Table Of ContentCENTRAL LIBRARY
REDISCOVERING
THE BALANCE SHEET
A Corporate Financial Reporting Theory Perspective
Arun Kumar Basu
Reader
Department of Commerce
Special Assistance Programme (UGC)
Department of Commerce
UNIVERSITY OF CALCUTTA
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To tin* memory vj my t'other
Lulc Bihlmli tthusiin Hnsu
(Q 2003 » Department of Commerce, University of Calcutla
Senale House, Kolhala 700073
'SCO 3307
Published : February, 2003
3 v 5a
Price : Rs. 250
Pnnted m India by Sn A K. Ba$u. DSA in Commerce* University of
Calcutta, at A/anta Printers, 78. Sitaram Ghosti Street. Koikata-700 009
ana published by him on be bait of the University of Calcutta
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Preface
This book is an exercise in corporate financial reporting theory,
ft is about the rediscovery ol the balance sheet. To be more specific,
the book is about the rediscovery of the balance sheet theory of
accounting. It is about why and how the rediscovery is taking place
and how that phenomenon is changing the way financial reporting
information is generated. Corporate Financial reporting theory is a
subset of general accounting theory with the former existing at a fower
level of generalization than the latter. The mam function of this theory
is to set Out the system ot abstract reasoning that should underlie
the preparation and presentation of corporate financial statements.
Ore of the cenlral premises of the book is that high quality corporate
financial reporting ^ of fundamental economic importance in a market-
driven economy and thai, achieving this, requires a firm commitment
to solid theoretical foundations. The balance sheet theory of
accounting is founded on the notion that the balance sheet is the
dominant financial statement and others are subordinate to it.
The balance sheet reigned supreme until the first quarter ol the
twentieth century. Prior to the 1930s the profit and loss account was
of minor significance. In the 1930s the profit and loss accounl rose
to prominence, thereby displacing the balance sheet in importance
Since then it has dominated financial reporting theory and practice.
It is this dominance that is now being called into question. Efforts are
being made to shift the focus of attention from the profit and loss
account to the balance sheet. Accounting standard-setting bodies
around the world have already started promoting the balance sheet
as the foundation ol their pronouncements. They have developed their
conceptual frameworks based upon the notion of the primacy of the
balance sheet. Assets and liabilities constitute the building blocks of
these frameworks. Accounting standard-setting is now being driven
by the diclates of these conceptual frameworks. Thus, the balance
sheet is making a comeback; it is conning once again to take the
centre-stage in corporate financial accounting and reporting
The prolit and loss account approach focuses on revenues and
expenses and it is governed by the definitions of those two elements.
Under this approach, profit is computed by periodic matching of
revenues and expenses. It is this matching process which determines
the figures to be put on the balance sheet Thus* the baFance sheet
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becomes, to ail intent and purposes, subservient to the profit and loss
account. The profit and loss account approach has so far failed to
deliver a rigorous basis lor addressrng conflicting and complex
financial accounting and reporting issues. II has so far failed to provide
a coherent and consistent basis for defining the elements of financial
statements. Revenues and expenses are nebulous concepts; they
have no real worid referenl. With such nebulous concepts it is difficult
to come up with a theoretical framework on which the architecture
of sound accounting practice can be constructed.
The balance sheet approach offers a different perspective. Under
this approach, the parameters of income or profit are defined in terms
of the parameters of wealth. In the balance sheet driven system, the
key financial statement elements are assets and liabilities. The
definitions of these two elements are crilical because the definitions
of the components of profit are derived from them. Profit under the
balance sheet approach is defined in terms of changes in net assets
(ie, assets less liabilities). The balance sheet approach does not allow
the matching notion to justify Ihe deferring of costs that do not involve
future economic benefits. The asset-liability view is underpinned by
economic theory, it adopts a capital maintenance approach to profit
Suggested by economists. According to this approach, protit results
only after capital has been maintained That is. asset growth is the
essence of profit. Since assets and liabilities are real world objects,
they are capable of providing a basis for considering all aspects of
generation of financial reporting information integrafively.
