Lecture 4

Unit 3 Financial Position (continued)

Learning Objectives
Explain the nature and purpose of the balance sheet
Demonstrate an understanding of assets in terms of definition, recognition,
measurement and classification
Demonstrate an understanding of liabilities in terms of definition, recognition,
measurement and classification
Discuss the nature and classification of owners equity
Explain the basic accounting equation
Contrast the alternative balance sheet formats
Discuss the main factors that influence the content and values in a balance sheet
Prepare a simple balance sheet
Analyse balance sheets of reporting entities
State the potential limitations of the balance sheet in portraying the financial position
of an entity

The Classification of Assets

Assets are normally categorised as either current, or non-current.

Current assets:

Are not held on a continuing basis

Include cash and other assets expected to be consumed or converted into cash within
the operating cycle
Also include inventory, trade debtors and pre-payments

AASB 101 Presentation of Financial Statements requires a current asset to be

classified according to the following criteria:

a) The asset is expected to be realised in, or is intended for sale or consumption

in, the entitys normal operating cycle;
b) The asset is held primarily for the purpose of being traded;
c) The asset is expected to be realised within twelve months after the reporting
date; or
d) The asset is cash or a cash equivalent unless it is restricted from being
exchanged or used to settle a liability for at least twelve months after the
reporting date

Non-Current assets:

Held for the purpose of generating wealth, rather than for resale
May be seen as the tools of the business
Normally held on a continuing basis for a minimum period of one year
Includes goodwill purchased - see page 90

AASB 101 Presentation of Financial Statements requires assets to be classified as non-

current if they do not satisfy any of the criteria for being classified as current (previous slide)
The Classification of Liabilities
Liabilities are normally categorised as either current or non-current

Current liabilities:
Amounts due for repayment to outside parties within 12 months of the statement of
financial position date

AASB 101 Presentation of Financial Statements requires a liability to be classified as

current when it satisfies the following criteria:

a) The liability is expected to be settled in the entitys normal operating cycle;

b) The liability is held primarily for the purpose of being traded;
c) The liability is due to be settled within twelve months after the reporting date;
or
d) The entity does not have an unconditional right to defer settlement of the
liability for at least twelve months after the reporting date

AASB 101 Presentation of Financial Statements also requires that liabilities be classified
according to their nature. This classification can be on:

Current / Non-Current basis, or

The order of liquidity (payment)

The alternative liquidity classification may be used for liabilities if it provides more relevant
and reliable information

Owners Equity (OE, or Equity)

Definition:
The claim of the owner(s) against the business

AASB Framework defines equity as the residual interest in the assets of the entity after
deducting all its liabilities.

Classification of owners equity:

Owners equity is normally classified as follows for a sole trader/sole proprietorship:

1) Capital
2) Drawings

Owners equity is normally classified as follows for a partnership:

1) Capital account for each partner
2) Current account for each partner (optional)

Owners equity is normally classified in three separate categories for a company:

1) Owners equity contributed (share capital) - represents profits left in the business by the
owners
2) Reserves
3) Retained profit
It is common to combine categories 2 and 3 into other reserves and then have them listed
as sub-categories of other reserves such as (a) retained profits and (b) other reserves.

Note: Reserves represent ownership interests in the assets, not the assets themselves.
Reserves are not separate deposits of cash available for other purposes.
Formats for Balance Sheets

Current +
Non-Current = Current +
Non-Current +Owners
Assets Assets Liabilities Liabilities Equity

Figure 3.2 The Horizontal layout and entity approach

The equation for the horizontal form of balance sheet layout

Example: page 93 of textbook for Brie Manufacturing (reproduced in lecture notes)

