COURSE TITLE:
CONCEPTUAL FRAMEWORK and ACCOUNTING SRANDARDS
Course Description:
A conceptual framework for financial accounting is an accounting theory
that is prepared by a body which sets standards. This body sets the standards to
test problems that are practical, objectively. A conceptual framework plays a
significant role in issues that concern financial reporting.
Course Credit: 3 units
Contact Hours: 54 hours
Prerequisite: none
Course Outline:
Part 1 – Introduction
Part 2 – Conceptual Framework and Accounting Standards
Chapter 1 – The Accountancy Profession
Chapter 2 –Conceptual Framework (Objective for Financial Reporting)
Chapter 3- Conceptual Framework (Qualitative Characteristics)
Chapter 4- Conceptual Framework (Financial Statements and Reporting Entity
Underlying Assumptions)
Chapter 5- Conceptual Framework (Elements of Financial Statements)
Chapter 6- Conceptual Framework (Recognition and Measurement
Chapter 7 –Conceptual Framework (Presentation and Disclosure Concepts of
Capital)
Chapter 8- Presentation of Financial Statements (Statement of Financial Position
PAS 1)
Chapter 9- Presentation of Financial Statements (statement of Comprehensive
Income PAS 1)
Chapter 10- Statement of Cash Flows (PAS 7)
Chapter 11 –Accounting Policies, Estimate and Errors (PAS 8)
Chapter 12 – Events after the Reporting Period (PAS 10)
Chapter 13 Related Party Disclosures (PAS 24)
Chapter 14 – Inventories (PAS 2)
Chapter 15 – Chapter 15 –Properties, Plant and Equipment (PAS 16)
Chapter 16 – Government Grant (PAS 20)
Chapter 17 –Borrowing Costs (PAS 23)
Chapter 18 –Investment in Associates (PAS 28)
Chapter 19 –Impairment of assets (PAS 36)
Chapter 20 – Intangible Assets (PAS 38)
Chapter 21 Investment Property (PAS 40)
Chapter 22 –Agriculture (PAS 41)
Chapter 23 –Provision, Contingent Liability and Asset (PAS 37)
Chapter 24 – Financial Instruments
Chapter 25 – Income Taxes (PAS 120
Chapter 26 – Employee Benefits (PAS 19)
Chapter 27 –Earnings per Share (PAS 33)
Chapter 28 –Interim Financial Reporting (PAS 34)
Chapter 29 –Reporting in Hyperinflationary Economy (PAS 29)
Chapter 30 –First Time Adoption of PFRS (PFRS 1)
Chapter 31- Share-Based Payment (PFRS 2)
Chapter 32 – Noncurrent Asset Held for Sale (PFRS 5)
Chapter 33 – Discontinued Operation (PFRS 5)
Chapter 34 – Exploration and Evaluation of Mineral Resources
Chapter 35 – Operating Segments (PFRS 8)
Chapter 36 – Financial Instruments (Measurement of Financial Asset PFRS 9)
Chapter 37 – Fair Value Measurement (PFRS 13)
Chapter 38 – Revenue from Contracts with customers (PFRS 15)
Chapter 39 – Leases (PFRS 16)
Chapter 40 – IFRIC Interpretations
TEXTBOOK:
CONCEPTUAL FRAMEWORK and ACCOUNTING STANDARDS
By: Conrado T. Valix
Jose F. Peralta
Christian Aris M. Valix
2020 Edition
Part 1 – Introduction to Course
This course aims to provide a solid foundation for the accounting students
before taking up the three intermediate or financial accounting subjects.
It will cover the description of the accountancy profession, the Conceptual
Framework, an introduction to the preparation of financial statements and
concise description of all Philippine Accounting Standards or PAS and Philippine
Financial Reporting Standards of PFRS related to financial accounting
Part 2 – Conceptual Framework and Accounting
Standards
Chapter 1 – The Accountancy Profession
What is accounting?
The Accounting Standards Council provides the following definition:
Accounting is a service activity.
The accounting function is to provide quantitative information, primarily financial
in nature, about economic entities, that is intended to be useful in making
economic decision.
The Committee on Accounting Terminology of the American Institutes of Certified
Public Accountants defines accounting as follows:
Accounting is the art of recording classifying and summarizing in a
significant manner and in terms of money, transactions and events which are in
part at least of a financial character and interpreting the results thereof.
The American Accounting Association in its Statement of Basic Accounting Theory
defines accounting as follows:
Accounting is the process of identifying, measuring and communicating
economic information to permit informed judgment and decision by users of the
information.
Important Points
The following important points made in the definition of accounting should be
noted:
One – accounting is about quantitative information
Two - the information is likely to be financial in nature
Three - the information should be useful in decision making
The definition that has stood the test of time is the definition given by the
American Accounting Association.
This definition states that the very purpose of accounting is to provide
quantitative information to be useful in making an economic decision.
The definition also states that accounting has a number of components, namely:
Identifying as the analytical component.
Measuring as the technical component
Communicating as the formal component.
IDENTIFYING
This accounting process is the recognition or non-recognition of business
activities as “accountable” events.
Not all business activities as accountable.
For example, the hiring of employees, the death of the entity president and
the entering into a contract are all business activities but such events are not
accountable because they cannot be quantified or expressed in terms of a unit of
measure.
An event is accountable or quantifiable when it has an effect on assets,
liabilities and equity.
In other words, the subject matter of accounting is economic activity or the
measurement of economic resources and economic obligations.
Only economic activities are emphasizes and recognized in accounting,
Sociological and psychological matters are beyond the province of
accounting.
External and Internal Transactions
Economic activities of an entity are referred to as transactions which may
be classified as external and internal.
External transactions or exchange transactions are those economic events
involving one entity and another entity.
Examples of external transactions are:
Purchase of goods from a supplier
Borrowing money from a bank
Sales of goods to a customer
Payment of salaries to employees
Payment of taxes to the government
Internal transactions are economic events involving the entity only.
Internal transactions are the economic activities that take place entirely within
the entity.
Production and casualty loss are examples of internal transactions.
Production is the process by which resources are transforms into products.
Casualty is any sudden and unanticipated loss from fire, flood, earthquake and
other event ordinarily termed as an act of GOD.
MEASURING
This accounting process is the assigning of peso amounts to the
accountable economic transactions and events.
If accounting information is to be useful, it must be expressed in terms of a
common financial denominator.
Financial statements without monetary amounts would be largely
unintelligible or incomprehensible.
The Philippine peso is the unit of measuring accountable economic
transactions.
The measurement bases are historical cost and current value.
Historical cost is the original acquisition cost and the most common
measure of financial transactions.
Current value includes fair value, value in use, fulfillment value and current
cost.
COMMUNICATING
Communicating is the process of preparing and distributing accounting
reports potential users of accounting information.
Identifying and measuring are pointless if the information contained in the
accounting records cannot be communicated in some form to potential users.
Actually, the communicating process is the reason why accounting has
been called “universal language of business”.
Implicit in the communication process are the recording, classifying and
summarizing aspects of accounting.
Recording or journalizing is the process of systematically maintaining a
record of all economic business transactions after they have been identified and
measured.
Classifying is the sorting or grouping of similar and interrelated economic
transactions into their respective classes. It is accomplished by posting to the
ledger.
The ledger is a group of accounts which are systematically categorized into
asset accounts, liability accounts, equity accounts, revenue accounts and expense
accounts.
Summarizing is the preparation of financial statements which include the
statement of financial position, income statement, statement of comprehensive
income, statement of changes in equity and statement of cash flows.
Accounting as an Information System
Accounting is an information system that measures business activities,
processes information into reports and communicates the reports to decision
makers.
A key product of this information system is a set of financial statements –
the documents that report financial information about an entity to decision
makers.
Financial reports tell us how well an entity is performing in terms of profit
and loss and where it stands in financial terms.
Overall Objective of Accounting
The overall objective of accounting is to provide quantitative financial
information about a business that is useful to statement users particularly owners
and creditors in making economic decisions.
An accountant’s primary task is to supply financial information so that the
statement users could make informed judgment and better decision.
The essence of accounting is decision-usefulness.
Investors and other users are interested in financial accounting information
necessary in making important and significant economic decisions.
THE ACCOUNTANCY PROFESSION
At present Republic Act No. 9298 is the law regulating the practice of
accountancy in the Philippines.
This law is known as the Philippine Accountancy Act of 2004.
Accountancy has developed as a profession attaining a status equivalent to
that of law and medicine.
In the Philippines, in order to qualify to practice the accountancy
profession, a person must finish a degree in Bachelor of Science in Accountancy
and pass a very difficult government examination given by the Board of
Accountancy.
The Board of Accountancy is the body authorized by law to promulgate
rules and regulations affecting the practice of the accountancy profession in the
Philippines.
The Board of Accountancy is responsible for preparing and grading the
Philippine CPA examination.
This computer-based examination is offered twice a year, one in May and
another in October, in authorized testing centers around the country.
Limitation of the Practice of public accountancy
Single practitioners and partnerships for the practice of public accountancy
shall be registered certified public accountant in the Philippines.
A certificate of accreditation shall be issued to certified public accountants
in public practice only upon showing in accordance with rules and regulations
promulgated by the Board of Accountancy and approved by the Professional
Regulation Commission that such registrant has acquired a minimum of three
years of meaningful experience in any of the areas of public practice including
taxation.
The Securities and Exchange Commission shall not register any corporation
organized for the practice of public accountancy.
Accreditation to Practice Public Accountancy
Certified public accountants, firms and partnerships of certified public
accountants, including partners and staff members thereof, are required to
register with the Board of Accountancy and Professional Regulation Commission
for the practice of public accountancy.
The Professional Regulation Commission upon favorable recommendation
of the Board of Accountancy shall issue the Certificate of Registration to practice
public accountancy which shall be valid for three years and renewable every three
years upon payment of required fees.
Certified Public Accountants generally practice their profession in three
main areas, namely:
Public accounting
Private accounting
Government accounting
PUBLIC ACCOUNTING
The field of public accounting or public accountancy is composed of
individual practitioners, small accounting firms and large multinational
organizations that render independent and expert financial services to the public.
Public accountants usually offer three kinds of services, namely auditing,
taxation and management advisory services.
As a matter of fact, large multinational accounting firms have separate
division for each of these services.
AUDITING
Auditing has traditionally been the primary service offered by most public
accounting practitioners.
Auditing or external auditing is the examination of financial statements by
independent certified public accountant for the purpose of expressing an opinion
as to the fairness with which the financial statements are prepared.
Actually, external auditing is the attest function of independent CPAs.
The Bureau of Internal Revenue requires audited financial statements to
accompany the filing of annual income tax returns.
Banks and other lending institutions frequently require an audit by an
independent CPA before granting a loan to the borrower.
Creditors and prospective investors place considerable reliance on audited
financial statements on making economic decision.
TAXATION
Taxation service includes the preparation of annual income tax returns and
determination of tax consequences of certain proposed business endeavors.
The CPA not infrequently represents the client in tax investigations.
To offer this service effectively and efficiently, the public accountant must be
thoroughly familiar with the tax laws and regulations and updated with changes in
taxation law and regulations and updated with changes in taxation law and court
cases concerned with interpreting taxation law.
MANAGEMENT ADVISORY SERVICES
Management advisory services have become increasingly important in recent
years although audit and tax services are undoubtedly the mainstay of public
accountants.
The term management advisory services has no precise coverage but is used
generally to refer to services to clients on matters of accounting, finance, business
policies, organization procedures, product costs, distribution and many other
phases of business conduct and operations.
Specifically, management advisory services include:
Advice on installation of computer system
Quality control
Installation and modification of accounting system
Budgeting
Forward planning and forecasting
Design and modification of retirement plans
Advice on mergers and consolidations
PRIVATE ACCOUNTING
Many Certified Public Accountants are employed in business entities in various
capacity as accounting staff, chief accountant, internal auditor and controller.
The highest accounting officer in an entity is known as the controller.
The major objective of the private accountant is to assist management in planning
and controlling the entity’s operations.
Private accounting includes maintaining the records, producing the financial
reports, preparing the budgets and controlling and allocating the resources of the
entity.
The private accountant has also the responsibility for the determination of the
various taxes the entity is obliged to pay.
GOVERNMENT ACCOUNTING
Government accounting encompasses the process of analyzing, classifying,
summarizing and communicating all transactions involving the receipt and
disposition of government funds and property and interpreting the results
thereof.
The focus of government accounting is the custody and administration of public
funds.
Many Certified Public Accountants are employed in many branches of the
government, mare particularly:
Bureau of Internal Revenue
Commission on Audit
Department of Budget and Management
Securities and Exchange Commission
Bangko Sentral ng Pilipinas
CONTINUING PROFESSION DEVELOPMENT (CPD)
Republic Act No. 10912 is the law mandating and strengthening the continuing
professional development program for all regulated professions, including the
accountancy profession.
All certified public accountants shall
regulations on continuing professional
Board of Accountancy, subject to the
Commission, in coordination with
abide by the requirements, rules and
development to be promulgated by the
approval of the Professional Regulation
the accredited national professional
organization of certified public accountants or any duly accredited educational
institutions.
Continuing professional development refers to the inculcation and acquisition of
advanced knowledge, skills, proficiency and ethical and moral values after the
initial registration of the Certified Public Accountant for assimilation into
professional practice and lifelong learning.
Continuing professional development raises and enhances the technical skill and
competence of the Certified Public Accountant.
CPD Credit Units
The CPD credit units refer to the CPD credit hours required for the renewal of CPA
license and accreditation of a CPA to practice the accountancy profession every
three years.
Under the new BOA Resolution, all Certified Public Accountants regardless of area
or sector of practice shall be required to comply with 120 CPD credit units.
The Continuing Professional Development is required for the renewal of CPA
license and accreditation of CPA to practice the accountancy profession.
As recently promulgated, only 15 CPD credit units are required for the renewal of
CPA license.
However, 120 CPD credit units are required for accreditation of a CPA to practice
the accountancy profession.
Excess credit units earned shall not be carried over to the next three-year period,
except credit units earned for masteral and doctoral degrees.
It is to be emphasized that the Continuing Professional Development has become
mandatory for Certified Public Accountants.
Exemptions from CPD
A CPA shall be permanently exempted from CPD requirements upon reaching the
age of 65 years.
However, this exemption applied only to the renewal of CPA license and not for
the purpose of accreditation to practice the accountancy profession.
Accounting VS Auditing
In a broad sense, accounting embraces auditing.
Auditing is one of the areas of accounting specialization.
In a limited sense, accounting is essentially constructive in nature. Accounting
ceases when financial statements are already prepared.
On the other hand, auditing is analytical. The work of an auditor begins when the
work of the accountant ends.
After the financial statements are prepared, the auditor will begin to perform the
task of auditing.
The auditor examines the financial statements to ascertain whether they are in
conformity with the generally accepted accounting principles.
Accounting VS Bookkeeping
Bookkeeping is procedural and largely concerned with development and
maintenance of accounting records.
Bookkeeping is the “how” of accounting.
Accounting is conceptual and is concerned with the why, reason or justification
for any action adopted.
Bookkeeping is a procedural element of accounting as arithmetic is a procedural
element of mathematics.
Accounting VS Accountancy
Broadly speaking, the two terms are synonymous because they both refer to the
entire field of accounting theory and practice.
Technically speaking, however, accountancy refers to the profession of
accounting practice.
