Accounting for Assets, Liabilities and Equity

Introduction

Assets, liabilities and equity are the principal elements of the statement of financial position. Their recognition and measurement affect reported profitability, liquidity, solvency and returns to shareholders. Accounting is therefore more than recording transactions: it requires judgements about economic benefits, obligations, useful lives, credit risk, impairment and uncertainty.

This chapter primarily applies International Financial Reporting Standards (IFRS Accounting Standards), particularly IAS 2, IAS 7, IAS 8, IAS 10, IAS 16, IAS 32, IAS 36, IAS 37, IAS 38, IFRS 7, IFRS 9, IFRS 13 and IFRS 15. National requirements may differ, so practitioners must confirm the applicable reporting framework.

Learning Objectives

After studying this chapter, students should be able to:

1. Account for cash, receivables and inventory.
2. determine the cost, depreciation and impairment of property, plant and equipment.
3. distinguish capitalised intangible assets from expenditure recognised immediately.
4. account for payables, borrowings, provisions and contingent liabilities.
5. explain share capital, reserves and dividends.
6. apply basic historical-cost, fair-value, amortised-cost and impairment measurements.
7. prepare and interpret relevant journal entries and supporting schedules.
8. evaluate estimation, governance and ethical issues affecting reported balances.

1. Recognition and Measurement Foundations

An asset is a present economic resource controlled by an entity as a result of past events. An economic resource is a right with the potential to produce economic benefits. A liability is a present obligation to transfer an economic resource as a result of past events. Equity is the residual interest in assets after deducting liabilities.

Recognition is appropriate when recording an item provides relevant information and a faithful representation, subject to cost constraints. Recognition and measurement are related but distinct: recognition decides whether an item appears in the statements, while measurement assigns a monetary amount.

The accounting equation is:

Every transaction must preserve this equality. Income normally increases equity, while expenses and distributions to owners normally decrease it.

Measurement bases

Classification and measurement should reflect economic substance rather than a desired accounting outcome.

Figure: Recognition, initial measurement and subsequent measurement are distinct stages of accounting analysis.

2. Cash and Cash Equivalents

Cash includes notes, coins and demand deposits. Cash equivalents are short-term, highly liquid investments that are readily convertible to known amounts of cash and subject to insignificant value-change risk. An investment normally qualifies only when it has a maturity of three months or less from acquisition. Equity investments generally do not qualify.

Restricted cash must be separately presented or disclosed when the restriction is material. Bank overdrafts are generally borrowings, although IAS 7 permits overdrafts repayable on demand that form an integral part of cash management to be included in cash and cash equivalents for cash-flow reporting.

Bank reconciliation

A bank reconciliation explains differences between the bank statement and cash ledger. Common reconciling items include:

• deposits in transit;
• outstanding cheques;
• bank fees and interest;
• direct customer deposits;
• dishonoured receipts; and
• errors by the bank or entity.

Only items missing from the entity’s accounting records require journal entries.

Example: The ledger balance is $24,600. The bank has credited customer receipts of $2,000 and charged fees of $150 not yet recorded. The adjusted ledger balance is:

The entries are:

• Debit Cash $2,000; Credit Trade Receivables $2,000.
• Debit Bank Fees Expense $150; Credit Cash $150.

Strong cash controls include segregation of authorisation, custody and recording; dual approval of payments; daily exception monitoring; and independent reconciliation.

3. Trade Receivables and Expected Credit Losses

Trade receivables arise when goods or services are supplied on credit. They are initially measured under IFRS 15 at the transaction price when they contain no significant financing component. They are subsequently measured at amortised cost less an expected credit loss allowance under IFRS 9.

A credit sale is recorded as:

• Debit Trade Receivables.
• Credit Revenue.

For trade receivables, an entity may apply the simplified IFRS 9 approach and recognise lifetime expected credit losses from initial recognition. A provision matrix may group customers by shared risk characteristics and ageing.

Here, Exposure_i is the gross receivable amount in category i, and Loss rate_i is the estimated lifetime default loss percentage for that category. Rates should incorporate historical experience, current conditions and supportable forecasts.

Worked example: Provision matrix

If the existing allowance has a $2,900 credit balance, the required adjustment is $5,500:

• Debit Impairment Loss $5,500.
• Credit Loss Allowance $5,500.

The statement of financial position reports net receivables of $181,600. A specific receivable judged uncollectible is written off against the allowance, not normally through a second impairment expense.

