Download Chapter 3

CHAPTER 3
Measurement concepts and the
balance sheet equation
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Contents
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
Introduction
Company characteristics affecting financial reporting
behaviour
Content of financial statements
The basics of accounting measurement
Generally accepted accounting principles
Conventional measurement bases
Accounting for transactions
The IASB definition and recognition criteria of
elements of the balance sheet and the income
statement
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Introduction –Annual financial
statements
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Single public source of economic company
data
Prime external communication tool and of
interest to all main business partners
Subject to verification by external experts
Starting point for tax assessment
Important device to monitor contracts
Public through mandatory filing and voluntary
disclosure
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© 2005 Peter Walton and Walter Aerts
Key financial statements

Balance sheet and income statement are the key financial
statements




Balance sheet: shows, at a given date, the company’s financial
position: the economic resources (assets) it controls and where its
finance comes from (liabilities and equity)
Income statement: sets out the performance (result) of a
company’s operations for the accounting period
They provide specific, but partial, economic information about a
company’s past activities, drawn up according to a fairly flexible
set of rules
Effective use necessitates knowledge of:
a)
b)
c)
What are the rules?
To what extent are they flexible?
How this impacts upon interpretation of the information.
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© 2005 Peter Walton and Walter Aerts
Company characteristics affecting
financial reporting behaviour


Financial reporting is deeply embedded in a
country’s culture and traditions =>national
accounting rules tend to vary significantly
Additionally, company characteristics will
impact its reporting behaviour, e.g.





Nature of ownership
Managerial objectives
Nature of activity
Legal form
Company size
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Content of financial statements

The core financial reporting process involves
preparing an annual income statement and balance
sheet




Income statement: brings together aggregated information
about a company’s performance during a fiscal year
Balance sheet: shows the state of the company’s financial
position at the end of the fiscal year
The income statement presents ‘flow’-data (covering
a period), while the balance sheet is a status report
(a ‘snapshot’ at a specific moment in time)
They are usually published with comparative data of
the previous year.
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Fig. 3.1 Time periods covered
Balance sheet
31/12/20X1
Balance sheet
31/12/20X2
Income
statement 20X2
Balance sheet
31/12/20X3
Income
statement 20X3
Balance sheet
31/12/20X4
Income
statement 20X4
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© 2005 Peter Walton and Walter Aerts
Company X – Income Statement
of period 20X2
Accomplishments =>
Revenues
less
Efforts
=>
-
Expenses
=>
Profit (or Loss)
equals
Performance
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© 2005 Peter Walton and Walter Aerts
Income statement structure

The income statement can be split into two different
sections:


Operating result (or ‘profit before interest and tax’): result
from the company’s operating activities, irrespective of the
financial structure of the company
Returns to interested parties others than the owners:



Income taxes due to government
Interest on loan finance
‘Profit available for shareholders’ is the residual
return to equity providers


It is the wealth generated by the company during the period
To pay dividend to shareholders or to finance future growth
(auto-financing)
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Income statement presentation 1
Income statement for period 200X
Sales
Raw materials
Salaries and wages
Depreciation
External services
€ ’000
5,356
1,739
783
462
873
(3,857)
Profit before interest and tax
1,499
Interest
(362)
Profit before taxation
1,137
Taxation
(384)
Profit available for shareholders
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753
Operating expenses

Two formats to present operating expenses:

Value-added approach




Shows inputs and outputs and enables one to calculate
the value added by the company
Operating expenses are presented by their nature
Most common in Europe
Functional approach


Presentation by type of activity to which the operating
expense was assigned
More common in UK and US
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© 2005 Peter Walton and Walter Aerts
Income statement presentation 2
Income statement for period 200X
€ ’000
Sales
Cost of sales
5,356
(2,601)
2,755
Distribution costs
Administrative expenses
382
874
(1256)
Profit before interest and tax
1,499
Interest
(362)
Profit before taxation
1,137
Taxation
(384)
Profit available for shareholders
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© 2005 Peter Walton and Walter Aerts
753
Operating expenses by
nature or function
Nature
Function
€ ’000
Raw materials
Salaries and wages
1,739
783
Depreciation
Other costs
Total
462
873
3,857
€ ’000
Cost of sales
Distribution costs
Administrative
expenses
2,601
382
Total
3,857
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© 2005 Peter Walton and Walter Aerts
874
Allocation of input costs
Function:
Cost of sales
Distribution
costs
Administrative
expenses
Salaries and
wages
Factory
employees
Sales agents
Accountants
Depreciation
Production hall
Cars
Administration
buildings
Input costs:
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© 2005 Peter Walton and Walter Aerts
Balance sheet structure