Accounting is used in reference only to a particular field of accountancy such as
public accounting, private accounting and government accounting.
Financial Accounting VS Managerial Accounting
Financial accounting is primarily concerned with the recording of business
transactions and the eventual preparation of financial statements.
Financial accounting focuses on general purpose reports known as financial
statements intended for internal and external users.
Financial accounting is the accumulation and preparation of financial reports for
internal users only.
In other words, managerial accounting is the area of accounting that emphasizes
developing accounting information for use within an entity.
GENERALLY ACCEPTED ACCOUNTING PRINCIPLES
Accounting has evolved through time changing with the needs of the society. As
new types of transactions occur in trade and commerce, accountants develop
rules and procedures for recording them.
These accounting rules, procedures and practices came to be known as generally
accepted accounting principles or simply GAAP.
The principles have developed on the basis of experience, reason, custom, usage
and practical necessity.
Generally accepted accounting principles represent the rules, procedures,
practice and standards followed in the preparation and presentation of financial
statements.
Generally accepted accounting principles are like laws that must be followed in
financial reporting.
The process of establishing GAAP is a political process which incorporates political
actions of various interested user groups as well as professional judgment, logic
and research.
Purpose of Accounting Standards
The overall purpose of accounting standards is to identify proper accounting
practices for the preparation and presentation of financial statements.
Accounting standards create a common understanding between preparers and
users of financial statements particularly the measurement of assets and
liabilities.
A set of high-quality accounting standards is a necessity to ensure comparability
and uniformity in financial statements based on the same financial information.
FINANCIAL REPORTING STANDARDS COUNCIL
In the Philippines, the development of generally accepted accounting principles is
formalized initially through the creation of the Accounting Standards Council or
ASC.
The Financial Reporting Standards Council or FRSC now replaces the Accounting
Standards Council.
The FRSC is the accounting standard setting body created by the Professional
Regulation Commission upon recommendation of the Board of Accountancy to
assist the Board of Accountancy in carrying out its powers and functions provided
under R.A. NO. 9298.
The main function is to establish and improve accounting standards that will be
generally accepted in the Philippines.
The accounting standards promulgated by the Financial Reporting Standards
Council constitute the highest hierarchy of generally accepted accounting
principles in the Philippines.
The approved statements of the FRSC are known as Philippine Accounting
Standards or PAS and Philippine Financial Reporting Standards of PFRS.
Composition of FRSC
The FRSC is composed of 15 members with a Chairman who had been or is
presently a senior accounting practitioner and 14 representatives from the
following:
Board of Accountancy
Securities and Exchange Commission
Bangko Sentral ng Pilipinas
Bureau of Internal Revenue
Commission on Audit
Major Organization of prepares and users of financial statementsFinancial Executives Institute of the Philippines or FINEX
Accredited national professional organizations of CPAs:
-for public practice
-commerce and industry
-academe or education
-government
Total
1
1
1
1
1
1
2
2
2
2
14
The chairman and members of the FRSC shall have a term of three years
renewable for another term. Any member of the ASC shall not be disqualified
from being appointed to the FRSC.
Philippine Interpretations Committee
The Philippine Interpretations Committee or PIC was formed by the FRSC in
august of 2006 and has replaced the Interpretations Committee or IC formed by
the Accounting Standards Council in May 2000.
The role of the PIC is to prepare interpretations of PFRS for approval by the FRSC
and to provide timely guidance on financial reporting issues not specifically
addressed in current PFRS.
In other words, interpretations are intended to give authoritative guidance on
issues that are likely to receive divergent or unacceptable treatment because the
standards do not provide specific and clear cut rules and guidelines.
The counterpart of the PIC in the United Kingdom is the International Financial
Reporting Interpretations Committee of IFRIC which has already replaced the
Standing Interpretations Committee or SIC.
INTERNATIONAL ACCOUNTING STANDARDS COMMITTEE
The International Accounting Standards Committee or IASC is an independent
private sector body, with the objective of achieving uniformity in the accounting
principles which are used by business and other organizations for financial
reporting around the world.
It was formed in June 1973 through an agreement made by professional
accountancy bodies from Australia, Canada, France, Germany, Japan, Mexico, the
Netherlands, the United Kingdom and Ireland. And the United States of America.
The IASC is headquartered in London, United Kingdom.
Objectives of IASC
To formulate and publish in the public interest accounting standards to be
observed in the presentation of financial statements and to promote their
worldwide acceptance and observance.
To work generally for the improvement and harmonization of regulations,
accounting standards and procedures relating to the presentation of financial
statements.
INTERNATIONAL ACCOUNTING STANDARDS BOARD
The International Accounting Standards Board or IASB now replaces the
International Accounting Standards Committee or IASC
The IASC publishes standards in a series of pronouncements called the
International Financial Reporting Standards or IFRS.
However, the IASB has adopted the body of standards issued by the IASC.
The pronouncements of the IASC continue to be designated as “International
Accounting Standards” or IAS.
The IASB standard-setting process includes in the correct order research,
discussion paper, exposure draft and accounting standard.
Move towards IFRS
In developing accounting standards that will be generally accepted in the
Philippines, standards issued by other standard setting bodies such as the USA
Financial Accounting Standards Board (FASB) and the IASB are considered.
In the past years, most of the Philippine standards issued are based on American
accounting Standards.
At present, the FRSC has adopted in their entirety all International Accounting
Standards and International Financial Reporting Standards.
The move toward IFRS is essential to achieve the goal of one uniform and globally
accepted financial reporting standards.
The Philippines is fully compliant with IFRS effective January 2005, a process
which was started back in 1997 in moving from USA GAAP to IFRS.
The following factors are considered in deciding to move totally to international
accounting standards:
Support of international accounting standards by Philippines organizations, such
as the Philippine SEC, Board of Accountancy and PICPA
Increasing internalization of business which has heightened interest in a common
language for financial reporting
Improvement of international accounting standards or removal of free choices of
accounting treatments
Increasing recognition of international accounting standards by the World Bank,
Asian Development Bank and World Trade Organization.
Philippine Financial Reporting Standards
The Financial Reporting Standards Council issues standards in a series of
pronouncements called “Philippine Financial Reporting Standards” or PFRS
The Philippine Financial Reporting Standards collectively include all of the
following:
Philippine Financial Reporting Standards which correspond to International
Financial Reporting Standards.
The Philippine Financial Reporting Standards are numbered the same as their
counterpart in International Financial Reporting Standards.
Philippine Accounting Standards which correspond to International Accounting
Standards.
The Philippine Accounting Standards are numbered the same as their counterpart
in International Financial Reporting Standards.
Philippine Interpretations which correspond to Interpretations of the IFRIC and
the Standing Interpretations Committee and Interpretations developed by the
Philippine Interpretations Committee.
Chapter 2 –Conceptual Framework (Objective for
Financial Reporting)
Conceptual Framework
The Conceptual Framework for Financial Reporting is a complete, comprehensive
and single document promulgated by the International Accounting Standards
Board.
The Conceptual Framework is a summary of the terms and concepts that underlie
the preparation and presentation of financial statements for external users.
In other words, the Conceptual Framework is an attempt to provide an overall
theoretical foundation for accounting.
The Conceptual Framework is intended to guide standard-setters, preparers and
users of financial information in the preparation and presentation of statements.
It is the underlying theory for the development of accounting standards and
revision of previously issued accounting standards.
The Conceptual Framework will be used in future standard setting decision but no
changes will be made to the current IFRS.
The Conceptual Framework provides the foundation for Standards that:
Contribute to transparency by enhancing international comparability and quality
of financial information
Strengthen accountability by reducing information gap between the providers of
capital and the people to whom they have entrusted their money
Contribute to economic efficiency by helping investors to identify opportunities
and risks across the world.
Purposes of Revised Conceptual Framework
To assist the International Accounting Standards Board to develop IFRS Standards
based on consistent concepts.
To assist preparers of financial statements to develop consistent accounting
policy when no Standard applies to particular transaction or other event or where
an issue is not yet addressed by an IFRS
The assist preparers of financial statements to develop accounting policy when a
Standard allows a choice of an accounting policy
To assist all parties to understand and interpret the IFRS Standards
Authoritative Status of a Conceptual Framework
If there is a standards or an interpretation that specifically applies to a
transaction, the standard or interpretation overrides the Conceptual Framework.
In the absence of a standard or an interpretation that specifically applies to a
transaction, management shall consider the applicability of the
Conceptual Framework in developing and applying an accounting policy that
result in information that is relevant and reliable.
However, it is to be stated that the Conceptual Framework is NOT an
International Financial Reporting Standard.
Nothing in the Conceptual Framework overrides any specific International
Financial Reporting Standard.
In case where there is a conflict, the requirements of the International Financial
Reporting Standards shall prevail over the Conceptual Framework.
Users of Financial Information
Under the Conceptual Framework for Financial reporting the users of financial
information may be classified into two, namely:
Primary users
Other users
The primary users include the existing and potential investors, lenders and other
creditors.
The other users include the employees, customers, governments and their
agencies and the public.
Primary Users
The primary users of financial information are the parties to whom general
purpose financial reports 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 of the financial information is needed.
Existing and Potential Investors
Existing and potential investors are concerned with the risk inherent in and return
provided by their investments.
The investors need information to help them determine whether they should buy,
hold or sell.
Shareholders are also interested in information which enables them to assess the
ability of the entity to pay dividends.
Lenders and Other Creditors
Existing and potential lenders and other creditors a r e interested in information
which enables them to determine whether their loans, interest thereon and other
amounts owing to them will be paid when due.
Other Users
By residual definition, “other users” are users of financial information other than
the existing and potential investors, lenders and other creditors.
Other users are so called because they are parties that may find the general
purpose financial reports useful but the reports are not directed to them
primarily.
Employees
Employees are interested in information about the stability and profitability of the
entity.
The employees are interested in information which enables them to assess the
ability of the entity to provide remuneration, retirement benefits and
employment opportunities.
Customers
Customers have an interest in information about the continuance of an entity
especially when they have a long-term involvement with or are dependent on the
entity.
Government and their agencies
Government and their agencies are interested in the allocation of resources and
therefore the activities of the entity.
These users require information to regulate the activities of the entity, determine
taxation policies and as a basis for national income and similar statistics.
Public
Entities affect members of the public in a variety of ways.
For example, entities make substantial contribution to the local economy in many
ways including the number of people they employ and their patronage of local
suppliers.
Financial statements may assist the public by providing information about the
trend and the range of its activities.
Scope of Revised Conceptual Framework
Objective of Financial Reporting
Qualitative Characteristics of Useful Financial Information
Financial Statements and Reporting entity
Elements of Financial Statements
Recognition and Derecognition
Measurement
Presentation and Disclosure
Concepts of Capital and Capital Maintenance
OBJECTIVES OF FINANCIAL REPORTING
The objective of financial reporting forms the foundation of the Conceptual
Framework.
The overall 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.
The objective of financial reporting is the “why”, purpose or goal of accounting.
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 information such as financial highlights, summary of important financial
figures, analysis of financial statements and significant rations.
Financial reports also include non-financial information such as description of
major products and a listing of corporate officers and directors.
Target Users
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 existing and potential investors, lenders and other creditors
have the most critical and immediate need for information in financial reports.
As a matter of fact, the primary users of financial information are the parties that
provide resources to the entity.
Moreover, information that meets the needs of the specified primary users is
likely to meet the needs of the users such as employees, customers, governments
and their agencies.
The management of a reporting entity is also interested in financial information
about the entity.
However, management need not rely on general purpose financial reports
because it is able to obtain or access additional financial information internally.
Specific Objectives of Financial Reporting
The overall objective of financial reporting is to provide information that is useful
for decision making.
The Conceptual Framework places more emphasis on the importance of providing
information needed to assess the management stewardship of the entity’s
economic resources.
Accordingly, the specific objectives of financial reporting are:
To provide information useful in making decisions about providing resources to
the entity
To provide information useful in assessing the cash flow prospects of the entity
To provide information about entity resources, claims and changes in resources
and claims.
Economic Decisions
Existing and potential investors need general purpose financial reports in order to
enable them in making decisions whether to buy sell or hold equity investments.
Existing and potential lenders and other creditors need general purpose financial
reports in order to enable them in making decisions whether to provide or settle
loans and other forms of credit.
Assessing Cash Flow Prospects
Decisions by existing and potential investors about buying, selling or holding
equity instruments depend on the returns that they expect from an investment,
for example, dividends.
Similarly, decisions by existing and potential lenders and other creditors about
providing or settling loans and other forms of credit depend on the principal and
interest payments or other returns that they expect.
Consequently, financial reporting should provide information useful in assessing
the amount, timing and uncertainty of prospects for future net cash inflows to the
entity.
Economic Resources and Claims
General purpose financial reports provide information about the financial position
of a reporting entity.
Financial position is information about the entity’s economic resources and the
claims against the reporting entity.
The economic resources are the assets and the claims are the liabilities and equity
of the entity.
In other words, the financial position comprises the assets, liabilities and equity of
an entity at a particular moment in time.
Information about the nature and amounts of an entity’s economic resources and
claims can help users identify the entity’s financial strengths and weaknesses.
Otherwise stated, the information about financial position can help users to
assess the entity’s liquidity, solvency and the need for additional financing.
Liquidity is the availability of cash in the near future to cover currently maturing
obligations.
Solvency is the availability of cash over a long term to meet financial
commitments when they fall due.
Information about priorities and payment requirements of existing claims can
help users to predict how future cash flows will be distributed among those with a
claim against the reporting entity.
Changes in Economic Resources and Claims
General purpose financial reports also provide information about the effects of
transactions and other events that change the economic resources and claims.
Changes in economic resources and claims result from financial performance and
from other events or transactions, such as issuing debt or equity instruments.
The financial performance of an entity comprises revenue, expenses and net
income or loss for a period of time.
In other words, financial performance is the level of income earned by the entity
through the efficient and effective use of its resources.
The financial performance of an entity is also known as results of operations and
is portrayed in the income statement and statement of comprehensive income.
Usefulness of Financial Performance
Information about financial performance helps users to understand the return
that the entity has produced on the economic resources.
Information about the return the entity has produces provides an indication of
how well management has discharged its responsibilities to make efficient and
effective use of the entity’s economic resources.
Information about past financial performance is usually helpful in predicting the
future returns on the entity’s economic resources.
Information about financial performance during a period is useful in assessing the
entity’s ability to generate future cash inflows from operations.
Accrual Accounting
Accrual accounting depicts the effect of transactions and other events and
circumstances on an entity’s economic resources and claims in the periods in
which those effects occur when even if the resulting cash receipts and payments
occur in a different period.
In other words, under the accrual basis, the effects of transaction and other
events are recognized when they occur and not as cash is received or paid.
Simply stated, accrual accounting means that income is recognized when earned
regardless of when received and expense is recognized when incurred regardless
of when paid.
Information about financial performance measures in accordance with accrual
accounting provides a better basis for assessing past and future performance than
information solely about cash receipts and payments during a period.
Limitations of Financial Reporting
General purpose financial reports do not and cannot provide all of the
information that existing and potential investors, lenders and other creditors
need.
These users need to consider pertinent information from other sources, for
example, general economic conditions, political events and industry outlook.
General purpose financial reports are not designed to show the value of an entity
but the report provides information to help the primary users estimate the value
of the entity.
