Lecture 3

Unit 3 Financial Position

Learning Objectives
Explain the nature and purpose of the balance sheet
Demonstrate an understanding of assets in terms of definition, recognition, measurement
and classification
Demonstrate an understanding of liabilities in terms of definition, recognition, measurement
and classification
Discuss the nature and classification of owners equity
Explain the basic accounting equation
Contrast the alternative balance sheet formats
Discuss the main factors that influence the content and values in a balance sheet
Prepare a simple balance sheet
Analyse balance sheets of reporting entities
State the potential limitations of the balance sheet in portraying the financial position of an
entity

Note: the term Statement of Financial Position and Balance Sheet refer to the same
report. The names may be used interchangeably in this course.

Nature and Purpose of a Balance Sheet

The purpose of the balance sheet is to set out the financial position of a business at a particular
point in time
It contains a snap shot of the assets, liabilities and equity position of the entity at a
particular point in time
As from January 2009 an accounting standard recommendation is that the balance sheet
should be referred to as a statement of financial position

Assets
Definition: An asset, according to the AASB Framework is a resource controlled by the entity as
a result of past events, and from which economic benefits are expected to flow to the entity

The main identifying characteristics of an asset are:

Expected future economic benefit

The business has exclusive right to control the benefit
The benefit must arise from some past transaction or event
The asset must be capable of reliable measurement in monetary terms

Think of an asset as an item of value that the business has. Assets are used to assist the business
in its operations and to achieve its objectives which for many businesses may be to earn a profit!
The business does not need to own the asset (just control it) but it is expected to provide some
future benefit to the business and be the result of a past transaction/event and be able to be
measured reliably.
Note that these conditions limit the kind of items that may be referred to as assets in financial
reports. Some examples of items that appear as assets in a business balance sheet include:

Freehold premises
Machinery and equipment
Fixtures and fittings
Patents and trademarks
Debtors (also known as accounts receivable) amounts owed by customers who have
purchased from the business on credit
Investments

Example: Lets consider if a delivery van that a florist (flower shop) has would be considered an
asset:

Future economic benefit: it can provide a future economic benefit to the business. That is, it can be
used to deliver flower arrangements for customers. Without the delivery van, the florist may be
restricted to just selling flowers from their shop and not provide a delivery service. [Alternatively,
they could pay a contractor to deliver the flower arrangements instead. In this case, the contractor
would be paid to do the deliveries and this would be an expense (cost) associated with running the
business. (Expenses will be covered in the next unit!)]

Control of the benefit: if the business can determine what the delivery van will be used for/who will
use/when it will be used etc. then the business effectively has control of the future benefit expected
from the asset.

Past event/transaction: if the business purchased the delivery van or leased it, there will be
contractual documents that provide evidence of this transaction.

Reliable measurement: the documentation mentioned above would provide information as to the
cost associated with purchasing/leasing the delivery van so a reliable measurement in monetary
terms can be obtained with little problem.

Assets may be either tangible (items with a physical substance such as the delivery van referred to
above) or intangible (no physical substance e.g. patents for an invention)

Lecture Activity 1

Question: Think about one asset that you personally have????

Claims against the Assets:
There are essentially two types of claims against the assets of an entity:

External claims - known as liabilities

Internal claims - labelled owners equity, equity, capital, share capital

Liabilities
Definition: A liability according to the AASB Framework 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

In addition to meeting the above definition, there is a twofold recognition criterion:

Probability of occurrence (in the case of liabilities, it is more likely than not that a future
sacrifice of economic benefits will occur)
Reliability of measurement (in the case of liabilities the amount of the claim can be determined
with acceptable precision or accuracy)

Think of a liability as being a debt that the business owes another entity. Some examples of items
that appear as liabilities in a business balance sheet include:
Creditors
Staff entitlements
Loans and other credit facilities
Warranty provisions and other social or moral obligations
Provision for employee bonuses

Example: Lets use the same example of the florist (flower shop) that we used earlier and consider
if an amount owed to a supplier by the florist (flower shop) would be considered a liability to the
florist using the definition and recognition criteria for a liability above.

Present obligation of the entity: the florist does have a present obligation as it currently owes an
amount of money to the supplier who in return provided flowers for the business.

