TAK: Liabilities and Owner's Equity

Proprietary and Entity Theory

 * Proprietary Theory
 * All accounting concepts, procedures and rules are formulated with the owner’s interest in mind


 * Entity Theory
 * The business is a separate entity and accounting record the transactions of the entity

Proprietary Theory
P = A - L


 * Proprietorship (owner's equity) is  (net worth of the owner of the business) is   less
 * The objective of accounting is to determine the net worth of the owner
 * The concept income which increases net worths, is seen as a return for “entrepreneurship”
 * Net income is the increase in the wealth of the owner from business operations during a given period


 * Change in net worth:
 * Income-generating activities
 * Changes in value of assets


 * To a large extent, present accounting practice → Proprietary Theory
 * Dividends : a distribution of profits rather than expenses because they are payment to owners
 * Interest on debt and income tax : expenses because the redice the owner’s wealth
 * Salary : paid to owners is not an expense because owner and firm are the same
 * The equity for long-term investments recognises the ownership or proprietary interest of the investor company
 * The parent company is seen as “owning” the subsidiary


 * A financial capital view is appropriate under this theory


 * With the advent of the company, the theory has proved inadequate as a basis for explaining company accounting
 * By law, there is a separation between the company and the owners which has its own rights
 * Shareholders can not withdraw their assets from the company
 * Shareholders depend on the information reported by management

individuals or a controlling organisation
 * There are cases where large companies are linked to one or a few key

Entity Theory

 * Entity theory was formulated in response to the shortcomings of the proprietary view → the company is a separate entity with its own identity


 * There are two related assumptions in the notion of an accounting entity:
 * Separation → the enterprise is separated from its owners
 * Viewpoint → Accounting procedures are conducted from the viewpoint of the entity


 * Supporters of this theory believe that this theory can be applied not only for corporate accounting because:
 * The accounts and transactions are classified and analysed from the point of the entity as an operating unit
 * Accounting principles and procedures are not formulated in terms of a single interest

In entity perspective, the objective of accounting may be stewardship or accountability


 * Traditional Version
 * The business firm operates for the benefit of the equityholders → have to report to equityholders the status and consequences of their investment -- associate


 * Recent Version
 * The entity as in business for itself and interested in its own survival → reports to equityholders to meet legal requirement and to maintain a good relationship with them -- outsiders

The information content of accounting statements for decision making can be easily assimilated into both interpretations of the entity theory

Assets = Equities


 * Focus on the assets and equities because the entity is the centre if attention.
 * Owners and creditors are seen as equityholders.
 * Assets and liabilities are for the firm


 * Income => The inflow of assets
 * Expenses => Reduce the worth of the entity’s assets

Net income accrues to the firm BUT Shareholders only have a contractual residual claim on the total assets → Net Income is placed in Retained Earnings

Proprietary vs Entity Theory

 * Both theories are influential in practice
 * Proprietary Theory
 * Interest charges are considered an expense
 * Dividends a distribution of profit
 * Entity Theory
 * Conventional accounting theory is based on this
 * Financial reports reflect to this

Liabilities Defined
=== Definition in Conceptual Framework for Financial Reporting

A liability is a present obligation of the entity to transfer an economic resource as a result of past events. For a liability to exist, three criteria must all be satisfied:
 * the entity has an obligation;
 * the obligation is to transfer an economic resource; and
 * the obligation is a present obligation that exists as a result of past events.

Liability Recognition
Recognition criteria:
 * Reliance on the law - legal enforceability
 * Determination of the economic substance of the event - ‘real’ obligation
 * 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

Reliance on the Law
If there is a legally enforceable claim, there is little doubt that a liability exists. Although equitable or constructive obligations are embraced in the definition of a liability, most liabilities are determined on the basis of whether there is a legal claim against the entity that it is obliged to meet.

Determination of the Economic Substance of the Event
Has some 'real' obligation arisen? How important to users is the recording and eventual display of a liability in the balance sheet?