Brie Manufacturing
Balance Sheet as at 31 December 2008
$ $ $ $
Current assets Current liabilities
Cash at bank 12,00 Trade creditors 37,00
0 0
Trade debtors 18,00
0
Inventory 23,00 Non current liabilities
0
53,000 Loan 50,00
0
87,000
Non current Owners equity
assets
Motor vehicle 19,00 Opening balance 50,00
0 0
Plant and 30,00 Add profit 14,00
machinery 0 0
Freehold premises 45,00 64,00
0 0
94,000 Less drawings 4,000
Ending balance 60,000
Total assets 147,00 Total liabilities and owners 147,00
0 equity 0

Source: Accounting-An Introduction, 4th edition, Atrill, McLaney, Harvey & Jenner, Pearson Education Australia 2009
Formats for Balance Sheets (continued)

Current Non-Current Current Non-Current

Assets + Assets - Liabilities -
Liabilities = Capital
Figure 3.3 The Vertical layout and proprietary approach
The equation for the vertical form of balance sheet layout

Example: page 94 of textbook for Brie Manufacturing (reproduced in lecture notes)

Brie Manufacturing
Balance Sheet as at 31 December 2008
$ $
Current assets
Cash at bank 12,000
Trade debtors 18,000
Inventory 23,000
53,000
Non current assets
Motor vehicle 19,000
Plant and machinery 30,000
Freehold premises 45,000
94,000
Total assets 147,000

minus

Current liabilities
Trade creditors 37,000

Non current liabilities

Loan 50,000
Total liabilities 87,000
Net assets equals 60,000

Owners equity
Opening balance 50,000
Add profit 14,000
64,000
Less drawings 4,000
Ending balance 60,000

Source: Accounting-An Introduction, 4th edition, Atrill, McLaney, Harvey & Jenner, Pearson Education Australia 2009

Analysis of balance sheets of reporting entities

The balance sheet is a statement of the financial position of the business at a specified point
in time

It is important to establish when reading a balance sheet the date it was drawn up hence it is
important to display the date prominently in the heading.
 Lecture Activity 1

The following is a list of assets and claims for A. Dunn, Solicitor, at March 15, 2009 that we
used in a previous lecture activity. Using this information, prepare a fully classified Balance
Sheet (using the horizontal format) for A. Dunn, Solicitor, as at March 15, 2009.

Account Name $
Bank 99,700
Office furniture/fittings 10,000
Computer 3,000
Office stationery 300
Office equipment 9,000
Loan-Excellent Finance Ltd (repayable in 2013) 9,000
Capital-A. Dunn 113,200
Drawings-A. Dunn 200

Solution:

Dunn, Solicitor
Balance Sheet as at March 15, 2009
Assets Liabilities

Owners equity
 Lecture Activity 2 (Application Ex 3.5 - Adapted)

The following is a list of assets and claims of a manufacturing business, We Make It Ltd at
June 30, 2010:

$
Bank overdraft 22,000
Freehold land and buildings 245,000
Inventory of raw materials 18,000
Trade creditors 23,000
Plant and machinery 127,000
Loan from National Australia Bank 100,000
Inventory of finished goods 28,000
Delivery vehicles 54,000
Trade debtors 34,000

Prepare a balance sheet in the standard vertical format incorporating these figures. Hint:
There is a missing figure which needs to be calculated and inserted.
Source: Accounting-An Introduction, 4th edition, Atrill, McLaney, Harvey & Jenner, Pearson Education Australia 2009
SOLUTION:
We Make It Ltd
Balance Sheet as at June 30, 2010

$ $

Factors Influencing the Form and Content of the Balance Sheet

There are three main influences on the accounts included in the balance sheet:

1. Traditional accounting conventions and doctrines

2. More recent theoretical developments in conceptual framework projects
3. Professional and statutory accounting standards

Conventional Accounting Practice:

Made up of doctrines, principles, assumptions and accepted ideas on which accounting
rules, records and reports were or are based
These have collectively been known as GAAP (Generally Accepted Accounting
Principles / Practices)

Business Entity Convention:

Holds that for accounting purposes, the business and its owner(s) are treated as
separate and distinct

