The statement of financial
position (SOFP)
Md. Habibullah, ACCA
BBA & MBA (RU)
US dept. of state alumni
Assistant Professor
Bangladesh Institute of Capital Market
Financial Condition
The Statement of Financial Position (SOFP) shows the financial condition or
financial position of a company on a particular date. The statement is a summary of
what the firm owns (assets) and what the firm owes to outsiders (liabilities) and to
internal owners (stockholders’ equity). By definition, the account balances on a
SOFP must balance; that is, the total of all assets must equal the sum of liabilities
and stockholders’ equity. The balancing equation is expressed as:
Assets = Liabilities + Stockholders’ equity
Balance Sheet Date
The SOFP is prepared at a point in time at the end of an accounting period, a year,
or a quarter. Non-financial companies in Bangladesh use fiscal year with the
accounting period ending on June 30 and financial companies in Bangladesh use
the calendar year with the accounting period ending on December 31.
The fact that the SOFP is prepared on a particular date is significant. For example,
cash on the SOPF represents the amount of cash on December 31; the amount
could be materially different on December 30 or January 2.
Comparative Data
Financial statements for only one accounting period would be of limited value
because there would be no reference point for determining changes in a company’s
financial record over time. The information presented in annual reports to
shareholders includes two-year audited financial statements.
SOFP Format
The FASB, SEC, and IASB do not prescribe the format of the SOFP. The majority of
firms prepare “classified” SOPF. This means that the asset and liability sections are
categorized into key sections. Asset classifications generally include a section for
current assets, property, plant and equipment, intangible assets and other assets,
while liability classifications include current liabilities and noncurrent liabilities.
The format used for companies using IFRS varies with some firms using the U.S.
format. A common format used by international firms is to list assets and liabilities
with noncurrent assets listed before current assets and noncurrent liabilities listed
before current liabilities.
Common-Size SOFP
A useful tool for analyzing the SOFP is a common-size SOFP. Common-size financial
statements are a form of vertical ratio analysis that allows for comparison of firms
with different levels of sales or total assets by introducing a common denominator.
Common-size statements are also useful to evaluate trends within a firm and to
make industry comparisons. A common-size SOFP expresses each item on the SOFP
as a percentage of total assets. Common-size statements facilitate the internal or
structural analysis of a firm.
Current Assets
Current assets include cash or those assets expected to be converted into cash
within one year or one operating cycle, whichever is longer. The operating cycle is
the time required to purchase or manufacture inventory, sell the product, and
collect the cash. For most companies, the operating cycle is less than one year, but
in some industries – such tobacco – it is longer. The designation “current” refers
essentially to those assets that are continually used up and replenished in the
ongoing operations of the business. The term working capital or net working capital
is used to designate the amount by which current assets exceed current liabilities
(current assets less current liabilities).
Cash and Cash Equivalents
Two accounts, cash and cash equivalents, are generally combined on the SOFP. The
cash account is exactly that, cash in any form – cash awaiting deposit or in a bank
account.
Cash equivalents are short-term, highly liquid investments, easily turned into cash
with maturities of three months or less. Money market funds, Government
Treasury bills, and commercial paper (unsecured short-term corporate debt)
generally qualify as cash equivalents.
Marketable Securities
Marketable securities, also referred to as short-term investments, are highly liquid
investments in debt and equity securities that can be readily converted into cash or
mature in a year or less. Firms with excess cash that is not needed immediately in
the business will often purchase marketable securities to earn a return.
Accounts Receivable
Cont…
Accounts receivable are customer balances outstanding on credit sales and are
reported on the balance sheet at their net realizable value, that is, the actual
amount of the account less an allowance for doubtful accounts. Management must
estimate – based on such factors as past experience, knowledge of customer
quality, the state of the economy, the firm’s collection policies – the BDT amount of
accounts they expect will be uncollectible during an accounting period. Actual
losses are written off against the allowance account, which is adjusted at the end of
each accounting period.
Accounts Receivable
Cont…
The allowance for doubtful accounts can be important in assessing earnings quality.
If, for instance, a company expands sales by lowering its credit standards, there
should be a corresponding percentage increase in the allowance account. The
estimation of this account will affect both the valuation of accounts receivable on
the SOFP and the recognition of bad debt expense on the Statement of Profit or
Loss and Other Comprehensive Income. The analyst should be alert to changes in
allowance account – both relative to the level of sales and the amount of accounts
receivable outstanding – and to the justification for any variations from past
practices.
Accounts Receivable
Cont…
There should be a consistent relationship between the rate of change or growth
rates in sales, accounts receivable, and the allowance for doubtful accounts. If the
amounts are changing at significantly different rates or in different direction – for
example, if sales and accounts receivable are increasing, but the allowance account
is decreasing or is increasing at a much smaller rate – the analyst should be alert to
the potential for manipulation using the allowance account. Of course, there could
be a plausible reason for such a change.
Accounts Receivable
To analyze the preceding information consider the following:
1. The relationship among changes in sales, accounts receivable, and
the allowance for doubtful accounts – are all three accounts
changing in the same directions and at consistent rates of change?
2. If the direction and rates of change are not consistent, what are
possible explanations for these differences?
3. If there is not a normal relationship between the growth rates, what
are possible reasons for the abnormal pattern?
Inventories
Inventories are items held for sales or used in the manufacture of products that will
be sold. A retail company lists only one type of inventory on the SOFP: merchandise
inventories purchased for resale to the public. A manufacturing firm, in contrast,
would carry three different types of inventories: raw materials or supplies, work-inprocess, and finished goods. For most firms, inventories are the firm’s major
revenue producer. Exception would be service-oriented companies that carry little
or no inventory.
Given the relative magnitude of inventory, the accounting method chosen to value
inventory and the associated measurement of cost of goods sold have a
considerable impact on a company’s financial position and operating results.
Prepaid Expenses
Certain expenses, such as insurance, rent, property taxes, and utilities,
are sometimes paid in advance. They are included in current assets if
they will expire within one year or one operating cycle, whichever is
longer. Generally, prepayments are not material to the SOFP as a
whole.
Property, Plant, and Equipment
Cont…
This category encompasses a company’s fixed assets (also called tangible,
long-lived, and capital assets) – those assets not used up in the ebb and flow
of annual business operations. These assets produce economic benefits for
more than one year, and they are considered “tangible” because they have a
physical substance. Fixed assets other than land (which has a theoretically
unlimited life span) are “depreciated” over the period of time they benefit
the firm. The process of depreciation is a method of allocating the cost of
long-lived assets. The original cost, less any estimated residual value at the
end of the asset’s life, is spread over the expected life of the asset. Cost is
also considered to encompass any expenditures made to ready the asset for
operating use. On any SOFP date, property, plant, and equipment is shown at
book value, which is the difference between original cost and any
accumulated depreciation to date.
Property, Plant, and Equipment
Management has considerable discretion with respect to fixed assets.
Management must choose a method of depreciation: the straight-line
method allocates an equal amount of expense to each year of the
depreciation period, whereas an accelerated method apportions larger
amounts of expense to the earlier years of the asset’s depreciable life
and lesser amounts to the later years. The total amount of depreciation
over the asset’s life is the same regardless of method, although the rate
of depreciation varies.
Investment Property
Investment property is property (land or a building or part of a building
or both) held (by the owner or by the lessee under a finance lease) to
earn rentals or for capital appreciation or both. [IAS 40.5]
Examples of investment property: [IAS 40.8]
land held for long-term capital appreciation, land held for a currently
undetermined future use, building leased out under an operating lease,
vacant building held to be leased out under an operating lease,
property that is being constructed or developed for future use as
investment property
Intangible Assets
Intangible asset is an identifiable non-monetary asset without physical
substance. An asset is a resource that is controlled by the entity as a
result of past events (for example, purchase or self-creation) and from
which future economic benefits (inflows of cash or other assets) are
expected. [IAS 38.8] Thus, the three critical attributes of an intangible
asset are: identifiability, control (power to obtain benefits from the
asset), and future economic benefits (such as revenues or reduced
future costs). Examples of intangible assets include patents, copyright,
trademarks, brand names, customer lists etc.
