Accounting and Finance

Week 2:
Measuring and Reporting Financial
Position

The Balance Sheet (Statement of

Financial Position)
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Chapter 2 Measuring and reporting financial position

LEARNING OUTCOMES
You should be able to:

Explain the nature and purpose of the three major financial

statements

Prepare a simple balance sheet and interpret the

information that it contains

Discuss the accounting conventions underpinning the

balance sheet

Discuss the uses and limitations of the balance sheet for

decision making purposes
Two different types of accounting
Before covering the primary financial statements, you should
be aware of the different types of accounting.

1. Cash Flow Accounting

2. Accrual Accounting.

Cash Flow accounting is the accounting for the movement

of money as it moves into or out of a business from
operating, investing, and financing activities. It is effectively
recognizing cash receipts and payments based on when cash
“physically” flows in an out of the business.
 Accruals Accounting
Cash Flow Accounting (cont’d)

An example of cash flow accounting is below, outlining cash receipts (in flows) and
cash payments (out flows) based on timing of said receipts and payments.
Two different types of accounting

Accrual accounting is the concept that accounting transactions

should be recorded in the accounting periods when they occur rather
than in the period where the cash flow is associated.

Under this concept the ‘cash receipts from customers’ and

‘payments to customers’ are replaced with revenue and expenses.

Revenues and expenses are recognized in the period when they

occur rather than in the period where the cash flow is associated.
 Accrual Accounting vs. Cash Accounting Example

- Let’s say a company receives a service on 15th December 2020.

- The company however does not pay for the service until 15th January 2021.

Accruals accounting –
expense would be recognised
@ 15th Dec 2020

Cash accounting – payment

to supplier recognised when
payment physically happens
@ 15th January.
The major financial statements – an overview

Accounting basis
prepared on

Statement of cash flows Cash flow accounting

basis

Income statement Accrual accounting

basis
(Profit & Loss Account)

Balance sheet Accrual accounting

basis
(Statement of Financial Position)
The major financial statements – an overview

Reports over

Statement of cash flows Period of time

Income statement Period of time

(Profit & Loss Account)

Balance sheet Point in time

(Statement of Financial Position)

 Relationship between the balance sheet,
income statement and cash flow statement
SoFP: As at a
point in time

E.g as at 31 E.g as at 31 E.g as at 31

December December December
2018 2019 2020

12 months 1 Jan 19 to 12 months 1 Jan 2020

31 Dec 2019 to 31 Dec 2020

12 months 1 Jan 19 to 12 months 1 Jan 2020

31 Dec 2019 to 31 Dec 2020
The Balance Sheet

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The Balance Sheet
The balance sheet shows a company’s assets, liabilities and owner’s equity at a point
in time (for a corporation, ‘owner’s equity’ is referred to as ‘shareholder’s equity’).

 An asset can be defined as a resource with economic value with the expectation it
will provide future benefits.
 A liability can be defined as an obligation to a person or entity as a result of a past
transaction or event.
 Equity is the corporation's owners' residual claim on assets after debts have been
paid. Equity is equal to a firm's total assets minus its total liabilities.

Assets and liabilities can be categorized further into “current” and “non-current”
- Current assets / liabilities will be used (asset) or settled (liability) in less than 1 year.
- Non-current assets / non-current liabilities will be used (asset) or settled (liability) in a period greater
than 1 year.
The Balance Sheet
An example of some current & non-current assets / liabilities are
illustrated in the table below.
Current Current
assets liabilities

Non-
Non-current
current
assets
liabilities
Financial Position

Non-current
assets

Current
assets

Current
liabilities

Non-current
liabilities

Equity
 Accounting Principles & Concepts
The dual aspect
This is the principle convention asserts
that a business is an that each transaction
entity unto itself and has two aspects, both
should be treated which will affect the
separately from its
owners Business Statement Dual statement of financial
position.
entity of financial aspect
convention position convention

Historic Going
Prudence
cost concern
convention
convention convention
The convention
financial statements
Transactions are recorded at
should be prepared on
their historic cost.
the assumption that a
Prudence is the business will continue
E.g. Land acquired at £1m, inclusion of a degree
its operations for the
but market value rises of caution in preparing
foreseeable future
subsequently to £1.5m financial statements. (unless evidence to
the contrary).
Under HCC = £1m
 The accounting equation

Equity/
Assets = Capital + Liabilities
 The accounting equation

We will now demonstrate how the ‘Accounting Equation’ is impacted through the use
of three transactions:

Transaction 1: Where an owner injects initial capital into a business.

