4
THE STATEMENT OF FINANCIAL POSITION
4.1
Introduction
We have already covered, you’ll be glad to know, the essence of the statement of financial
position. In paragraph 1.2 it was defined as ‘a statement of the final positions of a business at a
given date’.
But if you think about it, that is exactly what Percy’s accounting equation has been doing, each
time we prepared it. The statement of financial position is the accounting equation, only set out
in vertical form in order to be more readily understood.
In real life of course, we don’t prepare the statement of financial position (or even an
accounting equation) every time a business makes a transaction, as we have been doing up to
now. The statement of financial position is prepared at the end of a period, as we said in
Chapter 1, and the books of account, or accounting records, are kept to record individual
transactions as they happen.
We will look at these in detail in Chapter 6, after we have seen what the end products (the
statement of financial position and income statement) look like.
4.2
Layout of the statement of financial position
We will set out Percy Pilbeam’s final accounting equation as a formal statement of financial
position, and then explain each section in turn.
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P PILBEAM
Statement of financial position at 31 January 20X1
£
ASSETS
Non-current assets
Motor vehicles
Current assets
Inventories
Trade receivables
Cash
£
4,000
2,000

6,300
________
8,300
________
Total assets
CAPITAL AND LIABILITIES
Capital
As at 1 January
Profit for the period
Less drawings
At 31 January
12,300
10,000
800
(500)
10,300

Non-current liabilities
Current liabilities
Trade payables
2000
________
2000
________
Total capital and liabilities
12,300
______
Some headings have been shown for illustration: in practice, if there were, for example, no
receivables, this heading would be left out.
4.3
Non-current assets and current assets
An asset was defined in paragraph 2.4 as something owned by a business, available for use in
the business.
As you can see from Percy’s statement of financial position, there is a distinction between noncurrent assets and current assets.
Non-current assets can be defined as ‘assets acquired for use within a business over several
years, with a view to earning profits, but not for resale’.
Current assets are ‘assets acquired for conversion into cash in the ordinary course of business’.
In other words, non-current assets are those which a business keeps and uses in the long term,
and current assets are those which pass through the business as part of the normal trading
process.
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4.4
Non-current assets
Without looking at the answer, try to think of some types of assets which a business would be
likely to keep over several years.
Target  about 10.
………………………………………………. ………………………………………….
………………………………………………. ………………………………………….
………………………………………………. ………………………………………….
………………………………………………. ………………………………………….
………………………………………………. ……………………………………………
Answer:
Land, buildings, plant and machinery, patents, motor vehicles, tools, fixtures and fittings,
office equipment, computers, long-term investments, ships, works of art, locomotives.
A business will either pay cash or incur a liability when it buys any of these; but as we saw in
the example in Chapter 3 the same thing happens when it incurs an expense, such as an
electricity bill. We need to distinguish one type of payment from the other.
Taking the electricity bill first, this could not in any sense be called an asset. It is simply an
expense, to be charged against profit, and as such we call it a revenue expense. We will look
at this in Chapter 5.
Buying a non-current asset, on the other hand, is called a capital expense. We don’t simply
deduct its cost from profit; we show it in the statement of financial position as an asset.
But at what value do we show it?
4.5
Depreciation
Leaving Percy Pilbeam’s van in the statement of financial position at the amount it cost doesn’t
take account of the fact that vans are not immortal. Four years of carrying fruit and vegetables
around will probably be enough; and four years is the period which many businesses choose as
an ‘estimated useful life’ for motor cars, vans and lorries.
Other types of non-current asset will last for different periods; a business might choose, for
example, 10 years for plant and machinery and 20 years for furniture.
What all this is leading to is that it can’t be correct to have a non-current asset in the statement
of financial position at the amount which it cost all through its life. Can you remember the cost
of Percy’s van?
Cost
£4,000.
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It isn’t worth this amount, in terms of either physical condition or market value, when it is, say,
three years old, is it?
So what we do is to deduct from profit, or write off, a proportion of the cost of the van for each
of its estimated useful life. There are various ways of doing this; the simplest is to write off an
equal proportion each year. This exercise is called depreciation, and for Percy’s van it works
as follows:
£
4,000
(1,000)
Cost
Year 1 Depreciation  25% on cost
________
3,000*
(1,000)
Year 2 Depreciation
________
2,000*
(1,000)
Year 3 Depreciation
________
1,000*
(1,000)
Year 4 Depreciation
________

________
The amounts marked with an * are the amounts left at the end of each year after the charge has
been made for depreciation, and are called the carrying amount (or written-down value).
