Concepts, Rules, and Examples

General Concepts

Under international accounting standards, assets and liabilities are recorded in financial statements under the historical cost principle, although in many cases subsequent changes in values can be recognized. Historical exchange prices are used because they are objective and capable of being verified independently. When a balance sheet is presented, most assets are reported at cost. One very important limitation is that historical cost does not always (or even typically) reflect current value, and thus the balance sheet will not generally be indicative of the economic value of an enterprise.

Generally accepted accounting principles allow or require certain exceptions to the historical cost principle. For example, inventories and marketable equity securities may be reported at lower of cost or market, and certain long-term investments may be reported under the equity method, but neither of these exceptions is intended to result in a balance sheet that reflects current economic value. Depreciation, depletion, and amortization of long-term assets are acceptable practices, but appreciation of assets is not generally recorded. With certain exceptions (such as for investment property accounted for in accordance with IAS 40, and for plant assets and intangibles accounted for under the optional revaluation provisions of IAS 16 and 38, respectively), appreciation of assets is generally recorded only when realized through an arm's-length transaction (i.e., a sale to an unrelated party).

Many believe that the balance sheet would be more useful if all assets were restated in terms of current values, and a number of strategies to accomplish this have been proposed or tried over the years. In general, these current values could be market-related (i.e., based on changes in specific prices) or could simply be historical costs adjusted for the changing value of the dollar (i.e., based on changes in the general price level). For a range of reasons, none of these approaches have been widely accepted in practice, and thus the historical cost approach continues as the most widely employed measurement model for financial reporting. However, under current generally accepted accounting principles, although assets are usually stated at historical cost, if market information indicates a permanent and material decline in value, recognition of the economic loss is immediate.

Another limitation of historical cost based balance sheets is a consequence of the fact that estimates are used to determine the carrying, or book, values of many of the assets. Estimates are used in determining the collectibility of receivables, salability of inventory, and useful life of long-term assets, among other things. Estimates are necessary in order to divide and separate economic events occurring between two distinct accounting periods. However, such estimates require informed judgments for which there is perhaps not enough guidance in accounting literature.

An additional failing of the balance sheet is that it ignores items that are of financial value to the firm but the worth of which cannot be determined objectively. For example, internally generated goodwill, human resources, and secret processes are of financial value, but since these values are not measurable under current accounting principles and practices, they are not recorded on the balance sheet. Only assets obtained in a market transaction are incorporated into the financial statements of an entity. As the service economy becomes ever more dominant, the importance of assets that are not reflected in the traditional balance sheet (particularly those relating to human capital) will become a more critical issue which the accounting professions will eventually have to address.

A final constraint on the usefulness of the balance sheet is that it largely ignores the time value of its elements. Although certain receivables and payables may be discounted, most items are stated at face value regardless of the timing of the cash flows that they will generate. This tends to exacerbate the divergence between net worth as reported in balance sheets and the value of the enterprise in real economic terms.

The net result of the foregoing is that the balance sheet contains a mixture of historical costs and current values that may restrict its utility to users. It is true that, in the case of some assets and liabilities, cost is a reasonably close approximation of current value. Monetary assets such as cash, short-term investments, and receivables closely approximate current value. Current liabilities are payable within a short period, and the amounts reported thus also closely approximate current values. If these values were discounted, any discrepancy would be immaterial because of the short time period before payment. Current liabilities are not classified strictly on the basis of maturity value but on the concept that a current liability is one that requires either a current asset or another current liability to liquidate, and should be shown on the balance sheet at face value. Unless the allowed alternative treatment (i.e., revaluation) permitted under IAS is employed, productive assets such as property, plant, and equipment, and intangibles are to be reported at actual historical cost less accumulated depreciation, depletion, or amortization. Long-term liabilities are recorded as the discounted value of future payments to be made under contract, since, on the date of issuance, the discount rate equals the market rate. However, as time passes and the market rate fluctuates, the recorded cost will not necessarily approximate the current value.

The rights of the common shareholders of a firm and the rights of other capital-supplying parties (bondholders and other lenders, and preferred stockholders) of a firm are many and varied. Both sources of capital are concerned with two basic rights: the right to share in the cash or property disbursements (interest and dividends) and the right to share in the assets in the event of liquidation. The disclosure of these rights is an important objective in the presentation of financial statements.

Form of Balance Sheet

The titles commonly given to the primary financial statement that presents an entity's financial position are balance sheet, statement of financial position, or statement of financial condition. Use of any of these terms implies that the statement was prepared in conformity with generally accepted accounting principles. If some other comprehensive basis of accounting, such as income tax or cash, is adhered to instead, the title of the financial statement should be adjusted to reflect this departure. Thus, a title such as "Statements of Assets and Liabilities" would be necessary to differentiate the financial statement being presented from a balance sheet.

The three elements that are displayed in the heading of a balance sheet are

1. The entity whose financial position is being presented

2. The title of the statement

3. The date of the statement

The entity's name should appear exactly as written in the legal document that created it (e.g., the certificate of incorporation, partnership agreement, etc.). The title should also clearly reflect the legal status of the enterprise as a corporation, partnership, sole proprietorship, or division of some other entity. Where the entity's name does not disclose its legal status, the authors suggest that supplemental information be added to the title to clarify that status. A few examples are

ABC Company

(A partnership)

ABC Company

(A limited partnership)

ABC Company

(A sole proprietorship)

ABC Company

(A division of DEF, Inc.)

In practice, the title of the financial statement is generally "Balance Sheet" unless another name is indicative of the terminology used in the industry. For example, in the securities industry, the title "Statement of Financial Condition" is more widely used.

