Getting a Better Framework

THE ASSET/LIABILITY APPROACH

Bulletin

sept

2013

 2013 | European Financial Reporting Advisory Group (EFRAG), the French Autorit des Normes
Comptables (ANC), the Accounting Standards Committee of Germany (ASCG), the Organismo
Italiano di Contabilit (OIC) and the UK Financial Reporting Council (FRC).

Published bulletins:

The asset/liability approach

- Prudence
- Reliability of financial information
- Uncertainty
- The role of the business model in financial reporting
- The role of a Conceptual Framework
- The asset/liability approach
- Accountability and the objective of financial reporting

Getting a Better Framework

This Bulletin is issued by the European Financial Reporting Advisory Group (EFRAG), the
French Autorit des Normes Comptables (ANC), the Accounting Standards Committee of
Germany (ASCG), the Organismo Italiano di Contabilit (OIC) and the UK Financial Reporting
Council (FRC). The publication of Bulletins is part of their strategy to stimulate debate within
Europe, and keep European Constituents informed as the IASB develops its Conceptual
Framework. Any views expressed are tentative; the issuing bodies will develop their final
views after considering responses to this Bulletin and other developments in the debate.
Further information about the work of the project partners, including regular newsletters, is
available on the partners websites.

EFRAG
35 Square de Mees
B-1000 Brussels
Belgium
So as to arrive no later than 15 November 2013.

The asset/liability approach

We welcome views on any of the points addressed in this Bulletin. Specific questions
are given at the end of the document. These comments should be sent by email to
commentletters@efrag.org or by post to

All comments will be placed on the public record unless confidentiality is requested.

Getting a Better Framework

Background

1 One feature of the IASB Conceptual

Framework that has attracted some
controversy is that it defines assets and
liabilities first: the definitions of equity,
income and expenses rely on those
definitions. The consequence is that
income for a period equals changes in
net assets (apart from transactions with
shareholders). This is referred to in this
Bulletin as the asset/liability approach,
also called the balance sheet approach.
The current definitions are set out in the
panel.

The asset/liability approach

(a) An asset of an entity is a present

economic resource controlled by the
entity as a result of past events;
(b) A liability of an entity is a present
obligation of the entity to transfer an
economic resource as a result of past
events; and
(c) An economic resource is a right, or
other source of value, that is capable
of producing economic benefits.

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Getting a Better Framework

The IASB Discussion Paper A review of

the conceptual framework for financial
reporting, issued in July 2013, proposes
the following revised definitions:

No significant changes to the definitions

of income and expenses are proposed, so
the relationship between the definitions of
the elements will remain as at present.

The elements: Definitions as in the IASBs

Conceptual Framework (2010)
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.
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 is the residual interest in the
assets of the entity after deducting all
its liabilities.

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
equity participants.
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 equity
participants.

Some question whether the asset/liability approach is appropriate. They are concerned that it
has implications that impair the quality of financial reporting. The purpose of this Bulletin is to
consider whether these implications necessarily follow from the adoption of the asset/liability
approach. The issues addressed are:
Whether adoption of the asset/liability approach implies that the presentation of relevant
information on income will be subordinated to information on assets and liabilities
(paragraphs 5 to 10);
Whether the asset/liability approach provides an appropriate basis for allocating income
and expenses to a reporting period (paragraphs 11 to 19);
Whether the asset/liability approach requires that all assets and liabilities are recognised,
including some that are of limited relevance (paragraphs 20 to 22); and
Whether the asset/liability approach implies that all assets and liabilities are to be stated
at fair value (paragraphs 23 to 28).

The asset/liability approach

Getting a Better Framework

Discussion

Importance of information on income

5 It is sometimes suggested that the asset/liability approach does not provide an adequate
basis for financial reporting, which should be focused on the creation of value: financial
statements should explain how, and how efficiently, value is generated and reflected
in cash flows. Users of financial statements are primarily interested in information on
earnings, which shows the benefit to shareholders arising in the accounting period, and
may be used as a proxy for normalised cash flow. Information on the returns earned by
the business is also important for accountability/stewardship purposes1, as it is necessary
for an assessment of the efficiency and effectiveness with which management have used
their resources.2 Some conclude that the key element in the Framework should be that of
income, and that the definition of other elements should be dependent on that.

