Recognition and measurement of the elements of financial statements

Transcription

1 Chapter 8 Recogitio ad measuremet of the elemets of fiacial statemets Cotets 8.1 Itroductio Primacy of defiitios Hierarchy of decisios The first stage Recogitio Measuremet Icome recogitio 157 Summary 160 Refereces ad research 161 Exercises 161 Objectives After studyig the chapter carefully, you should be able to: explai the effects of the primacy of the defiitio of asset for the divisio of paymets ito assets ad expeses; show the implicatios of the defiitio of liability for recogitio of liabilities; illustrate whe a asset should be recogized i a balace sheet; explai the mai issues cocerig the iitial ad subsequet measuremet of assets ad liabilities; outlie the mai possible alteratives to historical cost measuremet; outlie the mai priciples for recogitio of icome. 145

2 Chapter 8 Recogitio ad measuremet of the elemets of fiacial statemets 8.1 Itroductio Part 2 of this book deals with recogitio, measuremet ad presetatio of the elemets of fiacial statemets: assets, liabilities, equity, reveues, expeses ad cash flows. As i the rest of this book, the geeral cotext of the discussio is the stadards of the IASB, with some referece to the regulatios of particular coutries ad the practices of particular compaies. This chapter deals with some basic recogitio ad measuremet issues. To take assets as the prelimiary example, there are two basic issues: As poited out i Sectio 2.4 of this book, it is helpful to establish a primacy of defiitios based o either: assets ad liabilities; or expeses ad icome. The, assumig a primacy of assets ad liabilities, ad focusig to start with o assets, there is a hierarchy of decisios: Is the item a asset? If yes, should the asset be recogized i the balace sheet? If agai yes, how should it be measured? These matters are itroduced i this chapter ad take further for various types of assets ad liabilities i Chapters Icome recogitio is also outlied at the ed of this chapter. The presetatio of cash flow statemets is examied i Chapter Primacy of defiitios The eed to establish which defiitios have primacy is examied first i the cotext of assets ad expeses. Whe cosiderig paymets related to assets, decisios are frequetly ecessary about whether such paymets should be added to the asset or should be treated as a expese. Examples of such paymets are those for: repairs; decoratig or redecoratig; extesios; improvemets; replacemets of parts; future ievitable paymets for dismatlig, decommissioig or cleaig up. All these items are applicatios of resources i terms of the discussio of Chapter 2. They are all recorded as debits i the double-etry system. Those costs that do ot geerate assets (ad are ot added to existig assets) are expeses. Figure 8.1 presets this i diagrammatic form. To summarize Chapter 2 o this issue, accoutig ca work o oe of two bases: Method 1 Expeses of 20X1 are the costs of ay period that relate to 20X1; ad therefore... Assets at the ed of 20X1 are ay remaiig costs. 146

3 Figure 8.1 The relatioship of paymets, assets ad expeses 8.2 Primacy of defiitios Method 2 Assets at the ed of 20X1 are resources cotrolled by the etity that are expected to give beefits; ad therefore... Expeses of 20X1 are ay remaiig costs. The IASB Framework gives primacy to the secod way of defiig the elemets, by startig with a asset defied as follows (paragraph 49): a resource cotrolled by the etity as a result of past evets ad from which future ecoomic beefits are expected to flow to the etity. This has the effect of reducig the importace of the matchig cocept, as discussed i Sectio If a expese is postpoed i order to match it agaist a future reveue, it would have to be stored i the balace sheet as a asset. However, this is ot allowed uder IFRS uless the amout meets the defiitio of a asset. This restrictio o the items to be show as assets does ot come from a desire to be prudet but from a desire to comply with a coheret framework. The IASB gives similar importace to the defiitio of liability as it does to asset. As oted i Chapter 2 (Framework, paragraph 49): a liability is a preset obligatio of the etity arisig from past evets, the settlemet of which is expected to result i a outflow from the etity of resources... A obligatio is a uavoidable requiremet to trasfer resources to a third party. May liabilities are clear legal obligatios of exact amouts, such as accouts payable or loas from the bak. Some liabilities are of ucertai timig or amout. These are called provisios (but see Chapter 11 for more discussio of the usage of this word). Depedig o the ature of legal cotracts, some of these provisios are also legally eforceable, such as provisios to pay pesios to retired employees or to repair machiery sold to customers that breaks dow soo after sale. Some obligatios are ot based o precise laws or legal cotracts but would probably be eforced by a court of law based o ormal busiess practices or, at least, the etity would suffer so much commercial damage if it did ot settle the obligatio that it caot reasoably avoid settlig it. However, outside of IFRS requiremets, some compaies might make provisios whe there is o obligatio. Let us take the example of provisios for repair expeses. The double etry for the creatio of the liability is a expese. At a year ed, it has bee traditioal Germa practice to charge the expected repair expeses of the first three moths of the followig year. This has a tax advatage i Germay because a (tax-deductible) expese ca thereby be charged earlier. The large 147

