Classifying transactions into accounts is a crucial step in the
accounting process. Asset and liability transactions are the biggest portion of
the whole accounting data. Classifying transactions into asset and liability
group, under the IAS 1, is a big challenge, for those who implement IFRS for the
first time. This post helps starters to understand the process of classifying
asset and liability transactions, under the IAS 1.
But before the main topic, let us have a look at a quick overview of statement of financial position.
In the United States, a statement of financial position, generally, is consisted of 3 major categories which are presented in the following manner:
Assets = xxx
Liabilities = xxx
Stockholders’ Equity = xxx
Note:
Entities, according to IAS 1, should make a distinction between current and noncurrent assets and liabilities, except when a presentation based on liquidity provides information that is more reliable or relevant.
Next let’s have a look how you should classify assets and liabilities under the IAS 1.
A. Current Assets – An asset is classified as a current asset when it meets any one of the following:
Note, however, that if a current asset category includes items that will have a life of more than twelve months, the amount that falls into the next financial year should be disclosed in the notes, according to IAS 1.
Based on the above criterion and notes, the following items would be classified as current assets:
1. Cash and Cash Equivalents – These include cash on hand, consisting of coins, currency, and undeposited checks (money orders and drafts; and deposits in banks). Anything accepted by a bank for deposit would be considered cash. Cash must be available for a demand withdrawal; thus, assets such as certificates of deposit would not be considered cash because of the time restrictions on withdrawal. Also, to be classified as a current asset, cash must be available for current use. According to IAS 1, cash that is restricted in use and whose restrictions will not expire within the operating cycle, or cash restricted for a noncurrent use, would not be included in current assets. According to IAS 7, cash equivalents include short-term, highly liquid investments that (1) are readily convertible to known amounts of cash, and (2) are so near their maturity (original maturities of three months or less) that they present negligible risk of changes in value because of changes in interest rates. Treasury bills, commercial paper, and money market funds are all examples of cash equivalents.
2. Trading Investments – Included on this category are those that are acquired principally for the purpose of generating a profit from short-term fluctuations in price or dealer’s margin. A financial asset should be classified as held-for-trading if it is part of a portfolio for which there is evidence of a recent actual pattern of short-term profit making. Trading assets include debt and equity securities and loans and receivables acquired by the entity with the intention of making a short-term profit. Derivative financial assets are always deemed held-for-trading unless they are designed as effective hedging instruments.
3. Trade Receivables (Receivables) – Included under this category are: accounts and notes receivable, receivables from affiliate companies, and officer and employee receivables. The term “accounts receivable” represents amounts due from customers arising from transactions in the ordinary course of business. Allowances due to expected lack of collectibility and any amounts discounted or pledged, however, should be disclosed clearly.
4. Inventories – Inventories are defined as assets held, either for sale in the ordinary course of business or in the process of production for such sale, or in the form of materials or supplies to be consumed in the production process or in the rendering of services—according to IAS 2. The basis of valuation and the method of pricing—which is now limited to FIFO or weighted-average cost—should be disclosed properly. In the case of a manufacturing entity, raw materials, work in process, and finished goods should be disclosed separately on the statement of financial position or in the footnotes.
5. Prepaid Expenses – These are assets created by the prepayment of cash or incurrence of a liability. Prepaid expenses expire and become expenses with the passage of time, use, or events, for example: prepaid rent, prepaid insurance and deferred taxes.
B. Noncurrent Assets – IAS 1 uses the term “noncurrent” to include tangible, intangible, operating, and financial assets of a long-term usage. It does not prohibit the use of alternative descriptions, as long as the meaning is clear. The EU may use the term “fixed assets”—which draws a distinction between fixed and circulating assets. Noncurrent assets include the followings:
1. Held-to-maturity Investments – These are financial assets with fixed or determinable payments and fixed maturity that the entity has a positive intent and ability to hold to maturity. Examples of held-to-maturity investments are: debt securities and mandatorily redeemable preferred shares. This category excludes loans and receivables originated by the entity, however, as under IAS 39 these represent a separate category of asset. Held-to-maturity investments are to be measured at amortized cost.
