chapter 3 measurement concepts and the balance sheet equation
TRANSCRIPT
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts
CHAPTER 3Measurement concepts and the
balance sheet equation
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts
Contents Introduction Company characteristics affecting financial
reporting behaviour Content of financial statements The basics of accounting measurement Generally accepted accounting principles Conventional measurement bases Accounting for transactions The IASB definition and recognition criteria of
elements of the balance sheet and the income statement
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Introduction –Annual financial statements
Single public source of economic company data
Prime external communication tool and of interest to all main business partners
Subject to verification by external experts
Starting point for tax assessment Important device to monitor contracts Public through mandatory filing and
voluntary disclosure
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Key financial statements Balance sheet and income statement are the key financial
statements Balance sheet: shows, at a given date, the company’s
financial position: the economic resources (assets) it controls and where its finance comes from (liabilities and equity)
Income statement: sets out the performance (result) of a company’s operations for the accounting period
They provide specific, but partial, economic information about a company’s past activities, drawn up according to a fairly flexible set of rules
Effective use necessitates knowledge of:a) What are the rules?b) To what extent are they flexible?c) How this impacts upon interpretation of the information.
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Company characteristics affecting financial reporting
behaviour Financial reporting is deeply embedded in
a country’s culture and traditions =>national accounting rules tend to vary significantly
Additionally, company characteristics will impact its reporting behaviour, e.g. Nature of ownership Managerial objectives Nature of activity Legal form Company size
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Content of financial statements
The core financial reporting process involves preparing an annual income statement and balance sheet Income statement: brings together aggregated
information about a company’s performance during a fiscal year
Balance sheet: shows the state of the company’s financial position at the end of the fiscal year
The income statement presents ‘flow’-data (covering a period), while the balance sheet is a status report (a ‘snapshot’ at a specific moment in time)
They are usually published with comparative data of the previous year.
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Fig. 3.1 Time periods covered
Balance sheet
31/12/20X4
Balance sheet
31/12/20X1
Balance sheet
31/12/20X2
Balance sheet 31/12/20X3
Income statement
20X2
Income statement
20X3
Income statement
20X4
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Company X – Income Statement of period 20X2
Accomplishments =>
lessEfforts =>equalsPerformance
=>
Revenues
- Expenses
Profit (or Loss)
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Income statement structure The income statement can be split into two
different sections: Operating result (or ‘profit before interest and tax’):
result from the company’s operating activities, irrespective of the financial structure of the company
Returns to interested parties others than the owners: Income taxes due to government Interest on loan finance
‘Profit available for shareholders’ is the residual return to equity providers It is the wealth generated by the company during the
period To pay dividend to shareholders or to finance future
growth (auto-financing)
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Income statement presentation 1
Income statement for period 200X € ’000
Sales 5,356 Raw materials 1,739 Salaries and wages 783 Depreciation 462 External services 873 (3,857) Profit before interest and tax 1,499 Interest (362) Profit before taxation 1,137 Taxation (384) Profit available for shareholders 753
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Operating expenses Two formats to present operating
expenses: Value-added approach
Shows inputs and outputs and enables one to calculate the value added by the company
Operating expenses are presented by their nature Most common in Europe
Functional approach Presentation by type of activity to which the operating
expense was assigned More common in UK and US
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Income statement presentation 2
Income statement for period 200X
€ ’000
Sales 5,356 Cost of sales (2,601)
2,755 Distribution costs 382 Administrative expenses 874 (1256)
Profit before interest and tax 1,499 Interest (362)
Profit before taxation 1,137 Taxation (384)
Profit available for shareholders 753
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Operating expenses by nature or function
Nature Function € ’000 € ’000 Raw materials 1,739 Cost of sales 2,601 Salaries and wages 783 Distribution costs 382
Depreciation 462 Administrative expenses 874
Other costs 873 Total 3,857 Total 3,857
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Allocation of input costs
Function:
Input costs:
Cost of sales
Distribution costs
Administrative expenses
Salaries and wages
Factory employees
Sales agents
Accountants
Depreciation
Production hall
Cars Administration buildings
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Balance sheet structure A balance sheet presents a picture of
the company’s finances at the end of the financial year, and the assets which it has acquired and which have not yet been consumed within the business
A balance sheet can be presented according to two basic formats: Horizontal balance sheet Vertical balance sheet
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Company X – Balance sheetat 31 December 20X2
Resources =
Assets =
Sources of finance
“Equities”
Owners’equity Liabilities (interests of owners) (interests of
creditors)
