Chapter 1
FINANCIAL STATEMENTS
Financial statements are the means by which the information accumulated and processed in
financial accounting is periodically communicated to the users.
Financial statements are a structured financial representation of the financial position and
financial performance of an entity.
General purpose financial statements
General purpose financial statements are the statements intended to meet the needs of users
who are not in a position to require an entity to prepare reports tailored to their particular
information needs.
Reports prepared at the request of management and bankers are not general purpose financial
statements because such reports are prepared specifically to meet the needs of management
and bankers.
Components of financial statements
A complete set of financial statements comprises the following components:
1.
2.
3.
4.
5.
6.
Statement of financial position
Income statement
Statement of comprehensive income
Statement of changes in equity
Statement of cash flows
Note, comprising a summary of significant accounting policies and other explanatory
information
Many entities also present reports and statements such as environmental reports and value
added statements, particularly in industries in which environmental factors are significant and
when employees are regarded as an important user group.
However, such statements and reports are not components of financial statements.
Objective of financial statements
The objective of general purpose financial statements is to provide information about the
financial position, financial performance and cash flows of an entity that is useful to a wide
range of users in making economic decisions.
Financial statements show the results of the stewardship of the management of the resources
entrusted to it.
To meet this objective, financial statements provide information about the following:
a.
b.
c.
d.
e.
f.
Assets
Liabilities
Equity
Income and expenses, including gains and losses
Contributions by and distributions to owners in their capacity as owners
Cash flows
Such information, along with other information in the notes, would assist users of financial
statements in predicting the entity’s cash flows and in particular their timing and certainty.
However, financial statements do not provide all the information that users may need to make
economic decisions.
The reason is that the financial statements largely portray the financial effects of past events
and do not necessarily provide nonfinancial information.
The financial position comprises the assets, liabilities and equity of an entity at a particular
moment in time.
Specifically, financial position pertains to the liquidity, solvency, and the need of the entity for
additional financing.
The financial performance comprises the revenue, expenses and net income or loss of an entity
for a period of time.
Performance is the level of income earned by the entity through the efficient and effective use of
its resources.
Cash flows are the cash receipts and cash payments arising from the operating, investing and
financing activities of the entity.
Financial reporting
Financial reporting is the provision of financial information about an entity to external users that
is useful to them in making economic decisions and for assessing the effectiveness of the
entity’s management.
The principal way of providing financial information to external users is through the annual
financial statements. However, financial reporting encompasses not only financial statements
but also other means of communicating information that relates directly or indirectly to the
financial accounting process.
Financial reports include no t only financial statements but also other information such as
financial highlights, summary of important financial figures and analysis of financial statements.
Financial reports also include nonfinancial information such as description of major products
and a listing of corporate officers and directors.
Objective of financial reporting
Under the revised conceptual framework for financial reporting, the objective of financial
reporting is to provide financial information about the reporting entity that is useful to existing
and potential investors, lenders and other creditors in making decisions about providing
resources to the entity.
General purpose financial reporting is directed primarily to the existing and potential investors,
lenders and other creditors which compose the primary user group.
The reason is that the primary users have the most critical and immediate need for information
in financial reports.
Specific objectives of financial reporting
a. To provide information useful in making investing and credit decisions about providing
resources to the entity.
b. To provide information useful in assessing the cash flow prospects of the entity.
c. To provide information about entity resources, claims and changes in resources and
claims.
Limitations of financial reporting
a. General purpose financial reports do not and cannot provide all of the information that
existing and potential investors, lenders and other creditors need.
b. General purpose financial reports are not designed to show the value of a reporting
entity but these reports provide information to help the primary users estimate the value
of the entity.
c. General purpose financial reports are intended to provide common information to users
and cannot accommodate every specific request for information.
d. To a large extend, financial reports are based on estimate and judgment rather than
exact depiction.
Responsibility for financial statements
The management of an entity has the primary responsibility for the preparation and presentation
of financial statements.
The board of directors in discharging its responsibilities reviews and authorizes the financial
statements for issue before these are submitted to the shareholders of the entity.
Management is accountable for the safekeeping of the resources and their proper, efficient and
profitable use.
Shareholders are interested in information that helps them assess how effectively management
has fulfilled this role as this is relevant to the decision concerning their investment and the
reappointment or replacement of management.
General features of financial statements
1. Fair presentation and compliance with PFRS
2. Going concern
3. Accrual basis
4. Materiality and aggregation
5. Offsetting
6. Frequency of reporting
7. Comparative information
8. Consistency of presentation
Fair presentation
The financial statements shall present fairly the financial position, financial performance and
cash floes of an entity.
Virtually, in all circumstances, fair presentation is achieved if the financial statements are
prepared in accordance with the Philippine financial reporting standards which represent the
GAAP in the Philippines.
The application of Philippines financial reporting standards, with additional disclosure when
necessary, is presumed to result in financial statements that achieve a fair presentation.
An entity whose financial statements comply with pfrs shall make an explicit and unreserved
statement of such compliance in the notes.
Fair presentation is defined as faithful presentation of the effects of transactions and other
events in accordance with the definitions and regnotions criteria for assets, liabilities, income
and expenses laid down in the conceptual framework.
Fair presentation requires an entity:
a. To select and apply accounting policies in accordance with pfrs.
b. To present information, including accounting policies, in a manner that provides relevant
and faithful represented financial information.
c. To provide additional discloses necessary for the users to understand the entity’s
financial statements.
An entity cannot rectify inappropriate accounting policies either by disclosure of the accounting
policies used or by notes or explanatory information.
Departure from standard
In the extremely rare circumstances in which management concludes that compliance with a
requirement is a standard would be so misleading, the entity shall depart from that requirement
provided the relevant regulatory conceptual framework requires, or otherwise does not prohibit,
such a departure.
This, an entity is permitted to depart from a standard:
a. In excitement rare circumstances
b. When management concludes that compliance with the standard would be misleading.
c. When the departure from the standard is necessary to achieve fair presentation
d. When the regulatory conceptual framework requires or otherwise does not prohibit such
a departure
In such circumstances, it is incumbent upon the entity to disclose the following:
1. The management has concluded that the financial statements present fairly the financial
positions, financial performance and cash flows of the entity.
2. That the entity has compiled with applicable standards except that it has departed from a
particular requirement to achieve a fair presentation.
3. The title of the standard from which the entity has departed, the nature of the departure,
including the treatment that the standard would require, the reason why that treatment
would be so misleading and the treatment adopted.
4. For each period presented, the financial impact of the departure on each item in the
financial statements that would have been reported in complying with the requirement.
Going concern
Going concern or continuity assumption means that the accounting entity is vied as continuing
in operation indefinitely in the absence of evidence to the contrary. The going concern postulate
is the very foundation of the cost principle.
In other words, financial statements are prepared normally on the assumption that the entity
shall continue in operation for the foreseeable future.
Thus, assets are normally recorded at original acquisition cost. As a rule, market values are
ignored.
However, some standards require measurements of certain assets at fair value.
Financial statements shall be prepared on a going concern basis unless management intends to
liquidate the entity or cease trading or has no realistic option but to do so.
If the financial statements are not prepared on a going concern basis, such fact shall be
disclosed together with the measurement basis and the reason thereof.
Accrual basis
An entity shall prepare the financial statements, using the accrual basis of accounting except for
cash flow information.
Under accrual basis, the effects of transactions and other events are recognized when they
occur and not as cash or cash equivalent is received or paid, and they are recorded and
reported in the financial statements of the periods to which they relate.
Accrual basis means that assets are recognized when receivable rather that when received and
liabilities are recognized when payable rather that when actually paid.
In simple language, accrual accounting means that income is recognized when earned
regardless of when received and expense is recognized when incurred regardless of when paid.
The essence of accrual accounting is the recognition of accounts receivable, accounts payable,
prepaid expenses, accrued expenses, deferred income, and accrued income.
Materiality and aggregation
An entity shall present separately each material class of similar items.
An entity shall present separately items of dissimilar nature of function unless they are
immaterial.
