CHAPTER 3: FINANCIAL STATEMENTS, CASH FLOWS AND TAXES

MBA206 Financial Management

by Honie Jane D. Amerila

I. BASIC FINANCIAL STATEMENT

Financial statements are the means by which the information accumulated and processed in
financial accounting is periodically communicated to the users.
It is a structured financial representation of the financial position and financial performance of an
entity.

Responsible for financial statement

Management: has the primary responsibility for the preparation and presentation of financial
statements
Board of Directors: reviews and authorizes the FS for issue before these are submitted to the
shareholders of the entity.
Shareholders: they are interested in information that helps them assess how effectively
management has fulfilled this role as this is relevant to the decision concerning their investment and
the reappointment or replacement of management.

Components of Financial Plan:

1. Balance Sheet
2. Income Statement
3. Statement of changes in equity
4. Statement of cash flows

THE BALANCE SHEET/ STATEMENT OF FINANCIAL POSITION

The balance sheet is a “snapshot” of a firm’s position at a specific point in time. The purpose of
the balance sheet , sometimes referred to as the statement of financial position , is to report a
company’s financial position on a particular date. Unlike the income statement, which is a change
statement reporting events that occurred during a period of time, the balance sheet presents an
organized array of assets, liabilities, and shareholders’ equity at a point in time. It is a freeze frame or
snapshot of financial position at the end of a particular day marking the end of an accounting period.
Figure below shows the layout of a typical balance sheet. The left side of the statement shows the
assets that the company owns, while the right side shows the firm’s liabilities and stockholders’ equity,
which are claims against the firm’s assets.
 3 PRIMARY ELEMENTS OF A BALANCE SHEET:
Assets are probable future economic benefits obtained or controlled by a particular entity as a
result of past transactions or events. Assets are divided into two major categories: current
assets and fixed or long-term assets.
⚫ Current assets consist of assets that should be converted to cash within one year; and
they include cash and cash equivalents, accounts receivable, and inventory.
⚫ Long-term assets are assets expected to be used for more than one year; they include
plant and equipment in addition to intellectual property such as patents and copyrights.
Plant and equipment is generally reported net of accumulated depreciation.
Liabilities are probable future sacrifices of economic benefits arising from present obligations of
a particular entity to transfer assets or provide services to other entities in the future as a result
of past transactions or events.
⚫ Current liabilities are those obligations that are expected to be satisfied through the use of
current assets or the creation of other current liabilities. So, this classification includes all
liabilities that are expected to be satisfied within one year or the operating cycle,
whichever is longer. The most common current liabilities are accounts payable, notes
payable (short-term borrowings), unearned revenues, accrued liabilities, and the currently
maturing portion of long term debt.
⚫ Long-term liabilities are obligations that will not be satisfied in the next year or operating
cycle, whichever is longer. They do not require the use of current assets or the creation of
current liabilities for payment. Examples are long-term notes, bonds, pension obligations,
and lease obligations.
Equity (or net assets), called shareholders’ equity or stockholders’ equity for a corporation, is
the residual interest in the assets of an entity that remains after deducting liabilities. Owners’
equity is simply a residual amount derived by subtracting liabilities from assets. For that reason,
it’s sometimes referred to as net assets.

STATEMENT OF COMPREHENSIVE INCOME/ INCOME STATEMENT

The income statement displays a company’s operating performance, that is, its net profit or loss,
during the reporting period.
The purpose of the income statement , sometimes called the statement of operations or statement
of earnings , is to summarize the profit-generating activities that occurred during a particular reporting
period. Many investors and creditors perceive it as the statement most useful for predicting future
profitability (future cash-generating ability).

Components:
The components of income from continuing operations are revenues, expenses (including income
taxes), gains, and losses, excluding those related to discontinued operations and extraordinary items.

