7.
What is in financial statements?

7.1 Introduction

As an organisation grows, its accountability to others increases, driving the need for accurate information to be supplied to external interested parties about the organisation’s financial position, performance and cash flows. Financial statements serve as a tool to communicate this key financial information, enabling interested parties to make decisions about their engagement with the organisation.

Two of the main statements are the Statement of Financial Position (SoFP) and the Income Statement (IS). Fundamental to these statements are the five elements:

• assets
• liabilities
• equity
• income
• expenses.

Throughout this unit we will explain the accounting principles that underpin financial reporting and will help you to prepare, use and think critically about financial statements.

This unit refers to International Financial Reporting Standards (IFRS) terminology of the Statement of Financial Position and the Income Statement. However, these statements can have other titles. For example:

• The Statement of Financial Position (SoFP) can also be called the balance sheet.
• The Income Statement (IS) can also be called the statement of profit and loss or the profit and loss account.

7.2 What are the aims of financial statements?

Financial statements tell part of an organisation’s story, explaining its financial activities as an entity separate from its owners (the business entity concept) over a specified period of time (the accounting period). Financial statements ensure that those who manage the organisation are held accountable for their decisions.

They are designed to provide useful information. The two characteristics of useful information are:

1. Faithful representation: Is this information sufficiently complete, neutral and error-free to meet an interested party’s need for data?
2. Relevance: Can this information influence users’ decisions?

An organisation’s management is often required to state that the financial statements are ‘true and fair’. This means that they are a faithful representation of what happened during an accounting period and the financial position of the reporting entity at the end of the accounting period and are free from any deliberate misrepresentations or omissions. The information presented should, as a result, be an honest view of the company’s financial performance and condition. In addition, the financial statements should be presented in a way that is unbiased and understandable to a reasonably informed third party. This implies that the information is presented without any undue emphasis on positive aspects or downplaying of negative ones. Thus, they are prepared in an objective manner given the choices, judgements and estimates involved. In the case of most larger reporting entities, in most jurisdictions, there is a requirement that an auditor confirm that these conditions are met. They do so by stating that the financial statements present a ‘true and fair’ view of the affairs of the reporting entity.

Enhancing characteristics

Financial statements are designed to meet the following four enhancing characteristics:

• Comparable: The information provided should allow a user to evaluate performance across different organisations in the same time period and for the same organisation over successive time periods, knowing that they have been prepared on a comparable basis. This basis usually requires adherence to either the financial reporting standards issued by the IFRS or country-specific generally accepted accounting practices (GAAP).
• Verifiable: The information included in the financial statements should be traceable back to source documentation or other evidence by a third party (for example, an auditor).
• Timely: The information supplied should be sufficiently recent to be useful for interested parties.
• Understandable: Financial statements should be comprehensible to reasonably informed interested parties, making use of language and terms that are clearly explained.

Historically, financial statements were expected to be prudent. Prudence promoted the use of judgements that prevented the inflation of profits and assets, ensuring the transparency of liabilities, and fostering user confidence by making conservative estimates. When faced with uncertainty, accountants were encouraged to take a conservative approach, acknowledging potential losses and liabilities that might arise in the future and ensuring the organisation’s health is not presented in an overly optimistic light. The 2018 Conceptual Framework considered this to be an exercise that supports neutrality (in other words, faithful representation). The Financial Accounting Standards Board, the US standard-setter, has removed references to prudence as it creates inconsistencies when determining whether assets, income, expenses and liabilities should be recorded in financial statements.

Financial statement contents

The core statements usually include:

• A statement of financial position (SoFP), which shows assets, liabilities and equity on the last day of the accounting period (usually a year). This is also known as a balance sheet.
• An income statement (IS) (or for charities, a statement of financial activities) shows the income and expenses over the accounting period. This is also known as a statement of profit or loss.
• A statement of cash flows showing the cash inflows and outflows over the accounting period. This is only required in the case of larger reporting entities.
• A statement of changes in equity showing how an organisation’s equity has changed over the period due to profits, losses, dividends, and other equity-related transactions.
• Accompanying notes of disclosures to further explain the balances presented.