Money Measurement Convention:

Holds that accounting should only deal with those items which are capable of being
expressed in monetary terms

Historic Cost Convention:

Holds that assets should be recorded at their historic (acquisition) cost

Going Concern (Continuity) Convention:

Holds that the business will continue operations for the foreseeable future i.e. no
intention or need to liquidate the business

Dual Aspect Convention:

Holds that each transaction has two aspects and that each aspect must be recorded in
the financial statements
Conservatism / Prudence Convention:
Holds that financial reports should err on the side of caution vis--vis, anticipating losses
but only recognising realised profits

Other conventions include: Stable monetary unit convention, Objectivity / reliability

convention, Accounting period convention, Realisation convention and Matching convention.
Further details are on pp 101 - 103

The Conceptual Framework:

Four Statements of Accounting Concepts (SACs) were current up until 2004, known as
SACs 1 - 4
SAC 3 and SAC 4 have now been replaced by the adoption of the AASB Framework,
SAC 1 and SAC 2 continue in their previous form
While the framework and statements are not mandatory, they have significant influence
on new and revised standards being issued

Accounting Standards:
The history and significance of accounting standard setting in Australia is covered in
detail in chapter 2
Regarding the balance sheet, there are numerous standards that directly affect recording
and reporting assets, liabilities and owners equity
The implications of the applicable Australian Accounting Standards will continue to be
considered
Basis of Valuation of Assets on the Balance Sheet

While the historical cost convention underlies the conventional accounting system, other
conventions have led to departures from it. Examples include:
Prudence convention
Accounting Period / Going Concern conventions
Full Disclosure / Relevant Financial Information convention

Basis of Valuation of Liabilities on the Balance Sheet

While liabilities in general do not have the same range of alternative measures as assets,
there are still several alternative bases for measurement, both in practice and in the
accounting standards. These include:
The Contracted Amount
Estimate of Expected Future Sacrifice
Present Value of the future known or expected cash outflows

Interpreting the Balance Sheet

The balance sheet provides useful insights into the financing and investment activities of a
business. In particular, the following aspects can be examined:

The liquidity of the business

The mix of assets held by the business
The financial structure of the business

Balance Sheet Deficiencies

Limitations of the balance sheet in portraying financial position are largely related to:

Limitations related to the element definitions

Limitations related to transaction recognition
The range of alternative asset and liability financial measures
Lecture Activity 3

1) The entity of Paddy Jim and Partners in preparing its balance sheet excludes Paddy
Jims personal motor vehicle (not used in the business) because of the following
assumption:
a. The accrual basis assumption
b. The period assumption
c. The accounting entity assumption
d. The going concern assumption
Source: Accounting Study Guide, Hoggett, Edwards, Medlin & Tilling, Prepared by Latimer, Wiley Publishing 2009

2) The assumption that a business entity will continue to exist for an undefined period of
time is:
a. The going concern assumption
b. The accounting entity assumption
c. The accrual basis assumption
d. The period assumption
Source: Accounting Study Guide, Hoggett, Edwards, Medlin & Tilling, Prepared by Latimer, Wiley Publishing 2009

3) At the end of an accounting period the Wagga Wagga Company had $21,000 in its bank
account, other assets totaling $5,000 and amounts owed to creditors totaling $11,000.
The total equity in the company was:
a. $15,000
b. $26,000
c. $37,000
d. $48,000
Source: Accounting Study Guide, Hoggett, Edwards, Medlin & Tilling, Prepared by Latimer, Wiley Publishing 2009

4) The business entity of Book and Book has total assets of $80,000, equity of $30,000 and
borrowings from the bank of $20,000. The entity has:
a. Net assets of $50,000
b. Other liabilities of $30,000
c. Profit of $20,000
d. Income of $20,000
Source: Accounting Study Guide, Hoggett, Edwards, Medlin & Tilling, Prepared by Latimer, Wiley Publishing 2009
Summary of Unit 3 . Continued .
Try summarising what we have covered in Unit 3
Lecture 5

