Chapter 1: Elements of Financial Statements and The Accounting Equation

Question 1

The financial statements produced by an accountant provide a summary of the business’s financial activities. The main financial statements are:

Answer 1

• Statement of Financial Position (SFP)
• Statement of Profit or Loss (SCF)

Financial statements are prepared and used by various stakeholders, including tax authorities, investors, borrowers, suppliers and the general public.

Question 2

The Statement of Financial Position (SFP) shows

Answer 2

the business’s financial position at the end of the year.

The financial position of a business is determined by the assets a business holds and the funding of these assets through a combination of liabilities and the owner’s capital.

The Statement of Financial Position reflects the accounting equation where assets equal the sum of capital and liabilities.
[includes: Title, Non-Current Assets, Current Assets, Capital, Capital brought forward, Profit for the Year, Capital Introduced, Drawings, Non-Current Liabilities, Current Liabilities, The TOTAL ASSET should equal the total capital and liabilities amount

Question 3

The Statement of Profit or Loss (SPL) highlights the business’s financial performance for the year.

A business makes a PROFIT when income exceeds expenses and a LOSS when expenses exceed income.

Answer 3

iNC: Title, Sales, Cost of Goods Sold, Gross Profit , Other Income, Expenses, Interest Paid, Net Profit t – is the excess of income after all business expenses have been paid. The Net Profit amount is transferred to the ‘Profit for the Year’ section of the Statement of Financial Position, thus increasing capital.
(If a net loss is made, a negative amount is transferred to the SFP, thus reducing the business’s capital).

Question 4

ASSETS - IAS 1 defines an ASSET as a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity.

Answer 4

Generally, an asset is something a business owns.

IAS 1 Presentation of Financial Statements sets out the overall requirements for financial statements.

Question 5

Resource CONTROLLED means that the entity can control benefits from the asset.

Answer 5

• An example is INVENTORIES. This refers to goods held for sale. The business exercises control in organising, holding, and selling the goods. Therefore, inventories are considered assets of the business.
• Businesses may refer to EMPLOYEES as their biggest asset. A business may have a contract of employment with an employee. However, that employee can leave and resign from that business. Thus, an employee cannot be controlled by the business and any costs incurred by the employee are recognised as an expense, not an asset.

Question 6

There must be a PAST EVENT that resulted in resource control. This means that assets are recorded only when the event to control the assets takes place.

Answer 6

• For example, a FACTORY is categorised as an asset of a business when the sale transaction (past event) has taken place. An intention or plan to purchase a factory does not constitute a past event.

Question 7

FUTURE ECONOMIC BENEFIT INFLOW is the probability of a rise in an economic benefit such as monetary gains (this can be in the form of income or cost savings).

Answer 7

• For example, TRADE RECEIVABLE represents money coming into the business. It is a present economic resource because the money the customer owes will lead to economic benefits.
  If there is no economic benefits inflow, the amount paid is an expense (For example, electricity and bills)

Question 8

Current and Non current assets
IAS 1 defines current assets as assets that are:

Answer 8

• Expected to be realised (used up, sold or collected) in the entity’s normal operating cycle and within/less than 12 months after the reporting period
• Held primarily for trading
• Cash and cash equivalent (converts into cash easily)

Examples: Inventory; trade receivables (money owed by customers; cash and bank)

Question 9

Non Current Asset

Answer 9

• expected to be used by a business over several years
• does not covert to cash easily
• buildings, motor vehicles, equipment and machinery

Question 10

Liabilities -
IAS1 defines a liability as a present obligation of the entity arising from past events, the settlement of which is expected to result in a probable outflow of economic benefits.

Generally, a liability is the amount owed by the business

Answer 10

A PRESENT OBLIGATION results in a legally enforceable rule. There is a duty or responsibility that the entity has no practical ability to avoid and must be fulfilled.

For example, a TRADE PAYABLE is a liability as an agreement exists for payment to the supplier. If the payables amount is not paid, the supplier can sue the business for non-payment.

