Purpose of the Statement of the financial position

Published:

First Part:

Statement of financial position which is also known as the Balance Sheet is one of the components of financial statements which presents financial outlook of an entity at a given date.

There are three main components of this statement which are:

  1. Assets
  2. Liabilities; and
  3. Equity

This statement primarily helps the users of financial statements to gauge the financial soundness of the business with respect to financial risk, liquidity risk and business risk.

Purpose of the Statement of the financial position:

The main purpose of the statement of financial position is to help the user of financial statements to evaluate the financial health of an entity. A very helpful purpose is fulfilled when this statement is analyzed over several accounting periods. It assists in identifying the underlying trends and patterns in the financial position of the business. It fulfils the purpose of determining the state of entity’s financial risk, liquidity risk and business risk. If we use this statement in combination of other financial statements of the same entity and the financial statements of its rival companies, the balance sheet may help to indicate trends and relationships showing potential areas of improvements. The primary purpose which this statement of financial position fulfils is to assist the users of financial statements to forecast the timing, amount and volatility of an entity’s future earnings outlook. The statement of financial position is helpful for different users to reach a rational financial decision.

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The accounting equation upon which the balance sheet is constructed is as follows:

Assets = Equity + Liabilities

Limitations of Statement of Financial Statements:

In financial reporting framework, a statement of financial position is a summary of balances of a business partnership, sole proprietorship, business organization or corporation. In this statement, assets, liabilities and shareholder’s equity are being recorded at a specific date which may be the end of the financial year. The balance sheet is the only component of financial statement which applies to a single point in time of the accounting year.

There are three basic limitations to this statement of financial position:

  1. Historical cost convention
  2. Use of Estimates
  3. Ignoring valuable intangibles

Now we discuss these drawbacks of balance sheet in the following paragraphs.

  1. Historic Cost Convention

In the statement of financial position, fixed assets are recorded at historical cost less depreciation and less any impairment loss up to the date of the statement. Depreciation expenses affects the carrying value of an asset and the historical cost will only equal the carrying value only if there is no addition or deletion took place since the date of acquisition. Due to this fact it is evident that the statement of financial position doesn’t show the exact value of assets. The statement of financial position shows that limitation of not reflecting the current market value of the assets of a business entity.

  1. Use of Estimates

There are some current assets which are being values on the basis of estimates and not the true valuation which leads to this drawback of not reflecting the true financial position of an entity. For example, goodwill, an intangible asset is being recorded in the balance sheet at a notional price which may have no linking to the market price. In this regard, IAS-38 of the International Accounting Standards Board (IASB) provides some guidance regarding the accounting treatment in the financial statements. As per the provisions of this standard, internally generated intangible assets are not to be recognized and only the intangible assets purchased from third parties will be recognized. Therefore, goodwill acquired from outside the organization will be recorded and similar internally generated intangible asset cannot be recognized, although the investors will account for this asset at its market value.

  1. Ignoring valuable intangibles

Finally, it is a general view that the statement of financial position does not reflect such assets which cannot be recorded in monetary terms such as intelligence, honesty, skills, loyalty of employees.

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Conventions of the Statement of Financial position:

Accounting conventions are set of standard rules which provide the basis of preparation of a balance sheet. There are different accounting conventions which can change the outlook of a company’s financial position. These conventions are summarized as follows:

Historic Cost convention:

This convention, which is also a limitation of the balance sheet, states that the assets are to be recorded at their original value and continue to appear at cost throughout their life. Such asset type which depreciates rapidly than normal and the cost of an asset which appreciates will continue to be represented at the original cost price. In such situation the financial representation of the balance sheet can be prejudiced.

Going concern Convention:

This is a more positive convention than others where an assumption is being made that the business entity will continue to perform its business for a foreseeable future period. If the business is to discontinue and liquidate, the assets will be sold off from less than its recorded or fair value.

Prudence Convention:

This convention is based on avoiding being over-optimistic estimations and projections by the management of an entity. All the profits will only be recorded once they are actually realized and all the possible losses are recognized once and in full. That implies actually taking on a bleak standing on the financial position and may lead to investors placing a lower value on their investments than the actual value.

Dual Aspect Convention:

The concept of balance sheet is based on this dual effect convention where each business transaction has a negative and positive effect and hence recorded in the relevant sections and this convention ensures that the balance sheet will always be balanced.

