TASK 2- Preparation of statements.

There are four types of financial statements that are prepared by the statements. These include:

 Income statement.
 Balance sheet.
 Cash flow statement.
 Owner’s equity statement.

Income statement.
An income statement shows the incomes and expenses that leads to a profit or loss of an organization. It
is the core of the financial statements of a business.

Importance of an income statement.

1. Income statements are prepared quarterly, monthly or even annually. This enables stakeholders
such as owners and venture capitalist to intently observe the performance of the business and
make right decisions. It also helps in identifying variances before they get costly.
2. The income statement identifies future costs or unanticipated costs incurred by the business and
areas where variances have occurred against the budget.
3. It provides venture capitalist with an overview of the organization which they intend to fund.
Banks and other financial institutions also analyze to determine the credit worthiness of the
transaction.

How to prepare an income statement.

o Firstly, a trial balance which is a summary report contains the year ending balances of each
account in the general ledger is used to identify transactions.
o The amount of sales and sales returns is identified and are recorded in the income statement.
o The cost of goods sold are identified later and recorded under cost of goods sold in the income
statement.
o The Gross Margin is then calculated as: total sales – Cost of sales.
o The expenses are identified and recorded in the income statement under expenses.
o The Profit or Loss is calculated as: Gross Margin – Expenses.
 o The Income Tax is calculated by multiplying the tax rate by pre-tax income figure which is then
entered at the end of the income statement.
o The Net Income is calculated by subtracting the income tax from the pre- tax income figure
which is the net income figure.

Format of the income statement.

https://businessjargons.com/wp-content/uploads/2019/09/income-statement1.jpg
Example of an income statement.

https://finance.zohocorp.com/wp-content/uploads/2019/08/multi-step-income-statement-768x1136.png
Limitation of the Income Statement.

i. Provide confirmation value: It is prepared after examining all financial data documented by the

company. Therefore, there is room for data manipulation is easily done by malicious parties. In
such cases, internal controls must be established and the annual financial statements, including
the income statement, must also be audited by a prominent external auditor.
ii. Provide predictive value: The income statement is created using various accounting policies and
methods. These are subject to the prejudices of managers or business owners. Forecasting is also
judgmental. If accounting policies change regularly, or if accounting principles are implemented
differently in each case, the income statement will inevitably become predictive and differ
significantly from the actual values. Therefore, the accounting method employed by the company
predicts the future in a predictive style based on prejudices and changing policies.
iii. Profits are opinions: The income statement is widely referred to in the investment community as
just an opinion. Investors value the cash flow statement and, in some cases, rely on cash flow
rather than the auditor's earnings judgment. So while profit is an opinion, cash is always a real
number. Cash must be physically notarized by an auditor, who is more trustworthy than an
income statement.
iv. Ignores non-revenue factors: The income statement is about the data that affect your income
and wages. Qualitative factors such as wage determinations, company service to customers and
sales policies are non-monetary and are not considered in the income statement.
v. Does not shows actual cost: Assets are recognized on the balance sheet and depreciation is part
of the income statement, but the asset's useful life should be well forecasted. Assets may last
longer than estimated. However, the cost has already been depreciated and charged to the income
statement. This indicates that costs are concentrated over a few billing periods and rather spread
across actual usage. Therefore, applying an income statement does not give you the actual cost of
the asset, but it does give you a reasonable estimate of the expense. Therefore, auditors are said to
express an opinion on the financial statements emphasizing that they represent a true and fair
view.  
Balance sheet.
A balance sheet is designed to accurately convey the value of an organization by totaling the assets,
liabilities, and equity at the end of the financial year.

Balance sheets are calculated using the accounting equation: Assets = Liabilities + Equity.

The terms used in the equation are defined as follows:

1. Assets- These are resources such as property owned by the business and can be changed into
cash. These assets can be split into:
 Current assets- these are short-term assets that can be changed into cash within a year.
 Non-current assets- are long-term assets such as land that are not expected to be changed
into cash.
2. Liabilities- This is when an organization owes to creditors. This can also be split into two:
 Current liabilities- these are due to one year.
 Non- current liabilities- these are liabilities that a business doesn’t expect to pay within
one year.
3. Equity- this refers to the net worth of a business and the amount that is left if liabilities were paid
through selling of assets.

How a balance sheet is prepared.