2. Investment Property – This denotes property being held to earn rentals, or for capital appreciation, or both, rather than for use in production or supply of goods or services, or for administrative purposes or for sale in the ordinary course of business. Investment property should be initially measured at cost. Subsequent to initial measurement an entity is required to elect either the fair value model or the cost model.
3. Property, Plant, and Equipment (PP&E) – These, essentially, are tangible assets that are held by an entity for use in the production or supply of goods or services, or for rental to others, or for administrative purposes—and which are expected to be used during more than one period. Included are such items as land, buildings, machinery and equipment, furniture and fixtures, motor vehicles and equipment. PP&E should be disclosed, with the related accumulated depreciation, as follows:
4. Intangible Assets – These are noncurrent assets of a business, without physical substance, the possession of which is expected to provide future benefits to the owner. Included in this category are the unidentifiable asset goodwill and the identifiable intangibles trademarks, patents, copyrights, and organizational costs. IAS 38 stipulates that where an intangible is being amortized, it should be carried at cost net of accumulated amortization.
5. Assets Held for Sale. Where an entity has committed to a plan to sell an asset or group of assets, these should be reclassified as assets held for sale and should be measured at the lower of their carrying amount or their fair value less selling costs—set forth by IFRS 5.
6. Other Assets – An all-inclusive heading for accounts that do not fit neatly into any of the other asset categories (e.g., long-term deferred expenses that will not be consumed within one operating cycle, and deferred tax assets).
A. Current Liabilities – A Liability, according to IAS 1, should be classified as a “current liability” when:
Current liabilities also include:
1. Obligations arising from the acquisition of goods and services entering into the entity’s normal operating cycle, for example:
Note: obligations that are due on demand or are callable at any time by the lender are classified as current regardless of the present intent of the entity or of the lender concerning early demand for repayment.
However, an entity would continue to classify as current liabilities its long-term financial liabilities when they are due to be settled within twelve months, if an agreement to refinance on a long-term basis was made after the date of the statement of financial position.
Similarly if long-term debt becomes callable as a result of a breach of a loan covenant, and no agreement with the lender to provide a grace period of more than twelve months has been concluded by the date of the statement of financial position, the debt must be classified as current. (This is different than under US GAAP, which permits a determination to be made as of the date of issuance of the financial statements, which may be months after the date of the statement of financial position.)
B. Noncurrent
Liabilities – Obligations that are not expected to be liquidated
within the current operating cycle, including:
Also, in the case of bonds and long-term notes, any premium or discount should be reported separately as an addition to or subtraction from the par (or face) value of the bond or note. Long-term obligations which contain certain covenants that must be adhered to are classified as current liabilities if any of those covenants have been violated and the lender has the right to demand payment. Unless the lender expressly waives that right or the conditions causing the default are corrected, the obligation is current.
However, the reduction of accounts receivable by the allowance for doubtful accounts, or of property, plant, and equipment by the accumulated depreciation, are acts that reduce these assets by the appropriate valuation accounts and are not considered to be the result of offsetting assets and liabilities.
Only where there is an actual right of setoff is the offsetting of assets and liabilities a proper presentation.
This right of setoff exists only when all the following conditions are met:
Intent is not of similar significance with regard to the classification of liabilities, however, because the creditor has the legal right to demand satisfaction of a currently due obligation, and even an expression of intent not to exercise that right does not diminish the entity’s burden should there be a change in the creditor’s intention.
Thus, whereas an entity can control its use of current assets, it is limited by its contractual obligations with regard to current liabilities, and accordingly, accounting for current liabilities (subject to the two exceptions noted above) is based on legal terms, not expressions of intent.
But before the main topic, let us have a look at a quick overview of statement of financial position.
How is a Statement of Financial Position Presented?