Depreciation, like everything else in accounting, has its dual effect.
(a)
Reduction in non-current asset value.
(b)
Reduction in profit
Each year the charge for depreciation is deducted from profit, but in the statement of financial
position these charges accumulate, and at the end of, for example, the third year of Percy’s
ownership of the van his statement of financial position would start off  how?
Cost
Non-current assets
Motor vehicles
4,000
Accumulated Carrying
Depreciation amount at
at end of year end of year
3,000
1,000
And how much is charged against profit, as an expense, each year?
£1,000.
In summary we are spreading the cost of the van over its useful life to the business eg. 4 years.
4.6
Current assets
In Chapter 4.3 we defined current assets as ‘assets acquired for conversion into cash in the
ordinary course of business’.
We also said that current assets are those which pass through the business as part of the normal
trading process.
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Just as people or animals cannot live without blood constantly moving through their bodies, so
a business cannot exist without the constant movement of current assets. The three types of
current assets shown in Percy Pilbeam’s statement of financial position in paragraph 4.2 were:
(a)
Inventories
(b)
Receivables
(c)
Cash
Assuming that Percy, once he gets started, makes most of his sales for credit, the ‘movement’
that we are talking about will happen as follows:
(a)
Assuming that Percy’s business has some cash in the bank, he will normally use most
of it to buy inventories.
(b)
If he sells his inventories for credit, he will have receivables.
(c)
When the receivables pay, as he hopes they will, he will have cash.
And so it goes on. Obviously, some of his cash will go elsewhere (expenses, drawings, etc),
some of his inventories may not be sold, and some of his receivables may not pay. But the
majority of cash, inventories and receivables will flow in this way.
We will now look at each of these current assets in a little more detail, taking them in the order
(inventories, receivables, cash) in which by convention they appear in the statement of financial
position.
4.7
Inventories
In Percy Pilbeam’s business it is fairly obvious what his inventories consists of.
What is it?
Fruit and vegetables.
For a retailer such as Percy, the inventories held at a given time are simply the goods which he
has available for sale. However, other businesses manufacture their inventories, and in their
statement of financial position ‘inventories’ will include not only finished goods, but also raw
materials and components. Also included in a manufacturing business are goods which at the
statement of financial position date are in the process of being manufactured. These are known
as work in progress.
To arrive at the physical quantity of inventories at the statement of financial position date,
Percy must of course count it, ie. carry out a stock-taking. But at what value should he show it
in the statement of financial position? The price it cost him, or the price he charges?
The conventional rule here is that inventories are valued at the lower of cost and net
realisable value. This means that a business should normally value its inventories at cost
price, unless it can’t sell it at a profit.
If it can only sell an item of inventory for less than it cost, it should reduce the value of that
item to the lower, selling value. ‘Net realisable value’ means selling price less any further costs
to be incurred before the item can be sold.
Finding out how ‘cost’ is calculated will take up quite a large proportion of your time later on.
For the moment, it is enough to say that ‘cost’ includes not only the cost of buying goods but,
in a manufacturing industry, the costs of manufacture too, ie. labour and some production
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expenses. In fact, it includes all costs incurred by a business in bringing inventories and
work in progress to its present location and condition.
4.8
Receivables
Clearly, receivables are people who owe money to the business, and the amount at which they
are shown in the statement of financial position should be the total of these receivables.
Inevitably, if a business makes sales on credit, it will sometimes have receivables that are slow
to pay, or argue about the amount owed, or even go bust. In such cases we have to take account
of this, and make an allowance against receivables. If we didn’t, we would be overstating our
assets by valuing receivables at a greater amount than they are likely to pay.
What do you think the dual effect is of such an allowance? (If you don’t know  don’t look at
the answer yet: look back at paragraph 4.5 and see if you can spot the similarity).
4.9
(a)
Reduction in receivables.
(b)
Reduction in profit.
Cash
No provisions against this  either you’ve got it or you haven’t. There are in fact two
categories of cash:
(a)
cash at bank;
(b)
cash in hand, or petty cash.
With cash at bank, remember that the amount on the business’s bank statement won’t always
be the same as the amount shown in the statement of financial position. This is because there
will usually be cash and cheques, both received and paid, which haven’t yet been processed by
the bank. It can take a few days for transactions to go through the system; the result of this is
that a bank reconciliation has to be done, adjusting the amount on the bank statement for such
items, and also serving the purpose of making sure that the business’s own cash records are
correct and up to date.
