This article throws light upon the top five elements of financial statements. They are: 1. Assets 2. Liabilities 3. Equity 4. Income 5. Expense.
Element # 1. Assets:
Features of an asset:
i. The future economic benefit embodied in an asset is the potential to contribute, directly or indirectly, to the flow of cash and cash equivalents to the entity. Potential to contribute may be either productive (Property, Plant and Equipment) or convertibility into cash or cash equivalent (Receivables).
ii. Future economic benefit embodied in an asset may flow to the entity in different manner and accordingly to be tested for asset recognition:
a. Usage in the production of goods and services;
b. Exchange for other assets;
c. Use to settle a liability;
d. Distribution to owners.
iii. Assets are not necessarily characterised by physical form (like property, plant and equipment). Intangible assets like copyright, trademark also qualify as assets based on the future economic benefit embodied.
iv. Assets signified by legal right (assets under lease) may not be with ownership right. Still they are recognized as assets based on the embodiment of future economic benefit. Another example is know-how wherein the entity may not have ownership right on the technology but the right to use only.
v. The assets of an entity result from past transactions or other past events. Transactions or events expected to occur in the future do not in themselves give rise to assets.
vi. There is a close association between incurring expenditure and generating assets but the two do not necessarily coincide. Incurrence of expenditure (for example, development expenditure may not satisfy the test of asset) is not conclusive proof of asset creation. On the other hand, incurrence of expenditure is not an essential condition for asset recognition (for example, asset may arise out of Government grant) as well.
Assets are classified as non-current and current. Tangible and intangible assets which are capable of generating cash flows for more than one accounting year are classified as non-current. Financial assets are classified into current and non- current categories on the basis of their maturity or management intention. If an investment is held for trading it is classified as current asset. If they are held for long term (i.e. for more than 12 months period) they are classified as non-current assets.
IFRSs have introduced concept of operating cycle for current non-current classification of assets.
Current assets should have any of the following characteristics:
a. These are expected to be realised within the normal operating cycle of the entity or within twelve months after the balance sheet date whichever is higher; examples are receivables, advances, etc. Financial instruments like available for sale, held to maturity and loans which will be realised within a period of twelve months from the balance sheet date.
b. They are intended for sale or consumption within the normal operating cycle of the entity; example inventories.
c. They are held primarily for the purpose of trading; example Held for Trading Financial Instruments.
d. They are cash and cash equivalents. As per IAS 7 cash comprises of cash on hand and demand deposits. Cash equivalents are highly liquid investments that are readily convertible to known amounts of cash, and which are subjected to insignificant risk of changes in value.
All other assets are classified as non-current assets. Tangible assets like property, plant and equipment, intangible assets and financial assets other than held for trading assets and which are realisable within a period of twelve months are treated as non-current assets.
Operating cycle is the time from acquisition of an asset in the normal course of business till its consumption in processing or sale and realisation in cash or cash equivalents. If the operating cycle of an entity is not clearly identifiable, it should be taken as 12 months. Current assets include assets (such as inventories and trade receivables) which are sold, consumed or realised as part of the normal operating cycle even when they are not expected to be realised within twelve months after the reporting period.
Farwan Ltd. Purchased certain items of inventory and held for consumption for a period more than 12 months. Operating cycle of the entity is 14 months. Should the inventories be treated as current asset?
These items should be treated as current assets. If the operating cycle of the entity is not clearly identifiable, then it is assumed to be of 12 months. In that case, the inventory will be classified as non-current asset.
Hiace Ltd. normally collects receivables by 6 months. An amount of Rs.1 million is due from Z Ltd. For 10 months. Its operating cycle cannot be clearly identified. Should the receivables be treated as non-current asset?
In this case the operating cycle of the entity is presumed to be 12 months and therefore, receivable is treated as current asset. Average collection period of the entity has no significance in ‘current non-current classification’.
Classify the following assets of X Ltd. into non-current and current categories: Plant and machinery Rs.2000 lacs of which the management has decided to sell a plant having book value of Rs.300 lacs, Held for trading investments Rs.10 lacs, Investment property Rs.200 lacs of which investment property having book value of Rs.50 lacs are held for sale, investments in subsidiary Rs.100 lacs, investments in joint venture Rs.100 lacs, investments in 180 days T-bills of Government of India Rs.20 lacs, Current account balance in bank Rs.30 lacs, cash in hand Rs.5 lacs, patent right Rs.20 lacs, export license Rs.40 lacs, inventories Rs. 60 lacs, receivables Rs.60 lacs of which Rs.10 lacs is not collected over 16 months and balance are due over 9 months. Operating cycle of the company is 6 months.
Check below the asset-structure of Volvo Group of Europe:
Element # 2. Liability:
An essential characteristic of a liability is that the entity has a present obligation. The term obligation may be signified by:
i. A duty to perform in a particular manner, for example to pay interest of a loan at the end of every quarter and repay the principal on a specific date.
ii. Legal enforceability; but not necessarily a liability is characterised by legal enforceability.
Refer to the term constructive obligation discussed below:
Constructive obligation-An obligation also arises from normal business practice, custom and a desire to maintain good business relations or act in an equitable manner. An announcement to pay bonus to employees becomes an obligation because of normal business practice or custom although there is no legally enforceable agreement.
