Conceptual Framework: Chapter 4

Chapter 4: The elements of financial statements

It is the central tenet of the Framework that users of financial information require information concerning the economic resources of and claims against an entity; and changes in those resources and claims.
These are described in the Framework as being linked to the ‘elements’ of financial statements which are:
Assets, liabilities, equity, income and expense.

Economic resources are rights which have the potential to produce economic benefits. Assets are present economic resources controlled by an entity as a result of past events;
Claims against an entity comprise:
– Liabilities, which are present obligations to transfer economic resources as a result of past events;
– Equity is the residual interest in the assets in an entity after deducting all its liabilities
Changes in economic resources and claims comprise:
– Income and expenses; and
– Other changes:

Income is increases in assets, or decreases in liabilities, that result in increases in equity, other than those relating to contributions from holders of equity claims.
Expenses are decreases in assets, or increases in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity claims.
Other changes are:
– exchanges of assets or liabilities that do not result in increases or decreases in equity; and
– contributions from and distributions to holders of equity claims.

It is apparent that the approach to the elements of financial statements reflects what is sometimes described as a ‘balance sheet approach’ to recording financial performance, whereby financial performance for a period is essentially derived as part of the overall movement in the entity’s financial position during that period. What this means is that all non-owner changes in equity comprise ‘performance’ in its broadest sense. A difficulty for the Board in developing the Framework is that there is in financial reporting a well-established idea of profit (and hence, a profit and loss account) which contains only a subset of all such performance.

Matters concerning both assets and liabilities

The Framework discusses three concepts which will apply both to assets and liabilities and are relevant for accounting purposes. These are: unit of account, executory contracts and the substance of arrangements.

Unit of account

The unit of account is the right or the group of rights, the obligation or the group of obligations, or the group of rights and obligations, to which recognition criteria and measurement concepts are applied.

A unit of account is selected for an asset or liability when considering how recognition criteria and measurement concepts will apply to that asset or liability and to the related income and expenses. In some circumstances, it may be appropriate to select one unit of account for recognition and a different unit of account for measurement. For example, contracts may sometimes be recognised individually but measured as part of a portfolio of contracts. For presentation and disclosure, assets, liabilities, income and expenses may need to be aggregated or separated into components.
If an entity transfers part of an asset or part of a liability, the unit of account may change at that time, so that the transferred component and the retained component become separate units of account.

A unit of account is selected to provide useful information, which implies that:
– the information provided about the asset or liability and about any related income and expenses must be relevant. Treating a group of rights and obligations as a single unit of account may provide more relevant information than treating each right or obligation as a separate unit of account if, for example, those rights and obligations:
– cannot be or are unlikely to be the subject of separate transactions;
– cannot or are unlikely to expire in different patterns;
– have similar economic characteristics and risks and hence are likely to have similar implications for the prospects for future net cash inflows to the entity or net cash outflows from the entity; or
– are used together in the business activities conducted by an entity to produce cash flows and are measured by reference to estimates of their interdependent future cash flows.
– the information provided about the asset or liability and about any related income and expenses must faithfully represent the substance of the transaction or other event from which they have arisen. Therefore, it may be necessary to treat rights or obligations arising from different sources as a single unit of account, or to separate the rights or obligations arising from a single source. Equally, to provide a faithful representation of unrelated rights and obligations, it may be necessary to recognise and measure them separately.

Also relevant here is the discussion in the Framework of the substance of rights and obligations –
Just as cost constrains other financial reporting decisions, it also constrains the selection of a unit of account. Hence, in selecting a unit of account, it is important to consider whether the benefits of the information provided to users of financial statements by selecting that unit of account are likely to justify the costs of providing and using that information. In general, the costs associated with recognising and measuring assets, liabilities, income and expenses increase as the size of the unit of account decreases. Hence, in general, rights or obligations arising from the same source are separated only if the resulting information is more useful and the benefits outweigh the costs.

Sometimes, both rights and obligations arise from the same source. For example, some contracts establish both rights and obligations for each of the parties. If those rights and obligations are interdependent and cannot be separated, they constitute a single inseparable asset or liability and hence form a single unit of account. For example, this is the case with executory contracts. Conversely, if rights are separable from obligations, it may sometimes be appropriate to group the rights separately from the obligations, resulting in the identification of one or more separate assets and liabilities. In other cases, it may be more appropriate to group separable rights and obligations in a single unit of account treating them as a single asset or a single liability.

