Assets, Liabilities and Equity

In partial fulfilment of:

Accounting Theory
Submitted to:

Yuni Nustini, Dra.,MAFIS, Ak

Prepared by
Tiyas Kurnia Sari 14312524
Immellita Budiarti 14312566
Luky Fitri Angraini 14312206

Economic Faculty / Accounting (IP)

Islamic University of Indonesia

Condongcatur, Depok, Sleman, Yogyakarta
2015/2016

I.

Assets

An asset is an item that the company owns, with the expectation that it
will yield future financial benefit. This benefit may be achieved through
enhanced

purchasing

power

(i.e.,

decreased

expenses), revenue generation or cash receipts.

A. Asset Defined
Asset can be defined in 3 essential characteristics, namely:
1. Future Economic Benefit
Future Economic Benefit, used in both the IASB and FASB definitions,
implies that there must be some future flow of economic benefits in
order that an asset exists and directs attention towards seeking to
identify those future flows. The benefit for a for profit business
entity are associated with the activities to generate profit. The
notion of future economic benefits is relating economic resources.
There are two main characteristics of an economic resources,
scarcity and utility. Scarcity means if a resource was not scarce then
the resource would not be economic. Utility relates to the future
benefits or services. Technically, in economic theory, the utility of a
commodity is its to satisfy human wants. Therefore, all economic
resources have value.
2. Control by entity
The economic benefit must be controlled by the entity in question to
quality as an asset. The control an owner has of property is not
absolute. An entitys right to use or control an asset is never
absolute. The right to use or control an asset as stated in the
definition does not imply that an entity must be able to do
absolutely whatever it pleases with the asset.
3. Past Event
Including the qualification that asset must be controlled by the
reporting entity as a result of past event in the framework definition
of assets ensures that planned assets are excluded.
B. Asset Recognition

Recognition assets on the balance sheet also involves conditions that can
be called recognition rules. These rules have been formulated because
accountants require evidence to support their record in an environment of
uncertainty.

Some

conventions,

and

recognition
others

are

rules

are

formally

informally
designated

expressed
in

as

authoritive

pronouncements. Two exampe of conventional recognition rules are:

An account receivable is recorded as an assets when a credit sale is

made
Equipment is recorded as an asset when it purchased.

Numerous recognition criteria have been applied in the past to assist

accountants to decide when to record assets. Not all of these criteria are
now formalised in the framework, and some have little or theoritical
foundation. The following list is not intended to be complete and the
criteria are not mutually excluxive.

Reliance on the law

Determinationn of economic substance of the transaction or event.
Use the conversatism (prudence principle) : anticipate losses, but

not gains.
C. Asset Measurement
Assets can be broadly categorized into short-term (or current) assets,
fixed assets, financial investments and intangible assets. Assets are
recorded on companies' balance sheets based on the concept of historical
cost, which represents the original cost of the asset, adjusted for any
improvements or aging. Historical cost is also called the book value.
Assets are all of the economic resources available to a firm. Types of
assets include,
1. Current Assets
Current assets are short-term economic resources that are expected
to be converted into cash within one year. Current assets include
cash and cash equivalents, accounts receivable, inventory, and
various prepaid expenses. While cash is easy to value, accountants
periodically reassess the recoverability of inventory and accounts
receivable. If there is persuasive evidence that collectability of

accounts receivable is impaired or that inventory becomes obsolete,

companies may write off these assets. Here several example and
explanation of current assets:
Cash Cash is the most liquid asset a company can own. It
includes any form of currency that can be readily traded
including coins, checks, money orders, and bank account

balances.
Accounts Receivable Accounts Receivable is an asset that
arises from selling goods or services to someone on credit.
The receivable is a promise from the buyer to pay the seller
according to the terms of the sale. This is an unusual asset
because it isn't an asset at all. It is more of a claim to an
asset. The seller has a claim on the buyer's cash until the

buyer pays for the goods or services.

Notes Receivable A note is a written promise to repay
money.

company

that

holds

notes

signed

by

another entity has an asset recorded as a note. Unlike

accounts receivable, notes receivable can be long-term assets

with a stated interest rate.

Prepaid Expenses Prepaid

expenses,

like

prepaid

insurance, are expenses that have been paid in advanced.

Like

accounts

receivable,

prepaid

expenses

are

assets

because they are a claim to assets. If six months worth of

insurance is paid in advance, the company is entitled to

insurance (a service) for the next six months in the future.

