Accounting for Assets and Liabilities - Literature review Example

Running header: Accounting Report Student’s name: Instructor’s name: Subject code: Date of submission: Assets and Liabilities Introduction Assets and liabilities are two of the primary elements that make up the ‘accounting equation’. They both come in a variety of classificatory forms and descriptions. Over the years, and in their various classificatory forms and descriptions, assets and liabilities have been associated with a variety of different definitions, recognition criteria and measurement bases. This is evidenced by the various definitions fronted by various scholars in regard of both assets and liabilities. Assets and liabilities can also be classified in various ways depending on their nature and characteristics. Due to existence of different recognition criteria, it has been difficult for accountants to accurately recognize assets and liabilities which at times result in inaccurate information. Existence of different measurement approaches for both assets and liabilities only serves to complicate this. In order to ensure that financial statements are accurate and consistent and hence able to influence decision making accurately, there should be a single criteria for recognition and measurement of assets and liabilities. This report attempts to establish the best definition for both assets and liabilities. The report also suggests the best criteria for recognition of assets and liabilities in addition to suggesting the best measurement method that should be used by all accountants. The report starts by conducting a literature review in order to establish what has been done by accounting scholars regarding definition, classification, recognition and measurement of assets and liabilities. This is followed by a detailed analysis of all the above issues. Different definitions, classifications, recognition criteria and measurement approaches are analyzed. This analysis forms the basis of conclusion which gives an opinion on the best definition, recognition criteria and measurement method that all entities should adopt. Literature review Lundin, P& Wright, J2008, Accounting for assets and liabilities: Issues surrounding description, recognition and measurement, Journal of accounting and economics, vol.25, no.14 pp.65-70. In their article, Lundin and Wright thoroughly examine the issues that relate to accounting for assets and liabilities. The article gives a number of commonly used definitions for assets and liabilities. It also gives a number of scenarios which would make recognition of assets a difficult task for accountants. The article also explains the various methods that accountants use in measuring and recording assets and liabilities in the financial statements. The authors however claim that there is no one best way of measuring the value of assets . They thus conclude that whatever the measuring method an entity adopts, it should ensure that the accounting objectives of accuracy, reliability and consistency are adhered to. This they say will ensure that entities produce statements that portray the true and fair picture of the entity. Macknon,W2011,Asset,Liability and Revenue recognition, International journal of accounting research, vol.45,no.12,pp.19-27. In her article, Macknon critically examines guidelines by various international accounting standards including GAAP, IAS and IFRS regarding assets, liability and revenue recognition. She acknowledges the fact that failure to follow the right recognition criteria could lead to erroneous accounting and hence inaccurate financial statements. As such, she establishes the criteria that accountants should follow in deciding on recognition of the items of the balance sheet. In addition, she suggests that the various accounting bodies should be dismantled and instead one body formed to be in charge of issuing accounting standards and guidelines. This she says will help in dealing with the confusion that accountants currently face in recognizing assets, liabilities and revenue. This is also seen as a way of increasing accuracy, reliability and consistency of financial statements around the world. Jones, J2011, Measurement of assets and liabilities, The Irish Journal of management, vol.30, no.12, pp.17-25. Jones outlines the various issues regarding the measurement of assets and liabilities. He appreciates the fact that for an asset or liability to be recorded in the financial statement, it has to be measured reliably. His article examines all the available methods of measuring assets and liabilities including their merits and demerits. He is of the opinion that a measurement method for assets ought to be objective as this would increase its reliability by limiting chances of manipulation by individual opinions. In addition, he suggests that a measurement method be relevant by making the value of the asset or liability in question be as close as possible to what it is in reality. He terms this as the fair value measurement. Although Japheth does not give a one best method for valuing assets and liabilities, he is of the opinion that organizations should use methods that are objective, reliable and relevant in their measurement so as to ensure accuracy of financial statements as they are vital to users in their decision making. Analysis Assets: definition and classification Many definitions have been advanced in regarding assets. In his book, Krigler (2009) defines assets as anything of economic value owned by a person or an organization that can be converted into cash. He gives various examples of assets including accounts receivables, securities, inventory, property and equipment among others. As such, it is an economic resource that the individual or organization owns with an expectation of future benefit. Wayvober (2010) on the other hand describes an asset as a balance sheet item that represents what is owned by a firm or organization. As such, assets are bought with an intention of increasing the organization's value or benefiting the firm's operations. An asset can therefore be described as something able to generate cash flow regardless of whether it is owned by an individual or the firm. In his book, Mendel (2007) has described assets as