Treating a set of rights and obligations as a single unit of account differs from offsetting assets and liabilities.
Possible units of account include:
– an individual right or individual obligation;
– all rights, all obligations, or all rights and all obligations, arising from a single source, for example, a contract;
– a subgroup of those rights or obligations, or both, for example, a subgroup of rights over an item of property, plant and equipment for which the useful life and pattern of consumption differ from those of the other rights over that item;
– a group of rights or obligations, or both, arising from a portfolio of similar items;
– a group of rights or obligations, or both, arising from a portfolio of dissimilar items (for example, a portfolio of assets and liabilities to be disposed of in a single transaction); and
– a risk exposure within a portfolio of items; if a portfolio of items is subject to a common risk, some aspects of the accounting for that portfolio could focus on the aggregate exposure to that risk within the portfolio.

Executory contracts
An executory contract is a contract, or a portion of a contract, that is equally unperformed. That is, either: neither party has fulfilled any of its obligations, or both parties have partially fulfilled their obligations to an equal extent.
An executory contract establishes a combined right and obligation to exchange economic resources. The right and obligation are interdependent and cannot be separated. Hence, the combined right and obligation constitute a single asset or liability. The entity has an asset if the terms of the exchange are currently favourable; it has a liability if the terms of the exchange are currently unfavourable. Whether such an asset or liability is included in the financial statements depends on both the recognition criteria and the measurement basis selected for the asset or liability, including, if applicable, any test for whether the contract is onerous.

To the extent that either party fulfils its obligations under the contract, the contract is no longer executory. If the reporting entity performs first under the contract, that performance is the event that changes the reporting entity’s right and obligation to exchange economic resources into a right to receive an economic resource.
That right is an asset. If the other party performs first, that performance is the event that changes the reporting entity’s right and obligation to exchange economic resources into an obligation to transfer an economic resource. That obligation is a liability.

Substance of contractual rights and contractual obligations

The terms of a contract create rights and obligations for an entity that is a party to that contract. To represent those rights and obligations faithfully, financial statements report their substance. In some cases, the substance of the rights and obligations is clear from the legal form of the contract. In other cases, the terms of the contract or a group or series of contracts require analysis to identify the substance of the rights and obligations.

All terms in a contract, whether explicit or implicit, are considered unless they have no substance. Implicit terms could include, for example, obligations imposed by statute, such as statutory warranty obligations imposed on entities that enter into contracts to sell goods to customers.

Terms that have no substance are disregarded. A term has no substance if it has no discernible effect on the economics of the contract. Terms that have no substance could include, for example:
– terms that bind neither party; or
– rights, including options, that the holder will not have the practical ability to exercise in any circumstances.

A group or series of contracts may achieve or be designed to achieve an overall commercial effect. To report the substance of such contracts, it may be necessary to treat rights and obligations arising from that group or series of contracts as a single unit of account. For example, if the rights or obligations in one contract merely nullify all the rights or obligations in another contract entered into at the same time with the same counterparty, the combined effect is that the two contracts create no rights or obligations. Conversely, if a single contract creates two or more sets of rights or obligations that could have been created through two or more separate contracts, an entity may need to account for each set as if it arose from separate contracts in order to represent faithfully the rights and obligations.

Definition of assets

The definition of an asset is an economic resource subject to three criteria: it is a right of the entity; it has the potential to produce economic benefits; and it is controlled by the entity. Each is discussed in turn in the following sections.

Rights
It is observed that rights that have the potential to produce economic benefits take many forms, including:
rights that correspond to an obligation of another party, for example, rights to:
– receive cash;
– receive goods or services;
– exchange economic resources with another party on favourable terms. Such rights include, for example, a forward contract to buy an economic resource on terms that are currently favourable or an option to buy an economic resource; and
– benefit from an obligation of another party to transfer an economic resource if a specified uncertain future event occurs;

rights that do not correspond to an obligation of another party, for example, rights:
– over physical objects, such as property, plant and equipment or inventories. Examples of such rights are a right to use a physical object or a right to benefit from the residual value of a leased object; and
– to use intellectual property.

Many rights are established by contract, legislation or similar means. For example, an entity might obtain rights from owning or leasing a physical object, from owning a debt instrument or an equity instrument, or from owning a registered patent. However, an entity might also obtain rights in other ways, for example:
– by acquiring or creating know-how that is not in the public domain; or
– through an obligation of another party that arises because that other party has no practical ability to act in a manner inconsistent with its customary practices, published policies or specific statements – that is, a constructive obligation.