Finally, the last day of the month should be used as the statement date unless the entity uses a fiscal reporting period always ending on a particular day of the week, such as a Friday or Sunday (e.g., the last Friday in December, or the Sunday falling closest to December 31). In these cases, the balance sheet can appropriately be dated accordingly (i.e., December 26, October 1, etc.). In all cases, the implication is that the balance sheet captures the pertinent amounts as of the close of business on the date noted.

Balance sheets should generally be uniform in appearance from one period to the next, as indeed should all of the entity's financial statements. The form, terminology, captions, and pattern of combining insignificant items should be consistent. The goal is to enhance usefulness by maintaining a consistent manner of presentation unless there are good reasons to change these and the changes are duly reported.

Classification of Assets

Assets, liabilities, and stockholders' equity are often separated in the balance sheet so that important relationships can be shown and so that attention can be focused on significant subtotals.

Current assets.

According to IAS 1, an asset should be classified as a current asset when it

1. Is expected to be realized in, or is held for sale or consumption in, the normal course of the enterprise's operating cycle; or

2. Is held primarily for trading purposes or for the short term, and is expected to be realized within twelve months of the balance sheet date; or

3. Is cash or a cash equivalent asset that is not restricted in its use.

All other assets should be classified as noncurrent assets, if a classified balance sheet is to be presented in the financial statements.

Thus, current assets include cash, cash equivalents and other assets that can be expected to be realized in cash, or sold or consumed during one normal operating cycle of the business. The operating cycle of an enterprise is the time between the acquisition of materials entering into a process and its realization in cash or an instrument that is readily convertible into cash. The default assumption is that the operating cycle is a period of twelve months, and thus the current assets are expected to be realized within the period of twelve months. IAS 1 makes an exception in the case of inventories and trade receivables and specifically states that even if these assets are not expected to be realized within twelve months from the balance sheet date they should still be classified as current assets in a classified balance sheet. However, marketable securities could only be classified as current assets if they are expected to be realized within twelve months of the balance sheet date, even though most would deem marketable securities to be more liquid than inventories and possibly even than receivables. The following items would be classified as current assets:

1. Cash and cash equivalents include cash on hand, consisting of coins, currency, and undeposited checks; money orders and drafts; and deposits in banks. Anything accepted by a bank for deposit would be considered cash. Cash must be available for a demand withdrawal; assets such as certificates of deposit would not be considered cash because of the time restrictions on withdrawal. Also, to be classified as a current asset, cash must be available for current use. According to IAS 1, cash that is restricted in use and whose restrictions will not expire within the operating cycle, or cash restricted for a noncurrent use, would not be included in current assets. According to IAS 7, cash equivalents include short-term, highly liquid investments that (1) are readily convertible to known amounts of cash, and (2) are so near their maturity (original maturities of three months or less) that they present negligible risk of changes in value because of changes in interest rates. Treasury bills, commercial paper, and money market funds are all examples of cash equivalents.

2. Trading investments are those that are acquired principally for the purpose of generating a profit from short-term fluctuations in price or dealer's margin. A financial asset should be classified as held-for-trading if it is part of a portfolio for which there is evidence of a recent actual pattern of short-term profit making. Trading assets include debt and equity securities and loans and receivables acquired by the enterprise with the intention of making a short-term profit. Derivative financial assets are always deemed held-for-trading unless they are designed as effective hedging instruments.

   As required by IAS 39, a financial asset held for trading should be measured at fair value. There is a presumption that fair value can be reliably measured for financial assets that are held for trading.

   Securities held for trading

   $xxx

3. Receivables include accounts and notes receivable, receivables from affiliate companies, and officer and employee receivables. The term accounts receivable represents amounts due from customers arising from transactions in the ordinary course of business. Allowances due to lack of collectibility and any amounts discounted or pledged should be stated clearly. The allowances may be based on a relationship to sales or based on direct analysis of the receivables. If material, the receivables should be analyzed into their component parts. The receivables section may be presented as follows:

   Receivables:
   Accounts	$xxx
   Notes	xxx	$xxxx
   Less allowance for doubtful accounts		(xxx)	$xxxx
   Associated companies			xxx
   Officers and employees			xxx
   Total			$xxxx

4. Inventories are assets held, either for sale in the ordinary course of business or in the process of production for such sale, or in the form of materials or supplies to be consumed in the production process or in the rendering of services (IAS 2). The basis of valuation and the method of pricing should be disclosed.

   Inventories—at the lower of cost (FIFO) or net realizable value

   $xxx

5. In the case of a manufacturing concern, raw materials, work in process, and finished goods should be disclosed separately on the balance sheet or in the footnotes.

   Inventories:
   Finished goods	$xxx
   Work in process	xxx
   Raw materials	xxx	$xxx

6. Prepaid expenses are assets created by the prepayment of cash or incurrence of a liability. They expire and become expenses with the passage of time, use, or events (e.g., prepaid rent, prepaid insurance, and deferred taxes).

Noncurrent assets.

IAS 1 (revised 1997) uses the term "noncurrent" to include tangible, intangible, operating, and financial assets of a long-term nature. It does not prohibit the use of alternative descriptions, as long as the meaning is clear. Noncurrent assets include held-to-maturity investments, investment property, property and equipment, intangible assets, and miscellaneous other assets, as described in the following paragraphs.

Held-to-maturity investments.

are financial assets with fixed or determinable payments and fixed maturity that the enterprise has a positive intent and ability to hold to maturity. Examples of held-to-maturity investments are debt securities and mandatorily redeemable preferred shares. This category excludes loans and receivables originated by the enterprise, however. Held-to-maturity investments are to be measured at amortized cost. (For a detailed discussion on financial instruments please refer to the relevant chapters of this book.)

Investment property.

