Information Sheet 1.1.

8: Prepare Financial Statements

Learning outcomes:
1. Prepare financial statements
2. Analyze financial statements

Learning Objectives:
A. Describe the different financial statements
B. Explain the purpose of each financial statement
C. Prepare financial statement using the standard format

Accountability refers to the obligation of a companys executives to show how well they have been
managing the firm. The proof can usually be found in the financial statements.

Users of financial statements

The most common users of financial statements are:

1. Managers use financial statements to improve results, increase productivity, eliminate

weaknesses, and make decisions.
2. Many owners (sole proprietors and partners) are not directly involved in the day-to-day
operations of their firms. As a result, owners use financial statements to measure the
performance of the people who are running the company on behalf of them.
3. The owners of a corporation (shareholders) must be provided with financial information on a
regular basis, as per the law, in order to protect their investments.
4. Potential investors in corporate shares (prospective shareholders) and their advisors
(stockbrokers) can often determine which corporations they wish to invest in (buy shares in)
based on a comparison of corporate financial statements.
5. Creditors, including banks and suppliers, ask for financial statements to determine the ability of
a firm to meet its debt obligations.

Quality of financial statements GAAPs and IFRS

Financial statements must be accurate, complete, up-to-date and reliable in order to have any utility. To
this end, the accounting profession has developed a set of reporting standards known as GAAPs. To
ensure that these standards are being met, most companies are required to undergo a formal
inspection known as an audit at least once a year. An audit is an independent review of a companys
internal controls and accounting records carried out by a public accountant like a CPA. Auditors
measure the practices and procedures of a company against the standards laid out in the various GAAPs
or IFRS and then provide their written opinion of the company's performance. Some of the more
significant GAAPs that are designed to ensure the fairness and accuracy of a companys financial
statements include:

1. The consistency principle requires a business to employ the same accounting methods and
procedures from period to period. If, however, there is a change, the financial statements must
clearly indicate such. The consistency principle prevents managers from manipulating figures on
financial statements by altering accounting methods in order to satisfy their own interests.

2. The materiality principle requires accountants to publicly disclose any information that might
be deemed material (important) to the users of a public companys financial statements.
Information that has an immediate and significant impact on the accounts (e.g, assets,
revenues) of a public company should be disclosed in the financial statements according to this
principle. As a result, the omission of a Php5 sale on a multi-billion-dollar companys income

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statement would not be considered material because it would not have affected the decision-
making of users of that statement.

3. The full disclosure principle requires all information necessary for a full understanding of a
public companys financial affairs to be disclosed to the public. Pursuant to this principle, events
that may potentially affect the accounts of the business in the future should be included in the
notes that accompany the financial statements. Items that are typically disclosed according to
this principle include ongoing or threatened lawsuits, tax disputes, potential mergers or
acquisitions, changes in senior management, and outstanding patent applications.

Financial Statements are summary accounting reports prepared periodically to inform the owner,
creditors, and other interested parties as to the financial condition and operating results of the
business. The four basic financial statements or reports are:

Balance Sheet-The financial statement which shows the amount and nature of business assets,
liabilities, and owner's equity as of a specific point in time. It is also known as a Statement Of
Financial Position or a Statement Of Financial Condition.

Income Statement-The financial statement that summarizes revenues and expenses for a
specific period of time, usually a month or a year. This statement is also called a Profit and Loss
Statement or an Operating Statement.

Capital Statement-The financial report that summarizes all the changes in owner's equity that
occurred during a specific period.

Statement of Changes in Financial Position-The financial statement that reports the sources
and uses of cash or working capital for a specific period of time, normally a year.

The Income Statement

The Income Statement is a formal financial statement that summarizes a company's operations
(revenues and expenses) for a specific period of time usually a month or year.

A fiscal year is the period used for calculating annual (yearly) financial statements. While a large
number of businesses use the calendar year (January-December) as their fiscal year, a business can
elect to use any other twelve month period such as June-May as their fiscal year.

The following types of accounts are used to prepare the Income Statement.

Revenue (Also Called Income)

Formal Definition: The gross increase in owner's equity resulting from the operations
and other activities of the business.

Informal Definition: Amounts a business earns by selling services and products.

Amounts billed to customers for services and/or products.

Expense (Also Called Cost)

Formal Definition:Decrease in owner's equity resulting from the cost of goods, fixed
assets, and services and supplies consumed in the operations of a business.

