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JOHN PAUL II INSTITUTE OF TECHNOLOGY

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Business Finance
Quarter I – Module 2:
REVIEW OF FINANCIAL STATEMENT
PREPARATION, ANALYSIS, and
INTERPRETATION
(Week 2-3)

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 Subject: Business Finance
Grade & Section: Grade 12-ABM
Module No. 2-3
Week No. 2-3
Instructor: Ms. Camille N. Cornelio

Objectives:

At the end of the lesson, students should be able to:

1. identify and explain the basic steps in the accounting process (accounting cycle); and
2. prepare financial statement.

Lesson REVIEW OF FINANCIAL STATEMENT

1 PREPARATION, ANALYSIS, and

INTERPRETATION

Pre-assessment
Directions. Match the letter with the definition that corresponds to the following terms:
_____ 1. Account a. Procedures used for analyzing, recording, classifying, and
summarizing the information to be presented in accounting reports.

_____ 2. Credit b. Exchanges of goods or services between/among two or more

entities or some other event having an economic impact on a
business enterprise.
_____ 3. Debit c. A record used to classify and summarize the effects of
transactions.

_____ 4. Transactions d. An entry on the left side of an account.

_____ 5. Accounting Process e. An entry on the right side of an account.

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 REVIEW of FINANCIAL STATEMENT
PREPARATION, ANALYSIS, and INTERPRETATION

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

business.

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.

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.
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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.
Example 1. 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.

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.

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Example 2. 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.

If journalized:

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BASIC 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.
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.
While all financial data helps paint a picture of a company’s financial health, an income statement is one
of the most important documents a company's leadership team and individual investors can review, because it
includes a detailed breakdown of income and expenses over the course of a reporting period.
This includes:
 Revenue: The amount of money a business takes in during a reporting period
 Expenses: The amount of money a business spends during a reporting period
 Costs of goods sold (COGS): The cost of component parts of what it takes to make whatever it is a business
sells
 Gross profit: Total revenue less COGS
 Operating income: Gross profit less operating expenses
 Income before taxes: Operating income less non-operating expenses
 Net income: Income before taxes less taxes
 Earnings per share (EPS): Division of net income by the total number of outstanding shares
 Depreciation: The extent to which assets (for example, aging equipment) have lost value over time
 EBITDA: Earnings before interest, depreciation, taxes, and amortization
These “buckets” may be further divided into individual line items, depending on a company’s policy and
the granularity of its income statement. For example, revenue is often split out by product line or company
division, while expenses may be broken down into procurement costs, wages, rent, and interest paid on debt.

https://online.hbs.edu/blog/post/income-statement-analysis

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 A multi-step statement is an income statement prepared to report a company’s sales and revenue, expenses and
overall profit or loss for any given period. It is a detailed report unlike the single-step income statement and utilizes
multiple accounting equations to calculate net profit for a business.

Here are the main three accounting equations used in the multi-step approach:

1. Gross Profit = Net Sales - Cost of Good Sold

2. Operating Income = Gross Profit - Operating Expense
3. Net Income = Operating Income + Non-Operating Items

Gross Profit = Net Sales - Cost of Good Sold

At the top section of this income statement, to compute the gross margin, subtract the cost of good from the net sales.
For instance, the gross margin of XYZ Company is a total of 340,000 (490,000 - 150,000).

Operating Income = Gross Profit - Operating Expense

In the midsection of this report, you will need to compute the operating income. The computation of the total operating
income involves deducting the total operating expense from the gross margin. Thus, the total operating revenue for this
company is 293,000 (340000 - 47,000).

Net Income = Operating Income + Non-Operating Items

Right after computing the total operating income, the other revenues and expenses section is the revenue and expense
incurred from non-operating activities. The non-operating income for XYZ Company shows a deficit of 2,000.

You will arrive at the net profit figure at the bottom of the report. By adding the operating income and non-operating
income, you should be able to compute the company's bottom line after deducting the income tax expense.
XYZ Company’s Net Profit = [(293,000 + (-2000) – 15,000)]
= 291,000 – 15,000
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 = 276,000

THE INCOME STATEMENT VS. THE BALANCE SHEET

While the definition of an income statement may remind you of a balance sheet, the two documents are
designed for different uses. An income statement tallies income and expenses; a balance sheet, on the other
hand, records assets, liabilities, and equity.