Question 11

There must be a PAST EVENT that resulted in the obligation arising. This means that liabilities are recorded only when the event creating the obligation takes place

Answer 11

• For example, a BANK LOAN is categorised as a liability when the business first received the loan principal (past event)

Question 12

FUTURE ECONOMIC BENEFIT OUTFLOW is the probability of a decrease in economic benefits, such as monetary losses (this can be in the form of expense or cash leaving the business)

Answer 12

• for example, a BANK OVERDRAFT is a liability as it represents money owing to the bank (economic benefit outflow).

Question 13

Current and non current liabilities
IAS1 defines current liabilities as those:
- expected to be settled within the entity’s normal operating cycle and due to be settled within 12 months (due for payment within one year)
- held for trading
- for which the entity does not have the right at the end of the reporting period to defer settlement beyond 12 months.
All other liabilities are non-current.

eg. Trade payables (money owed to suppliers); bank overdraft (bank balance in negative position); tax liabilities (money owed to tax authorities)

Question 14

Non current liability

Answer 14

• Liabilities which are not due for payment within one year
  eg. bank loans (repayable over more than one year); other long term borrowings

Question 15

CAPITAL
Capital equals the net assets of a business. The net assets is the difference between a business’s assets and liabilities

CAPITAL = ASSETS - LIABILITIES

Capital is the amount which the business owes to its owners

Answer 15

Capital is the owner’s interest in the business. It is made up of the following:
- The cash or assets introduced to the business by the owner
- Profits generated in previous years
- Less any amounts that the owner has withdrawn from the business for their personal use (known as drawings)

The capital balance is impacted by a change in any of these elements and is presented as a line item in the Statement of Financial Position

Question 16

Other Forms of Finance.
Businesses need cash to operate and survive. For a sole trader business, the initial cash investment typically comes from the owners.

As a business grows, it may need additional financial support. This can be funded with additional investment from its owners (capital) or borrowings (liabilities).

The sources of finance include:

Answer 16

• CAPITAL FROM OWNERS - Capital represents the combination of the owner’s invested amount and the accumulated profits and losses. The owner may take drawings from the business for personal use, essentially a repayment of the capital.
  Unlike other types of finance, capital has no fixed repayment date and does not incur interest costs, unlike a bank loan.
• BANK OVERDRAFT - Banks may offer a business an overdraft facility with a fixed limit, which is usually reviewed annually. A bank overdraft is an expensive form of finance as it carries a higher interest rate than other longer-term finance options, such as bank loans.
  A bank account in an overdraft position is classified as a liability.
• BANK LOANS - A bank may issue a loan with a fixed repayment date and pre-determined interest rate, usually lower than an overdraft.

The bank authorises a bank loan after looking into the business’s financial credibility. They may also require the business to put up its assets as security if it defaults on a loan.
Bank loans provided to a business are classified as liabilities.

• LEASES - a business may purchase assets by leasing instead of paying in full. A lease is a contractual arrangement between two parties to use an asset in exchange for periodic payments.
  When a business leases an asset, it will pay regular instalments to the other party in exchange for being able to use the asset. The business does not legally own the asset.
  The amount due under the lease for the asset is classified as a liability. The asset is also included in the business’s statement of financial position - although it does not legally own the asset, it controls it.
• BORROWINGS - s business may borrow money from outside the businesses, such as from family members or friends. The arrangements for the loan in terms of the repayment date or interest rates are agreed upon between the lender and the borrower. Like bank loans, amounts borrowed are classified as liabilities.

Question 17

INCOME
Income and expenses are financial transactions of a business. The total transactions are reflected in a business’s Statement of Profit or Loss during the year.

Answer 17

Income is a business’s received economic benefit in cash or assets from sales or other sources
- sunrise lighting is a business that sells light fittings and lamps. Income derived from its normal trading activities (selling light fittings and lamps) is categorised as SALES.
- OTHER INCOME of Sunrise Lighting could be rental income (from space the business does not use) or interest received on bank deposits.

Question 18

EXPENSES - an expense is the day-to-day running cost incurred by the business

Answer 18

Expenses can include electricity, rent, salaries, and interest paid. Expenses are reflected in the Statement of Profit or Loss.