General purpose financial reports are intended to provide common information
to users and cannot accommodate every request for information.
To a large extent, general purpose financial reports are based on estimate and
judgment rather than exact depiction.
Management Stewardship
Information about how efficiently and effectively management has discharged its
responsibilities to use the entity’s economic resources helps users to assess
management stewardship of those resources.
Such information is also useful for predicting how management will use the
entity’s economic resources in future periods.
Hence, the information can be useful for assessing the entity’s prospects for
future net cash flows.
For example, management can decide not to dispose or sell investments when
prices are declining in order to avoid realized losses.
Chapter 3
Conceptual Framework
Qualitative characteristics
QUALITATIVE CHARACTERISTICS
Qualitative characteristics are the qualities or attributes that make financial
accounting information useful to the users.
In deciding which information to include in financial statements, the objective is
to ensure that the information is useful to the users in making economic
decisions.
Under the Conceptual Framework for Financial Reporting, qualitative
characteristics are classified into fundamental qualitative characteristics and
enhancing qualitative characteristics.
Fundamental Qualitative Characteristics
The fundamental qualitative characteristics relate to the content or substance of
financial information.
The fundamental qualitative characteristics are relevance and faithful
representation.
Information must be both relevant and faithfully represented it is to be useful.
Neither a faithful representation of an irrelevant phenomenon nor an unfaithful
representation of a relevant phenomenon helps users make good decisions.
Application of Qualitative Characteristics
The most efficient and effective process of applying the fundamental qualitative
characteristics would usually be:
First, identify an economic phenomenon that has the potential to be useful.
Second, identify the type of information about the phenomenon that would be
most relevant and can be faithfully represented.
Third, determine whether the information is available.
Relevance
In the simplest terms, relevance is the capacity of the information to influence a
decision.
To be relevant, the financial information must be capable of making a difference
in the decisions made by users.
In other words, relevance requires that the financial information should be
related or pertinent to be economic decision.
Information that does not bear on an economic decision is useless.
To be useful, information must be relevant to the decision making needs of the
users.
For example, broadly, the statement of financial position is relevant in
determining financial position and the income statement is relevant in
determining performance.
More specifically, the earnings per share information is more relevant than book
value per share in determining the attractiveness of an investment.
Ingredients of Relevance
Financial information is capable of making a difference in a decision if it has
predictive value and confirmatory value.
Financial information has predictive value if it can be used as an input to
processes employed by users to predict future outcome.
In other words, financial information has predictive value when it can help users
increase the likelihood of correctly or accurately predicting or forecasting
outcome of events.
For example, information about financial position and past performance is
frequently used in predicting dividend and wage payments and the ability of the
entity to meet maturing commitments.
The net cash provided by operating activities is valuable in predicting loan
payment or default.
Financial information has confirmatory value if it provides feedback about
previous evaluations.
In other words, financial information has confirmatory value when it enables
users confirm or correct earlier expectations.
For example, a net income measure has confirmatory value if it can help
shareholders confirm or revise their expectation about an entity’s ability to
generate earnings.
Often, information has both predictive and confirmatory value. The predictive and
confirmatory roles of information are interrelated.
An example is an interim income statement which provides feedback about
income to date and serves as a basis for predicting the annual income.
The interim income statement for the first quarter shows net income of Php
2,000000. This is the confirmatory value.
If this trend continues for the entire year, it is logical to assume that the net
income after fourth quarters or one year would be Php 8,000,000. This is the
predictive value.
Materiality
Materiality is a practical rule in accounting which dictates that strict adherence to
GAAP is not required when the items are not significant enough to affect the
evaluation, decision and fairness of the financial statement.
The materiality concept is also known as the doctrine of convenience.
Materiality is really quantitative “threshold” linked very closely to the qualitative
characteristic of relevance.
The relevance of information is affected by its nature and materiality.
In other words, materiality is sub quality of relevance based on the nature or
magnitude or both of the items to which the information relates.
The conceptual framework does not specify a uniform quantitative threshold for
materiality or predetermine what could be material in a particular situation.
Materiality is a Relativity
Materiality of an item depends on relative size rather than absolute size.
What is material for one may be immaterial for another.
An error of Php 500,000 in the financial statement of a multinational entity may
not be important but may be so critical for a small entity.
When is an item Material?
There is no strict or uniform rule for determining whether an item is material or
not.
Very often, this is dependent on good judgment, professional expertise and
common sense.
However, a general guide may be given, to wit:
An item is material if knowledge of it could reasonably affect or influence the
economic decision of the primary users of the financial statements.
For example, small expenditures for tools are often expensed immediately rather
than depreciated over their useful lives to save on clerical costs of recording
depreciation because the effect on the financial statements is not large enough to
affect economic decision.
Another example of the application of materiality is the common practice of large
entities of rounding amounts to the nearest thousand pesos in their financial
statements.
Small entities may round off to the nearest peso.
New Definition of Materiality
The IASB provided 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, 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 materiality highlights three important aspects:
Could reasonably be expected to influence
Obscuring information
Primary users
Could reasonably be expected to Influence
It could reasonably be expected to influence threshold adds an element of
reasonability of financial information on which economic decision 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, it could reasonably be expected to influence threshold insures that
information capable of influencing economic decision 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 omitting or misstating the information.
Obscuring the information may be characterized by deliberate vagueness,
ambiguity and abstruseness.
Examples of obscured material information are:
The language is vague or unclear
The information is scattered throughout the financial statements
Dissimilar items are aggregated inappropriately
Similar items are disaggregated inappropriately
Primary users
The new definition of materiality narrows the definition of 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 the 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.
Factors of Materiality
Materiality depends on the magnitude and nature of the financial information.
In the exercise of judgment in determining materiality, the relative size and
nature of an item are considered.
The size of the item in relation to the total of the group to which the item belongs
is taken into account.
For example, the amount of advertising in relation to total selling expenses, the
amount of office salaries to total administrative expenses, the amount of prepaid
expenses to total current assets and the amount of leasehold improvements to
total property, plant and equipment.
The nature of the item may be inherently material because by its nature it affects
economic decision.
For example, the discovery of a Php 20,000 bribe is a material event even for a
very large entity.
Faithful representation
Faithful representation means financial reports represent economic phenomena
or transactions in words and numbers.
Stated differently, the descriptions and figures must match what really existed or
happened.
Simply worded, faithful representation means that the actual effects of the
transactions shall be properly accounted for and reported in the financial
statements.
For example, if the entity reports purchases of Php 5,000,000 when the actual
amount is Php 8,000,000, the information would not be faithfully represented.
To record a sale of merchandise as miscellaneous income would not also be
faithful representation of the sale transaction.
Ingredients of Faithful representation
To be perfectly faithful representation, a depiction should have three
characteristics, namely:
a- Completeness
b- Neutrality
c- Free from error
Completeness
Completeness requires that relevant information should be presented in a way
that facilitates understanding and avoids erroneous implication.
Completeness is the result of the adequate disclosure standard or the principle of
full disclosure.
A complete depiction includes all information necessary for a user to understand
the phenomenon being depicted, including all necessary descriptions and
explanations.
For example, a complete depiction of a group of assets would include description
of the assets, numerical depiction and description of the numerical depiction,
such as cost, current cost or fair value.
Standard of Adequate Disclosure
The standard of adequate disclosure means that all significant and relevant
information leading to the preparation of financial statements shall be clearly
reported.
Adequate disclosure however does not mean disclosure of just any data.
The accountant shall disclose a material fact known to him which is not disclosed
in the financial statements but disclosure of which is necessary in order that the
financial statements would not be misleading.
The standard of adequate disclosure is best described by disclosure of any
financial facts significant enough to influence the judgment of informed users.
Notes to Financial Statements
Actually, to be complete, the financial statements shall be accompanied by “notes
to financial statements”.
The purpose of the notes is to provide the necessary disclosures required by the
Philippine Financial Reporting Standards.
Notes to financial statements provide narrative description or disaggregation of
the items presented in the financial statements and information about items that
do not qualify for recognition.
Neutrality
A neutral depiction is without bias in the preparation or presentation of financial
information.
A neutral depiction is not slanted, weighted, emphasized, de-emphasized or
otherwise manipulated to increase the probability that financial information will
be received favorably or unfavorably by users.
In other words, to be neutral, the information contained in the financial
statements must be free from bias.
The financial information should not favor one party to the detriment of another
party.
The information is directed to the common needs of many users and not to the
particular needs of specific users.
Neutrality is synonymous with the all-encompassing principle of fairness
To be neutral is to be fair.
Prudence
The Revised Conceptual Framework has reintroduces the concept of prudence.
Prudence is the exercise of care and caution when dealing with the uncertainties
in the measurement process such that assets or income are not overstated and
liabilities or expenses are not understated.
Neutrality is supported by the exercise of prudence.
Conservatism
Conservatism is synonymous with prudence.
Conservatism means that when alternatives exist, the alternative which has the
least effect on equity should be chosen.
In the simplest words, conservatism means “in case of doubt, record any loss and
do not record any gain.”
For example, if there is a choice between two acceptable asset values, the lower
figure is selected.
Accordingly, inventories are measured at the lower of cost and net realizable
value.
Contingent loss is recognized as a “provision” if the loss is probable and the
amount can be reliably measured.
Contingent gain is not recognized but disclosed only.
It is to be emphasized that conservatism is not a license to deliberately understate
net income and net assets.
For example, if an entity has a cash of Php 500,000 and reports only Php 100,000,
this is not conservatism but fraud or inaccurate reporting.
Expressions of Conservatism
“Anticipate no profit and provide for probable and measurable loss.”
“In the matter of income recognition, the accountant takes the position that no
matter how sure the businessman might be in capturing the bird in the bush, he,
the accountant, must see it in the hand.”
“Don’t count your chicks until the eggs hatch”.
Free From Error
Free from error means there are no errors or omissions in the description of the
phenomenon or transaction.
Moreover, the process used to produce the reported information has been
selected and applied with no errors in the process.
In this context, free from error does not mean perfectly accurate in all respects.
For example, an estimate of an unobservable price or value cannot be determined
to be accurate or inaccurate.
However, a representation of that estimate can be faithful if the amount is
described clearly and accurately as an estimate.
Moreover, the nature and limitations of the estimating process are explained and
no errors have been made in selecting and applying an appropriate process for
developing the estimate.
Measurement Uncertainty
Measurement uncertainty arises when monetary amounts in financial reports
cannot be observed directly and must instead be estimated.
Measurement uncertainty can affect faithful representation if the level of
uncertainty in providing an estimate is high.
However, the use of reasonable estimate is an essential part of providing financial
information and does not undermine the usefulness of the financial information.
As long as the estimate is clearly and accurately described and explained, even a
high level of measurement uncertainty does not affect the usefulness of the
financial information.
Substance over Form
If information is to represent faithfully the transaction and other events it
purports to represent, it is necessary that the transactions and events are
accounted in accordance with their substance and reality and not merely their
legal form.
The economic substance of transactions and events are usually emphasized when
economic substance differs from legal form.
Substance over form is not considered a separate component of faithful
representation because it would be redundant.
Faithful representation inherently represents the substance of an economic
phenomenon or transaction rather than merely representing the legal form.
Representing a legal form that differs from the economic substance of the
underlying economic phenomenon or transaction could not result in a faithful
representation.
Example of Substance over Form
An example is when the lessee leased property from the lessor.
The terms of the lease provide that the lease transfers ownership of the asset to
the lessee by the end of the lease term.
In form, the contract is a lease as popularly understood.
But in substance, in reality, if the “transfer of ownership provision” is to be
considered, the real intent of the parties is an installment purchase of an asset by
the lessee from the lessor.
Accordingly, the lessee shall record an acquisition of right of use of asset and set
up a liability to the lessor.
The periodic rental is conceived as an installment payment representing interest
and principal.
Enhancing Qualitative Characteristics
The enhancing qualitative characteristics relate to the presentation or form of the
financial information.
The enhancing qualitative characteristics are intended to increase the usefulness
of the financial information that is relevant and faithfully represented.
The enhancing qualitative characteristics are comparability, understandability,
verifiability and timeliness.
Relevant and faithfully represented financial information is useful but the
information would be most useful if it is comparable, understandable verifiable
and timely.
Comparability
Comparability means the ability to bring together for the purpose of noting points
likeliness and difference.
Comparability is the enhancing qualitative characteristic that enables users to
identify and understand similarities and dissimilarities among items.
Comparability may be made within an entity or between and across entities.
Comparability within an entity is the quality of information that allows
comparisons within a single entity through time or form one accounting period to
next.
Comparability within an entity is also known as horizontal comparability or
intracomparability.
Comparability across entities is also known as intercomparability or dimensional
comparability.
For information to be comparable, like things must look alike and different things
must look different.
Comparability is not enhanced by making unlike thing look alike or making like
things look different.
Consistency
Implicit in the qualitative characteristic of comparability is the principle of
consistency.
Consistency is not the same as comparability.
In a broad sense, consistency refers to the use of the same method for the same
item, either from period to period within an entity or in a single period across
entities.
Comparability is the goal and consistency helps to achieve that goal.
In a limited sense, consistency is the uniform application of accounting method
from period to period within an entity.
On the other hand, comparability is the uniform application of accounting method
between and across entities in the same industry.
An entity cannot use the FIFO method of inventory valuation in one year, the
average method in the next year, again the FIFO 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
statement.
However, consistency does not mean that no change in accounting method can
be made.
If the change would result to more useful and meaningful information then such
change shall be made.
But there shall be full disclosure of the change and the peso effect thereof.
It is inappropriate for an entity to leave accounting policies unchanged when
better and acceptable alternative exist.
Understandability
Understandability requires that financial information must be comprehensive or
intelligible if it is to be most useful.
Accordingly, the information should be presented in a form and expressed in
terminology that a user understands.
Classifying, characterizing and presenting information “clearly and concisely”
make it understandable.
An essential quality of the information provided in financial statements is that it is
readily understandable by users.
But the complex economic activities make it impossible to reduce the financial
information to the simplest terms.
Accordingly, the users shall have an understanding of the complex economic
activities, the financial accounting process and the terminology in the financial
statements.
Financial statements cannot realistically be understandable to everyone.
Financial reports are prepared for users who have a reasonable knowledge of
business and economic activities and who review and analyze the information
diligently.
At times, even well-informed and diligent users may need to seek the aid of an
adviser to understand information about complex phenomena or transactions.
Understandability is very essential because relevant and faithfully represented
information may prove useless if it is not understood by users.
Verifiability
Verifiability means that different knowledgeable and independent observers
could reach consensus, although not necessarily complete agreement, that a
particular depiction is a faithful representation.
In other words, verifiability implies consensus.
The financial information is verifiable in the sense that it is supported by evidence
so that an accountant that would look into the same evidence would arrive at the
same economic decision or conclusion.
Verifiable financial information provides results that would be substantially
duplicated by measurers using the same measurement method.
Accordingly, verifiability helps assure users that information represents the
economic phenomenon or transaction it purports to represent.
Types of Verification
Verification can be direct or indirect.
Direct verification means verifying an amount or other representation through
direct observation, for example, by counting cash.
Indirect verification means checking the inputs to a model formula or other
technique and recalculating the inputs using the same methodology.
An example is verifying the carrying amount of inventory by checking the inputs in
quantities and costs and recalculating the ending inventory using the same cost
flow assumption such as first-in, first-out.
Timeliness
Timeliness means that financial information must be available or communicated
early enough when a decision is to be made.
Relevant and faithfully represented financial information furnished after a
decision is made is useless or of no value.
For example, the most important attribute of quarterly or interim financial
information is its timeliness.
Generally, the older the information, the less useful.
However, some information may continue to be timely long after the end of
reporting period because some users may need to identify and assess trends.
Timeliness enhances the truism that without knowledge of the past, the basis for
prediction will usually be lacking and without interest in the future, knowledge of
the past is sterile.
What happened in the past would become the basis of what would happen in the
future.
Cost Constraint on Useful Information
Cost is a pervasive constraint on the information that can be provided by financial
reporting.
Reporting financial information imposes cost and it is important that such cost is
justified by the benefit derived from the financial information.
In other words, the cost constraint is a consideration of the cost incurred in
generating financial information against the benefit to be obtained from having
the information.
The benefit derived from the information should exceed the cost incurred in
obtaining the information.
However, the evaluation of the cost constraint is substantially a judgmental
process.
Assessing whether the cost of reporting outweighs or falls short of the benefit is
difficult to measure and becomes a matter of professional judgment.
CHAPTER 4
CONCEPTUAL FRAMEWORK
FINANCIAL STATEMENTS and REPORTING ENTITY
UNDERLYING ASSUMPTIONS
General Objective of Financial Statements
Financial statements provide information about economic resources of the
reporting entity, claims against the entity and changes in the economic resources
and claims.
Financial statements provide financial information about an entity’s assets,
liabilities, equity, income and expenses useful to users of financial statements in:
a- Assessing future cash flows to the reporting entity
b- Assessing management stewardship of the entity’s economic resources.
The financial information is provided in the following:
1- Statement of financial position by recognizing assets, liabilities and equity
2- Statement of financial performance, by recognizing income and expenses.
3- Other statements and notes by presenting and disclosing information
about:
a- Recognized assets, liabilities, equity, income and expenses
bcde-
Unrecognized assets and liabilities
Cash flows
Contribution from equity holders and distribution to equity holders
Method, assumption and judgment in estimating amount presented.
Types of Financial Statements
The Revised Conceptual Framework recognizes three types of financial
statements.
1- Consolidated financial statements – these are the financial statements
prepared when the reporting entity comprises both the parent and its
subsidiaries.
2- Unconsolidated financial statements – these are the financial statements
prepared when the reporting entity is the parent alone.
3- Combined financial statements – these are financial statements when the
reporting entity comprises two or more entities that are not linked by a
parent and subsidiary relationship.
Consolidated Financial Statements
Consolidated financial statements provide information about the assets, liabilities,
equity, income and expenses of both the parent and its subsidiaries as a single
reporting entity.
The parent is the entity that exercises control over the subsidiaries.
Consolidated information is useful for existing and potential investors, lenders
and other creditors of the parent in their assessment of future net cash inflows to
the parent.
This is because net cash inflows to the parent include distributions to the parent
from its subsidiaries.
Consolidated financial statements are not designed to provide separate
information about the assets, liabilities, equity, income and expenses of a
particular subsidiary.
A subsidiary’s own financial statements are designed to provide such information.
Unconsolidated Financial Statements
Unconsolidated financial statements are designed to provide information about
the parent’s assets, liabilities, income and expenses and not about those of the
subsidiaries.
Such information can be useful to the existing and potential investors, lenders
and other creditors of the parent because a claim against the parent typically
does not give the holder of the claim against subsidiaries.
Information provided in unconsolidated financial statements is typically not
sufficient to meet the requirement needs of primary users.
Accordingly, when consolidated financial statements are required, unconsolidated
financial statements cannot serve as substitute for consolidated financial
statements.
Combined Financial Statements
Combined financial statements provide financial information about the assets,
liabilities, equity, income and expenses of two or more entities not linked with
parent and subsidiary relationship.
Reporting Entity
A reporting entity is an entity that is required or chooses to prepare financial
statements/
The reporting entity can be a single entity or a portion of an entity, or can
compromise more than one entity.
Accordingly, the following can be considered a reporting entity:
abcde-
Individual corporation, partnership or proprietorship
The parent alone
The parent and its subsidiaries as single reporting entity
Two or more entities without parent and subsidiary
A reportable business segment of an entity.
Reporting Period
The reporting period is the period when financial statements are prepared for
general purpose financial reporting.
Financial statements may be prepared on an interim basis, for example, three
months, six months, and nine months.
Interim financial statements are not required but optional.
However, financial statements must be prepared on an annual basis or a period of
twelve months.
Financial statements are prepared for a specified period of time and provide
information about:
a- Assets, liabilities and equity at the end of the reporting period
b- Income and expenses during the reporting period.
To help users of financial statements to identify and assess change in trends,
financial statements also provide comparative information for at least one
preceding reporting period.
Financial statements may include information about transactions and other
events that occurred after the end of reporting period if the information is
necessary to meet the general objective of financial statements.
Underlying Assumptions
Accounting assumptions are the basic notions or fundaments premises on which
the accounting process is based. Accounting assumptions are also known as
postulates.
Like a building structure that requires a solid foundation to avoid or prevent
future collapse and provide room for expansion and so with accounting.
Accounting assumptions serve as the foundation or bedrock of accounting in
order to avoid misunderstanding and usefulness of the financial statements.
The Conceptual Framework for Financial Reporting mentions only one
assumption, namely going concern.
However, implicit in accounting are the basic assumptions of accounting entity,
time period and monetary unit.
Going Concern
The going concern or continuity assumption means that in the absence of
evidence to the contrary, the accounting entity is viewed as continuing in
operation indefinitely.
In other words, the financial statements are normally prepared on the assumption
that the entity will continue in operations for the foreseeable future.
The going concern postulate is the very foundation of the cost principle.
Thus, assets are normally recorded at cost. As a rule, market values are ignored.
However, some new standards require measurement of certain assets at fair
value.
If there is evidence that the entity would experience large and persistent losses or
that the entity’s operations are to be terminated, the going concern assumption is
abandoned.
In this case, the users of the statements will have a great interest in the amount
of cash that will be generated from the entity’s assets in the short term.
Accounting Entity
In financial accounting, the accounting entity is the specific business organization
which may be a proprietorship, partnership or corporation.
Under this assumption, the entity is separate from the owners, managers and
employees who constitute the entity.
Accordingly, the transactions of the entity shall not be emrged with the
transactions of the owners.
The reason for the entity assumption is to have a fair presentation of financial
statements.
The personal transactions of the owners shall not be allowed to distort the
financial statements of the entity.
For example, the cash invested by the proprietor is treated as an asset of the
proprietorship.
If an enterprising entrepreneur owns department store, restaurant and
bookstore, separate statements shall be prepared for each business in order to
determine which business is profitable.
Each business is an independent accounting entity.
When major shareholder of a corporation borrows money from a bank on his own
personal account the loan is a liability of the shareholder alone and not of the
corporation.
The shareholder is not the corporation and the corporation is not the
shareholder.
However, where parent and subsidiary relationship exists, consolidated
statements for affiliates are usually made because for practical and economic
purposes, the parent and the subsidiary are a “single economic entity”.
The consolidation, however, does not eliminate the legal boundary segregating
the affiliated entities.
Accounting will continue to be done separately for each entity.
Time Period
A completely accurate report on the financial position and performance of an
entity cannot be obtained until the entity is finally dissolved and liquidated.
Only then can the final net income and net-worth of the entity be determined
precisely.
However, users of financial information need timely information for making an
economic decision.
It becomes necessary therefore to prepare periodic reports on financial position,
performance and cash flows of an entity.
The time period assumption requires that the indefinite life of an entity is
subdivided into accounting periods which are usually of equal length for the
purpose of preparing financial reports on financial position, performance and cash
flows.
By convention, the accounting period or fiscal period is one year or a period of
twelve months.
The “one year period” is traditionally the accounting period because usually is is
after one year that government reports are required.
The accounting period may be a calendar year or a natural business year.
A calendar year is a twelve-month period that ends on December 31.
A natural business year is twelve-month period that ends any month when the
business is at the lowest or experiencing slack season.
Monetary Unit
The monetary unit assumption has two aspects, namely quantifiability and
stability of the peso.
The quantifiability aspect means that the assets, liabilities, equity, income and
expenses should be stated in terms of a unit of measure which is the peso in the
Philippines.
How awkward to see financial statements without any common unit measure.
Such statements would be largely unintelligible and incomprehensible.
The stability of the peso assumption means that the purchasing power of the
peso is stable or constant and that its instability is insignificant and therefore may
be ignored.
The stable peso postulate is actually an amplification of the going concern
assumption so much so that adjustments are unnecessary to reflect any changes
in purchasing power.
The accounting function is to account for nominal pesos only and not for constant
pesos or changes in purchasing power.
In today’s world, the assumption that the peso is a stable measure over time is
not necessarily valid.
Consider an equipment that was imported 10 years ago from the United States
for $100,000 when the exchange rate was Php 35 to $1 or an equivalent of Php
3,500,000.
If the same equipment is purchased now and assuming there is no change in the $
100,000 purchase price, the replacement cost in terms of pesos would be in the
vicinity of Php 5,400,000, considering a current exchange rate of Php 54 to $1.
Obviously, there is a significant gap between historical cost and current
replacement cost.
In this regard, an entity may choose the revaluation model as an accounting
policy.
Chapter 5
Conceptual Framework
Elements of Financial Statements
Elements of Financial Statements
Financial statements portray the financial effects of transactions and other events
by grouping them into broad classes according to their economic characteristics.
These broad classes are termed the elements of financial statements.
The elements of financial statements refer to the quantitative information
reported in the statement of financial position and income statement.
The elements of financial statements are the “building blocks” from which
financial statements are constructed.
The presentation of these elements in the statement of financial position and the
income statement involves a process of classification and sub classification.
For example, assets and liabilities may be classified by their nature or function in
the business of the entity in order to display information in a manner most useful
to users for purposes of making economic decisions.
The elements directly related to the measurement of financial position are:
a- Asset
b- Liability
c- Equity
The elements directly related to the measurement of financial performance are:
a- Income
b- Expense
The conceptual framework identifies no elements that are unique to the
statement of changes in equity because such statement comprises items that
appear in the statement of financial position and the income statement.
Equity is the residual interest in the assets of the entity after deducting all of the
liabilities.
Asset
Under the Revised Conceptual Framework, an asset is defined as a present
economic resource controlled by the entity as a result of past events.
An economic resource is a right that has the potential to produce economic
benefits.
The new definition clarifies that an asset is an economic resource and that the
potential economic benefits no longer need to be expected to flow to the entity.
Essential Characteristics of Asset
a- The asset is present economic resource
b- The economic resource is a right that has the potential to produce
economic benefits.
c- The economic resource is controlled by the entity as a result of past events.
Right
Rights that have the potential to produce economic benefits may take the
following forms:
1- Rights that correspond to an obligation of another entity
a- Right to receive cash
b- Right to receive goods or services
c- Right to exchange economic resources with another party on favorable
terms
d- Right to benefit from an obligation of another party if a specified
uncertain future event occurs.
2- Rights that do not correspond to an obligation of another entity
a- Right over physical objects, such as property, plant and equipment or
inventories
b- Right to intellectual property.
3- Rights established by contract or legislation such as owning a debt
instrument or an equity instrument or owning a registered patent.
Potential to Produce Economic Benefits
An economic resource is a right that has the potential to produce economic
benefits.
For the potential to exist, it does not need to be certain or even likely that the
right will produce economic benefits.
It is only necessary that the right already exists.
A right can meet the definition of an economic resource even if the probability
that it will produce economic benefit is low.
The economic resource is the present right that contains the potential and not the
future economic benefits that the right may produce.
An economic resource could produce economic benefits if an entity is entitled:
abcde-
To receive contractual cash flows.
To exchange economic resources with another party on favorable terms
To produce cash inflows or avoid cash outflows
To receive cash by selling the economic resource
To extinguish a liability by transferring an economic resource
Control of an Economic Resource
An entity controls an asset if it has the present ability to direct the use of the
asset and obtain the economic benefits that flow from it.
Control also includes the ability to prevent others from using such asset and
therefore preventing others from obtaining the economic benefits from the asset.
Control may arise if an entity enforces legal rights.
If there are no legal rights, control can still exist if an entity has other means of
ensuring that no other party can benefit from an asset.
For example, an entity has access to technical know-how and has the ability to
keep this know-how secret.
Liability
Under the Revised Conceptual Framework, a liability is defined as a present
obligation of an entity to transfer an economic resource as a result of past events.
The new definition clarifies that a liability is the obligation to transfer an
economic resource and not the ultimate outflow of economic benefits.
The outflow of economic benefits no longer needs to be expected similar to the
definition of an asset.
The new definition of liability to some extent is inconsistent with the definition of
liability under IAS 37.
In case of conflict, the IASB stated that the requirements of a Standard shall
always prevail over the Conceptual Framework.
Essential Characteristics of Liability
a- The entity has an 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
c- The obligation is a present obligation that exists as a result of past
event.
This means that a liability is not recognized until it is incurred.
Obligation
An obligation is a duty or responsibility that an entity has no practical ability to
avoid. Obligations can either be legal or constructive.
Obligations may be legally enforceable as a consequence of a binding contract or
statutory requirement.
This is normally the case, for example, with accounts payable for goods and
services received.
Constructive obligations arise from normal business practice, custom and a desire
to maintain good business relations or act in an equitable manner.
For example, an entity decides as a matter of policy to rectify faults in the
products even when these become apparent after the warranty period.
Transfer of an Economic Resource
Obligations to transfer an economic resource include:
a- Obligation to pay cash
b- Obligation to deliver goods or noncash resources
c- Obligation to provide services at some future time
d- Obligation to exchange economic resources with another party on
unfavorable terms
e- Obligation to transfer an economic resource if specified uncertain future
event occurs.
Past Event
An obligation exists as a result of past event if both of the following conditions are
satisfied:
a- An entity has already obtained economic benefits
b- An entity must transfer an economic resource
Definition of Income
Income is defined as increases in assets or decreases in liabilities that result in
increase in equity, other than those relating to contributions from equity holders.
The definition of income has changed to reflect the change in the definition of
asset and liability.
The definition of income encompasses both revenue and gains.
Revenue arises in the course of the ordinary regular activities and is referred to by
variety of different names including sales, fees, interest, dividends, royalties and
rent.
The essence of revenue is regularity.
Gains represent other items that meet the definition of income and do not arise
in the course of the ordinary regular activities.
Gains include gain from disposal of non current asset, unrealized gain on trading
investment and gain from expropriation.
Statement of Financial Performance
The Revised Conceptual Framework introduces the term Statement of Financial
Performance.
This statement refers to the statement of profit or loss and a statement
presenting other comprehensive income.
The statement of profit or loss is the primary source of information about an
entity’s financial performance. As a general rule, all income and expenses are
included in profit or loss.
However, in developing accounting standards, there are some items of income
and expenses that are included in other comprehensive income and not in profit
or loss if such presentation would provide more relevant and faithfully
represented information about financial performance.
There are instances that an amount in other comprehensive income in one
reporting period may be recycled to profit or loss in another reporting period.
Such recycling is permitted as long as it would result to relevant and faithfully
represented information about financial performance.
