CHAPTER 4 CONCEPTUAL FRAMEW' ORK Financial statements and reporting entity Underlying assumptions TECHNICAL KNOWLEDGE To know the general objective of financial — statements. a To define a reporting entity, To explain the assumptions und, i erl Preparation of financial state erGENERAL OBJECTIVE OF FINANCIAL STATEMENTS i ial statements provide information about economic ‘ aes of the reporting entity, claims against the entity and changes in the economic resources and claims. Financial statements provide financial information about an entity's assets, liabilities, equity, income and expenses useful to users of financial statements in: a. Assessing future cash flows to the reporting entity. b. Assessing management stewardship of the entity's economic resources. The financial information is provided in the following: 1. Statement of financial position, by recognizing assets, liabilities and equity 2. Income statement, by recognizing income and expenses 8. Statement of cash flows, by recognizing cash flows from operating, investing and financing’ activities 4 Statement of changes in equity, by recognizing contributions from equity holders and distributions to equity holders 5. Notes to financial statements, by recognizing disclosures required by accounting standards Types of financial statements The Revised Conceptual Framework recognizes three types — of financial statements. mae lL Consolidated financial statements are the fin statements. prepared when the reporting entity co1 both the parent and its subsidiaries. - i dendt Unconsolidated financial statements 4 ‘th Statements prepared when the Parent alone, . Combined financial stateme: statements when the reportin more entities that are noi subsidiary relationship.nts stateme : ' idated financial ide information al 7 Consolidate¢ ial otatenentt prov ge of both the Cor noolidater ates, equity, incor fle reporting entity. the assets, lial Ss emries 08 O : bsidiarie: parent mah * Ree hy exercises control over the The parent is subsidiaries. pat ee lidated information is useful for rie o ede ate ial ireasttes lenders and other crsaitors or the parerite heir assessment of future net cash inflow: This is because net cash in! distributions to the parent from Consolidated ee Pa Po ne vi arate informatic t le pee ade and expenses of a particular subsidiary. A subsidiary's own financial statements are designed to provide such information. flows to the parent include its subsidiaries. Unconsolidated financial statements Unconsolidated financial statements are designed to provide information about the parent's assets, liabilities, income and expenses and. not about those of the subsidiaries. Such information can be useful to the existing and potential investors, lenders and other creditors of the parent because a claim against the parent typic: does not gi of that claim against oubeig aa sive the alga Accordingly, whe: ida required, unconsolidated Rane 1 a6 substitute for consolidated Combined financial Combined financial g about the eae two or more 7 relationship, nancial state: statements eee . : statements, _Reporting entity A reporting entity is an entity that is required or chooses to prepare financial statements. ‘The reporting entity can be a single entity or a portion of an entity, or can comprise more than one entity. A reporting entity is not necessarily a legal entity. Accordingly, the following can be considered a reporting entity: Individual corporation, partnership or proprietorship The parent alone The parent and its subsidiaries as single reporting entity Two or more entities without parent and subsidiary relationship as a single reporting entity e. A reportable business segment of an entity ae op Reporting period The reporting period is the period when financial statements are prepared fe general purpose financial reporting. Financial statements may be prepared on an interim basis, for example, three months, six months or nine months. Interim financial statements are not required but optional. However, financial statements must be prepared on an annual basis or a period of twelve months. Financial statements are prepared for a specified period of time and provide information about: a a. Assets, liabilities and equity at the end of the ae period. b. Income and expenses dusiee the reporting period. To help users of financial statements to identify and 3 e in trends, financial statements parte comparatit palerration for at least one, pReporting entity A reporting entity is an entity that is required or chooses to prepare financial statements. ‘The reporting entity can be a single entity or a portion of an entity, or can comprise more than one entity. A reporting entity is not necessarily a legal entity. Accordingly, the following can be considered a reporting entity: Individual corporation, partnership or proprietorship The parent alone The parent and its subsidiaries as single reporting entity Two or more entities without parent and subsidiary relationship as a single reporting entity e. A reportable business segment of an entity ae op Reporting period The reporting period is the period when financial statements are prepared fe general purpose financial reporting. Financial statements may be prepared on an interim basis, for example, three months, six months or nine months. Interim financial statements are not required but optional. However, financial statements must be prepared on an annual basis or a period of twelve months. Financial statements are prepared for a specified period of time and provide information about: a a. Assets, liabilities and equity at the end of the ae period. b. Income and expenses dusiee the reporting period. To help users of financial statements to identify and 3 e in trends, financial statements parte comparatit palerration for at least one, pMPTIONS UNDERLYING ASS! a tulates are the basie Accounting assumptions bam 7 , funda’ tio premises ‘on which the accounti, notions or mi process