Chapter 2: Review of Financial

Statement Preparation, Analysis

and Interpretations

- Ms. Edilene R. Cruzat

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 Learning
Objectives:

1. Prepare financial statements.

2. Define the measurement levels, namely, liquidity, solvency, stability, and profitability.
3. Perform vertical and horizontal analysis of financial statements of a single proprietorship.
MM.DD.20XX
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ADD A FOOTER
What is Accounting?
- Accounting is the systematic and
comprehensive recording of financial
transactions pertaining to a business.
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1. The Accounting Equation

The basic accounting equation is:

 
ASSETS = LIABILITIES + OWNER’S EQUITY

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. 4
1. The Accounting Equation

Example:

ASSETS = LIABILITIES + OWNER’S EQUITY

₱500.00 ₱500.00

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1. The Accounting Equation

Normal Balance
A normal balance, either a debit
normal balance or a credit normal
balance, is the side where a specific
account increases.
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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.
CASH ACCOUNTS PAYABLE

These are called Real or Permanent Accounts. These accounts

remain open and active for the life of the enterprise. 7
2. T-Account Analysis

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 are zero.

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2. T-Account Analysis

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.
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2. T-Account Analysis

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3. Nominal Accounts

Two major categories of nominal 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.

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3. Nominal Accounts

Two major categories of nominal accounts:

• 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.
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3. Nominal Accounts
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.
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3. Nominal Accounts

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3. Nominal Accounts
If journalized:

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4. 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.
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4. The Accounting Cycle

Step 1: Analyze Business Transactions.

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.
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4. The Accounting Cycle

Step 1: Analyze Business Transactions.

Illustrative Example:
• N. Juna resigned from Company X.
• B. Cano purchased PHP500 cash worth of supplies at
Ace Hardware.

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4. The Accounting Cycle

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, Special Journals are made. 19
4. The Accounting Cycle

Step 2: Record This in the Journal

Illustrative Example:
• M. Jaya resigned from Company X.
• C. Danto purchased PHP500 cash worth of
supplies to Ace Hardware.
- Debit Supplies PHP500, Credit Cash PHP500. 20
4. The Accounting Cycle

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. 21
4. The Accounting Cycle

Step 3: Post the Transactions on a Ledger.

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.

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4. The Accounting Cycle

Step 3: Post the Transactions on a Ledger.

Illustrative Example:

Subsidiary Ledgers

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4. The Accounting Cycle

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.

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4. The Accounting Cycle

Step 4: Prepare an Unadjusted Trial Balance

• 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.
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4. The Accounting Cycle

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.
• 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. 26
4. The Accounting Cycle

Step 5: Make adjustments. Journalize 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.

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4. The Accounting Cycle

Step 5: Make adjustments. Journalize adjusting entries.

• The following are normally adjusted at the end of a period:

- 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.
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4. The Accounting Cycle

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.

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4. The Accounting Cycle

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.

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4. The Accounting Cycle

Step 8: Make the closing entries.

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.

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4. The Accounting Cycle

Step 8: Make the closing entries.

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.

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4. The Accounting Cycle

Step 8: Make the closing entries.

In closing temporary accounts:

- 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.

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4. The Accounting Cycle

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.
 
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4. 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
b. Statement of Owner’s Equity
c. Statement of Financial Position
d. Statement of Cash Flows
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4. Basic Financial Statements

a. Income Statement
 

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4. Basic Financial Statements

b. Statement of Owner’s Equity

 

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4. Basic Financial Statements

c. Statement of Financial Position

 

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4. Basic Financial Statements

d. Statement of Cash Flows

 

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  Introduction

Financial Statements are the

summarized records of the financial
activities of an entity. These are formal
written reports which present the
financial condition or status, results of
operations or performance and liquidity
of a company. 40
Four Types
of
Financial
Statements

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1 Income Statement

Income Statement, also known as the Profit and Loss Statement. It reports the company’s financial performance in terms of net profit or loss over a specified period. Income Statement is composed of the following two
elements:
1.
Income – What the business has earned over a period (e.g. sales revenue, interest income, etc.)
2.
Expense – The periodic costs incurred by the business to generate income (e.g. salaries and wages, depreciation, rental charges, etc.)
Net profit or loss is arrived by deducting expenses from income.