Profitability is reported in the income statement, but it is important to note that profit (or a surplus in charity accounting) does not necessarily equate to having more cash available. Profit tells only part of the story. The story of cash is shown in the statement of cash flows, highlighting different categories of cash coming into and out of the organisation. Recognising the difference between cash and profit is essential in understanding the accruals principle.

Accruals principle

The accruals principle is fundamental to financial reporting. Under this principle, trading income is recognised when it is earned, and expenditure when it is incurred, regardless of when cash receipts (incoming) and cash payments (outgoing) occur. Recognising income and expenditure (and therefore profit) in this way can be difficult to measure as it involves numerous judgements and estimations. For example, when a contract is partially complete at a period end date, judgement must be made as to how much revenue has been earned to that point of time.

It is important to note that the accruals principle applies to routine trading transactions. It can be suspended to allow for non-trading adjustments to accounts such as the revaluation of the assets that it owns.

Cash vs profit questions

The difference between cash and profit is fundamental to understanding financial statements. Profit can be recognised without cash having been transferred. That is because profit is made by transferring property rights. For example, a sale can be made on credit terms, meaning a trade receivable asset is created as a result. Only later on might this turn into cash. Cash is affected by items being paid and money coming in or out of the bank account. Profit is affected by making a sale (transferring risks and rewards) and the expenses relating to the sale or to the accounting period. With this in mind, categorise each transaction below to show if you think it affects cash or profit, both or neither.

Shift to valuation basis

Accrual accounting emphasises the recognition of revenues and expenses when they are earned or incurred, known as historical cost. However, another way of measuring income focuses on the current fair market value of assets and liabilities. This is known as the valuation basis. This approach has been adopted by IFRS and often exists alongside an accruals approach in local GAAP, accounting resulting in considerable confusion.

7.3 The financial statements

Throughout this unit, we will refer to Rozim Fashion Limited’s (Rozim’s) simplified financial statements. Rozim is a clothing manufacturer based in the United Kingdom which has been trading for over 10 years with a dedication to sustainable resourcing of materials. Some background and the simplified financial statements can be downloaded here.

The statement of financial position

The statement of financial position (SoFP), also known as the balance sheet, is a snapshot in time on the period end date.

The SoFP presents the financial position by measuring assets, liabilities and equity on the last day of the accounting period. It is a snapshot in time on this final day of the period.

Assets, liabilities and equity are the first three building blocks of the SoFP. In the SoFP, assets, liabilities and equity are connected as follows:

ASSETS	=	LIABILITIES + EQUITY

Assets

A broad, universal definition of an asset is something that has value.

A formal definition is as follows:

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.¹

Even with the formal definition, it is not always easy to determine if an asset can be recognised or reliably measured.

For example, you have numerous public rights – walking through the park, driving on roads or pursuing legal action against wrongdoers. These universal entitlements are valuable but provide no specific advantages for a single organisation in particular. Consequently, such public assets are disregarded in financial reporting, even in the case that they benefit a business financially.

An important consideration is, therefore, whether the organisation has control over the asset. If the organisation has the authority to make decisions regarding the asset and expects future benefits to flow to them, then they can recognise the asset on their statement of financial position (SoFP). The final consideration is that the asset needs to be able to be reliably measured. If it cannot, then it must not be recognised as an asset.

For example, the SoFP of Next plc can include an asset for the brand Joules which they bought in December 2023. They control the brand, expect to get future benefits from it, and the brand can be faithfully represented as it has been bought. Next plc cannot, however, include the brand name of ‘Next’ on its SoFP as while it is controlled and Next plc will benefit from the brand, it cannot be faithfully represented because it was not separately bought, it has been internally generated.

Organisations have various types of assets, including those expected to be converted into economic benefits (usually cash) within one year. These are called current assets. Examples of current assets include cash, inventories, trade receivables and prepayments.

Other assets are expected to be used in the organisation on a long-term basis, converted to cash after one year. These are classified as non-current assets. Examples of non-current assets include buildings, vehicles, patents, software and equipment. Non-current assets are further split into tangible non-current assets (which are physical and can be touched) and intangible non-current assets (which cannot be touched).

