Introduction: Q9

Q9: What are the five elements of accounting? Define each element.

A:

The key ideas underlying accounting of proprietorship and the entity concept leads us to view a firm as having five key elements: Assets, Liabilities, Equity, Revenue and Expenses. As you study accounting you will learn a great deal about each of these five elements of a firm. In ACCT11059 Accounting, Learning & Online Communication, we looked at relatively simple definitions of each element. In this section, we will look at more complete definitions of the five elements of accounting. These will be based on the definitions in AASB CF Framework for the Preparation and Presentation of Financial Statements.

Assets

In ACCT11059, we saw that assets are a present economic resource controlled by a firm that has the potential to produce economic benefits; that is, has the potential to add value to a firm in the future. For example, Coffee Supreme, a firm based in Wellington in New Zealand, owns several small silver delivery vans. These delivery vans are assets because they have the potential to produce economic benefits to Coffee Supreme by transporting its products to customers (who are mainly coffee shops) in the future.

We can extend this definition of assets to ‘A present economic resource controlled by the entity as a result of past events. An economic resource is a right that has the potential to produce economic benefits’: AASB CF Framework paras 4.3 and 4.4.

Three key aspects of this definition are:

Rights that have the potential to produce economic benefits can take many forms, such as the right to receive cash, or goods and services, from another party; or the right to exchange economic resources with another party on favourable terms (for example, a forward contract to buy an economic resource on terms that are currently favourable or an option to buy an economic resource). Rights do not need to involve an obligation of another party, for example: a right to use a physical object, such as Property, plant and equipment or Inventories.

Many rights are legal rights, established by contract, legislation or similar means. For example, an entity might obtain rights from owning or leasing a physical object, from owning a debt instrument or an equity instrument, or from owning a registered patent. Although an economic resource derives its value from its present potential to produce future economic benefits, the economic resource is the present right that contains that potential, not the future economic benefits that the right may produce. And the potential economic benefits do not need to be certain or even likely. It would still be an asset (although the recognition and measurement of the asset may be affected). In many cases, the set of rights will arise from legal ownership of a physical object. Conceptually, the economic resource is the set of rights, not the physical object. Nevertheless, we will often describe the set of rights as the physical object.

Control is the link between an economic resource and an entity: “An entity controls an economic resource if it has the present ability to direct the use of the economic resource and obtain the economic benefits that may flow from it.” (AASB CF Framework para 4.20). If the entity controls an economic resource, then no other party also controls that resource.

You can see we have now focused on defining assets as a set of rights (in the present) to future economic benefits, not the future economic benefits themselves that may arise from those rights. The rights are in the present; the potential to produce economic benefits is in the future; and those rights are controlled by the entity as a result of past events: present, future and past.

Liabilities

In ACCT11059, we saw that liabilities are a present obligation of a firm to transfer an economic resource that a firm has no practical ability to avoid. For example, Coffee Supreme may have promised to pay $50,000 in two months to a firm in Brazil that has recently supplied it with raw coffee beans. This is a liability because it is a present obligation that will involve transferring $50,000 (an economic resource) out of Coffee Supreme’s bank account that it has no practical ability to avoid.

We can extend this definition of liabilities to ‘A present obligation of the entity to transfer an economic resource as a result of past events’ (AASB CF Framework para 4.26).

Three key aspects of the definition are:

(a) the entity has an obligation (see AASB CF Framework paras 4.28–4.35);

(b) the obligation is to transfer an economic resource (see paras AASB CF Framework 4.36–4.41); and

(c) the obligation is a present obligation that exists as a result of past events (see AASB CF Framework para 4.42).

An obligation is a duty or responsibility that an entity has ‘no practical ability to avoid’ (AASB CF Framework para 4.29). An obligation is always owed to another party (or parties). However, it is not necessary to know the identity of the other party (or parties); and could include ‘society at large’ (AASB CF Framework para 4.29).

Obligations will often be legally enforceable by other parties, but can also arise where an entity has made commitments it cannot practically avoid:

‘Obligations can also arise … from an entity’s customary practices, published policies or specific statements if the entity has no practical ability to act in a manner inconsistent with those practices, policies or statements’

(AASB CF Framework para 4.31).

Also, the obligation is to transfer an economic resource in the future. There must be the ‘potential’ of this occurring, but it does not need to be certain or even likely:

‘… the obligation must have the potential to require the entity to transfer an economic resource to another party (or parties). For that potential to exist, it does not need to be certain, or even likely, that the entity will be required to transfer an economic resource—the transfer may, for example, be required only if a specified uncertain future event occurs. It is only necessary that the obligation already exists and that, in at least one circumstance, it would require the entity to transfer an economic resource’  

(AASB CF Framework para 4.37).

Thirdly, the obligation is a present obligation that exists as a result of past events involving the entity obtaining economic benefits (for example goods or services) or ‘taking action’ such as operating a business:

‘A present obligation exists as a result of past events only if:

(a)     the entity has already obtained economic benefits or taken an action; and

(b)    as a consequence, the entity will or may have to transfer an economic resource that it would not otherwise have had to transfer’

(AASB CF Framework para 4.43).