is based. a i t Like ilding that require rovide room id. ee TaTOnt FAtUiee collapse and prov’ for id or na expehitons and so with Pee ie Accounti serve as the uM bedrock of eLiig otter 0 avoid misunderstanding bet _ ehhance the understanding and usefulness statements. ; ; = The Conceptual Framework for Financial ee mentions only one assumption, namely going concern. However, implicit in accounting are the ners acenin to of accounting entity, time period and monetary 2 Going concern The going concern or continuity assumption means that in the absence of evidence to the contrary, the accounting entity is viewed @s continuing in operation indefinitely. In other words, the financial statements are normally prepared on the assumption that the entity will continue in operations for the foreseeable future. The going concern postulate is the very foundation of the cost: principle, Thus, assets are normally recorded at cost. As a rule, market values are- ignored. : a However, some new standards i ure: ever, require certain assets at fair value, “4 pene oa If there is evidence that , ‘experi and persistent losses or pet salty bhi be terminated, the nae entity's | i In this case, the userg thé stat interest in the amount a stn the entity's assets in theOa are Accounting entity financial accounting, the accounting entity is the specific puaineel organization, which may te a proprietors: partnership or cérporation. Under this assumption, the entity is separate from the owners, managers, and employees who constitute the entity. Accordingly, the transactions of the entity shall not be merged with the transactions of the owners. The reason for the entity assumption is to have a fair presentation of financial statements. The personal transactions of the owners shall not be allowed to distort the financial-statements of the entity. For example, the cash invested by the proprietor is treated as an asset of the proprietorship. If an enterprising entrepreneur owns department store, restaurant and bookstore, separate statements shall be prepared for each business in order to determine which business is profitable. Each business is an independent accounting entity. When a major shareholder of a corporation borrows money from a bank on his own personal account; the loan is a liability of the shareholder alone and not of the corporation. The shareholder is not the corporation and the corpoi not the shareholder. shat Ae However, where parent and subsidiary consolidated statements for the affiliates because for practical and economic purp the subsidiary are a single economic The consolidation, however, does 1 boundary segregating the affiliated ¢ Accounting will continue entity. 2Time period i tion etely accurate report on. the financial Pr the easy Pa of an entity cannot ‘ obtain is finally dissolved and liquidated. Only then can the final net income @ be determined precisely. nd networth of the entity — nformation need timely f financial i However, users 0 ic decision. information for making an econom refore to prepare periodic reports on BETpAtor sete: ance and cash flows of an entity. financial position, perform: The time period assumption requires that the indefinite life of an entity is subdivided: into accounting periods which are usually of equal length for thé purpose.of preparing financial reports on financial position, performance and cash flows. By convention, the accounting period or fiscal period is one year or a period of twelve months. The one-year period is traditionally the accounting period because usually it is after one year that government reports are required. The accounting period may be a cal reaeanads lendar year or a natural A calendar year is a twelve-month Period that endl aad December 31.Monetary unit The monetary unit assumption has two aspects, namely quantifiability and stability of the peso. The quantifiability aspect means that the assets, liabilities, equity, income and expenses should be stated in terms of a unit of measure which is the peso in the Philippines. How awkward to see financial statements without any common unit of measure. Such statements would be largely unintelligible and incomprehensible. The stability of the peso assumption means that the purchasing power of the peso is stable or constant and that its instability is insignificant and therefore may be ignored. The stable peso postulate is actually an amplification of the going concern, assumption so much so that adjustments are unnecessary to reflect any changes in purchasing power. The accounting function is to account for nominal pesos only and not for constant pesos or changes in purchasing power. In today's world, the assumption that the peso is a stable measure over time is not necessarily valid. Consider an equipment that was imported”10 years ago from the United States for $100,000 when the exchange rate was P35 to $1 or an equivalent of P3,500,000. If the same equipment is purchased now and assuming is no change in the $100,000 purchase the cost in terms of pesos would be in the wecinity of considering a current exchange rate 0 Obviously, there ib a significant and current replacement cost. In this regard, an entity as an accounting policy.3. Explain a reporting entity. i ts, unconsolidated 4. Defin solidated financial statements, ! idat Beeaaiaay atatsnidata and combined financial statements, 5. Explain underlying assumptions in.the preparation of financial statements., 6. Explain going concern assumption. 7. Explain time period assumption. 8. Distinguish calendar year and natural business year. 9. Explain monetary unit. assumption. 