Some goods or services, for example, employee services, are received and immediately consumed. An entity’s right to obtain the economic benefits produced by such goods or services exists momentarily until the entity consumes the goods or services. Not all of an entity’s rights are assets of that entity; to be assets the rights must also satisfy the other two criteria noted above (the potential to produce economic benefits; and, control. For example, rights available to all parties without significant cost – for instance, rights of access to public goods, such as public rights of way over land, or know-how that is in the public domain – are typically not assets for the entities that hold them.

An entity cannot have a right to obtain economic benefits from itself. Accordingly:
– debt instruments or equity instruments issued by the entity and repurchased and held by it (for example, treasury shares) are not economic resources of that entity; and
– if a reporting entity comprises more than one legal entity, debt instruments or equity instruments issued by one of those legal entities and held by another of those legal entities are not economic resources of the reporting entity.

In principle, each of an entity’s rights is a separate asset. However, for accounting purposes, related rights are often treated as a single unit of account that is a single asset. For example, legal ownership of a physical object may give rise to several rights, including:
– the right to use the object;
– the right to sell rights over the object;
– the right to pledge rights over the object; and
– other rights.

In many cases, the set of rights arising from legal ownership of a physical object is accounted for as a single asset. Conceptually, the economic resource is the set of rights, not the physical object. Nevertheless, describing the set of rights as the physical object will often provide a faithful representation of those rights in the most concise and understandable way.

In some cases, it is uncertain whether a right exists. For example, an entity and another party might dispute whether the entity has a right to receive an economic resource from that other party. Until that existence uncertainty is resolved, for example, by a court ruling, it is uncertain whether the entity has a right and, consequently, whether an asset exists.

Potential to produce economic benefits

An economic resource is a right that has the potential to produce economic benefits. For that potential to exist, it does not need to be certain, or even likely, that the right will produce economic benefits. It is only necessary that the right already exists and that, in at least one circumstance, it would produce for the entity economic benefits beyond those available to all other parties.

A right can meet the definition of an economic resource, and hence can be an asset, even if the probability that it will produce economic benefits is low. Nevertheless, that low probability might affect decisions about what information to provide about the asset and how to provide that information, including decisions about whether the asset is recognised and how it is measured.

An economic resource could produce economic benefits for an entity by entitling or enabling it to do, for example, one or more of the following:
– receive contractual cash flows or another economic resource;
– exchange economic resources with another party on favourable terms;
– produce cash inflows or avoid cash outflows by, for example:
– using the economic resource either individually or in combination with other economic resources to produce goods or provide services;
– using the economic resource to enhance the value of other economic resources; or
– leasing the economic resource to another party;
– receive cash or other economic resources by selling the economic resource; or
– extinguish liabilities by transferring the economic resource.

Although an economic resource derives its value from its present potential to produce future economic benefits, the economic resource is the present right that contains that potential, not the future economic benefits that the right may produce. For example, a purchased option derives its value from its potential to produce economic benefits through exercise of the option at a future date. However, the economic resource is the present right, that is the right to exercise the option at a future date. The economic resource is not the future economic benefits that the holder will receive if the option is exercised.

There is a close association between incurring expenditure and acquiring assets, but the two do not necessarily coincide. Hence, when an entity incurs expenditure, this may provide evidence that the entity has sought future economic benefits, but does not provide conclusive proof that the entity has obtained an asset.

Similarly, the absence of related expenditure does not preclude an item from meeting the definition of an asset. Assets can include, for example, rights that a government has granted to the entity free of charge or that another party has donated to the entity.

Control

Control links an economic resource to an entity. Assessing whether control exists helps to identify the economic resource for which the entity accounts. For example, an entity may control a proportionate share in a property without controlling the rights arising from ownership of the entire property. In such cases, the entity’s asset is the share in the property, which it controls, not the rights arising from ownership of the entire property, which it does not control.

An entity controls an economic resource if it has the present ability to direct the use of the economic resource and obtain the economic benefits that may flow from it. Control includes the present ability to prevent other parties from directing the use of the economic resource and from obtaining the economic benefits that may flow from it. It follows that, if one party controls an economic resource, no other party controls that resource.

An entity has the present ability to direct the use of an economic resource if it has the right to deploy that economic resource in its activities, or to allow another party to deploy the economic resource in that other party’s activities.

Control of an economic resource usually arises from an ability to enforce legal rights. However, control can also arise if an entity has other means of ensuring that it, and no other party, has the present ability to direct the use of the economic resource and obtain the benefits that may flow from it. For example, an entity could control a right to use know-how that is not in the public domain if the entity has access to the know-how and the present ability to keep the know-how secret, even if that know-how is not protected by a registered patent.