any property possessed by a business or an individual. In his book, Simmons (2011) defines assets as future economic benefits that an individual or an entity controls resulting from past transactions or similar past events. He goes further to explain controlling of an asset as the capacity the entity posses to benefit from the asset in the pursuit of its objectives and its ability to regulate or deny others from benefiting from the asset. From all the above definitions, it is clear that for an item to qualify to be an asset, it has to fulfill a certain criteria including; a) There must be future economic benefits to be derived by the firm from the item/asset b) The organization/entity must have control over the future economic benefits derived from the said asset such that it can enjoy the benefits, deny or regulate others from deriving benefits from the asset. c) The transaction that accords the entity the control over the future economic benefit must have already occurred. Based on these characteristics and definitions, we can define an asset for accounting purposes as a resource that the entity controls resulting from past transactions/events from which the entity expects to derive future economic benefits. Classification: Assets can be classified into a number of forms based on their nature and characteristics as follows Fixed assets These include all assets acquired for long-term use by the firm in generating profits. They include property and equipments, land, building and machinery. Note that long-term investments are at times classified under long-term assets. Current assets These are assets that are short term in nature in that they are convertible into cash or consumed in the entity's operations without interfering with the entity's operations within its operating cycle or an year whichever is longer. During an entity's normal operating cycle, current assets are turned over continually. Current assets are in turn classified into a number of classes including; i) Cash and cash equivalents which forms the most liquid class of assets and includes negotiable instruments, money and deposit accounts. ii) Short term investments which include securities to be sold in the near future. iii) Accounts receivables -this is what an entity is owed by outsiders and is expected to be collected in the short term. iv) Inventory which includes the entity's trading assets in its normal operations. v) Prepaid expenses which include expenses that are paid for before the benefits accruing from them are enjoyed by the firm. Intangible assets These are assets lacking physical form and are not easy to evaluate. Intangible assets include goodwill, franchise, patents, trademarks etc. Tangible assets These include all assets with physical substance including those classified under fixed and current assets. Examples include cash, buildings, real estate etc. It is worth noting that more classification criteria for assets exist depending on their characteristics. For instance, current assets could further be classified as liquid assets and absolute liquid assets depending on their liquidity. Assets recognition criteria Unlike liabilities which are only recognized on accrual basis, there has been a concern over the best method for recognizing and recording assets. This is because two methods for recognition and recording of assets exist-cash basis and accrual basis. Should assets be recognized when the transaction of their acquisition takes place or when cash changes hands? In addition, there has been a concern over what criteria should be used in recognizing assets to be recorded in the balance sheet. This is because wrongful recognition could lead to provision of inaccurate information to the various users. Before an asset can be considered for recognition as an asset in the balance sheet, it must first of all satisfy all the characteristics of an asset earlier discussed. Tifany (2006) states that an asset should be recognized in the balance sheet if and only if there is a probability that future economic benefits will be derived from the said asset and that the asset posses a cost or a value that is capable of being measured reliably. a) Probable future economic benefits The ability to derive future economic benefits has been identified as an essential characteristic of an asset. Therefore, it should be probable that future economic benefits will be derived from the asset if the asset is to be recognized in the financial statements. In this case, probability implies that the chance of deriving the future economic benefits is more likely to occur than it is likely to fail to occur. This probability is based on logic and the available evidence. This imply that where an entity incurs an expenditure but at the time future economic benefits arising from the expenditure are not considered probable, the concerned asset does not qualify for recognition. For instance, future economic benefits that would arise from research and development expenditure may not qualify for recognition as assets since it may not be possible to establish whether future economic benefits will be derived at the date of the expenditure. This means that it is possible for an asset to fail to satisfy the criteria of probable future economic benefits at a particular time but satisfy the criteria at a later date resulting from subsequent events. Although such amount might have been recognized as expenses by the entity in the past, such asset will still qualify as an asset. For instance, an organization may have recorded exploration costs for a mineral as expenses in the past but recognize it as an asset when it is subsequently confirmed that it exists. b) The reliable measurement criteria It is necessary that an asset posses a cost or a value reliably measurable if it is to be recognized as an asset in the financial statements. The appropriateness of the basis of measurement will however be dependent on the accounting model in application. In many cases, assets usually have values capable of being measured reliably according to a specific accounting model or a specific cost that can be attached to them. However, some assets may not have a cost or a value that could be reliably measured. In such cases, the assets are considered