The accounting equation

The rest of the SoFP explains how these assets are funded. Whether a sole trader, partnership or incorporated company (like Rozim), the organisation is separate to the owners. The financial statements are always presented from the perspective of the organisation as separate from these owners.

Assume Rozim starts with £2,000. Where did this come from? When a company is formed, this initial funding usually comes from the owner and is called equity. Rozim has £2,000 cash (asset) and a £2,000 obligation to its owners (equity) which can be shown as follows:

ASSETS			=	LIABILITIES + EQUITY
Cash		▲ 2,000		Share capital		▲ 2,000

Rozim then borrows £500,000 cash. This funding has come from lenders and can be shown as a liability as follows:

ASSETS			=	LIABILITIES + EQUITY
Cash		▲ 2,000		Share capital		▲ 2,000
Cash		▲ 500,000		Bank loan		▲ 500,000

Liabilities

The term ‘liability’ is used to describe an obligation or duty to pay or perform, which can be settled by handing over an asset (most commonly cash). The formal definition 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 economic benefits.²

Liabilities, just like assets, are categorised into current and non-current. Current liabilities are expected to be settled within a year and non-current liabilities after a year. Example liabilities include loans, overdrafts, trade payables, accruals and provisions.

Equity

Equity is the shareholder contribution to the entity. They are the funds entrusted to the management of the business to support its activities. Equity represents the proportion of total assets owed by the organisation to its owners. Total equity makes the accounting equation balance. Equity includes retained earnings which are the residual profits left in the organisation. Other examples of equity are ordinary share capital, retained earnings and other reserves.

When a company like Rozim first comes into existence it issues shares to its owners (the shareholders). Throughout the life of the organisation, shares may be bought and sold, but the organisation will not benefit from shares being bought or sold unless they are issuing them. This is known as the secondary market.

Ordinary share capital represents the sum of money raised by an organisation through the issue of ordinary shares, and therefore is ‘contributed equity’, provided by shareholders. The amount in ordinary share capital is the number of shares times by the ‘nominal value’ as set by the organisation.

Share premium represents the excess which shares have been sold at above their ‘nominal value’.

Retained earnings is ‘generated equity’: equity that is generated from accumulated profits over time. Retained earnings represent the funds out of which dividends might be paid if the directors think it appropriate to do so. This can be shown as:

\[\begin{align} &\text{Retained earnings for the end of the current period (SoFP date)}\\ &= \text{Retained earnings brought forward (from previous period)}\\ &+ \text{Net profit (from income statement P&L)}\\ &- \text{Dividends} \end{align}\]

The income statement

Consider the income statement (IS), which is where an organisation shows their financial performance over an accounting period. For Rozim, this is the profit made in the year to 30 September 2035. It is also known as a profit and loss statement, however this does not reflect the increasing numbers of organisations who do not focus on profit as a main aim and thus we will use the term income statement.

The IS presents financial performance by measuring income and expenses for an accounting period.

Income and expenses are the final two fundamental financial elements and are related as follows:

\[\text{Income − Expenses = Profit or (Loss)}\]

Notice that the IS presents income and expenses for an accounting period, yet the SoFP presents assets, liabilities and equity at a point in time, the end of that accounting period. This is visualised in Figure 7.2.

Revenue and income are terms that are often used interchangeably in the UK, although this is not always the case. For our purposes, revenue represents the income generated from the sale of goods and services it is also sometimes known as turnover.

Revenue

Revenue is not a verb, but it can be helpful to think of it as one because it reminds us that it derives from an activity that results in the generation of value. For Rozim, revenue comes from the activity of selling clothing. Selling clothes generates cash for the company; the cash is the asset, and the selling of clothing is the revenue source. For other organisations, revenue could derive from the activity of providing a service to customers or the income from donations or grants. Revenue is measured by determining the economic value that the activity will generate, regardless of when the cash is paid.