Revenues, Expenses, Gains, and Losses

Revenues are inflows of resources resulting from providing goods or services to customers.
Expenses are outflows of resources incurred while generating revenue. They represent the
costs of providing goods and services. The matching principle is a key player in the way we
measure expenses. We attempt to establish a causal relationship between revenues and
expenses. If causality can be determined, expenses are reported in the same period that the
related revenue is recognized. If a causal relationship cannot be established, we relate the
expense to a particular period, allocate it over several periods, or expense it as incurred.
Gains and losses are increases or decreases in equity from peripheral or incidental
transactions of an entity. In general, these gains and losses result from changes in equity that
do not result directly from operations but nonetheless are related to those activities. For
example, gains and losses from the routine sale of equipment, buildings, or other operating
assets and from the sale of investment assets normally would be included in income from
continuing operations.
Income Tax Expense
Income tax expense is shown as a separate expense in the income statement. Taxable
income comprises of revenues, expenses, gains, and losses as measured according to the
regulations of the appropriate taxing authority.
Operating versus Nonoperating Income
Operating income includes revenues and expenses directly related to the primary revenue-
generating activities of the company. For example, operating income for a manufacturing
company includes sales revenues from selling the products it manufactures as well as all
expenses related to this activity. Similarly, operating income might also include gains and losses
from selling equipment and other assets used in the manufacturing process.
Nonoperating income relates to peripheral or incidental activities of the company. For
example, a manufacturer would include interest and dividend revenue, gains and losses from
selling investments, and interest expense in nonoperating income.
STATEMENT OF CHANGES IN OWNER’S EQUITY
All changes, whether increases or decreases to the owner’s interest on the company during the
period are reported here. This statement is prepared prior to preparation of the Statement of Financial
Position to be able to obtain the ending balance of the equity to be used in the SFP.

Initial Investment – The very first investment of the owner to the company.
Additional Investment – Increases to owner’s equity by adding investments by the
owner(Haddock, Price, & Farina, 2012).
Withdrawals –Decreases to owner’s equity by withdrawing assets by the owner (Haddock,
Price, & Farina, 2012).

STATEMENT OF CASH FLOWS

In addition to the income statement and the balance sheet, a statement of cash flows (SCF) is an
essential component within the set of basic financial statements. Specifically, when a balance sheet
and an income statement are presented, a statement of cash flows is required for each income
statement period.
The purpose of the statement of cash flows is to provide information about the cash receipts and
cash disbursements of an enterprise that occurred during a period. In describing cash flows, the
statement provides valuable information about the operating, investing, and financing activities that
occurred during the period. The statement of cash flows classifies all transactions affecting cash into
one of three categories: (1) operating activities, (2) investing activities, and (3) financing activities.
Operating Activities
The inflows and outflows of cash that result from activities reported in the income statement
are classified as cash flows from operating activities . In other words, this classification of cash
flows includes the elements of net income reported on a cash basis rather than an accrual basis.
Cash inflows include cash received from:
⚫ Customers from the sale of goods or services.
⚫ Interest and dividends from investments.
Cash outflows include cash paid for:
⚫ The purchase of inventory.
⚫ Salaries, wages, and other operating expenses.
⚫ Interest on debt.
⚫ Income taxes.
**The difference between the inflows and outflows is called net cash flows from operating
activities. This is equivalent to net income if the income statement had been prepared on a cash
basis rather than an accrual basis.
 **These amounts may differ from sales and investment income reported in the income
statement. For example, sales revenue measured on the accrual basis reflects revenue earned
during the period, not necessarily the cash actually collected. Revenue will not equal cash
collected from customers if receivables from customers or unearned revenue changed during
the period.
Investing Activities
Cash flows from investing activities include inflows and outflows of cash related to the
acquisition and disposition of long-lived assets used in the operations of the business (such as
property, plant, and equipment) and investment assets (except those classified as cash
equivalents and trading securities). The purchase and sale of inventories are not considered
investing activities. Inventories are purchased for the purpose of being sold as part of the
company’s operations, so their purchase and sale are included with operating activities rather
than investing activities.
Cash outflows from investing activities include cash paid for:
⚫ The purchase of long-lived assets used in the business.
⚫ The purchase of investment securities like stocks and bonds of other entities (other
than those classified as cash equivalents and trading securities).
⚫ Loans to other entities.
Later, when the assets are disposed of, cash inflow from the sale of the assets (or collection of
loans and notes) also is reported as cash flows from investing activities. As a result, Cash
inflows from these transactions are considered investing activities:
⚫ The sale of long-lived assets used in the business.
⚫ The sale of investment securities (other than cash equivalents and trading
securities).
⚫ The collection of a nontrade receivable (excluding the collection of interest, which
is an operating activity).
**Net cash flows from investing activities represents the difference between the inflows and
outflows.
Financing Activities
Financing activities relate to the external financing of the company. Cash inflows occur when
cash is borrowed from creditors or invested by owners. Cash outflows occur when cash is paid
back to creditors or distributed to owners. The payment of interest to a creditor, however, is
classified as an operating activity.
Cash inflows include cash received from:
⚫ Owners when shares are sold to them.
⚫ Creditors when cash is borrowed through notes, loans, mortgages, and bonds.
Cash outflows include cash paid to:
⚫ Owners in the form of dividends or other distributions.
⚫ Owners for the reacquisition of shares previously sold.
⚫ Creditors as repayment of the principal amounts of debt (excluding trade payables
that relate to operating activities).
**Net cash flows from financing activities is the difference between the inflows and outflows
 **Unlike the balance sheet, which is a position statement, the income statement and the statement of
cash flows are change statements. The income statement reports the changes in shareholders’ equity
(retained earnings) that occurred during the reporting period as a result of revenues, expenses, gains,
and losses. The statement of cash flows also is a change statement, disclosing the events that caused
cash to change

