Chapter 2: Statement of financial position and income statement

Chapter learning objectives

Upon completion of this chapter you will be able to:

• explain the main elements of financial statements:
  • statement of financial position
  • income statement
• explain the purpose of each of the main statements
• list the main types of business transactions
• explain how the accounting equation and business entity convention underpin the statement of financial position
• define assets and liabilities
• identify examples of receivables and payables
• explain how and why assets and liabilities are disclosed in the statement of financial position.
• draft a simple statement of financial position in vertical format
• explain the matching convention and how it applies to revenue and expenses
• explain how and why revenue and expenses are disclosed in the income statement
• illustrate how the statement of financial position and income statement are interrelated
• draft a simple income statement in vertical format
• identify the two sides of each transaction (duality concept)
• determine the accounting equation after each transaction.

1 Financial statements

There are two key elements to the financial statements of a sole trader business:

• Statement of financial position, showing the financial position of a business at a point in time, and
• Income statement, showing the financial performance of a business over a period of time.

The financial statements show the effects of business transactions. The main types are:

• sales of goods (either for cash or on credit)

  If a sale is made for cash, then cash in the business will increase and a sales transaction will have also been created. The cash will be recorded in the statement of financial position and the sale will be recorded in the income statement.

  If a sale is made on credit, then the payment for the goods has not been made immediately. Therefore we are still owed for these items. The sale will still be recorded in the income statement, however a receivable will be recorded in the statement of financial position.

• purchase of inventory for resale (either for cash or on credit)

  If we buy inventory for cash, then we are spending money. This decrease in cash will be recorded in the statement of financial position. The increase in inventory that we now own will also be recorded as an asset in the statement of financial position.

  If we buy inventory on credit, then we will owe the supplier for these goods. This is called a payable. Therefore inventory will increase and also a payable will be created. Both of these are entered onto the statement of financial position.

• purchase of non-current assets

  If we buy a non-current asset (e.g. a motor vehicle) then we are spending cash, so this will decrease. However, we have now gained a new asset, and both of these entries are recorded in the statement of financial position.

• payment of expenses such as utilities

  Making this payment will reduce our cash balance and this will affect our statement of financial position. We will have created an expense which we have made the payment for, utilities. This expense belongs on the income statement.

• introduction of new capital to the business

  If the owner of the business introduces funds into the business, this is called capital. We have increased the capital within the business and also increased our cash or bank balances. Both of these entries are recorded on the statement of financial position.

• withdrawal of funds from the business by the owner.

  If the owner then withdraws some of these funds back out of the business again, this is known as drawings. The capital will reduce and also the amount of funds within the bank account will too. Both of these are recorded on the statement of financial position.

The business entity concept

• The business entity concept states that financial accounting information relates only to the activities of the business entity and not to the activities of its owner.
• The business entity is treated as separate from its owners.

Entity concept

A company is both legally and for accounting purposes a separate entity distinct from its owners, the shareholders. On the other hand, the business of a sole trader is not a legal entity distinct from its proprietor; however, for accounting purposes, the business is regarded as being a separate entity and accounts are drawn up for the business separately from the sole trader’s own personal financial dealings.

The entity concept is essential in order to be able to account for the business as a separate economic unit. Flows of money between the business and the proprietors are also separately identified from other money flows.

The correct terms for these cash movements are:

The key link between the owner and the business is the amount stated as capital which is the amount the business owes to the proprietor.

2 Statement of financial position

The vertical format of the statement of financial position is shown below:

Note: This format relates to a sole trader only. The company format is looked at later within chapter 15.