as having not met the recognition criteria and are hence not recognized. For instance, even though a mining company may have discovered mineral deposits in one of its exploration sites, it may not recognize it in the financial statement if it is not in a position to know the value of the deposits at the reporting date. In some cases, the asset recognition criteria may not have been met although its knowledge may be considered relevant to those who use the financial statements in the making and evaluation of decisions regarding allocation of resources. In such cases, it is necessary that a disclosure be made in the notes to the financial statements. Liabilities Definition and classification Just like assets, many definitions have been advanced to refer to liabilities. For instance, Krigler (2009) refers to liability as pecuniary obligations or debts payable from the entity's assets. As such, liabilities are an entity's legally recognized debts and obligations which result from normal business operations and are settled over time using the entity's economic assets which include goods and services or money. On the other hand, Wayvober (2010) refers liabilities as financial obligations currently owed by an entity to outsiders. It is the obligation by an individual or an entity to settle debts owed to outsiders. Another definition is given by Mendel (2007) who describes liabilities as an entity's obligation that arises from its past transactions and events whose settlement usually result in the transfer and use of assets as well as yielding of corresponding future economic benefits or rendering of services. Despite there being different definitions of liabilities, some characteristics are evident in them which should help any organization in defining, recognizing and measuring its liabilities. These characteristics include; a) Liabilities include a borrowing whether from banks or any other sources by an entity intended for improvement of personal or entity income payable either in the short term or long-term. b) A liability entails a duty to other parties for future settlement through transfer of assets , service provision, or such other transaction that yields an economic benefit at a specific or determinable future date or on demand. c) A liability entails an obligation to the entity to another party that leaves no discretion to forfeit settlement. d) The transaction that gives rise to the obligation to pay has already taken place. Based on the above definitions and characteristics of a liability, we can define Liabilities as sacrifices of economic benefits occurring in the future which an entity is currently/ presently obliged to settle to other parties or entities resulting from past events or past transactions. Just like assets, liabilities can be classified into a number of classes based on their nature and characteristics. These include; Current Liabilities Current liabilities include those obligations or debts which are reasonably expected to be settled within the current year. Such Liabilities include short term payable such as those of wages , taxes, accounts payable, the portions of long-term bonds maturing in the current period, other short term obligations such as those arising from purchase of equipment on credit. When making adjusting entries, unearned revenue is treated as current liability. Long-term Liabilities Long-term liabilities include those obligations or debts that are reasonably expected not to mature in the current period or the current year. Long-term liabilities include long-term notes payable, long-term leases, long-term product warranties as well as long-term bonds. Contingent Liabilities Contingent Liabilities are those liabilities that an entity may or may not incur depending on the outcomes of expected future events such as a case that has not been concluded in the court of law that may result in the entity being fined. It is worth noting that such liabilities are only recorded in the balance sheet only when it is reasonably probable and estimable and must be accompanied by a footnote to describe their nature and extent. Recognition criteria for liabilities Providers of accounting information have the obligation to provide financial statements that are accurate, consistent and capable of being used in quality decision making by the various users of such information. As such, information regarding an entity's liabilities is key to offering accurate and consistent financial information and is key to through financial analysis. Despite the fact that various bodies such as the financial accounting standards board (FASB), and the securities and exchange commission have issued guidelines regarding recognition of liabilities and despite the fact that liabilities constitute a great part of the balance sheet, liabilities are of different nature which make their recognition to be a tricky one (Simon's 2011). For instance, not all liabilities are required to appear in the balance sheet. This implies that failure to apply the right recognition criteria could result in over or understatement of liabilities thereby resulting in inaccurate information. As such, it would be necessary to come up with single criteria for recognition that should guide those who prepare financial information in recognizing Liabilities in a bid to ensure provision of accurate financial information. Should the same criteria be used in recognizing current and long-term liability? What criteria should be applied in recognizing contingent liabilities such as cases going on in the case? According to Tifany (2006), entities ought to recognize liabilities if and only if there is a reasonable probability of a requirement of future sacrifice of economic benefits and that the amount of liability can be reliably measured. a) Probability that future sacrifice of economic benefits will be required An important characteristic of a liability earlier identified is the probability that future economic sacrifices will be required of an entity. This probability ranges from virtual certainty to virtual uncertainty (Brighton, 2010). The obligation for economic sacrifice may range from being mature in the current moment in case the sacrifice is due immediately and the performance of the obligation