The statement of financial position (sometimes called the balance sheet) is a statement that presents an entity's assets, liabilities and equity (net assets) at a given point in time (i.e., as at a specific date). During the early era of financial reporting standard setting, throughout the nineteenth century and first half of the twentieth century, the emphasis of legislation was almost entirely on the statement of financial position but by the mid-twentieth century owners were asking for more and more information about operating performance, leading to presentations of an increasingly complex income statement (sometimes called the profit and loss account).
There is a continuing tension between the two financial statements, since—because of double entry bookkeeping conventions—they are linked together and cannot easily serve differing objectives. The stock markets look primarily at earnings expectations, which are largely based on historic performance, as measured by the income statement. If earnings measurement drives financial reporting, this means that, of necessity, the statement of financial position carries the residuals of the earnings measurement process. For example, assets such as motor vehicles with service potential that is used up over several accounting periods will have their costs allocated to these periods through the depreciation process, with the statement of financial position left to report a residual of that allocation process, which may or may not reflect the value of those assets at the end of the reporting period. However, if reporting were truly driven by the statement of financial position, the reporting entity would value the vehicles at the end of each reporting period—for example, by reference to their replacement costs in current condition—and the change in statement of financial position values from one year to another would be reflected in the statement of comprehensive income.
By the 1960s many national GAAP standards were being designed to favour the income statement over the balance sheet, but the pendulum began to swing back to a balance sheet-oriented strategy when standard setters—firstly the FASB in the US and, later, others including the International Accounting Standards Committee, predecessor of the current IASB—developed conceptual frameworks intended to serve as the fundamental theory of financial reporting. Undertaking that exercise had the result of causing accounting theory to revert to its original purpose—namely, to measure economic activity—and implicitly to adopt the definition of income as the change in wealth from period to period. With this in mind, measurement of that wealth, as captured in the balance sheet, became more central to efforts to develop new standards.
In practice, IFRS as currently written are a mixture of both approaches, depending on the transaction being recognised, measured and reported. This mixed attribute approach is partially a legacy of earlier financial reporting rule making, but also reflects the practical difficulties of value measurement for many categories of assets and liabilities. For example, many financial instruments are remeasured at the end of each reporting period, whereas property, plant and equipment are normally held at original cost and are depreciated systematically over estimated useful lives, subject to further adjustment for impairment, as necessary.
Nonetheless, while existing requirements are not entirely consistent regarding financial statement primacy, both the IASB and the FASB, when developing new accounting standards, are now formally committed to a statement of financial position (balance sheet)-oriented approach. The conceptual framework is expressed in terms of measuring assets and liabilities, and reportedly the two standard-setting bodies and their respective staff analyse transactions affected by proposed standards from the perspective of whether they increase or diminish the assets and liabilities of the entity. Overall, the IASB sees financial reporting as being based on the measuring of assets and liabilities, and has the overall goal of requiring the reporting of all changes to those elements (other than those which are a result of transactions with owners, such as the payment of dividends) in a statement of comprehensive income.
The focus on earnings in the capital markets does not mean that the statement of financial position is irrelevant; clearly the financial structure of the company is an important aspect of the company's risk profile, which in turn is important to evaluating the potential return on an investment from the perspective of a current or potential shareholder. Lenders have an even greater interest in the entity's financial structure. This is why companies sometimes go to great lengths to keep some transactions off the statement of financial position, for example by using special-purpose entities and other complex financing structures. IAS 32 considers that any instrument that gives rise to a right to claim assets from an entity is a liability.
IAS 1 states that “each material class of similar items” should be presented separately in the financial statements. In addition, “items of dissimilar nature or function” should be presented separately, unless they are immaterial. The standard expresses a preference for a presentation based on the current/non-current distinction, but allows a presentation by liquidity if that is more reliable and relevant. An asset or liability is current if it is part of the reporting entity's normal operating cycle (e.g., customer receivables) or if it is expected to be realised or settled within 12 months after the end of the reporting period. Only one of these conditions needs to be satisfied—so, for example, inventory that remains on hand for two years should still be classified as current, while long-term liabilities should be reclassified as current for the final year before settlement. IAS 1 includes a sample of illustrative financial statement structure in its Guidance on Implementing IAS 1, but use of this format is optional.
This chapter discusses the format and content of the statement of financial position by incorporating guidance from the conceptual framework, IAS 1 and other standards.
The IASB conceptual framework describes the basic concepts by which financial statements are prepared. It does so by defining the objective of financial statements; identifying the qualitative characteristics that make information in financial statements useful; and defining the basic elements of financial statements and the concepts for recognising and measuring them in financial statements.