3 Income statement

The format of the income statement is shown below:

• Income is increases in economic benefits during the 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.
• Expenses are decreases in economic benefits during the period in the form of outflows or depletions of assets or increases of liabilities that result in decreases in equity, other than those relating to distributions to equity participants.
• The income statement shows the performance of the business over a period of time, in this case for a full year.
• The income statement is prepared following the accruals concept. This means that income and expenses are recorded in the income statement as they are earned/incurred regardless of whether cash has been received/paid.
• The sales revenue shows the income from goods sold in the year, regardless of whether those goods have been paid for.
• The cost of buying the goods sold must be deducted from the revenue. It is important that the cost of any goods remaining unsold is not included here.
• The current year’s sales will include goods bought in the previous year, so this opening inventory must be added to the current year’s purchases.
• Some of this year’s purchases will be unsold at 31 December 20X6 and this closing inventory must be deducted from purchases to be set off against next year’s sales.
• The income statement is split into two parts, the first part gives gross profit and the second part, net profit.
• Gross profit divided by sales revenue gives the gross profit margin which illustrates the profitability of the business at a trading level.
• We must distinguish between wages and drawings. Wages relate to payments to third parties (employees) and represent a deduction or charge in arriving at net profit. Amounts paid to the proprietor (even if he calls them ‘salary’!) must be treated as drawings.

4 Relationship between the statement of financial position and income statement

The link between the statement of financial position and income statement is shown below:

• The statement of financial position are not isolated statements; they are linked over time with the income statement.
• As the business records a profit in the income statement, that profit is added to the capital section of the statement of financial position, along with any capital introduced. Cash taken out of the business by the proprietor, called drawings, is deducted.

5 The accounting equation

The accounting equation

The statement of financial position shows the position of a business at one point in time. A statement of financial position will always satisfy the accounting equation as shown above.

• Each and every transaction that the business makes or enters into has two aspects to it and has a double effect on the business and the accounting equation. This is known as the duality concept.
• The accounting equation is a simple expression of the fact that at any point in time the assets of the business will be equal to its liabilities plus the capital of the business.
• It follows that assets less liabilities equal the capital of the business. Assets less liabilities are known as net assets.

Assets and liabilities

Assets are resources an entity controls as a result of past events and from which future economic benefits are expected to flow to the entity. Some examples are:

• inventory, e.g. goods manufactured or purchased for resale
• receivables, e.g. money owed by credit customers, prepaid expenses
• cash
• non-current assets
• and is available for use in the business.

A liability is an entity's present obligation arising from a past event, the settlement of which will result in an outflow of economic benefits from the entity. This is something owed by the business to someone else, such as:

• payables, e.g. amounts owed to credit suppliers, accrued expenses
• loans.

Equity is defined as the residual interest in the entity's assets after deducting its liabilities. You will become more familiar with this term when you come to look at Company accounts in chapter 17.

Capital is a type of liability. This is the amount that is due to the owner(s) of the business. It will increase each year by any new capital injected into the business and by the profit made by the business. It will decrease by any amounts withdrawn from the business by the owner(s).

Disclosure of assets and liabilities in the statement of financial position

Test your understanding 1

Classify the following items into current and non-current assets and liabilities:

• land and buildings
• receivables
• cash
• loan repayable in two years’ time
• payables
• delivery van.

Illustration 1 – The accounting equation

This illustration involves a series of transactions using the dual effect of transactions and then the accounting equation to build up a set of financial statements. The transactions are as follows:

Day 1 Avon commences business introducing $1,000 cash.

Day 2 Buys a motor car for $400 cash.

Day 3 Buys inventory for $200 cash.

Day 4 Sells all the goods bought on Day 3 for $300 cash.

Day 5 Buys inventory for $400 on credit.

Using the accounting equation, we will draw up a statement of financial position at the end of each day’s transactions.

Solution to the accounting equation

Solution

Day 1: Avon commences business introducing $1,000 cash

The dual effect of this transaction is:

(a) the business has $1,000 of cash

(b) the business owes the owner $1,000 – this is capital.

Day 2: Buys a motor car for $400 cash

The dual effect of this transaction is:

(a) the business has an asset of $400

(b) the business has spent $400 in cash

This transaction changes the form in which the assets are held.