therefore doesn't have to wait for an event to happen; to unconditional whereby passage of time is necessary in making the obligation due; to conditional whereby a certain event has to occur before the performance of the obligation can be deemed mature. Therefore, the recognition of a liability by an entity depends on the probability of whether economic sacrifice will be required of the entity in future. Unconditional and mature obligations satisfy the probability for economic sacrifice being required in the future criteria and subject to their being reliably measured; they should be recognized as liabilities. Conversely, conditional obligations despite meeting the reliable measurement criteria would only be recognized if it is probable that sacrifice of economic benefits would be required of the entity in the future arising from the conditional obligation. b) The reliable measurement criteria It is necessary that the amount of the liability can be reliably measured if the liability is to satisfy the recognition criteria. This arises from the fact that the amount recorded in the balance sheet as the liability will represent the monetary value of the obligation or the economic sacrifice that the entity has to make regarding the obligation. Different liabilities can have their measurements varying in reliability. However, most liabilities such as those arising from credit purchases usually have their values and dates of payments readily available although in some extremes such as court cases, it is possible for liabilities to have ranging monetary or measurement values. It is worth noting that for a liability to be recognized, it must also satisfy other characteristics of liabilities in addition to satisfying the recognition criteria. At times, a liability may fail to be recognized owing to its failure to meet one of the above criteria (Wayvober, 2010). However, if it is deemed that knowledge of the liabilities will be relevant to users of the financial statements in making and evaluation of decisions regarding allocation of scarce resources, it would be necessary to make a disclosure in the notes to the financial statements. This can include a case where an entity is involved in litigation on the reporting date in a case that can result in specific amount of damages. Measurement criteria for assets and liability As earlier noted one of the common criteria for recognition of both assets and liabilities in the balance sheet is the ability for them to be measured reliably. For any business transaction or events, assets or liabilities to be recognized and recorded in the books of account, they must be quantified reliably. This implies that the entity must be able to assign economic value to the assets, liabilities or transactions. Assignment of economic values to the entity's assets and liabilities assists in measuring the value of the assets, liabilities or transactions to the business. A number of measurement basis are used in measuring the value of assets and liabilities. The methods include Historical cost method, the current cost method, the realizable value method and the present value method. These methods are explained below. a) Historical method This is a technique of measuring the value of assets and liabilities. Using the method, the asset is recorded on the balance sheet using its nominal value or its original cost with which the entity acquired it. This method of valuation is allowed by the Generally accepted accounting principles (GAAP) and is commonly used for measuring assets in the United States as well as other parts of the world. The method makes use of the original costs of related to acquiring the asset including related expenses (Brighton, 2007). The method passes the test of reliability as the values are verifiable based on source documents including receipts, bank statements, supplier statements as well as invoices. The method can also be used in measuring the value of liabilities where the original value of the liability is recorded. Similarly, the value of the liability is verifiable using original documents which may include hire purchase agreements, leases or loan documents. The method passes the test of reliability as users of the financial information can agree on the nominal value of the asset or liability. However, it does not pass the test of relevance since an asset purchased ten years ago say land is obviously worth much more today than what is shown in the balance sheet since it does not show the current price. Due to its verifiability, most entities use the method in measuring and recording the value of assets and liabilities. One of the main advantages of using the measurement technique in financial statements is its reliability. Under historical accounting, there can be no room for manipulation of accounting information as there is evidence based on source documents such as receipts. All other techniques of measuring value of assets or liabilities are subjective depending on the individual’s point of view. However, historical cost method has been criticized for failing to recognize the current cost or value of an asset or liability and is hence not interested in the fair value of an asset(Branson,2009).the technique is also criticized for ignoring inflation in measuring assets or liability value. It relies on the assumption that the currency used in recording the transaction will remain stable in the long run which is not the case in real life. However, the method can be improved to make it more relevant by incorporating the effects of inflation and changes in values of assets or liabilities in its use. b) The current cost method As opposed to the historical cost technique, current cost technique of measurement aims at providing measurements which are more realistic through valuing assets at their current replacement cost as opposed to using the amounts actually paid for them. In other words, current cost refers to the amount the entity would pay for the asset currently. Using the approach, one calculates current cost by adjusting the historical cost for inflation as well as effects of depreciation and similar adjustments (Knight, 2006).The method is however not commonly used for statutory reporting but is useful to management for