GODFREY HODGSON HOLMES TARCA CHAPTER 8 LIABILITIES AND OWNERS’ EQUITY

Proprietary and entity theory Proprietary theory is based on the idea that the owner is the centre of attention accounting is done with the owners’ interests in mind Entity theory focuses on the firm as the centre of attention

Proprietary theory Proprietorship = net worth of owners = capital P = A – L The objective of accounting is to determine the net worth of the owners Profit is the increase in net worth includes operating profit includes changes in the values of assets

Proprietary theory Present accounting is largely based on this theory dividends salaries equity accounting consolidation accounting Has a financial view of capital emphasis on the financial investment of the owners and changes in owners’ wealth

Proprietary theory With the advent of the company the theory has proved inadequate as a basis for explaining company accounting developed when businesses were smaller a company is separate from its owners a company is a legal entity in its own right shareholders rely on managers for information no longer so relevant

Entity theory Inadequacies in proprietary theory led to the entity theory Formulated to address separate legal status of company

Entity theory The company is viewed as a separate entity with its own identity separation of owners and managers accounting views the entity as an operating unit accounting principles and procedures not formulated in terms of an ownership interest can also be applied in proprietorships, partnerships and not-for-profit organisations

Entity theory The objective of accounting may be either stewardship or accountability entity seen as being in business for itself interested in its own survival sees owners as outsiders reports to owners to meet legal requirements and maintain good relationships with them

Entity theory Focuses on the assets Assets are resources controlled by the entity Liabilities are obligations of the entity Profit increases net assets and accrues to the entity The owners only have a residual claim on the net assets of the entity

Entity theory Both proprietary and entity theories are still influential in practice entity theory conventional accounting theory based on it financial reports reflect it proprietary theory interest charges are an expense dividends are a distribution of profit

Liabilities defined IASB Framework definition of liabilities: A present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits

Present obligation The actual sacrifices are yet to be made Obligation is already present Planned obligation included if to an external party Legal enforceability Settlement of liability in various ways Equitable and constructive obligations

Past transaction A past transaction (or event) ensures that only present liabilities are recorded and not future ones What kind of past transaction or event is acceptable? wholly executory contracts

Liability recognition Recognition criteria: Reliance on the law legal enforceability Determination of the economic substance of the event ‘real’ obligation

Liability recognition Recognition criteria: Ability to measure the value of the liability normally the nominal amount if period longer than 12-months, based on the present value of expected future cash flows Use of the conservatism principle at what point is the entity too conservative

IASB Framework A liability should be recognised if it is probable that any future economic benefit associated with the items will flow to or from the entity; and the item has a cost or value that can be measured with reliability

IASB Framework What does probable mean? What is meant by reliable measurement?

Liability measurement The Framework provides little guidance about how to measure liabilities A number of different measurement bases may be used Under IFRS, historical cost is the most common Fair value measurement is more commonly being used leases financial instruments share based payments business combinations

Employee benefits – pension (superannuation) plans Unfunded commitments equitable obligations

Provisions and contingencies Provisions and contingencies occur where there is a blurring between present and future obligations Liabilities and provisions are recognised only when there is a present obligation, it is probable and it can be reliably measured Contingent liabilities do not meet these criteria notes

What impact will the credit crisis have on the provision for bad debts and the financial position of an entity?

Owners’ equity Framework defines equity as the residual interest in the assets of the entity after deduction of its liabilities Owners’ equity is a residual claim

Owners’ equity Essential features Rights of the parties Economic substance of the arrangement

Concept of capital Influenced by legal prescriptions Financial capital capital maintenance Financial capital invested money or invested purchasing power Physical capital the productive capacity of the entity Capital can be measured on either a nominal dollar or purchasing power (‘real’) scale

Classifications within owners’ equity The distinction between contributed and earned capital is useful retained earnings not all transactions fit nicely into categories share dividends

Challenges for standard setters IASB has several projects which will affect the definition, recognition and measurement of liabilities debt versus equity distinction extinguishing debt employee shares (share-based payment)

Issues for auditors The completeness of liabilities recognised on the balance sheet and the note disclosures about contingencies and other obligations are major issues for auditors evidence, timing, cut off concealment and understatement going concern overstatement - provisions reasonableness of fair values

Summary There two competing theories that help explain accounting practice - proprietary and entity theories There are definitions for both liabilities and equity There are recognition criteria for both liabilities and equity There are various measurement practices used in relation to liabilities and equity There are challenging issues for standard setters and auditors

Key terms and concepts Liabilities Owners’ equity Proprietary theory Entity theory Definitions Recognition criteria – probable, reliable Present obligation Past transaction Measurement and fair value Provisions and contingencies Rights of the parties Economic substance Concept of capital Debt versus equity, extinguishing debt and employee shares Issues for auditors