CHAPTER 3 UNDERSTANDING FINANCIAL STATEMENTS

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CHAPTER3 UNDERSTANDING FINANCIAL
STATEMENTS
I. Questions
1. A financial statement is a means of communicating information about an enterprise in financial
(i.e., peso) terms. It represents information that the accountant believes is a true and fair
representation of the financial activity of the enterprise.
2. Every financial statement relates to time in one way or another. A statement of financial position,
or balance sheet, represent a “picture” of the enterprise at a point in time (e.g.,the end of a month
or year). An income statement and a statement of cash flows, on the other hand, cover activity that
took place over a period of time(e.g., a month or year).
3. a. Creditors are interested in financial statements to assist them in evaluating the ability of a
business to repay its debts. No one wants
to extend credit to a company that is unable to meet its obligations as they come due.
b. Potential investors use financial statements in selecting among alternative investment
opportunities. They are interested in investing in companies in which the value of their
investment will increase as a result of future profitable operations.
c. Labor unions are interested in financial statements because the financial position of a company
and its profits are important factors in the company’s ability to pay higher wages and to employ
more people.
4. Business transactions affect a company’s financial position, and as a result they change the
statement of financial position or balance sheet. The other financial statements – the income
statement and the statement of cash flows – are detailed expansions of certain aspects of the
statement of financial position and help explain how the company’s position changed over time.
5. The cost principle indicates that many assets are included in the financial records, and therefore,
in the statement of financial position, at their original cost to the reporting enterprise. This
principle affects accounting for assets in several ways, one of which is that the amount of most
assets is not adjusted periodically for changes in the market value of the assets. Instead, cost is
retained as the basic method of accounting, regardless of changes in the market value of those
assets.
6. The going concernassumption statesthatin the absence of evidence tothe contrary (i.e.,bankruptcy
proceedings),an enterprise is expectedto continue to operate in the foreseeable future. This means,
for example, that it will continue to use the assets it has in its financial statements for the purpose
for which they were acquired.
7. The three categories and the information included in each are:
Operating activities – Cash provided by and used in revenue and expense transactions.

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Investing activities – Cash provided by and used as a result of investments in assets, such as
machinery, equipment, land, and buildings.
Financial activities – Cash provided by and used in debt and equity financing, such as borrowing
and repaying loans, and investments from and dividends paid to the enterprise’s owners.

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Chapter 8 Cost Conceptsand Classifications
8. Adequate disclosure refers to the requirement that financial statements, including accompanying
notes, must include information necessary for reasonably informed users of financial statements to
understand the company’sfinancial activities. This requirementis often met,in part,by the addition
of notes to the financial statements. Financial statement notes include both quantitative and
qualitative information that is not included in the body of the financialstatements.
9. A strong income statement is one that has significantly more pesos of revenue than expenses,
resulting in net income that is a relatively high percentage of the revenue figure. A trend of
relatively high income numbers over time signals a particularly strong incomesituation.
10. A strong statement of cash flows is one that shows significant amounts of cash generated from
operating activities. This means that the enterprise is generating cash from its ongoing activities
and is not required to rely on continuous debt and equity financing, or the sale of its major assets.
11. The purpose of classifications in financial statements is to develop useful subtotals,which help
users analyze the statements. The most commonly used classifications are:
In a balance sheet:current assets,plant and equipment, other assets,current liabilities, long-term
liabilities and equity.
In a multiple-step income statement: revenue, cost of goods sold, operating expenses, and
nonoperating items. The operating expense section often includes subclassifications for selling
expenses and for general and administrative expenses.
In a statement of cash flows: operating activities, investing activities, and financing activities.
12. In classified financial statements, similar items are grouped together to produce subtotals which
may assist users in their analyses. Comparative financialstatements show financial statements for
two or more time periods in side-by-side columns. Consolidated statements include not only the
financial statement amounts for the company itself but also for any subsidiary companies that it
owns. The financial statementsof large corporations often possess allthree ofthese characteristics.
13. In a multiple-step income statement, different categories of expenses are deducted from revenue in
a series of steps, thus resulting in various subtotals, such as gross profit and operating income. In
a single-step

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Cost Concepts and Classifications Chapter 8
income statement, all expenses are combined and deducted from total revenue in a single step.
Both formats result in the same amount of net income.
II. Matching Type
1.
1. d 3. a 5. e 7. f 9. c
2. g 4. j 6. h 8. b 10. i
2.
1. d 3. i 5. m 7. h 9. f 11. b 13. e
2. a 4. g 6. c 8. n 10. k 12. j 14. l
3.
a. F c. F e. I g. F I. I k. F
b. I d. I f. F h. F j. F l. I