To illustrate, a company found that some of its employees and their families were developing illnesses as a consequence of mining and living. The company recognised it had a 'real' obligation to provide compensation for diseases sufferers. It also knew that shareholders, investors and employees (the users of financial information) would be vitally concerned with the amount shown in the balance sheet for the liability (i.e. the estimate of the company's obligation)

Ability to Measure the Value of the Liability
For some liabilities, value is represented by a contract price, such as the amount of cash to be paid for the goods and services received. In the case of employee leave benefits, the nominal amount of the liability represents the amount to be paid to extinguish the liability. However, the value of the liability may be different to its nominal amount. For example, if the liability involves a period longer than 12 months (such as in the case of long service leave) we must consider the time value of money. Therefore the calculation of the value of the liability will be based on the present value of expected future cash flows, not its nominal amount.

Use of the Conservatism Principle
Historically, accountants have taken a conservative approach to the recognition of assets and liabilities. Generally speaking, they are more likely to record liabilities earlier than assets. After all, it is 'safer' to understate assets than liabilities. For example, a company may adopt the higher of estimates of expected future damages in a legal case, to ensure that the liability is sufficiently covered and to avoid an additional outflow in the future.

The IASB Framework
The IASB Framework provides guidance in relation to the recognition of balance sheet and income statement elements. Paragraph 91 gives additional specific guidance. It states that a liability is recognised in the balance sheet when it is probable that an outflow of resources embodying economic benefits will result from the settlement of a present obligation and the amount at which the settlement will take place can be measured reliably.

PSAK 71 (Instrumen Keuangan)
Initial Measurement
 * Except for accounts receivable, in the case of financial assets and financial liabilities that are not measured at fair value through profit or loss, on initial recognition, an entity shall measure the financial asset or financial liability at fair value plus or minus the transaction costs incurred directly related to the acquisition or issuance of a financial asset or financial liability.
 * However, if the fair value of a financial asset or financial liability at initial recognition differs from its transaction price, an entity shall apply paragraph B5.1.2A (The entity recognizes the difference between the fair value at initial recognition and the transaction price as a gain or loss).
 * If an entity uses settlement date accounting for assets that have been measured after initial recognition at amortized cost, those assets are initially recognized at fair value on the transaction date.
 * On initial recognition, an entity shall measure accounts receivable at the transaction price

Subsequent Measurement
 * An entity shall classify all financial liabilities after initial recognition as measured at amortized cost, except:
 * financial liabilities at fair value through profit or loss.
 * financial liabilities that arise when the transfer of a financial asset does not qualify for derecognition or when a continuing involvement approach is applied.
 * financial guarantee contracts.
 * commitments to provide loans at below-market interest rates.
 * contingent consideration recognized by the acquirer in a business combination to which PSAK 22 is applied.
 * An entity applies hedge accounting requirements to financial liabilities that are designated as hedged items.

PSAK 73 (Sewa)
Initial Measurement
 * At the commencement date, the lessee measures the lease liability at the present value of the unpaid lease payments at that date. The lease payments are discounted using the implicit interest rate in the lease, if such interest can be determined. If the interest rate cannot be determined, the lessee uses the lessee’s incremental borrowing rate.

Subsequent Measurement
 * After the commencement date, the lessee measures the lease liability by:
 * increase the carrying amount to reflect interest on the lease liability;
 * reduce the carrying amount to reflect the rent already paid; and
 * remeasure the carrying amount to reflect the revaluation or modification of the lease, or to reflect substantially revised lease payments.

Employee benefits - pension plans

 * In many countries pension plans are established by employers to provide retirement benefits for employees.
 * The pension funds are legal entities, separate from the employer firm.


 * Contributory: Employer and employee make contribution
 * Non-contributory: Only employer makes contribution


 * Fully Funded: Have sufficient cash or investments to meet the fund’s obligation to members
 * Partially Funded / Unfunded: Do not have cash or investments to cover the potential payouts under the plans


 * It might be presumed that unfunded commitments of the plans are not liabilities of an employer firm.
 * The firm has an equitable obligation to meet unfunded

Another issue relates to when to recognise liabilities for pension payouts. Is it:
 * As the employee renders services?
 * When the employee retires?
 * When the fund is required to make payments under the pension plan?


 * Pension plans is a promise by the entity to provide pensions to employees in return for past and current services.
 * These pension benefits are earned by employees and their cost accrues over the years the services are rendered
 * The critical past event is the rendering of services, so an obligation arises for those that have not been funded.

PSAK 57 (Provisions and Contingencies)
Provisions and contingencies occur where there is a blurring of the line between present and future obligations.

Based on PSAK 57
 * Provisions are liabilities whose timing and amount are uncertain
 * Contingent Liability is:
 * Potential obligation that arises from past events and whose existence will be confirmed by the occurrence or non-occurrence of one or more future events not wholly within the control of the entity; or
 * Present obligation that arises as a result of past events but is not recognized because:
 * it is not probable that the entity will incur economic benefits (hereinafter referred to as “resources”) to settle its obligations; or
 * the amount of the obligation cannot be measured reliably

A provision is recognized when:
 * the entity has a present obligation (legal or constructive) as a result of a past event;
 * it is probable that the settlement of the obligation will result in an outflow of resources; and
 * a reliable estimate can be made of the amount of the obligation.

The entity is not allowed to recognize a contingent liability

Owner's Equity
Equity is the residual interest in the assets of the entity after deducting all its liabilities. In other words, they are claims against the entity that do not meet the definition of a liability.

As a result of its residual nature, the amount shown in the balance sheet as representing equity is dependent on not only the assets and liabilities which are recognised but also how they are measured.

A fundamental question to be addressed in arriving at the amount of equity is whether an item represents a liability or equity of the entity. There are two essential features which can help us to distinguish between liabilities and owners' equity. They are:
 * the rights of the parties
 * the economic substance of the arrangement.

The Rights of the Parties
One feature of the rights given to the parties either by law or by company policy relates to the priority of rights to be (re)paid in the event that the entity is wound up. Legally, for a sole proprietorship or partnership, a creditor has a claim on the owner(s) and, for a corporation, a claim on the company. However, in accounting theory, no matter what the legal form of the organisation, the entity is recognised as a unit of accountability. Therefore, creditors have a claim on the entity and thus on its assets. Creditors have the following rights:
 * settlement of their claims by a given date through a transfer of assets (goods or services)
 * priority over owners in the settlement of their claims in the event of liquidation.

The Economic Substance of the Arrangement
Rights of Creditors and Owners

A key difference between the rights of creditors and owners is that creditors have a right to settlement, whereas owners have rights to participate in profits (the residual). The difference reflects the economic risk and return features of the two types of claims: creditors bear less risk and earn a relatively fixed return (interest and settlement of the principal), whereas owners bear greater risk and accordingly earn a variable (and often higher) rate of return through their participation in profits

Concept of Capital
Concept of Capital Maintenance

Concept of capital maintenance demands that companies maintain intact their initial (and any subsequent) capital base. The Framework recognises that whether or not a firm maintains its capital intact is a function not only of the definition of equity as a residual interest in an entity, but also of the concept of capital.

Framework

Firms would need to retain different amounts of resources to maintain different concepts and measures of capital. The objective of capital maintenance requirements is to protect creditors by providing a 'cushion' or 'buffer.

For example:

Suppose an entity holds no more than the legal capital of $10,000. If total assets are $100,000, this means that liabilities amount to $90,000. If the entity were to be liquidated and the carrying amount of the assets realised only $80 000, there would be enough to pay the creditors. This is possible because of the existence of the capital of $10 000. Without it, the creditors would not be paid in full. Capital is not a guarantee for the protection of creditors, but it does offer some safety.

