MODULE 3.

PREPARATION, ANALYSIS, AND INTERPRETATION

OF FINANCIAL STATEMENTS

Learning Outcomes:
At the end of this module, the learner should be able to
1. Describe financial statements,
2. identify the users of financial statements,
3. discuss the basic guidelines in the preparation of
financial statements, and
4. prepare financial statements.

3.1. FINANCIAL STATEMENTS

Most financial decisions are made based on the information

provided by financial statements. For example, a business owner
relies on financial statements to determine how much funds to
borrow from a bank for the proposed business expansion.
Similarly, financial statements assist the bank manger in
determining how much loans to extend to the borrower based on
his capacity to pay and the bank’s cash flow. (Aduana, Business
Finance)

Financial statements are a collection of summary-level

reports about an organization's financial results, financial
position, and cash flows.

They are useful for the following reasons:

1. To determine the ability of a business to generate cash, and

the sources and uses of that cash.

2. To determine whether a business has the capability to pay

back its debts.

3. To track financial results on a trend line to spot any looming

profitability issues.

4. To derive financial ratios from the statements that can

indicate the condition of the business.
 5. To investigate the details of certain business transactions,
as outlined in the disclosures that accompany the
statements.

The standard contents of a set of financial statements are:

1. Balance Sheet. Shows the entity's assets, liabilities, and

stockholders' equity as of the report date. It does not show
information that covers a span of time.

2. Income Statement. Show for the reporting period. It

includes revenues, expenses, gains, and losses.

3. Statement of cash flows. Shows changes in the entity's

cash flows during the reporting period.

4. Supplementary notes. Includes explanations of various

activities, additional detail on some accounts, and other
items as mandated by the applicable accounting
framework, such as FRSC or PFRS.
https://www.accountingtools.com/articles/2017/5/10/financial-
statements

3.2 USERS OF FINANCIAL STATEMENTS

There are various different users of financial statements,

each with different information needs. The users of the financial
statements are broadly classified as external users and internal
users.
• External users are individuals or parties that are not
directly involved in the operations of the business.
They include government agencies such as the
Securities and Exchange Commission( SEC), Bangko
Sentral ng Pilipinas (BSP), Bureau of Internal
Revenue (BIR) as well as the creditors, suppliers,
customers and prospective investors.

Prof. ANNA MITOS J. DIZON,MM

FIRST SEMESTER 2022-2023
 • Internal users are individuals who have direct and
active participation in various quantifiable
transactions of the business and in the preparation of
financial statements. The employees and the
management are considered financial users.

3.3 Basic Guidelines in the Preparation of Financial

Statements

The preparation of financial statements including the

content and presentation of items or information follows the
general requirements of the Framework and Standards may it be
in the Philippines or in the global business environment.

Basic accounting concepts used for the preparation of

financial statements are:

1. Money measurement concept. Accounting normally deals

with only those items that are capable of being expressed in
monetary terms. Money has the advantage that it is a useful
common denominator with which to express the wide variety
of resources held by a business. However, not all such
resources are capable of being measured in monetary terms
and so will be excluded from a balance sheet. The money
measurement concept, thus, limits the scope of accounting
reports.

2. Historic cost concept. Assets are shown on the balance at a

value that is based on their historic cost (that is, acquisition
cost). This method of measuring asset value has been adopted
by accountants in preference to methods based on some form
of current value. Many commentators find this convection
difficult to support as outdated historic cost are unlikely to
help in the assessment of current financial position. It is often
argued that recording assets at their current value would
provide a more realistic view of financial position and would
be relevant for a wide range of decisions. However, a system of
measurement based on current values can present a few
problems.

Prof. ANNA MITOS J. DIZON,MM

FIRST SEMESTER 2022-2023
3. Going concern concept. The going concern concept holds
that a business will continue operations for the foreseeable
future. In other words, there is no intention or need to sell off
the assets of the business. Such a sale may arise when the
business is in financial difficulties, and it needs cash to the
creditors. This convention is important because the value of
fixed assets on sale is often low in relation to the recorded
values, and an expectation of having to sell off the assets
would mean that anticipated losses on sale should be fully
recorded. However, where there is no expectation of the need
to sell off the assets, the value of fixed assets can continue to
be shown at their recorded values (that is, based on historic
cost). This concept, therefore, provides support for the historic
cost concept under normal circumstances.

