Bab 10

The Balance Sheet

LEARNING OBJECTIVES

After reading this chapter, you should be able to:

• Understand the underlying approaches to the linkage between the balance sheet and income
statement.

• Understand the evolving definitions of assets, liabilities, and own ers' equity.

. Appreciate the multiplicity of asset valuation techniques.

• Understand the changes occurring in the liabilities and stockholders' equities areas.

• Comprehend hybrid securities.

• Understand the nature of derivatives.

Comprehend balance sheet classification issues.

he next three chapters examine the balance sheet, income state ment, and cash flow statements,
respectively, in order to review the conceptual foundation of current financial reporting prac tices.
We emphasize the definitions of accounting elements and the rules of recognition and measurement
applicable to each financial statement. It is not our intent to cover all extant accounting standards:
such an ap proach is taken in intermediate accounting textbooks. Rather, we wish to encourage an
appreciation of the principles of accounting measurement or calculation embodied in the three basic
financial statements.

We commence this chapter by reviewing the relationship between the balance sheet and income
statement. If the statements are articulated, they are linked together mathematically without any
"loose ends," then either a revenue-expense view or an asset-liability view predominates. Revenue-
expense means that the income statement predominates whereas an asset-liability view means that
the balance sheet is primary. The nonarticulated view means that the two statements are indepen
dently defined.

The chapter then examines recognition and measurement problems in the three sections of the
balance sheet: assets, liabilities, and owners equity. We will see that a great many valuation
methods exist and that sometimes revenue-expense predominates and sometimes asset-liability
predominates. Nonarticulation is becoming scarce due to the arrival of comprehensive income
(Chapter 11). As we shall see, the asset-liability. view is slowly beginning to predominate over
revenue-expense. Many problems are relatively new such as derivatives and hybrid securities, and
solutions are just beginning to emerge. The chapter concludes with a brief discussion of classification
in the balance sheet.

THE RELATIONSHIP BETWEEN THE BALANCE SHEET AND INCOME STATEMENT

Two approaches, the articulated and the nonarticulated, have been ad vocated for defining
accounting elements and the relationship between the balance sheet and income statement.
Articulation means that the two statements are mathematically defined in such a way that net
income is equal to the change in owners' equity for a period, assuming no capi tal transactions or
prior period adjustments. The nonarticulated ap proach severs the mathematical relationship
between the balance sheet and income statement: each statement is defined and measured inde
pendently of the other.

Articulation

The accounting elements identified in SFAC No. 6 are assets, liabilities, owners' equity, revenues,
gains, expenses, and losses. Income is calcu lated from revenues, gains, expenses, and losses. Under
articulation, in come is a subclassification of owners' equity. Exhibit 10-1 illustrates the articulated
accounting model and classification system. For ease of pre sentation, we take a proprietary
approach, in which the net assets are equal to owners' equity.

Under the articulated concept, all accounting transactions can be classified by the model in Exhibit
10-1. There are three subclassifica tions of owners' equity: contributed capital, retained earnings,
and unre alized capital adjustments. Contributed capital is subclassified into legal capital (par value)
and other sources of contributed capital (for example. premiums and donated assets). Retained
earnings has three subclassi fications: income statement accounts, prior period adjustments, and
dividends. Because income is a subclassification of retained earnings. the income statement and
balance sheet articulate. There are further

Bagan

subclassifications within the income statement itself: the distinctions be tween revenues and gains
and expenses and losses, and the classifi cation of gains and losses as ordinary or extraordinary.
Some accounting transactions bypass the income statement altogether because they are considered
to be adjustments of previous years' income. These adjust ments are made directly to retained
earnings. Dividends represent a dis tribution of income. The third subclassification of owners' equity,
unre alized capital adjustments, arises from a few specific accounting rules. These are fast
disappearing as a result of SFAC No. 130 on comprehen sive income (Chapter 11).

The accounting classification system is rather simple, but this sim plicity causes some difficulty
because complex transactions cannot al ways be neatly categorized into one of the classifications in
Exhibit 10-1. New types of business transactions challenge the limits of the basic accounting model.
For example, mandatory redeemable preferred stock, because it is stock, has definite ownership
characteristics, but be- cause it must be redeemed, it also resembles bonds. The SEC prohibits its
inclusion in owners' equity. However, a case might be made for clas sification as owners' equity.
Such complex transactions go beyond the limits of the accounting classification system. Even so, it is
remarkable that the categoric framework used to classify accounting transactions is virtually
unchanged since Pacioli's time. It may be that supplemental disclosure is the only way to deal with
newer complexities short of de veloping an entirely new accounting classification system.

