Lesson 1 TITLE: UNDERSTANDING FINANCIAL STATEMENTS LESSON OBJECT! ‘Atthe end ofthe module, the learners will be able to: Identity he basic financial statements. Explain the contents of the Statement of Financial Position Explain the contents ofthe Income Statement Explain the contents ofthe Statement of Changes in Equity. Explain the contents ofthe Statement of Cash Flows. Know the challenges and obstacles contonting the user of financial statements. oo nene REFERENCES! SOURCES: . Management Accounting Concepts and Applications by Ma. Elenita Balatbat Cabrera, BBA, MBA CPA, CMA : Techniques of Financial Analysis by Erich A. Helfer,0 B.A Fifth Edtion ‘The Basic Financial Statements Financial statements and theie accompanying notes contain a wealth of useful information regarding the financial positon of a company. tho success of ts operations, the polcies and strategies of managoment, and insight ino its future performance. A Tinancial statements ser can find answers tothe following sample questions through analysis ofthe data presented therein together with other data generated by corporate financial reporting: . How well does the company compete in ts operating environment? . ‘Would an investment generate attractive returns? : Should existing investment holdings be continued or liquidated? . Will cash flows be sufficient to meet interest and principal payments? The four basic financial statements are: 1 ‘The statement of financial position which shows the financial position - assets, lablties and owners equity ofthe firm on 2 particular date such as the end of a quarter ora year, 2 ‘The income or oarnings statement which represents the results of operations - revenues, expenses, net profit or loss, for the accounting period: 3 ‘The statement of changes In equity which summarizes the changes in a company's equity fora period of time (generally fone year, 4 ‘The cash flow statement which provides information about the cash inflows and outiows from operating, financing and investing activities during an accounting period. Conceptual Framework for the Preparation and Presentation of Financial Statements, ‘Accountants prepare financial statements by applying a set of standards or rules refered to as fnanclal reporting standards. Consistent application of these Standards permits comparisons between companies and between years of a single company. Financial reporting standards allow for significant lalitude in how certain transactions should be accounted for, meaning thal professional judgement is particulary important. Qualitative Characteristics of Accounting Information In order to justify providing accounting information, the benefits which may be derived from the use ofthis information must exceed the costs of providing the data. There are several cosis of providing information, including: (1) costs of collecting, processing, and disseminating: (2) costs. of auditing; (3) costs associated with dangers of litgation and loss of competitive advantage: and (4) costs to {ho user for analysis and interpratalion, Also, there are berofils {othe proparers ofthe information as well as to the users. These benefits include improved access to capital markets and favorable impact cn public relations. THE STATEMENT OF FINANCIAL POSITION The statement of financial postion shows the nancial condition or financial position of a company on a particular date. The staternent is ‘a summary of what the fir owns (assets) and what the frm owes to outsiders (ablties) and to internal owners (stockholders equi) ‘While the accounts on a slatement of financial position may vary somewhat by fir or by industry, those described here are common to ‘most companies. CURRENT ASSETS Current assets include cash or those assets expected to be converted inlo cash, used or consumed within one year or one operating cycle whichever ts longer. The operating cycle isthe me required to purchase or manufacture Inventory, sell the product, and collect the cash, The designation “current” refers essentially to those asses that are continually used up and replenshed inthe ongoing‘operations of the businass. The term working capital or not working capital is used to designate the amount by which current assats exceed current lablties (current assets less current liabities). : Gash and Cash Equivalents ‘The cash account's exactly thal, cash In any form - cash awaiting deposit or in @ bank account. Cash equivalents are short-term and highly quid Investments that are readily convertible to cash and so near their maturity that they present insignificant risk of changes in ‘also be presented as Investment in Trading Secures. Reported on the statement ef financial postion at thei cost until gain orloss is tealized upon the sale ofthe debt instrument . Accounts Receivable Accounts receivable are customer balances outstanding on credit sales and are reported on the statement of fnancial postion at their ‘not realizable value, that is, the actual amount of the account less an alowance for doubtful accounts. Management must estimate - ‘based on such factors as past experience, knowledge of customer qualty, the stale ofthe economy, the firm's collecton policies - the peso amount of accounts they expect will be uncollectibie during the accounting period. Actual losses are wrtien off againet the ‘allowance account, whichis adjusted at the end of each accounting period. ‘The allowance for doubtful accounts can be important in assessing eamings quality. The analyst should be alert lo changes in the ‘lowance account - both relative to the level of sales and to the amount of accounts recelvatie outstanding - and to the Justification for ‘any variations from past practices. Estimating the Amount of Allowance for Doubtful Accounts Inthe example above, we estimated an arbitrary number forthe allowance for doubtful accounts. There are two primary methods