Lecture 2

Dr. Chaminda Wijethilake

Measuring and Reporting Financial Position:

(Statement of Financial Position/Balance Sheet)
 Lecture Outline

You should be able to:

Explain the nature and purpose of the three

major financial statements

Prepare a simple statement of financial position

and interpret the information that it contains

Discuss the accounting conventions

underpinning the statement of financial position

Discuss the uses and limitations of the statement

of financial position for decision-making purposes
The major financial statements – an overview

Statement of cash flows

Income statement

Statement of financial position

 The main financial statements
There are three main financial statements:
(i) The statement of financial position
(ii) The income statement
(iii) The cash flow statement
• The statement of financial position (or balance sheet as
previously known) shows the business’ accumulated ‘worth’ at a
particular point in time (i.e., snapshot).

• The income statement shows the income (profit or loss) generated

over a particular
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Comprehensive Income).

• The cash flow statement shows the cash movements over a

particular period.
 The relationship between the major financial
statements

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 Assume a simplest business set up (small company or
one person business)

 The accounting framework is based on a crucial

assumption, known as the entity concept namely that:

“Each individual business is an isolated entity, divorced

from its owners, employees, managers and other
Weekentities”
business 10
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 OWNERS’ EQUITY
INDVIDUAL / SHARE CAPITAL BUSINESS
SEVERAL COMPANY
SHAREHOLDERS

Capital of Equity: Amount of resources supplied by the

owner(s). This is involved in the business and can be in the form
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of cash or in 8kind (Land, Equipment, Shares, Motor vehicle etc.)
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In turn, the business invests these funds in resources, capable of

generating revenue and profits. These resources are known as
Assets.
 Identifying an asset for inclusion in the
statement of financial position

Does the resource provide a right for the No Examples?

potential to receive economic benefits?
• Office Equipment
Yes
• Buildings
Is this right also available to other parties at no
great cost?
Yes • Motor vehicles
• Inventory (stock)
No
• Cash in hand/at
Can the business exert control over the resource as a bank
No
result of a past transaction or event?
• Customers on
Week 10 Yes credit (Trade
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Can the resource be faithfully represented in No
monetary terms? Receivables)

Yes

Not an
Accounting accounting
asset asset
 Hence, Owner’s Capital = Assets

• This equation assumes that it is only the sole trader or

shareholder(s) who can bring resources in the business.

• Third parties (banks, suppliers) can provide their share in terms

of loans and credit facilities.

• These
Week are
10 known as Liabilities or amounts owed by the
business
Seminarto
8 external parties (except for owners). e.g. Loans and
creditors (suppliers granting credit, also known as trade
payables).
 Examples?
Loans
Bank Overdrafts
Suppliers on Credit
(Trade Creditors/Trade
Liabilities represent the claims of individuals
Payables)
and organizations (except from the owners), that
Week
have 10 from past transactions or events,
arisen
Pending Court Case for
suchSeminar 8
as supplying goods or lending money to the Damages
business.
Loan Guarantees in
favour of third party (last
two are examples of
contingent liabilities)
Hence,

Owner’s Capital (or Equity) + Liabilities = Assets

•This is valid at any point of time.
•The amounts will change after each financial transaction but the equality will
be maintained.
•Therefore, the amounts of capital, liabilities and assets will fluctuate from
period to period.
• What is the make up of the changes in capital? Why would capital grow (or
reduce)?
•This Week 10 is reflected in the format of any company BALANCE
equation
SHEET Seminar 8
(or known as STATEMENT OF FINANCIAL POSITION)

Note: A&M (Chapter 2) refers to the total of liabilities + equity as claims (p. 46)
This equation gives rise to the six basic elements of financial accounting

[Opening Capital + (Revenues – Expenses) + New Capital - Distributions] + Liabilities = Assets

Revenues – Expenses = Profit

• Capital increases via increases in profits

• All assets net of the liabilities (net assets) represent the net worth of the enterprise

• Distributions are funds returned to owners (e.g., in the form of dividends) not
expenses
 Example 1
Jerry and Co. deposits £20,000 in a bank account on 1 March in order to commence
business. Let us assume that the cash is supplied by the owner (£6,000) and by a lender
(£14,000) and paid into the business bank account. The raising of the funds in this way
will give rise to a claim on the business by both the owner (capital) and the lender
(liability).

Jerry and Co.

