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

CHAPTER 3Measurement concepts and the

balance sheet equation


Contents 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


Introduction –Annual financial statements

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


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) What are the rules?b) To what extent are they flexible?c) How this impacts upon interpretation of the information.


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


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.


Fig. 3.1 Time periods covered

Balance sheet

31/12/20X4

Balance sheet

31/12/20X1

Balance sheet

31/12/20X2

Balance sheet 31/12/20X3

Income statement

20X2

Income statement

20X3

Income statement

20X4


Company X – Income Statement of period 20X2

Accomplishments =>

lessEfforts =>equalsPerformance

=>

Revenues

- Expenses

Profit (or Loss)


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)


Income statement presentation 1

Income statement for period 200X € ’000

Sales 5,356 Raw materials 1,739 Salaries and wages 783 Depreciation 462 External services 873 (3,857) Profit before interest and tax 1,499 Interest (362) Profit before taxation 1,137 Taxation (384) Profit available for shareholders 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


Income statement presentation 2

Income statement for period 200X

€ ’000

Sales 5,356 Cost of sales (2,601)

2,755 Distribution costs 382 Administrative expenses 874 (1256)

Profit before interest and tax 1,499 Interest (362)

Profit before taxation 1,137 Taxation (384)

Profit available for shareholders 753


Operating expenses by nature or function

Nature Function € ’000 € ’000 Raw materials 1,739 Cost of sales 2,601 Salaries and wages 783 Distribution costs 382

Depreciation 462 Administrative expenses 874

Other costs 873 Total 3,857 Total 3,857


Allocation of input costs

Function:

Input costs:

Cost of sales

Distribution costs

Administrative expenses

Salaries and wages

Factory employees

Sales agents

Accountants

Depreciation

Production hall

Cars Administration buildings


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


Company X – Balance sheetat 31 December 20X2

Resources =

Assets =

Sources of finance

“Equities”

Owners’equity Liabilities (interests of owners) (interests of

creditors)


Horizontal balance sheetFourth EC Accounting DirectiveAssets Liabilities and equity Intangible assets 943 Ordinary shares 2,455 Tangible assets 1,988 Reserves 982 Investments 213 Retained profit 947

Fixed Assets 3,144 Shareholders’ equity 4,384 Stocks 1,589 Provisions 520 Debtors 973 Financial liabilities 1,500 Cash at bank 881 Trade liabilities 359 Deferred charges 176 Total 6,763 Total 6,763


Horizontal balance sheet US format

Assets Liabilities and equity Cash at bank 881 Trade payables 359 Deferred charges 176 Debt 1,500 Receivables 973 Provisions 520 Inventory 1,589 Fixed assets: Equity Investments 213 Ordinary stock 2,455 Tangible assets 1,988 Reserves 982 Intangible assets 943 Retained profit 947 Total 6,763 Total 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


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


Company X – Balance sheetat 31 December 20X2

Assets- Liabilities

Owners’equity => Residual claims of owners

Contributed funds (share capital)

Earned funds (accumulated profits)


Balance sheet – vertical format

€ ’000 € ’000

Intangibles 943 Tangible assets 1,988 Investments 213 3,144 Fixed assets Stocks 1,589 Debtors and prepaid1 1,149 Cash at bank 881 Current assets 3,619 Creditors due in less than one year (359) Net current assets 3,260 Creditors due in more than one year (1,500) Provisions (520) 4,384 Capital Ordinary shares 2,455 Reserves 982 Retained profits 947 4,384


Vertical balance sheet 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)


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


Generally accepted accounting principles

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’


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


Consistency 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


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


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


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


Matching principle

Revenue recognised in period when earned Expenses related to the sale are

recognised in the same period as the revenue

Income statement

Revenues and expenses with regard to a specific accounting period


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


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


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


Conventional measurement bases

Historical cost principle Monetary measurement unit

convention


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


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


Accounting for transactions

Balance sheet equation Constructing a balance sheet


Fig.3.3 Tracking finance

Finance

Production facility

Operations

Profit / CashRetained for growth Corporate taxation

Paid to shareholders as dividend


Balance sheet equation

The balance sheet equation is usually stated as:

Assets = Debt (liabilities) + Equity

(uses of finance = sources of finance)


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


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


Link income statement and balance sheet

Owner’s equity = Assets – Liabilities

1 jan. 20X1 Share capital 1/1 + Retained profits 1/1

= Net assets 1/1 (NA)

Income statement for year 20X1

During 20X1 Revenues- Expenses

= Increase NA= Decrease NA

+ Profit(- Loss)