This denotes property being held to earn rentals, or for capital appreciation, or both, rather than for use in production or supply of goods or services, or for administrative purposes or for sale in the ordinary course of business. Investment property should be initially measured at cost. Subsequent to initial measurement an enterprise is required to elect either the fair value model or the cost model. (For a detailed discussion on investment property please refer to Chapter 10.)

Property, plant, and equipment.

Tangible assets that are held by an enterprise for use in the production or supply of goods or services, or for rental to others, or for administrative purposes and which are expected to be used during more than one period. Included are such items as land, buildings, machinery and equipment, furniture and fixtures, motor vehicles and equipment. These should be disclosed, with the related accumulated depreciation, as follows:

Machinery and equipment	$xxx
Less accumulated depreciation	(xxx)	$xxx
or
Machinery and equipment (net of $xxx accumulated depreciation)		$xxx

Accumulated depreciation should be shown by major classes of depreciable assets. In addition to showing this amount on the balance sheet, the notes to the financial statements should contain balances of major classes of depreciable assets, by nature or function, at the balance sheet date, along with a general description of the method or methods used in computing depreciation with respect to major classes of depreciable assets (IAS 16).

Intangible assets.

Noncurrent, nonmaterialistic assets of a business, the possession of which provides anticipative benefits to the owner. Included in this category are such items as goodwill, trademarks, patents, copyrights, and organizational costs. These are defined by IAS 38, as identifiable, nonmonetary assets without physical substance that are held for use in the production or supply of goods or services, for rental to others, or for administrative purposes.

Generally, the amortization of an intangible asset is credited directly to the asset account, although it is acceptable to use an accumulated amortization account. The tradition of reporting tangible assets on a gross basis, with accumulated depreciation shown separately, developed from the goal of providing the reader with enough information to make a rough calculation of the age of plant assets used by the enterprise, partly to enable an assessment of the amount and timing of capital needed for the replacement of those assets. Intangible assets are not as regularly subject to replacement, however, and are often written down in carrying value for reasons other than the simple passage of time; therefore amortization is typically, but not necessarily, credited directly to the asset account.

Other assets.

An all-inclusive heading for accounts that do not fit neatly into any of the other asset categories (e.g., long-term prepaid expenses, deferred taxes, deferred bond issue costs, noncurrent receivables, and restricted cash).

Classification of Liabilities

The liabilities are normally displayed on the balance sheet in the order of payment.

Current liabilities.

According to IAS 1, a liability should be classified as a current liability when it

1. Is expected to be settled in the normal course of the enterprise's operating cycle; or

2. Is due to be settled within twelve months of the balance sheet date.

All other liabilities should be classified as noncurrent liabilities.

In other words, current liabilities are obligations the liquidation of which is reasonably expected to require the use of existing resources properly classifiable as current assets, or the creation of other current obligations. Obligations that are due on demand or are callable at any time by the lender are classified as current regardless of the present intent of the entity or of the lender concerning early demand for repayment.

1. Obligations arising from the acquisition of goods and services entering the operating cycle (e.g., accounts payable, short-term notes payable, wages payable, taxes payable, and other miscellaneous payables).

2. Collections of money in advance for the future delivery of goods or performance of services, such as rent received in advance and unearned subscription revenues.

3. Other obligations maturing within the current operating cycle to be met through the use of current assets, such as the current maturity of bonds and long-term notes.

Per IAS 1, certain liabilities, such as trade payables and accruals for operating costs, which form part of the working capital used in the normal operating cycle of the business, are to be classified as current liabilities even if they are due to be settled after more than twelve months from the balance sheet date.

Other current liabilities which are not settled as part of the operating cycle, but which are due for settlement within twelve months of the balance sheet date, such as dividends payable and the current portion of long-term debt, should also be classified as current liabilities. However, interest-bearing liabilities that provide the financing for working capital on a long-term basis and are not scheduled for settlement within twelve months should not be classified as current liabilities.

IAS 1 provides another exception to the general rule that a liability due to be repaid within twelve months of the balance sheet date should be classified as a current liability. If the original term was for a period longer than twelve months and the enterprise intended to refinance the obligation on a long-term basis prior to the balance sheet date, and that intention is supported by an agreement to refinance, or to reschedule payments, which is completed before the financial statements are approved, then the debt is to be reclassified as noncurrent as of the balance sheet date.

In two cases, obligations to be paid within one period should not be classified as current liabilities. Debt expected to be refinanced through another long-term issue, and debt that will be retired through the use of noncurrent assets, such as from the amount accumulated in a bond sinking fund, are treated as noncurrent liabilities because the liquidation does not require the use of current assets or the creation of other current liabilities.

The distinction between current and noncurrent liquid assets generally rests upon both the ability of the entity and the intent of the entity to liquidate or not to liquidate within the traditional one-year concept. Intent is not of similar significance with regard to the classification of liabilities, however, because the creditor has the legal right to demand satisfaction of a currently due obligation, and even an expression of intent not to exercise that right does not diminish the entity's burden should there be a change in that intention. Thus, whereas an entity can control its use of current assets, it cannot be the master of its own fate with regard to current liabilities, and accordingly, accounting for current liabilities (with the two exceptions noted above) is based on legal terms, not expressions of intent.

Noncurrent liabilities.

Obligations that are not expected to be liquidated within the current operating cycle, including

1. Obligations arising through the acquisition of assets, such as the issuance of bonds, long-term notes, and lease obligations;

2. Obligations arising out of the normal course of operations, such as pension obligations; and

3. Contingent obligations involving uncertainty as to possible losses. These are resolved by the occurrence or nonoccurrence of one or more future events that confirm the amount payable, the payee, and/or the date payable, such as product warranties (see the contingency section).

