Measuring and reporting

financial position

Chapter 2
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 limitations of the balance sheet in portraying

the financial position of a business.
The major financial statements – an overview

Cash flow statement

Income statement

Balance sheet
 The major financial statements:
There are three major financial statements
• the cash flow statement,
• the income statement (profit and loss account) and
• the balance sheet (statement of financial position).
• The cash flow statement shows the cash
movements over a particular period.
• The income statement shows the wealth (profit)
generated over a particular period.
• The balance sheet shows the accumulated wealth at
a particular point in time.
 The relationship between the major financial statement

Statement of Statement of Statement of

financial position financial position financial position

Income statement Income statement

Statement of cash Statement of cash

flows flows

Period 1 Period 2 Time

Figure 2.1 The relationship between the major financial statements

 The balance sheet
• The balance sheet shows the financial
position of the company at a particular
moment in time
• This sets out the assets of the business, on
the one hand, and the claims against those
assets, on the other.
• Assets are resources of the business that
have certain characteristics, such as the
ability to provide future benefits.
 The balance sheet
• Claims (obligations) are obligations on the
part of the business to provide cash, or some
other benefit, to outside parties.
• Claims are of two types – capital and
liabilities.
• Capital represents the owner’s claim and
liabilities represent the claims of others,
apart from the owner.
 Assets

Major characteristics

A probable future benefit exists.

The business has an exclusive right

to control the benefit.

The benefit must arise from some past

transaction or event.

The asset must be capable of

measurement in monetary terms.
 Classification of assets and
liabilities:
• Assets are normally categorised as being
current or non-current.
• Current assets are cash or near cash or are
held for sale or consumption in the
• Normal course of business, or for trading, or
for the short term.
• Non-current assets are assets that are not
current assets. They are normally held for
– the long-term operations of the business.
The classification of assets

The classification of assets

may vary according to the
nature of the business:

Current assets

Non-current assets.
 Examples of Assets
• Non current assets
– Land and buildings, Property
– Plant and equipment
– Fixtures and fittings
– Computer Equipment
– Motor vehicles
• Current Assets
– Stock
– Trade Receivables (Debtors)
– Bank/Cash
The circulating nature of current assets

Inventories

Cash Receivables
 Classification liabilities:
• A liability is an obligation on the part of the
business to provide cash, or some other form
of benefit, to an outside party
• 2 main types, capital and Liabilities
• Capital. This represents the claim of the
owner/s against the business.
• Also known as owner’s equity
• Liabilities . Represents the claims of all other
individuals and organisations. They have
arisen from a past transaction such as
supplying goods or services
 Liabilities

There are essentially two types of

claim against
a business:

Capital

Liabilities.
 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
 Classification of assets and
liabilities:
• Liabilities are normally categorised as being
current or non-current liabilities.
• Current liabilities represent amounts due in
the normal course of the business’s
• Operating cycle, or are held for trading, or
are to be settled within 12 months, or
• Cannot be deferred for at least 12 months
after the end of the reporting period.
• Non-current liabilities represent amounts
due that are not current liabilities.
 The accounting equation

Assets = Equity + Liabilities

 The effect of trading transactions on the
accounting equation

The accounting equation can be extended as follows:

Profit
Assets = Equity + (−) (Loss) + Liabilities
 Balance sheet layouts:
• The horizontal layout sets out the assets on
one side of the balance sheet and the capital
and liabilities on the other side.
• The vertical layout begins with the assets at
the top of the balance sheet and places
Capital and liabilities underneath.
 Brie Manufacturing
Statement of financial position as at 31 December 2012
£000
ASSETS
Non-current assets
Property 45
Plant and equipment 30
Motor vans 19
94
Current assets
Inventories 23
Trade receivables 18
Cash at bank 12
53
Total assets 147
 Brie Manufacturing
Statement of financial position as at 31 December 2012
(Continued)

£000
EQUITY AND LIABILITIES
Equity 60
Non-current liabilities
Long-term borrowings 50
Current liabilities
Trade payables 37
Total equity and liabilities 147
 Balance Sheet and Time
• It is a statement of the financial position of
the business at a specific point in time
• Described as a photograph at a particular
moment in time
• In a lot of cases, companies will prepare their
accounts for 12 months, ending on the 31st of
December in line with the calendar year
 Accounting conventions influencing the statement of
financial position

Business Statement Dual

entity of financial aspect
convention position convention

Historic Going
Prudence
cost concern
convention
convention convention

Figure 2.4 Accounting conventions influencing the statement of financial position

 Accounting conventions:
• Accounting conventions are the rules of
accounting that have evolved to deal with
practical problems experienced by those
preparing financial statements.
• The main conventions relating to the balance
sheet include business entity, historic cost,
prudence, going concern and dual aspect.
 Business Entity Convention
• Business and owners treated as owners are
treated as being separate and distinct
• For limited companies
 Historic Cost Convention
• This convention holds the value that the
assets shown on the balance sheet should be
based on their historic cost (acquisition cost)
• Original invoice value
• Disadvantage – outdated information
 Prudence Convention
• The prudence convention holds that caution
should be exercised when making
accounting judgements
• Uncertainty about the future is dealt with by
recording all losses at once and in full
• Profits on the other hand, are only
recognised when they actually arise
 Going Concern
• The going concern convention holds that the
financial statements should be prepared on
the assumption that the business will
continue operations for the foreseeable
future
• In the case of liquidation the balance sheet
should be prepared taking this into account
 Money measurement
• Using money as the unit of measurement
limits the scope of the balance sheet.
• Certain resources such as goodwill, product
brands and human resources are difficult to
measure. An ‘arm’s-length transaction’ is
normally required before such assets can be
reliably measured and reported on the
balance sheet.
• Money is not a stable unit of measurement –
it changes in value over time.
Money measurement

Key measurement problems:

Goodwill and brands

Human resources

Monetary stability
 Intangible Assets
• Goodwill and Brands
• Examples include patents, trademarks,
copyrights and licences
• Goodwill is often used to cover various
attributes such as the quality of the products,
the skills of employees and the relationship
with customers
 Asset valuation:
• The ‘benchmark treatment’ is to show
property, plant and equipment at historic
cost less any amounts written off for
depreciation. However, fair values may be
used rather than depreciated cost.
• The ‘benchmark treatment’ for intangible
non-current assets is to show the items at
historic cost. Only assets with a finite life will
be amortised (depreciated) and fair values
will rarely be used.
 Asset valuation:
• Where the recoverable amount from tangible
non-current assets is below their carrying
amount, this lower amount is reflected in the
balance sheet.
• Inventories are shown at the lower of cost or
net realisable value.
Uses of the statement of financial position

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