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Review of Financial Statement

Preparation, Analysis, and


Interpretation Pt.1
Specific Learning Outcomes At the end of
this lesson, the learners will be able to
identify and explain the basic steps in the
accounting process (accounting cycle).
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

Double entry bookkeeping - 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.

• 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 are
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.
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.
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.
Journalize the following transactions:

• 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.
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.
Example:
• N. Juna resigned from Company X.
• B. Cano purchased PHP500 cash worth of
supplies at Ace Hardware.
• 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.
Example:
• M. Jaya resigned from Company X.
• C. Danto purchased PHP500 cash worth of supplies to Ace
Hardware.
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.
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.
• 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.
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
Step 8: Make the closing entries.

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
• also 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.
1. Using the following (scrambled) accounts, prepare a balance sheet
for ABC, a retail company, for the year ending in December 31, 2014.
Assume that these are the only Balance Sheet Accounts.
2. Prepare a multi-step income statement for the retail
company, ABC, for the year ending December 31, 2014
given the information below: