BUSINESS FINANCE As discussed earlier, it is possible that the company has profits but its cash
Introduction to Financial Management
Learning Competency
The learners shall be able to explain the major role of financial management
and the different individuals involved. (ABM_BF12-IIIa-1)
Finance can be defined as the science and art of managing money. (Gitman &
Zutter, 2012).
Finance
How much of their earnings they spend
- How much they save or how much they need
- How they invest their savings
- How they raise additional funds they need (Gitman)
budgeting. - Budgeting is the act of estimating revenue (in the form of their
allowance) and expenses over a period of time (in this case, on a daily basis).
FORMS OF BUSINESS ORGANIZATIONS:
- Sole Proprietorship - A business owned by one person and operated for his
or her own profit.
- Partnership - A business owned by two or more people and operated for
profit.
- Corporation An entity created by law owned by shareholders.
Ask the learners if they recall how they can be shareholders of a corporation
by buying stocks.
ASK HOW AND WHERE CAN THEY BUY STOCKS?
- Corporations may either be privately owned or publicly owned.
- Privately owned corporations are often owned by family members whose
stocks may not be offered to outsiders unless consent by the family members
is secured.
- Companies which are publicly listed are owned by unrelated investors and
are traded in organized exchanges like the Philippine Stock Exchange. While
there are many stockholders, there is generally a group of investors or a
family which controls each listed company.
For example, in the case of BPI, the biggest stockholder is Ayala Corporation
and in the case of Banco De Oro, it is SM Investment Corporation. Prices of
stocks of listed corporations are driven by several factors such as the
earnings of the companies, the prospects of the industry where these
companies operate, the general market sentiment, and the economic
prospects of the country, among others.
1. Measurement of the shareholders wealth
Post the question of how do we measure shareholders wealth? Simplify the
example.
- Assume a learner bought 10 shares of Globe Telecom at PHP2,510 each on
September 9, 2010. This brings his investments to PHP25,100. What happens
to the value of his investment if the price goes up to PHP2,600 per share or it
goes down to PHP2,300 per share?
Conclude that shareholders wealth is measured based on the current
market price of the corporations stocks. The market price changes across
different periods. Hence, the value of your investment changes in different
points on time based on the market value at that time.
2. Factors that Influence Market Price
- Profitability
Profit is a measure of the financial performance of a company for a period
of time.
Although it is a major driver for increasing the value of stock, an investor
should not rely on profits alone.
flow is negative.
- Examples: Suppose the following Income Statements and Cash Flow
Statements of companies A, B and C were presented to you. Which do you
think is a more attractive company?
Good liquidity and reasonable leverage position.
Liquidity and leverage refers to the companys management of the type
and amount of assets and liabilities that it will hold in the course of its
operations.
Dividends.
Holders of shares receive dividends from a corporation as returns on their
investments in form of cash or other properties. Companies which have
better dividend policies are generally more attractive than companies who
do not pay out dividends.
Note that there may be times that companies do not pay out dividends
because of future expansions. Same with the other factors affecting share
price, dividend policies should go hand in hand with other factors in
determining market price.
- Competent management.
Competent managers may have any of the following attributes:
1) visionary
2) decisive
3) people-oriented,
4) inspiring,
5) innovative,
6) respected and
7) experienced/seasoned manager.
- Corporate plans that improve the business prospects.
Example: Company A which is in the business of selling Halo-halo in the
Dapitan area (or any other area) for 5 years. Company A is consistently
earning profits and has a positive cash flow. When asked how Company A
sees itself after 5 more years, Company A answered that it would continue to
sell Halo-halo in Dapitan (or any other area).
On the other hand, Company B sells Buko Juice in Katipunan area (or any
other area different from Company As area) for 5 years. Company B is
consistently earning profits and has a positive cash flow. When asked how
Company B sees itself after 5 more years, Company B answered that it has
generated enough cash to expand its business to Cubao area (or any other
area) to take advantage of the growing demand of Buko Juice in Cubao.
Between Company A and Company B, which would be a better investment?
External Factors
- These factors influences the general reaction of investors in making an
investment decision.
- Its effect is not only to a specific company but on all companies or a group
of companies under similar circumstances. - Such factors are a result of the
environment a company operates in rather than the decisions of the
companys management.
