BST511 FA&C

Lecture 2
Fundamentals of Accounting
Measuring and reporting financial
position

A&M Chapter 2
 Learning Outcomes

explain the main elements of financial statements

explain the purpose of the statement of financial position
account for the main types of business transactions
explain how the accounting equation and business entity
convention underpin the statement of financial position
define assets and liabilities
explain how and why assets and liabilities are disclosed in the
statement of financial position.
draft a simple statement of financial position in vertical
format
illustrate how the statement of financial position and income
statement are interrelated
The Objective of general purpose
financial reporting

The primary users of general purpose financial reporting

are present and potential investors, lenders and other
creditors, who use that information to make decisions
about buying, selling or holding equity or debt and
providing or settling loans or other forms of credit.
The primary users need information about the resources
of the entity to assess:
-an entitys prospects for future net cash inflows
-how effectively and efficiently management has
discharged their responsibilities to use the entitys
existing resources (i.e. stewardship).
(IFRS Framework, 2010)
 How the FS meet those objectives
Information about a reporting entitys economic resources, claims, and changes in
resources and claims

Economic resources and claims A reporting entitys economic resources and claims
are reported in the statement of financial position.

Changes in economic resources and claims - Information about a reporting entitys

financial performance during a period, representing changes in economic resources
and claims ... is useful in assessing the entitys past and future ability to generate net
cash inflows. The changes in an entitys economic resources and claims are
presented in the income statement.

Financial performance reflected by past cash flows - Information about a reporting

entitys cash flows during the reporting period also assists users to assess the
entitys ability to generate future net cash inflows. The changes in the entitys cash
flows are presented in the statement of cash flows. (IFRS Framework, 2010)
 Illustration of Income Statement
X Company Ltd Income statement for the year ended 30 June 2014
2013 2014
$ $
Revenue x x
Cost of sales (x) (x)
Gross profit x x
Distribution costs (x) (x)
Administrative expenses (x) (x)
Profit from operations x x
Investment income x x
Finance cost (x) (x)
Profit Before Tax x x
Tax expense (x) (x)
Profit after tax x x
 Statement of Financial Position
Statement of financial position for X Company as at 30 June 2014 $ $
ASSETS
Non-current assets
Property, plant and equipment x
Intangible Assets x
x
Current assets
Inventories x
Trade and other receivables x
Cash and cash equivalents x
x
Total assets X
EQUITY AND LIABILTIES
Equity
Share capital x
Retained earnings x
x
Non-current liabilities
Long-term borrowings x
Current liabilities
Trade and other payables x
Total equity and liabilities x
 Measuring Wealth
Financial performance can be measured in terms of:
1) cash generated
2) wealth
The wealth measure is more satisfactory since it takes
into account:
1) resources (assets) other than cash available to
the business.
2) claims on the business (liabilities) that will have
to be settled in cash some time in the future.
 Example: Cash Transactions

Mr Ex buys 100 units for 30 each & sells 80 for 100 each
Situation 1 Situation 2 Situation 3
Sell 80 buy 100 Cash sales and credit Cash sales (70units), credit
(all cash) purchases sales (10 units) & credit
purchases
Sales 80 units @ $100 80 units @ $100 Cash 70 units @ $100
=$8000 =$8000 =$7000

Purchases 100 units @ $30 100 units @ $30 100 units @ $30
=$3000 =No cash =No cash

Cash surplus $5000 $8000 $7000

Accruals or Matching Concept
The accruals basis of accounting means that to calculate
the profit for the period, we must include all the income
and expenditure relating to the period, whether or not the
cash has been received or paid or an invoice received.