4. Inventory

Inventory comprises assets held for sale, in production for sale, or consumed in production. IAS 2 measures inventory at the lower of cost and net realisable value (NRV).

All variables are measured in the same currency and relate to ordinary business conditions at the reporting date.

Inventory cost includes purchase costs, conversion costs and other costs incurred to bring inventory to its present location and condition. Purchase cost includes non-refundable taxes, transport and handling, net of trade discounts. Abnormal waste, most storage costs, administrative overhead unrelated to production, and selling costs are expensed.

Cost formulas

Specific identification is appropriate for non-interchangeable items. FIFO assumes the earliest purchased units are sold first. Weighted-average cost assigns a common average cost to interchangeable units. IAS 2 does not permit LIFO.

For a periodic weighted-average system:

Example: An entity purchases 100 units at $20 and 150 units at $22. It sells 180 units.

Under FIFO:

The remaining 70 units cost $1,540. If their NRV is $20 each, total NRV is $1,400. Inventory is written down by $140:

• Debit Inventory Write-down Expense $140.
• Credit Inventory $140.

A previous write-down is reversed when NRV subsequently recovers, but only up to the amount of the original write-down.

5. Property, Plant and Equipment

Property, plant and equipment (PPE) are tangible items held for production, supply, rental or administration and expected to be used for more than one period. An item is recognised when future economic benefits are probable and cost can be measured reliably.

Initial cost

IAS 16 cost includes:

1. purchase price, import duties and non-refundable purchase taxes, after discounts;
2. directly attributable costs of bringing the asset to the location and condition necessary for operation; and
3. the initial estimate of dismantling, removal and site-restoration obligations when recognition criteria are met.

Recoverable taxes are excluded because the entity can reclaim them. Training, opening ceremonies, initial operating losses and general administration are generally expensed.

Worked example: Equipment has a price of $80,000, non-refundable purchase tax of $4,000, delivery of $2,000, installation of $4,000 and staff training of $1,500. The present value of the restoration obligation is $5,000.

Training of $1,500 is expensed. The restoration liability is initially recognised at $5,000 and subsequently unwound through finance cost.

Depreciation

Depreciation systematically allocates an asset’s depreciable amount over its useful life. Land normally is not depreciated. Significant components with different useful lives are depreciated separately.

For straight-line depreciation:

The formula assumes a constant annual allocation and a full year of use. If the $95,000 equipment has a $5,000 residual value and five-year useful life:

Depreciation begins when the asset is available for use, not necessarily when production begins. Useful life, residual value and depreciation method are reviewed at least annually. Changes are accounted for prospectively as changes in estimates under IAS 8.

After recognition, an entity chooses the cost model or revaluation model for an entire PPE class. Revaluation increases generally enter other comprehensive income and accumulate in a revaluation surplus, subject to reversals of previous decreases.

Disposal

On disposal, both cost and accumulated depreciation are removed. The gain or loss equals disposal proceeds less carrying amount and is recognised in profit or loss.

6. Intangible Assets

An intangible asset is an identifiable non-monetary asset without physical substance. Identifiability normally arises from separability or contractual or legal rights. Examples include patents, licences and acquired software.

Recognition requires probable future economic benefits and reliable cost measurement. Separate acquisition cost is usually readily measurable. Internally generated goodwill is never recognised.

Research and development

Research expenditure is expensed when incurred. Development expenditure is capitalised only from the date the entity demonstrates all IAS 38 criteria:

• technical feasibility;
• intention to complete;
• ability to use or sell;
• probable future economic benefits;
• adequate technical, financial and other resources; and
• reliable measurement of attributable expenditure.

Expenditure previously expensed cannot later be reinstated as an asset.

Finite-life intangibles are amortised systematically over useful life and tested for impairment when indicators exist. Indefinite-life intangibles are not amortised but undergo annual impairment testing and testing whenever indicators arise. “Indefinite” does not mean infinite; the classification must be reviewed annually.

7. Impairment of Non-financial Assets

IAS 36 prevents assets from being carried above recoverable amount. Except for goodwill and indefinite-life intangibles, an impairment test is required when indicators exist, such as technological obsolescence, physical damage, adverse market changes or poor performance.

The second formula applies only when carrying amount exceeds recoverable amount; otherwise impairment is zero.

Example: A machine has a carrying amount of $240,000, value in use of $205,000 and fair value less costs of disposal of $215,000. Recoverable amount is $215,000 and impairment is $25,000.

