FUNDAMENTALS OF ACCOUNTANCY, BUSINESS, AND MANAGEMENT 2

CHAPTER 1: THE STATEMENT OF FINANCIAL POSITION

A Snapshot of the Financial Position

The Balance Sheet is divided into two parts (Figure 1). The assets are on one side and
the claims are on the other side. Claims of creditors are called liabilities while claims of owners
are referred to as equity. The total assets should equal the total of the claims. Hence, the
statement was endearingly referred to as Balance Sheet because it is a statement where the
two parts must balance.

Elements of the Statement of Financial Position

The SFP is a report based on the accounting equation: Assets = Liabilities +

(Owners’) Equity or known as ALOE. It was once called a Balance Sheet because the sum of
the assets should be “balanced” to the sum of the liabilities and equity. The SFP is “balanced”
as a consequence of a double-entry accounting.

On one side of the SFP are assets. Assets are resources with future benefits that are
within the control of the company. The asset should be useful to the company in the future.
Control means that the company can prevent others from benefiting from the asset. To
appreciate this, we will analyse how cash, a known asset, met this definition.

On the other side of the SFP are the claims. Liabilities and equity are sources of
financing. Liabilities are the claims of creditors while equity represents claims of owners.
Creditors require payments of principal and interest. Owners, on the other hand, are not
required to be repaid for their investment in the company. In the event of the company’s closure,
the owners are entitled to the assets of the company only after all the creditors had been paid.

Assets

The assets are resources with future benefits that are within control of the company.
Resources are classified into asset accounts based on its future use to the company. There are
many kinds of assets.

These are the following assets:

1. Cash
2. Receivables
3. Inventory
4. Prepaid Expenses
5. Property, Plant, and Equipment
6. Intangible Assets

Cash

Cash is the most well-known asset class first. Cash is money owned by the company.
Cash kept in the company’s premises is called cash on hand. Cash in bank refers to money in
the bank which can be kept in a savings or checking account. Generally, time deposit is not
categorized as cash.

Cash refers only to funds readily available to be spent for the company’s operations. It is
used for buying assets, paying suppliers, utilities, employee salaries and others. It is also used
for settlement of obligations. On the other hand, cash are sourced from contribution of owners,
proceeds from borrowings, sale of assets or collections from customers.

Cash in hand include bills, coins and bank checks kept in the premises of the company.
Bank checks, or checks, are bank documents used by the issuer to instruct the bank to pay the
assigned payee from funds in the issuer’s bank account. Checks maybe reported as part of
cash because these documents are accepted as payments and deposits. A check is classified
as cash if the date of the check is on or before the SFP date. A check dated after the SFP date
is a post-dated check and is classified as receivable rather than cash.

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Not all bank deposits are classified as cash. Some accounts are not readily available for
use such as a time deposit account. A time deposit account is a deposit in the bank that earns
higher interest because the depositor commits not to withdraw the funds over the agreed upon
time. Penalties are imposed if the depositor withdraws before the maturity of the deposit. Given
the withdrawal restrictions, time deposits are not classified as cash. Those with a term of up to
90 days are reported as cash equivalents while those that will mature longer than 90 days are
reported as investments.

Cash equivalents are technically not cash because it is not immediately available for
use. It is almost cash in the sense that it will become cash within the next 90 days. Time
deposits with term maturities of ninety days or less are examples of cash equivalents. It is
generally reported on the SFP together with cash. The line account is cash and cash
equivalents. However, the components of cash and cash equivalents (cash on hand, cash in
bank, cash equivalents) are required to be disclosed in the accompanying notes to financial
statements.

Receivables

Receivables is a general term that refers to the company’s right to collect or claim
payment. The right to collect comes from unpaid sales or lending activities. Generally, the
company collects cash from its receivables. There are also receivables that maybe settled in
other assets or services. For example, receivable from suppliers maybe settled in merchandise.

A sale agreement may require a customer to pay the seller immediately upon delivery of
goods. This is called cash on delivery (COD). In contrast to COD, a customer may instead
promise to pay the seller at some future time after delivery. This is a credit sales agreement and
it gives rise to Accounts Receivable. Normally referred to as AR, this account means receivable
from customers. It is evidenced by sales invoices and delivery receipts. Accounts receivable
normally has a term of 30 days which means a customer should pay 30 days from date of
delivery. Some sellers are more lenient and give terms of 60, 90 and 180 days.

Notes receivable is another kind of receivable. It is evidenced by promissory notes (PN).

PN is a legal document that says the borrower promises to pay, on scheduled payment dates, a
specific sum called the principal and interest based on principal and stated interest rate.
Customers who are unable to pay their accounts on due dates are sometimes required to sign a
PN. The company may also lend money to its employees or other companies if the company
has excess cash.

Inventory

The inventory account reports the cost of unsold merchandise. The inventory account of
a trading business contains merchandise held for resale. A manufacturing company will have
more complex inventories composed of raw materials, unfinished inventories in the middle of
the manufacturing process (may also be called work in process), and unsold finished goods.

Consignment is an important issue in inventory accounting. The owner places his goods
”on-consignment” in the premises of the store owner. The store is not obligated to purchase the
goods. The owner may also withdraw his unsold goods from the store at any time. The store
owner, on the other hand, will remit to the merchandise owner to proceeds from the sale of the
consigned items. The store owner’s income from this transaction maybe in the form of
commissions from the sale and/rent from the store space used to display the consigned goods.
The store should not report the consigned goods as inventory even if they are held in the store
premises. Rather, the consigned merchandise will be reported as inventory by the merchandise
owner.

Only merchandise held for sale are reported as Inventory. Those items that are to be
used in the day to day activities of the company are Supplies and not Inventory. For example, a
convenience store sells ballpoint pens. The owner also uses ballpoint pens in recording
transactions in the store’s accounting records. By definition, only those ballpoint pens for

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reselling are reported as Inventory. Those that are to be used in the businesses are classified
as Supplies.

Prepaid Expenses

Prepaid Expenses refer to future expenses that the company had paid for in advance. It
is placed in this account until the services or items are used and become expenses. Expenses
are recorded only when purchased goods and services are used.

Another kind of prepaid expense is insurance. The insured will pay premium at the
beginning of the contract period and the insurer (insurance company) will reimburse the insured
party for losses of the insured event occur.

Insurance contracts are time based. The buyer of the contract is insured only within the
contract period. This means that the advanced payment of the insured is at first a Prepaid
Expense. It is transferred to expense evenly over the contract period. Also, at the end of the
contract period, the entire advance payment should have been fully transferred to expense such
that the balance of the Prepaid Insurance is zero.

Property, Plant, and Equipment

Property, Plant and Equipment or PPE for short, are long-term assets that are used in
the operations of the company. These are classified as long-term asset (or non-current asset)
because these assets will be used in the business for more than one year.

Examples of such assets classified as PPE are:

Land Building
Warehouse Automobiles
Delivery vehicle Computer equipment
Manufacturing equipment

Only those assets owned and controlled by the company will be reported as PPE.
Rented facilities and equipment are excluded from PPE.

The assets are resources with future benefits for the company. For PPE, such benefits
are to be used for more than one year. The cost of purchasing PPE is not immediately reported
as expense, rather, it is recognized as asset. As the asset is used, a portion of the cost is
transferred to expense. The process of recognizing the asset is called capitalization while
depreciation refers to transferring of cost of asset to expense. Depreciation is linked to usage. It
seems necessary to estimate the pattern of usage in order to compute for depreciation. To
simplify, it is an acceptable assumption in accounting that the asset will be used evenly over its
life. This assumption enables accountants to simply divide the cost of the asset over its useful
life. This is the straight-line method of depreciation. The depreciation will increase the expense
account and decrease the asset account. It is normal accounting practice not to directly
decrease the PPE account. Rather, a contra-asset account called accumulated depreciation is
used to catch the depreciation and decrease the asset value to be reported in the SFP. The cost
of the PPE, net of the balance of accumulated depreciation as of the SFP date is called Net
Book Value of the PPE.

Not all PPEs are subject to depreciation. Land is not depreciated because this asset
does not have a useful life. More so, the value of Land increases with the passage of time.

Intangible Assets

Intangible Assets are long-term assets similar to PPE. These assets will be used in the
business for more than one year. The allocation of the cost of intangible assets to the year it
was used is called amortization. It is computed similar to depreciation such that the cost of the
asset is amortized evenly over its useful life. The main difference between the two assets is that

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intangible assets have no tangible properties. These are assets that you cannot see or touch.
There may be a piece of paper as evidence of the asset but the actual asset is "Intangible."

Some examples of Intangible Assets are patent, brand name and trademark.

A patent is a grant conferred by the government to the creator of an invention, whether

a product or a process, for the sole right to make, use, and sell that invention for a specified
period of time. In recent years, the patent infringement cases between Samsung and Apple
filled the business news.

Brand-name refers to word or words used to identify a specific product and its
manufacturer. Famous brands include Jollibee, McDonalds, Apple, Coca Cola, Samsung, Sony,
and Nike.

Trademark is the symbol that represents the brand. Take the case of the happy red bee
that represents Jollibee, the tall clown: in stripes of McDonalds and the swoosh checkmark of
Nike.

Liabilities

These are obligations that the company is required to pay. Payment for liabilities may be
in cash, goods, or services. Entities to whom the company is indebted are called creditors.

There are many different kinds of liabilities;

1.) Payables
2.) Accrued expenses
3.) Unearned income; and
4.) Long-term liabilities

Payables

The opposite of right to collect is the obligation to pay. Receivables are right to collect
payments from debtors while payables are obligations to make payments to creditors.