Statement of Financial Position as at 1 March
£ £
Assets Equity & Liabilities
Cash at bank 20,000 Capital 6,000
Week 10 Liability – loan 14,000
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Total Assets 20,000 Total Equity and Liabilities 20,000

We can see from the statement of Financial position that the total claims (equity and
Liabilities are the same as the total assets: Thus: Assets = Equity + Liabilities
 Example 1 continued
By way of illustration, consider the following transactions for Jerry and Co:
2nd March Purchased a motor van for £5,000, paying by cheque
(i.e. via bank account).
3rd March Purchased inventory (that is, goods to be sold) on one
month’s credit for £3,000.
4th March Repaid £2,000 of the loan from the lender.
6th March Owner introduced another £4,000 into the business
bank account.
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Each of these transactions give rise to a change in asset, liability or capital
and another corresponding change in asset, liability or capital
 Example 1 continued
2nd March Purchased a motor van for £5,000, paying by cheque
(i.e. via bank account).

A statement of financial position (SFP) may be drawn up after each day in which transactions have
taken place. In this way, the effect can be seen of each transaction on the assets and claims of the
business. The SFP as at 2 March will be as follows:
Jerry and Co.
Statement of Financial Position as at 2 March
£ £
Assets Equity & Liabilities
Cash at bank (20,000 - 5,000) 15,000 Capital 6,000
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Motor van 5,000 Liabilities – loan 14,000
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As can be seen, the effect of purchasing a motor van is to decrease the balance at the bank by
£5,000 and to introduce a new asset – a motor van – to the SFP. The total assets remain unchanged.
It is only the ‘mix’ of assets that will change. The claims against the business will remain the same
because there has been no change in the way in which the business has been funded.
 Example 1 continued
3rd March Purchased inventory (that is, goods to be sold) on one
month’s credit for £3,000.

The SFP as at 3 March, following the purchase of inventory, will be as follows:

Jerry and Co.
Statement of Financial Position as at 3 March
£ £
Assets Equity & Liabilities
Cash at bank 15,000 Capital 6,000
Motor van 5,000 Liabilities – loan 14,000
Stock (inventories) 3,000 Liabilities – trade creditor 3,000
Week 10 23,000 23,000
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The effect of purchasing inventory as been to introduce another new asset (stock) to the SFP. In
addition, the fact that the goods have not yet been paid for means that the claims against the
business will be increased by the £3,000 owed to the supplier, who is referred to as a trade creditor
(or trade payable) on the SFP.
 Example 1 continued
4th March Repaid £2,000 of the loan from the lender.

Hence, the SFP we drew up for Jerry and Co. as at 4 March was as follows:

Jerry and Co.

Statement of Financial Position as at 6 March
£ £
Assets Equity & Liabilities
Cash at bank (15,000-2,000) 13,000 Capital 6,000
Motor van 5,000 Liabilities – loan (14,000-2,000) 12,000
Stock (inventories) 3,000 Liabilities – trade creditor (payable) 3,000
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21,000 21,000
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 Example 1 continued
6th March Owner introduced another £4,000 into the business
bank account.

Hence, the SFP we drew up for Jerry and Co. as at 6 March was as follows:

Jerry and Co.

Statement of Financial Position as at 6 March
£ £
Assets Equity & Liabilities
Cash at bank (13,000+4,000) 17,000 Capital (6,000+4,000) 10,000
Motor van 5,000 Liabilities – loan 12,000
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Stock (inventories) 3,000 Liabilities – trade creditor (payable) 3,000
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25,000 25,000
 Example 1 - Final transaction

Let us assume that, on 7 March, the business managed to sell all of the stock for £5,000 and
received a cheque immediately from the customer for this amount. The SFP on 7 March, after
this transaction has taken place, will be as follows:

Jerry and Co.

Statement of Financial Position as at 7 March
£ £
Assets Liabilities & Equity
Cash at bank (17,000 + 5,000) 22,000 Capital [10,000 + (5,000 – 3,000) 12,000
Motor van 5,000 Liabilities: loan 12,000
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Stock (inventories) (3,000 – 3,000) - Liabilities: trade creditor (payable) 3,000
Seminar 8 27,000 27,000
 Example 1 - Final transaction

We can see that the stock (£3,000) has now disappeared from the SFP, but the cash at bank has
increased by the selling price of the stock (£5,000). The net effect has therefore been to increase
assets by £2,000 (that is, £5,000 - £3,000).