3.Role of Financial Management
Ask the learners, given the factors that influence market price, how will the
company ensure that such objectives will be achieved?
Financial management deals with decisions that are supposed to maximize
the value of shareholders wealth. (Cayanan)
- These decisions will ultimately affect the markets perception of the
company and influence the share price.
- The goal of financial management is to maximize the value of shares of
stocks. - Managers of a corporation are responsible for making the decisions
for the company that would lead towards shareholders wealth
maximization.
Tell the learners that for the next parts of this course, they will fill in the
shoes of a Chief Financial Officer (CFO) and every problem that they will
encounter for this course should be dealt with having shareholders wealth
maximization in mind.
IDENTIFYING THE ROLES IN A CORPORATE ORGANIZATION
Learning Competencies
The learners shall be able to:
Explain the major role of financial management and the different
individuals involved. (ABM_BF12-IIIa)
-1) Explain the flow of funds within an organization through and from the
enterpriseand the role of the financial manager. (ABM_BF12-IIIa-5)
The Corporate organization Structure
Illustrate the corporate organization structure and inform them that this
particular set of people each play a role in the decision making of the
company.
DISCUSS BRIEFLY THE ROLES OF EACH POSITION IDENTIFIED.
Shareholders: The shareholders elect the Board of Directors (BOD). Each
share held is equal to one voting right. Since the BOD is elected by the
shareholders, their responsibility is to carry out the objectives of the
shareholders otherwise, they would not have been elected in that position.
Ask the learners again what the objective of the shareholders is just to
refresh.
Board of Directors: The board of directors is the highest policy making
body in a corporation. The boards primary responsibility is to ensure that
the corporation is operating to serve the best interest of the stockholders.
The following are among the responsibilities of the board of directors:
- Setting policies on investments, capital structure and dividend policies.
- Approving companys strategies, goals and budgets.
- Appointing and removing members of the top management including the
president.
- Determining top managements compensation.
- Approving the information and other disclosures reported in the financial
statements (Cayanan, 2015)
President (Chief Executive Officer): The roles of a president in a
corporation may vary from one company to another. Among the
responsibilities of a president are the following: - Overseeing the operations
of a company and ensuring that the strategies as approved by the board are
implemented as planned.
- Performing all areas of management: planning, organizing, staffing,
directing and controlling. - Representing the company in professional, social,
and civic activities.
Determine from the list of roles written on the board the functions that
pertain to the respective VPs. Add the following functions if needed:
VP for Marketing: The following are among the responsibilities of VP for
Marketing
- Formulating marketing strategies and plans.
- Directing and coordinating company sales.
- Performing market and competitor analysis.
- Analyzing and evaluating the effectiveness and cost of marketing methods
applied.
- Conducting or directing research that will allow the company identify new
marketing opportunities, e.g. variants of the existing products/services
already offered in the market.
- Promoting good relationships with customers and distributors. (Cayanan,
2015).
VP for Production: The following are among the responsibilities of VP for
Production:
- Ensuring production meets customer demands.
- Identifying production technology/process that minimizes production cost
and make the company cost competitive.
- Coming up with a production plan that maximizes the utilization of the
companys production facilities. - Identifying adequate and cheap raw
material suppliers. (Cayanan, 2015)
VP for Administration: The following are among the responsibilities of VP
for Administration:
- Coordinating the functions of administration, finance, and marketing
departments.
- Assisting other departments in hiring employees.
- Providing assistance in payroll preparation, payment of vendors, and
collection of receivables. - Determining the location and the maximum
amount of office space needed by the company. Identifying means,
processes, or systems that will minimize the operating costs of the company.
(Cayanan, 2015).
1. Functions of a Financial Manager
Identify the four functions of a VP for finance (CFO) as follows:
- Financing
- Investing
- Operating
- Dividend Policies
Financing decisions include making decisions on how to fund long term
investments (such as company expansions) and working capital which deals
with the day to day operations of the company (i.e., purchase of inventory,
payment of operating expenses, etc.).
The role of the VP for Finance of the Financial Manager is to determine the
appropriate capital structure of the company. Capital structure refers to how
much of your total assets is financed by debt and how much is financed by
equity. To illustrate, show/draw the figure below:
Assets = Liabilities + Owners Equity.