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Informal Definition:The costs of doing business. The stuff we used and had to pay for or
charge to run our business.

Additional Explanation: Some examples of business expenses are office supplies,

salaries & wages, advertising, building rental, and utilities.

Hopefully a business earns a profit called net income (revenues are larger than expenses). If however,
expenses are larger than revenues a net loss results.

The major sections of an income statement are the heading, the revenue section, the expense section,
and the final calculation of a profit or loss. The heading should contain the name of the company, the
title of the statement, and the period covered by the statement.

ABC Mowing
Income Statement
For The Period Ending October 30, xxxx

Revenue from operations P1,205

Expenses
Advertising Expense P225
Mulch Expense 160
Total Expenses P385

Net Income P820

Report form income statements

Please note that a formal income statement known as a report form income statement appears
much as we have already seen. A report form income statement lists revenues and expenses in vertical
(or top to bottom) order. Furthermore, in this new income statement, expenses are more accurately
described as Operating Expenses in the subheading.

The income statement determines whether or not the company is profitable over both the short term
and the long term. Owners, managers, employees, lenders, CRA (tax) officials, suppliers, consumers and
competitors are all interested in learning about the profitability of the business.

Income statement analysis

Accountants may analyze the income statement of a particular business in a number of different ways:

(1) Comparative analysis (changes from year to year - horizontal analysis)

When comparing individual items (accounts or totals) on the income statement of a particular business
over two consecutive years, accountants may calculate:

(a) the dollar change (increase or decrease) from the first year to the second year

Year 2 - Year 1
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(b) the percentage change (increase or decrease) from the first year to the second year

Year 2 - Year 1 x 100%

---- Year 1

e.g. --- Year 1 -- Year 2 -- dollar change -- percentage change

Sales -- $500 ----- $600 ------- + $100 ----------------- + 20%
Rent --- $500 ----- $400 -------- - $100 ------------------ - 20%

(2) Trend analysis (changes over multiple years - horizontal analysis)

Accountants may also wish to examine individual income statement items (accounts or totals) of a
particular business over several consecutive years. This method always uses the year 1 figure as the
base figure (100%). Figures from subsequent years (years two, three, etc.) are each expressed as a
percentage of the year 1 base figure. Trends are most often viewed over a three or five-year period.
Please note that percentages are rounded to one decimal point in this example.

Year 3 x 100%
Year 1

e.g. ------------------Year 1 - Year 2 - Year 3 - Year 4 - Year 5

Rent Expense -- $1000 -- $1100 -- $1200 -- $800 -- $657.30
------------------------ 100% --- 110% -- 120% --- 80% ---- 65.7%

(3) Common-size analysis (vertical analysis)

Finally, accountants often prepare common-size income statements to compare each of the individual
items on the end-of-period income statement (accounts and totals) to a base figure (100%), which is
always the total revenue figure. Accordingly, on a common-size income statement, each and every
figure is expressed as a percentage of the total revenue figure.

Rent x 100%
Sales

e.g. Sales -------- $1000 --- 100%

------ Rent ----------- $200 ----- 20%
------ Wages ------- $500 ----- 50%
------ Total Exp. --- $700 ----- 70%
------ Net Income - $300 ----- 30%

Comparative analysis another perspective

Sometimes it is useful to compare the figures of one company with the figures of another company in
the same industry over the same period of time. At other times, company figures may even be
compared to industry averages. These comparisons (between two different companies or between one
company and an industry average) may either involve dollar figures or percentages. And as you have
already seen, it is always useful to compare the dollar figures or percentages of a single company over
many years in order to measure the degree of improvement (or lack of improvement) in company
performance.

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The Capital Statement

The next financial statement, the capital statement, is prepared to report all the changes in owner's
equity that occurred over a period of time usually a month or year. The major sections of the statement
are the heading, the owner's capital balance at the beginning of the period, the increases and
decreases during the period, and the calculated ending balance.

The capital statement serves as the bridge between the income statement and balance sheet. It uses
the net income/loss from the income statement in addition to the owner's investments and withdrawal
to determine the Owner's Capital balance shown on the balance sheet.

Let's illustrate this statement with a simple equation.

