CH 3

CHAPTER 3
Measurement concepts and the

balance sheet equation
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5

© 2005 Peter Walton and Walter Aerts
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:
a) What are the rules?
b) To what extent are they flexible?
c) 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 Balance sheet Balance sheet Balance sheet

31/12/20X1 31/12/20X2 31/12/20X3 31/12/20X4
Income Income Income

statement 20X2 statement 20X3 statement 20X4

Company X – Income Statement
of period 20X2
Accomplishments => Revenues

less
Efforts => - Expenses
equals
Performance => Profit (or Loss)

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)

Income statement presentation 1
Income statement for period 200X

€ ’000
Sales 5,356
Raw materials 1,739
Salaries and wages 783
Depreciation 462
External services 873 (3,857)
Profit before interest and tax 1,499
Interest (362)
Profit before taxation 1,137
Taxation (384)
Profit available for shareholders 753

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

Income statement presentation 2
Income statement for period 200X
€ ’000
Sales 5,356
Cost of sales (2,601)
2,755
Distribution costs 382
Administrative expenses 874 (1256)
Profit before interest and tax 1,499
Interest (362)
Profit before taxation 1,137
Taxation (384)
Profit available for shareholders 753

Operating expenses by
nature or function
Nature Function
€ ’000 € ’000
Raw materials 1,739 Cost of sales 2,601

Salaries and wages 783 Distribution costs 382
Administrative
Depreciation 462 expenses 874
Other costs 873
Total 3,857 Total 3,857

Allocation of input costs
Function: Cost of sales Distribution Administrative
costs expenses
Input costs:
Salaries and Factory Sales agents Accountants

wages employees
Depreciation Production hall Cars Administration

buildings

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

Company X – Balance sheet
at 31 December 20X2
Resources = Sources of finance
Assets = “Equities”
Owners’equity Liabilities
(interests of owners) (interests of
creditors)

Horizontal balance sheet
Fourth EC Accounting Directive
Assets Liabilities and equity
Intangible assets 943 Ordinary shares 2,455

Tangible assets 1,988 Reserves 982
Investments 213 Retained profit 947
Fixed Assets 3,144 Shareholders’ equity 4,384
Stocks 1,589 Provisions 520

Debtors 973 Financial liabilities 1,500
Cash at bank 881 Trade liabilities 359
Deferred charges 176

US format
Assets Liabilities and equity
Cash at bank 881 Trade payables 359

Deferred charges 176 Debt 1,500
Receivables 973 Provisions 520
Inventory 1,589
Fixed assets: Equity
Investments 213 Ordinary stock 2,455
Tangible assets 1,988 Reserves 982
Intangible assets 943 Retained profit 947

 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 sheet
at 31 December 20X2
Assets
- Liabilities
Owners’equity => Residual claims of owners
Contributed funds (share capital)
Earned funds (accumulated profits)

Balance sheet – vertical format
€ ’000 € ’000
Intangibles 943
Tangible assets 1,988
Investments 213 3,144
Fixed assets
Stocks 1,589
Debtors and prepaid1 1,149
Cash at bank 881
Current assets 3,619
Creditors due in less than one year (359)
Net current assets 3,260
Creditors due in more than one year (1,500)
Provisions (520)
4,384
Capital
Ordinary shares 2,455
Reserves 982
Retained profits 947
4,384

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
Income statement
Revenues and expenses with regard to a specific

accounting period
 Revenue recognised in period when earned

 Expenses related to the sale are recognised
in the same period as the revenue

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
Retained for growth Profit / Cash 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

Link income statement and balance sheet
Owner’s equity = Assets – Liabilities
1 jan. 20X1 Share capital 1/1 + Retained profits 1/1 = Net assets 1/1 (NA)
Income statement
for year 20X1
During 20X1 Revenues = Increase NA
- Expenses = Decrease NA
+ Profit
(- Loss)
- Dividend = Decrease NA
31 dec. 20X1 Share capital 31/12 + Retained profits 31/12 = Net assets 31/12

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

Alternative: debits and credits
 Assets Debit Asset Credit

 Increase (+) => debit
 Decrease (-) => credit
 Equity/Liabilities Debit Eq./Liab. Credit

 Increase (+) => credit
 Decrease (-) => debit
 P&L accounts Debit P&L Credit

 Revenue => credit Cost Revenue
 Cost => debit

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

Illustration – Constitution of share capital
Assets 1 2 3 4 Situation
Cash +20000
+15000
+15000
Receivables
Inventory
Property
Total +50000
Liab./Equity
Long-term debt
Shares +20000
+15000
+15000
Profit
Total +50000

