Question

Ten months ago, Tom Smith, a friend of yours from college, founded Smith Sales Company, and the business is doing quite well. Tom comes to you for advice. He needs to prepare financial statements to present to a bank for a expansion loan. His bookkeeper has recorded entries in a general journal and posted the entries to T-accounts in the ledger. However, the bookkeeper does not know how to prepare financial statements. Tom does not know what financial statements are and what they are supposed to report. He has asked for your help in preparing financial statements for the bank.

Requirements: (Part A: 50 points maximum; part B: 50 points maximum)

A. 1. Prepare for Tom a critical analysis of the financial statements that need to be prepared.

2. Include in your analysis the financial statements that need to be prepared, the stakeholders involved, and the informational needs of the stakeholders.

Answer 1

As per the given information,

• Tom and his friend started a sales company
• Tom is going for an expansion loan
• Tom need financials to submit to the bank in the process of availing loan facility
• Tom's accountant already prepared a general journal and posted the transactions to T-Accounts.
• Tom is asking for guidelines to prepare financial statements.

Financial statements need to be prepared:

Any organization's financial statements have the following major components

1. Train balance

2. Income statement

3. Statement of financial position

4. Statement of Changes in Owner's equity

5.Cash flow statement

1.Trail balance:

Trail balance prepared by posting all the ledger account balances to it against respective ledger account name.

The closing Debit and credit balances of ledger accounts to be posted to the respective columns of the trial balance

Trail balance proves the arithmetical accuracy of the transactions posted though it's no conclusive evidence that the postings are true and fair.

It is the first step in the process of preparation of financials.

Trail balance looks like the following proforma:

2.Income statement:

The income statement should be prepared for a specific period to show profit or loss during the said period.

the income statement should be prepared by posting all revenues and expenses related to the period.

Major components of the income statement are sales revenue, operating expenses, net income.

The income statement also contains income tax expenses, earnings appropriations, earnings per share, and retained earnings.

Income statement example:

3. Statement of financial position

The Statement of financial position also known as balance sheet.

It is prepared by posting all assets and liabilities accounts balances from trail balance

It provides network information of the business as on any particular date given

The major components of the balance sheet are:

• Noncurrent Assets: These are the assets held for long term revenue generation requirements of the organization
  • Ex: Buildings, plant, and equipment, etc.
• Current assets: these are held to meet short term requirements and to serve short term obligations of the organization.
  • Ex: Cash, inventory, accounts receivable, etc.
• Owners equity: This is the capital provided by the owner to the business initially. It contains equity shares, preference shares, and retained earnings, etc.
• Noncurrent liabilities: These are the obligations of the organization which need to serve in the long term, i.e., not in the coming period of 12 months.
  • Ex: Term loan from banks and other long term borrowings.
• Current liabilities: These are the current obligations of the organization which need to serve in the near term i.e., in the coming period of 12 months.
  • Ex: Trade payables, short term loans, and advances, etc.

The statement of financial position also contains notes which contain explanations to the figures in the statement.

The following is an example to show how a balance sheet looks like:

4. Statement of Changes in Owner's equity:

This contains any change happen in the owner's equity in the business from the previous reporting date to the present date.

It contains information like equity at the beginning of the period, changes happened at the end of the period and their closing balance as on the date of reporting.

Any new shares issued, any shares repurchased, net income for the period, the dividend declared, etc

5. Cash flow statement:

It is a component of the financial statements that summarize the inflow and outflow of the cash and cash equivalents of the organization.

Cash flows segregated into the following components:

• Cash flows from operating activities
  • It contains cash inflows from regular income-generating activities and expenses against such activities
  • Ex: Recipes from sales, interest, rent, electricity payments, etc
• Cash flows from investing activities
  • It contains sources and applications of cash from investing activities like sale and purchase of fixed assets, investment in other entities, etc.
• Cash flows from financing activities
  • These include cash flows from loans taken from banks, issues of new shares, payment of dividends, etc.

Stakeholders involved:

Stakeholders are the people interested in the activities of the business. It is an extensive list.

The following are the major stakeholders for any business:

• Shareholders
• Financial institutions who lend money to the organization like Banks, NBFCs
• Employees of the organization
• Lenders who lend money
• Suppliers
• customers
• government to collect taxes, etc.

Following types of Information required for the stakeholders through financial statements:

• Revenue from various activities of the organization
• Expenditure patterns
• Sales generated by different products
• Profit made during the period
• Interest and taxes paid
• Net earnings for the period
• Assets owned
• Liabilities to be rapid etc.

Banks need all these information to assess the ability of the organization to repay the loan provided.

Bank identifies the level of risk involved by analyzing these statements and determines the rate of interest, repayment structure, etc