CHAPTER 3

UNDERSTANDING FINANCIAL STATEMENTS

The Basic Financial Statements

Financial statements and their accompanyingnotes contain a wealth of useful
information regarding the financial position of a company, the success of its
operations, the policies and strategiesof management,and insight into its future
performance. A financial statementsuser can find answers to the following
sample questions through analysis of the data presentedtherein together with
other data generated by corporate financialreporting:
How well does the company compete in its operating environment?
Would an investment generate attractive returns?
Should existing investment holdings be continued or liquidated?
Will cash flows be sufficientto meet interest and principal payments?

The four basic financial statementsare

l. The statement of financial position which shows the financial position

- assets, liabilities and owners' equity of the firm on a particular date
such as the end of a quarter or a year;

2. The income or earnings statement which representsthe results of

operations - revenues, expenses,net profit or loss, for the accounting
period;
changes in equity which summarizesthe changes in a
3. The statement of of time (generally one
company's equity for a period year).

statement which providesinformationabout the cash

4. The cash flow from operating, financing and investing activities
inflows and outflows
period.
during an accounting
 88 C er3
of
Conceptual Framework for the Preparation and Presentation
Financial Statements
standards or rules
Accountantsprepare financial statements by applying a set of
these
referred to as financial reporting standards. Consistent application of
standards permits comparisons betweencompanies and between years of a single
company. Financial reportingstandardsallow for significant latitude in how
certain transactions should be accounted for, meaning that professional jUdynent
is particularly important.

Qualitative Characteristics of Accounting Information

In order to justify providing accounting information, the benefits which may be

derived from the use of this information must exceed the costs of providing the
data. There are several costs of providing information, including: (l) costs of
collecting, processing, and disseminating;(2) costs of auditing; (3) costs
associated with dangers of litigation and loss of competitive advantage; and (4)
costs to the user for analysis and interpretation. Also, there are benefits to the
preparersof the informationas well as to the users. These benefits include
improved access to capital markets and favorable impact on public relations.

THE STATEMENT OF FINANCIAL POSITION

The statement of financial position shows the financial condition or financial

position of a company on a particular date. The statement is a
summary of what
the firm owns (assets) and what the firm owes to
outsiders (liabilities) and to
internal owners (stockholders' equity). While the
accounts on a statement Of
financialposition may vary somewhat by firm or
by industry, those described
here are common to most companies.
 UnderstandingFinancial Statements 89

Illustrative Statement of Financial Position

Venetian, Inc.
Sbtements of Financial Positionat December31, 2018 and 2017
(in thousands)
2018 2017
Asseb
Current Assets
Cash and cash equivalents p 4,061 P 2,382
Marketable securities 5,272 8,004
Accounts receivable, less allowance for
doubtful
accounts of P448 in 2018 and P417 in 2017 8,960 8,350
Inventories 47,041 36,769
Prepaid expenses 759
512
Total current assets 65.846 56,264
Property, Plant and Equipment
Land
811 811
Buildings and leasehold improvements
18,273 11,928
Equipment 21.523 13.768
40,607 26,507
Less accumulated depreciation and amortization
11.528 7.530
Net property, plant and equipment 29.079 18,977
Other Assets
373 668
I Total Assets
Liabilities and Equity
Current Liabilities
Accounts payable P14,294 p 7,591
Accrued liabilities 5,669
Notes payable - banks (current) 5,313
5,614 6,012
Current maturities of long-term debt 1.884
Total current liabilities 1.516
27,461 20,432
Deferred Income Taxes 843 635
Long-term Debt
Total liabilities
-21,059 -L9Z5
38.042
Equity
Share capital, ordinary, par value PI, authorized
10,000,000 shares; issued, 4,803,000 shares in
2018 and shares in 2017 4,803 4,594
Additional paid-in capital 957 910
Retained earnings 40,175 32,363
Total equity 45.935
37,352
Total Liabilitiesand Equity
 90 3
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 that are continually used up and replenished
in the ongoing operations of the business. The term working capital or net
working capital is used to designatethe amount by which current assets
exceed current liabilities (current assets less current liabilities).