4. Business entity concept. For accounting purposes, the

business and its owner(s) are treated as quite separate and
distinct. Therefore owners are treated as being claimants
against their own business in respect of their investment in
the business. In the business entity concept must be
distinguished from the legal position that may exist between
businesses and their owners. For sole proprietorships and
partnerships, the law does not make any distinction between
the business and its owner(s). For limited companies, on the
other hand, there is a clear legal distinction between the
business and its owners. For accounting purposes, these legal
distinctions are irrelevant, and the business entity convention
applies to all businesses.

5. Dual aspect concept – Each transaction has two aspects, both

of which will affect the balance sheet. Thus, the purchase of a
motor car for cash results in an increase in one asset (motor
car) and a decrease in another (cash). The repayment of a loan
results in the decrease in liability (loan) and the decrease in
asset (cash/bank).

6. Prudence – The prudence concept holds that financial

statements should err on the side of caution. The concept

Prof. ANNA MITOS J. DIZON,MM

FIRST SEMESTER 2022-2023
 evolved to counteract the excessive optimism of some
managers and owners, which resulted, in the past, in an
overstatement of financial position. Operation of the prudence
concept results in the recording of both actual and anticipated
losses in full, whereas profits are not recognized until they are
realized (that is, there is reasonable certainty that the profit
will be received). When the prudence concept conflicts with
another concept, it is prudence concept that will normally
prevail.

7. Stable monetary unit concept – The stable monetary unit

concept holds that money, which is the unit of measurement
in accounting, will not change in value over time. However, in
India and throughout much of the world, inflation has been
persistent problem over the years, and this has meant that the
value of the money has declined in relation to other assets. In
past years, high rates of inflation have resulted in balance
sheets, which are drawn up on a cost basis, reflecting figures
for assets that were much lower than if current values were
employed. The value of freehold land and buildings increased
rapidly during recent times, at least partly as a result of the
reduction in the value of each rupee. Where land and buildings
were held for some time by a business, there was often a
significant difference between their original cost and their
current market value. This led to the criticism that balance
sheet values were seriously understated and, as a result, some
businesses broke away from the use of historic costs as the
basis for valuing this particular asset. Instead, freehold land
is periodically revalued to provide a more realistic statement
of financial position. Although this represents a departure
from the accounting concept, it is a practice that has become
increasingly common.

8. Objectivity concept – The objectivity concept seeks to reduce

personal bias in financial statements. As far as possible,
financial statements should be based on objective, verifiable
evidence rather than matters of opinion.

Prof. ANNA MITOS J. DIZON,MM

FIRST SEMESTER 2022-2023
9. Separate determination concept – The separate determination
concept refers to in determining the aggregate amount of each
asset or liability, the amount of each individual asset or a
liability should be determined separately from all other assets
and liabilities.

10. Substance concept – The substance over form holds if legal

form of the transaction differs from its real substance,
accounting should show the transaction in accordance with
its real substance, i.e., how the transaction affects the
economic situation of the business.
https://www.mbaknol.com/business-finance/accounting-concepts-used-for-the-
preparation-of-financial-statements/

IMPORTANCE AND LIMITATIONS OF FINANCIAL STATEMENTS

a. Importance of Financial Statements

Financial statements are the important sources of

information to all the users of accounting information like;
management, owners, debtors, creditors, employees, government
agencies, financial analysts, etc. The following are the points
which highlight the importance of financial statements:

1. Financial statements are a summary of information relating to

profitability, and resources owned by the firm.

2. Financial statements provide information which can be

compared with those of other firms.

3. Employees can use financial statements to demand for

increment in salary and other benefits.

4. Bankers and other financial institutions can use financial

statements to make the lending decisions.

5. The government bases on financial statements of the

companies for the calculation of tax revenue from the firms.

Prof. ANNA MITOS J. DIZON,MM

FIRST SEMESTER 2022-2023
6. Financial statements can be used as the basis for management
decision-making purposes like planning, promotion, research
and development decisions etc.

7. Existing investors can use financial statements to assess how

efficiently the firm is using their funds.

8. Potential investors can obtain information with the help of

financial statements which can be useful to take investment
decisions.

9. Financial statements reveal the history of the firm.

10. Financial statements can be used to assess the firm’s

liquidity and solvency position.

b. Limitations of Financial Statements

The financial statements suffer from the following limitations:

1. Financial statements include the quantitative information

which is expressed in monetary units. They do not provide any
qualitative information which may have a greater impact upon
the decision makers.