Definition of Expense
Expense is defined as decreases in assets or increases in liabilities that result in
decreases in equity, other than those relating to distributions to equity holders.
The definition of expense has changed to reflect the change in the definition of
asset and liability
Expense encompasses losses as well as those expenses that arise in the course of
the ordinary regular activities.
Expenses that arise in the course of ordinary regular activities include cost of
goods sold, wages and depreciation.
Losses do not arise in the course of the ordinary regular activities and include
losses resulting from disasters.
Examples include losses from fire, flood, storm surge, tsunami and hurricane, as
well as those arising from disposal of non current asset.
CHAPTER 6
Conceptual Framework
Recognition and Measurement
Recognition
The Revised Conceptual Framework defines recognition as the process of
capturing for inclusion in the financial statements an item that meets the
definition of an asset, liability, equity, income or expense.
The amount at which an asset, a liability or equity is recognized in the statement
of financial position is reported as carrying amount.
Recognition links the elements to the statement of financial position and
statement of financial performance.
The statements are linked because the recognition of an item in one statement
requires the recognition of the same item in another statement
For example, the recognition of income happens simultaneously with the
recognition of an increase in asset or decrease in liability.
The recognition of expense happens simultaneously with the recognition of a
decrease in asset or increase in liability.
Recognition Criteria
Only items that meet the definition of an asset, a liability or equity are recognized
in the statement of financial position.
Similarly, only items that meet the definition of income or expense are recognized
in the statement of financial performance.
In addition to meeting the definition of an element, items are recognized only
when their recognition provides users of financial statements with information
that is both relevant and faithfully represented.
Recognition does not focus anymore on how probable economic benefits will flow
to and from the entity and the cost can be measured reliably.
An asset or liability and any corresponding income or expense can exist even if
the probability of inflow or outflow of the benefits is low.
Point of Sale Income Recognition
The basic principle of income recognition is that income shall be recognized when
earned.
With respect to sale of goods in the ordinary course of business, the point of sale
is unquestionably the point of income recognition.
The reason is that it is at the point of sale that the entity has transferred to the
buyer the significant risks and rewards of ownership of the goods.
Stated differently, legal title to the goods passes to the buyer at the point of sale.
Moreover, it is at the point of sale that the entity has transferred control of the
goods to the customer.
However, under certain conditions, income may be recognized at the point of
production, during production and at the point of collection.
Expense Recognition
The basic expense recognition means that expenses are recognized when
incurred.
But the question is when are expenses incurred?
Actually, the expense recognition principle is the application of the matching
principle.
The generation of revenue is not without any cost. There has got to be some cost
in earning revenue.
“There is no gain if there is no pain.”
The matching principle has three applications, namely:
a- Cause and effect association
b- Systematic and rational allocation
c- Immediate recognition
Cause and Effect Association
Under this principle, the expense is recognized when the revenue is already
recognized.
The reason is the presumed direct association of the expense with specific items
of income. This is actually the “strict matching concept”.
This process, commonly referred to as the matching of cost with revenue,
involves the simultaneous or combined recognition of revenue and expenses that
result directly and jointly from the same transactions or events.
The best example is the cost of merchandise inventory.
Such cost is considered as an asset in the meantime that the merchandise is on
hand.
When the merchandise is sold, the cost thereof is expensed in the form of “cost of
goods sold” because at such time revenue may be recognized.
Other examples include doubtful accounts, warranty expense and sales
commissions.
Systematic and Rational Allocation
Under this principle, some costs are expensed by simply allocating them over the
periods benefited.
The reason for this principle is that the cost incurred will benefit future periods
and that there is an absence of a direct or clear association of the expense with
specific revenue.
When economic benefits are expected to rise over several accounting periods and
the association with income can only be broadly or indirectly determined,
expenses are recognized on the basis of systematic and allocation procedures.
Concrete examples include depreciation of property, plant and equipment,
amortization of intangibles and allocation of prepaid rent, insurance and other
prepayments.
Immediate Recognition
Under this principle, the cost incurred is expensed outright because of uncertainty
of future economic benefits or difficulty of reliability associating certain costs with
future revenue.
An expense is recognized immediately:
a- When expenditure produces no future economic benefit.
b- When cost incurred does not qualify or ceases to qualify for recognition as
an asset.
Examples include officers’ salaries and most administrative expenses, advertising
and most selling expenses, amount to settle lawsuit and worthless intangibles.
Many losses, such as loss from disposal of building, loss from sale of investments
and casualty loss are immediately recognized because they are not directly
related to specific revenue.
Derecognition
The Revised Conceptual Framework introduced the term derecognition.
Derecognition is defined as the removal of all or part of a recognized asset or
liability from the statement of financial position.
Derecognition normally occurs when an item no longer meets the definition of an
asset or a liability.
Derecognition of an asset occurs when an entity loses control of all or part of the
asset.
Derecognition of a liability occurs when the entity no longer has a present
obligation for all or part of the liability.
Measurement
Measurement is defined as quantifying in monetary terms the elements in the
financial statements.
The Revised Conceptual Framework mentions two categories:
a- Historical cost
b- Current value
Historical Cost
The historical cost or original acquisition cost of an asset is the cost incurred in
acquiring or creating the asset comprising the consideration paid plus transaction
cost.
The historical cost of a liability is the consideration received to incur the liability
minus transaction cost.
Simply stated, historical cost is the entity price or entry value to acquire an asset
or to incur a liability.
An application of the historical cost measurement is to measure financial asset
and financial liability at amortized cost.
The amortized cost reflects the estimate of future cash flows discounted at a rate
determined at initial recognition.
Historical Cost Updated
1- Historical cost of an asset is updated because of:
a- Depreciation and amortization
b- Payment received as a result of disposing part or all of the asset
c- Impairment
d- Accrual of interest to reflect any financing component of the asset
e- Amortized cost measurement of financial asset.
2- Historical cost of a liability is updated because of:
a- payment made or satisfying an obligation to deliver goods
b- increase in value of the obligation to transfer economic resources such
that the liability becomes onerous
c- accrual of interest to reflect any financing component of the liability
d- amortized cost measurement of financial liability
Current Value
Current value includes:
a- fair value
b- value in use for asset
c- fulfillment value for liability
d- current cost
Fair Value
Fair value of an asset is the price that would be received to sell an asset in an
orderly transaction between market participants at measurement date.
Fair value of liability is the price that would be paid to transfer a liability in an
orderly transaction between market participants at the measurement date.
Fair value is an exit price or exit value.
Fair value can be observed directly using market price of the asset or liability in an
active market.
In cases where fair value cannot be directly measured, an entity can use present
value of cash flows.
Fair value is not adjusted for transaction cost. The reason is that such cost is a
characteristic of the transaction and not of the asset or liability.
Value in Use
Value in use is the present value of the cash flows that an entity expects to derive
from the use of an asset and from the ultimate disposal.
Value in use does not include transaction cost on acquiring the asset but includes
transaction cost on the disposal of the asset.
Value in use is an exit price or exit value.
Fulfillment Value
Fulfillment value is the present value of cash that an entity expects to transfer in
paying or settling a liability.
Fulfillment value does not include transaction cost on incurring a liability but
includes transaction cost on fulfillment of a liability.
Fulfillment value is an exit price or exit value.
Current Cost
Current cost of an asset is the cost of an equivalent asset at the measurement
date comprising the consideration paid and transaction cost.
Current cost of a liability is the consideration that would be received less any
transaction cost at measurement date.
Similar to historical cost, current cost is also based on the entry price or entry
value but reflects market conditions on measurement date.
Selecting a Measurement Basis
In selecting a measurement basis for an asset or a liability and for the related
income and expense, it is necessary to consider the nature of the information that
the measurement basis will produce.
In most cases, no single factor will determine which measurement basis should be
selected.
The relative importance of each factor will depend on facts and circumstance.
The information produced by the measurement basis must be useful to the users
of financial statements.
To achieve this, the information must be both relevant and faithfully represented.
Historical cost is the measurement basis most commonly adopted in preparing
financial statements.
In many situations, it is simpler and less costly to measure historical cost than it is
to measure a current value.
In addition, historical cost is generally well understood and verifiable.
The IASB did not mandate a single measurement basis because the different
measurement bases could produce useful information under different
circumstance.
CHAPTER 7
CONCEPTUAL FRAMEWORK
PRESENTATION and DISCLOSURE CONCEPTS of CAPITAL
Presentation and Disclosure
The presentation and disclosure can be effective communication tool about the
information in financial statements.
A reporting entity communicates information about its assets, liabilities, equity,
income and expenses by presenting and disclosing information in the financial
statements.
Effective communication of information in financial statements makes the
information more relevant and contributes to a faithful representation on an
entity’s asset, liabilities, income and expenses.
Effective communication of information in financial statements also enhances the
understandability and comparability of information in the financial statements.
Effective communications in financial statements is supported by not duplicating
information in different parts of the financial statements.
Duplication is usually unnecessary and can make financial statements less
understandable.
Classification
Classification is sorting of assets, liabilities, equity, income and expenses on the
basis of shared or similar characteristics.
Classifying dissimilar assets, liabilities, equity, income and expenses can obscure
relevant information, reduce understandability and comparability and may not
provide a faithful representation of financial information.
For example, it could be appropriate to classify an asset or a liability into current
and non-current.
It may be necessary to classify components of equity separately if such
components are subject to legal, regulatory and other requirements.
Thus, ordinary share capital, preference share capital, share premium and
retained earnings should be disclosed separately.
Classification of Income and Expenses
Income and expenses are classified as components of profit loss and components
of other comprehensive income.
The Revised Conceptual Framework has introduced the term statement of
financial performance to refer to the statement of profit or loss together with the
statement presenting other comprehensive income.
The statement of profit or loss is the primary source of information about an
entity’s financial performance for the reporting period.
All income and expenses should be appropriately classified and included in the
statement of profit or loss.
However, there are certain items of income and expenses that are presented
outside of profit or loss but included in other comprehensive income.
The components of other comprehensive income are subsequently recycled or
reclassified to profit or loss or retained earnings.
Aggregation
Aggregation is the adding together of assets, liabilities, equity, income and
expenses that have similar or shared characteristics and are included in the same
classification.
Aggregation makes information more useful by summarizing a large volume of
detail. However, aggregation may conceal some of the detail.
Hence, a balance should be made so that relevant information is not obscured
either by a large amount of insignificant detail or by excessive aggregation.
Typically, the statement of financial position and the statement of financial
performance provide summarized or condensed information.
More detailed information is provided in the notes to financial statements.
Capital Maintenance
The financial performance of an entity is determined using two approaches,
namely transaction approach and capital maintenance approach.
The transaction approach is the traditional preparation of an income statement.
The capital maintenance approach means that net income occurs only after the
capital used from the beginning of the period is maintained.
In other words, net income is the amount an entity can distribute to its owners
and be as “well off” at the end of the year as at the beginning.
The distinction between return of capital and return on capital is important to the
understanding of net income.
Shareholders invest in entity to earn a return on capital or an amount in excess of
their original investment.
Return of capital is an erosion of the capital invested in the entity.
The Conceptual Framework considered two concepts of capital maintenance or
well-offness, namely financial capital and physical capital.
Financial Capital
Under a financial capital concept, such as invested money or invested purchasing
power, capital is synonymous with net assets or equity of the entity.
Financial capital is the monetary amount of the net assets contributed by
shareholders and the amount of the increase in net assets resulting from earnings
retained by the entity.
Financial capital is traditional concept based on historical cost and adopted by
most entities.
Net Income under Financial Capital
Under the financial capital concept, net income occurs “when the nominal
amount of the net assets at the end of the year exceeds the nominal amount of
the net assets at the beginning of the period, after excluding distributions to and
contributions by owners during the period.”
Illustration
The following assets, liabilities and other financial data pertain to current year:
Total Assets
Total Liabilities
Additional Investment during the Year
Dividends paid during the year
January 1
1,500,000
1,000,000
December 31
2,500,000
1,200,000
400,000
300,000
Computation of Net Income
Net Assets – December 31
Add: Dividends paid
Total
Less: Net Assets –January 1
Additional Investments
Net Income
1,300,000
300,000
1,600,000
500,000
400,000
900,000
700,000
Note that the amount of net assets is “the excess of total assets over the total
liabilities.”
This is the reason this approach is also known as the net asset approach.
Physical Capital
Physical capital is the quantitative measure of the physical productive capacity to
produce goods and services.
The physical productive capacity may be based on for example, units of output
per day or physical capacity of productive assets to produce goods and services.
This concept requires that productive assets be measured at current cost, rather
than historical cost.
Productive assets include inventories and property, plant and equipment.
The current costs for these productive assets must be maintained in order that
physical capital is also maintained.
Accordingly, physical capital is equal to the net assets of the entity expressed in
terms of current cost.
The physical concept of capital should be adopted if the main concern of users is
the operating capability of the entity, meaning, the resource of fund needed to
achieve that operating capability or capacity.
Under this concept, net income occurs “when the physical productive capital of
the entity at the end of the year exceeds the physical productive capital at the
beginning of the period, also after excluding distributions to and contributions
from owners during the period.”
Illustration
Assume in the previously given illustration, the net assets of Php 500,000 on
January 1 had a current cost of Php 800,000 by reason of inflationary condition.
Net Assets – December 31
Add: Dividends Paid
Total
Less: Net Assets at current cost –January1
Additional Investments
Net Income
1,300,000
300,000
1,600,000
800,000
400,000
1,200,000
400,000
CHAPTER 8
Presentation of Financial Statements
Statement of Financial Position
PAS 1
Financial Statements
Financial statements are the means by which the information accumulated and
processed in financial accounting is periodically communicated to the users.
The financial statements are the end product or main output of the financial
accounting process.
Financial statements are a structured financial representation of the financial
position and financial performance of an entity.
General Purpose Financial Statements
An entity shall prepare and present general purpose financial statements in
accordance with the International Financial Reporting Standards.
General purpose financial statements or simply referred to as financial
statements are those 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.
In other words, general purpose financial statements are directed to all common
users and not to specific users.
Components of Financial Statements
A complete set of financial statements comprises the following components:
1- statement of Financial Position
2- Income Statement
3- Statement of Comprehensive Income
4- Statement of Changes in Equity
5- Statement of Cash Flows
6- Notes, comprising a summary of significant accounting policies and
other explanatory notes.
Objective of Financial Statements
The objective of financial statement 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 also show the results of the management’s stewardshjip of
the resources entrusted to it.
To meet this objective, financial statements provide information about the
following:
abcdef-
Assets
Liabilities
Equity
Income and expenses, including gains and losses
Contributions by and distributions to owners in their capacity as owners
Cash flows
Frequency of Reporting
Financial statements shall be presented at least annually.
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.
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.
Definition of Asset
An asset is an economic resource controlled by an entity as a result of past event.
An economic resource is a right that has the potential to produce economic
benefits.
Classification of Assets
Assets are classified only in two, namely current assets and noncurrent assets.
When an entity supplies goods or services within a clearly identifiable operating
cycle, the separate classification of current and noncurrent assets is useful
information by distinguishing between net assets that are continuously circulating
as working capital from the net assets used in long term operations.
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 entity’s normal operating cycle is not clearly identifiable, the duration is
assumed to be twelve months.
Current Assets
PAS 1, paragraph 66, provides that an entity shall classify an asset as current
when:
a- The asset is cash or cash equivalent unless the asset is restricted to settle a
liability for more that 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.