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Horizontal balance sheetFourth EC Accounting DirectiveAssets Liabilities and equity Intangible assets 943 Ordinary shares 2,455 Tangible assets 1,988 Reserves 982 Investments 213 Retained profit 947
Fixed Assets 3,144 Shareholders’ equity 4,384 Stocks 1,589 Provisions 520 Debtors 973 Financial liabilities 1,500 Cash at bank 881 Trade liabilities 359 Deferred charges 176 Total 6,763 Total 6,763
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Horizontal balance sheet US format
Assets Liabilities and equity Cash at bank 881 Trade payables 359 Deferred charges 176 Debt 1,500 Receivables 973 Provisions 520 Inventory 1,589 Fixed assets: Equity Investments 213 Ordinary stock 2,455 Tangible assets 1,988 Reserves 982 Intangible assets 943 Retained profit 947 Total 6,763 Total 6,763
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Horizontal balance sheet Left-hand side - the assets:
Fixed assets: used over a period of more than one year
Tangible assets (e.g. physical plant and machinery) Intangible assets (patents, brand names, licences) Investments (shares of and loans to other
companies) Other (current) assets: constantly changing
during accounting period Inventories Receivables (amount due from customers) Cash
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Horizontal balance sheet (cont.)
Right-hand side - the financing: Share capital: put into the company by
the owners Provisions: a liability to pay in the
future, but amount or timing is uncertain Financial Liabilities: loans made by
banks and financial markets Trade liabilities: debts due to suppliers
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Company X – Balance sheetat 31 December 20X2
Assets- Liabilities
Owners’equity => Residual claims of owners
Contributed funds (share capital)
Earned funds (accumulated profits)
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Balance sheet – vertical format
€ ’000 € ’000
Intangibles 943 Tangible assets 1,988 Investments 213 3,144 Fixed assets Stocks 1,589 Debtors and prepaid1 1,149 Cash at bank 881 Current assets 3,619 Creditors due in less than one year (359) Net current assets 3,260 Creditors due in more than one year (1,500) Provisions (520) 4,384 Capital Ordinary shares 2,455 Reserves 982 Retained profits 947 4,384
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Vertical balance sheet Same content but different presentation Liabilities are shown as a deduction from assets Liabilities are split according to when they are
due for payment, with current liabilities deducted from current assets
Capital (or equity) is shown as the residual: it is more a proprietary approach (focusing on the interests of the owners) while the horizontal presentation follows an entity approach (company presented as an economic whole)
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The basics of accounting measurement
Accounting measurement is based on a set of assumptions and conventions which automatically limit the information content Generally accepted accounting principles Conventional measurement bases
Accounting measurement necessitates extensive use of estimates, which make it a subjective process
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Generally accepted accounting principles
A set of assumptions, conventions and rules underlying financial accounting, necessary to make financial statements comparable and useful, but introducing significant constraints on their content
Different Generally Accepted Accounting Principles (GAAP)-sets exist, such as European GAAP and related national GAAP, US GAAP, IFRS GAAP,...
The ‘true and fair view principle’ (or fair presentation) of financial statements is pragmatically linked to the proper application of ‘generally accepted accounting principles’
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True and fair view / Fair presentation
‘Financial statements are frequently described as showing a true and fair view of, or as presenting fairly, the financial position, performance and changes in financial position of an entity. Although this Framework does not deal directly with such concepts, the application of the principal qualitative characteristics and appropriate accounting standards normally results in financial statements that convey what is generally understood as a true and fair view of, or as presenting fairly such information.’
Source: IASB-Framework for the Preparation and Presentation of Financial Statements
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Consistency Consistency of measurement and presentation
principles Consistency in time and space
Same accounting principles should be applied from one year to another
And, within the same year, in relation to similar transactions.
If changes are necessary, they should be explained in the notes to the accounts, together with disclosure of extra information to enable external observers to make a knowledgeable evaluation of the effects of the change
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Accrual basis Financial accounting aims to measure
business transactions at the time they take place, rather than when cash changes hands This approach distinguishes financial accounting
from a simple record of cash transactions ‘Matching’: all costs and revenues
associated with a particular sale should be recognized together in the income statement when the sale takes place
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Accruals
“In order to meet their objectives, financial statements are prepared on the accrual basis of accounting. Under this basis, the effects of transactions and other events are recognised when they occur (and not as cash or its equivalent is received or paid) and they are recorded in the accounting records and reported in the financial statements of the periods to which they relate. Financial statements prepared on the accrual basis inform users not only of past transactions involving the payment and receipt of cash but also of obligations to pay cash in the future and of resources that represent cash to be received in the future. Hence, they provide the type of information about past transactions and other events that is most useful to users in making economic decisions.”
