The major financial statements meant to present the financial position of a business. To achieve this the accountants will generally produce three statements to present what cash movement took place and now much profit and wealth was generated at the end of the reporting period. Statement of cash flows, Income statement and Balance sheet is produced.
The three financial statements are often referred as final accounts of the business. They generally consist of information from the past from which we can identify trends from past performance and draw a picture of future performance.
Balance sheet - the statement of financial position
Assets
The Balance sheet sets out the assets of a business and the claims against the business.
An asset is essentially a resource held by a business. The resource must possess the following characteristics:
a. It shall be an economic resource and provide a right to economic benefits. These resources and benefits should not be available to others thus public good cannot be regarded as an asset. The benefits could be cash generated from producing goods or services, cash received from selling of the resource, the value received when exchanging for another resource, value generated to satisfy debt or cash generated from renting or leasing of the product. These benefits need not to be certain.
b. the resource must be under the control of the business which gives the business rights to derive benefits from the asset. The control is acquired from legal ownership or contractual agreement.
c. the event leading to control must of occurred in the past.
d. the resource must be capable of measuring in monetary terms. Generally these cannot be measured with a great deal of certainty and estimates may be used. Faithful representation will allow to add to statements as an asset.
All of the characteristics identified must exist for resource to quality as an asset. They will continue to be recognised until the benefits have been exhausted.
Examples of assets are: property, plant and equipment, fixtures and fittings, patents and trademarks, investments outside of the business, inventories or cash.
Claims
A claim is an obligation to provide cash or some other benefit to external party. These are generally:
a. Equity - claim of the owners against the business also referred as the owners capital. The business is being treated separately from the owner and the financial statements are prepared for the business and not for the owners.
b. Liabilities - represent the claims of other external parties. These are generally cash owned from past transactions. They are liabilities until they become settled.
An accounting equation that Assets = Liabilities + Equity will always be true.
The statement of financial position will always balance. If we need to acquire assets we need to raise funds to cover the costs of those assets. The funds are provided by the owners (Equity) or others (Liabilities).
The statement of financial situation is generally prepared at the end of certain period also known as the reporting period. It normally vary depending on the type of the business but an annual reporting period is a norm for most businesses.
Assets (at the end of the period) = Equity (amount on the start of the period + Profit or loss for the period) + Liabilities (at the end of the period)
This is assuming that the owners do not make injections or withdrawals of equity during the period. If the funds are not withdrawn it contributes to the growth of the business.
Assets classification
Assets and claims are generally grouped into categories. Assets can be current or non-current.
Current assets are held for a short term:
* held for sale or consumption during the business normal operating circle;
* expected to be sold within a year after the statement of financial position;
* held for trading;
* cash or investments.
The operating circle is the time between the buying or creating the product and receiving cash for its sale. For most businesses it will be less then a year even if sale is based on customer credit.
The most common current assets are inventories, trade receivables (cash owned by customers) and cash. These circulate within the business. Cash is used for inventories which are sold on credit.
Non-current assets (also called fixed assets) are held for long term operation. These can be tangible or non-tangible, for example property, plant and equipment and includes land, buildings, machinery, motor vehicles, fixtures, fittings etc. These also circulate and are used for long-term operations.
The purpose for which an asset is held may vary.
Claims classification
Claims are generally classified into Equity and Liabilities. Liabilities are then further classified as current and non-current.
Current liabilities are subject to settlement in a short term:
* these are expected to be settled within the business normal operating circle;
* they exist as a result of trading;
* due to be settled within a year after the date of statement of the financial position;
* there is no right to defer settlement after a year of the statement date.
Non-current liabilities represent amount due that do not meet the definition of current liabilities - these are long-term liabilities. Sometimes non-current liabilities become current liabilities. If the current liabilities are known and the amount of current assets then we can determine whether the business can cover its obligations.
The classification of liabilities helps to highlight the proportion of long term obligations that are raised through borrowing rather then the equity as its financial risk increase. Business may be forced to not trading if it cant fulfil its financial obligations.
Statement layouts
There is many ways in which the financial position can be presented. However the basic layout should include:
ASSETS
Non-current assets
Property
Plant and equipment
Motor vals
Current assets
Inventories
Receivables
Cash at bank
Total assets
EQUITY AND LIABILITIES
Equity
Non-current liabilities
Long-term borrowings
Current liabilities
Trade payables
Total equity and liabilities
The assets that are further from cash are shown first.
Another example:
ASSETS
Non-current assets
Property
Plant and equipment
Motor vans
Current assets
Inventories
Trade receivables
Cash at bank
Total assets
LIABILITIES
Non-current liabilities
Long term borrowings
Current liabilities
Trade payables
Total liabilities
Net assets
Equity
Here, the total liabilities are deducted from total assets which is forming Net assets which equals Equity.
Assets - Liabilities = Equity
In the UK businesses are free to chose the date of the end of their reporting period.
