In this article, we take a look at the elements of financial statements, in particular, the assets, liabilities and equity which are used to report the financial position of an entity.
An asset is defined as:
- a resource controlled by the entity;
- as a result of past events; and
- from which future economic benefits are expected to flow to the entity.
Let’s look closely at this definition.
When we say an asset is a resource controlled by the entity, we mean the entity has the ability to obtain economic benefits from the asset, or restrict others from getting economic benefits from the asset.
Many assets have a physical form, so you can see and hold them but there are also intangible assets such as trademarks and patents which have no physical form.
The result of past events means that assets are only created when the event to control them actually takes place.
An intention or plan to purchase an asset should not result in the recording of the asset on the financial statements.
It’s a bit like if you plan to buy a car, you pick out the one you’d like to buy, but you don’t tell the car dealer, and you don’t pay them. If you drive that car home, you’ll be convicted of stealing. It’s not your asset. Just because you intend to buy the car doesn’t mean it’s actually your asset.
When we say there will be expected future economic benefits from an asset, we mean the asset will contribute either directly or indirectly to the flow of cash and cash equivalents to the entity.
An asset should be expected to provide future economic benefits to the entity. If it will actually cost the entity money, it should be recorded as a liability.
An asset is only recognised in the statement of financial position when it is probable that the future economic benefits will flow to the entity and the asset has a cost or value that can be measured reliably.
If the economic benefits will not flow beyond the current accounting period, the amount paid in respect of this transaction should be recorded as an expense in the statement of comprehensive income.
Now let’s look at liabilities. A liability is defined as:
- a present obligation of an entity
- arising from past events
- the settlement of which is expected to result in an outflow of resources that embody economic benefits.
When we say a liability is a present obligation, we mean an obligation that already exists.
This usually means a legally enforceable right exists, such as a signed contract or a piece of legislation.
But sometimes good business practice means the entity will pay for this obligation, like when a company repairs products for customers outside the warranty period. They’ll do it to keep their customers happy even though they might not be legally obliged.
A past transaction or event means the event causing the liability has occurred, such as a contract to buy services, or perhaps a customer has bought your product, resulting in a warranty obligation.
If the event hasn’t occurred, so if the entity only intends to enter into an agreement at a later date, the liability should not be recognised.
Future outflow of economic resources
The settlement of a liability should result in an outflow of resources that embody economic benefits. This usually involves the payment of cash or cash equivalents.
It could also involve the transfer of other assets. A liability is measured by the value of these resources that will be paid or transferred.
Some liabilities can be measured only using a substantial amount of estimation. These are called provisions.
In practice, obligations under contracts that are unperformed (for example, liabilities for inventory ordered but not yet received) are generally not recognised as liabilities in the financial statements.
However, depending on the circumstances involved, these obligations may meet the definition of liabilities and, provided the recognition criteria are met in the particular circumstances, may qualify for recognition.
In situations like this, the recognition of a liability requires recognition of a related asset or expense.
Equity is the remaining interest in an entity, after all its liabilities have been deducted from the value of its assets.
It’s purely a ‘balance sheet valuation’ of the entity’s net assets and it not representative of the entity’s market value.
In the financial reports of an entity, equity will be broken down into share capital, share premium account and retained earnings.