financial accounting volume 1

8/2/2019 Financial Accounting Volume 1

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Financial Accounting Vol. 1

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FINANCIAL ACCOUNTING VOLUME 1

Chapter 1: Framework of Accounting

Guide Questions

1)

Define Accounting.2) Explain briefly the three activities in the accounting process as embraced in the accounting

definition.

3) What are transactions? Distinguish external transactions and internal transactions.

4) When is a transaction accountable or quantifiable?

5) Explain why accounting has been called the language of business?

6) What is the basic purpose of accounting?

7) Describe the accountancy profession.

8) What is the R. A. No. 9298?

9) Explain the limitation of the practice of public accountancy.

10)Explain the accreditation to practice public accountancy.

11)Explain briefly the three main areas in the practice of the accountancy profession.

12)Explain briefly the three kinds of services offered by accountant in the practice of public

accounting. Which is the primary service?

13)Distinguish:

a. Accounting and auditing

b. Accounting and bookkeeping

c. Accounting and accountancy

d. Financial accounting and managerial accounting

14)What is the meaning of generally accepted accounting principles?

15)What constitutes GAAP in the Philippines?

16)

What is the purpose of accounting standards?17)What do you understand about the Financial Reporting Standards Council?

18)What do you understand about PIC and IFRIC?

19)What do you understand about the International Accounting Standards Committee?

20)What are the twin objectives of IASC?

21)Explain why the Philippines has moved totally from American Accounting Standards to

International Accounting Standards?

22)What is IASB?

23)What do you understand by the International Financial Reporting Standards?

24)What is the meaning of accounting assumptions?

25)Explain briefly the five underlying accounting assumptions?

26)What is the meaning of the Framework?

27)What is the basic purpose of the Framework?

28)Is the Framework a Philippine Financial Reporting Standard?

29)Enumerate the users and their information needs.

30)What is the scope of the Framework?

31)What is the objective of financial statements?

32)Explain the Financial Position of an entity.


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33)Explain the performance of an entity.

34)Briefly explain entity theory, proprietary theory, residual equity theory and fund theory.

35)Explain financial reporting?

36)What are the specific objectives of financial reporting?

37)What is the meaning of qualitative characteristics of financial accounting information?

38)Explain briefly the four principal qualitative characteristics as embraced in the Framework?

39)Explain the three ingredients of relevance.

40)Explain briefly the five factors that would enhance the reliability of financial accounting

information?

41)What is the standard of adequate disclosure?

42)Briefly explain notes to financial statements.

43)Explain understandability.

44)Explain comparability.

45)Differentiate comparability within a single entity and comparability between and across entities.

46)What is the meaning of accounting constraints?

47)Enumerate and explain briefly the accounting constraints.

48)Enumerate and define the five elements of the financial statements.

49)What is the meaning of recognition of the elements of the financial statements?

50)State the following recognition principles:

a. Asset recognition principle

b. Liability recognition principle

c. Income recognition principle

d. Expense recognition principle

51)Explain future economic benefit.

52)What is the cost principle? How much is cost?

53)Explain the essential characteristics of a liability.

54)Define Income.

55)Distinguish income, revenue and gain.

56)What are the conditions for the revenue recognition from sale of goods?

57)What are the exceptions to the point of sale income recognition principle?

58)What are the conditions for the recognition of revenue from rendering of services?

59)Explain the revenue recognition from interest, royalties and dividends.

60)Explain the revenue recognition from installation fees, subscription fees, admission fees and

tuition fees.

61)Define expenses.

62)Distinguish expenses and losses.

63)What do you understand by the matching principle?

64)Explain the three applications of the matching principle?

65)Briefly explain the four measurement bases used in preparing financial statements.

66)Explain the capital maintenance approach of measuring financial performance.

67)Explain financial capital.

68)Explain physical capital.


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Chapter 1: Framework of Accounting

Accountingis a service activity. Its function is to provide quantitative information, primarily financial

in nature, about economic entities, that is intended to be useful in making economic decision.

(ASC)

- 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. (CAT-AICPA)

- is the process of identifying, measuring and communicating economic information to permit

informed judgment and decision by users of the information . (American Accounting

Association in its Statement of Basic Accounting Theory)

- is an information system that measures business activities, processes information into reports

and communicates the reports to decision makers.

e.g. Personal planning, education expenses, loans, car payments, income taxes

Financial Statementskey product of accounting

- documents that report financial information about an entity to decision makers.

- these reports tell us how well an entity is performing in terms of profits and losses and where

it stands in financial terms.

Components of Accounting (AAA):

a. Identifyinganalytical component

b. Measuringtechnical component

c.

Communicatingformal component

Identifying recognition or nonrecognition of business activities as accountable events. Not all

business activities are accountable.

Accountable or Quantifiablewhen it has an effect on assets, liabilities and equity. The subject

matter of accounting is economic activity or the measurement of economic resources and

economic obligations. Only economic activities are emphasized in financial accounting.

Sociological and Psychological matters are beyond the province of accounting.

Economic activitiesreferred to as transactions which may be classified as external and

internal.External transactionsor exchange transactions are those economic events involving

one entity and another entity. E.g. purchase of merchandise from a supplier, borrowing

money from a bank, sale of merchandise to a customer and payment to employees

Internal transactionseconomic events involving the entity only. These are economic

activities that take place entirely within the entity. E.g. production and casualty loss


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Productionthe process by which resources are transformed into products

Casualtyis any sudden and unanticipated loss from fire, flood, earthquake and

other event ordinarily termed as an act of God.

Measuringis the assigning of peso amounts to the accountable economic transaction and events.

If accounting information is to be useful, it must be expressed in a common financial

denominator. Financial statements without monetary amounts would be largely unintelligible or

incomprehensible.

Philippine pesounit of measuring accountable economic transactions.

Measurement bases:

a. Historical costmost common measure.

b. Current costc. Realizable valued. Present value

Communicating is the process of preparing and distributing accounting reports to potential users of

accounting information.

Identifying and measuring are pointless if the information contained in the accounting records

cannot be communicated to potential users like the investors, owners, managers, creditors and

other interested parties. It has been for this reason that accounting has been called the language

of business.

Implicit in the communication process:

Recording or journalizingis the process of systematically maintaining a record of alleconomic business transactions after they have been identified and measured.

Classifyingis the sorting or grouping of similar and interrelated economic transactions

into their respective classes.

E.g. Sale of merchandise can be grouped into one total sales figure and all

transactions involving cash can be grouped to report a single net cash figure.

- accomplished by posting to the ledger

Ledgeris a group of accounts which are systematically categorized into

asset accounts, liability accounts, equity accounts, revenue accounts and expense

accounts.

Summarizingis 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.


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Basic Purpose of Accounting

*Accounting identifies, measures and communicates information about entities for use in making

informed judgment and decision.

- Thus the basic 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. In otherwords, an accountants primary task is to supply financial information to statement users so that they

could make informed judgment and better decision.

THE ACCOUNTANCY PROFESSION

Republic Act No. 9298is the law regulating the practice of accountancy in the Philippines

- known as the Philippine Accountancy Act of 2004.

Board of Accountancy is the body authorized by law to promulgate rules and regulations

affecting the practice of the accountancy profession in the Philippines.

Limitation of the practice of public accountancy

- Single practitioners and partnerships for the practice of public accountancy shall be registered certified

public accountants 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 meaningful experience in any of the areas of public practice

including taxation.

- The Securities and Exchange Commission (SEC) shall not register any corporation organized for the

practice of public accountancy.

ACCREDITATION TO PRACTICE PUBLIC ACCCOUNTANCY

Professional Regulation Commission (PRC) upon favourable recommendation of the Board of

Accountancy shall issue the Certificate of Registration to practice public accountancy which shall be valid

for 3 years and renewable every 3 years upon payment of required fees.

3 MAIN AREAS IN THE ACCOUNTANCY PROFESSION:

Public Accounting composed of individual practitioners, small accounting firms and large

multinational organizations that render independent and expert financial services to the public

Public accountants - collect professional fees for their services, much the same as lawyers and

doctors do.


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- usually offer 3 kinds of services:

1) Auditingtraditionally has been the primary service offered by most public

accounting practitioners

- specifically, external auditing is the examination of financial

statements by independent certified public accountants for the purpose of

expressing an opinion as to the fairness with which financial statements

are prepared.

- attest function of independent CPAs.

BIRrequires audited financial statements to accompany the filing of annual

income tax return.

2) Taxation Serviceincludes the preparation of annual income tax returns and

determination of tax consequences of certain proposed business

endeavors.

- 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 court cases concerned with

interpreting taxation law.

3) Management Advisory Serviceshas no precise coverage but is used

generally to refer to services to clients on matters of accounting, finance,

business policies, organization procedures, product cost, distribution and

many other phases of business conduct and operations.

- specifically include advice on installation of computer system,

quality control, installation and modification of accounting system,

budgeting, forecasting, design or modification of retirement plans and

even company mergers and takeovers.

Private Accountingincludes accounting staff, chief accountant, internal auditor, and controller.

Controllerhighest accounting officer.

- the major objective of the private accountant is to assist management in planning and

controlling the entitys operations: this will include maintaining the records, producingthe financial reports, preparing the budgets and controlling and allocating the costs of the

business. Private accountant has also the responsibility for the determination of the

various taxes the business is obliged to pay.

Government Accountingencompasses 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.


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- focus on the custody and administration of public funds.

E. g. Bureau of Internal Revenue (BIR), Commission on audit (COA), Department of Budget and

Management (DBM), National Bureau of Investigation.

CONTINUING PROFESSIONAL EDUCATION (CPE)

- All CPAs shall abide by the requirements, rules and regulations on continuing professional

education to be promulgated by the Board of Accountancy, subject to the approval of the

Professional Regulation Commission, in coordination with the accredited national professional

organization of CPAs or any duly accredited educational institutions.

ACCOUNTING VS AUDITING

Broad Sense:

Accountingembraces auditing.

Auditingone of the areas of accounting specialization

Limited Sense:

Accountingessentially constructive in nature. Accounting ceases when financial statements are

prepared.

Auditingis 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 examine the

financial statements to ascertain whether they are in conformity with Generally Accepted

Accounting Principles (GAAP).

ACCOUNTING VS BOOKKEEPING

Bookkeeping is procedural and largely concerned with development and maintenance of accounting

records.

- it is the how of accounting.

- is a procedural element of accounting as arithmetic is a procedural element of

mathematics.

Accounting is conceptual and is concerned with the why reason or justification for any action

adopted.

ACCOUNTING VS ACCOUNTANCY

Broadly Speaking:

The two terms are synonymous because they both refer to the entire field of accounting theory

and practice.


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Technically Speaking:

Accountancyrefers to the profession of accounting practice.

Accountingis 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 Accountingprimarily concerned with the recording of business transactions and the eventual

preparation of financial statements.

- focuses on general purpose reports known as financial statements which are intended

for internal and external users.

- area of accounting that emphasizes reporting to creditors and investors.

Managerial Accountingis the accumulation and preparation of financial reports for internal users only.- is the area of accounting that emphasizes developing accounting information for use

within the entity.

GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP)

- encompasses the conventions, rules and procedures necessary to define what is accepted

accounting practice.

Conventional meaning, they become generally accepted by agreement often tacit

agreement rather than by formal derivation from a set of postulates and basic concepts.

Principles have developed on the basis of experience, reason, custom, usage and practical

necessity.

- represent the rules, procedures, practice and standards followed in the preparation and

presentation of financial statements.

- like laws that must be followed in financial reporting.

The process of establishing GAAP is a social process which incorporates political actions of

various interested user groups as well as professional judgment, logic and research.

The development of GAAP in the Philippines is formalized initially through the creation of

Accounting Standards Council (ASC) promulgated by Accounting Standards Council.

Statement of Financial Accounting Standards (SFAS)previously approved statements of the ASC.

- now known as Philippine Accounting Standards (PAS) and Philippine Financial

Reporting Standards (PFRS).


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Purpose of Accounting Standards:

- 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 on how items, for example the valuation of assets, are treated. FinancialStatements shall therefore comply with all applicable accounting standards.

FINANCIAL REPORTING STADARDS COUNCIL (PFRC)

- replacesthe Accounting Standards Council

- is the accounting standard setting body created by theProfessional Regulation Commission

upon recommendation of the Board of Accountancy to assist the Board of accountancy in

carrying out its powers and functions provided underR.A. Act No. 9298.

- main function is to establish and improve accounting standards that will be generally accepted

in the Philippines.

- composed of 15 members with a Chairman who has been or is presently a senior accounting

practitioner and 14 representatives from the following:

Board of Accountancy 1

Securities and Exchange Commission 1

Bangko Sentral ng Pilipinas 1

Bureau of Internal Revenue 1

Commission on Audit 1

Major Organization of preparers and users of financial statements 1

Accredited National Professional Organization of CPAs:

Public Practice 2Commerce and Industry 2

Academe or Education 2

Government 2

Total 14

- The Chairman and members of the FRSCshall have a term of3 years renewable for another

term. Any member of the appointed ASC shall not be disqualified from being appointed to the FRSC.

Philippine Interpretations Committee (PIC)replaced the Interpretations Committee (IC) formed by the

Accounting Standards Council in May 2000.

- prepare interpretations of PFRS for approval by the FRSC and in the context of the Framework,

to provide timely guidance on financial reporting issues not specifically addressed in current

PFRS.


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Interpretationsare intended to give authoritative guidance on issues that are likely to receive

divergent or unacceptable treatment because the standards do not provide specific and clearcut

rules and guidelines.

International Accounting Standards Committee (IASC)is an independent private sector body, with the

objective of achieving uniformity in the accounting principles which are used by business andother organizations for financial reporting around the world.

- formed in June 1973 through an agreement made by the professional accountancy bodies from

Australia, France, Germany, Japan, Mexico, the Netherlands, the United Kingdom and Ireland,

and the United States of America.

- subsequently, expanded to include representatives from over 100 countries and by 143

professional accounting bodies in 104 countries representing over 2 million accountants.

- headquartered in London, United Kingdom.

Objectives of IASC:a) 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.

b) To work generally for the improvement and harmonization of regulations, accounting standards

and procedures relating to the presentation of financial statements.

International Accounting Standards (IAS)the approved statements of the IASC.

Factors considered in deciding to move totally to international accounting standards:

a) Support international accounting standards by Philippine organizations, such as the Philippines

SEC, Board of Accountancy and PICPA.

b)

Increasing internalization of business which has heightened interest in a common language for

financial reporting.

c) Improvement of International Accounting Standards or removal of free choices of accounting

treatments.

d) Increasing recognition of International Accounting Standards by the World Bank, Asian

Development Bank and World Trade Organization.

International Accounting Standards Board (IASB)replaces the International Accounting Standards

Committee (IASC)

-publishes its standards in a series of pronouncements called International Financial Reporting

Standards (IFRS).

- its objective is to raise the quality and consistency of financial reporting and to have a platform

of high quality and improved standards.

- is a global phenomenon intended to bring greater transparency and a higher comparability in

financial reporting, both of which will benefit the investors and are essential to achieve the goal

of one uniform and globally accepted financial reporting standards.


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UNDERLYING ASSUMPTIONS

Accounting assumptions are the basic notions or fundamental premises on which the accounting

process is based.

- serve as the foundation or bedrock of accounting in order to avoid misunderstanding but rather

enhance the understanding and usefulness of the financial statements.

- also known as postulates.

2 Assumptions in the Framework for the Preparation and Presentation of Financial Statements:

1) Accrual Accounting income is recognized when earned regardless of when received andexpense is recognized when incurred regardless of when paid.

- the effects of transactions and other events are recognized when they occur and not

when cash or its equivalent is received or paid, and they are recorded and reported in the

periods to which they relate.

- the essence of accrual accounting is the recognition of accounts receivable, accountspayable, prepaid expenses, deferred income, and accrued income.

2) Going Concernin the absence of evidence to the contrary, the accounting entity is viewedas continuing in operation indefinitely.

- financial statements are normally prepared on the assumption that the entity will

continue in operations in the foreseeable future. Thus assets are normally

recorded at cost. As a rule, market value is ignored.

- is the very foundation of the cost principle.

- also known as the continuity assumption.

If there is evidenced that the entity would experience large and persistent losses or that the

entitys 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 entitys assets in the short term.

Implicit in accounting are the Basic Assumptions of:

Accounting Entityis 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. The transactions of the entity shall not be merged with the transactions of the

owners.

However, where parent and subsidiary relationship exists, consolidated statements for the

affiliates are usually made because for practical and economic reason purposes, the parent and the

subsidiary are a single economic entity. The consolidation, however, does not eliminate the


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legal boundary aggregating the affiliated entities. Accounting will continue to be done separately

for each entity.

