Defining Assets a Proposal for the Conceptual Framework

Document Sample
Defining Assets a Proposal for the Conceptual Framework Powered By Docstoc
					Redefining Assets: A Proposal for the Conceptual Framework



                            By



                    Richard Gore, Ph.D.


                    Associate Professor
             School of Business Administration
                      1000 Rim Drive
                    Fort Lewis College
                    Durango, CO 81301
                       970-247-7603
                  gore_r@fortlewis.edu

                            &


                Richard A. Samuelson, Ph.D.
                     Emeritus Professor
                 San Diego State University
                                         Abstract


In the project to revise the Conceptual Framework, the Financial Accounting Standards
Board has proposed a new definition of assets. In this paper, we examine and evaluate
the proposed definition. Our examination indicates that although the proposed definition
is an improvement to the existing definition of assets, there are still some major
shortcomings. The main shortcomings, which are elaborated in this article, concern two
characteristics of the proposed definition. First, the proposed definition equates assets
with economic resources and gives the existence of proprietary rights a secondary role.

We believe this relationship should be reversed. Second, the discussion of an economic
resource that accompanies the proposed definition defines resources in terms of future
cash flows (or economic value) as opposed to the utility (or economic use) of the
resource. This approach leads to confusion between the definition of assets and their
measurement. As an alternative, we suggest that an asset of an entity be defined as the
present right to the services (or uses) of an existing economic resource and that the
definition of an economic resource focus on the utility of the resource as opposed to the
value of the resource.




                                                                                            2
Introduction
The Conceptual Framework is based on the asset / liability view of accounting. The
adoption of the asset / liability view in the Conceptual Framework precipitated a shift
from the practice of accounting at that time, which was focused on the direct
measurement of income through the process of matching costs or expenses with revenue
(FASB 2005). In that approach, assets and liabilities were the amounts left over after
matching costs with revenues of the current period. Accounting regulators, however,
found the approach based on the matching principle unworkable as a basis for accounting
standards because of the inherent subjectivity of determining when and how expenditures
were linked to revenues (SEC 2003). Thus, the Financial Accounting Standards Board
(FASB) and the International Accounting Standards Board (IASB) have adopted the asset
/ liability view as the basis for financial reporting standards.


In the asset / liability view, the primary focus of accounting is the identification and
measurement of assets and liabilities, and the income statement is considered residual to
the balance sheet (SEC 2003). Hence, assets and liabilities represent the fundamental
concepts of accounting in this approach. Further, it is generally thought that the
definitions of assets and liabilities ought to be parallel – one should be a mirror image of
the other. Thus, once the definition of one of these elements has been determined, it

should naturally lead to the other. In connection with the project to revise and update the
Conceptual Framework, the FASB/IASB1 has elected to first develop a satisfactory
definition of assets before defining the remaining elements of accounting (IASB 2007b).


In the Conceptual Framework, the recognition and measurement of assets is a two-step
process. The first test for recognition is that the item must meet the definition of an asset.


1
 The project to revise the conceptual framework is a joint project with the International Accounting
Standards Board (IASB).


                                                                                                       3
The second test for measurement is that the item must have a relevant measurement
attribute (cost, fair value, etc.) that can be reliably measured. The first test (definition) is
independent of the second test (measurement). Thus, measurement or valuation should
only be considered if the definition is satisfied. This is consistent with “classical”
measurement theory, which has been recommended for the Conceptual Framework by the
FASB/IASB staff (IASB 2007e). In classical measurement theory, the numerical
representations of an object represent “qualities” or “attributes” of the object being
measured, but are considered separate and distinct from the item itself (IASB 2007e). In
other words, the object being measured is assumed to have an existence in reality apart
from how it is measured. In accounting, the measurement attributes are generally
exchange values (past or present), sometimes exchange values based on actual
transactions (entry or exit values), and sometimes exchange values based on hypothetical
transactions (fair value). However, the definition of the element being measured is
distinguished from the attribute used for measurement. If we define accounting elements
in terms of their measurement attribute, we confuse definition with measurement.
Deferred Charges reported as assets under the matching concept such as “pre-opening
costs” or “debt issuance costs” are examples of items that combine these two steps.


A clear and useful definition of assets independent of how they are measured is essential

to provide a solid foundation to the Conceptual Framework, and by extension, to
financial reporting. If the asset definition is overly vague or subjective, it may undermine
confidence in financial reports. This is particularly important in a principles-based
standard setting regime, which is one of the goals of the Financial Accounting Standards
Board (FASB 2005). However, the search for a satisfactory definition of assets is not a
simple task. Just over a century ago, the economist Irving Fisher suggested in his book
The Nature of Capital and Income (1906, 103) that a good definition should satisfy two
conditions. First, it should be useful for scientific analysis. This condition requires that


                                                                                               4
the definition be useful for classifying objects. In other words, the definition must be
capable of determining whether items fall within a particular class of objects or should be
excluded from that class. Second, the definition should harmonize with common usage.
Although a definition may have greater precision than the use of the term in everyday
expression, the definition should be consistent with a common sense understanding of the
term. In this paper, we adopt Fisher’s criteria for a good definition in evaluating three
possible asset definitions.


