could even make a different decision if unbiased information was presented. Thus, it can be argued that ‘information free rrom bias’ (Framework, para. 36) is essential for effective decision making.
The IASB Framework provides guidance in relation to the recognition of balance sheet and income statement elements. Paragraph 82 ststes that an item that meets the definition of an element should be recognized if :
(a) It is probable that any future economic benefit associated with the items will flow to or from the enity; and
(b) The item has a cost or value that can be measured with reliability
Paragraph 91 gives additional specific guidance. It states that a liability is recognised in the balance sheet when it is probable that an outflow of resources embodying economic benefits will result from the settlement of a present obligation and the amount at which the settlement will take place can be measured reliably. Therefore, the key issues to be considered in relation to recognizing liabilities are (a) the probable outflow of economic benefits and (b) reliability of measurement. In practice, it may be difficult to apply these criteria. For example, what does probable mean? It can be argued that it means more likely reather than less likely. However, individual differences in estimates of the probability of an event may vary, leading to inconsistency in measurement.
What is meant by reliable measurement? The Frameworks states that reliable measurement is that which is ’free from materials error and bias’; further, that an item is measured so that it ‘faithfully represents’ what it purports to represent (para. 31). The Framework states specifically that liabilities cannot be included if they cannot be measured reliably (para. 86). One example is a legal action. If the damages to be paid cannot be estimated reliabily then the items cannot be recognised as a liability. The legal action example illustrates the trade off made brtween relevance and rekiability. A probable future outflow of economic benefits associated with the lawsuit is relevant information, but to recognize an incorrect amount may be misleading to users of financial information.
Some people take the view that reliable measurement means verifiable measurement; that is, the measurement of the liability can be linked to objective evidence such aqs a contract amount or aq market value. However, in many cases accountants must use judgement to make their best estimate of a liability. Consider for example the liability for warranty claims. The accountant uses relevant past data (such as the level of prior claims) and predicted information (such as the level of sales) to estimate the liability. If the estimate is sufficiently reliable (which will only be know in the future) then the information will also be relevant for users of financials information. Evidence that there are different views about how to define and when to recognize liabilities is emerging as part of the IASB/FASB’s project on the conceptual framework. In October 2008 the boards tentatively adopted new working definitions for assets and liabilities. Discussion by the boards about when assets and liabilities should be recognised and derecognized is continuing.
A practical example of recognition of liabilities relates to accounting for public-private partnerships. These partnerships refer to the situation where the public sector (e.g. a government-controlled or –funded entity) contracts with the private sector (e.g. a company) for the construction of public-use assets such as roads, prisons, and schools. The question is: Which entity should record the assets and liabilities associated with eh transactions? To answer this question, accountants must apply the definition and recognition criteria outlined in accounting standards and the framework. However, a number of outcomes are possible, depending how standards are applied. A key question to guide application of the relevant standards relates to where the risks and benefits of ownership lie. These issues are explored further in theory in action 8.2.
Certainly, there are circumstance when the users of financial information want to know about potential losses or outgoings. IAS 37 ( para. 86 ) states that in some circumstances a note to the accounts ia required because the knowledge of liabilities is relevant to the users of the financial report in making and evaluating decisions about the allocation of scarce resource.That is future settlement may be required, but the estimated probability is not high enough to warrant formal recognition.this subjective probability test provides opportunities foor firms to exclude liabilities from their financial stattemens.however, the liabilities should still be disclosed when knowledge of them is likely to affect users decision making.theory in action 8.3 provides an example of contigent liability note from the public transport authority of western australia ( a public-sector entity ). it is a worthwhile excercise to consider the extent of disclosure included in the note and the reasons it has been provided.
Pension plans can be regarded as a promise by the entity to provide pensions to employes in return for past and curent sevices. Pension benefits are a form of deffered compantation offered by the firm in exchange for sevices by employees who have chosen, either implicitly or explicitly, to accept lower current compentation in return for future pension payments. These pention benefits are earned by employees, and their cost accurues over the years the service by employees and , therefore, and obligation arises for those pention benefits that have not yet been funded. Case study 8.2 considers issues relating to accounting for pensions ( superannuation ) in the united kingdom and australia by focusing on pension ( superannuation ) liabilities of a number of large listed companies.