Illustration – Bank loan
Cash +20000 +30000
+15000
+15000
Receivables
Inventory
Property
Total +50000 +30000
Liab./Equity
Long-term debt +30000

Shares +20000
+15000
+15000
Profit
Total +50000 +30000

Illustration – Buying a garage with office
Cash +20000 +30000 -55000
+15000
+15000
Receivables
Inventory
Property +55000
Total +50000 +30000 0
Liab./Equity

Shares +20000
+15000
+15000
Profit
Total +50000 +30000 0

Illustration – Buying second hand cars
Cash +20000 +30000 -55000 -18000
+15000
+15000
Receivables
Inventory +18000
Property +55000
Total +50000 +30000 0 0
Liab./Equity

Shares +20000
+15000
+15000
Profit
Total +50000 +30000 0 0

Illustration – Intermediate position tracking
Cash +20000 +30000 -55000 -18000 7000
+15000
+15000
Receivables
Inventory +18000 18000
Property +55000 55000
Total +50000 +30000 0 0 80000
Liab./Equity
Long-term debt +30000 30000

Shares +20000 50000
+15000
+15000
Profit
Total +50000 +30000 0 0 80000

Illustration – Intermediate balance sheet
Assets Equity and Liabilities
Tangible assets 55.000 Share capital 50000

(Property)
Fixed assets 55.000 Shareholders’equity 50000
Inventory (Cars) 18000 Financial liabilities 30000

(LT debt)
Cash at bank 7000

Current assets 25000 Liabilities 30000
Total 80000 Total 80000

Illustration – Sale of car and repairs
Assets Situation A 5 6 7 Situation B
Cash 7000 (a) +5000
(c) -250
Receivables
Inventory 18000 (b) -4000
Property 55000
Total 80000 +750
Liab./Equity
Long-term debt 30000

Trade creditor
Shares 50000
Profit (a) +5000

(b) -4000
(c) -250
Total 80000 +750

Illustration – Sale of car on credit
Cash 7000 +5000
-250
Receivables (a)+7000
Inventory 18000 -4000 (b) -5500
Property 55000
Total 80000 +750 +1500
Liab./Equity
Long-term debt 30000

Trade creditor
Shares 50000
Profit +5000 (a)+7000

-4000 (b) -5500
-250
Total 80000 +750 +1500

Illustration – Buying cars on credit
Cash 7000 +5000 11750
-250
Receivables +7000 7000
Inventory 18000 -4000 -5500 +12000 20500
Property 55000 55000
Total 80000 +750 +1500 +12000 94250
Liab./Equity
Long-term debt 30000 30000
Trade creditor +12000 12000
Shares 50000 50000
Profit +5000 +7000 2250

-4000 -5500
-250
Total 80000 +750 +1500 +12000 94250

Illustration – Income statement
Sales 12000
Cost of sales
- Cars 9500
- Repairs 250
9750
Net Profit 2250

Illustration – Balance sheet
Assets Equity and Liabilities
Tangible assets 55.000 Share capital 50000

(Property) Profit 2250
Fixed assets 55.000 Shareholders’equity 52250
Inventory (Cars) 20500 Financial liabilities 30000

Receivables 7000 (LT debt)
Cash at bank 11750 Trade creditor 12000

Current assets 39250 Liabilities 42000
Total 94250 Total 94250

Illustration -
Reconciliation of profit and net cash flow
Net Profit (Income statement) 2250

Value of inventory sold (paid previously) 9500
Amount due by customer (still to be received) -7000
Change in cash during period +4750

The IASB definition of elements of
financial statements
 Elements of financial statements are the
building blocks of a balance sheet and income
statement
 Broad categories according to their economic
characteristics
 The IASB Conceptual Framework identifies
and defines five elements of financial
statements
 assets, liabilities, equity, income and expenses

Elements of financial statements
 c.f. IASB Conceptual Framework

 Five basic elements:
 Assets
 Liabilities
Financial position
 Equity
 Income
Financial performance
 Expenses

Elements of financial statements
(cont.)
Financial position
Assets – Liabilities = Equity
Financial performance
Income – Expenses = Profit

IASB - Asset
 ‘A resource controlled by an entity as a
result of past events from which future
economic benefits are expected to flow to
the entity’
 Key elements:
a) Assets are resources, arising from past transactions or past
events
b) They embody future economic benefits: the capacity to
contribute directly or indirectly to future net cash inflows
c) Control: one has the capacity to benefit exclusively from
these economic benefits