Classification within Owners’ Equity
Contributed and Earned Capital

Distinguishing between contributed and earned capital is useful to keep separate the amount invested from the amount that is reinvested. Contributed capital is due to financing transactions, whereas the earned capital is derived from profit-directed activities. Retained earnings, or unappropriated profits, make up the earned capital. Retained earnings may be appropriated for specific purposes. Retained earnings are not assets in themselves and therefore the appropriations of retained earnings to specific reserve accounts do not represent particular assets.

A special committee of the American Accounting Association explained that appropriations are of three types:
 * Those that are designed to explain managerial policy concerning the reinvestment of profits
 * Those that are intended to restrict dividends as required by law or contract
 * Those that provide for anticipated losses

Debt vs Equity Distinction
Hybrid instruments: have the characteristics of both debt and equity.

For example, preference shares have traditionally been regarded as capital and, therefore, as part of owners' equity, but they have characteristics that also align them with liabilities, such as the following:
 * they are fixed claims
 * they might not participate in dividends other than at a pre-specified rate
 * they have priority over ordinary shares in the return of capital (as do liabilities)
 * they generally carry no voting rights

IAS 32/AASB 132 paragraph 18

The substance of a financial instrument, rather than its legal form, governs the classification…. Substance and legal form are commonly consistent, but not always. Some financial instruments take the legal form of equity but are liabilities in substance, others may combine features associated with equity instruments and features associated with financial liabilities.

IAS 32/AASB 132 state that preference shares are financial liabilities because that provide for mandatory redemption by the issuer for a fixed or determinable amount at a fixed or determinable future date.

Purpose of Distinguishing
 * To enhance the usefulness of information for decision making

Current Standard and Critics
 * The IASB has a current project on IAS 32/AASB 132, which aims to improve and simplify its requirements, Stakeholders have made criticisms of the standard, claiming that the principles are difficult to apply and that the application of those principles can result in inappropriate classification of some financial instruments. The IASB wants a better distinction between equity and non-equity instruments.

Starting Point for the Improvement
 * Any perpetual instruments (i.e. those that lack a settlement requirement) are equity. In addition, an instrument redeemable at the option of issuer would be equity.
 * Any instrument that mandatorily redeemable at a specific date or dates or is certain to occur are liability.

Extinguishing Debt
IAS 32/AASB 132 Paragraph 42: Offsetting A Financial Asset and Liability

The situation it deals with is referred to as the 'set-off and extinguishment of debt’ or 'in-substance defeasance'. This allows a debtor to remove a debt from the balance sheet and to report a net financial asset or liability only if the entity has a current legally enforceable right to set off the recognised amounts, and intends either to (a) settle on a net basis or (b) realise the assets and settle the liability simultaneously

The economic substance of the transaction involved in placing risk-free assets (i.e. government securities) or cash in an irrevocable trust for the purpose of payment of the debt is tantamount to extinguishing the debt. However, the company (debtor) is still legally liable for the debt so it is potentially misleading that the debt is not shown on balance sheet.

Example: Suppose Company A has bonds payable of $10 000 000, sold originally at par with a stated interest rate of 8 per cent and 10 years life remaining. Presently, because interest rates are higher, the market value of the bonds is lower than their maturity value. Company A will purchase government bonds with a face value of $10 000 000, stated interest rate of 8 per cent and 10 years life remaining, for $7 500 000. These will be placed in an irrevocable trust for the purpose of paying off the company's bonds payable.

Investment in Government Bonds    $ 7.500.000 Cash                                 $7.500.000

Bonds Payable $10000 000 Investment in Government Bond   $7.500.000 Gain on Bonds Payable                $2.500.000

The advantages to the company:
 * the debt is removed, therefore, the company's debt to equity ratio improves
 * profit for the current year increases by the amount of the gain
 * for tax purposes, the gain is not recognised because the company is still legally obligated to pay the bonds, the interest from the government bonds will be offset by the interest expense of the company's bonds
 * defeasance permits the company to manage the liability side of the balance sheet as it would its marketable securities on the asset side.