for ‘estimating the amount of accounts receivable Wal are not expected to be converted into cash 41. Percentage of Credit Sales ‘The percentage of crecit sales method s explained as follows: Ifa company and the industry reported a long-un average of 2% of credit sales being uncollectibe, the company would enter 2% of each period's credit sales a3 a debit lo bad debis expense and a credit te allowance for doubtful accounts 2. Accounts Receivable Aging Fiatctatia aca ws tnd ia reper at unpad cusiemar voles by la ranges and apple rao eau o weve ange Examplct an scont receivable agg ha Samest | rousam | 0-30Daye | 31—60Daye | 61-20Days | 00+ Daye Customera | 510,000 $5,000 55,000 : : Cunomers | $30,000 : 520,000 $6,000 $4,000 Cutomerc | 550,000 : : : a a Estimated Bad Debt % ‘To calculate the allowance for doubtlul accounts: (55000 x 1%) + ($25,000 x 20%) + ($6,000 x 25%) + ($54,000 x 60%) = $39,550 {we assume thatthe allowance for uncollectible accounts showed a credit balance of $5,000 before adjustment, we wil make the folowing adjusting entry: {$39,850 ~ $5,000 = $24,550 (adjusting entry) Bad Debts expense $34,880 ‘Allowance for Doubtful Accounts $34,550 Inventories, Ievontories are items held for sale or used inthe manufacture of products that willbe sold. A retail company, lists only one type of inventory on the statement of financial postion: merchandise inventories, purchased for resale tothe public. A manufacturing fim, in contrast, would carry three diferent Iypes of inventories: raw materials of supplies, work.in-process, and fnished goods. Reporied on the statement of financial postion al nel lower of coat or net realizable value. Given the relative magnitude of inventory the accounting method chosen to value inventory and the associated measurement of cost of ‘9o0ds sold have a conakierable impact on a company’s financial position and operating resuts. Understanding tne fundamentals ofInventory accounting and the effect various methods have on a company’s financial statements are essential to the user of financial statement information Because the inventory cost-fow assumption has a significant impact on financial statements - the amount of inventory reported on the statement of fnancial position and the cost of goods sold expense in the income statement - itis important to know where to fin its {isclosure. The method used to value inventory willbe shown either on the face ofthe statement of fnancial positon with the inventory ‘account or, more commonly, in the note tothe financial statements relating o inventory. How Inventory Is Valued ‘The three most widely Used methods for inventory valuation in accounting are 1 First-n, First-Out (FIFO) 2 Last-in, First-Out (LIFO) a Weighted Average Cost Flrst-in, First-Out (FIFO) According tothe first-4nfrst-out (FIFO) valuation method, the inventory Rems are sold in he same order in which they are purchased of ‘manufactured. The oldest inventory products are sold ist as per the FIFO method. The FIFO valuation method is the most commonly sed inventory valuation method as most ofthe companies sell their products in the same order in which they purchase it Lastn, First-Out (LIFO) ‘The last-in-irst-out (LIFO) inventory valuation method is precisely the opposite of the FIFO valuation method. It assumes thatthe most recently purchased or manufactured items are sold frst Weighted Average Cost (or Avg Cost) With the Weighted Average Cost inventory valuation method, inventory, and Cost of Goods Sold (COGS) are calculated based on the ‘average cost ofall tems purchased during a period, This method fs mainly used by businesses that don't have variation in their inventery. Cost of goods available for sale WAC per unit = Units available for sale : PREPAID EXPENSES Certain expenses, such as insurance, rent, property taxes, and ubltes are sometimes paid in advance. They are included in current assets if they will expire within one year or one operating cycle, whichever is longer. Generally, prepayments are nol material to the Statement of financial postion as a whole . PROPERTY, PLANT AND EQUIPMENT ‘This category encompasses a company's fixed assets (also called tangible, long:lved, and capital assets) - those assets not consumed in annual business operations. These assets produce economic benefits for more than one year and they are considered "tangible" because they have a physical substance. Fixed assets other than land (which theorelcally has an unlimited ife span) are “depreciated ‘over the period of time they benefit the firm, Depreciation is the method of allocating the cost of long-lived assets. The original cost loss any estimated residual valve athe end ofthe asset's ife, is spead over the expected lfe ofthe asset. Cos! is also considered to ‘encompass any expenditures made to ready the asset for operating use. On any slatement of financial postion date property, plant and ‘equipment are shown at Book value, which is the difference between orginal cost and any accumulated depreciation and amy ‘accumulated impairment losses to date. They may also be carried at a revalued amount being its far value at the date of revaluation Jess any subsequent depreciation and subsequent accumulated impairment losses. . OTHER NONCURRENT ASSETS ‘Other assets on a firm's statement of nancial position can include a mulitude of ether noncurrent items such the cash surrender value of Ife Insurance policies, and long-term advance payments. property held for sale, ‘Additional categories of noncurrent assets frequently encountered are long term Investments and intangible assels such a3 goodwall ‘recognized in business combination, patents, trademarks, copyrights, brand names, and franchises. OF the intangible assets, goodwil i the most important for analytical purposes because ofits potential materiality onthe statement of financial position of fms heavily {involved in acquisitons activity. Goodwil arises when one company acquites another company (in a business combination accounted for as a purchase) for a price in excess of the fair markel valve of the net identifiable assets (identifiable assets less labilties assumed) ‘acquired. This excess price Is recorded on the books of the acquiring company as goodwil. The cost of goodwil is not amortized but eniites are required to assess it annualy for possible impairment. Impairment refers to the permanent decrease in the falr value of a company’s intangible or fixed assets due to multiple factors, such as, Increased competion, physical damage, et. It helps organizations evaluate their assets periodically, ensuring thal they do not overstate the total valuo of the assets. CURRENT LIABILITIES Labilties represent claims against assets, and current liaillies ore those thal must be saisfed In one year or one operating cycle, ‘whichever is longer. Current labittes include accounts and notes payable, the current portion of iong-term debt, accrued labities, and elered taxes, . Accounts Payable ‘Accounts payable are shor-lerm obligations that arise from credit extended by suppliers for the purchase of goods and services . Notes Payable \Notes payable ara short-term obligations in the form of promissory notes to suppliors or financial insttut'ons.. Currant Maturities of Long-term Debt When a firm has bonds, mortgages, or ether forms of ang-term debt outstanding, the portion of the principal that willbe repaid during, the upcoming year is classified as a current lablity, The note ists the amount of iong-lerm debt outstanding, less the portion due current, . Accrued Liabilities ‘Accrued liabilities result from the recognition of an expense in the accounting records prior to the actual payment of cash. Thus, they are labilites because there will be an eventual cash outfiow to satsly the obligations. NONCURRENT LIABILITIES. Obligations with maturities beyond one year are designated on the statement of fnanclal position as noncurrent lables. This calegory can include bonded indebtedness. long-term notes payable, morigages, obligations under leases. pension liabillies, long-term, warranties, and deferred income taxes. Deferred tax abitties are the amounts of income taxes payable in future periods in respect of taxable temporary differences. ‘Other Habilty accounts such as pension and lease obligation. can appear under the noncurrent liabilties section ofthe statement of financial postion. Equity ‘The ownership Interests inthe company organized as 2 corporation are represented Inthe fnal section of the statement of financial positon, stockholders’ equity or shareholders" equily. Ownership equity isthe residual Interest in assets that remain after deducing Fables. The owners boar 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 Asset = Liabilities + Owner's Equity OERA-L . Share Capital Ordinary shareholders do not ordinarly receive a fixed retum but da have voting privileges In proportion to ownership interest. Dividends ‘on ordinary shares are dectared at the discretion of a company’s board of directors. Further, ordinary shareholders can benefit from stock ownership through potential price appreciation (or the reverse can occur i the share price decines) ‘The amount listed under the share capital account is based on the par or stated value ofthe 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 sol initially. ‘Types of Shares © Ordinary Shares ‘Authorised Share Capital - total amount of capital that a company can raise by issuing stocks Issued share capital - amount of capital a company raises by means of Issuing stocks. ‘Subscribed capita - percentage of issued capital to which investors have subscribed Paid-up Capital - amount that investors have actually paid against their shareholdings. ‘© Proterred Shares Redeemabie preference shares - Issuing and such shareholders agree that the company can redeem or buy-back shares ata later period luredeemable preference shares - exact opposite of a redeemable stock Convertible preference shares - can convert thelr holdings to equity shares upon meeting speciic conditions. Non-convertible preference shares - nol enliled of the conversion provision Participating preference shares - have the right fo partake in @ company once the company allots dividends to ordinary shareholders, Nor-partcipating preference shares - only entitled to a fixed dividend payment ‘Cumulative preference shares - I a company does not provide dividends for preference shares in a particulary dividend entitlement is carried forward tothe following year i tis a cumulative stock Non-cumulative preference shares - the dividend amount is not cartied forward if an organization does not pay dividends in a specif year . Adgitional Paldn Capital This account reflects the amount by which the original sales price ofthe stock shares exceeded par valve as wel as rom other sources such as donated capita, treasury stock transactions, etc. vey - ‘such vy y . Retalned Earnings The retained earings account is the sum of every peso a company has earned since its inception, less any paymenis made to shareholders in the form of cash or stock dividends. Retained eamings do not represent a pile of unused cash stashed away in corporate vaults; retained earnings are funds a company has elected to reinvest in the operations of the business rather than pay out to stockholders in dividends. Retained earnings should not be confused with cash or other financial resources currently or prospectively avaliable to satisfy financial ebigations, Rather, the retained earnings account is the measurement of all undistibuted earnings. . Other Equity Accounts ‘These include preferred stock, foreign currency translation elects, treasury stock, and the accumulation of unrealized gains or losses Con investments in debi and equity securties that are classified as “noncurrent investments.”