A firm holds assets because either owners or other parties have supplied funds to
acquire the assets. Therefore, the total amoG:lt of assets is subject to claims by some
party or parties, usually to pay money. There are two kinds of claims: by creditors
(liabilities) and by owners (owners' equity). The rights of creditors and owners are
different. Creditors have a prior claim on the assets in case of liquidation and their
claims are almost always more specific than those of owners with respect to the amount
and the timing of payment. The claims of creditors are obligations of the reporting
entity, whereas the entity is not obliged, usually, to make any specific transfer of assets
to the owners. Indeed, when an obligation arises, such as when a dividend is declared,
the claim of owners becomes a liability (i.e. dividends payable). As such, liabilities are
present obligations of an entity, whereas owners' equity is a residual interest or claim,
but not an obligation to transfer assets.
In this chapter, we first consider two theories which underlie accounting, namely
the proprietary and entity theories. Next, we explore the definition, recognition criteria
and measurement of liabilities and owners' equity. As in other chapters, we refer to
the IASB/AASB Framework for the Preparation and Presentation of Financial Statements to
examine the guidance provided by standard setters. We also discuss issues arising in
practice when applying the definition and recognition criteria for liabilities and equity.
Finally, we consider current challenging issues for standard setters and auditors in
relation to liabilities and equity.

PROPRIETARY A N D ENTITY THEORY
In this section we outline two theories which have been proposed to help us understand
accounting, namely proprietary theory and entity theory. Proprietary theory is based
on the idea that the proprietor (or owner) is the centre of attention. Under this view,
all accounting concepts, procedures and rules are formulated with the owner's interest
in mind. In contrast, entity theory proposes that the business is a separate entity and
accounting records the transactions of the entity.

Proprietary theory

Proprietorship represents the net worth of the business and can be represented in the
accounting equation:
P=A-L
Where proprietorship (or owner's equity) is equal to assets less liabilities. P represents
the net worth of the owner of the business. As Sprague states:
The balance sheet of proprietorship is a summing-up at some particular time of all
the elements which constitute the wealth of some person or collection of persons . . .
The whole purpose of the business struggle is increase of wealth, that is, increase of
proprietorship.
Assets belong to the proprietor and liabilities are the obligations of the proprietor. In
this light, we can see that the objective of accounting is to determine the net worth of
the owner. The economic theory of the firm takes a proprietary view, with its emphasis
on the role of the entrepreneur-owner. The concept of income, which increases net
worth, is seen as a return for 'entrepreneurship'.
Income is earned, and expenses are incurred, because of the decisions and actions of
the owner or the owner's representative. Income and expense accounts are subsidiary
accounts of P, which are temporarily segregated for the purpose of determining the
PART 2 Theory and accounting practice


pr-ofit of the owner. Income is the increase in proprietorship; expense is the decrease in
proprietorship. Vatter explains:
The theory of double entry is based on the idea that expense and revenue accounts have
the same algebraic characteristics as 'net worth', i.e. accounts tending to increase net
worth are increased by credits, accounts tending to decrease net worth are handled in
reverse order.2
Net income is, therefore, the increase in the wealth of the owner from business
operations during a given period. If this is what income represents, then it should
include all aspects that affect the change in the owner's wealth in that given period.
Thus, change in net worth derives from income-generating activities as well as changes

in value of assets. For example, the intrinsic value of a newspaper masthead may
increase in value and could attract a significant premium to the owner if realised (sold).
In such cases, the argument is that the increase in net wealth of the proprietor should
be recognised, even though the change in wealth is notional until such time as the
newspaper is actually sold to a third party. The problem for accounting is measuring
the notional change in value.
To a large extent, present accounting practice is based on the proprietary theory.
Dividends are considered a distribution of profits rather than expenses because they are
payments to owners. On the other hand, interest on debt and income tax are considered
expenses because they reduce the owner's wealth. For a sole proprietorship and partnership,
salaries paid to owners who work in the business are not considered an expense, because
the owner and the firm are the same entity and one cannot pay oneself and deduct that
as an expense. The equity method for long-term investments recognises the ownership or
proprietary interest of the investor company. It therefore authorises the investor company
to record as profit its percentage share of the investee's profit. In consolidating financial
statements, the parent company method is based on the proprietary theory. The parent
company is seen as 'owning' the subsidiary. Minority interest, from the point of view of the
'owner' of the subsidiary, represents the claims of a group of outsiders. The extent of the
minority interest is shown as a reduction in proprietorship.
A financial capital rather than a physical capital view is appropriate under proprietary
theory. The former emphasises the financial investment of the owners, whereas the
latter focuses on the firm's ability to maintain its physical operating level without
any regard to ownership claims. The proprietary view sees no distinction between the
assets of the proprietor and the assets of the entity. 'Therefore, all of the entity's profit is
distributable to the owners of the firm. If the entity requires additional resources, these
funds are available from the proprietor's own personal resources. Capital represents the
cash invested by the owners plus profits reinvested by retention in the business. Most
people adopt a financial view of capital and it is also the position taken in traditional
conventional accounting practices.
The proprietary view of accounting was developed at a time when businesses were

small and were mainly proprietorships and partnerships. However, with the advent
of the company, the theory has proved inadequate as a basis for explaining company
accounting. By law, the company is a separate entity from the owners and has its own
rights. As such, the company, not the shareholders, takes possession of the assets and
assumes the obligations of the business. Not only do companies assume the obligations
of the business, but also the feature of limited liability makes it absurd to say that
shareholders are responsible for the liabilities of the company. If shareholders of a
large company wished to exercise their presumed rights of ownership by withdrawing
assets from it, they would run foul of the law. Withdrawals of cash (dividends) are
really distributions by formal legal procedures.
CHAPTER 8 Liabilities and owners' equity


Accountability to owners is a significant function for a large company because of the
gap between management and shareholders. For the small firm, owners are aware of
the financial status of the business so that the notion of accountability or stewardship
is not as meaningful. In contrast, the contact of shareholders with the affairs of the
large company is at best minimal. Shareholders therefore depend on the information
reported to them by management.
However, there are cases where large companies are linked to one or a few key
individuals or a controlling organisation, in which the wealth of the key owner(s) and
the organisation are practically inseparable. An example is Rupert Murdoch and News
Corporation. In such cases, proprietary theory is still relevant.