- To be able to acquire assets, our funds must have come somewhere. If it
was bought using cash from our pockets, it is financed by equity.
- On the other hand, if we used money from our borrowings, the asset
bought is financed by debt.
- In the figure above, the total assets is financed by 60% debt and 40% equity.
Accordingly, the capital structure is 60% debt and 40% equity.
Note: The mix of debt and equity varies in different corporations depending
on managements strategies. It is the responsibility of the Financial Manager
to determine which type of financing (debt or equity) is best for the
company.
Investments may either be short term or long term.
- Short term investment decisions are needed when the company is in an
excess cash position.
 To plan for this, the Financial Manager should be able to make use of
Financial Planning tools such as budgeting and forecasting which will be
discussed in Lesson 3:
FINANCIAL PLANNING TOOLS AND CONCEPTS.
Moreover, the company should choose which type of investment it should
invest in that would provide an most optimal risk and return trade off. We
will learn more about this on Lesson 6: Introduction to investments. - Long
term investments should be supported by a capital budgeting analysis which
is among the responsibilities of a finance manager.
Capital budgeting analysis is a tool to assess whether the investment will be
profitable in the long run and will be further discussed in Lesson 5: Basic Long
Term Financial Concepts. This is a crucial function of management especially
if this investment would be financed by debt.
The lenders should have the confidence that the investments that
management will push through with will be profitable or else they would not
lend the company any money.
Operating decisions deal with the daily operations of the company. The
role of the VP for finance is determining how to finance working capital
accounts such as accounts receivable and inventories. The company has a
choice on whether to finance working capital needs by long term or short
term sources.
Why does a Financial Manager need to choose which source of financing a
company should use?
What do they need to consider in making this decision?
- Short Term sources are those that will be payable in at most 12 months.
This includes short-term loans with banks and suppliers credit. For short-
term bank loans, the interest rate is generally lower as compared to that of
long-term loans. Hence, this would lead to a lower financing cost.
- Suppliers credit are the amounts owed to suppliers for the inventories they
delivered or services they provided. While suppliers credit is generally free
of interest charges, the obligations with them have to be paid on time to
maintain good supplier relationship. Such relationships should be nurtured to
ensure timely delivery of inventories.
- Short term sources pose a trade-off between profitability and liquidity risk.
Because this source matures in a short period, there is a possibility that the
company may not be able to obtain enough cash to pay their obligation (i.e.
liquidity risk).
- Long term sources, on the other hand, mature in longer periods. Since this
will be paid much later, the lenders expect more risk and place a higher
interest rate which makes the cost of long term sources higher than short
term sources. However, since long term sources have a longer time to
mature, it gives the company more time to accumulate cash to pay off the
obligation in the future.
- Hence, the choice between short and long term sources depends on the risk
and return trade off that management is willing to take. The learners will
learn more about this on Chapter 4: Sources and uses of funds.
Dividend Policies. Recall that cash dividends are paid by corporations to
existing shareholders based on their shareholdings in the company as a
return on their investment. Some investors buy stocks because of the
dividends they expect to receive from the company. Non-declaration of
dividends may disappoint these investors. Hence, it is the role of a financial
manager to determine when the company should declare cash dividends.
- Before a company may be able to declare cash dividends, two conditions
must exist:
1. The company must have enough retained earnings (accumulated profits)
to support cash dividend declaration.
2. The company must have cash.
On the other hand, a company which has access to long term sources of
funds may be able to declare dividends even if they are faced with
investment opportunities. However these investment opportunities are
generally financed by both debt and equity.
- The management usually appropriates a portion of retained earnings for
investment undertakings and this may limit the amount of retained earnings
available for dividend declaration.
- Creditors are not willing to finance entirely the cost of a companys long
term investment. Hence, the need for equity financing (e.g. internally
generated funds or issuance of new shares).
- Examples of these companies are publicly listed companies such as PLDT,
Globe Telecom, and Petron. PLDT and Globe are two of the Philippine listed
companies which have generously distributed cash dividends for the last five
years (information as of 2014).
