Lesson 18

PREPARATION OF FINANCIAL STATEMENTS INCOME STATEMENT

Good day everyone. Today we are going to learn the preparation of financial statement and
capital statements. Preparation of the financial statements. Financial statements show how business
entities communicate their stories about their financial situations.
There are four basic financial statements every business must prepare. Together they represent the
profitability and strength of the company. The financial statement that reflects a business profitability is
the income statement. The statement of the owner's equity or capital, allows or shows the change in equity
or capital between the beginning and end of the period. The balance sheet reflects a company solvency
and financial position. The statement cash flows shows the cash inflows and outflows of the business over
a period of time. Financial statements are prepare are prepared in the following order. Income statement
first then the capital statement or statement of owner's equity. This is for the sole proprietorship and
partnership and we call it statement of retained earnings for corporations. The third is the balance sheet
and the fourth is the statement of cash flows. Let us go back to the basic accounting equation where asset
is equal to liabilities plus capital. Where capital is equal to beginning capital plus additional capital plus
net income which is equal to revenue minus expenses and then minus drawing. Note that the red accounts
are for the balance sheet. and the blue account are for the capital statement and the brown accounts are for
the income statement account. Therefore, the balance sheet formula is as with asset is equal to assets is
equal to liabilities plus capital.
The capital statement is equal to beginning capital plus additional capital plus net income or
minus net loss minus drawing. So the income statement account consists of revenue minus expenses. so
from the from the basic equation itself you will find all the financial almost all the financial statements
the only one that is not found in the finance in this basic accounting equation is the statement of cash flow
because the statement of cash flows was required only in 1984 and this statement flow, cash flow will
come from the analysis of the ledger account of the cash so all the details in the cash ledger will be
analyzed to come up with the cash flow statements. so the cash flow statement will merely show the
ending balance of the of the capital ledger but how these uh how these um activities using cash will be
unclassified will be shown in the cash flow statements. So the cash flows statement is the only financial
statement that cannot be found clearly from the basic accounting equation but it is from that but the date
details can be found from the cash ledger account. So the heart of the accounting cycle is the preparation
of the financial statement so we will begin with the preparation of the income statement.
There are two types or format for the presentation of the income statement but in our discussion,
we will discuss only the two commonly used formats the single step format and the multi- step format. So
the single step format of income statement presents information in a simplified format, it uses a single
subtotal for all revenue items, line items and a single subtotal for on all the expense items so to come up
with your net income. A single step format is not um heavily used because it forces the leaders of an
income statement to separately summarize subsets of information within the income statement we cannot
reduce any analysis from this kind of information this format is most commonly used by businesses that
have relatively simple operations with few lines item reported, smaller businesses may start reporting
their financial results and with using single step income statement format and then switch to the multi-
step format once their operations become larger and more complex. So, this is the illustration of a multi-
step format. This format uses subtotals for the gross margin then operating expenses and non- operating
expenses. This approached is used when there are many line items there by aggregate there by
aggregating information for easier comprehension. This is also called classified income statement.
So let's learn how to prepare the income statement, regardless of the format being used the steps
necessary in the preparation of the income statement will be the same the worksheet is to be prepared as
illustrated in the second stage of the accounting cycle where adjusted trial balance is prepared. Let us go
back to the worksheet being prepared for the Tarimacor Drug Store we stopped discussion on the
Lesson 18
PREPARATION OF FINANCIAL STATEMENTS INCOME STATEMENT