Entity theory
The entity theory was formulated in response to the shortcomings of the proprietary
view concerning the separate legal status of a company. The theory starts with the fact
that the company is a separate entity with its own identity. The theory goes beyond
the 'accounting entity assumption' regarding the separation of business and personal
affairs. Martin outlined the two related assumptions embodied in the notion of an

accounting entity:
Separation. For accounting purposes, the enterprise is separated from its owners.
Viewpoint. Accounting procedures are conducted from the viewpoint of the entity.3
Although the entity theory is especially suitable for corporate accounting, supporters
believe that it can be applied to proprietorships, partnerships and even to not-for-profit
organisations, providing:
the accounts and transactions are classified and analysed from the point of view of
the entity as an operating unit; and
accounting principles and procedures are not formulated in terms of a single interest,
such as proprietorship.
Paton states, for any business firm:
It is the 'business' whose financial history the bookkeeper and accountant are trying
to record and analyse; the books and accounts are the record of 'the business'; the
periodic statements of operations and financial condition are the reports of 'the
b~siness'.~
It is true that the entity is not a person and cannot act of its own accord. It is an
institution, but nonetheless it is a 'very real thing', argues P a t ~ n It. ~has a real and
measurable existence, even a personality of its own. For a company, once the share
capital is issued, the life of the company does not depend on the lives of its shareholders.
Broadly speaking, from an accounting perspective, an entity can be defined as any area
of economic interest that has a separate existence from its owners.
When an entity perspective is taken, the objective of accounting may be stewardship
or accountability. The traditional version of the entity theory is that the business firm
operates for the benefit of the equityholders, those who provide funds for the entity.
The entity must therefore report to equityholders the status and consequences of
their investment. The newer interpretation sees the entity as in business for itself and
interested in its own survival. Because it is concerned about its survival, the business
entity reports to equityholders in order to meet legal requirements and to maintain a
good relationship with them in case more funds are needed in the future.
Although both versions focus on the entity as an independent unit, the traditional

view looks on the equityholders as 'associates' in business, whereas the more recent
view sees them as outsiders. The information content of accounting statements for
PART 2 Theory and accounting practice


decision making, which has been emphasised in recent years, can be easily assimilated
into both interpretations of the entity theory.
Under entity theory, the focus of the accounting equation is assets and equities. Net
worth of the proprietor is not a meaningful concept, because the entity is the centre of
attention. Owners and creditors are seen simply as equityholders, providers of funds.
The accounting equation is thus:
Assets = equities
The balance sheet shows the assets of the entity, which Paton refers to as representing
a 'direct' statement of value for the entity, and equities, which he calls an 'indirect'
expression of the same total."he
assets belong to the firm and the liabilities are the
obligations of the firm, not the owners. It has been argued that because the amount
invested by the equityholders must be accounted for, this objective logically leads to
the use of historical cost for non-monetary assets, because the total on the right side
of the statement of financial position must equal the total on the left. After receiving
the funds provided by the equityholders, the firm invests the funds in assets. For
non-monetary assets, this is the original purchase price. But accountability does not
necessarily imply keeping track of the original amount of investment. Equityholders
are also interested in changes in the value of their investment. Current value advocates
point out that the entity theory assumes that investors are not close enough to the
business to make their own adjustments of values. Therefore, accountability should
imply that these adjustments, namely changes in values, are reported. It can also be
argued that the entity needs to know the current values of its assets in order to make
correct decisions.
Under the entity view, income is defined as the inflow of assets due to the transactions

undertaken by the firm and expense relates to the cost of the assets and other services
used up by the firm to create the income for the period. Expenses reduce the worth
of the entity's assets. The proprietary concept concentrates on the P of the accounting
equation. The entity concept focuses on the other side of the equation, the assets. This
is because assets are seen as the 'real' things the firm has to work with, whereas the
equities are more abstract, having to do with claims on the assets - an 'indirect' way,
as Paton put it, of viewing the value of the assets.
Assets and expenses are essentially the same in nature; they provide services. It is
simply a question of whether the services are used up or remain for future use. The
basic characteristic of income is that it creates more assets whereas expenses eventually
diminish assets:
Accounting theory, therefore, should explain the concepts of revenue [income] and
expense in terms of enterprise asset changes rather than as increases or decreases in
proprietors' or shareholders' e q ~ i t i e s . ~
Net income accrues to the firm. If that is so, why then is it closed to retained
earnings as though it belongs to the shareholders? Paton and Littleton argue that the
shareholders have a contractual residual claim on the total assets, and it is for this
reason that net income is placed in retained earning^.^ The shareholders get the residual,
the remainder, after the creditors have been paid in the event of liquidation of the firm.
This explanation evolves from the conventional version of equity theoly. The newer
interpretation sees the retained earnings account as the firm's equity or investment
in itself.' Payments for the use of money are expenses because both creditors and
shareholders are considered external parties. Therefore, interest charges and dividends,
as well as income tax, are expenses of the business. They reduce the amount of equity
the entity has in itself.
CHAPTER 8 Liabilities and owners' equity


In conclusion, we can say that b o t h proprietary and entity theories are influential in
practice. Conventional accounting theory is based o n the er-tity concept, and financial

reports reflect an entity view, w i t h their focus o n dividends and ealnings per share.
Companies trade in their o w n shares, which suggests the market accepts that they are
separate entities. However, the proprietary view is also influential. For example, based
o n the proprietary concept, interest charges are considered an expense and dividends
a distribution o f profit. Theory in action 8.1 considers proprietary and entity theory
in a practical setting by exzmining the ownership structure o f the United Kingdom's
Barclays Bank.

y problems remain
by Peter Thal Larsen
When John Varley and Marcus Agius take the stage at Barclays' annual meeting in a fortnight's
time, the chief executive and chairman of the banking group will be braced for some strident
words from shareholders. But they will also be hoping they are over the worst.
Just a few months ago, Barclays was fighting off speculation the bank would be forced to
turn to the British government for financial help. Investors were still seething about the bank's
decision to turn to Middle Eastern investors for f 7 b n in fresh capital last autumn, bypassing
existing shareholders. Opposition politicians were raising questions about Barclays' aggressive
tax structuring activities.
The episode was the culmination of a frenzied 18-month period in which Barclays
executives tried in vain to persuade critics who questioned whether the bank had genuinely
weathered the financial crisis in better shape than rivals such as Royal Bank of Scotland,
which was forced into national ownership after suffering hefty losses.
In the past few weeks, however, there have been signs that the storm is easing. Most
notably, the Financial Services Authority last month concluded the bank had enough capital
to withstand even a severe global econonlic downturn. The bank is close to boosting its
capital reserves further by selling iShares, its exchange-traded funds subsidiary, to CVC, the
private equity group. Barclays shares have trebled in value since late January. They closed
yesterday at 157.8p, up 0.1p.
Barclays Capital - the investment banking business that prompted much suspicion and
speculation during the credit crisis - is also one reason for the bank's new bounce. Its

opportunistic acquisition of the US assets of Lehman Brothers, combined with troubles at
some rivals, have boosted revenue. The bank traded twice as much foreign exchange in the
first quarter as in the same period two years ago. Fixed-income trading volumes were up
65 per cent in the same period.
Nevertheless, M r Varley and M r Agius continue to face several thorny problems. First, the
bank's capital ratios continue to look weak. Though Barclays' tier one ratio - a key measure
of balance sheet strength - is roughly the same as HSBC's, its capital base includes a higher
proportion of hybrid debt. The sale of the exchange-traded funds business of iShares, which
could be announced as early as today, will help boost its equity capital. The bank could boost
its capital ratios further by buying back hybrid debt instruments at a discount to face value,
though it would have to be careful not to upset the investors who are large buyers of debt that
Barclays Capital issues on behalf of other borrowers.
Some investors remain concerned about aspects of Barclays' balance sheet, such as
packages of corporate loans whose value is protected by ailing monoline insurers. But people
close to the bank point out that the FSA's stress test, which took several weeks and assumed
a severe five-year downturn in the bank's main markets, including the UK, US and Spain,
would have examined these exposures.