Unit 4 - Financial Performance

Learning Objectives
State the purpose of the income statement (profit and loss)
Explain the relationship between the income statement and the balance sheet
Present the profit and loss equation and identify alternative formats for the income
statement
Demonstrate an understanding of income in relation to definition, recognition,
classification and measurement
Demonstrate an understanding of expenses in relation to definition, recognition,
classification and measurement
Distinguish between accrual and cash-based transaction recognition
Analyse expense recognition for non-current tangible assets
Analyse expense recognition for accounts receivable
Prepare an income statement from relevant financial information
Review and interpret income statements

Note that the page readings for this topic are from chapter 4 and there are only selected
pages that you need to read. Please refer to the lecture/reading guide in the Study Learning
Guide for details.

NOTE: you will not be required to calculate profit using the stock
approach. You will need to be aware of the theoretical aspects of
the stock approach.

The Income Statement

The purpose of the income statement is to measure and report how much profit (wealth) the
business has generated over a period.

Profit (or loss) is the difference between Income and Expenses

Income is made up of Revenue (from operating activities) and Gains (usually from non-
operating activities)
Expenses are outflows of resources to generate income

Relationship between the Income Statement and the Balance Sheet:

The two are closely related, but NOT substitutes for each other in any way
The income statement can be viewed as linking the balance sheet at the start of a period
with the balance sheet at the end of the period
The accounting equation can thus be extended as:

Assets = OEbeg + Profit (or - Loss) +/- Other OE adj + Liabilities

or further extended to:

Assets = OEbeg + (Income - Expenses) +/- Other OE adj + Liabilities
Remember: this is an extension of the basic accounting equation of A = OE + L
As a result of the relationship between the income statement and two consecutive
balance sheets, profit and loss can be calculated for a period based on the stock
approach
The stock approach computes profit and loss by adjusting the change in net assets (A-L)
for the period by other changes in owners equity in the period

The equation for the stock approach is:

Profit (or Loss) = (Aend - Abeg) - (Lend - Lbeg) - New contributions + Owners distributions +/-
Other changes in owners equity

The stock approach can be used to check the accuracy of the transaction approach where
income less expenses is used to calculate profit. It can also be used where there are
incomplete records and may be used by insurance assessors or the Australian Taxation
Office.

NOTE: you will not be required to calculate profit using the stock
approach. You will need to be aware of the theoretical aspects of
the stock approach.

Format of the Income Statement

In practice, there are at least three forms of income statement:
Simple listings of accounts (small organisations)
Classified reports (larger organisations)
Regulatory presentations (companies)

Simple reports:
For smaller organisations, the income statement may be just a listing of income and
expenses in alphabetical or financial magnitude order

Example: page 145 of textbook for Newlands Soccer Club and reproduced in lecture notes.

Newlands Soccer Club

Income statement for the year ended 31 October 2008
$ $
Income
Ticket sales 9,200
Fundraising 5,700
Members fees 3,500
Government grant 2,700
Interest 600 21,700
Expenses
Players payments 8,300
Ground fees 2,900
Insurance 2,100
Travel costs 1,900
Uniforms 1,500
Repairs and maintenance 900
Telephone and postage 600
Sundries 400 18,600
Period profit (surplus) 3,100
Classified reports:
Relate to larger organisations and often called the classified financial report. Income and
expenses are not simply listed, but grouped into categories

Income would normally be broken down into sales, and other revenues

Expenses are often broken down into four categories:

1. Cost of sales
2. Selling and distribution
3. Administration and general
4. Financial

Example: page 147 of textbook for Hi-Price Stores (reproduced in lecture notes)

