ACC 101 FINANCIAL ACCOUNTING AND REPORTING 1

___________________________________________________________________________
Module 4
THE ESSENCE OF FINANCIAL STATEMENTS
(Week number)

Introduction

There are questions that the owner of a business periodically asks - How much did the business
entity earn? What is the financial condition of the business? How much is the owner's interest
in the entity today? What happened to the cash receipts? Where did cash go? Investorsm,
creditors, taxing arthritis and other users have their own questions about the business.These
questions can be answered through the financial statements of the business. In this module, the
set of financial statements as well as their uses will be discussed. It also presents how to
prepare these financial statements and how they are interrelated.

Learning Objectives

After studying this module, students should be able to:

1. Explain the usefulness of financial statements
2. Demonstrate skills in the preparation of financial statements 3. Explain how
the financial statements are interrelated.

Essence of Financial Statements

The financial statements are the end product of the accounting process. Information from the
journal and the ledger are meaningless to most users unless they are summarized and
communicated through the financial statements. The financial statements are the means by
which the information accumulated and processed in financial accounting is periodically
communicated to the users. Without accounting information embodied in the financial statements,
users may not be able to arrive at sound economic decisions. The objective of financial
statements is to provide information about the financial position, financial performance, and cash
flows of an entity that is useful to a wide range of users in making economic decisions.

Complete Set of Financial Statements

An entity shall present with equal prominence all the financial statements in a complete
set of financial statements. Per revised Philippine Accounting Standards (PAS) No.1, a
complete set of financial statements comprises:
1. a statement of financial position (balance sheet) at the end of the period;
2. a statement of profit or loss and other comprehensive income for the period (presented as
a single statement, or by presenting the profit or loss section in a separate statement of
profit or loss, immediately followed by a statement presenting comprehensive income
beginning with profit or loss);
3. a statement of changes in equity for the period;
4. a statement of cash flows for the period;
5. notes, comprising a summary of significant accounting policies and other explanatory
notes comparative information prescribed by the standard.

79

Classification: Public
 ACC 101 FINANCIAL ACCOUNTING AND REPORTING 1
___________________________________________________________________________
6. An entity may use titles for the statements other than those stated above. All financial
statements are required to be presented with equal prominence.
7. When an entity applies an accounting policy retrospectively or makes a retrospective
restatement of items in its financial statements, or when it reclassifies items in its financial
statements, it must also present a statement of financial position (balance sheet) as at the
beginning of the earliest comparative period.
In a nutshell, the statement of financial position or balance sheet lists all the assets, liabilities
and equity of an entity as at a specific date. The statement of profit or loss or income statement
presents a summary of the revenues and expenses of an entity for a specific period. The
statement of changes inequity presents a summary of the changes in capital such as
investments, profit or loss, and withdrawals during a specific period. The statement of cash
flows reports the amount of cash received and disbursed during the period. Accounting policies
are the specific principles, bases, conventions, rules and practices adopted by an enterprise in
preparing and presenting financial statements. Notes to financial statements provide narrative
descriptions of disaggregation of items presented in the statements and information about items
that do not qualify for recognition in the statements.

Preparing the Financial Statements

Preparation of the financial statement is an easy step after the worksheet is completed.
Most of the information needed can be derived from this worksheet.

Statement of Profit or Loss (Income Statement)

The statement of profit or loss or income statement shows the results of operations for a
given period of time. The result of operations are basically measured in terms of the income
earned through the utilization of its sources. It is prepared for a given period of time which
means a certain length of time is covered for example, a month, quarter or semi-annual or
annual.

80

Classification: Public
 ACC 101 FINANCIAL ACCOUNTING AND REPORTING 1
___________________________________________________________________________
Monstera Landscaping Services
Income Statement
For the month ended May 31, 2020

Revenues

Landscaping Revenues P 422,500

Expenses

Salaries Expense P 56.000

Supplies Expense 5,000

Rent Expense 70,000

Insurance Expense 20,000

Gas Expense 15,000

Advertising Expense 17,500

Depreciation Expense -Vehicles 45,000

Depreciation Expense - Equipment 10,000

Interest Expense 14,000

Total 252,500

Profit P 170,000

Information about the performance of an enterprise is required in order to assess the potential
changes in the economic resources that are likely to control in the future. It is also useful in
predicting the capacity of the business to generate cash flows from its existing resources.
An entity shall present all items of income and expense recognized in a period.: a.
In a single statement of comprehensive income, or
b. In two statements: a statement displaying components of profit or loss (separate income
statement) and a second statement beginning with profit or loss and displaying components of
other comprehensive income (statement of comprehensive income).

81

Classification: Public
 ACC 101 FINANCIAL ACCOUNTING AND REPORTING 1
___________________________________________________________________________
Statement of Changes in Equity
The statement of changes in equity summarizes the changes that occurred in owner’s
equity. The is statement is now a required statement. Changes in an entity’s equity between two
balance sheet dates reflect the increase or decrease in its net assets during the period. In the
case of sole proprietorships, increases in owner's equity arise from additional investments by
the owner and profit during the period. Decreases result from withdrawals by the owner and
from loss for the period. The beginning balance and additional investments are taken from the
owner’s capital account in the general ledger. The profit or loss amount comes from the income
statement while the withdrawals front the balance sheet column in the worksheet.

