CEARNING: OBJECTIVES, After reading this chapter, you should be * Understand the underlying approaches to the linkage between the bal- | ance sheet and income statement. * Understand the evolving definitions of assets, liabilities, and owners’ equity. * Appreciate the multiplicity of asset valuation techniques. © Understand the changes occurring in the liabilities and stockholders equities areas * Comprehend hybrid securities. * Understand the nature of derivatives. * Comprehend balance sheet classification issues. he next three chapters examine the balance sheet, income statement, and cash flow statements, respectively, in order to review the conceptual foundation of current financial reporting practices. We emphasize the definitions of accounting elements and the rules of recognition and meas- urement applicable to each financial statement. It is not our intent to cover all extant accounting standards: such an approach is taken in intermediate account: ing textbooks. Rather, we wish to encourage an appreciation of the principles of accounting measurement or calculation embodied in the three basic financial statements. We commence this chapter by reviewing the relationship between the bal ance sheet and income statement. If the statements are articulated. they are linked together mathematically without any “loose ends,” then either a revenue-expense view or an assetliability view predominates. Revenue-expense means that the income statement predominates whereas an assetliability view means that the balance sheet is primary. The nonar ticulated view means that the two statements are independently defined. The chapter then examines recognition and measurement problems in the three sections of the balance sheet: assets, liabilities, and owners’ equity. We ‘will see that a great many valuation methods exist and that sometimes revenue-expense predominates and sometimes assetliability predominates. Nonarticulation is becoming scarce due to the arrival of comprehensive income (Chapter 11).As we shall see, the asetliability view is slowly beginning to predominate over 316The Balance Sheet * Chapter 10 revenue-expense. Many problems are relatively new, such as derivatives and. hybrid securities, and solutions are just beginning to emerge. The chapter concludes with a brief discussion of classification in the balance sheet. The Relationship Between the Balance Sheet and Income Statement ‘Two approaches, the articulated and the nonarticulated, have been advo- cated for defining accounting elements and the relationship between the balance sheet and income statement. Articulation means that the two state- ments are mathematically defined in such a way that net income is equal to the change in owners’ equity for a period, assuming no capital transactions or prior period adjustments. The nonarticulated approach severs the math- ematical relationship between the balance sheet and income statement: each statement is defined and measured independently of the other. Articulation The accounting elements identified in Statement of Financial Accounting Concept (SFAQ) No. 6 are assets, liabilities, owners’ equity, revenues, gains, expenses, and losses.? Income is calculated from revenues, gains, expenses, and losses. Under articulation, income is a subclassification of owners’ equity. Exhibit 10-1 illustrates the articulated accounting model and classifi- cation system. For ease of presentation, we take a proprietary approach, in which the net assets are equal to owners’ equity. Under the articulated concept, all accounting transactions can be clas- sified by the model in Exhibit 10-1. There are three subelassifications of owners’ equity: contributed capital, retained earnings, and unrealized capi- tal adjustments. Contributed capital is subclassified into legal capital (par value) and other sources of contributed capital (for example, premiums and donated assets). Retained earnings has three subclassifications: income statement accounts, prior period adjustments, and dividends.“ Because — income is subclassification of retained earnings, the income statement and balance sheet articulate. There are further subclassifications within’ the income statement itself: the distinctions between revenues anid gains ‘and expenses and losses, and the classification of gains and losses as Ordinary.or extraordinary. Some accounting transactions bypass the income statemei altogether because they are considered to be adjustments of previous years income. These adjustments are made directly to retained “earnings. Dividends represent a distribution of income. The third subélawsification of owners’ equity, unrealized capital adjustnents, arises from afew specific accounting rules. These are fast disappearing as a result of SFAGNo. 130 comprehensive income (Chapter 11). 1 FASB (19760). 