A balance sheet presents a picture of the
company’s finances at the end of the financial
year, and the assets which it has acquired
and which have not yet been consumed
within the business
A balance sheet can be presented according
to two basic formats:


Horizontal balance sheet
Vertical balance sheet
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© 2005 Peter Walton and Walter Aerts
Company X – Balance sheet
at 31 December 20X2
Resources
=
Assets
=
Sources of finance
“Equities”
Owners’equity
(interests of owners)
Liabilities
(interests of
creditors)
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© 2005 Peter Walton and Walter Aerts
Horizontal balance sheet
Fourth EC Accounting Directive
Liabilities and equity
Assets
Intangible assets
Tangible assets
Investments
Fixed Assets
Stocks
Debtors
Cash at bank
Deferred charges
Total
943
1,988
213
3,144
Ordinary shares
Reserves
Retained profit
1,589
973
881
176
Provisions
Financial liabilities
Trade liabilities
6,763
Shareholders’ equity
Total
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© 2005 Peter Walton and Walter Aerts
2,455
982
947
4,384
520
1,500
359
6,763
Horizontal balance sheet
US format
Assets
Liabilities and equity
Cash at bank
Deferred charges
Receivables
Inventory
881
176
973
1,589
Trade payables
Debt
Provisions
Investments
Tangible assets
Intangible assets
213
1,988
943
Ordinary stock
Reserves
Retained profit
Fixed assets:
Total
6,763
Equity
Total
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© 2005 Peter Walton and Walter Aerts
359
1,500
520
2,455
982
947
6,763
Horizontal balance sheet

Left-hand side - the assets:

Fixed assets: used over a period of more than one
year




Tangible assets (e.g. physical plant and machinery)
Intangible assets (patents, brand names, licences)
Investments (shares of and loans to other companies)
Other (current) assets: constantly changing during
accounting period



Inventories
Receivables (amount due from customers)
Cash
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© 2005 Peter Walton and Walter Aerts
Horizontal balance sheet (cont.)

Right-hand side - the financing:
 Share
capital: put into the company by the
owners
 Provisions: a liability to pay in the future,
but amount or timing is uncertain
 Financial Liabilities: loans made by banks
and financial markets
 Trade liabilities: debts due to suppliers
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© 2005 Peter Walton and Walter Aerts
Company X – Balance sheet
at 31 December 20X2
-
Assets
Liabilities
Owners’equity
=> Residual claims of owners
Contributed funds (share capital)
Earned funds (accumulated profits)
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© 2005 Peter Walton and Walter Aerts
Balance sheet – vertical format
Intangibles
Tangible assets
Investments
Fixed assets
Stocks
Debtors and prepaid1
Cash at bank
Current assets
Creditors due in less than one year
Net current assets
Creditors due in more than one year
Provisions
€ ’000
€ ’000
943
1,988
213
3,144
1,589
1,149
881
3,619
(359)
Capital
Ordinary shares
Reserves
Retained profits
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© 2005 Peter Walton and Walter Aerts
3,260
(1,500)
(520)
4,384
2,455
982
947
4,384
Vertical balance sheet
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


Same content but different presentation
Liabilities are shown as a deduction from assets
Liabilities are split according to when they are due for
payment, with current liabilities deducted from
current assets
Capital (or equity) is shown as the residual: it is more
a proprietary approach (focusing on the interests of
the owners) while the horizontal presentation follows
an entity approach (company presented as an
economic whole)
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© 2005 Peter Walton and Walter Aerts
The basics of accounting
measurement

Accounting measurement is based on a set of
assumptions and conventions which
automatically limit the information content



Generally accepted accounting principles
Conventional measurement bases
Accounting measurement necessitates
extensive use of estimates, which make it a
subjective process
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© 2005 Peter Walton and Walter Aerts
Generally accepted accounting
principles