The asset/liability approach

6 In particular it is sometimes suggested that the asset/liability approach implies that the
income for a period is simply the change in the amount at which assets and liabilities
are reported - usually referred to as comprehensive income. Some take the view that the
amount of comprehensive income is not usually a particularly meaningful indicator of the
performance of the entity as it is the aggregate of a large number of diverse transactions
and events.
7

It seems, however, that at the least in the view of some standard-setters who have adopted
it, the asset/liability approach is compatible with attaching significant importance to the
income statement. Before the revisions made in 2010, the FASB Concepts Statements
stated that the primary focus of financial reporting is information about an enterprises
performance provided by measures of earning and its components. The Basis for
Conclusions to Chapter 1 of the IASBs Framework, which was published in 2010, states
that the Board concluded that to designate one type of information as the primary focus
of financial reporting would be inappropriate. And the Discussion Paper states that No
primary financial statement has primacy over the other primary statements and they should
be looked at as a group.

One justification for starting with definitions of assets and liabilities is that it is not possible
to define a change, without defining what it is that has changed. Therefore, assets and
liabilities must be defined before changes in them. However, some are unconvinced by
this argument: they note that it assumes that income and expenses are to be defined as
changes, and that definitions of assets and liabilities include notions of future inflows/
outflows, and hence income and expense.

Getting a Better Framework

9 Supporters of the asset/liability approach often contend that starting with definitions of
assets and liabilities does not imply that the balance sheet is the most important financial
statement. An analogy may be drawn with games: what is of most interest is the result of
a match and the quality of play. However, the rules (which usually attract little comment)
must be established and agreed, before a match can be played.
1
2

There is also a Bulletin on accountability/stewardship.

An assessment of return must take into account the risks incurred in order to achieve them.

10 The reporting of financial performance is unquestionably one of the most important

issues in financial reporting. Another Bulletin in this series will discuss how it should be
addressed in the Framework. For the present consideration of the asset/liability approach,
it is sufficient to note that, according to the supporters of the asset/liability approach, it
does not conflict with the development of sound thinking on performance, including the
reporting of components of comprehensive income and not merely the aggregate amount.
Indeed, the IASB has already done considerable work in this area, and it has not been
suggested that this is inconsistent with its Framework.

Allocating income and expenses to a reporting period

12 One approach to this question, which would not rely on the asset/liability approach, is
through matching. The idea of matching is that income and expenses are recognised in
the accounting period to which they relate. Income and expenses that relate to a future
period are deferred and reported in the balance sheet. For example, under a matching
approach, a gain or loss arising on the repurchase of debt might not be reported in the
period of the repurchase, but deferred and recognised over the remaining period of the
debt.
13 Supporters of this approach believe that it prevents the recognition of unrealised gains
in income, which they claim would be inappropriate and not reflect economic reality. In
their view, the matching approach solves a problem that can arise under the asset/liability
approach. They would suggest that the process should be the reverse: deferral should be
justified in principle, and the reported result should be the consequence of applying that
principle.
14 Critics of a matching approach may take the view that it does not directly address the
question of how to decide to what period a transaction relates. Some would go as far
as to suggest that in some cases matching may start from the premise that a particular
transaction should (or should not) affect the income for the current period, and then
selects the accounting treatment that gives that result. Matching, according to them,
would therefore not be the basis for reliable financial reporting.
15 In their view, the asset/liability approach provides greater clarity as income or expense is
deferred only if the deferral represents an asset or a liabilitythat is, there is a right to a
future inflow of benefit or an obligation for a future outflow.

