lecture 2: statement of financial position/income statement

statement of financial position

• Aka balance sheet
• Provides a “snapshot” of financial position at a point in time
• Key components:
▪ Assets: resources held by the company
▪ Liabilities: what the company owes to parties apart from the owner(s)
▪ Equity: what is left for the owner(s) after liabilities are settled
• The accounting equation:
Assets = Equity + Liabilities


Assets

An asset is a resource held by a business. To be included in the SoFP as an asset, a resource must possess all of these characteristics:
▪ Being an economic resource
▪ Under the control of the business
▪ Can be measured in monetary terms

Money measurement

  • Some economic resources cannot be faithfully measured in monetary terms and thus,
    cannot be recognised as assets on the SoFP.

  • For example:
    • Human resources (except in certain limited circumstances, such as football
    clubs)
    • Internally generated goodwill (e.g., a reputation for high-quality products, good
    customer relationships)
    • Internally generated product brands (e.g., brand image, trademark)


Classification of assets

  • Assets can be categorised as either current or non-current.


current assets

  • Definition: short-term held assets, which meet any of the following conditions:
    ❖ Held for sale/consumption during normal operating cycle
    ❖ Expected to be sold within a year after the date of the relevant SoFP
    ❖ Held for trading
    ❖ Cash or near cash such as easily marketable, short-term investments

  • Examples: inventories, trade receivables (amounts owed by customers for goods or
    services supplied on credit), and cash

  • the circulating nature of current assets:


Non-current assets

  • Definition: long-term held assets which do not qualify as current assets
    • Aka fixed assets
    • May be tangible (i.e., physical) or intangible (i.e., nonphysical)

  • Examples:


current vs non-current

  • The classification depends on the nature of the asset and the business.
    For example, a motor van retailer will normally hold inventories of the motor vans for
    sale; it would, therefore, classify them as part of the current assets. However, a
    business that buys one of these vans to use for delivering goods to customers (that
    is, as part of its long-term operations) would classify it as a non-current asset.

Equity and Liabilities

A claim is an obligation to provide cash, or some form of benefit, to an outside party.
There are two types of claim against a business:
▪ Equity: the claim of owner(s). Note that a business is viewed as being separate
from its owner(s) for accounting purposes.
▪ Liabilities: the claim of other parties, apart from the owner(s). They involve an
obligation to transfer economic resources (usually cash) as a result of past
transactions or events.

classification of equity


classification of Liabilities

Liabilities can be categorised as either current or non-current.

current Liabilities:

Definition: amounts due for settlement in the short term, which meet any of
the following conditions:
❖ Expected to be settled within the business’s normal operating cycle (e.g.,
accrued salaries)
❖ Exist primarily as a result of trading (e.g., trade payables)
❖ Due to be settled within a year after the date of the relevant SoFP (e.g.,
bank overdrafts)
❖ No right to defer settlement beyond a year after the date of the relevant
SoFP (e.g., a bank loan that must be repaid within 12 months)

Non-current Liabilities

  • Definition: amounts due that do not meet the definition of current liabilities
    ▪ Example: long-term loans (borrowings from banks or other financial institutions
    where the repayment is due over a period longer than one year)

statement of financial position

why is the SoFP useful?

  • Assessing overall financial health

  • Showing how the business is financed and how its funds are deployed

  • Providing a basis for valuing the business

Accounting conventions influencing the SoFP

  • Business entity convention (not the same as “limited liability”!)
    • Treats business and owners as distinct entities for accounting purposes
    • Ensures clear financial assessment, irrespective of legal business form

  • Historic cost convention
    • Values assets based on historic cost (i.e., acquisition cost)
    • Reliable but may not reflect current market values
    Prudence convention
    • Advocates caution in financial reporting
    • Aims to prevent overstatement or understatement of financial strength

  • Going concern convention
    • Assumes business will operate in foreseeable future
    • Important for asset valuation in financial difficulties

  • Dual aspect convention
    • Recognises that each transaction affects the business in at least two aspects
    • Ensures that the SoFP will continue to balance


Income statement

  • Aka profit and loss account

  • Measures financial performance of a business over a period

Key components:
▪ Revenue: income generated from sales of goods or services
▪ Expenses: costs incurred to generate the revenue
• Equation:
Revenue – Expenses = Profit (or loss)

Why is the income statement useful?

the income statement shows:

  • How effective the business has been in generating wealth

  • How profit was derived

Revenue

  • Aka sales, sales revenue, turnover

  • Definition: income generated from sales of goods or services

  • Example: a smartphone retailer has sold 100 smartphones at a price of £500 each
    during the period.
    Revenue = 100 Smartphones Sold x £500 per Smartphone = £50,000


Revenue recognition

  • Accruals convention: revenue is recognised when earned (i.e., control of the
    goods/services is transferred to the customer), regardless of when cash is received.

  • Revenue is NOT the same as cash received!
    ▪ Cash sales: sales is recognised when cash is received
    ▪ E.g., you buy a coffee at Caffè Nero for £3, paying cash at the counter. Caffè Nero
    recognises the £3 as revenue when the coffee is handed over to you.
    ▪ Credit sales: sales is recognised before cash is received
    ▪ E.g., Caffè Nero orders coffee beans from a supplier worth £1,000. The supplier
    delivers the beans today but allows Caffè Nero to pay in 30 days (credit terms). The
    supplier recognises the £1,000 as revenue today as the control of the coffee beans
    has been transferred to Caffè Nero, even though the payment will be received later.


Expense recognition

  • Accruals convention: expenses are recognised when incurred, regardless of when cash
    is paid.

  • Expenses are NOT the same as cash paid!

  • Example: Electricity Bill
    Caffè Nero receives its electricity bill for December 2024 for £500, but the payment is
    not due until end of January 2025. Even though the payment will be made in January,
    the £500 expense is recorded in December 2024 because that is when the electricity
    was used (the expense was incurred).

cost of sales

  • Aka cost of goods sold

  • Definition: cost of goods that are sold during the period

  • Some goods bought during the period may remain as inventories at the end of the
    period.

  • In some businesses, the cost of sales for each individual item is identified at the time of
    sale; however, this is not practical for many businesses.

  • Calculation of CoS:
    Cost of Sales = Opening Inzventories + Purchases – Closing Inventories

  • these are sometimes shown directly on the income statement

  • Matching convention: expenses should be matched to the revenue that they helped
    to generate.
    • Example below: the cost of sales was the cost of inventories that were sold, not the
    whole cost of inventories that were available for sale during the period.



accruals accounting

Profit = Revenue – Expenses
(not Cash Receipts – Cash Payments)