The balance sheet view has demonstrated its usefulness and
merits. It has helped place corporate financial reporting theory on a
sounder footing. It has helped deliver new visions and new ways of
looking at things. Already, the balance sheet view has brought aboul
significant changes in the way corporate financial reporting rules are
formulated and corporate financial reporting information is generated.
The visibility of assets and liabilities has increased, and many out-
of-date accounting practices have been eliminated. Value-based
accounting has replaced cosi-based accounting in many areas of
generation of financial reporting information. The roleol matching has
been restricted and this has significantly curtailed the scope of
manipulation of profil. But the balance sheet model still has many
difficult questions to answer and many difficult problems to solve Et
has to develop appropriate contexts necessary for addressing
explosive issues of accounting for knowledge-based intangibles,
innovative Imancial instruments, share-based payments and executory
contracts.
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The book is based on a research I have conducted under the
Special Assistance Programme (UGC) of the Department of Com
merce, University of Calcutta, I am graiefu! to the authority tor allowing
me to work on this highly conceptual topic and assuming the entire
financial burden of the project. Numerous people have been very
helpful, to whom I am deeply grateful. My gratilude goes first and
foremost to Professor Bhabatosh Banerjee, co ordinator of the DBA
Programme, who in numerous capacities has provided valuable
support. My colleagues in the Department have provided much
appreciated support and challenge to my thinking Some of them have
been very helpful in developing the conient and ideas that are at the
heart ot the study, t would like to lhank them all,
I have had the valuable opportunity of refining my ideas by
presenting sections of my work at seminars and conferences and I
am grateful to the participants at those seminars and conferences for
their valuable commenfs. t afso acknowledge my debt to Dr Sarmistha
Banerjee {Department of Business Management, University of
Calcutta), Ms Tanupa Chakraborty {Department of Commerce,
University of Calcutta), Dr, Debasis Bagchi (B. E_ College, Howrah)
and Sri Radhanath Pyne {S, A. Jaipuria College, Kolkata) for reading
and advising on the manuscript.
1 would like to express my deep gratitude to the two official
reviewers. Professor Asish Kumar Bhattacharyya (Indian Institute of
Management Calcutta) and Prolessor Shirin Rathore (University of
Delhi South Campus) for vafuabfe comments and suggestions. But the
responsibility for what has emerged is mine.
My special thanks go to Mte Ajanta Primers tor completing the
printing job within a very short time. Finally, I wish to record my thanks
to my wife Krishna, whose continuous inspiration and support were
essential to my undertaking and completing the project. Also my
appreciation lo my nephew Master Antra Basu for his quietness and
palience during Ihe time I was working on Ihe preparation of the project
report.
A, K. Basu
2S February 2003 Department of Commerce
University of Calcutta
M
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Contents
Pages
Chapter 1
Introduction and Background 1-30
Chapter 2
The Matching Principle and Its Shortcomings 31-54
Chapter 3
The Balance Sheet Model of Accounbng S5-91
Chapter 4
Recognition and Measurement ot Assets and
Liabilities 92-119
Chapter 5
Application of ihe Balance Sheet Model ot
Accounting : Some Evidence 120-144
Chapter 6
Recognition and Measurement of Intangible Assets 145-176
Chapter 7
Putting Off Balance Sheet Assets and
Liabilities on the Balance Sheet 177-209
Chapter 8
Recapitulation and Conclusion 210-219
Notes and Bibliography 220-237
238-240
index
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CHAPTER ONE
Introduction and Background
The issue as to whether corporate financial reporting should have
a balance sheet or a profit and loss account orientation has long been
discussed and debated This debate regarding the primacy of the
balance sheet or the profit and loss account has stemmed from
another long-standing and deep-rooted conceptual debate as to
whether the computation of accounting profit in income1 should be
dependent upon the computation of capital or. conversely, whether the
computation of capilal should be driven by Ihe compulation of profit.
