CHAPTER 2: Visual Overview

CHAPTER 2: Visual Overview

Objective: To present and explain the Statement of Financial Position and Statement of Profit or Loss and
other comprehensive income and their interrelationship.

2.1.1 Elements of the Statement of Financial Position

1.1 Elements of the Statement of Financial Position
The Statement of financial position provides a snapshot of an organisation’s assets, liabilities and capital
balances at a specified date.

1.1.1 Assets
IAS 1 defines an asset as a present economic resource controlled by the entity due to past events and has
the potential to produce economic benefits.
Assets can be split into two categories: current assets and non-current assets.
• Current assets – cash or assets that can be converted into cash or used within the next 12 months.
For example, cash in bank, amounts due from customers, and goods held for resale.
• Non-current assets – assets that a business uses for more than 12 months to generate
profits or cash flow. For example, offices, shops, warehouses, delivery vehicles and production
equipment.
 Non-Current Assets can be further split into two: tangible and intangible.
o Tangible non-current assets are non-current assets that have a physical form and can be
touched. For example, machinery, fixtures and fittings, and computer equipment.
o Intangible non-current assets are non-current assets that do not have a physical form. For
example, software licences purchased for use by the business for more than 12 months.
It is essential to understand the different categories of assets as current and non-current assets are
presented separately in the statement of financial position.

Activity 1
For each statement below, state whether they are True or False.
1. A telephone that is used daily is a current asset.
2. A machine used to create products is a tangible non-current asset.
3. A software licence that allows a business to use specific software for a period of three years is a tangible
non-current asset.
4. A truck a business uses to deliver goods to its customers is a tangible non-current asset.
5. Goods purchased by a business for resale to its customers are tangible non-current assets.
1.1.2 Liabilities
IAS 1 defines a liability as a present obligation of the entity to transfer an economic resource as a result of
past events.
Generally, a liability is an amount that is owed by the business. Liabilities imply legal responsibilities or
duties to other parties.
Liabilities can be split into two categories: current and non-current.
• Current liabilities – amounts owed by the business falling due for payment within one year of the
reporting date. For example, amounts due to suppliers for goods purchased on credit are trade payables.
• Non-current liabilities – amounts owed by the business falling due for payment beyond one year
from the reporting date (total liabilities − current liabilities).
Entities are frequently financed by credit from sources other than the owners, which gives rise to liabilities.
For example, a loan received in 20X5, which is to be repaid in five years, will be a non-current liability in
the 20X5 to 20X8 statements of financial position, with a year’s portion in current liability. In the 20X9
financial statement, the total balance owing will be classified as a current liability.

1.1.3 Capital/ Equity

A business's capital or equity balance is the residual interest owners hold in its assets after deducting all
its liabilities.
It is the difference between total assets and total liabilities:

Total Assets – Total Liabilities

It amounts to the total investment in a business entity (a proprietor's or shareholders' funds or capital) and
is sometimes called the net worth.

2.1.2 Elements of the Statement of Profit or Loss

1.2 Elements of the Statement of Profit or Loss
There are two absolute profit measures, only one of which is shown in the trading account.
1. Gross Profit - this is calculated in the trading account and is the excess of sales over the cost of goods
sold during the period.
2. Net Profit - this is calculated in the profit and loss account and is the remaining profit after all other
costs incurred in the period have been deducted from the gross profit.
The statement of profit or loss is a formal presentation of the trading and profit and loss accounts. It
summarises the organisation’s financial performance in income and expenses during the financial year.
1.2.1 Income
Income is increases in assets, or decreases in liabilities, that result in increases in equity - other than those
relating to contributions from holders of equity claims (i.e. shareholders)
Income reflects all sales made to customers in the year, regardless of whether they have been paid for.
Cash inflows from shareholders are not income.
• A sale is usually recognised as taking place when goods are despatched (or services provided) to a
customer.
• Sales made to customers on credit which have not been settled for cash at the reporting date are
shown in the Statement of Financial Position as trade receivables.