PART 2 Theory and accounting practice


Barclays also badly needs to patch up strained relations with the British government. That
is why the-bank is expected in the next few weeks to sign up to commitments to new lending
in return for increasing its use of the government's credit guarantee scheme.
If the recent revival can be sustained, Mr Varley's determination to keep Barclays clear of
government intervention will have been vindicated. Given the ongoing recession and the
precarious state of parts of the financial system, however, it is probably too soon for the bank
to declare victory.
Source: The Financial Times Limited, 9 April 2009


Questions
1 . Explain the ways in which Barclays Bank has increased its equity in the past year. Why was
raising more equity important in the 2007-08 economic conditions?
2. Describe the process by which the sale of its funds subsidiary ishares could 'boost capital
reserves further'?
3. Does the writer of the article take an entity view or proprietorship view of Barclays Bank?
4. Could the proprietorship perspective apply to Barclays Bank if the UK government took an
ownership (equity) interest in the bank, as occurred at Royal Bank of Scotland?

LIABILITIES DEFINED
Liabilities are a key element in accounting. We now consider how to define liabilities,
when they should be recognised in the accounts and how to measure them.
The IASB Framework paragraph 49(b) defines a liability 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.
We examine this definition in terms of its two main components:
the existence of a present obligation, requiring a future settlement
the result of a past transaction or other past event.

Present obligation
The Framework definition states that liabilities are expected to give rise to an outflow
of economic benefits. This definition, similar to that for assets, focuses on a 'future
event'. As such, the actual sacrifices are yet to be made. The underlying consideration
is that an obligation is already present in relation to the future sacrifice. For example,
accounts payable are a current obligation, arising from the provision of services (the
past event) by external parties. Planned maintenance can be a liability if there is a
present obligation to an external party (i.e. a contract) to complete the maintenance.
A plan to complete maintenance in the future without the commitment to an external
party will not give rise to a present obligation under the Framework.

The Framework, paragraph 62, recognises that settlement of the obligation could occur
in several ways such as cash payment, transfer of other assets, provision of services,
replacement of the obligation with another obligation, conversion of the obligation to
equity, or a creditor waiving the obligation. Of these methods of settling an obligation,
only the first two necessarily involve the outflow of assets recognised by the entity.
For example, accounts payable will be settled by cash (the outflow of an asset) while a
liability for unearned revenue (revenue paid in advance) is settled by the provision of
goods or services.
CHAPTER 8 Liabilities and owners' equity


Past transaction
The requirement that an obligation must be the result of a past event ensures that only
present liabilities are recorded and not future ones. As in the maintenance example on
the previous page, the past event of signing the contract for maintenance gives rise to
the present liability. However, the condition of past event may be difficult to interpret.
What kind of past event is acceptable? This qualification is critical in determining
whether there is an obligation in the first place. When a company places an order with
a supplier to purchase inventory, present rules prescribe that there is no obligation
until the goods are received or until title passes. Therefore, the past event in this case is
the receipt of the goods, not the placement of the order.
Wholly executory contracts provide an interesting case for interpreting the term
'past event'. The question is whether the signing of a contract creates a liability? For
example, is an unconditional purchase obligation a liability? Consider the situation
where the purchaser agrees to pay a certain amount periodically in return for products
or services, and these payments are to be made regardless of whether the purchaser
takes delivery of the products or services. The purchaser is obligated to make the
periodic payments, even if the seivice fails to ship the minimum quantity. At this stage,
there is an agreement between two parties, which is unperformed by both. Assuming
that the purchaser must make payments regardless of whether the products or services

are received, an obligation to sacrifice future economic benefits (by paying cash) to
another entity exists from the signing of the contract. Therefore, the unconditional
purchase obligation constitutes a liability, which arises from the past event of signing
the contract. The obligation exists even though it is unperformed.
Other examples can be used to illustrate the importance of correct interpretation of
present obligation and past event. When an extractive industry company commences
mining, does it have a present obligation to restore the mine site? The answer is yes,
if under law the company has an obligation for restoration in the future as a result of
the past event of beginning mining operations. Restoration will involve the outflow of
future economic benefits (cash payments in relation to restoration activity). Another
example relates to airline reward schemes. Do frequent flyer points give rise to a
liability for the airline? One must consider whether the awarding of points creates a
present obligation to sacrifice benefits in the future. We can argue that it does and that
the past event is the act of buying a ticket and travelling on the flight. Following the
flight, the airline awards points, which creates an obligation to be settled in the future
by providing a service (giving a free seat to the holder of the points).

Liability recognition
Background
Once the definition of a liability is met, accountants need rules to determine if it
should be recognised. The type of rules which have been applied in the past are similar
to those applied to the recognition of assets. They include:
reliance on the law
determination of the economic substance of the event
ability to measure the value of the liability
use of the conservatism principle.
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. The obligation for restoration of mining

PART 2 Theory and accounting practice


operations is a legal obligation if the law requires restoration but it could also be
considered an equitable one (i.e. it is only fair that the land be restored to allow use by
others in the future).
The second criterion requires that we consider the economic substance of a
transaction. Has some 'real' obligation arisen? How important to users is the recording
and eventual display of a liability in the balance sheet? The James Hardie Company
found that some of its employees and their families were developing illnesses as a
consequence of mining and living among asbestos in Wittenoom in Western Australia.
The company recognised it had a 'real' obligation to provide compensation for
sufferers of asbestos-related diseases. 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). Shareholders and investors were concerned about the magnitude of the
outflow of economic benefits associated with settling compensation claims, while
the employees and their families were concerned about how much the company had
provided to meet their present and potential future claims. In recent years, many
stakeholders (such as shareholders, creditors, employees and community groups) have
become increasingly concerned about the liability of companies in relation to their
impact on the environment. Questions about accounting for environmental liabilities
are considered in case study 8.1.
Another example about economic substance relates to how we account for a converting
note transaction (a hybrid security). Suppose a company borrows $10 000 from a bank
and promises to repay the loan by giving 1000 of its own ordinary shares. In essence, this
is a converting note but does it give rise to a liability? Converting notes are instruments
that confer a stream of interest payments for a defined period of time, after which the
notes must be converted into shares. Should we recognise a liability until such time as the
note converts, when equity is created, even though there is no future outflow of economic

benefits? It can be argued that we should, because a failure to record the obligation of the
transaction until equity is issued may fail to record its economic substance.
The third criterion relates to determining the value of liabilities. For some liabilities,
value is represented by a contract price, such as thp 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.
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. Such an approach is described as prudence in the IASB/AASB Framework
paragraph 37. However, there is a major problem with a company's decision to adopt
a conservative approach to measurement. At what point is the company too conservative, so that a bias is introduced into measurement? Decision makers seek neutral
(i.e. unbiased) information in order to make decisions. If information is biased, because
the company wants to portray a particular picture through its financial information,
decision makers have 'noisy' information on which to base their decision. In fact, they
CHAPTER 8 Liabilities and owners' equity


could even make a different decision if unbiased information was presented. Thus, it
can be argued that 'information free from bias' (Framework, para. 36) is essential for
effective decision making.