For all long-term liabilities, the maturity date, nature of obligation, rate of interest, and description of any security pledged to support the agreement should be clearly shown. Also, in the case of bonds and long-term notes, any premium or discount should be reported separately as an addition to or subtraction from the par (or face) value of the bond or note. Long-term obligations which contain certain covenants that must be adhered to are classified as current liabilities if any of those covenants have been violated and the lender has the right to demand payment. Unless the lender expressly waives that right or the conditions causing the default are corrected, the obligation is current.

Other liabilities.

Items that do not meet the definition of a liability, such as deferred income taxes or deferred investment tax credits, where measured by the deferred method. Often these items will be included in current or noncurrent liabilities even though technically, they are not similar.

Offsetting assets and liabilities.

In general, assets and liabilities should not be offset against each other. The reduction of accounts receivable by the allowance for doubtful accounts, or of property, plant, and equipment by the accumulated depreciation, are acts that reduce these assets by the appropriate valuation accounts. These are not equivalent to offsetting assets and liabilities, however.

The right of setoff must exist for the offsetting in the financial statements to be a proper presentation. This right of setoff exists only when all the following conditions are met:

1. Each of the two parties owes the other determinable amounts (although they may be in different currencies and bear different rates of interest).

2. The entity has the right to set off against the amount owed by the other party.

3. The entity intends to offset.

4. The right of setoff is legally enforceable.

In particular cases, laws of certain countries, including some bankruptcy laws, may impose restrictions or prohibitions against the right of setoff. Furthermore, when maturities differ, only the party with the nearest maturity can offset because the party with the longer maturity must settle in the manner determined by the earlier maturity party.

In the context of the presentation of current assets and current liabilities in financial statements, IAS 1 clearly states that unless a legal right of setoff exists and offsetting represents the expectation as to the realization of the asset or settlement of the liability, amounts should not be offset against each other.

IAS 30 establishes disclosure requirements for banks and similar financial institutions. It prohibits offsetting of assets or liabilities on similar grounds. The offsetting of cash or other assets against a tax liability or other amounts due to governmental bodies is also not acceptable except under limited circumstances. The only exception is when it is clear that the purchase of securities is in substance an advance payment of taxes payable in the near future and that the securities are acceptable for the payment of taxes. This occurs primarily as an accommodation to governmental bodies.

For forwards, interest rate swaps, currency swaps, options, and other conditional or exchange contracts, the conditions for the right of offset must exist or the fair value of contracts in a loss position cannot be offset against the fair value of contracts in a gain position. Neither can accrued receivable amounts be offset against accrued payable amounts. If, however, there is a master netting arrangement, fair value amounts recognized for forwards, interest or currency swaps, options, or other such contracts may be offset without respect to the conditions specified previously.

Classification of Stockholders' Equity

Stockholders' equity represents the interest of the stockholders in the assets of a corporation. It shows the cumulative net results of past transactions and other events.

Share capital.

This consists of the par or stated value of preferred and common shares. The number of shares authorized, the number issued, and the number outstanding should be clearly shown. For preferred share capital, the preference features must also be stated as follows:

6% cumulative preference shares, $100 par value, callable at $115, 10,000 shares authorized and outstanding	$xxx
Equity shares, $10 par value per share, 2,000,000 shares authorized, 1,500,000 shares issued and outstanding	$xxx

Preference share capital that is redeemable at the option of the holder is not considered to be part of equity but is usually shown in a separate caption between liabilities and equity. However, IAS 32 makes it clear that substance prevails over form in the case of compound financial instruments, including equity instruments such as mandatorily redeemable preference shares, which accordingly should be shown in the liability section of the balance sheet.

Retained earnings.

This represents the accumulated earnings since the inception of the enterprise, less any earnings distributed to owners in the form of dividends. In some countries it had been common, in the past, to permit the designation of some portion of retained earnings as being restricted or appropriated. These designations had no legal or contractual status, but rather, were only done to communicate with the stockholders regarding the availability of the remaining retained earnings for possible dividend declaration. This communication can also be handled in other ways, such as by means of a letter from the chief executive officer to the stockholders describing the enterprise's need for retaining its resources (e.g., for plant expansion purposes). The international standards do not explicitly address the possible use of retained earnings restrictions or appropriations, although these are not prohibited either.

Also included in the equity section of the balance sheet is treasury stock representing issued shares reacquired by the issuer. These are generally stated at their cost of acquisition and as a reduction of shareholders' equity.

Finally, net changes in available-for-sale securities portfolios and unrealized gains or losses on translations of foreign currency denominated financial statements will also be shown in stockholders' equity.

Classification of Partners' Capital

In partnership entities, the balance sheet is the same as for all other entities, except for the net worth section. In a partnership, this section is usually referred to as partners' capital. In partnership accounting, the net worth section of the balance sheet includes the equity interests of the partners. Although each individual partner's capital need not be displayed, the totals for each class of partner, general or limited, should be shown.

Loans to or from partners should be displayed as assets and liabilities of the partnership and not as reductions or additions to partners' capital, although a separate line item on the balance sheet may be combined with net worth in a separately defined subtotal on the balance sheet. Payments to partners of interest on loans are properly classified as expenses on the income statement. Payments of interest on capital or salaries to partners are considered an allocation of profits and are usually not expensed on the income statement. However, in an attempt to emulate corporate financial reporting, some partnerships, with adequate disclosure, do display part or all of such payments as expenses.

Relationship of the Balance Sheet to the Income Statement

The balance sheet and income statement are interrelated through the changes that take place in each as a result of business transactions. Choosing a method of valuing inventory determines the method of calculating cost of goods sold. This articulation enables the users of financial information to use the statements as predictive indicators of future cash flows.