worksheets so as not to confuse you on the stages of the accounting cycle. All the worksheet is prepared
in one sitting and all necessary data can be taken from the completed worksheet. The complete worksheet
of tarima core was not presented in the discussion of the recording of internal transactions and preparation
of adjusted trial balance to give focus on the preparation of adjusting entries, posting to the ledgers of the
adjusting journals and the preparation of the unadjusted trial balance here now we're going to complete
that worksheet of the remote drugstore. So, external transaction plus internal transaction is equal to
adjusted trial balance so we stopped from this discussion in the first on the preceding lesson so we'll
review this again so this is the end of our discussion in the previous lesson we were done with the
adjusted trial balance and adjusted balance plus adjusting entries is equal to adjusted trial balance.
Now, we're going to draft for the closing entries the preparation of the closing entry should have
been the next step in the accounting cycle but the preparation of the closing entries is delayed until the
final financial statements are prepared to make sure that the when closing entries are made to the books of
accounts, there would be no more adjustments that will be that will entail instead of making necessary uh
adjusting instead of making the the uh make the post-closing engine instead of making the closed entries
closing entries in the journals and posting them to the ledgers. This procedure is delayed until final
financial statements are prepared because there will be some adjustments still, on during the preparation
of the financial statements and if we're going to record the um closing entries to the books of accounts
right away we might be ending up erasing some of our closing entries to give way to a more accurate
financial statement. So, because some of the regulatory on the target of the preparation of the financial
statements is to comply with the regulatory requirements of the BIR and securities and exchange
commission so once these financial statements have been presented to the BIR and securities and
exchange commission meaning to say the financial statements are already finalized then the co the closing
entries can now be safely entered into the books of accounts although in the process of um preparation it
is uh it is logically this is uh logically seq sequential if you prepare first the closing entries but it is not
practical to do because there are still um the financial statements are still subject to the approval of the
regulatory body. So in theory in theory the preparation will be an adjusted trial balance adjusting entries
adjusted trial balance then closing entries but uh in practice we do not we we leave the closing entries on
the worksheet while we are preparing the financial statement until the financial statements are finally
submitted to the regulatory bodies to make sure that whatever uh we're going to record in the books of
accounts that will be permanent and final.
So, what is then closing entry. So, from the adjusted trial balance we're going to post or to plot
the closing entry for each affected account. A closing entry is a journal entry made at the end of the
accounting period it involves shifting adjusted balance of the temporary accounts to the income statement
account by reducing this balances to zero through the use of a cleaning account called income summary
so it is shifting the adjusted balance to the income statement by reducing the balances to zero, so our
target is to make that balance zero. First, we identify the temporary accounts. Second, we reduce the
temporary accounts to zero using the income summary account. So, we have discussed earlier that the
formula for income is; Revenue – Expenses = Income.
So, these are the accounts and the accounts are falling these titles will be considered temporary
account. So, we're going to find out one by one which are the revenue and expense accounts. So, we have
here sales, purchases have been closed already by the adjustment. So, salaries expense, rent expense,
utilities expense, but that is expense allowance for but is not that is a contra asset, supplies expense,
insurance expense, depreciation expense, accumulated depreciation is not it is a contra asset accounts.
The purchase returns and allowances has already been closed in the adjusting entry so we have freight out
or transportation expense, uh incurred rent asset prepaid utilities the we have Cost of goods sold. So, after
uhm after identifying all the revenue and expense items, we're going to reduce them to zero. So, what how
Lesson 18
PREPARATION OF FINANCIAL STATEMENTS INCOME STATEMENT