Transaction 2: A company purchases inventory (as asset) for cash
Transaction 3: The company then sells some units of the inventory that was
purchased.

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 The accounting equation

Equity/
Assets = Capital + Liabilities

Transaction 1: Owner of a business provides £10,000

capital to a new entity.

Assets: cash at
bank + = Equity: £10,000 + Liabilities: £0
£10,000
The accounting equation
An illustrative balance sheet
after this transaction would
look like:

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 The Accounting Equation

The impact of the accounting equation

will now be demonstrated on the
following transactions 2 & 3:

 Transaction 2: 100 units of stock is purchased at a

rate of £50 per unit (purchased in cash).
 Transaction 3: 30 units of stock are sold for £75
on credit
 The Accounting Equation

Transaction 2
100 units purchased @ £50 £5,000

Inventories increased £5,000

a

Cash decreased £5,000

 The Accounting Equation
Transaction 3 - matching principle
30 units sold @ £75 - record revenue £2,250
Matching principle
30 units cost @ £50 - matching principle* £1,500

*Matching principle - when revenue recorded related expense should also be charged

a a

Sales and trade receivable

recognised £2,250

Cost of sales and decrease in

inventory £1,500 required to be
recognised

Profit of £750 on transaction

 The Accounting Equation

a a a

Accounting Equation after transaction 1, 2 & 3:

Assets (£10,750) = Liabilities (£0) + Equity £10,750

 The Balance Sheet

Assets Liabilities

What the What the

company company
= +
owns owes

Equity/
Capital
The classification of assets
(what the business owns)

Assets can be broken down into two categories

Non-current assets

Current assets
Definition of an asset

 An asset can be defined as a

resource with economic value
with the expectation it will
provide future benefits

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 Identifying an asset for inclusion in the statement of financial position

Example to demonstrate:
Does the resource provide a right for the No
potential to receive economic benefits?
Company purchases a
building. Yes

Is this right also available to other parties at

Yes
no great cost?

No

Can the business exert control over the resource

No
as a result of a past transaction or event?

Yes

Can the resource be faithfully represented No

in monetary terms?

Yes

Not an
Accounting accounting
asset asset
Non-current
assets

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 Non-current Assets
 Examples of non-current tangible assets (fixed assets):
 Land & Buildings
 Plant & Machinery
 Motor Vehicles
 Equipment
 Fixtures & Fittings

 Examples of non-current intangible assets

 Goodwill
 Brands

 Most non-current assets are subject to depreciation

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 Depreciation
 Depreciation expense follows the matching principle. An
expense is recognized in the form of depreciation to reflect the
economic value of the asset being diminished over time.

 Four factors must be considered:

 The cost (or fair value) of the asset
 The useful life of the asset
 The residual value of the asset
 The depreciation method.

 Non-current assets are shown at Net Book Value in the

Balance Sheet (i.e. Asset Value – Depreciation)

 Depreciation is an accounting adjustment and it a ‘non-cash’

expense. 29
 Depreciation (Example)
Example:

 A business has just purchased a machine for a cost of

£210,000 (assume purchased at beginning of year, and
accounting period is 12 months)
 The residual value is estimated to be £nil
 Estimated useful life = 5 years
 Depreciation? (straight line method)
Step 1: Recognise fixed asset cost to SoFP
Step 2: Depreciation method?
Charge depreciation to Income Statement based on
Method of depreciation applied (straight line method)
 Depreciation (Example)
Value included Financial Statements
 Cost £210,000
 Estimated useful life: 5 years
 (No residual value)

=£42,000 per year

Income Statement (Extract)

Year 1 Year 2 Year 3 Year 4 Year 5

Depreciation charge 42,000 42,000 42,000 42,000 42,000

Balance Sheet (Extract)

End of each financial year
£ Day 1 Year 1 Year 2 Year 3 Year 4 Year 5
Cost 210,000 210,000 210,000 210,000 210,000 210,000
Accummulated depreciation - - 42,000 - 84,000 - 126,000 - 168,000 - 210,000
Net book value 168,000 126,000 84,000 42,000 -
 Current assets