Revenue cannot be recognised until the risks and rewards of providing the goods or services are transferred to the customer. Given the judgement involved in ascertaining whether this has happened, every set of accounts will have a policy for revenue recognition, which sets out when the revenue can be recognised. For example, for an airline like EasyJet, revenue is not recognised until the plane takes off, even though customers have paid in advance for their ticket. Review the revenue recognition policy in their latest financial statements.

If cash is received before revenue can be recognised, it will be a liability on the SoFP called deferred income, as there will be an obligation to pay it back if the sale does not take place. If cash is received afterwards, it will be an asset called accrued income. This can be complex, for example, in relation to construction. See for example, Barratt Homes’s revenue recognition policy.

Expenses

Expenses can be thought of as the result of activities that consume value. Organisations have many different types of expenses, including when inventory is sold, electricity is consumed, vehicles are driven and employees are paid. Proper recording of expenses often requires considerable estimates to be made because organisations need to recognise the expenses attributable to the period and to match these to the revenue recognised. Some such matches are straightforward to record (for example, the expense of most staff salaries), while others are more inherently uncertain (for example, recording the expense of an ongoing legal claim).

Like revenue, expenses are recognised when the activity takes place. It doesn’t matter if cash is paid before, at the same time as, or after the activity. It is the activity that determines when expenses are recognised.

Expenses are categorised to allow for more detailed subtotals of profit: gross profit, operating profit, profit before tax and profit for the year. See this guidance to help you identify items in the IS.

Profit and the link to the SoFP

The net profit for the year (sometimes known as a surplus in not-for-profit organisations) represents the net increase in the asset value of the organisation in the accounting period when all expenses have been deducted from all income. This net profit (or surplus) is included in the retained earnings within equity in the SoFP. This is because in the company law of most jurisdictions, retained profits can be used to permit the payment of dividends to shareholders. A profit would increase the overall potential obligation from the organisation to the shareholder and a loss would reduce it. Retained earnings represent the organisation’s potential obligation to its owners in relation to the organisation’s accumulated profits less any dividends which have been paid out to shareholders as distributed profit.

The connection between the SoFP and IS is that net profit is added to the brought forward retained earnings and a net loss is deducted from brought forward retained earnings, which is part of equity. This figure then becomes the balancing figure in the movement in the value of the SoFP for a period.

Alternative presentations

The presentation of the IS in the Rozim Fashion statements and in the statements of organisations reporting under IFRS is not the only way of showing this information and the rules as to how it must be presented can change over time. For example, for annual reports beginning on or after 1 January 2027, the categories in the IS will be investing, financing, income tax, discontinued operations and operating. The aim of creating organisations is to generate wealth, and the value added income statement shows how that wealth has been distributed. Consider the presentation suggested by Quattrone (2021) as applied to the case study company Rozim shown in Figure 7.3.

Quattrone (2021) also considered the idea of adding nature as another category to which wealth could be distributed. So, for Rozim, any donations or activities which benefit nature could be added to an additional line in the ‘wealth distributed’ section.

We have seen that organisations recognise assets, liabilities, equity, revenue and expenses in their financial statements, with a clear understanding of what these financial elements represent and in which specific statement they are placed. However, we need to more closely consider how these elements are measured.

7.4 Judgements and estimates

Financial statements are prepared using various measurement bases to ensure the information presented is relevant, reliable and comparable. Historical cost records items at their original purchase price, which is reliable but might not reflect their current worth. Alternatively, for some transactions, current entry value or market value is used to measure assets and liabilities:

• Current entry value is the cost to purchase the asset.
• Market value (current exit value), on the other hand, uses the current market price or estimated value, providing a more accurate picture of the company’s financial health. However, it can be less reliable due to potential estimation errors. It also assumes that the asset will be sold at the time it is revalued, which is not the case.

Different approaches to measurement can lead to different impacts in the accounts, for example, different approaches to valuation of non-current assets and inventory. The approach an organisation may take will depend on its perspective and the prevailing accounting standards in their industry.