Presentation of Current Assets
Current assets are usually listed in order of liquidity. PAS 1, paragraph 54,
provides that as a minimum, the line items under current assets are:
a- Cash and cash equivalents
b- Financial assets at fair value such as trading securities and other
investments in quoted equity instruments
c- Trade and other receivables
d- Inventories
e- Prepaid Expenses
Noncurrent Assets
The caption “noncurrent assets” is a residual definition.
PAS 1, paragraph 66, simply states that “an entity shall classify all other assets not
classified as current as noncurrent “.
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:
abcde-
Property, plant and equipment
Long-term investment
Intangible assets
Deferred tax assets
Other noncurrent assets
Property, plant and equipment
PAS 16, paragraph 6, 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 other or for administrative purposes and are expected to be used
during more than one period.”
Examples of property, plant and equipment include land, building, machineriy,
equipment, furniture, fixtures, patterns, molds, dies and tools.
Most property, plant and equipment except land are presented at cost less
accumulated depreciation.
Long-term Investments
The International Accounting Standards Committee defines investments 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 of for
other benefits to the investing entity such as those obtained through trading
relationships.”
Intangible Assets
An intangible asset is simply defined as an identifiable nonmonetary asset without
physical substance.
The common examples of identifiable intangible assets include patent, franchise,
copyright, lease right, trademark and computer software.
An example of an unidentifiable intangible asset is goodwill.
Other Noncurrent Assets
Other noncurrent assets are those assets that do not 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.
Definition of Liability
A liability is a present obligation of an entity to transfer an economic resource as a
result of past event.
An obligation is a duty or responsibility that an entity has no practical ability to
avoid.
An obligation can either be legal or constructive.
A liability is classified as current and noncurrent.
Current Liabilities
PAS 1, paragraph 69, provides that an entity shall classify a liability as a current
when:
a- The entity expects to settle the liability within the entity’s normal
operating cycle.
b- The entity holds the liability primarily for the purpose of trading.
c- The entity does not have an unconditional right to defer settlement of
the liability for at least twelve months after the reporting period.
Presentation of Current Liabilities
PAS 1, paragraph 54, provides that as a minimum, the face of the statement of
financial position shall include the following line items for current liabilities:
abcde-
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 also a residual definition.
PAS 1, paragraph 69, provides that all liabilities not classified as current are
classified as noncurrent.
abcde-
Noncurrent portion of long-term debt
Finance lease liability
Deferred tax liability
Long-term obligations to company officers
Long-term deferred revenue
Currently maturing long-term Debt
A liability which is due to be settled within twelve months after 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 reporting period and before the financial
statements is 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.
Discretion to Refinance
If the entity has the discretion to refinance or 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 reason for this treatment is that such obligation is considered to form part of
the entity’s long-term refinancing because the entity has an unconditional right
under the existing loan agreement to defer payment for at least twelve months
after the end of the reporting period.
Note that the refinancing or rolling over must be at the discretion of the entity.
Otherwise, if the refinancing or rolling over is not at the discretion of the entity,
the obligation is classified as a current liability.
Covenants
Covenants are often attached to borrowing agreements which represent
undertakings by the borrower.
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.
Effect of Breach of Covenants
PAS 1, paragraph 74, provides that the liability is classified as current even if the
lender has agreed, after the reporting period and before the statements are
authorized for issue, not to demand payment as a consequence of the breach.
This liability is classified as current because at reporting date the borrower does
not have an unconditional right to defer payment for at least twelve months after
reporting period.
However, Paragraph 75 provides that the liability is classified as noncurrent if the
lender has agreed on or before the end of reporting period to provide a grace
period ending at least twelve months after the end of reporting period.
Definition of Equity
The term equity is the residual interest in the assets of the entity after deducting
all of its liabilities.
Simply stated, equity means “net assets: or total assets minus liabilities.
The terms used in reporting the equity of an entity depending on the form of of
the business organization are;
a- Owner’s equity in a proprietorship
b- Partners’ equity in partnership
c- Stockholders’ equity or shareholders’ equity in a corporation.
However, the term equity may simply be used for all business entities.
Under PAS 1, paragraph 7, the holders of instruments classified as equity are
simply known as owners.
Shareholders’ Equity
Shareholders’ equity is the residual interest of owners in the net assets of a
corporation measured by the excess of the assets over liabilities.
Generally, the elements constituting shareholders’ equity with their equivalent
IAS term are:
Philippine Term
Capital Stock
Subscribed capital stock
Preferred stock
Common stock
Additional paid capital
Retained Earnings (Deficit)
Retained Earnings Appropriated
Revaluation Surplus
Treasury Stock
IAS Term
Chare Capital
Subscribed share capital
Preference share capital
Ordinary share capital
Share premium
Accumulated profits(losses)
Appropriation Reserve
Revaluation Reserve
Treasury Share
Notes to Financial Statements
Note to financial statements provide narrative description or 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, notes to financial statements are used to report information that
does not fit into the body of the financial statements in order to enhance the
understandability of the financial statements.
The purpose of the note to financial statements is “to provide the necessary
disclosures required by the Philippine Financial Reporting Standards.”
Forms of Statement of Financial Position
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.
The following is an illustration of the two forms of statement of financial position.
(scanned copy)
Chapter 9
Presentation of Financial Statements
(Statement of Comprehensive Income PAS 1)
Income Statement
An income statement is a formal statement showing the financial performance of
an entity for a given 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 its
resources.
The financial performance is also known as the results of operations of the entity.
The transaction approach is the traditional preparation of the income statement
in conformity with accounting standards.
The income statement for a period presents the income, expenses, gains and
losses and net income or loss recognized during the period.
Information about financial performance is useful in predicting future
performance and ability to generate future cash flows.
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:
a- Components of profit or loss
b- Components of other comprehensive income
Profit or Loss
The term profit or loss is the total of income less expenses, excluding the
components of other comprehensive income.
In other words, this 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
Other comprehensive income comprises items of income and expenses 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” 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 translation of 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, including actuarial gain or
loss
7- Change in fair value attributable to credit risk of a financial liability
designated at fair value through profit
Presentation of other Comprehensive Income
PAS 1, paragraph 82A, provides that the statement of comprehensive income
shall present line items for amounts of other comprehensive income during the
period classified by nature.
The line items for amounts of OCI shall be grouped as follows:
a- OCI that will be reclassified subsequently to profit or loss when specific
conditions are met.
b- OCI that will not be reclassified subsequently to profit or loss but to
retained earnings.
OCI that will be reclassified to Profit or Loss
a- Unrealized gain or loss on debt investment measured at fair value
through other comprehensive income
b- Gain or loss from translating financial statements of a foreign operation
c- Unrealized gains or loss on derivative contracts designated as cash flow
hedge.
OCI that will be reclassified to Retained Earnings
a- Unrealized gain or loss on equity investment measured at fair value
through other comprehensive income.
The Application Guidance of PFRS 9, paragraph B5.7.1 provides that such
unrealized gain or loss is reclassified to retained earnings upon disposal
of the investment.
b- Revaluation surplus during the year
The realization of the revaluation surplus is through retained earnings.
c- Remeasurements of defined benefit plan, including actuarial gain or loss
The remeasurements are not reclassified subsequently but are
permanently excluded from profit or loss.
However, the remeasurements may be transferred within equity or
retained earnings.
d- Change in fair value attributable to credit risk of a financial liability
designated at fair value through profit or loss.
Such gain or loss from change in fair value attributable to credit risk of a
financial liability may be transferred within equity or retained earnings.
Presentation of Comprehensive Income
An entity has two options of presenting comprehensive income, namely:
1- Two statements:
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 of Comprehensive Income
This is the combined statement showing the components of profit or loss
and components of other comprehensive income in a single statement.
The Revised Conceptual Framework calls this single statement as statement
of financial performance.
Sources of Income
a- Sales of merchandise to customers
The income from sales shall include all sales to customers during the
period.
Sales returns, allowances and discounts shall be deducted from gorss
sales to arrive at net sales.
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 category 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
abcde-
Cost of goods sold
Distribution costs or selling expenses
Administrative expenses
Other expenses
Income tax expense
Cost of Goods Sold of Merchandising Concern
Beginning Inventory
Net Purchases
Goods Available for Sale
Ending Inventory
500,000.00
2,000,000.00
2,500,000.00
(300,000.00)
Cost of Goods Sold
2,200,000.00
Gross Purchases
Freight In
Total
Purchase returns, allowance and discounts
Net Purchases
1,900,000.00
150,000.00
2,050,000.00
(50,000.00)
2,000,000.00
Cost of Goods Sold for Manufacturing Concern
Beginning raw material
Net purchases
Raw materials available for use
Ending raw materials
Raw materials used
Direct labor
Factory overhead
Total manufacturing cost
Beginning goods in process
Total cost of goods in process
Ending goods in process
Cost of goods manufactured
Beginning Finished goods
Goods available for sale
Ending finished goods
Cost of goods sold
Classification of Expenses
500,000
2,000,000
2,500,000
(300,000)
2,200,000
3,000,000
1,300,000
6,500,000
900,000
7,400,000
(1,000,000
6,400,000
1,600,000
8,000,000
(1,500,000)
6,500,000
Distribution costs constitute costs which are directly related to selling, advertising
and delivery of goods to customers.
Distribution costs ordinarily include:
abcdef-
Salesman’s salaries
Salesman’s commissions
Travelling and marketing expenses
Advertising and publicity
Freight out
Depreciation of delivery equipment and store equipment
Administrative expenses constitute cost of administering the business.
Administrative expenses ordinarily include all operating expenses not
related to selling and cost of goods sold.
Examples include:
abcdefghij-
Doubtful accounts
Office salaries
Expenses of general executives
Expenses of general accounting and credit department
Office supplies used
Certain taxes
Contribution
Professional fees
Depreciation of office building and office equipment
Amortization of intangible assets
Other expenses are those expenses which are not directly related to the
selling and administrative function.
Examples include:
abcd-
Loss on sale of trading investments
Loss on disposal of property, plant and equipment
Loss on sale of noncurrent investment
Casualty loss – flood, earthquake, fire
No more Extraordinary Items
PAS 1, paragraph 87, specifically mandates that an entity shall not present any
item of income and expense as extraordinary either on the face of the income
statement or statement of comprehensive income or in the notes.
Line Items
PAS 1, paragraph 82, provides that as a minimum, the income statement and
statement of comprehensive income shall include the following line items:
a- Revenue
b- Gain and loss from the derecognition of financial asset measured at
amortized cost as required by PFRS 9
c- Finance cost
d- Share in income or loss of associates and joint venture accounted for
using the equity method
e- Gain or loss on the reclassification of financial asset from amortized cost
to fair value profit or loss
f- Gain or loss on the reclassification of financial asset from fair value other
comprehensive income to fair value profit or loss
g- Income tax expense
h- A single amount comprising discounted operations
i- Profit or loss for the period
j- Total other comprehensive income
k- Comprehensive income for the period being the total of profit or loss
and other comprehensive income
The following items shall be disclosed on the face of the income statement and
statement of comprehensive income:
a- Profit or loss for the period attributable to non-controlling interest and
owners of the parent
b- Total comprehensive income for the period attributable to noncontrolling interest and owners of the parent
Forms of Income Statement
PAS 1, paragraph 99, provides that an entity shall present an analysis of expenses
recognized in profit or loss 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
This form classifies expenses according to their function as part of cost of goods
sold, distribution costs, administrative expenses and other expenses.
The functional presentation is also known as the cost of goods sold method.
An entity classifying expenses by function shall disclose additional information on
the nature of expenses, including depreciation, amortization and employee
benefit costs.
Natural Presentation
The natural presentation is referred to as the nature of expense method.
Under this form, expenses are aggregated according to their nature and not
allocated among the various functions within the entity.
In other words, the expenses are no longer classified as cost of goods sold,
distribution costs, administrative expenses and other expenses.
The expenses which are of the same nature are grouped or aggregated and
presented as one item.
For example, depreciation, purchases of raw materials, transport costs, employee
benefit costs and advertising costs are presented separately.
(Scanned)
Which Form of Income Statement?
PAS 1 does not prescribe any format.
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.
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 profit 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
Using the date in the preceding illustration, the statement of comprehensive
income may appear as follows:
EXEMPLAR COMPANY
STATEMENT OF COMPREHENSIVE INCOME
Year Ended December 31, 2020
Net income
1,550,000
Other comprehensive income to be reclassified to profit or loss:
Foreign Currency translation gain
Unrealized loss on derivative contract designated as cash flow hedge
150,000
(100,000)
Comprehensive Income
50,000
1,600,000
Comprehensive income for a period includes the net income or loss for the period
plus or minus the components of other comprehensive income.
However, the comprehensive income of Php 1,600,000 is not carried to retained
earnings. Only the net income of Php 1,550,000 is included in the determination
of retained earnings unappropriated.
The net other comprehensive income of Php 50,000 is carried to “reserves” or
shown separately in the statement of changes in equity.
Single Statement of Comprehensive Income
Another option in presenting the components of profit or loss and components of
other income comprehensive income is to prepare a single statement of
comprehensive income.
Again, this single statement is the combined income statement and statement of
comprehensive income.
Using the preceding data, the single statement of comprehensive income
following the “functional presentation” may appear as follows:
EXEMPLAR COMPANY
STATEMENT OF COMPREHENSIVE INCOME
Year Ended December 31, 2020
Net Sales
Cost of Goods Sold
Gross Income
Other Income
Investment Income
Total Income
Expenses:
Distribution Cost
Administrative Expenses
Other Expenses
Finance Cost
Income Before Tax
Income Tax Expense
Net Income
9,000,000
(5,400,000)
3,600,000
900,000
500,000
5,000,000
1,350,000
1,000,000
320,000
200,000
2,870,000
2,130,000
580,000
1,550,000
Other Comprehensive Income to be reclassified to profit or loss:
Foreign Currency translation gain
Unrealized loss on derivative contract designated as cash flow hedge
Comprehensive income
150,000
(100,000)
50,000
1,600,000
Statement of Retained Earnings
The statement of retained earnings shows the changes affecting directly the
retained earnings of an entity and relates the income statement to the statement
of financial position.
The important data affecting the retained earnings that should be clearly
disclosed in the statement of retained earnings are:
abcde-
Profit or loss for the period
Prior period errors
Dividends declared and paid to shareholders
Effect of change in accounting policy
Appropriation or retained earnings
Statement of Changes in Equity
The statement of changes in equity is a basic statement that shows the
movements in the elements or components of the shareholder’s equity.
The statement of retained earnings is no longer a required basic statement but it
is a part of the statement of changes in equity.
An entity shall present a statement of changes in equity showing the following:
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 components 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.
Chapter 10
Statement of Cash Flows
Statement of Cash Flows
A statement of cash flows is a component of financial statements summarizing
the operating, investing and financing activities of an entity.
In simple language, the statement of cash flows provides information about cash
receipts and cash payments on an entity during a period.
An entity shall prepare a statement of cash flows and present it as an integral part
of the financial statements for each period for which financial statements are
presented.
The primary purpose of a statement of cash flows is to provide relevant
information about cash receipts and cash payments of an entity during a period.
Cash and Cash Equivalents
The statement of cash flows is designed to provide information about the change
in an entity’s cash and cash equivalents.
Cash comprises cash on hand and demand deposits.
