FRS 102: The elements of financial statements
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FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland is the new suite of standards which becomes mandatorily effective for accounting periods commencing on or after 1 January 2015. There are many notable changes to the way in which reporting entities will prepare their financial statements under the new standards and accountants and practitioners are being advised to get to grips with the new UK GAAP now to enable them to ensure that the transition across to FRS 102 is as painless as possible. This article considers the elements which make up a set of general purpose financial statements and also interacts with various recognition and measurement principles found in FRS 102.
A set of general purpose (i.e. ‘statutory’) financial statements is made up of the following:
- A balance sheet (statement of financial position)
- A profit and loss account (an income statement/statement of comprehensive income/statement of profit or loss)
- A statement of total recognised gains and losses (statement of changes in equity)
- A cash flow statement
- Notes to the financial statements.
Section 2 to FRS 102 Concepts and Pervasive Principles deals with the elements that make up a set of financial statements as follows:
Statement of financial position (balance sheet)
The statement of financial position (balance sheet) is made up of:
- Assets
- Liabilities
- Equity
The above classifications are defined within Section 2 as follows:
- An asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity.
- A liability is 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.
- Equity is the residual interest in the assets of the entity after deducting all its liabilities.
Recognition of an asset
In order to be able to recognise an asset on the balance sheet, the (potential) asset must have the ability to contribute (directly or indirectly) to the flow of cash to the entity. This can be achieved by either using the asset or disposing of it.
Example
A company leases a machine that it is going to use within its business. The terms of the lease make provision for payments of lease rentals together with finance costs (interest). The machine has a useful economic life of five years and the company is expecting to use the machine for the whole of this useful economic life. In view of this, it has been concluded that at the end of this useful economic life, the machine will have a residual value of zero.
Paragraph 2.19 says that in determining the existence of an asset, the right of ownership is not essential. In the above scenario, the machine is subject to a finance lease. Section 20 Leases would require that this machine be recognised as a finance lease and accounted for as such (hence the recognition of an asset with an associated finance lease liability in the balance sheet). The key trigger of an asset in this example is the ‘control’ aspect – paragraph 2.19 says that I the entity ‘controls’ the benefits that are expected to flow from the property, then property held on a lease will be classified as an asset.
In addition, there are two specific criteria that have to be met before an asset can be recognised in the balance sheet according to paragraph 2.27 in FRS 102:
- It is probable that any future economic benefit associated with the item will flow to or from the entity; and
- The item has a cost or value that can be measured reliably.
Example
A company has produced its financial statements to 30 September 2013 and the auditors have discovered a batch of computer equipment, all of which meet the recognition criteria of an asset, that have not been included on the company’s balance sheet as the invoices were received in October (although dated 30 September 2013). The financial controller has suggested that rather than change the financial statements at this late stage, they could simply make disclosure in the financial statements.
In this scenario, liabilities will be understated because the company has failed to properly accrue for the late invoices. However, in addition, the financial controller is wrong in his assumption that the company can merely disclose these assets. Paragraph 2.28 says that the failure to recognise an item that satisfied the recognition criteria in paragraph 2.27 (a) and (b) is not rectified by disclosure of the accounting policies used or by notes or explanatory material. In order to comply with FRS 102, the company should restate the financial statements to include the additional assets discovered by the auditor.
Recognition of a liability
Paragraph 2.20 says that an essential characteristic of a liability is that the entity has a present obligation to act or perform in a particular way and that this obligation can be either a legal or a constructive obligation. A ‘legal’ obligation is legally enforceable as a consequence of a binding contract or statutory requirements. A ‘constructive’ obligation is not as clear cut as a legal obligation. According to paragraph 2.20 (a) and (b), a constructive obligation is an obligation that derives from an entity’s actions when:
- By an established pattern of past practice, published policies or a sufficiently specific current statement, the entity has indicated to other parties that it will accept certain responsibilities; and
- As a result, the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities.
