Statement of Financial Position Module 1 Topic 2

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1 Sourced from: Statement of Financial Position Module 1 Topic 2

2 Learning Objectives Describe the characteristics of business transactions Identify the impact of business transactions on the accounting equation Differentiate between a business transaction, a personal transaction and a business event Explain the accounting equation process of the double-entry system of recording Explain the nature and purpose of the balance sheet Discuss the definition and nature assets, liabilities and equity Apply the recognition criteria to assets, liabilities and equity Discuss the limitations of the balance sheet

3 Business and Personal Transactions Business transactions are occurrences that affects the financial position of an entity and must be recorded. A business transaction is recorded when: - It can be reliably measured in monetary terms - It occurs at arm s length Source documents (written proof) provide evidence of a business transaction for example an invoice. Sourced from: ze-security-business-transactions/.

4 Typical transactions for entities include: o contribution of capital by owner(s) o payment of wages o receipt of bank interest o payment of GST o purchase of equipment o payment of accounts payable o sale of goods to customers o charging interest on overdue accounts receivable o repayment of short-term loan to financial institution Sourced from: esentation/wendianorgeas/

5 Business and Personal Transactions Personal transactions are transactions of the owners, partners or shareholders that are unrelated to the operation of the business. Such transactions are not classified as business transactions because they do not involve an exchange of goods and services between the business entity and another entity. Sourced from: ategories/shopping-clip-art-forkids

6 Business events Business events are occurrences that have the potential to affect the entity in some way, but will not be recorded as business transactions until an exchange of goods (services) occurs between the entity and an outside entity (until they affect the financial position of the entity). Examples of such business events include negotiations between the entity and other parties. Sourced from:

7 Asset A resource controlled by the entity as a result of past event, from which future economic benefits are expected to flow to the entity. It has to be probable that those future economic benefits will flow from the asset and it must be able to be reliably measured. Sourced from:

8 Asset definition and recognition example - Inventory

9 Categories of assets The convention in Australia is to categorise assets as Current or Non-Current (elsewhere you may see them called Long Term Assets, or Fixed Assets). Current Assets assets that are expected to be realised within twelve months from the reporting date or within one operating cycle, whichever is the shorter. Examples: Cash and Cash Equivalents, Trade Receivables, Inventory

10 Non-Current Assets - are assets whose future economic benefits will be enjoyed over a period of time greater than the one year/period. Examples: Furniture and fittings, a Restaurant Kitchen Fit Out, Motor Vehicle, Computer, Land and Buildings. Sourced from:

11 Depreciation Depreciation is the systematic allocation of the depreciable amount of an asset over its useful life. AASB 116, paragraph 6. Why depreciate? Because the economic benefits derived from an item are finite. We must show the consumption of these economic benefits as an expense in the income statement.

12 Depreciation Depreciation answers the following question How do we spread the cost of the original asset over its useful life, thereby reflecting the usage of that asset (and its loss in value)? Sourced from: /depreciation

13 Methods of depreciation There are several methods of depreciation and the choice of methods depends on the type of asset being depreciated. The two most common methods are: Straight line method Reducing balance method

14 Straight line method Under the straight line method the asset is depreciated by equal amount every year.

15 Example: Below is an example of an asset with cost of $100,000, useful life of 4 years and $10,000 salvage value. Note that the depreciation expense is same every single year.

16 Reducing balance method The future benefits derived from the asset decline more quickly in the earlier years of the assets life, reducing as the asset ages. This is what is known as an accelerated depreciation method, meaning the asset is depreciated at a greater rate in the early years of its life.

17 Example: Below is an example of an asset with cost of $100,000, useful life of 4 years and $10,000 salvage value depreciated using 50% depreciation rate. Note that salvage value was ignored in the preliminary years calculations. For Year 4, however, the calculated amount (($100,000 - $87,500) X 50% = $6,250) would cause the lifetime depreciation to exceed the $90,000 depreciable base. Thus, in Year 4, only $2,500 is taken as expense.