The capital of the business has increased by £2,000, in line with the increase in assets. This
increase in capital reflects the fact that increases in wealth, as a result of trading or other
operations (revenue – expenses), will be to the benefit of the owners and will increase their stake
in the business.

Hence, Revenue – Expenses = Profit.

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 Categories of assets and liabilities

Alternative presentation in a statement of financial position (balance sheet)

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NCA CA CL NCL CAP
 The classification of assets

The classification of assets may vary

according to the nature of the business:

Current assets
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Non-current assets
 Current assets
Current assets are held for sale or consumption in the normal
course of business or are held for the short term.

Held for sale or consumption during the

business’s normal operating cycle

Expected to be sold within the

next year

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Cash or near cash

The circulating nature of current assets

Inventories

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 Non-current assets
Non-current assets are held for use within the business for
long-term operations.

Do not meet the definition of current

assets
 The classification of claims

Current liabilities

Non-current liabilities

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 Current liabilities
Current liabilities represent amounts due in the normal course of the
business’s operating cycle or due for repayment within 12 months.

Expected to be settled within the business’s

normal operating cycle

Held principally for trading

purposes

Due to be settled within a year after the

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statement of financial position date

No right to defer settlement beyond a

year after the statement of financial
position date
 Non-current liabilities
Non-current liabilities represent amounts due beyond 12 months.

Do not meet the definition of current

liabilities

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 Statement of Financial Position (NCA + CA = CL + NCL + EQUITY)
as at 31 December 2005

Non-current assets
Freehold premises 45,000
Plant and machinery 30,000
Motor vans 19,000
94,000
Current assets
Stock (inventories) 23,000
Trade debtors (receivables) 18,000
Cash at bank 12,000
53,000
Total Assets 147,000

Current liabilities
Trade creditors (payables) 37,000
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Non-current liabilities
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Loan 50,000

Equity and Reserves

Share capital 50,000
Profit and other reserves (Retained earnings) 10,000 60,000

Total Equity and Liabilities 147,000

 Statement of Financial Position (NCA + CA – CL – NCL = EQUITY)
as at 31 December 2005
Non-current assets
Freehold premises 45,000
Plant and machinery 30,000
Motor vans 19,000
94,000
Current assets
Stock (inventories) 23,000
Trade debtors (receivables) 18,000
Cash at bank 12,000
53,000
Total Assets 147,000

Less Current liabilities

Trade creditors (payables) 37,000

Week
Less 10
Non-current liabilities
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Loan 50,000
Net Assets 60,000

Equity and Reserves

Share capital 50,000
Profit and other reserves (Retained earnings) 10,000

Total Equity 60,000

 Activity

RIO LTD
WHICH ACCOUNT GROUP/SUB GROUP
ACCOUNTS (?)
Bill to pay –Payables (30 days)
Land
Revenue
Capital
Cash & Bank
Salaries Expenses
Stock (Inventories)
Clients - Receivables (60 days)
Buildings, Fixtures and fittings
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Expenses with Office Maintenance
Net ProfitSeminar 8
for the year
Payables (18 months)
Vans used for deliveries
Administrative Expenses
Expenses with Advertising
Payables (60 days)
Receivable (90 days)
Equipment & machines
 Summary
The Statement of Financial Position
• Sets out the assets of the business, on the one hand, and the claims against those assets,
on the other.
• Assets are resources of the business that have certain characteristics, such as the
potential to provide future economic benefits.
• Liabilities are obligations on the part of the business to provide cash, or some other
benefit, to outside parties.
• Capital and reserves represents the owner’s claims.
• The statement of financial position reflects the accounting equation:
Assets = Equity + Liabilities

Classification of Assets and Liabilities

• Current assets are cash or near cash or are held for sale or consumption in the normal
course of business, or for trading, or for the short term.
• Non-current assets are assets that are not current assets. They are normally held for the
long term operations of the business.
• Current liabilities represent amounts due in the normal course of the business’s
operating cycle, or are held for trading, or are to be settled within a year of, or cannot be
deferred for at least a year after, the end of the reporting period.
• Non-current liabilities represent amounts due that are not current liabilities.
Why accounting concepts?
A company started a computer shop business on 1st Jan 2017. In early
February 2017, it bought a consignment of 200 assembled computers at £300
each and these have been sold at an average price of £500 each. At the end of
the financial year (31st Dec 2017), the company has a stock of 50 assembled
computers. No other purchases were made during this year.
The current wholesale market price at 31st Dec 2017 for a similar stock of
assembled computers was £250 per item.