Financial statements result from processing large number of transactions or other events that
are aggregated into classes according to their nature or function.
The final stage in the princess of aggregation and classification is the presentation of
condensed and classified data which form line items in the financial statements.
For example, cash on hand, petty cash fund, cash in bank and cash equivalent shall be
presented as on item “cash and cash equivalents”.
Finished goods, goods in process, raw materials and manufacturing supplies are aggregated
and presented as one item “inventories”.
Materiality dictates that an entity need not provide a specific disclosure required buy standard if
the information is not material.
When is an item material?
There is no strict or uniform rule for determining whether an items is material or not.
Very often, this is dependent on good judgment, professional expertise and common sense.
As a general guide, an item is material if knowledge of it would affect the decision of the primary
users of the financial statements.
For example, small expenditures for tools are often expensed immediately rather than
depreciated over the useful life.
Another example is the common practice of large entities of rounding amounts to the nearest
thousand pesos in their financial statements. Small entities may round off the nearest peso.
New definition of materiality
The IASB provide the following new definition of materiality.
Information is material if omitting, misstating or obscuring it could reasonably be expected to
influence the economic decisions that primary users of general purpose financial statements
make on the basis of those statements which provide financial information about a specific
reporting entity.
In other words an information is material if the omission, misstatement and obscuring of the
information could reasonably affect the economic decision of primary users.
The revised definition of the materiality highlighted three important aspects:
a. Could reasonably be expected to influence
b. Obscuring information
c. Primary users
Could reasonably be expected to influence
The could reasonably expected to influence threshold adds an element of reasonability of
financial information on which economic decisions is based.
By including the term could reasonably be expected to influence in the new definition, material
information shall be limited to the economic decision of primary users rather than to all users
which is too broad in scope.
Moreover, the could reasonably be expected to influence threshold insures that information
capable of influencing economic decisions of the primary users shall be included in the financial
statements.
Obscuring information
Obscuring information is a new concept added to the new definition of materiality.
Information is obscured if presenting or communicating it would have a similar effect as emitting
or misstating the information.
Obscuring information means the presentation of financial information not readily understood or
not clearly expressed.
Obscuring information may be characterized by deliberate vagueness, ambiguity and
abstruseness.
Examples of obscured material information are:
a. The language is vague or unclear
b. The information is scattered throughout the financial statements.
c. Dissimilar items are aggregated inappropriately
d. Similar items are disaggregated inappropriately
Primary users
The new definition of materiality narrows the definition to primary users who are primarily
affected by general purpose financial statements.
The primary users include the existing and potential investors, lenders and other creditors.
The other users include employees, customers, government agencies and the public in general.
The new definition specified that only primary users of financial statements are considered
because these groups are the users to whom general purpose financial statements are primarily
directed.
Such primary users cannot require reporting entities to provide information directly to them and
therefore must rely on general purpose financial reports for how much financial information is
needed.
Materiality is a relativity
Materiality of an item depends on relative size rather than absolute size. What is material for
one entity may be immaterial for another.
An error of P100,000 in the financial statements of a multinational entity may not be important
but may be so critical for a small entity.
Factors of materiality
In the exercise of judgment in determining materiality, the following factors may be considered:
a. Relative size of the item in relation to the total of the group to which the item belongs.
For example, the amount of advertising in relation to total distribution cost and the
amount of prepaid expenses to total current assets.
b. Nature of the item - an item may be inherently material because by its very nature it
affects economic decision. For example, the discovery of a P20,000 bribe is a material
event even for a very large entity.
Offsetting
Assets and liabilities, and income and expenses, when material, shall not be offset against each
other. Offsetting may be done when it is required or permitted by another PFRS.
Gains and losses on disposal of noncurrent assets are reported by deducting from the proceeds
the carrying amount of the assets and the related selling expenses.
The expenditure related to a provision and any reimbursement from a third party can be offset,
and only the net expenditure is presented as expense.
Foreign exchange gains and losses or gains and losses arising from trading securities are netter
against the other.
The measurement of assets net of valuation allowance permitted because technically this is not
offsetting.
Thus, accounts receivable may be shown net of allowance for doubtful accounts.
Frequency of reporting
An entity shall present a complete set of financial statements at least annually. When an entity
changes the end of the reporting period and presents financial statements for a period longer or
shorter than one year, the entity shall disclose:
a. The period covered by the financial statements.
b. The reason for using a longer or shorter period.
c. The fact that amounts presented in the financial statements are not entirely comparable.
Comparable information
Except when permitted or required otherwise by standard, an entity shall disclose comparative
information in respect of the previous period for all amounts reported in the current period’s
financial statements.
In other words, the financial statements of the current period shall be presented with
comparative figures of the financial statements of the immediately preceding year.
Comparative information shall be included for narrative and descriptive information when it is
relevant to an understanding of the current period’s financial statements.
For example, details of a legal dispute, the outcome of which was uncertain at the end of the
preceding reporting period and is yet to be resolved, are disclosed in the current period.
Third statement of financial position
A third statement of financial position is required when an entity:
a. Applies an accounting policy retrospectively.
b. Makes retrospective restatement of items in the financial statements.
c. Reclassifies items in the financial statements
Under these circumstances, an entity shall present three statements of financial position as at:
1. The end of the current period
2. The end of the previous period
3. The beginning of the earliest comparative period
Consistency of presentation
Implicit in the presentation of comparable information is the principle of consistency.
The principle of consistency requires that the accounting methods and practices shall be applied
on a uniform basis from period to period.
The presentation and classification of financial statement items shall be uniform from one
accounting period to the next.
An entity cannot use the FIFO method of inventory valuation in one year, the average method in
the next year, another method in succeeding year and so on.
If the FIFO method is adopted in one year, such method is followed from year to year.
Consistency is desirable and essential to achieve comparability of financial statements.
However, consistency does not mean that tno changes in accounting method can be made.
If the change will result to information that is faithfully represented and more relevant to the
users of financial statements, then such change should be made.
But there should be full disclosure of the change and the peso effect of the change.
A change in the presentation and classification of items in the financial statements is allowed:
a. When it is required by another standard.
b. When a significant change in the nature if the operations of the entity will demonstrate a
more appropriate revised presentation and classification.
It is inappropriate for an entity to leave accounting policies unchanged when better and
acceptable alternatives exist.
Identification of financial statements
Financial statements shall be clearly identified and distinguished from other information in the
same published document.
Each component of the financial statements shall be clearly identified.
In addition, the following information shall be prominently displayed:
a. The name of the reporting entity
b. Whether the financial information covers the individual entity or a group of entities.
c. The end of the reporting period or the period covered by the financial statements or
notes
d. The presentation currency
e. The level of rounding used in the amounts in the financial statements
Financial statements are often made more understandable by presenting information in
thousands or millions of units of the presentation currency.
This is acceptable as long as the level of rounding in presentation is disclosed and relevant and
material information is not lost or omitted.
Chapter 2
Statement of Financial Position
A statement of financial position is a formal statement showing the three elements comprising
financial position, namely assets, liabilities and equity.
Investors, creditors and other statement users analyze the statement of financial position to
evaluate such factors as liquidity, solvency and the need of the entity for additional financing.
Liquidity is the ability of the entity to meet currently maturing obligations.
Solvency is the availability of cash over the longer term to meet maturing obligations.
Liquidity and Solvency is useful in predicting the ability of the entity to comply with future
financial commitments and to pay dividends to shareholders.
Current and noncurrent distinction
PAS 1 provides that an entity shall present current and noncurrent assets, and current and
noncurrent liabilities, as separate classifications in the statement of financial position.
When an entity supplies goods or services within a clearly identifiable operating cycle, the
separate classification of current and noncurrent assets and liabilities is a useful information.
The current and noncurrent distinction highlights assets that are expected to be realized within
the current operating cycle and liabilities that are due for settlement within the same period.
For some entities, such as financial institutions, a presentation of assets and liabilities in
increasing or decreasing liquidity provides information that is faithfully represented and more
relevant.