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2
Statement of Changes in Equity
The Statement of Changes in Equity details the movement in owner’s equity over a period. The movement in owner’s equity is derived from the following components:
2.1. Additional investment from the owner
2.2. Net profit or loss during the period as reported in the income statement
2.3. Withdrawal by the owner

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3
Statement of Financial Position
Statement of Financial Position, also known as the Balance Sheet, presents the financial position of an entity at a given date. It is comprised of the following three elements:
Assets – Something a business owns or controls (e.g. cash, inventory, plant and machinery, etc.)
Liabilities – Something a business owes to someone (e.g. creditors, bank loans, etc.)
Equity – What the business owes to its owners. This represents the amount of capital that remains in the business after its assets are used to pay off its outstanding liabilities. – Equity therefore represents the claims of the owners over the assets after
payment of the liabilities.
 

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4
Cash Flow Statement
Cash Flow Statement presents the movement in cash and bank balances over a period. The cash flows are classified into the following segments:
Operating Activities – Represents the cash flow from primary activities of a business.
Investing Activities – Represents cash flow from the purchase and sale of assets other than inventories (e.g. purchase of a factory plant)
Financing Activities – Represents cash flow from raising capital and repaying debt together with the payments of interest and distribution of dividends.

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Preparation of
Financial Statements

 Preparing properly classified financial

statements can be simple or complex
depending on the requirements of the
company. Some statements need footnote
disclosures while others can be presented
without any. The supporting details are
generally dependent on the purpose of the
financial statements.
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WORKSHEET
 An accounting worksheet is a tool
used to help bookkeepers and
accountants complete the
accounting cycle and prepare year-
end reports like unadjusted trial
balances, adjusting journal entries,
adjusted trial balances, and
financial statements.
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 WORKSHEET
 The accounting worksheet is a record that
summarizes the effects of each business
transaction following the different steps
of the accounting cycle. The worksheet
has five sets of columns that start with the
unadjusted trial balance accounts and end
with the financial statements. This
accounting worksheet facilitates the
preparation of the financial statements. 48
49
The columns of the Income Statement and the Financial Position will be the basis of preparing the
financial statements.
Examples of Financial Statements are given below:

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The columns of the Income Statement and the Financial Position will be the basis of preparing the
financial statements.
Examples of Financial Statements are given below:

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Measurement Levels

One of the most common tools for managerial decision making

using the financial statements is the financial ratios. These financial
ratios are mathematical comparisons of one number to another using
a simple division problem. Financial ratios involve the analyzing of the
various figures stated from the financial statements to arrive at a
meaningful information about a company’s performance. It is the
process of interpreting, rather than making calculation, which makes
financial ratios a useful tool for business managers in making
decisions. 52
 1. Liquidity
 The most common liquidity ratio is the
current ratio, which is the ratio of
current assets to current liabilities. The
current ratio indicates a company's
ability to pay its current or short-term
liabilities on time. As a general rule, a
ratio of greater than one is usually a
minimum which means the company
has more assets than liabilities.
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 2. Solvency
 Solvency ratios indicate financial stability
by measuring the company's ability to
borrow funds using its assets and equity.
A company with too much debt may not
have the flexibility to manage its cash
flow if interest rates rise or if business
conditions deteriorate. The common
solvency ratios are debt-to-asset and
debt-to-equity.
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 3. Stability
 Stability is the long-term counterpart of
liquidity. Stability analysis investigates
how much debt can be supported by the
company and whether debt and equity are
balanced. The most common stability
ratios are the Debt-to-Equity ratio and
gearing (also called leverage).
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 4. Profitability
 Profitability ratios indicate management's
ability to convert sales into profits and cash
flow. The common ratios are gross margin,
operating margin and net income margin. The
gross margin is the ratio of gross profits to
sales. The gross profit is equal to sales minus
cost of goods sold. The operating margin is the
ratio of operating profits to sales and net
income margin is the ratio of net income to
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sales.
Vertical and Horizontal Analysis of Financial Statements of a Single Proprietorship

1. Horizontal Analysis - This method analyses the trend of the company’s

financial information over a period of time. Each line item is examined
specifically the percentage change from the previous period.

