BUACC5901

Lecture Topic 6: The Balance sheet

Lecture Topic 7: The Income statement

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 TOPIC 6: THE BALANCE SHEET
• Learning objectives
• At the completion of this lecture, students should:
• Understand that the balance sheet is a representation of
the accounting equation of assets = liabilities + equity
• Understand the classification of assets and liabilities into
‘current’ and ‘non-current’ categories and appreciate the
significance of this.
• Have a broad comprehension of issues associated with the
valuation of assets for financial reporting purposes, and a
more detailed understanding of accounting practice
pertaining to the valuation of inventories and the
depreciation of non-current assets.
• Be aware of how the balance sheet may inform the decision
making processes and accountability evaluations of
financial report users.
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 HISTORICAL BACKGROUND
• The balance sheet (also sometimes called the
statement of financial position) is a formal
statement form, of the accounting equation.
• It is a static statement, showing a ‘snapshot’
of an entity at a particular date (hence the
balance sheet is headed ‘as at [date])’.

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 HISTORICAL BACKGROUND
• The balance sheet was the first of the financial
statements required to be prepared for companies,
with the United Kingdom Joint Stock Companies Act
of 1844 requiring companies to prepare a ‘full and
fair’ balance sheet. The requirement for an income
statement or statement of financial performance (to
be covered in Topic 7) came much later, and the
requirement for a statement of cash flows (to be
covered in Topic 8) much later still. The balance
sheet, then, was the foundation for company financial
reporting.

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 Classification of assets and liabilities
• Assets have been described as resources
expected to provide future economic benefits.
• When preparing a balance sheet it is usual to
classify the assets according to when the future
benefits are expected to be received.
• Assets which are expected to be used up or converted
to cash within one year of the statement date or
within one ‘accounting cycle’ (that is, assets with
short-term economic benefits) are classified as
current assets.
• The remaining assets (that is those with longer term
benefits) are classified as non-current assets.

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 Classification of assets and liabilities
• A similar approach is used to classify
liabilities.
• Liabilities that are payable within one year of
the statement date or within one ‘accounting
cycle’ are classified as current liabilities.
• The remaining liabilities (that is, those of a
longer term nature, such as long term
borrowings) are classified as non-current
liabilities.

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 Format and presentation of the
Balance Sheet
• Can be presented in either the ‘T’ (Horizontal)
format or narrative (Vertical) format
• Comparative statements from previous years
often used
• Parent (controller) and consolidated (for the
group) company statements (plus comparisons)
often reported

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 Valuation issues
• The basis upon which assets are valued for reporting
in the balance sheet is of obvious importance. There
are a number of theoretical possibilities, particularly
for physical assets such as equipment, land and
buildings.
• Four methods are outlined in the following
discussion:
• historical cost,
• current replacement cost,
• market value, and
• Present (economic) value.
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 Valuation issues
• Historical (or original) cost
• Under this method an asset is valued on the basis of its
acquisition price.
• The obvious limitation with this method is that costs
can very quickly become out of date information.
• For example, knowing that a vehicle was purchased four
years ago for $10,000 does not shed much light on the
present financial circumstances of the entity that bought it.
• However, supporters of the historical cost method
typically argue that the method is ‘reliable’ as it uses
actual transaction values.

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 Valuation issues
• Current replacement cost
• This method uses the current cost of the asset rather than the
historical or original cost.
• There are two approaches that could be used here. One would be
to find out the current cost of a similar asset in similar condition.
A second would be to find out the current cost of a new asset of
the same or similar specifications and then make some adjustment
for the existing asset being partly ‘used up’.
• Obviously there may be difficulties in determining the current
replacement cost of particular assets;
• for example, custom made machinery.
• Also some critics of this method contend that current
replacement cost only provides useful information when there
is an intention to replace an asset with an identical kind of
asset.
• Particularly in technology dynamic industries, this is perhaps the
exception rather than the norm.
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 Valuation issues
• Market value or net realisable value
• Under this method an asset is valued at the amount of
cash it could be converted to by selling it.
• When the term ‘net realisable value’ is used it implies
that any costs that would be incurred in selling the
asset (for example, delivery to the buyer) would need
to be deducted.
• Critics of this method of valuation suggest that it
ignores the concept of ‘value in use’ that is relevant
for many assets. Also, it may sometimes be difficult
to ascertain the market value of some specialised
assets.

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 Valuation issues
• Present (Economic) value
• This is a more theoretical approach to valuing
assets. It involves trying to value the future
benefits an asset is expected to provide by
estimating its future cash flows. These would
then be ‘discounted’ to take account of the
fact that they would not be received until
some time in the future (this will be
considered in more detail later in this unit).
• The main deficiency of this method is that it is
likely to be very subjective.

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 Valuation issues
• How then do accountants value assets?
• The answer is that accounting practice is not
currently guided by any single theory of asset
valuation. Rather, a variety of methods are used
(including all of those listed above). The
historical cost method has traditionally been the
main method employed, but there is now a current
trend towards the use of ‘fair values’ (typically
based on market values).