Assets and liabilities are presented on a statement of financial position—which is known as “balance sheet” in the past—and tells financial statements’ users about entity’s resources and claims to resources, at a moment in time.
Incase you haven’t noted it yet, the revised IAS 1
has changed the title of “balance sheet” to “statement of financial
position”—which, according to the IASB, better reflects the function of the
statement.
While the title “balance sheet” well reflects the accounting equation (Assets = Liabilities + Shareholder) that always in balance position, it does not identify the content or purpose of the statement.
In addition, according to the IASB, the term “financial position” is a well-known and accepted term—auditors’ opinions, internationally, have used the term to describe what “the balance sheet” presents.
The IASB Framework, in general, describes the basic concepts by which
financial statements are presented. To be included in the financial statements,
an event or transaction must meet definitional, recognition, and measurement
requirements, all of which are set forth in the Framework.While the title “balance sheet” well reflects the accounting equation (Assets = Liabilities + Shareholder) that always in balance position, it does not identify the content or purpose of the statement.
In addition, according to the IASB, the term “financial position” is a well-known and accepted term—auditors’ opinions, internationally, have used the term to describe what “the balance sheet” presents.
In the United States, a statement of financial position, generally, is consisted of 3 major categories which are presented in the following manner:
Assets = xxx
Liabilities = xxx
Stockholders’ Equity = xxx
Note:
Assets = Liabilities + Stockholders’ EquitiesAssets, liabilities, and stockholders’ equity are separated in the statement of financial position.
Entities, according to IAS 1, should make a distinction between current and noncurrent assets and liabilities, except when a presentation based on liquidity provides information that is more reliable or relevant.
Next let’s have a look how you should classify assets and liabilities under the IAS 1.
Classifying Assets under IAS 1 (IFRS)
Following on the IAS 1 requirement, assets is classified into two major categories: (a) current assets; and (b) noncurrent assets.A. Current Assets – An asset is classified as a current asset when it meets any one of the following:
- It is expected to be realized in, or is held for sale or consumption in, the normal course of the entity’s operating cycle;
- It is held primarily for trading purposes;
- It is expected to be realized within twelve months of the statement of financial position date;
- It is cash or a cash equivalent asset that is not restricted in its use.
Note: The operating cycle of an
entity is the time between the acquisition of materials entering into a process
and its realization in cash or an instrument that is readily convertible into
cash.
That said, inventories and trade receivables should still be classified as
current assets in a classified statement of financial position EVEN if these
assets are not expected to be realized within twelve months from the statement
of financial position date.Note, however, that if a current asset category includes items that will have a life of more than twelve months, the amount that falls into the next financial year should be disclosed in the notes, according to IAS 1.
Based on the above criterion and notes, the following items would be classified as current assets:
1. Cash and Cash Equivalents – These include cash on hand, consisting of coins, currency, and undeposited checks (money orders and drafts; and deposits in banks). Anything accepted by a bank for deposit would be considered cash. Cash must be available for a demand withdrawal; thus, assets such as certificates of deposit would not be considered cash because of the time restrictions on withdrawal. Also, to be classified as a current asset, cash must be available for current use. According to IAS 1, cash that is restricted in use and whose restrictions will not expire within the operating cycle, or cash restricted for a noncurrent use, would not be included in current assets. According to IAS 7, cash equivalents include short-term, highly liquid investments that (1) are readily convertible to known amounts of cash, and (2) are so near their maturity (original maturities of three months or less) that they present negligible risk of changes in value because of changes in interest rates. Treasury bills, commercial paper, and money market funds are all examples of cash equivalents.
2. Trading Investments – Included on this category are those that are acquired principally for the purpose of generating a profit from short-term fluctuations in price or dealer’s margin. A financial asset should be classified as held-for-trading if it is part of a portfolio for which there is evidence of a recent actual pattern of short-term profit making. Trading assets include debt and equity securities and loans and receivables acquired by the entity with the intention of making a short-term profit. Derivative financial assets are always deemed held-for-trading unless they are designed as effective hedging instruments.