Business Entity Convention:

The business is a separate legal entity which is different from its owners; such is the business entity convention. To elaborate this subject, if the business owner provides $ 100,000 in the business then this amount is a debt which the business entity owes to the owner.

http://www.michaelrauch.net/2011/11/accounting-conventions-and-their-effects-on-financial-position/

https://www.boundless.com/finance/financial-statements-taxes-and-cash-flow/the-balance-sheet/limitations-of-the-balance-sheet/

http://accounting-simplified.com/financial/statements/statement-of-financial-position.html

Second part:

Accounting for Fixed Tangible Assets:

Fixed tangible assets used by a business entity mainly comprises of property, plant and machinery and equipment. The International Accounting Standard which prescribes the accounting treatment of these fixed assets is IAS-16. The basic issues which are to be discussed relating to the accounting for fixed assets are the recognition of tangible fixed assets, determination of their carrying amounts, the depreciation charge and the impairment losses to be recorded for these assets.

Firstly, we are going to discuss the recognition criteria with respect to the tangible fixed assets.

Recognition of Fixed tangible assets:

Items of fixed assets shall be recognized and accounted for in the financial statements when the following two conditions are fulfilled:

  1. The cost of the assets is capable of being measured reliably
  2. It is anticipated that the future economic benefits relating to these assets will flow to the entity.

This above mentioned recognition principle will be applied to all the items of fixed assets costs when they are incurred. These costs include the costs incurred to construct or acquire fixed assets and any additional cost incurred subsequently to add or replace a part of it.

Initial measurement of cost

Initially, an item of fixed assets is to be recorded at cost. Cost of an asset comprises all the necessary expenses paid to bring the asset in its running condition for its intended use. This cost would consist of the original purchase price and the relating costs such as delivery and handling, cost for site preparation, professional fee of engineers and an estimated cost of removing and dismantling the asset and restoring the area. Also if the for the fixed assets is deferred in a future date, an amount of interest at market rate would also be included in the cost of the asset.

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If there is an exchange transaction occurred where an asset is exchanged for another asset the cost of the asset will be considered as the fair value of the asset.

Measurement subsequent to initial recognition

This accounting standard allows for two accounting models for measuring the subsequent transactions:

  1. Cost model. Where the asset is recorded at cost less accumulated depreciation and impairment loss, if any.
  2. Revaluation model. The asset is recorded at a revalued amount which is the fair value at the date of revaluation less related depreciation and impairment. If the revaluation model is adopted then it should be carried out regularly so the carrying amount is not materially different from its fair value. The depreciation rules are the same as for the assets under the cost model which we will discuss later on. This standard also provides that if an item of a particular asset is revalued then the entire class o such assets should be revalued.

Depreciation Charge:

Depreciation is a non cash expenses which is a result of wear and tear, age and obsolescence.

The depreciable amount is to be allocated on a systematic basis over the assets useful life. The entity should review the useful life and the residual value of the asset at least annually and if there is a change in expectations, any change in the estimate should be accounted for prospectively. The depreciation method reflects the pattern of economic benefits derived by the entity and such method should also be reviewed annually and if the pattern of consumption of benefits is found to be changed, the depreciation method should also be changed prospectively.

Depreciation is a business expenses, and it begins when the asset is available for use, it is charged against the revenues in the profit and loss account.

Depreciation method

Formula

1

Straight Line basis

(Cost – residual value)/useful life

2

Reducing balance method

Book value x depreciation rate

3

Sum of year digit method

(Cost-salvage value) x fraction

Impairment Loss:

An impairment loss in the profit and loss account will be recognized if the carrying amount of an asset is more than the recoverable amount, which is the higher of an assets value in use or its fair value less costs to sell.

Accounting for Disposal of an Asset:

An asset will cease to appear in the statement of financial position when it is disposed of or when it is no more in usage and no economic benefit is expected from its disposal. The difference between the sale proceeds of the asset and the carrying amount is the gain or loss to be recognized in the profit and loss for such asset.

Disclosures

For each class of asset, disclose:

  • basis of measurement of carrying amount
  • depreciation method adopted
  • depreciation rates used or useful lives
  • gross carrying amount and accumulated depreciation and impairment losses
  • reconciliation of the carrying amount at the beginning and the end of the period, shown as below in the table:

Cost at the beginning of period

Addition

Disposals

Cost at the end of period

Accumulated depreciation at the beginning of period

Depreciation charge for the year

Depreciation on disposal

Accumulated depreciation at the end of period

Net book value of the asset

A

B

C

D= A+B-C

E

F

G

H= E+F-G

I= D-H

http://www.iasplus.com/en/standards/ias/ias16

Third part:

Provisions, contingent liabilities and contingent assets are the non cash items on the face of the statement of financial position which require a certain amount of estimations based on the available facts and circumstances of the transactions. The International Accounting Standard which prescribes the treatment of these such transactions is IAS-37 which ensures that appropriate recognition and measurement criteria is applied to provisions, contingent assets and contingent liabilities. There is a key principle which is being set up by this standard that a provision should only be recognized when there is a present obligation resulting from past events. Thus the standard provides the accounting procedure to ensure that only legitimate obligations are dealt with and recorded in the financial statements.

