CHAPTER TWO

SUBJECT OF ACCOUNTING COVERAGE

Study objectives

1. Elements directly linked with measurement of financial position of a

legal entity
2. Definition, classification of assets, liabilities and equity
3. Elements directly linked with measurement of financial performance of
a legal entity
4. Definition, classification of revenues and expenses
5. Financial result profit or loss

6. ELEMENTS OF
FINANCIAL POSITION

Elements directly related to measuring (valuation) of financial position of a

legal entity are: assets, liabilities and equity, presented in balance sheet.
An asset is a resource controlled by a legal entity as a result of past
events and from which an inflow of future economic benefits into a legal
entity is expected, and whose cost or fair value at the moment of
acquisition can be reliably and objectively measured.

6. ELEMENTS OF
FINANCIAL POSITION

Assets are normally classified into the categories: fixed (non-current) and current
(short-term).
Fixed (non-current) assets have a life of use longer than one year. Current (shortterm) assets have a life of use shorter than one year. Liabilities are probably future
sacrifices of achieving economic benefits. A liability is 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 (Framework).
Liabilities are classified as non-current (long-term) due for the period longer than a
year and short-term (current) due for the period of one year.
Value of a liability indicates to a balance sheet user which part of total assets is not
his own, i.e. which needs to be returned or paid.
According to IAS 1 Presentation of Financial Statements, items from 66-76, of a
legal entity, which make reports in accordance with IFRS, in presentation of balance
sheet have a choice among alternatives:

* to separately present non-current and current assets and liabilities a criteria of life
of use and maturity, or
* if a criteria of useful life for assets, or maturity is not adopted for liabilities, assets
and liabilities should be more thoroughly presented with the aim of liquidity
assessment.

6. ELEMENTS OF
FINANCIAL POSITION

If presentation is not performed in line with useful life, then current assets comprise
the following positions (IAS 1, item 66):
if it is expected to be realized or there is an intention to sell or use in its regular
business cycle of a legal entity;
if it is kept primarily with the aim to be traded;
if it is expected to be realized within twelve months following reporting period, or
is cash or cash equivalent (as defined in IAS 7), unless a possibility for exchange or
use of assets for settlement of liabilities is limited in the period of at least twelve
months after reporting period.
All other assets should be classified as non-current, i.e. fixed.
Current liabilities comprise the following positions , if they fulfill some of the
following criteria (IAS 1, item 69):
it is expected they will be settled during a regular business cycle of a legal entity;
are created primarily in trading process;
are due for settlement within a period of twelve months after the end of a period,
or;
legal entity does not have unconditional right to delay settlement of liabilities for at
least twelve months after reporting date.
All other liabilities should be classified as non-current, i.e. long-term liabilities.
Equity (principal) is the residual interest in the assets of the entity after deducting
all its liabilities (Framework).

6.1.ASSETS

6.1.1. Fixed assets

6.1.1.1. Fixed intangible assets

Goodwill as a specific intangible asset can occur in business combinations, i.e.

acquiring control of one legal entity acquirer over one or more legal entities.
Goodwill is initially valued as a positive difference between acquisition cost and
acquirers share in net fair value of recognizable assets, liabilities and contingent
liabilities of acquired legal entity. Goodwill as a fixed intangible asset is elaborated
in IFRS 3 Business Combinations and IAS 36 Impairment of Assets. Therefore, a
goodwill acquired in business merger is not liable to depreciation. Instead, an
acquirer will test goodwill on impairment once a year, and even more often if
events or changed circumstances refer to a possible loss of value of a goodwill in
accordance with IAS 36 Impairment of Assets, (IFRS 3, item 54 and B 63);
patents, licenses and trademarks;
development expenses capitalized development expenses in accordance with item
57, IAS 38 Intangible assets;
computer programmes(software);
concessions and other assets;
fixed intangible assets in preparation;
advances for fixed intangible assets;
other intangible fixed assets.