Source: IASB, Framework, par.22
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Accrual versus Cash Basis
Cash basis: Revenue recognized when incoming cash flows occur Expenses recognized when outgoing cash flows occur No mutual link of expenses and revenues No measure of profitability feasible
Accrual basis: Expenses and revenue regarding a sale should be
recognized simultaneously (irrespective of time of payment)
Matching principle Measure of profitability of economic activities during
an accounting period
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Matching principle
Revenue recognised in period when earned Expenses related to the sale are
recognised in the same period as the revenue
Income statement
Revenues and expenses with regard to a specific accounting period
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Prudence Principle
Revenues should only be recognised when they are certain
Expenses are recognised when they become probable
Unrecoverable expenses should be recognized even if not yet realized
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Prudence (cont.) Controversial
Conflict with principle of matching Tax driven / Could lead to hidden reserves
IFRS: no priority for the prudence principle Meaning of prudence is restrained to an
attitude of caution in the exercise of judgements when these are needed to arrive at estimates under conditions of uncertainty such that assets/income are not overstated and liabilities/expenses understated
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Going concern In preparing financial statements it is assumed
that the company will continue in business for the foreseeable future Assumption is necessary to apply accrual principle
If no longer realistic: other set of measurement rules needed (probably based on short-term liquidation values)
IAS 1 Presentation of Financial Statements requires management to make an assessment of the company’s ability to continue as a going concern, when it prepares the financial statements
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Conventional measurement bases
Historical cost principle Monetary measurement unit
convention
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Historical cost Financial accounting is still largely based on
historical cost accounting Historical cost = acquisition cost of the item
Historical consideration given Past cost needed to acquire an asset on the date of
acquisition (the cash-equivalent acquisition cost) Pros and cons
Advantage: historical cost is relatively easy to determine and can be verified
Disadvantage: subsequent to the date of acquisition, the continued reporting of historical cost based values does not reflect any changes in market value
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Monetary measurement unit A/L/I/E are measured in monetary units
Money provides a common denominator by means of which heterogeneous facts and relationships can be expressed as numbers that can be added and substracted.
Pros and cons If nothing has been paid, no recognition of values in
the balance sheet, e.g. Trade mark loyalty Human capital
What if the value of monetary units changes ? Changes in purchasing power are not taken into account
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Accounting for transactions
Balance sheet equation Constructing a balance sheet
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Fig.3.3 Tracking finance
Finance
Production facility
Operations
Profit / CashRetained for growth Corporate taxation
Paid to shareholders as dividend
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Balance sheet equation
The balance sheet equation is usually stated as:
Assets = Debt (liabilities) + Equity
(uses of finance = sources of finance)
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Double-entry accounting
Any business transaction that will be recognized in the accounting system (‘accounting transaction’), will have a dual impact on the numbers in the company’s accounting records
The balance sheet equation is in fact the formal expression of the duality of accounting transactions
Double-entry accounting: any accounting transaction must be reflected in (at least) two accounts
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Double-entry accounting (cont.) Any accounting transaction must preserve the
equilibrium between sources and uses of funds, and will involve either a change in both, or a reallocation within one side of the balance sheet equation
Accounting transactions with impact on revenues and expenses fit into this fundamental equation approach If profit is generated, it adds to the ‘equity’ part of the
equation Revenues have a positive impact on profit and, thus,
on equity Expenses have a negative impact on profit and, thus,
on equity
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Link income statement and balance sheet
Owner’s equity = Assets – Liabilities
1 jan. 20X1 Share capital 1/1 + Retained profits 1/1
= Net assets 1/1 (NA)
Income statement for year 20X1
During 20X1 Revenues- Expenses
= Increase NA= Decrease NA
+ Profit(- Loss)
- Dividend = Decrease NA
31 dec. 20X1
Share capital 31/12 + Retained profits 31/12
= Net assets 31/12
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Constructing a balance sheet Every accounting transaction can be analysed according
to its dual impact on the balance sheet We will follow a spreadsheet approach for analysing
accounting transactions Rows represent accounts (upper part = asset rows; lower
part = equity and liability rows) and can be extended if needed
Columns represent the impact of accounting transactions on the balances (net amounts) of the accounts – this impact should be such that the balance sheet equation is preserved at all times