1.2.2 Expenses
Expenses are decreases in assets, or increases in liabilities, that result in decreases in equity - other than
those relating to distributions to holders of equity claims.
An expense of a business is the day-to-day running cost incurred. Payments to shareholders (such as
dividends) are not expenses.
• Cost of sales is the cost of goods that have been sold. It includes all the costs connected with the
purchase and manufacture of goods. Costs incurred are matched with revenues earned.
• Other expenses can include various costs such as electricity, rent, salaries, and interest paid.
Activity 2
In the following activity, classify the list of items into the elements of financial statements.
1. Shareholder's investment
2. Computers
3. Bookkeeper's annual salary
4. Warehouse
5. Unsold goods
6. Overdraft with the bank
7. Cash held at the bank
8. Sales of goods for cash in the factory shop
Activity 3
The following activity presents different items that need to be classified under the correct heading in the
financial statements.
• Cost of selling furniture and other costs of running Coltom Co.
• Buildings owned by Coltom Co.
• The amount paid to purchase shares in Coltom Co.
• Amounts Coltom Co. owes for goods and services purchased
• The income that Coltom Co. earns from selling furniture to its customers
Match each example to the correct financial statement heading below:
1. Assets in the Statement of Financial Position
2. Liabilities in the Statement of Financial Position
3. Equity in the Statement of Financial Position
4. Income in the Statement of Profit or Loss
5. Expense in the Statement of Profit or Loss

2.1.3 Asset Expenditure vs Expenses

1.3 Asset Expenditure vs Expenses
When items of expenditure are incurred, a decision must be made whether they affect:
• Statement of financial position as an asset expenditure
• Statement of profit or loss as expenses
 Ethics

The distinction between expenses and asset expenditure is essential in the real world.
If a business incorrectly classified expenses as asset expenditures, it would lead to expenses being
understated and profits being overstated. This would mean that the profit would not fairly represent the
business’s performance.

1.3.1 Asset Expenditure

Asset expenditure relates to the purchase of non-current assets. Asset expenditure is incurred in:
• Acquiring property and equipment for long-term use (benefits future accounting periods).
• Increasing the revenue-earning capacity of an existing non-current asset (by increasing efficiency or
useful life).
Items of asset expenditure (except for the cost of land) will ultimately be expensed to profit or loss (through
a charge called depreciation) as the asset is consumed through its use in the business.

1.3.2 Expenses
Expenses, commonly called operating expenses, are incurred in the business’s daily running (operation).
Examples include:
• buying or manufacturing goods which are sold and providing services
• selling and distributing goods
• administration costs
• repairing long-term assets
These costs are immediately charged to profit or loss and matched with the accounting period's revenues.

Activity 4
Classify the following items of expenditure as asset expenditures or expenses:
1. $27,000 on a new car.
2. $1,800 road tax incorporated in the car’s purchase price in (1) above.
3. $10,000 on a second-hand delivery van.
 4. $12,000 on refurbishing van in (3) above.
5. $1,000 monthly rental of a vehicle.
Activity 5
Rubin owns a business that sells office and computer equipment to corporate customers. His business
operates from a warehouse and has a small fleet of delivery vehicles.
Determine whether the expenditures made by Rubin's business should be classified as expenses
or asset expenditures.
1. Rubin’s business has bought some laptops and speakers from its suppliers, which will be sold to its
customer.
2. Rubin’s accountant prepares its financial statements. She ordered a photocopier to make copies of her
paperwork.
3. Rubin’s business is expanding, and he has rented a new warehouse.
4. Rubin ensures that all the vehicles have valid insurance. Each time he orders a new vehicle, he insures
it immediately.
5. Goods are delivered to customers using one of the business’s delivery vehicles. On the way back to the
warehouse, the driver crashes the side of the vehicle into the fence. The vehicle will need to be fixed to
be used again.
6. Rubin’s business orders a few new vehicles to keep up with customer orders.

