Financial Accounting and Reporting 2

Accounting 007
Mr. Dennis V. Dupitas, CPA

SHAIRA M. RAMIREZ
Bachelor of Science in Accountancy – 3
FINANCIAL STATEMENTS – These are documents that relay financial information to the
users in an understandable way.

- Financial information include the current status of the entity’s assets, liabilities and
equity, the permanent accounts, which is the Statement of Financial Position, and also
the income and expenses of the business, the temporary accounts, whether they are
profitable or not for the period, which is Statement of Financial Performance.

- Within the concepts and terms of Conceptual Framework

Conceptual Framework – the document that states the foundation for the preparation
and presentation of Financial Statements
- These serve as assistance and guide for accountants.
- help users interpret the information on the financial statements
- help auditors evaluate whether the prepared documents are in conformity with
the GAAP (Generally Accepted Accounting Principles)
*GAAP – principles that entities must follow when preparing financial
documents.

- They all give the information the users need in whatever aspect they might look into.
Users of Financial Information
There are two general users of Financial Information: (1) Primary users and (2) Other
users
(1) Primary users – main users, whom the financial information are directed to, usually
persons that have interest over the business
*Investors – existing and potential
- They are concerned with their investments in the entity
- The information will help them decide whether they should still keep
transactions with the entity or not.

*Creditors – they are concerned with their claims over the business

(2) Other users – secondary users, persons that will be slightly affected with the entity’s
decisions
*Employees – concerned with the stability, the ability of the company to remain in
the industry, the profitability of the business, the ability of the company to
generate profit with their assets, to assess whether they should stay in the
company or not and whether they should ask for salary increase.
*Customers – concerned with the life of the entity, to decide whether they should
continue their transactions if they are dependent on the entity.
*Government and government agencies – concerned with the activities of the entity,
whether the business is performing unlawful acts, and whether they are paying
their taxes right, which is the concern of the BIR (Bureau of Internal Revenue).
*Public – this is similar to the “customers”. Entities dependent on the company are
concerned with the outcome of business operations and the business’ current
status.
 - However, Financial Statements have limitations.
They cannot provide all the information needed by users. They don’t give the value of the
entity, but they help users estimate the value of the entity. They are just estimated reports
rather than the exact.

- There are also underlying accounting assumptions on which the preparation of Financial
Statements is based.
These assumptions are the basic or the fundamentals of accounting. They enhance the
usefulness of financial statements.

The main assumption is the Going Concern, which is the assumption that the business
will have an unlimited life and is expected to go on for an indefinite time.

- The end product and main output of the accounting process.

- A complete set of Financial Statements include:

a. Statement of Financial Position

b. Statement of Financial Performance
c. Statement of Comprehensive Income
d. Statement of Changes in Owner’s Equity
e. Statement of Cash Flows
f. Notes to Financial Statements

STATEMENT OF FINANCIAL POSITION

- Also known as “Balance Sheet”

- Reports the entity’s Assets, Liabilities and Equity
- Investors look into these document and compare it with the company’s past balance
sheets to see if the company if improving through time. They also compare it with other
companies to assess where they should put their money.
- Creditors are concerned with the company’s ability to pay their loans and they analyze it
with ratios.
- May be prepared in Report form or Account form.

STATEMENT OF FINANCIAL PERFORMANCE

- Also known as “Income Statement”

- Reports the entity’s outcome of operations within a period.
- Composed of the income and expenses of the entity during the operating period, and the
bottom line, the profit or loss generated
- The first financial statement to be prepared
- May be prepared in Functional way or Natural way

STATEMENT OF COMPREHENSIVE INCOME

- Reports items that are not included in the income statement

- These items are unrealized gains and losses, items don’t arise from the normal course of
business activities of the entity
- Usually, these items cause the change in the stockholder’s equity
- Composed of the Net income or Net loss for the period plus the unrealized gains or losses
STATEMENT OF CHANGES IN OWNER’S EQUITY

