2

REVIEW OF FINANCIAL STATEMENTS

PREPARATION

At the end of the chapter, the learners can:

1. Describe the components of financial statements;
2. Solve exercises and problems that require financial statements
preparation; and
3. Prepare financial statements.

INTRODUCTION

As established in the first topic, finance is the study of how players in a financial system acquire,
spend, manage, and make other sound financial decisions concerning money and other financial resources.
Integral in making sound financial decisions is knowing the financial health of a business. And in this
case, there can be no better basis than a well-prepared complete set of financial statements. Similar to your
report cards, financial statements tell us the financial progress made by the business. It can highlight the
financial strengths and surface the financial weakness. The strengths may then be used to remedy the
weaknesses.

At this point, it must be made clear that we are employing the user perspective in studying financial
statements, rather than the preparer’s perspective.

ACOUNTING CYCLE STEPS

Ordinary and common-sized businesses usually have an accounting cycle of one year and they
follow the calendar year. Accounting cycle is a series of recurring accounting steps or processes that span
from the start to the end of a particular account period.

The accounting cycle is composed of the following steps:

1. Analyzing business transactions from source documents;
2. Journalizing the business transactions;
3. Posting journal entries to the ledger;
4. Preparing trial balance;
5. Journalizing and posting adjusting journal entries;
6. Preparing adjusted trial balance;
7. Preparing financial statements;
8. Journalizing and posting closing journal entries;
9. Preparing post-closing trial balance; and
10. Journalizing and posting reversing journal entries.

Step 1: Analyzing business transactions from source documents. Recall that transaction analysis
entails a thorough understanding of the business transaction itself and its implication on assets,
liabilities, and owner’s equity. It is also helpful to remember the normal balances of each account
and how they increase or decrease.

Step 2: Journalizing business transactions. The next step is journalizing. The transactions would
now be journalized using a journal.
Step 3: Posting to the ledger. The next step after journalizing is posting. If journalizing is being
done in the journal, posting is being done in the ledger.

Step 4: Preparing the trial balance. The open balances in the ledger would now be summarized in
a trial balance. Recall that a trial balance is a list of accounts and their balances at a given time. It
shows the equality of the debits and the credits.

Step 5: Journalizing and posting adjusting journal entries. The next step after trial balance
preparation is to ensure that real and nominal accounts are appropriately reported at their adjusted
balances. In here, we would need to consider accruals, deferrals, depreciation, and doubtful
accounts, among others. Preparing and posting adjusting entries require going back to original
transactions and checking if there are additional pieces of information with respect to the accounts
that need adjustment. In accounting parlance, adjusting means ensuring that revenues are
recognized in the period in which they are earned regardless of when collected and that expenses
are recognized in the period in which they are incurred regardless of when paid.

Step 6: Preparing the adjusted trial balance. After all the adjusting entries have been journalized
and posted, the adjusted trial balance.

Step 7: Preparing the financial statements. The concept of financial statements was introduced
together with its complete components. A complete set of financial statements being prepared
periodically by a typical business is composed of the following:
• Statement of Financial Position;
• Income Statement;
• Statement of Changes in Equity;
• Statement of Cash Flows; and
• Notes, comprising a summary of significant accounting policies and other explanatory
information.

Step 8: Journalizing and posting closing entries. In the preparation for the next accounting period,
nominal accounts and drawing account are closed or brought to zero balances by transferring them
to an Income Summary account, a temporary account. The Income Summary account is
subsequently closed to owner’s capital account. On the other hand, real accounts or statement of
financial position accounts relate to one or more future accounting periods and for this reason,
their ending balances are not closed to zero but instead carried forward as beginning balances into
the next accounting period. The journal entries responsible for closing nominal accounts and
drawing account to zero balances are called closing entries. These journal entries are dated at the
end of an accounting period.

Step 9: Preparing post-closing trial balance. At this point, since all nominal and drawing accounts
have already closed, only the real accounts are left with balances in the ledger. From these
balances, we would now prepare the post-closing trial balance. The balances of the accounts in the
post-closing trial balance are exactly the beginning balances of the same accounts in the next
accounting period.

