use of diverse set of accounting policies amongst different entities impairs the level of comparability between financial statements. ‘The use of different accounting frameworks (e.g. IFRS, US GAAP) by entities operating in different geographic areas also presents similar problems when ‘comparing their financial statements. The problem is being overcome by the growing use of IFRS and the convergence process between leading accounting bodies to arrive at a single set of global standards. Accounting estimates Accounting requires the use of estimates in the preparation of financial statements where precise amounts cannot be established. Estimates are inherently subjective and therefore lack precision as they involve the use of management's foresight in determining values included in the financial statements. Where estimates are not based on objective and verifiable information, they can reduce the reliability of ‘accounting information Professional judgment The use of professional judgment by the preparers of financial statements is important in applying accounting policies in a manner that is consistent with the economic reality of an entity's transactions. However, differences in the interpretation of the requirements of accounting standards and their application to practical scenarios will always be inevitable. The greater the use of judgment involved, the more subjective financial statements would tend to be. Veritiability Audit is the main mechanism that enables users to place trust on financial statements. However, audit only provides ‘reasonable’ and not absolute assurance on the truth and faimess of the financial statements which means that despite carrying audit according to acceptable standards, certain material misstatements in financial statements may yet remain undetected due to the inherent limitations of the audit, Use of historical cost Historical cost is the most widely used basis of measurement of assets. Use of historical cost presents various problems for the users of financial statements as it fails to account for the change in price levels of assets over a period of time, This not only reduces the relevance of accounting information by presenting assets at19 amounts that may be far less than their realizable value but also fails to account for the opportunity cost of utilizing those assets. The effect of the use of historical cost basis is best explained by the use of an example, Company A purchased a plant for P 100,000 on 1st January 2016 which had a useful life of 10 years. Company B purchased a similar plant for P200,000 on 31st December 2020. Depreciation is charged on straight line basis. At the end of the reporting period at 31st December 2020, the balance sheet of Company B would show a fixed asset of P200,000 while A's financial statement would show an asset of P50,000 (net of depreciation). The scenario above presents an accounting anomaly. Even though the plant presented in A’s financial statements is capable of producing economic benefits worth 50% of Company B's asset, itis carried at a historical cost equivalent of just 25% of its value. ‘Moreover, the depreciation charged in A's financial statements (i.e. P10,000 p.a.) does not refiect the opportunity cost of the plant's use (i.e. P20,000 p.a.). As a result, over the course of the asset's life, an amount of P100,000 would be charged as depreciation in A's financial statements even though the cost of maintaining the productive capacity of its asset would have notably increased. If Company A were to distribute all profits as dividends, it will nat have the resources sufficient to replace its existing plant at the end of its useful life. Therefore, the use of historical cost may result in reporting profits that are not sustainable in the long term. Due to the disadvantages associated with the use of historical cost, some preparers of financial statements use the revaluation model to account for long-term assets. However, due to the limited market of various assets and the cost of regular valuations required under revaluation model, it is not widely used in practice. An interesting development in accounting is the use of ‘capital maintenance’ in the determination of profit that is sustainable after taking into account the resources that would be required to ‘maintain’ the productivity of operations. However, this accounting basis is stillin its early stages of development. Measurability ‘Accounting only takes into account transactions that are capable of being measured in monetary terms. Therefore, financial statements do not account for those resources and transactions whose value cannot be reasonably assigned such as the competence of workforce or goodwill. Limited predictive value Financial statements present an account of the past performance of an entity. They offer limited insight into the future prospects of an enterprise and therefore lack predictive value which is essential from the point of view of investors.20 "Fraud and error Financial statements are susceptible to