The asset/liability approach

11 The Framework notes that accruals accounting seeks to depict the effect of transactions
and other events in the periods in which those effects occur. It is therefore necessary for
the Framework to address how to determine in what period the income or expense from a
transaction or event should be recognised.

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Getting a Better Framework

16 Furthermore, they argue that the asset/liability approach ensures that only economic rights
and obligations are reflected in the balance sheet. In contrast, under a matching approach,
the balance sheet may contain deferred income and expenses that do not correspond
to any current economic rights and obligations, but are merely the consequence of the
accounting applied.
17 Some claim that the asset/liability approach has led to significant improvements in
financial reporting. Prior to its adoption, some income and expenses that were considered
not to relate to the reporting period were either not recognised at all or amortised over
periods of doubtful relevance. For example, pension deficits were not recognised, and
foreign exchange differences were sometimes deferred on the basis that the movement
was considered certain to reverse.
18 The Appendix contains a discussion of some further examples in order to assist an
assessment of the claim that the asset/liability approach can provide a basis for the
development of sound accounting standards.
The asset/liability approach

19 Some others would take the view, that even if the Framework adopts an asset/liability
approach, the effect on income of proposed accounting treatments should be fully
addressed in the development of standards. For example, if it appears that a day one
profit or loss might emerge on the acquisition of an asset, it should be considered whether
doing so would reflect economic reality, or whether the proposal should be reconsidered.
This would be consistent with the view referred to above that no primary financial statement
has primacy over the other primary statements.

Getting a Better Framework

 Proliferation of assets and liabilities

22 Some are concerned that the tentative decisions by the IASB may increase the risk that
assets and liabilities will be recognised that are of doubtful relevance. They note that the
new definitions of assets and liabilities seem more remote from inflows and outflows of
economic benefits than the current definitions. They also note that the existing recognition
criteria require that if an element is to be recognised, a future flow of benefit to or from
the entity must be probable: the Discussion Paper proposes that this will be deleted.
Those who take this view note that the Framework has always required that financial
statements should be relevant: elevating relevance into part of the tests for recognition
may therefore, they fear, have little impact and would not provide an effective replacement
for the probability requirement.

Fair value
23 Some believe that including in income changes in the fair value of assets and liabilities that
are used in an entity causes a misunderstanding of the underlying performance of the entity.
Furthermore, they believe that market-based valuation is the inevitable consequence of the
asset/liability approach, which they therefore oppose, claiming that it unavoidably relies on
abstract concepts and therefore generates complex valuations, thus less relevance and
considerable market uncertainty, triggering in turn volatility and procyclicality, far from the
entitys performance. The same explain that, in their view, accounting is primarily about
reflecting transactions, which consist in flows, and as a result they cannot understand how
starting with assets and liabilities would be relevant.

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Getting a Better Framework

21 Such a proliferation of assets and liabilities is not the inevitable result of the asset/liability
approach. The outcome will depend on other aspects of the Frameworkin particular the
definitions of assets and liabilities and recognition criteria. The Discussion Paper proposes
that relevance is a key consideration in determining which assets and liabilities are to
be recognised. Furthermore, the Discussion Paper states that assets or liabilities need
not, or should not, be recognised if no measure of the items would result in their faithful
representation.

The asset/liability approach

20 A possible concern is that the asset/liability approach would require all assets and liabilities
to be reported in financial statements. This would extend beyond those that have arisen
from the purchase of assets out of the entitys capital, and might include innumerable rights
(including internally-generated intangible assets) and obligations (including some that are
unlikely to require a payment in settlement). Some fear that identifying and reporting such
assets and liabilities in the balance sheet could impose a significant burden on preparers
with little benefit to users. It may also be argued that many of these assets and liabilities, and
changes in them, are not relevant to an understanding of the performance of the business,
or that relevant information on them might be given more simply and cost-effectively.