Time Period Assumptionrequires that the indefinite life of an entity is subdivided into time periods or

accounting periods which are usually of equal length for the purpose of preparing financial

reports on financial position, performance and cash flows.

Accounting Period or fiscal periodis one year or a period of 12 months.

- maybe a calendar year or a natural year:

Calendar year12- month period that ends on December 31.

Natural business year12- month period that ends on any month when the business is at

the lowest or experiencing slack season.

Monetary Unit Assumptionhas 2 aspects:

1) Quantifiabilitythe assets, liabilities, capital, income and expenses should be stated in terms of a

unit of measurement which is the peso in the Philippines.

2) Stability of the peso assumptionthe purchasing power of the peso is stable or constant and that

its instability is insignificant and therefore may be ignored.

Stable peso postulateactually 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 pesos only and not for changes in purchasing power.

PAS 16: provides that an entity shall choose either the cost model or revaluation model as its

accounting policy and shall apply that policy to an entire class of property, plant and equipment.

AICPA Financial Accounting Standards Board encourages entities to make supplementarydisclosures relating to the impact of changing prices.

Framework for the Preparation and Presentation of Financial Statements

- promulgated by the International Accounting Standards Board and adopted by the local Accounting

Standards Council which is now replaced by the Financial Reporting Standards Council.

- is a summary of the terms and concepts that underlie the preparation and presentation of financial

statements.

It is the underlying theory for the development of accounting standards and revision of previously

issued accounting standards

- is an attempt to provide an overall theoretical foundation for accounting which will guide standard-

setters, preparers and users of financial information in the preparation and presentation of

statements.

The concepts are the foundation on which financial statements are constructed and provide a

platform from which accounting standards are developed and revised.


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- concerned with general-purpose financial statements, including consolidated financial statements. Such

financial statements are prepared atleast annually and are directed toward the common needs of a

wide range of users.

Users and Their Information needs:

1) Investorsthe providers of risk capital and their advisers are concerned with risk inherent in andreturn provided by their investments.

they 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.

2) Employeesinterested in information about the stability and profitability of the entity.they are interested in information which enables them to assess the ability of the entity

to provide remuneration, retirement benefits and employment opportunities.

3) Lenders are interested in information which enables them whether their loans and interestthereon will be paid when due.

4) Suppliers and other trade creditors these users are interested in information which enablesthem to determine whether amounts owing to them will be paid on maturity.

5) Customer - have an interest in information about the continuance of an entity especially whenthey have a long-term involvement with or are dependent on the entity.

6) Government and their agenciesare interested in the allocation of resources and therefore theactivities of the entity.

- require information to regulate the activities of the entity, determine taxation policies

and as a basis for national income and similar statistics.

7)

Publicentities affect members of public in a variety of ways. Financial statements may assistthe public by providing information about the trends and recent developments in the prosperity of

the entity and the range of its activities.

Basic Purpose of Framework

a. Assist the FRSC in developing accounting standards that will represent Philippine GAAP.

b. Assists preparers of financial statements in applying accounting standards and in dealing with

issues not yet covered by GAAP.

c. Assists the FRSC in its review and adoption of International Financial Reporting Standards.

d. Assists users of financial statements in interpreting the information contained in the financial

statements.

e.

Assists auditors in forming an opinion as to whether financial statements conform with PhilippineGAAP.

f. Provides information to those interested in the work of the FRSC in the formulation of PFRS.

The Framework is not a Philippine Financial Reporting Standard and hence does not define standard for

any particular measurement or disclosure issue. Nothing in this Framework overrides any specific

Philippine Financial Reporting Standards.


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In case there is a conflict, the requirement of the PFRS shall prevail over the Framework.

Scope of Framework

a. Objective of the financial statements.

b.

Qualitative characteristics that determine the usefulness of information in financial statements.c. Definition, recognition and measurement of the elements from which financial statements are

construed.

d. Concepts of capital and capital maintenance.

The Framework applies to the financial statements of all commercial, industrial and business reporting

entities whether in the public or private sector.

Special purpose financial reportse.g. prospectuses and computations prepared for taxation purposes,

are outside the scope of the Framework.

Objective of Financial Statements

- 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.

- do not provide all information that users may need to make economic decisions since they largely

portray the financial effects of past events and do not necessarily provide nonfinancial

information.

- also show the results of the stewardship of management or the accountability of management for the

resources entrusted to it.

Management has the primary responsibility for the preparation and presentation of the financial

statements of the entity.

Financial Positioncomprises its assets, liabilities and equity at a particular time.

- pertains to the economic resources, liquidity, solvency, financial structure and capacity for

adaptation of an entity. This information is pictured in the statement of financial position.

Information about economic resources or assets controlled by the entity and its capacity to modify these

resources is useful in predicting the ability of the entity to generate cash and cash equivalents in the

future.

Liquidityis the availability of cash in the near future to cover currently maturing obligations.

Solvencyis the availability of cash over long term to meet financial commitments when they

fall due.

Information about liquidity and solvency is useful in predicting the ability of the entity to comply with its

future financial statements.


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Financial Structureis the source of financing for the assets of the entity.

indicates what amount of assets has been financed by owners which is the

invested or equity capital.

is the ratio of equity capital to liabilities.

Information about financial structure is useful in predicting future borrowing needs and howprofits and cash flows will be distributed between the creditors and owners

Capacity for adaptation is the ability of the entity to use its available cash for unexpected

requirements and investment opportunities.

This may be accomplished by raising cash at a short notice through borrowing and issuance of

securities or by raising cash through disposal of assets without disrupting normal operations. This

is also known as financial flexibility.