Privisions and contingencies
provisons and contingencies occur where there is a blurring of the line between present and future obligations.IAS 37 / AASB 137 provisions, contingent liabilities and contingent assets acknowledges the overlap of definitions of paragraph 12, when it states that all provisions are contingent because they are uncertain in timing or amount. Trying to distinguish between present, future and potential ( or contingent ) obligations is not as simple as may appear. the distinction depends to a large degree on the nature of the past event
IAS 37/AASB 137 paragraph 10 defines a contingent liability as :
(a) a possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity ; or
(b) a present obligation that arises from past events but is not recognised because:
(i) is not probable tahan an outflow of resources embodying economic benefits will be required to settle the obligation; or
(ii) the amount of the obligation cannot be measured with sufficient reliability.
The IASB 37/ AASB 137 paragraph 14 recognition criteria for provisions are consistent with the Framework criteria for recongition of a liability. As such, liabilities and provisions are permitted to be recognised only when there is a present obligation, it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation, and the amount of the obligation can be reliably measured. Contingent liabilities do not meet these criteria (just as contingent assets do not meet the criteria for recognition as asset). Hence, paragraph 27 of IAS 37/ AASB 137 states categorically that contingent liabilities are not to be recognised in the financial statements. IAS 37 is presently under review by the IASB as part of the liabilities project. One of the proposals is to eliminate the terms “provision” and “contingent liability”, replacing them with “non-financial liability”. The proposals aim to extend and clarify the application of IAS 37; however, as is usual, the proposals have received mixed responses from stakeholders.
The effect of IAS 37 is to limit the use of provisions. For example, a company may consider it prudent to create a provosion for uninsured losses. (i.e. the process of self insuring), however, a liability cannot be recognised under IAS 37 until the occurrence of an event necessitating the sacrifice of assets by the reporting entity. Another example relates to “provision for possible losses” or “provosion for restructuring” which may be created following poor performance. Since there is no existing obligation to an external party (i.e. a commitment to transfer resources from the enntity to an external party which cannot be avoided) such a provosion would not be permitted under the Framework or current standards.
Certainly, there are circumstances when the users of financial information want to know about potential losses or outgoings. IAS 37 ( para. 86 ) states that in some circumstances a note to the accounts is required because the knowledge of liabilities is relevant to the users of the financial report in making and evaluating decisions about the allocation of scarce resource. That is future settlement may be required, but the estimated probability is not high enough to warrant formal recognition. this subjective probability test provides opportunities for firms to exclude liabilities from their financial statements. however, the liabilities should still be disclosed when knowledge of them is likely to affect users decision making. theory in action 8.3 provides an example of contingent liability note from the public transport authority of western australia ( a public-sector entity ). it is a worthwhile exercise to consider the extent of disclosure included in the note and the reasons it has been provided.
The Framework provides little guidance about how to measure liabilities which meet the definition and recognition criteria. Paragraph 100 states that a number of different measurement bases may be employed. Under IFRS, the most commonly used measurement method for liabilities is historical cost (or modified historical cost). ‘Fair value’ measurement is used on initial measurement of transactions involving liabilities in relation to IAS 17 Leases, L\S 39 Recognition and Measurement of Financial Instruments, IFRS 2 Share-based Payment and IFRS 3 Business Combinations. What do we mean by fair value? The concept is defined in standards such as IAS 17 (para. 4) to be:
The amount for which an asset could be exchanged or a liability settled between knowledgeable, willing parties in an arm’s length transaction.
Thus, the liability arising under a finance lease is recognized at inception based on the fair value of the lease (which according to the above definition could be a market price for the leased property) or the present value of the Minimum lease payments if lower (IAS 17, para. 20). In subsequent years, the liability is measured based on the method ‘amortized cost’; that is, the ‘cost’ of the liability at inception (fair value or present value of minimum lease payments, if lower) adjusted on a yearly basis to reflect its estimated current value. The outstanding balance of the liability is based on the effective interest rate method of amortization (para. 25). In the case of finance leases, the standard gives clear guidance for determining the value of the lease liability. However, in other cases, fair value measurement of liabilities presents some challenges. For example, how do we estimate the fair value of a liability for which there is no market value ? many liabilities ,lie settled, not sold.
