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Section 2 – Concepts and Pervasive Principles
Section 2 outlines the concepts and persuasive principals to assist preparers in determining the accounting treatment in a transaction and provides guidance on the principles to be used where a transaction is not covered by the specific standards.
Assets – Definition and recognition criteria
Extract from FRS 105 – Section 2.2(a), 2.3 – 2.6 & S2.22 – 2.23
2.2 The financial position of a micro-entity is the relationship of its assets, liabilities and equity as of a specific date as presented in the statement of financial position. These are defined as follows:
(a) An asset is a resource controlled by the micro-entity as a result of past events and from which future economic benefits are expected to flow to the micro-entity.
2.3 Some items that meet the definition of an asset or a liability may not be recognised as assets or liabilities in the statement of financial position because they do not satisfy the criteria for recognition in paragraphs 2.22 and 2.24. In particular, the expectation that future economic benefits will flow to or from a micro-entity must be sufficiently certain to meet the probability criterion before an asset or liability is recognised.
Assets
2.4 The future economic benefit of an asset is its potential to contribute, directly or indirectly, to the flow of cash to the micro-entity. Those cash flows may come from using the asset or from disposing of it.
2.5 Many assets, for example property, plant and equipment, have a physical form. However, physical form is not essential to the existence of an asset. Some assets are intangible.
2.6 In determining the existence of an asset, the right of ownership is not essential. Thus, for example, property held on a lease is an asset if the micro-entity controls the benefits that are expected to flow from the property.
2.22 A micro-entity shall recognise an asset in the statement of financial position when it is probable that the future economic benefits will flow to the micro-entity and the asset has a cost or value that can be measured reliably. An asset is not recognised in the statement of financial position when expenditure has been incurred for which it is considered not probable that economic benefits will flow to the micro-entity beyond the current reporting period. Instead such a transaction results in the recognition of an expense in the income statement.
2.23 A micro-entity shall not recognise a contingent asset as an asset. When the flow of future economic benefits to the micro-entity is virtually certain, then the related asset is not a contingent asset, and its recognition is appropriate.
OmniPro comment
The above definition identifies what an asset is, it does not provide guidance on whether it should be recognised or not. To summarise an asset is:
- A resource controlled by an entity; and
- It has an ability to derive future economic benefits in the form of cash or cash equivalents; and
An asset is only recognised on the balance sheet if:
- It is probable (i.e. more likely than not) that the economic benefits will flow to the entity except for contingent assets
- Contingent assets should only be recognised when it is virtually certain. They should only be disclosed if the right to future economic benefits it probable. If they are remote no disclosure is required.
Examples with regard to contingent assets are included in Section 16 (Provisions and Contingencies) of this website.
Liabilities – Definition and recognition criteria
Extract from FRS 105 – Section 2.2(b), 2.7 – 2.8 & 2.24 – 2.25
2.2 (b) A liability is a present obligation of the micro-entity arising from past events, the settlement of which is expected to result in an outflow from the micro-entity of resources embodying economic benefits.
Liabilities
2.7 An essential characteristic of a liability is that the micro-entity has a present obligation to act or perform in a particular way. The obligation may be either a legal obligation or a constructive obligation. A legal obligation is legally enforceable as a consequence of a binding contract or statutory requirement. A constructive obligation is an obligation that derives from a micro-entity’s actions when:
(a) by an established pattern of past practice, published policies or a sufficiently specific current statement, the micro-entity has indicated to other parties that it will accept certain responsibilities; and
(b) as a result, the micro-entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities.
2.8 The settlement of a present obligation usually involves the payment of cash, transfer of other assets, provision of services, the replacement of that obligation with another obligation, or conversion of the obligation to equity. An obligation may also be extinguished by other means, such as a creditor waiving or forfeiting its rights.
2.24 A micro-entity shall recognise a liability in the statement of financial position when:
(a) the micro-entity has an obligation at the end of the reporting period as a result of a past event;
(b) it is probable that the micro-entity will be required to transfer resources embodying economic benefits in settlement; and
(c) the settlement amount can be measured reliably.