Cash and Cash Equivalents

The cash account is exactly that, cash in any form - cash awaiting deposit
or
in a bank account. Cash equivalents are short-term and
highly liquid
investnent that are readily convertible to cash and so near their
they present insignificantrisk of changes in value maturity that
because of change in
interestrates. Only highly liquid investmentsthat
are acquired three months
before maturity can qualify as cash equivalents.

Marketable Securities

Marketable securities are cash

substitutes, cash that is not
immediatelyin the business and is needed
These investmentsare in temporarily invested to earn a return.
instrumentswith short-term
one year) to minimizethe risk maturities (less than
of interest rate fluctuations.
relativelyriskless securities They must be
and highly liquid so that
withdrawnas needed. They funds can be readily
may also be presented
as Investment in Trading

Accounts Receivable

Accounts receivable
are customer balances
are reportedon the outstanding on credit sales
value, that is, the statement of financial position at and
actual amount of their net realizable
doubtfulaccounts. the account less
past experience, Managementmust estimate - an allowance for
the firm's knowledgeof based on such factors as
collection customer quality,
be uncollectible policies - the peso the state of the
amount of accounts economy
during the they expect will
accountingperiod.
Actual losses are written
off
 UnderstandingFinancial Statements 91

against the allowance account, which is adjusted at the end of each

accounting period.

The allowance for doubtful accounts can be important in assessing earnings

quality. The analyst should be alert to changes in the allowance account -
both relative to the level of sales and to the amount of accounts receivable
outstanding - and to the justification for any variations from past practices.

Inventories
Inventories are items held for sale or used in the manufactureof products
that will be sold. A retail company, lists .only one type of inventory on the
statement of financial position: merchandiseinventories purchased for resale
to the public. A manufacturingfirm, in contrast, would carry three different
Wpes of inventories: raw materials or supplies, work-in process, and
finished goods,

Given the relative magriitudeof inventory,the accounting method chosen to

value inventory and the associated measurementof cost of goods sold have a
considerable impact on a company's financial position and operating results.
Understanding the fundamentalsof inventoryaccounting 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-flow assumption has a significant impact on

financial statements - the amount of inventory reported on the statement of
financial position and the cost of goods sold expense in the income statement
- it is important to know where to find its disclosure. The method used to
value inventory will be shown either on the face of the statement of financial
position with the inventory account or, more commonly, in the note to the
financial statements relating to inventory.

Prepaid Expenses

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 is longer.
Generally, prepayments are not material to the statement of financial
position as a whole.
92 c 3
PIANT ANDEQUIPMENT

This categoryencompassesa company's assets (also called tangible,

and capital assets) those assets not consumed in annual bUSiness
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 theoretically has an unlimited life span)
are "depreciated" over the period of time they benefit the firm. Depreciation
is the methodof allocating the cost of long-lived assets. The original cost
less any estimated residual value at the end of the asset's life, is spread over
tie expectedlife of the asset. Cost is also. considered to encompass any
expendituresmade to ready the asset for operating use. On any statement of
financial position date property, plant and equipment are shown at book
value, which is the differencebetween original cost and any accumulated
depreciation and any accumulated impairment losses to date. They may also
be carried at a revalued amount being its fair va!ue at the date of revaluation
less any subsequent depreciation and subsequent accumulated impairment
losses.

OTHER NONCURRENT ASSETS

Other assets on a firm's statement of financial

position can include a
multitudeof other noncurrent items such as
property held for sale, the cash
surrender value of life insurance policies, and
long-term advance payment s•
Additional categories of noncurrent assets
term investments and intangible frequently encountered are long-
assets such as goodwill recognized in
business combination, patents,
trademarks, copyrights, brand names, and
franchises. Of the intangibleassets,
analytical purposes because of its
goodwill is the most important for
potential materiality on the statement Of
financial position of firms
heavily involved in
Goodwill arises when one company acquisitions activity
combinationaccountedfor as a acquires another company (in a business
purchase)for a price in excess
market value of the net
identifiableassets (identifiable of the fair
assumed) acquired. This assets less liabilities
excess price is recorded
acquiringcompanyas goodwill. on the books Of the
The cost of goodwill is not
entities are required to assess
it annually for amortizedbut
possible impairment.
 UnderstandingFinancial Statements 93

CURRENTLIABILITIES

Liabilities represent claims against assets, and current liabilities are those
that must be satisfied in one year or one 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
Accounts payable are short-term obligations that arise from credit
extended by suppliers for the purchase of goods and services.

