CHAPTER 1

FINANCIAL STATEMENTS
TECHNICAL KNOWLEDGE
To identify the components of financial statements.
To know the objective of financial statements.

To know the objective of financial reporting.

To understand the primary responsibility for the preparation of
financial statements.

To identify the general features in the preparation of financial

statements.
FINANCIAL STATEMENTS
Financial statements are the means by which the information
accumulated and processed in financial accounting io
periodically communicated to the users.
Financial statements are a structured financial representation of
the financial position and financial performance of an entity.

General purpose financial statements

General purpose financial statements are the statements intended to
meet the needs of users who are not in a position to require an entity
to prepare reports tailored to their particular information needs.
Reports prepared at the request of management and bankers are not
general purpose financial statements because such reports are
prepared specifically to meet the needs of management and bankers.

Components of financial statements

A complete set of financial statements comprises
the following.components:
1. 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 information
Many entities also present reports and statements such as
environmental reports and value added statements, particularly in
industries in which environmental factors are significant and when
employees are regarded as an important user group.
However,such statements and reports are not components of financial
statements.
Objective of financial statements
The objective of general purpose financial statements is to, provide
information about the financial position, financial performance and
cash flows of an entity that is useful to a wide range ofusers in
making economic decisions.
Financial statements show the results of the stewardship of
management of the resources entrusted to it.
To meet this objective, financial statements provide information
about the following: a. Assets
b. Liabilities
c. Equity
d. Income and expenses, including gains and losses
e. Contributions by and. distributions to owners in their capacity as
owners
f. Cash flows
Such information, along with other information in the notes, would
assist users of financial statements in predicting the entity's cash
flows and in particular their timing and certainty.
However, financial statements do not provide all the information that
users may need to make economic decisions.
The reason is that the financial statements largely portray the
financial effects of past events and do not necessarily provide
nonfinancial information.
The financial position comprises the assets, liabilities and equity of
an entity at a particular moment in time.
Specifically, financial position pertains to the liquidity, solvency, and
the need of the entity for additional financing.
The financial performance comprises the revenue, expenses and net
income or loss of an entity for a period of time.
Performance is the level of income earned by the entity through the
efficient and effective use of its resources.
Cash flows are the cash receipts and cash payments arising from the
operating, investing and financing activities of the entity.
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Financial reporting
Financial reporting is the provision of financial information about an
entity to external users that is useful to them in inaking economic
decisions and for assessing the effectiveness of the entity's
management.
The principal way of providing financial information to external users
is.through the annual financial statements. However, financial reporting
encompasses not only financial statements but also other means of
communicating information that relates directly or indirectly to the
financial accounting process.
Financial reports include not only financial statements but also other
information such as financial highlights, summary of important financial
figures and analysis of financial statements.
Financial reports also include nonfinancial information such as
description of major products and a listing of corporate officers and
directors.

Objective of financial reporting

Under the Revised Conceptual Framework for Financial Reporting, the
objective of financial reporting is to provide financial information about
the reporting entity that is useful to cxisting and potential investors,
lenders and other creditors in making decisions about providing
resources to the entity.
General purpose financial reporting is directed primarily to the existing
and potential investors, lenders and other creditors which compose the
primary user group.
The reason is that the primary users have the most critical and
immediate need for information in financial reports.

Specific objectives of financial reporting

a. To provide information useful in making investing and credit
decisions about providing resources to the entity.
b. To provide information useful in assessing the cash flow
prospects of the entity.
c. To provide information about entity resources, claims and
changes in resources and claims.
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Limitations of financial reporting
a. General purpose financial reports do not and cannot
provide all of the information that existing and potential
investors, lenders and other creditors need.
b. General purpose financial reports are not designed to
show the value of a reporting entity but these reports provide
information to help the primary users estimate the value of the
entity.
c. General purpose financial reports aré intended to provide
common information to users and cannot accommodate every
specific request for information.
d. To a large extent, financial reports are based on estimate
and judgment rather than exact depiction.

Responsibility for financial statements

The management ofan entity has the primary responsibility for
the preparation and presentation of financial statements.
The Board of Directors in discharging its responsibilities reviews
and authorizes the financial statements for issue before these
are submitted to the shareholders of the entity.
Management is accountable for the safekeeping of the resources
and their proper, efficient and profitable use.
Shareholders are interested in information that helps them
assess how effectively management has fulfilled this role as this
is relevant to the decision concerning their investment and the
reappointment or replacement of management.

General features of financial statements

1.Fair presentation and compliance with PFRS
2. Going concern
3.Accrual basis
4. Materiality and aggregation
5. Offsetting
6. Frequency of reporting
7. Comparative information

8. Consistency of presentation
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Fair presentation
The financial statements shall present fairly the financial position,
financial performance and cash flows of an entity.
Virtually, in all circumstances, fair presentation is achieved if the
financial,statements are prepared in accordance with the Philippine
Financial Reporting Standards which represent the GAAP in the
Philippines.