Held for sale or consumption during

the business’s operating cycle

Expected to be sold within

the next year

Held principally for trading

They are cash or near

equivalents to cash
Current
assets

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 Current Assets

 Examples

 Stocks(inventories)
 Debtors (trade receivables)
 Prepayments
 Cash/Cash Equivalents

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 Stocks/Inventories

 Goods bought and sold by the business

 ‘Inventories’ in the balance sheet refers to goods

bought with the intention of resale that have not
yet been sold – they are still owned by the
business

 ‘Inventories’ in the balance sheet refers to the

value of inventories at the end of the financial year

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 Debtors/Trade Receivables

 Sales that the business has made for which no

money has yet been received – so this is
MONEY OWED to the business
 Sometimes not all debtors pay so their debts
have to be written off (bad debts vs provision
for doubtful debts)
 The amount for ‘Trade Receivables’ appearing
in the balance sheet shows what the business
is confident about receiving the balance owed
from customers for these receivable balances. 36
 Cash & Cash Equivalents
 This is the actual cash the business has both on the
premises (‘in hand’) and in its bank account at the date of
the balance sheet.
 If the business has an overdraft, then the bank account
will appear as a liability, and will be shown under ‘Current
Liabilities’ in the balance sheet.

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The circulating nature of current assets

Inventories
(stock)

Trade
Cash receivables
(debtors)
 Prepayments
 A company has a yearend of 31 December 2020.

 They pay £3,000 for their annual rates bill for the period from 1st April
2020 to 31 March 2021.

 The accruals concept states that transactions should be recorded in the

accounting periods to which they relate rather than in the period where
the cash flow is associated.
 As the company’s accounting period is 31 December
 9 months of the rates relates to the year-ending 31 December 2020.
 3 months of the rates relates to year-ending 31 December 2021.

 Therefore at 31 December 2020, there is 3 months of rates prepaid

relating to the next accounting period.
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 Prepayments
INCOME STATEMENT (extract) for period ending 31/12/2020
£
Split of rates £
Sales
9 months rates (Apr to Dec 2020) 2,250 Cost of sales 0
3 months rates (Jan to Mar 2021) 750 Gross profit 0
Total rates 3,000 Operating costs -2,250
Net profit -2,250

BALANCE SHEET (extract) as at 31/12/2020

£
Assets
Current assets
Prepayment 750
Total assets 750
Liabilities
Current liabilities
Bank o/d -3,000
Total current liabilities -3,000
Total liabilities -3,000
Net (liabilities) -2,250
Equity
Owners capital
Retained earnings -2,250
Total Equity -2,250
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How assets are financed

Both liabilities and capital/equity represent how the

assets of a company are financed

Liabilities

Equity/Capital
Liabilities are classified in two ways

Current liabilities

Non-current liabilities
 Current
liabilities

Non-
current
liabilities

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Current liabilities

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 statement of financial position
date

No right to defer settlement beyond

a year after the statement of
financial position date
Current Liabilities
 Examples
 Amounts owing to suppliers (Trade Creditors / Trade
Payables): payables are purchases that the business has
made but has not yet paid for, so this is MONEY OWED by
the business to its suppliers
 Accrued expenses (accruals – ie expenses that are owed at
the end of the period)
 Bank overdrafts
 Longer term bank loans coming up for repayment within
the next year

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Non-current liabilities

Do not meet the definition of

current liabilities

Includes

Long-term loans
Pension obligations
 Equity/Capital

 Also referred to as Shareholders Funds

Includes
 Share capital (ordinary and preference
shares)
 Share premium account (excess of value
shares issued for above nominal value)
 Retained profits (ie profits that have yet to
be distributed)

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Equity

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 Money measurement

Key measurement problems:

Goodwill and brands

Human resources

Monetary stability
Uses of the Balance Sheet

Shows how the business is financed

and how funds are deployed

Can provide a basis for assessing

the value of the business

Relationships between assets and

claims can be assessed

Performance can be better assessed

 The Balance Sheet: Summary

 Provides users with information about the financial position of an

enterprise at a particular point in time, thereby helping the user
appreciate its assets and funding structure

 They have three components and are an elaboration of the fundamental

accounting equation

 They are not statements of the value or worth of the business - this is
because of the way in which assets are stated

 Not all assets are necessarily shown on the balance sheet

 Preparation involves judgement (eg depreciation policy etc.)