Chapter 7: Preparing The Financial Statements - incomplete

Question 1

When do financial statements become more useful?

Answer 1

The financial statements illustrated up to this point were purposely kept simple. We classified items as assets, liabilities and owner’s equity in the statement of financial position, and as revenue and expenses in the statement of profit or loss.

Financial statements, however, become more useful to management, creditors and existing and potential investors when the elements are classified into significant subgroups.

Question 2

What do classified financial statements do?

Answer 2

Classified financial statements assist users in making economic decisions about the allocation of resources.

Question 3

What do classifications in the statement of financial position do?

Answer 3

Classifications in the statement of financial position help the financial statement user determine such matters as

(1) the availability of assets to meet debts as they fall due and
(2) the claims of short- and long-term creditors on total assets.

A classified statement of financial position also makes it easier to compare entities in the same industry, such as Reebok, Puma and Adidas in the sporting apparel industry.

Question 4

What classifications will an entity use to present assets and liabilities on the statement of financial position?

Answer 4

An entity will present assets and liabilities on the statement of financial position in current and non-current classifications.

Question 5

What does the order and descriptions used on the statement of financial position ensure?

Answer 5

The order and descriptions used on the statement of financial position should ensure that the information presented is relevant and aids the user’s understanding of the financial statements so that informed investment decisions may be made.

Question 6

What are all the standard classifications on a statement of financial position?

Answer 6

Current assets and non-current assets.

Current liabilities and non-current liabilities.

Question 7

What are current assets?

Answer 7

Current assets are cash and other resources that are reasonably expected to be realised in cash or sold or consumed in the business within 1 year of the statement of financial position date or the business’s operating cycle, whichever is longer.

A current asset is also one that is held primarily for the purpose of being traded, such as inventory.

In a service entity, it is customary to recognise four types of current asset.

Question 8

What are examples of current assets?

Answer 8

Accounts receivable are current assets because they will be realised in cash through collection within 1 year.

A prepayment such as supplies is a current asset because of its expected use or consumption in the business within 1 year.

Question 9

What are the four types of current asset which are customary to recognise in a service entity?

Answer 9

(1) cash,
(2) short-term investments such as government bonds,
(3) receivables (e.g. notes receivable, accounts receivable and interest receivable) and
(4) prepaid expenses (insurance and supplies).

These items are listed in the order of liquidity. That is, they are listed in the order in which they are expected to be converted into cash.

Question 10

Financial assets.

Answer 10

Cash and accounts receivable are current financial assets that are shown as separate line items on the statement of financial position.

Other financial assets, classified as either current or non-current, include investments in debt and investment securities issued by other entities.

Question 11

Why are businesses current and non-current assets important?

Answer 11

A business’s current assets are important in assessing the business’s short-term debt-paying ability.

Non-current assets are long-term assets and are given meaningful descriptions, such as property, plant and equipment, intangible assets and investment property.

Question 12

What are investments?

Answer 12

Businesses investing in non-current assets other than financial assets report them under the line item of investments.

Question 13

What is property, plant and equipment?

Answer 13

Property, plant and equipment are tangible resources of a relatively permanent nature that are used in the business and not intended for sale.

This category includes land, buildings, machinery and equipment, delivery equipment, and furniture and fixtures.

Assets subject to depreciation should be reported at cost less accumulated depreciation.

Eg. On page 223

Question 14

What are intangible assets?

Answer 14

Intangible assets are non-current resources that do not have physical substance. They are recorded at cost, and this cost is expensed over the useful life of the intangible asset.

Intangible assets include patents, copyrights and trademarks or trade names that give the holder exclusive right of use for a specified period of time. Their value to a business is generally derived from the rights or privileges granted by government agencies.

Eg. On page 223

Question 15

What are current liabilities?

Answer 15

Listed first in the liabilities and owner’s equity section of the statement of financial posi- tion are current liabilities.

A liability is current if it satisfies any of the following criteria:
. The liability is expected to be settled within the entity’s normal operating cycle, or
. It is held primarily for the purpose of being traded (that is, expected to be paid from existing current assets or through the creation of other current liabilities), or
. Reasonably expected to be settled within the next twelve months after the reporting period.

Question 16

What do current liabilities include?

Answer 16

(1) debts related to the operating cycle, such as accounts payable and wages and salaries payable, and
(2) other short-term debts, such as bank loans payable, interest payable, taxes payable and current maturities of long-term obligations (payments to be made within the next year on long-term obligations).

Question 17

What is the arrangement of items within the current liabilities section?