Intangibles can be acquired: by separate purchase, as part of a business
combination, by a government grant, by exchange of assets, and by
self-creation (internal generation)
Investment in Associates
Investment in Associate refers to the investment in an entity in which
the investor has significant influence but does not have full control like
a parent and a subsidiary relationship. Usually, the investor has
significant influence when it has 20% to 50% of shares of another
entity.
Goodwill
Goodwill arises when one company acquires another company (in a business
combination accounted for as a purchase) for a price in excess of the fair
market value of the net identifiable assets (identifiable assets less liabilities
assumed) acquired. This excess price is recorded on the books of the
acquiring company as goodwill. Goodwill must be evaluated annually to
determine whether there has been a loss of value. If there is no loss of value,
goodwill remains on the SOFP at the recorded cost indefinitely. If it is
determined that the book value or carrying value of goodwill exceeds the fair
value, the excess book value must be written off as an impairment expense.
For many firms, goodwill is a material item on the SOFP and should be
assessed when analyzing the financial statements. If impairment charges are
related to goodwill, it is important to read the footnote disclosures to
determine why goodwill was impaired.
Financial Asset
Any asset that is: cash; an equity instrument of another entity; a
contractual right to receive cash or another financial asset from
another entity, or to exchange financial assets or financial liabilities
with another entity under conditions that are potentially favorable to
the entity.
Other Assets
Other assets on a firm’s SOFP can include a multitude of other
noncurrent items such as property held for sale, start-up costs in
connection with a new business, and long-term advance payments.
Liabilities
Current Liabilities
Liabilities represent claims against assets, and current liabilities are
those that must be satisfied in one year or one operating cycle,
whichever is longer. Current liabilities include accounts and notes
payable, the current portion of long-term debt, accrued liabilities,
unearned revenue, and deferred taxes.
Account Payable
Accounts payable are short-term obligation that arise from credit extended
by suppliers for the purchase of goods and services. For example, when a
company buys inventory on credit from a wholesaler for eventual sale to its
own customers, the transaction creates an account payable.
This account is eliminated when the bill is satisfied. The ongoing process of
operating a business result in the spontaneous generation of accounts
payable, which increase and decrease depending on the credit policies
available to the firm from its suppliers, economic conditions, and the cyclical
nature of the firm’s own business operations. Part of the SOFP analysis
should include an exploration of the causes for any increase or decrease in
accounts payable. Perhaps the increase in accounts payable is at least
partially explained by sales growth.
Short-term Debt
Short-term debt (also referred to as notes payable) consists of
obligations in the form of promissory notes to suppliers or financial
institutions due in one year or less. Commercial paper is unsecured,
short-term notes issued by a corporation to meet short-term financing
needs. Maturities are generally less than 270 days and are often issued
at discounted interest rates since only firms with high credit ratings can
find buyers for this form of debt.
Current Maturities of Long-Term Debt
When a firm has bonds, mortgages, or other forms of long-term debt
outstanding, the portion of the principal that will be repaid during the
upcoming year is classified as a current liability.
Accrued Liabilities
Cont..
Most companies use accrual rather than the cash basis of accounting:
Revenue is recognized when it is earned, and expenses are recorded
when they are incurred, regardless of when the cash is received or
paid. Accrued liabilities result from the recognition of an expense in the
accounting records prior to the actual payment of cash. Thus, they are
liabilities because there will be an eventual cash outflow to satisfy the
obligations.
Accrued Liabilities
Assume that a company has a $100,000 note outstanding, with 12%
annual interest due in semiannual installments on March 31 and
September 30. For a SOFP prepared on December 31, interest will be
accrued for three months (October, November, and December):
$100,000 * 0.12 = $12,000 annual interest
$12,000 / 12 = $1,000 monthly interest
$1,000 * 3 = $3,000 accrued interest for three months
The December 31 SOFP would include an accrued liability of $3,000.
Accruals also arise from salaries, rent, insurance, taxes, and other
expenses.
Unearned Revenue and Deferred Credits
Companies that are paid in advance for services or products record a
liability on the receipt of cash. The liability account is referred to as
unearned revenue or deferred credits. The amounts in this account will
be transferred to a revenue account when the service is performed or
the product delivered as require by the matching concept of
accounting. Generally, companies in high technology, publishing, or
manufacturing industries are apt to have unearned revenue accounts
on their SOFP.
