Equity is not a residual

People often describe equity as a residual. That description is not fully accurate and may mislead people.

There are probably three reasons why some people use that description:

• the definition of equity includes the word residual.
• the total amount of reported equity is measured as a residual.
• the pre-2018 version of the IASB’s Conceptual Framework for Financial Reporting stated—in former paragraph 4.20—that ‘equity is defined in [former] paragraph 4.4 as a residual’.

This post looks at:

• the definition of equity
• classes of equity and categories of equity
• recognising equity claims
• claims
• whether the definition of equity could be improved

Definition of equity

The Conceptual Framework defines 5 elements of financial statements: 3 elements of financial position (assets, liabilities and equity) and 2 elements of financial performance (income and expenses). It defines equity as the residual interest in the assets of the entity after deducting all its liabilities.

One reason for confusion is that writers and speakers often use the term equity without saying clearly which of 2 different meanings they intend. One meaning is about the nature of equity. The second meaning is about how to measure equity.

To distinguish those 2 meanings more clearly, the IASB added 2 important new statements in 2018:

• paragraph 4.64 introduced the term equity claim and defines equity claims as claims on the residual interest in the assets of the entity after deducting all its liabilities.
• paragraph 6.87 introduced the term total equity as shorthand for the total carrying amount of equity. That paragraph notes that total equity equals (a) the total of the carrying amounts of all recognised assets less (b) the total of the carrying amounts of all recognised liabilities.

These new definitions make it clearer why equity is not a residual:

• equity claims are not a residual, nor are they a residual interest. They are a type of claim: a claim on the residual interest (an interest in the residual).
• total equity is measured as a residual.

For total equity to be measured as a residual, at least one class of equity claim (and at least one category of equity) must always be measured as a residual. Nevertheless, that condition could be met if some classes of equity claim (or some categories of equity) are measured directly (not as a residual)—so long as at least one class of equity (and at least one category of equity) is measured as a residual.

Indeed, it is usual to measure some categories of equity directly. For example, this is often the case for share capital and for reserves set up to comply with a law.  One the other hand, it is usual to measure retained earnings as a residual.

Classes of equity claim and categories of equity

Many entities have more than one class of equity claim and more than one category of equity:

• Common example of classes of equity claim are: ordinary shares; deferred shares; and derivative instruments (such as share options) based on ordinary shares.
• Common examples of categories of equity are: share capital; reserves; and retained earnings. Whether an entity in fact has more than one category of equity depends on the laws governing the entity and perhaps also on the entity’s constitution.

Recognising equity claims

By saying that equity is a residual, people sometimes appear to imply that items included in equity do not need to be recognised. But in fact, just like assets and liabilities, equity claims are depicted by recognising them in the statement of financial position. Although total equity is measured as a residual, an entity needs to recognise all equity claims on the entity.

What is recognition? As explained in paragraph 5.1 of the Conceptual Framework, recognising an asset, a liability or equity item in the statement of financial position involves:

• depicting that item in that statement—either alone or in aggregation with other items—in words and by a monetary amount; and
• including that amount in one or more totals in that statement.

When an entity issues a new equity claim, the entity typically receives consideration in exchange and measures that new equity claim initially on a basis that reflects the amount of that consideration. At that time, the carrying amount of total assets and total equity both increase by the amount of that consideration.

Subsequently, total equity changes by changes in the total of the carrying amounts of all recognised assets less the total of the carrying amounts of all recognised liabilities. (At present, IFRS Standards do not specify how to attribute most changes in total equity across individual classes of equity claim, or across individual categories of equity.)  

Claims

The IASB introduced the concept of claims into the Conceptual Framework in 2010 when it revised chapters 1 and 2. The IASB designed some of the drafting of chapter 1 to avoid pre-empting future discussion of whether and how to continue distinguishing liabilities from equity. Thus, chapter 1 refers in several places to claims, rather than to obligations (liabilities) and to equity claims.

Table 4.1, placed after paragraph 4.2 of the Conceptual Framework, was added in 2018. This table confirms that both liabilities and equity are types of claim, even though these 2 types of claim are separate elements of the financial statements. Paragraph 4.90 of the Basis for Conclusions on the Conceptual Framework explains why the IASB decided in 2018 that it would still treat liabilities and equity as two distinct elements.

Could the definition of equity be improved?

The IASB revised the Conceptual Framework in 2018 without changing the definition of equity. The IASB had found then no compelling reason to change the definition. Nevertheless, the IASB knew that it might need to consider whether to amend the definition of equity in its planned future work on distinguishing liabilities from equity claims.

In my view, there is no urgent need to change the definition of equity, but it does contain 2 minor imperfections:

• the phrase residual interest is slightly unclear. The interest is an interest in a residual but that interest itself is not a residual.
• although the total carrying amount of liabilities can be deducted from the total carrying amount of assets, liabilities and assets themselves are not amounts and so liabilities cannot be ‘deducted’ from assets.     

If a suitable opportunity arises, one way to remove those minor imperfections might be to change the definition of equity along the following lines:

claims on the residual interest in that will be available if the entity’s assets of the entity after deducting are sufficient to fulfil all of the entity’s its liabilities.

That possible drafting underlines added wording and strikes through deleted wording. These possible changes:

• delete interest from the phrase residual interest
• replace the notion of deducting liabilities from assets. The replacement wording refers to the residual that will be available if the entity’s assets are sufficient to fulfil all of the entity’s liabilities.
  I suggest that wording to avoid a simplistic focus on total equity at the end of the reporting period, as determined by deducting the total amount of liabilities from the total carrying amount of assets at that date. It would be unwise to risk implying that an entity could safely, without risking insolvency, distribute to equity holders an amount equal to total equity as measured at one particular date. What matters is the following: when the entity needs to fulfil its liabilities, will it hold enough assets to fulfil all of its liabilities?  

Summary

It is inaccurate to describe equity as a residual. More accurately:

• equity claims are a type of claim: a claim on the residual that will be left if an entity has enough assets to fulfil all its liabilities. An entity recognises equity claims in the statement of financial position by depicting them in words and by a monetary amount included in total equity. Typically, an entity depicts all equity claims of a single class in aggregate.
• an entity measures total equity as a residual. To achieve this, an entity must measure at least one class of equity claim as a residual, and must also measure at least one category of equity as a residual.