Elements of financial statements and their
Question 1: Definite variables
Consider the following situations. In each case, do we have an asset or liability within the definitions given by the Framework? Give reasons for your answer.
(a) Pat Co has purchased a patent for $20 000. The patent gives the company sole use of a particular manufacturing process which will save $3 000 a year for the next five years.
(b) Baldwin Co paid Don Brennan $10 000 to set up a car repair shop, on condition that priority treatment is given to cars from the company's fleet.
(c) Deals on Wheels Co provides a warranty with every car sold.
(The answer is at the end of the chapter)
1.5 Equity
Equity is defined above as a residual, but it may be sub-classified in the statement of financial position into different reserves. This will indicate legal or other restrictions on the ability of the entity to distribute or otherwise apply its equity. Some reserves are required by statute or other law, e.g. for the future protection of creditors. The amount shown for equity depends on the measurement of assets and liabilities. It has nothing to do with the market value of the entity's shares.
1.6 Performance
Profit is used as a measure of performance, or as a basis for other measures (e.g. earnings per share). It depends directly on the measurement of income and expenses, which in turn depend (in part) on the concepts of capital and capital maintenance adopted.
The elements of income and expenses are therefore defined.
Definitions
x Income. Increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants.
x Expenses. Decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurring of liabilities that result in decreases in equity, other than those
relating to distributions to equity participants. (Framework)
LO 5.2 LO 5.2.3
Definition
Gains. Increases in economic benefits. As such they are no different in nature from revenue. (Framework)
Gains include those arising on the disposal of non-current assets. The definition of income also includes unrealised gains, e.g. on revaluation of marketable securities.
1.8 Expenses
As with income, the definition of expenses includes losses as well as those expenses that arise in the course of ordinary activities of an entity.
Definition
Losses. Decreases in economic benefits. As such they are no different in nature from other expenses.
(Framework)
Losses will include those arising on the disposal of non-current assets. The definition of expenses will also include unrealised losses, e.g. exchange rate effects on borrowings or the downward revaluation of property.
1.9 Capital maintenance adjustments
A revaluation results in an increase or decrease in equity.
Definition
Revaluation. Restatement of assets and liabilities. (Framework)
These increases and decreases meet the definitions of income and expenses. They are not included in the income statement under certain concepts of capital maintenance, however, but rather in equity. However, they will be shown in the statement comprehensive income under the heading of 'other comprehensive income'.
1.10 Section summary
Make sure you learn the important definitions:
x Financial position:
2 Recognition of the elements of financial statements
Section overview
x Items which meet the definition of assets or liabilities may still not be recognised in financial statements because they must also meet certain recognition criteria.
LO 5.2.5
Definition
Recognition. The process of incorporating in the statement of financial position or statement of comprehensive income an item that meets the definition of an element and satisfies the following criteria for recognition:
(a) it is probable that any future economic benefit associated with the item will flow to or from the entity; and
(b) the item has a cost or value that can be measured with reliability. (Framework)
Regard must also be given to materiality as defined in the Framework.
Definition
Materiality. Information is material if its omission or misstatement could influence the economic decisions
of users taken on the basis of the financial statements. (Framework)
2.1 Probability of future economic benefits
Probability here means the degree of uncertainty that the future economic benefits associated with an item will flow to or from the entity. This must be judged on the basis of the characteristics of the entity's environment and the evidence available when the financial statements are prepared.
2.2 Reliability of measurement
The cost or value of an item, in many cases, must be estimated. The Framework states, however, that the use of reasonable estimates is an essential part of the preparation of financial statements and does not undermine their reliability. Where no reasonable estimate can be made, the item should not be recognised, although its existence should be disclosed in the notes, or other explanatory material.
Items may still qualify for recognition at a later date due to changes in circumstances or subsequent events.
2.3 Recognition of items
We can summarise the recognition criteria for assets, liabilities, income and expenses, based on the definition of recognition given above.
Item Recognised in When
Asset The statement of financial position
It is probable that the future economic benefits will flow to the entity and the asset has a cost or value that can be measured reliably.
Liability The statement of financial position
It is probable that an outflow of resources embodying economic benefits will result from the settlement of a present obligation and the amount at which the settlement will take place can be measured reliably.
Income The statement of comprehensive An increase in future economic benefits related to an increase in LO
5.4
LO 5.5
3 The main financial statements
Section overview
x The principal financial statements of a business are the statement of financial position and the statement of comprehensive income.