Measuring non-current assets

Non-current assets (NCAs) can stay on the SoFP for many years and represent long-term resources owned by a company that are not intended for sale in the normal course of the organisation’s operations. The transaction amounts which are allocated to NCAs are known as ‘capital costs’. If a cost is capitalised it will be recorded on the balance sheet within assets, under NCA. If a cost is not capitalised, it is often ‘expensed’. This means that it will reduce profit and be recorded on the income statement. Organisations that want to maximise profit might be tempted to capitalise expenses so that they are on the SoFP and so not included as expenses in the income statement.

Non-current asset measurement

As a result of applying the adjusted historical cost measurement base, non-current assets are recorded at their carrying value (also sometimes called the net book value) which is calculated as follows:

\[\text{Carrying value = Initial cost − Depreciation or amortisation expenses charged to date}\]

The following discussion explains the judgement involved in estimating the initial costs and the depreciation or amortisation expense.

Estimating the initial cost

The initial costs which are classed as assets have to meet the criteria listed in Figure 7.4 to show that they relate to long-term resources owned by the organisation.

For tangible assets, the amount which can be included as a non-current asset is the purchase price, or costs of constructing the asset, plus any costs necessary to bring the asset into its intended use in its intended location. This includes delivery and installation costs.

When alternations are made to tangible assets, these costs can be capitalised if they are improving a tangible asset, for example extending its useful life or increasing its operating capacity, but not if the costs are for repairing it. This also brings with it judgement on what is an improvement and thus can be capitalised and what is a repair which cannot be capitalised and must be an expense (therefore reducing profit).

Estimating the amortisation or depreciation

Another estimation involved in measuring non-current assets is the amortisation (for intangible assets) or depreciation (for tangible assets) expense. This expense reduces the value of the asset (on the SoFP) and is an expense which reduces the profit of the organisation. It does not involve cash.

Recording depreciation or amortisation expenses is a way of spreading the expense of a non-current asset over its useful economic life. This means that instead of recognising the entire cost of a non-current asset as an expense in the year it is purchased, the cost is spread out over several years. It matches the expense of the non-current asset to the revenue that the asset helps to earn. The way depreciation (or amortisation) is calculated requires an estimation to be made of the useful economic life of the non-current asset and the residual or scrap value. Further, several methods can used to calculate depreciation or amortisation, with organisations expected to select an approach that reflects the usage of the asset over time.

Straight-line depreciation/amortisation

\[\text{Depreciation or Amorisation expense = } \frac{\text{Cost of the NCA − Residual value}}{\text{Useful economic life}}\]

Reducing balance depreciation/amortisation

\[\text{Depreciation or Amortisation expense = } \text{Carrying value}\ x\ \left(1 - \sqrt[{Years}]{\frac{\text{Residual value}}{\text{Cost of the NCA}}} \right)\]

For example, if one of Rozim’s NCAs, say a vehicle for one of their sales reps, was recorded at an initial cost of £20,000, had a useful economic value of 4 years and a residual value of £512, the depreciation (comparing the two methods) and NBV is shown in Figure 7.5.

It is clear from these calculations that at the end of the useful economic life, the total expense is the same for both methods, but how this is spread changes when using straight-line compared to reducing balance methods. It can be shown graphically in Figure 7.6.

When NCAs are sold

When NCAs are sold or disposed of for proceeds, the carrying value is used to calculate the profit or loss on disposal, which will be recorded in the income statement.

\[\text{Profit (or loss) on disposal = Proceeds − Carrying value at date of disposal}\]

Thus, the carrying value can have a significant effect on whether profits or losses are shown at the time of disposing of non-current assets.

Reducing the value of an asset through impairment

The value of NCAs can also be reduced through an impairment. This is when the asset is no longer worth its value on the SoFP. There are many factors which may indicate that an asset is impaired, such as a decline in the market value, changes in the economy, or laws which might change the value of the asset. For non-current assets the asset’s fair value is compared to its carrying value. Calculating the fair value can involve significant estimation where an open market price is not easily identified. In these situations, experts are often engaged to provide valuations. If the fair value is less, the asset is impaired, and an impairment will be recorded as an expense in the income statement.

\[\text{Impairment expense = Fair value of NCA − Carrying value of NCA}\]

The expense will reduce the profit of the organisation.

