AE27

LESSON 3
UNDERSTANDING FINANCIAL
STATEMENTS
Learning Objectives:

❖Understand how business activities are reported through

the financial statements.
❖Appreciate the general objectives of financial statements.
❖Enumerate and identify the needs of various users that
demand financial accounting information.
❖Enumerate the sources of information about a business
enterprise.
❖Understand the benefits and costs of supplying
accounting information
❖Identify the required financial statements and know how
they are interconnected.
How Business Activities are Reported
❖To be able to analyze a company effectively or know its value, it is
important that we understand the company’s business activities.
This can be attained through the financial statements.
❖Financial statements are reports on company’s performance and
financial condition and reveal executive management’s
privileged information and insights.
❖All Companies plan their business activities, finance those
activities, invest on those activities and then engage themselves
in operating activities.
❖Financial Statements also provide important input for strategic
planning , as well as information about the relative success of
those plans.
General Objectives of Financial
Statements
❖Below are the important objectives of Financial
Statements:
✔Providing information for economic decisions.
✔Providing information about financial position
✔Providing information about the performance of an
enterprise.
✔Providing information about the changes in financial
position
Demand for Financial Accounting
Information
❖In the Philippines, Publicly listed companies must file financial
accounting information with the Securities and Exchange
Commission (SEC). These financial statements are:
⮚ The audited annual report that includes the four financial statements
along with explanatory notes and the management’s discussion and
analysis of financial results. These four financial statements are:
a) Statement of Financial Position (Balance Sheet)
b) Statement of Comprehensive Income/ Profit or Loss Statement
c) Statement of Stockholder’s Equity
d) Statement of Cash Flows
⮚ The unaudited quarterly or interim reports that include summary
version of the four financial statements and limited additional
disclosure.
Financial Statements
❖Financial Statements are the “structured
representation of an entity’s financial position and
results of its operations” (PAS 1.9)
❖Business activities are periodically reported by
companies using four financial statements:
a) Statement of Financial Position (Balance Sheet)
b) Statement of Comprehensive Income
c) Statement of Stockholder’s Equity
d) Statement of Cash Flows
Linkage of Financial Statements
⚫The four financial statements are linked with each
other and linked across time, The linkage is also
known as articulation.
⚫The Statement of Financial Position and Statement of
Comprehensive Income are linked via retained
earnings. Retained Earnings are updated each period
and reflect cumulative income that has not yet been
distributed to shareholders.
⮚Figure below illustrates the linkage of Financial
Statements
⚫Qualitative Characteristics of Accounting Information
⚫Cost of providing accounting information includes:
1. Costs of collecting, processing and disseminating
2. Costs of auditing
3. Costs associated with dangers of litigation and loss of
competitive advantage.
4. Costs to the user for analysis and interpretation
⚫Benefits of Accounting information to the users and
preparers:
1. Improved access to capital markets
2. Favorable impact on public relations
Objectives of Financial Statements
⮚ Primary Objective – to provide information about the financial
position, financial performance, and cash flows of an entity that is
useful to a wide range of users in making economic decisions.
⮚ Secondary Objective – to show the results of management’s
stewardship over the entity’s resources.
⮚ To meet the above objectives, financial statements provide
information about an entity’s:
⚫ Assets
⚫ Liabilities
⚫ Equity
⚫ Expenses
⚫ Contributions by and distributions to owners; and
⚫ Cash Flows
Statement of Financial Position (Balance Sheet)
⮚ Statement of Financial Position reports a company’s
financial position at a point in time, the company’s
resources (assets) namely, what the company owns
and also the sources of asset financing.
⮚ Current Assets – include cash or those expected to be
converted into cash, used or consumed within one year
or one operating cycle whichever is longer.
⮚ Property Plant and Equipment (Fixed Assets) – those
assets not consumed in annual business operations
⮚ Other Noncurrent Assets – it can include items such as
property held for sale, cash surrender value of life
insurance policies, and long-term advance payments.
Statement of Financial Position (Balance Sheet)
⚫Current Liabilities – represents claims against assets
that must be satisfied in one year or one operating
cycle whichever is longer.
⚫Non-Current Liabilities(Long Term Liabilities) – are
obligations with maturities beyond one year.
⚫Equity – the ownership interests in the company
Current Assets and Current Liabilities
⚫ Current Assets – are assets that are:
⚫ a. Expected to be realized, sold or consumed in the entity’s normal
operating cycle.
⚫ b. Held primarily for trading
⚫ c. Expected to be realized within 12 months after the reporting period; or
⚫ d. Cash or cash equivalent, unless restricted from being exchanged or used
to settle a liability for at least twelve months after the reporting period.
⚫ Current Liabilities – are liabilities that are:
⚫ a. Expected to be settled in the entity’s normal operating cycle.
⚫ b. Held primarily for trading.
⚫ d. Due to be settled within 12 months after the reporting period; or
⚫ e. The entity doesn’t have an unconditional right to defer settlement of the
liability for at least twelve months after the reporting period.
Items included in the Statement of Financial Position
⚫ The statement of financial position shows the entity’s financial condition as at a
certain date, it includes line items that present the following amount:
⚫ Property, plant and equipment
⚫ Investment property
⚫ Intangible Assets
⚫ Financial assets (excluding (e), (h) ad (i);
⚫ Investments accounted for using the equity method
⚫ Biological Assets
⚫ Inventories
⚫ Trade and other receivables
⚫ Cash and Cash Equivalents
⚫ Assets held for sale, including disposal groups
⚫ Trade and other payables
⚫ Provisions
⚫ Financial Liabilities
⚫ Current Tax liabilities and current tax assets
⚫ Deferred Tax liabilities and deferred tax assets
⚫ Liabilities included in disposal groups
⚫ Non-controlling interests; and
⚫ Issued capital and reserves attributable to owners of the parent
Presentation of Statement of Financial
Position
⚫Manners of presentation of Statement of Financial
Position:
⚫Classified Presentation – shows distinctions between
current and noncurrent assets, and current and
noncurrent liabilities.
⚫Unclassified Presentation – shows no distinction
between current and noncurrent items.
Statement of Profit Or Loss
⚫The profit and loss (P&L) statement is a
financial statement that summarizes the revenues,
costs, and expenses incurred during a specified period,
usually a fiscal quarter or year. These records provide
information about a company's ability or inability to
generate profit by increasing revenue, reducing costs, or
both
⚫Profit or Loss is income less expenses, excluding the
components of other comprehensive income. The
excess of Income over expenses is profit; while the
deficiency is loss.
A Profit or Loss statement usually has five
main components
1. revenue (sales/service revenue)
2. cost of goods sold (COGS)
3. gross profit (revenue minus COGS)
4. expenses.
5. net profit (gross profit minus expenses)
 Purple Company
Statement of Comprehensive Income
For the Year Ended December 31, 2019