3.1 Statement of financial position
Definition
The statement of financial position is simply a list of all the assets owned and/or controlled and all the liabilities owed by a business as at a particular date. It is a snapshot of the financial position of the business at a particular moment. Monetary amounts are attributed to each of the assets and liabilities.
3.1.1 Assets
Examples of assets are factories, office buildings, warehouses, delivery vans, lorries, plant and machinery, computer equipment, office furniture, cash and goods held in store awaiting sale to customers.
Some assets are held and used in operations for a long time. An office building is occupied by administrative staff for years; similarly, a machine has a productive life of many years before it wears out. These types of assets are called non-current assets.
Other assets are held for only a short time. The owner of a newspaper shop, for example, has to sell his newspapers on the same day that he gets them. The more quickly a business can sell the goods it has in store, the more profit it is likely to make; provided, of course, that the goods are sold at a higher price than what it cost the business to acquire them. These are current assets.
Current/non-current distinction
An entity must present current and non-current assets as separate classifications on the face of the statement of financial position. A presentation based on liquidity should only be used where it provides more relevant and reliable information, in which case all assets and liabilities must be presented broadly in order of liquidity.
It is emphasised how helpful information on the operating cycle is to users of financial statements. Where there is a clearly defined operating cycle within which the entity supplies goods or services, then
information disclosing those net assets that are continuously circulating as working capital is useful.
This distinguishes them from those net assets used in the long-term operations of the entity. Assets that are expected to be realised and liabilities that are due for settlement within the operating cycle are
therefore highlighted.
3.1.2 Liabilities
Examples of liabilities are amounts owed to a supplier for goods purchased on credit, amounts owed to a bank (or other lender), a bank overdraft and amounts owed to tax authorities (e.g. in respect of sales tax/GST).
Some liabilities are due to be repaid fairly quickly e.g. suppliers. Other liabilities may take some years to repay (e.g. a bank loan).
Current/non-current distinction
The categorisation of current liabilities is very similar to that of current assets. Therefore, some current liabilities are part of the working capital used in the normal operating cycle of the business (i.e. trade payables and accruals for employee and other operating costs). Such items will be classed as current liabilities even where they are due to be settled more than 12 months after the end of the reporting period. All other liabilities should be classified as non-current liabilities.
LO 5.3
3.1.3 Capital or equity
The amounts invested in a business by the owner are amounts that the business owes to the owner. This is capital. In a limited liability company, capital usually takes the form of shares. Share capital is also known as equity.
3.1.4 Form of statement of financial position
A statement of financial position used to be called a balance sheet. The former name is apt because assets will always be equal to liabilities plus capital (or equity). A very simple statement of financial position for a company is shown below.
XYZ CO
STATEMENT OF FINANCIAL POSITION AS AT 30 APRIL 20X9
$ $
Non-current assets
Property, plant and equipment 55 000
Current assets
Inventory 5 000
Receivables (from customers) 1 500
Bank 500
Total equity and liabilities 62 000
3.2 Statement of comprehensive income
Definition
A statement of comprehensive income is a record of revenue generated and expenditure incurred over a given period. The statement shows whether the business has had more revenue than expenditure (a profit) or vice versa (loss).
3.2.1 Revenue and expenses
Revenue is the income for a period. The expenses are the costs of running the business for the same period.
3.2.2 Form of statement of comprehensive income
A simple statement of comprehensive income for a company is shown below.
XYZ CO
STATEMENT OF COMPREHENSIVE INCOME FOR THE YEAR ENDED 30 APRIL 20X9 $
Revenue 150 000
Cost of sales 75 000
Gross profit 75 000
Distribution costs 24 600
Administrative expenses 15 000
Finance costs 8 000
Profit before tax 27 400
Income tax expense 17 000
Profit for the year 10 400
3.3 Purpose of financial statements
Both the statement of financial position and the statement of comprehensive income are summaries of accumulated data. For example, the statement of comprehensive income shows a figure for revenue earned from selling goods to customers. This is the total amount of revenue earned from all the individual sales made during the period. One of the jobs of an accountant is to devise methods of recording such individual transactions, so as to produce summarised financial statements from them.
The statement of financial position and the statement of comprehensive income form the basis of the financial statements of most businesses. For limited liability companies, other information by way of statements and notes may be required by national legislation and / or accounting standards, for example a statement of cash flows.