In assessing information about overall firm performance, users are interested in bringing together information in the income statement and the balance sheet. The balance sheet can also be used as a guide to give an indication of a firm's continuing ability to earn income and pay dividends. By combining the two statements, investors can develop some important financial ratios. For example, users may wish to express income as a rate of return on net operating assets.

Supplemental Disclosures

In addition to the measurement accounting principles that guide the values placed on the elements included in the balance sheet, there are disclosure accounting principles which are necessary to make the financial statements not misleading because of their omission. The following are five techniques for providing informative disclosures:

1. Parenthetical explanations

2. Footnotes

3. Supporting schedules

4. Cross-references

5. Valuation accounts

Parenthetical explanations.

Supplemental information is disclosed by means of parenthetical explanations following the appropriate balance sheet items. For example

Equity share capital ($10 par value, 200,000 shares authorized, 150,000 issued)

$1,500.000

Parenthetical explanations have an advantage over both footnotes and supporting schedules. Parenthetical explanations place the disclosure in the body of the statement. The supplemental information tends to be overlooked when it is placed in a footnote.

Footnotes.

If the additional information cannot be disclosed in a relatively short and concise parenthetical explanation, a footnote should be used. For example

Inventories (see Note 1)

$2,550,000

The notes to the financial statements would then contain the following:

• Note 1: Inventories are stated at the lower of cost or market. Cost is determined by the first-in, first-out method, and market is determined on the basis of estimated net realizable value. As of the balance sheet date, the market value of the inventory is $2,720,000.

Supporting schedules.

To present adequate detail regarding certain balance sheet items, a supporting schedule may be used. Current receivables may be a single line item on the balance sheet, as follows:

Current receivables (see Schedule 2)

$2,500,000

A separate schedule for current receivables would then be presented as follows:

Schedule 2 Current Receivables
Customers' accounts and notes	$2,000,000
Associated companies	300,000
Nonconsolidated affiliates	322,000
Other	18,000
	2,640,000
Less allowance for doubtful accounts	(140,000)
	$2,500,000

Cross-references.

Cross-referencing is used when there is a direct relationship between two accounts on the balance sheet. For example, among the current assets, the following might be shown if $1,500,000 of accounts receivable were required to be pledged as collateral for a $1,200,000 bank loan:

Accounts receivable pledged to bank

$1,500,000

Included in the current liabilities would be the following:

Bank loan payable—secured by accounts receivable

$1,200,000

Valuation accounts.

Valuation accounts are used to reduce or increase the carrying amount of some assets and liabilities in financial statements. Accumulated depreciation reduces the book value for property, plant, and equipment, and a bond premium (discount) increases (decreases) the face value of a bond payable as shown in the following illustrations:

Equipment	$18,000,000
Less accumulated depreciation	(1,625,000)	$16,375,000
Bonds payable	$20,000,000
Less discount on bonds payable	(1,300,000)	$18,700,000
Bonds payable	$20,000,000
Add premium on bonds payable	1,300,000	$21,300,000

Accounting policies.

There are many different methods of valuing assets and assigning costs. IAS 1 requires financial statements to include clear and concise disclosure of all significant accounting policies that have been used in the preparation of those financial statements. Financial statement users must be aware of the accounting policies used by enterprises so that sound economic decisions can be made. The disclosures should identify and describe the accounting principles followed by the entity and methods of applying those principles that materially affect the determination of financial position, changes in cash flows, or results of operations. The accounting policies should encompass those accounting principles and methods that involve the following:

1. Selection from acceptable alternatives

2. Principles and methods peculiar to the industry

3. Unique applications of IAS

Fairness exception under IAS 1.

In what has become a somewhat controversial move, the IASC inserted what may be called a "fairness exception" in IAS 1. This acknowledges that, while the use of IAS will result in virtually all circumstances in financial statements that achieve a fair presentation, in some instances this may not be the case. In such eventualities, IAS 1 permits departure from the standards to achieve the greater good of fair presentation, provided, however, that the enterprise discloses the following:

1. That management has concluded that the financial statements fairly present the entity's financial position, financial performance, and cash flows;

2. That the entity has complied in all material respects with applicable IAS except that it departed from a standard to achieve a fair presentation; and

3. The standard from which the entity has departed; the nature of the departure, including the accounting treatment which the standard would have required; the reason why that treatment would have been misleading in the circumstances; the alternative treatment which was in fact applied; and the financial impact of the departure on profit or loss, assets, liabilities, equity, and cash flows for each period presented.

It might be noted that in the US, while there is no similar exception under the accounting standards, under US auditing standards there is a provision that an unqualified opinion may be rendered even when there has been a GAAP departure, if the auditor concludes that it provides a fairer presentation than would have resulted had GAAP been strictly adhered to. Under IAS, this logic is built into the accounting standards themselves, and thus is not dependent upon the level of service, if any, being rendered by an independent accountant, but rather makes it a management responsibility, including the need to disclose the logic and the financial statement impact.

IAS 1 requires that disclosure of these policies be an integral part of the financial statements. It recommends that these policies be disclosed in one location rather than being scattered throughout the footnotes. Though it makes it mandatory on enterprises to disclose all significant accounting policies, IAS 1 also recognizes that disclosure cannot rectify an incorrect or inappropriate treatment. Three considerations that govern the selection and application of the appropriate accounting policies are

1. Prudence

2. Substance over form

3. Materiality

The IASC not only encourages enterprises to present financial statements in conformity with the standards but also requires enterprises to disclose whether they have complied with or departed from the requirements of the standards (IAS 1 and the IASC's Framework).

Related-party disclosures.