4 Chapter 8 Recogitio ad measuremet of the elemets of fiacial statemets Germa chemical compay BASF provided a example (Aual Report of paret compay, 2008): Maiteace provisios are established to cover omitted maiteace procedures as of the ed of the year, ad are expected to be icurred withi the first three moths of the followig year. The double etry for a repair provisio would be as follows, at the ed of 20X1: Debit: Credit: Repair expese of 20X1 Provisio for repair expese (to be carried out i 20X2). Suppose that the defiitio of a expese is the traditioal oe as outlied above (Method 1), the it would be easy to argue that the Germa practice is right. The reaso for the eed for repair of a machie i early 20X2 was the wearig out of the machie i 20X1. So, the expese could be said to relate to 20X1, although this proportio is ot completely clear. However, let us ow give primacy to the IASB s defiitio of liability. I the above example of the repair, does the etity have a obligatio to a third party at the balace sheet date to trasfer resources? Probably ot. If ot, there is o liability at the ed of 20X1; therefore, there ca be o expese i 20X1; therefore the above double etry should ot be made. Why it matters This asset/liability approach seems to provide clearer aswers to some accoutig questios compared with the expese/reveue approach. The aswers are ofte differet for the two approaches, as will be oted several times i Part Hierarchy of decisios The first stage Havig decided upo the asset/liability approach, it is the ecessary to apply a three-stage hierarchy of decisios. As oted briefly before, the IASB Framework, ad most others, suggest that the first stage is to ask: Is there a asset/liability? The defiitios outlied above are useful for this purpose. However, ot all assets ad liabilities should be recogized, as ow explaied Recogitio The secod stage i the hierarchy of decisios is to ask whether a asset or liability should be recogized i the balace sheet. For example, the value of some assets may be so difficult to measure that they should be omitted from balace sheets. The Framework (paragraph 83) gives recogitio criteria for a asset as follows: (a) it is probable that ay future ecoomic beefit... will flow... to the eterprise; ad (b) the item has a cost or value that ca be measured with reliability. Let us apply these ideas to various itagible items that ca be foud i some balace sheets. For example, the balace sheet of Costa Crociere SpA, a Italia compay, for a year before IFRS adoptio i 2005, is show as Figure

5 8.3 Hierarchy of decisios Figure 8.2 Balace sheet of Costa Crociere SpA ASSETS FIXED ASSETS Itagible assets Pre-operatig ad expasio costs 430,788,400 Research, developmet ad publicity 8,322,744,995 Goodwill 17,504,906,718 Other 7,728,844,063 33,987,284,176 Tagible assets Fleet 1,545,376,990,994 Furiture, office equipmet ad vehicles 12,533,869,794 Lad ad buildigs 13,724,722,607 Advaces to suppliers 4,200,980 1,571,639,784,375 Fiacial assets Ivestmets I subsidiary compaies 2,361,047,604 I associated compaies 9,585,321,141 I other compaies 441,359,551 12,387,728,296 Receivables due from Third parties, curret 810,299,509 Third parties, o-curret 15,241,145,498 16,051,445,007 28,439,173,303 TOTAL FIXED ASSETS 1,634,066,241,854 CURRENT ASSETS Ivetories Materials ad cosumables 26,935,395,415 Costs of ucompleted cruises Fiished goods ad goods for resale 180,531,558 Paymets o accout for goods 181,248,671 27,297,175,644 Receivables due from Customers 115,202,164,925 Subsidiary compaies 597,461,385 Third parties, curret 18,819,167,035 Advaces to suppliers ad agets 13,635,070, ,253,863,974 Fiacial assets ot held as fixed assets Other securities 3,811,127,944 Liquid fuds Bak deposits 72,303,268,761 Cash ad cash equivalets 14,333,697,020 86,636,965,781 TOTAL CURRENT ASSETS 265,999,133,343 ACCRUED INCOME AND PREPAID EXPENSES Accrued icome 1,208,376,573 Prepaid expeses 36,780,748,166 37,989,124,739 TOTAL ASSETS 1,938,054,499,936 LIABILITIES AND STOCKHOLDERS EQUITY STOCKHOLDERS EQUITY Capital stock 123,406,166,000 Additioal paid-i capital 100,019,657,500 Legal reserve 9,957,183,361 Other reserves Merger surplus Reserve for grats received re article 55, Law 917/ ,626,003,837 16,626,003,837 Cumulative traslatio adjustmets 4,146,160,964 Retaied earigs 272,122,576,707 Net icome for the year 61,230,802, ,508,550,593 Miority iterests 13,090, ,521,641,244 RESERVES FOR RISKS AND CHARGES Icome taxes Other risks ad charges 9,685,481,239 9,685,481,239 RESERVE FOR SEVERANCE INDEMNITY 16,908,221,646 RESERVE FOR GRANTS TO BE RECEIVED RE ARTICLE 55, LAW 917/ ,686,803,797 PAYABLES Bods 271,083,750,000 Baks Advaces 1,334,387,305 Secured loas Curret 37,620,176,560 No-curret 407,861,924,572 Usecured loas Curret 723,271,076 No-curret 1,808,177, ,347,937,215 Other providers of fiace, curret 4,543,000,000 Advaces received 27,208,610,892 Suppliers, curret 128,837,650,343 Subsidiary compaies Paret compay 1,267,000,000 Tax authorities 6,056,148,078 Social security authorities 4,129,308,302 Other 28,404,868, ,878,272,958 ACCRUED EXPENSES AND DEFERRED INCOME Accrued expeses 25,688,281,827 Deferred icome 131,685,797, ,374,079,052 TOTAL LIABILITIES AND STOCKHOLDERS EQUITY 1,938,054,499,936 Guaratees ad commitmets are detailed i Notes to cosolidated fiacial statemets Source: Published compay fiacial statemets. 149

