1. GODFREY HODGSON HOLMES TARCA
CHAPTER 8
LIABILITIES AND OWNERS’ EQUITY

2. 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

3. 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

4. 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

5. 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

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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

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

15. 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

16. 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

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

18. 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

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

20. 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

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

22. 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

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

24. 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

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

26. 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)

27. 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

28. 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

29. 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