Elements of Financial Statements
When a transaction occurs, it affects one or more aspects of financial statements which are called elements of financial statements. The analysis of the transactions is carried out to decide which one or more elements needs updating as a result of the transaction. There are five elements of financial statements;
- Capital/Equity
- Assets
- Liabilities
- Income
- Expense
These elements can also be called head of accounts as usually each element would have many accounts under it. In this Article, I will be discussing “Liabilities” in detail.
Liabilities
Liabilities are disclosed in the Balance Sheet. In simple terms, A liability is anything which is owed by the business. However, the following definition has been given by the accounting framework issued by the accounting regulatory body “International Accounting Standards Board (IASB)”,
“A liability 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.
The above could be explained by taking an example of a university student like yourself. The university has an obligation to teach and support you to complete your studies and award you a degree (if you pass) as they have taken the fee (Past event i.e., transaction). This would require the university to make sure they have staff to teach and other support facilities (outflow of resources embodying economic benefits). As a result, the university will record fees (or part of it) as a deferred income and present the amount as its liability rather than income. For example, the financial statements of University of the West of England for year ending 31 July 2019 contains a figure of £37 million for “Accrual and deferred income”.
Just like assets, liabilities are also sub-categorised into two main types, Current and Non-current.
Current Liabilities
In the above example, advance fees will be presented under current liabilities headings as students usually pay for a year in advance and the liability will be settled within a year. Other examples of current liabilities for a university are suppliers for stationary, utilities etc which need to be paid within a year time. However, those businesses which manufacture (e.g., Air Bus) or buy good to resell (e.g., Tesco) would have suppliers (Accounts Payables/Creditors) as their main current liabilities. Bank overdraft is also an example of current liability.
Non- Current Liabilities
Loan taken from a bank which needs repaying over a long period of time (usually 3-10 years) is an example of non-current liability. However, the part which needs repaying next year will be disclosed as a current liability. Other examples of non-current liabilities are “Loan Notes” and “Debentures”. These are loans which are raised from the markets like London Stock Exchange where general public and institutions lend money to the companies by buying loan notes or debentures. These are certificates normally with a value of £100 with a specified rate of interest and date of maturity (payback time). These are a useful tool to collect money from a wider pool of lenders who can lend variable amounts as per their lending appetite.
Another example of a liability is a provision which is a tricky one. As per the definition, “A provision is a liability of uncertain timing or amount.” (IASB, 2020) Examples of provisions may include: warranty obligations; legal or constructive obligations to clean up contaminated land (thinking of BP oil spill in Gulf of Mexico?) or restore facilities; and obligations caused by a retailer’s policy to make refunds to customers. If you do not have an accounting & finance background, I would suggest not to dig too much in this area as it does not have much significance when it comes to financial analysis of a company.
This article is written by Raja Mizan who is a senior lecturer in accounting & finance in a UK university. He is an ACCA member and also runs his own accountancy practice RMR Accountants & Business Advisors.