Chapter 5

Main financial statements: The statement of financial position (balance sheet)

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Introduction

The statement of financial position, along with the income statement and statement of cash flows, is one of the most important financial statements. However, it is only in the last century that the income statement or profit and loss account gained in importance. Before then, the statement of financial position ruled supreme. There is great debate on whether you should give pre-eminence to the statement of financial position so that the income statement becomes the secondary statement or vice versa. The statement of financial position is prepared from an organisation's trial balance. It consists of assets, liabilities and equity. For UK companies, it is required by the Companies Act 1985. The statement of financial position seeks to measure an organisation's net assets at a particular point in time. It developed out of concepts of stewardship and accountability. Although useful for assessing liquidity, statements of financial position do not actually represent an organisation's market value. In this chapter, the primary focus will be on understanding the purpose, nature and contents of the statement of financial position. The preparation of the statement of financial position of sole traders, partnerships and limited companies from the trial balance is covered, in depth, in Chapters 6 and 7, respectively. For listed companies, a different terminology and presentation is adopted. This is mentioned in this chapter, but dealt with in more depth in Chapter 7.

Context

The statement of financial position is one of the key financial statements. It is prepared from the trial balance at a particular point in time, which can be any time during the year. The statement of financial position is usually prepared for shareholders at either 31 December or 31 March. The statement of financial position has three main elements: assets, liabilities and equity. Essentially, the assets less the third party liabilities (i.e., net assets) equal the owner's equity. Thus,

Alternatively:

The statement of financial position and income statement are complementary (see Figure 5.1). The income statement shows an organisation's performance over the accounting period, normally a year. It is thus concerned with income, expenses and profit. A statement of financial position, by contrast, is a snapshot of a business at a particular point in time. It thus focuses on assets, liabilities and equity. As Soundbite 5.1 shows, the statement of financial position provides basic information which helps users to judge the value of a company.

Definitions

As Definition 5.1 shows a statement of financial position is essentially a collection of the assets, liabilities and equity of an organisation at a point in time. It is prepared so as to provide a true and fair view of the organisation.

Broadly, assets are the things an organisation owns or leases; liabilities are things it owes. Assets can bring economic benefits by either being sold (for example, inventory) or being used (for example, a car). Equity (sometimes known as ownership interest) is accumulated wealth. Equity is effectively a liability of the business because it is ‘owed’ to the owner: standard setters more formally define assets in terms of rights to future economic benefits and liabilities as obligations. Equity (ownership interest) is what is left over. In other words, assets less third party liabilities equal owner's equity. By formally defining assets and liabilities, the statement of financial position tends to drive the income statement. In Definition 5.2 we present both formal and working definitions of assets, third party liabilities and equity (ownership interest).

Layout

Traditionally, the statement of financial position was always arranged with the assets on the right-hand side of the page and the liabilities on the left-hand side of the page. However, more recently, the vertical format has become most popular. For UK companies, the use of the vertical format was set out by the 1985 Companies Act. Examples of Marks & Spencer plc's and AstraZeneca plc's statements of financial position are given in Company Snapshots 2.2 (in Chapter 2) and 7.4 (in Chapter 7), respectively. However, even organisations which are not companies now commonly use the vertical format. This sets out the assets and liabilities at the top. The equity employed is then put at the bottom. This modern format is the one which this book will use from now on. However, Appendix 5.1 (at the end of this chapter) gives an example of the traditional ‘horizontal’ format which readers may occasionally encounter.

In order to be more realistic, we use the adapted statement of financial position of a real person, a sole trader who runs a public house. This is given in Figure 5.2. In Chapter 6, we show the mechanics of the preparation of the statement of financial position from the trial balance. The purpose of this section is to explain the theory behind the presentation.

Main Components

Figure 5.3 lists the main components commonly found in the statement of financial position of a sole trader. It provides some general examples and, wherever possible, a specific example. The main components of the statement of financial position are then discussed in the text. The same order is used as for R. Beer's statement of financial position. Finally, in Figure 5.6 on page 116, we summarise the major valuation methods used for the main assets. An overview of the structure of the statement of financial position is shown in Figure 5.4.