2. Vertical Analysis - This method compares the relationship between a

single item on the Financial Statements to the total transactions within one
given period. It will show the percentage of change of the financial
information from the last period and can be performed on both Income
Statement and Balance Sheet.
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Horizontal Analysis
Horizontal analysis is the comparison of historical financial
information over a series of reporting periods to show trends
and changes as a tool in making decisions. The conduct of a
horizontal analysis for all of the financial statements at the
same time is useful in scrutinizing the complete impact of
operational results on a company's financial condition over the
review periods. Also, a variation to the horizontal analysis is
trend analysis. Under a trend analysis, the comparison of
financial information extends beyond two periods, normally
five or more. The computational procedures in a trend analysis
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 Below is the Income Statement information for the years December 31, 2017 and
1. Horizontal Analysis of the Income Statement

December 31, 2018 of Rhea Merchandising Enterprises and the corresponding

horizontal analysis and interpretation:
 

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 Interpretation
1. Horizontal Analysis of the Income Statement

 
1.1. Sales have increased at a higher rate than cost of goods sold (20%
vs. 14%). This could mean that more sales activities were undertaken
which increased sales and at a minimal increase in cost.
1.2. Gross margin and all operating expenses have increased due to the
corresponding increase in Sales and Cost of goods sold.
1.3. The profitability of the business has greatly improved in 2018 with
the increase in net profit by 38.9%
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 Below is the Statement of Financial Position information for the years December
1. Horizontal Analysis of Statement of Financial Position

31, 2017 and December 31, 2018 of Rhea Merchandising Enterprises and the
corresponding horizontal analysis and interpretation:
 

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 Interpretation:
 
1. Horizontal Analysis of the Income Statement

1. The liquidity of the business has improved in 2018. This is

reflected by the increase in total current assets compared to the
decrease in total current liabilities. However, the increase in
Accounts Receivable in 2018 means that the business must exert
extra effort in the collection to avoid doubtful account expense
while the increase in the inventory in 2018 means that the business
has too many stocks of inventories where if not sold immediately
will result to losses.
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 Interpretation:
 
1. Horizontal Analysis of the Income Statement

2. The solvency of the business has also improved in 2018. This

is reflected by the decrease in Notes Payable which means
that the business has honoured the commitment in paying its
obligation.
3. The main source of business financing in 2018 is capital,
primarily from the profits rather than additional contribution by
the owner. This is reflected in the increase in capital by 56.71%.
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Vertical Company Financial Statement Analysis

Vertical analysis is the proportional analysis of

each line item on a financial statement in a
percentage form. The process will involve
computations of every line item on an income
statement stated as a percentage of total assets.
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 The following are the Income Statement information for December 31, 2018 of
1. Vertical Analysis of the Income Statement

Lea’s Merchandising Company with the corresponding vertical analysis including its
interpretation:
 

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 Interpretation
1. Vertical Analysis of the Income Statement

 
Cost of goods sold is 53.33% of sales which means that for every
P1 peso of sale, 53 centavos represent the cost of goods sold.
Likewise, the total expenses are 34.83% of sales which also means
that for every P1 peso of sale, 34 centavos go to the operating
expenses. In summary, after deducting the cost of goods sold
(53.33%) and operating expenses (34.83%), only 11.83% is left as
profit. The business can consider this information in making a
decision like reducing the cost of goods sold to increase the profit.
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 The following are the Statement of Financial Position for December 31, 2018 of
2. Vertical Analysis of Statement of Financial Position

Lea’s Merchandising Company with the corresponding vertical analysis including its
interpretation:
 

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 Interpretation:
2. Vertical Analysis of Statement of Financial Position

 
The resources of the business are tied up to Inventory which is
almost 25% of the total assets while the accounts receivable is also
about 19% of the total assets. The business can consider this
information as a go signal to improve the collection effort and
manage its inventory. Also, the business can consider also to settle
its notes payable to avoid interest expense and improve its
profitability.
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