Every business needs a certain amount of petty cash (notes and coins) on the premises to pay
for casual expenses such as coffee, biscuits and newspapers. Although the amount held will be
small, it is still an asset and has to be shown in the statement of financial position.
4.10
Current liabilities
In paragraph 2.4 we defined a liability as an amount owed by the business, ie. an obligation to
pay money at some future date.
A current liability is simply a short-term liability  ie. an amount owed by the business,
payable within one year. The commonest examples of current liabilities are:
(a)
trade payables;
(b)
accrued charges;
(c)
bank overdraft.
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4.11
Trade payables
These are suppliers of goods, such as Percy Pilbeam’s wholesaler, from whom the business is
buying items directly for resale, and whom it isn’t paying immediately. Many businesses give
one month’s credit, and many more take longer than that.
4.12
Accrued charges (Accruals/Prepayments)
Accrued charges include services such as rent, electricity, gas and telephone which a trader may
have used but not yet paid for. Sometimes it will be an exact bill outstanding, sometimes the
bill will not be due yet; but we will have to estimate how much, say, electricity has been used
up to and including the date of the statement of financial position.
Charges like this tend to be paid in arrears (live now, pay later). We refer to the outstanding
amount for the service used as an accrual. An accrual is shown within current liabilities.
However sometimes a business may have to pay for a service in advance eg. rent or rates.
Instead of the amount being a liability as we’ve not yet used the service, it’s a current asset
known as a prepayment.
If during his first month’s trading, Percy had paid 3 months rent, he would have paid 2 months
in advance. This 2 months of rent would be an example of a prepayment and should be shown
alongside receivables in the statement of financial position.
4.13
Bank overdraft
If you owe money to the bank (you have an overdraft), the bank actually has an asset
(receivable) in its own books; this may not be very convincing as an argument next time you try
to negotiate an overdraft.
Conversely, if you have cash in the bank (ie. a positive balance) the bank owes you money,
which you can, and doubtless will, withdraw.
Don’t get confused by this: you will be writing up only one business’s books at a time.
4.14
Non-current liabilities
These are amounts owed by the business, payable more than one year after the date of the
statement of financial position. Long-term loans are much the commonest example.
4.15
Format of the Statement of financial position
Previously we looked at the accounting equation:
Net assets = Capital; or
Assets – Liabilities = Capital
Now we have simply rearranged the equation to show:
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Assets = Capital + Liabilities
4.16
Revision questions
(1)
Define non-current assets.
(2)
Define current assets.
(3)
Are the following non-current or current assets?
(a)
Buildings
(b)
Receivables
(c)
Petty cash
(d)
Fixtures & fittings
(e)
Work in progress
(f)
Long-term investments
(4)
Is the purchase of a non-current asset called a capital or a revenue expense?
(5)
(a)
If a van cost £5,000 and is written off in equal proportions over four years,
how much depreciation should be charged against profit each year?
(b)
At what value should the van be shown in the statement of financial position
at the end of the third year?
(6)
What is the dual effect of charging depreciation?
(a)
(b)
(7)
Name three types of inventories which you might expect to find in a manufacturing
business:
(a)
(b)
(c)
(8)
What is the conventional rule on the valuation of inventories?
(9)
Define a current liability?
(10)
Name three types of current liability.
(a)
(b)
(c)
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Answers
(1)
Fixed assets are assets bought by the business for use over a number of years, with the
aim of earning profits, but not for resale.
(2)
Current assets are assets acquired for conversion into cash in the ordinary course of
business.
(3)
(a)
(b)
(c)
(d)
(e)
(f)
(4)
Capital
(5)
(a)
£5,000 ÷ 4 = £1,250 (cost ÷ useful life = depreciation per annum)
(b)
£5,000  (3 x 1,250) = £1,250 (cost  accumulated depreciation)
(6)
(a)
(b)
Reduction in profit
Reduction in value of fixed asset
(7)
(a)
(b)
(c)
(d)
Raw materials
Components
Finished goods
Work in progress
(8)
Inventories should be valued at the lower of cost and net realisable value.
(9)
A current liability is an amount owed by the business which is payable within one
year.
(10)
(a)
(b)
(c)
fixed
current
current
fixed
current
fixed
Trade payables
Accruals
Bank overdraft
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