Inventory Inventory consists of goods owned a company
that is in the business of selling those goods. For example, a
car would be considered inventory for a car dealership
because it is in the business of selling cars. A car would not be
considered inventory for a pizza restaurant looking to selling it

delivery car.
Supplies Many companies have miscellaneous assets that
are entire in product production that are too small and
inexpensive to capitalize. These assets are expenses when
they are purchased. A good example is car factory's bolts. It's

difficult to account for each bolt as it is used in the assembly

process, so they are just expensed.
2. Fixed asset
Fixed assets are long-term resources, such as plants, equipment and
buildings. An adjustment for aging of fixed assets is made based on
periodic charges called depreciation, which may or may not reflect
the loss of earning power of a fixed asset. Generally accepted
accounting principles (GAAP) allow depreciation under two broad
methods: the straight-line method assumes that a fixed asset loses
its value in proportion to its useful life, while the accelerated
method assumes that the asset loses its value faster in its first years
of use.
3. Financial Assets
Financial assets represent investments in the assets and securities
of other institutions. Financial assets include stocks, sovereign and
corporate bonds, preferred equity, and other hybrid securities.
Financial assets are valued depending on how the investment is
categorized and the motive behind it.
4. Intangible assets
Intangible assets are economic resources that have no physical
presence. These are assets that lack physical substance but provide
economic rights and advantages: patents, franchises, copyrights,
goodwill, trademarks and organization costs. These assets have a
high degree of uncertainty in regard to whether future benefits will
be realized. They are reported at historical cost net of accumulated
depreciation.
The value of an identifiable intangible asset is based on the rights or
privileges conveyed to its owner over a finite period, and its value is
amortized over its useful life. Identifiable intangible assets include
patents, trademarks and copyrights. Intangible assets that are
purchased are reported on the balance sheet at historical cost less
accumulated amortization.
An unidentifiable intangible asset cannot be purchased separately
and may have an infinite life. Intangible assets with infinite lives are

not amortized, and are tested for impairment annually, at least.

Goodwill is an example of an unidentifiable intangible asset.
Goodwill is recorded when one company acquires another at an
amount that exceeds the fair market value of its net identifiable
assets. It represents the premium paid for the target company's
reputation, brand names, customers, suppliers, human capital, etc.
When computing financial ratios, goodwill and the offsetting
impairment charges are usually removed from the balance sheet.
II.

Liabilities

According to IASB Framework liability is defined as follows:

A liability is a present obligation of the enterprise arising from past
events, the settlement of which is expected to result in an outflow from
the

enterprise

of

resources

embodying

economic

benefits

(IASB

Framework).
The liabilities of a business are those things that belong to the business
but unlike assets have a negative financial value i.e. items that will require
the payment of money by the business at some point in the future.
Examples of liabilities include unpaid bills, unpaid taxes, unpaid wages,
rusty motor vehicles, stock that has passed its use-by date, overdrawn
bank accounts and money owed by the business to its creditors.
In simple words, liability is an obligation of the entity to transfer cash or
other resources to another party. Liability could for instance be a bank
loan, which obligates the entity to pay loan installments over the duration
of the loan to the bank along with the associated interest cost.
Alternatively, an entity's liability could be a trade payable arising from the
purchase of goods from a supplier on credit.
Liabilities imply a duty or responsibility to pay on demand or on an
occurrence of certain transaction or event. Liabilities also arise from
borrowings which may be made to improve business or personal income
and are paid back over an agreed period of an interval, which may be of
the short period or long period.

Types of Liabilities
1 Current Liabilities or Short Term Liabilities
Liabilities which are normally due and payable within one year are
grouped as current liabilities. These liabilities are also known as
short-term liabilities as they become due within a shorter period
(say within 1 year). Creditors, salaries and wages payable, gratuity
or bonus payable, interest payable, bills payable, sundry creditors,
bank overdraft or cash credit, unclaimed dividends, pre-received
incomes, sales tax payable, income tax payable, provisions, other
taxes payable, accrued expenses, instalments due within 1 year for
term loans, etc. are all examples of current liabilities. Current
liabilities are short-term financial obligations that are paid off within
one year or one current operating cycle, whichever is longer. (A
normal operating cycle, while it varies from industry to industry, is
the time from a company's initial investment in inventory to the
time of collection of cash from sales of that inventory or of products
created from that inventory.) Typical current liabilities include such
accrued expenses as wages, taxes, and interest payments not yet
paid; accounts payable; short-term notes; cash dividends; and
revenues collected in advance of actual delivery of goods or
services.
Economists, creditors, investors, and other members of the financial
community all regard a business entity's current liabilities as an
important indicator of its overall fiscal health. One financial indicator
associated with liabilities that is often studied is known as working
capital. Working capital refers to the dollar difference between a
business's total current liabilities and its total current assets.
Another financial barometer that examines a business's current
liabilities

is

known

as

the

current

ratio.