2.2.1 The Duality Concept

2.1 The Duality Concept
The Duality concept is one of the accounting principles used in recording financial information. It states that
every transaction has a double (or dual) effect on the business's position as recorded in its accounts.
The second effect is equal to and "opposite" of the first effect.

Activity 6
Match the transactions to the corresponding duality statements.
Transaction Duality Statement

Sells goods on cash Sales income increases, and receivables asset increases.

Sells goods on credit Payables liability decreases, and bank asset decreases.

Goods for resale expense increase, and bank asset

Purchases goods for resale for cash decreases.

Purchases goods for resale on credit Capital introduced increases and bank asset increases.

Pays a supplier for some equipment bought on

credit Sales income increases, and bank asset increases.

Purchases some equipment for cash Equipment asset increases, and bank asset decreases.

Goods for resale expense increases, and payables liability

Starts the business by introducing cash increases.
2.2.2 The Accounting Equation
2.2 The Accounting Equation

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:

Capital or Net Assets = Assets – Liabilities

At any point in time when transactions have been recorded correctly, the accounting equation will always
balance. The accounting equation can be manipulated to encompass every type of element of 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:

Key Point

Assets – Liabilities = Total Capital Introduced – Drawings + Income – Expense

Activity 7
Match the equation to the corresponding rearranged accounting equation.
Transaction Duality Statement

Assets Opening capital + Profit for the period − Drawings

Closing Net Assets Closing net assets − Opening net assets + Drawings

Opening Net Assets Capital + Liabilities

Closing Capital Assets − Capital

Liabilities Closing net assets − Profit for the period + Drawings

Profit for the period Closing capital

2.2.1 The Accounting Equation and Double Entries
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:
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.

Category A debit entry will… A credit entry will…

Asset Increase an asset Decrease an asset
Liability Decrease a liability Increase a liability
Income Decrease income Increase income
Expense Increase an expense Decrease an expense
Capital Decrease capital Increase capital
Drawings Increase drawing Decrease drawing
Example 1
Yuma owns a business that makes and delivers handmade furniture to customers.
What is the effect of the transaction on the business and the double entry to record the
transaction?
1. She buys a vehicle for the business and pays $5,000 using funds from the bank.
The vehicle (Asset) increases by $5,000, and the bank (Asset) decreases by $5,000.
The double entry to record this is DR Vehicles $5,000 and CR Bank $5,000.
2. She obtains a loan of $2,000 from a friend.
The bank (Asset) increases by $2,000, and the loan (Liability) increases by $2,000.
The double entry to record this is DR Bank $2,000 and CR Loan $2,000.
3. She buys office furniture paying $500 cash.
The office furniture (Asset) increases by $500, and the bank (Asset) decreases by
$500. The double entry to record this is DR Office Furniture $500, and CR Bank $500.
4. She pays a supplier for chairs and a table bought on credit for $1,200 credit.
The payable (Liability) decreases by $1,200, and the bank (Asset) reduces by $1,200.
The double entry to record this is DR Payables $1,200 and CR Bank $1,200.
5. She purchases a batch of raw materials paying $800 cash.
The purchases (Expense) increase by $800, and the bank (Asset) decrease by $800.
The double entry to record this is DR Purchases $800 and CR Bank $800.
6. Yuma pays rent in cash of $2,000 for the year.
The rent (Expense) increases by $2,000, and the bank (Asset) decreases by $2,000.
The double entry to record this is DR Rent $2,000, and CR Bank $2,000.
Activity 8
What is the double entry to record the following transactions?
1. Starts the business by introducing cash.
2. Purchases some equipment for cash.
3. Pays a supplier for some equipment bought on credit.
4. Purchases goods for resale on credit.
5. Purchases goods for resale for cash.
6. Sells goods on credit.
7. Sells goods for cash.