Obligation arising from past events: the present obligation has arisen as a result of the florist
purchasing flowers on credit from the supplier.

Expected to result in an outflow from the entity of resources embodying economic benefits: as the
florist now owes an amount of money to the supplier, it is expected that in the future an outflow of
resources from the florist will occur (usually in terms of cash) to settle the amount owed. The
resource in this instance, cash, does embody economic benefits as cash can be used in exchange
for other items (to buy assets, to pay expenses, to invest, etc).

Probability of occurrence: it is more likely than not that a future sacrifice of economic benefits will
occur as non payment may result in the supplier taking action to enforce payment through
bankruptcy proceedings and/or may be unwilling to deal with the florist again. If other suppliers are
aware of non payment for supplies this may also result in other suppliers being unwilling to deal
with the florist. Hence, the probability of occurrence is high as it is expected that the florist will pay
amounts that the business owes to external parties.

Reliable measurement: the documentation arising from the purchase of flowers from the supplier
on credit (eg. Invoice) would provide information as to the value of the purchase so a reliable
measurement in monetary terms can be obtained with little problem.
 Lecture Activity 2

Question: Think about one liability that you personally have or perhaps your family or friends
have????

Owners equity - The claim of the owner(s) on the assets of the business (as the owner/s of a
business are considered separate entities to the business itself). Think of the owner as being an
investor in the business. Any assets the owner contributes to the business are seen as the
owners claim on the business. Hence it is necessary to record any contributions the owner makes
to the business but also any items of value the owner takes from the business (known as
Drawings)!!! The owners investment in the business is expected to provide a return to the owner.
This return is the result of the business performance and is measured as the value of profit/loss
made by the business. A profit is added to the owners investment (owners equity section) while a
loss is subtracted from the owners investment.

How do we calculate profit or loss?

It is calculated by taking Income earned by the business and subtracting from this figure Expenses
incurred in earning this income for the business. That is, Income less Expenses = Profit/Loss.

A profit occurs where Income is greater than Expenses.

A loss occurs where Income is less than Expenses.

Owners Equity

Contribution by the owner/s +/- Result of business

performance (+ profit or - loss)

- Drawings by the owner/s

Income
Less
Expenses
 Lecture Activity 3

1. The best description of assets is:

(a) The financial claims of non owners
(b) Resources capable of providing future benefits to the enterprise
(c) Amounts intended to be converted into cash within 12 months
(d) Items owned by the business and held for use.
Source: Accounting-A Framework for Decision Making, 2nd edition, Jackling, Raar, Williams & Wines, McGraw-Hill Irwin 2007

2. Liabilities are:
(a) Obligations to make future dispositions of economic benefits
(b) Debts owed by a business to outside parties called creditors
(c) Amounts owed to employees for wages and salaries not yet paid
(d) All of the above.
Source: Accounting Study Guide, Hoggett, Edwards, Medlin & Tilling, Prepared by Latimer, Wiley Publishing 2009

3. The best description of liabilities is:

(a) Creditors and lenders
(b) Financial claims on assets after all debts have been paid
(c) Claims of non owners
(d) A list of future cash payments due.
Source: Accounting-A Framework for Decision Making, 2nd edition, Jackling, Raar, Williams & Wines, McGraw-Hill Irwin 2007

Lecture Activity 4

Classify the following items as an asset (A), liability (L) or owners equity (OE):

1. Office equipment
_______________________
2. Accounts payable
_______________________
3. Capital B. Bob
_______________________
4. Bank loan
_______________________
5. Cash at bank
_______________________
6. Creditors
_______________________
7. Drawings
_______________________
8. Bank overdraft
_______________________
9. Loan to R. Roger
_______________________
10. Debtors
_______________________
The 5 Basic Accounting Elements
We have looked in detail at Assets, Liabilities and Owners Equity (Equity). They are 3 of the
basic accounting elements in an Accounting Information System. We have also mentioned the
remaining 2 basic accounting elements when looking at the components of Owners Equity
(Equity) as they indirectly have an impact on Owners Equity - they are Income and Expenses.

Transactions occur in the business. These accounting elements form the basis for analysing and
recording these transactions into the accounting information system.

