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14/02/2018

BUSS 1030 Accounting, Business and


Society Chapter 2
Pgs 46-76
Lecture 6: Statement of Financial Position
PLEASE bring the
Lecture example we
covered in Weeks 3
Abdul Razeed and 4

BUSINESS SCHOOL

Recap

Business Transactions
Chapter 4 Pages 162-179; 183-187; 195-203; Skim Read Pages 179-183
- Provide an overview of the recording process (LO1)
- Explain how the use of double-entry bookkeeping mirrors the first-
principles approach (LO2)
- Explain the importance of a trial balance (LO3)
- (Skim Read Only) Close off a simple set of accounts (LO4)
- Record a series of period-end adjustments in the accounts (LO5) – Only
up to an including depreciation
- Use an adjusted trial balance and a worksheet to complete a final set of
accounts (LO7)
- Describe a chart of accounts and its importance (LO8)

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Learning Objectives
When you have completed your study of this chapter, you should be able to:
1) Explain the nature and purpose of the statement of financial position
(balance sheet) and its component parts.
2) Explain the accounting equation, and use it to build up a statement of
financial position at the end of a period.
3) Classify assets and claims.
4) Apply the different possible formats for the statement of financial position.
5) Identify the main factors that influence the content and values in a
statement of financial position.
6) Explain the main ways in which the statement of financial position can be
useful for users of accounting information.
7) Identify the main deficiencies or limitations in the statement of financial
position.

The Accounting Equation (LO5)

Economic Claims to
Resources Economic Resources

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US Central Bank

Fed flags 'relatively soon' cut to balance sheet


The Federal Reserve kept interest rates unchanged and said it expected to start
winding down its massive holdings of bonds "relatively soon" in a sign of
confidence in the US economy. The US central bank kept its benchmark lending
rate in a target range of 1.00 per cent to 1.25 per cent and said it was continuing
the slow path of monetary tightening that has lifted rates by a percentage point
since 2015.

After pushing rates nearly to zero to fight the 2007-2009 financial crisis and
recession, the Fed pumped over $US3 trillion into the economy in a bond-buying
spree to further reduce rates. Its balance sheet has grown to $US4.5 trillion.
Unwinding the balance sheet will mark the end of a controversial tool that drew
criticism from Republican lawmakers in Congress. While Fed researchers have
concluded the bond buying only modestly boosted the economy, Fed chair Janet
Yellen has said the central bank could use asset purchases again if the economy
fell into a deep rut.
Read more: http://www.smh.com.au/business/markets/fed-flags-relatively-soon-
cut-to-balance-sheet-20170726-gxjiq1.html accessed on 9th Feb 2018

Accounting Processes

Business Transactions Weeks 2/3

Journal Week 3

Ledger Weeks 3/4

Trial Balance Weeks 3/4

Financial Statements Week 6/7/8/9

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Nature and purpose of the statement


of financial position

› The purpose of the statement of financial position is to set out the


financial position of a business at a particular point in time.
› Also referred to as a ‘balance sheet’.
› Contains a snapshot of the assets, liabilities and equity position of the
entity at a particular point in time.
› Sets out the assets of the business on the one hand, and the claims
against it on the other.

Assets

• AASB Framework definition:

“A resource controlled by the entity as a result of past events,


and from which economic benefits are expected to flow to the
entity”
• Main identifying characteristics are:
• Expected future economic benefit
• The business has exclusive right to control the benefit
• The benefit must arise from some past transaction or event
• The asset must be capable of reliable measurement in monetary terms

• These conditions limit the kind of items that may be referred to as


‘assets’ in financial reports

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Assets

• Examples of items that appear as assets in a business statement of


financial position:
• Cash
• Freehold premises
• Machinery and equipment
• Fixtures and fittings
• Patents and trademarks
• Accounts receivable
• Investments
• Assets may be either tangible (items with a physical substance) or intangible (no
physical substance e.g. copyrights, trademarks, patents, goodwill)

Nature and purpose of the statement


of financial position (cont’d)

Claims against the assets


› A claim is an obligation on the part of the business to provide cash or
some other benefit to an outside party.
› The other side of the statement of financial position includes claims
against the assets of an entity, or simply the different interests in those
assets.
› Two types of claims:
• External claims – liabilities
• Internal claims – owners’ equity or equity/capital.

