So far in this blog series, we have learned about the framework of financial statements, their components and users, fundamental accounting assumptions, and the qualitative characteristics that make financial information useful.
Now it is time to understand the actual building blocks of financial statements. These building blocks are known as the Elements of Financial Statements.
Every figure you see in a balance sheet or a profit and loss account belongs to one of these elements. If you understand these elements properly, financial statements become much easier to read and interpret.
The framework groups all financial information into five main elements:
- Assets
- Liabilities
- Equity
- Income
- Expenses
Let us explore each of these in a clear and practical way.
What are Elements of Financial Statements?
Elements of financial statements are the basic categories used to classify all financial data. They help us answer important questions such as:
- What does the business own?
- What does it owe?
- How much belongs to the owners?
- How much was earned?
- How much was spent?
These elements are used in both the Balance Sheet and the Statement of Profit and Loss.
1. Assets
Meaning
An asset is something that a business controls and from which it expects to receive future economic benefits.
In simple words:
“An asset is anything that will help the business earn money in the future.”
Examples of assets:
- Cash
- Machinery
- Buildings
- Inventory
- Debtors
- Patents and trademarks
Assets may be physical (like machines) or non-physical (like copyrights or software).
Key Features of an Asset
For something to be treated as an asset, three conditions must be satisfied:
- It is controlled by the business - Ownership is not always necessary. If the business controls the use and benefits of a resource, it can be an asset.
- It must give future economic benefits - If it does not help in earning income in the future, it is not an asset.
- Its value must be measurable - We must be able to measure its cost or value reliably.
Asset vs Expense
If a business buys a machine, it is an asset because it will be used for many years. But if it buys stationery, it is an expense because it will be used immediately.
This difference is very important in accounting.
2. Liabilities
Meaning
A liability is a present obligation of a business that arises from past events and will result in an outflow of resources in the future.
In simple words:
“A liability is something the business has to pay.”
Examples of liabilities:
- Loans
- Creditors
- Outstanding expenses
- Taxes payable
Key Features of a Liability
To be called a liability:
- It must be a present obligation
- It must be the result of a past transaction
- It must lead to payment or sacrifice of resources in the future
Provisions and Contingent Liabilities
Sometimes the amount of liability is not exactly known. In such cases:
- Provision is made if payment is likely
- Contingent liability is disclosed if payment is uncertain
For example, if a company is likely to lose a court case, it should create a provision.
3. Equity
Meaning
Equity is the owner’s share in the business.
It is calculated as:
“Assets – Liabilities = Equity”
Equity represents what remains for the owners after all debts are paid.
What Equity Includes
Equity includes:
- Capital invested by owners
- Profits earned and retained
- Reserves
It changes when:
- Owners invest or withdraw money
- Business earns profit or suffers loss
4. Income
Meaning
Income is the increase in economic benefits during a period that increases equity, except when it comes from owners.
Income includes:
- Sales
- Interest earned
- Rent received
- Profit on sale of assets
Income increases either:
- Assets (cash received)
- Or reduces liabilities
Revenue vs Gains
- Revenue comes from regular business activities
- Gains come from non-regular activities like selling old machinery
Both are forms of income.
5. Expenses
Meaning
An expense is a decrease in economic benefits during a period that reduces equity.
Examples:
- Wages
- Rent
- Electricity
- Depreciation
Expenses arise when:
- Assets are used up
- Or liabilities are created
Expense vs Loss
- Expenses arise from normal business activities
- Losses arise from unusual events like fire, theft, or selling assets at low price
Both reduce profit.
Relationship Between Elements
All elements are linked:
Profit = Income – Expenses
Equity = Assets – Liabilities
So any change in assets or liabilities affects equity and profit.
Why These Elements Matter
Understanding these elements helps:
- Investors judge company value
- Banks decide whether to lend
- Management control costs
- Government assess taxes
They are the language of financial statements.
Conclusion
The Elements of Financial Statements form the core of accounting. Every figure you see in financial statements belongs to one of these five elements.
Once you understand assets, liabilities, equity, income, and expenses, you can easily understand how a business is performing and how strong it is financially.
In the next blog, we will explore Measurement of Financial Statement Elements and how these items are valued.
Frequently Asked Questions (FAQs)
1. What are the elements of financial statements?
They are assets, liabilities, equity, income, and expenses, which form the foundation of financial reporting.
2. What is an asset in accounting?
An asset is a resource controlled by a business that is expected to provide future economic benefits.
3. What does liability mean?
A liability is a present obligation of a business that will result in payment or sacrifice of resources in the future.
4. How is equity calculated?
Equity is calculated as Assets minus Liabilities and represents the owner’s interest in the business.
5. What is the difference between income and expenses?
Income increases the financial position of a business, while expenses reduce it.
6. Are gains and losses part of income and expenses?
Yes. Gains are a type of income and losses are a type of expense.
7. Why are these elements important?
They help users understand the financial position and performance of a business.
