Lecture 4: Elements Definitions and Recognition Criteria
This section is the most important part out of the framework discussions. Here we’re going to look at the definitions of elements: assets, liabilities, equity, income and expenses, as well as when you can recognise them; put them into the financial statements. Then we’re going to look at recognition criteria, so let's get going.
First up, what are financial statements? Just remember that there is the difference between recognition versus disclosure. I'm going to address that in a second, once I explain what's in a financial statement. So the financial statements, first and foremost, have the statement of financial position. You've often heard this referred to as a balance sheet, that's the old name. Then there is a statement of profit or loss and other comprehensive income, this we used to talk about an income statement. Then there’s a statement of changes in equity, a statement of cash flows, and last but definitely not least, there are the notes to the financial statements.
Now when I say recognition, I'll go and I actually pass an accounting journal. I put my figures into the Pastel bookkeeping system, and it comes out in these statements of financial position, profit and loss, equity, as well as cash flows. When I'm talking disclosure, it is not recognised in any of those statements; it's only in the notes. Please understand the difference between recognition in the balance sheet or in the financial position, and profit and loss. If it's disclosure, it's only in the notes, and the notes are there to just to describe and add on to the actual statements of financial position, etc.
What's important to understand is we've got two concepts here within accounting.
and financial performance.
Financial position is what we call a wealth concept. So, if I look at it, I've got a pile of cash hiding in the bank. That pile of cash has been accumulated since the day I was born, and it's built year after year to give me a total amount today, so it is cumulative. What's very important is this is going to link to the statement of financial position obviously, and you will see that we always talk about, in the heading, ABC Limited Pty (financial position at a specific date). So there's no beginning date, the beginning date was when the company was incorporated. And it's everything; all the assets and liabilities up until that reporting date.
That is quite different to financial performance. Financial performance is an income concept. It's done over a period. So it’s done for a fixed period, and our statement of profit and loss and other comprehensive income must illustrate that. It will say profit or loss for the period ending. So here we will have a beginning and end, and it's for that period. Whereas the financial position wealth concept is from the beginning of time for that company all the way up to a specific date.
Now it's important to understand this because when we talk about elements, we are going to split the elements. We are going to split the “what” in the financial statements into both of these - financial position elements, as well as financial performance elements. Now, the financial position elements are going to be assets, liabilities and equity.
When I’m talking about assets, I want you to think about ‘benefits’. Cash brings benefits - if I have a debtor, if someone owes me money, that’s a benefit. They’re going to give me cash. If I have a machine that I’m using to manufacture stock, well that’s a benefit, because the stock will come out, get sold and turned into cash.
Liabilities are what we will think of as ‘obligations’. These aren't the pure definitions yet, but it's a starting point. Obligation is when we owe someone something. We must perform in a certain way. Remember obligations require settlement. It’s not quite as simple, but you must think about debt, you always must pay your debts.
Equity is quite an easy definition - we call it the residual interest, which is just assets minus liabilities.
Remember your accounting equation for a second. Your accounting equation was:
Assets = Owner's Equity + Liabilities.
Now we define each of those - assets, equity and liability - all in terms of that accounting equation as you learned in FAC1502.
On the financial performance side, remember this is done over a period, we are going to have income and expenses. And for both of these, when they accumulate, they accumulate into equity. So every year, for that period, we have a financial performance. Income minus expenses becomes part of profit; profit then goes to retained earnings; which is equity. So they fit together guys, everything in accounting is a piece of a puzzle.
How do I define income then? Well, along with an income, either there's going to be an increase in an asset or a decrease in a liability.
There's one scenario where that happens where it's not income. It’s where people or companies issue shares, then there's a direct transaction with a shareholder. That's not income, that's equity by itself.
Expenses are the other way around. When I pay out cash to pay salaries, well then the asset of cash or bank goes down. Or maybe I have to borrow money to make the payment; then there would be an increase in my liability.
All this does is provide definitions, the framework provides definitions, for each of these different elements. Then, the framework will go on to tell you when can you put those elements into the financial statements, and that will be once the definition is met, but then there are also two recognition criteria. We will deal with that once we finish with definitions properly.
So I've given you a very basic concept of definitions; being benefits, obligations, residual, and the income and expenses. But what I need to now do, is give you the formal definitions. You need to learn these. You will use these in second year, third year, honours, masters and the rest of your life if you are staying in accounting.