Hi-Price Stores
Income Statement for the year ended 31 October 2008
$ $
Sales 432,000
Less Cost of sales 254,000
Gross profit 178,000
Other revenue
Interest from investments 2,000
Rent from properties 5,000 7,000
185,000
Less Expenses
Selling and distribution
Advertising 5,000
Commissions 4,000
Delivery 3,000
Display 2,000
Salary and wages 37,000 51,000
Administration and general
Salary and wages 41,000
Rates 2,000
Heat and light 3,000
Telephone and postage 2,000
Insurance 1,000
Repairs and maintenance 5,000
Motor vehicle running expenses 4,000
Depreciation plant and equipment 1,000
Depreciation motor vehicles 2,000
Depreciation buildings 3,000 64,000
Financial
Interest 3,000
Bad debts 7,000 10,000
Total expenses 125,000
Net profit 60,000

Regulatory reports:
 Required to be produced by companies and other entities in accordance with statutory
standards
AASB 101 Presentation of Financial Statements requires that the income statement
should classify expenses according to their nature or function
Refer to page 149 for a list of AASB 101 requirements
For external reporting, the reporting cycle is normally one year
For internal functions, it is common for profit figures to be prepared on a monthly basis
Example: page 150/151 of textbook
 Lecture Activity 1 (Adapted from Application Exercise 4.5)

Prepare an income statement for the year ended 30 June 2008 given the following account
balances. (Note: some accounts may not be relevant)

$
Cash 3,000
Sales 280,000
Salary and wages 37,000
Accounts receivable 15,000
Loan interest 4,000
Insurance 2,000
Loan 40,000
Telephone and postage 1,500
Rent and rates 12,400
Cost of sales 160,000
Inventory 11,000
Accounts payable 9,100
Heat and light 3,700
Motor vehicles 32,000
Equipment repairs 1,600
Depreciation-motor vehicles 4,500
Motor vehicle running costs 1,700
Depreciation-equipment 3,200
Royalties received 1,700
Accounting and audit 3,400
Bad and doubtful debts 800

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Cash versus Accrual Transaction Recognition
Distinguish between accrual and cash-based transaction recognition:

Cash-based accounting recognises income when it is received and expenses when

they are paid
Accrual-based accounting recognises income on the basis that it has been earned
irrespective of whether the cash receipt is in arrears or in advance and expenses are
recognized on the basis that the expense has been used up/incurred/consumed by the
business

Profit Measurement and Recognition of Income

Income should only be recognised in the accounts when it has been realised
Realisation is considered to have occurred when:
Activities necessary to generate the revenue are substantially complete
The amount of the revenue can be objectively determined
Reasonable certainty that amounts owing will be received
Any other outstanding items can be determined with reasonable certainty

The Accrual Basis for Recognising Revenue

It is common for adjustments to be made to accounting information prior to it being published
in the financial reports. These adjustments are known as balance day adjustments. The
adjustments are required to ensure that revenue earned is reflected in the Income
Statement for the period rather than revenue received when using the cash basis for
revenue recognition. The need for such adjustments arises where:
1. Revenue earned for the period is greater than the cash received for the revenue
2. The amount received for the revenue is greater than the revenue earned for the
period

1. Revenue earned for the period is greater than the cash received for the revenue
(accrued revenue)
For example, a business earns rental income from renting out part of their premises
but there is an amount of rental income that relates to the current financial period but
has not been received. Hence, the revenue has been earned but has not been
received so it should be recognised as revenue in the current financial period. That
is, included in the Income Statement as revenue.
In this case, the revenue account is increased (and shown in the Income Statement)
and a temporary asset is created for the amount that is owed to the business. This
temporary asset appears in the balance sheet as effectively it is an asset at the date
of the balance sheet.