2. Financial statements record and reveal only the historical data

in nature. They do not include any future possible results.

3. Financial statements are strictly confined within the boundary

of some accounting principles. They are used as the guidelines
in recording and reporting financial transactions.

4. Financial statements are just the summary reports of the

company’s financial transactions. All the detailed information
regarding such transactions cannot be disclosed in the
financial statements.

5. Financial statements show the information on a cost basis i.e.

the price paid on the transaction’s date. The effect of price level

Prof. ANNA MITOS J. DIZON,MM

FIRST SEMESTER 2022-2023
 changes (inflation) is not shown in the financial statements. In
other words, the information are not given in the current
value.
https://www.mbaknol.com/financial-management/importance-and-limitations-
of-financial-statements/

Note: Review your Accounting lessons on Preparation of

Financial Statements.

3.4 Statement of Financial Position

The statement of financial position, often called the balance

sheet, is a financial statement that reports the assets, liabilities,
and equity of a company on a given date. In other words, it lists
the resources, obligations, and ownership details of a company
on a specific day. You can think of this like a snapshot of what
the company looked like at a certain time in history.

This definition is true in the sense that this statement is a

historical report. It only shows the items that were present on the
day of the report. This is in contrast with other financial reports
like the income statement that presents company activities over
a period. The statement of financial position only records the
company account information on the last day of an accounting
period.

In this sense, investors and creditors can go back in time to

see what the financial position of a company was on a given date
by looking at the balance sheet.
https://www.myaccountingcourse.com/financial-statements/statement-of-
financial-position#:~

The template example below, the balance sheet account is

listed in the accounting equation order. The company gives the
investors and creditors a clean and easy view of the company’s
resources, debts, and economic position that can be used for
financial analysis purposes.

Investors use this information to compare the company’s

current performance with past performance to gauge the growth

Prof. ANNA MITOS J. DIZON,MM

FIRST SEMESTER 2022-2023
and health of the business. They also compare this information
with other companies’ reports to decide where the opportune
place is to invest their money.

Creditors, on the other hand, are not typically concerned

with comparing companies in the sense of investment decision-
making. They are more concerned with the health of a business
and the company’s ability to pay its loan payments. Analyzing
the leverage ratios, debt levels, and overall risk of the company
gives creditors a good understanding of the risk involved in
loaning a company money.

While the internal management also uses the financial

position statement to track and improve operations over time.

The statement of financial position is arranged according to

the accounting equation where: Assets = Liabilities + Equity,
that is why the assets are always listed first.

The Assets

Assets are resources of the company that is used to create

goods or provide services and generate revenues. Most common
size balance sheet divides the assets into two sub-categories:
current and non-current. The current assets include cash,
accounts receivable, and inventory. These resources are typically
consumed in the current period or within the next 12 months.

The non-current assets section includes resources with

useful lives of more than 12 months. These assets last longer
than one year and can be used to benefit the company beyond
the current period. The most common non-current assets include
property, plant, and equipment.

The Liabilities

Prof. ANNA MITOS J. DIZON,MM

FIRST SEMESTER 2022-2023
 Liabilities are obligations that the company owes other
companies, individuals, or institutions. These range from
commercial loans, personal loans, or mortgages. The two main
sub-categories show the difference between obligations that are
due in the next 12 months, current liabilities, and non- current
liabilities that mature in future years, long-term liabilities.

Current liabilities usually include accounts payable and

accrued expenses. Both types of debts typically become due in
less than 12 months. The non-current or long-term liabilities
include all other obligations that mature more than a year into
the future like mortgages and long-term notes.

The Equity

Equity consists of the ownership of the company. This

displays the stake depending on the type of entity. For example,
a corporation would list the common stock, preferred stock,
additional paid-in capital, treasury stock, and retained earnings.
While a partnership would simply list the members’ capital
account balances including the current earnings, contributions,
and distributions. The simplest entity displays only the
proprietors capitalization.

In the accounting of a nonprofit organization, the statement

of financial position is called the net assets section because it
shows the assets that the organization owns after all the debts
have been paid off. So, the equity of a non-profit organization is
equal to the assets less any outstanding liabilities.