Increasing the value of an asset through revaluation

If it is believed the value of NCAs is higher than its carrying value, organisations can choose to revalue it, which may show a more relevant amount for the users of financial statements.

\[\text{Revaluation amount = Carrying value of NCA − Fair value of NCA}\]

In this case the NCA value will increase by the revaluation amount but the increase cannot be recorded in the income statement until the asset is actually sold. The increase will be recorded in a separate equity account called a revaluation surplus.

This example shows the nature of accounting which does not allow profits to be recognised simply because assets have increased in value; they can only be recognised when items have been sold. This leads to an apparent mismatch in IS accounting treatment between impairments and revaluations: while both are recognised as adjustments to non-current assets on the SoFP, only impairments affect the profit in the IS.

Measuring current assets

Current assets are those assets owned by an organisation which are expected to be turned into cash within 12 months. However, measuring current assets in particular inventory and trade receivables involves significant choice, estimation and judgement.

Inventory

Inventory can include raw materials, work in progress, and finished goods held for sale. They are valued at the lower of cost and net realisable value.

To calculate the cost, raw materials are measured at the value they were bought for. Finished goods are measured by the raw materials costs plus allocated direct costs. Determining the cost, especially when costs may fluctuate, and which direct costs to allocate rather than record as an expense, involves judgement. Work in progress include the raw materials and allocated direct costs multiplied by the percentage of completion, which is, of course, judgement.

To calculate the net realisable value for each item of inventory, the following calculation is used:

\[\text{Net realisable value = Selling price − Costs incurred to sell the item}\]

This approach ensures that damaged or unsellable inventory is not overstated in value.

Most inventory items are measured at cost, and usually the net realisable value will be higher than this. However, finished goods which are being sold at a loss will need to be adjusted. The organisation must reduce the value of these current assets down from the cost of finished goods (including any allocated direct costs) to the selling price less any costs incurred to sell the item, which is likely to involve significant estimation. This reduction in value will be an expense, reducing the profit of the organisation.

Considering that organisations might be purchasing large amounts of inventory at prices which could change over time, how do they work out which cost to allocate to individual inventory items? There are number of different methods they can choose from. Three of these are weighted average cost (WAC), first in, first out (FIFO) and last in, first out (LIFO).

Weighted average cost reflects a blend of costs and is relatively simple to calculate. It is calculated by

\[\text{WAC = } \frac{\text{Quantity}\ x\ \text{cost1} + \text{Quantity}\ x\ \text{cost2} + \text{Quantity}\ x\ \text{cost3}\ldots}{\text{Total quantity}}\]

It is used when items in inventory can’t be differentiated between, but prices may vary, for example, oil, copper or sand.

In the FIFO method, the first items in inventory are assumed to be used up first. This means that the costs of items will be much closer to the recent purchase costs.

Finally, the LIFO method assumes that the items last bought are the first to be sold and might be appropriate for fast-moving inventory or inflationary environments.

Trade receivables

Trade receivables include any amounts owing to organisations by their customers. To measure trade receivables, companies first identify the total amount of money owed to them by customers as of the year-end date. They then subtract any amounts that they will not receive (known as bad debts), and an estimated amount for debts that they believe may not be collected from those customers (doubtful debts). This is called a credit loss, sometimes known as a bad and doubtful debt expense.

Provisions for doubtful debts reflect a degree of estimation, informed by prior experience. For example, receivables over 90 days may be fully provided for, and those between 60 and 90 days provided for at the rate of 10% and those below 60 days not provided for. The provision for doubtful debts is shown as a reduction of trade receivables in the SoFP and is typically adjusted up or down via the IS each year.

Measuring liabilities

Measuring current liabilities also involves significant judgement and estimation about when, how and at what value they should be recorded. For example, an organisation might have unpaid rent for the period or are likely to have to pay out because they are being sued. Financial statements must contain a complete summation of all liabilities that the organisation is obligated to pay.

