Chapter 5

Learning objectives

After studying this chapter you should be able to:

1. identify the financial reporting obligations of an entity
2. explain the nature and purpose of the balance sheet
3. outline the effect of accounting policy choices, estimates
and judgements on financial statements
4. apply the asset definition and recognition criteria
5. apply the liability definition and recognition criteria
6. discuss the definition and nature of equity
7. describe the format and presentation of the balance sheet.
 Nature and purpose
of the balance sheet

• The balance sheet is a financial statement that details

the entity’s assets, liabilities and equity as at a particular
point in time — the end of the reporting period
• It shows
– what the entity owns (or controls) as at a particular date —
the assets
– the external claims on the entity’s assets — the liabilities
(owe)
– the internal claim on the entity’s assets — the equity (owners)
 Balance sheet example

• Note the formula

Total Assets – Total Liabilities = Net Assets = Equity
 The definition and recognition
of assets

• An asset is formally defined in the Conceptual

Framework (para. 4.4(a)) as ‘a resource controlled by
the entity as a result of past events and from which
future economic benefits are expected to flow to the
entity’. The essential characteristics for an asset are:
1. the resource must be controlled by the entity
2. the resource must be as a result of a past event
3. future economic benefits are expected to flow to the
entity from the resource.
 Recognition

• Recording items in the financial statements with

a monetary value assigned to them.
• Satisfying the definition criteria is only part of
the process in recording an item on the balance
sheet
• The recognition criteria must also be satisfied
 Recognition of an asset

• Probable
– It is more than likely that the future economic
benefits will flow from the asset to the business
controlling it.
• Reliably Measured
– The value of the asset can be measured reliably
– Involves the use of estimates
 The definition and recognition
of liabilities
• A liability is formally defined in the Framework (para. 4.4(b))
as ‘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’. The essential characteristics for a liability are:
1. a present obligation to another entity
2. the present obligation arises as a result of past events
3. an outflow of resources embodying economic benefits is
expected to flow from the entity as a result of settling the
present obligation.
 Recognition of a liability

• Probable
– It is more than likely that the future economic
benefits will flow from the business to another entity
• Reliably Measured
– The value of the liability can be measured reliably
– Involves the use of estimates
Asset and liability definition and
recognition criteria
 The definition and nature of equity

• Equity is defined in the Conceptual Framework

(para. 4.4(c)) as ‘the residual interest in the
assets of the entity after deducting all its
liabilities’.
EQUITY = ASSETS – LIABILITIES
• Equity comprises various items, including capital
contributed by owners (shareholders) and profits
retained in the entity.
 Format and presentation
of the balance sheet

• Two main formats

– T-format
• Assets on LHS and liabilities on RHS
• Often used for smaller entities
– Narrative format
• Assets, liabilities and equity presented down the page
• Comparative information allows users to see
how firm’s financial position has changed
between the previous and current periods
 Format and presentation of the
balance sheet continued

• Balance sheets may also report

– Parent entity financial statements (for controller)
– Consolidated financial statements (for group)
• A group
– Refers to the parent entity and all its subsidiaries
– Often referred to as the economic entity
Concept of parent entity
and group
 Presentation and disclosure of
elements on the balance sheet

• Accounting standards exist that prescribe the

presentation, classification and disclosure
requirements for assets, liabilities and equity on
the balance sheet
• Even though not legally required, some entities
with no public accountability voluntarily adopt
similar classification, presentation and disclosure
practices as required by IFRSs
 Current and non-current
assets and liabilities
• Distinction between current and non-current
classification is based on timing
• If the economic benefits (of asset) or outflow of
resources (for liability) are expected to be realised
in the next reporting period, the asset or liability is
categorised as current
• If economic benefits (of asset) or outflow of
resources (of liability) are expected beyond next
the reporting period, the classification is non-
current
 Presentation and disclosure
of assets

• Assets are classified according to their nature or

function
• Classifications can reflect
– Liquidity
– Marketability
– Physical characteristics
– Expected timing of future economic benefits
– Purpose
 Classification of assets

Assets – Classes include:

• Cash and cash • Financial assets
equivalents • Property, plant and
• Trade receivables equipment
• Inventories • Deferred tax assets
• Non-current assets held • Agricultural assets
for sale • Intangible assets
• Investments accounted • Goodwill
for using equity method
Presentation and disclosure
of assets example
 Presentation and disclosure
of liabilities

