Liabilities and Owners EquitySession 7

Course : F0812 – Accounting TheoryYear : February 2011

GODFREYHODGSON

HOLMESTARCA

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

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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

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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

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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

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Entity theory

• Inadequacies in proprietary theory led to the entity theory

• Formulated to address separate legal status of company

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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

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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

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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

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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

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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

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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 obligations14

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

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Liability recognition

Recognition criteria:

• Reliance on the law– legal enforceability

• Determination of the economic substance of the event– ‘real’ obligation

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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

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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

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IASB Framework

• What does probable mean?• What is meant by reliable measurement?

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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

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

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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

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What impact will the credit crisis have on the provision for bad debts and the financial

position of an entity?

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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

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Owners’ equity

Essential features• Rights of the parties• Economic substance of the arrangement

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Concept of capital

• Influenced by legal prescriptions– 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

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Classifications within owners’ equity

• The distinction between contributed and earned capital is useful– retained earnings– not all transactions fit nicely into categories• share dividends

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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)

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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

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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

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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

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