The elements of financial statements are the broad classifications and groupings which convey the substantive financial effects of transactions and events on the reporting entity. To be included in the financial statements, an event or transaction must meet definitional, recognition and measurement requirements, all of which are set out in the conceptual framework.
The elements of a statement of financial position are:
An asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity.
The following three characteristics must be present for an item to qualify as an asset:
In addition, the asset must be capable of being measured reliably. The conceptual framework states that reliable measurement means that the number must be free from material error and bias and can be depended upon by users to give faithful representation. In the Basis for Conclusions of IFRS 2, the IASB notes that the use of estimates is permitted, and that there may be a trade-off between the characteristics of being free from material error and possessing representational faithfulness.
Assets have features which help to identify them in that they are exchangeable, legally enforceable and have future economic benefit (service potential). It is this potential which eventually brings cash in to the entity and which underlies the concept of an asset.
A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying future benefits.
The following three characteristics must be present for an item to qualify as a liability:
Liabilities are similarly recognised subject to the constraint that they must be able to be measured reliably.
Liabilities usually result from transactions which enable entities to obtain resources. Other liabilities may arise from non-reciprocal transfers, such as the declaration of dividends to the owners of the entity or the pledge of assets to charitable organisations.
An entity may involuntarily incur a liability. A liability may be imposed on the entity by government or by the court system in the form of taxes, fines or levies. A liability may arise from price changes or interest rate changes. Liabilities may be legally enforceable or they may be equitable obligations, which arise from social, ethical or moral requirements. Liabilities continue in existence until the entity is no longer responsible for discharging them.
The diagram which follows, which is taken from one of the statements produced from the conceptual framework project by the US standard setter, the FASB, identifies the three classes of events which affect an entity, and shows the relationship between assets and liabilities, on the one hand, and comprehensive income, on the other.
Equity is the residual interest in the assets of the entity, which remains after deducting all of its liabilities.
In a business enterprise, the equity is the ownership interest. Equity arises from the ownership relationship and is the basis for distributions of earnings to the owners. Distributions of entity assets to owners are voluntary. Equity is increased by owners' investments and comprehensive income and is reduced by distributions to owners.
In practice, the distinction between equity and liabilities may be difficult to determine. Securities such as convertible debt and certain types of preference shares may have characteristics of both equity (residual ownership interest) and liabilities (non-discretionary future sacrifices). Equity, aside from exchanges with owners, is a residual of the asset/liability recognition model.
Statement of financial position: a statement of financial position (balance sheet) presents an entity's assets, liabilities and equity as at a specific date.
Under IFRS, assets and liabilities are recorded at cost or fair value at inception in the financial statements, which for assets and liabilities arising from arm's-length transactions will generally be equal to negotiated prices. Subsequent measurement is under the historical cost principle or fair value, depending on the requirements of the relevant standard and available accounting policy election made by the entity. IAS 36, Impairment of Assets, requires assets to be reduced in value if their carrying value exceeds the higher of fair value or value in use (expected future cash flows from the asset). IFRS 9, Financial Instruments, IAS 40, Investment Property, and IAS 41, Agriculture, all include some element of subsequent measurement at fair value. Where assets are classified as held-for-sale, they are carried at the lower of their carrying amount or fair value less selling costs (IFRS 5).
Historical exchange prices, and the amortised cost amounts which are later presented, are sometimes cited as being useful because these amounts are objectively determined and capable of being verified independently. However, critics point out that, other than at transaction date, historical cost does not result in presenting, in the statement of financial position, numbers which are comparable between companies so, while they are reliable, they may not be relevant for decision-making purposes. This captures the fundamental conflict regarding accounting information: absolutely reliable or objective information may not be sufficiently relevant to current decision making.
The titles commonly given to the primary financial statement which presents the state of an entity's financial affairs include the “statement of financial position” and “balance sheet.” The revised IAS 1 changed the title of the “balance sheet” to the “statement of financial position,” the title used throughout this publication. The IASB concluded that “statement of financial position” better reflects the function of the statement and is consistent with the conceptual framework. In addition, the title “balance sheet” simply reflected the convention that double entry bookkeeping requires all debits to equal credits, and did not identify the content or purpose of the statement. According to the IASB, the term “financial position” was a well-known and accepted term, and had already been used in auditors' opinions internationally for more than 20 years to describe what the “balance sheet” presents.
The three elements which are always to be displayed in the heading of a statement of financial position are:
The entity's name should appear exactly as written in the legal document which created it (e.g., the certificate of incorporation, partnership agreement, etc.). The title should also clearly reflect the legal status of the entity as a corporation, partnership, sole proprietorship, or division of some other entity.