6 Chapter 8 Recogitio ad measuremet of the elemets of fiacial statemets It cotais several items treated as itagible assets, icludig: (a) pre-operatig expeses (set-up costs of a busiess); (b) research expediture; (c) developmet expediture; (d) publicity. Accordig to IAS 38 (Itagible Assets) the correct treatmet for these items should be as follows: (a) Pre-operatig expeses are ot a asset, because there is o resource with a future beefit (paragraph 69). (b) Research expediture ca give rise to a asset but (if it is spet iside the etity) it is too difficult to demostrate that the beefits are probable for the expediture to be recogized i a balace sheet (paragraph 54). (c) Developmet expediture ca give rise to a asset, which should be recogized if, ad oly if, certai criteria are met such as there beig a separately idetifiable project that is techically feasible ad commercially viable (paragraph 57). (d) Publicity caot be capitalized for the same reaso as research caot be (paragraph 69). Cosequetly, Costa Crociere s treatmet of pre-operatig, publicity ad research expeses would ot be acceptable uder IAS 38, but its treatmet of developmet expediture might be, depedig o the detailed circumstaces. Real-world examples Whe Volkswage adjusted from Germa accoutig to IFRS, it discovered a ew asset, developmet costs, of early A4 millio. This aloe icreased its et assets by 41 per cet. This is show i Figure 8.3. Figure 8.3 Volkswage 2001 (opeig recociliatio) Equity (Germa law) ,811 Capitalizatio of developmet costs 3,982 Ameded useful lives ad depreciatio methods of tagible ad itagible assets 3,483 Capitalizatio of overheads i ivetories 653 Differig treatmet of leasig cotracts as lessor 1,962 Differig valuatio of fiacial istrumets 897 Effect of deferred taxes 1,345 Elimiatio of special items 262 Ameded valuatio of pesio ad similar obligatios 633 Ameded accoutig treatmet of provisios 2,022 Classificatio of miority iterests ot as part of equity 197 Other chages 21 Equity (IFRS) ,918 Source: Volkswage Aual Report Am Nokia, the Fiish telephoe compay, shows several itagible assets i its balace sheet, as i Figure

7 8.3 Hierarchy of decisios Figure 8.4 Nokia s itagible assets, 2008 Am % of o-curret assets Developmet costs Goodwill 6, Other itagible assets 3, Source: Authors ow work based o published compay fiacial statemets. Views differ aroud the world o these issues. May compaies i Frace, Italy ad Spai follow Costa s practices for their ucosolidated statemets. At the other extreme, uder the rules of the Uited States, eve developmet expediture caot be recogized as a asset uless it relates to software. A more geeral Europea example of problems cocerig the recogitio of assets ca be see i the list of items show uder the headig Assets i the EU Fourth Directive o compay law, o which laws i EU coutries (ad i some others) are based. Table 8.1 shows the first two levels of headigs i the Eglish-laguage versio of the balace sheet, from Article 9 of the Directive, as show i more detail i Chapter 6. The right-had side of the balace sheet (capital ad liabilities) is dealt with i more detail i Chapter 11. Table 8.1 Balace sheet cotets specified by the EU Fourth Directive Assets Capital ad Liabilities A B C Subscribed capital upaid a Formatio expeses Fixed assets I Itagible assets II Tagible assets III Fiacial assets A Capital reserves I Subscribed capital a II Share premium accout III Revaluatio reserve IV Reserves V Profit or loss brought forward VI Profit or loss for the year D E Curret assets I Stocks II Debtors III Ivestmets IV Cash Prepaymets ad accrued icome b B C D E Provisios for liabilities ad charges Creditors Accruals ad deferred icome d Profit for the year c F Loss for the year c Notes: a Ca be etted off, i which case the amout ucalled ca be show as a asset uder A or D.II. b Ca be show uder D.II. c Ca be show uder reserves A.VI. d Ca be show as creditors uder C. 151