Non-current Assets

These are the assets that a business uses for its continuing operations. Non-current assets can be divided into tangible assets and intangible assets. There are generally recognised to be four main types of tangible assets more usually called property, plant and equipment or fixed assets (intangible assets, i.e. those which do not physically exist, are discussed in Chapter 7): land and buildings, plant and machinery, fixtures and fittings, and motor vehicles. For sole traders, these different types of asset are separately listed. However, for presentation purposes they are aggregated into one heading for listed companies. Property, plant and equipment are traditionally valued at historical cost. In other words, if a machine was purchased 10 years ago for £100,000, this £100,000 was originally recorded in the books. Every year of the property, plant and equipment's useful life, an amount of the original purchase cost will be allocated as an expense in the income statement. This allocated cost is termed depreciation. Thus, depreciation simply means that a proportion of the original cost is spread over the life of the property, plant and equipment and treated as an annual expense. In essence, this allocation of costs relates back to the matching concept. There is an attempt to match a proportion of the original cost of the property, plant and equipment to the accounting period in which property, plant and equipment were used up.

The most common methods of measuring depreciation are the straight line method and the reducing balance method. The straight line method is the one used in Figure 5.5. Essentially, the same amount is written off the property, plant and equipment every year. With reducing balance, a set percentage is expensed or written off every year. Thus, if the set percentage was 20%, then in Figure 5.5 £20,000 would be written off in year 1. This would leave a net book value of £80,000 (£100,000 − £20,000). Then 20% of the net book value of £80,000 (i.e., £16,000) would be written off in year 2, and so on).

Companies have great flexibility when choosing appropriate rates of depreciation. These rates should correspond to the useful lives of the assets. So, for example, if the directors believe an item of property, plant and equipment has a useful life of five years they would choose a straight line rate of depreciation of 20%. Company Snapshot 5.1 gives the rates of depreciation used by Manchester United plc.

Interestingly, up until 1999 the club used the reducing balance method, which is relatively uncommon in the UK. However, it has now changed to the more conventional straight line depreciation.

Finally, it is important to realise that nowadays, many businesses regularly revalue some non-current assets such as property, plant and equipment every five years. Businesses can also revalue their non-current assets whenever they feel it is necessary (or, alternatively, devalue them if they have lost value). Where revaluations occur, the depreciation is based on the revalued amount. A devaluation of non-current assets is generally called an impairment. Indeed, the term impairment is used more generally for the loss of value of assets.

Current Assets

Current assets are those assets which a company owns which are essentially short-term. They are normally needed to perform the company's day-to-day operations. The five most common forms of current assets are inventories, trade receivables, prepayments, cash and bank.

1. Inventories (Stocks)

Inventories are an important business asset. This is especially so in manufacturing businesses. Inventories can be divided into three categories: raw materials, work-in-progress and finished goods (see, for example, Company Snapshot 5.2).

Each category represents a different stage in the production process.

• Raw materials. These are the inventories a company has purchased and is ready for use. A carpenter, for example, might have wood awaiting manufacture into tables.
• Work-in-progress. These are partially completed inventories, sometimes called inventories in process. They are neither raw materials nor finished goods. They may represent partly manufactured goods such as tables with missing legs. Some of the costs of making the tables should be included.

• Finished goods. This represents inventories at the other end of the manufacturing process, for example, finished tables. Cost includes materials and other manufacturing costs (e.g., labour and manufacturing overheads).

Inventories at the year-end are often determined after a stock take. As Real-World View 5.1 shows, inventories can often represent a substantial percentage of a company's net assets. This is especially true for Rolls-Royce, a manufacturing company. By contrast, Vodafone and Nokia carry relatively little inventories.

