(Last Updated On: January 28, 2018)
The Elements of Financial Statements
The qualitative characteristics are applicable to all information contained in the financial statements. The following elements of the financial statements will be considered separately:
The first three elements, i.e. assets, liabilities, and equity, relating to the financial position of an entity as set out in the balance sheet. The last two elements, i.e. income and expenses, related to the performance of an entity as set out in the income statement. The definition and recognition criteria for each of the above elements are discussed below. At this stage, however, it is appropriate to note that the underlying substance of elements needs to be considered, not merely their legal form – a notion that is called substance over form. The Conceptual Framework cites, in paragraph 4.6, the example of finance leases to illustrate this phenomenon. Although finance leases are legally construed as leases, their substance is such that they are not treated as typical leases, but are capitalized and treated as assets acquired from borrowing proceeds.
What is an Asset?
An asset of an entity is:
a) a resource;
b) that is under the control of the entity;
c) that is expected to result in future economic benefits flowing to the entity; and
that originated as a result of past events.
Assets are generally scarce resources that are exhausted in economic activities such as
consumption, production, and exchange. Certain assets have a physical form, although this is not a requirement for qualification as an asset. Goodwill and patents are examples of non-physical or intangible assets. They qualify as assets if future economic benefits are expected to flow from them to the entity and if they are controlled by the entity.
The requirement that an item should be under the control of an entity to qualify as an
asset can be achieved through the legal ownership of the item, but this may not be a
conclusive indication of control.
Control may also be exercised when access to the particular economic benefits of the asset is restricted, for example, through a secret formula or process. According to paragraph 4.12 of the Conceptual Framework, assets such as receivables and property, are associated with a legal right, for instance, the right of ownership. The right of ownership is, however, not essential for qualification as an asset. Should an entity control the benefits that are expected to flow from a leased property, such property qualifies as an asset. An item may, therefore, meet all the requirements of the definition of an asset even where legal control is absent, for example, whereby keeping acquired know-how a secret, an entity controls the benefits that are expected to flow from it.
The common characteristic of all assets is that they represent future economic benefits
that will eventually result in the inflow of cash or cash equivalents. Assets are either used to produce goods or services for resale or for own use in the production process. These goods or services satisfy the needs of customers; consequently, they are prepared to pay for them and hence contribute to the cash flow of the entity. Through this process, economic benefits are generated for the entity. Such economic benefits may flow to the entity in a number of ways.
Assets are usually obtained through the closing of transactions, either through purchase or through production using resources obtained through other transactions. Other events, such as inheritance, or property received from the government as part of a programme to encourage economic growth in an area or the discovery of mineral deposits, may also result in the acquisition of assets.
Assets, therefore, result from past transactions or other past events. It is important to
note, though, that transactions or events that are expected to occur in the future do not in themselves give rise to assets. An intention to purchase an asset does not, of itself,
constitute the acquisition of an asset. According to paragraphs 4.13 and .14 of the Conceptual Framework, a close association exists between the incurring of expenditure and the generating of assets. These two do not, however, necessarily coincide. Therefore, when an entity incurs expenditure, this may indicate the possible inflow of future economic benefits, but it is not conclusive proof that an asset has been acquired. Also, where expenditure has not been incurred, it does not automatically follow that an asset has not been acquired. Items that have been inherited or donated to the entity may indeed meet all the requirements of the definition of an asset.
What is a Liability?
A liability of an entity is:
a) a present obligation;
b) arising from past events; and
c) the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.
The most distinctive characteristic of liabilities is that they represent a present obligation for a particular entity. The obligation may be legally enforceable but may also be the result of normal business practice, or flow from a desire to maintain healthy business relationships or to act in an equitable manner. Should an entity, for example, decide to rectify faults in its products even after the warranty period has expired, a liability may be created for amounts that are expected to be expended in respect of goods already sold.
According to paragraph 4.16 of the Conceptual Framework, a distinction should, however, be made between a present obligation and a future commitment. A present obligation is not necessarily created by a decision of management to acquire assets at a future date. Normally, an obligation only arises when an asset is delivered or an irrevocable agreement has been entered into to acquire the asset.
The irrevocable nature of the agreement commits the entity to an outflow of resources to another party. Since liabilities result from past transactions or other past events, the purchase of goods and services usually gives rise to a liability (trade payables). Similarly, the receipt of a bank loan results in an obligation to repay the loan and a liability is thus created.
Future rebates by the entity based on annual purchases may also be recognized as liabilities since the sale of the goods in the past gave rise to the liability. Although in certain instances, an estimate of the amount of the obligation may be required, this does not in itself disqualify the item as a liability. The establishment of the precise amount of the obligation is not a prerequisite. As a result, provisions also qualify as liabilities.
What is an Equity?
Equity is defined in paragraph 4.4 of the Conceptual Framework as the residual
interest in the assets of the entity after deducting all its liabilities; in other words, equity is the difference between the assets and liabilities of an entity. This is referred to as the
accounting equation (E = A – L).
The amount of equity is, therefore, dependent on the number of assets and liabilities, not on the market value of the entity’s shares. Any correspondence between the market value of the entity’s shares and the value of its equity is usually purely coincidental. Similarly, the amount that could be raised by disposing of either the net assets on a piecemeal basis or the entity as a whole on a going concern basis bears little relationship to the value of an entity’s equity.
Equity can be subdivided into contributions by owners – for example, share capital and
retained earnings – and other reserves. The creation of such reserves may sometimes be
mandated by law to protect the capital base of the entity and to provide creditors with some protection from the effects of losses. Not all reserves are, however, created because of legal requirements; some may be established upon a decision by the entity’s governing body. The existence and size of these reserves should be disclosed to users. Sub-classifications of this nature are useful indicators of legal or other restrictions on the ability of the entity to distribute equity or utilize it in some other way.
They also serve as an indication that different categories of equity holders may have different rights regarding the receipt of dividends or the repayment of capital. Transfers between the various categories of reserves are appropriations of retained earnings, rather than expenses. Not all business activities are, however, performed by companies. Such activities are often undertaken through close corporations, sole proprietorships, partnerships, and trusts, as well as through various other types of government business undertakings.
The definition of equity (and the other aspects of the Conceptual Framework that deal with equity) also applies to such entities, although the legal and regulatory framework within which they operate may differ from that applying to companies. For example, in such other entities, there may be few, if any, restrictions on the distribution to owners or other beneficiaries of amounts included in equity.