Non-current liabilities are due to be settled in over a year’s time. Some of these are subject to clear documentation, such as loans, while others require estimation like provisions. Provisions are liabilities for uncertain events, such as legal cases (being sued) or other future probable obligations (such as product warranties). If a future event is likely to result in an outflow of cash, a provision must be recorded in the current year, as soon as it becomes probable. However, if it is not probable (generally accepted as less than a 50% likelihood) it will not be recorded as a provision liability. The decision regarding when an outflow of cash is deemed probable is significant and will influence the profit of an organisation! It is often the case that external expert opinions help to inform the accounting, for example, legal opinions on court cases.

Measuring equity

The contents of the equity for an organisation will very much depend on the type of organisation it is. Most will have a version of retained earnings (or reserves) but only companies will have shares.

Retained earnings

Retained earnings is one particular category which is derived from the income statement, as it includes profit. It is the residual remaining balance which is owned by the shareholders and is what makes a SoFP balance. Recall that the retained earnings for the end of the current period (SoFP date) includes retained earnings brought forward (from previous periods) plus net profit (Revenue less costs of sales less sales from the Income Statement) minus dividends.

Retained earnings for the end of the current period (SoFP date) equals retained earnings brought forward (from previous period) plus net profit (Revenue less costs of sales less sales from the Income Statement) minus dividends.

The net profit calculation starts with revenue, which is recognised when the risks and rewards of the sale are transferred to the customer, not when the customer pays. Net profit also includes costs of sales, which are affected by the inventory valuation methods. It includes expenses such as depreciation, amortisation, impairments and provisions, which all involve a high degree of estimation and judgement.

Dividends are recognised as liabilities on the date the organisation is obligated to pay them, thus the retained earnings can be manipulated by moving the date of announcement of dividends.

Equity in a non-profit organisations

In non-profit organisations, equity, often referred to as net assets, represents the difference between the organisation’s assets and liabilities. Unlike for-profit businesses, this equity belongs to the organisation itself and is used to further its mission. There are two main categories:

• unrestricted net assets, which are funds that can be used for any purpose within the organisation’s mission; they are the most flexible type of net assets
• restricted net assets, which are funds that are permanently restricted by donors for specific purposes or endowments; the organisation cannot use these funds for any other purpose.

It is critical to be clear on whether funds are restricted or not as there can be dire consequences for organisations that inappropriately use restricted funds.

Share capital in companies

Share capital is in companies is relatively easy to measure when shares are sold for cash. However, it becomes much more complex when shares are sold through ‘rights’ or ‘bonus issues’ or offered to directors as part of a share scheme. Within companies the ‘share capital’ category will always show shares at their nominal value with any excess being shown as share premium.

Sometimes a company might back its own shares; this means it essentially repurchases them from existing shareholders. This reduces the number of shares outstanding in the market and the company will pay out cash to existing shareholders. Fewer shares outstanding can increase the demand for the remaining shares, potentially driving up the share price.

7.5 Summary

• Financial statements seek to communicate relevant and reliable financial information to interested parties.
• These statements seek to faithfully represent an organisation’s financial position and performance by recognising and measuring assets, liabilities, equity, income and expenditure.
• The SoFP and IS are generally prepared under the accruals basis, by which operating income is recognised when earned, and expenditure incurred, regardless of cash movement. This is adjusted for any variations in asset and liabilities on the valuation basis.
• The SoFP shows assets, liabilities and equity, linked by the accounting equation, on the last day of the accounting period.
• The IS shows income, expenditure and therefore profit/loss for the accounting period.
• It is important to consider the accounting policies adopted by an organisation given the range of decisions that an organisation can make about how to account for transactions and assets, for example, inventory valuation, depreciation and revenue recognition. Understanding the five elements of financial statements is the foundation for understanding all of accounting. No matter how complex transactions become, they can always be recorded using just these five elements.
• Although financial reports run to many hundreds of pages, you can always find your way around them from the principal financial reports: the income statement, the statement of financial position, and the statement of cash flows and follow the note numberings for additional explanations of the balances.
• Significantly, these foundational principles and statements are universal. So, no matter where you are in the world, financial reports will resemble what you have learned here.