lASB Framework

The IASB Framework provides guidance in relation to the recognition of balance sheet
and income statement elements. Paragraph 82 states that an item that meets the
definition of an element should be recognised if:
(a) it is probable that any future economic benefit associated with the items will flow to
or from the entity; and
(b) the item has a cost or value that can be measured with reliability.
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. Therefore,
the key issues to be considered in relation to recognising liabilities are (a) the probable
outflow of economic benefits and (b) reliability of measurement. In practice, it may
be difficult to apply these criteria. For example, what does probable mean? It can be
argued that it means more likely rather than less likely. However, individual differences
in estimates of the probability of an event may vary, leading to inconsistency in
measurement.
What is meant by reliable measurement?The Framework states that reliable measurement
is that which is 'free from material error and bias'; further, that an item is measured so
that it 'faithfully represents' what it purports to represent (para. 31). The Framework
states specifically that liabilities cannot be included if they cannot be measured reliably
(para. 86). One example is a legal action. If the damages to be paid cannot be estimated
reliably then the items cannot be recognised as a liability. The legal action example
illustrates the trade off made between relevance and reliability. A probable future
outflow of economic benefits associated with the lawsuit is relevant information, but to
recognise an incorrect amount may be misleading to users of financial information.
Some people take the view that reliable measurement means verifiable measurement;
that is, the measurement of the liability can be linked to objective evidence such as
a contract amount or a market value. However, in many cases accountants must use
judgement to make their best estimate of a liability. Consider for example the liability
for warranty claims. The accountant uses relevant past data (such as the level of prior

claims) and predicted information (such as the level of sales) to estimate the liability.
If the estimate is sufficiently reliable (which will only be known in the future) then the
information will also be relevant for users of financial information. Evidence that there
are different views about how to define and when to recognise liabilities is emerging
as part of the IASB/FASB's project on the conceptual framework. In October 2008 the
boards tentatively adopted new working definitions for assets and liabilities. Discussion
by the boards about when assets and liabilities should be recognised and derecognised
is continuing.
A practical example of recognition of liabilities relates to accounting for publicprivate partnerships. These partnerships refer to the situation where the public sector
(e.g. a government-controlled or -funded entity) contracts with the private sector
(e.g. a company) for the construction of public-use assets such as roads, prisons

PART 2 Theory and accounting practice


a n d schools. The question is: W h i c h entity should record the assets a n d l ~ a b i l i t i e s
associated w i t h the transactions? T o answer this question, accountants must apply the
definition and recognition criteria outlined in accounting standards and the Framework.
However, a number o f outcomes are possible, depending h o w standards are applied.
A key question t o guide application o f the relevant standards relates t o where the
risks a n d benefits o f ownership lie. These issues are explored further in theory in
action 8.2.

by Annabel Hepworth
Public-private partnership projects might be recorded on government balance sheets under
new global accounting rules, a new Productivity Commission paper suggests.
There are concerns that having outlays off-balance sheet can cloud the liability and costs
facing taxpayers and consumers to meet cost-recovery and other requirements under PPP
contracts.
PPPs, where government and private sector work as joint partners, grew in popularity in

the last decade and because they often were off-balance sheet, use of the model helped lower
state government borrowing levels and support credit ratings.
Most economic PPPs have been treated by government as operating leases which, under
accounting standards, typically meaning the risks and benefits of the project are treated as
though they are with the private sector.
But following Australia's introduction of the International Financial Reporting Standards a
few years ago, some PPP deals have already been re-classified as finance leases, which would
tend to see them recorded on the balance sheet. Social PPPs, such as schools, are generally
treated as finance leases.
"Most economic infrastructure PPP projects are not recorded on government balance sheets,
bypassing expenditure controls and reducing parliamentary and public scrutiny of projects,"
says the staff working paper, Public infrastructure Financing: an lnternational Perspective.
"Off-balance sheet accounting can obscure the level of government liabilities or fiscal costs
required to meet future PPP contractual service payments and guarantees. However, it is
possible that more PPP projects could be reclassified and recorded on government balance
sheets under new accounting rules."
Experts say that treatment can vary project-by-project depending on the risk transfer in
contractual arrangements. The PC estimated about 5 per cent of public infrastructure was
delivered using PPPs, compared with about 16 per cent in the UK. The commission also found
PPPs could ensure efficiency by bundling design, construction and operation of projects,
but the off-budget treatment of future obligations for some PPPs could "reduce the scrutiny
applied to the investment".
"PPPs offer considerable potential to reduce project risk, but are costly to transact," it said.
"If such transactions are off-budget, this may inhibit the scrutiny needed to ensure efficient
investment," NSW and Victoria had keenly embraced PPPs, but the credit crisis had led to new
caution of the "innovative financial products utilised in some PPP financing arrangements".
Source: The Australian Financial Review, 1 April 2009, p. 10.

Questions
1. Describe what is represented by a public-private partnership project (PPP)?

2. What is meant by the phrase 'off-balance sheet' liabilities?
3. Why did the government favour PPPs which allowed debt to be off-balance sheet?
4. Explain the reasons in favour of recording economic infrastructure PPP projects on
government balance sheets.

CHAPTER 8 Liabilities and owners' equity


-I

LIABILITY MEASUREMENT
The Framework provides little guidance about how to measure liabilities which
meet the definition and recognition criteria. Paragraph 100 states that a number of
different measurement bases may be employed. Under IFRS, the most commonly used
measurement method for liabilities is historical cost (or modified historical cost). 'Fair
value' measurement is used on initial measurement of transactions involving liabilities
in relation to IAS 17 Leases, IAS 39 Recognition and Measurement of Financial Instruments,
IFRS 2 Share-based I3ayment and IFRS 3 Business Combinations. What do we mean by fair
value? The concept is defined in standards such as IAS 17 (para. 4) to be:
The amount for which an asset could be exchanged or a liability settled between
knowledgeable, willing parties in an arm's length transaction.
Thus, the liability arising under a finance lease is recognised at inception based on the
fair value of the lease (which according to the above definition could be a market price
for the leased property) or the present value of the minimum lease payments if lower
(IAS 17, para. 20). In subsequent years, the liability is measured based on the method
'amortised cost'; that is, the 'cost' of the liability at inception (fair value or present value
of minimum lease payments, if lower) adjusted on a yearly basis to reflect its estimated
current value. The outstanding balance of the liability is based on the effective interest
rate method of amortisation (para. 25). In the case of finance leases, the standard gives
clear guidance for determining the value of the lease liability. However, in other cases,

fair value measurement of liabilities presents some challenges. For example, how do we
estimate the fair value of a liability for which there is no market value? Many liabilities
are settled, not sold.
Table 8.1 shows the variety of measurement methods used under IFRS for subsequent
measurement of liabilities.1° We can see that historical cost (or rather modified
historical cost, in this case amortised cost) is the most commonly used method for
subsequent measurement of liabilities. Two examples where fair value measurement is
required subsequent to acquisition are post-employment obligations such as pensions
(superannuation) under IAS 19/AASB 113 Employee Benefits and long-term provisions
under IAS 37/AASB 137 Provisions, Contingent Liabilities and Contingent Assets. Note
that in both cases the liability is long term and likely to be affected by the time
value of money. In present value terms, the longer the time period until settlement
of the liability, the lower its value. This is because an entity benefits from the ability
to earn interest on the funds which have not been used today to settle the liability.
The next section explores the measurement of the liabilities associated with pensions
(superannuation) and provisions and contingencies.

