CHAPTER 5: UNDERSTANDING 📌 Accounting information must be

FINANCIAL STATEMENTS interpreted within business context.

I. INTRODUCTION III. GENERAL OBJECTIVES OF

FINANCIAL STATEMENTS
Purpose of the Chapter
1. Provide Information for Economic
To provide a framework and tools to: Decisions
●​ Analyze companies Users evaluate:
●​ Assess performance
●​ Evaluate risk ●​ Ability to generate cash
●​ Value securities ●​ Timing of cash generation

📌 Always imagine yourself as: ●​ Certainty of cash flows

Why is it important?​
●​ A manager (acquire/divest decision) Because it determines ability to:
●​ An investor (buy/sell shares)
●​ A credit analyst (approve loan or ●​ Pay employees
not) ●​ Pay suppliers
●​ Pay interest
Perspective matters in financial analysis. ●​ Repay loans
●​ Pay dividends
II. HOW BUSINESS ACTIVITIES
ARE REPORTED 2. Provide Information About
Financial Position
All businesses perform 4 major activities:
Focus Areas:
1.​ Planning
2.​ Financing a. Economic Resources
3.​ Investing
4.​ Operating ●​ Assets controlled by company
●​ Ability to generate future cash
These activities are reported through
financial statements. b. Financial Structure
Financial statements: ●​ Mix of debt and equity
●​ Future borrowing capacity
●​ Report performance
●​ Report financial condition
●​ Reveal management insights
●​ Follow accounting standards
c. Fundraising Ability IV. DEMAND FOR FINANCIAL
ACCOUNTING INFORMATION
●​ Can the company raise more
capital?
1. Managers & Employees
d. Liquidity vs Solvency
Use financial statements for:
Concept Meaning
●​ Salary negotiations
Liquidity Short-term ability to pay obligations ●​ Bonuses
●​ Job security
Solvency Long-term ability to survive financially
●​ Financing decisions

2. Investors & Analysts

3. Provide Information About
Performance Used to:

Measures: ●​ Buy/sell shares

●​ Predict future profitability
●​ Profitability ●​ Assess valuation
●​ Variability of earnings
●​ Efficiency of resource usage Stock price reacts to earnings expectations.

Used to assess: 3. Creditors & Suppliers

●​ Future earning potential Use for:
●​ Management effectiveness
●​ Loan approval
4. Provide Information About ●​ Credit terms
Changes in Financial Position ●​ Interest rates
●​ Required collateral
Shows:
4. Shareholders & Directors
●​ Investing activities
●​ Financing activities Evaluate:
●​ Operating activities
●​ Profitability
Helps evaluate: ●​ Risk
●​ Managerial performance
●​ Cash generation ability
●​ Cash usage needs
5. Regulatory & Tax Agencies ●​ Notes
●​ Management Discussion & Analysis
Examples in Philippines:
2. Unaudited Quarterly Reports
●​ SEC
●​ BIR All corporations must file audited financial
●​ BSP statements annually.

Purpose:
VI. BENEFITS OF DISCLOSURE
●​ Legal compliance
●​ Public protection Better disclosure leads to:
●​ Taxation
●​ Lower cost of capital
6. Customers & Strategic Partners ●​ Higher stock price
●​ Better employee recruitment
Evaluate: ●​ Stronger supplier relationships
●​ Competitive advantage
●​ Reliability
●​ Stability Reliable audited information improves
●​ Long-term viability credibility.

7. Other Decision Makers VII. COSTS OF DISCLOSURE

Includes: Includes:
●​ Environmental regulators ●​ Preparation costs
●​ Policy makers ●​ Competitive disadvantage
●​ Legal institutions ●​ Legal risks
●​ Political costs
V. SOURCES OF INFORMATION Highly visible firms face higher scrutiny.
In the Philippines:
VIII. CONSTRAINTS ON
Companies file with SEC:
INFORMATION
1. Audited Annual Report
1. Timeliness vs Reliability
Includes:
Fast reporting may reduce reliability.​
●​ Statement of Financial Position Delayed reporting reduces relevance.
●​ Statement of Comprehensive
Income Balance is required.
●​ Statement of Stockholders’ Equity
●​ Statement of Cash Flows
2. Cost vs Benefit Key Concepts:

Information benefits must exceed the cost ●​ Historical cost

of producing it. ●​ Fair value debate
●​ Capital structure trade-offs
3. Balance of Qualitative
Characteristics Working Capital

Trade-offs between: Current Assets – Current Liabilities

●​ Relevance Net Working Capital:

●​ Reliability
●​ Comparability CA – CL
●​ Understandability
Net Operating Working Capital:
4. True and Fair View
CA – Non-interest bearing CL
Financial statements must fairly present:
2. Statement of Comprehensive
●​ Financial position
●​ Performance Income
●​ Changes in position
📍 Over a period
Formula:
IX. THE FOUR FINANCIAL
STATEMENTS Revenue – Expenses = Net Income

Manufacturing & Merchandising:

1. Statement of Financial Position
(Balance Sheet) Revenue​

📍 Point in time – Cost of Goods Sold​

= Gross Profit​
– Operating Expenses​
Shows: = Net Income
Assets = Liabilities + Equity
Key Accounting Questions:
Financing Sources:
●​ Revenue recognition (accrual vs
1.​ Owner financing (Equity) cash)
2.​ Nonowner financing (Debt) ●​ Depreciation of long-term assets
●​ Matching principle
●​ Unrealized gains
●​ Accrued wages​
 ●​ No income from own stock Flow:
transactions
Income Statement​
⬇​
3. Statement of Stockholders’ Retained Earnings (Equity)​
Equity ⬇​
Balance Sheet​
Shows movement in: ⬇​
Cash Flow Statement explains cash
●​ Contributed Capital changes
●​ Retained Earnings
●​ Other Equity Components Preparation Order:

Formula: 1.​ Income Statement

2.​ Update Retained Earnings
Ending RE = Beginning RE + Net Income – 3.​ Balance Sheet
Dividends 4.​ Statement of Equity
5.​ Cash Flow Statement
Retained earnings links income statement
and balance sheet.
XI. BIG ANALYSIS FRAMEWORK
4. Statement of Cash Flows When analyzing a company, always ask:

Reports cash inflows and outflows. 1.​ Is it profitable?

2.​ Is it liquid?
Three Sections: 3.​ Is it solvent?
4.​ Is cash from operations positive?
1️⃣ Operating Activities​ 5.​ Is growth financed by debt or
2️⃣ Investing Activities​ equity?
3️⃣ Financing Activities 6.​ Is performance sustainable?​

Key Analytical Questions:

●​ Is operating cash flow positive?

●​ Is the company funding operations
through debt?
●​ Are investments growth-oriented?
●​ What is the financing source?

X. LINKAGE (ARTICULATION)

Statements are interconnected.