Chapter 2: Elements of Financial Statements and Double-Entry
Bookkeeping
1.1 Elements of the Statement of Financial Position
The statement of financial position provides a snapshot of an organisation’s assets, liabilities
and capital balances at a specified date.
1.1.1 Assets
Definition
An asset is a present economic resource controlled by the entity as a result of
past events.
An economic resource is a right that has the potential to produce economic
benefits.
(IFRS Conceptual Framework)
Assets can be split into two categories: current assets and non-current assets.
Per IFRS 18, an entity should classify an asset as current when:
1. it expects to realise the asset, or intends to sell or consume it, in its normal operating
cycle;
2. it holds the asset primarily for the purpose of trading;
3. it expects to realise the asset within 12 months after the reporting period; or
4. The asset is cash or a cash equivalent (as defined in IAS 7).
Current assets – include cash at bank, amounts due from customers, and goods held
for resale.
Non-Current Assets – are all other assets that do not meet any of the criteria above
that would make them current assets. For example, offices, shops, warehouses,
delivery vehicles and production equipment.
Non-current assets can be further split into two: tangible and intangible.
o Tangible non-current assets are non-current assets that have a physical form
and can be touched. For example, machinery, fixtures and fittings, and computer
equipment.
o Intangible non-current assets are non-current assets that do not have a
physical form. For example, software licences purchased for use by the business
for more than 12 months.
It is essential to understand the different categories of assets as current and non-current
assets are presented separately in the statement of financial position.
1.2 Elements of the Statement of Profit or Loss
As discussed in chapter 1, the statement of profit or loss includes:
1. Gross Profit - this is the profit from trading and is the excess of sales over the cost of
goods sold during the period.
2. Profit - this is the remaining profit after all other income earned and expenses
incurred in the period have been deducted from the gross profit.
The statement of profit or loss summarises the organisation’s financial performance during
the financial year.
The statement of profit or loss and other comprehensive income for companies presents
more detail in terms of performance for the year, including additional sub-totals for profit in
between ‘gross profit’ (at the top) and ‘profit’ (at the bottom). See chapter 15 for details.
1.2.1 Income
Definition
Income is increases in assets, or decreases in liabilities, that result in increases in
equity, other than those relating to contributions from holders of equity claims.
(IFRS Conceptual Framework)
Income reflects all sales made to customers in the year, regardless of whether they have
been paid for. Cash inflows from shareholders are not income.
A sale is usually recognised as taking place when goods are dispatched (or services
provided) to a customer.
Sales made to customers on credit which have not been settled for cash at the
reporting date are shown in the statement of financial position as trade receivables.
1.2.2 Expenses
Definition
Expenses are decreases in assets, or increases in liabilities, that result in decreases in
equity, other than those relating to distributions to holders of equity claims.
(IFRS Conceptual Framework)
An expense of a business is a day-to-day cost incurred in operating the business. Payments
to shareholders (such as dividends) are not expenses.
Cost of sales is the cost of goods that have been sold. It includes all the costs
connected with the purchase and manufacture of goods. Costs incurred are matched
with revenues earned.
Other expenses can include various costs such as electricity, rent, salaries, and
interest paid.
1.3 Asset (Capitalised) Expenditure versus Expenses
When an item of expenditure is incurred, a decision must be made whether it affects the:
Statement of financial position, as asset (capitalised) expenditure; or
Statement of profit or loss, as an expense.
Ethics
The distinction between expenses and asset expenditure is essential in the real world.
If a business incorrectly classified an expense as asset expenditure, it would lead to
expenses being understated and profits being overstated. This would mean that the
profit would not fairly represent the performance of the business.
1.3.1 Asset Expenditure
Asset expenditure relates to the purchase of non-current assets. Asset expenditure is
incurred in:
Acquiring property and equipment for long-term use (the business benefits from the
use of the asset in the current and in future accounting periods).
Increasing the revenue-earning capacity of an existing non-current asset (by increasing
its efficiency or useful life).
Items of asset expenditure (except for the cost of land) will ultimately be charged to profit or
loss (through depreciation) as the asset is consumed through its use in the business.
1.3.2 Expenses
Expenses, commonly called operating expenses, are incurred in the daily running (operation)
of the business. Examples include:
buying or manufacturing goods which are sold
providing services
selling and distributing goods
administration costs
repairing long-term assets
These costs are immediately charged to profit or loss and matched with the accounting
period's revenues.
2.1 The Duality Concept
The duality concept is the fundamental accounting principle upon which the recording of
financial information is based. It states that every transaction must be recorded twice in the
accounting records, and is the reason for the name ‘double-entry bookkeeping’.
When a transaction is recorded, the second effect is equal to, and the opposite of, the first
effect.
2.2 The Accounting Equation
The elements of financial statements are assets, liabilities, capital (equity), income and
expenses. These elements relate to one another, and their relationship is expressed in the
accounting equation:
Capital or Net Assets = Assets – Liabilities
At any point in time when transactions have been recorded correctly, the accounting
equation will always balance. The accounting equation can be manipulated to encompass
every type of element of financial statements.
The simple accounting equation is: Assets – Liabilities = Capital or Net Assets
Capital is also known as net assets and belongs to the owner. It is the amount the owner
invested minus any amounts that owners have taken out of the business (drawings) plus the
profit made by the business.
Closing Capital = Total Capital Introduced – Drawings + Profits
Closing capital is the capital at the end of the accounting year
Total capital introduced is the capital at the start of the accounting year plus any
additional capital invested during the year
Drawings are taken and profits or losses are achieved during the year
The formula below shows the expanded accounting equation once the above elements are
included: