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Balance Sheet General purpose and special purpose financial statements For entities required to prepare financial statements for external users, regulators or other bodies, the entity may have to prepare general purpose financial statements or special purpose financial statements. In Australia, the determination of whether an entity has to prepare general purpose financial statements or special purpose financial statements is based on whether the entity is a reporting entity. The reporting entity concept is not a legal concept, but an accounting concept linked to the information needs of users. An entity is assessed as a reporting entity when there are users who depend on general purpose financial statements for their decision-making. The factors taken into consideration when deciding if an entity is a reporting entity include its financial characteristics, the separation of the entity’s management and ownership, and its economic or political significance. If an entity has indicative factors that suggest it is a reporting entity, then the entity should prepare general purpose financial statements. If an entity is assessed as a non-reporting entity then it can prepare special purpose financial statements. What is the difference between general purpose financial statements and special purpose financial statements? Statements that are purported to be general purpose financial statements must be prepared in accordance with generally accepted accounting principles (GAAP), whereas special purpose financial statements can be prepared without adhering to GAAP. GAAP is a set of rules and practices that guide financial reporting. Public accountability refers to entities with securities, debt or equity, traded in a public market or entities that hold assets in a fiduciary capacity as their main business activity.

Nature and purpose of the balance sheet A primary objective of a for-profit entity is the generation of profits. A not-for-profit entity’s objective may be the provision of services to a community. To generate profits, or to provide services, entities need to invest in productive assets. Assets are items controlled by an entity that provide the entity with future economic benefits. Value creation can also occur if the assets in which an entity invests appreciate in value. Decisions concerning the acquisition and sale of assets are referred to as investing decisions. The acquisition of assets requires financing, which may be provided by external parties (e.g. lenders) and/or internal parties (e.g. the owners). The external claims on the entity’s assets are termed liabilities. The term ‘debt’ is often used interchangeably with ‘liabilities’. The internal claims on the entity’s assets are referred to as equity. The mix of debt and equity financing an entity chooses reflects its financing decisions. The balance sheet (also known as the statement of financial position) is a financial statement that details the entity’s assets, liabilities and equity as at a particular point in time — the end of the reporting period. For example, entities with financial years ending on 30 June produce a balance sheet as at 30 June each year. Note that a balance sheet can be

prepared more frequently than on an annual basis — indeed; it can be prepared as at any date. However, common practice is to prepare the balance sheet annually as at the end of the reporting period.

Accounting policy choices, estimates and judgements In introducing the balance sheet, we have presented a balance sheet for CCS; an entity that is not required to prepare financial statements, and the Qantas Group, a group that is required to prepare general purpose financial statements in compliance with accounting standards. In this, and subsequent chapters, some of the key recognition, presentation and disclosure requirements for financial statements elements contained in accounting standards are explored. JB Hi-Fi Ltd.’s financial statements will be used to illustrate these requirements. The financial statements for many listed entities are available from the entities’ websites. JB Hi-Fi Ltd.’s financial statements can be accessed at www.jbhifi.com.au, or alternatively may be accessed through databases that provided annual reports for listed companies such as those found at a university library. The relevant financial statements and notes for JB Hi-Fi Ltd are reproduced in the appendix to this book. Even when preparing financial statements in compliance with accounting standards, such as IFRSs, the accounting standards provide preparers with choices. Therefore, most items in the financial statements involve the exercise of judgement and estimations on behalf of preparers. Users of financial statements need to appreciate that accounting flexibility and discretion exist, and to consider the potential impact this has on reported information in the balance sheet and income statement. We will explore some of the permissible choices in the recording of transactions and estimations and judgements required by preparers. Accounting choices applied to the recognition and measurement of elements in the financial statements is referred to as accounting policies. This is why an analysis of an entity’s accounting policies is important. There are numerous accounting rules that permit choices. Examples include the alternative methods of costing inventory, the valuation of property, plant and equipment subsequent to acquisition, and the treatment of development expenditure as an asset (known as capitalisation) or as an expense. When reviewing financial statements, a user must be cognisant of the particular accounting policies used, and of financial numbers that involve preparer estimations. Many accounting policy choices are transparent, as accounting standards require disclosure of such choices. However, entities are not obliged to detail all estimations used to derive various financial statement elements.

Asset definition An asset is formally defined in the Conceptual Framework (Para. 4.4(a)) as ‘a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity’. The essential characteristics for an asset are:

1. The resource must be controlled by the entity 2. The resource must be as a result of a past event 3. Future economic benefits are expected to flow to the entity from the resource.

Control An entity must control the item for that item to be considered an asset and recognised on the balance sheet. Legal ownership is synonymous with control; however, legal ownership is not a necessary prerequisite for control. The concept of control refers to the capacity of the entity to benefit from the asset in the pursuit of its objectives, and to deny or regulate the access of others to the benefit. Examples of assets where control is present in the absence of legal ownership include licences and management rights.

Past event Another criterion necessary for an item to be defined as an asset is the existence of a past event that has resulted in the entity controlling the asset. Most assets are generated as a result of an exchange transaction, non-reciprocal transfers or discoveries. Consider an office building that is to be used as a rental property. The first two asset definition criteria are satisfied, as the building creates future economic benefits in the form of rental income, and the entity owns the building. If the building is purchased, an exchange transaction has occurred and the requirement that there be a past event is satisfied. If the building is bequeathed to the entity, a non-reciprocal transfer (a past event) is also deemed to have occurred. If the entity is in the process of finding a suitable property and has enlisted the services of a commercial real estate agent to assist in the task, the past event criterion is not satisfied as no exchange has occurred yet. The building is not considered an asset until this exchange has occurred.

Future economic benefits ‘Future economic benefits’ refers to service potential. It means that the items must provide benefits to the entity that uses them in order to be regarded as assets. The provision of benefits can take the form of having goods and services desired by customers available for sale. It can also take the form of being able to satisfy human wants. For example, an item of plant and equipment that produces goods for sale is an asset because it provides service potential (that is, it produces goods that can be sold for cash). An art gallery’s public collection of artwork is an asset, as the collection provides service potential to the gallery (that is, the collection attracts visitors to the gallery and enables the gallery to achieve its objective of attracting a certain number of visitors). The latter example highlights that the future benefits do not necessarily have to involve cash.

Asset recognition

The term recognition refers to recording items in the financial statements with a monetary value assigned to them. Therefore, ‘asset recognition’ means that the asset is recorded and appears on the balance sheet. Central to the recognition principle is that items can be measured in monetary terms. This is referred to as the monetary concept. As money is the language used to quantify items recognised in the financial statements, if items cannot be assigned a monetary value then they cannot appear on the balance sheet. Satisfying the definition criteria is only part of the process in recording an item on the balance sheet — the asset recognition criteria must also be satisfied. The asset recognition criteria in the Conceptual Framework (Para. 4.44) requires it to be ‘probable that the future economic benefits will flow to the entity’, and that the asset ‘has a cost or value that can be measured reliably’. The threshold used to assess ‘probable’ is that the future economic benefits are more likely than less likely. This is an assessment that the preparer of the accounts is required to make. Finally, the asset must be capable of being measured reliably. If the asset is acquired as a result of an exchange transaction, the asset possesses a cost and satisfies this requirement. If the asset is acquired as a result of a non-reciprocal transfer or discovery, assigning a reliable value is more problematic. ‘Reliably measured’ does not mean that the asset is measured with certainty. Measurement of elements of financial statements may involve estimations and assumptions, as previously discussed. A reasonable basis and justification for estimations and assumptions is important. In relation to assets, an example of exercising judgement and making estimations involves the measurement of the value of accounts receivable to report on the balance sheet. An entity is required to estimate the expected cash that will be received from its customers who owe money. This involves consideration of amounts unlikely to be collected.

Liability definition A liability is formally defined in the Conceptual Framework (Para. 4.4(b)) as ‘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’. The essential characteristics of a liability are: 1. A present obligation 2. The present obligation arises as a result of past events 3. An outflow of resources embodying economic benefits is expected to flow from the entity as a result of settling the present obligation.

Present obligation An essential element of the liability definition is a present obligation to another entity, even if the entity cannot be identified. A legal contractual obligation clearly creates a present obligation; however, the ‘obligation’ for accounting definition purposes is more far-reaching

than a legal obligation. The obligation can arise as a result of a duty to do what is fair, just and right; or it can arise if a particular set of facts creates valid expectations in other parties that the entity will satisfy the obligation.

Past event Another essential element for a liability is the existence of a past event. The event resulting in the future sacrifice of economic benefits must have occurred.

Outflow of resources embodying economic benefits Future sacrifices of economic benefits are associated with adverse financial consequences for the entity. For example, accounts payable involve future sacrifices of economic benefits because the entity must remit cash to the supplier in the future. Similarly, a bank loan is a liability, as the entity must make future sacrifices in the form of cash payments for interest and loan repayments to service the loan. The future sacrifice does not necessarily have to be a cash sacrifice. For example, the requirement to transfer goods constitutes a future sacrifice.