Week 10
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What are 8
the alternative values that one can assign to the stock at 31st
December 2017?
Which one would you select?
Accounting concepts or conventions are assumptions
underlying the recording, summarizing and preparation of
accounting information/reports.
Traditionally, they have evolved other time in response to
particular practical accounting problems and it is only recently
that they have been (partially) linked to theoretical arguments.
They are often implicit (not stated) in financial statements,
they are not necessarily rigid as a rule and they can conflict
each other…..
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(M&A, Chapter 2, pp. 51-58)
1. (Business) Entity – separate from the owner or his/her
personal transactions
2. Money Measurement – deals only with items that are
capable of being expressed in monetary terms.
3. Historic Cost – transactions are usually measured using
their original (historic cost) but exceptions are possible.
4. Stable Monetary Unit – money, which is the unit of
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measurement in accounting, has a stable value over time i.e.
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inflation is minimal.
5. Materiality – the way we could record or present
transactions should have an impact on our bottom-line results.
6. Objectivity – financial statements should be based on
objective verifiable information.
What limitations or impact do these could have on your
perceived usefulness of accounting information?

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7. Going Concern – business is assumed to be operating
normally for the foreseeable future.
8. Prudence Concept – always play it safe? Minimize our gains
/ assets but maximise our losses / liabilities.
9. Consistency Concept – To a large extent, companies are
allowed to apply the accounting principles and methods to their
context but one expects that they do not change them too often.
This would impact on the comparability of reported numbers.
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10. Matching Concept – Profit is arrived at comparing the
expected revenue with the expenses incurred in generating that
revenue. It is not important to whether actual payment (or receipt)
has occurred. A related concept is Accruals concept (i.e. time-
related). This is a crucial concept in accounting and heavily
influences the estimation of revenues and profits.
11. Substance Over Form – in some cases, the legal form of
certain transactions may be different from its commercial form.
Accounting should reflect its commercial form and not the legal
form. Week 10
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E.g., A company buys vans from a bank under a lease agreement for the purposes of transport. Under that
agreement, the company will have to pay some advance and will pay the remaining amount for vans in 4
year instalments. Now although after paying the advance bank will provide the company with the
possession of the vans and company will own those vans from an “economic point of view”, but it will not
be recognized as the “legal owner” of those vans until it pays the final instalment.
Comments by the owner (of a parts factory) when reading the
draft accounts:
• “My knowledge and skills in the business is an asset to this
business, but it does not seem to have been included in the
balance sheet.” Money measurement

• “The stock valuation of certain items at 31st December 2018

should be increased to its market price since there is are no
difficulties
Weekin
10selling them. This will result in an increase in the
gross profit of 8£50,000” Prudence
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• “I have just been informed that the government has decided not
to renew our business licence, which is due to expire in 6 months’
time” Going concern
 Asset valuation

Initially show non-current assets at historic

costs

Fair values may be used if they can be reliably

obtained

Non-current assets with finite lives shown at cost (or fair

value) less accumulated depreciation

Week 10
Seminar 8Non-current assets with impaired value written down to
recoverable amount

Inventories shown at lower of cost or net realisable

value
• Accounting concepts/conventions are often practical rules developed in a
particular business context and environment (e.g. timing and country) and are thus
not consistently applied.

• Country examples:
accounting for stock, upward asset revaluations

• Industry examples
- contract accounting,
- accounting for oil-exploration costs.
Week 10 of accounting guidelines and standards is basically an attempt at
• The introduction
Seminar
improving 8 rules behind accounting concepts and conventions.
the initial
 Any set of financial statements is subject to various (and often
implicit) conventions or concepts. These concepts shape how a
company reports its performance or position.
 Some of these conventions can be inferred from the “accounting
policies” section of an annual report
 Some concepts and conventions have now been “strengthened” or
improved via accounting standards (IFRS). However, loopholes
continue to exist.
Week 10
Country-related
Seminar 8 resources:
http://www.iasplus.com/en/jurisdictions
http://www.worldbank.org/ifa/rosc_aa.html