WEEK 5/6 LECTURECovers: Chapter 5 of the textbook up to learning objective 9

on page 172

In this presentation...

1. explain the nature and purpose of the balance sheet2. apply the asset definition and recognition criteria3. apply the liability definition and recognition criteria4. apply the definition and nature of equity5. describe the format and presentation of the balance sheet6. describe the presentation and disclosure requirements for

elements on the balance sheet7. illustrate the measurement of various assets and liabilities

on the balance sheet. (Week 6 lecture)8. discuss the limitations of the balance sheet. (Week 6

lecture)

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Nature and Purpose of the Balance Sheet

• The balance sheet is a financial statement that details the entity’s assets, liabilities and equity as at a particular point in time — the end of the reporting period

• The balance sheet sets out the financial position of an entity at a particular point in time

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Nature and Purpose of the Balance Sheet (cont)

• The balance sheet is a financial statement that shows:

– what the entity owns (or controls) as at a particular date — the assets

– the external claims on the entity’s assets — the liabilities (owe)

– the internal claim on the entity’s assets — the equity (owners)

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Balance Sheet Example

• Note the formula Total Assets – Total Liabilities = Net Assets = Equity

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The definition of an asset

• An asset is formally defined in the Conceptual Framework (para. 4.4(a)) 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’. The essential characteristics for an asset are:1. the resource must be controlled by the entity

2. the resource must be as a result of a past event

3. future economic benefits are expected to flow to the entity from the resource.

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Control

• An entity must control the item for that item to be considered as an asset and recognised on the balance sheet.

• The concept of control refers to the capacity of the entity to benefit from the asset in the pursuit of its objectives, and to deny or regulate the access of others to the benefit.

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Past Event

• Every asset must have arisen from a transaction that has happened

• A company cannot include an asset it will be getting in the future.

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Future Economic Benefit

• Items must provide benefits to the entity that uses them in order to be regarded as assets

• Benefit can be cash or control of resources

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Recognition of an asset

• Recording items in the financial statements with a monetary value assigned to them.

• Satisfying the definition criteria is only part of the process in recording an item on the balance sheet

• Recognition criteria must also be satisfied

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Recognition of an Asset

• Probable

– It is more than likely that the future economic benefits will flow from the asset to the business controlling it.

• Reliably Measured

– The value of the asset can be measured reliably

– Involves the use of estimates

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Criteria to be satisfied to recognise an asset

• The essential characteristics for an asset are:

1. the resource must be controlled by the entity

2. the resource must be as a result of a past event

3. future economic benefits are expected to flow to the entity from the resource.

• To be recognised as an asset on the balance sheet, the future economic benefits must be probable and capable of being measured reliably.

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The definition of a liability

• A liability is formally defined in the Framework (para. 4.4(b)) as ‘a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits’. The essential characteristics for a liability are:

1. a present obligation to another entity2. the present obligation arises as a result of past

events3. an outflow of resources embodying economic

benefits is expected to flow from the entity as a result of settling the present obligation.

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Present Obligation

• A commitment to another entity to provide resources to that entity.

– Can be formal (legal) or informal

– Entity may not be known

• e.g. sales of goods that may be returned (warranty)

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Past Event

• The obligation must have arisen as a result of a past event

• Can be an obligation arising in the future if the event is currently occurring e.g. court case

• Cannot be an obligation you intend to get.

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Outflow of resources

• Future sacrifices of economic benefits are associated with adverse financial consequences for the entity

– Once resources flow out of business, they cannot be used to generate revenue or obtain assets in the future.

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Recognition of a Liability

• Probable

– It is more than likely that the future economic benefits will flow from the business to another entity

• Reliably Measured

– The value of the liability can be measured reliably

– Involves the use of estimates

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Criteria for recognising and recording liabilities

• The essential characteristics for a liability are:1. a present obligation to another entity2. the present obligation arises as a result of past

events3. an outflow of resources embodying economic

benefits is expected to flow from the entity as a result of settling the present obligation.

• To be recognised as a liability on the balance sheet, the outflow of resources embodying future benefits must be probable and capable of being measured reliably.

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Presentation and disclosure of elements on the balance sheet

• Accounting standards exist that prescribe the presentation, classification and disclosure requirements for assets, liabilities and equity on the balance sheet

• Even though not legally required, some entities with no public accountability voluntarily adopt similar classification, presentation and disclosure practices as required by IFRSs

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Current and non-current assets and liabilities

• Distinction between current and non-current classification is based on timing

• If the economic benefits (of asset) or outflow of resources (for liability) are expected to be realised in the next reporting period, the asset or liability is categorised as current

• If economic benefits (of asset) or outflow of resources (of liability) are expected beyond next the reporting period, the classification is non-current

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Presentation and disclosure of assets

• Assets are classified according to their nature or function

• Classifications can reflect

– Liquidity

– Marketability

– Physical characteristics

– Expected timing of future economic benefits

– Purpose

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Classification of Assets

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• Cash and cash equivalents

• Trade receivables

• Inventories

• Non-current assets held for sale

• Investments accounted for using equity method

• Financial assets

• Property, plant and equipment

• Deferred tax assets

• Agricultural assets

• Intangible assets

• Goodwill

Assets – Classes include:

Presentation and disclosureof assets (example)

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Presentation and disclosure of liabilities

• Liabilities are classified according to their nature

• Classifications may be based on:

– Liquidity

– Level of security of guarantee

– Expected timing of the future sacrifice

– Source

– Conditions attached to the liabilities

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Classification of Liabilities

Classes include:-

• Trade and other payables

• Borrowings

• Tax liabilities

• Provisions

• Financial liabilities

• Secured debts

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Presentation and disclosureof liabilities(example)

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The definition and nature of equity

• Equity is defined in the Conceptual Framework (para. 4.4(c)) as ‘the residual interest in the assets of the entity after deducting all its liabilities’.

• Equity comprises various items, including capital contributed by owners (shareholders) and profits retained in the entity.

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EQUITY = ASSETS – LIABILITIES

Presentation and disclosure of Equity

• Depending on the entity structure, the terminology and equity classifications appearing on the balance sheet will vary between entities.

– Sole Traders & Partners will have Profit/Loss and Drawings contributing directly to equity

– Companies will have retained earnings and reserves

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Classification of Equity

• Share capital– Paid-up share capital, contributed capital

• Retained earnings

• Reserves

• Minority interests of controlled entities

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Presentation and disclosureof equity (example)

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Summary

1. The balance sheet reports an entity’s financial position at a point in time

2. Various criteria govern the recognition and measurement of assets, liabilities and equity

3. A breakdown of various classifications of assets, liabilities and equity is usually included in the notes to the accounts

END

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