 Firstly, all the total assets are identified from the trial balance and any additional information on
the assets such as depreciation is gotten from the Income Statement. The current assets include
resources such as debtors, inventory, other incomes while non-current assets include resources
such as property and machinery.
 Liabilities are also identified from the trial balance and additional information such as accrued
expenses are also included. Current liabilities include creditors, short-term debts, accrued
expenses, while non-current liabilities will include long-term debt.
 Equity are generally straightforward when the business is privately owned. However, equity held
by public companies then calculation can be more difficult depending on the types of shares
issued. Some of the stocks include common stock, preferred stock, treasury stock and retained
earnings.
 Total liabilities and total equity is added and is compared to total assets.
Format of a balance sheet.

https://imgs.search.brave.com/0-v9W1HcxkF8LRpBcMmpZrGGy532Rz9kKBoa9pgJl5k/rs:fit:1200:1200:1/
g:ce/aHR0cDovL3RlbXBs/YXRlbGFiLmNvbS93/cC1jb250ZW50L3Vw/bG9hZHMvMjAxNi8w/
MS9CYWxhbmNlLVNo/ZWV0LVRlbXBsYXRl/LTAxLmpwZw

Example of Balance sheet.

https://online.hbs.edu/online/PublishingImages/balance_sheet_graphic_RED_V2.png

Purpose of Balance sheets.

1. Solvency Assessment - There are several subsets of details that can be used to understand an
organization's short-term financial position. Comparing the current assets subtotal with the
current liabilities subtotal provides an estimate of whether the company will have access to
sufficient funds to pay off its current liabilities in the short term. 
2. Assessing borrowing levels – You can also compare total debt and total equity on your balance
sheet to see if the resulting debt-to-equity ratio indicates dangerously high levels of borrowing.
 This information is especially useful for lenders and creditors who want to know if additional
credit could lead to bad debts. 
3. Dividend Paying Ability Assessment – Investors want to check their balance sheet cash balance
to see if they have enough cash to pay dividends. However, this decision may need to be adjusted
if additional funds need to be invested in the company. 
4. Asset Valuation - A prospective acquirer of an organization assesses the balance sheet to
determine if there are assets that may be deductible without harming the underlying business. For
example, acquirers can compare reported inventory to sales to derive inventory turnover that may
show the presence of surplus inventory. The same comparison can be applied to debtors.
Alternatively, you can compare total fixed assets to sales to derive a fixed asset sales metric and
compare it to the best business in the same industry to determine if fixed asset investments are
overinvested. 

Limitation of balance sheet.

1. Non-current assets are shown at their book value. A conventional balance sheet doesn’t show the
original cost of assets.
2. Non- current assets are not related to the market value as they are recorded at book value.
3. In some cases, fictitious assets are reported as assets in the balance sheet. This may increase the
amount of total property.
4. The balance sheet does not show the cost of certain assets such as employee skills and loyalty to the
business.
5. Conventional balance sheets can mislead readers who are not fully knowledgeable about balance
sheets during inflation.
6. The cost of most liquid assets relies on several estimates and may not show the company’s actual
financial situation.

Cash flow statement.

A cash flow statement provides the movement of cash in and out of the business highlighting the
management of cash.

The cash flow statement have three categories that include:

i. Operating activities shows how money is created from a business’s commodities and services.
This may include rent payment, receipts from sales and etc
 ii. Venturing activities includes all sources and usage of cash from a business’s ventures. This may
include purchasing or selling assets.
iii. Financing activities shows the cash flow from dividends paid to shareholders and venture
capitalists and payment of loans.

Cash flow statement is calculated in two ways:

 Direct method- Used to calculate the operational section based on cash-impacting transaction
information during the period. To calculate the operating segment using the direct method, all
cash income from operations and subtract all cash payments from operations. This method is
more suitable for small business.
 Indirect method- This method relies on accrual accounting methods in which accountants record
income and expenses at times other than cash payments or receipts. In other words, these accrual
accounting entries and adjustments cause cash flows from operations to differ from net income.
Rather than laying down transaction data in the same way as the direct method, accountants start
with the net income figures on the income statement and make adjustments to reverse the effects
of occurrences that occurred during the period. Basically, accountants convert net income into
actual cash flow by generating net income through the process of identifying all non-cash
expenses for the period from the income statement. The most common and consistent of these are
depreciation and amortization (the spread of payments over multiple periods). 

With any method used, the accountant will end up with the same value.

The values from the cash flow statement can either be positive or negative. Positive values shows that
there is more inflow than outflow of cash while negative values shows that there is more outflow than
inflow. Net cash= cash inflow – cash outflow
The calculations involved are; Closing balance = net cash + opening balance.