According to IAS 24, financial statements should include disclosure of material related-party transactions that are defined by the standard as "transfer of resources or obligations between related parties, regardless of whether a price is charged."

A related party is essentially any party that controls or can significantly influence the financial or operating decisions of the company to the extent that the company may be prevented from fully pursuing its own interests. Such groups would include associates, investees accounted for by the equity method, trusts for the benefit of employees, principal owners, key management personnel, and immediate family members of owners or management.

Disclosures should take place even if there is no accounting recognition made for such transactions (e.g., a service is performed without payment). Disclosures should generally not imply that such related-party transactions were on terms essentially equivalent to arm's-length dealings. Additionally, when one or more companies are under common control such that the financial statements might vary from those that would have been obtained if the companies were autonomous, the nature of the control relationship should be disclosed even if there are no transactions between the companies.

The disclosures generally should include

1. Nature of relationship

2. Description of transactions and effects of such transactions on the financial statements for each period for which an income statement is presented

3. Dollar amount of transactions for each period for which an income statement is presented and effects of any change in establishing the terms of such transactions different from that used in prior periods

4. Amounts due to and from such related parties as of the date of each balance sheet presented together with the terms and manner of settlement

Reporting comparative amounts for the preceding period.

IAS 1 requires that financial statements should show corresponding figures for the preceding period. To increase the usefulness of financial statements, many companies include in their annual reports five- or ten-year summaries of condensed financial information. These comparative statements allow investment analysts and other interested readers to perform comparative analysis of pertinent information. The presentation of comparative financial statements in annual reports enhances the usefulness of such reports and brings out more clearly the nature and trends of current changes affecting the enterprise. Such presentation emphasizes the fact that the statements for a series of periods are far more significant than those for a single period and that the accounts for one period are but an installment of what is essentially a continuous history.

When comparative financial statements are presented (as they normally will be), the related footnote disclosures must also be presented on a comparative basis, except for items of disclosure that would be not meaningful, or might even be confusing, if set forth in such a manner. Although there is no official guidance on this issue, certain details, such as schedules of debt maturities as of the year earlier balance sheet date, would be of little interest to users of the current statements and would be largely redundant with information provided for the more recent year-end. Accordingly, such details are often omitted from comparative financial statements. Another example of superfluous comparative data is the amount of undrawn borrowing capacity at the earlier year-end. Most other disclosures, however, continue to be meaningful and should be presented for all years for which basic financial statements are displayed.

Subsequent events.

The balance sheet is dated as of the last day of the fiscal period, but a period of time may elapse before the financial statements are actually prepared and issued. During this period, significant events or transactions may have occurred that materially affect the company's financial position. These events and transactions are usually referred to as subsequent events. IAS 10 refers to them as "events after the balance sheet date." If not disclosed, significant events occurring between the balance sheet date and issue date could make the financial statements misleading.

There are two types of subsequent events described by IAS 10. The first type consists of events that provide additional evidence with respect to conditions that existed at the date of the balance sheet and which affect the estimates inherent in the process of preparing financial statements. The second type consists of events that provide evidence with respect to conditions that did not exist at the date of the balance sheet being reported on but arose subsequent to that date (and prior to the actual issuance of the financial statements). Such post-balance-sheet events require either adjusting the financial statements or only disclosing them, depending on the character and timing of the event in question. The characterization of these events as being either adjusting or nonadjusting events is not unique to the international accounting standards. In fact, this terminology is found in other (i.e., national) accounting standards, such as UK GAAP.

Examples of post-balance-sheet date events

1. A loss on an uncollectible trade account receivable as a result of a customer's deteriorating financial condition leading to bankruptcy subsequent to the balance sheet date would usually (but not always) be indicative of conditions existing at the balance sheet date, thereby calling for adjustment of the financial statements before their issuance. On the other hand, a loss on an uncollectible trade account receivable resulting from a customer's major casualty, such as a fire or flood subsequent to the balance sheet date, would not be indicative of conditions existing at the balance sheet date, and adjustment of the financial statements would not be appropriate. However, if the amount is material, disclosure would be required.

2. A loss arising from the recognition after the balance sheet date that an asset such as plant and equipment had suffered a material decline in value arising out of reduced marketability for the product or service it can produce. Such a reduction would be considered an economic event in process at the balance sheet date and would require adjustment and recognition of the loss.

3. Nonadjusting events, which are those not existing at the balance sheet date, require disclosure but not adjustment. These could include

   1. Sale of a bond or share capital issue after the balance sheet date, even if planned before that date.

   2. Purchase of a business, if the transaction is consummated after year-end.

   3. Settlement of litigation when the event giving rise to the claim took place subsequent to the balance sheet date. The settlement is an economic event that would be accounted for in the period of occurrence. (However, if the event occurred before the balance sheet date, IAS 37 would require that the estimated amount of the contingency be accrued, in most instances, as discussed further in the next section of this chapter.)

   4. Loss of plant or inventories as a result of fire or flood.

   5. Losses on receivables resulting from conditions (such as a customer's major casualty) arising subsequent to the balance sheet date.

   6. Gains or losses on certain marketable securities.

Contingencies.

Contingencies are defined and described by IAS 37. IAS 37 has created a complex typology comprised of provisions and contingencies. Under this standard, the term "provisions" is used in the sense that contingent liabilities was employed under a predecessor standard—to denote those contingencies that are deemed probable of occurrence and are no longer considered to be contingent at all, but rather merely uncertain as to timing and/or amount.

Under IAS 37, the term contingencies is reserved for those potential obligations which are not to be accrued and formally reported in the balance sheet. In other words, contingencies that are not remote must be disclosed in the notes.