2 FASB (19R5),318 Chapter 10 + The Balance Sheet Exhibit 10-1 Accounting Classification System Assets — Liabilities = Owners" Equity : [ror en Deg el Contributed Retained Unrealized_ Capital Earnings Capital ~ ot Adjustments Legal Capital Other Contributed Seen Se Capital OT Income Statement. - Prior Period Dividends Accounts Adjustments 2 Debits Credits —— — Expenses Losses Revenues Gains Ordinary Extraordinary Ordinary Extraordinary The accounting classification system is rather simple, but this simplicity causes some difficulty because complex transactions cannot always be neatly categorized into one of the classifications in Exhibit 10-1. New types of busi- ness transactions challenge the limits of the basic accounting model. For example, mandatory redeemable preferred stock, because it is stock, has definite ownership characteristics; but because it must be redeemed, it also resembles bonds. The Securities and Exchange Commission (SEC) pro- ibits its inclusion in owners’ equity. However, a case might be made for cla sification as owners’ equity. Such complex transactions go beyond the limits of the accounting classification system. Even so, it is remarkable that the cat- egoric framework used to classify accounting transactions is virtually unchanged since Pacioli’s time. It may’ be that supplemental disclosure is the only way to deal with newer complexities—short of developing an entirely new accounting classification svstem, Within the articulated system, there are two alternatives for defining accounting elements. One approach, called revenue-expense, focuses on defin- ing the income statement elements. It places primacy on the income state- ment, principles of income recognition, and rules of income measurement. Assets and Liabilities are defined, recognized, and measured as a by-product of revenues and expenses. The other approach is called asset-iabiliy. Itis the antithesis of the revenue-expense approach because it emphasizes the defi- nition, recognition; and-measurement-of assets and liabilities. Income is— defined, recognized, and measured as a by-product of asset and liability measurement,Tne Balance S: eet + Chapter 10 319, Revenue-Expense Approach’ a - Since the 1980s, accounting policy has been mainly concerned with the def. inition, recognition, and measurement of income. Income is derived by matching costs (including arbitrary allocations such as depreciation) to recognized revenues. Both the income statement and balance sheet are pri- marily governed by accounting rules of revenue recognition and cost match- ing, and these rules represent a revenue-expense orientation. One consequence of the revenue-expense approach is to burden the balance sheet with by-products of income measurement rules, As a result, the balance sheet contains not only assets and liabilities (defined later in this chapter), but also ambiguous debits and credits called deferred charges and deferred credits. These items do not conform to current definitions of assets and liabilities, yet are included in the balance sheet because of deferred recognition in the income statement. An example of a deferred charge is organizational startup costs. These costs are allocated to the income statement over a number of years rather than expensed immedi- ately. Once incurred, organizational costs are a sunk cost and cannot be recovered, Therefore, it is questionable if such costs should be carried for- ward in the balance sheet. The same is true of some deferred credits, Many of these types of credit balances are not really liabilities; they are simply future income statement credits arising from present transactions that are deferred to future income statements. An example of this type of deferred credit—now largely gone—is the investment tax credit accounted for under the deferral method per Accounting Principles Board (APB) Opinion No. 2 Deferred investment tax credits are not a legal liability; rather, they simply arise from a difference between how the tax credits are treated in the firm's tax return and financial statements. There are many examples of accounting standards that emphasize the effects of transactions on the income statement somewhat to the exclusion of their impact on the balance sheet. For example, pension accounting under APB Opinion No, 8 was mainly concerned with income ‘statement recognition of pension expenses.* Virtually no consideration was given to the question of whether a pension liability exists. The recognition and amor- Uzation of intangible assets under APB Opinion No. 17 introduces a dubious debit into the balance sheet (arising from the purchase method of account. ing for business combinations) and arbitrarily amortizes it over a maximum of 40 years." The question of whether an intangible asset (goodwill) really exists is not addressed. Asset-Liability Approach a The assetliability approach is directly concerned with measuring and Feporting assets and liabilities. In SFAC No. 6, the Financial Accounting 3 APB (1 This has, of course, been superseded by SEAS No. 87, which does take the balance sheet into consideration 4 APB (970