24 For some, subtotals within the statement of comprehensive income may be proposed
as a way to meet these concerns, so that under an asset/liability approach relevant
performance reporting can be provided. Some others, however, consider that inadequate.
In their view, the bottom line of a statement of performance is a key line that users find
highly significant, and would expect to have a greater importance than a mere subtotal.
This was the view expressed by many respondents to the EFRAG PAAinE Discussion
Paper on Performance Reporting issued in March 2009.

The asset/liability approach

25 Others argue that the Framework requires that separate consideration is given to the
definition of elements, the recognition criteria and the selection of a measurement basis.
Hence the selection of a measurement basis is not predetermined by the definition of the
elements: the asset/liability approach is consistent with the use of a number of measurement
bases (or combination of bases). For example, the approach being developed by the IASB
to revenue recognition is, arguably, consistent with the asset/liability approach, yet it uses
an entry value (transaction price) to measuring performance obligations, rather than fair
value, which is defined as an exit value. Therefore, they do not believe that the only way to
provide information on future cash flows is by using fair value: other measurement bases
are possible, and the balance sheet is not the only basis to assist users in forecasting
future cash flows.
26 They note that it is, however, the case that under the asset/liability approach the
measurement basis affects the amount of income reported in subsequent periods. It
may be noted that the Discussion Paper proposes that the IASB should consider, when
selecting the measurement basis, what information it will produce in BOTH the statement
of financial position and the statement(s) of profit or loss and OCI.

Getting a Better Framework

10

27 The IASB has also discussed whether there may be circumstances where the most relevant
basis for the balance sheet differs from that which is most relevant for profit or loss. One
development of this approach would be to report assets and liabilities at fair value in
the balance sheet, the change in amortised cost in profit or loss, and the balance of any
change in other comprehensive income.
28 However, those who oppose the asset/liability approach because they believe that
measurement of assets and liabilities should not be the starting point for financial reporting,
cannot be satisfied by the IASBs preliminary views. Others welcome the IASBs early
directions as promising for a sound application of the asset/liability approach.

Our tentative views

29 We support the IASBs conclusion that No primary financial statement has primacy over
the other primary statements and they should be looked at as a group. A consequence
of this is that the effect on income of proposed accounting treatments should be fully
addressed in the development of standards.

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Getting a Better Framework

31 EFRAG, the ASCG, the OIC and the FRC do not think that the asset/liability approach
defining income and expenses in terms of changes in assets and liabilitiesin itself
prevents satisfactory approaches to these issues being developed. Also, in many cases,
it seems to provide greater clarity for the development of accounting standards. The ANC
does not share this view and considers that concerns and arguments developed in many
parts of this Bulletin (paragraphs 5, 6, second part of 8, 12, 13, 23, second part of 24 and
first part of 28) are important enough to call for a different approach: indeed performance
cannot be appropriately represented in the accounts if primacy continues to be given to
the balance sheet.

The asset/liability approach

30 Many of the issues raised by those who have reservations about the asset/liability
approach are valid. The Framework should provide satisfactory principles for the reporting
of financial performance: that assets and liabilities are not recognised where the benefits
of doing so outweigh the costs, and that assets and liabilities are stated at fair value only if
it is appropriate. We will continue to seek to influence the development of the Framework
to ensure that its treatment of these issues is satisfactory. It is particularly important that
the representation of performance should not be obscured by changes in asset and liability
values that are not part of performance: the implications for reported performance should
be explicitly addressed in the development of all proposed accounting treatments.

Questions for respondents

We would welcome views on any of the points addressed in this Bulletin.

In particular:
(i) Are there any arguments for and against the asset/liability approach defining income and expenses in terms of changes in assets and liabilities
- that are not discussed in the Bulletin?
(ii) Do you believe that the asset/liability approach should be retained or
revised? If changed, what alternative would you propose?
(iii) Do you have any other comments on this Bulletin?

The asset/liability approach

Comments should be addressed to: commentletters@efrag.org, so as to be

received before 15 November 2013.