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.
The amount of owner's equity is increased by income and owner contributions. The balance is
decreased by losses and owner draws. Thus, the format of the statement of owner's equity may include the
following line items:

Beginning capital balance

+ Income earned during the period
- Losses incurred during the period
+ Owner contributions during the period
- Owner draws during the period
= Ending capital balance

Example of a Statement of Owner’s Equity

Example 1. A business has $100,000 of capital at the beginning of a reporting period. The entity earns
$15,000 of income, and the owner withdraws $5,000 from the capital account. The resulting statement of
owner's equity reveals the following information:
$100,000 Beginning capital balance
+15,000 Income
- 5,000 Draw
= $110,000 Ending capital balance
The report may also be described as the statement of changes in owner's equity.

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Example 2. Owner’s equity is calculated by adding up all of the business assets and deducting all of its
liabilities.
Let’s look at a fictional company, Rodney’s Restaurant Supply. It’s Rodney’s first year in business, and he had
the following transactions:
 Rodney invested $20,000 in the company to rent a location, purchase initial inventory, and pay other
startup costs
 Rodney got additional funding from an SBA loan
 In his first year in business, Rodney’s Restaurant Supply’s income statement shows net income of
$150,000 after accounting for all revenues and business expenses
 Rodney took $75,000 in draws from the business
On December 31, here’s the balance sheet of Rodney’s Restaurant Supply:

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 If you look at the balance sheet, you can see that the total owner’s equity is $95,000. That includes the
$20,000 Rodney initially invested in the business, the $75,000 he took out of the company, and the $150,000 of
profits from this year’s operations.
It’s also the total assets of $117,500 minus total liabilities of $22,500. Either way you calculate it,
Rodney’s state in the business is $95,000.
It’s important to note that owner’s equity is not necessarily a reflection of the actual value of the
business. If Rodney wanted to sell the company, the sales price of the business would vary depending on other
factors, including:
 The value of the company’s cash flows
 The fair market value of the company’s fixed assets and inventory
 The value of the company’s revenue stream
 Intangibles such as brand recognition and the customer list
The book value of owner’s equity might be one of the factors that go into calculating the market
value of a business. But don’t look to owner’s equity to give you a complete picture of your company’s market
value.

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.

1. Assets
An asset is anything a company owns which holds some amount of quantifiable value, meaning that it
could be liquidated and turned to cash. They are the goods and resources owned by the company.
Assets can be further broken down into current assets and non-current assets.
 Current assets are typically what a company expects to convert into cash within a year’s time, such as cash
and cash equivalents, prepaid expenses, inventory, marketable securities, and accounts receivable.
 Non-current assets are long-term investments that a company does not expect to convert into cash in the
short term, such as land, equipment, patents, trademarks, and intellectual property.
Assets will often be split into the following line items:
Current Assets: Non-current Assets:
Cash and cash equivalents Long-term marketable securities
Short-term marketable securities Property
Accounts receivable Goodwill
Inventory Intangible assets
Other current assets Other non-current assets
Current and non-current assets should both be subtotaled, and then totaled together.
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 2. Liabilities
A liability is anything a company or organization owes to a debtor. This may refer to payroll expenses,
rent and utility payments, debt payments, money owed to suppliers, taxes, or bonds payable.
As with assets, liabilities can be classified as either current liabilities or non-current liabilities.
 Current liabilities are typically those due within one year, which may include accounts payable and other
accrued expenses.
 Non-current liabilities are typically those that a company doesn’t expect to repay within one year. They are
usually long-term obligations, such as leases, bonds payable, or loans.
Similarly, you will need to identify your liabilities. Again, these should be organized into both line items
and totals, as below:
 Current Liabilities: Non-Current Liabilities:
Accounts payable Deferred revenue (non-current)
Accrued expenses Long-term lease obligations
Deferred revenue Long-term debt
Current portion of long-term debt Other non-current liabilities
Other current liabilities
As with assets, these should be both subtotaled and then totaled together.

3. Shareholders’ Equity
Shareholders’ equity refers generally to the net worth of a company, and reflects the amount of money
that would be left over if all assets were sold and liabilities paid. Shareholders’ equity belongs to the
shareholders, whether they be private or public owners.
Just as assets must equal liabilities plus shareholders’ equity, shareholders’ equity can be depicted by this
equation:
Shareholders’ Equity = Assets - Liabilities
Common line items found in this section of the balance sheet include:
Common stock
Preferred stock
Treasury stock
Retained earnings

Example 1.

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Example 2.

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Example 3. 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.

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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.
You use information from your income statement and your balance sheet to create your cash flow
statement. The income statement lets you know how money entered and left your business, while the balance
sheet shows how those transactions affect different accounts—like accounts receivable, inventory, and accounts
payable.
So, the process of producing financial statements for your business goes:

Income Statement + Balance Sheet = Cash Flow Statement

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There’s a fair amount to unpack here. But here’s what you need to know to get a rough idea of what this cash
flow statement is doing.