8 Chapter 8 Recogitio ad measuremet of the elemets of fiacial statemets The left-had side of Table 8.1 cotais various optios, reflectig previous (ad preset) practice i parts of Europe. Let us examie the problems: 1. Subscribed capital upaid is amouts that a compay could ask for from its shareholders, or amouts it has asked for but are as yet upaid. The secod of these seem to be assets (receivables), but the first are rather more cotiget o future evets. The compay may ever call i the moey, which would mea that the compay had o probable receipt, so o asset. 2. Formatio expeses are discussed above as pre-operatig expeses. The EU Fourth Directive icludes a potetial headig for use i some coutries for these doubtful assets. 3. Loss for the year. This clearly has a debit balace, ad its presetatio o the assets side would still eable the balace sheet to balace. However, the amout is equally clearly ot a asset uder the IASB s defiitio, ad so it should be show as a egative part of capital. The use of headig F i Table 8.1 was ormal Frech practice util 1984, Spaish practice util 1990, ad so o. Why it matters The readers of a balace sheet will sometimes be iterested i et assets or total assets to assess the stregth of a compay, usig such ratios as those itroduced i Chapter 7. They might be misled by phatom assets such as a former year s legal expeses of settig up the compay, let aloe by a asset called this year s loss Measuremet Oce it has bee decided that a asset or liability should be recogized, it is the ecessary to measure its value before it ca be put ito a balace sheet. Uder most systems of accoutig that have bee used i practice, iitial recogitio takes place at cost. If this were ot the case, the the very act of purchasig a asset might lead to the recogitio of a gai or loss. Sometimes the cost of a asset is obvious, such as whe a machie is bought i exchage for cash. However, eve the, decisios have to be made about what to do with taxes o the purchase, delivery charges, ad so o. The cost should iclude ot oly the ivoice price of the asset but also all costs ivolved i gettig the asset ito a locatio ad coditio where it ca be productive. So, this will iclude delivery charges, sales taxes ad istallatio charges i the case of plat ad machiery. For lad ad buildigs, cost will iclude legal fees, architect s fees, clearig the lad ad so o, as well as the builder s bill ad the cost of the lad. If a compay has used its ow labour or materials to costruct a asset, these should also icrease the cost of the asset rather tha beig treated as curret expeses; that is, they are capitalized. It is also possible to capitalize the iterest cost o moey borrowed to create fixed assets. Ideed, this is required by both US GAAP ad IFRS. Where labour or material is capitalized, certai formats of the icome statemet (described as by ature i Chapter 6) show this item as reveue. This is because all the labour ad materials used have bee charged elsewhere i the icome statemet. However, the items capitalized do ot relate to curret operatios, ad so they are added back as though they were reveue (see Sectio 8.4), although they could more logically be see as reductios i 152

