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LECTURE 11 (A): ASSETS, LIABILITIES AND OWNERS’ EQUITY

LECTURE 11 (A): ASSETS, LIABILITIES AND OWNERS’ EQUITY. Prepared By: MS. NARIMAH HASHIM Jabatan Perakaunan & Kewangan Fakulti Ekonomi & Pengurusan Universiti Putra Malaysia Serdang Selangor Darul Ehsan. THE IMPORTANCE OF DEFINITIONS & CLASSIFICATIONS.

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LECTURE 11 (A): ASSETS, LIABILITIES AND OWNERS’ EQUITY

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  1. LECTURE 11 (A): ASSETS, LIABILITIES AND OWNERS’ EQUITY Prepared By: MS. NARIMAH HASHIM Jabatan Perakaunan & Kewangan Fakulti Ekonomi & Pengurusan Universiti Putra Malaysia Serdang Selangor Darul Ehsan NHashim....UPM....30.9.2005

  2. THE IMPORTANCE OF DEFINITIONS & CLASSIFICATIONS • From individual users’ perspective of financial statements: • It affects their interpretation of the risk and solvency of the reporting entity • It affects their understanding of reported financial performance. The classification of expenses & profit appropriations is dependent upon the classifications of the elements in the balance sheet • The rules governing the classification and recognition of A, L & O.E. determine how various contractual agreements are measured NHashim....UPM....30.9.2005

  3. ASSETS : DEFINITIONS SAC 4(AASB) & SFAC No.6 (FASB): Future economic benefitscontrolled by the entity as a result of past transactions or past events NHashim....UPM....30.9.2005

  4. FUTURE ECONOMIC BENEFITS • Is the first essential component in the definition of assets = the essence of an asset • Associated with the activities that can generate profit • Broad enough to include non-profit organizations NHashim....UPM....30.9.2005

  5. FUTURE ECONOMIC BENEFITS (FEB) For profit organizations: To provide goods & services for exchange with the objective of generating net cash inflows For non-profit organizations: To provide services to beneficiaries, may include parks, monuments, roads etc. Conclusion 1: Assets enables or assists entities to pursue their objectives NHashim....UPM....30.9.2005

  6. CHARACTERISTICS OF FUTURE ECONOMIC BENEFITS (FEB) What provide the future economic benefits? • Resources or properties (Paton 1962) • Scarcity – the supply not sufficient for everyone, that’s why its term ‘economic’ resources • Utility – the ability to satisfy human wants • Paton’s assets have value: … material or otherwise owned by a specific business enterprise & have value to that enterprise NHashim....UPM....30.9.2005

  7. FEB OR SERVICES OR INSTRUMENT OF SERVICES • Paton & Littleton (1940): “Service is the significant element behind the account i.e. service potentialities, which when exchanged, bring still other service-potentialities into the enterprise” • Vatter (1947): “…an expression of future satisfaction in the form of service potentials that may be transformed, exchanged or stored against future events” NHashim....UPM....30.9.2005

  8. CONCLUSION 2 • Assets CAN BE in ‘tangible’ form • Such as buildings & machines; • Or in an ‘intangible’ form • Such as “rights” (like prepaid rent & prepaid insurance) NHashim....UPM....30.9.2005

  9. ASSETS EXIST NOW • However, SAC 4 definition does not give the impression that assets must have ‘present existence’ since it equate assets with future economic benefits; & this may encourage the idea that assets are not ‘real’ since it has not happened yet • Shall have real world application: Assets exist now but capable of rendering services or benefits, now or in the future NHashim....UPM....30.9.2005

  10. CONTROLLED BY THE ENTITY • The second component ‘control’ refers to: “…the capacity of the entity to benefit from the assets;… and TO DENY or REGULATE ACCESS of others to that benefit” (SAC 4 & Ijiri 1967) • Control means ‘ownership’ for ‘owned’ indicates entity have title to the asset but OWNERSHIP is NOT absolute NHashim....UPM....30.9.2005

  11. CONTROLLED DEFINED • According to Sprague (1907): • It is more than the “right of possession” It must mean “ the right to use” & “the right to prevent” others from using the assets NHashim....UPM....30.9.2005

  12. CONTROLLED DEFINED • Again the right to use or control the assets is not absolute • It does not imply that an entity can do whatever it pleases with the asset • Control is always subjected to the general rights of the state or the particular statutory limitations NHashim....UPM....30.9.2005

  13. CONTROL VERSUS OWNERSHIP • Ownership is normally synonymous with control but it is not an essential characteristic • Example: An agent who holds goods on behalf of the principle, the goods would not be an asst of the agent but the agent has possession & control NHashim....UPM....30.9.2005

  14. CONTROL NOT OWNERSHIP • Having ‘title’ of assets means an entity has legal right to use but the ownership (the legal document) may belong to other people • Title is divisible. • Example: If an entity buys a vehicle, paid cash as down payment & the remainder on loan from a finance company NHashim....UPM....30.9.2005