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A set of assumptions, conventions and rules
underlying financial accounting, necessary to make
financial statements comparable and useful, but
introducing significant constraints on their content
Different Generally Accepted Accounting Principles
(GAAP)-sets exist, such as European GAAP and
related national GAAP, US GAAP, IFRS GAAP,...
The ‘true and fair view principle’ (or fair presentation)
of financial statements is pragmatically linked to the
proper application of ‘generally accepted accounting
principles’
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© 2005 Peter Walton and Walter Aerts
True and fair view / Fair presentation
‘Financial statements are frequently described as
showing a true and fair view of, or as presenting
fairly, the financial position, performance and
changes in financial position of an entity. Although
this Framework does not deal directly with such
concepts, the application of the principal qualitative
characteristics and appropriate accounting standards
normally results in financial statements that convey
what is generally understood as a true and fair view
of, or as presenting fairly such information.’
Source: IASB-Framework for the Preparation and Presentation of Financial
Statements
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© 2005 Peter Walton and Walter Aerts
Consistency
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Consistency of measurement and presentation
principles
Consistency in time and space



Same accounting principles should be applied from one year
to another
And, within the same year, in relation to similar transactions.
If changes are necessary, they should be explained in
the notes to the accounts, together with disclosure
of extra information to enable external observers to
make a knowledgeable evaluation of the effects of
the change
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Accrual basis

Financial accounting aims to measure
business transactions at the time they take
place, rather than when cash changes hands


This approach distinguishes financial accounting
from a simple record of cash transactions
‘Matching’: all costs and revenues associated
with a particular sale should be recognized
together in the income statement when the
sale takes place
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© 2005 Peter Walton and Walter Aerts
Accruals
“In order to meet their objectives, financial statements are
prepared on the accrual basis of accounting. Under this basis, the
effects of transactions and other events are recognised when they
occur (and not as cash or its equivalent is received or paid) and
they are recorded in the accounting records and reported in the
financial statements of the periods to which they relate. Financial
statements prepared on the accrual basis inform users not only of
past transactions involving the payment and receipt of cash but
also of obligations to pay cash in the future and of resources that
represent cash to be received in the future. Hence, they provide
the type of information about past transactions and other events
that is most useful to users in making economic decisions.”
Source: IASB, Framework, par.22
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© 2005 Peter Walton and Walter Aerts
Accrual versus Cash Basis

Cash basis:





Revenue recognized when incoming cash flows occur
Expenses recognized when outgoing cash flows occur
No mutual link of expenses and revenues
No measure of profitability feasible
Accrual basis:



Expenses and revenue regarding a sale should be
recognized simultaneously (irrespective of time of
payment)
Matching principle
Measure of profitability of economic activities during an
accounting period
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Matching principle
Income statement
Revenues and expenses with regard to a specific
accounting period


Revenue recognised in period when earned
Expenses related to the sale are recognised
in the same period as the revenue
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Prudence

Principle


Revenues should only be recognised when
they are certain
Expenses are recognised when they become
probable

Unrecoverable expenses should be
recognized even if not yet realized
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Prudence (cont.)

Controversial



Conflict with principle of matching
Tax driven / Could lead to hidden reserves
IFRS: no priority for the prudence principle

Meaning of prudence is restrained to an attitude of
caution in the exercise of judgements when these
are needed to arrive at estimates under conditions
of uncertainty such that assets/income are not
overstated and liabilities/expenses understated
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Going concern

In preparing financial statements it is assumed that
the company will continue in business for the
foreseeable future



Assumption is necessary to apply accrual principle
If no longer realistic: other set of measurement rules
needed (probably based on short-term liquidation
values)
IAS 1 Presentation of Financial Statements requires
management to make an assessment of the
company’s ability to continue as a going concern,
when it prepares the financial statements
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© 2005 Peter Walton and Walter Aerts
Conventional measurement bases


Historical cost principle
Monetary measurement unit convention
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Historical cost


Financial accounting is still largely based on historical
cost accounting
Historical cost = acquisition cost of the item



Historical consideration given
Past cost needed to acquire an asset on the date of
acquisition (the cash-equivalent acquisition cost)
Pros and cons


Advantage: historical cost is relatively easy to determine and
can be verified
Disadvantage: subsequent to the date of acquisition, the
continued reporting of historical cost based values does not
reflect any changes in market value
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© 2005 Peter Walton and Walter Aerts
Monetary measurement unit

A/L/I/E are measured in monetary units


Money provides a common denominator by means of which
heterogeneous facts and relationships can be expressed as
numbers that can be added and substracted.
Pros and cons

If nothing has been paid, no recognition of values in the
balance sheet, e.g.