9 8.3 Hierarchy of decisios expeses. I the example of Figure 8.5 (CEPSA of Spai), the 4,079 millio of capitalized expeses are a partial credit for the expeses show o the debit side. Activity 8.A As a digressio from the discussio of the measuremet of assets, it is worth checkig that you ca uderstad the format of the icome statemet show i Figure 8.5. This is horizotal, by ature (see Chapter 6, Tables 6.5 ad 6.6). Why, for example, did CEPSA show operatig icome as a debit, ad fiacial loss ad extraordiary loss as credits? Feedback CEPSA was usig a double-etry format ad showig subtotals as it wet dow the page. The operatig icome (of 67,674) is the excess of the operatig credits (1,172,175) over the operatig debits (1,104,501). Strictly speakig, this is ot very good double etry, because the debit balace of 67,674 for operatig icome is itroduced as though it were a extra debit etry but ot matched by a ew credit etry of that size. Similarly, the fiacial loss of 12,684 is the excess of the four debit items of that sort over the three credit items; ad the extraordiary loss of 7,925 is the excess of the four debit items of that sort over the four credit items. Expediture o a asset after its iitial recogitio should sometimes also be added i. This icludes ievitable future costs of dismatlig or cleaig up. Ay paymets that make the asset better tha it was origially are capitalized (added) to the asset. Ay other paymets are expeses. The priciple i Figure 8.1 is beig maitaied here. I geeral, repairs ad maiteace are treated as curret expeses, whereas improvemets are capitalized. So, a ew egie for a compay vehicle will usually be treated as a expese, sice it keeps the vehicle i ruig order rather tha improvig it, uless the egie is recorded as a separate asset. I cotrast, the paitig of advertisig sigs o the compay s fleet of vas may well be treated as a capital item, if material i size. However, repaitig the sigs would be a expese. Obviously, the accoutat eeds to cosider whether the amouts relatig to the improvemets are material eough to capitalize them. He or she teds to treat as much as possible as expese, sice this is the prudet ad admiistratively more coveiet method. If the ispector of taxes ca be coviced that items are expeses, this will also speed up their tax deductibility, although this ought ot to ifluece the accoutig. Activity 8.B There was a list of six paymets at the begiig of Sectio 8.2, amely: repairs; decoratig or redecoratig; extesios; improvemets; replacemet of parts; future ievitable paymets for dismatlig, decommissioig or cleaig up. Which of these should be added to the cost of a asset, ad which should be treated as a immediate expese? 153

10 Chapter 8 Recogitio ad measuremet of the elemets of fiacial statemets Figure 8.5 Cosolidated statemet of icome for CEPSA* DEBIT Expeses: Procuremets 556,672 Persoel expeses 53,225 Period depreciatio ad amortizatio 31,604 Variatio i operatig provisios 6,469 Other operatig expeses: Excise tax o hydrocarbos 292,529 Other expeses 163,972 1,104,501 Operatig icome 67,674 Fiacial expeses 14,604 Losses o short-term fiacial ivestmets 5 Variatio i fiacial ivestmet provisios 178 Traslatio losses ,223 Amortizatio of goodwill i cosolidatio 383 Icome from ordiary activities 59,397 Losses o fixed assets 308 Variatio i itagible assets, tagible fixed assets ad cotrol portfolio provisios 3,094 Extraordiary expeses 16,539 Prior years expeses ,317 Cosolidated icome before taxes 51,472 Corporate icome taxes 13,058 Cosolidated icome for the year 38,414 Icome attributed to miority iterests 376 Icome attributed to the cotrollig compay 38,038 * As published by the compay for the year before IFRS adoptio i Source: CEPSA Cosolidated Statemet of Icome for Year Eded 31 December CREDIT Reveues: Sales ad services o ordiary activities 868,148 Excise tax hydrocarbos charged o sales 292,392 Net Sales 1,160,540 Icrease i fiished products ad work-i-process ivetories 3,693 Capitalized expeses of Group i-house work o fixed asset 4,079 Other operatig reveues 3,863 1,172,175 Reveues from shareholdigs 2 Other fiacial reveues 2,093 Gais o short-term fiacial ivestmets 81 Traslatio gais Exchage gais 363 2,539 Fiacial loss 12,684 Share i icome of compaies carried by the equity method 4,790 Gais o fixed assets 9,270 Capital subsidies trasferred to icome for the year 814 Extraordiary reveues 1,947 Prior years reveues ,392 Extraordiary loss 7,

