The balance sheet imperfectly describes both resources and financing (claims on those resources). Explain why applying asset and liability definitions and recognition criteria under U.S. GAAP and IFRS does not result in the balance sheet including all economic benefits (resources) and obligations

Answer 1

The terms assets and liabilities, mean resources and obligations that appear on the balance sheet. Further, measurement rules do not always ensure that the balance sheet shows amounts for assets, liabilities, and shareholders' equity that reflect current economic conditions, even though presumptively an investor would view measurements that reflect current conditions as the most relevant for making investment decisions. Although analysts should keep these limitations in mind, they should not ignore the balance sheet. U.S. GAAP and IFRS require that balance sheets recognize most resources and claims (sources of financing), and measurement guidance has increasingly focused on fair values, at least for financial assets and financial liabilities. In addition, even if authoritative guidance introduces biases into the reported amounts, these biases usually affect firms consistently, so the financial statements are reasonably comparable. By adjusting for known biases, users can accommodate many of the deficiencies in the balance sheet caused by the application of U.S. GAAP and IFRS.

The balance sheet displays three classes of items: assets, liabilities, and shareholders' equity. These items depict a firm's financial position at a point in time. Broadly speaking, assets represent future economic benefits in the form of resources available to carry out operations; liabilities and shareholders' equity show the sources of funds the firm used to acquire the resources and show the claims on them. Two key factors in preparing a balance sheet are:

1 . Deciding whether items meet the definitions and recognition criteria for assets and liabilities and, if so,

2 . Deciding how to measure the items.

For a firm to recognize an asset, a resource must represent a future economic benefit that the firm controls as a result of a past transaction or exchange, and the firm must be able to measure the resource with sufficient reliability. For a firm to recognize an obligation as a liability, the obligation must impose a future economic sacrifice because of a past event or transaction that the firm has little or no discretion to avoid, and the firm must be able to measure the obligation with sufficient reliability. Shareholders' equity reports the amounts of funding attributable to owners' contributions and resulting from the retention of net assets generated by earnings. Shareholders' equity equals the difference between total assets and total liabilities and typically comprises contributed (paid-in) capital and retained earnings.

Most asset and liability definitions and recognition criteria are similar under U.S. GAAP and IFRS. One difference pertains to internally developed intangibles. U.S. GAAP generally does not permit firms to recognize research or development expenditures as assets on the balance sheet. IFRS requires, under specified conditions, the recognition as an asset of development expenditures. Under both sets of standards, the firm must expense expenditures on research, so these do not result in an asset.

Once an item has met the appropriate recognition criteria, the firm must measure the amount it will report on the balance sheet. Measurement depends on the item being considered. U.S. GAAP and IFRS specify how a firm should measure each asset and liability. Firms generally measure financial assets other than investments in marketable securities at their cash equivalent amounts on the balance sheet, while they generally report nonfinancial assets at acquisition cost, reduced for use and impairment. Asset and liability measurement approaches and rules (particularly for the assets and liabilities) are generally similar under U.S. GAAP and IFRS, although there are exceptions; for example, the specifics of impairment testing and the IFRS option to revalue certain nonfinancial assets upward to amounts that exceed acquisition costs.

The balance sheet does not present a complete portrayal of all resources and obligations, nor does it report the details of operating activities. In addition to intentionally not capturing information included in other financial statements, balance sheets based on U.S. GAAP and IFRS omit some items and measure others with bias, relative to measurements based on current economic conditions. These omissions and biases involve the nonrecognition of certain resources and obligations as assets and liabilities and the measurement of recognized assets and liabilities at amounts that do not reflect current economic conditions.