2.25 A contingent liability is either a possible but uncertain obligation or a present obligation that is not recognised because it fails to meet one or both of the conditions (b) and (c) in paragraph 2.24.
OmniPro comment
The above definition is in line with the guidance provided in Section 16-Provisions and Contingencies. A liability exists where:
- There is a present obligation (which is either constructive or legal) as a result of a past event;
A liability will be measured in the balance sheet if it meets the above criteria but also:
- It is probable (i.e. more likely than not) that future economic benefits will be payable; and
- It can be reliably measured.
Where a liability is possible or it is probable but cannot be reliably measured it should be disclosed as a contingent liability. Examples of the application of the above guidance is provided in Section 16.
Equity – Definition and recognition criteria
Extract from FRS 105 – Section 2.9
2.9 Equity is the residual interest in the assets of the micro-entity after deducting all its liabilities.
OmniPro comment
Equity is in effect anything that remains after deducting the liabilities. Section 17 of this manual discusses equity in further detail.
Definition and recognition of income/revenue
Extract from FRS 105 – Section 2.10 – 2.13 & 2.26
2.10 Performance is the relationship of the income and expenses of a micro-entity during a reporting period. Income and expenses are defined as follows:
(a) Income is increases in economic benefits during the reporting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity investors.
2.11 The recognition of income and expenses results directly from the recognition and measurement of assets and liabilities.
Income
2.12 The definition of income encompasses both revenue and gains.
(a) Revenue is income that arises in the course of the ordinary activities of a micro- entity and is referred to by a variety of names including sales, fees, interest, dividends, royalties and rent.
(b) Gains are other items that meet the definition of income but are not revenue.
Expenses
2.13 The definition of expenses encompasses losses as well as those expenses that arise in the course of the ordinary activities of the micro- entity.
(a) Expenses that arise in the course of the ordinary activities of the micro-entity include, for example, cost of sales, wages and depreciation. They usually take the form of an outflow or depletion of assets such as cash, inventory, or property, plant and equipment.
(b) Losses are other items that meet the definition of expenses and may arise in the course of the ordinary activities of the micro-entity.
2.26 The recognition of income results directly from the recognition and measurement of assets and liabilities. A micro-entity shall recognise income in the income statement when an increase in future economic benefits related to an increase in an asset or a decrease of a liability has arisen that can be measured reliably.
OmniPro comment
Whether an item is shown as turnover/revenue in the financial statements or instead other income is driven by what the entity’s main ordinary activities are.
Example 1: Turnover/revenue versus other income
An entity who is in the business of buying and selling goods, would classify that income in the turnover line of the financial statements. If that same entity also generates income from the rental of investment properties which is incidental to its main trade, this would not be shown within turnover/revenue instead it would be disclosed as other income on the face of the profit and loss.
The same would be the case if that entity had some income from dividends on investments, this would not be shown in the turnover line.
Example 2: Turnover/revenue versus other income
If we take another entity whose business involves the purchase of land and development of properties on this land which includes in certain instances the holding of some of these properties for future rental as investment properties. In this case the sale of the land and properties to third parties would be shown as revenue. In addition, the rental income would be classified as turnover as this is also part of its business.
Example 3: Turnover/revenue versus other income
Company A is involved in the holdings of investments. In this case dividend income, gains on sale of shares would be shown in revenue in the profit and loss account.
Revenue recognition rules are dependent on when the risks and reward of ownership transfer. This is discussed further in Section 18.
Definition and recognition of expenses
Extract from FRS 105 – Section 2.10(b), 2.11, 2.13 & 2.27
2.10 (b) Expenses are decreases in economic benefits during the reporting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity investors.
2.11 The recognition of income and expenses results directly from the recognition and measurement of assets and liabilities.
2.13 The definition of expenses encompasses losses as well as those expenses that arise in the course of the ordinary activities of the micro- entity.
(a) Expenses that arise in the course of the ordinary activities of the micro-entity include, for example, cost of sales, wages and depreciation. They usually take the form of an outflow or depletion of assets such as cash, inventory, or property, plant and equipment.
(b) Losses are other items that meet the definition of expenses and may arise in the course of the ordinary activities of the micro-entity.