2. The amount received for the revenue is greater than the revenue earned for the
period (prepaid / unearned revenue)

For example, a business earns rental income from renting out part of their premises
and the tenant has paid rent in advance. Part of this amount relates to the next
financial period. In this case, the revenue account is decreased and a temporary
 liability is created for the unused amount. The temporary liability appears in the
balance sheet as effectively it is an amount that has been received but not earned at
the date of the balance sheet.
In the next period, the prepayment will cease to be an liability and become revenue in
the income statement in the period it relates to.
Profit Measurement and Recognition of Expenses
Expenses measure the outflow of assets (such as cash) or the increase in liabilities that
result from trading and generating revenues

The Matching Principle and Common Basis for Recognition

The Matching principle dictated that expenses should be matched to the income they
helped to generate. More recently, there have been moves away from matching in favour of
a common basis for recognition of income and expenses. The common basis is that if an
item satisfies recognition criteria, it will be recognised if its occurrence is probable, and it can
be reliably measured

The Accrual Basis for Recognising Expenses

It is common for adjustments to be made to accounting information prior to it being published

in the financial reports. These adjustments are known as balance day adjustments. The
adjustments are required to ensure that expenses incurred are reflected in the Income
Statement for the period rather than expenses paid when using the cash basis for expense
recognition. The need for such adjustments arises where:
1. An expense incurred for the period is greater than the cash paid for the expense
2. The amount paid for an expense is greater than the expense incurred for the period.

1. An expense incurred for the period is greater than the cash paid for the expense
(accrued expense)
For example, the wages account may show the total wage expense however the next
pay period occurs in the new financial year. However, we are aware that a portion of
the wages to be paid next financial year have actually been used up in the current
financial year and therefore should appear as wages expense in the current year.
In this case, the wages account is increased (and shown in the Income Statement)
and a temporary liability is created for the unpaid amount. This temporary liability
appears in the balance sheet as effectively it is an expense at the date of the balance
sheet that has been used up but not paid for.

2. The amount paid for an expense is greater than the expense incurred for the period
(prepaid expense)
For example, some expenses may be paid in advance (such as insurance,
advertising) but not all of the amount paid may have been used up/consumed by the
end of the financial year.
In this case, the expense account is decreased and a temporary asset is created for
the unused amount and appears in the balance sheet as effectively it is an amount
that has been paid but not used up at the date of the balance sheet
In the next period, the prepayment will cease to be an asset and become an expense
in the income statement in the period it relates to.
Summary:

Adjustment Explanation Impact on Impact on Balance

Income Sheet
Statement
Prepaid expenses Prepaid expenses relate to expenses Decrease Create asset
paid in advance but not yet expense (eg.Prepaid Expense)
consumed item
Accrued expenses Accrued expenses are where the Increase Create liability (eg.
expense has been incurred but expense Accrued Expense)
payment has not yet been made item
Accrued revenue Accrued revenue relates to revenue Increase Create asset (eg.
earned but not received at the end revenue Accrued Revenue)
of the financial year item
Prepaid revenue Prepaid revenue occurs where Decrease Create liability (eg.
revenue has been received but has revenue Prepaid Revenue or
not been earned item Unearned Revenue)

Profit and Cash:

It is important to note that profit and cash (liquidity) are not the same. Profit is a measure
of achievement, or productive effort rather than of cash generated

Profit measurement

In the next lecture, we will look at two common assets and how they impact on expense
recognition:
Non-current tangible assets (depreciation expense)
Accounts receivable (bad and doubtful debts)
 Lecture Activity 2

Identify the following items as an Asset (A), Liability (L), Owners Equity (OE), Income (I) or
Expense (E) from the perspective of a business:

ITEM A, L, OE, I or
E
Cash at bank
Fees revenue
Wages
Debtors
Interest on loan
Insurance
Loan from XYZ Bank
Postage
Electricity
Accrued wages
Inventory
Creditors
Sales
Delivery vehicles
Repairs to machinery
Depreciation-delivery vehicles
Motor vehicle insurance
Depreciation-equipment
Unearned fees revenue
Accounting and audit
Prepaid rent
Accounts payable
Accrued revenue
Depreciation on delivery vehicles
Bank overdraft
Goodwill