fraud and errors which can undermine the overall credibility and reliability of information contained in them. Deliberate manipulation of financial statements that is geared towards achieving predetermined results (also known as ‘window dressing’) has been a unfortunate reality in the recent past as has been popularized by major accounting disasters such as the Enron Scandal. * Cost benefit compromise Reliability of accounting information is relative to the cost of its production. At times, the cost of producing reliable information outweighs the benefit expected to be gained which explains why, in some instances, quality of accounting information might be compromised. ‘The statement of financial position shows the financial condition or position of a company on a particular date. The statement is a summary of what the firm owns(assets) and what the fim owes to outsiders( liabilities) and to intemal owners(stockholders' equity). ‘Statement of Financial Position helps users of financial statements to assess the financial soundness of an entity in terms of liquidity risk, financial risk, credit risk and business risk, ‘Statement of financial position helps users of financial statements to assess the financial health of an entity. When analyzed over several accounting periods, balance sheets may assist in identifying underlying trends in the financial position of the entity. Itis particularly helpful in determining the state of the entity's liquidity risk, financial risk, credit risk and business risk. When used in conjunction with other financial statements of the entity and the financial statements of its competitors, balance sheet may help to identify relationships and trends which are indicative of potential problems or areas for further improvement. Analysis of the statement of financial position could therefore assist the users of financial statements to predict the amount, timing and volatility of entity's future earnings.a Example’ Following is an illustrative example of a Statement of Financial Position prepared under the format prescribed by IAS 1 Presentation of Financial Statements. Statement of Financial Posi As at 31" December 2019 2019 2018 Notes PHP PHP ASSETS Current assets Cash and cash equivalents 4 8,000,000 10,000,000 Trade receivables 5 25,000,000 30,000,000 Inventories 6 12,000,000 __ 10,000,000 45,000,000 50,000,000 Non-current assets Property, plant and equipment 7 130,000,000 120,000,000 Goodwill 8 30,000,000 30,000,000 Intangible assets 9 60,000,000 __ 50,000,000 220,000,000 _ 200,000,000 TOTAL ASSETS 265,000,000 250,000,000 LIABILITIES AND EQUITY Current liabilities Trade and other payables 10 35,000,000 25,000,000 Short-term borrowings 11 10,000,000 8,000,000 Current portion of long-term borrowings 12 15,000,000 15,000,000 Current tax payable 13, 5,000,000 __ 2,000,000 Total current liabilities 65,000,000 50,000,000 Non-current liabilities Long term borrowings 12 35,000,000 50,000,000 Total liabilities 100,000,000 — 100,000,000 Equity Share capital 14 100,000,000 100,000,000 Retained earnings 45 50,000,000 40,000,000 Revaluation reserve 16 15,000,000 __ 10,000,000 Total equity 165,000,000 _ 750,000,000 TATAL EQUITY AND LIABILITIES 265,000,000 250,000,00022 Statement of financial position consists of the following key elements: = Assets ‘An asset is something that an entity owns or controls in order to derive economic benefits from its use. Assets must be classified in the balance sheet as current or non-current depending on the duration over which the reporting entity ‘expects to derive economic benefit from its use. An asset which will deliver ‘economic benefits to the entity over the long term is classified as non-current whereas those assets that are expected to be realized within one year from the reporting date are classified as current assets, Assets are also classified in the statement of financial position on the basis of their nature: - Tangible & intangible: Non-current assets with physical substance are classified as property, plant and equipment whereas assets without any physical substance are classified as intangible assels. Goodwill is a type of an intangible asset. - Inventories balance includes goods that are held for sale in the ordinary course of the business. Inventories may include raw materials, finished goods and works in progress. Trade receivables include the amounts that are recoverable from customers upon credit sales. Trade recelvables are presented in the statement of financial position after the deduction of. - Cash and cash equivalents include cash in hand along with any short term investments that are readily convertible into known amounts of cash. + Liabilities A liability is an obligation that a business owes to someone and its settlement involves the transfer of cash or other resources, Liabilities must be classified in the statement of financial position as current or non-current depending on the duration ‘over which the entity intends to settle the liability. A liability which will be settled over the