Apart from the terminological changes (which admittedly do have the potential to confuse), the actual accounting requirements are essentially unchanged. Provisions are to be accrued by a charge to income and the recording of a liability if

1. The enterprise has a present obligation as a result of past events;

2. It is probable that an outflow of the enterprise's resources will be required; and

3. A reliable estimate can be made of the amount.

If an estimate cannot be made for the obligation with a reasonable degree of certitude, accrual is not prescribed, but rather disclosure in the notes to the financial statements is needed.

For obligations which do not rise to the level of probable as used above, but which are more than remote in terms of likelihood of occurrence, disclosure in the notes is mandated. In general, unless the obligation is deemed more than remote, disclosure is not required. However, it should be noted that common practice has long been to disclose certain categories of remote contingencies; an example is disclosure of the guarantee of the indebtedness of another party, even if it is not anticipated presently that the enterprise will be asked to honor that guarantee following a failure to perform by the primary obligor.

No disclosure is required for unasserted claims or assessments when no act by the potential claimant has transpired to suggest that there is an intent to make a claim. Also, general or unspecific business risks (e.g., the inherent possibility that foreign operations could be affected by changes in government) are neither accrued for nor disclosed.

Examples of loss contingencies

1. Collectibility of receivables

2. Obligations related to product warranties and product defects

3. Risk of loss or damage of enterprise property by fire, explosion, or other hazards

4. Threat of expropriation of assets

5. Pending or threatened litigation

6. Actual or possible claims and assessments

7. Risk of loss from catastrophes assumed by property and casualty insurance companies including reinsurance companies

8. Guarantees of indebtedness of other entities

9. Obligations of commercial banks under standby letters of credit

10. Agreements to repurchase receivables (or to repurchase the related property) that have been sold

Accrual and disclosure of loss contingencies should be based on an evaluation of the facts in each particular case. Accrual is not a substitute for disclosure, and disclosure is not a substitute for accrual.

An estimated gain from a gain contingency usually is not reflected in the accounts since to do so might be to recognize revenue prior to its realization. Adequate disclosure of the gain contingency shall be made, but care must be taken to avoid misleading implications as to the likelihood of realization.

Contracts and negotiations.

All significant contractual agreements and negotiations should be disclosed in the footnotes to the financial statements. For example, lease contract provisions, pension obligations, requirements contracts, bond indenture covenants, and stock option plans should be clearly disclosed in the footnotes.

Other disclosures required by IAS 1.

IAS 1 has added several new, required disclosure items. If not otherwise disclosed within the financial statements, these items should be reported in the footnotes.

1. The domicile and legal form of the entity, its country of incorporation, and the address of the registered office (or principal place of business, if different);

2. A description of the nature of the enterprise's operations and its principal activities;

3. The name of the parent entity and the ultimate parent of the group; and

4. The number of employees either at the end of the period or an average during the period being reported upon.

These disclosures (which may have been modeled on those already imposed under UK GAAP) are particularly of interest given the multinational character of many enterprises reporting in conformity with IAS.

Balance Sheet Format

The format of a balance sheet is not presently specified by International Accounting Standards but has become established as a matter of tradition and, in some circumstances, as a result of specific industry practices. However, the appendix to IAS 1 gives an example of a balance sheet format but also clarifies that it be considered as an example of the way in which the requirements of the proposed standard might be put into practice.

In general, the two types of formats are the report form and the account form. In the report form the balance sheet continues line by line from top to bottom as follows:

Assets	$xxx
Liabilities	$xxx
Stockholders' equity	xxx
Total liabilities and stockholders' equity	$xxx

In the account form the balance sheet appears in a balancing concept with assets on the left and liabilities and equity amounts on the right as follows:

Assets	$ xxx	Liabilities	$ xxx
		Stockholders' equity	xxx
Total assets	$ xxx	Total liabilities and stockholders' equity	$ xxx

The balance sheet format presented in Schedule 4 to the UK Companies Act of 1985, wherein a net asset total is presented (as a total of assets minus liabilities) as being equal to equity plus reserves, may be seen as a third variation, and is known as the UK GAAP format. This is, in fact, a report format, as illustrated above, with merely a minor alteration made to explicitly reveal the equality between net assets and net worth.

The format of the balance sheet as illustrated by the appendix to IAS 1 is the following:

XYZ Limited Consolidated Balance Sheet as at 31 December 2002 (in thousands of currency units)

	2002	2002	2001	2001
Assets
Noncurrent assets:	x		x
Property, plant and equipment	x		x
Goodwill	x		x
Investments in associates	x		x
Other financial assets	x	xx	x	xx
Current assets:
Inventories	x		x
Trade and other receivables	x		x
Prepayments	x		x
Cash and cash equivalents	x	xx	x	xx
Total assets		xx		xx
Equity and Liabilities
Capital and reserves
Issued capital (Note__)	x		x
Reserves (Note__)	x		x
Accumulated profit (losses)	x	xx	x	xx
Minority interest		xx		xx
Noncurrent liabilities:
Interest-bearing borrowings	x		x
Deferred taxes	x		x
Retirement benefit obligations	x	xx	x	xx
Current liabilities:
Trade and other payables	x		x
Short-term borrowings	x		x
Current portion of interest-bearing borrowings	x		x
Warranty provisions	x	xx	x	xx
Total equity and liabilities		xx		xx

First-Time Application of IAS

International accounting standards, gaining wide acceptance over the years (and shortly, due to the decree by the EC, to be adopted by as many as 7,000 more companies), have been used to prepare financial statements by entities which previously had reported in compliance with some other generally accepted set of accounting principles (national standards of one jurisdiction or another). Questions have arisen regarding the nature, if any, of adjustments to be made in the initial adoption of IAS, and of any expanded disclosures necessitated by the change from one method of reporting to another.