Notes Payable
Notes payable are short-termobligationsin the form of promissory notes
to suppliers or financial institutions.

Current Maturities 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
upcomingyear is classifiedas a current liability. The note lists the
amount of long-term debt outstanding, less the portion due currently.

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
liabilities because there will be an eventualcash outflow to satisfy the
obligations.

NONCURRENTLIABILITIES

Obligations with maturities beyond one year are designated on the statement
of financial position as noncurrentliabilities. This category can include
bonded indebtedness, long-term notes payable, mortgages, obligations under
leases, pension liabilities, long-term warranties, and deferred income taxes.
94 3

Deferred tax liabilities are the amounts of income taxes payable in future
periods in respect of taxable temporary differences.

Other liability accounts such as pension and lease obligation, can appear
under the noncurrent liabilities section of the statement of financial position.

EQUITY

ne ownership interests in the company organized as a corporation are

represented in the final section of the statement of financial position,
stockholders' equity or shareholders' equity. Ownership equity is the
residual interest in assets that remain after deducting liabilities. 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. The relationship between the amount of debt and equity in a
firm's capital structure and the concept of financial leverage, by which
shareholder returns are magnified, will be explored in Chapter 4.

Share Capital

Ordinary shareholders do not ordinarily receivß fixed return but do have

voting privileges in proportion to ownership intnst.
Dividends on ordinary
shares are declared 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 if the share price
declines).
The amountlisted 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 wh ich the
stock cannot be sold initially.

Additional Paid-In Capital

This account reflects the

stock shares exceeded amount by which the original sales price Of the
par value as well
donated capital, treasury as from other sources such as
stock transactions,
etc.
 Retained Earnings

The retained earnings

account is the sum of every peso a company has
earned since its inception,
less any payments made to shareholders in the
form of cash or stock dividends.
Retained earnings 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
available to satisfy financial obligations.
Rather, the retained earnings
account is the measurement of all undistributed
earnings.

Other Equity Accounts

These include preferred stock, foreign currencytranslation effects, treasury

stock, and the accumulation of unrealizedgains or losses on investments in
debt and equity securities that are classified as "noncurrent investments."

THE INCOME STATEMENT

Regardless of the perspective of the financial statementuser - investor, creditor,
employee, competitor, supplier, regulator - it is essential to understand and
analyze the earnings statement. But it is also importantthat the analyst realizes
that a company's report of earnings and other informationpresented on the
income statement are not complete nor exact barometers of financial
performance. The income statement is one of many pieces of a financial
sntement 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 earnings statement in a multiple-step format,
provides several intermediate profit measures - gross profit, operating profit, and
earnings before income tax - prior to the amount of net earnings for,the period.
The single-step version of the income statement groups all items of revenue, then
deducts all categories of expense to arrive at a figure for net income.
Camin special iems, if they occur during an accounting period, must be
separately on an income statement,regardlessof format. This includes
diwontinuing operations. Discontinuing operations occur when a firm sellsa
major portion of its business. The results of continuing operationsare shown
from the operating results of the discontinued portion of the business.
Any or loss on the disposal is also disclosed separately.