Assets
The Revised Conceptual Framework defines an asset as a present economic resource
controlled by the entity as a result of past events.
An economic resource is right that has the potential to produce economic benefits.
In layman’s language and in short, assets are properties owned.
The essential characteristics of an asset are:
a. The asset is controlled by the entity.
b. The asset is the result of a past event.
c. The asset has the potential to produce economic benefits.
Current Assets
PAS 1 provides that an entity shall classify an asset as current when:
a. The asset is cash or a cash equivalent unless the asset is restricted to settle a liability for
more than twelve months after the reporting period.
b. The entity holds the asset primarily for the purpose of trading.
c. The entity expects to realize the asset within twelve months after the reporting period.
d. The entity expects to realize the asset or intends to sell or consume it within the entity’s
normal operating cycle.
Cash and cash equivalents
This category includes cash on hand, petty cash, cash in bank and any cash equivalent.
However, the cash and cash equivalent shall be unrestricted in use, meaning available anytime
for the payment of current obligations.
PAS 7, defines cash equivalents as short-term, highly liquid investments that are readily
convertible into known amount of cash and which are subject to an insignificant risk of changes
in value.
For an investment to qualify as a cash equivalent, it must be readily convertible into a known
amount of cash and be subject to an insignificant risk of change in value.
Therefore, an investment normally qualifies as a cash equivalent only when it has a short
maturity of three months or less from the date of acquisition.
Examples of cash equivalents
a. Three-month BSP treasury bill
b. Three-year BSP treasury bill purchased three months before date of maturity.
c. Three-month time deposit
d. Three-month money market instrument
Note that what is important is the date of purchase which should be three months or less before
maturity.
Thus, a BSP treasury bill that was purchased three years ago cannot qualify as cash equivalent
even if the remaining maturity is three months or less.
Equity securities cannot qualify as cash equivalent because shares do not have a date of
maturity.
However, preference shares with a specified redemption date and acquired three months before
redemption date can qualify as cash equivalents.
Held for trading
Appendix A of PFRS 9 provides that a financial asset is classified as held for trading when:
a. It is acquired principally for the purpose of selling it in the near term.
b. On initial recognition, it is part of a portfolio of identified financial instruments that are
managed together and for which there is evidence of a recent actual pattern of
short-term profit taking.
c. It is a derivative, except for a derivative that is a financial guarantee contract or a
designated and an effective hedging instrument.
Financial assets held for trading are debt and equity securities that are purchased with the intent
of selling them in the “near term” or very soon in order to generate short-term gain.
Expected to be realized within twelve months
This category refers to short-term nontrade receivables.
Nontrade receivables represent claims arising from sources other than the sale of merchandise
or services in the ordinary course of business.
Nontrade receivables are classified as current assets if collectible within one year from the end
of reporting period, the length of the operating cycle notwithstanding.
Otherwise, the nontrade receivables are classified as noncurrent assets.
Realize, sold and consumed
This current asset category refers to trade receivables, inventories, and prepayments.
These assets are classified as current assets because they are expected to be realized, sold or
consumed within the normal operating cycle or one year, whichever is longer.
Operating Cycle
The operating cycle of an entity is the time between the acquisition of assets for processing and
their realization in cash or cash equivalents.
When the normal operating cycle is not clearly identifiable, the duration is assumed to be twelve
months.
The operating cycle of a trading entity is the average period of time that it takes to acquire the
merchandise inventory, sell the inventory to customers and ultimately collect cash from the sale.
The operating cycle of a manufacturing entity is defined as the period of time between
acquisition of materials entering into a process and their realization in cash or an instrument that
is readily convertible into cash.
The normal operating cycle is significant as it is the basis of determining the proper
classification of assets into either current or noncurrent.
Presentation of current assets
Current assets are usually listed in the statement of financial position in the order of liquidity.
PAS 1, provides that as a minimum the line items under current assets are:
a. Cash and cash equivalents
b. Financial assets at fair value through profits or loss, such as trading securities and other
investments in quoted equity instruments.
c. Trade and other receivable
d. Inventories
e. Prepaid expenses
Noncurrent Assets
The caption noncurrent assets is a residual definition.
PAS 1, simply states that “an entity shall classify all other assets not classified as current as
noncurrent assets”.
In other words, what is not included in the definition of current assets is deemed excluded. All
others are classified as noncurrent assets, Accordingly, noncurrent assets include the following:
a. Property, plant and equipment
b. Long-term investments
c. Intangible assets
d. Other noncurrent assets
PAS 1, provides that deferred tax asset is classified as noncurrent asset.
Property, plant and equipment
PAS 16, defines property, plant and equipment as tangible assets which are held by an entity for
use in production or supply of goods and services, for rental to others, or for administrative
purposes, and are expected to be used during more than one period.
The major characteristics of the definition of property, plant and equipment are:
a. The property, plant and equipment are tangible assets, meaning with physical
substance.
b. The property, plant and equipment are used in business, meaning used in production or
supply of goods and services, for rental purposes and for administrative purposes.
Assets that are held for sale, including land, or held for investment are not included in
property, plant and equipment.
c. The property, plant and equipment are expected to be used over a period of more than
one year.
Examples of property, plant and equipment
a. Land
b. Land improvement
c. Building
d. Machinery
e. Ship
f. Aircraft
g. Motor Vehicle
h. Furniture and fixtures
i. Office equipment
j. Patterns, molds and dies
k. Tools
l. Bearer Plants
The old term for property, plant and equipment is fixed assets.
Long-term investments
The international accounting standards committee defines investment as an asset held by an
entity for the accretion of wealth through capital distribution, such as interest, royalties,
dividends and rentals, for capital appreciation or for other benefits to the investing entity such as
those obtained through trading relationships.
A current investment is an investment that is by nature readily realizable and is intended to be
held for not more than one year.
A noncurrent or long-tern investment is an investment other than a current investment or
investment intended to be held for more than one year.
Examples of long-term investments
a. Investment in shares
b. Investments in bonds
c. Investments in subsidiaries
d. Investments in associates
e. Investments in funds such as sinking fund, plant expansion fund and preference share
redemption fund
f. Investment property
g. Cash surrender value of life insurance policy
h. Investment in joint venture
Intangible Assets
PAS 38, simply defines an intangible asset as an identifiable nonmonetary asset without
physical substance.
Intangible assets do not have physical substance but are expected to provide future economic
benefits to the entity.
The essence of intangible assets is the future economic benefits that will flow to the entity.
PAS 38, provides that an intangible asset is identifiable:
a. When it is separable or capable of being sold, transferred, licensed, rented or
exchanged separate from the entity.
b. When it arises from contractual or other legal right.
The common examples of identifiable intangible assets include patent, franchise, copyright,
trademark, and computer software.
An example of an unidentifiable intangible asset is goodwill.
Other noncurrent assets
Other noncurrent assets are those assets that do no fit into the definition of the previously
mentioned noncurrent assets.
Examples of other noncurrent assets include long-term advances to officers, directors,
shareholders and employees, or abandoned property and long-term refundable deposit.
Liabilities is defined as a present obligation of an entity to transfer an economic resource as a
result of past events.
The essential characteristics of a liability are:
a. The entity has a present obligation.
The entity liable must be identified
It is not necessary that the payee or the entity to whom the obligation is owed to be
identified.
b. The obligation is to transfer an economic resource.
This is the very heart of the definition of a liability.
Specifically, the obligation must be to pay cash, transfer noncash asset or provide
service at some future time.
c. The liability arises from past events.
This means that the liability is not recognized until it is incurred.
Current Liabilities
PAS 1, provides that an entity shall classify a liability as current when:
a.
b.
c.
d.
The entity expects to settle the liability within the entity’s normal operating cycle
The entity holds the liability primarily for the purpose of trading.
The liability is due to be settled within twelve months after the reporting period.
The entity does not have the right at the end of reporting period to defer settlement of
the liability for at least twelve months after the reporting period.
Examples of current liabilities
a. Trade payables and accruals for employee and other operating costs are part of the
working capital used in the entity’s normal operating cycle.