5 Basic Accounting Elements

Owners
Assets Liabilities Equity Income Expenses
(Equity)

The Accounting Equation

An understanding of the accounting equation helps form an understanding of how transactions are
identified, understood, analysed, recorded and reported through the accounting information
system.

The basic accounting equation is expressed as:

Assets = Liabilities + Owners Equity OR A = L + OE

This equation will always hold true, as total claims (against the assets) are always the same as
total assets, ensuring that the balance sheet always balances.
 Lecture Activity 5

1. Fill in the missing dollar amount (represented by ?) in the accounting equation for each of the
situations given below:

Situation Assets Liabilities Equity

$ $ $
1 ? 8,000 24,000
2 60,000 32,000 ?
3 36,000 ? 22,000
4 25,980 5,380 ?
5 ? 27,120 16,880
6 729,554 220,214 ?
7 11,948 3,912 ?
Source: Accounting Study Guide, Hoggett, Edwards, Medlin & Tilling, Prepared by Latimer, Wiley Publishing 2009

Effect of trading operations (transactions) on the balance sheet-

transaction analysis and the basic accounting equation

Every transaction has at least 2 effects (usually 2 but in

some cases more than 2) on the accounting equation.

When we analyse a transaction (often referred to as transaction analysis) to determine what

these effects are, we consider the following:
how assets, liabilities and/or owners equity are affected; and
o which specific asset (cash at bank, motor vehicle, etc) and/or
o which specific liability (creditor, loan, etc) and/or
o which specific part of owners equity (capital, drawings) is actually affected.

It is necessary to identify the specific account/s affected by a transaction as the financial reports
such as the balance sheet displays details of the business assets, liabilities and equity items and
NOT JUST TOTAL assets, TOTAL liabilities and TOTAL owners equity. Similarly, the income
statement shows details of income and expense items and NOT JUST TOTAL income and TOTAL
expenses. Both totals and detailed information are provided in both reports.
Example:
Transaction: A sole proprietor contributes $100,000 to commence a business:

Specific owners equity

Accounting element/s
item/account affected by
affected by this
this transaction (capital)
transaction (OE)

Owners equity (capital) by $100,000

Assets (cash at bank) by $100,000

Accounting element/s Specific asset

affected by this item/account affected by
transaction (A) this transaction
(cash at bank)

The Balance Sheet

The Balance Sheet can be shown in a number of different formats. We will look at these formats in
detail in the next lecture. However, in order to understand the impact of transactions and the
accounting equation on the balance sheet, it is necessary to introduce you to a very basic format of
the balance sheet. As you may recall, the balance sheet contains three of the five basic
accounting elements assets, liabilities and owners equity. The balance sheet that we will show
you now is called the T format of a balance sheet as it normally takes the shape of the letter T:

Balance Sheet
$ $
ASSETS LIABILITIES
Cash at bank 13,000 Trade creditors 33,000
Trade debtors 10,000 Loan 50,000
Inventory 30,000
Motor vehicle 30,000 OWNERS EQUITY
Plant and machinery 100,000 Capital 100,000
Total assets 183,000 Total liabilities and owners equity 183,000

Lecture Activity 6

Using the transactions that appear below:

1. Analyse each of the following transactions (transaction analysis).
2. Show the effect of each transaction on a very basic balance sheet for the business.
3. Show that the basic accounting equation balances after each transaction.

Transactions:
May 1 T. Nguyen contributes $150,000 to commence his plumbing business.
May 3 Van purchased for $40,000 by obtaining finance from Happy Bank
May 4 Purchased plumbing supplies for $5,000 on credit from ABC Plumbing.
May 7 T. Nguyen took $1,000 from the business bank account for personal use.
Solution
May 1 T. Nguyen contributes $150,000 to commence his plumbing business.