Cash equivalents are short term highly liquid investments that are readily
convertible to known amount of cash and which are subject to an insignificant risk
of change in value.
PAS 7, paragraph 7 provides that an investment normally qualifies as a cash
equivalent only when it has a short maturity of three months or less from date of
acquisition.
In other words, the investment must be acquired three months or less before the
date of maturity.
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- Thee month money market instrument or commercial paper.
Classification of Cash Flows
Cash flows are inflows and outflows of cash and cash equivalents.
The statement of cash flows shall report cash flows during the period classified as
operating, investing and financing activities.
Operating Activities
Operating activities are the cash flows derived primarily from the principal
revenue producing activities of the entity
In other words, operating activities generally result from transactions and other
events that enter into the determination of net income or loss.
Examples of cash flows from operating activities are:
a- Cash receipts from sale of goods and rendering services
b- Cash receipts from royalties, rental, fees, commissions and other
revenue
c- Cash payments to suppliers for goods and services
d- Cash payments for selling, administrative and other expenses
e- Cash receipts and cash payments of an insurance entity for premiums
and claims, annuities and other policy benefits
f- Cash payments or refunds of income taxes unless specifically identified
with financing and investing activities
g- Cash receipts and payments for securities held for trading
Trading Securities
PAS 7, paragraph 15, provides that cash flows arising from the purchase and sale
of dealing or trading securities are classified as operating activities.
Similarly, cash advances and loans made by a financial institution are usually
classified as operating activities since they relate to the main revenue producing
activity of that entity.
Investing Activities
Investing activities are cash flows derived from the acquisition and disposal of
long term assets and other investments not included in cash equivalent.
As a simple guide, investing activities include cash flows from transactions
involving non-operating assets.
Examples of Cash Flows from Investing Activities
a- Cash payments to acquire property, plant and equipment, intangible
and other long term assets.
b- Cash receipts from sales of property, plant and equipment, intangibles
and other long term assets.
c- Cash payments to acquire equity or debt instruments of other entities
{current and long-term investments}
d- Cash receipts from sales of equity or debt instruments of other entities
e- Cash advances and loans to other parties other than advances and loans
made by financial institution
f- Cash receipts from repayment of advances and loans made to other
parties
g- Cash payments for futures contract, forward contract, option contract
and swap contract
h- Cash receipts from future contract, forward contract, option contract
and swap contract
Financing Activities
Financing activities are the cash flows derived from the eqtuity capital and
borrowings of the entity
In other words, financing activities are the cash flows that result from
transactions:
a- Between the entity and the owners – equity financing
b- Between the entity and the creditors – debt financing
As a simple guide, financing activities include the cash flows from transactions
involving non-trade liabilities and equity of an entity.
Examples of Cash Flows from Financing Activities
A- CASH RECEIPTS FROM ISSUANCE OF ORDINARY AND PREFERENCE SHARES
B- CASH PAYMENTS TO ACQUIRE TREASURY SHARES
C- CASH RECEIPTS FROM ISSUING DEBENTURES, LOANS, NOTES, BONDS,
MORTGAGES AND OTHER SHORT OR LONG TERM BORROWINGS
D- Cash payments by a lessee for the reduction of the outstanding principal
lease liability
Cash payments to settle such obligations as trade accounts and notes payable,
income tax payable, accrued expenses are operating activities, not financing
activities.
Noncash Transactions
PAS 7, paragraph 43, provides that investing and financing transactions that do
not require use of cash or cash equivalents shall be excluded from the statement
of cash flows.
Noncash investing and financing transactions shall be disclosed elsewhere in the
financial statements either in the notes to financial statements or in a separate
schedule or in a way that provides all relevant information about these
transactions.
The statement of cash flows is strictly a cash concept.
Accordingly, the following noncash transactions are disclosed separately:
abcde-
Acquisition of asset by assuming directly related liability
Acquisition of asset by issuing share capital
Acquisition of asset by issuing bonds payable
Conversion of bonds payable into share capital
Conversion of preference shares into ordinary shares
Interest
PAS 7, paragraph 33, provides that interest paid and interest received shall be
classified as operating cash flows because such items enter into the
determination of net income or loss.
Alternatively, interest paid may be classified as financing cash flow because it is a
cost of obtaining financial resources.
Alternatively, interest received may be classified as investing cash flows because it
is a return on investment.
For a financial institution, interest paid and interest received are usually classified
as operating cash flows.
Dividends
PAS 7, paragraph 33, provides that dividend received shall be classified as
operating cash flow because it enters into the determination of net income.
Alternatively, dividends may be classified as investing cash flow because it is a
return on investment.
PAS 7, paragraph 34, provides that dividend paid shall be classified as financing
flow because it is a cost of obtaining financial resources.
Alternatively, dividends paid may be classified as operating cash flow in order to
assist the users to determine the ability of the entity to pay dividends out of
operating cash flows.
Income Taxes
PAS 7, paragraph 35, provides that cash flows arising from income taxes shall be
separately disclosed as cash flows from operating activities unless they can be
specifically identified with investing and financing activities.
Tax cash flows are often difficult to match to the originating underlying
transaction, so most of the time all tax cash flows are classified as arising from
operating activities.
Chapter 11
Accounting Policies, Estimate and Errors
PAS 8
Accounting Policies
Accounting policies are the specific principles, bases, conventions, rules and
practices applied by an entity in preparing and presenting financial statements
Accounting policies are essential for a proper understanding of the information
contained in the financial statements
An entity is required to outline all significant accounting policies applied in
preparing financial statements.
Under accounting standards, alternative treatments are possible.
In this case, it becomes all the more important for an entity to clearly state the
accounting policies used in preparing financial statements.
The entity shall select and apply the same accounting policies each period in order
to achieve comparability of financial statements or to identify trends in the
financial position, performance and cash flows of the entity.
Change in Accounting Policy
Once selected, accounting policies must be applied consistently for similar
transactions and events.
A change in accounting policy shall be made only when:
a- Required by an accounting standard
b- The change will result in more relevant and faithfully represented
information about the financial position, financial performance and cash
flows of the entity
Examples of Change in Accounting Policy
A change in accounting policy arises when an entity adopts a generally accepted
accounting principle which is different from the one previously used by the entity.
Examples of change in accounting policy are:
a- Change in the method of inventory pricing from FIFO to weighted
average method
b- Change in the method of accounting for long term construction contract
from cost recovery method to percentage of completion method
c- The initial adoption of policy to carry assets at revalued amount is a
change in accounting policy to be dealt with as revaluation.
d- Change from cost model to fair value model in measuring investment
property.
e- Change to a new policy resulting from the requirement of a new PFRS
How to Report a Change in Accounting Policy
A change in accounting policy required by a standard or an interpretation shall be
applied in accordance with the transitional provision therein.
If the standard or interpretation contains no transitional provisions or if an
accounting policy is changed voluntarily, the change shall be applied
retrospectively or retroactively.
Retrospective Application
Retrospective application means that any resulting adjustment from the change in
accounting policy shall be reported as an adjustment to the opening balance of
retained earnings.
The amount of the adjustment is determined as of the beginning of the year of
change.
If comparative information is presented, the financial statements of the prior
period presented shall be restated to conform to the new accounting policy.
Absence of Accounting Standard
PAS 8, paragraph 10, provides that in the absence of an accounting standard that
specifically applies to a transaction or event, management shall use judgment in
selecting and applying an accounting policy that results in information that is
relevant to the economic decision making needs of users and faithfully
represented.
Paragraphs 11 and 12 specify the following hierarchy of guidance which
management may use when selecting accounting policies in such circumstances:
a- Requirements of current standards dealing with similar matters
b- Definition, recognition criteria and measurement concepts for assets,
liabilities, income and expenses in the Conceptual Framework for
Financial Reporting
c- Most recent pronouncements of other standard setting bodies that use
a similar Conceptual Framework, other accounting literature and
accepted industry practices
Accounting Estimate
A change in accounting estimate is a normal recurring correction or adjustment of
an asset or liability which is the natural result of the use of an estimate.
An estimate may need revision if changes occur regarding the circumstances on
which the estimate was based or as a result of new information, more experience
or subsequent development.
By very nature, the revision of the estimate does not relate to prior periods and is
not a correction of an error.
Sometimes it is difficult to distinguish a change in accounting estimate and a
change in accounting policy.
In such a case, the change is treated as a change in accounting estimate, with
appropriate disclosure.
Examples of Accounting Estimate
As a result of the uncertainties in business activities, many items in financial
statements cannot be measured with precision but can only be estimated.
Estimation involves judgment based on the latest available and reliable
information.
Estimates may be required for the following:
a- Doubtful accounts
b- Inventory obsolescence
c- Useful life, residual value and expected pattern of consumption of
benefit of depreciable asset
d- Warranty cost
e- Fair value of asset and liability
How to Report Change in Accounting Estimate
The effect of a change in accounting estimate shall be recognized currently and
prospectively by including it in income or loss of:
a- The period of change if the change affects that period only
b- The period of change and future periods if the change affects both
A change in an accounting estimate shall not be accounted for by restating
amounts reported in financial statements of prior periods.
Changes in accounting estimates are to be handled currently and prospectively, if
necessary.
Prospective recognition of the effect of a change in accounting estimate means
that the change is applied to transactions, other events and conditions from the
date of change in estimate.
Chapter 12
Events after the Reporting Period
PAS 10
Events after the Reporting Period
PAS 10, paragraph 3, defines events after reporting 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.
Events after the reporting period are also known as subsequent events.
Such events may require either adjustment or disclosure.
Types of Events after the Reporting Period
a- Adjusting events after reporting period are those that provide evidence
of conditions that exist at the end of reporting period
b- Non-adjusting events after reporting period are those that are indicative
of conditions that arise after the end of reporting period
It is appropriate to adjust the financial statements for all events that offer clarity
concerning the conditions that existed at the end of reporting period and that
occur prior to the date the financial statements are authorized for issue.
Accordingly, an entity must adjust the amounts recognized in the financial
statements for adjusting events that provide evidence of conditions that existed
at the end of reporting period.
However, an entity does not recognize events after the reporting period that
relate to conditions that only arose after the reporting period.
The entity is required only to disclose significant non-adjusting events.
Examples of Adjusting Events
Examples of adjusting events after reporting period which require the entity to
adjust the financial statements are:
1- Settlement after the reporting period of a court case because it
confirms that the entity already had a present obligation at the end
of reporting period.
2- Bankruptcy of a customer which occurs after the reporting period
3- Sale of inventories after the reporting period may give evidence
about the net realizable value at reporting date
4- The determination after reporting period of the cost of asset
purchased or the proceeds from asset sold before the end of
reporting period
5- 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
6- The discovery of fraud or errors that show the financial statements
were incorrect.
Examples of Non-adjusting 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
transaction 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 a significant effect on current and deferred tax asset and
liability
Financial Statements Authorized for Issue
Financial statements are authorized for issue when the board of directors reviews
the financial statements and authorizes them to issue.
In some cases, an entity is required to submit the 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.
Chapter 13
Related Party Disclosures
PAS 24
Related Party
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 reporting entity
Control is the power over investee or 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:
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Representation in the board of directors
Participation in policy making process
Material transactions between the investor and the investee
Interchange of managerial personnel
Provision of essential technical information
Joint control is the contractually agree sharing of control over an economic
activity.
Examples of Related Parties
1- Affiliates –meaning the parent, the subsidiary and fellow subsidiaries
2- Associates – meaning the entities over which one party exercises
significant influence
The term “associate” includes subsidiary or subsidiaries of the associate.
3- Venture in a joint venture
A joint venture includes the subsidiary or subsidiaries of the joint
venture.
4- Key management personnel are those persons having authority and
responsibility for planning, directing and controlling the activities of the
entity, directly or indirectly, including any executive director or nonexecutive director
5- Close family members of an individual are those family members who
may be expected to influence or be influenced by that individual in their
dealings with the entity.
a- The individual’s spouse and children
b- Children of the individual’s spouse
c- Dependents of the individual or the individual’s spouse
6- Individuals owning directly or indirectly an interest in the voting power
of the reporting entity that gives them significant influence over the
entity and close family members of such individuals.
7- Postemployment benefit plan for the benefit of employees
Examples of 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 or related party
transaction:
1234567-
Purchase and sale of goods
Purchase and sale of property and other asset
Rendering or receiving services
Leases
Transfer of research and development
License agreement
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 Disclosure
PAS 24, paragraph 12, requires disclosure of related party relationships where
control exists irrespective of whether there have been transactions between the
related parties.
In other words, relationships between parent 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 nest 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 an understanding of the financial statements.
As a minimum, the disclosures of related party transaction shall include:
a- The amount of transaction
b- The amount of outstanding balance, terms and conditions, whether
secured or unsecured and nature of consideration to be provided in
settlement
c- The allowance for doubtful accounts related to the outstanding balance
d- The doubtful accounts expenses recognized during the period in respect
of amount due from related parties
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:
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Short term employee benefits
Postemployment benefits, for example, retirement pension
Other long term benefits
Shared based payment transactions, for example, share options
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 venture.
However, Paragraph 4 provides that intergroup related transactions and
outstanding balances are eliminated in the preparation of consolidated financial
statements of the group.
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
Chapter 14
Inventories
PAS 2
Inventories
Inventories are assets held for sale in the ordinary course of business in the
process of production for such sale or in the form of materials or supplies to be
consumed in the production process or in the rendering of services.
Inventories encompass goods purchased and held for resale, for example:
a- Merchandise purchased by a retailer and held for resale
b- Land and other property held for resale by a subdivision entity and real
estate developer.
Inventories also encompass finished goods produced, goods in process and
materials and supplies awaiting use in the production process.
Classes of Inventories
Inventories are broadly classified into two, namely- inventories of a trading
concern and inventories of manufacturing concern.
A trading concern is one that buys and sells goods in the same form purchased.
The term merchandise inventory is generally applied to goods held by a trading
concern.
A manufacturing concern is one that buys goods which are altered or converted
into another from before they are made available for sale.
The inventories of a manufacturing concern are:
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Finished goods
Goods in process
Raw materials
Factory or manufacturing supplies
Cost of Inventories
The cost of inventories shall comprise:
a- Cost of purchase
b- Cost of conversion
c- Other cost incurred in bringing the inventories to their present
location and condition
Cost of Purchase
The cost of purchase of inventories comprises the purchase price, import duties
and irrevocable taxes, freight, handling and other cost directly attributable to the
acquisition of finished goods, materials and services.
Trade discounts, rebates and other similar items are deducted in determining the
cost of purchase.
Cost of Conversion
The cost of conversion of inventories includes cost directly related to the units of
production such as direct labor. It also includes a systematic allocation of fixed
and variable production overhead that is incurred in converting materials into
finished goods.
Fixed production overhead is the indirect cost of production that remains
relatively constant regardless of the volume of production.
Examples are depreciation and maintenance of factory building and equipment
and the cost of factory management and administration.
Variable production overhead is the indirect cost of production that varies directly
with the volume of production.
Examples are indirect labor and indirect materials.
Other Cost
Other cost is included in the cost of inventories only to the extent that it is
incurred in bringing the inventories to their present location and condition.
For example, it may be appropriate to include the cost of designing product for
specific customers in the cost of inventories.
However, the following costs are excluded from the cost of inventories and
recognized as expenses in the period when incurred:
a- Abnormal amounts of wasted materials, labor and other production
costs
b- Storage costs, unless necessary in the production process prior to a
further production stage.
