Chapter 4—The elements of financial statements

Introduction

4.1

The elements of financial statements defined in the Conceptual Framework are:

(a)            assets, liabilities and equity, which relate to a reporting entity’s financial position; and

(b)            income and expenses, which relate to a reporting entity’s financial performance.

4.2

Those elements are linked to the economic resources, claims and changes in economic resources and claims discussed in Chapter 1, and are defined in Table 4.1.

Table 4.1—The elements of financial statements

 

Item discussed in Chapter 1

Element

Definition or description

Economic resource

Asset

A present economic resource controlled by the entity as a result of past events.

An economic resource is a right that has the potential to produce economic benefits.

Claim

Liability

A present obligation of the entity to transfer an economic resource as a result of past events.

Equity

The residual interest in the assets of the entity after deducting all its liabilities.

Changes in economic resources and claims, reflecting financial performance

Income

Increases in assets, or decreases in liabilities, that result in increases in equity, other than those relating to contributions from holders of equity claims.

Expenses

Decreases in assets, or increases in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity claims.

Other changes in economic resources and claims

Contributions from holders of equity claims, and distributions to them.

Exchanges of assets or liabilities that do not result in increases or decreases in equity.

4.5

This section discusses three aspects of those definitions:

(a)            right (see paragraphs 4.6–4.13);

(b)            potential to produce economic benefits (see paragraphs 4.14–4.18); and

(c)            control (see paragraphs 4.19–4.25).

Right

4.6

Rights that have the potential to produce economic benefits take many forms, including:

(a)            rights that correspond to an obligation of another party (see paragraph 4.39), for example:

(i)             rights to receive cash.

(ii)            rights to receive goods or services.

(iii)           rights to exchange economic resources with another party on favourable terms. Such rights include, for example, a forward contract to buy an economic resource on terms that are currently favourable or an option to buy an economic resource.

(iv)           rights to benefit from an obligation of another party to transfer an economic resource if a specified uncertain future event occurs (see paragraph 4.37).

(b)            rights that do not correspond to an obligation of another party, for example:

(i)             rights over physical objects, such as property, plant and equipment or inventories. Examples of such rights are a right to use a physical object or a right to benefit from the residual value of a leased object.

(ii)            rights to use intellectual property.

4.7

Many rights are established by contract, legislation or similar means. For example, an entity might obtain rights from owning or leasing a physical object, from owning a debt instrument or an equity instrument, or from owning a registered patent. However, an entity might also obtain rights in other ways, for example:

(a)            by acquiring or creating know-how that is not in the public domain (see paragraph 4.22); or

(b)            through an obligation of another party that arises because that other party has no practical ability to act in a manner inconsistent with its customary practices, published policies or specific statements (see paragraph 4.31).

4.9

Not all of an entity’s rights are assets of that entity—to be assets of the entity, the rights must both have the potential to produce for the entity economic benefits beyond the economic benefits available to all other parties (see paragraphs 4.14–4.18) and be controlled by the entity (see paragraphs 4.19–4.25). For example, rights available to all parties without significant cost—for instance, rights of access to public goods, such as public rights of way over land, or know-how that is in the public domain—are typically not assets for the entities that hold them.

4.10

An entity cannot have a right to obtain economic benefits from itself. Hence:

(a)            debt instruments or equity instruments issued by the entity and repurchased and held by it—for example, treasury shares—are not economic resources of that entity; and

(b)            if a reporting entity comprises more than one legal entity, debt instruments or equity instruments issued by one of those legal entities and held by another of those legal entities are not economic resources of the reporting entity.

4.11

In principle, each of an entity’s rights is a separate asset. However, for accounting purposes, related rights are often treated as a single unit of account that is a single asset (see paragraphs 4.48–4.55). For example, legal ownership of a physical object may give rise to several rights, including:

(a)            the right to use the object;

(b)            the right to sell rights over the object;

(c)            the right to pledge rights over the object; and

(d)            other rights not listed in (a)–(c).

4.13

In some cases, it is uncertain whether a right exists. For example, an entity and another party might dispute whether the entity has a right to receive an economic resource from that other party. Until that existence uncertainty is resolved—for example, by a court ruling—it is uncertain whether the entity has a right and, consequently, whether an asset exists. (Paragraph 5.14 discusses recognition of assets whose existence is uncertain.)

4.15

A right can meet the definition of an economic resource, and hence can be an asset, even if the probability that it will produce economic benefits is low. Nevertheless, that low probability might affect decisions about what information to provide about the asset and how to provide that information, including decisions about whether the asset is recognised (see paragraphs 5.15–5.17) and how it is measured.