Example
A company has been in existence for over twenty years’ and has a long-established practice of paying bonuses to its management team, using a pre-determined formula, on year-end profits if they exceed a certain benchmark. This benchmark has not been increased for the last ten years’ and the directors have intimated that they have no intention of increasing the benchmark.
Monthly management accounts are prepared, with reasonable accuracy, and at the year-end 31 December 2013, these show a relatively high level of profitability. The company accountant has made an accrual for a bonus, together with the associated employer’s national insurance contributions.
The company has created a constructive obligation by way of an established pattern of past practice of paying bonuses. It is this past practice that has given rise to the constructive obligation because it has created an expectation in the mindsets of management that they will receive a bonus. As the company has a constructive obligation, it would be permissible to recognise the bonus provision in the year-end 31 December 2013 financial statements.
Example
A company has an item of machinery that requires an overhaul every five years. The directors wish to provide for 1/5th of the cost of the future overhauls in its current financial statements.
The directors cannot provide for the future overhaul costs as a liability. These costs are merely an ‘intention’ at the balance sheet date as opposed to an ‘obligation’. The directors could decide to sell the item of machinery before the five years has expired.
Liabilities must also be recognised in an entity’s financial statements when:
- The entity has an obligation at the end of the reporting period as a result of a past event;
- It is probable that the entity will be required to transfer resources embodying economic benefit in settlement; and
- The settlement amount can be measured reliably.
Example
Company A Limited has decided to close down its maintenance department. It puts a full announcement out to the maintenance staff on 20 November 2013. It has calculated the redundancy provisions and has included the redundancy provision as a liability in the financial statements to 31 December 2013.
Company B Limited has made a provision for damages amounting to £10,000 in its financial statements for the year-ended 31 December 2013 in respect of a legal case brought against it by a customer. At the year-end date, the legal advisers of Company B have advised that they are not currently certain as to the outcome of the court case. The amount of £10,000 is considered to be material to the company’s financial statements.
Company A Ltd
Company A Ltd has an obligation as a result of a past event (the announcement on 20 November 2013 of the redundancies).
It is probable (i.e. more likely than not) that an outflow of economic benefits will be required to settle the obligation (the redundancy provision).
It can reliably estimate the redundancy provision.
Therefore, Company A Ltd can make a provision (i.e. recognise a liability) for the redundancy payments in the financial statements to 31 December 2013.
Company B Ltd
Company B Ltd should not recognise a provision or damages of £10,000 because it is not ‘probable’ that an outflow of economic resources will be required to settle the liability. The legal advisers are unsure as to the outcome of the case.
Instead, Company B Ltd should disclose the potential damages as a contingent liability in the financial statements to 31 December 2013.
In the second example above, Company B Ltd had a ‘contingent liability’. Paragraph 2.40 to FRS 102 says:
A contingent liability is either a possible but uncertain obligation or a present obligation that is not recognised because it fails to meet one or both of the conditions (b) and (c) in paragraph 2.39. An entity shall not recognise a contingent liability as a liability, except for contingent liabilities of an acquire in a business combination (see Section 19 Business Combinations and Goodwill).
Recognition of equity
Equity is the residual interest in the assets of the entity after deducting all its liabilities.
Example
A company wishes to raise finance and therefore decides to raise shares by issuing 10,000 ordinary shares at £1.50 (the par value of the shares is £1).
(10,000 shares x £1) £10,000 will be credited to shares in the equity section of the balance sheet, a further (10,000 x £0.50) £5,000 will be credited to the share premium account which represents the premium on the share issue.
Example
A company issues 5,000 preference shares at £2 par value, the terms of which provide for 5% preference dividends to be paid each year, with redemption in eight years’ time. The financial controller has accounted for the share issue as follows:
DR cash at bank £10,000
CR equity £10,000
As the preference shares contain a redemption feature (dividends on the preference shares and redemption at the end of the term), the issuance of preference shares should not be classified as equity, but instead classified as a liability to accord with the provisions in Section 11 Basic Financial Instruments.