long term is classified as non-current whereas those liabilities that are expected to be settled within one year from the reporting date are classified as current liabilities. Liabilities are also classified in the statement of financial position on the basis of their nature: Trade and other payables primarily include liabilities due to suppliers and contractors for credit purchases. Sundry payables which are too insignificant to be presented separately on the face of the balance sheet are also classified in this category. - Short term borrowings typically include bank overdrafts and short term bank loans with a repayment schedule of less than 12 months.23 ~ Long-term borrowings comprise of loans which are to be repaid over a period that exceeds one year. Current portion of long-term borrowings include the installments of long term borrowings that are due within one year of the reporting date. - Current Tax Payable is usually presented as a separate line item in the statement of financial position due to the materiality of the amount. Equity Equity is what the business owes to its owners. Equity is derived by deducting total liabilities from the total assets. It therefore represents the residual interest in the business that belongs to the owners. Equity is usually presented in the statement of financial position under the following categories: - Share capital represents the amount invested by the owners in the entity, - Retained Earnings comprises the total net profit or loss retained in the business after distribution to the owners in the form of dividends. - Revaluation Reserve contains the net surplus of any upward revaluation of property, plant and equipment recognized directly in equity. Current Assets Current assets include cash or those assets expected to be converted into cash, used or consumed within one year or one operating cycle whichever is longer. The operating cycle is the time required to purchase or manufacture inventory, sell the product and collect the cash. The designation current refers essentially to those assets thal are continually used up and replenished in the ongoing operations of the business, Cash and Cash Equivalents- cash in any form- cash awaiting deposit or in a bank account, Cash equivalents are short-term and highly liquid investment that are readily convertible into cash and so near their maturity that they present insignificant risk of changes in value because of changes in interest rates. Only highly liquid investments that are acquired three months before maturity can qualify as cash equivalents. ‘Marketable Secunties- are cash substitute, cash that is not needed immediately in the business and is temporarily invested to earn a return, Accounts receivable- are customer balances outstanding on credit sales and are reported on the statement of financial position at their net realizable value, that is, te actual amount of the account less an allowance for doubful accounts.24 + Inventories: are items held for sale or used in the manufacture of products that wil be sold. A retail company, lists only one type of inventory on the statement of financial position: merchandise inventories purchased for resale to thepublic. A manufacturing firm, in contrast, would carry three different types of inventories: raw materials or supplies, work-in process, and finished goods. * Prepaid expenses- are expenses paid for in advance. Certain expenses, such as insurance, rent, property taxes, and utilities are sometimes paid in advance. They are included in current assets if they will expire within one year or one operating cycle, whichever's longer. Generally, prepayments are not material to the statement of financial position as a whole. + Property, Plant and Equipment. are physical or tangible assets that are long-term assets that typically have a life or more than one year. Examples of property, plant and equipment(PP&E) include: vehicles like trucks, office furniture, machinery buildings and land * Other noncurrent assets- include a multitude of other noncurrent items such as property held for sale, the cash surrender value of life insurance policies, and long- term advance payments. additional categories of noncurrent assets frequently encountered are long-term investments and intangible assets such as goodwill recognized in business combination, patents, trademarks, copyrights, brand names and franchises. Current Liabilities- represents claims against assets that must be salisfies in one year or fone operating cycle, whichever is longer. Current liabilities include 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 purhcase of goods and services. * Notes payable-are short-term obligations in the form of promissory notes to ‘suppliers or financial institutions. * Current matunties 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 classifiedm as a current liability, The note lists the amount of long-term debt outsdtanding, 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. Thus, they are liabilities because there will be an