Deferred Income Taxes
Cont…
Deferred taxes are the result of temporary differences in the recognition of
revenue and expense for taxable income relative to reported income. Most
large companies use one set of rules for calculating income tax expense, paid
to the NBR, and another set for figuring income reported in the financial
statements. The objective is to take advantage of all available tax deferrals to
reduce actual tax payments, while showing the highest possible amount of
reported net income. There are many areas in which firms are permitted to
use different procedures for ta and reporting purposes. Most firms use an
accelerated method of depreciation (the Modified Accelerated Cost Recovery
System) to figure taxable income and the straight-line method for reporting
purposes. The effect is to recognize more depreciation expense in the early
years of an asset’s useful life for tax calculations.
Deferred Income Taxes
Cont…
Although depreciation methods are the most common source, other
temporary differences arise from the methods used to account for
installment sales, long-term contracts, leases, warranties and service
contracts, pensions and other employee benefits, and subsidiary investment
earnings. They are called temporary differences because, in theory, the total
amount of expense and revenue recognized will eventually be the same for
tax and reporting purpose.
The deferred tax account reconciles the temporary differences in expense
and revenue recognition for any accounting period. Business firms recognize
deferred tax liabilities for all temporary differences when the item causes
financial income to exceed taxable income with an expectation that the
difference will be offset in future accounting periods.
Deferred Income Taxes
Deferred tax assets are reported for deductible temporary differences
are operating loss and tax credit carryforwards. A deductible temporary
difference is one that causes taxable income to exceed financial
income, with the expectation that the difference will be offset in the
future.
Long-Term Debt
Obligations with maturities beyond one year are designated on the
balance sheet as noncurrent liabilities. Many different types of debt
exist, but the most common forms found on SOFP are…
Long-term notes payable: contractual agreement between borrower
and lender (generally a bank) which designates the principal and
interest repayment schedule and other conditions of the loan.
Mortgage: loan agreement secured by real estate.
Debentures: unsecured debt backed by the company’s general credit
standing.
Long-Term Debt
Convertible debt: debt in the form of bonds or notes that allows the
investor or lender the opportunity to exchange a company’s debt for
common stock of that company. The terms of the agreement are
specified in a document referred to as the bond indenture. The
conversion price, or dollar value at which the debt may be converted
into common stock, is generally set at an amount higher than the
current market price of the firm’s stock when the debt is issued.
Long-Term Warranties: nonmonetary liabilities that promise the
delivery of goods or services during a specified warranty period.
Examples would include a two-year warranty offered for new home
construction or three-year warranty offered for new car purchased.
Capital Lease Obligations
A commonly used type of leasing arrangement is a capital lease. Capital
leases are, in substance, a “purchase” rather than a “lease”. A capital
lease affects both the SOFP and the SPL&OCI. An asset and a liability
are recorded on the lessee’s balance sheet equal to the present value
of the lease payments to be made under the contract. The asset
account reflects what is, in essence, the purchase of an asset, and the
liability is the obligation incurred in financing the purchase.
Stockholders’ Equity
The ownership interests in the company are represented in the SOFP,
stockholders’ equity or share holders’ equity. Ownership equity is the
residual interest in assets that remains after deducting liabilities. The
owns bear the greatest risk because their claims are subordinate to
creditors in the event of liquidation, but owners also benefit from the
rewards of a successful enterprise.
Common Stock
Common shareholders do not ordinarily receive a fixed return but do
have voting privileges in proportion to ownership interest. Dividends on
common stocks are declared at the discretion of a company’s board of
directors. Further, common shareholders can benefit from stock
ownership through potential price appreciation (or the reverse can
occur if the share price declines).
Retained Earnings
The retained earnings account is the sum of every dollar a company has
earned since its inception, less any payments made to shareholders in
the form of cash or stock dividends. Retained earnings do not represent
a pile of unused cash stashed away in corporate vaults; retained
earnings are funds a company has elected to reinvest in the operations
of the business rather than pay out to stockholders in dividends. The
retained earnings account is the measurement of all undistributed
earnings.
Other Equity Accounts
In addition to the stockholders’ equity accounts shown in the SOFP,
there are other accounts that can appear in the equity section. These
include share premium, other component of equity, and noncontrolling interest.
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