6.1.1.1. Fixed intangible

assets

Fixed intangible assets are non-financial assets without physical features

and can be identified. Apart from this, in order for some asset to be
recognized as intangible fixed asset in balance sheet, it is necessary that
a company controls resources from which future economic benefits, which
can be ascribed to an asset, will be flowing into a company, and that
acquisition cost of such asset can be reliably measured. Fixed intangible
asset should be identified in order to be clearly differentiated from a
goodwill (IAS 38, item 11).

Fixed intangible assets should be depreciated with the best assessment of

their useful working life which, according to IAS 38 should not exceed 20
years, unless there are convincing evidences for otherwise. IAS 38 in item
69 explicitly says that expenses of initial activities (beginning of business
operation costs) are recognized as an expense, as new fixed intangible
asset has not been created. Therefore, foundation expenses, according to
the provisions of IAS 38 cannot be recognized as a property item in
balance sheet.

6.1.1.2. Fixed
tangible assets

Fixed tangible assets encompass :

land;
construction buildings;
plants and equipment (machinery);
tools, plant and office furniture and transport means;
property, plants and equipment in preparation;
residential buildings and apartments;
advances for property, plants and equipment;
biological assets;
other fixed tangible assets;
investments in property investment property.

6.1.1.2. Fixed
tangible assets

Fixed tangible assets in line with IFRS and IAS should be classified as:
Fixed tangible assets in full ownership of a company which an owner uses in
production of products, shipment of goods, for various services or for
administrative purposes. Those are actually property, plants and
equipment regulated in accounting terms by IAS 16 Property, Plants and
Equipment.
Investment into a property for lease purposes in accordance with the
provisions of IAS 40
Investment in Property.
Property, plants and equipment which a company acquired through a
financial lease (except for property for lease in accordance with IAS 40)
according to the provisions of IAS 17 Lease. (It is entered into books in a
group together with assets, which are in the ownership, but items are
separately disclosed in line with item 31 and item 47 of IAS 17 Leases).
Fixed tangible assets held for sale and discontinued business operations
according to IFRS 5 Fixed assets held for sale and discontinued
operations.
Biological assets related to agricultural activities - IAS 41.
Agriculture.
Land and forests are a specific type of fixed tangible assets, i.e., those are

6.1.1.2. Fixed
tangible assets

individual parts of property, plants and equipment that fulfill requirements

of recognition in an asset should be initially measured per acquisition cost,
i.e. acquisition (IAS 16, item 15).
amount which is depreciated is an acquisition cost of an asset or other
amount which replaces it, reduced by residual value.
Depreciation is a systemic allocation of the amount, which is depreciated
during its useful life.

Useful life of use is:

period in which it is expected that a company shall use an asset, or
number of products or similar units for which there is expectation that
a company shall realize from that asset.
Biological assets plants, living animals and forests in accordance with
IAS 41 Agriculture.
At initial recognition, and on each date of balance sheet, biological assets
(property) are valued at fair value deducted by an estimated sale costs. If
a fair value cannot be reliably measured, biological asset is valued at
acquisition cost with the depreciation calculation and testing on decreased

6.1.1.2. Fixed
tangible assets

Investment in property according to IAS 40, item 5, represents a

category of fixed assets, which are presented in balance sheet as a
separate item. Those are assets comprised of land, or buildings, or both.

A company keeps them in:

- ownership or lease for the following reasons:

o to earn on lease of those property, or
o to increase the value of those property, or
o for both of the aforementioned.

Investment in property is initially measured at an investment cost.

Transaction costs are also included in acquisition value (IAS 40, item 20). If
a property is purchased, acquisition costs include a selling price, as well
as all direct costs related to the acquisition.

6.1.1.3. Long- term

financial assets

Long-term financial assets represent investments with the aim of

achieving future economic benefits, which are most often occurred in a
form of profit or interests, or certain indirect benefits, as it is a case with
mandatory long-term investments.
In this case, period of return on investment is expected within a period
longer than one year.

Positions of long-term financial assets, definition, recognition and

valuation (measurement) are regulated with IAS 32 Financial
Instruments: Disclosure and Presentation, IAS 39-Financial Instruments:
Recognition and Measurement and IFRS 7-Financial Instruments Disclosure.

Long-term financial assets are:

long-term financial placement
long-term receivables
deferred tax assets and long-term accruals.