Profit is therefore:

Income earned X
Expenditure incurred (X)
____
Profit X
The Income Statement
Gross Profit

Sales
X
Less: Cost of Sales
Opening Inventory X
+Purchases X
-Closing Inventory (X)

(X)
Gross Profit XX
 Cash v Profit Example
COS Situation 1 COS Situation 2 COS Situation 3 credit
working working credit working sales of 10 units &
purchases credit purchases

Sales 80 units @ 80 units @ Cash 70 units @

$100 = $100 = $100 =$7000 +
$8000 $8000 credit sales (10 units
@ $100) $1000 =
Cost of $8000
goods sold:
Purchases 100 units 100 units 100 units
@ $30 @ $30 @ $30
=$3000 =$3000 =$3000
Less Closing 20 units 20 units 20 units
Inventory @ $30 @ $30 @ $30
= $600 = $600 = $600

Cost of Sales ($2400) ($2400) ($2400)

Gross Profit $5600 $5600 $5600

Cash surplus $5000 $8000 $7000

Profit = Increase in Wealth
Accounting uses wealth as well as cash to measure performance.
The wealth measure takes into account all transactions relevant to
the period and generally tries to reflect the economic substance of
what has occurred.

Situation 3:
Mr Ex Wealth: $
1. Cash received: 7000
2. Cash owed by customer: 1000
3. Value of inventory: 600
8600
LESS: owed to suppliers (3000)
Net wealth: 5600
 Wealth from SOFP view:
Statement of financial position for Mr Example $ $
ASSETS
Non-current assets
Property, plant and equipment

Current assets
Inventories 600
Trade and other receivables 1000
Cash and cash equivalents 7000
8600
Total assets 8600
EQUITY AND LIABILTIES
Equity
Share capital -
Retained earnings 5600
5600
Non-current liabilities
Long-term borrowings
Current liabilities
Trade and other payables 3000
Total equity and liabilities 8600
 Accounting equation

USES OF FUNDS = SOURCES OF FUNDS

ASSETS = EQUITY + LIABILITIES

(future benefits = owners funds + borrowed funds)

ASSETS - LIABILITIES = EQUITY

the net assets (wealth) of a firm are equal to the stake
of the owner(s)
Accountants do it very cautiously...

Definition of accounting concept:

Underlying assumptions used when preparing
financial statements

Fundamental concepts:
ACCRUALS (or MATCHING)
GOING CONCERN
CONSISTENCY
PRUDENCE
 Accounting Concepts
Going Concern
The company will continue to be in operational existence for
the foreseeable future
Consistency
The use of the same methods for the same items, either from
period to period within a reporting entity or in a single
period across entities.
Prudence Concept
Do not recognise income until it is reasonably certain that
you will get it. However record all costs as soon as you
know that you have incurred them
Accruals Concept discussed earlier
 More on concepts
Entity
The business is treated as a separate entity from its owners
even if a sole proprietorship
Substance over form
Accounts should show the economic substance of a transaction
and not just the legal form
Money measurement
Only things that have a monetary value are included in accounts
Realisation
Profit is not recorded until the gain is realised
Materiality
Only if information is significant to the understanding of
users of accounts should it be included
 SOFP - ASSETS

Assets are probable future economic benefits obtained or controlled by

entity as a result of past transactions or events
Non-Current (fixed) Assets Current Assets
Assets that have an expected Assets to be converted into
life of more than one year or cash within one year
Not expected to be converted Cash
into cash within the next Inventories
12months Receivables (debt
They include: owed to the company)
TANGIBLE ASSETS
Plant and machinery
Office furniture
Land and Buildings
INTANGIBLE ASSETS
Purchased Brands
Goodwill
 SOFP - LIABILITIES

Liabilities are probable future sacrifices of economic benefits arising from

present obligations of a particular entity to transfer assets or provide services
to other entities in the future as a result of past transactions or events

Non-current liabilities Current liabilities

Financial obligations that are Debts and other obligations that
unlikely to be met for a year the company expects to settle
or more within the next 12months
Include: Include:
Long-term bank loans Accounts payable
Other long term Borrowing short-term loans
borrowings and overdrafts
Accruals
 SOFP - EQUITY

Shareholders Equity
It equates to the companys net worth
It is simply assets minus liabilities
Includes:
Ordinary Share capital
Preference share capital
Reserves
Share premium
Retained earnings
Revaluation reserves etc
 SOFP: Worked Example

Consider the following transactions:

1. Owner starts a business with 10k cash
2. Purchases a van for 6k cash
3. Buys goods for resale for 2k paid in cash
4. Buys goods for resale for 1k on credit
5. Raises a long-term loan of 2k in cash
Draw up a SOFP for this new business
Solution to Worked Example
Statement of financial position for Mr Example 000 000
ASSETS
Non-current assets
Property, plant and equipment 6

Current assets
Inventories 3
Trade and other receivables
Cash and cash equivalents 4
7
Total assets 13
EQUITY AND LIABILTIES
Equity
Share capital 10
Retained earnings -
10
Non-current liabilities
Long-term borrowings 2
Current liabilities
Trade and other payables 1
3
Total equity and liabilities 13
 Revised Equation

Next week we will extend this equation to show the

effects of trading (i.e. add income and expenses)
and generate the following:

Assets + Expenses = Equity + Liabilities + Income

Assets Liabilities = Equity + (Income Expenses)

Demonstrating that profit (derived in the IS)

accrues to the owners
 Non-Current Assets &
Depreciation
An asset is a resource controlled by the entity as a result of past
events and from which future economic benefits are expected to
flow to the entity. (IFRS Framework, 2010)
Areas to consider:
Purchase: Capital v Revenue
Depreciation
Valuation basis
Recognition, Measurement and Disclosure are
all dealt with under IAS 16 Property Plant &Equipment
 IAS 16 - PROPERTY, PLANT &
EQUIPMENT
tangible assets, have physical substance & used to generate
income.
Recognition:
A probable flow of future economic benefits
Cost of the item can be measured reliably
Cost can include: Purchase price including import duties & Other
directly attributable costs, e.g. Site preparation, Installation and
Dismantling costs
All assets with a limited useful life must be depreciated (not land)
Depreciation should be allocated on a systematic basis, based on
the assets economic useful life and charged as an expense in the
income statement.
 REVALUATIONS &
INTANGIBLES
An entity must chose either the cost model or the revaluation model as its
accounting policy for a class of P,P&E.
If an asset is revalued, all assets in the same class must be revalued.
The increase in the carrying value is the revaluation surplus. This is posted
to the revaluation reserve (part of equity unrealised reserve).
Intangible assets do not have physical substance.
Intangibles can be acquired or developed.
If its probable that the investment in the intangible will result in future
economic benefits flowing to the enterprise, the cost can be recognised as an
asset instead of an expense. Three key criteria:
Identifiability
Control
Future Economic Benefits
 Measurement in financial
statements

Historical cost: Assets are stated in the SOFP at cost less

depreciation and any impairment losses
Fair Value: the amount that an asset or liability could be
exchanged in an arms length transaction between
informed and willing parties, other than in a forced or
liquidation sale
Replacement cost: the cost of replacing the asset at
current prices less accumulated depreciation
Net Realisable Value: selling price less selling cost
Economic Value: the present value of future net cash
flows from an asset
 IAS 10
IAS 10 Events after the Balance Sheet Date
- adjusting events are events after the reporting period
which provide additional evidence of conditions existing at
the reporting date
- Examples:
- irrecoverable debts and inventory
- discovery of fraud or error which show the FS were
incorrect
- Non-adjusting events are events after the reporting period
which concern conditions that did not exist at the
reporting date (e.g. issues of shares or loans after the SOFP
date but before the issue of the FS)
Uses of the statement of financial position

It shows how the business is financed and how these

funds are deployed

It can provide a basis for assessing the value of the

business

Relationships between assets and claims can be

assessed

Performance can be better assessed

Limitations of the statement of financial position

Recognition: The balance sheet does not report

items that cannot be objectively determined.

Issues regarding off-balance sheet financing

and Intangibles

Measurement: Most assets and liabilities are

stated at historical cost.

Judgments and estimates are used in

determining many of the items

Valuation
 Next lecture....

Lecture 3
Fundamentals of Accounting
Measuring & reporting financial performance

Chapter 3 A&M:
Income Statement
Accruals
Depreciation