You can see we have now focused on defining liabilities as a present obligation to transfer an economic resource (in the future), as a result of past events: past, present and future. And remember, liabilities do not need to be legally enforceable; there simply needs to be ‘no practical ability to avoid’ (which will require some judgement).

Equity

In ACCT11059, we saw that equity is often referred to as a ‘left over’ concept: what is ‘left over’ for the owners of a firm after liabilities are deducted from assets. This is how equity is referred to in the AASB CF Framework: equity is ‘the residual interest in the assets of the entity after deducting all its liabilities’: AASB CF Framework para 4.63. I expressed the view in the ACCT11059 Study Guide that this definition of equity does miss the point somewhat. Rather, the concept of equity is grounded in the concept of proprietorship and of a firm being a separate entity to its owners. It is the ‘other side of the coin’ to a firm’s assets and liabilities. Assets and liabilities represent the current value of a firm. Equity represents the current value of the interest of its owners in the firm.

Based on our view of business reality underlying accounting, equity will always equal assets less liabilities as summarised and expressed in our fundamental accounting equation. This is how the definition of equity is treated in AASB CF Framework. But equity is not in essence a residual item. Equity has its own conceptual ‘reality’ in our view of the economic and business realities of a firm that informs the discipline of accounting. Indeed, it is because equity does have its own separate conceptual ‘reality’ in the way we view business in accounting, that all transactions of a firm conceptually have a dual nature, affecting either a firm’s assets and liabilities and, also, its equity.

Revenue

We saw in ACCT11059, that revenue are increases in assets or decreases in liabilities of a firm that result in increases in equity, other than those relating to contributions from equity investors. For example, this would include sales by Coffee Supreme of fresh roasted coffee to Gibbon St, a café in Woolloongabba in Brisbane, near the Gabba stadium. If Day Made paid for this coffee in cash, this would increase an asset (that is, cash) of Coffee Supreme. Although there is not a definition of revenue in AASB CF Framework there is a definition of income as ‘increases in assets, or decreases in liabilities, that result in increases in equity, other than those relating to contributions from holders of equity claims’  (AASB CF Framework para 4.68).

This definition of income is also repeated in AASB 15 Revenue from Contracts with Customers (Appendix A) and is largely the same as the definition of revenue we used in ACCT11059. In AASB CF Framework, income (rather than revenue) is one of the five elements of accounting. Rather than income, we are using the term revenue in this Study Guide, to ensure it is clearly distinguished from some of the uses of the word income, which can refer to measures of profit; and terms such as corporate income tax and taxable income can also refer to measures of profitability, rather than revenue.

Although there is not a definition of revenue under AASB CF Framework, there is a definition of revenue in AASB 15 Revenue from Contracts with Customers (Appendix A) which defines revenue as ‘Income arising in the course of an entity’s ordinary activities.’ This defines revenue as occurring in ‘the course of the ordinary activities’ of an entity. If we include the definition of income, then we see the definition of revenue can be expressed as: ‘increases in assets, or decreases in liabilities, that result in increases in equity, other than those relating to contributions from holders of equity claims, arising in the course of an entity’s ordinary activities’. In 2019, Wesfarmers included as revenue in its accounts, Revenue from contracts with customers ($27.8 billion), Interest revenue ($26m) and Other revenue ($76m). In the same year, Ryman Healthcare included as revenue Care fees ($302.0m), Management fees ($78.9m), Interest received ($0.5m) and Other revenue ($0.9m).

Revenue is limited to gains arising in ‘the course of the ordinary activities’ of a firm. The definition of income includes revenue as well as gains that may not have occurred in the ordinary activities of a firm, for example gains on the disposal of non-current assets or on the revaluation of marketable securities. For example, Wesfarmers in 2019 had as part of its income Gains on disposal of property, plant and equipment of $124m (from the sale of property, plant and equipment at greater than their book value in Wesfarmer’s accounts) and Other income ($115m); and Ryman Healthcare had Fair value movement of investment properties of $293m (which result from revaluations of retirement village units owned by Ryman Healthcare and which are effectively ‘leased’ to residents and for which residents pay an occupancy advance which gives them the right to use the retirement village unit for life). In Ryman Healthcare’s 2019 Consolidated income statement, you can see how Ryman Healthcare has distinguished between Total revenue ($382m) and Total income ($675m). total income includes revenue ($382m) as well gains not in the course of the ordinary activities of the firm (Fair value movement of investment properties: $293m).

Expenses

And we saw in ACCT11059, that expenses are decreases in assets or increases in liabilities of a firm that result in decreases in equity other than those relating to distributions to equity investors. For example, this would include the cost of electricity used to power the coffee grinders and roasters in Coffee Supreme’s manufacturing operations in Hopper Street, Wellington. And transactions between a firm and its equity owners are entered directly into equity and are not treated as revenue or expenses. They do not add value to our equity investors; they simply represent a transfer of value between equity investors and the firm. In AASB CF Framework para 4.69, the definition of expenses is similar to what we used in ACCT11059: ‘Expenses are decreases in assets, or increases in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity claims’. (AASB CF Framework para 4.69).