The financial statements and its elements

This chapter introduces the five components of the financial statements 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.

Component of the financial statements

A complete set of financial statements consists of five (5) statements:

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

The principal statements are the statement of financial position and the statement of profit or loss and OCI.

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) statement

This shows other unusual gains and losses that have risen in the period.

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.

Notes to the financial statements:

• This provides additional detailed explanations and breakdowns of financial statement items, offering context, accounting policies, and supplementary information to help users better understand the financial statements.
• Expenses and revenues used in the preparation of the statement of profit or loss and OCI are not limited only to cash paid or received. This will further be explored in subsequent topics.

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:

• Asset
• Liabilities
• Equity
• Expenses
• Revenue

Assets

Assets are categorised mainly as:

• Current asset.
• Non-current assets.

Definitions

Assets

It is 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.

The IASB highlighted that an entity shall classify 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 debtors, as these are expected to be 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

It is a present obligation of an entity to transfer an economic resource as a result of past events. In the layman’s view, 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: debenture, long-term loans, among others.

Equity

Definitions

Equity

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

Basically, it means the amount resulting from the difference between the entity’s assets and liabilities (i.e., assets minus liabilities).

Assets are the resources controlled by the entity, and liabilities are the claims of third parties (amounts owed). Equity is what remains after accounting for those obligations.

In view of this, many refer to equity as a net asset, which is defined as total assets minus total liabilities.

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: $Equity=Assets-Liabilities$

We explored the accounting equation further here chapter.

Income

The concept of income encompasses both revenue and gains.

Definitions

Income

Represents 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

Is income arising in the course of the ordinary activities of the entity.

Gains

Represents other items that meet the definition of income. For example, assuming the dealer in the sale of cars receives a discount from its suppliers, it is income, but it is not as a result of its ordinary activity, which is the sale of cars. Gains may be recognized in the statement of profit or loss or in the statement of other comprehensive income. Gains are mostly presented as other incomes in the financial statement.

For example, if a business entity deals in the sales of cars, income from the sale of a car becomes revenue. This is because the income arises from the sale of a car, which is an ordinary activity of the entity. Revenue is recognized in the statement of profit or loss.

Expenses

Definitions

Expense

Represents 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 encompass expenses or losses.

Expenses

Are those arising in the normal course of activities (such as cost of sales, operating costs).

Losses

Are those (such as the loss on disposal of non-current assets, and losses arising from damage due to fire or flooding).