II. FREE CASH FLOW ITS IMPORTANCE IN THE COMPANY’S VALUES

Accounting statements are designed primarily for use by creditors and tax collectors, not for
managers and stock analysts. Therefore, corporate decision makers and security analysts often
modify accounting data to meet their needs. The most important modification is the concept of FREE
CASH FLOW (FCF), defined as “the amount of cash that could be withdrawn without harming a firm’s
ability to operate and to produce future cash flows.”
Free cash flow (FCF) is a company's available cash repaid to creditors and as dividends and
interest to investors.
Free cash flow is important to large companies because security analysts use FCF to help
estimate the value of the stock, and managers use it to assess the value of proposed capital
budgeting projects and potential merger candidates.
Many analysts regard FCF as being the single most important number that can be developed from
accounting statements, even more important than net income. After all, FCF shows how much cash
the firm can distribute to its investors.
III. INDIVIDUAL AND CORPORATE TAX (PHILIPPINE SETTING)

Types of Income
Ordinary or regular income
Refers to the income such as compensation income, business income, income from practice of
profession, income from sale and/or dealings of property etc. Ordinary income are subject to
graduated tax or the basic tax.
Passive income derived from Philippine sources; and
Subject to final withholding taxes are certain passive income from sources within the
Philippines as enumerate under Section 24 (B) of the Tax Code. Passive income could be as
follows:
⚫ Interest income
⚫ Dividend income
⚫ Royalties
⚫ Prizes
⚫ Other winnings
Capital gains subject to capital gains tax
This could be:
⚫ Capital gains from sale of shares of stocks of a domestic corporation not traded in
the local stock exchange;
⚫ Capital gains from sale of real property in the Philippines

PERSONAL/ INDIVIDUAL INCOME TAX

INDIVIDUAL TAXPAYERS are natural persons with income derived from within the territorial
jurisdiction of taxing authority. Under the Tax Code (NIRC), individual taxpayers are classified as:
1. Resident Citizen
2. Nonresident Citizen
3. Resident Aliens
4. Nonresident Aliens
⚫ engaged in trade/business
⚫ nonresident aliens not engaged in trade or business
Importance of Classification

They differ as to:

⚫ Situs of income
⚫ Manner of computing tax
⚫ Treatment of certain passive incomes
⚫ Allowable deductions
⚫ Reference in the tax code

Resident Citizen
Under section I, Article III of the Philippine Constitution, a Filipino citizen is a natural person who
is/has
1. Born (by birth) with father and/or mother as a Filipino citizen
2. Born before January 17, 1973 of Filipino mother who elects Philippine citizenship upon
reaching the age of majority
3. Acquired Philippine citizenship after birth (naturalized) in accordance with Philippine
Laws