Trade mark loyalty
Human capital
What if the value of monetary units changes ?

Changes in purchasing power are not taken into account
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Accounting for transactions


Balance sheet equation
Constructing a balance sheet
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Fig.3.3 Tracking finance
Finance
Production facility
Operations
Retained for growth
Profit / Cash
Corporate taxation
Paid to shareholders as dividend
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Balance sheet equation
The balance sheet equation is usually
stated as:
Assets = Debt (liabilities) + Equity
(uses of finance = sources of finance)
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© 2005 Peter Walton and Walter Aerts
Double-entry accounting



Any business transaction that will be recognized in
the accounting system (‘accounting transaction’), will
have a dual impact on the numbers in the company’s
accounting records
The balance sheet equation is in fact the formal
expression of the duality of accounting transactions
Double-entry accounting: any accounting
transaction must be reflected in (at least) two
accounts
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Double-entry accounting (cont.)


Any accounting transaction must preserve the
equilibrium between sources and uses of funds, and
will involve either a change in both, or a reallocation
within one side of the balance sheet equation
Accounting transactions with impact on revenues and
expenses fit into this fundamental equation approach



If profit is generated, it adds to the ‘equity’ part of the
equation
Revenues have a positive impact on profit and, thus, on
equity
Expenses have a negative impact on profit and, thus, on
equity
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Link income statement and balance sheet
Owner’s equity
1 jan. 20X1
Share capital 1/1 + Retained profits 1/1
= Assets – Liabilities
=
Net assets 1/1 (NA)
Income statement
for year 20X1
During 20X1
Revenues
- Expenses
=
=
Increase NA
Decrease NA
=
Decrease NA
+ Profit
(- Loss)
- Dividend
31 dec. 20X1
Share capital 31/12 + Retained profits 31/12
=
Net assets 31/12
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Constructing a balance sheet


Every accounting transaction can be analysed according to its
dual impact on the balance sheet
We will follow a spreadsheet approach for analysing accounting
transactions



Rows represent accounts (upper part = asset rows; lower part =
equity and liability rows) and can be extended if needed
Columns represent the impact of accounting transactions on the
balances (net amounts) of the accounts – this impact should be
such that the balance sheet equation is preserved at all times
The spreadsheet represents the accounting database


Each row (or account) = a data file
Balance sheet = a highly aggregated summary of these data files
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Alternative: debits and credits

Assets
Debit
Equity/Liabilities
Debit
P&L accounts
Debit
Asset
Credit
 Increase (+) => debit
 Decrease (-) => credit

 Increase (+) => credit
 Decrease (-) => debit

 Revenue => credit
 Cost => debit
Eq./Liab.
P&L
Cost
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Credit
Credit
Revenue
Constructing a balance sheet Illustration