The purpose of this paper is to evaluate the new definition of assets proposed by the
FASB and the IASB and to suggest an alternative definition. The paper proceeds as
follows: First, we review the current FASB definition of assets and explain why it ought
to be revised. Second, we present the definition proposed by the FASB and IASB and
analyze it through a series of examples. Third, we propose an alternative definition of
assets and explain why we believe this definition would provide a better foundation for
accounting.


Current Definition
Statement of Financial Accounting Concepts No. 6 (FASB 1985) defines assets as
follows:
       Assets are probable future economic benefits obtained or controlled by a
       particular entity as a result of past transactions or events.


This definition has two essential components: an economic component and a proprietary
(or legal) component. The economic component (“future economic benefits”) describes
the economic nature of assets and the proprietary component (“obtained or controlled”)
identifies the assets with a particular entity. In addition, the definition suggests that
assets arise from past transactions or events.




                                                                                            5
This definition of assets has been widely criticized. Scheutze (1993), a former chief
accountant for the S.E.C., says that the FASB’s definition is “so complex, so abstract, so
open-ended, so all-inclusive, and so vague that we cannot use it to solve problems.” He
further states, “The definition does not discriminate and help us to decide whether
something or anything is an asset.” In his opinion, the existing FASB definition
describes “a large empty box” that is so open to interpretation that “almost everything
and anything can be fit into it.” Thus, Scheutze suggests that the current FASB asset
definition is useless for the purpose of resolving accounting issues.


Samuelson (1996) also identified several weaknesses with the current asset definition.
First of all, the definition confuses definition with measurement. Probable future
benefits, which are generally interpreted as future cash inflows associated with an asset,
are a measurement attribute, not a defining characteristic of the asset itself. If the
definition is to be distinct from measurement, Samuelson asserts that the defining
characteristic of assets must be non-financial in nature. Next, he explains that the
definition confuses stocks and flows. Assets are defined as future economic benefits,
which are events expected to occur over a period of time; however, assets exist at a
particular point in time. They are stocks, not flows. What exists now is an expectation of
future benefits, a right to future benefits, or a source of future benefits. Expectations are

in the mind of the measurer and have no independent existence. If assets are defined as
“future economic benefits,” the focus is on future events that are inherently unverifiable.
Thus, the asset definition lacks empirical content because it does not link the “future
economic benefits” to anything that currently exists. Finally, Samuelson is critical of the
FASB definition because it gives precedence to the economic component of an asset over
its proprietary or legal component by stating the economic component first. The order in
which each component is included in the definition is significant because in applying the
definition, the second component only becomes relevant when the first component is


                                                                                                6
satisfied. He suggests that once the existence of future economic benefits (i.e., net cash
flows) is assumed to exist, the “control” requirement is seldom significant because it is
obvious that the cash flows, if they occur, will flow to the entity. This is nothing more
than the entity concept. The fact that the entity has no present right to the future benefits
is ignored.


The FASB/IASB staff has also identified four weaknesses with the current asset
definition in Agenda Paper 3 (IASB 2007a). First, they state that the term “probable” as
a modifier to the economic component of the definition is often misinterpreted to suggest
that an item must be nearly certain to qualify as an asset. This interpretation is
inconsistent with the original intent of the Board and should be removed. Thus, the staff
suggests that an asset exists even if there is a low probability of future benefits. Second,
consistent with Samuelson, they conclude that the definition confuses stocks with flows
by defining assets, which are stocks, in terms of future benefits, which are flows. Third,
in their view the phrase in the definition “as a result of past transactions or events” places
undue reliance on identification of some past transaction or event as opposed to
identifying an existing resource of the entity. Fourth, the staff concludes that the term
“control” in the definition is often confused with the control requirement for filing
consolidated financial statements and should be replaced with a term more specific to the

determination of whether an entity has rights to a resource.


In summary, the current FASB asset definition fails Fisher’s test for a good definition.
As suggested by Scheutze it isn’t useful in determining whether something is or is not an
asset; and as demonstrated by Samuelson and the FASB/IASB staff, it is inconsistent
with any common understanding of the term “assets.” Consequently, the current
definition is inadequate for the development of principles-based financial reporting
system.


                                                                                               7
Proposed Definition
To address these issues, the FASB and the IASB have been working together to develop a
new definition of assets. After much deliberation, they have adopted the following
working definition of assets as May 20, 2008:

An asset of an entity is a present economic resource to which, through an enforceable
right or by other means, the entity has access or can limit access by others.


The economic nature of assets is now captured by the phrase “economic resource,” and

the proprietary component is expressed by the phrase “to which … the entity has access
or can limit access by others.” The definition also elaborates that this access may be
established “through an enforceable right or by other means.”


The revised wording in the proposed definition versus the current definition is intended to
focus attention on the existence of an economic resource as opposed to assessing the
likelihood of future economic benefits. It avoids the term “control” in favor of the terms
“right” and “access.” Also, under the proposed definition it would no longer be
necessary to trace the existence of an asset to a past transaction or event.


In the proposed definition, it would appear that the identification of an asset is a two-step
process. The first step is to identify an existing “economic resource.” The second step is
to determine if the entity has “access to” that resource. To clarify the first step, the
proposed definition is accompanied by explanatory language that defines an economic
resource as follows:

An economic resource is something that is scarce and capable of producing cash inflows
or reducing cash outflows, directly or indirectly, alone or together with other economic
resources.