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Liabilities

• AASB Framework Definition:


“A present obligation of the entity arising from past events, the
settlement of which is expected to result in an outflow from the
entity of resources embodying economic benefits”

• In addition there is a twofold recognition criteria:


• Probability of occurrence (in the case of liabilities, it is more likely than not that
a future sacrifice of economic benefits will occur)
• Reliability of measurement (in the case of liabilities the amount of the claim can
be determined with acceptable precision or accuracy)

Liabilities

• Examples of items that appear as liabilities in a business balance sheet


include:
• Accounts payable
• Staff entitlements
• Loans and other credit facilities
• Warranty provisions and other social or moral obligations
• Provision for employee bonuses or owners’ distribution

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Nature and purpose of the statement


of financial position (cont’d)

Claims against the assets (cont’d)


› Provision are estimated liabilities for which there is greater uncertainty
regarding the amount or timing of the amount than for a normal liability.
› A contingent liability is a potential liability that might arise in the event
of a particular event occurring.
› Will become a liability contingent on that event happening.
› Not recognised in financial statements until the event actually occurs,
but often disclosed in a note in the annual report.

Owners equity (OE or equity)

• The claim of the owner(s) against the business

• AASB Framework definition


“residual interest in the assets of the entity after deducting all its liabilities.”
• On the statement of financial position, there are two additional accounts
to the owner’s equity contributed account:

• Owner’s equity retained: represents profits left in the business by the


owners
• Reserves: represent ‘special purpose’ owners’ equity accounts e.g. ‘Capital
profits reserve’

• Reserves represent ownership interests in the assets, not the assets themselves.
Reserves are not separate deposits of cash available for other purposes

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The accounting equation

• The basic accounting equation is expressed as:

Assets = Liabilities + Owners’ equity (A = L + OE)

• This equation will always hold true, as total claims are always the same as
total assets, ensuring that the balance sheet always ‘balances’
• Trading introduces additional transactions to the statement of financial
position
• To cover the effect of trading, the statement of financial position equation is
extended:

Assets = Owners’ equity beginning


+ Profit (or - Loss)
+/- Other Owners’ Equity Changes
+ Liabilities

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 next 12 months or 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) it expects to realise the asset, intends to sell or consume it in its normal
operating cycle;
a) it holds the asset primarily for the purpose of trading;
b) it expects to realise the asset within twelve months after the reporting period; or
c) The asset is cash or a cash equivalent unless the asset is restricted from being
exchanged or used to settle a liability for at least twelve months after the reporting
period

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Classification of assets

• Non-current assets are those:


• 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’

• 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

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 or one
operating cycle 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 entity’s 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

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Classification of liabilities

• Non-Current liabilities:
• Those amounts due to other parties which are not liable for repayment within
the next 12 months
• Only the period for which the liability is outstanding matters - not the purpose
it is held for

• AASB 101 ‘Presentation of Financial Statements’ requires liabilities to be


classified as non-current if they do not satisfy any of the criteria for being
classified as current
• 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

Classification of owners’ equity

• Owners’ equity is normally classified in three separate categories:


1) Owners’ equity contributed
2) Reserves
3) Retained profit
• It is common to combine categories 2 and 3 into ‘reserves’ with sub-
categories (a) retained profits and (b) other reserves

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Format of the statement of financial position

Formats for statements of financial position

› Two choices within narrative (vertical) format:

› Entity approach › Proprietary approach


Current assets (CA) Current assets (CA)
+ Non-current assets (NCA) + Non-current assets (NCA)
= – Current liabilities (CL)
Current liabilities (CL) – Non-current liabilities (NCL)
+ Non-current liabilities (NCL) = Owners’ equity (OE)
+ Owners’ equity (OE)

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Factors influencing the form and content of the financial


reports

Conventional accounting practice


› Accounting is based on a number of conventions—rules that have
been devised over time in order to deal with practical problems
experienced by preparers and users of financial reports.
• The principles, assumptions or accepted ideas on which
accounting rules, records and reports were or are based.
• Known as GAAP (generally accepted accounting
principles).