6.1.1.4. Fixed assets

as assets held for
sale

Non-current assets held for sale and assets on which operations are
discontinued are elaborated in International Financial Reporting Standard 5
Non-current assets held for sale and discontinued operations.
Legal entity shall classify non-current assets (or a group for disposal) as an
asset held for sale if their carrying amount is mainly compensated through
sale transaction, and not with continuous use (item 6, IFRS 5).
According to the International Accounting Standard 1- Presentation of
Financial Statements, item 54 and International Financial Reporting
Standard 5 Non-current assets held for sale and discontinued operations,
item 3 in non-current assets held for sale, include the following types of
non-current assets:
intangible assets,
tangible assets and
financial long-term assets.

6.1.1.4. Fixed assets

as assets held for
sale

A legal entity shall not classify non-current assets (or a group for disposal)
as an asset held for sale if they are intended for write off (item 13, IFRS 5).

A legal entity shall not calculate non-current assets, which are currently out
of use if they were written off (item 14, IFRS 5).

Non-current assets classified for sale (or a group for disposal) are measured
at the carrying amount or at the fair value deducted by sale costs,
depending on what is the lower value (item 15, IFRS 5).

After non-current assets are classified for sale, a legal entity shall not do
the depreciation, and assets are subsequently measured at the fair value
reduced by sale costs.
Non-current assets which are classified for sale should be separately
disclosed in the balance sheet, and results of discontinued operations
should be disclosed separately in the income statement. Main types of
assets and liabilities should be separately disclosed either on the front page
or in the notes (item 38, IFRS 5).

6.1.2. Current assets

6.1.2.1. Current tangible assets

Raw materials and material (basic and support material, semi-products,

spare parts, fuel and oil, small tools and inventory and parts originating
from written off non-current assets).

Production: non-finalized production at production spots; own semiproducts and parts held for production and wastage held for further
production.

Products: objects which, from an aspect of legal entity are intended for
sale.

Goods: objects, which a legal entity acquired and intended for sale.

6.1.2.2. Cash, shortterm receivables, shortterm placements

include:

cash and cash equivalents;

receivables from sale;
receivables from specific activities;
other short-term receivables;
short-term financial placements;
prepayments and accrued income
receivables for value added tax input tax;
loss above the amount of equity.

6.2. LIABILITIES

Current liabilities are:

short-term financial liabilities;

liabilities from operations;
liabilities from specific activities
liabilities related to salaries, fees and other income of
employees;
other liabilities;
liabilities for VAT;
liabilities for other taxes, contributions and other liabilities;
accruals and deferred income.

6.2.2. Non-current
(long-term) liabilities

Non-current (long-term) liabilities are:

long-term liabilities;
long-term accruals, provisions and deferred tax liabilities;
long-term liabilities classified in a group with assets held for
sale or disposal.

The main feature of a liability is its existence in the current

period. It is necessary to make a distinction between the
current and future liability. Decision of a management of a
legal entity to acquire an asset in future does not mean by
itself incurrence of a current liability. A liability occurs once an
asset is delivered or when a legal entity makes irrevocable
agreement on acquisition of assets.

6.3 EQUITY

Equity implies the following:

original equity,
subscribed unpaid equity,
reserves,
revaluation reserves and unrealized gains and losses,
accumulated profit,
loss to the amount of equity,
purchased own shares and stakes.

In American accounting theory and practice, retained earning is used

in terms of non-allocated profit.
Elements directly related to the measurement (valuation) of financial
position of a legal entity company can be written down in a form of
an accounting equation:

Assets = liabilities + initial equity + retained earning

7. ELEMENTS OF
BUSINES
OPERATIONS
PERFORMANCE

Elements, that is, components of a balance sheet, income statement

directly related to the measurement (valuation) of performance of
operations of a legal entity are:
Revenues are an increase of economic benefits during an accounting
period in a form of inflow or increase of assets or decrease of
liabilities, which leads to an increase of equity, except for those
connected with payments of equity participants. Revenues encompass
revenues from a regular activity of a legal entity and gains
(Framework).
Expenses are a decrease of economic benefit during the accounting
period in a form of outflow or decrease of assets or creation of
liabilities, which leads to decrease of equity, accept for those, which
are linked with the allocation of participants in equity. Expenses
encompass expenses, which arise from a regular activity of a legal
entity and losses. (Framework).
Profit is frequently used as a measure of performance or as the basis
for other measures, such as return on investment or earnings per
share (Framework, item 69).
Profit is defined as a positive difference between a sum of revenues
and sum of expenses of a legal entity within an accounting period.
Loss is a negative difference between a sum of revenue and sum of

7. ELEMENTS OF
BUSINES
OPERATIONS
PERFORMANCE

Therefore, elements directly linked with measuring performance of operations are

revenues and expenses.
Dividends are income from investing in shares. It is usual that they are paid out
to shareholders in cash on the basis of profitable business operations. In
American accounting theory and practice, payment of cash dividends to
shareholders is entered into accounting records at the account of retained
earnings.
We can present elements of measuring a financial position and performance of
operations of a legal entity on the basis of extended accounting equation:

Assets = liabilities + original equity +retained earning dividends +

+revenues expenses

Example: Effect of ordinary business transactions on the accounting equation:

1. James and John Shanon are opening Real estate agency named Shanon property, they are
submitting an application and contract on foundation and getting an approval. In order to
resume their activities on 1st December of current year, they invested in Shanon property 50
000 in return for 5 000 shares with nominal value of 10 per share.

Business transactions after foundation:

2. After they found a location, a company is buying land and a small building. Expense of land
purchase amounted to 10 000, and building amounted to 25 000 and all was paid in cash.
3. A company buys at deferred payment, office supplies in the amount of 500.
4. A company settled a part of liabilities in cash, the amount of 200 (reference,
transaction 3).
5. A company sold a house to a client and at the account of service of sale of property got the
commission (fair value) in cash 1 500.
6. A company sold a house to some other client. Negotiated commission amounts to
2 000 (fair value) and an invoice was submitted to a client.
7. Few days later, a company charges a client on the basis of invoiced commission,
1 000 (reference transaction 6).
8. A company leased equipment for office and pays expense for lease 1 000 in cash.
9. A company temporarily engaged a worker as an assistance and cost of salary was assessed to
400, which represents an expense paid in cash.
10. A company receives an invoice 300, an expense of electricity for December of a current year.
11. Dividend was disclosed in the amount of 600 and was paid by withdrawing funds from a bank
account of a company and payment to shareholders cash dividends because of an investment
to their private accounts.

Solution:

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7. ELEMENTS OF
BUSINES
OPERATIONS
PERFORMANCE

Solution:

7. ELEMENTS OF
BUSINES
OPERATIONS
PERFORMANCE

Solution:

7. ELEMENTS OF
BUSINES
OPERATIONS
PERFORMANCE

Payment of dividends reduces cash in gyro account and equity of a company

(retained earning).
We present a balance sheet and income statement from which we can see that
the previous records were correctly conducted. We see that from balance sheet in
which a sum of assets is 51 800, and presented liabilities and equity 51 800.
Thus, there is always a balance of an accounting equation.

7. ELEMENTS OF
BUSINES
OPERATIONS
PERFORMANCE

Three types of transactions have an effect on retained earning: revenues,

expenses and dividends, and we illustrate it in the following way:

QUESTIONS FOR ASSESSING KNOWLEDGE AND UNDERSTANDING:

1.Which elements are directly linked with the measurement of financial
position of a legal entity?
2. Explain definition of assets, liabilities and equity.
3. What are the criteria of classification of assets and liabilities?
4. List correct classification of intangible and tangible non-current assets.
5. Explain a correct classification of long-term financial assets.
6. What is the correct structure of private equity?
7. Corporation Arnold Smith,s has assets 22 000 and liabilities 10 000.
On the basis of an accounting equation calculate the amount of private equity.
8. Which elements are directly linked with the measurement of financial
performance of a legal entity?
9. What is the correct definition of revenues and expenses, profit or losses.
10. Provide two examples of transactions:
a) increase of assets and
b) decrease of assets.