The first point to note here is that economic resources have value because they are scarce


                                                                                             8
or limited by nature. Air is not an economic resource because it is not scarce. This is
generally consistent with Concept Statement No. 6, in which economic resources are
defined as the “scarce means that are useful for carrying out economic activities, such as
consumption, production, and exchange” (FASB 1985). The second point of interest is
that the benefit derived from having an economic resource is expressed in terms of its
ability (either alone or together) to produce net cash inflows. Thus, the definition links
the concept of economic resources to the potential of producing future benefits in the
form of net cash flows to the entity.


The second step in identifying assets under the proposed definition is to determine if an
entity has some means of accessing the economic resource. The Boards were obviously
concerned that the term “right” might be too restrictive of a requirement for the existence
of an asset. Hence, they relax the proprietary component of the definition by requiring
only “access” to the economic resource. Enforceable rights are only one means of
assuring access to resources, according to their definition. Under this view, an entity may
establish access to unpatented technology or so-called “secret” knowledge even though it
has no enforceable right to prevent others from using the knowledge. Presumably, access
in such cases would be established if the cash flows from the economic resource would
flow to the entity.



Analysis of Proposed Definition
To analyze the proposed asset definition, we apply it to a number of items. First, we
apply the proposed definition to items that are universally accepted as assets to
understand how the definition works. We also consider the case of goodwill. We think
that if goodwill, which is unidentifiable, satisfies the proposed asset definition, the
definition lacks the precision necessary to be useful for classification purposes.




                                                                                             9
Accounts Receivable
Claims to cash (e.g., ordinary accounts and notes receivable) are obviously assets, but are
they assets because they are rights or because they are resources? Per example 2 of
Agenda Paper 16B, the receivable is an economic resource because the unconditional
promise by another party to pay cash will result in the collection of cash (IASB 2007c).
In addition, access to the receivable is established by the right, often contractual, which
identifies the entity as the beneficiary of the resource. Thus, accounts receivable qualify
as an asset on both counts.


However, claims to cash are also rights, since they represent the legal entitlement to
receive cash from an external source. If rights are given precedence in an asset
definition, an asset is a right to a resource. The resource underlies the right. In the case
of claims to cash, the external source is the individual, a business enterprise, or a not-for-
profit entity. Where the external source is an individual, the resource underlying the
claim is a human being; where it is a business enterprise or a not-for-profit entity, the
resources are the human and non-human objects that comprise the wherewithal to make
the future payments.



If rights are distinct from resources, then a claim to cash cannot be both a right and a
resource. In our opinion, resources are useful if they can provide enjoyment through
consumption or if they can be used to produce other things. Exchangeability is a
characteristic of the right to the resource. It is the right to a resource that can be sold or
used to settle liabilities. We define “usefulness” (as a characteristic of economic
resources) as the ability to use the resource in consumption and production activities, but
not in exchange activities.




                                                                                                 10
Prepaid Expenses
A prepaid expense is another form of a right. In the case of prepaid rent, it is the right to
receive the services of property, plant, or equipment. In the case of prepaid wages, it is
the right to receive the human services of an employee. In the case of prepaid
advertising, it is the right to receive advertising services from a vendor in the future.
Underlying each of these rights is an economic resource, such as a building, a person, or
a collection of resources represented by a business entity.


According to example 3 in Agenda Paper 16B, the economic resource in question is not
an object (building, equipment, human being, etc.) that yields the services, but rather it is
the intangible, unconditional promise of the other party to provide the services in the
future (IASB 2007c). This raises an important question about resources. Are promises
economic resources? In the case of prepaid wages, is the resource the employee, his
(implied) promise to work in the future, or both? If it is both, then it would seem to count
the resource twice from a macro-economic viewpoint. There would be two resources: the
human being (or employee) and his promise (or obligation) to work in the future. This
implies that economic resources can be created through making promises. A business
enterprise could create as many resources as it pleases simply by entering into contractual
arrangements that result in promises being made by some external party. Economic

resources in that case are not scarce. They can be created ad infinitum.


From a macro-economic viewpoint, contractual arrangements do not create resources:
they merely create offsetting rights and obligations. In the case of prepaid wages, the
right of the business to receive services is offset by the obligation of the employee to
perform services. While both rights and obligations would appear as assets and liabilities




                                                                                             11
of the two entities, underlying each asset and liability is a single resource: the employee.2
We therefore think that the resource underlying a prepaid expense is the object that yields
the technical services. It is unique and cannot be enhanced by promises of its owner.
The promise is the obligation (liability) of the other entity, which offsets the right (asset)
of the entity holding the prepaid asset.


Leasehold Interest
Leaseholds (from the standpoint of the lessee) also represent rights to receive services.
The services are technical in nature such as shelter, if the underlying resource is a
building, or transportation, if the underlying resource is a vehicle. According to
FASB/IASB, rights to receive services are economic resources and therefore assets. But
this conclusion makes little if any distinction between the right and the resource. In our
view, the asset is the right, while the underlying object (land, building, equipment, etc.) is
the resource.