Such operating items are classified as current liabilities even if they are settled more
than twelve months after the end of reporting period.
b. Obligations that are not settled as part of the normal operating cycle but are due for
settlement within twelve months after the end of reporting period.
Examples of such current obligations are bank overdraft, dividends payable, income
taxes, other nontrade payable and current portion of noncurrent financial liabilities.
c. Financial liabilities held for trading are financial liabilities that are incurred with an
intention to repurchase them in the near term.
An example of a financial liability held for trading is a quoted debt instrument that the
issuer may buy back in the near term depending on changes in fair value.
Long-term debt currently maturing
PAS 1, provides that a liability which is due to be settled within twelve months after the end of
reporting period is classified as current, even if:
a. The original term was for a period longer than twelve months.
b. An agreement to refinance or to reschedule payment on a long-term basis is completed
after the end of reporting period and before the financial statements are authorized for
issue.
However, if the refinancing on a long-term basis is completed on or before the end of the
reporting period, the refinancing is an adjusting event and therefore the obligation is classified
as noncurrent.
Right to roll over
PAS 1, provides that if the entity has the right at the end of reporting period to roll over an
obligation for at least twelve months after the reporting period under an existing loan facility, the
obligation is classified as noncurrent even if it would otherwise be due within a shorter period.
The right to defer settlement of a liability for at least twelve months after the end of reporting
period must exist at the end of reporting period.
If the right is subject to specified conditions, the entity must comply with the conditions at the
end of reporting period.
Covenants
Covenants are often attached to borrowing agreements which represent undertakings by the
borrower.
These covenants are actually restrictions on the borrower as to undertaking further borrowings,
paying dividends, maintaining specified level of working capital and so forth.
Under these covenants, if certain conditions relating to the borrower’s financial situation are
breached, the liability becomes payable on demand.
PAS 1, states that such a liability is classified as current even if the lender has agreed, after the
end of the reporting period and before the statements are authorized for issue, not to demand
payment as a consequence of the breach.
The grace period is a period within which the borrower can rectify the breach and during which
the lender cannot demand immediate payment.
Presentation of current liabilities
PAS 1, provides that as a minimum, the face of the statement of financial position shall include
the following line items for current liabilities:
a.
b.
c.
d.
e.
Trade and other payables
Current provisions
Short-term borrowing
Current portion of long-term debt
Current tax liability
The term trade and other payables is a line item for accounts payable, notes payable, accrued
interest on note payable, dividends payable and accrued expenses.
No objection can be raised if the trade accounts and notes payable are separately presented.
Noncurrent liabilities
The term noncurrent liabilities is a residual definition.
PAS 1, simply states that all liabilities not classified as current liabilities are classified as
noncurrent liabilities.
Examples of Noncurrent liabilities
a. Noncurrent portion of long-term debt
b. Lease liability
c. Deferred tax liability
d. Long-term obligations to entity officers
e. Long-term deferred revenue
f.
PAS 1, provides that deferred tax liability is classified as noncurrent liability.
Working Capital
The entity’s liquidity is of primary concern to most statement users and this can be properly
evaluated through the current and noncurrent classifications.
For example, working capital is the excess of current assets over current liabilities and the
working capital ratio is current assets divided by current liabilities.
Contingent Liability
PAS 37, defines a contingent liability in two ways:
A Contingent liability is a possible obligation that arises from past event and whose existence
will be confirmed only by the occurrence or nonoccurrence of one or more uncertain future
events not wholly within the control of the entity.
A contingent liability is a present obligation that arises from past event but is not recognized
because:
a. It is not probable that an outflow of resources embodying economic benefits will be
required to settle the obligation.
b. The amount of the obligation cannot be measured reliably.
Thus, a contingent liability is either probable or measurable but not both.
Range of outcome
The range of outcome of uncertainty relating to future event may be described as:
a. Probable - the future event is likely to occur. As a rule of thumb probable means more
than 50% likely.
b. Possible - The future event is less likely to occur. The occurrence is 50% or less.
c. Remote - The future event is least likely to occur or the chance of the future event
occurring is very slight. The occurrence is 10% or less.
Treatment of contingent liability
A contingent liability is not recognized in the financial statements. A contingent liability shall be
disclosed only.
a.
b.
c.
d.
Possible and measurable - disclosure only
Probable but not measurable - disclosure only
Remote and measurable - no disclosure
Probable and measurable - recognize loss and an estimated liability as a provision.
Contingent Asset
PAS 37, defines contingent asset as a possible asset that arises from past event and whose
existence will be confirmed only by the occurrence or nonoccurrence of one or more uncertain
future events not wholly within the control of the entity.
Contingent assets usually arise from unplanned or other unexpected events that give rise to the
possibility of an inflow of economic benefits to the entity.
An example is a claim that an entity is pursuing through legal processes when the outcome is
uncertain.
Treatment of contingent asset
A contingent asset shall not be recognized because this may result to recognition of income that
may never be realized.
However, when the realization of income is virtually certain, the related asset is no longer
contingent asset and its recognition is appropriate.
Reporting of contingent asset
a. A contingent asset is recognized in the period when realized.
b. A contingent asset is only disclosed when it is probable.
c. If the contingent asset is possible, no disclosure is required.
d. If the contingent asset is remote, no disclosure is required.
Equity
The term equity is the residual interest in the assets of the entity after deducting all of the
liabilities
Simply stated, equity means net assets or total assets minus liabilities.
Equity is increased by profitable operations and contribution by owners.
Conversely, equity is decreased by unprofitable operations and distribution to owners.
The terms used in reporting equity of an entity depending on the form of the entity are:
a. Owner’s equity in a proprietorship
b. Partner’s equity in a partnership
c. Shareholder’s equity in a corporation
However, the term equity may simply be used for all business entities.
Shareholders’ Equity
Shareholders’ equity or stockholders’ equity is the residual interest of owners in the net assets
of a corporation measured by the excess of assets over liabilities.
Philippine Term
Capital Stock
Subscribed capital stock
Common stock
Preferred stock
Additional paid capital
Retained earnings (deficit)
Retained earnings appropriated
Revaluation Surplus
Treasury Stock
IAS Term
Share capital
Subscribed share capital
Ordinary share capital
Preference share capital
Share premium
Accumulated profits (losses)
Appropriation reserve
Revaluation reserve
Treasury share
Share Capital and share premium
Share capital is the portion of the paid in capital representing the total par or stated value of the
shares issued.
Subscribed share capital is the portion of the authorized share capital that has been subscribed
but not yet fully paid and therefore still unissued.
Subscriptions receivable shall preferably be reflected as a deduction from the related
subscribed share capital.
However, subscriptions receivable collectible within one year shall be classified as current
asset.
Share premium is the capital contributed by the shareholders in excess of the par or stated
value of the shares subscribed and issued.
Retained Earnings
Retained earning represents the cumulative balance of periodic net income or loss, dividend
distributions, prior period errors, changes in accounting policy and other capital adjustment.s
Unappropriated retained earnings represent that portion which is free and can be declared as
dividends to the shareholders.
Appropriated retained earnings represent that portion which is restricted and therefore not
available for any dividend declaration.
A deficit is a debit balance in retained earnings. The deficit is not presented as an asset but as
deduction from shareholders’ equity.
Revaluation Surplus
Revaluation surplus is the excess of sound value over carrying amount of the revalued asset.
Sound value is equal to the fair value or depreciated replacement cost.
Depreciated replacement cost is equal to replacement cost minus accumulated depreciation.
Carrying amount is computed by deducting accumulated depreciation on cost from historical
cost.
Treasury Shares
Treasury shares are an entity’s own share that have been issued and then reacquired but not
canceled.
Treasury shares are usually recorded at cost and are not recognized as an asset
The cost of treasury shares shall be reported as a deduction from the shareholders’ equity.
When treasury shares are acquired, the retained earnings must be appropriated to the extent of
the cost of the treasury shares.
Reserves
The term reserves is not officially defined in any accounting standard or in the Conceptual
Framework.