Sales 536,231
Less: Cost of Sales 280,360
Gross Profit 255,871
Less: Operating Expenses 161,230
Net Operating Income 94,641
Less: Income Tax 33,124
Net Income 61,517
Add: Other Comprehensive Income 2,000
Net Comprehensive Income 63,517
⚫ Cost of Sales:
Beg. Inventory xxxx
Add: Purchases xxxx
Add: Freight In xxxx
Less: Purchases Discounts xxxx
Purchase Returns & Allow. Xxxx xxxx
Total Goods Available for Sale xxxx
Less: Ending Inventory xxxx
Cost of Sales or Cost of Goods Sold xxxx
⚫ Expensesofmay
Presentation be presented using either of the
Expenses
following methods:
⚫ Nature of Expense Method – under this method expenses
are aggregated according to their nature and are not
reallocated according to their functions within the
entity.
⚫ e.g. Depreciation, purchases of materials, transport costs,
administrative expenses, and other functional classifications.
 Function of Expense Method – under this method, an
entity classifies expenses according to their function.
Cost of Sales shall be presented separately from other
expenses.
⚫ e.g. Cost of Sales, Distribution costs(selling expenses),
Administrative Expenses, Other expenses, Finance Costs,
Income Tax Expense
Statement of Cash Flow
⚫ Statement of Cash Flows – reports the change in a company’s Cash
Balance over a period of time.
⚫ The statement reports on cash inflows and outflows from Operating
activities, Investing activities and financing activities.

⚫ Cash flows in the statement are divided into the following three areas:
⚫ Operating activities. These constitute the revenue-generating activities of a
business. Examples of operating activities are cash received and disbursed
for product sales, royalties, commissions, fines, lawsuits, supplier and
lender invoices, and payroll.
⚫ Investing activities. These constitute payments made to acquire long-term
assets, as well as cash received from their sale. Examples of investing
activities are the purchase of fixed assets and the purchase or sale of
securities issued by other entities.
⚫ Financing activities. These constitute activities that will alter the equity or
borrowings of a business. Examples are the sale of company shares, the
repurchase of shares, and dividend payments.
⚫ There are two ways in which to present the statement
of cash flows, which are the
⚫ direct method
⚫ indirect method.
⚫ The direct method requires an organization to present
cash flow information that is directly associated with
the items triggering cash flows, such as:
⚫ Cash collected from customers
⚫ Interest and dividends received
⚫ Cash paid to employees
⚫ Cash paid to suppliers
⚫ Interest paid
⚫ Income taxes paid
⚫The Indirect Method
⚫Under the indirect approach, the statement begins with
the net income or loss reported on the company's
income statement, and then makes a series of
adjustments to this figure to arrive at the amount of net
cash provided by operating activities. These
adjustments typically include the following:
⚫ Depreciation and amortization
⚫ Provision for losses on accounts receivable
⚫ Gain or loss on sale of assets
⚫ Change in receivables
⚫ Change in inventory
⚫ Change in payables
 Purple Company
Cash Flow Statement
For the Year Ended December 31, 2019

Net Income 63,517

Additions to Cash:
Depreciation 10,000
Decrease in Accounts Receivable 18,000
Increase in Accounts Payable 9,000
Increase in Taxes Payable 11,000
Deductions from Cash:
Increase in Inventory (7,000)
Net Cash From Operations 104,517
Investing Activities:
Purchase of Equipment (20,000)
Financing Activities:
Bank Loan 50,000
Net Cash Flow 134,517
Add: Cash, Jan 1, 2019 21,385
Cash Balance, December 31, 2019 155,902
⚫Statement of Stockholders’ Equity
⚫ The statement of stockholders’ 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.

Purple Company
Statement of Stockholders' Equity
For the Year Ended December 31, 2019

Contributed Retained
Capital Earnings Other Equity Total
Particulars
December 31, 2018 Balance ₱53,060 ₱117,824 ₱50,478 221,362
Stock Issuance(Repurchase) 860    860
Net Income (Loss)   26,426  26,426
Dividends       0
Other   56 (1,902) (1,846)
December 31, 2019 Balance 53,920 144,306 48,576 246,802
⚫Contributed Capital represents the cash that the
company received from the sale of stock to
stockholders, less any funds used up for the
repurchase of stock.
⚫Retained Earnings 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 changes in Retained earnings are computed as
follows:
Retained Earnings Beg. + Net Income(-Loss) -
Dividends