• Liabilities are classified according to their nature

• Classifications may be based on:
– Liquidity
– Level of security of guarantee
– Expected timing of the future sacrifice
– Source
– Conditions attached to the liabilities
 Classification of liabilities

Classes include:-
• Trade and other payables
• Borrowings
• Tax liabilities
• Provisions
• Financial liabilities
• Secured debts
Presentation and disclosure
of liabilities example
 Presentation and disclosure
of equity

• Depending on the entity structure, the

terminology and equity classifications appearing
on the balance sheet will vary between entities.
– Sole Traders & Partners will have Profit/Loss and
Drawings contributing directly to equity
– Companies will have retained earnings and reserves
 Classification of equity

• Share capital
– Paid-up share capital, contributed capital
• Retained earnings
– Cumulative profits that have not been distributed
• Reserves
– A component of equity that takes many forms (see
examples on page 181)
• Minority interests of controlled entities
Presentation and disclosure
of assets example
 Measurement of
assets and liabilities

• The dollar value assigned to assets and liabilities

is called their carrying amounts or book values
• Alternative measurement systems include:
– Historical cost; i.e., original cost
– Current cost  
– Market value  
– Present value
 Measurement of
assets and liabilities continued

• Current cost and market values measures can be

thought of as an item’s fair value
• Fair value is defined as the price that would be
received to sell an asset or paid to transfer a
liability in an orderly transaction between
market participants at the measurement date.
 Measurement of
assets and liabilities continued

• Financial information must be relevant and

reliable so that it is useful for decision making
• Although it is common to leave assets at their
cost price (or cost price adjusted for
depreciation), entities are also permitted (and
sometimes required) to revalue certain items to
fair value
 Measuring receivables

• The carrying amount of receivables is the

expected cash to be received
• Thus the amount owing must be reduced by the
amount expected to be uncollectable using an
account called allowance for doubtful debits
• On the balance sheet, receivables are usually
shown at their net amount
– Net amount = gross value – allowance for dd
– The details for the gross value and allowance disclosed
in notes
Measuring receivables
example
 Measuring inventory

• Carrying value of inventory must be the lower of

its cost price or net realisable value
• Measuring inventory at cost requires a cost flow
assumption because inventory can be purchased
at different times at different cost prices
• 2 cost assumptions permitted under IFRSs
– First-in, first-out (FIFO)
– Weighted average
 Measuring inventory continued

• The net realisable value of inventory is the

expected selling price, less the expected costs
associated with getting the inventory to a
saleable state, plus the costs of marketing,
selling and distribution
 Measuring non-current assets

• All assets with limited useful lives must be

depreciated
• Land is not depreciated
• Depreciation is the allocation of the depreciable
amount of the life of the asset
• On balance sheet, depreciable assets are carried
at their cost (or fair value) less accumulated
depreciation
 Measuring non-current assets
continued

Notable exceptions
– Goodwill cannot be revalued upwards and must be
tested at least annually for impairment
– Identifiable intangibles can be revalued upwards only
if an active and liquid market exists
– Financial instruments are measured at their fair value
– Agricultural assets are measured at their value less
costs to sell
 Measuring non-current assets
continued

• Carrying amount of non-current assets at cost must be

no more than their recoverable amount
• Recoverable amount is higher of expected fair value
less costs to sell, and value in use
• Value in use refers to present value of expected future
cash flows associated with the use and subsequent
disposal of the asset
IMPAIRMENT LOSS = VALUE IN USE – RECOVERABLE AMT

• Any impairment loss (an expense) must be recognised

immediately
Measuring non-current assets
example
Measuring non-current assets
example
 Potential limitations
of the balance sheet

1. Shows asset, liability and equity values at a

particular point in time and may not be
representative of other points in time
2. The entity’s value is not reflected due to:
– Items that generate future benefits or involve future
sacrifices not satisfying definition and/or recognition
criteria
– The historical nature (or combinations of cost and
fair values) of the balance sheet
 Potential limitations
of the balance sheet

3. Preparing a balance sheet involves:

– management choices
– judgements
– estimations
 Summary

1. The balance sheet reports an entity’s financial

position at a point in time
2. Various criteria govern the recognition and
measurement of assets, liabilities and equity
3. A balance sheet may be presented in a narrative or
T-format
4. A breakdown of various classifications of assets,
liabilities and equity is usually included in the
notes to the accounts
 References

Birt, J., K. Chalmers, S.Maloney, A. Brooks, & J. Oliver.

(2014). Accounting Business Reporting for Decision making
(5th e.d.). Australia: John Wiley & Son. ISBN:
9781118624180