If an individual asset does not generate largely independent cash inflows, it is tested within a cash-generating unit (CGU). CGU impairment is generally allocated first to goodwill and then proportionately to other assets, subject to specified floors. Impairment of assets other than goodwill may be reversed if estimates improve; goodwill impairment is never reversed under IFRS.

8. Payables and Borrowings

Trade payables are obligations for goods or services received. They are normally initially measured at fair value and subsequently at amortised cost. Short-term payables without a significant financing element are commonly recorded at invoice amount.

Accrued expenses are obligations for goods or services already received but not yet invoiced or paid. They prevent understatement of expenses and liabilities.

Effective-interest method

Most conventional borrowings are subsequently measured at amortised cost. Transaction costs directly attributable to issuing the liability are included in its initial carrying amount.

The effective interest rate is the rate that exactly discounts contractual future cash flows to the initial carrying amount. Amounts must cover consistent time periods and use the corresponding periodic rate.

Worked example: Bond issued at a discount

A five-year bond has a face value of $100,000, pays annual coupons of 6%, and has an effective annual yield of 8%. Its issue price is the present value of coupons and redemption:

The calculation assumes annual end-of-year coupons, redemption at the end of year 5, no issue costs and an 8% annual effective market rate.

The final line includes rounding to the redemption amount. In year 1, the entry is:

• Debit Finance Cost $7,361.17.
• Credit Bond Liability $1,361.17.
• Credit Cash $6,000.

9. Provisions and Contingencies

A provision is a liability of uncertain timing or amount. IAS 37 requires recognition when:

1. a present legal or constructive obligation results from a past event;
2. an outflow of resources is probable; and
3. the amount can be estimated reliably.

The provision is the best estimate of expenditure required to settle the obligation. For a large population, expected value may be appropriate:

If warranties have a 60% probability of costing $30,000 and a 40% probability of costing $10,000, expected expenditure is:

Material long-term provisions are discounted at a pre-tax rate reflecting current time-value and liability-specific risks not already included in cash flows. Periodic unwinding of the discount is finance cost.

A contingent liability is generally disclosed rather than recognised when an outflow is possible rather than probable, or reliable measurement is unavailable. Disclosure is unnecessary when outflow is remote. A contingent asset is disclosed when inflow is probable and recognised only when realisation becomes virtually certain.

Provisions cannot be used to create hidden reserves or smooth profit. Future operating losses do not create present obligations.

10. Share Capital, Reserves and Dividends

Equity instruments evidence a residual interest after liabilities. Classification depends on contractual substance. An instrument requiring cash redemption may be a financial liability even if legally labelled a share.

Share issues

Suppose a company issues 10,000 ordinary shares with $1 par value for $6 each:

• Debit Cash $60,000.
• Credit Share Capital $10,000.
• Credit Share Premium $50,000.

Direct incremental equity-issue costs are deducted from equity, net of related tax effects. They are not ordinary operating expenses.

Reserves

Reserves may include retained earnings, share premium, revaluation surplus, foreign currency translation reserve and other accumulated comprehensive income. A reserve does not necessarily represent cash available for distribution. Legal rules may restrict distributions.

Treasury shares are an equity deduction. Purchases, sales and cancellation of an entity’s own equity instruments do not generate gains or losses in profit or loss.

Dividends

Dividends are distributions to owners, not expenses. A liability is recognised when the dividend is appropriately authorised and no longer at the entity’s discretion under applicable law. A dividend declared after the reporting date is normally a non-adjusting event under IAS 10 and is disclosed if material.

If a properly authorised dividend is $0.20 on 100,000 eligible shares:

The entry is Debit Retained Earnings and Credit Dividends Payable for $20,000.

11. Integrated Illustrative Case: Meridian Manufacturing Ltd

This is a fictional illustrative case.

Background and problem

Meridian Manufacturing is preparing year-end financial statements. Management wants stronger profits before negotiating a bank facility. The accountant must resolve the following matters:

• cash ledger balance of $124,900;
• bank balance of $128,400, with a $9,000 deposit in transit and $7,200 outstanding cheques;
• a customer deposit of $5,800 and bank fees of $500 omitted from the ledger;
• receivables of $200,000 requiring an $8,000 allowance, against an existing $3,000 credit allowance;
• 70 inventory units costing $22 each but having NRV of $20 each;
• new equipment with capitalised cost of $95,000, residual value of $5,000 and five-year life;
• the five-year $100,000 bond described earlier; and
• expected warranty expenditure of $22,000.