Getting a Better Framework

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Appendix: examples

The following discusses a number of accounting issues and considers the possible implications of
the asset/liability approach for their accounting treatment. It is intended to assist in a consideration
of whether the asset/liability approach provides a satisfactory basis for the development of
accounting standards.
Revenue recognition

Major overhaul costs

A3

Some long-lived assets such as ships, aircraft and blast furnaces require significant overhauls
at intervals every few years. It is generally agreed that the cost of such overhauls should not be
treated as an expense of the year in which the overhaul is carried out but rather as an expense
of the periods in which the asset is operated.

A4 In past practice this was achieved by accruing a liability for the cost of such overhauls.
However, this is arguably incompatible with an asset/liability approach because the accrual
does not represent a liability. Reflecting this view, IAS 37 prohibits such accruals. However,
a similar pattern of expense recognitions is obtained under IFRS by reflecting the need for
overhauls in depreciation, and by capitalising the cost of overhauls when they are carried out.
Transaction costs
A5 Transaction costs include expenses such as commissions, legal fees or tax that are sometimes
paid on the acquisition of an asset. Some take the view that these costs should be treated as
part of the cost of the asset. Others consider that they should be reported as an expense of
the period in which the asset is acquired: it may be suggested that this is consistent with the
asset/liability approach as the costs relate to the transaction rather than the asset.
A6 The current treatment under IFRS is inconsistent. Under IAS 16 they are treated as part of the
cost of an asset, but under IFRS 3 they are treated as expenses in the period in which they are
incurred. Transaction costs are excluded from the concept of fair value as set out in IFRS 13:
that standard requires that such costs are accounted for in accordance with other IFRS.

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Getting a Better Framework

A2 Some who favour the asset/liability approach have argued that deferred revenue does not
represent a liability, and conclude that the income should be recognised on receipt, after
allowing for the cost of fulfilling the order. However, the IASB has concluded in its project on
revenue recognition that unfulfilled performance obligations are liabilities. It has also agreed
that these obligations are measured at the transaction price. The result is that revenue is
recognised in the period in which performance takes place. It can be argued that this is
consistent with an asset/liability approach.

The asset/liability approach

A1 An issue that arises in the context of revenue recognition is the accounting treatment that
should be used when a customer makes a payment before goods are delivered (or services
are rendered). Many would agree that the payment should be recognised as revenue in the
period in which it is earned, i.e. when the company performs what is required to earn the
payment. Before then, the payment should be credited to deferred revenue.

Regulatory assets
A7 An entity which is subject to regulation that limits the prices it is allowed to charge its
customers may incur costs that would normally be treated as an expense of the period in
which they are incurred. However, if regulation permits the entity to increase its prices in
subsequent periods so as to recover the cost, the accounting treatment is questionable. If the
asset/liability approach is adopted and it is concluded that there is no asset (which may be
because the entity has no right to make sales at the increased price, only to charge that price
to those who agree to pay it) the costs would be reported as an expense when incurred, and
income for subsequent periods would be increased, reflecting the increased charges made on
customers. Whilst some would agree that this is appropriate, considering that this treatment
properly reflects the economic events, others would not. Those favouring deferral of the costs
might consider that doing so provides an amount of income for each period that provides a
better basis for the assessment of future income.

The asset/liability approach

Share-based payment

Getting a Better Framework

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A8 IFRS 2 requires that an expense is recognised for the issue of employee share options. This
may be seen as inconsistent with the asset/liability approach as the issue of such options
does not result in any change to the entitys assets and liabilities.
A9 The contrary view is that the asset/liability approach is consistent with the recognition of an
expense for employee share options. On this view, the entity receives an assetemployee
servicesin exchange for the issue of the options. Just because that asset is immediately
consumed does not justify omitting the expense of consuming those services. It may be
noted, however, that this analysis suggests that the measurement of the transaction should
be at the value of the consideration received, and some would argue that if the value of equity
instruments issued exceeds the consideration, it is also necessary to reflect the excess as an
expense. It is not clear how this would be reconciled with the asset/liability approach.

Getting a Better Framework

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The asset/liability approach