Creditors

and

others compute the current ratio by dividing total current assets by

total current liabilities, which provides the company's ratio of assets
to liabilities. For example, a company with $1.5 million in current

assets and $500,000 in current liabilities would have a three-toone

ratio of assets to liabilities.
2 Long Term Liabilities
Liabilities which are not immediately due but become due after a
year or more are classified as long-term liabilities. Long term
bank loans like term loans, debentures, deferred tax liabilities,
mortgage liabilities (payable after 1 year), and payments examples
of long-term liabilities. Interest payable is also treated as the longterm liability if interest is payable on maturity. Liabilities that are not
paid off within a year, or within a business's operating cycle, are
known as long-term or noncurrent liabilities. Such liabilities often
involve large sums of money necessary to undertake opening of a
business, major expansion of a business, replace assets, or make a
purchase of significant assets. Such debt typically requires a longer
period of time to pay off. Examples of long-term liabilities include
notes, mortgages, lease obligations, deferred income taxes payable,
and pensions and other post-retirement benefits. When debt that
has been classified as long-term is paid off within the next year, the
amount of that paid-off liability should be reported by the company
as a current liability in order to reflect the expected drain on current
assets. An exception to this rule, however, comes into effect if a
company decides to pay off the liability through the transfer
of noncurrent assets that have been previously accumulated for that
very purpose. Investors, creditors, and other users view the
separation of liabilities into current and noncurrent classifications as
important because their decision models use the working capital
concept, current ratios, and projections of expected future cash
flows to analyze and compare the performance of firms. The amount
of long-term debt relative to equity is also relevant because the
debt-to-equity ratio is directly related to the risk associated with
investing in the firm's stock. 1 As the debt-to-equity ratio of a firm
increases, the market's perception of the riskiness of investing in

the firm's stock also rises. Thus it is important that accountants

have criteria to appropriately classify liabilities as short-term or
long-term, so that decision makers can reliably evaluate the firm's
ability to meet current needs and to determine the level of riskiness
inherent in projections of future cash flows over time.
3 Contingent Liabilities
Certain liabilities are payable on the occurrence of some event or
contingency. Contingency signifies something which may or may not
take place. If a liability is due on happening of such an event, it is
termed as the contingent liability. Default in supply, breach of
contract, damage to the environment or to the prestige of some
person or entity, an outcome of accidents and other law-suits, are
examples of some such cases where a liability is contingent to
occur. Such liabilities are calculated on the basis of what if the
actual loss occurs where ever possible and with an addition of a
notional calculation of damage occurred to the person or entity.
Generally, these liabilities are not included in the Balance Sheet but
are mentioned separately as a note to the balance sheet. A third
kind of liability accrued by companies is known as a contingent
liability. The term refers to instances in which a company reports
that there is a possible liability for an event, transaction, or incident
that has already taken place; the company, however, does not yet
know whether a financial drain on its resources will result. It also is
often uncertain of the size of the financial obligation or the exact
time that the obligation might have to be paid.
Contingent liabilities often come into play when a lawsuit or other
legal measure has been taken against a company. An as yet
unresolved lawsuit concerning a business's products or service, for
example, would qualify as a contingent liability. Environmental
cleanup and/or protection responsibility sometimes falls under

this classification as well, if the monetary impact of new regulations

or penalties on a company is uncertain.
Companies are legally bound to report contingent liabilities. They
are typically recorded in notes that are attached to a company's
financial statement rather than as an actual part of the financial
statement. If a loss due to a contingent liability is seen as probable,
however, it should be included as part of the company's financial
statement.
III.
Equity
A. Definition of Equity by framework
Equity is defined as the residual interest in the assets of the entity after
deducting all its liabilities. The effect of this definition is to acknowledge
the supreme conceptual importance of indentifying, recognising and
measuring assets and liabilities, as equity is conceptually regarded as a
function of assets and liabilities, ie a balancing figure (Cotter, 2012).
Equity includes the original capital introduced by the owners, ie share
capital and share premium, the accumulated retained profits of the entity,
ie retained earnings, unrealised asset gains in the form of revaluation
reserves and, in group accounts, the equity interest in the subsidiaries not
enjoyed by the parent company, ie the non-controlling interest (NCI)
(Kieso, Weygandt, & Warfield, 2010). Slightly more exotically, equity can
also include the equity element of convertible loan stock, equity settled
share based payments, differences arising when there are increases or
decreases in the NCI, group foreign exchange differences and contingently
issuable shares. These would probably all be included in equity under the
umbrella term of Other Components of Equity (Cotter, 2012).
B. Financial Accounting Standards Board (FASB) has listed the
following characteristics of equity:
1. Equity in a business enterprise stems from ownership rights. It
involves a relation between an enterprise and its owners as owners
rather than as employees, suppliers, customers, lenders or in some
other non-owner role.