Under international accounting standard, the use of equity reserves is based on whether a
reserve is part of distributable equity or non distributable equity.
Distributable equity is that portion that can be distributed to shareholders as dividends without
impairing the legal capital of the entity.
Distributable equity squarely pertains to unappropriated retained earnings.
Nondistributable equity is that portion that cannot be distributed to the shareholders in any form
during the lifetime of the entity.
Generally, nondistributable equity reserves represent those items of equity other than the
aggregate par or stated value of share capital and retained earning unappropriated.
Example of reserves
A. Share premium reserve or additional paid in capital
B. Appropriation reserve or technically known as retained earnings appropriated
C. Asset revaluation reserve or revaluation surplus
D. Other comprehensive income reserve
Line Items - Statement of Financial Position
PAS 1, state that as a minimum, the statement of financial position shall include the following
line items:
1. Cash and cash equivalents
2. Financial assets
3. Trade and other receivables
4. Inventories
5. Property, plant and equipment
6. Investment in associates using the equity method
7. Intangible assets
8. Investment property
9. Biological assets
10. Total of Assets classified as held for sale and assets included in disposal group classified
as held for sale
11. Trade and other payables
12. Current tax asset and liability
13. Deferred tax asset and deferred tax liability
14. Provisions
15. Financial Liabilities
16. Liabilities included in disposal group held for sale
17. Noncontrolling interest
18. Share capital and reserves
The listing of the line items is not exclusive
Paragraph 54 simply provides a list of items that are sufficiently different in nature and function
to warrant separate presentation on the face of the statement of financial position.
Paragraph 55 provides that additional line items, headings and subtotals shall be presented on
the face of the statement of financial position when such presentation is relevant to the
understanding of the financial position of an entity.
The judgment on whether additional line items are presented separately is based on
assessment of the following:
a. Nature and liquidity of assets
b. Function of assets within the entity
c. Amount, nature and timing of liabilities
Forms of statement of financial position
The format of a statement of financial position is not specified in PAS 1.
In practice, there are two customary forms in presenting the statement of financial position,
namely:
a. Report form
This form sets forth the three major sections in a downward sequence of assets,
liabilities and equity.
b. Account form
As the title suggests, the presentation follows that of an account, meaning, the assets
are shown on the left side and the liabilities and equity on the right side of the statement
of financial position.
Actually, the statement of financial position is an expansion of the accounting equation “asset
equals liability plus equity”
PAS 1, provides that the standard does not prescribe the order or format in which line items are
to be presented.
Under Philippine jurisdiction, the common practice is to present in the statement of financial
position current assets before noncurrent assets, current liabilities before noncurrent liabilities,
and equity after liabilities.
Other formats may be equally appropriate provided the distinction is clear in accordance with
paragraph 7 of the preface to IAS 1
Note that the format of the statement of financial position as illustrated in the appendix to IAS 1
is in the following order.
Noncurrent assets
Current assets
Equity
Noncurrent Liabilities
Current Liabilities
This may be the practice in other jurisdiction, like the United Kingdom
Chapter 3
NOTES TO FINANCIAL STATEMENTS- Related parties- Events after reporting period
Notes to financial statements
Notes to financial statements provide narrative description of disaggregation of items presented
in the financial statements and information about items that do not qualify for recognition.
Notes contain information in addition to that presented in the statement of financial position,
income statement, statement of comprehensive income, statement of changes in equity and
statement of cash flows.
In other words, note to financial statements are used to report information that does not fit into
the body of the statements in order to enhance the understandability of the statements.
Notes provide additional and help clarify the items presented in the financial statements.
PAS 1, paragraph 113, provides that an entity shall, as far as practicable, present notes in a
systematic manner.
Purpose of notes to financial statements
The purpose of notes to financial statements is to provide the necessary disclosures required by
Philippine financial reporting standards.
Specifically, PAS1, paragraph 112, provides that the notes to financial statements shall:
a. Present information about the basis of preparation of the financial statements and the
specific accounting policies.
b. Disclose the information required by philippine financial reporting standards that is not
presented in the financial statements
c. Provide additional information which is not presented in the financial statements but is
relevant to an understanding of the financial statements.
Order of presenting the notes
PAS 1, paragraph 114, provides that an entity normally presents notes in the following order to
assist users understand the financial statements and to compare them with finan of other
entities:
a. Statement of compliance with pfrs
b. Summary of significant accounting policies used
c. Supporting information or computation for line items presented in the financial
statements
d. Other disclosures, such contingent liabilities, unrecognized contractual commitments and
nonfinancial disclosures.
In some circumstances, it may be necessary or desirable to vary the order of specific items
within the notes. However, the entity must retain the systematic presentation and structure of
the notes as far as practicable.
Compliance with PFRS
PAS 1, paragraph 16, provides that an entity whose financial statements comply with Philippines
financial reporting standards shall make an explicit and unreserved statement of such
compliance in the notes.
An entity shall not describe financial statements as complying with PFRS unless they comply
with all the requirements of each applicable Philippine financial reporting standard.
Accounting policies
Accounting policies are defined as the specific principles, methods, practices, riles, bases and
conventions adopted by an entity in preparing and presenting financial statements.
Accounting standards set out the required recognition and measurement principle that an entity
shall follow in preparing its financial statements, and shall often prescribe the accounting policy
to be adopted.
Significant accounting policies
The summary of significant accounting policies shall disclose the following:
a. The measurement basis used
b. The accounting policies used
Disclosure of measurement basis
It is important for an entity to inform users of the measurement basis used in the financial
statements because the basis on which the entity prepared the financial statements significantly
affects the users’ analysis.
Under the revised conceptual framework, the measurement bases are historical cost and
current value.
Current value includes fair value, value in use, fulfillment value and current cost.
Disclosure of accounting policies
In deciding whether a particular accounting policy should be disclosed, management shall
consider whether the disclosure would assist users in understanding how transactions, other
events and conditions are reflected in the financial statements.
Disclosure of particular accounting policies is especially useful to users when those policies are
selected from alternatives allowed in Philippine financial reporting standards.
Disclosure of judgment
PAS 1, paragraph 122, provides that an entity shall disclose in the summary of significant
accounting policies the judgments that management has made in the process of applying
accounting policies and that have effect on the amounts recognized in the financial statements.
For example, management makes judgment in determining the following:
a. Whether financial assets are to be measured at fair value or at amortized cost.
b. Whether in substance particular sales of goods are product financing arrangement and
therefore do not give rise to revenue.
The disclosure of information about judgment is mandatory.
Disclosure of estimation uncertainty
PAS 1, paragraph 125, provides that an entity shall disclose information about the assumptions
it makes about the future and other major sources of uncertainty at the end of the reporting
period that have a significant risk of resulting in a material adjustment to the carrying amount of
assets and liabilities within the next financial year.
With respect to those assets and liabilities, the notes shall include the nature and carrying
amount of the assets and liabilities at the end of the reporting period.
The disclosure of information about key sources of estimation uncertainty is mandatory.
Other disclosures
PAS 1, paragraph 138, provides than an entity shall disclose the following:
a. The domicile and legal form of the entity, its country of incorporation and the address of
the registered office or principal place of business.
b. A description of the nature of the entity’s operations and its principal activities.
c. The name of the parent and the ultimate parent of the group.
Paragraph 137 provides that an entity shall disclose the following:
a. The amount of dividends proposed or declared before the financial statement wer
authorized for issue but not recognized as distribution during the period and the related
amount per share.
b. The amount of any cumulative preference dividends not recognized.
Examples of notes to financial statements (amounts are assumed)
Note 1 - Compliance with PFRS
The financial statements have been prepared in compliance with the philippines financial
reporting standards and rules and regulations of the philippine securities and exchange
commission.
The accounting policies adopted in the preparation of financial statements have been applied on
a consistent basis.
Note 2 - Significant accounting policies
Measurement basis - the financial statements have been prepared on the basis of historical
cost, and except where stated, do not take into account changing prices and current cost of
noncurrent assets.
