Preparing a statement of financial position is just one of the many financial reports that will need to be regularly generated when running a limited company. It’s often best to secure professional advice and support to prepare these types of reports, although it can still be useful to understand the principles and purpose behind this key accounting process.
Below we look at why and what’s involved.
What is a statement of financial position (SOFP)?
A ‘statement of financial position’ (SOFP) — also known as a balance sheet — is one of three financial statements that need to be prepared on behalf of a company, along with the ‘income statement’ and ‘cash flow statement’. The SOFP essentially sets out the company’s assets and liabilities, and the difference between the two, at any single point in time. In this way, the statement will provide a picture of a company’s equity or net worth at that particular point.
Based on the following accounting equation (assets = liabilities + equity), the company’s total assets equal the total of its liabilities and equity. Assets include anything the company owns, whereas liabilities refer to what the company owes. The equity is the remaining proportion of the shareholder’s financial interest, after deducting any liabilities from the total assets.
By showing the assets and resources that a company has, as well as any debts that it needs to settle, this will then show the overall value of the business at the date of the statement. SOFPs are therefore different to other financial reports in that they’re not prepared for a given period, but are instead prepared at a certain date, for example, a balance sheet or SOFP generated on 31 December 2021 would show what the business is worth as of that date only.
Every financial transaction that a company is involved in affects the SOFP accounting equation, such that the value of the assets, liabilities and equity are constantly changing. Statements of financial position are therefore typically prepared at the close of each accounting period, such as monthly, quarterly and annually. However, these can be produced as regularly as a business would like, depending on the reason that insight into the company’s net worth is needed.
What is the purpose of a statement of financial position?
In broad terms, a statement of financial position will provide a snapshot of a company’s financial health at a specific point in time, allowing company directors and other interested parties, including shareholders, to assess how well the company is performing.
Most limited companies are limited by shares, where each shareholder owns a part of the company and, although they don’t take part in the day-to-day running of the company, unless a shareholder is also acting as a director, they’re still entitled to know the company’s financial results via an annual report, including a statement of financial position.
Every limited company is also required by law to produce annual statutory accounts as part of their year-end procedures, again including a SOFP showing everything that the company owns, owes and is owed on the last day of the financial year. These accounts must be submitted to both Companies House and HMRC, and copies provided to shareholders.
However, the information on a SOFP, can also be used for various other purposes, including:
- to show to suppliers to determine the level of risk involved in supplying to a business
- to show to creditors to determine the level of risk involved in lending to a business
- to show to potential investors to determine their likely return on investment
- to show the value of all current and long-term assets and liabilities to potential buyers
- to inform day-to-day and future decision-making in relation to the company, for example, to analyse ratios to ensure that there’s no liquidity problem and that the business can support its immediate obligations, or to see if working capital is being used efficiently.
A statement of financial position is a very good indicator of how stable a business is. By regularly generating these types of financial report, this will help those responsible for running limited companies to keep track of spending and earnings, avoid cash flow problems and make informed financial decisions on essential cutbacks or potential growth.
What does a statement of financial position include?
There are various components to a statement of financial position, where the way in which a SOFP is presented can vary. However, there are some key elements at the core of each statement that all the other components are built around. As the purpose of the SOFP is to provide an overview of what a company owns and what it owes at any given point in time, the statement will typically show its assets on the left and its liabilities and equity on the right.
However, there are many types of assets, liabilities and equity, so it’s necessary to distinguish between them. Assets can be broken down broadly into two main categories: current assets and non-current assets. Current assets are short-term assets that can be converted into cash within a period of one year, whereas non-current assets are long-term assets that are used to help in the running of the business to generate profit. These cannot be easily converted into cash, where the company would expect to hold onto these for more than a year.
Some of the most common types of current assets are:
- Cash: this refers to notes, coins, bank balances and cheques held by the company.
- Accounts receivable: this refers to money owed to the company by customers or clients.
- Supplies: this refers to supplies to be used by the company in the course of its business.
- Inventory: this refers to assets that are intended to be sold, including raw materials, works in progress, finished goods and parts for resale.
- Pre-paid expenses: this refers to costs paid but goods or services not yet received.
Some of the most common types of non-current assets are long-term investments, including the company’s goodwill. These also include any property, plant and equipment, such as land, buildings, motor vehicles, computer equipment and machinery that the company owns.