The statement of financial position presents a “snapshot” of the resources (assets) and claims to resources (liabilities and equity) as at a specific date. The last day of a month is normally used as the statement date (in jurisdictions where a choice is allowed) unless the entity uses a fiscal reporting period always ending on a particular day of the week, such as a Friday or Sunday (e.g., the last Friday in December, or the Sunday falling closest to December 31). In these cases, the statement of financial position can be dated accordingly (e.g., December 26, October 1, etc.). In all cases, the implication is that the statement of financial position captures the pertinent amounts as at the close of business on the date noted.
Statements of financial position should generally be uniform in appearance from one period to the next, as indeed should all of the entity's financial statements. The form, terminology, captions and pattern of combining insignificant items should be consistent. The goal is to enhance usefulness by maintaining a consistent manner of presentation unless there are good reasons to change these and the changes are duly reported.
IAS 1 does not prescribe the sequence or format in which items should be presented in the statement of financial position. Thus, for example, in a standard classified statement of financial position, non-current assets may be presented before or after current assets, and within the current assets, cash can be presented as the first or the last line item. However, the standard stipulates the following list of minimum line items, which are sufficiently different in nature or function to justify separate presentation in the statement:
The format of the statement of financial position as illustrated by the appendix to IAS 1 is along the following lines:
Exemplum Reporting PLC Consolidated Statement of Financial Position as at 31 December 20XX |
||
20XX | 20XX-1 | |
€ | € | |
Assets | ||
Non-current assets: | X | X |
Property, plant and equipment | X | X |
Investment property | X | X |
Goodwill | X | X |
Other intangible assets | X | X |
Investments in associates and joint ventures | X | X |
Deferred income tax assets | X | X |
Financial assets | X | X |
X | X | |
Current assets: | ||
Inventories | X | X |
Trade receivables | X | X |
Other current assets | X | X |
Other financial assets | X | X |
Cash and cash equivalents | X | X |
X | X | |
Non-current assets held for sale | X | X |
X | X | |
Liabilities | ||
Current liabilities: | ||
Trade and other payables | X | X |
Current borrowings | X | X |
Current portion of long-term borrowings | X | X |
Current tax payable | X | X |
Finance lease liabilities | X | X |
Current provisions | X | X |
X | X | |
Liabilities of a disposal group classified as held-for-sale | X | X |
Net current assets | X | X |
Non-current liabilities: | ||
Non-current borrowings | X | X |
Deferred tax | X | X |
Finance lease liabilities | X | X |
Non-current provisions | X | X |
Retirement benefit obligations | X | X |
X | X | |
Net assets | X | X |
Equity applicable to equity holders of the parent | ||
Ordinary shares | X | X |
Share premium | X | X |
Translation reserve | X | X |
Fair value reserve | X | X |
Retained earnings | X | X |
Equity attributable to owners of the parent | X | X |
Non-controlling interest | X | X |
Total equity | X | X |
Assets, liabilities and equity are presented separately in the statement of financial position. In accordance with IAS 1, companies should make a distinction between current and non-current assets and liabilities, except when a presentation based on liquidity provides information that is more reliable or relevant. As a practical matter, the liquidity exception is primarily invoked by banks and some other financial organisations, for which fixed investments (e.g., in property and equipment) are dwarfed by financial instruments and other assets and liabilities.
An asset should be classified as a current asset when it satisfies any one of the following:
If a current asset category includes items that will have a life of more than 12 months, the amount that falls into the next financial year should be disclosed in the notes. All other assets should be classified as non-current assets, if a classified statement of financial position is to be presented in the financial statements.
Thus, current assets include cash, cash equivalents and other assets that are expected to be realised in cash, or sold or consumed during one normal operating cycle of the business. The operating cycle of an entity is the time between the acquisition of materials entering into a process and their realisation in cash or an instrument which is readily convertible into cash. Inventories and trade receivables should still be classified as current assets in a classified statement of financial position even if these assets are not expected to be realised within 12 months from the end of the reporting period. However, marketable securities could only be classified as current assets if they were expected to be realised (sold, redeemed or to mature) within 12 months after the end of the reporting period, even though most would deem marketable securities to be more liquid than inventories and possibly even than receivables. Management intention takes priority over liquidity potential. The following items would be classified as current assets:
Inventories—at the lower of cost (FIFO) or net realisable value | xxx |
In the case of a manufacturing concern, raw materials, work in process and finished goods should be disclosed separately on the statement of financial position or in the footnotes.