‘THE INCOME STATEMENT Regardless of the perspective of the financial statement user - inventor, creditor, employee, competitor, supplier, regulator - itis ‘essential to understand and analyze the eamings statement. But tis also imporiant vat the analyst realizes thal a company's report of ‘earnings and other informalion presented on the income siatement are nol complete nor exact barometers of fnancial performance. The income statement is one of many pieces of a financial statement package. Earnings are measured on an accrual rather than a cash basis, which means that income reported on the Income statement is not the ‘same as cash generated during the accounting period. ‘The income statement comes in two basic formats and with considerable variation in detail presented. The eamings statement in a ‘mutiple-step format, provides several intermediate profit measures - gross profit, operating profit. and earings before income tax - prior othe amount ef net earings for the period. The single-step version of the income statement groups all tems of revenue, then deducts all categories of expense to arrive at a igure for nel income. Cortain special toms, if they occur during an accounting period, must bo disclosed separately on an income statement, rogardless of format. This includes discontinuing operations. Discontinuing operations occur when a fir sel's a major portion ofits business. The tesutls of continuing operations are shown separately from the operaling results of the discontinued portion of the business, Any gain or loss on the disposol is also disclosed separately : NET SALES Total sales revenue for each year Is shown net of returns and allowances. A sales relum is a cancellation of a sale, and a sales allowance is a deduction fram the original sales invoice price. Since sales are the major revenue source for most companies, the trend Of this igure Is @ Key element in performance measurement. The remainder of the Income statement reveals managements abilty 10 translate sales peso into profits. . Cost oF Goons soLD ‘The first expense deduction from sales is the cost to the seller of the products sold to customers. This expense Is called cost of goods ‘sold or cost of sales. The relationship between cost cf goods sold and net sales - called the cost of goods sold percentage - Is an Important one for profit determination because cost of goods sold isthe largest expense item for many firms. . GROSS PROFIT ‘The difference between net sales and cost of goods sold is called gross profit or gross margin. Gross profit isthe fist step of profit ‘measurement on the muliple-step income statement and is a key analytical oo! in assessing a fim's operating performance. The gross. profit figure indicates how much profit the firm is generating after deducting the cost of products sold. . OPERATING EXPENSES Operating expenses include selling and administrative, advertising. lease payments, depreciation and repairs and maintenance among cothers. These are all areas over which management exercises discretion and which have considerable impact on the fimn’s current and Tuture profitabilty. Thus, It ls important fo track these accounts carefully In terms of ends, absolute amounts, relalionship to sales, and ‘relationship to industry competitors. Solling and administrative expenses are expenses that relate to the sale of products or services and to the management Cf the Business. They include salaries, rent, Insurance, ullties, supplies, and sometimes depreciation and advertising expenses 2. Advortising costs are (or should be) a major expense in the budgets of companies for which marketing is an important element of success. 3. Lease payments include tne costs of rontals of leased facities for retail outlets, 4. Depreciation, Depletion and Amortization - The cost of assets other than land that will benefit a business enterprise for more than a year is allocated over the asset's service Ife rather than expensed in the year of purchase. Land Is an exception to the rule because land is considered to have an unlimited useful ie, The cost allocation procedure is determined by the nature of the long-lived asset. Depreciation is used to allocate the cost of tangible fixed assets such as buildings, machinery, equipment. fumiture and fixtures, aind motor venicies. Amortization is te term applied to the cost expiration of intangble assets such as patents, copyrights, trademarks, licenses, franchises, and goodwill. The cast of acquiring and developing natural resources - oll and gas, other minerals, and standing limber - is allocated through depletion. The amount of expense recognized in any accounting peried will dopend on the level of investment in the relovant asset; estimates with regard to the asset's service Ife and residual valve; and for depreciation, the method used. Depreciation expense is calculated principally by the straight-line method based upon estimated useful lives for bullings. Estimated useful lives of leasehold improvements represent the remaining term of the lease in effect at the time the improvements are made. Other methods may be used such as sum-ol-years' digits, declining balance method, etc. \Wnat are the Main Types of Depreciation Methods? ‘There are several types of depreciation expense and different formulas for determining the book value of an asset. The mest common depreciation methods include: ‘Staighttine Double dectining balance Units of production ‘Sum of years digits Straight-Line Depreciation Mathod ‘Staightiine depreciation is a very common, and the simplest, method of calculating depreciaton expense. In straightsine epreciaton. he expense amount is the same every year over the useful ofthe > 99> Depreciation Formuta forthe Straight Line Method Depreciation Expense = (Cost - Salvage valve) / Useful life