10. Explain quantifiability and stability of the peso in relation to monetary assumption unit.PROBLEMS : gree ane an ret Problem 4-1 Multiple choice (Conceptual Framework) pe 1. What is the general objective of financial statements? a To provide information about economic resources c a an entity claims against the entity and changes in the economic resources and claims. b, To assess future cash flows to the entity. , c. To assess management stewardship of economic i resources, d. To satisfy the information needs of users of financial statements, 2. A reporting entity is a. Necessarily a legal entity. b. Necessarily an economic entity. c. An entity that is required or chooses to prepare financial statements. d. A regulatory government authority. bad A reporting entity a. Can be a single entity b. Can be a portion of a single entity c. Can comprise more than one entity d. All of these can be considered a reporting entity 4. If the reporting entity comprises both the parent and its subsidiaries, the financial statements are referred to as a. Consolidated financial statements b. Unconsolidated financial statements c. Combined financial statements d. Separate financial statements 5. Combined financial statements provide fin information about The parent and its subsidiaries The parent The subsidiaries Two or more entities without ; relationship : ae opProblem 4-2 Multiple choice ing concern? i ibes the term 80! ? 1. Which best descril syad. current) acceta jlities ex ‘ fmt ‘ f. When current lisbenuity to continue in Operation fo e The foreseeable Meoneribute to the flow of-cash ang . The potential e : cash Rquivalénts to the entity d. The expenses exceed income 7 Which is an implication of the going concern assumption? X historical cost principle is credib! aren b Deeranisn and amortization policies are justifiable d. appropriate. ei : The marion and noncurrent classification of assets and liabilities is justifiable and significant. d. All of these are an implication of going concern. c 3. The relatively stable economic, political and social environment supports Conservatism Materiality Timeliness Going concern f.0 op 4. Which of the following is not i i underlying financial accounting? neste er j a. Economic entity assum; tio) Going concern ass bis Periodicity asi Bae Historical cost agg6. The economic entity assumption GTS a. Is inapplicable to unincorporated businesses. b. Recognizes the legal aspects of business organizations. c. Requires periodic income measurement. d. Is applicable to all forms of business organizations. . What is being violated if an entity provides financial reports in connection with a new product introduction? x Economic entity Periodicity Monetary unit Continuity ao op 8. Which underlying assumption serves as the basis for preparing financial statements at regular artificial points in time? a. Accounting entity b. Going concern c. Accounting period d. Stable monetary unit 9. Which basic accounting assumption is threatened by the existence of severe inflation in the economy? a. Monetary unit assumption b. Periodicity assumption ¢. Going concern assumption d, Economic entity assumption 10. Inflation is ignored in acco\eo : CPA Adapted) - Problem 4-8 Multiple choice e b ible concept of accounting entity is applica! 1. The ae organizations Only 5 cts of business 0 ation b Only e a eae ie aspects of business organizationg ce. Only to business organ vated d. Whenevér accounting is 1m idiary relationship exists, a nears only are prepared in 2. When a parent and consolidated: financia. recognition of a. Legal entity b. c, d. Economic entity. 4 Stable monetary unit Time period 3. The valuation of a promise to receive cash in the future at present value is valid because. of what accounting concept? a. Entity b. Time period c. Going concern d. Monetary unit 4. What is the accountin, concept justi on ing pt that justifies the usage of a Going concern b. Materiality P 5 Consistency ; a ) 4. Stable thonetary unit, 6. During the lifetime of ‘nancial stateme ul accordance with wha a Accrual b. Pe; zProblem 4-4 (IAA) For each situation, identify the Gnesi aganmonion jnvolved. 1. The operations of a saving bank are being evaluated by the. Bangko Sentral. ng Pilipinas. During the investigation, the BSP has determined hat numerous loans made by top management were unwise and have seriously endangered the future of the’ saving bank. 2. The parent entity in Manila has a subsidiary in Japan. The financial statements of the subsidiary are translated to pesos for consolidation with the financial statements of the parent entity at year-end. 3. A machinery was imported from USA at a certain cost five years ago. Because of inflation, the machinery has now a current replacement cost which is very much higher than the historical cost. Management would like to report the machinery at current replacement cost. 4, An entity has experienced a drastic reduction in revenue by reason of a long dry spell in the area where the entity grows its tobacco. The management decided to wait until next-year and present financial ‘statements for a two-year period rather than prepare now. the: prauiaca pyle financial statements. AProblem 4-5 Identification (IAA) fdentify the assumption that is most clearly violated by the accounting practice. tity decided to publish financial statements only in ok eas when it had good news to report. 2. An entity reported inventory, property, plant and equipment and intangible assets at current value at year-end. 1 8. An electronics entity owned by a propfietor reported the cost of the proprietor's swimming pool as an asset of the entity. 4. An entity prepared financial statements adjusted for changes in purchasing’ power. 5. A mining entity kept no accounting records after starting business. The entity is waiting until the mine is exhausted to determine the success or failure of business. Problem 4-6 Identification (IAA) Identify the assumption defined or described. 1. An entity reported financial statements in nominal pesos that have mixed rather than uniform’ amount of purchasing power. : 2A multinational entity published a complete set of cial statements at least once a year, regardless of whether the financial results were good or bad. The pesos of to n buy f : the pesos five ea ree nia i ast $ r