The financial statements and its elements

This chapter introduces the four primary financial statements (plus the notes) and defines the fundamental elements (assets, liabilities, equity, income, and expenses) that form the building blocks of these statements.

Learning objectives

By the end of this chapter, you should be able to:

• List the financial statements and explain the purpose of each.
• Identify and define assets, liabilities, equity, income, and expenses.

Components of the financial statements

Under IFRS 18, a complete set of financial statements comprises four primary statements, plus the notes:

• Statement of financial position
• Statement of profit or loss and other comprehensive income (OCI)
• Statement of changes in equity
• Statement of cash flows

The notes to the financial statements give additional explanations, accounting policies and breakdowns of line items. They accompany these statements but are not themselves counted as one of the primary statements.

Definitions

Statement of financial position

It provides a snapshot of a business’s financial position at a specific point in time. It reports assets, liabilities, and equity - showing what the company controls or owns, what it owes, and the shareholders’ interest.

Statement of profit or loss and other comprehensive income

There are two statements embedded in this: statement of profit or loss and other comprehensive income (OCI).

Statement of profit or loss

This shows the company’s financial performance over a specific period by reporting revenues, income, and expenses. The difference between revenue and expenses is referred to as a profit or a loss. It is a profit when revenue exceeds expenses, and a loss when expenses exceed revenue.

Other comprehensive income (OCI)

The section of the statement that reports gains and losses which IFRS Accounting Standards require to be recognised outside profit or loss. The main example in this exam is a revaluation gain on a tangible non-current asset, which goes to the revaluation surplus through OCI, not to profit or loss.

Statement of changes in equity

This shows changes in the company’s ownership interests. It explains how equity has been affected by profits, losses, dividends, and other transactions that affect shareholders’ equity.

Statement of cash flows

This shows how cash moves in and out of the business. It classifies cash flows into operating, investing, and financing activities, helping you see the company’s ability to generate and manage cash. While the statement of profit or loss shows profit or loss made during the period, the statement of cash flows helps determine how much of the profit is actually cash.

Elements of the financial statements

The elements of financial statements are the fundamental building blocks used to prepare them. The IASB conceptual framework for financial reporting highlights these elements:

• Assets
• Liabilities
• Equity
• Income
• Expenses

Assets

Assets are categorised mainly as:

• Current assets
• Non-current assets

Definitions

Assets

A present economic resource controlled by the entity as a result of past events.

Current assets

An asset is said to be current when the economic benefit arising from the asset is consumable within the short term (i.e., usually not beyond one year).

Non-current assets

They are those assets whose economic benefits are consumable beyond one year. They are sometimes referred to as long-term assets.

An entity classifies 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 trading.
3. It expects to realise the asset within twelve months after the reporting period; or
4. The asset is cash or a cash equivalent (as defined in IAS 7) unless the asset is restricted from being exchanged or used to settle a liability for at least twelve months after the reporting period.

An asset that does not meet the definition of a current asset is a non-current asset.

Examples of current assets include inventories, cash, and receivables, as these are expected to be realised, sold or consumed within one year.

Examples of non-current assets include plant and machinery, factory and office buildings, and land, among others.

In preparing the statement of financial position, the assets are presented under these two main categories.

Liabilities

Liabilities are also categorised as:

• Current liabilities
• Non-current liabilities.

Definitions

Liability

A present obligation of an entity to transfer an economic resource as a result of past events. Put simply, it is an amount that the business entity owes to other parties.

Current liabilities

These are those liabilities that are payable within one year. Examples: trade payables, bank overdraft, short-term loans, etc

Non-current liabilities

These are those that are payable beyond one year (i.e., not payable within one year). Examples: loan notes, long-term loans, among others.

Equity

Definitions

Equity

The residual interest in the assets of the entity after deducting all its liabilities.

Assets are the resources controlled by the entity, and liabilities are the claims of third parties. Equity is what remains after accounting for those obligations, which is why it’s sometimes referred to as the entity’s net assets.

The relationship between assets, liabilities, and equity is widely known as the accounting equation, which forms the basis of the statement of financial position.

The accounting equation is given as: $\text{Equity}=\text{Assets}-\text{Liabilities}$

We explore the accounting equation in more detail in a later chapter, The accounting equation.

Income

The concept of income encompasses both revenue and gains.

Definitions

Income

Increases in assets, or decreases in liabilities, that result in increases in equity, other than those relating to contributions from holders of equity claims.

Revenue

Income arising in the course of the ordinary activities of the entity.

Gains

Other items that meet the definition of income.

Example: Revenue vs gains

A car dealer sells cars, so income from the sale of a car is revenue: it arises from the dealer’s ordinary activity. Revenue is recognised in the statement of profit or loss.

If the same dealer pays a supplier early and receives a settlement discount, that discount is income, but it doesn’t come from selling cars. It is a gain, presented as other income in the statement of profit or loss.

Gains may be recognised in profit or loss or in other comprehensive income. For example, a revaluation gain on a non-current asset is recognised in OCI. A trade discount, by contrast, is deducted from the price and never recorded.

Expenses

The concept of expenses encompasses both expenses arising from ordinary activities and losses.

Definitions

Expenses

Decreases in assets, or increases in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity claims.

Expenses arising from ordinary activities

Expenses arising in the normal course of activities, such as cost of sales and operating costs.

Losses

Other decreases in economic benefits that meet the definition of expenses but do not arise from ordinary activities, such as a loss on disposal of a non-current asset or damage from fire or flooding.