Generally, inventories are valued at the lower of cost or net realisable value (i.e., the value they could be sold for). In the case of work-in-progress and finished goods, cost could include some overheads (i.e., costs associated with making the tables). In Chapter 16, we will look at several different ways of calculating cost (e.g., FIFO and AVCO).

2. Trade Receivables (Debtors)

Trade receivables are sales which have been made, but for which the customers have not yet paid. If all transactions were in cash, there would be no trade receivables. Trade receivables at the year end are usually adjusted for those customers who it is believed will not pay. These are called a variety of terms such as bad and doubtful debts, impaired receivables, irrecoverable debts. In this book, for consistency, we use provision for the impairment of receivables. Bad debts are those debts which will definitely not be paid. Doubtful debts have an element of uncertainty to them. Usually, businesses estimate a certain proportion of their debts as doubtful debts. These bad and doubtful debts are also included in the income statement.

3. Prepayments

Prepayments are those items where a good or service has been paid for in advance. A common example of this is insurance. A business might, for example, pay £1,000 for a year's property insurance on 1 October. If the accounts are drawn up to 31 December, then at 31 December there is an asset of nine months’ insurance (January–September) paid in advance which is £750. The £750 represents an asset as it represents a future benefit to the firm.

4. Cash and bank

This is the actual money held by the business. Cash comprises petty cash and unbanked cash. Bank comprises money deposited at the bank or on short-term loan. For limited companies the term cash and cash equivalents is often used. This recognises that sometimes businesses own assets that can be turned into cash at relatively short notice, such as short-term deposits. As Soundbite 5.2 shows, money has long been the topic of humour.

Current Liabilities

These are the amounts which the organisation owes to third parties. For a sole trader, there are three main types:

1. Trade Payables (Creditors)

These are the amounts which are owed to suppliers for goods and services received, but not yet paid (for example, raw materials).

2. Accruals

‘Accruals’ is accounting terminology for expenses owed at the financial reporting date. Accruals comply with the basic accounting concept of matching. In other words, because an expense has been incurred, but not yet paid, there is no reason to exclude it from the income statement. Accruals are amounts owed, but not yet paid, to suppliers for services received. Accruals relate to expenses such as telephone or light and heat. For example, we might have paid the telephone bill up to 30 November. However, if our year end was 31 December then we might owe, say, another £250 for telephone. Importantly, accruals do not relate to purchases of trade goods owing: these are trade payables.

3. Loans

Loans are the amounts which a third party, such as a bank, has loaned to the company on a short-term basis and which are due for repayment within one year.

The current assets less the current liabilities is, in effect, the operating capital of the business. It is commonly known as a business's working capital. Businesses try to manage their working capital as efficiently as possible (see Chapter 22). A working capital cycle exists (see Figure 5.7), where cash is used to purchase goods which are then turned into inventory. This inventory is then sold and cash is generated. Successful businesses will sell their goods for more than their total cost, thus generating a positive cash flow. In some cases, a business may have more current liabilities than current assets. Instead of being net current assets, this section becomes net current liabilities. This is the situation with Tesco in 2005, see Company Snapshot 5.3.

Loans give rise to debt. Many leading companies have large debts. As Soundbite 5.3 shows, debt is a particular problem for football clubs globally, especially in the English Premier League.

Non-current Liabilities

Non-current liabilities are liabilities that the organisation owes and must repay after more than one year. The most common are long-term loans. The total assets of a business less current liabilities and non-current liabilities give the total net assets of the business. Total net assets represent the total equity employed by a business.

Contingent Liabilities

These are liabilities that sometimes occur in organisations. They are contingent because they are dependent on the occurrence of an event (for example, the outcome of a law suit).

Equity (Capital Employed)

For a sole trader the owner's equity or capital employed is opening equity plus profit less drawings. Thus for R. Beer it is:

Opening equity is that equity at the start of the year (e.g., 1 April 2013). In essence, it represents the total net assets at the start of the year (i.e., all the assets less all the liabilities). If the business had made a loss, opening equity would have been reduced. It is important to realise that the profit (or loss) recorded under owner's equity represents the net profit (or loss) as determined from the income statement. It is, thus, a linking figure.