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 Valuation issues
• ‘Recoverable amount’ test
• Where assets are ‘over valued’ it creates a particular
danger for financial report users. To guard against
this, an accounting standard (AASB 136 ‘Impairment
of Assets’) provides that where the ‘recoverable
amount’ of a non-current asset is less than the asset’s
carrying amount (that is, the amount at which it would
otherwise be reported in the balance sheet), the asset
must be ‘written down’ (reduced) to its ‘recoverable
amount’. Recoverable amount is defined as the higher
of the asset’s net selling price and its value in use.
Asset write-downs to ‘recoverable amount’ are
described as ‘impairments’.

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 Assets & Depreciation
• Assets are characterised by ‘future economic benefits’, but for
many non-current assets these benefits are gradually
consumed or used up over time due to the effects of wear and
tear and/or obsolescence. This of course implies that many
non-current assets gradually become expenses (remember that
expenses are associated with decreases in economic benefits).
In contemporary accounting practice this expense is called
depreciation.
• Conceptually, depreciation is not different from other
expenses. Just as rent paid one year in advance is an asset that
gradually becomes an expense (with the passing of time) the
same is true of many non-current assets that must be expensed
(depreciated) as their benefits are gradually used up or
consumed.

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 Assets & Depreciation
• Some issues in Calculation & Recording
• Calculation
• Cost
• Useful life
• Residual value
• Depreciable Value
• Methods
• Recording
• Depreciation Expense (in Income Statement)
• Accumulated Depreciation (Presented as a ‘Contra’
Asset in the Balance Sheet)
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 Inventory valuation
There are two cost flow assumptions
permitted by Australian Accounting
Standards:
1. FIFO (first in first out)
2. Weighted average

LIFO (last in first out) is not allowed in

Australia but it is used in USA

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 Limitations of the Balance Sheet
1. Asset, Liability and Equity values are at a particular point
in time only
(these values would have been different yesterday and
will be different tomorrow)
2. The entity’s value is not really reflected due to:
• Items that generate future benefits or involve future
sacrifices not satisfying definition/recognition criteria
• Eg Human Resources
• The historical nature (or combinations of cost and fair
values) of the balance sheet
3. Preparing a Balance Sheet involves:
• management choices
• judgements
• estimations
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 TOPIC 7:Income Statement & Statement of
Changes in Owner’s Equity
• Learning objectives
• At the completion of this lecture, students should:
• Understand that the income statement summarises
changes in equity resulting from an entity’s operations
during an accounting period.
• Understand the format of the income statement.
• Appreciate the often subjective nature of the calculations
and estimates involved in the determination of profit.
• Be aware of how the income statement may inform the
decision making processes and accountability evaluations
of financial report users.
• Understand the format and purpose of the statement of
changes in equity.

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 BASIC CONCEPTS
• The following concepts form the basis for the
preparation and presentation of the Income
Statement
• Going Concern
• Accounting Period Concept
• Recognition of Revenue & Expenses
• Accrual or Cash Accounting
• Matching Principle
• Profit(2008)=Revenue(2008) – Expenses(2008)
• Adjusting entries
• Prepayments & Accruals
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 Calculation of Cost of Sales
• Under Perpetual System
• Already determined by Accounts
• Under Periodic system
Cost of sales
= Inventory at beginning of period
+ net purchases
– Inventory at end of period

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 PRESENTATION
• REPORTING ENTITIES
• An accounting standard (AASB) exists that prescribes
the form and content of the income statement for
reporting entities.
Entities must disclose any item that is material (an
item is material if it could influence a decision by
users)
1. Revenue and expenses from ordinary activities
2. Finance costs
3. Share of profit or loss of associates and joint ventures
if equity accounted
4. Tax expense
5. Profit or loss
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 Presentation
• Non Reporting Entities
There is no prescribed reporting format for
statements of financial performance prepared
by non-reporting entities.

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 Profit (earnings) can be measured at various
levels
Gross profit – i.e. income less cost of sales
• Net profit – i.e. gross profit less all other operating
expenses
• Profit pre and post tax
• Earnings before interest
• Profit before and after material items
• Profit including and excluding discontinued operations
• Earnings before interest and tax (EBIT)
• Earnings before interest, tax and depreciation and
amortisation (EBITDA)

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 The statement of changes in equity
• Required by all reporting entities
• The statement details the changes in equity from the
beginning to the end of the reporting period
• The essential purpose of the statement is to provide a
comprehensive summary of all changes in equity,
including those not included in the income statement.
• It shows:
• Income and expenses as per the income statement
• Income and expenses recognised directly in equity (e.g. non
current asset revaluations)
• Transactions with equity holders as equity holders (e.g.
shares repurchased, dividends paid)
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 Link between IS, Statement of changes in Equity
and BS
• The Income Statement presents the profit (or loss) made by
the entity over the accounting or reporting period.
• The Statement of Changes in equity explains the changes in
equity from the beginning to end of the reporting period
• The Balance Sheet shows the financial position of the entity
as at the end of the reporting period.
• The profit (loss) for the reporting period is added to the
retained profits as at the start of the period.
• The entity can make distributions from (i.e. dividends) and
transfers to/from retained profits.
• The balance of the retained profits as at the end of the
reporting period is included as an equity item in the Balance
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