Step 10: Journalizing and posting reversing journal entries. Reversing entries are made at the
beginning of the next accounting period, just after the closing of the books of accounts but before
the recording of the regular transactions for the next accounting cycle. Though this step is optional
in the accounting cycle, many accountants prefer to reverse certain adjusting entries for ease and
convenience. Recall that reversing entries are literally the exact opposite of adjusting entries except
those reversing entries are not applicable to adjusting entries made for deferrals initially recorded
 using statement of financial position accounts or real accounts method. In other words, adjusting
entries arising from the following may be reversed:
• Accrued expenses
• Accrued revenues
• Deferred revenues under the revenue method
• Prepayments under the expense method

COMPARING AND CONTRASTING FINANCIAL STATEMENTS OF A SERVICE BUSINESS

AND A MERCHANDISING BUSINESS

The main difference between a service business and a merchandising business is the obvious fact
that the former is concerned with selling services to customers and that the latter is concerned with selling
goods to customers. As a result, the reporting of their financial health (condition and operation) also
differs. This is being manifested in some account titles that are peculiar to merchandising business only.
These account titles emanate from merchandising’s very nature of buying goods and selling them after. In
particular, these are inventory, purchasing, and selling-related accounts. Aside from these, the financial
statements, in substance and in form, of a service business and a merchandising business are essentially
the same.
MODULE NO.: ______________________________

NAME: ____________________________________

ACTIVITY NO.1

On the space provided, write TRUE if the idea being expressed is correct and FALSE if otherwise.

__________________ 1. Knowledge of accounting is important in studying finance.

__________________ 2. Accounting cycle is a series of recurring accounting steps or processes that span
from the start to the end of a particular accounting period.

__________________ 3. Transactions in merchandising businesses are usually simpler than the

transactions in service businesses.

__________________ 4. The first step in the accounting cycle is journalizing.

__________________ 5. When an accounting period begins on January 1 and ends on December 31, such
an accounting period is called a calendar year.

__________________ 6. Transaction analysis is an optional step in the accounting cycle.

__________________ 7. Initial business investments cannot include liabilities.

__________________ 8. Business transactions are recorded in the journal chronologically.

__________________ 9. Journalizing is the process of entering a business transaction in the form of an

accounting entry in the “journal” or the so-called “book of original entry.”

__________________ 10. A balanced trial balance guarantees accuracy in posting.

__________________ 11. All journal entries require an explanation.

__________________ 12. If the net effect of the business transaction results in zero for any among assets,
liabilities, and owner’s equity accounts, there is no need to journalize such a business transaction.

__________________ 13. Posting refers to the procedure of transferring journal entries to the ledger
accounts.

__________________ 14. Both journalizing and posting are done in chronological manner.

__________________ 15. All adjusting entries make use of real account and nominal accounts.
ACTIVITY NO. 2

The following accounts were taken from the adjusted trial balance of Alvaro Printing Press, a calendar-
year business, as of December 31, 2015 (disregarding effect of income taxes):

Debit Credit
Accounts Payable ₱35,000
Accounts Receivable ₱82,000
Accumulated Depreciation – 1,000
Furniture and Fixtures
Accumulated Depreciation – 2,250
Office Equipment
Accumulated Depreciation – 6,250
Pressing Machine
Accumulated Depreciation – 10,000
Printing Machine
Allowance for Doubtful 5,000
Accounts
Alvaro, Capital ?
Alvaro, Drawing 30,000
Cash 120,000
Depreciation Expense 19,500
Doubtful Accounts Expense 5,000
Furniture and Fixtures 10,000
Insurance Expense 12,000
Interest Expense 3,600
Interest Income 18,000
Interest Receivable 18,000
Interest Payable 3,600
Investment in Trading Securities 70,000
Mortgage Payable 15,000
Notes Payable – due in two years 30,000
Notes Receivable – due in six 150,000
months
Office Equipment 20,000
Office Supplies 8,000
Pressing Machine 40,500
Printing Machine 55,000
Printing Revenue 580,000
Printing Supplies 25,000
Rent Expense 48,000
Salaries Expense 260,000
Salaries Payable ` 10,000
Supplies Expense 12,000
Utilities Expense 27,500
TOTALS ₱1,016,100 ₱1,016,100
Prepare the following:
• Income Statement – natural form;
• Statement of Changes in Owner’s Equity;
• Statement of Financial Position – report form; and
• Notes to financial statements.