- Details the movements in the Equity of the owner/s of the entity

- Reports the items that cause the changes, such as: comprehensive income for the period
and transaction of the owner with the entity.
Statement of Retained Earnings – shows the changes in Retained earnings, which is
now part of the Statement of changes in Owner’s Equity

STATEMENT OF CASH FLOWS

- Also known as “Cash Flow Statement”

- Summarize the activities of the entity that involve inflows (cash receipts) and outflows
(cash disbursements) of cash
- Provide information about how able the entity is in generating cash and cash equivalents
- It shows how cash is generated and used up for the period
- Includes Operating, Investing, Financing Activities

NOTES TO FINANCIAL STATEMENTS

- Contain disclosures and additional information to the financial statements that cannot be
measured for recognition
- They support the other financial statements for them to give the information more
effectively
- They also give clarification for items in the financial statements to present it more clearly
and to emphasize the details
- This is also required by the PFRS (Philippine Financial Reporting Standards) to give
important disclosures to the Financial Statements that are not reported in the documents
Order of Presenting the Notes
a. Statement of compliance to PFRS
b. Summary of the policies used
c. Information for computation for the items in the Financial Statements
d. Others
LIABILITIES – These are accounting elements caused by past business transactions which
result to a present obligation in which the settlement of it expects to have an outflow of
economic benefits.

a. Caused by past business transactions – the obligation arises from a past event
Obligating event – the past event that causes the liability to exist
b. Present obligation – the entity is required to settle the liability
Obligation – a compulsory requirement
An obligation may be (1) Legal or (2) Constructive.
1. Legal – obligations permitted by law; supported by signed documents
2. Constructive – obligations that arise from normal business transactions
c. Outflow of economic benefits – the future settlement of the accounting liability may
be payment in cash, transfer of non-cash assets or other ways that will probably result
to an outflow of benefits.

Initial measurement of liabilities

 Fair value less transaction costs directly related to the issue of the financial liability
(if not designated through profit or loss)
 Transaction costs are added; measured at amortized cost
Transaction costs – direct incremental cost to the issue of the financial liability
Incremental cost – costs that would have not taken place if not for the issue of the
liability
 Fair value is equal to the discounted amount of the future settlement measured using
the rate of interest in the market otherwise known as “present value.”

Subsequent measurement of liabilities

1. Amortized cost
 Face value less present value, the difference of which is allocated through interest
expense with the use of interest expense method
 The difference may be either a discount or a premium on the liability.

Measurement of Non-current Liabilities

 First measured at present value then subsequently at amortized cost.

However, if the payable is interest-bearing, it is measured initially and the same

subsequently because the face amount of it is equal to the present value in which it is
expected to be settled.

Measurement of Current Liabilities

 All liabilities are initially measured at present value then at amortized cost, but, for
current liabilities, since they are short-term, the difference between the face amount
and the present value is usually immaterial and is ignored.
 Therefore, current liabilities are recorded and reported at their face amount.

2. Fair value
 When fair value option for initial measurement of liabilities is used, amortization
rules are no longer applicable.
  It is the measurement of a liability at the present value of it in accordance with the
market rate, and is measured every year-end, and any change in fair value is
recognized as profit or loss.

Classification of Liabilities

(1) Current Liabilities

To be classified as current, the liability must be

a. It is expected to be settled within the operating cycle of the entity.

Operating cycle – the certain period an entity commences and winds up business
activities, not necessarily within the 12-month period, but when the duration is
unidentifiable, it is assumed to be 12 months.
b. The liability is held for primary purpose of trading.
- intended to be repurchased in the future
c. The liability is due within 12 months after the reporting period.
- It is expected to be settled within the following reporting period.
d. The entity has no ability to defer the settlement of the liability for at least 12 months
until the next reporting period.
- The entity cannot delay the payment of the liability.

 The liability will be classified as current if it is due within 12 months even if the original
term of the liability was a period longer than 12 months.
 If, in some cases, an agreement to reschedule the payment of the liability on a longer term
is done after the reporting period, the liability will still be classified as
current.