We will follow a sequence of accounting transactions
up to the construction of a balance sheet
Initially, equity represents the finance put into the
company by the shareholders; equity changes
regularly as a result of operating activities
The net change in equity over a period is the profit
which has been made by the company during that
period - it is analysed in the income statement
A balance sheet can, potentially, be drawn up after
each transaction
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Illustration – Constitution of share capital
Assets
1
Cash
2
3
+20000
+15000
+15000
Receivables
Inventory
Property
Total
+50000
Liab./Equity
Long-term debt
Shares
+20000
+15000
+15000
Profit
Total
+50000
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© 2005 Peter Walton and Walter Aerts
4
Situation
Illustration – Bank loan
Assets
Cash
1
2
+20000
+15000
+15000
+30000
+50000
+30000
3
Receivables
Inventory
Property
Total
Liab./Equity
Long-term debt
Shares
+30000
+20000
+15000
+15000
Profit
Total
+50000
+30000
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© 2005 Peter Walton and Walter Aerts
4
Situation
Illustration – Buying a garage with office
Assets
Cash
1
2
3
+20000
+15000
+15000
+30000
-55000
Receivables
Inventory
Property
+55000
Total
+50000
+30000
0
Liab./Equity
Long-term debt
Shares
+30000
+20000
+15000
+15000
Profit
Total
+50000
+30000
0
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4
Situation
Illustration – Buying second hand cars
Assets
Cash
1
2
3
4
+20000
+15000
+15000
+30000
-55000
-18000
Receivables
Inventory
+18000
Property
+55000
Total
+50000
+30000
0
0
0
0
Liab./Equity
Long-term debt
Shares
+30000
+20000
+15000
+15000
Profit
Total
+50000
+30000
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Situation
Illustration – Intermediate position tracking
Assets
Cash
1
2
3
4
Situation
+20000
+15000
+15000
+30000
-55000
-18000
7000
+18000
18000
Receivables
Inventory
Property
+55000
Total
+50000
+30000
0
55000
0
80000
Liab./Equity
Long-term debt
Shares
+30000
30000
+20000
+15000
+15000
50000
Profit
Total
+50000
+30000
0
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© 2005 Peter Walton and Walter Aerts
0
80000
Illustration – Intermediate balance sheet
Assets
Equity and Liabilities
Tangible assets
(Property)
55.000
Fixed assets
Inventory (Cars)
Cash at bank
18000
50000
Shareholders’equity
Financial liabilities
(LT debt)
50000
30000
7000
Current assets
Total
55.000
Share capital
25000
80000
Liabilities
Total
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© 2005 Peter Walton and Walter Aerts
30000
80000
Illustration – Sale of car and repairs
Assets
Situation A
5
7000
(a) +5000
(c) -250
Inventory
18000
(b) -4000
Property
55000
Cash
6
Receivables
Total
80000
+750
Liab./Equity
Long-term debt
30000
Trade creditor
Shares
50000
Profit
(a) +5000
(b) -4000
(c) -250
Total
80000
+750
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7
Situation B
Illustration – Sale of car on credit
Assets
Cash
Situation A
5
7000
+5000
-250
Receivables
6
(a)+7000
Inventory
18000
Property
55000
Total
80000
-4000
(b) -5500
+750
+1500
+5000
-4000
-250
(a)+7000
(b) -5500
+750
+1500
Liab./Equity
Long-term debt
30000
Trade creditor
Shares
50000
Profit
Total
80000
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© 2005 Peter Walton and Walter Aerts
7
Situation B
Illustration – Buying cars on credit
Assets
Cash
Situation A
5
7000
+5000
-250
Receivables
6
7
11750
+7000
Inventory
18000
Property
55000
Total
80000
-4000
Situation B
-5500
7000
+12000
20500
55000
+750
+1500
+12000
94250
Liab./Equity
Long-term debt
30000
30000
Trade creditor
Shares
+12000
50000
Profit
Total
80000
12000
50000
+5000
-4000
-250
+7000
-5500
+750
+1500
2250
+12000
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© 2005 Peter Walton and Walter Aerts
94250
Illustration – Income statement
Sales
12000
Cost of sales
- Cars
9500
- Repairs
250
9750
Net Profit
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© 2005 Peter Walton and Walter Aerts
2250
Illustration – Balance sheet
Assets
Equity and Liabilities
Tangible assets
(Property)
55.000
Fixed assets
55.000
Share capital
Profit
50000
2250
Shareholders’equity
52250
Inventory (Cars)
Receivables
20500
7000
Financial liabilities
(LT debt)
30000
Cash at bank
11750
Trade creditor
12000
Current assets
Total
39250
94250
Liabilities
Total
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42000
94250
Illustration Reconciliation of profit and net cash flow
Net Profit (Income statement)
Value of inventory sold (paid previously)
Amount due by customer (still to be received)
Change in cash during period
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© 2005 Peter Walton and Walter Aerts
2250
9500
-7000
+4750
The IASB definition of elements of
financial statements

Elements of financial statements are the
building blocks of a balance sheet and income
statement


