chapter 3

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Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011

Chapter 3

Financial statements fromthe accounting equation

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Primary financial statement Purpose is to report

Statement of financial position (balance sheet)

Financial position

Income statement(profit and loss account)

Performance

Statement of cash flows Financial adaptability

Primary financial statements

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Preparing financial statements

• TRANSACTIONS AND EVENTS ↓• practice of bookkeeping ↓• ACCOUNTING RECORDS ↓• rules of measurement and disclosure ↓• FINANCIAL STATEMENTS

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Statement of financial position (balance sheet)

• The statement of financial position (balance sheet) reflects the accounting equation in the form:

− Assets minus Liabilities equals Ownership interest

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Assets

minus

Liabilities

equals

Ownership interest

Statement of financial position is usually presented

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Subdivisions

• Assets are subdivided into non-current (fixed) assets and current assets.

• Liabilities are subdivided into current liabilities (due within one year) and longer-term liabilities (due after one year).

• Ownership interest may also be subdivided.

• Current assets and current liabilities are grouped close to each other.

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Non-current (fixed) assets

Plus

Current assets

Minus

Current liabilities

Minus

Non-current (long-term) liabilities

equals

Capital at start of yearplus/minus

Capital contributed or withdrawnplus

Profit of the period

Structure

Table 3.1 Structure of a statement of financial position (balance sheet)

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Other forms of statement – horizontal

Assets equals Ownership interest plus

Liabilities

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Assets

equals

Ownership interest

plus

Liabilities

Other forms of statement – vertical

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Income statement(profit and loss account)

The income statement (profit and loss account) reflects that part of the accounting equation which defines profit.

Profit equals Revenue minus Expenses

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Revenue

minus

Expenses

equals

Profit

Income statement (profit and loss account) (Continued)

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Statement of cash flows

Liquidity is measured by the cash and near-cash assets and the change in those assets, so a financial statement which explains cash flows should be of general interest to user groups.

Cash flow = • cash inflows to the enterprise minus• cash outflows from the enterprise

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Change in cash and similar liquid assets

equals

Cash outflows

minus

Cash inflows

Statement of cash flows (Continued)

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Subdivisions of cash flow

• Operating activities: Provision of services, and the manufacturing, buying and selling of goods for resale.

• Investing activities: Buying and selling non-current (fixed) assets for long-term purposes.

• Financing activities: Raising and repaying the long-term finance of the business.

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Operating activities

Cash inflows minus Cash outflows

plus

Investing activities


plus

Financing activities


equals

Change in cash assets

Statement of cash flows

Table 3.6 Structure of a statement of cash flows

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Profit does not equal cash

Working capital

• Some sales are made on credit, customers pay later.

• Some purchases are made on credit, pay suppliers later.

• Cash is used to buy inventory (stock) which is sold later.

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Inventory

Receivables(debtors)

Cash

Payables (creditors)

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Profit does not equal cash (Continued)

• Cash is used to buy more non-current (fixed) assets.

• Cash is used to buy investments.

• Cash is used to repay loans.

• Cash is raised from issuing shares.

• Cash is raised from borrowing.

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Practical illustration

See P. Mason illustration in Chapter 3 for

• Statement of financial position.

• Income statement.

• Statement of cash flows.

• Comparison of profit and cash flow.

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Chapter 3

Bookkeeping Supplement

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DEBIT ENTRIES CREDIT ENTRIES

Left-hand side of the equation

Asset Increase Decrease

Right-hand side of the equation

Liability Decrease Increase

Ownership interest Expense Revenue

Capital withdrawn Capital contributed

Debit and Credit recording

Table 3.9 Rules for debit and credit recording

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1 Sept: P. Mason deposits £140,000 in a bank account to commence the business under the name P. Mason’s legal practice

Transaction number: 1

DEBIT CREDIT

Asset BANK £140,000

Ownership interest CAPITAL CONTRIBUTED£140,000

Analysis of transaction

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1 Sept: P. Mason’s legal practice borrows £150,000 from a finance business to help with the intended purchase of a property for use as an office. The loan is to be repaid in five years’ time.


DEBIT CREDIT

Asset BANK £150,000

Liability LONG-TERM LOAN £150,000

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1 Sept: A property is purchased at a cost of £75,000 for the land and £175,000 for the buildings. The full price is paid from the bank account.


DEBIT CREDIT

Asset LAND & BUILDINGS £250,000

BANK £250,000

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3 Sept: Office furniture is purchased from Style craft at a cost of £30,000. The full price is to be paid within 90 days.


DEBIT CREDIT

Asset FURNITURE £30,000

Liability TRADE PAYABLE(STYLECRAFT) £30,000

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5 Sept: An insurance premium of £540 is paid in advance. The insurance cover will commence on Oct 1.


DEBIT CREDIT

Asset PREPAYMENT £540 BANK £540

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8 Sept: An applicant is interviewed for a post of legal assistant. She agrees to start work on Sept 10 for a salary of £24,000 per annum.

No accounting recognition takes place until the payment has occurred. It is the expense of the past which is recognised, rather than the asset of benefit for the future

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11 Sept: Invoices are sent to some clients showing fees due for work done in preparing contracts for them. The total of the invoiced amounts is £8,820. Clients are allowed up to 30 days to pay.


DEBIT CREDIT

Asset TRADE RECEIVABLES (DEBTORS) £8,820

Ownership interest (revenue)

FEES FOR WORK DONE £8,820

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19 Sept: Cheques received from clients in payment of invoices amount to £7,620.


DEBIT CREDIT

Asset BANK £7,620 TRADE RECEIVABLES (DEBTORS) £7,620

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26 Sept: Payment is made to Stylecraft for the amount due for office furniture, £30,000


DEBIT CREDIT

Asset BANK £30,000

Liability TRADE PAYABLE: (STYLE-CRAFT) £30,000

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28 Sept: Bills are received as follows: for computer rental and on-line searches, £1,500; gas, £100; electricity, £200 and telephone/fax £1,000 (Total £2,800)


DEBIT CREDIT

Liability TRADE PAYABLES £2,800

Ownership interest EXPENSES £2,800

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30 Sept : Legal assistant is paid salary of £1,800 for period to end of month


DEBIT CREDIT

Asset BANK £1,800

Ownership interest EXPENSE £1,800

Analysis of transaction (Continued)

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TRIAL BALANCE Debit Credit

£ £

ASSETS

Land and buildings 250,000

Office furniture 30,000

Traders receivables debtors 1,200

Prepayment 540

Cash at bank 15,280

LIABILITIES

Trade payables 2,800

Long-term loan 150,000

TRIAL BALANCE

Table 3.11 Summary of debit and credit entries for each category of asset, liability and ownership interest

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OWNERSHIP INTEREST

Revenue 8,820

Expenses 4,600

Capital contributed 140,000

Totals 301,620 301,620

TRIAL BALANCE (Continued)

Table 3.11 Summary of debit and credit entries for each category of asset, liability and ownership interest (Continued)

chapter 3

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