Financial performancecomprises revenue, expenses and net income or loss for a period of

time.

- is the level of income earned by the entity through the efficient and effective use of its

resources.

- previously known as results of operations and is portrayed in the income statement and

statement of comprehensive income.

Information about financial performance is useful in predicting the capacity of the entity to

generate cash flows from its operations. It is also useful in forming judgment about the

effectiveness of the entity in employing additional resources.

Cash flows information about cash flows is useful in order to assess the operating, investing andfinancing activities of the entity during a period. This information is found in the statement of

cash flows.

Accounting Concepts

1. Entity theorythe accounting objective id geared in toward proper income determination. Propermatching of cost against revenue is the ultimate end.

- emphasizes the importance of the income statement. This is explained by the equation:

Assets = Liabilities + Capital

2. Proprietary theorythe accounting objective id directed toward proper valuation of assets.- emphasizes the importance of the statement of financial position. It is exemplified bythe equation:

AssetsLiabilities = Capital

3. Residual equity theory the accounting objective is also proper valuation of assets. This isapplicable where there are two classes of shareholders, ordinary and preference.

AssetsLiabilitiesPreference Shareholders Equity = Ordinary Shareholders Equity


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4. Fund theory the accounting objective is neither proper income determination nor propervaluation of assets but the custody and administration of funds.

- Government accounting and fiduciary accounting are examples of the application of this

concept.

Fund = Cash inflowsCash outflows

Financial Reportingis 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 entitys

management.

- the principal way of providing financial information to external users is through the annual financial

statements.

- encompasses not only financial statements but also other means of communicating information that

relates directly or indirectly to the financial accounting process.

Financial Reportsinclude not only financial statements but also other information such as

financial highlights, summary of important financial figures, analysis of financialstatements and significant ratios.

- also include nonfinancial information such as description of major products and a listing

of corporate officers and directors.

Objective of Financial Reporting

Overall objective: To provide information that is useful for decision making.

Specifically: provided by the AICPA Financial Accounting Standards Board in its Statement of

Financial Accounting Concepts:a) To provide information useful in investment, credit and similar decision.

b) To provide information useful in assessing cash flow prospects.

c) To provide information about entity resources, claims to those resources and changes in them.

Qualitative Characteristics are the qualities or attributes that make financial accounting information

useful to the users.

Characteristics that relate to content:

1) Relevance the capacity of information to make a difference by helping users formpredictions about the outcome of past, present and future events, or confirm and correct

prior expectations.

- capacity of information to influence a decision.

Ingredients of relevance:

Predictive Value information has a predictive value when it can help users increase the

likelihood of correctly or accurately predicting or forecasting outcome of events.


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Feedback value Information has feedback value when it enables the users confirm or

correct earlier expectations.

E.g. A net income has a feedback value if it can help shareholders confirm or revise their

expectation about an entitys ability to generate earnings.

For instance, if the interim income statement for the first quarter is P2,000,000 (feedback

value), and this trend continues for the entire year, it is logical to assume that the net income

after four quarters or one year would be P8,000,000 (predictive value).

Timelinessproviding information to the decision maker while it has the capacity to affect a

decision

- is an important ingredient of relevance because relevant information furnished after a

decision is made is useless or of no value.

E.g. The most important attribute of quarterly or interim financial information is its

timeliness.

2) Reliability is the degree of confidence users place upon the truthfulness of therepresentation in the financial statements

- is the quality of information that assures users that the information is free from bias and

error, and faithfully represent what it purports to represent.

Factors that enhances the reliability of financial information:

a. Faithful representationthe actual effects of the transactions shall be properlyaccounted for and reported in the financial statements.

- synonymous with verifiability or objectivity.- financial statements are verifiable or objective in the sense that they are

supported by evidence so that an accountant that would look into the

same evidence would arrive at the same economic decision or

conclusion.

b. Substance over formIf information is to represent faithfully the transactions andother events it purports to represent, it is necessary that they are accounted in

accordance with their substance and not merely their legal form.

E.g. When the lessee leased property from the lessor: the terms of the lease, among

others, provide that the lease transfer 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 is an instalment purchase of property by the lessee from the

lessor.

Accordingly, the lessee shall be accounted for as a finance lease. Thus, the lessee

shall record the finance lease as an instalment payment representing interest and

principal.


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c. Neutralitythe information contained in the financial statements must be free frombias. Thus, to be neutral, the financial information should not favour one party to

the detriment of another party.

- information is directed to the common needs of many users, and not to the

particular needs of specific users.

- synonymous with the all-encompassing principle of fairness. To be neutral isto be fair.

d. Conservatism or prudence when alternatives exist, the alternative which has theleast effect on equity should be chosen.

E.g. If there is a choice between two acceptable asset values, the lower figure is

selected. Accordingly, inventories are valued at the lower of cost or net realizable

value.

Contingent loss is recognized as a provision if the loss is probable and the

amount can be reasonably estimated.

Contingent gainis not recognized but disclosed only.

- conservatism is not a license to deliberately understate net income and net

assets. E.g. If an entity has a cash of P500,000 and reports only P100,000, this

is not conservatism but fraud or inaccurate reporting.

- synonymous with prudence.

Prudence is the desire to exercise 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.

Expression of conservatism or prudence

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.

Dont count your chicks until the eggs hatch.

e. Completenessrequires that relevant information shall be presented in a way thatfacilitates understanding and avoids erroneous implication

- is the result of the adequate standard or the principle of full disclosure.- to be reliable, the information in financial statements shall be complete within

the bounds of materiality and cost. An omission can cause misleading

and false information and therefore unreliable.