2.27 The recognition of expenses results directly from the recognition and measurement of assets and liabilities. A micro-entity shall recognise expenses in the income statement when a decrease in future economic benefits related to a decrease in an asset or an increase of a liability has arisen that can be measured reliably.
OmniPro comment
From the above guidance, it is clear that anything that involves distributions to shareholders are not expenses e.g. a dividend paid to a shareholder is not an expense however a salary paid to the director is an expense.
An expense is recognised when a liability is created on the balance sheet i.e. when it is probable that it will be incurred.
Measurement of assets, liabilities, income and expenses – Initial and Subsequent Measurement
Extract from FRS 105 – Section 2.19 – 2.20
2.14 Recognition is the process of incorporating in the statement of financial position or income statement an item that meets the definition of an asset, liability, equity, income or expense and satisfies the following criteria:
(a) it is probable that any future economic benefit associated with the item will flow to or from the micro-entity; and
(b) the item has a cost or value that can be measured reliably.
2.15 The uncertainties that inevitably surround many events and circumstances are acknowledged by the exercise of prudence in the preparation of the financial statements. Prudence is the inclusion of a degree of caution in the exercise of the judgements needed in making the estimates required under conditions of uncertainty, such that assets or income are not overstated and liabilities or expenses are not understated. However, the exercise of prudence does not allow the deliberate understatement of assets or income, or the deliberate overstatement of liabilities or expenses. In short, prudence does not permit bias.
The probability of future economic benefit
2.16 The concept of probability is used in the first recognition criterion to refer to the degree of uncertainty that the future economic benefits associated with the item will flow to or from the micro-entity. Assessments of the degree of uncertainty attaching to the flow of future economic benefits are made on the basis of the evidence relating to conditions at the end of the reporting period available when the financial statements are prepared. Those assessments are made individually for individually significant items, and for a group for a large population of individually insignificant items.
Reliability of measurement
2.17 The second criterion for the recognition of an item is that it possesses a cost or value that can be measured with reliability. In many cases, the cost or value of an item is known. In other cases it must be estimated. The use of reasonable estimates is an essential part of the preparation of financial statements and does not undermine their reliability. When a reasonable estimate cannot be made, the item is not recognised in the financial statements.
2.18 An item that fails to meet the recognition criteria may qualify for recognition at a later date as a result of subsequent circumstances or events.
2.19 Measurement is the process of determining the monetary amounts at which a micro- entity measures assets, liabilities, income and expenses in its financial statements. Measurement involves the selection of a basis of measurement. This FRS specifies which measurement basis a micro-entity shall use for many types of assets, liabilities, income and expenses.
Initial measurement
2.30 At initial recognition, a micro-entity shall measure assets and liabilities at cost.
2.31 Under limited circumstances this FRS requires a micro-entity to estimate the cost of an asset or liability based on its fair value. Where this FRS requires a micro-entity to determine the fair value of an asset or liability, it shall use the following hierarchy to estimate the fair value:
(a) The best evidence of fair value is the open market price for an identical asset or liability in an active market.
(b) When an open market price is not available, the price of a recent transaction for an identical asset or liability provides evidence of fair value as long as there has not been significant change in economic circumstances or a significant lapse of time since the transaction took place.
(c) If neither (a) nor (b) above are available, the fair value shall be estimated using a valuation technique. The objective of using a valuation technique is to estimate what the price of a recent transaction for an identical asset or liability would have been on the measurement date in an arm’s length exchange motivated by normal business considerations.
Subsequent measurement
Financial assets and financial liabilities
2.32 A micro-entity measures financial assets and financial liabilities as follows:
(a) Investments in preference shares or ordinary shares and investments in subsidiaries and associates and interests in jointly controlled entities shall be measured at cost less impairment.
(b) Derivatives are measured at cost adjusted for amounts recognised in profit or loss over the term of the instruments and any impairment loss.
(c) Financial instruments other than financial instruments covered by paragraphs (a) and (b) are measured at cost adjusted for the allocation of interest, the amortisation of any transaction costs included in the cost of the instruments and any impairment loss.
Non-financial assets
2.33 Property, plant and equipment, investment property and biological assets are measured at cost less accumulated depreciation and accumulated impairment losses.