Since it ranks after liabilities as a claim to or interest in the

assets of the enterprise, it is a residual interest:
(a) Equity is the same as net assets, the difference between the
enterprises assets and its liabilities and
(b) Equity is enhanced or burdened by increases and decreases in net
assets from sources other than investments by owners and distributions to
owners. Owners equity is the interest that, perhaps in varying degrees,
bears the ultimate risk of enterprise failure and reaps the ultimate rewards
of enterprise success.
2. Equity represents the source of distributions by an enterprise to its
owners, whether in the form of cash dividends or other distributions
of assets. Owners and others expectations about distributions to
owners may affect the market prices of an enterprises equity
securities, thereby indirectly affecting owner compensation for
providing equity or risk capital to the enterprise. Thus, the essential
characteristics of equity centre on the conditions for transferring
enterprise assets to owners.
3. An enterprise may have several types of equity (e.g., equity shares,
preference share) with different degrees of risk stemming from
different rights to participate in distributions of enterprise assets or
different priorities of claims on enterprise assets in the event of
liquidation. That is, some classes of owners may bear relatively
more of the risks of an enterprises unprofitability or may benefit
relatively more from its profitability (or both) than other classes of
owners.
4. Owners equity is originally created by owners investments in an
enterprise and may from time to time be augmented by additional
investments by owners. Equity is reduced by distributions by the
enterprise to owners (Kieso et al., 2010).

C. The Theory about Equity

1. Proprietary Theory:
Under the proprietary theory, the entity is the agent, representative, or
arrangement through which the individual entrepreneurs or shareholders
operate.
In this theory, the viewpoint of the owners group is the center of interest
and it is reflected in the way that accounting records are kept and the
financial

statements

are

prepared.

The

primary

objective

of

the

proprietary theory is the determination and analysis of the proprietors net

worth(Hatfield, Walster, Walster, & Berscheid, 1978).
Accordingly, the accounting equation is viewed as:
Assets Liabilities = Proprietors Equity
In other words, the proprietor owns the assets and liabilities. If the
liabilities may be considered negative assets, the proprietary theory may
be said to be asset centered and, consequently, balance-sheet oriented.
Assets are valued and balance sheets are prepared in order to measure
the changes in the proprietary interest or wealth Revenues and expenses
are as increases or decreases, respectively, in proprietorship not resulting
from proprietary investments or capital withdrawals by the proprietor.
Thus, net income is an increase in the proprietors wealth to be added to
capital. Losses, interest on debt, and corporate income taxes are
expenses, while dividends are withdrawals of capital.
The proprietary theory has some influence of financial accounting
techniques and accounting treatment of items. For example, net income
of a company, which is arrived at after treating interest and income taxes
as expense, represents net income to equity share holders rather than
to all providers of capital. Similarly, terms such as earnings per share,
Book value per share, and dividend per share indicate a proprietary
emphasis.
The proprietary theory has two classifications depending upon who is
considered to be included in the proprietary group. In the first type, only

the common shareholders are part of the proprietor group, and preferred
shareholders are excluded. Thus, preferred dividends are deducted when
calculating the earnings of the proprietor (equity shareholders)(Bird,
Davidson, & Smith, 1974).
This narrow form of the proprietary theory is identical to the residual
equity concept in which the net income is extended to deduct preferred
dividends and arrive at net income to the residual equity on which will be
based the computation of earnings per share.
In the second form of the proprietary theory, both the common capital and
preferred capital are included in the proprietors equity. Under this wider
view, the focus of attention becomes the shareholders equity section in
the balance sheet and the amount to be credited to all shareholders in the
income statement.
2. Entity Theory:
In entity theory, the entity (business enterprises) is viewed as having
separate and distinct existence from those who provided capital to it.
Simply stated, the business unit rather than the proprietor is the center of
accounting interest. It owns the resources of the enterprises and is liable
to both, the claims of the owners and the claims of the creditors.
Accordingly, the accounting equation is:
Asset = Equities or
Assets = Liabilities + Shareholders Equity
Assets are rights accruing to the entity, while equities represent sources
of the assets, consisting of liabilities and the shareholders equity. Both
the creditors and the shareholders are equity holders, although they have
different rights with respect to income, risk, control and liquidation.
Thus, income earned is the property of the entity until distributed as
dividends to the shareholders. Because the business unit is held
responsible for meeting the claims of the equity holders, the entity theory

