Implication of statement of financial position to business
Statement of financial position is divided in to two parts, the asset and the liability side. The statement carry both broad and specific implications on the entrepreneur’s business existence and operations. In this level three, an in depth interrogation of these implications will be discussed and brought to the full understanding of the entrepreneur/learner so as to make accountancy profession more practical in the day to day operations. Each of the various implications of statement of financial position of the business will be discussed separately.
Investment and Source of Finance Implications
The statement of financial position is generally divided in to two parts, namely; asset and liability perspectives. The liability side represents the various sources of finance available to the business. Whereas, the asset side represent the investment perspective.
a) Source of Finance Implication
This refers to diverse financing options available to the business. When a business is established, the entrepreneur will always have different alternatives of financing the business to make it operational. This call for further interrogation of the different ways of financing the business. Based on the criteria used, sources of finance are classified as follows;
Duration of Financing Business Operations
Based on this criteria, sources of finance can either be long or short term
Long Term Sources of Finance: This refers to the sources of finance where by the time duration such finances facilitate business operations is more than one year. Also referred to as long-term debt or liability. According to IFRS, it is known as non-current liabilities. This is evident by the terms of borrowing that are used. If the lender gives one year repayment period, then it means that the debt will act as a source of financing to the business for that one year. The same thing applies if the amount borrowed is to be repaid within a period of five years, it means that the debt will finance the business activities for five years after which it will have been repaid in full and it no longer acts as a source of finance. Examples of long term sources of finance are such as a 5 year bank loan, 2 year debentures, 10 year bond and mortgages all repayable with interest.
Short Term Sources of Finance: This refers to the sources of finance where by the time duration such finances facilitate business operations is less than one year. Also referred to as short-term debt or liability. According to IFRS, it is known as current liabilities. This is evident by the terms of borrowing that are used. If the lender gives six months credit period or repayment period, then it means that the debt will act as a source of financing to the business for six months only. The same thing applies if the amount borrowed is to be repaid within a period of ten months, it means that the debt will finance the business activities for ten months after which it will have been repaid in full and it no longer acts as a source of finance. Examples of short term debts are, trade creditors, bank overdraft, accrued expenses, income in advance etc.
Therefore, the entrepreneur/learner need to consider the most convenient source of financing he or she will give priority to avoid liquidity and operational risks. That is, the entrepreneur should match his income generation from his assets to cover the repayment costs associated with the debt used. For example, if one is using a long term source of finance, he/she should ensure that in the long run, the assets he is utilizing to generate cash inflows is capable of doing so. Similarly, if the repayment period is short, the assets utilized in doing business should generate cash inflows within a short period and faster to avoid a state of illiquidity. This approach will save the entrepreneur from unnecessary closure of business (operational risks) and avoid defaulting debt repayment due to lack of cash availability (liquidity risk).
Business Ownership Criteria
Business ownership refers to a case whereby a person, whether natural or artificial like a company is in control of a particular business by the fact that he or she initiated its incorporation by contributing wholly or majority of its capital. Hence the person is in control of the business in all aspects of decision making. For a business to get started with its operations, somebody has to provide the finances. Either the owner or a third party. Hence, based on business ownership criteria, sources of finance can either be from internal sources where by it is the owner who contributes his/her resources to finance the business operations or external sources where by a lender such as a friend or a financial institution like a bank agrees to finance the business.
Internal Sources of Finance:
In this case, it is the owner of the business also known as the business promoter who finance the business. This nature of financing is also referred to as capital, owner’s contribution, owner’s equity or owner’s claim. This source of finance has several terms commonly used in accountancy and this are; capital, additional capital (ie investment), net profit of the year, retained earnings, general reserve, capital redemption reserve fund, net worth, net assets, owner’s wealth and share premium.
Further Explanation;
-Capital is the owner’s contribution. It is any cash and non-cash contribution made by the owner(s) towards the start of the business operations.
Additional Capital is also referred to as investment as it was described in level one accounting tutorial series. It is owner’s contribution to an already existing business. It is any cash and non-cash contribution made by the owner(s) towards an already existing business to revitalize its operations.
Net Profit of the Year is the operational income or gain generated by the business as determined at the end of the financial period or any other preferred period.
Retained Earnings is the amount of net profit of the year that is ploughed back to the business to be a source of finance. It is sometimes known as undistributed profits.
General Reserve is that part of net profit of the year that is set apart to finance general activities of the business in the future.
Capital Redemption Reserve Fund (CRRF) is that part of net profit of the year that is set apart to redeem/buy back a certain type of shares/stock. For example, for private and public limited companies which have various sources of finances, they can raise funds using redeemable preference shares. This type of stocks have a provision that give the issuing business an option to purchase them back at some point of time. Therefore, the CRRF is used for this purpose.
