Business Finance: Financial Statement Preparation, Analysis, and Interpretation

Accounting is the systematic and comprehensive recording of financial transactions pertaining to a

business. (Investopedia - Sharper Insight. Smarter Investing. | Investopedia. (2016). Investopedia.
Retrieved 8 May 2016, from http://investopedia.com)

1. The Accounting Equation

The basic accounting equation is: ASSETS = LIABILITIES + OWNER’S EQUITY

• This means that the whole assets of the company comes from the liability, or debt of the company,
and from the capital of the owner of the business, and the income it generated from the business
operations. This reflects the double-entry bookkeeping, and shown in the balance sheet.

• Double entry bookkeeping tells us that if we add something from the one side, which is asset, we must
add the same amount to the other side to keep them in balance.

• For example, if we were to increase cash (an asset) we might have to increase note payable (a liability
account) so that the basic accounting equation remains in balance.

ASSETS = LIABILITIES + OWNER’S EQUITY

P 500.00 P 500.00

• In double-entry bookkeeping, there is the concept of debit (dr) and credit (cr). Debit is the left, and
credit is the right.

• There is also a concept of normal balances. A normal balance, either a debit normal balance or a
credit normal balance, is the side where a specific account increases.

• In the accounting equation, asset is on the left side, while liabilities and equity is on the right side.
Therefore, asset has a debit normal balance, meaning that cash as an asset is debited to increase, while
credited to decrease.

• On the other hand, liabilities and owners’ equity have a credit normal balance. This means that a
liability account is credited to increase, while debited to decrease. The accounting equation provides the
foundation for what eventually becomes the balance sheet.

2. T-Account Analysis

In double-entry bookkeeping, the terms debit and credit are used to identify which side of the ledger
account an entry is to be made. Debits are on the left side of the ledger and Credits are on the right side
of the ledger. It does not matter what type of account is involved.

CASH ACCOUNTS PAYABLE

Debit (Dr) Credit (Cr) Debit (Dr) Credit (Cr)

P500.00 P500.00

• The debit to cash increases the Cash Account by PHP500 while the credit to Accounts Payable
increases this liability account by the same PHP500.

• In the above example, we analyzed the accounting equation in terms of assets, liabilities, and owners’
equity. These are called Real or Permanent Accounts. These accounts remain open and active for the life
of the enterprise.

• In contrast, there are accounts that reflect activities for a specific accounting period. These are called
Nominal or Temporary Accounts. After the end of the specific period and the start of a new period, the
balance of the nominal accounts is zero.

• Using the accounting equation, we can now expand the analysis that will include both real and
nominal accounts. All nominal accounts will be then closed to a Retained Earnings account at the end of
the period, which is an owner’s equity account.
Business Finance: Financial Statement Preparation, Analysis, and Interpretation

Illustrative Example:

Calvo Delivery Service is owned and operated by Noel Calvo. The following selected transactions were
completed by Calvo Delivery Service during February:

A. Received cash from owner as additional investment, P35,000.

B. Paid creditors on account, P1,800.
C. Billed customers for delivery services on account, P11,250.
D. Received cash from customers on account, P6,740.

ASSETS = LIABILITIES + OWNER’S EQUITY

CASH ACCOUNTS ACCOUNTS CALVO SERVICE
RECEIVABLE PAYABLE CAPITAL REVENUE
A. PHP 35,000 PHP 35,000
B. PHP 1,800 PHP 1,800
C. PHP 11,250 PHP 11,250
D. PHP 6,740 PHP 6,740

3. Nominal Accounts There are two major categories of nominal accounts: Expense and Revenue
accounts.

• Expense Accounts

- A resource, when not yet used up for the current period, is considered an Asset and will provide
benefits at a future time.

- On the other hand, a resource that has been used for the current period is called an Expense. At the
end of each accounting period, expenses are closed out to the Retained Earnings Account which
decreases the Owners’ Equity. Since expenses decrease the owners’ equity, those expense accounts
carry a normal debit balance.

• Revenue Accounts

- Revenue Accounts reflect the accumulation of potential additions to retained earnings during the
current accounting period.

- At the end of the accounting period accumulation of revenues during the period are closed to the
Retained Earnings Account which increases Owners’ Equity.

- Therefore revenue accounts carry a normal credit balance meaning the same balance as the Retained
Earnings Account.

Illustrative Example:

J. F. Outz, M.D., has been a practicing cardiologist for three years. During April 2009, Outz completed the
following transactions in her practice of cardiology:

Mar 1 Provide medical services to clients for cash P35,000.

Mar 2 Paid rent for the month, P3,000. Paid advertising expense, P1,800.

Mar 6 Purchased office equipment on account, P12,300.

Mar 15 Paid creditor on account, P1,200.

Mar 27 Paid cash for repairs to office equipment, P500.

Mar 30 Paid telephone bill for the month, P180.