Lecture Example

› Let’s revisit the lecture example we covered in Weeks 3 and 4 (Please


bring this with you to lectures)

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Factors influencing the form and content of the financial


reports

Conventional accounting practice (cont’d)


› Business entity convention holds that, for accounting purposes, the
business and its owner(s) are treated as quite separate and distinct.
› Historic cost convention holds that assets should be recorded at
their historic (acquisition) cost.
› Prudence convention holds that financial reports should err on the
side of caution, effectively anticipating losses and only recognising
profits when they are realised.
› Going concern (or continuity) convention holds that the business
will continue operations for the foreseeable future, i.e. there is no
intention or need to liquidate the business.

Factors influencing the form and content of the financial


reports

Conventional accounting practice (cont’d)


› Dual aspect convention holds that each financial transaction has two
aspects and that each aspect must be recorded in the financial
statements
› Money measurement convention holds that accounting should only
deal with those items which are capable of being expressed in
monetary terms
› Stable monetary unit convention holds that money, which is the unit
of measurement in accounting, will not change in value over time.

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Factors influencing the form and content of the financial


reports

Valuing assets
› Non-current assets have lives that are either finite or indefinite
› Non-current assets with finite lives are used up over time, and their
cost is recognised as an expense in each period (depreciation or
amortisation)
› Non-current assets with indefinite lives may, or may not, be used up
over time, and are not subject to routine annual depreciation over
time.

Factors influencing the form and content of the financial


reports

Valuing assets (cont’d)


› Fair values are alternative method for recording non-current assets,
provided these values can be measured reliably.
› Fair values mean the current market values, i.e. the exchange values
in an arm’s length transaction.
› Revaluations can be used only where there is an active market,
thereby permitting fair values to be properly determined.
› Intangible assets are seldom revalued to fair values because active
markets for them do not exist.

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Factors influencing the form and content of the


financial reports (cont’d)
Valuing assets (cont’d)
› When a non-current asset suffers a significant fall in value, this fall in
value may lead to the carrying amount of the asset being higher than
the amount that could be recovered from the asset through its
continued use or through its sale
› This fall could be caused by changes in market conditions,
technological obsolescence, and so on
› The asset value is impaired
› Impairment is the amount of loss that must be written-off for an asset
in the situation where the carrying amount of the asset exceeds its
recoverable amount
› Impairment also applies to current assets such as inventories.

Factors influencing the form and content of the


statement of financial position

› Conceptual framework
• Represents a logical theoretical structure to support and direct accounting
practice
• Major implications:
• SAC1: Definition of the Reporting Entity
• SAC2: Objective of General Purpose Financial Reporting
• AASB Framework: Qualitative Characteristics of Financial Information
• AASB Framework: Definition and Recognition of the Elements of Financial
Statements
• Conceptual Framework for Financial Reporting 2010
• Adopted in 2010
• Lists two fundamental qualitative characteristics of useful financial
information:
• Relevance and faithful representation
• Comparability, verifiability, timeliness and understandability

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Usefulness of the statement of financial position

› It provides insights about how the business is financed and how its
funds are deployed
› It provides insights into the liquidity of the business
› It can provide a basis for assessing the value of the business
› It provides a means of assessing relationships between assets and
claims
› It provides insights into the ‘mix’ of assets held by the business
› It can help users in assessing performance.

Statement of financial position deficiencies


› Potential conflicts within GAAP; for example, the monetary unit is not
always stable and GAAP does not take fluctuations in exchange rates
or inflation into account
› The use of judgement and the requirement to make estimates or
guesses about future events; for example, uncollectable accounts,
sales returns, useful lives of assets
› The wide range of methods which are equally acceptable under GAAP
but which result in different financial statement figures; for example,
inventory costing and asset depreciation methods.
› Non-Financial Information?

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Summary
When you have completed your study of this chapter, you should be able to:
1) Explain the nature and purpose of the statement of financial position
(balance sheet) and its component parts.
2) Explain the accounting equation, and use it to build up a statement of
financial position at the end of a period.
3) Classify assets and claims.
4) Apply the different possible formats for the statement of financial position.
5) Identify the main factors that influence the content and values in a
statement of financial position.
6) Explain the main ways in which the statement of financial position can be
useful for users of accounting information.
7) Identify the main deficiencies or limitations in the statement of financial
position.

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