Under the former approach, profit is computed based on how capital
is computed; while under the latter approach capital is computed
based on how prolrt is computed- These two alternative approaches
to ihe measurement of prolit and capital are referred to in financial
reporting literature as the asset-Uabiiity approach and the revenue-
expense approach, respectively. When financial results are computed
based on ihe asset-liability approach, Ihe balance sheet becomes the
dominant financial statement. In this scheme, the values in the profit
and loss account are determined by the balance sheet* But when profit
computation is based on the revenue-expense approach, the profit and
toss account becomes the centre of interest and the balance sheet
is relegated to a position of secondary importance. In this system,
Ihe balance sheet emerges as a by-producl of the process of profit
measurement. The real implications of Ihe two alternative approaches
for the generation of corporate financial reporting information may not
be readily apparent to those who are nol fully conversant wilh the
intricacies of operation of the corporate financial accounting and
reporting system, Bui to those possessing expert knowledge in the
subjecl Ihe two approaches represent completely different ways of
thinking about accounting issues The difference that exists between
the two approaches is indeed a fundamental difference which lies at
Ihe very heart of corporate financial accounting and reporting, II alfects
the way that the elements ol the basic financial statements are defined
and the way specific linancial reporting issues are addressed. In Ihe
asset-liability onented system the focus is on the elements ol The
balance sheet, which are defined independently ot the etements ol
the proht and loss account. Since the profit and loss account is
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2 Rediscovering the Balance Sheet
subordinate to the balance sheet. Ihe elements ol Ihe former are
determined by the elements ol the latter. The revenue-expense
approach offers a different perspective. It places primacy on
revenues and expenses; the elements of the balance sheet are
derived as a by-product of the elements of ihe profit and loss
account Mathematically, the two approaches should arrive at the
same destination. Bui that may nol happen in real practice. In
extremely simple casesf the two approaches may lead to identical
conclusions concerning the financial position and performance of Ihe
enterprise but when situalions are complex, they may give rise to
dissimilar results, For example, il Ihe entire operating cycle ot the
enterprise occurs within one accounting period, both approaches will
yield the same recording of prolit and capital. Bui if that does not
happen, that is, if the operating cycle of the enterprise extends over
several accounting periods, the resells generated based on the
application of the asset-liabtlily approach may dilfer materially from
those generated based on the application of the other approach. The
main reason why this happens so is that the two approaches offer
different treatments with regard to the recognition and measurement
of incomplete performance at the end of the accounting period.
The corporate financial reporting system, as it currently exists,
is basically a profit and loss account-driven system. El is designed
!o pul emphasis on the rules of computalion of periodic profit. Under
this system, the accountanl first determines what figures he should
report on the prolit and loss account and Ihen adjusts the balance
sheet amounts accordingly Corporate financial accounting reports
are prepared according to generally accepted accounting principles
(GAAP), which represent the various rules, practices, procedures,
and methods lhat have evolved over lime in response to the need
lor regulating the generation of corporate linancial reporting informa-
lion. The major elements of the GAAP prevailing at the present time
have Ihetr origin in the idea that Ihe profit and loss account takes
the first place ol interesi in corporate linancial accounting and
reporting. The profit and loss account has dominated corporate
financial accounting and reporting for more than 70 years. The
balance sheet reigned supreme until the middle of the second
quarter ol Ihe twentieth century when it was demoted fn favour ol
the profit and loss account. With the emergence ol the matching-
attaching paradigm in Ihe 1930s Ihe profit and loss account rose
to prominence by displacing the balance sheet in importance. Since
then it has been occupying the central position of attention in the
corporate financial accounting and reporting system. But the pre-
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Introduction and Background 3
eminence of the profit and loss account is now being called
increasingly into queslion Recently there has been a resurgence of
interest in (he role of the balance sheet as the foundation of corporate
financial accounting and reporting This interest reflects dissatisfac
tion with the profit and loss account, which has failed to provide an
adequate conceptual basis for delivering a scheme of interrelated
and internally consistent ideas and concepts on the manner by which
the function of generation of corporate financial reporting information
can be understood or realized. There is now increasing awareness
that the profit and loss account approach is incapable of providing
a logical starting point for addressing the complex financial
accounting and reporting issues businesses are now being required
to tackle in a highly dynamic and rapidly changing environment.