are we going to reduce these items to zero? So, we're going to use the income summary account, the
income summary account will be the clearing account.
Clearing accounts are used to record transactions on a temporary basis until it's time to post them
to a permanent account. So, all sales and revenue accounts to be zero must be debited and the income
summary account to be use as a credit. To make all expenses zero the income summary is debited and
each expense item is credited. Whatever is debited should be credited and what should what has been
credited should be debited to make them zero. The difference in the income summary account will be
either net income or net loss that's why it is called income summary account because we can get the
difference as an income or as a loss from this summary account.
So, let's take a look here. Take a look at the presentation here. So, we're going to the sales, the
sales is a credit so to make it zero we have to debit it and credit it to the income summary account. So,
we're going to have an entry of debit sales, credit income summary account. So, it will appear in the
income summary account on the credit side. It has been removed from the credit side of the sales account
and transferred to the income summary account. Now, with regards to expense. The individual expense
account will be debited uh will be credit and the income summary account will be debited. So, the total of
this expense item which is 104,738 will be debited in the income summary account. It is debited in the uh
individual expense account but the total will be debited in the incurring income summary account to make
those individual debits zero. So, we have the sales as a credit in the income summary and the expense
debit in the income summary. So, when the debit is greater than credit it means to say that expenses are
greater than income, because what's in the debit in the income summary is the total of expenses and when
the credit is greater than the debit there is net income or the sales is greater than the expenses, because the
sale is in the credit side of income summary. So, if on the difference is on the credit side then that is net
income but if the difference is on the debit side then that is a net loss. Now, the net, this is a net income.
In the presentation of the uh closing entries section it is put in the in the debit side because of our rule on
balancing of accounts. We put the difference on the lighter side. So, the lighter side here is the debit side
and the heavier side is the credit side. So, the credit side is heavier therefore there is net income because
the net income is the uh is the represent uh the credit side represent sales which is the source of income.
So, the 75 to 6 to here represent net income it was just placed here on the debit side for the purposes for
the purpose of balancing the accounts. Meaning to say you have to present the accounts in a balanced
format. That's how we do that in accounting like this one the closing entries we present this on a balance
format, therefore we put the difference on the lighter side. So, the lighter side is the debit side, therefore it
came from a credit side. A credit side in the income summary account represent income. So, if the income
is greater than expenses there will be net income if income lesser than expenses there would be net loss.
So, we're going to do the same the thing with what we did on the unadjusted trial balance in the
unadjusted trial balance we record the adjusting entries and then after the adjusting entries being plotted,
we prepare the adjusted trial balance. This time we're going to use as the basis the adjusted trial balance
and then we prepare the closing entries.
The closing entries uh the purpose of the closing entries is to segregate the nominal accounts
from the real accounts, because the nominal accounts will be placed in the income statement and the real
accounts are the ones will be left after the closing process will be transferred to the balance sheet account.
So, we will do the same thing we will plot the closing entries to arrive at the post-closing trial balance.
So, we have three kinds of trial balance to prepare in a accounting cycle in the complete accounting cycle
we have the unadjusted trial balance, after adjustment we will have trial balance after the closing entries
we will have the post-closing trial balance. So, we'll take a look at the example of the drawing, the
drawing has a debit balance to close it it's not going to be part of the income summary account. It will be
directly uh credited uh debited to the capital account.
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PREPARATION OF FINANCIAL STATEMENTS INCOME STATEMENT

So, to make zero the drawing we have to credit it and so what are we going to debit will it be the
income summary, no. It's not part of the Revenue minus expenses formula, so, it will go directly to the
capital. A drawing will always decrease a capital account. So, we're going to entry of the drawing is debit,
so debit on drawing credit cash. Now, we're going to record it as a closing entry we're going to make it
zero. We're going to debit the capital and credit the drawing account. So, at the end of the period there
will be no drawing account to be seen in the uh in the balance.
A drawing is also a nominal account but it is not part of the income statement so it is a partly
somewhat a real account because it will go to the capital account. Anyway, the net income also partly a
real account because the result of the operation will go to the capital account but they are not carried
forward to the next accounting period so they stay in February uh they stay in February uh financial
statement but they will not affect anymore the march financial statement, unlike the real accounts the ones
that will be left after the closing process these are called real accounts and they will be forwarded to the
next accounting period. So, let’s look at the details of what I have explained earlier. So, this is the
accounts payable. Okay… this is um- i'm sorry… this is not for the accounts payable, it is for the capital
rather, rather the arrow is not so perfectly aligned with the account so, it is this line is for the capital and
this line is for the drawing so, we will remove this line on the accounts payable this is not necessary so,
the only lines we need to understand is the study,
Terimacor, Capital and Terimacor, Drawing so, this we have an adjusted balance uh, adjusted
balance of a debit in the drawing account. To make it zero we have to make it credit so, but, what would
be debited will be the capital account not the income summary account. Okay, Now, we go to the income
summary accounts or the revenue and expense items that will be closed or reduced to zero. So, we have
the sales. So, the sales account is originally a credit on the adjusted trial balance. To make it zero you
have to debit it. But where is the credit here in the income summary account. So, this is the process you
debit the sales and credit the income summary account. Now with regards to the different expenses, the
remaining expense accounts in the adjusted balance is the… what is this one? Salaries Expense.
So we have the salaries expense. Then, the rent expense. And then the utilities expense. Cash shortage.
We have cash this cash shortage but that’s expense. And what else, supplies expense. We have these two
lines. Then, Insurance expense; 100. Depreciation expense; 833. Uh… purchase returns no more entry on
that. What is this one? Freight out. Transportation expense. Then, this one, why do we have salaries
payable here? Oh, we have this in an adjusted trial balance but this is not an expense it is a payable.
Prepaid rent. So, the last item is the cost of goods sold. So, we’re going to uh… see the effects of the
closing entries on the accounts in the adjusted trial balance. So, we have already identified the accounts to
be closed. So, we have the drawing here. Which is closed to the capital, and the individual expense
account. We have the… what is this? Sales. We debit the sales and credit the income summary account.