Future economic benefits
 Economic benefits may result from:
 the productive capacity of the asset

 plant and equipment
 the ability of the asset to reduce future cash outflows
 renewal expenditure on equipment that results in future
production cost savings
 the rights incorporated in the asset to receive services in the
future
 prepayments
 direct claims to cash inflows
 receivables and short-term investments
 cash in hand
 can be exchanged for goods and services (economic benefits)

IASB - Liability
 ‘A present obligation of an entity arising
from past events, the settlement of which is
expected to result in an outflow from the
entity of resources embodying economic
benefits’
 Key elements:
a) Present (at balance sheet date) responsibility obligating the
company to act or perform in a certain way (towards third
parties)
b) Arising from an obligating event in the past
c) Leading to a sacrifice of economic benefits
(transfer of cash or other assets, rendering of services,
replacement by another obligation, ...)

IASB - Equity
 ‘The residual interest in the assets of an
entity after deducting all liabilities’
 Key elements:
 The residual interest is the ownership interest
 Representing a claim to the company’s net assets
 Equity will be usually sub-divided:
 Funds contributed by shareholders
 Retained profits
 Reserves representing appropriation of retained profits

IASB - Income
 ‘Increases in economic benefits during the

accounting period in the form of inflows or
enhancements of assets or decreases of
liabilities that result in increases in equity,
other than those relating to contributions
from equity participants’
 Key elements:
 Defined in terms of changes in assets and liabilities
 Results in increases of equity
 Must not come from capital contributions of owners
 Encompasses both revenue and gains
IASB - Expenses
 ‘Decreases in economic benefits during the

period in the form of outflows or depletions of
assets or incurrences of liabilities that result
in decreases of equity, other than those
relating to distributions to equity participants’
 Key elements:
 Defined in terms of changes in assets and liabilities
 Results in decreases of equity
 May not relate to distributions to owners
 Encompasses both expenses and losses

Additional IFRS specifications
 The IASB standards contain additional rules with
respect to specific occurrences of elements of
 In addition to more detailed definitions, the IASB
standards typically focus on three aspects of financial
statement elements:
 Recognition: process of incorporating an item (meeting
one of the definitions) in the financial statements
 Measurement: process of determining the monetary units
at which they are to be recognised and carried in the
 Disclosure: process of additional information dissemination
in the notes to the accounts

Generic recognition criteria
An item meeting one of the definitions will only

be recognised in the financial statements, if:
1) It is probable that any future economic benefit

associated with the item will flow to or from the
entity, and
2) The item has a cost or value than can be
measured with reliability

Fig. 3.4 Decision stages for inclusion of
an item
Stage 1 - Definitions
Does the item meet the definition of a financial statement element ?
Stage 2 – Recognition
Can the item be recognized according to the generic recognition criteria ?
Are there any specific recognition rules for the item?
Stage 3 – Measurement
Select the appropriate measurement base to determine the monetary amount at
which the item will be recognized and carried in the balance sheet or income
statement
Stage 4 – Disclosure
Is any (additional) mandatory or recommended information to be included in the
notes to the accounts?

Balance sheet as a representation of
the value of a company?
 Historical value versus economic value
 Conservatism: assets are measured at
the minimum amount that can be
expected from sale or use
 Characteristics of economic value
 Related to future net cash flows
 Taking into account time value of money
 Corrected for risk

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CHAPTER 3

Measurement concepts and the

Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5

Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5

Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5

Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5

Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5

Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5

Balance sheet Balance sheet Balance sheet Balance sheet

Income Income Income

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Accomplishments => Revenues

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Income statement for period 200X

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Raw materials 1,739 Cost of sales 2,601

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Salaries and Factory Sales agents Accountants

Depreciation Production hall Cars Administration

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Resources = Sources of finance

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Intangible assets 943 Ordinary shares 2,455

Stocks 1,589 Provisions 520

Total 6,763 Total 6,763

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Cash at bank 881 Trade payables 359

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Contributed funds (share capital)

Earned funds (accumulated profits)

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Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5

Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5

Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5

Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5

Source: IASB, Framework, par.22

Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5

Revenues and expenses with regard to a specific

 Revenue recognised in period when earned

Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5

Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5

Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5

Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5

Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5

Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5

Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5

Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5

Retained for growth Profit / Cash Corporate taxation

Paid to shareholders as dividend

Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5

Assets = Debt (liabilities) + Equity

(uses of finance = sources of finance)

Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5

Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5