Answer 17

The arrangement of items within the current liabilities section has evolved through custom rather than from a prescribed rule.

Trade and other payables are usually listed first, followed by short-term borrowings.

Other items are then listed in any order.

Eg. Page 224

Question 18

What do users of financial statements look closely at?

Answer 18

The relationship between current assets and current liabilities.

This relationship is important in evaluating an entity’s liquidity - its ability to pay obligations that are expected to become due within the next year or operating cycle.

When current assets exceed current liabilities at the reporting date, the likelihood for paying the liabilities is favourable.

When the reverse is true, short-term creditors may not be paid, and the entity may ultimately be forced into bankruptcy.

Question 19

Liquidity summary.

Answer 19

Liquidity - business ongoing (current assets exceed current liabilities at the reporting date = likelihood for paying the liabilities is favourable)

Illiquidity - out of business (When the reverse is true, short-term creditors may not be paid, and the entity may ultimately be forced into bankruptcy)

Question 20

What are non-current liabilities?

Answer 20

Obligations expected to be paid after 1 year or after an operating cycle are classified as non-current liabilities.

Liabilities in this category include interest-bearing loans, bonds payable, mortgages payable, long-term notes payable, lease liabilities and obligations under superannuation plans.

Many entities report long-term debt maturing after 1 year as a single amount in the statement of financial position. They then show the details of the debt in the notes that accompany the financial statements. Others list the various sources of long-term liabilities.

Eg. Page 224

Question 21

Explain the owner’s equity section of the statement of financial position.

Answer 21

The content of the owner’s equity section varies with the form of business entity.

In a proprietorship, there is one capital account. In a partnership, there is a capital account for each partner. For a company, owners’ equity is divided into three accounts — Share Capital, Reserves and Retained Earnings.

Eg. Page 225

Question 22

Explain the three owner’s equity accounts for a company.

Answer 22

Investments of assets in the company by the shareholders are recorded by debiting an asset account and crediting the Share Capital account.

Reserves are increases in equity from sources other than contributed capital from the owners and retained earnings. Examples of reserves include Asset Revaluation Reserve and General Reserve.

Income retained for use in the company is recorded in the Retained Earnings account.

The Share Capital, Reserves and Retained Earnings accounts are combined and reported as owner’s equity on the statement of financial position.

Question 23

How is the statement of financial position most often presented?

Answer 23

The statement of financial position is most often presented in report form, with assets listed above liabilities and owner’s equity.

The statement of financial position may also be presented in account form: the assets section is placed on the left and the liabilities and owner’s equity sections on the right.

Question 24

What do entities include in addition to the financial statements?

Answer 24

In addition to the financial statements, entities include other relevant information in their reports such as notes to the financial statements.

The notes to the financial statements are important as they describe how some of the numbers on the face of the statement of financial position were calculated, and they often provide additional information about some of the reported items.

Eg. Page 226

Question 25

How is a classified statement of financial position presented in account form?

Answer 25

Company name
Statement of financial position
as at date

                   Assets (left)
Current assets 
     Cash
     Accounts receivable 
     Etc.
         Total current assets 
Property plant and equipment 
     Office equipment 
     Less: accumulated depreciation 
        TOTAL ASSETS

   Liabilities and owner's equity (right) 
Current liabilities 
    Interest-bearing loans 
    Accounts payable 
    Unearned revenue 
    Etc.
        Total current liabilities
Long term liabilities 
    Interest-bearing loans
        TOTAL LIABILITIES 
Owner's equity
    *name* capital 
         TOTAL LIABILITIES AND OWNER'S EQUITY  

Following figure 7.10 on page 226

Question 26

What are non-current liabilities also called?

Answer 26

Non-current liabilities are also called long-term debt or long-term liabilities.

Question 27

How is a classified statement of financial position presented in report form?

Answer 27

Company name
Statement of financial position
as at date

                                                    Assets 
Current assets 
     Cash
     Accounts receivable 
     Etc.
         Total current assets 

Non-current assets
Financial assets

Property plant and equipment
Office equipment
Less: accumulated depreciation

Intangible assets
Patents

    TOTAL ASSETS

                                   Liabilities and owner's equity 
Current liabilities 
    Interest-bearing loans 
    Accounts payable 
    Unearned revenue 
    Etc.
        Total current liabilities

Long term liabilities
Long-term borrowings
Deferred tax liabilities
Totals long-term liabilities

         TOTAL LIABILITIES 

Owner’s equity
name capital
TOTAL LIABILITIES AND OWNER’S EQUITY

Following figure 7.11 on page 226