The spreadsheet represents the accounting database Each row (or account) = a data file Balance sheet = a highly aggregated summary of these
data files
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Alternative: debits and credits
Assets Increase (+) => debit Decrease (-) => credit
Equity/Liabilities Increase (+) => credit Decrease (-) => debit
P&L accounts Revenue => credit Cost => debit
Debit Asset Credit
Debit Eq./Liab. Credit
Debit P&L Credit
Cost Revenue
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Constructing a balance sheet -Illustration
We will follow a sequence of accounting transactions up to the construction of a balance sheet
Initially, equity represents the finance put into the company by the shareholders; equity changes regularly as a result of operating activities
The net change in equity over a period is the profit which has been made by the company during that period - it is analysed in the income statement
A balance sheet can, potentially, be drawn up after each transaction
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Illustration – Constitution of share capital
Assets 1 2 3 4 Situation
Cash +20000+15000+15000
Receivables
Inventory
Property
Total +50000
Liab./Equity
Long-term debt
Shares +20000+15000+15000
Profit
Total +50000
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Illustration – Bank loan
Assets 1 2 3 4 Situation
Cash +20000+15000+15000
+30000
Receivables
Inventory
Property
Total +50000 +30000
Liab./Equity
Long-term debt +30000
Shares +20000+15000+15000
Profit
Total +50000 +30000
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Illustration – Buying a garage with officeAssets 1 2 3 4 Situatio
n
Cash +20000+15000+15000
+30000 -55000
Receivables
Inventory
Property +55000
Total +50000 +30000 0
Liab./Equity
Long-term debt +30000
Shares +20000+15000+15000
Profit
Total +50000 +30000 0
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Illustration – Buying second hand cars
Assets 1 2 3 4 Situation
Cash +20000+15000+15000
+30000 -55000 -18000
Receivables
Inventory +18000
Property +55000
Total +50000 +30000 0 0
Liab./Equity
Long-term debt +30000
Shares +20000+15000+15000
Profit
Total +50000 +30000 0 0
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Illustration – Intermediate position trackingAssets 1 2 3 4 Situatio
n
Cash +20000+15000+15000
+30000 -55000 -18000 7000
Receivables
Inventory +18000 18000
Property +55000 55000
Total +50000 +30000 0 0 80000
Liab./Equity
Long-term debt +30000 30000
Shares +20000+15000+15000
50000
Profit
Total +50000 +30000 0 0 80000
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Illustration – Intermediate balance sheet
Assets Equity and Liabilities
Tangible assets (Property)
55.000 Share capital 50000
Fixed assets 55.000 Shareholders’equity 50000
Inventory (Cars) 18000 Financial liabilities (LT debt)
30000
Cash at bank 7000
Current assets 25000 Liabilities 30000
Total 80000 Total 80000
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Illustration – Sale of car and repairs
Assets Situation A
5 6 7 Situation B
Cash 7000 (a) +5000(c) -250
Receivables
Inventory 18000 (b) -4000
Property 55000
Total 80000 +750
Liab./Equity
Long-term debt 30000
Trade creditor
Shares 50000
Profit (a) +5000(b) -4000(c) -250
Total 80000 +750
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Illustration – Sale of car on credit
Assets Situation A
5 6 7 Situation B
Cash 7000 +5000-250
Receivables (a)+7000
Inventory 18000 -4000 (b) -5500
Property 55000
Total 80000 +750 +1500
Liab./Equity
Long-term debt 30000
Trade creditor
Shares 50000
Profit +5000-4000-250
(a)+7000(b) -5500
Total 80000 +750 +1500
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Illustration – Buying cars on credit
Assets Situation A
5 6 7 Situation B
Cash 7000 +5000-250
11750
Receivables +7000 7000
Inventory 18000 -4000 -5500 +12000 20500
Property 55000 55000
Total 80000 +750 +1500 +12000 94250
Liab./Equity
Long-term debt 30000 30000
Trade creditor +12000 12000
Shares 50000 50000
Profit +5000-4000-250
+7000-5500
2250
Total 80000 +750 +1500 +12000 94250
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Illustration – Income statement
Sales 12000
Cost of sales
- Cars 9500
- Repairs 250
9750
Net Profit 2250
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Illustration – Balance sheet
Assets Equity and Liabilities
Tangible assets (Property)
55.000 Share capitalProfit
500002250
Fixed assets 55.000 Shareholders’equity 52250
Inventory (Cars)Receivables
205007000
Financial liabilities (LT debt)
30000
Cash at bank 11750 Trade creditor 12000
Current assets 39250 Liabilities 42000
Total 94250 Total 94250
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Illustration -Reconciliation of profit and net cash flow
Net Profit (Income statement) 2250
Value of inventory sold (paid previously) 9500
Amount due by customer (still to be received) -7000
Change in cash during period
+4750
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The IASB definition of elements of financial statements
Elements of financial statements are the building blocks of a balance sheet and income statement Broad categories according to their
economic characteristics The IASB Conceptual Framework
identifies and defines five elements of financial statements
assets, liabilities, equity, income and expenses
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Elements of financial statements
c.f. IASB Conceptual Framework Five basic elements:
Assets Liabilities Equity Income Expenses
Financial position
Financial performance
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Elements of financial statements (cont.)