eventual cash outflow to satisty the obligations ‘Noncurrent Liabilities- obligations with maturities beyond one year. This include bonded indebtedness, long-term notes payable, mortgages, obligations under leases, pension liabilities, long-term warranties, and deferred income taxes. = Mortgage- a loan used either by purchasers of real property to raise funds to buy real estate, or alternatively by existing peoprty owners to raise funds for any purpose while putting a lien on the property being mortgaged.25 * Doferred tax liabilities. the amounts of income taxes payable in future periods in respect to taxable temporary differences. = Pension liabilities-the difference between the total amount due to retirees and the actual amount of money the company has on hand to make those payments. + Warranty liability- an account in which a company records the amount of the repair or replacement cost that it expects to incur for products already shipped or services already provided Equity-the residual interest in assets that remain after deducting abilities. The owners bear the greatest risk because their claims are subordinate to creditors in the event of liquidation but owners also benefit from the rewards of a successful enterprise. * Share capital- also known as capital stock, is the portion of a corporation's equity that has been obtained by the issue of shares in the corporation to a shareholder, usually for cash. There are two general types of share capital, which are common ‘stock (also known as ordinary shares) and preferred stock, ‘Common stock is a security that represents ownership in a corporation. Holders of ‘common stock elect the board of directors and vote on corporate policies. This form of equity ownership typically yields higher rates of return long term. However, in the event of liquidation, common shareholders have rights to a company's assets only after bondholders, preferred shareholders, and other debt holders are paid in ful Preferred stock refers to a class of ownership that has a higher claim on assets and earnings than common stock has. Holders of preferred stock have a higher claim ‘on distributions (e.g. dividends) than common stockholders. Preferred stockholders usually have no or limited, voting rights in corporate govemance. In the event of liquidation, preferred stockholders claim on assets is greater than common stockholders but less than bondholders. Also, preferred stock has characteristics of both bond and common stock which enhances its appeal to certain investors, ‘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 (APIC)- also known as capital surplus is the amount of money that a company’s shareholders pay for shares in excess of the par value of the shares. APIC can be created whenever a company issues new shares and can be reduced when a company repurchases its shares, APIC applies both common stocks and preferred stocks. + Retained Earnings- is the amount of net income left over for the business after it has paid out dividends to its shareholders. Often this profit is paid out to shareholders but it can also be re-invested back into the company for growth purposes. This amount is adjusted whenever there is an entry to the accounting records that impacts a revenue or expenses account. A large retained eamings balance implies a financially healthy organization,26 * Other Equity Accounts- include foreign currency translation effects, treasury stock, and the accumulation of unrealized gains and losses on investments in debt and equity securities that are classified as noncurrent investments. ‘Rationale - Why the balance sheet always balances? The balance sheet is structured in a manner that the total assets of an entity equal to the sum of liabilities and equity. This may lead you to wonder as to why the balance sheet must always be in equilibrium, Assets of an entity may be financed from intemal sources (i. share capital and profits) or from external credit (e.g. bank loan, trade creditors, etc.). Since the total assets of business must be equal to the amount of capital invested by the owners (i. in the form of share capital and profits not withdrawn) and any borrowings, the total assets of a business must equal to the sum of equity and liabilities. This leads us to the Accounting Equation: Assets = Liabilities + Equity Income Statement, also known as Profit & Loss Account, is a report of income, ‘expenses and the resulting profit or loss eared during an accounting period. ‘An income statement reports a company's financial performance over a specific accounting period. This provides valuable insights into a company’s operations, the efficiency of its management, underperforming sectors and its performance relative to industry peers. Income statement is prepared on the accruals basis of accounting. This means that income (including revenue) is recognized when it is earned rather than when receipts are realized (although in many instances income may be eamed and received in the same accounting period). Conversely, expenses are