Inventories: | 20XX | 20XX-1 |
€ | € | |
Finished goods | xxx | xxx |
Work in process | xxx | xxx |
Raw materials | xxx | xxx |
Receivables: | 20XX | 20XX-1 | ||
€ | € | |||
Customer accounts | xxx | xxx | ||
Customer notes/commercial paper | xxx | xxx | xxx | |
Less allowance for expected credit loss | (xxx) | (xxx) | ||
xxx | xxx | |||
Due from associated companies | xxx | xxx | ||
Due from officers and employees | xxx | xxx | ||
Total | xxx | xxx |
IAS 1 uses the term “non-current” to include tangible, intangible, operating and financial assets of a long-term nature. It does not prohibit the use of alternative descriptions, as long as the meaning is clear. Non-current assets include:
An all-inclusive heading for amounts which do not fit neatly into any of the other asset categories (e.g., long-term deferred expenses, which will not be consumed within one operating cycle, and deferred tax assets).
Liabilities are normally displayed in the statement of financial position in the order of due dates for payment.
According to IAS 1, a liability should be classified as a current liability when:
All other liabilities should be classified as non-current liabilities. Obligations which are due on demand or are callable at any time by the lender are classified as current regardless of the present intent of the entity or of the lender concerning early demand for repayment. Current liabilities also include:
Certain liabilities, such as trade payables and accruals for operating costs, which form part of the working capital used in the normal operating cycle of the business, are to be classified as current liabilities even if they are due to be settled more than 12 months from the date of the statement of financial position.
Other current liabilities which are not settled as part of the operating cycle, but which are due for settlement within 12 months of the date of the statement of financial position, such as dividends payable and the current portion of long-term debt, should also be classified as current liabilities. However, interest-bearing liabilities which provide the financing for working capital on a long-term basis and are not scheduled for settlement within 12 months should not be classified as current liabilities.
IAS 1 provides another exception to the general rule that a liability due to be repaid within 12 months from the end of the reporting period should be classified as a current liability. If the original term was for a period longer than 12 months and the entity intended to refinance the obligation on a long-term basis prior to the date of the statement of financial position, and that intention is supported by an agreement to refinance, or to reschedule payments, which is completed before the financial statements are approved, then the debt is to be reclassified as non-current as at the date of the statement of financial position.
However, an entity would continue to classify as current liabilities its long-term financial liabilities when they are due to be settled within 12 months, if an agreement to refinance on a long-term basis was made after the date of the statement of financial position. Similarly, if long-term debt becomes callable as a result of a breach of a loan covenant, and no agreement with the lender to provide a grace period of more than 12 months has been concluded by the date of the statement of financial position, the debt must be classified as current.
The distinction between current and non-current liquid assets generally rests upon both the ability and the intent of the entity to realise or not to realise cash for the assets within the traditional one-year time frame. Intent is not of similar significance with regard to the classification of liabilities, however, because the creditor has the legal right to demand satisfaction of a currently due obligation, and even an expression of intent not to exercise that right does not diminish the entity's burden should there be a change in the creditor's intention. Thus, whereas an entity can control its use of current assets, it is limited by its contractual obligations with regard to current liabilities and, accordingly, accounting for current liabilities (subject to the two exceptions noted above) is based on legal terms, not expressions of intent.
Non-current liabilities are obligations which are not expected to be settled within the current operating cycle, including:
For all long-term liabilities, the maturity date, nature of obligation, rate of interest and description of any security pledged to support the agreement should be clearly shown. Also, in the case of bonds and long-term notes, any premium or discount should be reported separately as an addition to or subtraction from the par (or face) value of the bond or note. Long-term obligations which contain certain covenants, which must be adhered to, are classified as current liabilities if any of those covenants have been violated and the lender has the right to demand payment. Unless the lender expressly waives that right or the conditions causing the default are corrected, the obligation is current.
In general, assets and liabilities may not be offset against each other. However, the reduction of accounts receivable by the allowance for expected credit losses, or of property, plant and equipment by the accumulated depreciation, are acts that reduce these assets by the appropriate valuation amounts and are not in fact the offsetting of assets and liabilities.
Only where there is an actual right of setoff is the offsetting of assets and liabilities a proper presentation. This right of setoff exists only when all of the following conditions are met:
The laws of certain countries, including some bankruptcy laws, may impose restrictions or prohibitions against the right of setoff. Furthermore, when maturities differ, only the party with the nearest maturity can offset because the party with the longer maturity must settle in the manner determined by the earlier maturity party.