Table 8.1 shows the variety of measurement methods used under IFRS for subsequent measurement of liabilities. We can see that historical cost (or rather modified historical cost, in this case amortised cost) is the most commonly used method for subsequent measurement of liabilities. Two examples where fair value measurement is required subsequent to acquisition are post-employment obligations such as pensions (superannuation) under IAS 19 AASB 119 Employee Benefits and long-term provisions under IAS 37/AASB 137 Provisions, Contingent Liabilities and Contingent Assets. Note that in both cases the liability is long term and likely to be affected by the time value of money. In present value terms, the longer the time period until settlement of the liability, the lower its value. This is because an entity benefits from the ability to earn- interest on the funds which have not been used today to settle the liability The next section explores the measurement of the liabilities associated with pensions (superannuation) and provisions and contingencies.
Employee benefits – pension (superannuation) plans
In many countries pension (or superannuation) plans are established by employers to provide retirement benefits for employees. Employers make payments to pension funds which hold assets, in trust, to fund payments when employees retire. The pension funds are legal entities, separate from the employer firm.
Pension plans may be contributory (both the employer and the employee contribute to the hind) or non-contributory (where only the employer makes contributions). For a defined benefit fund, the amounts to be paid to the employee are at least partially a function of the employee’s final or average salary. In contrast, a defined contribution (or accumulated benefit) fund pays an amount that is a function of the contributions made to the fund.
|Table8.1 Subsequent measurement of liabilities in IFRS consolidated financial statement|
usual measurement oasis
allowed by IFRS and adopted
Fair value option*
|Long-term borrowings||Amortised cost||
|Finance lease obligations||Amortised cost||
|Defined benefit post employment
|Present value of expected
payments less fair value of plan
|Deferred tax||Expected payments||
|Long-term provisions||Present value of expected
|Trade payables||Amortised cost||
|Short-term borrowings||Amortised cost||
|Current portion of long-term
|Other financial liabilities||Amortised cost||
|Current tax payable||Expected payments||
|Short-term provisions||Expected payments||
Source: Cairns 2007.
- The for value option may be used for financial liabilities only where there is an accounting mismatch or when the liabilities are managed and evaluated on a fair value basis in accordance with a documented risk strategy (IAS 39, para 11A)
Pension funds may be fully funded, partially funded or unfunded. Fully funded plans have sufficient cash or investments to meet the fund’s obligation to members. In contrast, unfunded plans do not have cash or investments to cover the potential payouts under the plans. To the extent at amounts held in trust and being paid into the pension fund are insufficient to meet obligations under the plan as they fall due, the pension plan is underfunded.
Since pension funds are separate legal entities, it might be presumed that unfunded commitments of the plans are not liabilities of an employer firm that pays into a fund. However, it can be argued that the firm has an equitable obligation to meet unfunded commitments and, therefore, has a liability. In support of this argument. Whittred, Zimmer and Taylor offer the example of a firm that lets its sponsored superannuation fund default and suffers loss of reputation in labour and other markets as a consequence, thereby incurring a sacrifice of economic benefits. I although some firms traditionally have not recognised unfunded commitments as liabilities, under the Framework and IAS 37/AASB 137 it is difficult to argue that they are not liabilities.
Another issue relates to when to recognise liabilities for pension (superannuation) payouts. Is it:
- as the employee renders services? The notion is that the payout is a form of compensation earned by tile employee as services are rendered. However, it is paid in the future, after retirement
- when the employee retires?
- when the fund is required to make payments under the pension plan?
Owners’ equity is the third of the fundamental accounting concepts captured in the accounting equation. It represents the net assets (assets minus liabilities) of the entity (P = A – L). Thus, owners’ equity (or proprietorship) captures the owners’ claims against the entity’s net assets, which the entity has no current obligation to pay. It represents the owners’ interest or capital in the firm. Owners’ equity (the residual interest) is a claim or right to the net assets of the entity. The framework defines equity in paragraph 49(c) as follows:
‘Equity’ is the residual interest in the assets of the entity after deducting all its liabilities.
Therefore, owners’ equity is not an obligation to transfer assets, but a residual claim. Further, it cannot be defined independently of assets and liabilities. As such, the definitions of assets and liabilities must be agreed on before a definition of equity can be finalised and applied in a sound theoretical or practical sense. As a result of its residual nature, the amount shown in the balance sheet as representing equity is dependent on not only the assets and liabilities which are recognised but also how they are measured. For example, assume Firm A undertakes an upward revaluation of property under IAS 16/AASB 116 Property, Plant and Equipment but Firm B, which holds an identical asset, does not. Firm A will report higher assets and equity than Firm B.