When should a liability cease to be recognised?

The Framework definition of a liability implies that it is settled when assets or services have been transferred to other entities. On the other hand, although an obligation may be removed from the accounts, the liability may in fact revert to the debtor.

What would happen if the assets were lost or misappropriated?

In such a case, the debtor would have to reinstate the liability

New Approach for Derecognition

IASB proposes to a new approach for derecognition based on a single concept of control rather than multiple concepts (risks and rewards, control, continuing involvement). In addition, disclosures will be extended and improved so that users can better understand the relationship of transferred assets and associated liabilities so as to assess risk exposure.

Some Arguments
Create An Expense
 * The employee is obtaining something of value to the employee; therefore, there is a cost to the company. This cost is an expense, and a corresponding liability exists until it is settled with shares, when equity is increased accordingly.

Doesn’t Create An Expense
 * The entity perspective deems that an entity cannot sacrifice future economic benefits through the issue of its own equity since it is not giving up anything. They argue that the firm is no worse off for issuing additional shares. Rather, it is the shareholders whose individual holdings may have been diluted in value.

IFRS 2/ AASB 2 (Share-based Payment)
Share-based Payment distinguishes between share-based payments that are cash-settled and those that are equity-settled. When goods and services are received or acquired in a share-based payment transaction, the entity records the event when it obtains the goods or as the services are received. If the goods or services were received in an equity-settled share-based payment transaction, the credit side of the entry is to owners' equity. In contrast, if the goods or services were received in a transaction that will be settled in cash, the corresponding credit entry is to a liability

Management Assertions

 * Completeness
 * Liabilities recognised on the balance sheet and the note disclosures.


 * Valuation or Allocation
 * Liabilities are recorded at the proper value.


 * Cut off
 * Possibility of timing irregularities, where a liability incurred prior to the end of the financial period is not recorded by the entity until the commencement of the new accounting period.


 * Rights and Obligation
 * Accounts payable, accruals, and other liabilities include all amounts owed by the entity to other parties.

ASA 570 (Pr 63)
Requires an auditor to specifically consider whether management's use of the going concern basis is appropriate and, if there is any doubt, whether the relevant circumstances have been disclosed correctly. If the auditor concludes that the entity will not be able to continue as a going concern, the auditor is required to express an adverse opinion if the financial report had been prepared on a going concern basis.

Key Takeaway
Understatement of liabilities is a concern for auditors, especially if it creates doubt about the company's solvency, overstatement of provisions also raises issues for auditors.

Cookie Jar
Provisions for future expenditures, such as maintenance, allow the company to 'store' excess earnings for a 'rainy day'. Auditors are required to test the appropriateness of any provision (including both those shown as liabilities and those recognised as contra assets, such as a provision for doubtful debts)

 IFRS 2/AASB 2 

Share-based Payment has increased the authoritative guidance for auditors when assessing the reasonableness of the fair values assigned to equity-based transactions. The standard states that fair value may be determined by either the value of the shares or rights to shares given up, or by the value of the goods or services received, depending on the type of payment.

Auditors need to evaluate the substance of the arrangement and the accounting principles that could be applicable, rather than simply accept management's assertions of the nature, timing and valuation of the transaction

QA Session Notes

 * Jika ada seorang pengusaha yang memiliki dua perusahaan, maka kita perlu mempertimbangkan apa kepentingan pemilik untuk memutuskan apakah perlu untuk mengonsolidasikan atau tidak. Namun pada umumnya, tidak akan melakukan konsolidasi karena itu merupakan dua entitas yang berbeda.


 * Proprietary Theory masih applicable untuk digunakan oleh perusahaan proprietorship dan partnership (firma) untuk menjelaskan laporan keuangannya