recognized in the income statement when they are incurred even if they are paid for in the previous or subsequent accounting periods. Income statement does not report transactions with the owners of an entity, Hence, dividends paid to ordinary shareholders are not presented as an expense in the income statement and proceeds from the issuance of shares is not recognized as an income. Transactions between the entity and its owners are accounted for separately in the statement of changes in equity Income Statement provides the basis for measuring performance of an entity over the course of an accounting period.ar Performance can be assessed from the income statement in terms of the following: = Change in sales revenue over the period and in comparison to industry growth + Change in gross profit margin, operating profit margin and net profit margin over the period * Increase or decrease in net profit, operating profit and gross proft over the period = Comparison of the entity's profitability with other organizations operating in similar industries or sectors Income statement also forms the basis of important financial evaluation of an entity when it is analyzed in conjunction with information contained in other financial statements such as: = Change in earnings per share over the period = Analysis of working capital in comparison to similar income statement elements (e.g. the ratio of receivables reported in the balance sheet to the credit sales reported in the income statement, i.e, debtor turnover ratio) = Analysis of interest cover and dividend cover ratios Income statement comprises of the following main elements: = Revenue Revenue includes income earned from the principal activities of an entity. So for ‘example, in case of a manufacturer of electronic appliances, revenue will comprise of the sales from electronic appliance business. Conversely, if the same manufacturer earns interest on its bank account, it shall not be classified as revenue but as other income. * Cost of Sales Cost of sales represents the cost of goods sold or services rendered during an accounting period Hence, for a retailer, cost of sales will be the sum of inventory at the start of the period and purchases during the period minus any closing inventory. In case of a manufacturer however, cost of sales will also include production costs incurred in the manufacture of goods during a period such as the cost of direct labor, direct material consumption, depreciation of plant and machinery and factory overheads, ete. + Other income Other income consists of income earned from activities that are not related to the entity's main business. For example, other income of an entity that manufactures electronic appliances may include: Gain on disposal of fixed assets Interest income on bank deposits Exchange gain on translation of a foreign currency bank account28 Distribution Cost Distribution cost includes expenses incurred in delivering goods from the business premises to customers. Administrative Expenses Administrative expenses generally comprise of costs relating to the management and support functions within an organization that are not directly involved in the production and supply of goods and services offered by the entity, Examples of administrative expenses include: Salary cost of executive management Legal and professional charges Depreciation of head office building Rent expense of offices used for administration and management purposes Cost of functions / departments not directly involved in production such as finance department, HR department and administration department Other Expenses This is essentially a residual category in which any expenses that are not suitably classifiable elsewhere are included Finance Charges Finance charges usually comprise of interest expense on loans and debentures. ‘The effect of present value adjustments of discounted provisions are also included in finance charges (e.g. unwinding of discount on provision for decommissioning cost). Income tax Income tax expense recognized during a period is generally comprised of the following three elements: Current period's estimated tax charge Prior period tax adjustments Deferred tax expense29 Example’ Following is an illustrative example of an Income Statement prepared in accordance with the format prescribed by JAS 1 Presentation of Financial Statements. Income Statement for the Year Ended 31- December 2019 2019 2018 Notes PHP PHP Revenue 16 420,000,000 100,000,000 Cost of Sales 7 (65,000,000) (55,000,000) Gross Profit 55,000,000 45,000,000 Other income 8 17,000,000 42,000,000 Distribution Cost 19 (10,000,000) (8,000,000) ‘Administrative Expenses 20 (18,000,000) (16,000,000) Other Expenses 2 (3,000,000) (2,000,000) Finance Charges 22 (1,000,000) (1,000,000) Profit before tax Income tax 23 (12,000,000) (9,000,000) Net Profit 28,000,000 27,000,000 + Net sales- are total revenue less the cost of sales retums, allowances, and discounts. This is the primary sales figure reviewed by analyst when they examine the income