3. Trade Receivables (Receivables) – Included under this category are: accounts and notes receivable, receivables from affiliate companies, and officer and employee receivables. The term “accounts receivable” represents amounts due from customers arising from transactions in the ordinary course of business. Allowances due to expected lack of collectibility and any amounts discounted or pledged, however, should be disclosed clearly.
4. Inventories – Inventories are defined as assets held, either for sale in the ordinary course of business or in the process of production for such sale, or in the form of materials or supplies to be consumed in the production process or in the rendering of services—according to IAS 2. The basis of valuation and the method of pricing—which is now limited to FIFO or weighted-average cost—should be disclosed properly. In the case of a manufacturing entity, raw materials, work in process, and finished goods should be disclosed separately on the statement of financial position or in the footnotes.
5. Prepaid Expenses – These are assets created by the prepayment of cash or incurrence of a liability. Prepaid expenses expire and become expenses with the passage of time, use, or events, for example: prepaid rent, prepaid insurance and deferred taxes.
B. Noncurrent Assets – IAS 1 uses the term “noncurrent” to include tangible, intangible, operating, and financial assets of a long-term usage. It does not prohibit the use of alternative descriptions, as long as the meaning is clear. The EU may use the term “fixed assets”—which draws a distinction between fixed and circulating assets. Noncurrent assets include the followings:
1. Held-to-maturity Investments – These are financial assets with fixed or determinable payments and fixed maturity that the entity has a positive intent and ability to hold to maturity. Examples of held-to-maturity investments are: debt securities and mandatorily redeemable preferred shares. This category excludes loans and receivables originated by the entity, however, as under IAS 39 these represent a separate category of asset. Held-to-maturity investments are to be measured at amortized cost.
2. Investment Property – This denotes property being held to earn rentals, or for capital appreciation, or both, rather than for use in production or supply of goods or services, or for administrative purposes or for sale in the ordinary course of business. Investment property should be initially measured at cost. Subsequent to initial measurement an entity is required to elect either the fair value model or the cost model.
3. Property, Plant, and Equipment (PP&E) – These, essentially, are tangible assets that are held by an entity for use in the production or supply of goods or services, or for rental to others, or for administrative purposes—and which are expected to be used during more than one period. Included are such items as land, buildings, machinery and equipment, furniture and fixtures, motor vehicles and equipment. PP&E should be disclosed, with the related accumulated depreciation, as follows:
Machinery and equipment = xxxor
Less accumulated depreciation (xxx) = xxx
Machinery and equipment (net of $xxx accumulated depreciation) = xxx
Note: Accumulated depreciation
should be shown by major classes of depreciable assets.
In addition to showing this amount in the statement of financial position,
required by the IAS 16, the notes to the financial statements should contain
balances of major classes of depreciable assets, by nature or function, at the
date of the statement of financial position, along with a general description of
the method or methods used in computing depreciation with respect to major
classes of depreciable assets.4. Intangible Assets – These are noncurrent assets of a business, without physical substance, the possession of which is expected to provide future benefits to the owner. Included in this category are the unidentifiable asset goodwill and the identifiable intangibles trademarks, patents, copyrights, and organizational costs. IAS 38 stipulates that where an intangible is being amortized, it should be carried at cost net of accumulated amortization.
5. Assets Held for Sale. Where an entity has committed to a plan to sell an asset or group of assets, these should be reclassified as assets held for sale and should be measured at the lower of their carrying amount or their fair value less selling costs—set forth by IFRS 5.
6. Other Assets – An all-inclusive heading for accounts that do not fit neatly into any of the other asset categories (e.g., long-term deferred expenses that will not be consumed within one operating cycle, and deferred tax assets).