Format of the cash flow statement.

https://templatelab.com/wp-content/uploads/2016/09/cash-flow-statement-37.jpg

Example of cash flow statement.

https://cdn.corporatefinanceinstitute.com/assets/direct-vs-indirect-method-cash-flows.png

https://www.google.com/url?sa=i&url=https%3A%2F%2Fwww.tutor2u.net%2Fbusiness
%2Freference%2Fcash-flow-forecasting-example-
startup&psig=AOvVaw2CBxFEtg5Dljl3DaFfwJc-
&ust=1681570244166000&source=images&cd=vfe&ved=0CBEQjRxqFwoTCOCC-
7_Pqf4CFQAAAAAdAAAAABAf

Importance of the cash flow statement.

a. Shows cost details- The cash flow statement helps to get clear understanding of capital
expenditure a business is making to its creditors. It presents transactions recorded in cash not
reflected in other financial statement. It includes purchasing inventory, purchasing capital goods
and extending credit to debtors.
b. Helps maintain an optimal cash balance- the cash flow statement assists to keep the cash
balance at optimum. A business must assess whether it has excess unused cash or whether it is
overfunded or underfunded. When excess cash is left, the business can use for investing in stock
or purchase inventory. When funds are tight, businesses can borrow money to find sources of
funding to sustain their operations.
 c. Helps focus on cache generation- profit is a crucial part in growing businesses by generating
cash. However, there are diverse way to earn money.
d. Beneficial for short-term planning- the cash flow statement is crucial in managing cash flow.
Therefore, having sufficient liquid funds to meet short- term obligations such as upcoming
payments. Financial managers assess deposits and withdrawals from previous transactions to
make important decisions. Situations where decisions are made based on cash flow include
predicting cash shortfalls to pay off debt or providing the basis for applying for a bank loan.

Limitations of cash flow statement.

1. It doesn’t present net income as it includes no-cash items that are identifiable in the income statement.
2. It is not useful in assessing a company’s liquidity or solvency. Adequate liquidity position cannot be
assessed form the statement as it only represents the cash flow.
3. It cannot perform the functions of equity flow and income statement.
4. It is prepared as per AS3 which contrasts with the income statement and balance sheet which follow
the Companies Act.
5. It is based on historical value and doesn’t help in forecasting future cash flow.

Owner’s equity statement.

The owner’s equity statement shows the change in corporate capital from the opening balance sheet to
the closing balance sheet. Changes include earnings earned, dividends, equity inflows, equity exits, and
net losses. 

Equity is the amount of money that the owners and shareholders have ventured in the organization.

On a company's balance sheet, equity appears under the heading 'Equity'. This section usually consists of
three components; share capital, retained earnings and net income.

The items found in the statement include:

o Opening balance – This is taken form the closing balance of the previous statement. All other
additions and disposals in the current financial year are included in the opening balance of the
owner’s equity statement.
 o Net income- Net income is a business’s gross income during the financial year after recording all
operating and non-operating expenses. The values are taken from the income statement prepared
at the end of the financial year.
o Other incomes: unrecognized income in the income statement is recognized in the statement of
equity. Examples of other income are actuarial gains or unrealized gains on financial instruments.
o Issuance of new capital: When new shares are issued, there is an inflow of capital. This is added
to the total capital. 
o Net loss: A net loss is a loss incurred by a company during a financial year as a result of its
operations. It is deducted from the statement of shareholders' equity as it reduces the total capital.
o Other losses: unrecognized expenses and losses in the income statement are included in the
statement of equity. A good example of other comprehensive losses is actuarial or unrealized
losses on financial derivative instruments.
o Dividend: A dividend is a reward or return received by shareholders for venturing in the
business’s stock. Dividends paid to shareholders are deducted from the statement of changes in
equity as they reduce the total capital.
o Withdrawal of capital: When shares are cancelled or capital is withdrawn from a company, this
is shown as a deduction in the statement of shareholders' equity as the company's total capital is
reduced. 

General format of the owner’s equity statement.

https://cdn.corporatefinanceinstitute.com/assets/equity-statement2.png

Example of owner’s equity statement.

https://wsp-blog-images.s3.amazonaws.com/uploads/2022/07/22042037/Statement-of-Owners-Equity-
Example.jpg

Importance of owner’s equity statement.

The owner’s equity statement assists stakeholders to assess factors causing changes in the owner’s equity
statement during the financial year.

The statement is not disclosed independently elsewhere in the financial documents and provides
important information to stakeholders understand the nature of changes in equity accounts .

Accounting standard and how they affect financial statements.

Accounting standards are a set of practices and guidelines used to organize bookkeeping and other
accounting functions across businesses over time.
Accounting standards apply to the entire financial situation of a company, including assets, liabilities,
income, expenses and equity.
Banks, investors and regulators rely on accounting standards to ensure that information about a particular
company is relevant and accurate. 
In the United States, the Financial Accounting Standards Board (FASB) published Generally Accepted
Accounting Principles (GAAP).
Internationally, the International Accounting Standards Board (IASB) published International Financial
Reporting Standards (IFRS) for non- GAAP users.
The main aim of standardized accounting principles is to enable users of financial statements to examine
a company's financial information with confidence that the information disclosed in the report is
complete, consistent and comparable.
These standards require businesses to:
 Oblige in publishing accounts: All businesses are required by law to prepare annual financial
statements. The law also requires certain non-corporate businesses to publish accounts.
Companies are obliged to present their accounts at the Companies House for examination before releasing
to the public. Private companies are to file their accounts within ten months while public companies are to
file their accounts within seven months and if either of the companies deal with exports then they are
given three months extra before they file their accounts. All companies with an annual turnover of more
than £1m are required to have their annual accounts audited. Nonprofits must have their accounts audited
if their annual turnover exceeds £90,000. Auditors must be members of an approved audit firm. The
auditor's primary responsibility is to express an opinion on whether the financial statements present a "fair
and equitable view."
The set of accounts includes:

• CEO’s Report
• Director's Report
• Auditor’s report
• Income statement.
• Balance sheet
• cash flow statement
• Consolidated accounting (for holding companies)
• Explanatory text 

Limitations of financial statements.

a. Financial statements are derived from historical acquisition costs- Transactions are originally
recorded at their cost. This is a problem when reviewing balance sheets where the value of assets
and liabilities can change over time. Some items such as marketable securities change to reflect
changes in market values. It is a fixed asset but does not change. Therefore, the balance sheet can
be misleading if the majority of reported amounts are based on historical costs.
b. Financial statements are not adjusted for inflation- When inflation is relatively high, the amounts
related to assets and liabilities appear unduly low on the balance sheet because they are not
adjusted for inflation. This is especially true for long-term assets.
c. Some intangible assets are not included in the financial statements- Many intangible assets are
not recognized as assets. Instead, the expenditure to create the intangible asset is immediately
expensed. This policy could significantly underestimate the value of companies, especially those
that have spent a lot of money building their brand image and developing new products. This is
especially a problem for start-ups with marginal returns. Annual accounts only cover a specific
period
d. Financial statement users can get a misleading picture of a company's financial results and
cash flows by looking at just one reporting period. Individual periods may deviate from the
company's normal performance due to sudden increases in sales or seasonal effects. To get an
overview of running results, we recommend viewing several consecutive deals.
e. Annual accounts may not be comparable- If a user wants to compare the results of different
companies, financial statements are not always comparable as companies use different accounting
methods. These issues can be identified by examining the information accompanying the
financial statements. Financial reporting may be incorrect due to fraudulent activity
f. Company management may have intentionally distorted the results presented. This situation can
occur when there is too much pressure to report good results. Bonus Plans only provide
 payouts when reported sales levels increase. When reported results reach levels that exceed
industry standards, or far exceed the historical trend line of a company's reported results, one
might suspect the existence of this problem.
g. Financial reporting does not cover non-financial matters- Financial statements do not address
non-financial issues such as environmental awareness and cooperation with local communities in
business activities. Companies reporting excellent financial results can fail in these other areas.  
h. Financial statements may not have been validated- If the financial statements have not been
audited, it means that the issuer's accounting policies, practices and controls have not been
examined to ensure that it produces accurate financial statements. The auditor's report
accompanying the annual financial statements is evidence of this review.
i. Financial statements do not have forecast values- Information in the financial statements reflects
the historical results or financial condition of a company as of a particular date. These statements
do not necessarily provide predictive value for what may happen in the future. For example, a
company may report excellent results one month and no sales at all the next month. This is
because the contract it was dependent on has expired. 

References
How to prepare an income statement [Online]: https://www.accountingtools.com/articles/how-to-prepare-an-
income-statement.html
Vidhya Krishnan: Income statement – Definition, Importance and Example [Online]:
https://www.zoho.com/books/guides/what-is-an-income-statement.html
Tim Stobierski {August 12, 2022}How to prepare a balance sheet: 5 steps for beginners [Online]:
https://online.hbs.edu/blog/post/how-to-prepare-a-balance-sheet
The purpose of the balance sheet [Online]: https://www.accountingtools.com/articles/the-purpose-of-the-
balance-sheet.html
Chris B. Murphy {9 March 2023} Cash flow statement: what it is and examples [Online]:
https://www.investopedia.com/investing/what-is-a-cash-flow-statement/
Tim Stobierski {30 April 2020} How to read and understand cash flow statements [Online]:
https://online.hbs.edu/blog/post/how-to-read-a-cash-flow-statement
Vidya Krishnan: Cash flow statement – definition and importance [Online]:
https://www.zoho.com/books/guides/what-is-a-cash-flow-statement.html
Statement of owner’s equity definition [Online]: https://www.accountingtools.com/articles/statement-of-
owners-equity.html
CFI team {12 Dec 2022} equity statement [Online]:
https://corporatefinanceinstitute.com/resources/accounting/equity-statement/
Limitations of financial statements [Online]: https://www.accountingtools.com/articles/limitations-of-
financial-statements.html