Inventories - inventories are measured at the lower of FIFO cost and net realizable value.
Store preopening costs - such costs are charged to expense in the year incurred.
Property, plant and equipment - property, plant and equipment are recorded at cost. Tha straight
line method is used in recording depreciation on the basis of the estimated useful life of the
assets.
Capital expenditures - expenditures incurred subsequent to the acquisition of property, plant and
equipment are expensed outright if the amounts are P5,000 and below.
Such expenditures amounted to P100,000 in 2022 and P30,000 in 2021 on the aggregate.
Cash equivalents - the entity considered all highly liquid investments with maturities of three
months or less when purchased as cash equivalents.
Intangible assets - goodwill represents the difference between the purchase price of an acquired
entity and the related fair values of net assets acquired.
Goodwill is not amortized but tested for impairment annually.
The cost of patents, copyrights and other intangible assets are amortized over their estimated
useful life. The straight line method is used for amortization.
Research and development - all expenditures for research and development are charges to
expense in the year incurred.
Income taxes - income taxes include deferred income taxes that result from all taxable and
deductible temporary differences between carrying amount for financial reporting and tax base
for tax reporting of assets and liabilities.
Earning per share - earnings per share amounts are based on the weighted average number of
ordinary shares outstanding after recognition of preference dividends. Potential ordinary shares
are not material.
Note 3 - Inventories page 85
Note 4 - Property, plant and equipment page 85
Note 5 - Contingent liability
The entity is a defendant in a patent infringement suit seeking damages of P2,000,000. The suit
is still pending and the entity's legal counsel firmly believes that the case will prosper.
Note 6 - Long term debt page 86
Note 7 - Shareholders’ equity page 86
Note 8 - Share options page 86
Related parties
Related party - parties are considered to be related if one party has:
a. The ability to control the other party
b. The ability to exercise significant influence over the other party
c. Joint control over the entity
Control is the power over the investee of the power to govern the financial and operating
policies of an entity so as to obtain benefits.
Control is ownership directly or indirectly through subsidiaries of more than half of the voting
power of an entity.
Significant influence is the power to participate in the financial and operating policy decision of
an entity but not control of those policies.
Significant influence may be gained by share ownership of 20% or more.
If an investor holds, directly or indirectly through subsidiaries, 20% or more of the voting power
of the investee, it is presumed that the investor has significant influence, unless it can be clearly
demonstrated that this is not the case.
Beyond the mere 20% threshold of ownership, the existence of significant influence is usually
evidenced by the following factors:
a. Representation in the board of directors
b. Participation in policy making process
c. Material transactions between the investor and the investee
d. Interchange of managerial personnel
e. Provision of essential technical information
Joint control is the contractually agreed sharing of control over an economic activity
Examples of related parties
1. Affiliates - meaning the parent, the subsidiary and fellow subsidiaries. If the investor
owns more that 50% of an investee, the investor is known as parent and the investee is
known as the subsidiary. The subsidiary is related to the parent and fellow subsidiaries
of one parent are also related to each other
2. Associates - meaning the entities over which one party exercises significant influence. In
an investor owns at least 20% of the investee, the investee is known as associate. The
associate is related to the investor. The term associate includes the subsidiary or
subsidiaries of the associate.
3. Ventures are related to the joint venture because they have joint control of the activities
of the joint venture. However, the fellow venturers are not related to each other, unlike
fellow subsidiaries.
Other related parties
1. Key management personnel - these are the person with managerial positions, like the
president, vice-president, chief executive officer and other officers with responsibility of
controlling the activities of entity.
2. Close family members of key management personnel
a. The individual’s spouse and children
b. Children of the individual’s spouse
c. dependents of the individual or the individual’s spouse
3. Individuals or shareholders owning at least 20% of the reporting entity. The close family
members of sire individuals are also related to the reporting entity.
4. Postemployment benefit plant for the benefit of employees. Normally, the retirement plan
of an entity is funded by contributions from the entity. Such contributions constitute the
trust fund handled by a trustee. Such trust fund is related to the reporting entity.
Related Party transaction
A related party transaction is a transfer of resources or obligations between related parties,
regardless of whether a price is charged,
PAS 24, paragraph 20, provides the following examples of elated party transaction:
1. Purchase and sale of goods
2. Purchase and sale of property and other asset
3. Rendering or receiving services
4. Leases
5. Transfer of research and development
6. License agreement
7. Finance arrangements, including loans and equity contributions in cash or in kind
8. Guarantee and collateral
9. Settlement of liabilities on behalf of the entity or by the entity on behalf of another party.
Related party disclosures
PAS 24, paragraph 12, requires disclosure of related party relationships where control exist
irrespective of whether there have been transactions between the related parties.
In other words, relationships between parents and subsidiaries shall be disclosed regardless of
whether there have been transactions between those related parties.
An entity shall disclose the name of the entity’s parent and if different, the ultimate controlling
party.
If neither the entity’s parent nor the ultimate controlling party produces financial statements
available for public use, the name of the next most senior parent that does so shall also be
disclosed.
Disclosures of related party transaction
PAS 24, paragraph 17, provides that if there have been transactions between related parties, an
entity shall disclose the nature of the related party relationship as well as information about the
transactions and outstanding balances necessary for understanding the financial statement.
As a minimum, the disclosures of related party transaction shall include:
a. The amount of the transaction
b. The amount of outstanding balance, terms and condition, whether secured or
unsecured, the nature of consideration to be provided in settlement.
c. The allowance for doubtful accounts related to the outstanding balance
d. The expense recognized during the period in respects to doubtful accounts due to from
related parties.
Disclosures that related party transactions were made on terms equivalent to those that prevail
in arm’s length transactions are made only if such terms can be substantiated.
Key management personnel compensation
PAS 24, paragraph 16, provides that an entity shall disclose key management personnel
compensation in total and for each of the following categories:
a. Short-term employee benefits
b. Postemployment benefits, for example, retirement pensions
c. Other long-term benefits
d. Termination benefits
e. Share based payment transactions, for example, share options.
Unrelated parties
Unrelated parties include the following:
1. Two entities simply because they have a director or key management personnel in
common.
2. Providers of finance, trade unions, public utilities and government agencies in the course
of their normal dealings with an entity by virtue only of those dealings.
3. A single customer, supplier, franchisor or general agent with whom an entity transacts a
significant volume of business merely by virtue of the resulting economic dependence.
4. Two venturers simply because they share joint control over a joint venture. Dellow
venturers are unrelated to each other.
Transactions with government-related entities
A reporting is exempted from providing the normal disclosures for transactions with:
a. A government that has control, joint control or significant influence over the entity.
b. Other entities controlled, jointly controlled or significantly influenced by the same
government.
In applying the exemption, the reporting entity is required to disclose only the following:
a. The name of the government and the nature of the relationship with the reporting entity.
b. The information on the nature and amount of each “individually” significant transaction
with the government.
Related party disclosures not required
PAS 24, paragraph 3, requires disclosure of related party transactions and outstanding balances
in the separate financial statements of a parent, subsidiary, associate or venturer.
However, paragraph 4 provides that intragroup related party transactions and outstanding
balances are eliminated in the preparation of consolidated financial statements of the group.
Pricing policies
Accounting recognition of transfer of resources is normally based on the price agreed upon
between the parties. Between unrelated parties, the price is an arm’s length price.
Between related parties, there may be a degree of flexibility in the price setting process that is
not present between unrelated parties.
PAS 24 did not provide for the measurement of related party transactions. However, a variety of
methods is used to price transactions between related parties.
1. Uncontrolled price method - this sets the price by reference to comparable goods sold in
an economically comparable market to a buyer unrelated to the seller.
2. Resale price method - this method is often used where goods are transferred between
related parties before a sale to an independent party is made. This reduces the resale
price by a margin, representing an amount from which the reseller would seek to recover
cost and make an appropriate profit.
3. Cost plus method - this method seeks to add an appropriate markup to the supplier’s
cost.
4. No price method - literally, no price is charged, as in the case of free provision of
management services and the extension of free credit on a debt.