18 Intangible assets Non-Current assets that lack physical substance, yet still provide future economic benefits and have value. They exist but we can t see them or touch them as tangibly as we could do to say a table, a chair, or a building for example. Examples: Patents, Trademarks, Franchises, Intellectual property and Goodwill. Sourced from:

19 Amortisation For those intangible assets that are deemed to have a finite life, e.g. copyrights and patents, a process similar to depreciation, called amortisation (essentially the same process) is performed over the useful life of the asset.

20 Liabilities Liability is 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. Can be expressed as amounted owed by the entity. As with assets, probability and reliability of measurement are necessary. Sourced from:

21 Liabilities definition and recognition example Accounts Payable

22 Categories of liabilities Current Liability A liability that becomes due within the accounting period, normally defined as a year. Examples: Creditors (our suppliers who have extended us credit), Bank overdraft, Tax payable, Accrued expenses. Non-Current Liabilities - A liability that does not need to be repaid within a year. Examples: 3-year bank loan, a 20-year mortgage.

23 Equity (or Owners Equity) A residual claim (by the owners ) on the assets of the business after all other liabilities have been settled. Equity is increased through the contributions of owners and through the excesses of the entity s income over its expenses. Equity is decreased by excesses of expenses over income and by distributions to owners.

24 The accounting equation Assets = Liabilities + Owners Equity The accounting equation expresses the relationship between the assets of the entity and how the assets are financed. Assets are resources controlled by the entity. They can be financed either by incurring liabilities or by obtaining funding from the owners of the business (equity part of the equation). The liabilities and equity represent the claims against the entity s assets either from creditors or owners.

25 Sourced from: Additions to or subtractions from one of the sides of the scale must be counterbalanced with an equal addition to, or subtraction from, the other side of the scale if the formula is to stay in balance. As a result, the scale is to remain in its mandatory equal position. It is also possible, of course, to make changes (additions or subtractions) to only one side of the scale. For example, an equal dollar value added to and then subtracted from the asset total would not cause the overall formula to be out of balance.

26 The concept of duality Every business transaction has a dual effect (this means it will affect at least 2 items in the accounting equation). This ensures that the accounting equation always remains in balance. It is often referred to as Double Entry Accounting. Double entry accounting requires that the person recording a financial transaction makes at least two separate accounting entries (changes to its accounts) to ensure that the equation stays in balance.

27 Example A firm borrows 60,000 from a bank to purchase a truck. Assets = Liabilities + Owners Equity Truck $60,000 = Loan $60, One of the owners of a business contributes additional $50,000 in cash to the business. Assets = Liabilities + Owners Equity Cash $50,000 = 0 + Capital $50,000 Firm purchases a new laptop for $3500 and pays by cash. Assets = Liabilities + Owners Equity Laptop $3,500 = Cash $3,500

28 The Statement of Financial Position The Statement of Financial Position (commonly called Balance Sheet) is a financial statement that documents: o what the entity owns (or controls) at a particular date (the Assets) o the external claims on the entity s assets (the Liabilities) o the internal claims on the entity s assets (the Equity) It helps information users to assess the entity s financial solvency and stability. It is usually prepared at the end of the reporting period, but it can be done at any point in time.

29 Example:

30 Example:

31 Limitations of the Balance Sheet when used for decision making It relates to one point in time and represents past information. It does not necessarily reflect an entity s value due to: o Items that generate economic benefits or involve economic sacrifices not being recognised on the balance sheet as they do not satisfy the definition or measurement criteria. o Assets and Liabilities being recognised at historical cost which may be reliable but less relevant. The preparation of the Balance Sheet involves management choices, judgements and estimations.

32 References Birt, J., Brooks, A., Chalmers, K., Maloney, S., Oliver, J. (2017). Accounting: business reporting for decision making (6 th ed.). Milton, Qld: John Wiley & Sons. Birt, J., Brooks, A., Chalmers, K., Maloney, S., Oliver, J. (2014). Accounting: business reporting for decision making (5 th ed.). Milton, Qld: John Wiley & Sons.