Statement of Financial Position

Introduction:

This note will briefly discuss the meaning of the statement of financial position, all the key components of the statement of financial position such as assets, liabilities, and capital, the essence of the statement of financial position, and the various ways in which the statement of financial position can be prepared.

What is the Statement of Financial Position?

Also known as the balance sheet, the statement of financial position sets forth the assets, liabilities, and owner’s equity (capital) of a business at a particular point in time. It may thus be said that the components of the statement of financial position are:

1. Assets

2. Liabilities

3. Capital.

These are now discussed in detail.

1. Assets of a Business:

A. Meaning:

Per the Black’s Law Dictionary, an asset is:

1. An item that is owned and has value. 2. (pl.) The entries on a balance sheet showing the items of property owned, including cash, inventory, equipment, real estate, accounts receivable, and goodwill 3. (pl.) All the property of a person … [may be natural or artificial]

Summarily, assets are resources that are used in running the business or the resources in the business. It consist of anything that has current or future economic value to a business.

Common examples of assets are cash in hand, cash at bank, furniture, and accounts receivable (debtors).

B. Types of Assets:

There are two types of assets that are captured in the balance sheet. These are:

i. Current assets or circulating assets.

ii. Non-current assets or fixed assets.

These are now explained

i. Current Assets or Circulating Assets:

In the Financial Handbook foy Bankruptcy Professionals, 1991, current assets are defined as:

Assets expected to be converted to cash, sold, or consumed during the next twelve months, or within the business's normal operating cycle if the cycle is longer than a year.

Similarly, according to the International Accounting Standard (IAS), an asset is classified as current asset when:

1. The entity expects to realise [sell or use] the asset, or intends to sell or consume it, within its normal operating cycle;

2. The asset is primarily held for trading purposes;

3. The entity anticipates realising [selling or using] the asset within twelve months after the reporting period; or

4. The asset is cash or a cash equivalent, unless usage of the asset is restricted for at least twelve months after the reporting period.

Key examples of current assets are cash, cash equivalents like bank balances, accounts receivables (monies owed to the business), inventory (goods bought to be resold), prepaid expenses, short-term loans given out by the business, among others.

ii. Non-Current Assets or Fixed Assets:

On the other hand, these are assets acquired to improve business efficiency and not necessarily for resale or for conversion into cash or cash equivalents. They are acquired for long-term use and the benefits derived from them usually exceed twelve months or the business period.

Among others, an asset can be said to be non-current if it has the following characteristics:

1. The business does not expect to realise, sell, or consume it within an accounting cycle.

2. The asset is not held primarily for trading purposes.

3. The asset is not cash or a cash equivalent.

Common examples of non-current assets are land, buildings, machinery, motor vehicles, furniture, goodwill, copyright, among others.

C. Note on Classifying Assets as Current and Non-Current:

While assets like vehicles, land, and buildings are often classified as non-current assets, their classification actually depends on the objectives of the business. For example, for Mercedes-Benz, vehicles are current assets because they are manufactured for realisation within a year, are easily convertible into cash, and form part of the company’s inventory. Similarly, for a real estate company, land may be a current asset if it is acquired for the purpose of resale within an accounting period.

1. Liabilities of a Business:

A. Meaning:

These are the financial obligations of the business towards third parties. The Blacks Law Dictionary defines liabilities as “A financial or pecuniary obligation; DEBT”

B. Types of Liabilities:

There are similarly two types of liabilities that are captured in the balance sheet. These are:

i. Current liabilities or short term liabilities.

ii. Non-current liabilities or long term liabilities.

These are now explained

i. Current Liabilities or Short-Term Liabilities:

These are short term debts or financial obligations. According to the International Accounting Standard (IAS), a liability is said to be current if:

1. It anticipates settling the liability within its normal operating cycle; It primarily holds the liability for trading purposes;

2. The liability is due for settlement within twelve months after the reporting period; or

3. [The business] does not have a right to defer the settlement of the liability for a minimum of twelve months after the reporting period.

Key examples of current liabilities are short-term loans and borrowings by the company, accrued expenses (expenses incurred but not yet paid), accounts payable (monies owed to creditors or suppliers of goods on credit). They are often paid for using the revenue generated by the operating activities of the business.

ii. Non Current Liabilities or Long Term Liabilities:

These are liabilities that are not payable within a year. Examples of these include long-term loans, debentures, among others.

3. Capital:

The capital is often the resources invested in the business by the owner of the business. It may be in the form of cash, equipment, or other assets.

Essence of the Statement of Financial Position:

1. Determination of risks: The assets of a business, particularly its non-current assets, indicate the level of risk involved in engaging with the business. For example, if a business has substantial non-current assets, these can be realised (sold) to settle a loan or used as collateral in legal enforcement. Conversely, a business with minimal non-current assets may pose a higher risk to creditors and investors.

2. Securing loans: A business with substantive assets showing on its balance sheet can be used to secure notes as lenders are more confident in the ability of the business to repay.

3. Reveals liquidity: The assets of a business, particularly its current assets, reveal the liquidity of the business, which is the ability of the business to fulfil short term liabilities and debts using current assets.

4. Business decision-making: By revealing the assets and liabilities of the business, the owners of the business can make decisions on expansions, investments, and cutting cost. For instance, if the company has substantive liabilities, they may decide to delay expansion plans to enable them settle the liabilities or reduce operational expenses.

5. Track Growth: A business can track its growth by comparing their current balance sheet to their previous balance sheets or to those of competitors.

How the Statement of Financial Position is Prepared:

There are two ways of preparing the statement of financial position. These are:

i. The vertical format.

ii. The horizontal format (uses the T-account)

These are now discussed:

i. The Vertical Format for a Balance Sheet:

From the above, all the non-current assets of the business were listed, and their value summed up to give “ Total Non-Current Assets.” Similarly, all the current assets were listed, and their value summed up to give “Total Current Assets.” Then the two totals (total of current assets and total of non-current assets) were summed up to give “Total Assets.” The same was repeated for the liabilities section.

For capital, we added net profit to the initial capital and subtracted drawings (assets taken by the owner of the business for personal use).

If prepared correctly, the total assets should be equal to the net worth + total liabilities. This is essentially the accounting equation.

Also, note that in some statements of financial positions, the current liabilities are separated from the current assets to give net assets. The non-current liabilities are then added to capital, and the sum of these two will still equal the net assets.

i. The Horizontal Format for a Balance Sheet:

From the above, all the assets are entered on one side (debit side) and all the capital and liabilities are entered on another side (credit side). Note, however that it is possible and still correct to have recorded all the assets on the credit side and all the liabilities and capital on the debit side. What is essential is to keep assets on a side separate from liabilities and capital.

Conclusion and Notice of Adjustments:

Note that the balance sheet as presented above does not account for factors such as depreciation and bad debts. All of these will be considered in a subsequent note and the formats of the balance sheet presented above will be slightly modified.