decision making. For instance, it is more realistic in using current cost in charging a mark up based on current cost rather than historical cost when making pricing decisions in a n inflationary environment. As such, it may be more convenient to use current cost method in dealing with inflationary effects as this makes more sense as historical approaches are likely to distort the entity's current financial affairs hence misleading users of financial statements. This could result in wrong decisions being made and effected. However, the method is a complex one and has been criticized for failing to be clear on what adjustments are to be made or are appropriate. It is for this reason that the method has been hard to implement. However, if carefully implemented, the method can provide more accurate information to users of financial information than historical methods of measurement. c) The realizable value approach This approach uses the amount that an entity would get if it sold the asset now or which it would pay now to settle an existing liability. The approach is commonly used in valuation of stock and inventory in many organizations. The approach is justified in that at times, the value of an asset say stock may be lower than their historical cost of acquisition resulting from damage or expiry (Jones, 2011).In such instances, the stock has to be valued at the lower of cost or net realizable value if the financial statements are to show the entity's true and fair value. This would be necessary in reflecting the extent of damage to the asset/ stock and hence its being valued at lower than its original cost. d) The present value approach This is measurement technique that makes use of discounted cash flow approaches in measuring asset values. There are circumstances that can necessitate assets and liabilities being shown in the financial statements using the present value of their future expected cash inflows (Macknon, 2011). This is commonly used in measuring the value of such transactions as assets and finance leases with the scope of International accounting standards (IAS 39). As can be seen above, there are numerous approaches to measuring the value of assets and liabilities. This raises questions as to what approach is best suited for application by all organizations in ensuring provision of accurate and consistent financial information that can influence decision making. This calls for the test of objectivity, reliability and relevance. This is because the financial information provided to users need to be reliable and relevant if they are to believe in it and use it in their decision making. Of all the measurement methods commonly used, it is only the historical cost method that passes the test of objectivity (Lundin and Wright, 2008). This is because its information can be verified reliably from source documents. All other methods are subjective as they largely depend on the opinion of those preparing the financial statements. We should therefore use historical method in measuring and recording the value of assets and liabilities. However for it to be relevant and hence overcoming its shortcomings identified above, it would always be necessary to adjust such costs for inflation, depreciation and similar adjustment before recording in the financial statements ( Krigler, 2009). However, the need to measure the value of such assets as stock at their present value can not be underestimated. It would not be wise to overstate such items by use of the historical cost method. In other words, no matter the measuring approach that is adopted for assets and liabilities, it is necessary that it passes the test of objectivity, reliability and relevance. Conclusion It has been established that various descriptions and classifications of assets and liabilities exist. These descriptions and classifications have been discussed in detail. In deciding the criteria for defining assets and liabilities, a number of characteristics have been identified. The characteristics formed the basis of identifying the best definition for assets and liabilities. As such assets have been defined as resource that the entity controls resulting from past transactions/events from which the entity expects to derive future economic benefits. Similarly, liabilities have been best defined as sacrifices of economic benefits occurring in the future which an entity is currently/ presently obliged to settle to other parties or entities resulting from past events. These definitions were found to be most relevant as far as recognition, measurement and recording of assets and liabilities is concerned. Although the report does not identify a one best approach for recognition of assets and liabilities, it has established the best criteria that should guide accountants as they prepare financial statements. Consequently the best criterion for recognition of assets has been identified as two fold i.e. probability of future economic benefit criteria and the reliable measurement criteria. Regarding the best measurement method for assets and liabilities, it has been suggested that entities should endeavor to ensure that the measurement method they choose is objective, reliable and relevant. As such, the Historical costing method was found to be the best method for measuring assets and liabilities as it is both reliable and objective. However, in order to make the method more relevant, it is suggested that accountants should always make adjustments to cater for inflation, depreciation and related adjustments. The report however, exempts stock and inventory from this method by maintaining that stock be valued at the lower of cost or net realizable value in order to enhance accuracy. References: Lundin, P& Wright, J2008, Accounting for assets and liabilities: Issues surrounding description, recognition and measurement, Journal of accounting and economics, vol.25, no.14 pp65-70. Macknon,W2011,Asset,Liability and Revenue recognition, International journal of accounting research, vol.45,no.12,pp.19-27. Jones, J2011, Measurement of assets and liabilities, The Irish Journal of management, vol.30, No.12, pp.17-25. Knight,S2006, Fundamentals of accounting, London, Rutledge. 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