The question of setoff is sometimes significant for financial institutions which buy and sell financial instruments, often repackaging them as part of the process. IFRS 9 provides detailed rules for determining when derecognition is appropriate and when financial assets and financial liabilities must be retained on the statement of financial position.
Shareholders' equity represents the interests of the owners in the net assets of a corporation. It shows the cumulative net results of past transactions and other events affecting the entity since its inception.
This consists of the par or nominal value of preference and ordinary shares. The number of shares authorised, the number issued and the number outstanding should be clearly shown. For preference share capital, the preference features must also be stated, as the following example illustrates:
6% cumulative preference shares, €100 par value, callable at €115, 15,000 shares authorised, 10,000 shares issued and outstanding | €1,000,000 |
Ordinary shares, €10 par value per share, 2,000,000 shares authorised, 1,500,000 shares issued and outstanding | €15,000,000 |
Preference share capital that is redeemable at the option of the holder should not be treated as a part of equity—rather, it should be reported as a liability. IAS 32 makes it clear that substance prevails over form in the case of compound financial instruments; any instrument which includes a contractual obligation for the entity to deliver cash is considered to be a liability.
This represents the accumulated earnings since the inception of the entity, less any earnings distributed to owners in the form of dividends. In some jurisdictions, notably in continental Europe, the law requires that a portion of retained earnings, equivalent to a small proportion of share capital, be set aside as a legal reserve. Historically, this was intended to limit dividend distributions by young or ailing businesses. This practice is expected to wane, and in any event is not congruent with financial reporting in accordance with IFRS and with the distinction made between equity and liabilities.
Also included in the equity section of the statement of financial position is treasury stock representing issued shares that have been reacquired by the issuer, in jurisdictions where the purchase of the entity's own shares and holding in treasury is permitted by law. These shares are generally stated at their cost of acquisition, as a reduction of shareholders' equity.
Finally, some elements of comprehensive income, the components of other comprehensive income, are reported in equity. These components of other comprehensive income include net changes in the fair values of financial assets classified at fair value through other comprehensive income and unrealised gains or losses on translations of the financial statements of subsidiaries denominated in a foreign currency, net changes in revaluation surplus, actuarial gains and losses on defined benefit plans, and the effective portion of gains and losses on hedging instruments in a cash flow hedge. In accordance with the revised IAS 1, net changes in all items of other comprehensive income should be reported in a new statement called the “statement of profit or loss and other comprehensive income,” and accumulated balances in these items are reported in equity. (For a detailed discussion of the statement of profit or loss and other comprehensive income, refer to Chapter 5.)
Non-controlling interests should be shown separately from owners' equity of the parent company in group accounts (i.e., consolidated financial statements), but are included in the overall equity section.
An entity is required to disclose information which enables the users of its financial statements to evaluate the entity's objectives, policies and processes for managing capital. This information should include a description of what the entity manages as capital, and the nature of externally imposed capital requirements, if there are any, as well as how those requirements are incorporated into the management of capital. Additionally, summary quantitative data about what the entity manages as capital should be provided as well as any changes in the components of capital and methods of managing capital from the previous period. The consequences of non-compliance with externally imposed capital requirements should also be included in the notes. All these disclosures are based on the information provided internally to key management personnel.
An entity should also present either in the statement of financial position or in the statement of changes in equity, or in the notes, disclosures about each class of share capital as well as about the nature and purpose of each reserve within equity. Information about share capital should include the number of shares authorised and issued (fully paid or not fully paid); par value per share or that shares have no par value; the rights, preferences and restrictions attached to each class of share capital; shares in the entity held by the entity (treasury shares) or by its subsidiaries or associates; and shares reserved for issue under options and contracts (including terms and amounts).
The IASB started with a financial statements project to improve the structure and content of the primary financial statements.
Comparative statements are encouraged but not required by US GAAP. The SEC requires balance sheets for two years.
The balance sheet is usually presented in order of most liquid or current to least. This is usually the opposite of the order in IFRS. US GAAP contains captions for long-term assets and long-term liabilities. The SEC calls for display of a total for current assets and a total for current liabilities, where appropriate, and public companies must comply with the detailed layout requirements of Regulation S-X.
Non-current debt that matures within one year can be classified as non-current if the entity has the intent and ability to refinance the obligation on a long-term basis. Evidence of intent includes:
Debt for which there has been a covenant violation may be classified as non-current, if there is a lender agreement to waive the right to demand repayment for more than one year and that agreement exists before the financial statements are issued or available to be issued.
Current portions of deferred tax assets and liabilities must be shown as current. The term “reserve” is discouraged in US GAAP.