For an entity to control an economic resource, the future economic benefits from that resource must flow to the entity either directly or indirectly rather than to another party. This aspect of control does not imply that the entity can ensure that the resource will produce economic benefits in all circumstances. Instead, it means that if the resource produces economic benefits, the entity is the party that will obtain them either directly or indirectly.

Having exposure to significant variations in the amount of the economic benefits produced by an economic resource may indicate that the entity controls the resource. However, it is only one factor to consider in the overall assessment of whether control exists.

Sometimes one party (a principal) engages another party (an agent) to act on behalf of, and for the benefit of, the principal. For example, a principal may engage an agent to arrange sales of goods controlled by the principal. If an agent has custody of an economic resource controlled by the principal, that economic resource is not an asset of the agent. Furthermore, if the agent has an obligation to transfer to a third party an economic resource controlled by the principal, that obligation is not a liability of the agent, because the economic resource that would be transferred is the principal’s economic resource, not the agent’s.

Definition of liabilities

The Framework defines a liability as a present obligation of the entity to transfer an economic resource as a result of past events.
For a liability to exist, three criteria must all be satisfied:
– the entity has an obligation;
– the obligation is to transfer an economic resource; and
– the obligation is a present obligation that exists as a result of past events.

Obligation

The first criterion for a liability is that the entity has an obligation. An obligation is a duty or responsibility that an entity has no practical ability to avoid. An obligation is always owed to another party (or parties). The other party (or parties) could be a person or another entity, a group of people or other entities, or society at large. It is not necessary to know the identity of the party (or parties) to whom the obligation is owed.

If one party has an obligation to transfer an economic resource, it follows that another party (or parties) has a right to receive that economic resource. However, a requirement for one party to recognise a liability and measure it at a specified amount does not imply that the other party (or parties) must recognise an asset or measure it at the same amount. For example, particular standards may contain different recognition criteria or measurement requirements for the liability of one party and the corresponding asset of the other party (or parties) if those different criteria or requirements are a consequence of decisions intended to select the most relevant information that faithfully represents what it purports to represent.

Many obligations are established by contract, legislation or similar means and are legally enforceable by the party (or parties) to whom they are owed. Obligations can also arise, however, from an entity’s customary practices, published policies or specific statements if the entity has no practical ability to act in a manner inconsistent with those practices, policies or statements. The obligation that arises in such situations is sometimes referred to as a ‘constructive obligation’.

In some situations, an entity’s duty or responsibility to transfer an economic resource is conditional on a particular future action that the entity itself may take. Such actions could include operating a particular business or operating in a particular market on a specified future date, or exercising particular options within a contract. In such situations, the entity has an obligation if it has no practical ability to avoid taking that action.

A conclusion that it is appropriate to prepare an entity’s financial statements on a going concern basis also implies a conclusion that the entity has no practical ability to avoid a transfer that could be avoided only by liquidating the entity or by ceasing to trade.

The factors used to assess whether an entity has the practical ability to avoid transferring an economic resource may depend on the nature of the entity’s duty or responsibility. For example, in some cases, an entity may have no practical ability to avoid a transfer if any action that it could take to avoid the transfer would have economic consequences significantly more adverse than the transfer itself. However, neither an intention to make a transfer, nor a high likelihood of a transfer, is sufficient reason for concluding that the entity has no practical ability to avoid a transfer.

In some cases, it is uncertain whether an obligation exists. For example, if another party is seeking compensation for an entity’s alleged act of wrongdoing, it might be uncertain whether the act occurred, whether the entity committed it or how the law applies. Until that existence uncertainty is resolved, for example, by a court ruling, it is uncertain whether the entity has an obligation to the party seeking compensation and, consequently, whether a liability exists.

Transfer an economic resource

The second criterion for a liability is that the obligation is to transfer an economic resource. To satisfy this criterion, the obligation must have the potential to require the entity to transfer an economic resource to another party (or parties). For that potential to exist, it does not need to be certain, or even likely, that the entity will be required to transfer an economic resource; the transfer may, for example, be required only if a specified uncertain future event occurs. It is only necessary that the obligation already exists and that, in at least one circumstance, it would require the entity to transfer an economic resource.