Now, we go to the next item. Salaries Expense; Credit, because all these expenses are debit
before. Salaries expense, rent expense, utilities expense, cash shortage, bad depts, supplies expense,
insurance expense, depreciation expense, freight out, and cost of good sold. So the total of all of these
will be a debit to the income summary. So, this one. So this debit is the total of all uh... of all expense in
the income summary accounts. This becomes the income summary account except for the… for the
capital, drawings and… capital and drawings so this uh 180 and this the total of these expenses will be on
the difference in the total expenses and the total sales will be the net income or net loss, so, what is the
heavier side in the closing entries column? The heavier side is the credit therefore, the income is greater
than expenses so the difference is uh net income. We put, as I said, we put it in the debit column for the
purpose of balancing but that not necessary that this is the balance that the balance is a balance, It is a
credit balance because the credit balance is heavier than debit balance so the balance is credit but, in the
presentation, here to balance this ending total, we have to put the difference on the debit column So, this
is a credit balance in the income summary which is a net income. Now. Take note; all the zero here
Lesson 18
PREPARATION OF FINANCIAL STATEMENTS INCOME STATEMENT

except the, except this uhmm… capital, drawings. That is the drawing so, Except for the drawings, all the
zero will be forwarded to the income statement so take note this is zero forwarded this is zero, What is the
zero? That is the purchases. So what has been made zero with an amount so let’s put it that way. So this is
a zero with amount, then this zero with amount. It is forwarded to the income statement in the adjusted
trial balance. Okay, from the adjusted trial balance to the post-closing trial balance. They are removed
but they are forwarded to the income statement. They are removed from the post-closing trial balance to
identify only the real accounts but they are move forward to the income statement so these are all the
balances that are moved forward to the income statement.

Take note of the income, it is again on the debit but that is a net income because it came from the
heavier side. We just put it here for the purpose of balancing the accounts. That’s all. But in your analysis,
this is a credit balance. Now, so, what has been left? Will be forwarded to the balance sheet. So, we have
this cash forwarded to the balance sheet, merchandise inventory at the end on supplies rather, That is
supplies or accounts receivable, accounts receivable sorry, accounts receivable, then we have the
merchandise inventory, then the supplies, then prepaid insurance what else, trucks this is trucks, then we
have the accounts payable, then the capital then we have the uh allowance for bad debts, then allowance
for depreciation, then salaries payable, we have this prepaid rent then prepaid utilities. So, these are the
real accounts so it should be balance because asset is equal to liabilities plus capital. So, it’s a beautiful
story of operation because it has a net income of 75,262. When the original capital is only 25,000. It
started with 25,000 and it ended with how much is the capital at the end of the period, so it become 100
plus; 100 thousand. So it is a good story of a drug store in the income statement so let’s take a good look
at how the worksheet would appear after all the transaction isn’t it a beautiful story of a business
operation? So financial statement tells a story about the business operations About the business strength
and weaknesses So, it's like a photo of a person A worksheet is like a photo of the business entity Also
this is the picture of the Terimacor Drugstore on February 28, 2020.

So there are... There are two kinds of income statement presentation or format And here is the
presentation of the income statement using multi-step financial statement Multi-step income statement So
we have presented the sales of Terimacor 180,000 Then the cost of sales, we arrived at the gross profit
from sales And then we compute individual selling expenses, we have the freight out, bad debts and the
depreciation expenses to come up with our selling expenses Total selling expenses Then we have the
salaries expense for administrative employees, then supplies expense, insurance, utilities and rent
expenses to come up with our administrative expense So we have these other expense which is the cash
shortage We cannot classify either as selling or administrative, we put it in non-operating or other revenue
items So we have three kinds of income here. First, the we have the gross profit from sale or the income
from selling and then the operating income the income from the operation how we manage the business
and then we have net income the total income we have earned during the period, it includes non-operating
income. So for presentation purposes we have this single steps so in the single step we only have the
revenue and the total of all the expenses to come up with your net income This is a two dollar of
Terimacor drugstore so it does not present much information except the total revenue and total expense
You don't know how much is the cost of good selling and cost of operating