Illustrative Income Statement

Venetian, Inc.
of Income for the Years Ended December 31, 2018 and 2017
(in thousands except per share amounts)

2018 2017

Sales P215,600 P153,OOO

of goods 129.364 91.879

G•os 86,236 61,121

Selling and admini±rative expenses 32,664 26,382

14,258 10,792
Evertigng
13,058 7,111
Lease paymene
and amoüaöon 3,998 2,984
Repairs and maintenance 49, 315
operaing 66.993
19,243
"une (expenses) 838
Interä income 422
zw)se (2.585) ----cuzn
(2.163)
Emunß bes 17,080 10,367

7.686
earnings incon»euxe

Eamings ordinaryiare
 Understandin Financial Statements 97
NET SALES

Total sales revenue for each

year is shown net of returns and allowances. A
sales return is a cancellation
of a sale, and a sales allowance is a deduction
from the original sales invoice
price. Since sales are the major revenue
source for most companies,the trend
of this figure is a key element in
performance measurement. The remainderof the income statement reveals
management's ability to translate sales peso into profits.

COST OF GOODS SOLD

The first expense deductionfrom sales is the cost to the seller of the
products sold to customers. This expenseis called cost of goods sold or
cost of sales. Venetian, Inc. uses.the LIFO method,which means that the
last purchases made during the year have been charged to expense. The
relationship between cost of goods sold and net sales - called the cost of
goods sold percentage - is an importantone for profit determination
because cost of goods sold is the 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 is the first step of profit measurement
on the multiple-step income statement and is a key analytical tool in
assessing a firm's operatingperformance. The gross profit figure indicates
how much profit the firm is generatingafter deductingthe cost of products
sold.

OPERATING EXPENSES

Operating expenses include selling and administrative, advertising, lease

payments, depreciation and repairs and maintenanceamong others. These
are all areas over which managementexercises discretion and which have
considerable impact on the firm's current and future profitability. Thus, it is
important to track these accounts carefully in terms of trends, absolute
amounts, relationship to sales, and relationship to industry competitors.

Selling and administrative expensesare expensesthat relate to the sale of

products or services and to the managementof the business. They include
98 C/nter3
salaries, rent, insurance, utilities, supplies, and sometimes depreciation and
advertising expense.

Advertising costs are (or should be) a major expense in the budgets of
companies for which marketing is an important element of success.

Lease payments includethe costs of rentals of leased facilities for retail

Outlets.

Depreciation and Amortization - The cost of assets other than land that
will benefit a businessenterprisefor more than a year is allocated over the
asset's service life rather than expensed in the year of purchase. Land is an
exceptionto the rule because land is considered to have an unlimited useful
life. 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, furniture and fixtures, and motor
vehicles. Amortization is the term applied to the cost expiration of
. intangible assets such as patents, copyrights, trademarks, licenses,
franchises, and goodwill. The cost of acquiring and developing natural
resources- oil and gas, other minerals, and standing timber,- is
allocated
through depletion. The amount of expense recognized
in any accounting
period will depend on the level of investment in
the relevant asset; estimates
with regard to the asset's service life
and residual value; and for
depreciation,the method used.

Depreciationexpense is calculated
principally by the straight-line method
based upon estimated useful lives
for buildings. Estimated useful
leasehold improvementsrepresentthe lives Of
the time the improvementsare remaining term of the lease in effect at
made. Other methods may
sum-of-years' digits,declining balance method, be used such as
etc.
Repairs and maintenance are
the annual cost of
the property, plant and repairing and maintaining
equipment. Expenditures
correspondto the level of in this area should
investment in capital
condition of the company's equipment and to the age and
fixed assets.
 UnderstandingFinancial Statements 99

OPERATINGPROFIT

Operating profit (also called EBIT or earnings 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 successof a companyapart from its financingand investing
activities and separate from tax considerations.

OTHER INCOME (EXPENSE)

This category includes revenues and costs other than from operations, such
as dividend and interest income, interest expense, gains (losses) from
investments and gains (losses) from the sale of fixed assets.

In the assessment of earnings quality, it is important that the analyst consider

the materialityand the variabilityof the nonoperatingitems of income, for
example, gains and losses on the sale of major capital assets, investment
income from temporary investmentsin cash equivalents, and investment
income recognized under the equity method.