An obligation can meet the definition of a liability even if the probability of a transfer of an economic resource is low. Nevertheless, that low probability might affect decisions about what information to provide about the liability and how to provide that information, including decisions about whether the liability is recognised

Obligations to transfer an economic resource include, for example, obligations to:
– pay cash;
– deliver goods or provide services;
– exchange economic resources with another party on unfavourable terms. Such obligations include, for example, a forward contract to sell an economic resource on terms that are currently unfavourable or an option that entitles another party to buy an economic resource from the entity;
– transfer an economic resource if a specified uncertain future event occurs; and
– issue a financial instrument if that financial instrument will oblige the entity to transfer an economic resource.
Instead of fulfilling an obligation to transfer an economic resource to the party that has a right to receive that resource, entities sometimes decide to, for example:
– settle the obligation by negotiating a release from the obligation;
– transfer the obligation to a third party; or
– replace that obligation to transfer an economic resource with another obligation by entering into a new transaction.
In these situations, an entity has the obligation to transfer an economic resource until it has settled, transferred or replaced that obligation.

Present obligation existing as a result of past events

The third criterion for a liability is that the obligation is a present obligation that exists as a result of past events. That is:
– the entity has already obtained economic benefits or taken an action; and
– as a consequence, the entity will or may have to transfer an economic resource that it would not otherwise have had to transfer.

The economic benefits obtained could include, for example, goods or services. The action taken could include, for example, operating a particular business or operating in a particular market. If economic benefits are obtained, or an action is taken, over time, the resulting present obligation may accumulate over that time.

If new legislation is enacted, a present obligation arises only when, as a consequence of obtaining economic benefits or taking an action to which that legislation applies, an entity will or may have to transfer an economic resource that it would not otherwise have had to transfer. The enactment of legislation is not in itself sufficient to give an entity a present obligation. Similarly, an entity’s customary practice, published policy or specific statement of the type mentioned above gives rise to a present obligation only when, as a consequence of obtaining economic benefits, or taking an action, to which that practice, policy or statement applies, the entity will or may have to transfer an economic resource that it would not otherwise have had to transfer.

A present obligation can exist even if a transfer of economic resources cannot be enforced until some point in the future. For example, a contractual liability to pay cash may exist now even if the contract does not require a payment until a future date. Similarly, a contractual obligation for an entity to perform work at a future date may exist now even if the counterparty cannot require the entity to perform the work until that future date.

An entity does not yet have a present obligation to transfer an economic resource if it has not yet obtained economic benefits, or taken an action, that would or could require the entity to transfer an economic resource that it would not otherwise have had to transfer. For example, if an entity has entered into a contract to pay an employee a salary in exchange for receiving the employee’s services, the entity does not have a present obligation to pay the salary until it has received the employee’s services. Before then the contract is executory; the entity has a combined right and obligation to exchange future salary for future employee services

Definition of equity

Equity is the residual interest in the assets of the entity after deducting all its liabilities; accordingly, equity claims are claims on this residual interest. Put another way, equity claims are claims against the entity that do not meet the definition of a liability. Such claims may be established by contract, legislation or similar means, and include, to the extent that they do not meet the definition of a liability:
– shares of various types, issued by the entity; and
– some obligations of the entity to issue another equity claim.
Different classes of equity claims, such as ordinary shares and preference shares, may confer on their holders different rights, for example, rights to receive some or all of the following from the entity:
– dividends, if the entity decides to pay dividends to eligible holders;
– the proceeds from satisfying the equity claims, either in full on liquidation, or in part at other times; or
– other equity claims.

Sometimes, legal, regulatory or other requirements affect particular components of equity, such as share capital or retained earnings. For example, some such requirements permit an entity to make distributions to holders of equity claims only if the entity has sufficient reserves that those requirements specify as being distributable.
Business activities are often undertaken by entities such as sole proprietorships, partnerships, trusts or various types of government business undertakings. The legal and regulatory frameworks for such entities are often different from frameworks that apply to corporate entities. For example, there may be few, if any, restrictions on the distribution to holders of equity claims against such entities. Nevertheless, the Framework makes clear that the definition of equity applies to all reporting entities.

Definition of income and expenses

Income and expenses are the elements of financial statements that relate to an entity’s financial performance.
Users of financial statements need information about both an entity’s financial position and its financial performance. Hence, although income and expenses are defined in terms of changes in assets and liabilities, information about income and expenses is just as important as information about assets and liabilities.
– Income is increases in assets, or decreases in liabilities, that result in increases in equity, other than those relating to contributions from holders of equity claims;
– Expenses are decreases in assets, or increases in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity claims;
each excluding those relating to contributions from holders of equity claims; accordingly:
– Contributions from holders of equity claims are not income; and
– Distributions to holders of equity claims are not expenses.
Different transactions and other events generate income and expenses with different characteristics. Providing information separately about income and expenses with different characteristics can help users of financial statements to understand the entity’s financial performance.

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