How would a decrease in net assets arising from a peripheral or incidental transaction be classified?

 – February 3, 2022

The Financial Accounting Standards Board (FASB) issued a revised statement in December that simplifies definitions used in financial reporting — Statement of Financial Accounting Concepts Statement No. 8, (CON 8), chapter 4, “Elements of Financial Statements,” which supersedes Concepts Statement No. 6 (CON 6), “Elements of Financial Statements.” FASB’s objective was to eliminate much of the terminology that created difficulties in applying and understanding the prior elements. With few exceptions, the Board stated that the impact of the statement is not expected to significantly change the population of assets and liabilities or modify the classification of revenues, gains, expenses and losses. Nonetheless, a careful analysis of 36 comment letters responding to FASB’s Exposure Draft since July 2020 seem to indicate that the revised concepts statement could result in changes in the population of assets and liabilities as well as impact the classification of items on the income statement.

Analysis of the Revised Elements

Here is a comparison of the asset and liability definitions included in the revised chapter 4 and CON 6:

Exhibit 1: Comparison of the Definitions of Assets and Liabilities

Definition of Assets

As noted in Exhibit 1, the revised definition of assets eliminates the term “control” and the need for a “past transaction or event.” However, the new asset definition includes the notion of a “present right.” Examining the comment letters specifically mentioning the implications of each of these changes, we first note many respondents agreed that the term “control” should be maintained. Of the respondents who addressed the notion of control, 82 percent believe that that it is crucial to the definition. Some of the comments indicated that the term “control” is used extensively in many accounting standards, most notably ASC 606 and ASC 842, and its elimination creates a possible inconsistency with current practice. Others noted that “control” continues to be included in the IFRS Conceptual Framework, and its exclusion by FASB in the statement creates another lack of convergence with IASB standards. Many respondents objected to the fact that the Board first eliminated the specific use of the term “control” from the formal definition but then went on to add supplemental paragraphs and they used the basis for conclusions to explain why and how control is interrelated to the definition of an asset, and therefore, suggested that control is important. This inconsistency was seen as confusing and contradicts the Board’s objective to simplify the concepts statement.

By eliminating a “past transaction or event,” several respondents raised the possibility that internally generated intangible assets could be recognized because they will generate future economic benefits, and possibly proprietary rights to those benefits. That is, the capitalization of internally generated intangible assets may be justified in a manner similar to rationale used to capitalize internal software development costs and intellectual property. Perhaps, proprietary processes may eventually be considered assets under the revised definition.

Finally, many respondents noted that the Board was not clear as to what is meant by a “present right” and if that right can exist prior to performance. There were several questions raised by respondents. The ambiguity surrounding these questions prompted 83 percent of respondents to request that additional clarification be added to the recognition of intangibles. Some questions raised include the following:

• Does an enforceable contract create a “present right?”
• Is performance needed prior to asset recognition and, if so, are assets related to variable consideration no longer assets?
• Can assets exist prior to performance (e.g., assets recognized from executory contracts)?

In addition, many respondents specifically raised concerns regarding the new definition’s effect on future reporting of research and development costs.

Definition of Liabilities

As seen in Exhibit 1 and like the revised asset definition, the new statement changes the definition of a liability by eliminating the term “probable” and removing the need for a “past transaction or event.” More than half of the respondents maintain that the revised definition of liability is inadequate, specifically as it relates to the removal of these terms. The Board specifically notes that additional liabilities will be created for obligations to transfer a variable number of an entity’s own shares. While 82 percent of respondents that directly addressed the revised change agreed with the sentiment, more than half of all responses included a request for clarification regarding the treatment obligations to transfer a fixed number of shares.