2.34 Inventories are measured at the lower of cost and selling price less costs to complete and sell.
2.35 Measurement of assets at amounts lower than their initial historical cost is intended to ensure that an asset is not measured at an amount greater than the micro-entity expects to recover from the sale or use of that asset.
Liabilities other than financial liabilities
2.36 Most liabilities other than financial liabilities are measured at the best estimate of the amount that would be required to settle the obligation at the reporting date.
OmniPro comment
FRS 105 requires the historical cost convention to be used unless otherwise stated. For example:
- Investments of all types to be carried at cost less impairment;
- PPE, intangible assets, investment property, goodwill at cost less accumulated depreciation/amortisation and impairment;
- Stock – lower of cost or NRV;
- Trade debtors, creditors at the transaction price less unamortised transaction costs when material;
- Creditors, loans at market and non-market rates etc. at the transaction amount less repayments, plus interest if any etc.;
- Bank loans at transaction amount net of transaction costs where material on initial recognition and subsequently at transaction amount less repayments, plus interest less unamortised transaction costs.
FRS 105 does not permit assets or liabilities to be held at fair value subsequently and only on initial recognition if the standards states (e.g. stock in an non-exchange transaction).
Pervasive recognition and measurement principles
Extract FRS 105 – Section 2.20
2.20 In the absence of a requirement in this FRS that applies specifically to a transaction or other event or condition, paragraph 8.4 provides guidance for making a judgement and paragraph 8.5 requires a micro-entity to look to the definitions, recognition criteria and measurement concepts for assets, liabilities, income and expenses and the pervasive principles set out in this section.
OmniPro comment
It is clear that where a transaction is not specifically dealt with by the FRS then the following should be utilised as stated in Section 8.5:
- Management should use its judgement in developing and applying an accounting policy that results in information that:
- Represents faithfully the transactions, other events or conditions;
- Reflects the economic substance of the transactions, other events and conditions, and not merely the legal form;
- Is neutral, i.e. free from bias; and
- Is prudent
- Refer to the recognition criteria and measurement concepts in Section 2.
There is no requirement to refer to FRS 102 unless stated in the standard. However it could be a good reference point.
For liabilities which are not financial instruments e.g. provisions etc. the amount to be recognised initially is the best estimate of the amount that would be required to settle the obligation at the period end date. Where material discounting should be applied and unwound each year to the P&L.
Accruals basis
Extract FRS 105 – Section 2.21
2.21 A micro-entity shall prepare its financial statements using the accrual basis of accounting. On the accrual basis, items are recognised as assets, liabilities, equity, income or expenses when they satisfy the definitions and recognition criteria for those items.
OmniPro comment
The accruals basis should be utilised. This basis ensures that costs are matched with revenues and that costs incurred in the period even where not invoiced are included in the results for that period.
Recognition in financial statements
Extract FRS 105 – Section 2.29-2.29
Expenses
Profit or loss
2.28 Profit or loss is the arithmetical difference between income and expenses. It is not a separate element of financial statements, and a separate recognition principle is not needed for it.
2.29 Generally this FRS does not allow the recognition of items in the statement of financial position that do not meet the definition of assets or of liabilities regardless of whether they result from applying the notion commonly referred to as the ‘matching concept’ for measuring profit or loss.
OmniPro comment
Section 2.29 does not permit the use of the matching concept if the asset and liability do not meet the recognition criteria.
Offsetting
Extract FRS 105 – Section 2.37
2.37 A micro-entity shall not offset assets and liabilities, or income and expenses, unless required or permitted by this FRS.
(a) Measuring assets net of valuation allowances (for example, allowances for inventory obsolescence and allowances for uncollectible receivables) is not offsetting.
(b) If a micro-entity’s normal operating activities do not include buying and selling fixed assets, including investments and operating assets, then the micro-entity reports gains and losses on disposal of such assets by deducting from the proceeds on disposal the carrying amount of the asset and related selling expenses.
OmniPro comment
The rules on offsetting are dealt with in each relevant section of FRS 105 and have been discussed in each relevant section of this manual. The general rule is that:
- Offsetting should only occur where there is a legal right of offset.
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