Analysis and solution

The adjusted bank balance is:

The adjusted ledger balance is also:

Meridian records the customer deposit and bank fee. It increases the receivables allowance by $5,000. Inventory is written down by 70 × ($22 − $20) = $140. Annual equipment depreciation is $18,000. First-year bond finance cost is $7,361.17 rather than the $6,000 coupon payment. A $22,000 warranty provision is recognised because the sales creating the obligation occurred before year-end and expenditure is probable and measurable.

Outcome

The adjustments reduce short-term overstatement of profit and assets while recognising obligations and financing costs faithfully. Cash is unchanged by reconciling timing differences, but omitted ledger items are recorded. Management’s preference for higher earnings cannot override IFRS recognition and measurement requirements.

Learning points

• Reconciliations distinguish timing differences from recording omissions.
• Asset cost includes only qualifying expenditure.
• Expected losses and provisions incorporate forward-looking estimates.
• Coupon cash flow is not necessarily equal to effective interest expense.
• Professional judgement must be supported by evidence and protected from managerial bias.

12. Governance, Technology and Contemporary Issues

Asset and liability balances are vulnerable to manipulation through premature revenue recognition, delayed write-downs, excessive useful lives, unsupported development capitalisation and understated provisions. Audit committees should challenge sensitive assumptions, require reconciliations and monitor changes in estimates.

Enterprise resource planning systems can automate three-way matching, depreciation and inventory costing. Artificial intelligence can identify unusual payments, predict defaults and detect obsolete inventory. Nevertheless, models may reproduce biased historical patterns or rely on unreliable data. Human review, access controls, validation, explainability and audit trails remain essential.

Contemporary challenges include accounting for cloud-computing arrangements, digital assets, climate-related restoration obligations and rapidly changing technology lives. Classification depends on contractual rights and economic substance; no single treatment applies to every digital arrangement. IFRS 18, effective for annual periods beginning on or after 1 January 2027, changes financial-statement presentation and disclosure but does not replace the asset and liability recognition principles discussed here.

13. Practical Best Practices

Reliable accounting is supported by:

• maintaining complete asset and liability subledgers;
• reconciling bank, receivable, payable and inventory records regularly;
• documenting useful lives, loss rates, discount rates and assumptions;
• separating estimate preparation from approval;
• reviewing impairment indicators at each reporting date;
• aligning accounting estimates with budgets and operational evidence;
• applying policies consistently while updating genuine changes in estimates; and
• disclosing material judgements and estimation uncertainty transparently.

Chapter Summary

Assets, liabilities and equity require careful recognition, classification and measurement. Cash must be reconciled and controlled; receivables are reported net of expected credit losses; and inventory is measured at the lower of cost and NRV. PPE cost includes directly attributable expenditure and non-refundable purchase taxes, while recoverable taxes and training are excluded. PPE is depreciated over useful life and tested for impairment when indicators exist.

Intangible assets require identifiability, control and reliable measurement, with strict conditions for development capitalisation. Payables and many borrowings are measured at amortised cost using effective interest. Provisions recognise probable, measurable obligations, while contingencies usually require disclosure. Share capital and reserves form equity, and dividends are owner distributions rather than expenses. Across all areas, faithful representation depends on evidence, consistent policies, sound controls and ethically independent judgement.

Key Terms

Amortised cost: Initial carrying amount adjusted for repayments, effective interest and impairment.

Cash equivalent: A highly liquid short-term investment subject to insignificant value-change risk.

Cash-generating unit: The smallest asset group generating largely independent cash inflows.

Contingent liability: A possible obligation, or an unrecognised present obligation, subject to IAS 37 conditions.

Depreciation: Systematic allocation of a tangible asset’s depreciable amount over useful life.

Effective interest rate: The rate that exactly discounts contractual cash flows to initial carrying amount.

Equity: Residual interest in assets after deducting liabilities.

Expected credit loss: Probability-weighted estimate of credit losses on a financial asset.

Fair value: Market-based price to sell an asset or transfer a liability in an orderly transaction.

Impairment loss: Excess of carrying amount over recoverable amount.

Intangible asset: Identifiable non-monetary asset without physical substance.

Net realisable value: Estimated selling price less completion and selling costs.

Provision: Liability of uncertain timing or amount that satisfies recognition criteria.

Recoverable amount: Higher of value in use and fair value less costs of disposal.

