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
2
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
3
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
4
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
5
Entity theory
• Inadequacies in proprietary theory led to the
entity theory
• Formulated to address separate legal status of
company
6
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
7
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
8
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
9
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
10
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
11
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
12
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
13
Liability recognition
Recognition criteria:
• Reliance on the law
– legal enforceability
• Determination of the economic substance of
the event
– ‘real’ obligation
14
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
15
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
16
IASB Framework
• What does probable mean?
• What is meant by reliable measurement?
17
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
18
Employee benefits – pension
(superannuation) plans
• Unfunded commitments
– equitable obligations
19
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
20
What impact will the credit crisis have on the
provision for bad debts and the financial
position of an entity?
21
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
22
Owners’ equity
Essential features
• Rights of the parties
• Economic substance of the arrangement
23
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
24
Classifications within owners’
equity
• The distinction between contributed and
earned capital is useful
– retained earnings
– not all transactions fit nicely into categories
• share dividends
25
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)
26
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
27
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
28
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
29
30