By eliminating the need for a past transaction or event, a binding performance contract,

such as a take or pay contract, could be recognized as a liability. The elimination of the need for the future transfer of economic benefits to be “probable” could expand the population of liabilities (e.g., executory contracts) and may create an inconsistency with ASC 606 recognition of variable consideration and constraining estimates. Finally, the obligation to issue a variable number of shares that maintains a fixed value for a shareholder (e.g., contingent consideration in an M&A deal) meets the revised definition of a liability. However, respondents believed that the Board is not clear as to why issuing a fixed number of shares is also not considered a liability if they are also classified as “share settled instruments.” All the uncertainty surrounding the above-mentioned matters is reflected by the 56 percent of respondents who deemed the revised definition of liability inadequate.

Revenue and expense definitions included in the revised chapter 4 and CON 6 are compared in Exhibit 2.

Exhibit 2: Comparison of the Definitions of Revenues and Expenses

Revenues and Expenses

The exposure draft indicated that distinguishing revenues and expenses from gains and losses is a “matter of presentation” versus “essential to the elements.” An overwhelming 81 percent of respondents disagreed with this concept by noting that revenues and expenses are of a fundamentally different character from gains and losses. Blurring these distinctions could create confusion among practitioners, particularly because stakeholders often employ these definitions to guide practice. Lack of clarity could also result in misclassifications, particularly with the phrase “other activities” maintained while the definition of revenues and expenses removed the phrase “ongoing major or central operations.” These comments relate to the revised definitions of gains and losses as well.

Exhibit 3 presents a comparison of the gains and loss definitions included in the revised chapter 4 and CON 6.

Exhibit 3: Comparison of the Definitions of Gains and Losses

Gains and Losses

Regarding gains and losses, the revised definitions presented in Exhibit 3 remove the need for the transaction to be “peripheral or incidental.” The elimination of this phrase is a significant change in what would meet these definitions. Eighty-five percent of the responses objected to the removal of the previous, clearer distinctions and claimed that the revised definitions would likely result in misclassifying gains as revenues, etc. Another issue is the continued use of a residual approach: comprehensive income includes all transactions except contributions by owners and distributions to owners. Using a residual approach to distinguish revenues from gains and expenses from losses may not be sufficient to properly identify the sources of comprehensive income. The “other activities” as defined in the standard is too broad and coupled with the removal of “ongoing major or central operations” may lead to confusion regarding proper classification and presentation and could result in providing less decision-useful information to financial statement users.

We found that most of the respondents to the FASB’s changes agreed that the revised definitions will accomplish the Board’s objective of simplification by eliminating terminology that makes the definitions of assets and liabilities difficult to understand and apply. However, there is general disagreement with the definitions of assets, liabilities, revenue, gains, expenses and losses included in the new statement.

Eliminating the terms “probable” and “past transaction or event” from the definition of liabilities could increase the population of liabilities and potentially include executory contracts as obligations. A significant number of respondents disagreed with the Board’s assertion in the Exposure Draft that the distinguishing revenues from gains and expenses from losses was a “matter of presentation” versus as “essential to the elements.” Removing the phrase “ongoing major or central operations” from the definition of revenues and expenses and eliminating the phrase “peripheral or incidental transactions of an entity” from the definition of gains and losses could create a lack of clarity and result in misclassification of revenues, gains expenses and losses.

FASB’s Basis for Conclusions

The Board maintained that the “control” should not be used in the definition of an asset for three reasons:

1. Removing the word “control” eliminates redundancy. If an entity has a present right, that is sufficient to establish the fact that the asset is an asset of that entity. The existence of a present right sufficiently captures the concept of control. If an entity has exclusive rights, it presumably can deny or regulate access to that benefit by others.
2. Removing the term “control” eliminates common misunderstanding of the word. “Control” could be misunderstood by applying the word as it is used in accounting for mergers and acquisitions. In addition, many may believe that control is over the economic benefit (e.g., the amount cash collected from a receivable). The Board notes that what is controlled is the existing right that gives rise to economic benefits, or potential economic benefits, (e.g., the right to collect the receivable), rather than the amount of the economic benefits themselves. The rationale for removing the term “control” is the same as removing other terms, such as future and probable, from the definition of an asset. Finally, removal of the term control eliminates any confusion with the IASB’s Conceptual Framework use and meaning of control in its asset definition which would lead one to understand that the control is over the economic benefit and not the right to the economic benefit. Convergence with the IASB’s definition of an asset is not critical at this point because it will continue this misunderstanding.
3. The elimination of the phrase “past transactions or events” from the asset and liability definitions was also viewed as redundant because if an entity has a present right or a present obligation, one can reasonably assume that it was obtained from some past transaction or event. The term “probable” and the phrases “future economic benefit” and “past transactions or events” were eliminated from definitions of both an asset and a liability. The term “probable” in the definitions in the prior statement has been misunderstood because it implies that a future economic benefit or a future sacrifice of economic benefit must be probable to a certain threshold before the definition of an asset, or a liability is met (e.g., 75 to 80 percent or “More Likely than Not”). The potential issue here is that if the probability of future economic benefit is low, the asset or liability definition may be considered as not met by a stakeholder. As a result, the Board eliminated these terms from the new definitions of assets and liabilities.

The Board concluded that an obligation to transfer either assets or a variable number of shares of the entity’s own shares meets the definition of a liability. The transfer of a variable number of shares to accumulate to a specific, fixed value has the characteristics of an obligation. The value to the recipient is fixed. The obligation does not convey the returns and rewards of an equity shareholder. Conversely, an instrument that will result in a fixed number of shares with variable value will subject the holder to the risks and rewards of ownership and therefore would qualify as an equity instrument.

The phrase “ongoing major or central operations” was removed from the definition of revenue and expenses and the phrase “from peripheral or incidental transactions of an entity” was removed from the definition from gains and losses. The Board supported this decision to remove these phrases by noting that delivery of or producing goods or rendering services should always result in revenues and expenses.

The new concepts statement retained the phrase “other activities” although most respondents suggested clarifications. The Board indicated that the phrase is derived from the description of revenues and general activities in APB Statement No. 4, Basic Concepts and Accounting Principles Underlying Financial Statements of Business Enterprises. The phrase is not intended to be all-inclusive but is best defined as those activities that permit others to use economic resources of the entity, which result in interest, rent, royalties, fees, etc. The Board decided that no additional clarifications were necessary because the phrase “other activities” is derived from APB Statement No. 4.

Finally, the Board made it clear that it is the primary user of any guidance provided by the Concepts Statements. The Board reiterated that the Concepts Statements are used to guide the development of accounting and reporting standards using a common foundation and theoretical rationale to consider alternatives. It is also used as a basis for evaluating existing authoritative guidance and practices. The Board is aware that in certain respects current generally accepted accounting principles (GAAP) may be inconsistent with what might be derived from the objectives and fundamental concepts set forth in Concepts Statements.

However, the Conceptual Framework is often used by stakeholders to better understand accounting and reporting guidance, and this is expected to enhance usefulness of and confidence in GAAP and may also provide some assistance in practice in those cases where there is no existing authoritative guidance. But it was made clear that the Concepts Statements does not have authoritative support.

The effect of the new definitions will not be known until the revised statement is used by the Board as a tool in future standard setting.

Rivka Fried, a doctoral candidate at Rutgers Business School, contributed to this article. She can be reached at .

Alexander J. Sannella Alexander J. Sannella, Ph.D, CPA, is a professor of accounting at Rutgers Business School and the director of the MBA in Professional Accounting Program and the Rutgers Business School Teaching Center. He can be reached at .

What are decreases in a company's net assets arising from peripheral or incidental operations of a company?

Which basic element of financial statements arises from peripheral or incidental transactions?

When should an expenditure be recorded as an asset rather than an expense?

Which accounting assumption or principle is being violated if a company provides financial reports only when it introduces a new product?