  15. CONTROL BUT NOT OWNERSHIP • The vehicle is an asset of the entity but legally the ’title’ belong to the finance company until the loan has been fully paid up CONCLUSION The objective of accounting does not focused on the legal concepts but on the economic substance of the transactions and EVENTS THAT EFFECT its financial position NHashim....UPM....30.9.2005

  16. PAST TRANSACTIONS OR OTHER PAST EVENTS • This third component in SAC 4 definition of asset is to ensure that contingent assets are excluded • Example: • A machine that an entity INTENDS to purchase is NOT AN ASSET because the transaction has not taken place NHashim....UPM....30.9.2005

  17. CONTRACTS? • Signing a contract constitutes an event & the contract is called: • “WHOLLY EXECUTORY CONTRACT” or “AGREEMENTS EQUALLY PROPORTIONATELY UNPERFORMED” (AEPUs) • Which means each party in the contract HAS YET to perform their part of the obligations NHashim....UPM....30.9.2005

  18. SAC 4 (1992) • Requires that leases, non-cancellable purchase contracts & forward exchange contracts that gave rise to assets & liabilities be reported • This requirement caused great political debate & lobbying • The main reason against AEPUs being reported as separate assets & liabilities because it will increased leverage without any real change in the economic indebtedness of the firm NHashim....UPM....30.9.2005

  19. AEPUs • Sometimes such assets & liabilities offset each other but sometimes not for example financial leases • SAC 4 (1995): • A revised version acknowledge the practical difficulty & no longer require these items to be reported in the financial statements NHashim....UPM....30.9.2005

  20. UNITED STATE’S VERSION • In the US, as long as the contractual agreement meets the recognition criteria of an asset such as usefulness or the firmness of the contractual agreement, therefore it is recommended that ‘these rights” should be regarded as assets NHashim....UPM....30.9.2005

  21. EXCHANGEABILTY • SAC 4 defines ‘exchangeability’ as an item “separable from the entity and has a separate disposable value” • MacNeal’s argument (1939) apply here: A good that lacks exchangeability must lack economic value because its purchase or sale must forever remain impossible, and thus no market price for it can ever exist NHashim....UPM....30.9.2005

  22. GOODWILL • The asset directly affected by this condition is GOODWILL, since it cannot be sold separately from the other assets • Chambers (1966): • The determination of financial position requires the measurement of the values of assets & liabilities but goodwill is not measured but to be ‘valued’ NHashim....UPM....30.9.2005

  23. GOODWILL • The value is expected value & not subjective & cannot be verified objectively • MacNeal: The balance sheet should report the value of a company’s assets, not the value of the business which involves predicting future cash flows, and • THIS is a function of investors not accountants NHashim....UPM....30.9.2005

  24. EXCLUDE ‘EXCHANGEABILITY’ • Opposition to including “exchangeability” for defining assets include: • Only inventories value is achieved through exchange, most assets’ value is obtained from their use. • Economic value depends on scarcity & utility not exchangeability NHashim....UPM....30.9.2005

  25. EXCLUDE ‘EXCHANGEABILITY’ • Exchange does not make value but only reveals it • Inclusion of intangibles such as goodwill as assets is not an attempt to value the business but rather an attempt to identify and value particular sources of future benefits to the firm NHashim....UPM....30.9.2005

  26. CONCLUSION ON ‘EXCHANGEABILITY’ CONCLUSION 1: SAC 4 include ‘exchangeability’ as other supporting characteristics for defining assets CONCLUSION 2: Applying only definition characteristics involves numerous ad hoc conditions that ‘can be’ called recognition rules NHashim....UPM....30.9.2005

  27. RECOGNITION RULES • These rules help accountants get evidence to support their records in an environment of uncertainty so that assets information are relevant & reliable: • An account receivable is recorded as an asset when a credit sale is made • Equipment is recorded as an asset when it is purchased NHashim....UPM....30.9.2005

  28. RECOGNITION CRITERIA • SAC 4 stipulates that • “Assets are to be recognized only when it is PROBABLE that their future economic benefits will eventuate (take place)” and • “The assets possesses a cost or other value that can be measured reliably” NHashim....UPM....30.9.2005

  29. RECOGNITION RULES VERSUS CRITERIA • Some assets meet the definition but not the recognition criteria examples human resources, operating leases, losses, R&D • Recognition rules or guidelines are different from recognition criteria • The recognition rule that is formally specified is the guideline adopted for the recognition of capital leases as assets NHashim....UPM....30.9.2005

  30. LEASES AS ASSETS • For a lessee, if one of the following criteria is met, than a non-cancellable lease is to be capitalized: • The lease is for 75% or more of its useful life of the leased property • The present value, at the beginning of the lease term, of the minimum lease payments equals or exceeds 90% of the fair value of the leased property to the lessor at the inception of the lease NHashim....UPM....30.9.2005

  31. CONCLUSION • Recognition rule is a specific rule to identify a particular asset • Recognition criterion is a general guideline used to formulate recognition rules NHashim....UPM....30.9.2005

  32. RECOGNITION CRITERIA • SAC 4 provides for recognition criteria which are an extensions of the qualitative characteristics of relevance & reliability of accounting information • Numerous recognition criteria have been applied in the past when accountants decide to record assets, some are now formalized but some have little or no theoretical foundations, such as: NHashim....UPM....30.9.2005

