Elements of Accounting 1

Chapter 4: The Elements of Financial Statements
Financial statements portray the financial effects of

transactions and other events by grouping them into
broad classes according to their economic characteristics.
These broad classes are termed the Elements of

Financial Statements or Elements of Accounting.
In order for an element to be recognized in the financial statements, it
must meet the definition and criteria laid down in the Conceptual
Framework.
Definitions of the Elements of Financial Statements:
Elements relating to Financial Position
Asset. An asset is a resource controlled by the entity as a result of past events
and from which future economic benefits are expected to flow to the entity.
Liability. A liability is a present obligation of the entity arising from past events,
the settlement of which is expected to result in an outflow from the entity of
resources embodying economic benefits.
Equity or Ownership Interest. Equity is the residual interest in the assets of the
entity after deducting all its liabilities.
Definitions of the Elements of Accounting:
Elements relating to Financial Performance
Income. Income is increases in economic benefits during the accounting 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
owners (Conceptual Framework).
Expense. Expenses are decreases in economic benefits during the accounting

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 owners.
The following criteria of the Elements:
Assets
Control
An asset is not the item of property itself, but rather the rights or other access to all of the future
economic benefits derived from the item of property. Often, they are obtained by legal ownership of
the item of property.
The definition of an asset requires that the rights or other access to future economic benefits are
controlled by the reporting entity.
Legal rights to future economic benefits derived from an item of property can be obtained without
having legal ownership of the property itself. It can be thru lease or unpatented invention.
An entity will control the rights or other access if it has the ability both to obtain for itself any
economic benefits that will arise and to prevent or limit the access of others to those benefits.
Assets
Economic Benefits
Capacity to obtain future economic benefits is the essence of an asset and is common to all assets
irrespective of their form.
An asset is included in the Statement of Financial Position when it is probable that the future
economic benefits will flow to the entity and the asset has a cost or value that can be measured
reliably.
• It is probable that any future economic benefit associated with the item will flow to or from
the entity; and
• The item’s cost or value can be measured with reliability.
Result of Past Transactions or Events
The reporting entity's control of the rights or other access to the future economic benefits to an
asset needs to be the result of past transactions or events.
A reporting entity that obtained the right to access to future economic benefits or to restrict the
access of others to those benefits only after the reporting period did not have an asset at the balance
sheet date.
Liability
Obligation
For there to be a liability there must be an obligation that might result in the transfer of economic
benefits.
The notion of an obligation implies that the business entity is not free to avoid the outflow of resources.
Although many liabilities are based on legal obligations, a legal obligation is not a necessary condition.
A liability can exist in the absence of legal obligations if commercial considerations create a constructive
obligation.
A constructive obligation would be created if such a decision was coupled with a valid expectation that
the creditor would implement the decision and the business entity could not realistically withdraw
from it.
The reporting entity’s obligation to transfer economic benefits to an asset needs to be the result of
past transactions or events.
Liability
Transfer of economic benefits
A liability is included in the Statement of Financial Position when it is probable that an outflow of
resources embodying economic benefits will result from the settlement of a present obligation and the
amount at which the settlement will take place can be measured reliably.
• The outflow of resources embodying economic benefits (such as cash) from the entity is probable.
It is logical to recognize a liability only if it is likely that the entity will be required to settle it.
• The cost/value of the obligation can be measured reliably. It ensures that only liabilities that can
be objectively measured are recognized in the financial statements.
If an obligation meets the definition of a liability but fails to meet the recognition criteria, it is classified
as a contingent liability. Contingent liability is not presented as a liability in the statement of financial
position but is instead disclosed in the notes to the financial statements. Like a pending suit in court.
Result of Past Transactions or Events
The reporting entity’s obligation to transfer economic resources needs to be the result of past
transactions or events.
Equity or Ownership Interest
Equity or Ownership interest is the residual amount calculated after deducting all of the entity's liabilities
from all of the entity's assets.
Equity is what the owners of an entity have invested in a business entity.
It represents what the business owes to its owners. It is also a reflection of the capital left in the business
after assets of the entity are used to pay off any outstanding liabilities.
This is what the owners take home in the event of liquidation of the entity.
Since ownership interest is defined as a residual interest, the distinction between liabilities and ownership
interest is highly significant. Owners invest in an entity in the hope of a return, at least part of which will
usually be provided by the transfer to them from the business entity of economic benefits (for example
the payment of dividends).
However, owners, unlike creditors, do not have the ability to insist that a transfer is made to them
regardless of the circumstances: theirs is a residual interest in the assets of the entity after all the liabilities
have been deducted.
Equity or Ownership Interest
The Equity or Ownership Interest relates to transactions with the owners in their capacity as owners and
are defined as follows:
• Contributions from owners involve the owners making a contribution to the entity by transferring assets,
performing services, or accepting ownership interest by paying the liabilities of the business entity.
Rights in the ownership interest are usually granted in return for a contribution from owners.
• Distributions to owners include withdrawals by, return of investments of and payments of dividends to
the owners.
Gains are increases in ownership interest not resulting from contributions from owners. Losses are
decreases in ownership interest not resulting from distributions to owners.
The following criteria of the Elements:
Income
Income is recognized when an increase in economic benefits during the accounting period in the
form of an enhancement of an asset or a decrease of a liability has arisen other than those relating
to contributions from equity holders. This means, in effect, that recognition of income occurs
simultaneously with the recognition of increases in assets or decreases in liabilities.
The definition of income encompasses both revenue and gains. Revenue arises in the course of the
ordinary activities of an entity and is referred to by a variety of different names including sales, fees,
interest, dividends, royalties and rent.
Gains represent other items that meet the definition of income and may, or may not, arise in the
course of the ordinary activities of an entity. Gains represent increases in economic benefits and as
such are no different in nature from revenue. Hence, they are not regarded as constituting a separate
element in the Conceptual Framework.
Expenses
Expenses is recognized when a decrease in economic benefits during the accounting 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 participants. This means, in effect, that recognition of
expenses occurs simultaneously with the recognition of an increase in liabilities or a decrease in assets.
The definition of expenses encompasses losses as well as those expenses that arise in the course of the
ordinary activities of the entity. Expenses that arise in the regular course of the operating activities of
the 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 and cash equivalents, inventory, property, plant and
equipment.
Losses represent other items that meet the definition of expenses and may, or may not, arise in the
course of the ordinary activities of the entity. Losses represent decreases in economic benefits and as
such they are no different in nature from other expenses. Hence, they are not regarded as a separate
element in this Conceptual Framework.
Statement of Cash Flows
Elements have been specified and defined to analyze comprehensively the way in which the financial
effects of transactions and other events are represented in financial statements. However, as the cash
flow statement represents only one type of financial effect, that is, cash flows, the analysis into
elements is not relevant to the cash flow statement.

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Chapter 4: The Elements of Financial Statements

Financial statements portray the financial effects of

These broad classes are termed the Elements of

Expense. Expenses are decreases in economic benefits during the accounting

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