When future cash flows are introduced into the definitions of assets or resources, the
concepts become even more muddled. It is true that leaseholds of business enterprises
are generally expected to produce future net cash inflows to the owner (though not
necessarily to individuals or not-for-profit entities). However, the determination of

whether the leasehold will produce future net cash inflows is a difficult assessment in
many cases. In many businesses, the leasehold produces cash inflows by using the
underlying resource simultaneously with other resources. There is no definitive way of
assigning joint cash inflows to individual resources. If the business has operating losses,
should negative cash inflows be assigned to the resources? If the leasehold is transferred

2
  It might be argued that accounting is only concerned with the assets (and resources) of specific entities,
and that the canceling effect from an economic viewpoint is irrelevant. However, this view seems short
sighted to us. Until accounting specifies how the assets of entities relate to the economic resources of the
economy as a whole, there will be an incomplete understanding of the concepts we are trying to define, and
the definitions will lack precision.


                                                                                                         12
to someone else through a sub-lease that generates less cash inflow than the required cash
outflow under the original lease, does the original leasehold still qualify as an asset?


By introducing future cash flows into the definition of assets or resources, the
measurement of assets is confused with the definition of assets. Future cash flows are
relevant when measuring an asset by its net realizable value or its discounted present
value. In our view, the leasehold represents an asset not because it is a resource in itself,
but because it is a right to use the services of the underlying resource owned by someone
else. It remains an asset whether or not it is expected to generate positive net cash
inflows.


Plant and Equipment
Buildings and equipment are obviously economic resources and therefore represent assets
of an entity that has rights to use them. They are material objects that are scarce and
useful. A building is useful in the sense that it provides shelter, a vehicle in the sense that
it provides transportation. Shelter and transportation are the technical services provided
by these resources. We could also say that buildings and equipment are useful in the
sense that they are sources of future cash inflows, but that is an unnecessary condition. If
an individual or a non-profit entity owns the resources, they may not be used to produce

future cash inflows. In fact, they can be expected to produce cash outflows rather than
cash inflows. They are still assets to the owner, however, whether the owner is a
business enterprise, a not-for-profit entity, or an individual3.




3
  One might argue that by owning a building or a piece of equipment, an individual or a not-for-profit entity
is avoiding future cash outflows that it would otherwise make. But that assumes that the owner would
replace the item if he were deprived of it. That assumption is not necessarily true and relates to a
hypothetical decision that has not been made.


                                                                                                          13
While buildings and equipment qualify as assets when assets are defined as resources,
they also qualify as assets when assets are defined as rights. The asset then is the right to
use the resource (the material object). While the resource provides services, the right
assigns the privilege of using the services to a particular entity. Where an entity has title
of ownership to the resource, it has a complete set of rights: it can use the resource over
its entire life, or it can transfer rights to use the resource to someone else by leasing or
selling it.4 Transferability is a common feature of most rights, but it is not a necessary
characteristic of a resource. Some resources held by not-for-profit entities such as
municipalities or trusts are non-transferable. They are still resources, nevertheless, as
long as they are capable of producing services. It is also important to note that when
assets are defined as rights rather than resources, all assets are technically intangible. The
distinction between tangible and intangible assets becomes irrelevant.


Goodwill
According to example 16 in a FASB/IASB staff report, goodwill qualifies as an asset
under the proposed definition (IASB 2007c). Although the staff recognizes that goodwill
can’t be separately identified, the staff suggests that whether something is identifiable or
not is a practical consideration and does not affect the existence of an asset (IASB

2007d). The staff uses the term “synergies” to describe the underlying economic
resource, and indicates that the existence of synergies may be observed from the physical
or financial performance of the target (IASB 2007c). Thus, the staff concludes that
goodwill is an economic resource because it is capable of producing future cash inflows
to the entity, and that rights to this unidentifiable resource (i.e. the cash inflows) are
established through ownership in the business. In other words, because the net cash flow


4
  In fact, there are always some limitations on rights of ownership. An owner may not be able to use a
resource in a way that would harm the environment or injure other people.


                                                                                                         14
of the business flows to itself, the entity has access to the resource and can prevent access
to others.


The existence of synergies is the most frequently given explanation for a business
combination (Damodaran 2005a). However, whether synergies should always qualify as
an asset requires closer scrutiny. In some cases synergies resulting from the business
combination do not exist absent the acquisition. Some synergies may arise from new
growth opportunities for the products of the target. For example, the purchase price for
Coca Cola’s acquisition of Glaceau was in part justified by Coca Cola’s ability to expand
sales of Glaceau’s main product, Vitamin Water, through its extensive distribution
network. This opportunity does not arise to Glaceau as a stand-alone entity, but only
arises from the acquisition. The question is, however, should future growth be
considered an asset? In our view, an opportunity or the potential of future sales is not an
economic resource, nor does the firm have a right to these future sales. Thus, it should
not qualify as asset. Recording synergies related to future growth opportunities as an
asset, is also inconsistent with the FASB/IASB staff’s own view that future sales of an
established business are not an asset (see example 24 in agenda paper 16B, IASB 2007c).


Another form of synergy occurs when there are possible cost savings available to the

combined entity from eliminating duplicate facilities, sales forces, administrative
personnel, etc (Damodaran 2005a). In this scenario, the purchaser, by acquiring the
target may achieve economies of scale by restructuring the operations of one or more of
the two firms. This is often the driving force behind many bank mergers where the
purchaser closes down redundant bank branches and consolidates back-room operations
to enhance the value of the combined firm. These cost savings would not occur absent
the business combination. Hence, they should not give rise to an asset because there is no
existing right or economic resources acquired by the purchaser. In a sense, the cost


                                                                                           15
savings is the opposite of an asset because it represents the opportunity to dispose of
redundant economic resources.