11 8.3 Hierarchy of decisios Feedback Repairs would ormally be expesed because they do ot improve the asset beyod its origial state. Decoratig costs might be capitalizable if they were material i size ad made a asset better tha it ever had bee. However, redecoratig souds like a expese. The cost of buildig extesios should ormally be added to the asset beig exteded, or could create a separately idetified asset. Improvemets should probably be capitalized. Replacemet of parts should be a expese uless the part is treated as a separate depreciable asset, so that replacemet is treated as a disposal followed by a purchase. Future costs of dismatlig, etc. should be discouted (see Chapter 11) ad added to the cost of the asset. The topic of depreciatio was itroduced briefly i Chapter 3 ad will be cosidered at legth i Chapter 9. For ow, it should just be oted that the depreciatio treatmet of the ew egie metioed above will deped o the depreciatio uits that the accoutat works o. Normally, a whole vehicle will be a uit, ad so a ew egie will be a curret expese. If the vehicle ad the egie were separate uits for depreciatio, the ew egie would be a capital item ad the old egie would have bee scrapped. Some purchases are ot made with cash but i exchage for the future paymet of cash or for exchage with other assets. The geeral rule is that the curret fair value of the purchase cosideratio should be estimated as accurately as possible. The term fair value is of great importace i IFRSs. It meas: the amout at which a asset could be exchaged, or a liability settled, betwee kowledgeable, willig parties i a arm s legth trasactio. [From IASB Glossary; a arm s legth trasactio is oe where the parties are ot related.] After iitial recogitio, a major problem arises cocerig whether to take accout of subsequet chages i the value of a asset. For assets that are to be sold, the issue really becomes ot whether, but whe, to take accout of chages i value, because evetually the curret value is recogized at the poit of sale i the calculatio of profit. Covetioal accoutig i most coutries cotiues to use cost as the basis for valuig most assets util the poit of sale. The argumets i favour of this approach are substatial: cheapess ad greater reliability. Historical cost is a easier ad cheaper method of valuatio tha most, because it uses iformatio already recorded ad does ot require expesive estimatios ad the audit of them. I additio, for most assets the cost is more reliably determied tha the fair value or other curret valuatio could be. It will be remembered that oe of the key characteristics for exteral reportig, as examied i the IASB s Framework, is reliability. The Framework (paragraph 44) also suggests that regulators ad preparers should be aware of the cost of the accoutig, to esure that it does ot exceed the beefits to the users. The problem is that the Framework s other key characteristic is relevace for ecoomic decisios. It is difficult to see that the historical cost is the most relevat iformatio for makig decisios which ormally requires estimatio of the future, particularly the predictio of cash flows. 155

12 Chapter 8 Recogitio ad measuremet of the elemets of fiacial statemets Activity 8.C Suppose that a etity buys a ivestmet for A800 i Jue 20X1. It has a market value of A1,000 at the ed of the accoutig year, amely at 31 December 20X1. It is the sold for A950 i Jue 20X2. I order to give useful iformatio, should the balace sheet show cost or market value at the ed of 20X1? Feedback It seems that the A800 cost is ot a very useful predictor of cash flows at 31 December 20X1, particularly if the asset had bee held for a loger period. Also, if oly cost is recorded util sale, the a gai of A150 will be show i 20X2 eve though the asset has falle i value i 20X2. The result of maagemet s decisio ot to sell the asset early i 20X2 is ot reflected i the 20X2 statemets. The mai asset valuatio bases that could be used istead of cost are: fair value (as defied above), which assumes that the busiess is either buyig or sellig; replacemet cost, which takes accout of the trasactio costs of replacemet; et realizable value, which is defied as expected sales receipts less ay costs to fiish ad to sell; value i use (or ecoomic value), which is the preset value (i.e. discouted value) of the expected et cash flows from the asset. It ca easily be see that, although these values may be more relevat tha past values, they ivolve much more subjectivity tha historical cost valuatios. I practice, as will be show, it is possible to itroduce some covetios to arrow the rage of choice. Also, some systems of accoutig ivolve a choice of basis depedig o circumstaces. (This whole area is discussed i more detail i Chapter 16.) The alteratives metioed i this sectio are summarized diagrammatically i Figure 8.6. Figure 8.6 Valuatio methods 156

13 8.4 Icome recogitio The choice of valuatio method may also deped o who requires the valuatio. Owers ad prospective buyers will wat the most realistic estimate of the worth of the busiess as a goig cocer. O the other had, leders may wat a much more coservative valuatio, based o the lowest likely valuatio of the idividual assets i the evet that the busiess has to be closed dow. Maagers will, of course, also be iterested i accoutig iformatio. They may be prepared to put up with more estimated umbers, because they ca trust themselves to estimate fairly. However, this book is maily cocered with iformatio preseted to outsiders for example, i the form of published aual reports of compaies. Cosequetly, there is a eed for reliability ad therefore a difficult trade-off betwee relevace ad reliability. I covetioal accoutig for most assets i most coutries, the cheapess ad reliability of historical cost has esured its domiace, despite doubts about relevace. However, for certai assets particularly those where there are active markets, such as some markets for shares fair values are reliable. For such assets, there seems a strog argumet for the use of fair values i fiacial reportig. I the case of IFRS, there has bee a gradual move toward the use of fair values for various assets sice the begiig of the 1990s. Why it matters A compay ows two idetical office blocks ext door to each other i the cetre of Stockholm. They are used as the compay s head office. Office 1 was bought i 1980 for B1m ad Office 2 was bought very recetly for B4m. Uder covetioal accoutig practice, Office 1 will be show at less tha B1m because it has wor out (depreciated) to some extet sice The idetical Office 2 will be show at B4m. Is this a fair presetatio? You ca perhaps see, by this example, why the topic is importat. Of course, eve covetioal accoutig sometimes takes accout of market values before the sale of assets. For example, i order to be prudet, ivetories are usually valued at the lower of cost ad et realizable value, ad fixed assets are writte dow below cost if their value is impaired. All the issues of this sectio are discussed agai i the followig chapters. 8.4 Icome recogitio It has bee agreed, i early all coutries, that the recogitio of icome does ot always eed to await the receipt of cash; that is, the accruals covetio is used. Cosequetly, the determiatio of the exact momet whe icome should be recogized becomes a major practical problem. Uder EU laws, for example, the aswer is expressed i terms of realizatio : icome should be recogized i the icome statemet whe it is realized. I practice, this does ot help much because there is o clear way to defie what is realized, if it does ot mea received i cash. Oe possibility is to defie realized as havig either received cash or a cotractual right to cash. This allows icome recogitio before a customer pays a bill. 157