Employee benefits - pension (superannuation) plans
In many countries pension (or superannuation) plans are established by employers to
provide retirement benefits for employees. Employers make payments to pension funds
which hold assets, in trust, to fund payments when employees retire. The pension funds
are legal entities, separate from the employer firm.
Pension plans may be contributory (both the employer and the employee contribute
to the fund) or non-contributory (where only the employer makes contributions). For
a defined benefit fund, the amounts to be paid to the employee are at least partially a
function of the employee's final or average salary. In contrast, a defined contribution
(or accumulated benefit) fund pays an amount that is a function of the contributions
made to the fund.
PART 2 Theory and accounting practice



Usual measurement basis
allowed by IFRS and adopted
in practice

Fair value option*

Non-current liabilities

Long-term borrowings
Finance lease obligations

Amortised cost

1 Amortised cost

No

I

No

Defined benefit post employment
obligations

Present value of expected
payments less fair value of plan
assets

No


Deferred tax

Expected payments

No

Long-term provisions

Present value of expected
lsavments

I

No

Current liabilities

Trade payables
Derivatives

Amortised cost

No

I

/ Fair value

-


Short-term borrowings

Amortised cost

No

Current portion of long-term
borrowings

Amortised cost

No

Other financial liabilities

I Amortised cost

1

Yes

Current tax payable

Expected payments

No

Short-term provisions


Expected payments

No

Source: Cairns 2007.

* The fair value option may be used for financial liabilities only when there is an 'accounting mismatch'

or when the liabilities
are managed and evaluated on a fair value basis in accordance with a documented risk strategy (IAS 39, para. 11A).

Pension funds may be fully funded, partially funded or unfunded. Fully funded
plans have sufficient cash or investments to meet the fund's obligation to members.
In contrast, unfunded plans do not have cash or investments to cover the potential
payouts under the plans. To the extent that amounts held in trust and being paid into
the pension fund are insufficient to meet obligations under the plan as they fall due,
the pension plan is underfunded.
Since pension funds are separate legal entities, it might be presumed that unfunded
commitments of the plans are not liabilities of an employer firm that pays into a fund.
However, it can be argued that the firm has an equitable obligation to meet unfunded
commitments and, therefore, has a liability. In support of this argument, Whittred,
Zimmer and Taylor offer the example of a firm that lets its sponsored superannuation
fund default and suffers loss of reputation in labour and other markets as a consequence,
thereby incurring a sacrifice of economic benefits." Although some firms traditionally
have not recognised unfunded commitments as liabilities, under the Framework and
IAS 37/AASB 137 it is difficult to argue that they are not liabilities.
Another issue relates to when to recognise liabilities for pension (superannuation)
payouts. Is it:
as the employee renders services? The notion is that the payout is a form of
compensation earned by the employee as services are rendered. However, it is paid

in the future, after retirement.
when the employee retires?
when the fund is required to make payments under the pension plan?
CHAPTER 8 Liabilities and owners' equity


Pension plans can be regarded as a promise by the entity to provide pensions to
employees in return for past and current services. Pension benefits are a form of
deferred compensation offered by the firm in exchange for services by employees who
have chosen, either implicitly or explicitly, to accept lower current compensation in
return for future pension payments. 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 by employees and, therefore, an obligation arises for those
pension benefits that have not yet been funded. Case study 8.2 considers issues relating
to accounting for pensions (superannuation) in the United Kingdom and Australia
by focusing on pension (superannuation) liabilities of a number of large listed
companies.

Provisions and contingencies
Provisions and contingencies occur where there is a blurring of the line between present
and future obligations. IAS 37JAASB 137 Provisions, Contingent Liabilitie3 and Contingent
Assets acknowledges the overlap of definitions in paragraph 12, when it states that all
provisions are contingent because they are uncertain in timing or amount. Trying to
distinguish between present, future and potential (or contingent) obligations is not as
simple as it may appear. The distinction depends to a large degree on the nature of the
'past event'
IAS 37JAASB 137 paragraph 10 defines a contingent liability as:
(a) a possible obligation that arises from past events and whose existence will be
confirmed only by the occurrence or non-occurrence of one or more uncertain
future events not wholly within the control of the entity; or

(b) a present obligation that arises from past events but is not recognised because:
(i) it is not probable that an outflow of resources embodying economic benefits
will be required to settle the obligation; or
(ii) the amount of the obligation cannot be measured with sufficient reliability.
The IAS 37JAASB 137 paragraph 14 recognition criteria for provisions are consistent
with the Framework criteria for recognition of a liability. As such, liabilities and
provisions are permitted to be recognised only when there is a present obligation, it is
probable that an outflow of resources embodying economic benefits will be required
to settle the obligation, and the amount of the obligation can be reliably measured.
Contingent liabilities do not meet these criteria (just as contingent assets do not
meet the criteria for recognition as assets). Hence, paragraph 27 of IAS 37JAASB 137
states categorically that contingent liabilities are not to be recognised in the financial
statements. IAS 37 is presently under review by the IASB as part of the Liabilities project.
One of the proposals is to eliminate the terms 'provision' and 'contingent liability',
replacing them with 'non-financial liability'. The proposals aim to extend and clarify
the application of IAS 37; however, as is usual, the proposals have received mixed
responses from stakeholders.12
The effect of IAS 37 is to limit the use of provisions. For example, a company may
consider it prudent to create a provision for uninsured losses (i.e. the process of selfinsuring), however, a liability cannot be recognised under IAS 37 until the occurrence
of an event necessitating the sacrifice of assets by the reporting entity. Another example
relates to 'provision for possible losses' or a 'provision for restructuring' which may be
created following poor performance. Since there is no existing obligation to an external
party (i.e. a commitment to transfer resources from the entity to an external party which
cannot be avoided) such a provision would not be permitted under the Framework or
current standards.
PART 2 Theory and accounting practice

-



Certainly, there are circumstances when the users of financial information want
to know about potential losses or outpings. IAS 37 (para. 86) states that in some
circumstances a note to the accounts is required because the knowledge of the liabilities
is relevant to the users of the financial report in making and evaluating decisions about
the allocation of scarce resources. That is, future settlement may be required, but the
estimated probability is not high enough to warrant formal recognition. This subjective
probability test provides opportunities for firms to exclude liabilities from their financial
statements. However, the liabilities should still be disclosed when knowledge of them
is likely to affect users' decision making. Theory in action 8.3 provides an example of
a contingent liability note from the Public Transport Authority of Western Australia
(a public-sector entity). It is a worthwhile exercise to consider the extent of disclosure
included in the note and the reasons it has been provided.

The following extracts are from the Public Transport Authority ( P I'A) Annual Report
200612007 Notes to the Financial Statements and detail the current legal actions in progress
against the entity.
----"
- - "-

Contingent Liabilities
In addition to the liabilities included in the financial statements, therc are the following
contingent liabilities:
Litigation in progress
Quantifiable Contingencies
Leighton Contractors Pty Ltd, the contractor engaged by the PTA to design and construct
the City portion of the Southern Suburbs Railway, has commenced Supreme Court actions
against the PTA. Two of the actions relate to contractual disputes between the PTA and
Leighton Contractors, on Leighton Contractors' alleged entitlements under the rise and fall
and contaminated material provisions of the contract. The estimated value of these two claims
is $64 million. The PTA has denied all liability and is vigorously defending the action.

The amount that has been claimed by John Holland Pty Ltd, the contractor engaged by the
PTA to construct a package of three stations on the Southern Suburbs Railway, but rejected by
PTA, which is now subject to dispute, is $6.89 million. PTA is defending the claims.
The amount that has been claimed by RailLink Joint Venture, the contractor engaged by
the PTA to construct the civil, rail and structures portion of the Southern Suburbs Railway,
but rejected by PTA, which is now subject to dispute, is $2.62 million. PTA is defending the
claims.
Unquantifiable Contingencies
As at 30 June 2007, PTA has a number of claims lodged against it by several contractors
engaged in construction of the Southern Suburbs Railway. One significant claim is from
Leighton Contractors on allegations of misleading and deceptive conduct in relation to the
contracts work insurance effected by the PTA pursuant to the contract. PTA has denied liability
and is defending the claim. It is not possible to estimate the amount of any eventual payments
in relation to these claims at balance sheet date.
Source: The Government of Western Australia, Public Transport Authority, Annual Report 200612007,
Note 38, Notes to the Financial Statements, pp. 112- 1 13.

Questions
1 . Name the parties listed in the note that are taking legal action against the PTA. State the
matters or matters under dispute and the amount of the claim if provided.
2 . To what extent has the PTA incurred losses of economic benefits in relation to these
matters?
CHAPTER 8 Liabilities and owners' equity


3. 'Contingent liabilities are not liabilities of an entity; in fact, they may qever eventuate so

their disclosure is misleading.' Explain whether you agree or disagree with this statement
and provide reasons for your view.
4. The PTA is a government business enterprise, with one shareholder, the Western Australian

State Government. Discuss whether disclosure of contingent liabilities is less relevant for
the PTA than for a publicly listed company with widely held shares.

Owners' equity
Owners' equity is the third of the fundamental accounting concepts captured in the
accounting equation. It represents the net assets (assets minus liabilities) of the entity
(P = A - L). Thus, owners' equity (or proprietorship) captures the owners' claims against
the entity's net assets, which the entity has no current obligation to pay. It represents
the owners' interest or capital in the firm. Owners' equity (the residual interest) is a
claim or right to the net assets of the entity. The Framework defines equity in paragraph
49(c) as follows:
'Equity' is the residual interest in the assets of the entity after deducting all its
liabilities.
Therefore, owners' equity is not an obligation to transfer assets, but a residual claim.
Further, it cannot be defined independently of assets and liabilities. As such, the
definitions of assets and liabilities must be agreed on before a definition of equity can be
finalised and applied in a sound theoretical or practical sense. 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.
For example, assume Firm A undertakes an upward revaluation of property under
IAS 1G/AASB 116 Property, Plant and Equipment but Firm B, which holds an identical
asset, does not. Firm A will report higher assets and equity than Firm B.
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.
Legal rights are a very important consideration. However, they should not be the only
basis of distinction between creditor and owner. After all, the definition of a liability
includes constructive and equitable obligations as well as legal obligations. Another reason

is that the legal viewpoint is too narrow a focus to be useful in achieving the decisionusefulness objective of accounting. Therefore, economic substance must also be studied.

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.
PART 2 Theory and accounting practice


Note that creditors' claims are limited to specified amounts (which may vary over
time according to the terms of the agreement). In contrast, the owners have a residual
interest only, although by contractual arrangement different classes of owners may have
different priorities in the return of capital.
Another aspect of the rights of creditors and owners relates to the use of the assets or
to the operations of the business. Creditors do not have the right to use the assets of the
firm other than as specified in contracts. Except in an indirect way in some cases, they
do not possess rights in the decision-making process in the operations of the business.
In a limited way, by contract, they may intrude on operations by requiring that retained
earnings be restricted, or that a given asset not be sold without their approval. On the
other hand, owners have the right or authority to operate the business.

Economic substance
Both liabilities and owners' equity represent claims against the entity. All claimants

against the entity bear a risk of loss but, because of the prior claims of creditors, their
risk is less than that of owners. Owners must bear any losses stemming from the
activities of the firm. They carry the brunt of the risk in the business. In each firm, the
degree of risk for creditors and owners depends on their rights. As such, 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. Figure 8.1 provides a diagrammatic
representation of the relationship between economic substance and rights.
Rights

Economic substance

Interest and settlementi
Participation in profits

+Risk and return

Use of assets

+Control

FIGURE 8.1 The relationship between economic substance and rights

Owners or their representatives have control of the acquisition, composition, use and
disposition of the firm's assets. They have control of operations and the responsibility
for running the business and for its survival and profitability. Generally speaking,
company owners (shareholders) delegate most of these responsibilities and control to

directors and managers.
These arguments correspond with the notions of the entrepreneur in economics. The
concept of entrepreneur may be idealistic when applied to the average shareholder in
a large, publicly owned company but this misfit is due to the insistence of accountants
that a distinction is made between liabilities and owners' equity for all business
enterprises. The recognition of owners' equity presumes a proprietary theory position,
which, to begin with, is awkward when imposed on a large company.

Concept of capital
Accounting for shareholders' equity is influenced by legal prescriptions. For example,
in the United Kingdom and Australia company law includes statutes relating to
accounting for capital. Foremost is the requirement of 'capital maintenance', which
CHAPTER 8 Liabilities and owners' equity


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. Capital can be conceptualised as the invested money or
invested purchasing power (financial capital) or as the productive capacity of the entity
(physical capital). Further, capital can be measured on either a nominal dollar or a
purchasing power ('real') scale. Various combinations of the concept of capital and the
measurement scale are used in different models that yield different measures of capital
under identical circumstances. The Framework provides no guidance regarding which
model is most appropriate, but does recognise in paragraphs 108 and 109 that firms
would need to retain different amounts of resources to maintain different concepts and
measures of capital.
Another 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 $100000, this means that liabilities

amount to $90 000. That is:

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.
The importance of capital reserves was highlighted in the banking and liquidity crises
of 2007-08.

Classifications within owners' equity
The distinction between contributed and earned capital is one that accountants find
useful. The rationale is to keep separate the amount invested from the amount that is
reinvested. The former is due to financing transactions, whereas the latter is derived
from profit-directed activities. Retained earnings, or unappropriated profits, make up
the earned capital.
Retained earnings may be appropriated for specific purposes. Remember that retained
earnings are not assets in themselves and therefore the appropriations of retained
earnings to specific reserve accounts do not represent particular assets. In 1950, 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.13
The committee stated the following.
The first type did not effectively achieve the objective and would be best explained in
narrative form elsewhere.
For the second type, the committee believed a note to the accounts would be
preferable to an appropriation.
For the third type, the committee felt an appropriation was unnecessary and often

misleading; a note would be more suitable.
The committee emphasised that appropriations must not affect profit determination.
There is little that can be accomplished by appropriations. Some accused companies of
PART 2 Theory and accounting practice


using appropriations as a ploy to decrease the amount available for dividends, hoping
thereby to lessen complaints by shareholders about the- level of dividends paid. Such
arguments assume that managers believe shareholders are naive. The demarcation
between contributed and earned capital cannot be strictly maintained because of
transactions that do not fall neatly into these categories. For example, share dividends
(i.e. dividends that are 'paid' in the form of an allocation of shares) represent a change
in classification from earned to contributed capital.

CHALLENGES FOR STANDARD SETTERS
The IASB has several current projects which will affect the definition, recognition and
measurement of liabilities, including those relating to the conceptual framework,
financial instruments, provisions and employee entitlements. The Board is amending
IAS 37 Provisions, Contingent Liabilities and Contingent Assets and IAS 19 Employee
Benefits as part of the Liabilities project. The objective of the project is to (a) converge
IASB standards with US GAAP and to (b) improve current standards in relation to
the identification and recognition of liabilities.14 The work on the Liabilities project
illustrates how standards are interconnected and changes likely affect a number of
standards; for example, the work on IAS 37 will be relevant to projects on leasing,
insurance and the conceptual framework.
To illustrate challenges currently faced by standard setters, we now discuss three
key topics which are relevant to issues discussed in this chapter. First, we consider the
distinction between the classification of items as liabilities or equity, the so-called debt
versus equity distinction. Second, we discuss when liabilities are extinguished; that is,
when it is appropriate for companies to remove liabilities from their balance sheets.