4.16

An economic resource could produce economic benefits for an entity by entitling or enabling it to do, for example, one or more of the following:

(a)            receive contractual cash flows or another economic resource;

(b)            exchange economic resources with another party on favourable terms;

(c)            produce cash inflows or avoid cash outflows by, for example:

(i)             using the economic resource either individually or in combination with other economic resources to produce goods or provide services;

(ii)            using the economic resource to enhance the value of other economic resources; or

(iii)           leasing the economic resource to another party;

(d)            receive cash or other economic resources by selling the economic resource; or

(e)            extinguish liabilities by transferring the economic resource.

4.27

For a liability to exist, three criteria must all be satisfied:

(a)            the entity has an obligation (see paragraphs 4.28–4.35);

(b)            the obligation is to transfer an economic resource (see paragraphs 4.36–4.41); and

(c)            the obligation is a present obligation that exists as a result of past events (see paragraphs 4.42–4.47).

4.31

Many obligations are established by contract, legislation or similar means and are legally enforceable by the party (or parties) to whom they are owed. Obligations can also arise, however, from an entity’s customary practices, published policies or specific statements if the entity has no practical ability to act in a manner inconsistent with those practices, policies or statements. The obligation that arises in such situations is sometimes referred to as a ‘constructive obligation’

4.35

In some cases, it is uncertain whether an obligation exists. For example, if another party is seeking compensation for an entity’s alleged act of wrongdoing, it might be uncertain whether the act occurred, whether the entity committed it or how the law applies. Until that existence uncertainty is resolved—for example, by a court ruling—it is uncertain whether the entity has an obligation to the party seeking compensation and, consequently, whether a liability exists. (Paragraph 5.14 discusses recognition of liabilities whose existence is uncertain.)

4.38

An obligation can meet the definition of a liability even if the probability of a transfer of an economic resource is low. Nevertheless, that low probability might affect decisions about what information to provide about the liability and how to provide that information, including decisions about whether the liability is recognised (see paragraphs 5.15–5.17) and how it is measured.

4.39

Obligations to transfer an economic resource include, for example:

(a)            obligations to pay cash.

(b)            obligations to deliver goods or provide services.

(c)            obligations to exchange economic resources with another party on unfavourable terms. Such obligations include, for example, a forward contract to sell an economic resource on terms that are currently unfavourable or an option that entitles another party to buy an economic resource from the entity.

(d)            obligations to transfer an economic resource if a specified uncertain future event occurs.

(e)            obligations to issue a financial instrument if that financial instrument will oblige the entity to transfer an economic resource.

4.40

Instead of fulfilling an obligation to transfer an economic resource to the party that has a right to receive that resource, entities sometimes decide to, for example:

(a)            settle the obligation by negotiating a release from the obligation;

(b)            transfer the obligation to a third party; or

(c)           replace that obligation to transfer an economic resource with another obligation by entering into a new transaction.

4.41

In the situations described in paragraph 4.40, an entity has the obligation to transfer an economic resource until it has settled, transferred or replaced that obligation.

4.45

If new legislation is enacted, a present obligation arises only when, as a consequence of obtaining economic benefits or taking an action to which that legislation applies, an entity will or may have to transfer an economic resource that it would not otherwise have had to transfer. The enactment of legislation is not in itself sufficient to give an entity a present obligation. Similarly, an entity’s customary practice, published policy or specific statement of the type mentioned in paragraph 4.31 gives rise to a present obligation only when, as a consequence of obtaining economic benefits, or taking an action, to which that practice, policy or statement applies, the entity will or may have to transfer an economic resource that it would not otherwise have had to transfer.

4.47

An entity does not yet have a present obligation to transfer an economic resource if it has not yet satisfied the criteria in paragraph 4.43, that is, if it has not yet obtained economic benefits, or taken an action, that would or could require the entity to transfer an economic resource that it would not otherwise have had to transfer. For example, if an entity has entered into a contract to pay an employee a salary in exchange for receiving the employee’s services, the entity does not have a present obligation to pay the salary until it has received the employee’s services. Before then the contract is executory—the entity has a combined right and obligation to exchange future salary for future employee services (see paragraphs 4.56–4.58).

Assets and liabilities

4.50

If an entity transfers part of an asset or part of a liability, the unit of account may change at that time, so that the transferred component and the retained component become separate units of account (see paragraphs 5.26–5.33).