1.
Transaction Accounting Element or in Accounting Specific Account Amount
Date (A, L, OE) Element Name $
May 1

2.
Balance Sheet
Assets Liabilities

Owners equity

3.
Check if the accounting equation balances . A = L + OE
Solution
May 3 Van purchased for $40,000 by obtaining finance from Happy Bank

1.
Transaction Accounting Element or in Accounting Specific Account Amount
Date (A, L, OE) Element Name $
May 3

2.
Balance Sheet
Assets Liabilities
Bank
Owners equity
Capital

3.
Check if the accounting equation balances . A = L + OE
Solution
May 4 Purchased plumbing supplies for $5,000 on credit from ABC Plumbing.
1.
Transaction Accounting Element or in Accounting Specific Account Amount
Date (A, L, OE) Element Name $
May 4

2.
Balance Sheet
Assets Liabilities
Bank Loan-Happy Bank
Van Owners equity
Capital

3.
Check if the accounting equation balances . A = L + OE
Solution
May 7 T. Nguyen took $1,000 from the business bank account for personal use.
1.
Transaction Accounting Element or in Accounting Specific Account Amount
Date (A, L, OE) Element Name $
May 7

2.
Balance Sheet
Assets Liabilities
Bank Loan-Happy Bank
Van Creditor-ABC Plumbing
Plumbing supplies Owners equity
Capital

3.
Check if the accounting equation balances .A = L + OE
Effect of trading operations (transactions) on the balance sheet the
expanded accounting equation
Trading operations (i.e. the sale of goods or services) introduces additional transactions that
impact on the balance sheet.

To take into account the effect of trading, the accounting equation previously described is extended
as follows to take into account the impact of income and expenses and therefore, changes
in owners equity.

Recall that this is the basic accounting equation:

Assets = Liabilities + Owners Equity OR A = L + OE

This is the expanded accounting equation shown in your textbook:

Assets = Owners equity beginning + Profit (or -Loss) +/- Other Owners Equity Changes + Liabilities

While the expanded accounting equation may look daunting, it is really just expanding on
the Owners Equity part of the equation as shown below:
Owners Equity

Assets = Owners equity beginning + Profit (or -Loss) +/- Other Owners Equity Changes + Liabilities

You may also notice that the equation above shows that A = OE + L.
This has the same effect as A = L + OE.

Income and Expenses have been indirectly included in the accounting equation now as the result
of Income minus Expenses will provide you with profit/loss. You may recall that the result of
trading (profit or loss) is added to/subtracted from the owners investment in the business (capital)
which is therefore part of owners equity.
Any additional contributions by the owner are added to capital and any assets taken from the
business by the owner for personal use are subtracted from the owners investment and are
usually known as drawings for a sole trader. These components of owners equity are illustrated
below in the expanded accounting equation.
 Owners Equity

Assets = Owners equity beginning + Profit (or -Loss) +/- Other Owners Equity Changes + Liabilities

+ additional contributions by owner

Income (I) less Expenses (E)
- drawings by the owner

You can summarise the expanded accounting equation to make it easier to understand by using
abbreviations. This is illustrated below.

A = L + OE (OE at beginning + I E + C D)

Where:

A = assets
L = liabilities
OE = owners equity
I = income
E = expenses
C = additional capital contributions
D = drawings

Remember: the five major accounting elements that result from these equations are:

Assets (A)
Liabilities (L)
Owners Equity (OE)
Income (I)
Expenses (E)

While additional capital contributions and drawings have been shown separately in the expanded
accounting equation, they are not an accounting element in their own right. They are both part of
owners equity. Income and expenses are separate accounting elements. However it is the end
result of trading (profit/loss) that is then added to owners equity (capital).

In summary, three of these accounting elements (assets, liabilities and owners equity) are shown
in the Balance Sheet while the remaining two accounting elements (income and expenses) are
shown in the Income Statement. This is shown in the diagram that follows:
 Assets

Liabilities Balance Sheet

Profit

Loss
Owners Equity

Income
Income Statement

Expenses

Lecture Activity 7 (Adapted from Activity 3.10 from Textbook)

Using the transactions that appear below for A. Dunn, Solicitor:

1. Analyse each of the following transactions (transaction analysis) showing their impact on
assets, liabilities, owners equity, income and expenses.
2. Show the effect of each transaction on a very basic balance sheet for the business
3. Show that the expanded accounting equation balances after each transaction.