INTRODUCE THE CONCEPT OF A FINANCIAL SYSTEM
Learning Competencies The learners shall be able to:
Distinguish a financial institution from financial instrument and financial
market. (ABM_BF12-IIIa-2)
Enumerate the varied financial institutions and their corresponding
services. (ABM_BF12-IIIa-3)
Compare and contrast the varied financial instruments. (ABM_BF12-IIIa-4)
Explain the flow of funds within an organization through and from the
enterpriseand the role of the financial manager. (ABM_BF12-IIIa-5)
the transfers of funds from one party to another are made through Financial
Instruments.
1. FINANCIAL INSTRUMENTS
When a financial instrument is issued, it gives rise to a financial asset on
one hand and a financial liability or equity instrument on the other.
- A Financial Asset is any asset that is:
Cash
An equity instrument of another entity
A contractual right to receive cash or another financial asset from another
entity.
A contractual right to exchange instruments with another entity under
conditions that are potentially favorable. (IAS 32.11)
Examples: Notes Receivable, Loans Receivable, Investment in Stocks,
Investment in Bonds.
- A Financial Liability is any liability that is a contractual obligation:
To deliver cash or other financial instrument to another entity.
To exchange financial instruments with another entity under conditions
that are potentially unfavorable. (IAS 32)
Examples: Notes Payable, Loans Payable, Bonds Payable - An Equity
Instrument is any contract that evidences a residual interest in the assets of
an entity after deducting all liabilities. (IAS 32)
Examples: Ordinary Share Capital, Preference Share Capital
Identify common examples of Debt and Equity Instruments.
- Debt Instruments generally have fixed returns due to fixed interest rates.
Examples of debt instruments are as follows:
Treasury Bonds and Treasury Bills are issued by the Philippine
government. These bonds and bills have usually low interest rates and have
very low risk of default since the government assures that these will be paid.
Corporate Bonds are issued by publicly listed companies. These bonds
usually have higher interest rates than Treasury bonds. However, these
bonds are not risk free. If the company which issued the bonds goes
bankrupt, the holder of the bonds will no longer receive any return from
their investment and even their principal investment can be wiped out.
- Equity Instruments generally have varied returns based on the
performance of the issuing company. Returns from equity instruments come
from either dividends or stock price appreciation.
The following are types of equity instruments:
Preferred Stock has priority over a common stock in terms of claims over
the assets of a company. This means that if a company were to be liquidated
and its assets have to be distributed, no asset will be distributed to common
stockholders unless all the claims of the preferred stockholders have been
given.
Moreover, preferred stockholders have also priority over common
stockholders in cash dividend declaration. Dividends to preferred
stockholders are usually in a fixed rate. No cash dividends will be given to
common stockholders unless all the dividends due to preferred stockholders
are paid first. (Cayanan, 2015).
Holders of Common Stock on the other hand are the real owners of the
company. If the companys growth is spurring, the common stockholders will
benefit on the growth. Moreover, during a profitable period for which a
company may decide to declare higher dividends, preferred stock will receive
a fixed dividend rate while common stockholders receive all the excess.
2. Financial Markets
Classify Financial Markets into comparative groups:
- Primary vs. Secondary Markets
To raise money, users of funds will go to a primary market to issue new
securities (either debt or equity) through a public offering or a private
placement.
The sale of new securities to the general public is referred to as a public
offering and the first offering of stock is called an initial public offering. The
sale of new securities to one investor or a group of investors (institutional
investors) is referred to as a private placement.
However, suppliers of funds or the holders of the securities may decide to
sell the securities that have previously been purchased. The sale of
previously owned securities takes place in secondary markets. The
Philippine Stock Exchange (PSE) is both a primary and secondary market.
- MONEY MARKETS VS. CAPITAL MARKETS
Money markets are a venue wherein securities with short-term maturities
(1 year or less) are sold. They are created because some individuals,
businesses, governments, and financial institutions have temporarily idle
funds that they wish to invest in a relatively safe, interest-bearing asset. At
the same time, other individuals, businesses, governments, and financial
institutions find themselves in need of seasonal or temporary financing.
On the other hand, securities with longer-term maturities are sold in
Capital markets. The key capital market securities are bonds (long-term debt)
and both common stock and preferred stock (equity, or ownership).