EARNINGS BEFORE INCOME TAXES

Earnings before income taxes is the profit recognizedbefore the deduction

of income tax expense.

NET EARNINGS

Net earnings or "the bottom line" representsthe firm's profit after

consideration of all revenue and expense reported during the accounting
period.

EARNINGS PER ORDINARY SHARE

Earnings per ordinary share is the net earningsfor the period divided by
the average number of ordinary shares outstanding.
 STATEMENT OF CHANGES IN EQUITY

As in PAS i , Zltetpriæ shouldpregnt as a component of

along wifr tir financial statement,a statement

a. FOfit lossfor
b. æns of income (including gain) and expense(including loss) which are
in quity, as by this standard, and the total of these

c. effect of change in accounting policy and the correction

errors (when the benchmark treatment, retrospective
Qplicatim and of beginning retained earnings, respectively.
is PAS 8);
d. and with/to owners of the enterprise,
e. of or loss at the beginning of the pertod
at the statemen of financialpsition date, and the movements
and
f. o bawæ' carrying amounts of each class of equit>
and merve at the and the end
diElosing
æh
 Understanding Financial Statements 101

Illustrative Statement of Changes in Equity

XYZ & CO. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CHANGES IN EQUITY
FOR THE YEAR ENDED DECEMBER 31, 2018
(in thousands of pesos)

Additional
Share Paid-in Revaluation Translation Retained
Capibl Capital Increment Differences Eamings Toul
uarte at
31, 2012 x x x x
(x) x
Cimges in acounöng
policy (x) (x)
balance x x x x x
9.rg*us on revaluation
of properties x x
Mat on revaluation
of invesbnene (x)
Currency translation
differences (x)
Net gains and losses
not recognized in the
mome sbternent x (x) x
incorne for the
#nod x x
Dvjdends (x)
Is-lance of share
capibl x x x
Bdance at
31, 2013 x x x x
on revaluation
of properües (x)
on revaluabon
x
x
Qrrency transladm
differences
Net gatns and loses
not tn
(x)
inune (x)
income for
period x x
(x) (x)
Isuance share x
capital x x
Balance at December x x
x x x
31, 2014
102 3

THE CASH FLOW STATENÆNT

Cash Flow Statement,required by the PAS 7, provides information about
cash inflows and outflows during an accounting period segregated according to
activities, investingactivities, andfinancing activities.

An mterprise should report cash flows from operating activities using either:
l) The direct method,whereby major classes of gross cash receipts and
goss cash payments are disclosed; or
2) The indirect method,whereby net income or loss is adjusted for the
effects of of a non-cash nature, any deferrals or accruals of
past or future operating cash receipts or payments, and items of income
or expense associated with investing or financing cash flows.

The Illustrative Cash Flow Statement presents cash flows from operations using
direct method.

mustrative Cash Flow Statement

Venetian, Inc.
Statementsof Cash Flows
For tie Years Ended December 31, 2018 and 2017
(in thousands)

How from Operating Activities • Direct 2018 2017

Cash received from cu±omers
Method
received P214,990 P149,661
Ca#i paid to suppliers for inventory 838
paid to employees (S&A expenses) (132,933) (99,936)
Cash for (32,664) (26,382)
expenses
Intere paid (29,728) (21,350)
Taxes paid (2,585) (2,277)
Ne c.a*l provided (us4 (7.478) (4.321)
by operating
How from InvesBng Actlvltle E.--LQ24
Mdjbons to pr»erty, plant and
inv&ng activities (14,100) (4,773)
Ne cash provided(used) by 295
inv&ng a&åitie p (13.805) p--ßD3)
Cash Flow from Financing AcevIUu
Sales of shares 183
Increase (decreaæ) in short-term 256
current maturfies of long-tern (indudes
1,854
(30)
 UnderstandingFinancial Statements 103