Profit is the profit as determined from the income statement (i.e., revenue less cost of sales and other expenses). Drawings is the money that R. Beer has taken out of the business for his own personal spending. Finally, closing equity is equity at the statement of financial position date. It must be remembered at all times that:

Businesses need capital to operate. However, the capital needs to be used wisely (see Soundbite 5.4).

Limitations

To the casual observer, it looks as if the statement of financial position places a market value on the net assets of the organisation. Unfortunately, this is wrong. Very wrong! To understand why, one must look at the major components of the statement of financial position. The statement of financial position is a collection of individual assets and liabilities. These individual assets and liabilities are usually not valued at a real-world, market value, so neither is the statement of financial position as a whole. Taking the property, plant and equipment, for example, only selected property, plant and equipment are revalued. These valuations are neither consistent nor necessarily up-to-date. There is, therefore, a considerable amount of subjectivity involved in their valuation. Also depreciation does not accurately measure the loss in value of property, plant and equipment (nor is it supposed to). The statement of financial position is thus a tangle of assets all measured in different ways.

Another problem, especially for companies, is that significant assets are not shown in the statement of financial position. All the hard work of an owner to generate revenue and goodwill will only be recognised when the business is sold. Many key items that drive corporate value, such as know-how and market share, are also not recorded (see Real-World View 5.2). Neither is the value of human assets recorded! For example, what is the greatest asset of football clubs? You might think it was the footballers like David Beckham, Wayne Rooney or Andy Carroll. However, conventionally these players would not be valued as assets on the statement of financial position unless they have been transferred from another club. Nor, in the case of zoos, would the animals bred in captivity be valued.

In addition to these assets which are not required to be shown on the statement of financial position, there is concern that many companies are deliberately omitting assets, and more importantly liabilities from their financial statements. This is shown in Soundbite 5.5.

Interpretation

Given the above limitations, any meaningful interpretation of amounts recorded in the statement of financial position is difficult. However, there are ratios which are derived from the statement of financial position which are used to assess the financial position of a business. These ratios are dealt with in more depth in Chapter 9. Here we just briefly comment on liquidity (i.e., cash position) and long-term capital structure.

The statement of financial position records both current assets and current liabilities. These can be used to assess the short-term liquidity (i.e., short-term cash position) of a business. There are a variety of ratios such as the current ratio (current assets divided by current liabilities) and quick ratio (current assets minus inventories then divided by current liabilities) which do this. In addition, the statement of financial position records the long-term capital structure of a business. It is particularly useful in determining how dependent a business is on external borrowings. In Soundbite 5.6, for example, excessive borrowing created a statement of financial position where there was negative net worth.

Listed Companies

Listed Companies in Europe follow International Financial Reporting Standards. Their statement of financial position are presented differently from those of sole traders or partnerships. Several examples of listed companies’ statements of financial position are given in this book (see, for example, Marks and Spencer in Appendix 2.2, Volkswagen in Appendix 2.5 and AstraZeneca in Company Snapshot 7.4). They are all slightly different as there is no standardised format.

In this book, we use a standardised terminology for simplification and ease of understanding. Therefore, we use the listed companies’ terminology throughout. However, sometimes an alternative terminology is used. We present this in Figure 5.8. For sole traders and partnerships traditionally more detail is given. Listed companies are covered in more depth in Chapter 7.

Conclusion

The statement of financial position is a key financial statement. It shows the net assets of a business at a particular point of time. The three main constituents of the statement of financial position are assets (non-current and current), liabilities (current and non-current) and equity. Normally a vertical statement of financial position is used to portray these elements. The statement of financial position itself is difficult to interpret because of missing assets and inconsistently valued assets. However, it is commonly used to assess the liquidity position of a firm.

Appendix 5.1: Horizontal Format of Statement of Financial Position

R. Beer's Statement of Financial Position as at 31 March 2013 (presented in horizontal format)

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