Ending Owner's Equity = Beginning Equity + Additional Capital Contributed + Profit or - Loss - Draws

ABC Mowing
Capital Statement
For The Period Ending October 30, xxxx

Capital Beginning P7500

Capital Contributed 0
Net Income 820
Less withdrawals 1,100
Decrease in capital 280
Ending Capital P7,220

The Balance Sheet

A Balance Sheet is simply a picture of a business at a specific point in time, usually the end of the
month or year. By analyzing and reviewing this financial statement the current financial "health" of a
business can be determined. The balance sheet is derived from our accounting equation and is a
formal representation of our equation

Assets = Liabilities + Owner's Equity.

The categories and format of the Balance Sheet are based on what are called Generally Accepted
Accounting Principles (GAAP). These principles are the rules established so that every business prepares
their financial statements the same way.

Assets
Formal Definition: The properties used in the operation or investment activities of a business.

Informal Definition: All the good stuff a business has (anything with value). The goodies.

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Additional Explanation: The good stuff includes tangible and intangible stuff. Tangible stuff you
can physical see and touch such as vehicles, equipment and buildings. Intangible stuff is like
pieces of paper (sales invoices) representing loans to your customers where they promise to pay
you later for your services or product. Examples of assets that many individuals have are cars,
houses, boats, furniture, TV's, and appliances. Some examples of business type assets are cash,
accounts receivable, notes receivable, inventory, land, and equipment.

Assets are listed based on how quickly they can be converted into cash which is called liquidity.
In other words, they're ranked. The asset most easily converted into cash is listed first followed
by the next easiest and so on. Of course since cash is already cash it's the first asset listed.

Liabilities
Formal Definition:Claims by creditors to the property (assets) of a business until they are paid.

Informal Definition:Other's claims to the business's stuff. Amounts the business owes to others.

Additional Explanation: Usually one of a business's biggest liabilities (hopefully they are not past
due) is to suppliers where they have bought goods and services and charged them. This is similar
to us going out and buying a TV and charging it on our credit card. Our credit card bill is a
liability. Another good personal example is a home mortgage. Very few people actually own
their own home. The bank has a claim against the home which is called a mortgage. This
mortgage is another example of a personal liability. Some examples of business liabilities are
accounts payable, notes payable, and mortgages payable.

Liabilities are listed in the order of how soon they have to be paid. In other words, the liabilities
that need to be paid first are also listed first.

Owner's Equity (Capital)

Formal Definition: The owner's rights to the property (assets) of the business; also called
proprietorship and net worth.

Informal Definition: What the business owes the owner. The good stuff left for the owner
assuming all liabilities (amounts owed) have been paid.

Additional Explanation: Owners Equity represents the owner's claim to the good stuff (assets).
Most people are familiar with the term equity because it is so often used with lenders wanting
to loan individuals money based on their home equity. Home equity can be thought of as the
amount of money an owner would receive if he/she sold their house and paid off any mortgage
(loan) on the property.

Owner's equity (or net worth or capital ) is increased by money or property contributed and any
profits earned and decreased by owner withdrawals and losses.

All Balance Sheets contain the same categories of assets, liabilities, and owner's equity.

If you look below at our Balance Sheet for ABC Mowing you can readily see that there are three main
sections, assets, liabilities, and owner's equity just like the accounting equation. The major sections of a
balance sheet are the heading, the assets, the liabilities, and the owner's equity. The heading contains
the name of the company, the title of the statement, and the date of the statement.

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ABC Mowing
Balance Sheet
As Of October 31, xxxx
Assets Liabilities
Cash $5,080 Accounts Payable 2,060
Accounts Receivable 1,600 Notes Payable 10,000
Office Supplies 100
Mowing Equipment 12,500 Total Liabilities 12,060
Owner's Equity
ABC Capital 7,220
Total Assets $19,280 Total Liabilities & Equity $19,280

This layout is called the account form. In this form the major categories are presented side by side.

Another layout sometimes used is called the report form. In this form the major categories are stacked
on top of each other. An example of the report form follows.

ABC Mowing
Balance Sheet
As Of October 31, xxxx
Assets
Cash $5,080
Accounts Receivable 1,600
Office Supplies 100
Mowing Equipment 12,500
Total Assets $19,280

Liabilities
Accounts Payable $2,060
Notes Payable-Bank 10,000
Total Liabilities $12,060
Owner's Equity
ABC Capital $7,220
Total Liabilities & Equity $19,280

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Balance sheet analysis

Each of the analytical methods employed with respect to income statements may also be used when
examining balance sheets. That is to say, accountants may employ comparative analysis, trend analysis
and common-size analysis when reviewing the balance sheet.

