Classification

Framework-based teaching

I use framework based teaching to help students to develop a conceptual and principles-based understanding of financial reporting. Framework based teaching is explained in more detail in this article by Mike Wells [1]. In essence it means using the principles in the Conceptual Framework for Financial Reporting [2] to help students develop a coherent understanding.

Introduction

When deciding how to report an event in financial statements, the starting point is to identify whether or not the event changes the financial position of the entity. In other words, does this event give rise to new or changed assets and/or liabilities? (See our posts on teaching the elements of financial statements – like this one about assets). If so, then a whole sequence of questions follows along the lines of how the impact of that event should be reported and measured and what information should be presented.

Information

After identifying a potential asset or liability the next stage is to classify it so that we can decide how best to report it in the financial statements. One way that financial statements convey meaningful information about the financial effects of transactions and events is by grouping the elements of financial statements into classes, based on their nature or function.

I explain to students that when a business is trying to convey information to its investors, information about the nature of the economic resources and obligations that the entity has can help users of the financial statements to better understand the entity’s financial position and financial performance.

Different types of resources or assets exhibit different characteristics and can be held for a variety of uses in order to generate future economic benefits. The nature and use of an entity’s assets determine the classification of those assets. Therefore different types of assets will have different effects upon an investor’s assessment of the entity’s prospects for generating returns.

Using assets and settling liabilities

Different assets have different characteristics – some are tangible (like land and buildings), some are intangible (like brands), some are very liquid (like cash). Investors and lenders are likely to place different values on different types of assets, knowing, for example, that cash in the bank is more useable in the short term than unsold inventory. 

Some future cash flows will result directly from existing resources (eg selling inventory, collecting accounts receivable). Other cash flows result from using several resources in combination with each other to produce and sell goods or services to customers (for example, combining machinery (property plant and equipment (PPE)) and brands (intangible assets) in the production and sale of branded products).  Although those cash flows cannot be identified with individual economic resources, users of financial reports need to know the nature and amount of the resources available for use in an entity’s operations, and how they are used with each other. 

While some assets, such as cash and receivables, are highly liquid, some other assets, such as specialist equipment, might in fact be almost useless outside of the context of the current business operations. Therefore a lender looking for security for a loan may decide to undervalue assets that cannot be readily sold or put to a different use.

On the other side of the balance sheet, a liability may be financial, for example a loan, or non-financial, for example a performance obligation in the context of a contract with a customer.  Those two different liabilities will be settled in different ways, and financial statements should reflect that difference in order to provide more useful information.

Standards

Individual standards deal with different classes of assets and liabilities, reflecting the differences in the nature and use of those different assets and liabilities. So it is only when we have classified our asset or liability that we can determine which rules apply. For example investment property is usually measured at fair value, since that reflects how economic benefits will be obtained; whereas PPE requires an accounting policy choice as to whether it should be measured at cost or fair value, depending on how and when the preparer of financial statements expects economic benefits to be obtained.

Perspective and professional judgement

Perspective is always key to financial reporting. Accounts tell a story, from the perspective of the person whose story it is. The financial statements of an entity reflects that entity’s use of its resources, irrespective of how another entity might use the same resources.

Professional judgement is sometimes needed to classify assets and liabilities. Hence why I use framework based teaching so much; it requires students to develop their professional judgement in analysing events and transactions before deciding how to report them. For example, I ask the question ‘How should a demonstration car used by a car dealer be classified?’ As PPE, presumably? But should that classification change to inventory if the dealer then decides to sell that car? What if the intention to sell the car was always there?

Another example that I use to illustrate classification and perspective is to ask students what a postage stamp represents? From the perspective of the mail company, a postage stamp represents a liability, a performance obligation. From the perspective of the retailer it’s inventory. From the perspective of the person buying the postage stamp it’s a simple prepayment. But all this assumes that it is going to be used… otherwise it might be an investment.

This sort of discussion can also make the point that classification systems, while powerful, also have their limitations. When accounting students understand that classification of assets and liabilities is an important step towards deciding how to report events, then they appreciate the importance of professional judgement in accounting.

[1] Wells, M. J. C. (2011), Framework-based Approach to Teaching Principle-based Accounting Standards, Accounting Education, Avaliable at: https://doi.org/10.1080/09639284.2011.569128 Accessed 26 January 2022

[2] IFRS Foundation (2018), Conceptual Framework for Financial Reporting. Available at: https://www.ifrs.org/issued-standards/list-of-standards/conceptual-framework/. Accessed 26 January 2022