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Standard of Adequate Disclosure

- means that all significant and relevant information leading to the preparation of financial statements

shall be clearly reported.

The financial statements shall report relevant, reliable, understandable and comparable

information for external users to make knowledgeable decisions about the entity.

- however does not mean disclosure of any data. The rule is that 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 statements would not be misleading.

Notes to Financial Statements

- provide the necessary disclosures required byPhilippine Financial Reporting Standards.

- provide narrative description or disaggregation of the items presented in the financial statements that do

not qualify for recognition.

Understandabilityrequires that financial information must be comprehensible if it is to be useful.

- the information should be presented in a form and expressed in terminology that a

user understands.

Financial statements cannot realistically be understandable to everyone, and therefore,

users are assumed to have a reasonable knowledge of the economic activities and

accounting and a willingness to study the information with diligence.

Understandability is very essential because even if the financial information is relevant andreliable, it may prove to be useless if it is not understood by the users or decision-makers.

Comparabilitythe ability to bring together for the purpose of noting points of likeness and difference.

Comparable information presents similarities and dissimilarities

- may be within an entity or between and across entities.

Comparability within an entityis the quality of information that allows comparisons within a

single entity through time or from one accounting period to the next.

- also known as horizontal comparability.

- necessary in order to identify trends in the financial position and performance of the

entity.

Knowing the past trends, users can reasonably make more accurate predictions about the

future cash flows of the entity.

Comparability within and across entitiesis the quality of information that allows comparisons

between two or more entities in the same industry.


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- also known as intercomparability or dimensional comparability.

To be useful, financial information shall be compared with similar information of

previous periods, or with similar information provided by another entity.

Consistencyimplicit in the characteristics of comparability is the principle of consistency.

- requires that the accounting methods and practices should be applied on a uniform basis from

period to period.

- technically: is the uniform application of accounting method from period to period.

(comparability is the uniform application of accounting method between and across in the

same industry.)

- essential to achieve comparability of financial statements.

However, it does not mean that no change in the 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.

ACCOUNTING CONSTRAINTS

- are the factors that may affect the relevance and reliability of financial accounting information.

These constraints are:

a. Timelinessrequire that the accounting information must be available or communicated early

enough when a decision is to be made.

- the essence in presenting financial information.

- information furnished after a decision has been made is of no value.

Relevant information may lose its relevance if there is undue delay in its reporting. Management

may need to balance the relative merits of timely reporting and provision of reliable information.

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.

b. Cost-benefitbalance between cost and benefit is a pervasive constraint rather than qualitative

characteristic.

- is a consideration of the cost incurred in generating information against the benefit to be

obtained from having the information.

- the rule is the benefit derived from the information should exceed the cost incurred in

obtaining the information. Otherwise, the financial accounting information may

not be reported.

- evaluation of cost-benefit is usually a judgmental process.


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c. Materialityis 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 statements.

- is also known as the doctrine of convenience.

- really a quantitative threshold constraint linked very closely to the qualitative characteristic

of relevance. The relevance of information is affected by its nature and materiality.

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 would

affect or influence the decision of the information users of the financial statements.

- Information is material if its omission or misstatement could influence the economic decision of

the users taken on the basis of the financial statements.

E.g. Small expenditures for tools are often expensed immediately rather than depreciated over

their useful lives to save clerical costs of recording depreciation because the effect on the

financial statements is not large enough to affect economic decision.

-materiality is relativity. Materiality of an item depends on its relative size rather than absolute

size.

E.g. An error of P100,000 in the financial statements of a multinational entity may not be

important but may be so critical for a small entity.

Factors of Materiality:

1. Size of the Itemin relation to the total of the group to which the item belongs.

E.g. 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.

2. Nature of the Iteman item may be inherently material because by its very nature it

affects economic decision.

E.g. The discovery of a P20,000 bribe is a material event for a very large entity.

Balance between Relevance and Materiality

- There is a trade-off between reporting relevant information in a timely manner and taking time

to ensure that the information is reliable. If the information is not reports in a timely manner, it

may lose its relevance.


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Elements of Financial Statements

- refer to the quantitative information shown in the statement of financial position and income

statement.

- are the building blocks from which financial statements are constructed.

- are the broad classes of events or transactions that are grouped according to their economic

characteristics.

Elements directly related to the measurement of financial position: assets and liabilities.

Elements directly related to the measurement of financial position: income and expenses.

Definition of Terms

Assetsresources controlled by the entity arising as a result of past transactions or events and from which

future economic benefits are expected to flow to the entity.

Liabilitiesare present obligations of the entity arising from past transactions or events the settlement ofwhich is expected to result in an outflow from the entity of resources embodying economic benefits.

Equityis the residual interest in the assets of the entity after deducting all of its liabilities.

Incomeis increase in economic benefit during the accounting period in the form of inflow or increase in

asset or decrease in liability that results in increase in equity, other than contribution from equity

participants.

Expense is decrease in economic benefit during the accounting period in the form of an outflow or

decrease in asset or increase in liability that results in decrease in equity, other than distribution to equity

participants.

Recognition of Elements

Recognition is the reporting of an asset, liability, income or expense on the face of the financial

statements of an entity.

4 Main Recognition Principles:

a. Asset recognition principle

b. Liability recognition principle

c. Income recognition principle

d. Expense recognition principle

Asset Recognition Principle- an asset is recognized when it is probable that future economic benefits will flow to the entity

and the asset has a cost or value that can be measured reliably.

- 2 conditions must be present:

1. It is probable that future economic benefits will flow to the entity.

Probablethe chance of the future economic benefit arising is more likely rather than less

likely.


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2. The cost or value of the asset of the asset can be measured reliably.