statement. Since sales are the major revenue source for most ‘companies, the trend of this igure is a key element in performance measurement, * Gross profit- the difference between net sales and cost of goods sold. A high gross profit indicates that a company is successfully producing profit over and above its costs. * Operating expenses- include selling and administrative, advertising, lease payments, depreciation and repairs and maintenance among others. These are all areas over which management exercises discretion and which have considerable impact on the firm’s current and future profitability. It is important to track these accounts carefully in terms of trends, absolute amounts, relationship to sales, and relationship to industry competitors.30 = 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 -covers expenses associated with promoting an industry, entity, brand, product, or service. They cover ads in print media and online venues, broadcast time, radio time, and direct mail advertising, + Lease payments- is the monthly rent on real estate holdings, manufacturing ‘equipment, computers, software, or other fixed assets for a specified amount of time. * Depreciation expense- the amount of an asset cost that has been allocated and reported as an expense for the period (year, month, etc.) * Amortization expense- is the write —off of an intangible asset over its expected period of use which reflects the consumption of the asset. + Repairs and Maintenance-the annual cost of repairing and maintaining the property, plant and equipment. Expenditures in this area 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 earings 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. The figure for operating profit provides a basis for assessing the success of ‘a company apart from its financing and investing activities and separate from tax considerations. + Earnings before income taxes- the profit recognized before the deduction of income tax expense, * Net eamings- “the bottom line” represents the firm's profit after consideration of all revenue and expense reported during the accounting period, + Earnings per ordinary share- the net earings for the period divided by the average number of ordinary shares outstanding, Prior period financial information is presented alongside current period's financial results to facilitate comparison of performance over a period. It is therefore important that prior period comparative figures presented in the income statement relate to a similar period, For example, if an organization is preparing income statement for the six months ending 31 December 2019, comparative figures of prior period should relate to the six months ending 31 December 2018.a” Lesson 2.7.The Statement of Changes in Equity Statement of Changes in Equity, details the change in owners’ equity over an accounting period by presenting the movement in reserves comprising the shareholders’ equity. Movement in shareholders’ equity over an accounting period comprises the following elements: Net profit or loss during the accounting period attributable to shareholders Increase or decrease in share capital reserves. Dividend payments to shareholders, Gains and losses recognized directly in equity Effect of changes in accounting policies Effect of correction of prior period error ‘Statement of changes in equity helps users of financial statement to identify the factors that cause a change in the owners’ equity over the accounting periods. Whereas ‘movement in shareholder reserves can be observed from the balance sheet, statement of changes in equity discloses significant information about equity reserves that is not presented separately elsewhere in the financial statements which may be useful in understanding the nature of change in equity reserves. Examples of such information include share capital issue and redemption during the period, the effects of changes in accounting policies and correction of prior period errors, gains and losses recognized outside income statement, dividends declared and bonus shares issued during the period, Gomponents Following are the main elements of statement of changes in equity: = Opening Balance This represents the balance of shareholders’ equity reserves at the start of the ‘comparative reporting period as reflected in the prior period's statement of financial position, The opening balance is unadjusted in respect of the correction of prior Period errors rectified in the current period and also the effect of changes in ‘accounting policy implemented during the year as these are presented separately in the statement of changes in equity (see below). "Effect of Changes in Accounting Policies Since changes in accounting policies are applied retrospectively, an adjustment is required in stockholders’ reserves at the start of the comparative reporting period to restate the opening equity to the amount that would be arrived if the new accounting policy had always been applied.32 Effect of Correction of Prior Period Error The effect of