Chapter Organization
2.4 The Conceptual Framework
2.4.3 Elements of Financial Statements
2.4. The Conceptual Framework 17
of producing benefits beyond those available to other parties. An artistic work that is legally available in the public domain cannot be considered an asset to an entity, since other parties can also equally access the work.
Many assets have a tangible, or physical, form. However, some assets, such as accounts receivable or a patent, have no physical form. In the case of an account receivable from a customer, the future benefit results from the legal right the company holds to enforce payment.
For a patent, the future benefit results from the company’s ability to sell its product while maintaining some protection from competitors. Cash in a bank account does not have physical form, but it can be used as a medium of exchange.
It should also be noted that, although we can generally think of assets as something we own, the actual legal title to the resource does not necessarily need to belong to the company for it to be considered an asset. A contract, such as a long-term lease that conveys benefits to the leasing party over a significant portion of the asset’s useful life may be considered an asset in certain circumstances.
Liabilities
A liability is defined as “a present obligation of the entity to transfer an economic resource as a result of past events.” (CPA Canada, 2019, 4.26). This definition can be visualized through a time-continuum graphic:
EVENT
Past Present OBLIGATION Future TRANSFER
When we prepare a balance sheet, it represents the present moment, so the obligation gets reported as a liability. This obligation is often a legal obligation, as in the case when goods are purchased on account, resulting in an accounts payable entry, or when money is borrowed from a bank, resulting in a loan payable. As well, this legal obligation can exist even in the absence of a formal contract. A company still has to report wages payable for any work performed by an employee but not yet paid, even if that work was performed under the terms of an informal, casual labour agreement.
Liabilities can also result from common business practice or custom, even if there is no legally enforceable amount. If a retailer of mobile telephones agrees to replace one broken screen per customer, then the expected cost of these replacements should be reported as a liability, even if the damage resulted from the customer’s neglect and there is no legal obligation to pay.
This type of liability is referred to as a constructive obligation. As well, companies may record
liabilities based on equitable principles. If a company significantly reduces its workforce, it may feel a moral obligation to provide career transition counselling to its laid-off employees, even though there is no legal obligation to do so. In general, an obligation is considered a duty or responsibility that an entity has no practical ability to avoid.
The settlement of the liability usually involves the future transfer of cash, but it can also be settled by transferring other assets. As well, liabilities are sometimes settled through the provision of services in the future. A health club that requires its members to pay for one year’s fees in advance has an obligation to make the facilities available to its members for that time. Less common ways to settle liabilities include replacing the liability with a new liability and converting the liability into equity of the business. It should be noted that the determination of the value of the liability to be recorded sometimes requires significant judgment. An example of this would be the obligation under a pension plan to make future payments to retirees. We will discuss this estimation problem in more detail in later chapters dealing with liabilities.
Equity
Equity is the owners’ residual interest in the business, representing the remaining amount of assets available after all liabilities have been settled. Although equity can be thought of as a balancing figure, it is usually subdivided into various categories when presented on the balance sheet. Many of these classifications are related to legal requirements regarding the ownership interest. The usual categories of equity include share capital, which can include common and preferred shares, retained earnings, and accumulated other comprehensive income (IFRS only). However, other types of equity can arise on certain types of transactions, such as contributed surplus, appropriated retained earnings, and other reserves that may be allowed under local law. The purpose of all these subcategories of equity is to give readers enough information to understand how and when the owners may be able to receive a distribution of their interests. For example, restrictions on retained earnings or levels of preferences on shares issued may constrain the future payment of dividends to common shareholders. A potential investor would want to know this before investing in the company.
It should also be noted that the company’s reported equity does not represent its value, either in a real sense or in the market. The prices that shares trade at in the stock market represent the cumulative decisions of investors, based on all information that is available. Although financial statements form part of this total pool of information, there are so many other factors used by investors to value a company that it is unlikely that the market value of a company would equal the reported amount of equity on the balance sheet.
Income
Income is defined as “increases in assets, or decreases in liabilities, that result in increases in equity, other than those relating to contributions from holders of equity claims.” (CPA Canada, 2019, 4.68). Notice that the definition is based on presence of changes in assets or liabilities, rather than on the concept of something being earned. This represents the balance sheet approach used in the conceptual framework, which considers any measure
2.4. The Conceptual Framework 19
of performance, such as profit, to simply be a representation of the change in balance sheet amounts. This perspective is quite different from some historical views adopted previously in various jurisdictions, which viewed the primary purpose of accounting to be the measurement of profit (an income-statement approach).
Income can include both revenues and gains. Revenues arise in the course of the normal activities of the business; gains arise from either the disposal of noncurrent assets (realized gains) or the revaluation of noncurrent assets (unrealized gains). Unrealized gains on certain types of assets are usually included in other comprehensive income, a concept that will be discussed in later chapters.
Expenses
Expenses are defined as “decreases in assets, or increases in liabilities, that result in de-creases in equity, other than those relating to distributions to holders of equity claims.” (CPA Canada, 2019, 4.69). Note that this definition is really just the inverse of the definition of income. Similarly, expenses can include those that are incurred in the regular operation of the business and those that result from losses. Again, losses can be either realized or unrealized, and the definition is the same it was for gains.