Events after reporting period
PAS 10, paragraph 3, defines events after the reporting period as those events, whether
favorable or unfavorable, that occur between the end of reporting period and the date on which
the financial statements are authorized for issue.
Types of events after the reporting period
Events after the reporting period may require either adjustment or disclosure:
a. Adjusting events after the reporting period are those that provide evidence of conditions
that exist at the end of the reporting period.
b. Nonadjusting events after reporting period are those that are indicative of conditions that
arise after the end of reporting period.
Examples of adjusting events
1. Settlement after the reporting period of a court case because it confirms that the entity
already has a present obligation at the end of reporting period.
2. Bankruptcy of a customer which occurs after the reporting period.
3. The determination after the reporting period of the cost of assets purchased of the
proceeds from assets sold before the end of reporting period.
4. The determination after the reporting period of the profit sharing or bonus payment if the
entity has the present obligation at the end of reporting period to make such payment.
5. The discovery of fraud or errors that show the financial statements were incorrect.
Examples of nonadjusting events
1. Business combination after the reporting period
2. Plan to discontinue an operation
3. Major purchase and disposal of asset or expropriation of major asset by government
4. Destruction of a major production plant by a fire after the reporting period
5. Major ordinary share transactions and potential ordinary share transactions after the
reporting period
6. Announcing or commencing the implementation of a major restructuring
7. Abnormally large changes after the reporting period in asset prices or foreign exchange
rates
8. Entering into significant commitments or contingent liabilities, for example, by issuing
guarantees.
9. Commencing major litigation arising solely from events that occurred after the reporting
period
10. Change in tax rate enacted or announced after the end of reporting period that has
significant effect on current and deferred tax assets and liabilities
Financial statements authorized for issue
Financial statements are authorized for issue when the board of directors reviews the financial
statement and authorizes the issue.
In some cases, an entity is required to submit its financial statements to the shareholders for
approval after the financial statements have been issued.
In such cases, the financial statements are authorized for issue on the date of issue by the
board of directors and not on the date when shareholders approve the financial statements.
Disclosure of date of authorization for issue
PAS 10, paragraph 17, provides that an entity shall disclose the date when the financial
statements are authorized for issue and who gave the authorization.
If the entity’s owners or others have the power to amend the financial statements after issue, the
entity shall disclose such fact.
It is important for users to know when the financial statements are authorized for issue because
the financial statements do not reflects events after this date.
Chapter 4
INCOME STATEMENT
An income statement is a formal statement showing the financial performance or profit or loss of
an entity for a period of time.
The financial performance of an entity is primarily measured in terms of the level of income
earned by the entity through the effective and efficient utilization of resources.
The financial performance is also known as the results of operations.
The income statement for a period presents the income, expenses, gains, losses and net
income or loss recognized during the period.
The transaction approach is the conventional or traditional preparation of income statement in
conformity with PFRS.
This approach of computing net income or loss requires the determination of how much income
was earned during the year and how much expenses were incurred in earning the revenue.
Information about the financial performance of an entity, in particular its profitability, is useful in
predicting the capacity of the entity to generate cash flows from existing resources.
Comprehensive income
Comprehensive income is the change in equity during a period resulting from transactions and
other events, other than changes resulting from transactions with owners in their capacity as
owners.
Accordingly, comprehensive income includes profit or loss and other comprehensive income.
Profit or loss
Profit or loss is the total of income less expenses, excluding the components of other
comprehensive income.
This amount is the bottom line in the traditional income statement.
An entity may use net income or net loss to describe profit or loss.
Other comprehensive income (OCI)
Other comprehensive income comprises items of income and expense including reclassification
adjustments that are not recognized in profit or loss as required or permitted by Philippine
Financial Reporting Standards.
The components of other comprehensive income include the following:
1. Unrealized gain or loss on equity investment measured at fair value through other
comprehensive income
2. Unrealized gain or loss on debt investment measured at fair value through other
comprehensive income
3. Gain or loss from translating the financial statements of a foreign operation
4. Revaluation surplus during the year
5. Unrealized gain or loss from derivative contracts designated as cash flow hedge
6. Remeasurements of defined benefit plan
7. Change in fair value attributable to credit risk of a financial liability designated at fair value
profit or loss
Presentation of other comprehensive income
PAS 1, paragraph 82A, provides that the other comprehensive income section shall present line
items for amounts of other comprehensive income in the period, classified by nature.
The line items for amounts of OCI shall be grouped as:
a. OCI that will be reclassified subsequently to profit or loss when specific conditions are met.
b. OCI that will be reclassified subsequently to retained earnings.
OCI that will be reclassified subsequently to profit or loss
a. Gain or loss from translating financial statements of a foreign operation.
b. Unrealized gain or loss on derivative contracts designated as a cash flow hedge.
c. Unrealized gain or loss on debt investment measured at fair value through OCI.
Reclassification adjustments are amounts reclassified to profit or loss in the current period that
we recognized in other comprehensive income in the current or previous periods.
OCI that will be reclassified to retained earnings
a. Unrealized gain or loss on equity investment measured at fair value through OCI
Under PFRS 9, the unrealized gain or loss is reclassified to retained earnings upon
disposal of the investment.
b. Change in revaluation surplus
The realization of the revaluation surplus is through retained earnings.
c. Remeasurements of a defined benefit plan
The remeasurements are not recycled subsequently to profit or loss but may be
transferred within equity or retained earnings.
d. Gain or loss attributable to credit risk of a financial liability designated at fair value
through profit or loss.
The gain or loss may be recycled subsequently within equity or retained earnings.
Presentation of comprehensive income
PAS 1, paragraph 81, provides that an entity has two options of presenting comprehensive
income, namely:
1. Two-statement approach
a. An income statement showing the components of profit or loss.
b. A statement of comprehensive income beginning with profit or loss as shown in the
income statement plus or minus the components of other comprehensive income.
2. Single statement approach
This is the combined statement showing the components of profit or loss and
components of other comprehensive income.
Sources of income
a. Sales of merchandise to customers
The income from sales shall include all sales to customers during the period minus sales
returns, allowances and discounts.
b. Rendering of services
Income from rendering of services, among others, includes professional fees, media advertising
commissions, insurance agency commissions, admission fees for artistic performance and
tuition fees.
c. Use of entity resources
This income includes interest, rent, royalty and dividend income.
d. Disposal of resources other than products
Examples include gain on sale of investments, gain on sale of property, plant and equipment
and gain on sale of intangible assets.
Components of expense
a. Cost of goods sold or cost of sales
b. Distribution costs of selling expenses
c. Administrative expenses
d. Other expenses
e. Income tax expense
Classifications of expenses
Distribution costs or selling expenses constitute costs which are directly related to selling,
advertising and delivery of goods to customers.
Distribution costs include:
a. Salesmen’s salaries
b. Sales commissions
c. Traveling and marketing expenses
d. Advertising and publicity expenses
e. Freight out
f. Depreciation of delivery equipment and store equipment
Administrative expenses constitute cost of administering the business. These ordinarily include
all operating expenses not related to selling and cost of goods sold.
Administrative expenses include:
a. Doubtful accounts
b. Office salaries and expenses of general executives
c. Office supplies expense
d. Contributions to charity
e. Professional fees
f. Depreciation of office building and office equipment
g. Amortization of intangible assets
Other expenses are those expenses which are not directly related to the distribution and
administrative function.
The other expenses are the expenses and losses from peripheral or incidental transactions of
the entity.
Other expenses include:
a. Loss on sale of trading investment
b. Loss on sale of property, plant and equipment
c. Loss on sale of noncurrent investment
d. Loss on sale of intangible asset
e. Casualty loss from earthquake, typhoon, hurricane, tsunami, flood, fire, storm surge and
other natural disaster
f. Expropriation loss
No more extraordinary items
PAS 1, paragraph 87, specifically mandates that an entity shall not present any items of income
and expenses as extraordinary items, in the income statement or statement of comprehensive
income or in the notes.
Unusual and infrequent items of income and expense are considered component of income
from continuing operations.