The application of Philippine Financial Reporting Standards, with

additional disclosure when necessary, is presumed to result in
financial statements that achieve a fair presentation.

An entity whose financial statements comply with PFRS shall make

an explicit and unreserved statement ofsuch compliance in the
notes.
Fair presentation is defined as faithful representation of the effects
of transactions and other events in:accordance with the definitions
and recognition criteria for assets, liabilities, income and expenses
laid down in the Conceptual Framework.

Fair presentation requires an entity:

a. To select and apply accounting policies in accordance with

PFRS.

b. To present information, including accounting policies, in a

manner that provides relevant and faithfully represented financial
information.

с. Тo provide additional disclosures necessary for the users to

understand the entity's financial statements

An entity cannot rectify inappropriate accounting policies either by

disclosure of the accounting policies used or by notes or
explanatory information.

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Departure from standard
In the extremely rare circumstances in which management
concludes that compliance with a requirement in a standard would
be so misleading, the entity shall depart from that requirement
provided the relevant regulatory Conceptual Framework requires,
or otherwise does not prohibit, such,a departure. Thus, an entity is
permitted to depart from a standard:

a. In extremely rare circumstances.

b. When management concludes that compliance with the
standard would be misleading.
c. When the departure from the standard is necessary to achieve
fair presentation.
d. When the regulatory Conceptual Framework requires or
otherwise does not prohibit such a departure.
In such circumstances, it iș incumbent upon the entity to disclose
the following:
1. The management has concluded that the financial
statements present fairly the financial position, financial
performance and cash flows of the entity.
2. That the entity has complied with applicable standards
except that it has departed from a particular requirement to
achieve a fair presentation.
3. The title of the standard from which the entity has departed,
the nature of the departure, including the treatment that the
standard would require, the reason why that treatment would be
so misleading and the treatment adopted.

4.For each period presented, the financial impact of the departure

on each item in the financial statements that would have been
reported in complying with the requirement.

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Going concern
Going concern or continuity assumption means that the
accountingentity is viewed as continuing in operation indefinitely in the
absence of evidence to the contrary. The going concern postulate is
the very foundation of the cost principle.
In other words, financial statements are prepared normally an the
assumption that the entity shall continue in operation for the
foreseeable future.
Thus, assets are nòrmally recorded at original acquisition cost. As a
rule, market values are ignored.
However, some standards require measurement of certain assets at·
fair value.
Financial statements shall be prepared on a going concern basis
unless management intends to liquidate the entity or cease trading or
has no realistic option but to do so.
If the financial statements are not prepared on a going corcern, basis,
such fact shall be disclosed together with the measurement basis and
the reason therefor.

Accrual basis
1n entity sh~ll prepare the financial statements, using the accrual basis
of accounting except for cash flow information.
Under accrual basis, the effects of transactions and other events are
recognized when they occur and not as cash or cash equivalent is
received or paid, and they are recorded and reported in the financial
statements of the periods to which they relate.
Accrual basis means that assets are recognized when receivable
rather than when received and liabilities are recognized when payable
rather than when actually paid.
In simple language, accrual accounting means that income is
recognized when earned regardless of when received and expense is
recognized when incurred regardless of when paid.
The essence of accrual accounting is the recognition of accounts
receivable, accounts payable, prepaid expenses, accrued expenses,
deferred income, and accrued income.
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Materiality and aggregation
An entity shall present separately each material class of similar
items.
An entity shall present separately items of dissimilar nature or
function unless they are immaterial.
Financial statements result from processing large number of
transactions or other events that are aggregated into classes
according to their nature or function.
The final stage in the process of aggregation and classification is
the presentation of condensed and classified data which form line
items in the financial statements.
For example, cash on hand, petty cash fund, cash in bank and
cash equivalent shall be presented as one item “ cash and cash
equivalents”.
Finished goods, goods in process, raw materials and
manufacturing supplies are aggregated and presented as one item
“inventories”.
Materiality dictates that an entity need not provide a specific
disclosure required by standard if the information is not material.

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.
As a general guide, an item is material ifknowledge ofit would
affect the decision of the primary users of the financial statements.
For example, small expenditures for tools are often expensed
immediatély rather than depreciated over the useful life.
Another example is the common practice of large entities of
rounding amounts to the nearest thousand pesos in their financial
statements. Small entities may round off to the nearest peso.
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New definition of materiality
The IASB provided the following new definition of materiality.
Information is máterial ifomitting, 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 ofthose statements which provide financial information
about a specific reporting entity.
In other words, an information is material if the omission,
misstatement and obscuring of the information could reasonably
affect the economc decision of primary users.
The revised definition of materiality highlights three important
aspects:
a. Could reasonably be expected to influence
b. Obscuring information
c. Primary users
Could reasonably be expected to influence
The could reasonably 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 scopé.
Moreover, the 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.