Within the articulated system, there are two alternatives for defining accounting elements. One
approach, called revenue-expense, focuses on defining the income statement elements. It places
primacy on the in come statement, principles of income recognition, and rules of income
measurement. Assets and liabilities are defined, recognized, and mea sured as a by-product of
revenues and expenses. The other approach is called asset-liability. It is the antithesis of the
revenue-expense ap proach because it emphasizes the definition, recognition, and measure ment of
assets and liabilities. Income is defined, recognized, and mea sured as a by-product of asset and
liability measurement.

Revenue-Expense Approach

Since the 1930s, accounting policy has been mainly concerned with the definition, recognition, and
measurement of income. Income is derived by matching costs (including arbitrary allocations such as
depreciation) to recognized revenues. Both the income statement and balance sheet are primarily
governed by accounting rules of revenue recognition and cost matching, and these rules represent a
revenue-expense orientation.

One consequence of the revenue-expense approach is to burden the balance sheet with by-products
of income measurement rules. As a re sult, the balance sheet contains not only assets and liabilities
(defined later in this chapter), but also ambiguous debits and credits called de ferred charges and
deferred credits. These items do not conform to current definitions of assets and liabilities, yet are
included in the balance sheet because of deferred recognition in the income statement. An example
of a deferred charge is organizational startup costs. These costs are allo caled to the income
statement over a number of years rather than ex pensed immediately. Once incurred, organizational
costs are a sunk cost and cannot be recovered. Therefore, it is questionable if such costs should be
carried forward in the balance sheet. The same is true of some deferred credits. Many of these types
of credit balances are not really li abilities, they are simply future income statement credits arising
from present transactions that are deferred to future income statements. An example of this type of
deferred credit-now largely gone is the in vestment tax credil accounted for under the deferral
method per APB Opinion No. 2. Deferred investment tax credits are not a legal liability; rather, they
simply arise from a difference between how the tax credits are treated in the firm's tax return and
financial statements. There are many examples of accounting standards that emphasize the effects
of transactions on the income statement somewhat to the exclu sion of their impact on the balance
sheet. For example, pension ac counting under APB Opinion No. 8 was mainly concerned with
income statement recognition of pension expenses. Virtually no consideration was given to the
question of whether a pension liability exists. The recog nition and amortization of intangible assets
under APB Opinion No. 17 introduces a dubious debit into the balance sheet (arising from the pur
chase method of accounting for business combinations) and arbitrarily amortzes it over a maximum
of 40 years. The question of whether an intangible asset (goodwill) really exists is not addressed.

Asset-Liability Approach

The asset-liability approach is directly concerned with measuring and reporting assets and liabilities.
In SFAC No. 6, the FASB defines com prehensive income as the change in the firm's net assets (assets
minus liabilities) from nonowner sources. The income statement is regarded as simply a way of
classifying and reporting on certain changes that have occurred in the firm's net assets. Because
assets and liabilities are real, it seems logical that measurement should focus on them. The owners'
eq uity account is merely an invention to make possible the double-entry accounting system. Income
and its components (revenues, gains, ex penses, and losses) are thus regarded as secondary
concepts that are simply a way of reporting on changes in assets and liabilities.
The asset-liability approach focuses on the measurement of net as sets. This approach is arguably
superior to a revenue-expense approach because, as we have noted, assets and liabilities are real. It
is the in crease in the value of net assets that gives rise to what we call income, not vice versa. The
revenue-expense approach turns things around the other way and implies that changes in net assets
are the consequences of "income" measurement. The current value models presented in Ap pendix
1-A of Chapter 1 are examples of the asset-liability approach.

Although the revenue-expense approach is the basic orientation of current financial reporting
practices, some specific accounting stan dards reflect an asset-liability emphasis. SFAS No. 7
proscribes loss capitalization for companies that are in the development stage. Previous practice had
been to capitalize losses while in the development stage and tò write off the losses against future
income. The requirement under SFAS No. 7 keeps a deferred charge out of the balance sheet. SFAS
No. 109 focuses income tax accounting on the recognition of tax "assets" and "liabilities."

The Nonarticulated Approach

The possibility for nonarticulated financial statements has not been widely discussed in accounting
literature. However, the idea appears to have some merit. There is a great deal of tension between
proponents of the traditional revenue-expense approach and the asset-liability ap proach because
revenue-expense proponents are primarily concerned with stabilizing the fluctuating effect of
transactions on the income state ment and are prepared to introduce deferred charges and deferred
cred its in order to smooth income measurement. On the other hand, assel liability advocates are
mainly concerned with reporting changes in the value of net assets, and they are prepared to
tolerate a fluctuating income statement that may include unrealized holding gains and losses.