(2) Noncurrent Liabilities

 These are long-term obligations.
 The entity has the ability to defer the settlement of the liability.
 If an agreement to reschedule the payment of the liability on a longer term is done on
or before the reporting period, the liability will be adjusted and will be classified as
noncurrent.

Covenants - stated limitations of the borrower

Breach of covenants – violation of contract; going beyond stated limitations

 If breach of covenants takes place, the liability is considered to be a payable on demand,

and is classified as current, even if the lender has not demanded any payment with the
violation of contract.
 However, if the same situation exists, but the lender agreed on or before the end of the
reporting period to consider a grace period ending at least 12 months, the liability is
classified as noncurrent.

Grace period – time during which the entity is given an opportunity to correct the breach
and the lender cannot demand urgent settlement of the liability
Estimated Liabilities

 Either current or noncurrent

 Obligations set at the end of the period for provision to probable liabilities that may exist
in the future at measurable amount.
 Premiums, Award points, Warranties, Gift certificates and Bonus

Current Liabilities

Premium Liability

- promotions given to customers to stimulate sales

- An accounting liability must be set up upon sales of merchandise related to the
distribution of premium

Customer Loyalty Program

- Entities use this program in which customers get award points that they can use in the
future from their every purchase. In this way, the business can “take care” of the
customers they already have and persuade them to keep on purchasing products from the
entity.
- May be required to earn a stated amount of points before redemption of reward/s.
- A third party may also be involved in the granting of rewards.
- A liability is set up for future distributions of rewards.

Measurement
Allocation of the fair value of the consideration received with respect to the initial
sale between the award credits and the sale based on relative stand-alone selling price
basis.

Recognition
Award credits shall be recognized initially as deferred revenue, and recognized as
revenue as the award credits are redeemed.

Warranty Liability

- products are sold and customers are guaranteed free repair service or replacement of the
product in case they are defective.
- In this case, the entity sets up a liability beforehand, if products are defective.

Approaches in Accounting for Warranty

1. Accrual Approach
- matches cost with revenue
- estimated warranty liability is set

2. Expense as Incurred Approach

- Expensing warranty costs as incurred
Accrued Liabilities and Deferred Revenue

Payroll Taxes
- deductions to salaries of employees for government contributions are considered current
liability until these are remitted to the government authority.

Value Added Tax (VAT)

- Value Added Taxes collected by entities from customers are current liabilities until they
are remitted to the Bureau of Internal Revenue.

Gift Certificates Payable

- a redeemable voucher that has equivalent amount of cash or merchandise
- A current liability is set when gift certificates are sold.

Refundable Deposits
- these are cash collected by the entity which are expected to be returned to the customer
after compliance to conditions.

Bonus
- Giving additional compensation to employees will cause a liability to arise at the point of
setting it up.

Deferred Revenue
- these are revenue with the reception of income that may be in the form of cash or other
noncash asset that is not yet earned, but is expected to be settled within the period.
- Realizable within the next period classified as current, otherwise, noncurrent.

Provision

- A liability of uncertain timing or amount

- a liability set up to cover probable expenditures that may exist within the period.
- Limited only to expenses for which the provision is originally allocated.
- Unlike other liabilities that are certain with the existence and amount equal to how much
the liability is to be settled, a provision is an obligation set up for uncertain events.
- Most acceptable estimate for expected expenditures on a present obligation

Contingent Liability

- a potential obligation depending on the outcome of uncertain events

- Depends on occurrence or nonoccurrence of uncertain events which are not in full control
of the entity.
- The difference between a contingency and a provision is that contingencies are set up for
uncertain obligations that may exist. But for a provision, there is already an expected
obligation.
- Not recognized in the financial statements, rather, disclosed only.
- If remote, the contingent liability needs not to be disclosed.
Financial Liabilities at Amortized Cost

1. Bonds Payable
2. Notes Payable
3. Loans Payable

Bonds Payable

- A formal unconditional promise, made under seal, to pay a specified sum of money at a
determinable future date, to make periodic interest payment at a stated rate until the
principal sum is paid.
- A bond is issued to an entity that borrows large amount of funds
- Bond issue - a binding contract; a proof of indebtedness