A fundamental question to be addressed in arriving at the amount of equity is whether an item represents a liability or equity of the entity. There are two essential features which can help us to distinguish between liabilities and owners’ equity. They are:
- the rights of the parties
- the economic substance of the arrangement
Legal rights are a very important consideration. However, they should not be the only basis of distinction between creditor and owner. After all, the definition of a liability includes constructive and equitable obligations as well as legal obligations. Another reason is that the legal viewpoint is too narrow a focus to be useful in achieving the decision usefulness objective of accounting. Therefore, economic substance must also be studied.
Rights of the parties
One feature of the rights given to the parties either by law or by Company policy relates to the priority of rights to be (re)paid in the event that the entity is wound up. Legally, for a sole proprietorship or partnership, a creditor has a claim on the owner(s) and, for a corporation, a claim on the company. However, in accounting theory, no matter what the legal form of the organisation, the entity is recognised as a unit of ‘accountability. Therefore, creditors have a claim on the entity and thus on its assets.
Creditors have the following rights:
- settlement of their claims by a given date through a transfer of assets (goods or services)
- priority over owners in the settlement of their claims in the event of liquidation.
Note that creditors’ claims are limited to specified amounts (which may vary over time according to the terms of the agreement). In contrast, the owners have a residual interest only, although by contractual arrangement different classes of owners may have different priorities in the return of capital.
Another aspect of the rights of creditors and owners relates to the use of the assets or to the operations of the business. Creditors do not have the right to use the assets of the firm other than as specified in contracts. Except in an indirect way in some cases, they do not possess rights in the decision-making process in the operations of the business. In a limited way, by contract, they may intrude on operations by requiring that retained earnings be restricted, or that a given asset not be sold without their approval. On the other hand, owners have the right or authority to operate the business.
Both liabilities and owners’ equity represent claims against the entity. All claimants against the entity bear a risk of loss but, because of the prior claims of creditors, their risk is less than that of owners. Owners must bear any losses stemming from the activities of the firm. They carry the brunt of the risk in the business. In each firm, the degree of risk for creditors and owners depends on their rights. As such, a key difference between the rights of creditors and owners is that creditors have a right to settlement whereas owners have rights to participate in profits (the residual). The difference reflects the economic risk and return features of the two types of claims: creditors bear less risk and earn a relatively fixed return (interest and settlement of the principal), whereas owners bear greater risk and accordingly earn a variable (and often higher) rate of return through their participation in profits. Figure 8.1 provides a diagrammatic representation of the relationship between economic substance and rights.
FIGURE 8.1 The relationship between economic substance and rights
Owners or their representatives have control of the acquisition, composition, use and disposition of the firm’s assets. They have control of operations and the responsibility for running the business and for its survival and profitability. Generally speaking, company owners (shareholders) delegate most of these responsibilities and control to directors and managers.
These arguments correspond with the notions of the entrepreneur in economics. the concept of entrepreneur may be idealistic when applied to the average shareholder in a large, publicly owned company but this misfit is due to the insistence of accountants that a distinction is made between liabilities and owners’ equity for all business enterprises. The recognition of owners’ equity presumes a proprietary theory position, which, to begin with, is awkward when imposed on a large company.
Concept of capital
Accounting for shareholders’ equity is influenced by legal prescriptions. For example, in the United Kingdom and Australia company law includes statutes relating to accounting for capital. Foremost is the requirement of ‘capital maintenance’, which demands that companies maintain intact their initial (and any subsequent) capital base. The Framework recognises that whether or not a firm maintains its capital intact is a function not only of the definition of equity as a residual interest in an entity, but also of the concept of capital. Capital can be conceptualised as the invested money or invested purchasing power (financial capital) or as the productive capacity of the entity (physical capital) further, capital can be measured on either a nominal dollar or a purchasing power (‘real’) scale. Various combinations of the concept of capital and the measurement scale are used in different models that yield different measures of capital under identical circumstances. The Framework provides no guidance regarding which ‘model is most appropriate, but does recognise in paragraphs 108 and 109 that firms would need to retain different amounts of resources to maintain different concepts and measures of capital.