The FASB/IASB staff’s view that goodwill is an asset even though it can’t be separately
identified is analogous to an astrophysicist using the gravitational effect on surrounding
objects to verify the existence of a black hole. In advocating for the asset / liability view,
Robert Sprouse argued against recording “What-You-May-Call-Its” on the Balance Sheet
(Sprouse 1966). His view was that the application of the matching principle resulted in
the recognition of assets such as deferred costs, which did not correspond to real world
economic phenomena. Likewise, we believe that reporting unidentifiable items or “black
holes” on the Balance Sheet may lead to the recognition of assets that do not exist in the
real world.


We believe that if the asset definition is going to be operational, practical considerations
are important. As demonstrated by the examples regarding synergies related to future
growth or cost saving opportunities, there is more than one possible explanation for
synergies to occur in a business combination. Other possibilities include higher debt
capacity, or lower borrowing costs of the combined firm due to increased size or
diversification. We don’t believe these “synergies” should give rise to an asset because

the entity does not have a present right to the potential future benefits nor do they
constitute present economic resources. In essence, they represent potential benefits from
hypothetical future transactions.


As it is currently employed in accounting, goodwill is a master valuation account. It is

the excess of the fair value of an entity as a whole over the fair value of its identifiable

net assets (SFAS 141R). The treatment of goodwill in the financial statements is a matter

of measurement and display, not a matter of definition. Perhaps, reporting the value of


                                                                                               16
goodwill can be justified by the need to provide relevant information, but that is not an

adequate reason for concluding that goodwill satisfies the definition of an asset5.

Goodwill demonstrates the problem of defining economic resources in terms of future

cash flows and of emphasizing the economic component of the definition over the right to

the resource. Unlike the astrophysicist, who can be certain that “black holes” physically

exist in the universe, accountants can’t verify the existence of economic resources by

measuring future benefits no matter how rigorous or standardize the procedures because

there is no meaningful way of allocating the joint benefits of an entity to the separate

resources that make up a business unit (Watts 2003). If economic resources are defined

as anything that produces future cash inflows and the rights to those cash inflows are

assumed simply because they flow to the entity, then the asset definition has no

boundaries and it cannot be used for classification. The proposed definition would open

the door to a whole host of other intangible items such as real options6 that may not

represent economic resources. In any case, we do not believe that the definition of assets

should be distorted to include goodwill in order to conform to current practice.


Summary of examples
These examples illustrate two critical weaknesses with the proposed asset definition that
will make it difficult to implement and prevent it from being a significant improvement
upon the current definition. The first weakness is the association of economic resources
with the future cash inflows they may produce. This aspect of the definition focuses
attention on the financial characteristics of assets and expectations about future events.


5
  If goodwill were deemed relevant to users, policy-makers could require a mandatory footnote that
discusses management’s explanation of the existence of goodwill. There it could be attributed to things
that are not recognizable as assets.
6
  Damodaran (2005b) defines real options as the opportunity to engage in a future transaction or activity
relating to an existing asset (e.g., the option to expand or abandon projects).


                                                                                                            17
As we discussed in the criticisms of the current asset definition, this shifts attention from
the present resource to the future and leads to a confusion of definition with
measurement.


The second weakness with the proposed definition is that the economic component of the
definition precedes the proprietary component. In this construction, the proprietary
component is weakened and is likely to be assumed to be satisfied whenever the future
net cash inflows associated with a resource will flow to the entity. This shifts the focus
from the right to the resource to the right to the potential future economic benefits (i.e.
cash inflows). In our opinion, this feature of the proposed definition renders it inoperable
because it has no boundaries; “anything” or “everything” that may produce cash inflows
either real or imagined may qualify as an asset in this definition. In addition, including
rights in the form of unconditional promises within the term “economic resources”
muddles the whole concept of assets.


Alternative Definition
As an alternative, we suggest the following definition: An asset of an entity is the present
right to the services (or uses) of an existing economic resource7. This definition is simple
and straightforward, and emphasizes what we think are the essential characteristics of

assets. First of all, they are rights to something. In our definition the term “rights”
includes all legally enforceable rights, both statutory and contractual or those that are
enforceable through social custom or common law. A right conveys the privilege of
using an economic resource and the ability to prevent others from using it. We avoid the
terms “control” or “access by other means” because they cast a wider net that brings into
the category of assets things we think do not belong.

7
 This definition is essentially the same as the one proposed by Samuelson (1996) and with respect to the
emphasis on rights is similar to the one adopted by the Accounting Standards Board of the United Kingdom
prior to its adoption of IFRS. The ASB definition is quoted in IASB Agenda Paper 16C.


                                                                                                     18
Secondly, economic resources are scarce things that are useful in production or
consumption activities. Because rights to resources can be distributed among multiple
owners, we include the notion of services, or uses, in the definition. Services refer to the
technical, non-financial benefits yielded by economic resources. A building is capable of
producing the technical services of “shelter” and the financial benefits of “rents.” In this
case, if we refer to resources in terms of services, we are referring to the building’s ability
to provide shelter. The term “uses” can be used interchangeably with “services” and also
refers to the benefits obtainable from a resource. The term services (or uses) helps to
clarify the nature of assets such as leaseholds and prepaid expenses, which represent only
partial rights to underlying resources. An economic resource can also be viewed as a
bundle of services.