Conversely, current liabilities are the obligations on a company that need to be settled within one year, including accounts payable, salaries payable, taxes payable and accrued expenses, whilst non-current liabilities are obligations that are not expected to be settled by the company within one year, like long-term loans.
The final piece of the puzzle is the equity, where there are two broad categories to consider: owner’s equity and retained earnings. Retained earnings are essentially the profit earned by the company to date and held for future use, which is key because it’s the profit in the retained earnings that forms the link between the balance sheet and the company’s income statement — one of the other key financial reports that a limited company will need to generate.
In summary therefore, the asset information on a SOFP is subdivided into current and long-term assets. Similarly, the liability information is subdivided into current and long-term liabilities. One side of the balance sheet will list the assets, moving from the most liquid (eg, cash) to the least liquid (eg, plant and equipment), whilst the other side of the balance sheet will list the liabilities in order of immediacy. Under each of these main headings, will need to be all the individual groups of accounts summarised with their closing balances.
At the bottom of the SOFP there will then be the total assets and total liabilities of the company, plus equity, where both of these numbers must be exactly the same. This is because the SOFP, or balance sheet, as suggested by its name, always has to balance.
How to prepare a statement of financial position
The key principle in building an accurate balance sheet is double-entry accounting. Single-entry bookkeeping has one entry per transaction, whilst double-entry bookkeeping has two entries per transaction: a debit and a credit. The debit is recorded in one account and the credit is recorded in another, such that every entry has an opposite corresponding entry in a different account. This basically means that anything the business owns is equal to anything the business owes. When a business owes money to third parties like suppliers, lenders or employees these are referred to as liabilities, but when a business owes something to its owners, it’s referred to as equity. This is the basic accounting equation and it always balances.
In theory, this sounds relatively straightforward, but given that every transaction that a company is involved in affects the SOFP accounting equation, and that double entry bookkeeping affects at least two accounting entries at the same time, the calculations can often become complex. For example, if a company takes out a loan of “x” amount, this will affect both the ‘cash’ entry on the left of the balance sheet under assets, as this cash is now available to spend, and the ‘long-term loan’ entry on the right under liabilities, because this loan has to be repaid. If some of this money is then used to buy equipment, the cash balance under assets will decrease but the ‘property, plant and equipment’ balance will increase.
Equally, if a company buys supplies but pays for these on account, so agreeing to pay the supplier at a later date, the entries for both ‘supplies’ on the left of the balance sheet and ‘accounts payable’ on the right of the balance sheet will need to be adjusted accordingly.
Some SOFP transactions can involve several elements, each with their own double entries. They can also involve a degree of correlation with the company’s income statement. This is a summary of the revenue earned and expenses incurred over a period of time. For example, where a company earns revenue of “x” amount, but uses up some of its supplies in so doing, this will involve both recognising the money earned, as well as the supplies used as these can no longer be treated as an asset, in both the SOFP and income statement.
A bridge then needs to be built between the profit in the income statement and the retained earnings or profit for future use in the equity section of the SOFP. It’s only in this way, that the statement of financial position can be made to balance.
Should accountants prepare a statement of financial position?
Many online accounting software packages include the ability to generate real-time financial reports, including a statement of financial position, although even with the help of modern technology, double-entry accounting can still be tricky. Ensuring that a SOFP is accurate, means having a good understanding of the necessary accounting principles to input the financial data into all the correct entry points ‘and’ to be able to correlate this correctly with your company’s income statement. This is why it’s often best to get expert help and advice when generating financial reports for your company, including a SOFP.
There is no better substitution than having balance sheets explained to you by an expert, especially in the context of your own business and its unique workings. Further, by securing professional advice and assistance in the preparation of your SOFP, and all other necessary financial reports, this will help to ensure that your company records provide an accurate, up-to-date and complete reflection of your company’s overall financial health.
The matters contained in this article are intended to be for general information purposes only. This article does not constitute legal or financial advice, nor is it a complete or authoritative statement of the law or tax rules and should not be treated as such.
Whilst every effort is made to ensure that the information is correct, no warranty, express or implied, is given as to its accuracy and no liability is accepted for any error or omission.
Before acting on any of the information contained herein, expert professional advice should be sought.