Chapter 2: Review of Financial Statement Preparation, Analysis, and Interpretation

Learning Objectives

At the end of this lesson, the students shall be able to:

• Prepare a Financial Statement

• Define the measurement levels namely; liquidity, solvency, stability, and profitability
• Perform vertical and horizontal analysis of financial statement of a single proprietorship
• Compute, analyze, and interpret financial ratios such as current ratio, working capital, gross profit ratio,
net profit ratio, receivable turnover, inventory turnover, debt-to-equity ratio, and the likes

Learning Proper

The Accounting Cycle

The accounting cycle is a set of steps that are repeated in the same order every period. The culmination
of these steps is the preparation of financial statements.
The Process:
Step 1: Analyze the Business Transactions
• In this step, a transaction is analyzed to find out if it affects the company and if it needs to be recorded.
• Personal transactions of the owners and managers that do not affect the company should not be recorded.
• In this step, a decision may have to be made to identify if a transaction needs to be recorded in special
journals such as sales or purchases journal.
Therefore, what you should to is:
✓ Carefully read the description of the transaction to determine whether an asset, a liability,
an owner’s equity, a revenue, an expense, or a drawing account is affected.
✓ For each account affected by the transaction, determine whether the account increases or
decreases.
✓ Determine whether each increase or decrease should be recorded as a debit or credit,
following the rules of debit and credit.
Illustrative Example:
➢ N. Juna resigned from Company X. This does not affect any asset, liability, or the owner’s equity
account.
➢ B. Cano purchased Php500 cash worth of supplies at Ace Hardware. This affects cash and supplies,
both asset accounts.
Step 2: Record Transaction in the Journal (Journalizing)
• Using the rules of debit and credit, transactions are initially entered in a record called a Journal and the
entry made is called a Journal Entry.
• The journal serves as a record of when transactions occurred and were recorded.
Illustrative Example:
➢ N. Juna resigned from Company X. No journal entry
➢ B. Cano purchased Php500 cash worth of supplies at Ace Hardware. Debit Supplies Php 500, Credit
Cash Php 500.
Step 3: Post the Transactions on a Ledger (Posting)
• A transaction is first recorded in a journal. Periodically, the journal entries are transferred to the accounts
in the ledger.
• The process of transferring the debits and credits from the journal entries to the accounts is called Posting.
• Ledgers provide chronological details as how transaction affects individual accounts.
Step 4: Prepare and Unadjusted Trial Balance
• Errors may occur in posting debits and credits from the journal to the ledger. One way to detect each
error is by preparing a trial balance.
 • Double-entry accounting requires the debits must be always equal to credits. The trial balance verifies
this equality.
• The steps in preparing a trial balance are as follows:
✓ List the name of the company, the title of the trial balance, and the date the trial balance is
prepared.
✓ List the accounts from the ledger and enter their debit or credit balance in the Debit or Credit
column of the trial balance.
✓ Total the Debit and Credit columns of the trial balance.
✓ Verify that the total of the Debit column equals the total of the Credit column.
Step 5: Make Adjustments. Journalize adjusting entries.
• At the end of accounting period, many of the account balances in the ledger can be reported in the
financial statements without change.
• For example, the balances of the cash and land accounts are normally the amount reported on the balance
sheet. However, some accounts in the ledger require updating.
• This updating is required to the following reasons:
➢ Some expenses are not recorded daily. For example, the daily use of supplies would require many
entries with small amounts. Also, managers usually do not need to know the amount of supplies
in hand in a day-to-day basis.
➢ Some revenues and expenses are earned as time passes rather that as separate transactions. For
example, rent received in advance (unearned rent) expires and becomes revenue with the passage
of time. Likewise, prepaid insurance expires and becomes an expense with the passage of time.
➢ Some revenues and expenses may be unrecorded. For example, a company may have provided
services to customers that are has not billed or recorded at the end of the accounting period.
Likewise, a company may not pay its employees until the next accounting period even though
the employees have earned their wages in the current period.
➢ The analysis and updating of accounts at the end of the period before the financial statements are
prepared is called the Adjusting Process. The journal entries that bring the account up to date at
the end of the accounting period are called Adjusting Entries.
➢ The following are normally adjusted at the end of a period:
✓ Accruals – these include unpaid salaries for the accounting period, unpaid interest
expense, or unpaid utility expenses.
✓ Prepayments – if a company has prepaid expenses such as prepaid rent or prepaid
insurance then the correct balances for these accounts have to be established at the end of
each accounting period to reflect their correct balances.
✓ Depreciation and Amortization Expenses – depreciation expenses are recognized at the
end of each accounting period through adjusting entries. If there are intangible assets such
as franchise, the allocation of their costs which is called amortization expense, is also
recognized at the end of each accounting period through adjusting entries.
✓ Allowance for Uncollectible Accounts – bad debt expense from accounts receivable is
also recognized through adjusting entries.
Step 6: Prepare an Adjusted Trial Balance
• An adjusted trial balance is prepared after taking into consideration the effects of the adjusting entries.
Again, this is to ensure that the total debit balance equal the credit balances after posting and journalizing
adjusting entries made.
Step 7: Prepare the financial statements
• From the adjusted trial balance, the financial statements can then be prepared. These are the statement
of financial position, statement of profit or loss, and the statement of cash flows.
Step 8: Make the closing entries
• The accounts to be closed are accounts that can be seen in the income statement.
Upon closing:
✓ If the revenues exceed expenses during an accounting period, retained earnings will increase.
✓ The reverse is true which means that if the expenses exceed revenues, the retained earnings will
decrease.
In closing temporary accounts:
✓ Revenue account balances are transferred to an account called Income Summary Account
✓ Expense account balances are also transferred to the Income Summary Account.
✓ The balance of the Income Summary (net income or net loss) is transferred to the owner’s capital
account.
✓ The balance of the owner’s drawing account is transferred to the owner’s capital account.
Step 9: Make a Post-Closing Trial Balance
• A post-closing trial balance shows the accounts that are permanent or real. These are the accounts that
can be seen in your balance sheet. The post-closing trial balance is prepared to test if the debit balances
equal the credit balances after closing entries are considered.
Financial Statement
A financial statement is basically a summary of all transactions that are carefully recorded and
transformed into meaningful information. It also shows the company’s permanent and temporary accounts.
These are written reports that quantify the financial strength, performance and liquidity of a company.
a. Income Statement
o These are also known as the Profit/Loss Statement, Statement of Comprehensive Income, or
Statement of Income.
o This is a summary of the revenue and expenses of a business entity for a specific period of time,
such as month or year.
b. Statement of Changes in Owner’s Equity
o This reports the changes in the owner’s equity over a period of time.
o It is prepared after the income statement because the net income or net loss for the period must
be reported in this statement.
o Similarly, it is prepared before the balance sheet since the amount of owner’s equity at the end of
the period must be reported on the balance sheet.
o Because of this, the statement of owner’s equity is often viewed as the connecting link between
the income statement and balance sheet.
c. Balance Sheet
o Known as the Statement of Financial Position
o This provides information regarding the liquidity position and capital structure of a company as
of a given date.
o It must be noted that the information found in this report are only true as of a given date.
o It shows a list of the assets, liabilities, and owner’s equity of a business entity as of specific date,
usually at the close of the last day of a month or a year.
d. Statement of Cash Flows
o The statement of cash flows reports a company’s cash inflows and outflows for a period.
o This is used by managers in evaluating past operations and in planning future investing and
financing activities.
o It is also used by external users such as investors and creditors to assess a company’s profit
potential and ability to pay its debt and pay dividends.