Additions to long-term borrowings 5,609 7,882

Reductions of long-term borrowings (1,516) (1,593)
Dividends paid (1,582) (1.862)
Net cash provided (used) by financing activities p 2,728 p 6.464
Increase (decrease) in cash and marketable securities
Supplementary Schedule
Cash Flow from Operating Activities - Indirect Method
Net income p9,394 P5,910
Adjustments to reconcile net income to cash flows from
operating activities
Depreciation 3,998 2,984
Deferred income taxes 208 136
Changes in current assets and liabilities:
Accounts receivable (610) (3,339)
•Inventories (10,272) (7,006)
Prepaid expenses 247 295
Accounts payable 6,703 (1,051)
Accrued liabilities 356
Net cash provided (used) by operations

CASH FLOWS FROM OPERATING ACTIVITIES

These include cash effects of transactions and other events that enter into the
determination of income such as delivery or production of goods for sale,
providing services, operating expenses and other income and expenses.

Operating activities are principal revenue-producing activities of an

enterprise and include delivering or producing goods for sale and providing
services. In general, cash flows that relate to, or are the corollary of, items
reported in the income statement are operating cash flows.

CASH FLOWS FROM INVESTING ACTIVITIES

These include cash effects of transactionsinvolving acquiring and selling or

otherwise disposing of (a) securities that are not cash equivalents and (b)
productive assets that are expectedto benefit for long periods of time; and
lending and collecting on loans.
acquisition and disposition of property, plant
Investing activities include the
long-term assets and debt and equity instruments of
and equipment and other
not considered cash equivalents or held for dealing
Other enterprises that are
Investing activities also include (l) cash advances and
or trading purposes.
104 Chapter 3

collections on loans made to other parties (other than advances and loans of
a financial institution);(2) cash payments and receipts for future contracts,
formal contracts, option contracts and swap contracts except when the
contracts are held for dealing and trading purposes or the payments or
receipts are classified as financing activities.

CASH FLOWS FROM FINANCING ACTIVITIES

These include cåsh effects of transactions involving borrowing from

creditors and repaying the principal; and obtaining resources from owners
and providing them with a return on the investment.

Financing activities include obtaining resources from and returning

resources to owners as well as obtaining resources through borrowings
(short-term or long-term) and repayments of the amounts borrowed.

The mechanics and pi ocedures in the preparation of the Statement of Cash Flows
are fully discussed in Chapter 6.

Challenges and Obstacles Confronting the User of Financial

Statements

Financialstatementsand their accompanyingnotes contain a wealth of useful

informationregardingthe financial position of a company, the success of its
operations, the policies and strategies of management, and insight into its future
performance. There are however certain challenges, obstacles and blind alleys
that may confront the user of financial statements. Some of the more significant
problems are related to
l. Volumeof information
2. Complexityof the accountingrules
3. Variations in the quality of financial reporting
4. Impact of inflationof financial statement data
5. Omission or Difficult to find financial information
 UnderstandingFinancial Statements 105

Volume of Information

The user of a firm's annual report usually encounters a great quantity of

information that encompasses the required information such as
financial statements
notes to the financialstatements
the auditor's report
summary of key financial data
high and low stock prices
management's discussion and analysis of operations
effect of foreign currency translation
segmented data, and others.

Auditor's Report

The sheer quantity of informationcontainedin the financial statements can

be overwhelming and intimidating. There are unfortunately maze-like
interferences in financial statement data that hinder understanding of the
valuable information they contain.

Related to the financial statements and notes is the report of an independent

auditor. Although the auditor's report is independent,the user should be
aware that the auditor is hired by the firm whose financial statements are
under review. Because the auditor must satisfy the client, the potential for
conflict of interest always exists.

Complexity of the AccountingRules

Financial statements are prepared according to Philippine Financial Reporting

Standards that have been adopted in order to achieve a presentation of financial
information that is both understandableby users and relevant and reliable for
decision making. The accountingrules that have been issued in order to achieve
these objectives can be complicated and sometimes confusing.