Sample statement of financial position:

Ziven’s Digital Shop

Prof. ANNA MITOS J. DIZON,MM

FIRST SEMESTER 2022-2023
 Statement of Financial Position
December 31, 2020
Assets
Current Assets
Cash P 52,950
Accounts receivable 91,080
Merchandise inventory 62,150
Office supplies 480
Prepaid insurance ________50
Total current assets P 209,310
Property, plant, and equipment
Land P 20,000
Store equipment P 27,100
Less: accumulated depreciation __5,700 21,400
Office equipment P 15,570
Less: accumulated depreciation __4,720 ____10,850
Total property, plant, and ___52,250
equipment
Total assets P261,560
Liabilities and Owner’s Equity
Liabilities
Current liabilities
Accounts payable P 22,420
Notes payable (current portion) 5,000
Salaries payable 1,140
Unearned rent _____1,800
Total current liabilities P 30,360
Long-term liabilities
Note payable (due 2025) ___20,000
Total liabilities P 50,360
Owner’s Equity
Ziven’s capital 211,200
Total liabilities and owner’s equity P261,560

3.5 The Statement of Equity, Statement of Owner’ Equity, or

Statement of Partners’ Capital

Statement of equity, often called the statement of changes

in equity, is one of four general purpose financial statements and
is the second financial statement prepared in the accounting
cycle.

For corporation, it’s the statement of stockholder’s equity that

displays all equity accounts that affect the ending equity balance
including common stock, net income, paid in capital, and
dividends. The statement of stockholder’s equity is a basic
Prof. ANNA MITOS J. DIZON,MM
FIRST SEMESTER 2022-2023
reconciliation of how the ending equity is calculated. How did the
equity balance on January 1 turn into the equity balance on
December 31? https://www.myaccountingcourse.com/financial-
statements/statement-of-stockholders-equity

For sole proprietorship, it’s the statement of owner’s equity

that displays all equity accounts that affect the ending balance
including additional investment, net loss or net income.

For partnership, its statement of partners’ capital shows the

changes in each partner’s capital account for the year or period
being reported. It uses net income or and the partner
contributions and distributions throughout the year to calculate
the ending capital balance.

This statement has four sections:

• — Beginning balance
• — Additions
• — Subtractions
• — Ending Balance

The beginning equity balance is always listed on its own line

followed by two indented sections: additions and subtractions.
Additions include new investments and net income if the
company is profitable. If the company is not profitable, net loss
for the year is included in the subtractions along with any
dividends to the owners. The last line on this statement always
lists the ending equity balance.
Like all financial statements, the statement of stockholder’s
equity has a heading that display’s the company name, title of
the statement and the time of the report.

Sample statement of owner’s equity

Ziven’s Digital Shop

Statement of Owner’s Equity

Prof. ANNA MITOS J. DIZON,MM

FIRST SEMESTER 2022-2023
 For the year ended December 31, 2020

Ziven, capital, January 1, 2020 P 153,800

Net Income for the year P 75,400
Less: withdrawals 18,000
Increase in owner’s equity 57,400
Ziven, capital, December 31, 2020 P 211,200

3.6 Statement of Comprehensive Income

The income statement, also called the profit and loss

statement, is a report that shows the income, expenses, and
resulting profits or losses of a company during a specific time
period. The income statement is the first financial statement
typically prepared during the accounting cycle because the net
income or loss must be calculated and carried over to the
statement of owner’s equity before other financial statements can
be prepared.

The income statement calculates the net income of a

company by subtracting total expenses from total income. This
calculation shows investors and creditors the overall profitability
of the company as well as how efficiently the company is at
generating profits from total revenues.

The income and expense accounts can also be subdivided

to calculate gross profit and the income or loss from operations.
These two calculations are best shown on a multi-step income
statement. Gross profit is calculated by subtracting cost of goods
sold from net sales. Operating income is calculated by
subtracting operating expenses from the gross profit.

Who Uses an Income Statement?

Prof. ANNA MITOS J. DIZON,MM

FIRST SEMESTER 2022-2023
 There are two different groups of people who use this
financial statement: internal users and external users.

Internal users like company management and the board of

directors use this statement to analyze the business as a whole
and make decisions on how it is run. For example, they use
performance numbers to gauge whether they should open new
branch, close a department, or increase production of a product.

External users like investors and creditors, on the other

hand, are people outside of the company who have no source of
financial information about the company except published
reports.
• Investors want to know how profitable a company is and
whether it will grow and become more profitable in the
future. They are mainly concerned with whether or not
investing their money is the company with yield them a
positive return.

• Creditors, on the other hand, aren’t as concerned about

profitability as investors are. Creditors are more concerned
with a company’s cash flow and if they are generating
enough income to pay back their loans.