Characteristics of a liability:
i. Normally liability arises from present obligation. But future obligation may also create liability if they are irrevocable. A forward contract to buy goods is irrevocable; therefore, gain or loss on such contract is evaluated and recognized as an asset or a liability.
ii. Liabilities result from past transactions or other past events. Even future obligation which are irrevocable arises from past transactions or commitment (events) only.
iii. Normally liabilities are measurable in money terms. Sometimes liabilities are estimated which are termed as provisions. IFRS Framework defines the term liability broadly that includes provisions.
iv. Settlement of a liability means giving up resources embodying economic benefits.
Liabilities are settled in any of the following manner:
a. Payment cash or transfer other assets;
b. Provision of services (services are rendered or to be rendered)
c. Replacement by a new obligation;
d. Conversion of an obligation into equity;
e. Extinguished by way of waiver from the creditors.
Liabilities are classified as current liabilities if they satisfy any of the following criteria:
a. They are expected to be settled in the entity’s normal operating cycle.
b. They are primarily held for trading.
c. They are due to be settled within a period of twelve months from the balance sheet date.
d. The entity does not have an unconditional right to defer settlement of the liability for at least twelve months after the balance sheet date.
All other liabilities are classified as non-current liabilities.
Therefore, liabilities can be classified into current liabilities based on operating cycle concept, maturity and held for trading. The same concept of operating cycle regards current assets is applicable for classifying certain items of liability as current or non-current.
An entity has trade payables – Rs.5, 00,000 due for 3 months which are expected to be settled by a month’s time and Rs.1, 000,000 due for 6 months which are expected to be settled within 3 months after the reporting date. Normal operating cycle of the entity is 4 months. Should these trade payables be classified as current liabilities?
Both categories of trade payables are classified as current liabilities. The first category of payables are expected to be settled with in the normal operating cycle; and the second category of liabilities although are not expected to be settled with in the normal operating cycle, these are expected to be settled with in twelve months from the balance sheet date.
Maturity based current liabilities are those which are to be settled within a period of 12 months from the reporting date. Examples are short term liabilities, long term liabilities to be settled within 12 months, dividend payable, tax payable, etc.
Example 5 [Current portion of non-current liability]:
An entity has raised 10 million of Rs.100 9% Bank Loans in June 2005. As per terms of the loan agreement 25% of the debentures will be redeemed at par after 3 years, balance 25% after 4 years and balance 50% after 5 years. The entity finalises accounts every December. Should any portion of loans be classified as an item of current liability as on 31 December, 2007?
The first installment of redemption amounting to Rs.250 million will be due after June 2008 which is falling within twelve months from the balance sheet date. Therefore, current portion of 9% Debentures Rs.250 million should be classified as current liability. Balance Rs.750 million are classified as non-current liability.
Provisions are special type of liability. An entity may have claims against it which cannot be estimated with certainty, for example, possible liability in a law suit against the entity. In case the management believes that there will be an obligation but the amount of the obligation will be known after the court’s decision, then there exists a liability. Only there is a problem for estimating the amount of the liability – in such a case a provision is created based on the best estimate of the management.
Other examples of provision: tax provision, provision for retirement benefits of employees.
Check below the liability-structure of Volvo Group of Europe:
Element # 3. Equity:
Equity is the residual interest in the assets of the entity after deducting all its liabilities. It is presented in the statement of financial position in a classified manner which helps the user-groups (particularly the investors) in decision making. In a corporate entity, funds contributed by shareholders, retained earnings (meaning profit retained in the business) are examples of equity.
X Ltd. raised 1,000,000 equity shares of Rs.10 at a premium of Rs.100 totaling Rs.110,000,000. This is classified as equity. This represents contribution by shareholders towards capital of the entity.
It has two components:
Equity Share capital – Rs. 10,000,000
Share Premium – Rs. 100,000,000
Element # 4. Income:
Income encompasses revenue and gain. While the former arises out of ordinary activities of entity, gain is not the outcome of the ordinary activities.
Examples of revenue are:
(i) Sale of goods,
(ii) Rendering services,
(iii) Income, royalties and dividend arising out of use of entity’s assets by others.
Gains represent other items that meet the definition of income and may, or may not, arise in the course of the ordinary activities of an entity. Gains may be realised or unrealised. Examples are profit on sale of non-current assets, fair value gain on assets, surplus on settlement of liabilities, etc. Although they are not different by nature from revenue, they are presented in the income statement as separate line item. Gains are often presented net of related expenses.
X Ltd., sold goods for Rs.300,00,000. Can this transaction be classified as an income?
Income of an entity arises from sale goods. It is an item of income.
Element # 5. Expense:
Expenses encompass expenses that arise in the course of the ordinary activities of the entity and losses. Examples of expenses that arise in the course of the ordinary activities of the entity are cost of sales, wages, repairs and depreciation. They usually take the form of an outflow or depletion of assets. On the other hand, losses do not arise in the course of the ordinary activities of the entity.
They may be realized or unrealized Examples are loss on sale of non- current assets, fair value loss on assets, loss on settlement of liabilities, losses resulting from disasters such as fire and flood, etc. Fair value loss without actual sale is an example of unrealised loss.
Observe the presentation of accounting elements in Figure 2.1. This is the basis of accounting equation.