CHAPTER 5

U N D E R S TA N D I N
G FINANCIAL
S TAT E M E N T S

MA. ROSALINA ARARAO-BESARIO, CPA, Ph.D.

NEGROS ORIENTAL STATE UNIVERSITY
COLLEGE OF BUSINESS ADMINISTRATION
BACHELOR OF SCIENCE IN ACCOUNTANCY
Learning Outcomes:
At the end of the chapter, student should be able to:

1. Discuss how business activities are reported through the financial statements,
2. Explain the general objectives of financial statements,
3. Enumerate and identify the needs of various users that demand financial
accounting information,
4. Enumerate the sources of information about a business enterprise,
5. Explain the benefits and costs of supplying accounting information, and
6. Identify the required financial statements and know how they are
interconnected .
Understanding Financial Statements

How are business activities reported?

- through financial statements

Financial statements

 reports on a company’s performance and financial condition

 the needs of different users
 provide crucial input for strategic planning
General Objectives of Financial Statements

1. Providing Information for Economic Decisions

Users of financial statements help them evaluate a

business’ ability to generate cash and cash
equivalents, its ability to pay its employees and
suppliers, meet interest payments, repay loans and
make distributions to its owners.
General Objectives of Financial Statements

2. Providing Information About Financial Position

The financial position of an enterprise is affected by the economic resources

such as:
- Information about the economic resources controlled by
the enterprise
- Information about financial structure is useful in predicting
- future funding needs
- Information is useful in predicting success of the business
- Information about liquidity and solvency
General Objectives of Financial Statements

3. Providing Information About Performance of an

Enterprise

In particular its profitability which is required to assess

potential changes in the economic resources that are likely
to control the future.
General Objectives of Financial Statements

4. Providing Information About Changes in

Financial Position

This is useful to assess it investing, financing and

operating activities during the reporting period – cashflows.
Demand for Financial Accounting Information

The broad classes of users that demand financial accounting information

include the following:

1. Managers and Employees –for their own well being and prospective
earnings.
2. Investors and Analysts – to decide whether to buy or sell equity
shares.
3. Creditors and Suppliers – for lenders, to determine credit to
extend the company, and for suppliers
to determine their long-term
commitment to supply-chain relations. 4.
Shareholders and Directors – to assess it profitability and risks,
evaluate managerial performance and
to help to make leadership decisions.
Demand for Financial Accounting Information

The broad classes of users that demand financial accounting information

include the following:

5. Regulatory and Tax Agencies – SEC, BIR, BSP and other

legal institutions to monitor compliance.
6. Customers and Potential Strategic Partners – to evaluate a
company’s ability to provide products and
services as agreed.
7. Other decision makers – for varied purposes like assessing
damages for environmental abuses & making
policy decisions involving economic, social,
taxation and other initiatives
Sources of Information

In the Philippines, publicly listed companies must file financial accounting

information with the Securities and Exchange Commission (SEC) as follows:

1. The audited Annual Report that includes four (4) financial statements –
balance sheet, income statement, statement of stockholders’ equity and
statement of cash flow.

2. The unaudited quarterly or interim reports that include summary

versions of the 4 financial statements as mentioned above and
limited additional disclosure. All other registered corporations and
partnerships are likewise required to file annually audited financial
statements with notes to SEC.
 Benefits of Disclosure

 It extend to a company’s capital, labor, input and output markets as

companies compete in these markets. Example, debt and equity
financing are sourced from capital markets and the better a company’s
prospects, the lower will be its costs of capital.

 Same is true for the company’s recruitment efforts in labor markets and
its ability to establish and maintain superior supplier-customer relations.
It also enables the company better compete in capital, labor, input and
output markets.
Costs of Disclosure

 Preparation and dissemination of supplying accounting information

can be substantial Possibility for information to produce competitive
disadvantages is high

 Disclosure of activities like product or segment success or failures,

strategic initiatives, technology or systems innovations could harm
their competitive advantages. Disclosures that creates expectations that
are not eventually met may face possible lawsuits.
 Constraints on Relevant and Reliable Information
Timeliness
Balance Between Benefit and Cost
Balance Between Qualitative Characteristics
True Fair View of Fair Presentation
Undue delay in reporting information may lose its relevance.
Management may need to balance the relative merits of timely
reporting and the provision of reliable information.
The balance between cost and benefits is a pervasive constraint
rather than a qualitative characteristic. Benefits derived from
information should exceed the costs of providing it. The
evaluation if benefits and cost is a judgmental process.
Aim is to achieve an appropriate balance among the
characteristics to meet the objective of the financial statements.
The relative importance of the characteristics in different cases is
a matter of judgment.
Financial statements are frequently describes as showing a true
and fair view of the financial position, performance, and changes
in the financial position of an enterprise. Although framework
does not deal directly with such concepts, qualitative
characteristics and accounting standards, normally results in fs
that convey what is generally understood as a true and fair view
of such information.
The Link Between Financial Statements
The Link Between Financial Statements
The Link Between Financial Statements

There is an order of financial statement preparation:

• First statement prepared is the Statement of Comprehensive Income
– net income figure and dividend information is used to update
the retained earnings account.
• Second, it prepares the Statement of Financial Position
- using the updated retained earnings account along with the
remaining statement of financial position accounts from the
Trial Balance.
• Third, it prepares the Statement of Stockholders Equity
• Fourth, it prepares the Statement of Cash Flows using information
from the cash accounts and other sources.
Articulation of Financial Statements
Statement of Financial Position

Reports a company’s financial position at a point in time, the company’s

resources (assets), what the company owns and also the sources of asset
financing.

Two (2) Ways to Finance Company Assets

1. Owner Financing – it can raise money from shareholders
2. Non-owner Financing – it can also raise money from banks or
other creditors or suppliers.
Statement of Financial Position
Statement of Financial Position
Statement of Comprehensive Income
Statement of Comprehensive Income

 Manufacturing and merchandising companies typically include an additional expense account,

called Cost of Goods Sold (or Cost of Sales), in the statement of comprehensive income
following revenues.

 It is also common to report a subtotal called Gross Profit (or Gross Margin), which is revenues
less cost of goods sold. The company’s remaining expenses are then reported below gross profit.
This income statemen layout follows:
Statement of Shareholder’s Equity

The statement of stockholder equity reports on changes in key types of Equity

over a period of time. For each type of equity, the statement reports the
beginning balance, a summary of the activity in the account during the year
and the ending balance.
Statement of Shareholder’s Equity

Contributed capital represents the cash that the company received

form the sale of stock to stockholders, less any fund expended for the repurchase of
stock.

Retained earnings (also called earned capital or reinvested capital) represent the
cumulative total amount of income that the company has earned and that has been
retained in the business and not distributed to shareholders in the form of
dividends.

The change in retained earnings links consecutive statement of financial position

via the income statement:

End. Retained Earnings = Beg. Retained Earnings + Net Income - Dividends

Statement of Shareholder’s Equity