Net Worth is the actual capital that belong to the owner of the business. It is also referred to as the net asset or owners claim. The entrepreneur should note that net worth of a business refers to actual monetary wealth that belongs to the owner of the business. To clarify this aspect, the entrepreneur need to ask him/herself this question; if the business closes down, what will be the take home of the owner of the business? This means that a further scrutiny is necessary to determine what actually belong to the owner of the business for apart from his/her contribution, there is what the external parties have contributed and incase of business closure, they are paid first (ie given first priority) from the cash realized from sale/disposal of the available assets of the business. What remains after paying all external debts (whether long term or short term) is what the owner of the business takes home and this is also referred to as owner’s claim or net worth (represented by net asset value as indicated in the net asset balance sheet format-please re-visit).
Owner’s Wealth is the overall income/gain or returns of the owner of the business, whether of capital or revenue nature. It is also referred to as capital base. When somebody establishes a business, the main objective is to undertake business activities which are profit making in nature. The expectation of the owner of the business is to realize growth of the original capital that was initiated in to the business. This expected growth in capital base is brought about by profits generated during ordinary and extra-ordinary business activities. Therefore, all sorts of income/gain generated by the business affiliated to the capital that was originally contributed by the owner forms owner’s wealth.
Share premium is the excess income/gain generated from issuance of shares. This arises when a firm issue shares at a price above the nominal price, as we shall discuss in level four of this accounting tutorial series.
Asset Revaluation Reserve is gain from revaluation of assets such as land and buildings and good will. This happens commonly with partnership when a new partner is being admitted or an existing one is leaving the partnership. For limited companies, whether, private or limited ones, re-valuation of non-current assets/real estate results to increase in owners’ claim for the additional amount represent additional reserve.
External Sources of Finance:
This is funding of a business from a third party who is not the owner of the business. Therefore, the lender provides the funds with terms of repayment but this act does not qualify him or her to control the organization. The lender of this type of debt is a third party and has no ownership rights. External sources of finance may either be of long term or short term as discussed earlier. Examples of external sources of finance are the ‘more than one year’ bank loans, debentures, mortgage and bonds etc.
NB: Level of stringent terms and conditions
First, as a matter of fact, the accounting practice demands that external debt lenders be paid first before the internal debt lenders (owners of the business) whether during the time the business is in operation or when terminated.
Second, management strictly adheres to the loan covenants, terms and conditions provided in the indenture concerning default and rarely breaches them. Unlikely, this is not the case with equity financing which is also an internal debt form the owners of the business to the business itself. This is why there is a common mentality that the capital contributed by the business owner and the business itself are one and the same thing. Even the scenario is not taken as business borrowing from the owner. In other words, there is no clear demarcation between the business and the owner(s). Such that an entrepreneur will a bind to all service terms of the external debt lenders but will put less weight to his/her capital contribution to the business. This causes collapsing of most small and medium organizations.
b) Investment Perspective
According to (a) aforementioned, the sources of finance identified by the owner of business is meant for funding the acquisition of assets which are income generating in nature. Be it non-current or current assets. The asset side of the statement of financial position represents the investment perspective of the business. The owner of the business should be concerned of the kind of investment to engage in for the assets being acquired should guarantee sufficient/ sustaining income generation to cover the cost of loan, be it the principal amount and interest expense to be paid. This therefore calls for the entrepreneur considering using the finances available to acquire assets that are optimally profitable in the sense that they should generate interest/profit or returns that can cover cost of both internal and external debt amongst other relevant costs.
After discussion on (a) and (b) perspectives of sources of finance and investment respectively, it is clear that the entrepreneur need to make investment decisions when starting or expanding his/her business. This is because there are underlying returns-cost aspects that determine the survival of the business and unless a critical investigation is undertaken by the management or the owner of the business, it may not end well with the business. Therefore, the owner of the business need to assess the returns/gains generated by the assets acquired and match that with the cost associated to the sources of finance used. One way of matching the right investment decision is to select the cheapest source of finance and the most profitable investment capital outlay.
Debt to Equity Ratio Implication
The liability side of the statement of financial position represents two main sources of finance. One, the external and two, the internal source of funds. The external sources of fund are referred to as external debt whereas the internal sources are termed as equity. Therefore, the relationship between the external debt and equity is theoretically termed as debt to equity ratio. If a firm has a big debt/equity ratio such that external debt value is bigger than equity value, the firm is said to be highly geared. On the other hand, if equity value is more than debt then the firm is said to be lowly geared. Theoretically, this is true for in most cases, the owner of the business or the management endeavor to retain low gearing state. However, the entrepreneur should know that either way the ratio should be balanced. This is because, on one side, the entrepreneur fills insecure when external debt is more than equity which represents contribution from the owner(s) of the business which may result to liquidation. On another side, when equity is more than external debt, equally the entrepreneur need to worry for the owner’s contribution is subjected to default risk and in case the firm is closed down, then it implies than he cannot recover his or her contribution to the business. That is, the debt extended to the firm is irrecoverable. Since either way the entrepreneur will have to suffer, there is need to factor in a favorable ratio of 1:1 holding other factors constant.