correction of prior period errors must be presented separately in the statement of changes in equity as an adjustment to opening reserves. The effect of the corrections may not be netted off against the opening balance of the equity reserves so that the amounts presented in current period statement might be easily reconciled and traced from prior period financial statements, Restated Balance This represents the equity attributable to stockholders at the start of the ‘comparative period after the adjustments in respect of changes in accounting policies and correction of prior period errors as explained above. Changes in Share Capital Issue of further share capital during the period must be added in the statement of changes in equity whereas redemption of shares must be deducted therefrom. ‘The effects of issue and redemption of shares must be presented separately for share capital reserve and share premium reserve. Dividends Dividend payments issued or announced during the period must be deducted from shareholder equity as they represent distribution of wealth attributable to stockholders, Income / Loss for the period This represents the profit or loss attributable to shareholders during the period as reported in the income statement. Changes in Revaluation Reserve Revaluation gains and losses recognized during the period must be presented in the statement of changes in equity to the extent that they are recognized outside the income statement, Revaluation gains recognized in income statement due to reversal of previous impairment losses however shall not be presented separately in the statement of changes in equity as they would already be incorporated in the profit or loss for the period. Other Gains & Losses Any other gains and losses not recognized in the income statement may be presented in the statement of changes in equity such as actuarial gains and losses arising from the application of IAS 19 Employee Benefit. Closing Balance This represents the balance of shareholders’ equity reserves at the end of the reporting period as reflected in the statement of financial position.Example’ 33 Following is an illustrative example of a Statement of Changes in Equity prepared according to the format prescribed by PAS 1 Presentation of Financial Statements. ABC Ple Statement of changes in equity for the year ended 31% December 2019 Share Retained Revaluation Total Capital Earnings ‘Surplus Equity Php Php Php Php Balance at 1 January 2018 100,000,000 30,000,000 = 130,000,000 Changes in accounting policy - - : Correction of prior period error - - : Restated balance 100,000,000 30,000,000 = _ 130,000,000 Changes in equity for the year 2018 Issue of share capital - - - : Income for the year - 25,000,000 = 25,000,000 Revaluation gain = 10,000,000 10,000,000 Dividends = (15,000,000) = (15,000,000) Balance at 31 December 2018 100,000,000 40,000,000 10,000,000 150,000,000 Changes in equity for the year 2019 Issue of share capital = 2 - : Income for the year - 30,000,000 = 30,000,000 Revaluation gain 7 5 5,000,000 5,000,000 Dividends = (20,000,000) = (20,000,000) Balance at 31 December 2019 100,000,000 50,000,000 15,000,000 165,000,00034 Statement of Cash Flows, also known as Cash Flow Statement, presents the movement in cash flows over the period as classified under operating, investing and financing activities. Statement of cash flows provides important insights about the liquidity and solvency of a company which are vital for survival and growth of any organization. It also enables analysts to use the information about historic cash flows to form projections of future cash flows of an entity (e.g. in NPV analysis) on which to base their economic decisions. By summarizing key changes in financial position during a period, cash flow statement serves to highlight priorities of management. For example, increase in capital expenditure and development costs may indicate a higher increase in future revenue streams whereas a trend of excessive investment in short term investments may suggest lack of viable long term investment opportunities. Furthermore, comparison of the cash flows of different entities may better reveal the relative quality of their earnings since cash flow information is more objective as opposed to the financial performance reflected in income statement ‘which is susceptible to significant variations caused by the adoption of different accounting policies. Example: Following is an illustrative cash flow statement presented according to the indirect, method suggested in IAS 7 Statement of Cash Flows: ‘ABC PLC Statement of Cash Flows forthe year ended 31 December 2019 2019 2018 Notes PHP PHP Cash flows from operating activities Profit before tax 40,000,000 35,000,000 Adjustments for: Depreciation 4 10,000,000 8,000,000 ‘Amortization 4 8,000,000 7,500,000 Impairment losses 5 12,000,000 3,000,000 Bad debts written off 4 500,000 : Interest expense 16 800,000 1,000,000 Gain on revaluation of investments (21,000,000) - Interest income 15 (11,000,000) (9,500,000) Dividend