Accounting conventions
Accounting has a number of conventions (rules).
Business entity convention - the business and owners are treated separately. Owners can claim against their investments. There is different legal position from the business and the owners, particularly for limited liabilities companies. This does not apply for sole proprietorship or partnerships. But limited company has a separate legal existence.
Historic cost convention - the value of assets on the statement should be based on their historic cost (acquisition cost). Reliance on opinion is avoided that enhance the credibility of the information. Some businesses may want to show, however, the current value of the assets. Here, the choice of the valuation methods is important as value derived from replacement costs and current realisable values may vary. This is particularly difficult to assess for customer built equipment identifying the replacement costs or assessing current value can be very difficult. If there are opinions to be form there are higher risks of low credibility. Many businesses prepare the financial statements on modified historic costs.
Prudence convention - means that caution should be exercised when preparing financial statements. It can be used to support bias towards the understatement of the financial strength rather then overstatement. Because by overstating the financial position users of the statements and investments may be mislead to make poor decisions. Understatements can also lead to the same. Therefore there is a need for neutrality in preparing financial statements. Neutrality is needed for faithful representation.
Going concern convention - the financial statements should be prepared on the assumption that the business will continue operation in the foreseeable future, unless there is an evidence to the contrary. There should be no intention to sell non-current assets. In practice the sale value of current assets is often much lower then the value reported thus significant losses may arise.
Dual aspect convention - each transaction has two aspects that will affect the statements. For example a purchase of equipment results in increase of assets and decrease in cash. A repayment of borrowings results in decrease in liability and decrease in assets (cash). This will ensure that the statements will balance.
Other economic resources
Assets can be included into a statement only if these can be measured with a certain degree of certainly. What about human resources, business reputation, its location, customer and supplier relationships? Sometimes businesses try and attempt to measure those to provide a clearer picture of financial situation.
Goodwill and brands - some intangible non-current assets are similar to tangible non-current assets. These include patents, trademarks, licences and copyrights. Other intangible assets lack clear identify. Goodwill as a term is often uses as quality of the product, skills and relationships. These have been generated internally by the users and it is often difficult to assess and measure the values. These are, therefore excluded from the financial statements. However, if these are acquired from a transaction the problem of measuring of uncertainty is resolved and it can be regarded as asset.
Human resources - attempts have also been made to measure human resources in monetary values. This has been, however, unsuccessful. Football clubs may acquire rights to players from other clubs and these are showed on the statements of financial position.
Monetary stability - monetary values change over time but inflation causes value of money to deplete. If financial statements are presented based on historic values the figures may be lower then the current values.
Valuing assets
When preparing financial statements preparing the historic value convention is normally applied. But things are a little bit more complex then this.
Non-current assets values can be finite or infinite. Those with finite lives can provide value to the business only for a limited period of time. This applies to both tangible and non-tangible assets. Initially, non-current assets are recorded at their historic cost which will include any amount spent on getting them ready to use.
Assets with finite life assets will change depending on market changes as well as wear and tear. The amount used up is often called as depreciation or amortisation. These must be measured in each reporting period. The amounts shall be deducted from the costs. This net figure is referred as the carrying amount. Thus the proportion of the historic cost has been consumed in the process of generating of benefits from the business.
Assets with indefinite lives such as property may or may not be used over time.
Non-current assets of all types are recorded at cost using fair value that can be measured fairly. It represents the selling price that can be obtained under current market conditions. The use of fair values rather then the cost provides user with more to date information. Where fair values are used revaluations should be frequent enough. If plant and equipment is revalued based on fair value all assets from the group must be revalued.
Intangible assets are often not revalued based on fair value this is because an active market is required to determine fair values. For most intangible assets an active market does not exist.
All non-current assets are at risk of decreasing in value. This may be caused by changes in market conditions, technological obsolescence and so on. Sometimes the amount of assets is higher then the amount that can be recovered from those assets. The asset value is then said to be impaired and we should reduce the amount on the financial statements to recoverable amount. The asset value is then reduced to impairment loss. Impairment tests may be carried out by independent testers. They involve making judgement about the appropriate value to place on assets. Employing third party gives the users a confidence in the information reported.
The inventories of a business can also suffer significant fall in value. These can result from market changes, obsolescence, deterioration, damage and so on. This loss must be reflected in the financial statements. If the selling price is less then selling cost and it falls below the historic cost it must be reflected on the financial statements. This, again, reflects the prudence in preparing the statements of financial situation.
Summary
In summary, the statement of financial situation help users in the following ways:
provides information about how the business is financed and how its funds are deployed;
It can provide a basis of assessment of the value of the business;
relationships between assets and claims can be assessed;
performance can be assessed.
References
Artill Peter (et al.) 2018, "Accounting and finance for non-specialists" Pearsons Education, pp. 28-64
International Accounting Standards Board, 2018, "Conceptual framework for financial reporting", IASB, pp. 28-31
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