Red dollar amounts decrease cash. For instance, when we see ($30,000) next to “Increase in
inventory,” it means inventory increased by $30,000 on the balance sheet. We bought $30,000 worth of
inventory, so our cash balance decreased by that amount.

Black dollar amounts increase cash. For example, when we see $20,000 next to “Depreciation,” that
$20,000 is an expense on the income statement, but depreciation doesn’t actually decrease cash. So we
add it back to net income.

You’ll also notice that the statement of cash flows is broken down into three sections—Cash Flow from
Operating Activities, Cash Flow from Investing Activities, and Cash Flow from Financing Activities. Let’s look
at what each section of the cash flow statement does.

The three sections of a cash flow statement

 Cash Flow from Operating Activities is cash earned or spent in the course of regular business
activity—the main way your business makes money, by selling products or services

Net income is the total income, after expenses, for the month. We get this from the income statement.
Depreciation is recorded as a $20,000 expense on the income statement. Here, it’s listed as income. Since no
cash actually left our hands, we’re adding that $20,000 back to cash on hand.
Increase in Accounts Payable is recorded as a $10,000 expense on the income statement. That’s money we
owe—in this case, let’s say it’s paying contractors to build a new goat pen. Since we owe the money, but
haven’t actually paid it, we add that amount back to the cash on hand.
Increase in Accounts Receivable is recorded as a $20,000 growth in accounts receivable on the income
statement. That’s money we’ve charged clients—but we haven’t actually been paid yet. Even though the money
we’ve charged is an asset, it isn’t cold hard cash. So we deduct that $20,000 from cash on hand.
Increase in Inventory is recorded as a $30,000 growth in inventory on the balance sheet. That means we’ve
paid $30,000 cash to get $30,000 worth of inventory. Inventory isn’t an asset, but it isn’t cash—we can’t spend
it. So we deduct the $30,000 from cash on hand.
Net Cash from Operating Activities, after we’ve made all the changes above, comes out to $40,000.
Meaning, even though our business earned $60,000 in October (as reported on our income statement),
we only actually received $40,000 in cash from operating activities.

 Cash Flow from Investing Activities is cash earned or spent from investments your company makes,
such as purchasing equipment or investing in other companies.
This section covers investments your company has made—by purchasing equipment, real estate, land, or
easily liquidated financial products referred to as “cash equivalents.” When you spend cash on an
investment, that cash gets converted to an asset of equal value.
Purchase of Equipment is recorded as a new $5,000 asset on our income statement. It’s an asset, not cash—so,
with ($5,000) on the cash flow statement, we deduct $5,000 from cash on hand.

 Cash Flow from Financing Activities is cash earned or spent in the course of financing your company
with loans, lines of credit, or owner’s equity.

At the bottom of our cash flow statement, we see our total cash flow for the month: $42,500.

Even though our net income listed at the top of the cash flow statement (and taken from our income
statement) was $60,000, we only received $42,500.

That’s $42,500 we can spend right now, if need be. If we only looked at our net income, we might
believe we had $60,000 cash on hand. In that case, we wouldn’t truly know what we had to work with—
and we’d run the risk of overspending, budgeting incorrectly, or misrepresenting our liquidity to loan
officers or business partners.

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 Assessment

A. Indicate whether the following items would appear on the income statement (IS), or balance sheet (BS).
________ 1. Accounts Receivable
________ 2. Accounts Payable
________ 3. Computer Equipment
________ 4. Commission Fees Earned
________ 5. Salaries Expense

B. Answer the following questions.

1. What are the 3 (three) major financial statement and how they’re interconnected?
2. Explain the importance of Income Statement.
3. What is the purpose of Statement of Owner’s Equity?
4. Does a balance sheet always balance? Why?
5. Why do you need Cash Flow Statement?

C. Using the following (scrambled) accounts, prepare a balance sheet for XYZ, a retail company, for the year
ending in December 31, 2018. Assume that these are the only Balance Sheet Accounts. (See balance statement
example for your reference)

Accounts Payable 35,000

Accrued Expenses 6,000
Accumulated Depreciation 49,000
Additional Paid-In Capital 76,000
Allowance for Doubtful Accounts 1,500
Cash 20,000
Common Stock 43,000
Current Portion of L.T. Debt 5,000
Gross Accounts Receivable 40,000
Gross Fixed Assets 480,000
Inventories 52,000
Long-Term Debt 210,000
Net Accounts Receivable 38,000
Net Fixed Assets 430,000
Retained Earnings 135,000
Short-Term Bank Loan (Notes Payable) 18,000

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