Financial position
Assets – Liabilities = Equity
Financial performance
Income – Expenses = Profit
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IASB - Asset
‘A resource controlled by an entity as a result of past events from which future economic benefits are expected to flow to the entity’
Key elements:a) Assets are resources, arising from past transactions
or past eventsb) They embody future economic benefits: the
capacity to contribute directly or indirectly to future net cash inflows
c) Control: one has the capacity to benefit exclusively from these economic benefits
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Future economic benefits Economic benefits may result from:
the productive capacity of the asset plant and equipment
the ability of the asset to reduce future cash outflows renewal expenditure on equipment that results in future
production cost savings the rights incorporated in the asset to receive services in
the future prepayments
direct claims to cash inflows receivables and short-term investments
cash in hand can be exchanged for goods and services (economic
benefits)
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IASB - Liability ‘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’
Key elements:a) Present (at balance sheet date) responsibility
obligating the company to act or perform in a certain way (towards third parties)
b) Arising from an obligating event in the pastc) Leading to a sacrifice of economic benefits
(transfer of cash or other assets, rendering of services, replacement by another obligation, ...)
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IASB - Equity
‘The residual interest in the assets of an entity after deducting all liabilities’
Key elements: The residual interest is the ownership interest Representing a claim to the company’s net assets
Equity will be usually sub-divided: Funds contributed by shareholders Retained profits Reserves representing appropriation of retained
profits
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IASB - Income
‘Increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants’
Key elements: Defined in terms of changes in assets and liabilities Results in increases of equity Must not come from capital contributions of owners Encompasses both revenue and gains
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IASB - Expenses
‘Decreases in economic benefits during the period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases of equity, other than those relating to distributions to equity participants’
Key elements: Defined in terms of changes in assets and liabilities Results in decreases of equity May not relate to distributions to owners Encompasses both expenses and losses
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Additional IFRS specifications The IASB standards contain additional rules with
respect to specific occurrences of elements of financial statements
In addition to more detailed definitions, the IASB standards typically focus on three aspects of financial statement elements: Recognition: process of incorporating an item
(meeting one of the definitions) in the financial statements
Measurement: process of determining the monetary units at which they are to be recognised and carried in the financial statements
Disclosure: process of additional information dissemination in the notes to the accounts
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Generic recognition criteria
An item meeting one of the definitions will only be recognised in the financial statements, if:
1) It is probable that any future economic benefit associated with the item will flow to or from the entity, and
2) The item has a cost or value than can be measured with reliability
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Fig. 3.4 Decision stages for inclusion of an item
Stage 2 – RecognitionCan the item be recognized according to the generic recognition criteria ?
Are there any specific recognition rules for the item?
Stage 1 - DefinitionsDoes the item meet the definition of a financial statement element ?
Stage 3 – MeasurementSelect the appropriate measurement base to determine the monetary amount at
which the item will be recognized and carried in the balance sheet or income statement
Stage 4 – DisclosureIs any (additional) mandatory or recommended information to be included in the
notes to the accounts?
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts
Balance sheet as a representation of the value of a
company? Historical value versus economic value Conservatism: assets are measured at the
minimum amount that can be expected from sale or use
Characteristics of economic value Related to future net cash flows Taking into account time value of money Corrected for risk