Another objective of capital maintenance requirements is to protect creditors by providing a ‘cushion’ or ‘buffer’. For example, suppose an entity holds no more than the legal capital of $10000. If total assets are $100000, this means that liabilities amount to 590000. That is:
$100 000 = $90 000 + $10 000
If the entities were to be liquidated and the carrying amount of the assets realised only $80000, there would be enough to pay the creditors. This is possible because of the existence of the capital of $10000. Without it, the creditors would not be paid in full. Capital is not a guarantee for the protection of creditors, but it does offer some safety. The importance of capital reserves was highlighted in the banking and liquidity crises of 2007-08.
Classifications within owners’ equity
The distinction between contributed and earned capital is one that accountants find useful. The rationale is to keep separate the amount invested from the amount that is reinvested. The former is due to financing transactions, whereas the latter is derived from profit-directed activities. Retained earnings, or unappropriated profits, make up the earned capital.
Retained earnings may be appropriated for specific purposes. Remember that retained earnings are not assets in themselves and therefore the appropriations of retained earnings to specific reserve accounts do not represent particular assets. In 1950, a special committee of the American Accounting Association explained that appropriations are of three types:
- those that are designed to explain managerial policy concerning the reinvestment of profits
- those that are intended to restrict dividends as required by law or contract
- those that provide for anticipated losses. 13
The committee stated the following.
- the first type did not effectively achieve the objective and would be best explained in narrative form elsewhere.
- For the second type, the committee believed a note to the accounts would be preferable to an appropriation.
- For the third type, the committee felt an appropriation was unnecessary and often misleading; a note would be more suitable.
The committee emphasised that appropriations must not affect profit determination. There is little that can be accomplished by appropriations. Some accused companies of using appropriations as a ploy to decrease the amount available for dividends, hoping thereby to lessen complaints by shareholders about the level of dividends paid. Such arguments assume that managers believe shareholders are naive. ‘Me demarcation between contributed and earned capital cannot be strictly maintained because of transactions that do not fall neatly into these categories. For example, share dividends (i.e. dividends that are ‘paid’ in the form of an allocation of shares) represent a change in classification from earned to contributed capital.
CHALLENGES FOR STANDARD SETTERS
The IASB has several current projects which will affect the definition, recognition and measurement of liabilities, including those relating to the conceptual framework, financial instruments, provisions and employee entitlements. The Board is amending IAS 37 Provisions, Contingent Liabilities and Contingent Assets and LAS 19 Employee Benefits as part of the liabilities project. The objective of the project is to (a) converge IASB standards with US GAAP and to (b) improve current standards in relation to the identification and recognition of liabilities. The work on the liabilities project illustrates how standards are interconnected and changes likely affect a number of standards; for example, the work on LAS 37 will be relevant to projects on leasing, insurance and the conceptual framework.
To illustrate challenges currently faced by standard setters, we now discuss three key topics which are relevant to issues discussed in this chapter. First, we consider the distinction between the classification of items as liabilities or equity, the so-called debt versus equity distinction. Second, we discuss when liabilities are extinguished; that is, when it is appropriate for companies to remove liabilities from their balance sheets. Third, we examine share-based payment transactions and consider the extent to which they give rise to liabilities or equity.
Debt vs equity distinction
Based on the definitions and recognition criteria discussed in this chapter, we can agree that shares issued to investors form part of equity and that loans from creditors are liabilities. However, questions are raised about hybrid instruments which have the characteristics of both debt and equity. For example, preference shares have traditionally been regarded as capital and, therefore, as part of owners’ equity, but they have characteristics that also align them with liabilities, such as the following
- they are fixed claims
- they might not participate in dividends other than at a pre-specified rate (akin to interest)
- they have priority over ordinary shares in the return of capital (as do liabilities)
- they generally carry no voting rights.
Although they are called shares, it is likely that they sometimes meet the definition of liabilities, and should be classed as liabilities. IAS 32/AASB 132 paragraph 18 comments:
The substance of a financial Instrument, rather than its legal form, governs the classification … Substance and legal form are commonly consistent, but not always. Some financial instruments take the legal form of equity but are liabilities in substance and others may combine features associated with equity instruments and features associated with financial liabilities.
LAS 32/AASB 132 goes on to state that preference shares that provide for mandatory redemption by the issuer for a fixed or determinable amount at a fixed or determinable.