Nonresident Citizen
Sec. 22 (E) of the NIRC describes a nonresident citizen as a citizen who:
 1. Establishes, to the satisfaction of the commissioner of Internal Revenue, the fact of his
physical presence abroad with a definite intention to reside therein;
2. Leaves the Philippines during the taxable year to reside abroad
⚫ As an immigrant; or
⚫ For employment on a permanent basis; or
⚫ For work and derives income abroad and whose employment thereat requires
him to be physically abroad most of the time during the taxable year
3. A citizen of the Philippines who shall have stayed outside the Philippines for one hundred
eighty-three (183) days or more by the end of the year (aggregate)

Resident Aliens
An alien is a foreign-born person who is not qualified to acquire Philippine citizenship by birth or
after birth.
Section 22(F) of the Tax Code defines resident alien as an individual whose residence is
within the Philippines and who is not a citizen thereof. Aliens who are actually present I the
Philippines and who are not mere transient or sojourners are classified as resident aliens. An
alien who live I the Philippines with no definite intention as to his stay is also a resident alien.
Likewise an alien who come to the Philippines for the purpose that requires extended stay for
its accomplishment, so he makes his home stay temporarily in the Philippines, is a resident,
regardless of his intention to return to his residence abroad.

Nonresident Alien
The term nonresident alien under Section 22 (G) of the Tax Code means an individual whose
residence is not in the Philippines and who is not a citizen thereof. They are aliens who come to
the Philippines for a definite purpose, which in its nature my be promptly accomplished. They are alien
who are mere transients or non-residents, hence, classified as nonresident alien.
Aliens who stayed in the Philippines for an aggregate period of more than 180 days during
the taxable year and/or aliens who have business income in the Philippines are considered as
nonresident aliens engaged in trade or business. Under Section 22(S) of the Tax Code, trade or
business include performance of the functions of a public office or performance of a personal services
I the Philippines (except performance of services by the taxpayer as an employee). If an alien stay in
the Philippines for only 180 days or less, or he is no deriving business income in the
Philippines, he is considered as a nonresident alien engaged in trade or business.
A nonresident alien not engaged in business or trade is subject to 25% income tax based on
gross income from all the sources within the Philippines (ordinary income or passive income except
for income subject to capital gains tax) as interest, cash and/or property dividends, rents, salaries,
wages, premiums, annuities, compensation, renumeration, emoluments, or other fixed or determinable
annual or periodic or casual gains, profits and capital gains.

TAXPAYER TAX BASE TAX RATE TAXABLE SOURCE

Resident Citizen Net Income Graduated w/in or W/out Phil
Nonresident Citizen Net Income Graduated Within only
Resident Alien Net Income Graduated Within only
Nonresident Alien-ETB Net Income Graduated Within only
Nonresident Alien- Gross Income Final Tax 25% Within only
NETB
 CORPORATE INCOME TAX
CORPORATION is an artificial being created by operation of law, having the right of succession and
the powers, attributes and properties expressly authorized by the law or incident to its existence.
The term Corporation includes:
⚫ Partnerships
⚫ Joint stock companies
⚫ Joint accounts
⚫ Associations
⚫ Insurance companies
Classification of Corporation
⚫ Domestic corporations- created or organized in the Philippines under its laws.
⚫ Resident foreign corporation-a foreign corporation which is not domestic and
engaged in business in the Philippines.
⚫ Nonresident foreign corporations- a foreign corporation which is not domestic and
not engaged in business in the Philippines.

CLASSIFICATION SOURCES OF INCOME

WITHIN PHIL WITHOUT PHIL
DOMESTIC Yes yes
FOREIGN yes

References:
Intermediate Accounting (7th Edition)
By: Spiceland, Sepe, Nelson
Fundamentals of ABM 2: A teaching guide for SHS
By: CHED
Intermediate Accounting
By: Valix and Peralta
Income Taxation
By: Enrico Tabag
Fundamentals of Financial Management (8th Edition)
By: Eugene Brigham and Joel Houston