Future Economic Benefitembodied in an asset is the potential to contribute directly or indirectly to the

flow of cash and cash equivalents to the entity.

- the potential may be a productive one that is part of the operating activities of the entity.

- it may also take the form of convertibility into cash or cash equivalents or a capability to reducecash outflows, such as when an alternative manufacturing process lowers the costs of production.

Future economic benefit embodied in an asset may flow to the entity by:

a. Used singly or in combination with other assets in the production of goods or services to be sold

by the entity.

b. Exchanged for other assets.

c. Used to settle liability.

d. Distributed to the owners of the entity.

Cost Principlerequires that assets should be recorded initially at original acquisition cost.

The initial cost may be carried without change, may be changed by depreciation, amortization or

writeoff, or may be shifted to other categories as in the case of raw materials being converted into

finished goods.

How much is the cost?

In a cash transaction, cost is equivalent to the cash payment. Thus if an equipment is acquired for

P100,000 cash, the cost of the equipment is P100,000.

In noncash or an exchanged transaction, the cost is equal to the fair value of the asset received,whichever is clearly evident. In the absence of fair value, the cost is equal to the book value of the

asset given.

Liability Recognition Principle - a liability is recognized when it is probable that an outflow of resources

embodying economic benefits required for the settlement of a present obligation and the amount

of the obligation can be measured reliably.

-2 conditions must be present:

a. It is probable that an outflow of economic benefits will be required for the settlement of a

present obligation.

b. The amount of obligation can be measured reliably.

Liabilities essential characteristic is that the entity has a present obligation which may be legal or

constructive.

Obligations may be legally enforceable as a consequence of a binding contract or statutory

requirement


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- normally the case.

e.g. with amounts payable for goods and services received

Constructive obligationsarise from normal business practice, custom and desire to maintain

good business relations or act in an equitable manner

.e.g. If an entity decides as a matter of policy to rectify faults in its products even whenthese becomes apparent after the warranty period has expired, the amounts that

are expected to be expended in respect of goods already sold are liabilities.

A distinction should be drawn between a present obligation and future commitment.

A decision by the management of an entity to acquire assets in the future does not in itself give

rise to present obligation.

An obligation normally arises only when the asset is delivered or the entity enters into an

irrevocable agreement to acquire the asset.

Settlement of Present Obligation may occur in:

a.

Payment of cash.

b. Transfer of noncash assets.

c. Provision of services.

d. Replacement of the obligation with another obligation.

e. Conversion of the obligation into equity.

Income Recognitionthe basic principle income shall be recognized when earned .

When is income considered to be earned?

The Frameworkprovides that income is recognized when it is probable that an increase in

future economic benefit related to an increase in an asset or a decrease in a liability has arisen andthat the increase in economic benefits can be measured reliably.

-2 conditions must be present for the recognition of income:

a. It is probable that future economic benefits will flow to the entity as a result of an increase in

an asset or a decrease in a liability.

b. The economic benefits can be measured reliably.

Both conditions are present at the point of sale.

Point of Saleis the point of income recognition.

- it is at the point of sale that the entity has transferred to the buyer the significant risksand rewards of ownership of the goods.

- legal title to the goods passes to the buyer at the point of sale

- incidentally, is usually the point of delivery, which may be actual or constructive

- legally, it is delivery that transfers ownership from the seller to the buyer.

Incomeencompasses both revenue and gains.


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Revenue - arises in the course of the ordinary regular activities of an entity and is referred

to by a variety of different names including sales, fees, interest, dividends, royalties and

rent.

- its essence is irregularity.

Gainsrepresent other items that meet the definition of income and do not arise in the course of

the ordinary regular activities of an entity.E.g. Gains include gain from disposal of noncurrent assets, unrealized gain on trading

securities and gain from expropriation.

Revenue from Sale of Goods

PAS 18 provides the following conditions:

1. The entity has transferred to the buyer the significant risks and rewards of ownership of

the goods.

2. The entity retains neither continuing managerial involvement nor effective control over

the goods sold.

3. The amount of revenue can be measures reliably.

4.

It is probable that economic benefits associated with the transaction will flow to the

entity.

5. The cost incurred or to be incurred in respect of the transaction can be measured reliably.

Exceptions to the Point of Sale

Installment MethodRevenue is recognized at the point of collection

The amount of revenue is determined by multiplying the gross profit rate by the

amount of collections.

The reason for this approach is the uncertainty of collection or the possibility of

cancellation of the instalment sales contract.

Cost Recovery Method or Sunk Cost MethodRevenue is recognized also at the point of

collection.

- unlike the instalment method, all collections are first applied to the cost of the

merchandise sold. When the cost of the merchandise sold is fully recovered

through collections, then all subsequent collections are considered revenue.

- usually followed when the collection of the instalment sales contract is very uncertain

or highly speculative.

Cash MethodRevenue is recognized when received regardless of when earned.

- all collections are treated as revenue.- there are no accruals and deferrals

- like the cost recovery method, this approach may be used when there is considerable

uncertainty in the collection of the sales price.

Percentage of Completion Methodwhen the outcome of a construction contract can be

estimated reliably, contract revenue and contract costs associated with the construction


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contract shall be recognized as revenue and expenses, respectively, by reference to the

stage of completion of the contract activity.

Production Methodrevenue is recognized at the point of production.

- is applicable to agricultural, forest and mineral products.

-the production method is allowed when a sale is assured under a forward contract or agovernment guarantee, or when a homogeneous market exists and there is a negligible

risk of failure to sell.

Revenue from Rendering Services

PAS 18 provides the following conditions:

1. The amount of revenue can be measured reliably.

2. It is probable that the economic benefits associated with the transaction will flow to the

entity.