To evaluate this definition we think it is helpful to apply it first to the simplest social
environments before applying it to a more realistic, complex environment. Therefore we
start with a Robinson Crusoe scenario (no exchange), advance to a barter exchange
economy (exchange but no money), and then consider a complex economy (with
exchange and money).



Robinson Crusoe
For Robinson Crusoe, the resources of his island are its forests, meadows, and streams,
and all the products produced there, such as fruit, game, and fish. Why are these
considered “resources”? Because they have “utility8,” i.e., they are potentially useful to
him. Forests, meadows, and streams, can be called “productive resources” because they
have the capacity of producing things that he wants to consume. Fruits, game, and fish


8
 We use the term “utility” here in a general sense as something that is “useful.” The main point is that
utility should not be confused with value.


                                                                                                           19
have “utility” in the sense that they have the capacity to provide “enjoyment” to Crusoe
when he consumes them. We might say that the resources have “value” but only in the
sense of “subjective value” (the potential benefit derived from their use). They have no
“exchange value” since there is no one to exchange them with. Subjective value is
unique to an individual (Robinson Crusoe) and is psychic in nature. We like the word
“utility” in describing resources because utility can be viewed as residing in the resource
itself rather than in the mind of a potential user.


The term “assets” is a redundant in this environment. However, we could think of
“assets” in the possessive sense, as all of the resources that Robinson Crusoe possesses.
Since there is no one else on the island, he possesses exclusive rights to all of the
resources of the island, and they are all his assets. In this limited case, assets are simply
economic resources.


Barter Exchange
Suppose that a couple arrives on the island. The resources of the island must now be
shared among three people (or two households). A natural outcome would be that
Robinson Crusoe would enter into contracts with the couple to agree on how the
resources of the island should be shared among them. The contracts might provide

exclusive control over specific resources (e.g., all forests on the eastern half of the island
to Crusoe, all forests on the western half to the new couple), or it might provide that each
household has an equal share of the island’s output of fruit, game, and fish.


At this point, it is necessary to distinguish “assets” from “resources.” Robinson Crusoe’s
ability to use the resources of the island is now limited. If the contracts specify an equal
sharing of all resources, his “assets” represent a 50% interest in all of the resources of the
island. The assets are not the economic resources per se, but the limited rights to use the


                                                                                            20
resources of the island. The resources can still be defined as all things on the island that
are useful to its inhabitants, but the assets of each inhabitant are the restricted rights to
use those resources. The resources now have “exchange value” because it is conceivable
that they could be exchanged (e.g., Robinson Crusoe may exchange two fish for ten
bananas). A balance sheet could now be drawn up for each household, and each asset
could be measured by its exchange value (e.g., using bananas as the medium of
exchange). However, the exchange value is not an essential characteristic of the assets
nor the resources. It is merely a convenient way of expressing their equivalence.


The contractual arrangements made between Robinson Crusoe and the inhabitants
represent the exchanges of promises. Suppose that Crusoe agrees to supply X number of
game to the couple during the next year in exchange for their promise to supply Y
number of fish to Crusoe. These promises do not add any new resources to the island.
They may be viewed as adding new assets however. Crusoe now has the conditional
right to receive Y number of fish, the right being represented by the promise.9
Underlying that promise are the human resources represented by the couple. If Crusoe
delivers some game to the couple, the contract becomes partially executed. His asset (the
unconditional right to receive Y number of fish) remains, but his liability (to provide X
number of game) is decreased. His net worth increases, but the resources of the island

remain the same.


Money Economy
Generations later, the population of the island has grown significantly. The inhabitants
form a government that has authority to enforce contracts and issue money to facilitate
exchange. It is now possible to express all exchanges and assets in terms of money.


9
  This right is conditional on the performance under the contract of the new couple. Whether conditional
rights should be recorded as assets is a question of recognition and display, not definition.


                                                                                                           21
Although most assets have “exchange value,” there may be legal restrictions on the
ability to sell certain assets, and the exchange value of some assets may be difficult to
determine. However, consistent with classical measurement theory, the monetary values
assigned to objects are merely numerical representations of some attribute of the
underlying asset. As measurement attributes, exchange values and/or their related cash
flows are related to the measurement of assets and not to their definition.


Summary
The above examples demonstrate that assets and resources exist and can be defined even
when there is no money. A definition of assets that deals with their fundamental essence
should be free from any references to exchange value or money. We think that the one
term that captures the essence of economic resources is “utility,” and the one term that
captures the essence of assets is “property right.” Resources possess “utility” if they can
be consumed or if they can be used to produce other things. As the Robinson Crusoe
case illustrates, exchangeability is not a defining characteristic of an economic resource.
There needs to be a clear distinction between economic resources and rights to those
resources if the definition of assets is to have operational meaning. To Robinson Crusoe,
a fish itself is an economic resource, not a “property right.” The right to eat the fish is his
property or his asset (Fisher 1906, 23). The term “economic resource” is broader than the

term “property rights.” Economic resources relate to the welfare of the society as a
whole, whereas property rights identify the resources or assets of a particular entity
(Fisher 1906, 38). Therefore, the right to use an economic resource should be
emphasized in the definition by stating it first, and economic resources should be defined
in terms of the technical non-financial benefits they produce.