So let's start:
Let’s start with assets. Assets are a resource controlled by an entity; resulting from past events; with the expected inflow of future economic benefits. So that’s very important to understand. Let’s quickly discuss that.
What’s a resource? A resource is any benefits or gains we’re going to make, possibly in the future. It is important that they need to be controlled by us. So if I’ve got a river that runs past my farm, is that a resource? Yes, because I can pull the water out, I can irrigate my farm to grow crops, which I will then sell to make a profit. But, do I control that river? No, I don’t. What do I mean by control? Can I restrict others from accessing that resource? With a river, I can’t, so it’s not controlled by me. Therefore it’s definitely not meeting the definition of an asset.
The next thing that’s very important is that the resource must’ve arisen because of a past event. Usually, it’s a contract or some type of agreement that gives rise to that past event. But it can’t be – I’m going to sign a contract in the future to manufacture a train for Transnet and therefore receive money. That’s a future contract, it hasn’t happened yet, so I can’t recognise it as an asset.
And the last thing, there must be a future inflow of economic benefits expected. So, I’ve gone to Transnet, I’ve agreed to sign a contract, and I have actually signed the contract, which makes me able to manufacture a train for Transnet. For the manufacture of that train, I’m going to receive money in the future. That’s a future benefit.
What do I have? I have a future benefit from a past event from which a resource has arisen that I control.
A liability is a present obligation resulting from a past event and has an expected outflow of economic resources to settle. So, where this is different to an asset - First of all, an asset is all about future economic benefit, where a liability is all about future outflows.
Liability is an obligation, but it must be a present obligation, which means it must’ve been a past event. So, along with the contract that you signed, you have an obligation to behave in a certain way. So, if I’ve taken a loan from the bank, as soon as I sign that contract and get the money from the bank into my account, I have an obligation to pay it back. What is the past event? Well, that is me signing the contract and taking the money from the bank. Quite simple, right?
In the future, I will have to settle that with an outflow of future benefits.
I want you to think of equity in terms of your accounting equation – Assets minus Liabilities. That comes from your original accounting equation which is Assets = Equities + Liabilities. If I reshuffle that, I get my Equity = Assets – Liabilities.
Income, as I said, is either an increase in assets or a decrease in liabilities, other than contributions by equity participants (shareholders). So if it’s a transaction directly with a shareholder – I issue a shareholder shares; I receive money; my assets go up. But that’s not income; it’s specifically excluded.
Expenses are an increase in liabilities or a decrease in assets, other than transactions with shareholders. So, if I pay a dividend to a shareholder, that’s not an expense, that’s just a decrease in equity.
So, definitions you must learn, and you must know off by heart. What I need you to understand is our accounting and IFRS prioritises assets. So if I look at a journal and I go debit asset, let’s say I purchased an asset on credit. I purchased the asset nice and easy.
I first look at the definition and then I look at the recognition criteria, which I'm going to do with you next. If I say yes, I'll put the asset in. If I had to go and say it does not meet the definition, then this is probably not an asset it is probably an expense.
First, try and define the asset or liability. If the debit that you wanted, or you thought was an asset doesn't meet the definition or recognition criteria, then you need to think what else could it ever be. It might be an expense, but how do we define an expense? An expense is a decrease in an asset or increase in liability. Therefore, the other side here is an increase in the liability or a decrease in an asset.
Now, these recognition criteria. This is answering when can I recognise that element. First, it must meet the definition, if it doesn't meet the definition of an asset or liability etc. you cannot put it into the statement of financial position or any of the other statements. If it does meet their definition, you will look at the two recognition criteria.
First of all, it is probable, and probable here means more likely than not. Slightly different for assets and liabilities but a future problem we'll discuss. However, I need the probability, so at least greater than 50%, that the cash in the future or the benefits in the future will either flow to my business or out of my business. If it’s flowing to my business, I'm talking assets. If it’s flowing out of my business, I'm talking liability. That element must also have a cost or value that can be measured with some reliability. We know there's estimation here, but I must be able to make a reliable estimate of any cost or value attached to an asset, liability etc.
We looked at the elements definitions and recognition criteria in detail. You MUST learn these. I need you to be able to list all of those, learn them off by heart and make sure you can write them down at two o'clock in the morning, as well as the two recognition criteria right at the bottom. If you don't know those, you will not succeed in accounting, go and learn them now.