14 Chapter 8 Recogitio ad measuremet of the elemets of fiacial statemets Activity 8.D A example may be useful here. Suppose that a maufacturig busiess produced a batch of output i the followig way: 12 Jauary Buy raw materials; store them 19 February Begi work o processig the materials 3 April Fiished goods produced; store them 10 May Receive order for goods; order accepted 17 May Goods delivered; customer ivoiced 5 Jue Customer pays ivoice for goods It is clear that the evetual profit will be the differece betwee the fial sales receipts ad the various costs ivolved. However, at what poit should the icome be recogized? Is the profit eared gradually over the maufacturig process, or whe a cotract of sale is agreed, or whe the goods are delivered, or whe cash is fially paid? Feedback The aswer to the foregoig questio for accoutats is give by the realizatio covetio that is, profits that have ot bee realized are ot recorded. I this case, the covetio would require that icome is ot recogized util the goods are delivered. It must be admitted that realized is a vague word. This postpoemet of the recogitio of icome coforms with the covetio of prudece ad with other aspects of reliability, because there is o reasoable certaity of icome util the sale is made. I the above example, the sale is o credit rather tha for cash, but the acquisitio of a receivable is cosidered to be sufficietly reliable. The IASB ad the FASB have bee workig for some years o a project to reform reveue recogitio. A Discussio Paper was issued i Sometimes the case is more complicated tha i Activity 8.D. Suppose that a Dutch compay has delivered goods to a US customer who will later pay a agreed amout of US dollars. If the US dollar rises by the balace sheet date, so that the Dutch compay ow has a cotractual right to receive a amout worth more i euros, has the compay made a further gai? It seems obvious that the compay is better off, but is the gai realized? Eve this relatively simple questio is cotetious, ad is addressed further i Chapter 15. The IASB s approach, as examied earlier i this chapter, is to give primacy to the defiitio of assets ad liabilities, such that reveue is defied i the followig way (Framework, paragraph 70): Icome is icreases i ecoomic beefits durig the accoutig period i the form of iflows or ehacemets of assets or decreases of liabilities that result i icreases i equity, other tha those relatig to cotributios from equity participats. Cofusigly, the Framework cotrasts the word icome (rather tha the word reveue ) with the word expese. The Framework uses the word reveue to mea icome from customers, but says that there is o importat distictio betwee that ad ay other icome (called gais). 158

15 8.4 Icome recogitio The defiitio quoted above of icome seems to suggest that special icome recogitio criteria are ot ecessary because ay icrease i a asset is a icome. However, there are two sorts of problem here: practical problems for the recogitio of reveue from the sale of goods ad rederig of services; ad major theoretical problems of whe to recogize the gais o assets if they are revalued i the balace sheet. The IASB addresses the first of the above two issues i IAS 18, Reveue, i approximately the same way as occurs already i most coutries. I summary, Figure 8.7 Cosolidated icome statemet, ad cosolidated statemet of recogised icome ad expese, Marks ad Specer plc 52 weeks eded 28 March 2009 Cosolidated icome statemet m Reveue 9,062.1 Operatig profit Fiace icome 50.0 Fiace costs (214.5) Profit o ordiary activities before taxatio Aalysed betwee: Before property disposals ad exceptioal items Profit o property disposals 6.4 Exceptioal costs (135.9) Exceptioal pesio credit Icome tax expese (199.4) Profit for the year Attributable to: Equity shareholders of the Compay Miority iterests (1.2) Profit for the year Foreig currecy traslatio differeces 33.1 Actuarial (losses)/gais o retiremet beefit schemes (927.1) Cash flow ad et ivestmet hedges fair value movemets i equity recycled ad reported i et profit (206.8) amout recogised i ivetories (8.6) Tax o items take directly to equity Net (losses)/gais ot recogised i the icome statemet (578.8) Total recogised icome ad expese for the year (72.0) Attributable to: Equity shareholders of the Compay (70.8) Miority iterests (1.2) (72.0) Source: Adapted from Marks ad Specer plc Fiacial Statemets