income (3,000,000) (2,500,000) Gain on disposal of fixed assets (1,200,000) (1,850,000) 35,100,000 40,650,000Working Capital Changes: Movement in current assets (Increase) / Decrease in inventory Decrease in trade receivables Movement in current liabilities: Increase / (Decrease) in trade payables Cash generated from operations Dividend paid Income tax paid Net cash from operating activities (A) Cash flows from investing activities Capital expenditure Purchase of investments. Dividend received Interest received Proceeds from disposal of fixed assets Proceeds from disposal of investments (8) Cash flows from financing activities Issuance of share capital Bank loan received Repayment of bank loan Interest expense Net cash from financing activities (C) 4 " 6 Net increase in cash & cash equivalents (AtB+C) Cash and cash equivalents at start of the year Cash and cash equivalents at end of the year_24 (1,000,000) 550,000 3,000,000 1,400,000 2,500,000 (1,300,000) 39,600,000 _ 47,300,000 (8,000,000) (6,000,000) (12,000,000) (10,000,000) 719,600,000 25,300,000 (100,000,000) (85,000,000) (25,000,000) - 5,000,000 3,000,000 3,500,000 7,000,000 18,000,000 5,500,000 2,500,000 2,200,000 (86,000,000) (73,300,000) 1000,000,000 - = 100,000,000 (100,000,000) - (8,600,000) (7,400,000) 896,400,000 92,600,000 20,000,000 44,601 00 77,600,000 33,000,000 897,600,000 77,600,000 3536 Statement of Cash Flows presents the movement in cash and cash equivalents over the period. Cash and cash equivalents generally consist of the following: Cash in hand Cash at bank Short term investments that are highly liquid and involve very low risk of change in value (therefore usually exchides investments in equity instruments) Bank overdrafts in cases where they comprise an integral element of the organization's treasury management (e.g. where bank account is allowed to float between a positive and negative balance (ie. overdraft) as opposed to a bank overdraft facility specifically negotiated for financing a shortfall in funds (in which case the related cash flows will be classified under financing activities). As income statement and balance sheet are prepared under the accruals basis of accounting, it is necessary to adjust the amounts extracted from these financial statements (e.g. in respect of non cash expenses) in order to present only the movementin cash inflows and outflows during a period. All cash flows are classified under operating, investing and financing activities as. discussed below. Operating Activities Cash flow from operating activities presents the movement in cash during an accounting period from the primary revenue generating activities of the entity For example, operating activities of a hotel will include cash inflows and outflows {from the hotel business (e.g. receipts from sales revenue, salaries paid during the year etc), but interest income on a bank deposit shall not be classified as such (i.e. the hote''s interest income shall be presented in investing activities). Profit before tax as presented in the income statement could be used as a starting point to calculate the cash flows from operating activities. Following adjustments are required to be made to the profit before tax to arrive at the cash flow from operations: 1. Elimination of non cash expenses (e.g. depreciation, amortization, impairment losses, bad debts written off, etc) 2. Removal of expenses to be classified elsewhere in the cash flow statement (eg. interest expense should be classified under financing activities) 3. Elimination of non cash income (e.g. gain on revaluation of investments) 4. Removal of income to be presented elsewhere in the cash flow statement (e.g. dividend income and interest income should be classified under investing activities unless in case of for example an investment bank) 5. Working capital changes (e.g, an increase in trade receivables must be deducted to arrive at sales revenue that actually resulted in cash inflow during the period)37 Investing Activities Cash flow from investing activities includes the movement in cash flow as a result of the purchase and sale of assets other than those which the entity primarily trades in (eg. inventory). So for example, in case of a manufacturer of cars, proceeds from the sale of factory plant shall be classified as cash flow from investing activities whereas the cash inflow from the sale of cars shall be presented under the operating activities. Cash flow from investing activities consists primarily of the following: Cash outflow expended on the purchase of investments and fixed assets - Cash inflow from income from investments - Cash inflow from disposal of investments and fixed assets Financing Activities Cash flow from financing activities includes the movement in cash flow resulting from the following: - Proceeds from issuance of share capital, debentures & bank loans ~ Cash outflow expended on the cost of finance (i. dividends and interest expense) - Cash outflow on the repurchase of share capital and repayment of debentures & loans