Third, we examine share-based payment transactions and consider the extent to which
they give rise to liabilities or equity.

Debt vs equity distinction
Based on the definitions and recognition criteria discussed in this chapter, we can
agree that shares issued to investors form part of equity and that loans from creditors
are liabilities. However, questions are raised about hybrid instruments which 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 (akin to
interest)
they have priority over ordinary shares in the return of capital (as do liabilities)
they generally carry no voting rights.
Although they are called shares, it is likely that they sometimes meet the definition
of liabilities, and should be classed as liabilities. IAS 32JAASB 132 paragraph 18
comments:
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
and others may combine features associated with equity instruments and features
associated with financial liabilities.
IAS 32JAASB 132 goes on to state that preference shares that provide for mandatory
redemption by the issuer for a fixed or determinable amount at a fixed or determinable
CHAPTER 8 Liabilities and owners' equity


future date, for example, are financial liabilities. Similarly, a financial instrument thdt
gives the holder the right to retxrn the instrument to the issuer for cash or another

financial asset (a 'puttable instrument') is a financial liability. Preference shares,
convertible debt and 'perpetual' capital notes are examples of securities whose names
may not accurately describe the dominant characteristics of the securities.
The classification of financial instruments as liabilities or equity has effects beyond
the balance sheet since the classification determines whether interest, dividends, losses
or gains relating to that instrument are recognised as income or expenses in calculating
net income, or whether they are treated as a distribution of the calculated profits.
Distributions of interest, dividends, losses and gains relating to financial instruments
or components of financial instruments that are liabilities are recognised as income or
expenses. In contrast, distributions to holders of an equity instrument are treated as a
distribution of the profits once they have been calculated.
In summary, consistent with the theoretical bases of the definitions, IAS 32/AASB 132
requires classification of financial instruments to be based on their economic substance
rather than their legal form. Consequently, preference shares redeemable at the option of
the holder are classified as a liability. Compound financial instruments have both debt
and equity characteristics and the component parts are to be accounted for separately.
For example, the issuer of convertible notes providing their holders with the right to
convert the interest-bearing note into ordinary shares of the issuer should allocate the
proceeds from the convertible note issue into liability and equity components. The
equity components reflect the holders' right to convert the security into ordinary shares.
Thereafter, payments to the holders (other than any return of principal) are classified as
interest or dividends on a pro rata basis according to the proportion of the security that is
defined as debt or as equity.
The purpose of distinguishing between owners' equity and liabilities is to enhance
the usefulness of information for decision making. Interesting questions are raised
about how investors view so-called hybrid securities, which combine features of
both debt and equity such as convertible notes, redeemable preference shares and
subordinated debt (see theory in action 8.4). In their study of the usefulness of hybrid
security classifications, Kimmel and Warfield found that the dichotomous classification
of redeemable preference shares as straight debt or straight equity does not reflect the

risk-return relationship that can be useful for decision making. Interestingly, though,
Kimmel and Warfield concluded that the merit of classification within financial
statements as a means of conveying information about hybrid securities is questionable
when the nature of securities does not correspond to the elementary classification and
the securities are non-divisible.15
The IASB has a current project on IAS 32JAASB 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. It is currently considering
how best to define what is, and what is not, an equity instrument. A starting point is
the idea that all 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. In contrast, a liability is mandatorily redeemable at a specific date or dates or
is certain to occur.lGThe Board is exploring feedback on the discussion paper issued
in February 2008. One of their challenges will be to provide the guidance sought by
preparers without compromising the Board's principles-based approach.
PART 2 Theory and accounting practice


---

-

*

A dynamite solution
by Ciles Parkinson
When Australia's Orica bought the international assets of explosives group Dyno Nobel for
$902 million in late 2005, it was faced with a delicate funding problem. It had already used

a lot of debt to fund other acquisitions and investments, and it was important to protect its
strong BBB plus credit rating.
Borrowing more might have placed that rating at risk. It raised $500 million in new equity
through a rights issue, but issuing more equity would have been costly and reduced its earnings
per share, an important calculation for investors.
Fortunately, Orica had done a lot of planning ahead of time. According to Frank Micallef,
general manager of treasury operations, the company had been working for four years on
developing a new form of hybrid security that combined the elements of debt and equity and
best suited the needs of both the investor and the issuing company.
In early 2006, Orica introduced a new generation of hybrid securities, which it called StepU p Preference (SPSj Securities. It offered to sell $400 million, but in the end demand was so
great that it sold $516 million to institutional investors.
The key features of these securities were that they were treated as equity for accounting
purposes, and so strengthened its balance sheet, and were viewed as a form of subordinated
debt by investors, who received a higher interest payment than they would for corporate
bonds.
The SPS offered a return of 135 points (or 1.35 per cent) over the prevailing bank bill
rate - then 5.45 per cent. The payments are discretionary, but they can only be suspended
if all dividend payments were suspended. The securities are also perpetual, but they can be
redeemed by Orica at the conclusion of five years. If they are not redeemed by the company
at this time, the interest rate payable on the securities, or the coupon, will "step up" by
another 2.25 per cent.
"It was a good transaction," says Micallef. "It enabled us to minimise the ordinary equity
that we could issue, and that helped in the earnings-per-share calculation. "Even though these
instruments were more expensive than vanilla debt, we looked at it as a form of cheap equity
rather than expensive debt."
Source: Extract from 'Rainbow Connection', Real Business, Spring 2007, pp. 30-1.

Questions
1 . Outline the debt and equity situation of Orica at the time of the purchase of Dyno Nobel
in 2005.

2. Describe the features of Step-Up Preference Securities (SPS) created by the company.
3. Explain how the securities could be considered as equity for accounting purposes but as
debt by investors?

Extinguishing debt
A debt m a y b e settled in ways other than b y direct payment o r rendering o f services t o
the creditor. The obligation, for example, may b e 'forgiven' b y the creditor, thus releasing
the debtor f r o m making any future sacrifice. IAS 32/AASB 132 outlines offsetting a
financial asset and liability in paragraph 42. The situation it deals w i t h is referred t o
as the 'set-off and extinguishment o f debt' o r 'in-substance defeasance'. This allows a
debtor t o remove a debt f r o m the balance sheet and t o report a net financial asset o r
liability o n l y if the entity has a current legally enforceable right t o set o f f the recognised
amounts, a n d intends either t o (a) settle o n a net basis o r (b) realise the assets and
settle the liability simultaneously.