  33. Examples • Reliance on law – Even though legal rights of ownership or control of benefits are often used as recognition criteria, the overriding recognition criterion is that of economic substance rather than legal form NHashim....UPM....30.9.2005

  34. EXAMPLES 2. Determination of the economic substance of the transaction or event - Relates to the objective of reporting relevant information & materiality concept - Though capital & financial leases involve probable future economic benefits, the substance of the benefits differ NHashim....UPM....30.9.2005

  35. Financial Versus Operating Leases • The financial leases convey “in substance” ownership-style & obligations whereas operating leases are in the nature of short-term hire & do not have such rights & obligations attached • The former is an asset the latter is not NHashim....UPM....30.9.2005

  36. RECOGNITION CRITERIA - EXAMPLES • Use of the conservatism principle: anticipate losses but not gains • Liabilities can be recorded early but gains do not, example: • If a company is the defendant & loses a lawsuit, even if it appeals, it would record a liability. However, if the company is the plaintiff, and it wins but the defendant will appeal, no asset will be recorded NHashim....UPM....30.9.2005

  37. ANTICIPATE LOSSES BUT NOT GAINS • In completing a long-term construction project, an anticipated loss is recorded even before the project is completed, but for an anticipated profit it is not • Accounting for R&D costs where expenses are to be charged to operating profit as incurred (except where future benefits are expected beyond reasonable doubt, to equal or exceed these costs) NHashim....UPM....30.9.2005

  38. RECOGNITION CRITERIA - EXAMPLES • Ability to measure the value of the asset • If the value cannot be determined without being arbitrary or subjective, than it will not be recorded as asset • This is the main reason for not recording human resources as asset or recording goodwill until after the purchased NHashim....UPM....30.9.2005

  39. SAC 4 • SAC 4 states that assets can be derecognized, • ONLY IF it no longer satisfies the definition of an asset, • Or it is no longer probable that the asset will deliver economic benefits to the entity, • Or the asset cannot be measured reliably NHashim....UPM....30.9.2005

  40. LIABILITIES SAC 4 DEFINITION: • Are the future sacrifices of economic benefits that the entity is PRESENTLY OBLIGED TO MAKE to other entities as a RESULT OF PAST TRANSACITONS OR OTHER PAST EVENTS NHashim....UPM....30.9.2005

  41. PRESENT OBLIGATIONS • Are obligations of a particular entity which necessitate the entity to transfer assets to other entities in the future, • AND are the result of past transactions NHashim....UPM....30.9.2005

  42. TYPES OF CLAIMS Liabilities are ‘specific claims’ on the assets of the entity; 2 types of claims: • Claims by creditors - Have prior claim on the assets in case of liquidation & their claims are almost always more specific than those of the owners with respect - Even dividends when declared becomes a liability (dividend payable) & are present obligations that must be met NHashim....UPM....30.9.2005

  43. TYPES OF CLAIMS • Claims by owners - Are residual claims or residual interest but not amounting an obligation to transfer assets NHashim....UPM....30.9.2005

  44. LEGAL ENFORCEABILITY • Must a legally enforceable claim exist before there is a liability? • Almost all liabilities are based legally enforceable obligations but some are based on equitable or constructive obligations NHashim....UPM....30.9.2005

  45. EQUITABLE OBLIGATION • Arises as a moral or social obligation • Example: • A firm decides to pay & clean-up work where it has polluted the area, but it is under no legal obligation to rectify the problem NHashim....UPM....30.9.2005

  46. CONSTRUCTIVE OBLIGATION - It is ‘created, inferred or construed from the facts in a particular situation’ so a liability does not arise as a result of legally enforceable claims NHashim....UPM....30.9.2005

  47. CONSTRUCTIVE OBLIGATIONS • In other cases, a company may settle in the same way, as a matter of its policy or procedure, as a legally binding contract • Example: When a firm refunds damaged goods, damages sustained by customers, paying periodic bonuses, when it is not legally obliged to do so • Allowing other than legally enforceable claims to be considered, allows judgment to be made about the existence of a liability NHashim....UPM....30.9.2005

  48. CONCLUSION • Inclusion of equitable & constructive obligations as liabilities became a matter of opinion & in practice will be applied inconsistently NHashim....UPM....30.9.2005

  49. SETTLEMENT OF LIABILITY • Any obligations will require the transfer of assets for it to be considered ‘settled’ • OR a debt may be settled in other ways than direct payment or rendering of services to the creditor • For example: The obligation may be forgiven by the creditor • This situation is referred to as the “set-off & extinguishments of debt” or “in-substance defeasance” NHashim....UPM....30.9.2005

  50. EXTINGUISHMENT OF DEBT • The debtor may removed the debt from the balance sheet if: • Risk-free assets have been transferred legally to an independent trustee whose trust is used to administer the assets for servicing the debt • The amount & type of assets suitable for servicing the debt, have been transferred to a trust. • The economic substance of the above transactions, is tantamount to extinguishing the debt NHashim....UPM....30.9.2005

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