Date Transaction
1/3/2009 Commenced business by contributing $100,000 cash and office furniture and fittings valued at $10,000
2/3/2009 Purchased computer equipment for cash $3,000
3/3/2009 Billed client, C. Crime, for services $1,500
4/3/2009 Purchased office stationery for cash, $300
5/3/2009 Solicitor fees received in cash for services provided $2,500
7/3/2009 Paid wages to staff $800
10/3/2009 Received full payment from client, C. Crime
12/3/2009 Owner withdrew cash, $200 for personal use
15/3/2009 Purchased office equipment for $9,000 by taking a loan out with Excellent Finance Ltd
Source: Accounting-An Introduction, 4th edition, Atrill, McLaney, Harvey & Jenner, Pearson Education Australia 2009
Solution
1/3/2009 Commenced business by contributing $100,000 cash and office furniture/fittings valued at $10,000
1.
Transaction Accounting Element or in Accounting Specific Account Name Amount
Date (A, L, OE) Element $
1/3/2009

1/3/2009

2.
Balance Sheet
Assets Liabilities

Owners equity

3.
Check if the accounting equation balances . A = L + OE

Solution
2/3/2009 Purchased computer for cash $3,000

1.
Transaction Accounting Element or in Accounting Specific Account Name Amount
Date (A, L, OE) Element $
2/3/2009 Asset Bank 3,000
Asset Computer 3,000

2.
Balance Sheet
Assets Liabilities
Bank
Office furniture/fittings Owners equity
Capital

3.
Check if the accounting equation balances . A = L + OE

Solution
3/3/2009 Billed client, C. Crime, for services $1,500

1.
Transaction Accounting Element or in Accounting Specific Account Name Amount
Date (A, L, OE) Element $
3/3/2009

2.
Balance Sheet
Assets Liabilities
Bank
Office furniture/fittings Owners equity
Computer Capital

3.
Check if the accounting equation balances . A = L + OE

Solution
4/3/2009 Purchased office stationery for cash $300
1.
Transaction Accounting Element or in Accounting Specific Account Name Amount
Date (A, L, OE) Element $
4/3/2009

2.
Balance Sheet
Assets Liabilities
Bank
Office furniture/fittings Owners equity
Computer Capital
Debtor C.Crime Fees revenue

3.
Check if the accounting equation balances . A = L + OE

Solution
5/3/2009 Solicitor fees received in cash for services provided $2,500
1.
Transaction Accounting Element or in Accounting Specific Account Name Amount
Date (A, L, OE) Element $
5/3/2009

2.
Balance Sheet
Assets Liabilities
Bank
Office furniture/fittings Owners equity
Computer Capital
Debtor C. Crime Fees revenue
Office stationery

3.
Check if the accounting equation balances . A = L + OE
Solution
7/3/2009 Paid wages to staff $800

1.
Transaction Accounting Element or in Accounting Specific Account Name Amount
Date (A, L, OE) Element $
7/3/2009

2.
Balance Sheet
Assets Liabilities
Bank
Office furniture/fittings Owners equity
Computer Capital
Debtor C. Crime Fees revenue
Office stationery

3.
Check if the accounting equation balances . A = L + OE

Solution
10/3/2009 Received full payment from client, C. Crime

1.
Transaction Accounting Element or in Accounting Specific Account Name Amount
Date (A, L, OE) Element $
10/3/2009

2.
Balance Sheet
Assets Liabilities
Bank
Office furniture/fittings Owners equity
Computer Capital
Debtor C. Crime Fees revenue
Office stationery Wages expense

3.
Check if the accounting equation balances . A = L + OE

Solution
12/3/2009 Owner withdrew cash, $200 for personal use
1.
Transaction Accounting Element or in Accounting Specific Account Name Amount
Date (A, L, OE) Element $
12/3/2009

2.
Balance Sheet
Assets Liabilities
Bank
Office furniture/fittings Owners equity
Computer Capital
Office stationery Fees revenue
Wages expense

3.
Check if the accounting equation balances . A = L + OE

Solution
15/3/2009 Purchased office equipment for $9,000 by taking a loan out with Excellent Finance Ltd
1.
Transaction Accounting Element or in Accounting Specific Account Name Amount
Date (A, L, OE) Element $
13/3/2009

2.
Balance Sheet
Assets Liabilities
Bank
Office furniture/fittings Owners equity
Computer Capital
Office stationery Fees revenue
Wages expense
Drawings

3.
Check if the accounting equation balances . A = L + OE