Note that the acquiring of an asset must lead to one of the following:

• reducing another asset by a corresponding amount (as above)
• incurring a corresponding liability (Day 5)
• increasing the capital contributed by the proprietor (Day 1).

Day 3: Buys inventory for $200 cash

The dual effect of this transaction is:

(a) the business has $200 of inventory

(b) the business has spent $200 in cash.

Again this is merely a change in the form in which the assets are held. $200 is withdrawn from cash and invested in inventory.

Day 4: Sells all the goods bought on day 3 for $300 cash

This is an important new development. It is true that one asset (inventory) is being replaced by another (cash), but the amounts do not correspond.

Thus total assets have increased by $100. Since there are no liabilities involved, if the fundamental equation is to remain valid the capital must increase by $100.

Profit is the difference between purchase price and sale proceeds and it belongs to the proprietor(s) of the business. It is an increase in the capital of the business.

The dual effect of this transaction is:

(a) The business has received $300 of cash.

(b) The business has reduced inventory by $200 and made a profit of $100.

Day 5: Buys inventory for $400 on credit

The dual effect of this transaction is:

(a) The business has $400 of inventory.

(b) The business has a liability to the supplier of $400.

Assets can be increased by a corresponding increase in liabilities as follows:

Note that the payables are acting in effect as a source of finance for the business.

Test your understanding 2

Continuing from the illustration above, prepare the statement of financial position at the end of each day after accounting for the transactions below:

Day 6 Sells half of the goods bought on Day 5 on credit for $250.

Day 7 Pays $200 to his supplier.

Day 8 Receives $100 from a customer.

Day 9 Proprietor draws $75 in cash.

Day 10 Pays rent of $40 in cash.

Day 11 Receives a loan of $600 repayable in two years.

Day 12 Pays cash of $30 for insurance.

Your starting point is the statement of financial position at the end of Day 5, from the illustration above.

Once you have dealt with each of the transactions, prepare a statement of financial position at the end of Day 12 and an income statement for the first 12 days of trading.

Statement of comprehensive income

Later on in this textbook you will be introduced to the Statement of comprehensive income. This relates to a company and not to a sole trader.

Test your understanding answers

Test your understanding 1

• Land and buildings – non-current asset.
• Receivables – current asset.
• Cash – current asset.
• Loan repayable in two years time – non-current liability.
• Payables – current liability.
• Delivery van – non-current asset.

Test your understanding 2

Day 6: Sells half of the goods bought on Day 5 on credit for $250

This transaction introduces two new concepts:

• Sale on credit. Essentially this is the same as a sale for cash, except that the asset increased is not cash, but receivables.
• Sale of part of the inventory. In practice this is the normal situation. The important accounting requirement is to separate:
  • inventory still held as an asset, from
  • cost of inventory sold.

Day 7: Pays $200 to his supplier

• The dual effect of this transaction is:

This is simply the reduction of one liability (payables) and one asset (cash) by a corresponding amount ($200).

Day 8: Receives $100 from a customer

• The dual effect of this transaction is:

Day 9: Proprietor draws $75 in cash

This shows on the statement of financial position as a reduction of capital, and as a reduction of cash.

Cash or other assets taken out of the business by the owner are called ‘amounts withdrawn’, or ‘drawings’.

• The dual effect of this transaction is:

Day 10: Pays rent of $40

This is an example of a business expense.

The dual effect of this transaction is:

(a) The business pays out $40 in cash.

(b) The business has a rent expense of $40 which reduces profit.

Day 11: Receives a loan of $600 repayable in two years’ time

The dual effect of this transaction is:

(a) The business receives $600 in cash.

(b) The business has a liability of $600.

Day 12: Pays cash of $30 for insurance

The dual effect of this transaction is:

(a) the business pays out $30 in cash

(b) the business has an insurance expense of $30 which reduces profit.

This marks the end of the transactions. The financial statements for the 12 day period can now be considered.

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