4.51

A unit of account is selected to provide useful information, which implies that:

(a)            the information provided about the asset or liability and about any related income and expenses must be relevant. Treating a group of rights and obligations as a single unit of account may provide more relevant information than treating each right or obligation as a separate unit of account if, for example, those rights and obligations:

(i)             cannot be or are unlikely to be the subject of separate transactions;

(ii)            cannot or are unlikely to expire in different patterns;

(iii)           have similar economic characteristics and risks and hence are likely to have similar implications for the prospects for future net cash inflows to the entity or net cash outflows from the entity; or

(iv)           are used together in the business activities conducted by an entity to produce cash flows and are measured by reference to estimates of their interdependent future cash flows.

(b)            the information provided about the asset or liability and about any related income and expenses must faithfully represent the substance of the transaction or other event from which they have arisen. Therefore, it may be necessary to treat rights or obligations arising from different sources as a single unit of account, or to separate the rights or obligations arising from a single source (see paragraph 4.62). Equally, to provide a faithful representation of unrelated rights and obligations, it may be necessary to recognise and measure them separately.

4.53

Sometimes, both rights and obligations arise from the same source. For example, some contracts establish both rights and obligations for each of the parties. If those rights and obligations are interdependent and cannot be separated, they constitute a single inseparable asset or liability and hence form a single unit of account. For example, this is the case with executory contracts (see paragraph 4.57). Conversely, if rights are separable from obligations, it may sometimes be appropriate to group the rights separately from the obligations, resulting in the identification of one or more separate assets and liabilities. In other cases, it may be more appropriate to group separable rights and obligations in a single unit of account treating them as a single asset or a single liability.

4.54

Treating a set of rights and obligations as a single unit of account differs from offsetting assets and liabilities (see paragraph 7.10).

4.55

Possible units of account include:

(a)            an individual right or individual obligation;

(b)            all rights, all obligations, or all rights and all obligations, arising from a single source, for example, a contract;

(c)            a subgroup of those rights and/or obligations—for example, a subgroup of rights over an item of property, plant and equipment for which the useful life and pattern of consumption differ from those of the other rights over that item;

(d)            a group of rights and/or obligations arising from a portfolio of similar items;

(e)            a group of rights and/or obligations arising from a portfolio of dissimilar items—for example, a portfolio of assets and liabilities to be disposed of in a single transaction; and

(f)           a risk exposure within a portfolio of items—if a portfolio of items is subject to a common risk, some aspects of the accounting for that portfolio could focus on the aggregate exposure to that risk within the portfolio.

Substance of contractual rights and contractual obligations

4.59

The terms of a contract create rights and obligations for an entity that is a party to that contract. To represent those rights and obligations faithfully, financial statements report their substance (see paragraph 2.12). In some cases, the substance of the rights and obligations is clear from the legal form of the contract. In other cases, the terms of the contract or a group or series of contracts require analysis to identify the substance of the rights and obligations.

4.61

Terms that have no substance are disregarded. A term has no substance if it has no discernible effect on the economics of the contract. Terms that have no substance could include, for example:

(a)            terms that bind neither party; or

(b)            rights, including options, that the holder will not have the practical ability to exercise in any circumstances.

4.62

A group or series of contracts may achieve or be designed to achieve an overall commercial effect. To report the substance of such contracts, it may be necessary to treat rights and obligations arising from that group or series of contracts as a single unit of account. For example, if the rights or obligations in one contract merely nullify all the rights or obligations in another contract entered into at the same time with the same counterparty, the combined effect is that the two contracts create no rights or obligations. Conversely, if a single contract creates two or more sets of rights or obligations that could have been created through two or more separate contracts, an entity may need to account for each set as if it arose from separate contracts in order to faithfully represent the rights and obligations (see paragraphs 4.48–4.55).

4.65

Different classes of equity claims, such as ordinary shares and preference shares, may confer on their holders different rights, for example, rights to receive some or all of the following from the entity:

(a)            dividends, if the entity decides to pay dividends to eligible holders;

(b)            the proceeds from satisfying the equity claims, either in full on liquidation, or in part at other times; or

(c)            other equity claims.

4.67

Business activities are often undertaken by entities such as sole proprietorships, partnerships, trusts or various types of government business undertakings. The legal and regulatory frameworks for such entities are often different from frameworks that apply to corporate entities. For example, there may be few, if any, restrictions on the distribution to holders of equity claims against such entities. Nevertheless, the definition of equity in paragraph 4.63 of the Conceptual Framework applies to all reporting entities.

4.72

Different transactions and other events generate income and expenses with different characteristics. Providing information separately about income and expenses with different characteristics can help users of financial statements to understand the entity’s financial performance (see paragraphs 7.14–7.19).