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CHAPTER 3 Measurement 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
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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: • What are the rules? • To what extent are they flexible? • 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 31/12/20X1 Balance sheet 31/12/20X4 Balance sheet 31/12/20X2 Balance sheet 31/12/20X3 Income statement 20X2 Income statement 20X3 Income statement 20X4
Accomplishments => less Efforts => equals Performance => Revenues Expenses Profit (or Loss) Company X – Income Statement of period 20X2
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)
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
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
Resources = Assets = Sources of finance “Equities” Owners’equity Liabilities (interests of owners) (interests of creditors) Company X – Balance sheetat 31 December 20X2
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)
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 / Cash Retained 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
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
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 Alternative: debits and credits
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