Revaluation surplus: Equity reserve generally arising from upward asset revaluation.

Share premium: Consideration received above the par or stated value of issued shares.

Trade payable: Obligation to pay for goods or services received from suppliers.

Treasury shares: An entity’s own shares reacquired and presented as a deduction from equity.

Useful life: Period or production units over which an asset is expected to be available for use.

Value in use: Present value of cash flows expected from an asset or CGU.

Review Questions

Short Answer Questions

1. Distinguish cash from cash equivalents.
2. Why are trade receivables reported net of an expected credit loss allowance?
3. Which purchase taxes are included in PPE cost?
4. Define the recoverable amount of a non-financial asset.
5. When is a dividend recognised as a liability?

Long Answer Questions

1. Explain the recognition, measurement and control of cash and receivables.
2. Compare FIFO and weighted-average inventory costing and discuss the lower-of-cost-and-NRV rule.
3. Explain the initial and subsequent accounting for PPE, including depreciation, revaluation and disposal.
4. Discuss the distinction between research expenditure, development expenditure and acquired intangible assets.
5. Explain the recognition and measurement of provisions and distinguish them from contingent liabilities.

Analytical / Application Questions

1. A machine costs $120,000, delivery is $5,000, refundable tax is $12,000, installation is $8,000 and training is $3,000. Its restoration obligation has a present value of $7,000. Determine initial cost and justify every inclusion or exclusion.
2. A bond is issued below face value and its effective yield exceeds its coupon rate. Explain and calculate qualitatively how its carrying amount changes over its term.
3. Management proposes extending equipment lives, reducing expected credit loss rates and delaying an inventory write-down to satisfy a loan covenant. Evaluate the accounting, ethical and governance implications.

Multiple Choice Questions with Answers

Question 1

Which purchase tax is included in the initial cost of property, plant and equipment under IAS 16?

A. A fully recoverable value-added tax

B. A non-refundable purchase tax

C. Tax on future operating profits

D. Tax withheld from employee wages

Correct Answer: B. A non-refundable purchase tax

Question 2

Inventory costing $1,540 has a net realisable value of $1,400. At what amount should it be reported under IAS 2?

A. $140

B. $1,400

C. $1,540

D. $2,940

Correct Answer: B. $1,400

Question 3

Which expenditure is normally capitalised as part of a newly acquired machine?

A. Staff training

B. Opening ceremony costs

C. Direct installation costs

D. Initial operating losses

Correct Answer: C. Direct installation costs

Question 4

A provision matrix gives expected credit losses of $8,400. The existing loss allowance has a $2,900 credit balance. What impairment expense is required?

A. $2,900

B. $5,500

C. $8,400

D. $11,300

Correct Answer: B. $5,500

Question 5

A machine has a carrying amount of $240,000, value in use of $205,000 and fair value less costs of disposal of $215,000. What impairment loss is recognised?

A. $25,000

B. $35,000

C. $205,000

D. $215,000

Correct Answer: A. $25,000

Question 6

Which statement about internally generated intangible assets is correct?

A. All research and development expenditure is capitalised

B. Research is capitalised once management approves a project

C. Development expenditure is capitalised only after all recognition criteria are demonstrated

D. Internally generated goodwill is recognised at estimated fair value

Correct Answer: C. Development expenditure is capitalised only after all recognition criteria are demonstrated

Question 7

A five-year $100,000 bond pays annual coupons of $6,000 and is issued for $92,014.58 at an 8% effective annual yield. What is first-year finance cost, rounded to the nearest dollar?

A. $6,000

B. $7,361

C. $8,000

D. $9,201

Correct Answer: B. $7,361

Question 8

Which condition is required before recognising a provision under IAS 37?

A. The expenditure has already been paid

B. A possible future management decision exists

C. A present obligation from a past event exists and outflow is probable

D. The amount is known with complete certainty

Correct Answer: C. A present obligation from a past event exists and outflow is probable

Question 9

A company issues 10,000 shares with $1 par value for $6 each. Ignoring issue costs, how much is credited to share premium?

A. $10,000

B. $50,000

C. $60,000

D. $70,000

Correct Answer: B. $50,000

Question 10

Which statement concerning dividends is correct?

A. Dividends are operating expenses

B. Dividends always create liabilities at the reporting date

C. Dividends declared after the reporting date are normally non-adjusting events

D. Dividends increase retained earnings

Correct Answer: C. Dividends declared after the reporting date are normally non-adjusting events