ACCT1501_LEC02 11th March 2017

Ch2 Measuring & Evaluating Financial Position & Performance

1. Balance sheet – asset, liabilities and equity
2. Connecting the income statement and balance sheet
3. Income statement – revenues and expenses
4. Capitalise Vs. expense – recording expense as an asset

1. Balance sheet
Balance sheet – a statement tells the financial position of an enterprise at a particular time
Balance sheet relies on the accounting entity assumption.

What does a balance sheet provide

• Financial structure – debt to equity ratio
• Liquidity – the ease of converting assets to cash; working capital, current ratio
• Solvency – ability to pay debts when they fall due (long-term)

What is a on a balance sheet

1. Name of the accounting entity
2. Type of financial statement (balance sheet)
3. Date (point of time it refers to)
4. Currency ($M, $AUD)
5. Assets (resources)
a. Current or non-current (cash, trade and other receivables, inventories)
6. Liabilities
a. Current or non-current (accounts payable, borrowings)
7. Equity
a. The residual (what remain) (e.g. share capital retain profits)

Characteristics of assets
1. Future economic benefits – assets that are used to provide goods or services with the
objective of generating net cash flow
2. Control by an entity – the capacity of an entity to benefits from the asset in pursuing
its objectives to regulate the access of others
3. Occurrence of past transactions or other past events

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1.1 Asset
Assets – are resources that is controlled by an entity as a result of past event, and from which
future economic benefits are expected to flow to the entity. Must pass the reliable
measurement (its value can be measured reliably).

Working capital and current ratio

Working capital = CA – CL
Current ratio = CA/CL

Current asset – expected to turn into cash within 12 months (cash, accounts receivable,
inventory)
Non-current asset – turn into cash over than 12 months (equipment, building and land)

• Future economic benefit: assets are used to provide products and services to generate
net cash flows
• Control by entity: the capacity of an entity to access from the asset
• Occurrence of past transactions or other past events: a transaction must have
occurred with a future economic benefit (e.g. paid cash or credit)

To be reported on a balance sheet, assets and liabilities must meet recognition criteria:

• It is probable that any future economic benefit associated with the item will flow to
or from the entity and
• The item has a cost or value that can be measured reliably
If definition requirements are met, but we cannot say yes to the above, then we disclose
details about the item in the notes.

1.2 Liability
Liability: a present obligation of the entity arising from past events, the settlement (of
payment) is expected to result in an outflow from the entity of resources.

• Present obligation exists and the obligation involves settlement in the future
• The entity is obligated to sacrifice economic benefits

Current liability – liabilities to be paid off within a year (bank overdraft, accounts payable,
wages payable, dividends payable)
Non-current liabilities – to be paid off over 1 year (mortgages, leading, financing)

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Notes payable (NP) – evidenced by a promissory note or bill of exchange (e.g. credit purchase
of equipment)

• The interest-bearing characteristics are the written documentation that distinguish

notes payable from accounts payable

1.3 Equity
Equity – is the residual interest in the assets of the entity after deducting all liabilities.

• They include share capital and retained earnings

• Equity is the link between the balance sheet and the income statement

Retained Profits
Retained profits – is the sum of net profits earned over the life of a company less dividends
declared to shareholders.
It can be distributed to shareholder as dividends or kept in the business for growth.
Retain Profit Account is the link between the balance sheet and the income statement

• Income statement accounts are temporary accounts

• Balance sheet accounts are permanent accounts
• Income statement accounts are ‘closed’ and their balances transferred to the retained
profits account (on the balance sheet) at the end of each accounting period

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3 Income Statement
Income statement – shows the results of business’s operation over a period of time

• Relates to the accounting period assumption

• Reports revenues earned less any expenses occurred
• Provides a measure of organisational efficiency
• Calculates the profit that may be available to shareholders

3.1 Revenue
Revenue – is the gross inflows of economic benefits during the period arising in the ordinary
activities of an entity when those inflows result in increases in equity other than those relating
to contributions from equity participants.
Revenue represents an increase in the wealth of the business. It is recognised when it is
considered to be ‘earned’

• Requires a ‘trigger point’

• E.g., when goods/services have been provided to customers
• Receipt of cash is not necessary!
• E.g. sales revenue, interest revenue, rent revenue, dividends revenue etc.

3.2 Expense
Expenses represent decreases in the entity’s wealth. They are incurred in order to earn revenue.
Expenses do not include payments or returns to owners (i.e. withdrawal by owners and
dividends to shareholders). Payments to owners are considered to be ‘distributions’ of net
profit to owners.

Wealth decreases because:

• Operating costs have to be paid

• Long term assets wear out
o Referred to as ‘depreciation’ or ‘amortisation’
o Notice this has no direct effect on cash!
o Valuation v.s. cost allocation (matching principle)
• Assets are used up (e.g. prepayments, inventory)

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4. Capitalise vs. Expense

• Recording a cost as an asset is capitalisation. If cost is not capitalised, it is expensed.
• For example: This decision can be affected by the amount and/or for how long it would
last/definition of an asset (e.g. recording a purchase of an $1M equipment as an asset)

5. Cash v accrual profit

• Accrual accounting records:
a. Revenues when they are earned, not received.
b. Expenses when they are incurred, not paid.
• The earning of a revenue is not necessarily accompanied by an inflow of cash.
• The incurrence of an expense is not necessarily accompanied by an outflow of cash

Next week Chapter 3: Double Entry System