Thus, expropriation loss and casualty loss from earthquake, typhoon, flood, fire and other
natural disaster are considered component of income from continuing operations.
Separate disclosure
PAS 1, paragraph 97, provides that when items of income and expense are material, their
nature and amount shall be disclosed separately.
Paragraph 98 provides the circumstances that would give rise to the separate disclosure of
items of income and expense.
Items of income and expense requiring disclosure
a. Writedown of inventory to net realizable value and reversal of such writedown
b. Writedown of property, plant and equipment to recoverable amount and reversal of such
writedown
c. Restructuring of the activities of an entity and reversal of any provision for the cost
restructuring
d. Disposal of an item of property, plant and equipment
e. Disposal of investment
f. Discontinued operation
g. Litigation settlement
h. Other reversal of provision
Line items
PAS 1, paragraph 82, provides that the line items in the statement of comprehensive income
are:
a.
b.
c.
d.
Revenue
Gain or loss from derecognition of financial assets measured at amortized cost
Finance cost
Share of income or loss of associate and joint venture accounted for using the equity
method
e. Income tax expense
f.
Gain or loss on reclassification of a financial asset from amortized cost to fair value
through profit or loss
g. Gain or loss on reclassification of a financial asset from fair value through OCI to fair
value through profit or loss
The cumulative amount in OCI is reclassified to profit or loss.
h. A single amount comprising discounted operations
i. Profit or loss for the period
j. Other comprehensive income
k. Comprehensive income for the period
The following items shall be disclosed on the face of the income statement and statement of
comprehensive income:
a. Profit or loss attributable to noncontrolling interest and owners of the parent.
b. Total comprehensive income attributable to noncontrolling interest and owners of the
parent.
An entity shall present additional line items, headings and subtotals in the statement of
comprehensive income or separate income statement when such presentation is relevant to an
understanding of the financial performance of the entity.
Forms of income statement
PAS 1, paragraph 99, provides that an entity shall present on the face of the income statement
an analysis of expenses using a classification based on either the function of expenses or their
nature within the entity, whichever provides information that is reliable and more relevant.
Accordingly, the income statement may be presented in two ways, namely functional and
natural.
Functional presentation
The functional presentation is the traditional and common form of income statement.
The functional presentation is also known as the cost of goods sold method.
This form classifies expenses according to their function as part of cost of goods sold,
distribution costs, administrative activities and other activities.
Entities classifying expenses by function shall disclose additional information on the nature of
expenses, including depreciation, amortization and employee benefit costs.
Natural presentation
This presentation is referred to as the nature of expense method.
Under this form, expenses are aggregated according to their nature and not allocated among
various functions within the entity.
In other words, the natural expenses are no longer classified as cost of goods sold, distribution
costs, administrative and other activities.
The expenses which are of the same nature are grouped or aggregated and presented as one
item.
Functional income statement - page 125
Note 1 - Net sales
Note 2 - COGS
Note 3 - Other income
Note 4 - Investment income
Note 5 - Distribution costs
Note 6 - Administrative expenses
Note 7 - Other expenses
Note 8 - Finance cost
Natural income statement- page 127
Note 1 - Net sales
Note 2 - Other income
Note 3 - Investment income
Note 4 - Increase in inventory
Note 5 - Net purchases
Note 6 - Employee benefit costs
Note 7 - Supplies expense
Note 8 - Depreciation
Note 9 - Other expenses
Note 10 - Finance cost
Which form of income statement?
There is no prescribed format.
PAS 1, paragraph 105, simply states that because each method of presentation has merit for
different types of entities, management is required to select the presentation that is reliable and
more relevant.
The cost of goods sold method usually would provide more relevant information to the users.
Besides, the income statement is simple and easy to understand.
STATEMENT OF COMPREHENSIVE INCOME
As stated earlier, in addition to the income statement, a statement of comprehensive income is
also prepared in order to show the total comprehensive income.
The statement of comprehensive income starts with the net income or loss as shown in the
income statement plus or minus the components of other comprehensive income.
The purpose of this statement is to provide a more comprehensive information on financial
performance measured more broadly than the income as traditionally computed.
Illustration - page 130
Single statement of comprehensive income
Another option in presenting the components of profit or loss and components of other
comprehensive income is to prepare a single statement of comprehensive income.
This single statement is the combined income statement and statement of comprehensive
income.
The single statement of comprehensive income following the functional presentation may
appear as: page 131
Chapter 5
STATEMENT OF CHANGES IN EQUITY
TECHNICAL KNOWLEDGE
To Define Equity
To know the preparation of the statement of changes in equity
To identify the components of equity
To identify the items directly affecting retained earnings.
EQUITY
Equity is defined as the residual interest in the assets of an entity after deducting all of the
liabilities.
In other words, equity is the equivalent of net assets, menning total assets minus total
liabilities. Although equity is defined as a residual, it may be subclassified in the statement
of financial position
In a corporate entity, the following subclassifications may be shown separately:
a. Share capital - funds contributed by shareholders equal to the par or stated value
b. Share premium - funds contributed by shareholders in excess of par or stated value
c. Retained earnings which may be unappropriated and appropriated
The holders of instruments classified as equity are simply known as "owners".
STATEMENT OF CHANGES IN EQUITY
The statement of changes in equity is a formal statement that shows the movements in the
elements or components of the shareholders' equity.
An entity shall present a statement of changes in equity showing:
1. Comprehensive income for the period.
2. For each component of equity, the effects of changes in accounting policies and
corrections of errors.
3. For each component of equity, a reconciliation between the carrying amount at the
beginning and end of the period, separately disclosing changes from:
a. Profit or loss
b. Each item of other comprehensive income
c. Transactions with owners in their capacity as owners showing separately contributions by
and distributions to owners
Generally, reserves include share premium, retained earnings appropriated, revaluation
surplus and other comprehensive income. No objection if such reserves are shown
separately.
Statement of retained earnings
The statement of retained earnings shows the changes affecting directly the retained
earnings of an entity.
The statement of retained earnings is no longer a separate financial statement but now a
part of the statement of changes in equity.
The important data affecting the retained earnings that should be clearly disclosed in the
statement of retained earnings are:
a. Net income or loss for the period
b. Prior period errors
c. Dividends declared and paid to shareholders
d. Effect of change in accounting policy
e. Appropriation of retained earnings
Items directly affecting retained earnings
Net income or loss for the period
Net income is added because it increases retained earnings and net loss is deducted
because it decreases retained earnings.
Prior period errors
The prior period errors are shown as adjustment of the beginning balance of retained
earnings to arrive at the corrected beginning balance.
If the net income of the prior period is understated, the amount of error is added to retained
earnings. If the net income of the prior period is overstated, the amount of the error is
deducted from retained earnings.
Dividends to shareholders - The dividends declared or paid during the year shall be
deducted from the retained earnings.
Effect of change in accounting policy is shown as an adjustment of the beginning balance of
retained earnings.
If the net income of prior period is understated because of change in accounting policy, the
effect is added to the. beginning retained earnings.
If the net income of prior period is 'overstated because of change in accounting policy, the
effect is deducted from the beginning retained earnings.
Other comprehensive income
Some components of other comprehensive income are subsequently reclassified to
retained earnings.
Retirement of treasury shares
If the cost of treasury shares is more than the original issue price, the difference is charged
to retained earnings.
Conversion of preference shares into ordinary shares
If the total par or stated value of the ordinary shares is more than the original issue price of
the preference shares, the difference is charged to retained earnings.
Retained Earnings appropriated
The amount of appropriation is deducted from the unappropriated balance of retained
earnings
Retained earnings
Related earnings appropriated
xx
xx
Conversely , if the appropriation is subsequently canceled, it is reverted or added back to
the unappropriated balance.
Related earnings appropriated
Retained earnings
xx
xx
Retained earnings may be appropriated for the following reasons:
a. Legal requirement as in the case of treasury shares
b. Contractual requirement, as in the case of bond redemption
c. Entity policy, as in the case of an appropriation for contingencies