• Competitors are also external users of financial statements.

They use competitors’ P&L to gauge how well other
companies are doing in their space and whether they should
enter new markets and try to compete with other
companies.

Income Statement Format

There are two income statement formats that are generally

prepared.

Single step income statement shows one category of income

and one category of expenses. This format is less useful of
external users because they can’t calculate many efficiency and
profitability ratios with this limited data.
Prof. ANNA MITOS J. DIZON,MM
FIRST SEMESTER 2022-2023
Multi-step income statement separates expense accounts into
more relevant and usable accounts based on their function.
• Cost of goods sold, operating and non-operating expenses
are separated out and used to calculate gross profit,
operating income, and net income.

• In both income statement formats; revenues are always

presented before expenses. Expenses can be listed
alphabetically or by total dollar amount. Either
presentation is acceptable.

• P&L expenses can also be formatted by the nature and the

function of the expense.

All income statements have a heading that display’s the

company name, title of the statement and the period of the report.
Income Statement | Example | Template | Format | How to Use Explanation
(myaccountingcourse.com)

Sample single step income statement

Ziven’s Digital Shop

Income Statement
For the year ended December 31, 2020

Revenues
Net Sales P 708,255
Rent revenue 600
Total Revenues P
708,855
Expenses
Cost of merchandise sold P 525,305
Selling expenses 70,820
Administration expenses 34,890
Interest expense 2,440
Total expenses 633,455
Net income P 75,400

3.7 Statement of Cash Flow

Prof. ANNA MITOS J. DIZON,MM

FIRST SEMESTER 2022-2023
 The statement of cash flows, also called the cash flow
statement, is the fourth general-purpose financial statement and
summarizes how changes in balance sheet accounts affect the
cash account during the accounting period. It also reconciles
beginning and ending cash and cash equivalents account
balances.

This statement shows investors and creditors what

transactions affected the cash accounts and how effectively and
efficiently a company can use its cash to finance its operations
and expansions. This is particularly important because investors
want to know the company is financially sound while creditors
want to know the company is liquid enough to pay its bills as
they come due. In other words, does the company have good cash
flow?

The term cash flow generally refers to a company’s ability to

collect and maintain adequate amounts of cash to pay its
upcoming bills. In other words, a company with good cash flow
can collect enough cash to pay for its operations and fund its
debt service without making late payments.

The cash flow statement format is divided into three main

sections: cash flows from operating activities, investing activities,
and financing activities.

Operating Activities

Cash flows from operating activities include transactions

from the operations of the business. In other words, the operating
section represent the cash collected from the primary revenue
generating activities of the business-like sales and service
income. Operating activities are short-term and only affect the
current period. For example, payment of supplies is an operating
activity because it relates to the company operations and is
expected to be used in the current period.

Operating cash flows are calculated by adjusting net income

by the changes in current asset and liability accounts.

Prof. ANNA MITOS J. DIZON,MM

FIRST SEMESTER 2022-2023
 Operating Activities: includes all activities that are reported
on the income statement under operating income or expenses.

Investing Activities

Cash flows from investing activities consist of cash inflows

and outflows from sales and purchases of long-term assets. In
other words, the investing section of the statement represents the
cash that the company either collected from the sale of a long-
term asset or the amount of money spent on purchasing a new
long-term asset. You can think of this section as the company
investing. The investments are long-term in nature and expected
to last more than one accounting period.

Investing cash flows are calculated by adding up the

changes in long-term asset accounts.

Investing Activities includes all cash transactions used to buy

or sell long-term assets. Think of these as the company investing
in itself.

Financing Activities

Cash flows from financing consists of cash transactions

that affect the long-term liabilities and equity accounts. In other
words, the financing section on the statement represents the
amount of cash collected from issuing stock or taking out loans
and the amount of cash disbursed to pay dividends and long-
term debt. You can think of financing activities as the ways a
company finances its operations either through long-term debt
or equity financing.

Financing cash flows are calculated by adding up the

changes in all the long-term liability and equity accounts.

Financing Activities: includes all cash transactions that affect

long-term liabilities and equity. Whenever long-term debt or equity
is involved, it is considered a financing activity.

Prof. ANNA MITOS J. DIZON,MM

FIRST SEMESTER 2022-2023
Cash Flow Statement - Example | Template | How to Prepare Explanation
(myaccountingcourse.com)

Prof. ANNA MITOS J. DIZON,MM

FIRST SEMESTER 2022-2023