F1 2.03 Elements of the financial statements

Elements of the financial statements

The Conceptual Framework for Financial Reporting tells us that the amounts recorded in a company’s Statement of Financial Position and its Statement of Profit or Loss can be categorized between five different elements.

The Statement of Financial Position includes three of these elements; i.e.

• Assets
• Liabilities
• Equity

The Statement of Profit or Loss includes the other two of these elements; i.e.

• Income
• Expenses

Assets

According to the Conceptual Framework, an asset is “a present economic resource controlled by the entity as a result of past events”

But what does this mean? Well, an “economic resource” is a right that has the potential to generate, save, or be converted into cash either directly or indirectly. An item of inventory, for example, has the potential to be sold for money and thereby generate cash, a computer might have the potential to improve productivity and thereby save money for company and money owed by customers will be converted into money once the customers pay – so all of these can be described as economic resources.

The term “controlled by the entity” means that the entity (e.g. a company) will receive the benefit from the resource’s use or sale. So if a company has purchased a rental property it would be able to receive any rent generated from the property or the proceeds from its sale. We can therefore say that the company controls the property.

The term “past events” mean that an asset cannot be anticipated, so the intention to create an asset does not mean that an asset exists. A company that buys a machine after its financial year-end of 31/10/2020 would not include that machine as an asset in the financial statements for the year ended 31/10/2020.

So an asset of a company is something that has value and is controlled by the company at its financial year-end.

Assets – examples

• Land and buildings, plant and machinery, fixtures and fittings, motor vehicles, computer equipment
• Investments (e.g. shares owned in other companies, or loans made to others)
• Patent rights, goodwill, brands
• Inventories, trade receivables
• Cash at bank

Liabilities

Liabilities are defined as “a present obligation of the entity to transfer an economic resource as a result of past events”

A “present obligation to transfer an economic resource” refers to the requirement to provide money, goods or services or something else of value to settle, or pay, the obligation. This requirement can exist because of a binding contract, legal requirements or because of normal business practices.

Liabilities – examples

• Bank loans, mortgages, debentures
• Bank overdrafts, lease obligations
• Trade payables
• Taxes

Equity

Equity is defined as “the residual interest in the assets of the entity after deducting all of its liabilities”

Equity is therefore defined according to its relationship to assets and liabilities. It is defined in the accounting equation

ASSETS LESS LIABILITIES EQUALS EQUITY

Another way to describe equity is to say that it represents the money that the owners have tied up in the company.

Types of equity

Companies divide their equity into different sections; including

• Share capital and Share premium that together represent the money actually invested in the company by the company’s shareholders
• Retained earnings which record the past profits of the company that have not been paid out as dividends to the shareholders

Income

Income is defined as “increases in assets, or decreases in liabilities, that results in increases in equity, other than those relating to contributions from holders of equity claims”

So income is anything that improves the finances of a company (by increasing its assets or decreasing its liabilities) that is not as a result of the shareholders investing more money into the business (e.g. by way of a share issue).

Income – examples

• Sales revenue
• Fee income
• Rental income
• Interest receivable
• Dividends receivable
• Gains or profits on disposal of assets

Expenses

Expenses are defined as “decreases in assets, or increases in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity claims”

So expenses are the opposite of income. They are anything that worsens a company’s finances (by decreasing its assets or increasing its liabilities) that are not as a result of payments to the shareholders (e.g. by way of dividends or share buy-backs).

Expenses – examples

• Purchases of materials, production staff wages, depreciation of machinery
• Advertising, promotions, sales team wages
• Carriage outwards, vehicle expenses, depreciation of delivery vehicles, driver wages
• Administration staff wages, legal costs, accountancy costs
• Rent, rates, insurance, light and heat
• Bank loan interest, interest on leases
• Losses on the sale of assets
• Corporation tax