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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 information means the presentation of financial
information nat readily understood or not clearly expressed.
Obscuring information may be characterized by deliberate
vagueness, ambiguity. and abstruseness.
Examples of obscured material information are: a.
The language is vague or unclear.
b. The information is scattered throughout the financial statements.
c. Dissimilar items are aggregated inappropriately.
d. Similar items are disaggregated inappropirately.

Primary users
The new definition of materiality narrows the definition to primary
users who are primarily affected by general purpose financial
statements.
The primary users include the existing and potential investors,
lenders and other creditors.
The other users include the employees, customers, government
agencies and the public in general.
The new definition specified that only primary users of financial
stateménts 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 miust rely on general
purpose financial reports for how much financial information is
needed.

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Materiality is a relativity
Materiality of an item depends on relative size rather than absolute
size. What is material for one entity may be immaterial for another.
An error of P100,000 in the financial statements of a multinational
entity may not be important but may be so critical for a small entity.
Factors of materiality
In the exercise of judgment in determining materiality, the following
factors may be considered:
a. Relative size ofthe item in relation to the total of the group to
which the item belongs.
For example, the amount of advertising in relation to total
distribution costs and the amount of prepaid expenses to total
current assets.
b. Nature of the item -An item may be inherently material because
by its very nature it affects economic decision.
For example, the discovery of a P20,000 bribe is a material event
even for a very laxge entity.
Offsetting
Assets and liabilities, and income and expenses, when material, shall
not be offset against each other.
Offsetting may be done when it is required or permitted by another
PFRS.
Gains and losses on disposal of noncurrent assets are reported by
deducting from the proceeds the carrying amount of the assets and
the related selling expenses.
The expenditure related to a provision and any reimbursement
froin a third party can be offset, and only the net expenditure is
presented as expense.
Foreign exchange gains and losses or gains and losses arising from
trading securities are netted against the other.
The measurement of assets net of valuation allowance is permitted
because technically this is not offsetting.
Thus, accounts receivable may be shown net of allowance for doubtful
accounts.
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Frequency of reporting
An entity shall present a complete set of financial statements at
least annually. When an entity changes the end of the reporting
period and presents financial statements for a period longer or
shorter than one year, the entity shall disclose:
a. The period covered by the financial statements.
b. The reason for using a longer or shorter period.
c. The fact that amounts presented in the financial statements are
not entirely comparable.

Comparable information
Except when permitted or required otherwise by standard,an entity
shall disclose comparative information in respect of the previous
period for all amounts reported in the current period's financial
statements.
In other words, the financial statements of the current period shall
be presented with comparative figures of the financial statements of
the immediately preceding year.
Comparative information shall be included for narrative and
descriptive information when it is relevant to an understanding of
the current period's financial stateinents.
For example, details of a legal dispute, the outcome of which was
uncertain at the end of the preceding reporting period and is yet to
be resolved, are disclosed in the current period.

Third statement of financial position

A third statement of financial position is required when an entity: a.
Applies an accounting policy retrospectively.
b. Makes retrospective restatement of items in the financial
statements.
c. Reclassifies items in the financial statements.
Under these circumstances, an entity shall present three
statements of financial position as at: 1. The end of the current
period

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2. The end of the previous period
3. The beginning of the earliest comparative period
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Consistency of presentation
Implicit in the presentation of comparable information is the
principle of consistency.
The principle of consistency requires that the accounting
methods and practices shall be applied on a uniform basis from
period to period.
The presentation and classification of financial statement items
shall be uniform from one accounting period to the next.
An entity cannot use the FIFO method of inventory valuation in
one year, the average method in the next year, another method
in succeeding year and so on.
If the FIFO method is adopted in one year, such method is
followed from year to year.
Consistency is desirable and essential to achieve comparability
of financial statements.
However, consistency does not mean that no change in
accounting method can be made.
If the change will result to information that is faithfully
represented and more relevant to the users of financial
statements,then such change should be made.

But there should be full disclosure of the change and the peso
effect of the change.
A change in the presentation and classification of items in the
financial statements is allowed:
a. When it is required by another Standard.
b. When a significant change in the nature of the operations of
the entity will demonstrate a more appropriate revised
presentation and classification.
It is inappropriate for an entity to leave accounting policies
unchanged when better and acceptable alternatives èxist.

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Identification of financial statements
Financial statements shall be clearly identified and distinguished
from other information in the same published document.
Each component of the financial statements shall be clearly
identified.
In addition, the following information shall be prominently
displayed:

a. The name of the reporting entity.

b. Whether the financial statements cover the individual ·entity or a
group of entities.
c. The end of the reporting period or the period covered by the
financial statements or notes.

d. The presentation cúrrency.

e. The level of rounding used in the amounts in the financial
statements.
Financial statements are often made more understandable by
presenting information in thousands or millions of units of the
presentation currency.

This is acceptable as long as the level of rounding in

presentation is disclosed and relevant and material information
is not lost or omitted.

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