CHAPTER 8 Liabilities and owners' equity


The eccnomic 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.
To illustrate why the in-substance defeasance arrangement became popular during
the 1980s, consider the following 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 $10000000, 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. The following entries will be made:
(1) lnvestment in Government Bonds
Cash
(2) Bonds Payable

lnvestment in Government Bonds
Gain o n Bonds Payable

The advantages to the company are:
the debt is removed and, 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
for tax purposes, 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.
In-substance defeasance raises the question: 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. The question remains as to what would happen if the trustee proved to
be unreliable and the assets were lost or misappropriated. In such a case, the debtor
would have to reinstate the liability. As is clear from this example, there can sometimes
be many variations of transactions and events that challenge the theoretical structure of
accounting standards.
The importance of reliable recognition and measurement of assets and liabilities
has been highlighted through the events of the 'sub-prime crisis' which emerged in the
United States in mid-2007 and led to global financial market turmoil and a more general
economic crisis (referred to at the time as the 'global financial crisis'). Given the central

role of financial instruments in the crisis, the ways in which financial instruments are
regulated came under close scrutiny by a broad range of parties. The relevant standards
of the IASB and FASB were put under the spotlight and changes made to ease the effect of
mark-to-market accounting for instruments without liquid markets. l7 The IASB published
an exposure draft related to derecognition of financial instruments in March 2003.
Amendments are proposed to IAS 33 Financial Instruments: Recognitzon and Disclosure and
IFRS 7 Financial Instruments: Disclosure. As explained above, companies may respond to
incentives to remove items from their balance sheets, or to ensure that items do not appear
on their balance sheet. Such activities interfere with financial statement users' ability to
PART 2 Theory and accounting practice


assess company risk. In the derecognition project, the 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 expo~ure.'~

Employee shares (share-based payment)
Accountants debate whether share-based payment gives rise to an expense. Another
aspect of the issue is whether the remuneration 'paid' to employees by way of company
shares or stock options (options to buy shares) gives rise to liabilities or equity. Sharebased payment plans normally cover a number of years. When shares or options have
been offered under a plan, but prior to the issue of shares, does the company have
a liability? If so, what is the economic benefit to be sacrificed in the future? When
shares are issued under the plan, has equity increased, or merely been redistributed?
Those who argue that the issue of shares creates an expense and a liability contend that
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. 'Those who argue that
the issue of shares in a share-based payment plan does not constitute payment of an

expense maintain that 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.
The IASB has decided to treat share based remuneration as an expense. IFRS 2/AASB 2
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 (e.g. an amount of cash equal to the value of the entity's shares at the time the
payment is made), the corresponding credit entry is to a liability. The current approach
in IFRS 2/AASB 2 leads to a differential treatment for the fair value changes associated
with equity-settled compared with cash-settled plans. The fair value of transactions in
equity-settled plans is determined on grant date and subsequent changes are ignored.
However, the transactions classified as liabilities under cash-settled plans are adjusted
to fair value at each balance date, with gains and losses included in income. The
differential treatment raises the question whether items which are the same in substance
(share-based payment) should be accounted for in different ways.19

Issues for auditors
The completeness of liabilities recognised on the balance sheet and the note disclosures
about contingencies and other obligations are major issues for auditors. They are
required to gather evidence that accounts payable, accruals, and other liabilities
include all amounts owed by the entity to other parties. Auditors need to consider
the 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. Cut-off tests are designed to gather evidence that transactions are
recorded in the proper period. In addition, auditors need to test whether the liabilities

are recorded at the proper value.
CHAPTER 8 Liabilities and owners' equity


Concealment by managers of the entity's obligations, such as contingent liabilities,
loan guarantees, or commitments under varicz~scontractual agreements, understates
liabilities and creates an impression of greater solvency for the company. In an extreme
case, such concealment means that it is inappropriate for the financial statements to
be prepared on a going concern basis, and the auditor will fail to qualify the audit
opinion. Auditing standard ASA 57020 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 (ASA 570 para. 63).
An example of a company which appeared to have problems with the completeness
of its reported liabilities was Enron, which filed for bankruptcy in December 2001.21
Although the transactions and other arrangements were complex, it can be argued that
Enron understated its liabilities through improper use of unconsolidated special purpose
entities (SPES).~~
Benston and Hartgraves note that Enron was not required by US GAAP
in place at the time to consolidate the many SPEs it used if independent third parties had
a controlling and substantial equity interest in the
Enron therefore treated the SPEs
as separate entities and sold assets to them, creating profits without having to recognise the
SPEs' liabilities. However, because the principal assets for the SPEs were shares in Enron,
the fall in Enron's share price meant that it became liable for the SPEs' debt (which was
guaranteed by Enron). When Enron's use of SPEs was reviewed by their auditors, Arthur
Andersen, in 2001 it was decided to retroactively consolidate the entities which resulted in
a massive reduction in Enron's reported net income and a massive increase in its reported

debt. Within months of the announcement of a $1.2 billion reduction in shareholders'
equity, Enron's shares were practically worthless.24
Although 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. Commonly labelled 'cookie-jar' reserves, provisions for future expenditures,
such as maintenance, allow the company to 'store' excess earnings for a 'rainy day'.25As
discussed earlier, blatant use of this technique is now limited by IAS 37/AASB 137, but
auditors are still 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).
The introduction of 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. A similar standard forms part
of US GAAP. In the United States, the Public Company Accounting Oversight Board
(PCAOB) inspected audit firms for the period 2004 to 2006 and reported that in
some cases auditors were not properly evaluating whether their clients, particularly
their newer or smaller company clients, had used appropriate values for share-based
payment transactions. For example, some auditors were allowing equity instruments
issued as consideration for the cancellation of outstanding debt to be valued at the
carrying values of the debt even though there was evidence that the equity instruments'
market values exceeded those carrying v a l ~ e s . ~ V
general,
n
to properly audit these types
of transactions 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.
PART 2 Theory and accounting practice



-i

The proprietary and entity perspectives of the firm
We began this chapter by exploring two theories: proprietary and entity theory, which
help us understand our approach to accounting. Under proprietary theory, we see the
owner or proprietor of the business as the party for whom the accounting information
is prepared. The proprietor's interest or equity is represented by the net assets of the
business. The assets generate income, which in turn increases equity or the wealth of
the proprietor. The proprietorship perspective takes a 'financial' view of capital because
capital is seen as the investment ofthe proprietor which increases or decreases, depending
on the financial success of the business.
The diverse nature of the modern-day corporation has raised questions about the
proprietorship perspective and led to the development of entity theory. Under this
theory, the business for which accounts are prepared is legally and practically separated
from its owners. Accounting provides information about the entity's use of its assets to
generate income. This information is used by a range of stakeholders including current
and potential shareholders, creditors, employees and tax authorities. Under this view,
assets are resources controlled by the entity and liabilities are obligations of the entity,
not the owners. Income generated from assets increases equity and the entity then makes
decisions about the portion, if any, which will be distributed to shareholders. The entity
is assumed to have a financial view of capital if users are primarily concerned with
maintenance of nominal capital or purchasing power of capital. On the other hand, if
the entity is focused on maintaining the operating capacity of assets (i.e. the physical
productive capacity) then a concept of physical capital is useful leading to, in theory at
least, the use of current value measurement to maintain capital.
Issues involved in defining liabilities and equity, applying those definitions, and why
the definition and recognition criteria are important


The practice of accounting is based on a shared understanding of principles and
concepts. Definitions help us interpret concepts such as assets, liabilities and equity.
Since definitions must be stated in general terms, we also have recognition rules to assist
accountants to apply definitions in practical situations. Recognition rules may be drawn
from generally accepted accounting practices (e.g. recognise liabilities as soon as they are
foreseen) and from specific accounting standards (e.g. a finance lease is to be recognised
on the balance sheet when certain conditions are met).
The current definition of liabilities draws from the 1989 IASBIAASB Framework. It has
two elements relating to the existence of a present obligation and a past transaction.
CHAPTER 8 Liabilities and owners' equity