Please note that on a common-size balance sheet, every item (account or total) is expressed as a
percentage of Total Assets or Total Liabilities and Equity, which is the base figure (100%).

Classified report form balance sheet

In previous chapters, you looked at an account form balance sheet which presented data in a
horizontal, or side-by-side, format. In this chapter, you will look at a report form balance sheet in which
data is presented in a vertical, or top to bottom, format. Furthermore, the balance sheet introduced in
this chapter is a little different because it is known as a classified report form balance sheet. A classified
balance sheet groups data according to major categories.

Assets are divided into two subcategories:

current assets (assets used up or converted into cash within a relatively short period of time,
usually a few months)
fixed assets (assets held for a considerable length of time because of their usefulness in producing
goods or services)

Liabilities are divided into two subcategories, as well:

current liabilities ( short-term debts that must be repaid relatively soon, usually within one year)
long-term liabilities (debts that are not due within one year)

Finally, the Owners Equity section is considerably different in the classified report form balance sheet.
Specifically,

the subheading is ABC, Capital and not Owner`s Equity

the equity equation is employed:

beginning capital
+ net income (or - net loss)
- drawings
= ending capital

Working capital and working capital ratio

A classified balance sheet can be used to calculate the working capital and working capital ratio of a
business on a particular date.

Working capital = current assets current liabilities

= $40,000 - $30,000
= $10,000

The working capital ratio for a business involves the same figures.

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Working capital ratio = current assets / current liabilities : 1

= $40,000 / $30,000 : 1
= 1.3:1

A business needs a high working capital (and working capital ratio) in order to pay off its short-term
debts as they become due. This is because businesses typically rely on their current assets to satisfy
their current liabilities. (By the way, working capital ratio is more commonly referred to as "current
ratio.")

Statement of Changes in Financial Position

The last financial statement, the statement of changes in financial position, is prepared to report all
the changes in cash or working capital that occurred over a period of time usually a month or year.

The working capital form of the statement explains the increase or decrease in working capital for a
period.
Note:Working capital is the difference between current assets and current liabilities (Working Capital =
Current Assets - Current Liabilities).

As you might expect, the cash form of the statement explains the increase or decrease in cash for a
period. The statement is often called the Sources and Uses of Cash Statement when cash is used as the
basis for preparing the statement.

Since more and more of the accounting regulatory agencies are promoting using cash instead of
working capital as the basis for preparing this statement, our example statement will also use cash.

The major sections of the statement are the heading, a section for reporting the increases in cash
(resources provided by), a section for reporting the decreases in cash (resources applied to), and a
summary of the change in cash (increase/decrease) for the period.

If the business was in operation in the previous year, the prior year balance sheet along with the current
year balance sheet and current year income statement is needed in order to prepare the statement.
Additional analysis of some of the accounts may also be needed.

Our example assumes that ABC Mowing's prior year balance sheet is as follows:

ABC Mowing
Balance Sheet
As Of October 31, xxxx (Prior Year)
Assets
Cash $6,400
Accounts Receivable 600
Mowing Equipment 2,500
Total Assets $9,500
Liabilities
Accounts Payable $2,000
Total Liabilities $2,000
Owner's Equity
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ABC Capital $7,500

Total Liabilities & Equity $9,500

Using the above prior year balance sheet along with the current year balance sheet and income
statement we prepared the following Statement Of Changes in Financial Position:

Summary of how to prepare the statement:

1. The first step is determining the cash provided or used by operations and begins with the
operating income for the period.
2. Adjustments are made to the income for revenue or expenses items that did not provide or use
cash.
3. Additional adjustments are made for all current and noncurrent accounts and are recorded as
addition or subtractions depending upon their effect on cash based on their beginning of the
year and end of the year balances.

ABC Mowing
Statement Of Changes in Financial Position (Cash)
As Of october 31, xxxx (Current Year)
Sources of cash:
Financing from bank loan $10,0000
Total sources $10,000
Uses of cash:
Income from operations $820
Add:
Increase in accounts payable 60 $880
Deduct:
Increase in supplies inventory 100
Increase in accounts receivable 1000 1,100
Cash used by operations 220
Payment of owner's draws 1,100
Acquisition of equipment 10,000
Total uses 11,320
Decrease in cash $1,320
Change in cash balance:
Cash balance, December 31, xxxx (Current Year) $5,080
Cash balance, December 31, xxxx (Prior Year) 6,400
Decrease in cash $1,320

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