The single step format is not heavily used, this format is most commonly used by businessess that
have relatively simple operations with few items to be reported So, this is not a preffered format of
presentation because it does not offer much story to deliver Its just like saying someone died that is the
story, someone died, that is the single step income statement. But once you make a story a bit more
interesting you say, someone died but he was hospitalized for six months and then he was over to recover
for a little while but finally his succumb to his death then that becomes a more interesting story and that is
a multi-step income statement How to prepare a multi-step income statement. First you have to select the
Lesson 18
PREPARATION OF FINANCIAL STATEMENTS INCOME STATEMENT

period to report, for our case we have selected the February 2020 operation of Terimacor drugstore, then
write the income statement header. We have the income stament header natin is the name of Terimacor
drugstore, the the income statement and the period for which the income statement was prepared. Then,
we compute the total of all operating revenues then compute the total of operating expenses.

We calculate the gross profit by subtracting from sales the cost of goods sold, then we calculate
the operating income by deducting gross profit the total of operating expenses and then we deduct from
operating income, other non-operating expense which is the cash shortage, if it has other non-operating
revenues such as interest on bank deposit that should be included in this item, then we arrived at the net
income. So we have to be computing first for the gross profit from sales. Then, to arrive at a net income
we will reduce this by operating expenses and then other expense and income items will be adjustments to
the operating income to arrive at the net income. Let's compare the different financials, the income
statement for the different business activities. So, the business activities vary according to the, the income
statement vary according to the business activity. In here we illustrate a simple income statement because
nature of the business is service business, so when the activity is less complex the income statement is
less complex too. So it is service activity only therefore presentation of income statement much simple
than merchandising business because in the merchandising business you have to compute for the cost of
sales, so, that will include lot of details include in the financial statements. Then, the most complex is the
manufacturing business because you have to show the cost goods manufactured. When you manufacture
you have three items to include, the direct materials, direct labor and factory overhead, it's unlike with the
merchandising business you only have to compute for the cost of sales, meaning to say if the cost of
purchasing the goods to be sold but in the manufacturing you have to to compute how much is the cost to
manufacture what has been sold. So manufacturing has many costs involved, this is the difference in the
presentation financial of statements. on the different types of businesses so this is for the service business,
so simple and then this is the merchandising business income statement, a little complex and the most
complex is the income statement for the manufacturing business but for me I prefer the manufacturing
business because it is more challenging, not necessarily mind breaking but it is challenging in a way that
you have to gather so many data to come up with a good presentation.

Okay, we'll go to the details of the finance of the income statement. So, we're going to change the
title of the business instead of Terimacor Drug Store, will use Terimacor bicycle rental business because
it is a service business. So, to come up with service business this kind of income statement you have to
have a business on service, service revenue, that is the account for the revenue then discounts, you have
the net revenue less cost of services this is the counterpart of cost of sales, then you have your expenses to
come up with your operating income and other operating income you arrived at other operating expenses
you arrived at the net income or loss then you deduct the income tax that is another spence after the
presentation of the net income that is your net income for the period. So, this illustration has a provision
for income tax. So here is the income statement for merchandising concern. So, a little longer a little
bigger than the service business because there are so many things to complete you have to compute for
the cost of goods sold, you have to present the beginning inventory, the purchases and the ending
inventory but the same you have the same accounts for the expenses and other items on the operation
non-operating item. Now we go to the manufacturing business, this is too complicated to look at. You you
have to compute for the cost of goods sold but it's not only about purchases it's about the direct materials
the direct labor and the factory overhead so you will come up with a work in process inventory and
finished goods inventory to compute for your cost of goods sold. So, the same expenses you maintain the
same expenses as with service and merchandising but the activity in the production of goods is quiet
complex. So that ends up our discussion on the on the preparation of the income statement.
Lesson 18
PREPARATION OF FINANCIAL STATEMENTS INCOME STATEMENT

I hope you understand how an income statement is prepared and if you are learning from this
presentation please don't forget to like share and hit the subscribe button for the latest updates on this
channel. Thank you and I hope that you will continue to watch more of my videos. The next is the
presentation of the balance sheet, capital statement and cash flow statement. I hope you will be with me in
the discussion of this topic so that your knowledge and information about the accounting cycle will be
complete. God bless, keep safe until we meet again in the outside world, thank you.