3. Financial Institutions
Identify examples of financial institutions: - Commercial Banks - Individuals
deposit funds at commercial banks, which use the deposited funds to provide
commercial loans to firms and personal loans to individuals, and purchase
debt securities issued by firms or government agencies. - Insurance
Companies - Individuals purchase insurance (life, property and casualty, and
health) protection with insurance premiums. The insurance companies pool
these payments and invest the proceeds in various securities until the funds
are needed to pay off claims by policyholders. Because they often own large
blocks of a firms stocks or bonds, they frequently attempt to influence the
management of the firm to improve the firms performance, and ultimately,
the performance of the securities they own.
- Mutual Funds - Mutual funds are owned by investment companies which
enable small investors to enjoy the benefits of investing in a diversified
portfolio of securities purchased on their behalf by professional investment
managers. When mutual funds use money from investors to invest in newly
issued debt or equity securities, they finance new investment by firms.
Conversely, when they invest in debt or equity securities already held by
investors, they are transferring ownership of the securities among investors.
- Pension Funds - Financial institutions that receive payments from
employees and invest the proceeds on their behalf. - Other financial
institutions include pension funds like Government Service Insurance System
(GSIS) and Social Security System (SSS), unit investment trust fund (UITF),
investment banks, and credit unions, among others.
Review of Financial Statement Preparation, Analysis, and Interpretation
Pt.1
Brief introduction on learning objectives
Learning Competencies The learners shall be able to prepare financial
statements (ABM_BF12-III-6)
Accounting is the systematic and comprehensive recording of financial
transactions pertaining to a business. (Investopedia - Sharper Insight.
Smarter Investing. | Investopedia. (2016). Investopedia. Retrieved 8 May
2016, from http://investopedia.com) 1.
The Accounting Equation The basic accounting equation is:
ASSETS = LIABILITIES + OWNERS 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.
In double-entry bookkeeping, there is the concept of debit (dr) and credit
(cr). Debit is the left, and credit is the right.
There is also a concept of normal balances. A normal balance, either a debit
normal balance or a credit normal balance, is the side where a specific
account increases.
In the accounting equation, asset is on the left side, while liabilities and
equity is on the right side. Therefore, asset has a debit normal balance,
meaning that cash as an asset is debited to increase, while credited to
decrease.
On the other hand, liabilities and owners equity have a credit normal
balance. This means that a liability account is credited to increase, while
debited to decrease. The accounting equation provides the foundation for
what eventually becomes the balance sheet.
2. T-Account Analysis In double-entry bookkeeping, the terms debit and
credit are used to identify which side of the ledger account an entry is to
be made. Debits are on the left side of the ledger and Credits are on the
right side of the ledger. It does not matter what type of account is
involved.
 The debit to cash increases the Cash Account by PHP500 while the
credit to Accounts Payable increases this liability account by the same
PHP500.
In the above example, we analyzed the accounting equation in terms
of assets, liabilities, and owners equity. These are called Real or
Permanent Accounts. These accounts remain open and active for the
life of the enterprise.
In contrast, there are accounts that reflect activities for a specific
accounting period. These are called Nominal or Temporary Accounts.
After the end of the specific period and the start of a new period, the
balance of the nominal accounts are zero.
Using the accounting equation, we can now expand the analysis that
will include both real and nominal accounts. All nominal accounts will
be then closed to a Retained Earnings account at the end of the period,
which is an owners equity account.
Illustrative Example:
Calvo Delivery Service is owned and operated by Noel Calvo. The
following selected transactions were completed by Calvo Delivery
Service during February:
A. Received cash from owner as additional investment, P35,000.
B. Paid creditors on account, P1,800.
C. Billed customers for delivery services on account, P11,250.
D. Received cash from customers on account, P6,740.
3. Nominal Accounts
There are two major categories of nominal accounts: Expense and
Revenue accounts.
Expense Accounts
- A resource, when not yet used up for the current period, is
considered an Asset and will provide benefits at a future time. - On the
other hand, a resource that has been used for the current period is
called an Expense. At the end of each accounting period, expenses are
closed out to the Retained Earnings Account which decreases the
Owners Equity. Since expenses decrease the owners equity, those
expense accounts carry a normal debit balance.