Monstera Landscaping Services

Statement of Changes in Equity
For the month ended May 31, 2020

Monstera,Capital, May 1, 2020 P 450,000

Add: Additional investment P -0-

Profit 170,000 170,000

Total P 620,000
Less: Withdrawals 50,000
Monstera, Capital, May 31, 2020 P 570,000

Statement of Financial Position (Balance Sheet)

A Statement of Financial Position (Balance Sheet) is a formal statement showing the
financial position of an enterprise as of a particular date. The balance sheet represents the three
elements of financial position namely: assets; liabilities, and equity or proprietorship.
Users of financial statements analyze the balance sheet to evaluate an entity’s liquidity,
its financial flexibility, and its ability to generate profits, and its solvency. Liquidity refers to the
availability of cash in the near future after taking account of the financial obligations over this
period. Financial flexibility is the ability to take effective actions to change the amounts and
timings of cash flows so that it can respond to unexpected needs and opportunities. This
includes the ability to raise new capital. Solvency refers to the availability of cash over the
longer term to meet financial commitments as they fall due.

In practice there are two customary forms of balance sheet namely:

a. The Report form - this form sets forth the three major sections in a downward sequence of
assets, liabilities and proprietorship.

82

Classification: Public
 ACC 101 FINANCIAL ACCOUNTING AND REPORTING 1
___________________________________________________________________________

Report Form

b. The Account form - this form lists the assets on the left and the liabilities and owner’s equity
on the right.

83

Classification: Public
 ACC 101 FINANCIAL ACCOUNTING AND REPORTING 1
___________________________________________________________________________

Account Form

It is proper to present a classified balance sheet. Assets are classified as current assets and
noncurrent assets; while liabilities as current liabilities and noncurrent liabilities. Classifying
balance sheet aids in the analysis of financial statement data. Assets are classified and
presented in decreasing order of liquidity. Cash is the most liquid. Liabilities are generally
classified and presented baked on time of maturity, so obligations which are currently due are
listed first.

Statement of Cash Flows

The statement of cash flows provides information about the cash receipts and cash
payments of an entity during a period. It is a formal; statement that classifies cash receipts
(inflows) and cash payments (outflows) into operating, investing and financing activities. This
statement shows the net increase or decrease in cash during the period and the cash balance
at the end of the period; it also helps project the future net cash flows of the entity. The
discussion below gives an overview of some important concepts involved in the preparation of
a cash flow statement.
The cash flow statement explains the change during the period in cash and cash equivalents.
Cash includes currency on hand and demand deposits. Cash equivalents are short-term, highly
liquid investments that are readily convertible to cash.

Components of a cash flow statement Operating Activities

The statement provides information about the cash generated from a company’s daily
operating activities. Operating activities are those which produce either revenue or are the direct
cost of producing a product or service. Operating activities which generate cash inflows include
customer collections from sales of their primary products or services, receipts of interest and
dividends, and other operating cash receipts. Operating activities which create cash outflows

84

Classification: Public
 ACC 101 FINANCIAL ACCOUNTING AND REPORTING 1
___________________________________________________________________________
include payments to suppliers, payments to employees, interest payments, payment of income
taxes and other operating cash payments.
Investing Activities
Investing activities include buying and selling noncurrent assets which will be used to
generate revenues over a long period of time; or buying and selling securities not classified as
cash equivalents. Cash inflows generated by investing activities include sales of noncurrent
assets such as property, plant, and equipment. Investing activities can also include the
purchase or sale of stock and securities. Lending money and receiving loan payments would
also be considered investing activities.
Financing Activities
Financing activities include borrowing and repaying money, issuing stock (equity) and paying
dividends. For example, if you borrow funds to purchase equipment or pay off a loan, the cash
flow statement will enable you to determine how much cash was either generated or used as a
result of those transactions.
Income Flows and Cash Flows
The income statement and balance sheet are based on accrual accounting which was
developed nbased on the principle of matching. The matching principle states that revenues
generated and the expenses incurred to generate those revenues should be reported in the
same income statement. This emphasizes the cause-and-effect association between revenue
and expense. Many revenues and expenses result from accruals and allocations that do not
affect cash. A company can operate at a profit and continually be short of cash. It can also
generate huge inflows of cash from operations and still report a loss. The statement of cash
flows can explain how these situations might occur. Answers to these questions cannot be
found in the other financial statements. There are two types of items that cause differences
between income flows and outflows: non cash income or expense and nonoperating income or
expense. An example of a noncash item on the income statement would be depreciation or
amortization. An example of a non operating item on the income statement would be a gain on
the sale of an asset. These transactions must be reported on a cash flow statement in order to
properly determine the true effect of conducting business on cash.
Information used to prepare a cash flow statement is taken from the income statement for the
current year and balance sheets for the past two years. Net income is adjusted for deferrals and
accruals. The purpose of these adjustments is to convert the accrual basis income statement to
a cash flow statement. The cash flow statement follows an activity format and is divided into
three sections: operating, investing and financing activities. Generally, the operating activities
are reported first, followed by the investing and finally, the financing activities. Additionally, there
are two methods of calculating and reporting the net cash flow from operating activities. Both
methods result in identical figures for net cash flow from operating activities because the
underlying accounting concepts are the same.
• The direct method reports gross cash inflows and gross outflows from operating activities.
• The indirect method reconciles net income with net cash flow from operating activities by
adjusting net income
The first step in preparing the cash flow statement is to determine the net increase in cash and
cash equivalents for the period. This amount will be a control figure and the cash flow statement
will reconcile the inflows and outflows (sources and uses) to this figure.