Broad categories according to their economic
characteristics
The IASB Conceptual Framework identifies
and defines five elements of financial
statements

assets, liabilities, equity, income and expenses
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© 2005 Peter Walton and Walter Aerts
Elements of financial statements


c.f. IASB Conceptual Framework
Five basic elements:
 Assets
 Liabilities
 Equity
 Income
 Expenses
Financial position
Financial performance
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© 2005 Peter Walton and Walter Aerts
Elements of financial statements
(cont.)
Financial position
Assets – Liabilities = Equity
Financial performance
Income – Expenses = Profit
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© 2005 Peter Walton and Walter Aerts
IASB - Asset


‘A resource controlled by an entity as a
result of past events from which future
economic benefits are expected to flow to
the entity’
Key elements:
a)
b)
c)
Assets are resources, arising from past transactions or past
events
They embody future economic benefits: the capacity to
contribute directly or indirectly to future net cash inflows
Control: one has the capacity to benefit exclusively from
these economic benefits
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Future economic benefits

Economic benefits may result from:

the productive capacity of the asset


the ability of the asset to reduce future cash outflows


prepayments
direct claims to cash inflows


renewal expenditure on equipment that results in future
production cost savings
the rights incorporated in the asset to receive services in the
future


plant and equipment
receivables and short-term investments
cash in hand

can be exchanged for goods and services (economic benefits)
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IASB - Liability

‘A present obligation of an entity arising
from past events, the settlement of which is
expected to result in an outflow from the
entity of resources embodying economic
benefits’

Key elements:
a)
b)
c)
Present (at balance sheet date) responsibility obligating the
company to act or perform in a certain way (towards third
parties)
Arising from an obligating event in the past
Leading to a sacrifice of economic benefits
(transfer of cash or other assets, rendering of services,
replacement by another obligation, ...)
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© 2005 Peter Walton and Walter Aerts
IASB - Equity


‘The residual interest in the assets of an
entity after deducting all liabilities’
Key elements:



The residual interest is the ownership interest
Representing a claim to the company’s net assets
Equity will be usually sub-divided:



Funds contributed by shareholders
Retained profits
Reserves representing appropriation of retained profits
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© 2005 Peter Walton and Walter Aerts
IASB - Income


‘Increases in economic benefits during the
accounting period in the form of inflows or
enhancements of assets or decreases of
liabilities that result in increases in equity,
other than those relating to contributions
from equity participants’
Key elements:




Defined in terms of changes in assets and liabilities
Results in increases of equity
Must not come from capital contributions of owners
Encompasses both revenue and gains
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© 2005 Peter Walton and Walter Aerts
IASB - Expenses


‘Decreases in economic benefits during the
period in the form of outflows or depletions of
assets or incurrences of liabilities that result
in decreases of equity, other than those
relating to distributions to equity participants’
Key elements:




Defined in terms of changes in assets and liabilities
Results in decreases of equity
May not relate to distributions to owners
Encompasses both expenses and losses
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© 2005 Peter Walton and Walter Aerts
Additional IFRS specifications


The IASB standards contain additional rules with
respect to specific occurrences of elements of
financial statements
In addition to more detailed definitions, the IASB
standards typically focus on three aspects of financial
statement elements:



Recognition: process of incorporating an item (meeting
one of the definitions) in the financial statements
Measurement: process of determining the monetary units
at which they are to be recognised and carried in the
financial statements
Disclosure: process of additional information dissemination
in the notes to the accounts
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Generic recognition criteria
An item meeting one of the definitions will only
be recognised in the financial statements, if:
1)
2)
It is probable that any future economic benefit
associated with the item will flow to or from the
entity, and
The item has a cost or value than can be
measured with reliability
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© 2005 Peter Walton and Walter Aerts
Fig. 3.4 Decision stages for inclusion of
an item
Stage 1 - Definitions
Does the item meet the definition of a financial statement element ?
Stage 2 – Recognition
Can the item be recognized according to the generic recognition criteria ?
Are there any specific recognition rules for the item?
Stage 3 – Measurement
Select the appropriate measurement base to determine the monetary amount at
which the item will be recognized and carried in the balance sheet or income
statement
Stage 4 – Disclosure
Is any (additional) mandatory or recommended information to be included in the
notes to the accounts?
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Balance sheet as a representation of
the value of a company?

Historical value versus economic value
Conservatism: assets are measured at
the minimum amount that can be
expected from sale or use

Characteristics of economic value




Related to future net cash flows
Taking into account time value of money
Corrected for risk
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© 2005 Peter Walton and Walter Aerts