Classifying Liabilities under IAS 1 (IFRS)
As the assets do, liabilities are classified into two major categories: (a) current lliabilities and (b) noncurrent liabilities.A. Current Liabilities – A Liability, according to IAS 1, should be classified as a “current liability” when:
- It is expected to be settled in the normal course of business within the entity’s operating cycle; or
- It is due to be settled within twelve months of the date of the statement of financial position; or
- It is held primarily for the purpose of being traded; or
- The entity does not have an unconditional right to defer settlement beyond twelve months
Current liabilities also include:
1. Obligations arising from the acquisition of goods and services entering into the entity’s normal operating cycle, for example:
- Accounts Payable
- Short-term Notes Payable
- Wages Payable
- Taxes Payable
- Miscellaneous Payable
- Rent Received in Advance
- Unearned Subscription Revenues
- Current Maturity of Bonds
- Long-term Notes
- Trade Payables
- Accruals for Operating Costs
Note: obligations that are due on demand or are callable at any time by the lender are classified as current regardless of the present intent of the entity or of the lender concerning early demand for repayment.
Important Notes On Classifying Liabilities
IAS 1 provides another exception to the general rule that a liability due to be repaid within twelve months of the date of the statement of financial position should be classified as a current liability. If the original term was for a period longer than twelve months and the entity intended to refinance the obligation on a long-term basis prior to the date of the statement of financial position, and that intention is supported by an agreement to refinance, or to reschedule payments, which is completed before the financial statements are approved, then the debt is to be reclassified as noncurrent as of the date of the statement of financial position.However, an entity would continue to classify as current liabilities its long-term financial liabilities when they are due to be settled within twelve months, if an agreement to refinance on a long-term basis was made after the date of the statement of financial position.
Similarly if long-term debt becomes callable as a result of a breach of a loan covenant, and no agreement with the lender to provide a grace period of more than twelve months has been concluded by the date of the statement of financial position, the debt must be classified as current. (This is different than under US GAAP, which permits a determination to be made as of the date of issuance of the financial statements, which may be months after the date of the statement of financial position.)
- Obligations arising as part of the long-term capital structure of the entity, such as the issuance of bonds, long-term notes, and lease obligations;
- Obligations arising out of the normal course of operations, such as pension obligations, decommissioning provisions, and deferred taxes; and
- Contingent obligations involving uncertainty as to possible expenses or losses. These are resolved by the occurrence or nonoccurrence of one or more future events that confirm the amount payable, the payee, and/or the date payable.
Also, in the case of bonds and long-term notes, any premium or discount should be reported separately as an addition to or subtraction from the par (or face) value of the bond or note. Long-term obligations which contain certain covenants that must be adhered to are classified as current liabilities if any of those covenants have been violated and the lender has the right to demand payment. Unless the lender expressly waives that right or the conditions causing the default are corrected, the obligation is current.
Is It Allowed, under IFRS, to Offset Assets and Liabilities?
In general, assets and liabilities may not be offset against each other.However, the reduction of accounts receivable by the allowance for doubtful accounts, or of property, plant, and equipment by the accumulated depreciation, are acts that reduce these assets by the appropriate valuation accounts and are not considered to be the result of offsetting assets and liabilities.
Only where there is an actual right of setoff is the offsetting of assets and liabilities a proper presentation.
This right of setoff exists only when all the following conditions are met:
- Each of the two parties owes the other determinable amounts (although they may be in different currencies and bear different rates of interest).
- The entity has the right to set off against the amount owed by the other party.
- The entity intends to offset.
- The right of setoff is legally enforceable.
Final Notes On Classifying Assets and Liabilities Under IAS 1
The distinction between current and noncurrent liquid assets generally rests upon both the ability and the intent of the entity to realize or not to realize cash for the assets within the traditional one-year concept.Intent is not of similar significance with regard to the classification of liabilities, however, because the creditor has the legal right to demand satisfaction of a currently due obligation, and even an expression of intent not to exercise that right does not diminish the entity’s burden should there be a change in the creditor’s intention.
Thus, whereas an entity can control its use of current assets, it is limited by its contractual obligations with regard to current liabilities, and accordingly, accounting for current liabilities (subject to the two exceptions noted above) is based on legal terms, not expressions of intent.
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