ACC 00145 Financial reporting
Example 2.1 Recognition of an asset
Entity X enters into a legal arrangement to act as trustee for entity Y by holding listed shares on entity Y’s behalf. Entity Y makes all investment decisions and entity X will act according to entity Y’s instructions. Entity X will earn a trustee fee for holding the shares. Any dividends or profit/(loss) from the investments belong to entity Y. Elements of financial statementsThe elements of financial statements53 Entity X should not recognise the listed shares as its asset even though it is in posses- sion of the shares. Entity X does not control the investment’s future economic benefits. Benefits from the investments flow to entity Y and entity X earns a trustee fee for holding the shares regardless of how the shares perform. The listed shares, therefore, do not meet the criteria of an asset in entity X’s balance sheet. In assessing whether an item meets the definition of an asset (or a liability or equity), attention needs to be given to its underlying substance and economic reality and not merely its legal form. Thus, for example, in the case of finance leases, the substance and economic reality are that the lessee acquires the economic benefits of the use of the leased asset for the major part of its useful life in return for entering into an obligation to pay for that right an amount approximating to the fair value of the asset and the related finance charge. Hence, the finance lease gives rise to items that satisfy the definition of an asset and a liability and are recognised as such in the lessee’s balance sheet (Framework para 51). Thus, the Framework stresses economic substance over legal form and reminds us that not all assets and liabilities will meet the criteria for recognition. Many assets, for example, property, plant and equipment, have a physical form. However, physical form is not essential to the existence of an asset; hence patents and copyrights, for example, are assets if future economic benefits are expected to flow from them to the entity and if they are controlled by the entity (Framework para 56). Many assets, for example, receivables and property, are associated with legal rights, including the right of ownership. In determining the existence of an asset, the right of ownership is not essential; thus, for example, property held on a lease is an asset if the entity controls the benefits which are expected to flow from the property. Although the capacity of an entity to control benefits is usually the result of legal rights, an item may nonetheless satisfy the definition of an asset even when there is no legal control. For example, know-how obtained from a development activity may meet the definition of an asset when, by keeping that know-how secret, an entity controls the benefits that are expected to flow from it (Framework para 57). The assets of an entity result from past transactions or other past events. Entities normally obtain assets by purchasing or producing them, but other transactions or events may generate assets; examples include property received by an entity from the government as part of a programme to encourage economic growth in an area and the discovery of mineral deposits. Transactions or events expected to occur in the future do not in themselves give rise to assets; hence, for example, an intention to purchase inventory does not, of itself, meet the definition of an asset (Framework para 58). There is a close association between incurring expenditure and generating assets but the two do not necessarily coincide. Hence, when an entity incurs expenditure, this may provide evidence that future economic benefits were sought but is not con- clusive proof that an item satisfying the definition of an asset has been obtained. Similarly the absence of a related expenditure does not preclude an item from satis- fying the definition of an asset and thus becoming a candidate for recognition in the balance sheet; for example, items that have been donated to the entity may sat- isfy the definition of an asset (Framework para 59). 54
2: Conceptual framework for financial reporting
Liabilities. A liability is a present obligation of an entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits (Framework para 49(b)). Obligations may be legally enforceable as a consequence of a binding contract or statutory requirement. This is normally the case, for example, with amounts payable for goods and services received. However, obligations do not have to be legally bind- ing. If, for example, an entity decides as a matter of policy to rectify faults in its products even when these become apparent after the warranty period has expired, the costs that are expected to be incurred in respect of goods already sold are liabil- ities. Obligations do not include future commitments (Framework paras 60 to 63). Some liabilities can be measured only by using a substantial degree of estimation. Some entities describe these liabilities as provisions. In some countries, such provi- sions are not regarded as liabilities because the concept of a liability is defined narrowly so as to include only amounts that can be established without making estimates. The definition of a liability in paragraph 49 follows a broader approach. Thus, when a provision involves a present obligation and satisfies the rest of the definition, it is a liability even if the amount has been estimated. Examples include provisions for payments to be made under existing warranties and provisions to cover pension obligations (Framework para 64). Equity. Equity represents the residual amount after all the liabilities have been deducted from the assets of an entity. Although equity is defined as a residual, it may be sub-classified in the balance sheet into various types of capital and reserves, such as shareholders’ capital, retained earnings, statutory reserves, tax reserves, etc. Such classifications can be relevant to the decision-making needs of the users of financial statements when they indicate legal or other restrictions on the ability of the entity to distribute or otherwise apply its equity. They may also reflect the fact that parties with ownership interests in an entity have differing rights in relation to the receipt of dividends or the repayment of contributed capital (Framework paras 65 and 66). Performance. The income and expense elements of performance are also mea- sured in terms of assets and liabilities. Income is measured by increases in assets or decreases in liabilities, other than those relating to contributions from equity par- ticipants. Expenses, on the other hand, are measured by increases in liabilities or decreases in assets (Framework para 70). Income and expenses may be presented in the income statement in different ways so as to provide information that is relevant for economic decision making. For example, it is a common practice to distinguish between those items of income and expenses that arise in the course of the ordinary activities of the entity and those that do not (Framework para 72). Distinguishing between items of income and expense and combining them in different ways also permit several measures of entity performance to be displayed. These have differing degrees of inclusiveness. For example, the income statement could display gross margin, profit from ordinary activities before taxation, profit from ordinary activities after taxation, and net profit (Framework para 73). We illus- trate in depth the income statement layouts in Chapter 3. Recognition. IASB Framework para 83 calls for recognition of elements when: The elements of financial statements55 (a) it is probable that any future economic benefit associated with the item will flow to or from the entity; and (b) the item has a cost or value that can be measured reliably. It is possible for an item to meet the definition of an asset, but not the recognition criteria as illustrated below. Example 2.2 Asset recognition
Entity W is in the beverage business and its brand name is known throughout the world. Its main products command premium prices and the product names repre- sent considerable future economic benefits. The brand has a market value and may be sold. Management should not recognise its brand name as an asset, although it meets the definition of one. Management is prohibited from recognising internally generated brands, mastheads, publishing titles, customer lists and items similar in substance (IAS 38 para 63). The recognition criteria for intangible assets are more narrowly defined by IAS 38, limiting recognition of assets for which cost can be measured reliably (IAS 38 para 21(b)). The standard takes the view that the cost of brand generated internally cannot be distinguished from the cost of developing the busi- ness as a whole. Such items should not be recognised as intangible assets since the cost cannot be reliably measured. When similar assets are acquired from a third party, the consideration given to acquire those assets is clearly distinguishable from the general costs of developing the business as a whole and, therefore, should be recognised, provided that they also meet the criteria of control and the probable flow of future economic benefits. Uncertainty surrounds the meaning of probable. The concept of probability used in the recognition criteria refers to the degree of uncertainty that the future economic benefits associated with the item will flow to or from the entity. The concept is in keeping with the uncertainty that characterises the environment in which an entity operates. Assessments of the degree of uncertainty attaching to the flow of future economic benefits are made on the basis of the evidence available when the fin- ancial statements are prepared. For example, when it is probable that a receivable owed by a customer will be paid, it is then legitimate, in the absence of any evidence to the contrary, to recognise the receivable as an asset (Framework para 85). Some see ‘probable’ as representing 51 per cent likelihood, while others consider that a higher threshold is required for asset or income recognition. This is an area where there is little explicit guidance, so professional judgement should be exercised. The second criterion for recognition is reliability. The Framework notes that the use of reasonable estimates is an essential part of the preparation of financial state- ments and that estimates in themselves do not undermine the reliability of finan- cial information. Where an item has the characteristics of an element, but does not 56
2: Conceptual framework for financial reporting
meet the recognition criteria, then it may be that disclosure in the notes is required (Framework paras 86 to 88). The Framework takes an asset and liability approach rather than focusing on matching of income and expenses. This is borne out by the recognition criterion for income and expenses: Income is recognised in the income statement when an increase in future economic benefits related to an increase in an asset or a decrease in a liability has arisen that can be measured reliably. This means, in effect, that recognition of income occurs simultaneously with the recognition of increases in assets or decreases in liabilities (for example, the net increase in assets arising on a sale of goods or services or the decrease in liabilities arising from the waiver of a debt payable) (Framework para 92)6. The example below illustrates this concept. Example 2.3 Accrued revenue
Entity T, a telecom company, invoices its customers for call charges on a monthly basis. At the beginning of March the total value of invoices that entity T sent out to its customers was EUR 1m. The invoices relate to calls customers made during the month of February. The invoices are payable by customers by the end of April. Entity T should recognise revenue of EUR 1m in the income statement of February. A corresponding increase in assets (Sales invoice to be issued, under Other receiv- ables, or Trade receivables should be recognised in the balance sheet. The effects of transactions and other events are recognised as they occur. They are reported in the financial statements of the periods to which they relate (Framework para 22). Revenue is not deferred to match the timing of the receipt of cash or the raising of the invoices. The recognition criterion for expenses is the mirror of the recognition criterion for income. Expenses are recognised in the income statement when a decrease in future economic benefits related to a decrease in an asset or an increase in a liabil- ity has arisen that can be measured reliably. This means, in effect, that recognition of expenses occurs simultaneously with the recognition of an increase in liabilities or a decrease in assets (for example, the accrual of employee entitlements or the depreciation of equipment) (Framework para 94). Expenses are recognised in the income statement on the basis of a direct associ- ation between the costs incurred and the earning of specific items of income. This process, commonly referred to as the matching of costs with revenues, involves the simultaneous or combined recognition of revenues and expenses that result directly and jointly from the same transactions or other events; for example, the various components of expense making up the cost of goods sold are recognised at the same time as the income derived from the sale of the goods. However, the application of the matching concept under this framework does not allow the recognition of Measurement of the elements of financial statements
2.4
Measurement of the elements of financial statements57
items in the balance sheet which do not meet the definition of assets or liabilities (Framework para 95). When economic benefits are expected to arise over several accounting periods and the association with income can only be broadly or indirectly determined, expenses are recognised in the income statement on the basis of systematic and rational allocation procedures. This is often necessary in recognising the expenses associated with the using up of assets such as property, plant, equipment, patents and trade marks; in such cases the expense is referred to as depreciation or amort- isation. These allocation procedures are intended to recognise expenses in the accounting periods in which the economic benefits associated with these items are consumed or expire (Framework para 96). An expense is recognised immediately in the income statement when an expendi- ture produces no future economic benefits or when, and to the extent that, future economic benefits do not qualify, or cease to qualify, for recognition in the balance sheet as an asset. An expense is also recognised in the income statement in those cases when a liability is incurred without the recognition of an asset, as when a liability under a product warranty arises (Framework paras 97 and 98).
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