Revenue Accounts
- Revenue Accounts reflect the accumulation of potential additions to
retained earnings during the current accounting period.
- At the end of the accounting period accumulation of revenues during
the period are closed to the Retained Earnings Account which increases
Owners Equity.
- Therefore revenue accounts carry a normal credit balance meaning
the same balance as the Retained Earnings Account.
Illustrative Example:
J. F. Outz, M.D., has been a practicing cardiologist for three years.
During April 2009, Outz completed the following transactions in her
practice of cardiology:
Mar 1 Provide medical services to clients for cash P35,000.
Mar 2 Paid rent for the month, P3,000.
Paid advertising expense, P1,800.
Mar 6 Purchased office equipment on account, P12,300.
Mar 15 Paid creditor on account, P1,200.
Mar 27 Paid cash for repairs to office equipment, P500.
Mar 30 Paid telephone bill for the month, P180.
Mar 31 Paid electricity bill for the month, P315.
4. The Accounting Cycle
Because accounting is all about getting data and putting them into
the accounting equation, the end products are financial statements
such as a balance sheet and income statements, the process of
accounting follows a cycle called the Accounting Cycle.
It starts with the identification of whether a transaction is
accountable or can be quantified, and ends with a post-closing trial
balance.
The Process:
Step 1: Analyze Business Transactions.
In this step, a transaction is analyzed to find out if it affects the
company and if it needs to be recorded.
Personal transactions of the owners and managers that do not affect
the company should not be recorded.
In this step, a decision may have to be made to identify if a
transaction needs to be recorded in special journals such as a sales or
purchases journal.
Therefore, what you should do is:
A. Carefully read the description of the transaction to determine
whether an asset, a liability, an owners equity, a revenue, an expense,
or a drawing account is affected.
B. For each account affected by the transaction, determine whether the
account increases or decreases.
C. Determine whether each increase or decrease should be recorded as
a debit or a credit, following the rules of debit and credit.
Illustrative Example:
N. Juna resigned from Company X. This does not affect any asset,
liability, or the owners equity account.
B. Cano purchased PHP500 cash worth of supplies at Ace Hardware.
This affects cash and supplies, both asset accounts.
Step 2: Record This in the Journal.
Using the rules of debit and credit, transactions are initially entered in
a record called a Journal and the entry made is called a Journal Entry.
The journal serves as a record of when transactions occurred and
were recorded.
For repetitive transactions or high volume transactions (e.g. one
thousand sales transactions in one day), Special Journals are made.
These special journals include sales journal, purchases journal, cash
receipts journal, and cash disbursements journal.
Note: The Source Document is the file or document (i.e. official receipt,
purchase order, contract) that will provide a basis or reason for a
journal entry. For example, an official receipt issued by the business will
tell you that a sale transaction occurred and will be reflected by the
journal entry.
Illustrative Example:
M. Jaya resigned from Company X. No journal entry.
 C. Danto purchased PHP500 cash worth of supplies to Ace Hardware. The analysis and updating of accounts at the end of the period before
Debit Supplies PHP500, Credit Cash PHP500. the financial statements are prepared is called the Adjusting Process.
The journal entries that bring the accounts up to date at the end of the
Step 3: Post the Transactions on a Ledger. accounting period are called Adjusting Entries.
A transaction is first recorded in a journal. Periodically, the journal The following are normally adjusted at the end of a period: - Accruals.
entries are transferred to the accounts in the ledger. These include unpaid salaries for the accounting period, unpaid interest
The process of transferring the debits and credits from the journal expense, or unpaid utility expenses.
entries to the accounts is called Posting. - Prepayments. If a company has prepaid expenses such as prepaid rent
Ledgers provide chronological details as to how transactions affect or prepaid insurance then the correct balances for these accounts have
individual accounts. There are two types of ledgers: the General Ledger to be established at the end of each accounting period to reflect their
and Subsidiary Ledger. The general ledger is a summary of the different correct balances.