Performance
The performance of an entity is reported in its statement of comprehensive income/income statement (commonly known in the UK and Republic of Ireland as the ‘profit and loss account’). For clarity, I shall continue using the term ‘profit and loss account’ going forward, but it is to be noted that FRS 102 does refer to the income statement or statement of comprehensive income.
For the purposes of the profit and loss account and FRS 102, income and expenses are defined as follows:
- Income is increases in economic benefits during the reporting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity investors.
- Expenses are decreases in economic benefits during the reporting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity investors.
Distinction between ‘revenue’ and ‘gains’
A company will generate income (usually sales/turnover/revenue) and incur expenses in its ordinary course of activities. This type of income-generation is classified as ‘revenue’ and according to paragraph 2.25 (a), can include:
- Sales
- Fees
- Interest
- Dividends
- Royalties
- Rent
Income is recognised in the financial statements when an increase in future economic benefits directly related to an increase in an asset or a decrease of a liability has arisen and that increase/decrease can be measured reliably.
When we refer to the term ‘gain’ we are not referring to sales/turnover/revenue because these are the types of income that arise in the entity as a routine course of undertaking ordinary business. Gains are other items which meet the definition of income, but are not sales/turnover/revenue (for example the disposal of an item of machinery, or a gain on disposal of an investment). Such gains are usually displayed separately because they serve to enhance usefulness and therefore aid users’ in making economic decisions.
Distinction between ‘expenses’ and ‘losses’
Paragraph 2.26 (a) gives examples of ‘expenses’ that are incurred in the ordinary course of business, which can include:
- Cost of sales
- Wages
- Depreciation
Expenses are recognised in the financial statements when a decrease in future economic benefits directly related to a decrease in an asset or an increase of a liability has arisen that can be measured reliably.
Expenses will result in a reduction in cash balances (or other assets such as inventory, or fixed assets).
Losses, on the other hand, are other items which meet the definition of expenses and which may occur in the ordinary course of business, such as a loss on disposal of a building or investment. It is usual practice to show losses separately in the profit and loss account as they are useful in making economic decisions.
Measurement of assets, liabilities, income and expenses
The term ‘measurement’ is the process of arriving at a monetary amount at which an entity will measure assets, liabilities, income and expenses within its financial statements. In order to arrive at a monetary amount, the entity will need to select a basis for measurement. There are two common methods of measurement bases:
- Historical cost; and
- Fair value
Historical cost
Historical cost is the amount of cash (or cash equivalents) paid, or the fair value of the purchase price paid at the time of acquisition of the asset. In contrast, for liabilities, historical cost is the amount of cash or cash equivalents received, or the fair value of non-cash assets received in exchange for the obligation at the time the obligation is incurred. There can also be estimations of such amounts to discharge obligations, such as the estimation of amounts required to settle a company’s corporation tax liability (as such liabilities are often calculated before the tax computation is finalised). Historical cost, therefore, is based on past amounts.
Fair value
Paragraph 2.34 (b) in FRS 102 defines fair value as follows:
‘Fair value is the amount for which the asset could be exchanged, a liability settled, or an equity instrument granted could be exchanged, between knowledgeable, willing parties in an arm’s length transaction.’
Fair value accounting is fairly prominent in FRS 102 given the number of areas of the financial statements to which it affects, such as:
- Property, plant and equipment
- Biological assets
- Investment property
- Business combinations
- Financial instruments
Offsetting
Section 2 prohibits an entity from offsetting assets against liabilities and income against expenses, unless required or permitted by an FRS.
Example
A company has a year-end date of 31 October 2013 and on this date makes a provision for 5% of its total trade debtors amounting to £15,000. The entries in the books are:
DR general bad debt provisions £15,000
CR bad debt provision £15,000
(against trade debtors)
In this example, the company has included a liability (the provision for bad debts) against an asset – this is not considered ‘offsetting’ as the company is merely measuring assets net of an allowance for bad debts. The same thing can be said for stock provisions and depreciation of fixed assets.
Category: Accounting and standards, Audit