There are generally two kinds of payables:

1. Accounts Payable (AP)

2. Notes Payable (NP)

AP normally refers to obligation to the suppliers of inventories. It is evidenced by the

supplier's sales invoices and delivery receipts. Most suppliers give credit terms of 30 to 90 days.
A 30 day credit term means that the company should pay for the purchases 30 days from the
date of delivery. Some suppliers give discounts for early payments. The credit term 2/10, n/30
(reads: two ten net thirty) means payment of full amount is due in 30 days but a 2% discount
may be taken if paid within ten days (after delivery). This kind of credit term encourages debtors
to pay earlier than their due dates.

NP refers to an obligation evidenced by a promissory note. Promissory note (PN) is a

document that expresses the borrower's promise to pay. The issuer of the promissory note
reports this as NP in his accounting books. On the other hand, the holder of the promissory note
has the right to collect and reports NR in his accounting books.

Accrued Expenses

Accrued Expense refers to the unpaid expenses of the company as of the cut-off date of
the Statement of Financial Position.

There are many kinds of accrued expenses such as,

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a. Salaries Payable
b. Utilities Payable
c. Rent Payable
d. Interest Payable

Unearned Income

Customer deposits or down payments are customer payments received before the
delivery of goods or services. These will not count as sales until deliveries are made. These
payments are initially recorded as Unearned Income - a liability payable in goods of services.

Unearned income is a liability. However, unlike regular liability, the settlement of

Unearned income is not through direct cash payments to the customer. Rather, it is settled by
the delivery of goods or rendering of services. The settlement of this liability is dependent on the
contractual agreement between the seller and the buyer. In the case of the tailor, it is job based.
However, some contracts are time based. An example of this is advance rent.

Long-Term Liabilities

Long-term liabilities refer to obligations with due dates that fall more than one year from
the date of the SFP. Bank loan is a common example. It is documented by a promissory note.
The company pays interest periodically. The repayment of the principal is based on the
contractual agreement. It can all be paid at maturity or in instalment over the term of the loan.
Long-term liability is part of the financing activities of the company.

Equity

Equity is the net assets of the business. It is composed of the owners' investments and
the accumulated net income of the company, net of any distributions to the owners. It reflects
the portion of the asset that belongs to the owners of the business.

For a sole proprietorship, the SFP will reflect only one equity account - Owner's Capital.
This one line account reflects all transactions of the business with its owner in his capacity as
the owner. This account will reflect the balance of the owner's investments in the business such
as cash contributions. The net income earned by the company is also closed to the capital
account. While a separate Drawings account may be maintained to follow the withdrawals of the
owners during the year, this too is closed to the capital account at the end of the year.

Presentation of Statement of Financial Position

There are two acceptable format of the SFP- the account form and the report form. The
account form mimics the general ledger T-account format. The assets are reported on the left
and the list of liabilities and equity are on the right. In the account format, the total assets and
the total liabilities and equity are shown side by side to highlight that both totals are equal.

On the other hand, the report form SFP is a simple list. All the assets are listed first,
followed by liabilities and finally the equity account.

A modification in the statement is called the classified Statement of Financial Position.

This means that assets and liabilities are classified as to current or non-current. On the asset
side, assets are classified as current if it can be used or converted to cash within one year.
Examples of current assets are cash, accounts receivable and Inventory. Prepaid Expenses
maybe classified as current if the advance payment is expected to be used within one year. The
classification of notes receivable is dependent on the term of payments on the promissory note.
The payments collectible within one year are as current. Those collectibles after one year are

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reported as non-current. Property, Plant, and Equipment and Intangible Assets are classified as
non-current given their long-term nature.

Liabilities may also be classified in similar terms. Current liabilities are payables due to
be paid within one year of the SFP date. Examples of current liabilities are accounts payable
and accrued expenses. Unearned income is current if the delivery of goods or services for the
settlement of the advance payment is to be made within one year. Similar to notes the
classification of notes payable is dependent on the terms of payment on the promissory note.
Long-term liabilities are generally classified as non-current. If the long term liability is to be
settled in installments, then those scheduled to be paid within twelve months are classified as
current and referred to as current portion of long-term debt. The remaining installments are
reported as non-current

A classified SFP is helpful to the readers of the SFP. Current liabilities are those
obligations that are coming due in the next twelve months. As a result, the readers are
Interested to determine if the company has sufficient current assets to afford the payment of the
liabilities on their scheduled date.

Normal Balances

The account form of Statement of Financial Account is called the account form because
its format was based on the general ledger T-account. The t-account format is not used in actual
business but is a very effective tool in teaching accounting.

Debit and credit refers to the sides of the T-account. A debit entry means that the
amount should be placed on left side of the T-account. A credit entry means that the amount
should be placed on the right side of the T-account.

In summary, asset accounts have debit normal balances and are thus increased by
debits. Liability and equity accounts have credit normal balances and are thus increased by
credits.

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