What Are Future Economic Benefits in Accounting?
Understand the core accounting principle that determines if a resource is an asset and how its value is recognized and consumed on financial statements.
In accounting, future economic benefits represent the potential of a resource to contribute, either directly or indirectly, to a company’s cash flow. This potential is the quality that elevates an item into something a business can classify as an asset. Understanding this characteristic is the first step in deciphering a company’s financial position on its balance sheet. Without this potential to generate value, an expenditure is simply a consumed cost, not a resource that holds promise for the future.
The Essential Characteristic of an Asset
The Financial Accounting Standards Board’s (FASB) conceptual framework defines an asset as “a present right of an entity to an economic benefit.” This definition rests on two characteristics. First, the “present right” means the company already has control over the benefit, stemming from a past transaction or event; it is not based on a future intention.
The second characteristic is the right to an “economic benefit,” which refers to the capacity of a resource to yield value. This capacity can manifest by being used to produce goods or services, exchanged for other assets, used to settle a liability, or distributed to the company’s owners. This forward-looking potential is what gives an item economic significance.
Manifestations of Economic Benefits in Business
Tangible assets provide benefits in straightforward ways. Cash is the most liquid asset, offering the direct benefit of being a medium of exchange to acquire other resources or settle obligations. Inventory, including raw materials and finished goods, holds its economic benefit in its ability to be sold to customers, generating revenue.
Property, plant, and equipment (PPE) offer their benefits differently. A delivery truck, factory machine, or office building are not typically held for resale. Instead, their future economic benefits are consumed through their use in daily business activities. The truck helps deliver goods, the machine produces inventory, and the building provides a space for operations, all of which help generate revenue.
Intangible assets, which lack physical substance, generate value in other ways. A patent provides an economic benefit by granting its owner exclusive rights to an invention, which can lead to higher sales or pricing power. Similarly, a copyright provides the benefit of controlling the reproduction and distribution of a creative work, often generating revenue through licensing agreements.
Criteria for Financial Statement Recognition
For an item to be formally recorded on a company’s financial statements, it must meet specific recognition criteria. These rules ensure that the information on the balance sheet is useful for making decisions. According to the FASB, an item should be recognized if it is measurable and can be depicted with faithful representation.
The asset must be measurable, meaning a monetary value can be assigned to it that is useful for analysis; for many assets, this is the purchase price. The information must also be a faithful representation, meaning the measurement is a realistic and unbiased depiction of the asset’s economic value. This principle ensures that assets are not recorded based on overly speculative or uncertain values.
The Consumption and Expiration of Benefits
Once an asset is recognized on the balance sheet, its value is systematically consumed over time as the business reaps its economic benefits. This process of converting an asset into an expense is guided by the matching principle. The principle seeks to align the cost of an asset with the revenues it helps to generate in the same accounting period.
For tangible assets like buildings and machinery, this consumption of benefits is recognized through depreciation. Depreciation is the systematic allocation of an asset’s cost over its useful life. Each year, a portion of the asset’s cost is recorded as depreciation expense, and the asset’s carrying value on the balance sheet is reduced, reflecting its use.
A similar concept, amortization, applies to intangible assets with finite useful lives, such as patents and copyrights. The cost of the intangible asset is expensed over its legal or economic life. For inventory, the cost is matched to revenue through an expense called the cost of goods sold. When the inventory is sold, its cost is transferred from the balance sheet to the income statement.
Sometimes, the future economic benefits of an asset decline unexpectedly before it is fully consumed. An impairment occurs when an asset’s carrying value on the balance sheet is no longer recoverable and exceeds its fair value. This can happen due to technological obsolescence, physical damage, or adverse changes in the business environment. When an asset is impaired, the company must write down its value and recognize a loss.