- Dividend = Decrease NA

31 dec. 20X1

Share capital 31/12 + Retained profits 31/12

= Net assets 31/12


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


Alternative: debits and credits

Assets Increase (+) => debit Decrease (-) => credit

Equity/Liabilities Increase (+) => credit Decrease (-) => debit

P&L accounts Revenue => credit Cost => debit

Debit Asset Credit

Debit Eq./Liab. Credit

Debit P&L Credit

Cost 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


Illustration – Constitution of share capital

Assets 1 2 3 4 Situation

Cash +20000+15000+15000

Receivables

Inventory

Property

Total +50000

Liab./Equity

Long-term debt

Shares +20000+15000+15000

Profit

Total +50000


Illustration – Bank loan


Cash +20000+15000+15000

+30000

Receivables

Inventory

Property

Total +50000 +30000

Liab./Equity

Long-term debt +30000

Shares +20000+15000+15000

Profit

Total +50000 +30000


Illustration – Buying a garage with officeAssets 1 2 3 4 Situatio

n

Cash +20000+15000+15000

+30000 -55000

Receivables

Inventory

Property +55000

Total +50000 +30000 0

Liab./Equity


Shares +20000+15000+15000

Profit

Total +50000 +30000 0


Illustration – Buying second hand cars


Cash +20000+15000+15000

+30000 -55000 -18000

Receivables

Inventory +18000

Property +55000

Total +50000 +30000 0 0

Liab./Equity


Shares +20000+15000+15000

Profit

Total +50000 +30000 0 0


Illustration – Intermediate position trackingAssets 1 2 3 4 Situatio

n

Cash +20000+15000+15000

+30000 -55000 -18000 7000

Receivables

Inventory +18000 18000

Property +55000 55000

Total +50000 +30000 0 0 80000

Liab./Equity

Long-term debt +30000 30000

Shares +20000+15000+15000

50000

Profit

Total +50000 +30000 0 0 80000


Illustration – Intermediate balance sheet

Assets Equity and Liabilities

Tangible assets (Property)

55.000 Share capital 50000

Fixed assets 55.000 Shareholders’equity 50000

Inventory (Cars) 18000 Financial liabilities (LT debt)

30000

Cash at bank 7000

Current assets 25000 Liabilities 30000

Total 80000 Total 80000


Illustration – Sale of car and repairs

Assets Situation A

5 6 7 Situation B

Cash 7000 (a) +5000(c) -250

Receivables

Inventory 18000 (b) -4000

Property 55000

Total 80000 +750

Liab./Equity

Long-term debt 30000

Trade creditor

Shares 50000

Profit (a) +5000(b) -4000(c) -250

Total 80000 +750


Illustration – Sale of car on credit

Assets Situation A

5 6 7 Situation B

Cash 7000 +5000-250

Receivables (a)+7000

Inventory 18000 -4000 (b) -5500

Property 55000

Total 80000 +750 +1500

Liab./Equity

Long-term debt 30000

Trade creditor

Shares 50000

Profit +5000-4000-250

(a)+7000(b) -5500

Total 80000 +750 +1500


Illustration – Buying cars on credit

Assets Situation A

5 6 7 Situation B

Cash 7000 +5000-250

11750

Receivables +7000 7000

Inventory 18000 -4000 -5500 +12000 20500

Property 55000 55000

Total 80000 +750 +1500 +12000 94250

Liab./Equity

Long-term debt 30000 30000

Trade creditor +12000 12000

Shares 50000 50000

Profit +5000-4000-250

+7000-5500

2250

Total 80000 +750 +1500 +12000 94250


Illustration – Income statement

Sales 12000

Cost of sales

- Cars 9500

- Repairs 250

9750

Net Profit 2250


Illustration – Balance sheet

Assets Equity and Liabilities

Tangible assets (Property)

55.000 Share capitalProfit

500002250

Fixed assets 55.000 Shareholders’equity 52250

Inventory (Cars)Receivables

205007000

Financial liabilities (LT debt)

30000

Cash at bank 11750 Trade creditor 12000

Current assets 39250 Liabilities 42000

Total 94250 Total 94250


Illustration -Reconciliation of profit and net cash flow

Net Profit (Income statement) 2250

Value of inventory sold (paid previously) 9500

Amount due by customer (still to be received) -7000

Change in cash during period

+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


Elements of financial statements

c.f. IASB Conceptual Framework Five basic elements:

Assets Liabilities Equity Income Expenses

Financial position

Financial performance


Elements of financial statements (cont.)

Financial position

Assets – Liabilities = Equity

Financial performance

Income – Expenses = Profit


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) Assets are resources, arising from past transactions

or past eventsb) They embody future economic benefits: the

capacity to contribute directly or indirectly to future net cash inflows

c) Control: one has the capacity to benefit exclusively from these economic benefits


Future economic benefits Economic benefits may result from:

the productive capacity of the asset plant and equipment

the ability of the asset to reduce future cash outflows renewal expenditure on equipment that results in future

production cost savings the rights incorporated in the asset to receive services in

the future prepayments

direct claims to cash inflows receivables and short-term investments

cash in hand can be exchanged for goods and services (economic

benefits)


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) Present (at balance sheet date) responsibility

obligating the company to act or perform in a certain way (towards third parties)

b) Arising from an obligating event in the pastc) Leading to a sacrifice of economic benefits

(transfer of cash or other assets, rendering of services, replacement by another obligation, ...)


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


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


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


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


Generic recognition criteria

An item meeting one of the definitions will only be recognised in the financial statements, if:

1) It is probable that any future economic benefit associated with the item will flow to or from the entity, and

2) The item has a cost or value than can be measured with reliability


Fig. 3.4 Decision stages for inclusion of an item

Stage 2 – RecognitionCan the item be recognized according to the generic recognition criteria ?

Are there any specific recognition rules for the item?

Stage 1 - DefinitionsDoes the item meet the definition of a financial statement element ?

Stage 3 – MeasurementSelect 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 – DisclosureIs any (additional) mandatory or recommended information to be included in the

notes to the accounts?


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

CHAPTER 3 Measurement concepts and the balance sheet equation.

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Transcript of CHAPTER 3 Measurement concepts and the balance sheet equation.