85

Classification: Public
 ACC 101 FINANCIAL ACCOUNTING AND REPORTING 1
___________________________________________________________________________
Cash Effects of Balance Sheet Account Changes
Cash Inflow Cash Outflow
A Decrease in an Asset Account An Increase in an Asset Account
An Increase in a Liability Account A Decrease in a Liability Account
An Increase in an Equity Account A Decrease in an Equity Account

Operating Activities The Direct Method

The first method performed will be the direct method of calculating cash flow. This method
combines information from both the Income Statement and the Cash Flow worksheet we
created using the Balance Sheet. The result is an accurate indication of exactly what funds were
collected in the form of cash, paid in the form of cash, and if the company actually generated
cash.

The Indirect Method

The second method used to calculate the Cash Flows from Operating Activities is referred to as
the Indirect Method. Using the Indirect Method, cash flows from Operating Activities are reported
by adjusting net income for revenues, expenses, gains, and losses that appear on the income
statement but do not have an effect on cash.

86

Classification: Public
 ACC 101 FINANCIAL ACCOUNTING AND REPORTING 1
___________________________________________________________________________

Investing Activities
Cash flow from investing activities is the second part of both types of cash flow statements.
Investing activities are the changes to the cash position created by the buying or selling of
noncurrent assets. This includes selling and replacing equipment that wears out or acquiring a
new building or land to facilitate growth in a company. Investing activities can also include the
purchase or sale of stocks, bonds and securities. Lending money and receiving loan payments
are also considered investing activities. For a small business, the investing activities section of a
cash flow statement usually reports the following information:

For a given period, there may not be much in the way of investing activities. But over time, it is
an important consideration for assessing how to choose to use the cash generated by your
business.

87

Classification: Public
 ACC 101 FINANCIAL ACCOUNTING AND REPORTING 1
___________________________________________________________________________
Financing Activities
Financing activities on a cash flow statement reflect borrowing money and repaying money,
issuing stock, and paying dividends. The financing activities section of the cash flow statement
can be reduced to the following formula:

88

Classification: Public
 ACC 101 FINANCIAL ACCOUNTING AND REPORTING 1
___________________________________________________________________________

Accounting Errors
Accounting errors are unintentional mistakes in book-keeping of transactions. Accounting errors
are different from accounting fraud because in fraud an intentional mistake is made to
misrepresent financial information or to conceal misappropriation of assets.
Accounting errors are easier to identify when they cause a difference between debit and credit
totals of a trial balance. However accounting errors may not always cause a trial balance to
imbalance, in which case they are relatively difficult to identify. Where a trial balance is
imbalanced by accounting errors, the difference between the debit and credit totals of the trial
balance is temporarily kept in suspense account until the errors are corrected. Types
Accounting errors can be broadly classified into the following types. Please note that different
types of errors may have overlapping characteristics.
1. Errors of Principle. Errors that involve violation of accounting principles, misinterpretation of
facts, unintentional unrealistic estimates or incorrect method of calculation. These errors
are usually caused due to insufficient accounting knowledge.
Example: Recognizing expense in wrong accounting period, recognizing unearned revenue as
income instead of a liability, inconsistent application of accounting principles, etc.
2. Clerical Errors. It is in human nature to make mistakes. For example, an accountant may
inadvertently enter an incorrect figure in accounts. Such errors are known as clerical errors.
Clerical errors may be minimized with experience. Clerical errors have following sub-types:
• Arithmetic: Errors in calculations other than incorrect method of calculation.
Example: Calculations such as 3+2×6 may be incorrectly done by performing addition before
multiplication, thus arriving at 30 as the answer. However the correct answer is 15 because we
have to perform multiplication before addition.

89

Classification: Public
 ACC 101 FINANCIAL ACCOUNTING AND REPORTING 1
___________________________________________________________________________

• Input Errors: Incorrect figures input into accounting records. Most common input error is a
transposition error in which a number is input with incorrect order of digits.
Example: Entering 120000 as 12000 or 2389 as 3289. These errors may be minimized by using
comma as a separator i.e. formatting 120000 as 120,000.
• Omissions: Forgetting to enter a transaction in accounting records. Example: Forgetting
to record a purchase transaction.
• Misplacement: Entering a transaction in wrong account.
Example: Recording amount receivable from Customer A in Customer B’s account.

90

Classification: Public