Another downside ol the profit and loss account approach is that it
lacks a dearly defined concept ol profit Under this approach, profit
is computed according to some specified accounting rules rather
than by the application of any logically developed concept. According
to current Ihinking, if meaningful financial reporting is to lake place,
Ihe preparation and presentation of linancial statements should be
based on a solid theoretical foundation, The balance sheet approach,
it is being thought, is capable of providing a basis for the
development ol such a theoretical: foundation. This realization has
prompted many to promote measures tor bringing the balance sheet
back to lake the centre-stage in corporate linancial accounting and
reporting. The leading accounting standard-setting bodies of the world
have already recognized the pre-eminence of the balance sheet in the
conceptual frameworks they have developed m recent years with the
objective of providing a logical foundation for deriving appropriate
financial accounting and reporting standards, The balance sheet focus
is clearly evident in many of Ihe new accounting standards that these
bodies have promulgated during the recent years. It seems that a
paradigm shift in corporate financial reporting is in the offing; the
balance sheet is poised to take over from the profit and loss account.
In the prolit and loss account-driven system of corporate linancial
reporting, periodic profit is computed by looking at transactions. The
underlying premise of the system is that flows are more important than
stocks and that profit can best be measured in terms of inflows and
outflows of resources. The most important par! ot the entire sysiem
is (he principle ot matching. According to this principle, the revenues
recognized during the accounting period should be matched with the
costs incurred in generating those revenues. Profit is Ihe residue
which results from matching revenues and costs Revenues reflect
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4 Rediscovering Ihe Balance Sheet
accomplishments and costs represent efforts. Hence matching
actually involves associating efforts and accomplishments, A| first
glance, the logic seems compelling. But as the matching principle
is subjected to a deeper scrutiny, the logic begins to crumble. The
key assumption underlying the principle is I hat costs can be related
to products or periods based on some discernible positive correlation..
But that may not be a valid assumption in all cases in many cases
il becomes difficult to determine how different cost imputs contribute
to the generation of output. This is why costs are often allocated based
on some arbitrarily determined rules and procedures. In many cases
personal value judgements and preferences play a very crucial role
in determining whether a cost is applicable or inapplicable to the
revenue recognized during a given period. The matching principle
requires the balance sheet to accommodate many debit and credil
balances that lack any interpretative quality: they are simply the by
product of the process of matching revenues and expenses. Matching
has the effect of reducing the balance sheet to merely a statement
ot residuals or sheel of balances. The ability ot such a balance sheet
lo provide meaningful information as to the financial condition or health
of the enterprise cannot but be limited.
The matching approach lacks analytical rigour, il is difficult to
deduce sound accounting rules based on Ihe idea of matching
revenues and expenses. Underlying the matching approach is the
model of a business firm which seems to be very simple, simple
enough to be encapsulated within a fixed framework. II assumes lhat
the investments that are made in one period can conveniently be
matched with accomplishments in a subsequent period, This simple
model is no longer operative at the present time. Today's business
enterprises are very complex economic entities and they operate in
an environment in which everything is in a state of flux. In this
environment in which nothing is fixed enterprises are required to
constantly change their investment policies, paiterns, and strategies
in order to ensure their survival and growth. The matching approach
is unable to cope with I his new economic reality of the modern
business world.
Another weakness of the matching-based approach is that it has
a rule-making bias As new problems arise, eftoris are made to solve
those problems by formulaiing some addilional new rules. The
ultimate effect of this is the proliferation of accounting rules. As a
result, corporate linanciai reporting is eventually reduced to reporting
by rules. Moreover, since these rules are not formulated based on any
sound theory, they often lack coherence and consistency. The