Provisions

This standard defines a provision as a liability of uncertain amount and timing.

There is a basic recognition criteria being provided by the standard which must be followed:

A provision should be recognized only when:

  • (a) an entity has a present obligation (legal or constructive) as a result of a past event;
  • (b) it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and
  • (c) a reliable estimate of the amount of the obligation can be made.

If any of these conditions are not met, no provision shall be recorded. There are some rate cases where it is not clear whether there is a present obligation or not. In such cases, a past event is considered to give rise to a present obligation if it is more than probable that a present obligation exists at the end of the reporting period.

Measurement

Where the recognition criteria is met, the amount recognized as a provision should be the best possible estimate of the expense required to settle the present obligation at the end of the reporting period. The best estimate is the amount that an entity would rationally pay to settle the obligation at the end of the reporting year or to transfer it to a third party at that time.

Where the provision being measured involves a large population of items, the obligation is estimated by weighting all possible outcomes by their associated probabilities. The individual most likely outcome would be the best estimate where a single obligation is being measured. However, even in that case, the entity will continue to consider other possible outcomes.

Contingent liabilities

A contingent liability is defined by the standard as a liability fulfilling these two conditions:

(a) a possible obligation whose existence will be confirmed only by the occurrence or non-occurrence of future uncertain events which are not wholly within the control of the organization and that arises from past events; or

(b) it may be a present obligation that arises from past events but is not recognised due to the following two reasons:

(i) an outflow of resources, is not probable, embodying economic benefits will be required to settle the obligation; or

(ii) the amount of the obligation is not capable of being measured with sufficient reliability.

An entity is restricted to recognise a contingent liability. An entity, however, should disclose a contingent liability, unless the possibility of an outflow of resources involving economic future benefits is remote.

Contingent assets

The standard defines a contingent asset as a possible asset that arises from past events whose existence will be confirmed by the occurrence or non-occurrence of one or more uncertain future events and such event is not wholly within the control of the business.

As for the recognition, an entity shall not recognise a contingent asset. However, where the realisation of income from such asset is virtually certain, then the related asset is not a contingent asset and its recognition is normal under the IAS-16.

Disclosures

Reconciliation for each class of provision:

  • opening balance
  • additions
  • used (amounts charged against the provision)
  • unused amounts reversed
  • unwinding of the discount, or changes in discount rate
  • closing balance

Opening balance of provision

Additions made during the year

Provision used during the year

Unused provision reversed

Unwinding of discount

Closing balance of provision

A brief description of the following for each class of provision:

  • nature
  • timing
  • uncertainties
  • assumptions
  • Reimbursement, if any.

Tables—Provisions, Contingent Liabilities and Contingent Assets

Where, as a result of past events, there is an outflow of resources involving service potential or future economic benefits in settlement of:

(a) a present obligation; or

(b) a possible obligation whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity.

There is a present obligation that probably requires an outflow of resources.

There is a present obligation or possible obligations that may, but probably will not, require an outflow of resources.

There is a possible obligation or a present obligation where there is likelihood of an outflow of resources is remote.

A provision will be recognized.

No provision will be recognized.

No provision is to be recognized.

A disclosure will be required for this provision.

Disclosures, however, will be required for the contingent liability.

No disclosure is required.

In extremely rare cases a contingent liability also arises where there is a liability that cannot be recorded because a reliable estimate cannot be made. Only disclosures are required for the contingent liabilities.

Contingent Assets

Where, as a result of past events, there is a possible asset whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity.

The inflow of service potential or economic benefits is virtually certain.

The inflow of service potential or economic benefits is probable, but not virtually certain.

The inflow of service potential or economic benefits is not probable.

The asset is not contingent but a normal asset under IAS-16

No asset will be recognized

No asset will be recognized

Disclosures will be required

No disclosures will be required.

http://www.iasplus.com/en/standards/ias/ias37

http://www.icaew.com/en/library/subject-gateways/accounting-standards/ifrs/ias-37

https://www.ifac.org/sites/default/files/publications/files/ipsas-19-provisions-cont.pdf