Features of bond issue

- Bond indenture – document that shows the significant details of the loan
- Bond certificates – shows a part of the whole loan in same denominations
- Trustee – a representative of the lending company who holds the property held for the
security of the loan
- Registrar – acts as the disbursing agent; the borrower pays interest to him and he
distributes to the bondholders

Types of Bonds

- Term – bonds that have single maturity date; matures once

- Serial – bonds that have multiple maturity dates
- Mortgage – bonds secured by property
- Collateral – bonds secured by bonds of other entities
- Debenture – unsecured bonds
- Registered – name of bondholders are recorded on the books
- Bearer – Unregistered bonds
- Convertible – exchangeable for shares of the lending company
- Callable – can be redeemed anytime
- Guaranteed – another party is presented to settle the bond if the borrower cannot do so
- Junk – high-risk bonds issued by declining companies

Initial Measurement

Bonds Payable classified as Financial Liability at Amortized Cost shall be initially

measured at Fair Value less transaction costs, equal to the net proceeds from the bond
issuance (interest date issuance).

Subsequent Measurement

1. Amortized Cost - Effective Interest Method “interest method”

- Nominal rate – coupon/stated rate
- Effective rate – yield/market rate
- Face amount – stated rate is equal to market rate
- Premium – stated rate is higher than market rate
- Discount – stated rate is lower than market rate
- Effective Interest Expense – Effective rate x Carrying Amount of Bonds
 2. Fair Value through Profit or Loss
- Bonds payable initially recognized at FVPL shall be remeasured at every year-end
with any changes in fair value generally recognized in profit or loss.
- No more amortization of bond discount/bond premium.
- Transaction costs/bond issue costs – expensed outrightly
- Interest expense recognized using nominal/stated rate

Treasury bonds – own bonds of the entity that are reacquired and are still issued

Notes Payable

- A promissory note is an unconditional promise in writing made by one person to another,

signed by the maker, engaging to pay on demand or at a fixed or determinable future time
a sum certain in money to order or to bearer.
- A liability issued to a borrowing entity with a written promise to settle the obligation

Initial Measurement
- Designated at FVAC - measured initially at fair value minus transaction costs that
are directly attributable to the issue of the note payable
- Designated at FVPL – measured at present value; transaction costs expensed
immediately

Subsequent Measurement
- Amortized Cost - Effective Interest Method “interest method”
- Fair Value through Profit or Loss

Compound Financial Instruments

- Financial Instruments that both have a liability and an equity component from the issuer’s
perspective
- The equity component is assigned the residual amount after deducting from the fair value
of the instrument as a whole, the amount separately determined for the liability
component. “residual approach”
a. Bonds payable issued with share warrants
- Entitle the bondholder to acquire equity securities of the bond issuer at an
agreed subscription price
b. Convertible bonds
- Bonds that give the holder an option to convert the bonds into bond
issuer’s equity securities.

Debt Restructuring

- Situation where the creditor, for economic or legal reasons related to the debtor’s
financial difficulties, grants to the debtor concession that would not otherwise be granted
in a normal business relationship.
- Either stems from an agreement or imposed by law or court.
Types of Debt Restructuring

a. Asset Swap
- Transfer by the debtor to the creditor of any asset, such as real estate, inventory,
receivables and investment, in full payment of an obligation
Dacion en Pago
- Mortgaged property is offered by the debtor in full settlement of the debt.

b. Equity Swap
- Transaction whereby a debtor and creditor may renegotiate the terms of a
financial liability with result that the liability is fully or partially extinguished by
the debtor issuing equity instruments to the creditor
- Issuance of share capital by the debtor to the creditor in full or partial payment of
an obligation

c. Modification of Terms
- Modification of interest, maturity value, or both.
- Interest concession – reduction of interest rate/forgiveness of unpaid
interest/moratorium on interest
- Maturity value concession – extension of maturity date