Application of the Alternative Definition
The alternative definition provides three criteria for determining whether something is or


                                                                                            22
is not an asset. The first criterion is that the entity must posses a “present right.” The
second criterion is that this “right” must provide access to the “services or uses” of
“something.” The third criterion is that the “something” from which the services are
derived must be an “existing economic resource” (Fisher 1906, 24). If all three criteria
are satisfied, then the item meets the definition of an asset.


The application of these criteria to the examples discussed in a previous section of this
paper is summarized in the following table:


Item                Right                Service or use        Economic             Asset:
                                                               Resource            Yes or No
Accounts            Claim to cash        Receipt of cash       The customer          Yes
Receivable
Prepaid wages       Right to future      The services of the   The individual        Yes
                    services             individual
Leasehold of a      Right to use space   Shelter               The building          Yes
building            in a building
Plant & Equipment   Ownership            Use of the item       The tangible item     Yes
Goodwill            No right is          NA                    NA                     No
                    established



In the first four cases, we can identify a present right to the services or uses of an existing
economic resource. Therefore, these items qualify as assets under our alternative
definition. On the other hand, we cannot identify a present right of the entity to the
potential benefits that are often characterized as goodwill. Thus, goodwill does not
qualify as an asset under our alternative definition.


In applying our definition, we always attempt to identify an existing resource before we
accept something as being an asset. In the case of goodwill, there are by definition no
identifiable resources. Sometimes, what is thought of as goodwill is an attribute of some


                                                                                               23
other resource. Loyal customers and a good reputation, for example, may increase the
value of a business, but customer loyalty and a good reputation are not resources. They
are attributes of other resources, namely the customers who are loyal and the employees
of the business who have a history of providing quality products and services.


If the attributes of resources are counted as assets separately from the resources
themselves, there may be a double counting of assets. For example, assume that a firm
owns some land. The land may have several desirable qualities or attributes. It could be
well located, perhaps with access to the sea. The property might also be suitable for
development. However, these qualities are attributes of the land; they do not represent
separate resources. The land itself, with its list of attributes, is the resource. The
attributes of the land affect its value, but they are not separate resources. If we value the
land as one thing and its attributes as another, we would be double counting. Coca Cola
acquired many valuable resources in its acquisition of Glaceau (e.g., brand-name, plant &
equipment, etc.), which are used to produce and sell Vitamin Water. These resources
along with existing resources of Coca Cola make it possible for the firm to exploit the
opportunity to increase future sales of Vitamin Water. However, the opportunity is not a
separate resource; instead, it effects the value-in-use of the existing resources of the
combined firm.



In our definition we propose that the concept of rights be limited to rights that are
enforceable by statutory, contractual or common law (social custom). Furthermore, the
right should not only convey the privilege of using an existing resource but it should
prevent others from using the same resource as well. Thus customers and employees are
not assets of a business, because the business cannot prevent others from using those
same resources (unless they are under contract with the business). This contrasts sharply
with the FASB/IASB proposed definition in which “established customer relationships”


                                                                                           24
and an “assembled workforce” apparently qualify as assets (Agenda Paper 16B).


In the case of physical resources, such as inventory or property, plant and equipment,
possession of the resource is ordinarily sufficient to prevent others from using it. In the
case of some intangible resources, however, it may be difficult if not impossible to
prevent others from using the resource. A good design for a product can be copied once
the product is released or an unpatented formula may be discovered and used by someone
else. Even if a business is successful in keeping the design or the formula secret, we do
not think that an asset should be recognized. Once the idea is patented or copyrighted,
however, there is a substantial change in circumstances that warrants recognition of an
asset. The business now has the ability to prevent others from using the idea. Thus
intangible resources such as patents and copyrights are assets under our definition.


We recognize that the choice of an asset definition is not simply a matter of logic or
theoretical speculation. There are policy implications for any definition of assets. If the
assets are defined too broadly, assets may be recognized and reported on financial
statements that do not represents real things in the real world. On the other hand, if assets
are defined too narrowly, important economic phenomena may be excluded from the
balance sheet. In our opinion, the FASB/IASB proposed definition of assets includes too

much within the term. This results from defining rights and resources too broadly, as
discussed in this paper. Our preference would be to define assets more narrowly. We
think that narrowing the types of things that qualify as assets by definition is the
preferable choice in a principles-based accounting system.


If economic resources and rights were defined more narrowly, a greater portion of the
value of a business enterprise would be attributable to its goodwill. For us, goodwill is
not an asset (by definition); it is part of the value of the net assets viewed collectively. Its


                                                                                             25
treatment in the financial statements is an issue of measurement and display, not an issue
of definition. Under the FASB/IASB proposed definition of assets, goodwill is an asset.
It follows, then, that it should be recognized for all enterprises whose value taken as a
whole exceeds the value of its identifiable net assets. We question whether this would
provide relevant and reliable information to users.


By recognizing only assets that are enforceable rights to underlying resources, we think
that the objectives of financial reporting will be more adequately met than they would be
using the broadly inclusive definition proposed by FASB/IASB. Enforceable rights are
grounded in law and are inherently more verifiable than resources defined in terms of
potential cash flows. They also correspond more closely to the commonly understood
meaning of the term asset. In this sense they provide a more faithful representation of the
underlying concept of an asset. Therefore, we think that our definition is more suitable
for a principles-based system of financial reporting.