For example, with the adoption of PAS 39 Financial Instruments: Recognition

and Measurement,entities are requiredto present in the statementof financial
POSitionat fair value existing financial assets and financial liabilities including
derivatives. Accounting for and reporting derivatives, whether using hedge
 3

not, can be quite complex and difficult. Effective January 1,

PAS 39 was supersededby PFRS 9.

of Financial Reporting

lt• has already been pointed out that management has considerable discretion
wiåin the overall framework of financial accounting and reporting standards.As
a result, the potential exists for managementto affect the quality of financial
suem<lb. Some of these opportunitiesare discussed below.

l. Management can make choices with respect to accounting policies and

make estimations in the application of these policies. The complexity
of accounting policies underlying the preparation of financial statements
can lead to confusion and variations in the quality of information
presented and these roles are constantly evolving and changing. For
example, in choosing the depreciation method, management decides how
to allocate the depreciation expense associated with a fixed asset
uquisition. The choice of depreciation method can affect the earnings
stream associated with the asset and it also affects the quality of the
eamings reported. Use of accelerated depreciation would produce lesser
income in the earlier years as compared to the straight-line method
which will show higher earnings in the early years.

2. Management can exercise discretion regarding the timing of the

expense and revenue recognition. Management discretion in a number
of areas influence financial statement content and presentation in ways
that affect and even impede evaluation. Although
accounting rules
provide guidelines helpful in making the
necessary and appropriate
allocation so that expenses are matched with
the generation of revenues
in order to determine net income for
an
are not always precise. For example, accounting period, these rules
near the end of an accounting suppose that a company learns
period that a material accounts receivable
is probably uncollectible,
When will the account
—currently or in the next be written off as a loss
accounting period? When
is made? This is a situation a final determinati0n
where management may
arbitrary decision which have to makean
implies that the choice
the firm, the higher the that is least favorableto
quality of earnings
information will be.
 UnderstandingFinancial Statements 107

3. Many of the expendituresmade by a businessfirm are discretionary.

Management exercises control over the budget level and timing of
expenditures for the repair and maintenance of machinery and
equipment, marketing and advertising, research and development, and
capital expansion. Policies are also flexible with respect to the
replacement of plant assets, development of new product lines and the
disposal of an operating division. Each choice regarding these
discretionary items has both an immediate and a long-term impact on
profitability, perhaps not in the same direction. The user or the financial
analyst should carefully scrutinize management policies with respect to
these discretionary items through an examination of expenditure trends
(absolute and relative amounts) and comparison wi.th industry
competitors.

4. Existence of nonrecurring and nonoperating items such as gain on sale

of a major plant asset or loss on sale of discontinued division may affect
the future operating potential and should be reviewed and possibly
eliminated from earnings.

5. Missing and Difficult to Find Information.Someof the key facts or

information needed to enable the users or financial analyst to evaluate a
company are not available in the financial statements. Some are difficult
to find and still some are impossible to measure. Examples are
(l) intangibles as employee relations with management,
(2) the morale and efficiency of employees,
(3) the reputation of the firm with its customers,
(4) its prestige in the community,
(5) the effectivenessof management,and
(6) potential exposure to change in regulation.

These qualities impact the firm's operating success (directly or

indirectly) but are difficult to quantify.

There are many other examplesof materialthat must be extracted from

notes, supplementary schedules, or the management discussion and
analysis section in order to interpretthe financialstatement. The facts
involve a tedious search.
are there but finding them may
 108 C/npler 3

Impact of Inflation

Changing prices can erode the usefulness of financial statement numbers.

Although the applicationof the new Philippine Financial Reporting Standards
allows the recognitionof statementof financial position accounts at fair value
net realizable value, present value or in case of property, plant and
its recoverable amount if it is less than the carrying amount,
historical or original transaction coastsremains the more predominant basis of
recording and valuing assets and liabilities. During a period of inflation,
however, distortions occur in the valuation of assets and the determination of net
income. For example, the effect of inflation on the statement of financial
position property, plant and equipmentaccounts for many firms which do not use
revalued amount would result to understatement of the asset account and
understatement of depreciation expense.

The financial statement user should continue to be aware,

however, that any
inflation
distorts asset valuations and income measurement.