Case Overview

Understanding and Preparing Financial Statements

For a Service Business

build a diverse base of customers, develop a demand that could translate to

more revenues, and eventually expand her business.

Rosario Deangs expertise as a dressmaker and designer was a source

of wonder to her family members and friends. Having idle time when her
husband was in the office and her children were in school, she decided to
enroll in a designing and dressmaking class. At the end of the first month of
her sewing class, she could already sew curtains, pillow covers, table runners
and baby dresses. By the time her classes ended, she could already design and
sew beautiful dresses. Each month she would surprise her three daughters with
new dresses which they thought their mother purchased from a local boutique
shop. Even her friends would ask her to design and make clothes which they
could wear in the office or on special occasions. After some prodding from
her daughters and friends, she decided to put up a small dress shop in front of
their house where it was most visible to all passersby. Carefully, she kept
inside a shoebox all the receipts of her disbursements for the materials used in
constructing the shop, as well as the invoices on her purchases for sewing tools
and sewing supplies.

As she counted her cash, however, she became painfully aware that
there was not much as she had hoped. What had happened? Where was the
cash? These questions kept nagging her and she knew she had to get an
answer before she could plan for the coming year.

Business at Rosarios Dress Shop went well. One might describe the
shop as a beehive of activity since many of the working mothers in the
neighborhood would regularly visit the shop and order dresses that were
designed according to their personal taste and specifications. To attract more
customers, Rosario set her prices at half of the amounts charged by wellknown local couturiers. Rosario succeeded beyond her expectations and had to
hire a master cutter and dressmaker to help her in the shop.
By the end of the year, Rosario wanted to know if she had
accumulated enough cash. She wanted to buy additional sewing equipment
and tools so that she and her assistants could sew different types of apparel
simultaneously. Through this, she would

Statement of Cash Flows

Rosario contacted her friend Marie Guadalupe, a Certified Public
Accountant, who suggested she go back through her records. She pulled out
the shoebox where she had kept records of her cash outflows for the shop
employees and utilities. Then she collected the duplicate copy of her daily
official receipts. With these data, she would try to establish her business cash
flows.
Marie helped Rosario classify her payments. These included the (a)
small shop; (b) sewing equipment and other tools; (c) salaries; (d) sewing
supplies, which included threads, buttons, scissors and tailor chalk; (e) utilities,
which included electricity, water, and telephone costs; and (f) miscellaneous
expenses for small expenses that were too petty to warrant individual
disclosures.
Columns were set up and cash outflows were grouped under the
appropriate categories. The checkbook and bank statements were examined
and reconciled to identify the sources of cash.
Although cash came primarily from services rendered, Rosario had
also invested some personal savings and was able to obtain a loan from the
bank. She issued a two-year note for this loan. The amount secured from the
bank was used to purchase the sewing machine. All the data that have been
collected are presented in Exhibit 1.

1
2

Exhibit 2
Rosarios Dress Shop
Statement of Cash Flows
For the Year Ended December 31, 2011

Exhibit 1
Rosarios Dress Shop
Summary of Cash Receipts and Payments
Cash receipts from:
Personal savings (original investment)
Bank loan
Clients for services rendered
Total inflows
Cash payments for:
Dress shop (building)
Sewing equipment
Salaries
Sewing supplies
Utilities
Miscellaneous (including cost of paper bags)
Total outflows
Net cash inflow

50,000
10,000
219,300
P 279,300
P

50,000
35,000
117,000
34,250
22,000
1,750
P 260,000
P

19,300

After Rosario had collected the information, Marie rearranged the cash
flows by activity. This format is presented in Exhibit 2.
The ease with which she understood the logic of the cash flows
statement surprised Rosario (she had thought accounting was difficult). The
personal savings she has put in her business was reflected in the financing
activities section. Her start-up investment in sewing machine and the dress
shop were included under investing activities and the cash generated by
operations was at the top of the form under operating activities. This grouping
included cash receipts for services rendered, collection of accounts, and cash
payment of expenses and short-term liabilities.

Cash flows from operating activities

Receipts from cash customers
Cash payments for:
Salaries
Sewing supplies
Utilities
Miscellaneous
Net cash provided by operating activities
Cash flows from investing activities
Construction of the dress shop
Purchase of sewing equipment
Net cash used in investing activities

P 219,300
(117,000)
(34,250)
(22,000)
(1,750)

(P 50,000)
(35,000)

Cash flows from financing activities

From personal savings
From bank loan
Net increase in cash
Cash balance at beginning of period
Cash balance at the end of the period

P50,000
10,000

P 44,300

(85,000)

60,000
P 19,300
0
P 19,300
==========

Income Statement
From Exhibit 2, Rosario understood that while her operations had
generated a decent cash flow, her investment activities had significantly
reduced her net cash position. She wondered how this would affect her
expansion plans and how she could use this information to plan for next years
operations.

She wanted to be clarified, however, on some items that still confused

her. For instance, why would the purchase of sewing machine not be shown
under operating activities when obviously it is being used in business
operations? Marie explained that the purchase of assets that benefit many
years of operations is an investing activity.

Again, Marie offered some advice. She suggested that Rosario

prepare another statement to determine if the business performed favorably.
Marie explained that the statement of cash flows shows only the sources and
uses of cash and its balance at the end of the period but it does not show other
equally important information like revenue and expenses. This type of
information is normally presented in an income statement. Exhibit 3
summarizes the shops revenues and expenses for the first year of operations.