Cost/Liability Implication
The capital and liability side of statement of financial position is composed of net profit of the year and other reserves. One thing the learner/entrepreneur need to comprehend is that net profit of the company is a liability or cost to the firm and not a gain to the firm per se’. To clarify this idea, remember that when an entrepreneur starts a business, the intension is to enjoy profits and suffer losses if that be the case.
One, the implication of a liability comes in when the firm generates income in terms of net profit or otherwise. This profits belong to the owners of the business and as long as it is not distributed to them at the end of the financial period, the net profit generated is added to capital to form the total amount due to the owners in future or incase the firm closes down. This means that the business in its capacity as an artificial person separate from the owner(s) has an obligation to pay the business owners the net profit for the year together with the original capital in case it closes down.
Two, the implication of cost to the business as a separate entity arises when the management distributes the net profit generated to the owners in form of dividend. This involves actual cash outflow from the business which is a cost or an expense for that matter. Therefore, the entrepreneur should not assume that the net profit generated by the firm belongs to the business. This knowledge should therefore guide the owner of the business in making decision on how profits generated should be managed.
Balance Sheet Equation Implication
The balance sheet equation is of the expression (A=L). Conventionally, the equation is made up of assets, capital and liabilities. In this level three study, the model is modified to imply that all assets are financed by debt. The idea behind this argument is that whether the liability is internally borrowed by the organization (capital) or externally borrowed from third parties, the fact remains that all sources of funding should be given the same weight in accounting treatment. The A=L model further implies that the entrepreneur need to consider accounting for only liabilities used to finance the assets of the business. Hence, for assets not financed by the business debts, should be excluded in bookkeeping. The formula (A=L) may assume other format based on the sources of financing as follows;
i) If the entrepreneur used his or her own contribution, the equation to represent that information will be;
A=C where: A=Assets
C=Capital which is a debt internally borrowed by the business from the business owner
ii) If the entrepreneur used external debt only, the equation to represent that information will be;
A=L where: A=Assets
L=Debt which is a debt externally borrowed by the business from the business owner
iii) If the entrepreneur used both his or her own contribution and external debt, the equation to represent that information will be;
A=C+L where: A=Assets
C=Capital which is a debt internally borrowed by the business from the business owner
L=Debt which is a debt externally borrowed by the business from the business owner
NB: The entrepreneur need to note that it is only the specific source of finance that is indicated in the balance sheet equation.
Summary
The chapter is the first one in level three of this accounting tutorial series and it highlights the aspect of the accounting cycle with in depth demonstration of the implications of statement of financial position to entrepreneur’s business. The chapter first focuses on how the statement of financial position which is the first component of accounting cycle is presented. The chapter portrays four approaches based on the criteria used. The structural format is divided in to vertical and horizontal design. The second format is based on net and gross asset approach. It should be noted that all the methods are basically the same for the same information is included in each statement and again the totals of assets and liabilities are usually the same.
The implication the balance sheet has to the entrepreneur/learner is manifold. It focuses on investment and source of finance which is a topic in finance as a discipline and require the entrepreneur to consider his choices on both sources of finance and investment options to go for to avoid cases of closure of business due to using either costly sources of finance or inappropriate assets which cannot cover the costs thereof. The aspect of debt to equity was of concern in this chapter where by the two aspects of source of finance should be given equal treatment for both can result to business failure or financial distress hence discontinuation of the firm.
The implication of net profit was made clearer to the business entrepreneurs for historically, it is treated as a gain or income of the business. This is common whereby the readers of accounting materials and practicing business men/women think that there is no demarcation between the owner and the business. In this tutorial series, it has been clarified that the net profit or other income generated by the firm is on behalf of the owner hence if not paid at the end of the financial period, it is a liability to the firm and the moment it is paid it becomes a cost/appropriation.
The chapter also has made clarification on the balance sheet equation implications to the entrepreneur’s business. That is, it is only the sources of finance actually utilized in financing the business that form the balance sheet equation. Therefore, the equation can be used to represent the gross capital used to finance the business or to represent net asset or net worth of the business. The chapter has therefore enriched the aspect of equity by introducing all other terms that represent owners’ equity.