It is evident that the two groups are polarized partly because the bal ance sheet and income
statement are mathematically articulated. Since articulation exists only by custom, the two
statements could be severed and both groups might be satisfied with a revenue-expense-based in
come statement and an asset-liability-based balance sheet. However, rather than going in the
direction of nonarticulation, the comprehensive income approach required in SFAS No. 130 (Chapter
11) is beginning to close the gap in favor of articulation.

ASSETS

In discussing assets, liabilities, and owners' equity, we present the evo lution of definitions first
because definitions are necessary for classify ing business transactions into the appropriate
categories (as illustrated in Exhibit 10-1). The next step is to define the point in time when ele ments
are recognized in the balance sheet. Finally, we review the attrib utes to be measured for specific
types of assets, liabilities, and owners equity.

Definition of Assets

The definition of assets is important because it establishes what types of economic factors will
appear in the balance sheet. It identifies the ele ments to be recognized, measured, and reported in
the balance sheet. A definition of assets should be solely concerned with the criteria for clas sifying
accounting transactions as assets. As indicated in Chapter 1, the attribute to be measured should be
stated independently of the object to be measured. Many definitions of assets can be found in
accounting lit erature. However, the accounting profession in the United States has made only three
formal attempts to define assets:

Something represented by a debit balance that is or would be prop erly carried forward upon a
closing of books of account according to the rules or principles of accounting (provided such debit
balance is not in effect a negative balance applicable to a liability), on the basis that it represents
either a property right or value acquired, or an ex penditure made which has created a property or is
properly applica-. Ble to the future. Thus, plant, accounts receivable, inventory, and a deferred
charge are all assets in balance sheet classification. Economic resources of an enterprise that are
recognized and mea sured in conformity with generally accepted accounting principles. Assets also
include certain deferred charges that are not resources but that are recognized and measured in
conformity with generally accepted accounting principles.

Assets are probable future economic benefits obtained or controlled by a particular entity ns a result
of past transactions or events.

The first definition emphasizes legal property but also includes deferred charges on the basis that
they are "properly" included with assets. A dis tinetion is made between assets and deferred
charges, but both are con sidered to be assets. The justification is that deferred charges relate to
future period income statements. They are included with assets solely because of income statement
rules that defer the recognition of these costs as expenses until future periods. This aspect of the
definition rep resents a revenue-expense approach to the financial statements.

The second definition emphasizes that assets are economic resources.. These are defined as "the
scarce means available... for the carrying out of economic activity. 8 Assets are perceived to be more
than legal prop erty; anything having future economic value is an asset. For example, a lease
agreement that grants the lessee property use rights (though not ownership rights) would satisfy
this broader definition. Deferred charges are separately identified in this definition but are still
grouped with assets.

The third definition is a further evolution of the concept that assets are economic resources. Key
characteristics of an asset are its capacity to provide future economic benefits, control of the asset
by the firm, and the occurrence of the transaction giving rise to control and the economic benefits.
The capacity to provide economic benefits has also been called future service potential. It means
that an asset is something that will pro duce positive net cash flows in the future. These cash flows
may occur in one of two ways: in a direct market exchange for another asset or through conversion
in a manufacturing operation to finished goods (which are then exchanged for another asset in a
market exchange). SFAC No. 6 also attempts to reconcile this definition with certain types of
deferred charges. Some deferred charges, it argues, do benefit the cash flows of future periods. For
example, prepaid costs are deferred charges that will reduce future period outflows of cash.
However, other deferred charges, such as organizational startup costs, are sunk costs and do not
have any impact on future cash flows.

The "economic resources" approach represents a broader concept of assets than the legal property
concept and is consistent with the eco nomic notion that an asset has value because of a future
income (cash) stream. The genesis of this broader definition can be found in both eco nomic and
accounting literature. It represents an emphasis on control of assets rather than legal ownership.
Because the concept of economic re- sources is broad, it encompasses a wide variation in (1)
methods of real izing the future benefits and (2) determining the probability of realizing future
benefits. The only subclassification reported within the asset group is the current-noncurrent
distinction. This tells very little, though, about how the benefits are to be realized and the probability
of realizing the benefits. Classification of assets is discussed further in the final sec tion of the
chapter.

The breadth of the economic resources concept has led some accoun tants to prefer a narrower
concept of assets based on the notions of ex changeability and severability. According to this
narrower viewpoint, an accounting asset should represent only those economic resources that can
be severed from the firm and sold. This narrower asset definition would reduce variation in the
reporting of assets in terms of the realiza tion of future benefits-because having value only from
productive use would be excluded by this narrower definition. Assets held for use can be argued to
have a higher risk of realizing future benefits than assets