Liability recognition As we discussed with assets, determining that the liability definition is satisfied does not necessarily mean that the liability appears on the balance sheet. The liability recognition criteria must also be satisfied before this occurs. The terms ‘probable’ and ‘measured reliably’ are as critical to the liability recognition criteria as to the asset recognition criteria. The term ‘probable’ is interpreted as ‘more likely than less likely’. Therefore, absolute certainty that future sacrifices of economic benefits will occur is not necessary. Consider Entity A, which has acted as guarantor for a loan for Entity B. This will require Entity A to service the loan in the event of Entity B defaulting. Provided that Entity B is financially stable, the probability of loan default is very low. This means that the probability of Entity A being required to sacrifice future economic benefits to service the loan is less likely than more likely, so no liability would be recognised. If subsequent events suggest that Entity B is in financial distress and the probability of Entity A’s guarantee being activated is more likely than less likely, Entity A would have a liability to recognise on its balance sheet. One of the contentious issues in financial reporting has been how lease financing should be addressed in financial reporting. If an entity leases assets, should the leased assets be recorded as assets and the future lease obligations as liabilities? The reporting of leased assets is covered by an accounting standard. Currently, the accounting treatment depends on the contractual terms of the lease and whether the substantial risks and benefits associated with the assets transfer from the lessor to the lessee. If they do, the leased assets are recorded as assets and must be amortised. Correspondingly, the lease obligations are recorded as liabilities. If the substantial risks and benefits associated with the assets remain with the lessor, then lease financing has no balance sheet implications. The lease payment is recorded as an expense in the income statement. This is why lease financing is referred to as ‘off

balance sheet financing’. However, at the time of writing, accounting for leases is under review with the likelihood all leases of longer than 12 months will be required to be recognised on the balance sheet.

The definition and nature of equity The remaining element of the balance sheet to discuss is equity. Equity is defined in the Conceptual Framework (para. 4.4(c)) as ‘the residual interest in the assets of the entity after deducting all its liabilities’. This means that equity cannot be determined without reference to assets and liabilities. The definition is such that the entity’s assets less liabilities (that is, net assets) at a particular point in time equal its equity. The equity balance represents the owner’s (or owners’) claims on the assets of the entity. Equity is a difficult concept to define independently of assets and liabilities, as the equity section of a balance sheet contains many different items. For example, one item within the equity section of the balance sheet is contributions made by the owner(s). The term given to the funds contributed by owner(s) is share capital for a company, or contributed capital for a partnership or sole trader. Retained earnings, also referred to as ‘unappropriated earnings’ or ‘undistributed profits’, are another equity item. Retained earnings are the cumulative profits made by an entity since it commenced operation that have been retained in the entity for reinvestment rather than distributed to the owner(s).

Presentation and disclosure of elements on the balance sheet Accounting standards exist that prescribe the presentation and disclosure requirements for financial statements. In this section, we will explore some of the key presentation and disclosure requirements applicable to the balance sheet. Recall that all listed entities such as the Qantas Group and JB Hi-Fi Ltd, are required to comply with the presentation and disclosure requirements of the accounting standards. Small entities with no public accountability, such as CCS, are not required to comply with accounting standards. This means that they are unconstrained in the preparation of their financial statements. A small business operation such as CCS has not raised equity or debt capital from the public and does not have investors and shareholders who depend on financial statements to monitor and assess their investment decisions. Some entities with no public accountability voluntarily adopt presentation and disclosure practices required by accounting standards.

Current and non-current assets and liabilities When preparing a balance sheet, assets and liabilities should be presented in a current/noncurrent format unless an alternative presentation, such as listing the assets and liabilities in order of their liquidity, provides information that is more relevant and reliable. The distinction between current assets and non-current assets is based on the timing of the future economic benefits. Similarly, the distinction between current liabilities and non-current liabilities is based on the timing of the expected future sacrifices. If the economic benefits (outflow of resources) attached to the asset (liability) are expected to be realised within the next reporting period (assumed to be 12 months), then the asset (liability) is categorised as

current. However, if the economic benefits (outflow of resources) attached to the asset (liability) are expected over a period extending beyond the next reporting period, a noncurrent categorisation is appropriate.

Presentation and disclosure of assets, liabilities and equity On the balance sheet, assets are classified according to their nature or function. This means that the asset classifications can reflect an asset’s: • Liquidity • Marketability • Physical characteristics • expected timing of future economic benefits • Purpose. Liabilities and equity are classified according to their nature. The following factors could be used to classify liabilities: • Liquidity • Level of security or guarantee • expected timing of the future sacrifice • Source • Conditions attached to the liabilities. Classification of equity items on the balance sheet can be based on their origin or source (that is, contributions from owners or retained earnings), and/or the rights attached to the item. NOTES • Assets and liabilities should be presented in a current or non-current format unless an alternative presentation — such as listing the assets and liabilities in order of their liquidity — provides information that is more relevant and reliable. The distinction between current and non-current assets (liabilities) is based on the timing of the expected future economic benefits (future sacrifices) — current if expected within the next 12 months, and non-current if expected beyond the next 12 months. • For the purpose of reporting on the balance sheet, assets, liabilities and equity are usually aggregated and listed by class. Details of the assets, liabilities and equity within the various classes may be found in the notes to the accounts. • The typical asset classes are cash; receivables; investments; financial assets; property, plant and equipment; intangible...