Question 19

The accounting equation
Capital or Net Assets = Assets - Liabilities

Answer 19

The elements of financial statements are assets, liabilities, capital, income and expenses. These elements relate to one another, and their relationship is expressed in the accounting equation

**WHEN TRANSACTIONS HAVE BEEN RECOREDED CORRECTLY, the accounting equation will always BALANCE

Question 20

The expanded accounting equation

Answer 20

The accounting equation can be manipulated to encompass every type of element of the Financial Statements.

The simple accounting equation: Assets − Liabilities = Capital/Net Assets

Capital is also known as net assets and belongs to the owner. It is the amount the owner invested minus any amounts that owners have taken out of the business (drawings) plus the profit made by the business.

Closing Capital = Total Capital Introduced − Drawings + Profits

• Closing capital is the capital at the end of the accounting year
• Total capital introduced is the capital at the start of the accounting year plus any additional capital invested during the year
• Drawings and profits/losses are during the year
  The formula below shows the expanded accounting equation once the above elements are included:

Question 21

**
assets - liabilities = total capital introduced - drawings +expense

Question 22

Double Entry and the Accounting equation

A transaction recorded using double entries will always cause the Accounting Equation to balance. This is due to the dual impact of Double Entry, where each transaction creates a Debit and Credit entry that equals.

The expanded accounting equation can be rearranged to show only positive signs:

Answer 22

Assets + Drawings + Expenses = capital + liabilities + income

The positive elements on the right side of the formula increase with a debit entry, while the negative elements on the left increase with a credit entry.
[see table]

Question 23

Key principles in accounting
Accounting principles are fundamental rules applied when preparing or reporting any accounting information.

The Conceptual Framework provides a formal definition for each of the principles considered below.

Answer 23

GOING CONCERN
- Financial statements assume the business will continue operational existence for the foreseeable future and has neither the intention nor the need to enter liquidation or cease trading.

Question 24

SEPARATE ENTITY

Answer 24

A separate entity concept states that the owner and the business are separate entities (even though they may be the same legally).

The owner and the business may have transactions between them (for example, capital introduced and drawings). Ultimately, all information in the financial statements relates only to the business, not the owner.

For example, an owner’s personal assets are not included in the business records. Similarly, reasons for an owner’s cash drawings are not detailed other than the record of fund withdrawal.

Question 25

DOUBLE ENTRY

Answer 25

Also known as the dual effect or dual aspect, the double entry concept explains that every transaction has two impacts on a business.

For example, if a business buys a van for cash, this impacts the cash account and the motor vehicle account. Cash has decreased while a new asset (the van) is introduced to the business.

Question 26

ACCRUALS

Answer 26

The accruals concept is also known as the matching concept. The accruals concept state that all income and expenses incurred should be recognised in the period to which they relate. The impact of income and expense transactions is recognised when they occur, not on whether cash has been received or paid.

This concept is the underlying principle for Chapter 9 Accruals and Prepayments.

Question 27

HISTORICAL COST

Answer 27

The historical cost concept states that all transactions are initially recorded at historical cost, which is the cost at the time of the transaction. The historical cost system of accounting is particularly relevant to assets.

Question 28

CONSISTENCY

Answer 28

The consistency concept requires that all similar transactions apply a consistent accounting treatment from one accounting period to the next. This allows for a better comparison of financial statements between different years and transactions of the same nature.

For example, the same depreciation method should apply to all motor vehicles. For similar types of inventories, a consistent method of valuation is used.

Question 29

MATERIALITY

Answer 29

The materiality concept ensures that all material (significant) information is included in the financial statements. Financial information is material if its omission can affect the decisions made by users of that information, and so should be accurately included in the financial statements.

For example, a potential investor might decide to sell stakes in a business if it has too many liabilities. This means that the quantity of liabilities is material information to this investor.

Question 30

PRUDENCE

Answer 30

The prudence concept ensures that caution is exercised when making judgements about events that may be uncertain. The prudence concept means that assets and income are not overstated, while liabilities and expenses are not understated.

Gains should not be recognised until they materialise. If the business becomes aware of a potential loss, details of the loss should be made known to users of accounts immediately.