Q9: What are the five elements of accounting? Define each element.
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.
We saw in ACCT11059, that assets are those aspects of a firm we expect will provide future economic benefits to a firm, or in other words, we expect will 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 are expected to provide future 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 resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity’: AASB CF Framework para 49 (a). As well as including the expectation of providing future economic benefits, we have now added to our definition of assets the aspect of control (which means the firm is able to benefit economically from the asset and to restrict others from those benefits). This usually means the firm has formal legal ownership of the asset; but a firm may still be able to control an asset it does not own (for example, with certain leases). The third aspect in the definition is that the events giving rise to the firm controlling the asset have already occurred. In the case of the delivery vans of Coffee Supreme, these are assets because they are expected to provide future economic benefits to Coffee Supreme and they are controlled by the company as a result of past events (ie Coffee Supreme owns the vans because it bought them in the past).
We saw in ACCT11059, that liabilities are those aspects of a firm that we expect will use up future economic benefits of a firm, or in other words, we expect will take away value from a firm in the future. 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 we expect this will involve using up future economic benefits of Coffee Supreme, that is $50,000 moving out of Coffee Supreme’s bank account in two months.
In AASB CF Framework, this definition of liabilities is extended to ‘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’: AASB CF Framework para 49 (b). As well as including the expectation of the outflow from the firm in the future of economic benefits, we have now added to our definition of liabilities that it is a present obligation. This could be a legal obligation to pay a debt; but it need not be. The obligation could also be due to normal business practices or due to notions of equity or fairness. The third aspect in the definition is that a liability must have resulted from a past transaction or event. In the case of the promise by Coffee Supreme 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 we expect it will involve Coffee Supreme using up economic benefits in the future, is a present obligation (indeed, a legal obligation) and has resulted from a past transaction of Coffee Supreme having been supplied raw coffee beans by its Brazilian supplier.
We saw in ACCT11059, 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 49 (c). 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.
We saw in ACCT11059, that revenue are additions to equity as a result of increases to assets or reductions in liabilities of a firm (other than those relating to transactions between a firm and its equity owners). For example, this would include sales by Coffee Supreme of fresh roasted coffee to Day Made, 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 economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants’: AASB CF Framework para 70 (a).
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 (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 economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in an increase in equity, other than those relating to contributions from equity participants arising in the course of an entity’s ordinary activities’. In 2017, Wesfarmers included as revenue in its accounts, Sale of goods ($68.0 billion), Rendering of services ($12m) and Interest revenue ($84m). In the same year, Ryman Healthcare included as revenue Care fees ($227.4m), Management fees ($61.0m) and Interest received ($0.5m).
We can see that revenue is limited to gains arising in ‘the course of the ordinary activities’ of a firm. Now 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 2017 had as part of its income Other income from gains on disposal of property, plant and equipment of $123m (from the sale of property, plant and equipment at greater than their book value in Wesfarmer’s accounts); and Ryman Healthcare had Fair value movement of investment properties of $325m (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 the 2017 Consolidated income statement of Ryman Healthcare, you can see how Ryman Healthcare has distinguished between Total revenue ($289m) and Total income ($614m), which includes revenue ($289m) as well gains not in the course of the ordinary activities of the firm (Fair value movement of investment properties: $325m).
We saw in ACCT11059, that expenses are reductions to equity as a result of decreases to assets or increases in liabilities of a firm (other than those relating to transactions between a firm and its equity owners). 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 70 (b), the definition of expenses is similar to what we used in ACCT11059: ‘decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants’.