3. The stage of completion of the transaction at the end of reporting period can be measured

reliably.

4.

The cost incurred for the transaction and the costs to complete can be measured reliably.

Revenue from interest, royalties and dividends

Interest Revenue shall be recognized on a time proportion basis that takes into account the

effective yield on the asset.

Royalties shall be recognized on an accrual basis in accordance with the substance of the

relevant agreement.

Dividends shall be recognized as revenue when the shareholders right to receive payment is

established, meaning, when the dividends are declared.

Other Income Recognition1. Installation fees are recognized as revenue over the period of installation by reference to the

stage of completion.

2. Subscription revenue should recognized on a straight line basis over the subscription period

3. Admission fees are recognized as revenue when the event takes place.

4. Tuition fees are recognized as revenue over the period which tuition is provided.

Expense Recognition Principle - expenses are recognized when incurred.

When are expense incurred?

The Frameworkprovides that expenses are recognized when it is probable that a decrease in future

economic benefits in an asset or an increase in liability has occurred and that the decrease in economic

benefit can be measured reliably.

- 2 conditions must be present:

a. It is probable that a decrease in future economic benefits has occurred as a result of a decrease

in an asset or an increase in liability.

b. The decrease in economic benefits can be measured reliably.


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Expensesencompasses losses as well as those expenses that arise in the course of the ordinary regular

activities of the entity

An expense that arises from the ordinary course of business: e.g. cost of sales, wages and

depreciation.

Lossesrepresent other items that meet the definition of expenses and do not arise in the course

of the ordinary regular activities of the entity.

e.g. fire, flood, tsunami and hurricane as well as those arising from disposal of noncurrent

assets.

Matching Principlethe expense recognition principle is the application of the matching principle.

There is no gain if there is no pain.

- requires that those costs and expense incurred inn earning a revenue shall be reported in the

same period.

- there shall be a simultaneous or combined recognition of revenue and expense that result

directly from the same transactions and events.

- has3 applications:

1. Cause and Effect Associationthe expense is recognized when the revenue is already

recognized.

The reason is the presumed direct association of the expense with specific items

of income.

- actually the strict matching concept.- commonly referred to as the matching of costs with revenue, involves the simultaneouos

or combined recognition of revenue and expenses that result directly and jointly

from the same transactions or other events.

E.g. The cost of merchandise inventory is considered as an asset in the meantime that the

merchandise is sold, the cost thereof is expensed in the form of cost of sales because at

such time revenue may be recognized.

Other examples: doubtful accounts, warranty expense and sales commissions.

2. Systematic and Rational Allocationsome costs are expensed by simply allocating over theperiods benefited.

The reason is that the cost incurred will benefit future periods and 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.

- used when economic benefits are expected to arise over several accounting periods with

income can only be broadly or indirectly determined.


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E.g. depreciation property, plant and equipment, amortization of intangibles, and

allocation of prepaid rent, insurance, other prepayments and deferred charges.

3. Immediate Recognition the cost incurred is expensed outright because of uncertainty offuture economic benefit or difficulty of reliably associating certain costs with future

revenues.

- reflects a conservative or prudent approach which is the accountants general guide for

dealing with uncertain situations.

- expense is recognized immediately when an expenditure produces no future economic

benefits or when future economic benefits do not qualify, or cease to qualify for

recognition in the statement of financial position as an asset.

E.g. Officers salaries and most administrative expenses, advertising and most selling

expenses, amount to settle lawsuit and worthless intangibles.

Many losses, such loss from sale of investments, and casualty loss, are immediately

recognized because they are not directly related to specific revenues.

Measurement of Elements

Measurement is the process of determining the monetary amounts at which the elements of the

financial statements are to be recognized and carried in the statement of financial position and income

statement.

a. Historical Cost is the amount of cash or cash equivalent paid or the fair value of the

consideration given to acquire an asset at the time of acquisition.

also known as past purchase exchange price.

is the measurement basis most commonly adopted in preparing their financial

statements.

b. Current Costis the amount of cash or cash equivalent that would have to be paid if the same or

equivalent asset was acquired concurrently.

also known as current purchase exchange price.

c. Realizable Valueis the amount of cash or cash equivalent that could be obtained by selling the

asset in an orderly exchange price.

d. Present Valueis the discounted value of the future net cash inflows that the item is expected to

generate in the normal course of business.

also known as future exchange price.

Financial Performance of an entity is determined using 2 approaches:


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1. Transaction Approachis the traditional preparation of income statement.

2. Capital Maintenancenet income occurs only after the capital used from the beginning of the period

is maintained.

Net incomeis the amount an entity can distribute to its owners and be as well off at the end ofthe year as at the beginning.

The Framework considers 2 concepts of Capital Maintenance:

1. Financial Capitalis the absolute monetary value of the net assets contributed by shareholders

and the value of the increased in net assets resulting from earnings retained by

the entity.

based on historical cost.

concept that most adopted by most entities.

net income occurs when the financial or nominal amount of the net assets at the end of

the period exceeds the financial or nominal amount of the net assets at thebeginning of the period, after excluding distribution to and contributions by

owners during the period.

2. Physical Capitalis the quantitative measure of the physical productive capacity to produce

goods and services.

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.

requires that productive assets shall be measured at current cost rather than historical

cost.

Productive Assets include: inventories and property, plant and equipment.

Current cost must be maintained in order that physical capital is also maintained.

equal to the net assets of the entity expressed in terms of current cost.

net income occurs when physical productive capital of the entity at the end of the

period exceeds the physical productive capital at the beginning of the period,

after excluding distributions to and contributions from owners during period.

financial accounting volume 1

Documents