Subsidiary Ledgers and can serve as a control account. - Depreciation and amortization expenses. Depreciation expenses are
For example, a general ledger for accounts receivable summarizes the recognized at the end of each accounting period through adjusting
balances found in the different subsidiary ledgers for different entries. If there are intangible assets such as franchise, the allocation
customers. of their costs which is called amortization expense, is also recognized at
the end of each accounting period through adjusting entries.
Illustrative Example: - Allowance for uncollectible accounts. Bad debt expense from
J. Gaya, a CPA, is an independent auditor with only two clients. The accounts receivable is also recognized through adjusting entries.
Accounts Receivable ledger account has a balance of PHP100,000. His
two clients are A. Rania, and X. Campos. The subsidiary ledger of A. Step 6: Prepare an Adjusted Trial Balance.
Rania has a balance of PHP25,000. X. Camposs ledger balance is An adjusted trial balance is prepared after taking into consideration
PHP75,000. The sum of subsidiary ledgers must total the general ledger the effects of the adjusting entries. Again, this is to ensure that the
or else there must be an investigation to identify the source of total debit balances equal the credit balances after posting and
discrepancies. journalizing adjusting entries made.
Step 7: Prepare the nancial statements. From the adjusted trial
balance, the financial statements can then be prepared. These are the
statement of financial position, statement of profit or loss, and the
statement of cash flows.
Step 8: Make the closing entries. In the discussion about accounts, it
was discussed that nominal accounts (revenue and expense accounts)
are closed to retained earnings, or an owners capital account because
these accounts refer only to a specific accounting period. Actually,
these accounts to be closed are accounts that can be seen in the
income statement.
Posting in the subsidiary ledgers can be done anytime and the balances
Upon closing:
are summarized at the end of an accounting period. Posting in the
- If the revenues exceed expenses during an accounting period,
general ledger is done at the end of an accounting period.
retained earnings will increase.
- The reverse is true which means that if the expenses exceed revenues,
Step 4: Prepare an Unadjusted Trial Balance.
the retained earnings will decrease.
Errors may occur in posting debits and credits from the journal to the
In closing temporary accounts:
ledger. One way to detect such errors is by preparing a trial balance.
- Revenue account balances are transferred to an account called
Double-entry accounting requires that debits must always equal
Income Summary Account (sometimes profit or loss summary). -
credits. The trial balance verifies this equality.
Expense account balances are also transferred to the Income Summary
The steps in preparing a trial balance are as follows:
Account.
1. List the name of the company, the title of the trial balance, and the
- The balance of the Income Summary (net income or net loss) is
date the trial balance is prepared.
transferred to the owners capital account.
2. List the accounts from the ledger and enter their debit or credit
- The balance of the owners drawing account is transferred to the
balance in the Debit or Credit column of the trial balance.
owners capital account.
3. Total the Debit and Credit columns of the trial balance.
4. Verify that the total of the Debit column equals the total of the
Step 9: Make a Post-Closing Trial Balance.
Credit column.
A Post-Closing Trial Balance shows the accounts that are permanent or
real. These are the accounts that can be seen in your balance sheet.
Step 5: Make adjustments. Journalize adjusting entries.
The post-closing trial balance is prepared to test if the debit balances
At the end of the accounting period, many of the account balances in
equal the credit balances after closing entries are considered. 5. Basic
the ledger can be reported in the financial statements without change.
Financial Statements. A nancial statement is basically a summary of all
For example, the balances of the cash and land accounts are normally
transactions that are carefully recorded and transformed into
the amount reported on the balance sheet. However, some accounts in
meaningful information. It also shows the companys permanent and
the ledger require updating.
temporary accounts. Basically, financial statements are comprised of
This updating is required for the following reasons:
the following:
1. Some expenses are not recorded daily. For example, the daily use of
supplies would require many entries with small amounts. Also,
managers usually do not need to know the amount of supplies on hand
on a day-to-day basis.
2. Some revenues and expenses are earned as time passes rather than
as separate transactions. For example, rent received in advance
(unearned rent) expires and becomes revenue with the passage of
time. Likewise, prepaid insurance expires and becomes an expense with
the passage of time.
3. Some revenues and expenses may be unrecorded. For example, a
company may have provided services to customers that are has not
billed or recorded at the end of the accounting period. Likewise, a
company may not pay its employees until the next accounting period
even though the employees have earned their wages in the current
period.