is said to be income centered and consequently, income statement

oriented.
Accountability to the equity holders is accomplished by measuring the
operating and financial performance of the firm. Accordingly, income is an
increase in the shareholders equity after the claims of other equity
holders are metfor example, interest on long-term debt and income
taxes.
The increase in shareholders equity is considered income to the
shareholders only if a dividend is declared. Similarly, undistributed profits
remain the property of the entity because they represent the companys
proprietary equity in itself.
It should be noted that strict adherence to the entity theory would dictate
that interest on debt and income taxes be considered distributions of
income rather than expenses. The general belief and interpretation of the
entity theory, however, is that interest and income taxes are expenses.
The entity theory is most applicable to the corporate form of business
enterprise, which is separate and distinct from its owners. The impact of
the entity theory may be found in some of the accounting techniques and
terminology used in practice.
First, the entity theory favours the adoption of LIFO inventory valuation
rather than FIFO because LIFO achieves a better income determination.
Because of its better inventory valuation on the balance sheet, FIFO may
be considered a better technique under the proprietary theory.
Second, the common definition of revenue as product of an enterprise and
expenses as goods and services consumed to obtain this revenue is
consistent with the entity theorys preoccupation with an index of
performance and accountability to equity holders.
Third, the preparation of consolidated statements and the recognition of a
class of minority interest as additional equity holders is also consistent
with the entity theory.

Finally, both the entity theory, with its emphasis on proper determination
of income to equity holders, and the proprietary theory, with its emphasis
on proper asset valuation, may be perceived to favour the adoption of
current values or valuation bases other than historical costs (Clark, 1993).
D. The transactions and events that change equity.
The transactions and events that influence or do not influence equity have
been displayed in the Exhibit 7.1. In this Exhibit class B shows the sources
of changes in equity and distinguishes them from each other and from
other transactions, events and circumstances affecting an enterprise
during a period (classes A and C)(IASB, 2013).
The possible sources of changes in equity can be (1) Comprehensive
income (2) all changes in equity from transfers between the enterprise
and its owners. Further, comprehensive income is the result of revenues
and expenses, gains and losses. The changes in equity due to transfers
between the enterprise and its owners may be in the form of investments
by owners and distribution to owners.
In the Exhibit class C includes no changes in assets or liabilities. Class A
includes all changes in assets and liabilities not accompanied by changes
in equity such as exchange of assets for assets, exchange of liabilities for
liabilities, acquisitions of assets by incurring liabilities, settlement of
liabilities by transferring assets. It means all transactions and events do
not affect owners equity.

The items covered in Class A, B and C of the Exhibit can be listed

as follows:
(A) All changes in assets and liabilities not accompanied by changes in
equity.
This class comprises four kinds of exchange transactions that are common
in most business enterprises.
1. Exchange of assets for assets, for example, purchase of assets for
cash or barter exchanges.
2. Exchange of liabilities for liabilities, for example, issues of notes
payable to settle accounts payable or refundings of bonds payable
by issuing new bonds to holders that surrender outstanding bonds.
3. Acquisition of assets by incurring liabilities, for example, purchase of
assets on account, borrowings, or receipts of cash advances for
goods or services to be provided in the future.
4. Settlements of liabilities by transferring assets, for example,
repayments of borrowings, payments to suppliers on account,
payments of accrued wages or salaries or repairs (or payment for
repairs) required by warranties.

(B) All changes in assets or liabilities accompanied by changes in equity.

This class comprises:
1. Comprehensive income whose components are:
a) Revenues and expenses
b) Gains and losses
2. All changes in equity from transfers between the enterprises
and its owners.
This comprises:
a) Investments by owners in the enterprise,
b) Distributions by the enterprise to owners.
c) Changes within equity that do not affect assets or liabilities, for
example, share dividends, conversion of preferred shares into
common shares and some share recapitalisation. This class contains
only changes within equity and does not affect the definition of
equity or its amount.

IV.

Refrences

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https://www.efinancemanagement.com/financialaccounting/meaning-and-types-of-liabilities
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