16 Chapter 8 Recogitio ad measuremet of the elemets of fiacial statemets reveue from the sale of goods is to be recogized whe cotrol ad risks have passed to the customer. For services provided, recogitio should occur whe both the reveue ad the stage of completio ca be measured reliably. This is of particular relevace where there are log-term cotracts (see Chapter 10). The secod issue (gais o usold assets) is more of a problem. For example, where a compay ows listed equities that rise i value, it was oted earlier that it might seem relevat ad reliable to record the assets i the balace sheet at the higher values. Are such gais to be treated as icome? The IASB cocludes that sometimes they should ideed be (see Chapter 11). However, whe buildigs are revalued (see Chapter 9), the resultig gais are ot treated as icome but go to a secod icome statemet uless the buildigs are ivestmet property. As oted i Chapter 6, two icome statemets are ow to be foud i some form uder the rules of the IASB, the UK ad the US. A British example is show as Figure 8.7 from Marks ad Specer plc, the stores group. Some of the issues raised by Figure 8.7 are too complex for us to cosider at this stage, but ote that gais ad losses appear i both statemets. However, there is o clear ratioale for the distictio betwee the gais i oe statemet ad those i the other. I coclusio, a reform of the icome statemet is likely, such that there will be oly oe statemet cotaiig all icome as defied above (see Sectio 6.2). Why it matters Does a compay gai whe its ivestmets rise i value, although it has ot sold them? The aswer seems ituitively to be yes. Should this gai be show as icome? If ot, where should it be show? The readers of fiacial statemets try to use the profit figure to help them to make fiacial decisios. So, we eed aswers to these questios. Eve if there are several plausible aswers, it may be better to impose oe of them, so that there is cosistecy betwee compaies. A further iterestig complicatio is that reveues (such as sales) are recorded as gross receipts, whereas gais (such as those o sellig fixed assets) are recorded et. So, the sale of ivetory at a loss is still recorded as reveue. Summary This chapter examies some fudametal issues relatig to the recogitio ad measuremet of the elemets of fiacial statemets. The implicatios of basig fiacial reportig o the defiitios of asset ad liability are explored. For example, expeses caot be postpoed uless they create a asset (as defied), ad they caot be aticipated uless they create a liability (as defied). The fact that somethig is a asset or a liability does ot automatically lead to its iclusio i a balace sheet. It must still meet the recogitio criteria: basically beig reliably measurable. Measuremet is iitially made at cost, which icludes a umber of expeses related to the purchase ad to subsequet improvemet of the asset. There are various possibilities for subsequet revaluatio. May of these provide measuremets that may be more relevat but less reliable. Icome recogitio depeds i priciple upo movemets i assets ad liabilities. However, o a day-to-day basis, practical rules are eeded for the 160

17 Exercises exact date of recogitio. Also, ot all icreases i assets are presetly treated as icome. & Refereces ad research The mai, relevat IASB documets for this chapter are: The Framework. IAS 18 (revised 1993), Reveue. Notes o the research related to recogitio ad measuremet of particular assets ad liabilities are icluded i the followig chapters.? EXERCISES Feedback o the first two of these exercises is give i Appedix D. 8.1 Explai, i a way that is uderstadable to a o-accoutat, the followig terms: (a) asset (b) liability (c) reveue (d) expese (e) equity 8.2 The historical cost covetio looks backwards but the goig cocer covetio looks forwards. (a) Does traditioal fiacial accoutig, usig the historical cost covetio, make the goig cocer covetio (see Chapter 3) uecessary? Explai your aswer fully. (b) Which do you thik a shareholder is likely to fid more useful: a report o the past or a estimate of the future? Why? 8.3 Please arrage the followig five symbols ito a equatio with o mius sigs i it: A 1 = assets at ed of period. L 1 = liabilities at ed of period. OE 0 = ower s equity at begiig of period. R 1 = reveues ad gais for the period. E 1 = expeses for the period. 8.4 Why is it ecessary to defie a expese i terms of chages i a asset (or vice versa) rather tha defiig the terms idepedetly? 8.5 What geeral rule ca be used to decide whether a paymet leads to a expese or to a asset? 8.6 What disadvatages are there i measurig assets o the basis of historical cost? 8.7 What various alteratives to historical cost could be used for the valuatio of assets? Which do you prefer? 161