An early interpretation, SIC 8, which presently remains in effect, states that in the period of first-time application of IAS as the primary accounting basis, the financial statements of an enterprise, including comparative information, should be prepared and presented as if the financial statements had always been prepared in accordance with the IAS effective for the period of first-time application. Therefore, the Standards and Interpretations are to be applied retrospectively, except when Standards and Interpretations require or permit a different transitional treatment or when the amount of the adjustment relating to prior periods cannot be reasonably determined. Adjustment amounts are to be treated as an adjustment to the opening balance of retained earnings of the earliest period presented in accordance with IAS. If adjustments relating to prior periods or comparative information cannot be determined, the fact must be disclosed in the notes.

SIC 8 thus requires that the body of IAS in effect in the period when the adoption is effected are to be applied to all prior periods being reported on, explicitly (via comparatives) or implicitly (in the adjustment to beginning retained earnings of the earlier comparative period displayed). It is not necessary, or permitted, to attempt to identify the effective dates when specific standards would have first impacted the financial statements. This was done as a pragmatic solution to what would otherwise have been, for many reporting entities, a massive undertaking (and one which might well have dissuaded some from adopting IAS).

Currently, IASB has exposed a new standard, First-Time Application of IFRS, which would supercede SIC 8 and alter some of the present procedures for implementation of IAS-compliant financial reporting. The proposal differs from SIC 8 in (1) creating targeted exemptions, notably in specified areas where retrospective application is likely to cause undue cost or effort, while SIC 8 contained less specific exemptions that applied when retrospective application would be impracticable; (2) clarifying that an entity applies only the latest version of IFRS, if the exemptions are applied; (3) clarifying how a first-time adopter's estimates under IFRS relate to the estimates it made for the same date using its previous basis of accounting; (4) specifying that the transitional provisions in other IFRS do not apply to a first-time adopter; and (5) requiring enhanced disclosure about how the transition to IFRS affected an entity's reported financial position, financial performance, and cash flows.

If adopted, the standard will require that an entity adopting IAS (which are now called IFRS) for the first time will need to prepare an opening IFRS balance sheet at the beginning of the earliest comparative period presented in its first IFRS financial statements (to be known as the "date of transition to IFRS"). Thus, if an entity's first IFRS financial statements are for the year ended 31 December 2005, it will need to prepare an opening IFRS balance sheet at 1 January 2004 (or earlier, if it presents comparative information for more than a single year). It would

• Recognize all assets and liabilities whose recognition is required by IFRS

• Not recognize items as assets or liabilities if IFRS do not permit such recognition

• Reclassify items that the entity recognized under its previous basis of accounting (previous GAAP) as one type of asset, liability or component of equity, but are a different type of asset, liability or component of equity under IFRS, and

• Apply IFRS in measuring all recognized assets and liabilities

The proposed standard would permit limited exemptions from the above requirement, which would be optionally available to the reporting entity. The standard would, however, require that, if an entity uses any of the exemptions, it would have to apply all applicable exemptions.

These proposed exemptions fall into three categories. First, since determination of cost-based measurements long after acquisition dates of assets (or incurrence date of liabilities) is expected to be problematic, the proposal would require an entity to measure some assets, liabilities, and components of equity on a different basis and use that measurement as a deemed cost. This requirement would apply only to (1) property, plant and equipment; (2) goodwill and other assets and liabilities acquired in business combinations recognized before the date of transition to IFRS; (3) net employee benefit assets or liabilities under defined benefit plans (at the date of transition to IFRS, an entity would measure them in accordance with IAS 19, except that no actuarial gains or losses would remain unrecognized); and (4) cumulative translation differences relating to a net investment in a foreign operation.

Second, IASB has acknowledged that some amounts determined under prior accounting standards may have been based on valuations rather than on original cost, and in some instances those amounts will be found to be more relevant, notwithstanding the departure from the cost basis. Accordingly, the proposed standard will permit the use of the previously ascertained valuations, in lieu of cost, in two defined situations, even when cost data could be reconstructed without undue effort or expense.

The first such situation pertains to prior revaluations which were accomplished by means of applying general or specific price indices to cost amounts that were broadly comparable to those which would have been determined under IFRS. It furthermore pertains to those instances where prior revaluations were effected in ways that approximated what would have been identified as the corresponding fair values as defined under IFRS. In both these scenarios, the reporting entity will be allowed to carry forward these revalued amounts as "deemed costs" under IFRS.

The other case involves the situation where an entity had established a deemed cost under previous GAAP for some or all of its assets and liabilities by measuring them at their fair values at one particular date, because of an event such as a privatization or initial public offering. Such event-driven measurements would establish a deemed cost at that date for subsequent accounting under IFRS.

Third, the standard would prohibit the full retrospective application of IAS 39 in one area that relies on designation by management; namely, hedge accounting.

If a reporting entity chooses to not use the exemptions discussed above, it would apply the IFRS that were effective in each period. This means that it might, therefore, need to consider superseded versions of IFRS if later versions required prospective application. By contrast, if an entity uses the exemptions, it would apply only the latest version of IFRS.

The proposal states that an entity's estimates under IFRS at the date of transition would be consistent with estimates made for the same date under previous GAAP (after adjustments to reflect any difference in accounting policies), unless there was objective evidence that those estimates had been in error. If estimates under IFRS at the date of transition need to be made, and corresponding estimates were not required under previous GAAP, those estimates would not be permitted to reflect conditions that arose after that date. In particular, estimates of market prices, interest rates or foreign exchange rates at the date of transition of IFRS would reflect market conditions at that date. Hindsight would not be permitted, in other words.