Mar 31 Paid electricity bill for the month, P315

Business Finance: Financial Statement Preparation, Analysis, and Interpretation

ASSETS = LIABILITIES + OWNER’S EQUITY

MAR CASH ACCOUNTS OFFICE ACCOUNTS SERVICE EXPENSES
RECEIVABLE EQUIPMENT PAYABLE REVENUE
1 PHP 35,000 PHP 35,000

2 PHP 3,000 PHP 3,000

2 PHP 1,800 PHP 1,800
6 PHP 12,300 PHP 12,300
15 PHP 1,200 PHP 1,200
27 PHP 500 PHP 500
30 PHP 180 PHP 180
31 PHP 315 PHP 315

If journalized:

March 1 Debit Cash for PHP35,000; Credit Service Revenue for PHP35,000
2 Debit Rent Expense for PHP3,000; credit Cash for PHP3,000
2 Debit Advertising Expense for PHP1,800; Credit Cash for PHP1,800
6 Debit Office Equipment for PHP12,300; Credit Accounts Payable for PHP12,300
15 Debit Accounts Payable for PHP1,200; Credit Cash for PHP1,200
27 Debit Repairs Expense for PHP500; credit Cash for PHP500
30 Debit Utilities Expense (or telephone) for PHP180; Credit Cash for PHP180
31 Debit Utilities Expense (or energy) for PHP315; credit Cash for PHP315

4. The Accounting Cycle

• Because accounting is all about getting data and putting them into the accounting equation, the end
products are financial statements such as a balance sheet and income statements, the process of
accounting follows a cycle called the Accounting Cycle.

• It starts with the identification of whether a transaction is accountable or can be quantified, and ends
with a post-closing trial balance.

The Process:

Step 1: Analyze 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 a sales or purchases journal.

Therefore, what you should do is:

A. 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.

B. For each account affected by the transaction, determine whether the account increases or decreases.
C. Determine whether each increase or decrease should be recorded as a debit or a credit, following the
rules of debit and credit.
Business Finance: Financial Statement Preparation, Analysis, and Interpretation

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 This in the Journal.

• 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.

• For repetitive transactions or high volume transactions (e.g. one thousand sales transactions in one
day), Special Journals are made. These special journals include sales journal, purchases journal, cash
receipts journal, and cash disbursements journal.

The Source Document is the file or document (i.e. official receipt, purchase order, contract) that will
provide a basis or reason for a journal entry. For example, an official receipt issued by the business will
tell you that a sale transaction occurred and will be reflected by the journal entry.

Illustrative Example:

• M. Jaya resigned from Company X. No journal entry.

• C. Danto purchased PHP500 cash worth of supplies to Ace Hardware. Debit Supplies PHP500, Credit
Cash PHP500.

Step 3: Post the Transactions on a Ledger.

• 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 to how transactions affect individual accounts. There are two
types of ledgers: the General Ledger and Subsidiary Ledger. The general ledger is a summary of the
different Subsidiary Ledgers and can serve as a control account.
• For example, a general ledger for accounts receivable summarizes the balances found in the different
subsidiary ledgers for different customers.
Illustrative Example:

J. Gaya, a CPA, is an independent auditor with only two clients. The Accounts Receivable ledger account
has a balance of PHP100,000. His two clients are A. Rania, and X. Campos. The subsidiary ledger of A.
Rania has a balance of PHP25,000. X. Campos’s ledger balance is PHP75,000. The sum of subsidiary
ledgers must total the general ledger or else there must be an investigation to identify the source of
discrepancies.

ACCOUNTS RECEIVABLE
Date
Dec.31,2015 Bal. Php 100,000

Subsidiary Ledgers

A. RANIA X.CAMPOS
Date Date
Dec.31,2015 Bal. Php 25,000 Dec.31,2015 Bal. Php 75,000

Posting in the subsidiary ledgers can be done anytime and the balances are summarized at the end of an
accounting period. Posting in the general ledger is done at the end of an accounting period.
Business Finance: Financial Statement Preparation, Analysis, and Interpretation

Step 4: Prepare an Unadjusted Trial Balance.

• Errors may occur in posting debits and credits from the journal to the ledger. One way to detect such
errors is by preparing a trial balance.

• Double-entry accounting requires that debits must always equal credits. The trial balance verifies this
equality.

• The steps in preparing a trial balance are as follows:

1. List the name of the company, the title of the trial balance, and the date the trial balance is prepared.
2. List the accounts from the ledger and enter their debit or credit balance in the Debit or Credit column
of the trial balance.
3. Total the Debit and Credit columns of the trial balance.
4. 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 the 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 for the following reasons:
1. 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 on
hand on a day-to-day basis.
2. Some revenues and expenses are earned as time passes rather than 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.
3. 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 accounts 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 balances 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.
Business Finance: Financial Statement Preparation, Analysis, and Interpretation

Step 8: Make the closing entries.

In the discussion about accounts, it was discussed that nominal accounts (revenue and expense
accounts) are closed to retained earnings, or an owner’s capital account because these accounts refer
only to a specific accounting period. Actually, these 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 (sometimes
profit or loss summary).
- 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.

5. Basic Financial Statements.

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. Basically, financial statements are comprised of the following:

a. Income Statement
• These are also known as the Profit/Loss Statement, Statement of Comprehensive Income, or
Statement of Income.
• This is a summary of the revenue and expenses of a business entity for a specific period of time, such
as a month or a year.
b. Statement of Owner’s Equity
• These are also known as the Statement of Changes in Equity.
• This reports the changes in the owner’s equity over a period of time.
• It is prepared after the income statement because the net income or net loss for the period must be
reported in this statement.
• 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.
• 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

• Formerly known as the Statement of Financial Position.

• This provides information regarding the liquidity position and capital structure of a company as of a
given date.
• It must be noted that the information found in this report are only true as of a given date.
• It shows a list of the assets, liabilities, and owner’s equity of a business entity as of a specific date,
usually at the close of the last day of a month or a year.

d. Statement of Cash Flows

• The statement of cash flows reports a company’s cash inflows and outflows for a period.
• This is used by managers in evaluating past operations and in planning future investing and financing
activities.
• 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.
Business Finance: Financial Statement Preparation, Analysis, and Interpretation