Conclusion
In a Conceptual Framework based on the asset / liability view, the definition of assets is
key. The asset definition in the asset / liability view is corollary to the matching principle
in the revenue / expense view. The revenue / expense view of accounting was abandoned

because of the subjectivity of determining when and how expenses matched to revenue
(SEC 2003). We don’t want this same subjectivity to weaken the asset / liability view;
therefore, if the asset / liability view is to fulfill its promise of providing a solid
foundation for the development of principle-based reporting standards, the definition of
assets needs to be operational. A definition of assets that is overly subjective and open to
interpretation will lead to selective identification of assets and result in ad hoc
recognition rules. These outcomes will likely impede the development of principles-
based accounting standards and may undermine confidence in financial reporting.


                                                                                            26
Although the asset definition proposed by the FASB/IASB is an improvement upon the
current FASB definition, it is uncertain that in application it will be any more useful.
Thus, we propose that assets be defined as the present right to the services (or uses) of an
existing economic resource. Furthermore, we suggest economic resources be defined in
terms of their utility or technical services as opposed to whether they are capable of
producing future net cash inflows to the entity. We believe defining assets in this manner
results in a definition that satisfies Fisher’s two criteria of a good definition. First,
placing emphasis on “rights” would make the definition more operational because rights
are founded in law. Second, defining economic resources, which underlie all assets, in
terms of their utility disentangles the definition of assets with their measurement and
harmonizes the term with common usage. Thus, we suggest the Boards consider
adopting the alternative asset definition proposed in this paper for the revised Conceptual
Framework.




                                                                                            27
References
Damodaran, A. 2005(a). The Value of Synergy. Working Paper, New York University.
      Available at: http://pages.stern.nyu.edu/~adamodar/.

_________. 2005(b). The Promise and Peril of Real Options. Working Paper, New York
      University. Available at: http://pages.stern.nyu.edu/~adamodar/.

Financial Accounting Standards Board (FASB). 1985. Elements of Financial Statements.
       Statement of Financial Accounting Concepts No. 6. Stamford, CT: FASB.
       Available at: http://www.fasb.org.

______. 2005. Revisiting the Concepts: A New Conceptual Framework Project.
      Available at: http://www.fasb.org.

______. 2007. Business Combinations. Statement of Financial Accounting Standards
      No. 141 (Revised 2007) Stamford, CT: FASB. Available at: http://www.fasb.org.

Fisher, I. 1906. The Nature of Capital and Income. New York: Reprints of Economic
        Classics, Augustus M. Kelley, Publisher.

International Accounting Standards Board (IASB). 2007a. Phase B: Elements –
        Definition of an Asset (Agenda Paper 3). Available at: http://www.iasb.org/
        NR/rdonlyres/8081445E-3717-42B2-9B5E-30EF05E67B52/0/CF0611b03obs.pdf

_____. 2007b. Phase B: Elements and Recognition – Asset Definition Cover Note
       (Agenda Paper 16A). Available at: http://www.iasb.org/NR/rdonlyres/
       47C474EE-CF84-4264-9D0A-D410BD72DE3B/0/CF0710b16aobs.pdf

_____. 2007c. Phase B: Elements and Recognition – Asset Definition Examples
      (Agenda Paper 16B). Available at: http://www.iasb.org/NR/rdonlyres/67630968-
      6F4D-4FF1-AA12-EFFE5C367589/0/CF0710b16bobs.pdf

_____. 2007d. Phase B: Elements and Recognition – Asset Definition Converging and
      Improving the Definition (Agenda Paper 16C). Available at: http://www.iasb.org/
      NR/rdonlyres/94544F19-D1F3-44EC-81F7-E434FD8599E7/0/CF0710b16
      cobs.pdf

_____. 2007e. Phase C: Measurement Concepts and Principles Elements (Agenda Paper
      2B). Available at: http://www.iasb.org/NR/rdonlyres/E14BE7C2-0B08-4BA1-
      B80D-542C0334B042/0/CF0707b02bobs.pdf

Samuelson, R.A. 1996. The Concept of Assets in Accounting Theory. Accounting
      Horizons 10 (September): 147-157.

Schuetze, W. P. 1993. What is an Asset? Accounting Horizons 7 (September): 66-70.




                                                                                    28
Sprouse, R.T. 1966. Accounting for What-You-May-Call-Its. The Journal of
      Accountancy, (October): 45-53.

U.S. Securities and Exchange Commission (SEC). 2003. Study Pursuant to Section
       108(d) of the Sarbanes-Oxley Act of 2002 on the Adoption by the United States
       Financial Reporting System of a Principles-Based Accounting System.
       Washington D.C.: SEC. Available at: http://www.sec.gov/news/studies/
       principlesbasedstand.htm

Watts, R. L. 2003. Conservatism in Accounting Part I: Explanations and Implications.
Accounting Horizons 17 (September): 207-221.




                                                                                       29

				
DOCUMENT INFO
Shared By:
Categories:
Tags:
Stats:
views:537
posted:1/18/2011
language:English
pages:29
Description: Defining Assets a Proposal for the Conceptual Framework document sample