Exhibit 3
Rosarios Dress Shop
Income Statement
For the Year Ended December 31, 2011
Revenues
Service Revenue
Expenses
Salaries Expense
Sewing Supplies Expense
Utilities Expense
Depreciation Expense
Miscellaneous Expenses
Total expenses

Statement of Changes in Equity

P 220,300

Rosario wanted to know if her initial investment of P50,000 increased

by the end of the year. Marie told her that she needed to prepare a statement of
changes in equity. Marie asked her if she took out some cash or any non-cash
asset for her personal use. Rosario shook her head.

188,500

After a few minutes, Rosario was looking at the statement of changes

in equity (Exhibit 4) that she prepared through the help of Marie. Her initial
investment of P50,000, which was also her beginning capital balance when she
opened her business, was increased by her business net income of P31,800. A
net loss for the period would have reduced her capital. Marie further explained
that had she (Rosario) took out cash or some non-cash asset for her personal
use, this also would have decreased her capital balance.

P 117,000
34,250
22,000
13,500
1,750

Net Income

31,800

The above exhibit shows the effects of all the activities that she had
undertaken for the whole year. For example, she had used P34,250 worth of
sewing supplies out of the total supplies of P36,750 acquired during the year.
Expenses associated with her fixed assets were also included in the
income statement. Rosario had determined that the dress shop (building)
would benefit operations for five (5) years. For the sewing machine
(equipment), it was estimated that it would benefit operations for ten (10)
years. Marie told her that these expenses are grouped under Depreciation
Expense. This expense could be obtained by dividing acquisition costs by the
estimated number of years the assets would benefit her shop.
Rosario also discovered that an income statement would be helpful in
setting her price for the next period. She realized that if her total revenues do
not exceed all her costs by a comfortable margin, her business would not
survive in the long run. Looking at the net income figure of P31,800 generated
by her business, she could hardly believe her outstanding performance .

Exhibit 4
Rosarios Dress Shop
Statement of Changes in Equity
For the Year Ended December 31, 2011
Rosario Deang, Capital, January 1
Add: Net income
Rosario Deang, Capital, December 31

P
P

50,000
31,800
81,800

Statement of Financial Position

Glad that her business posted a net income which increased her
capital, Rosario needed to know also how much assets and liabilities her
business had accumulated during the year.
She knew from Marie that assets are resources owned or controlled by
the business and used in business operations to generate revenues. Liabilities
are commitments to give out assets (typically cash) or to render services to
creditors.

Rosario first listed her assets as follows: Cash, Unused Sewing Supplies,
Dress Shop, and Sewing Equipment. The sewing equipment was purchased at
a cost of P35,000 on terms: P25,000 down and the balance settled with a 2year note. Later, she thought, she would be able to buy a parcel of land. She
had a collectible from Maffy, a customer and friend, amounting to P1,000 for a
graduation gown.
In addition to the 2-year note payable, she also owed her friend in
Divisoria amounting to P2,500 for sewing supplies bought during the year.
After completing her list, she sat down with Marie to prepare her first
statement of financial position. Exhibit 5 on the next page presents the
statement of financial position of Rosarios Dress Shop as of December 31,
2010.
With the completed statement of financial position before them, Marie
explained that assets are listed at their purchase price or acquisition cost minus
depreciation where appropriate. Thus, the dress shop would be shown at
P40,000the original cost of P50,000 less P10,000 depreciation during the
first year; and the sewing equipment at P31,500the original cost of P35,000
less depreciation of P3,500. Marie reminded Rosario that assets and liabilities
should be properly classified into current (used or paid within one year) or
non-current items (used or paid beyond one year).
Rosario was amazed at how things just fell into place, like the
statement of financial position being balancedthe total of assets equaled the
total of liabilities and owners equity! She recalled Marie telling her about an
accounting procedure that should be followed in recording activities to ensure
a balanced statement of financial position. It is called double-entry recording
system. Well, I can always ask Marie about that later, she thought. For now,
she was so glad because she was able to prepare all the basic financial
statements and know how these statements relate to one another. Accounting
is easy and fun after all!

Exhibit 5
Rosarios Dress Shop
Statement of Financial Position
December 31, 2011
Assets
Current Assets
Cash
Accounts Receivable
Sewing Supplies
Total current assets
Non-Current Assets
Property, Plant, and Equipment (Note 1)

P 19,300
1,000
2,500
P 22,800
71,500

Total Assets

P 94,300
Liabilities and Owners Equity

Current Liabilities
Accounts Payable
Non-Current Liabilities
Notes Payable (due in 20X9)
Total Liabilities
Owners Equity
Rosario Deang, Capital

10,000
P 12,500
81,800

Total Liabilities and Owners Equity

P 94,300

Notes to Financial Statements

Note 1 Property, Plant, and Equipment
Building
Less: Accumulated Depreciation

P 50,000
10,000

Sewing Equipment
Less: Accumulated Depreciation
Carrying Value

P 35,000
3,500

P 40,000
31,500
P 71,500

Reference: Portable MBA in Finance and Accounting by J.L Livingstone, 1992.

2,500

Discussion Questions

1.

Why would Rosario or anyone else go into business?

2.

How will accounting meet the information needs of business

owners like Rosario?

3.

How well did Rosario Dress Shop perform during the year?

4.

What are the factors to be considered in assessing the equity

of a business owner like Rosario?

5.

What identifies a strong financial position of any company?