Thus storage costs on goods in process are capitalized but storage costs
on finished goods are expensed.
c- Administrative overheads
d- Distribution or selling costs
Cost of Inventories of a Service Provider
The cost of inventories of a service provider consists primarily of the labor and
other costs of personnel directly engaged in providing the service, including
supervisory personnel and attributable overhead.
Labor and other costs relating to sales and general administrative personnel are
not included but are recognized as expenses in the period in which they incurred.
Cost Formulas
PAS 2, paragraph 25, expressly provides that the cost of inventories shall be
determined by using either:
a- First in, first out
b- Weighted Average
The standard does not permit anymore the use of the last in first out (LIFO) as an
alternative formula in measuring cost of inventories.
First in, First out (FIFO)
The FIFO method assumes that the goods first purchased are first sold and
consequently the goods remaining in the inventory at the end of the period are
those most recently purchased or produced.
In other words, the FIFO is in accordance with the ordinary merchandising
procedure that the goods are sold in the order they are purchased.
The rule is first come first sold.
The inventory is thus expressed in terms of recent or new prices while the cost of
goods sold is representative of earlier or old prices.
This method favors the statement of financial position in that the inventory is
stated at current replacement cost.
The objection to the method is that there is improper matching of cost against
revenue because the goods sold are stated at earlier or older prices resulting in
understatement of cost of goods sold.
Accordingly, in a period of inflation or rising prices, the FIFO method would result
to the highest net income.
However, in a period of deflation or declining prices, the FIFO method would
result to the lowest net income.
Weighted Average
The cost of the beginning inventory plus the total cost of purchases during the
period is divided by the total units purchased plus those in the beginning
inventory to get a weighted average unit cost.
Such weighted average unit cost is then multiplied by the units on hand to derive
the inventory value.
In other words, the average unit cost is computed by dividing the total cost of
goods available for sale by the total number of units available for sale.
The argument for the weighted average method is that it is relatively easy to
apply, especially with computers.
Moreover, the weighted average method produces inventory valuation that
approximated current value if there is a rapid turnover or inventory.
The argument against the weighted average method is that there may be
considerable lag between the current cost and inventory valuation since the
average unit cost involves early purchases.
Last in, first out (LIFO)
The LIFO method assumes that the goods last purchased are first sold and
consequently the goods remaining in the inventory at the end of the period are
those first purchased or produced.
The inventory is thus expressed in terms of earlier or old prices and the cost of
goods sold is representative of recent or new prices.
The LIFO favors the income statement because there is matching of current cost
against current revenue, the cost of goods sold being expressed in terms of
current or recent cost.
The objection of the LIFO is that the inventory is stated at earlier or older prices
and therefore there may be a significant lag between inventory valuation and
current replacement cost.
Actually, in a period of rising prices, the LIFO method would result to the lowest
net income. In a period of declining prices, the LIFO method would result to the
highest net income.
Specific Identification
Specific identification means that specific costs are attributed to identified items
of inventory.
The cost of inventory is determined by simply multiplying the units on hand by
the unit cost.
PAS 2, paragraph 23, provides that this method is appropriate for inventories that
are segregated for a specific project and inventories that are not ordinarily
interchangeable.
Measurement of Inventory
PAS 2, paragraph 9, provides that inventories shall be measured at the lower of
cost and net realizable value.
The cost of inventory is determined using either FIFO cost or average cost.
The measurement inventory at the lower of cost and net realizable value is
known as LCNRV.
Net Realizable Value
Net realizable value or NRV is the estimated selling price in the ordinary course of
business less the estimated cost of completion and the estimated cost of disposal.
The cost of inventories may not be recoverable under the following
circumstances:
abcd-
The inventories are damaged
The inventories have become wholly or partially obsolete
The selling prices have declined
The estimated cost of completion or the estimated cost of
disposal has increased.
Inventories are usually written down to net realizable value on an item by item or
individual basis.
Accounting for Inventory Write-down
If the cost is lower than net realizable value, there is no accounting problem
because the inventory is stated at cost and the increase in value is not recognized.
If the net realizable value is lower than cost, the inventory is measured at net
realizable value.
In this case, the problem is that proper treatment of the write-down of inventory
to net realizable value.
The write-down of inventory to net realizable value is accounted for using the
allowance method.
Allowance Method
The inventory is recorded at cost and any loss on inventory write-down is
accounted for separately.
This method is also known as loss method because a loss account loss on
inventory write-down is debited and a valuation account allowance for inventory
write-down is credited.
In subsequent years, this allowance account is adjusted upward or downward
depending on the difference between the cost and net realizable value of the
inventory at year end.
If the required allowance increases an additional loss is recognized.
Id the required allowance decreases a gain on reversal of inventory write-down is
recorded.
However, the gain is limited only to the extent of the allowance balance.
The allowance method is used in order that the effects of write-down and
reversal of write-down can be clearly identified.
As a matter of fact, PAS 2 paragraph 36 requires disclosure of the amount of any
inventory write-down and the amount of any reversal of inventory write-down.
Chapter 15
Property, Plant and Equipment
PAS 16
Property, Plant and Equipment
Property, plant and equipment are tangible assets that are held for use in
production or supply of goods or services, for rental to others or for
administrative purposes and are expected to be used during more than one
period.
Accordingly, the major characteristics in 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 or services for rental
purposes and for administrative purposes
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
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Land
Land improvements
Building
Machinery
Ship
Aircraft
Motor vehicle
Furniture and fixtures
Office equipment
Patterns, molds and dies
Tools
Bearer plants
Recognition of property, plant and equipment
An item of property, plant and equipment shall be recognized as an asset when:
a- It is probable that future economic benefits associated with the asset
will flow to the entity
b- The cost of the asset can be measured reliably
Measurement at Recognition
An item of property, plant and equipment that qualifies for recognition as an
asset shall be measured at cost.
Cost is the amount of cash or cash equivalent paid and the fair value of the other
consideration given to acquire an asset at the time of acquisition or construction.
Elements of Cost
The cost of an item, property and equipment comprises:
a- Purchase price including import duties and non-refundable purchase
taxes after deducting trade discounts and rebates
b- Cost directly attributable to bringing the asset to the location and
condition necessary for it to be capable of operating in the manner
intended by management
c- Initial estimate of the cost of dismantling and removing the item and
restoring the site on which it is located for which an entity has a present
obligation.
Directly Attributable Costs
Examples of directly attributable costs that qualify for recognition include:
a- Cost of employee benefit arising directly from the construction or
acquisition of the item of property, plant and equipment
b- Cost of site preparation
c- Initial delivery and handling cost
d- Installation and assembly cost
e- Professional fee
f- Costs of testing whether the asset is functioning properly
Costs not qualifying for Recognition
Examples of costs that are expensed rather than recognized as element of costs of
property, plant and equipment are:
a- Cost of opening a new facility
b- Cost of introducing a new product or service, including cost of
advertising and promotion
c- Cost of conducting business in a new location or with a new class of
customer including cost of staff training
d- Administration and other general overhead cost
e- Cost incurred while an item capable of operating in the manner
intended by management has yet to be brought into use or is operated
at less than full capacity
f- Initial operation loss
g- Cost of relocating or reorganizing part or all of an entity’s operations
Measurement after Recognition
After initial recognition, an entity shall choose either the cost model or the
revaluation model as the accounting policy for property, plant and equipment.
The entity shall apply such accounting policy to an entire class of property, plant
and equipment.
The cost model means that property, plant and equipment are carried at cost less
any accumulated depreciation and any accumulated impairment loss.
The revaluation model means that property, plant and equipment are carried at
revalued carrying amount.
The revalued carrying amount is the fair value at the date of revaluation less any
subsequent accumulated depreciation and subsequent accumulated impairment
loss.
Acquisition on a Cash Basis
The cost of an item of property, plant and equipment is the cash price equivalent
at the recognition date.
The cost of asset acquired on a cash basis simply includes the cash paid plus
directly attributable costs such as freight, installation cost and other costs
necessary in bringing the asset to the location and condition for the intended use.
Acquisition on Account
When an asset is acquired on account subject to cash discount, the cost of the
asset is equal to the invoice price minus the discount regardless of whether the
discount is taken or not.
Cash discounts are generally considered as reduction of cost and not as income.
Acquisition on Installment Basis
When payment for an item of property, plant and equipment is deferred beyond
normal credit terms, the cost is the cash price equivalent.
In other words, if an asset is offered at a cash price and at an installment price
and is purchased at an installment price, the asset shall be recorded at cash price.
The excess of the installment price over the cash price is treated as an interest to
be amortized over the credit period.
Issuance of Share Capital
Philippine GAAP provides that if shares are issued for consideration other than
actual cash, the proceeds shall be measured by the fair value of the consideration
received.
Accordingly, where a property is acquired through the issuance of share capital,
the property shall be measured at an amount equal to the following in the order
or priority:
a- Fair value of the property received
b- Fair value of the share capital
c- Par value or stated value of the share capital
Issuance of Bonds Payable
PFRS 9, paragraph 5.1.1, provides the asset acquired by issuing bonds payable is
measured in the following order:
a- Fair value bonds payable
b- Fair value of asset received
c- Face amount of bonds payable
Exchange
PAS 16, paragraph 24 , provides that the cost of an item of property, plant and
equipment acquired in exchange for a non-monetary asset or a combination of
monetary and non-monetary asset is measured at fair value plus any cash
payment.
However, the exchange is recognized at carrying amount if the exchange
transaction lacks commercial substance.
Definition of Commercial Substance
Commercial substance is a new notion and is defined as the event or transaction
causing the cash flows of an entity to change significantly by reason of the
exchange.
An exchange transaction has commercial substance when the cash flows of the
asset received differ significantly from the cash flows of the asset transferred.
Construction
The cost of self-constructed asset is determined using the same principle as for an
acquired asset.
The cost of self constructed property, plant and equipment includes:
1- Direct cost of materials
2- Direct cost of labor
3- Indirect cost and incremental overhead specifically identifiable or
traceable to the construction.
PAS 16, paragraph 22, provides that the cost of abnormal amount of wasted
material, labor or overhead incurred in the production of self-constructed asset is
not included in the cost of the asset.
Derecognition
Derecognition means that the cost or property, plant and equipment together
with the related accumulated depreciation shall be removed from the statement
of financial position.
PAS 16, paragraph 67, provides that the carrying amount of an item of property,
plant and equipment shall be derecognized on disposal or when no future
economic benefits are expected from the use or disposal.
The gain or loss from the derecognition of an item of property, plant and
equipment shall be included in profit or loss.
Gains shall not be included in revenue but treated as other income.
The gain or loss arising from the derecognition of an item of property, plant and
equipment shall be determined as the difference between the net disposal
proceeds and the carrying amount of the item.
Fully Depreciated Property
A property is said to be fully depreciated when the carrying amount is equal to
zero or the carrying amount is equal to the residual value.
In such a case, the asset account and the related accumulated depreciation
account are closed and the residual value is set up in a separate account.
However, it is not uncommon for an entity to continue to use an asset after it has
been fully depreciated.
The cost of fully depreciated asset remaining in service and the related
accumulated depreciation ordinarily shall not be removed from the accounts.
However, entities are encouraged but not required to disclose fully depreciated
property.
Concept of Depreciation
Depreciation is defined as the systematic allocation of the depreciable amount of
an asset over useful life.
Depreciation is not so much a matter of valuation.
Depreciation is a matter of cost allocation in recognition of the exhaustion of the
useful life of an item of property, plant and equipment.
The objective of depreciation is to have each period benefiting from the use of
the asset bear an equitable share of the asset cost.
Depreciation Period
The depreciable amount of an asset shall be allocated on a systematic basis over
the useful life.
Depreciation of an asset begins when it is available for use, meaning, when the
asset is in the location and condition necessary for the intended use by
management.
Depreciation ceases when the asset is derecognized.
Therefore, depreciation does not cease when asset becomes idle temporarily.
Temporarily idle activity does not preclude the depreciating the asset as future
economic benefits are consumed not only through usage but also through wear
and tear and obsolescence.
Factors of Depreciation
In order to properly compute the amount of depreciation, three factors are
necessary, namely depreciable amount, residual value and useful life.
Depreciable Amount
Depreciable amount is the cost of an asset or other amount substituted for cost
less the residual value.
Each part of an item of property, plant and equipment with a cost that is
significant in relation to the total cost of the item shall be depreciated separately.
For example, it may be appropriate to depreciate separately the airframe,
engines, fittings (seat and floor coverings) and tires of an aircraft.
The entity also depreciates separately the remainder of the item and the
remainder consists of the parts of the item that are individually not significant.
Residual Value
Residual value is the estimated net amount currently obtainable if the asset is at
the end of the useful life.
The residual value of an asset shall be reviewed at least at each financial year-end
and if expectation differs from previous estimate, the change shall be accounted
for as a change in an accounting estimate.
The residual value of an asset may increase to an amount equal to or greater than
the carrying amount.
If it does, the depreciation charge is zero unless and until the residual value
subsequently decreases to an amount below the carrying amount.
Depreciation is recognized even if the fair value of the asset exceeds the carrying
amount as long as the residual value does not exceed the carrying amount.
Useful Life
Useful life is either the period over which an asset is expected to be available for
use by the entity or the number of production or similar units expected to be
obtained from the asset by the entity.
Factors in Determining Useful Life
a- Expected usage of the asset – usage is assessed by reference to the
asset’s expected capacity or physical output.
b- Expected physical wear and tear – this depends on the operational
factors such as the number of shifts the asset is used, the repair and
maintenance program, and the care and maintenance of the asset while
idle.
c- Technical or commercial obsolescence – this arises from changes or
improvements in production or change in the market for the product
output of the asset.
d- Legal limits for the use of the asset, such as the expiry date of the
related lease.
Depreciation Method
The depreciation method shall reflect the pattern in which the future economic
benefits from the asset are expected to be consumed by the entity.
The depreciation method shall be reviewed at least at every year-end.
If there has been a significant change in expected pattern of economic benefits,
the method shall be changed to reflect the change pattern.
Such change shall be accounted for as a change in accounting estimate.
A variety of depreciation methods can be used.
Depreciation methods include straight line, production method and diminishing
balance method.
Straight Line Method
Under the straight line method, the annual depreciation charge is calculated by
allocating the depreciation amount equally over the number of years of useful
life.
In other words, straight line depreciation is a constant charge over the useful life
of an asset.
The straight line method is adopted when the principal cause of depreciation is
passage of time.
The straight line approach considers depreciation as a function of time rather
than as a function of usage.
Production Method
The production or output method assumes that depreciation is more of a function
of use rather than passage of time.
The useful life of the asset is considered in terms of the output it produces or the
number of hours it works.
Thus, depreciation is related to the estimated production capability of the asset
and is expressed is a rate per unit of output or per hour of use.
The production method is adopted if the principal cause of depreciation is usage.
Diminishing Balance or Accelerated Methods
The diminishing balance or accelerated methods provide higher depreciation in
the earlier years and lower depreciation in the later years of the useful life of the
asset.
Thus, these methods result in a decreasing depreciation charge over useful life.
The accelerated depreciation is on the philosophy that new assets are generally
capable of producing more revenue in the earlier years than in the later year.
The accelerated methods include sum of years’ digits method and double
declining balance method.