CFAS 11 – CONCEPTUAL FRAMEWORK AND ACCOUNTING STANDARDS

SEMI FINALS – WEEK 3 (PAS 32, PAS 12 & PAS 33)

PAS 32 – FINANCIAL INSTRUMENTS: PRESENTATION

Financial Instruments – any contract that gives rise to a financial asset of one entity and a financial liability or equity
instrument of another entity.
Three main types of financial instruments (from the definition above):
a. Financial asset
b. Financial liability
c. Equity instrument
Financial Asset – any asset that is:
a. cash;
b. an equity instrument of another entity;
c. a contractual right:
i. to receive cash or another financial asset from another entity; or
ii. to exchange financial assets or financial liabilities with another entity under conditions that are potentially
favorable to the entity; or
d. a contract that will or may be settled in the entity’s own equity instruments.
Examples of financial assets:
a. cash and cash equivalents;
b. receivables;
c. investments in equity or debt instruments of other entities;
d. sinking fund

NOTE: The following are not financial assets:

a. physical assets, such as inventories, biological assets, PPE and investment property;
b. intangible assets;
c. prepaid expenses and advances to suppliers;
d. the entity’s own equity instrument
Financial Liability - any liability that is:
a. a contractual obligation:
i. to deliver cash or another financial asset to another entity; or
ii. to exchange financial assets or financial liabilities with another entity under conditions that are potentially
unfavorable to the entity; or
b. a contract that will or may be settled in the entity’s own equity instruments and is not classified as the entity’s own
equity instrument.
Examples of financial liabilities:
a. payables
b. lease liabilities
c. held for trading liabilities and derivative liabilities
d. redeemable preference shares issued
e. security deposits and other returnable deposits
 NOTE: The following are not financial liabilities:
a. unearned revenues and warranty obligations
b. taxes, SSS, Philhealth, and Pag-Ibig payables
c. constructive obligations
Equity Instrument - any contract that evidences a residual interest in the assets of an entity after deducting all of its
liabilities.
Presentation
The rule provided by the standard is to classify the financial instruments on initial recognition as a financial liability, a
financial asset or an equity instrument in accordance with:
a. The substance of the contract, and
b. The definitions of a financial asset, financial liability and an equity instrument.

NOTE: It is not such a big deal to classify financial assets, but sometimes there are challenges to distinguish
between financial liabilities and equity instruments. The main question to respond when classifying an instrument
as either a financial liability or an equity instrument is:

Is there a contractual obligation to deliver cash or another financial asset to another entity? Or alternatively, to
exchange financial assets or financial liabilities under potentially unfavorable conditions? If YES, then the
instrument is a financial liability. If NOT, then the instrument is an equity instrument.

QUERY: What if there is an obligation to deliver own equity instruments and not cash or another financial asset?

PAS 32 provides that an equity instrument is:

a. A non-derivative that includes no contractual obligation to deliver a variable number of own equity
instruments, or
b. A derivative that will be settled only by the issuer exchanging a fixed amount of cash or another financial
asset for a fixed amount of its own equity instruments.

To make it simple, two most important things to watch out are:

c. Are equity instruments own or issued by somebody else?
d. Is the amount to deliver or exchange fixed or variable?

To illustrate:

a. You sell an option to deliver 100 shares of San Miguel Corporation to your friend. This is a financial
liability, because the shares are NOT YOUR OWN shares. They are shares of somebody else (SMC in
this case).

b. You sell an option to deliver your own shares in total value of P1,000.00 to your friend. This is a
financial liability, too, because although the shares are yours, their number is variable. Why? Because,
the exact number of shares will depend on the current price of the share at the delivery.

c. You sell an option to deliver 100 pieces of your own shares to your friend. This is an equity instrument,
because the shares are yours and their amount is fixed – 100.
In a summary:
Financial asset/Financial Liability Equity instrument
➢ Variable number for a fixed amount. ➢ Fixed number for a fixed amount.
➢ Fixed number for a variable amount.
 NOTE: If you acquire your own shares (known as “Treasury shares”), you need to deduct them from equity and
NOT recognize them as financial assets.

Compound Financial Instrument (from the issuer’s standpoint) – a financial instrument that contains both a liability and
an equity component.
NOTE: These components are classified and accounted for separately. In order to do this, first, allocate the value
of the liability component from the fair value of the whole instrument. The remainder will be allocated to the equity
component.
Offsetting a financial asset and a financial liability
PAS 32 sets the following rules when you must offset a financial asset with a financial liability:
a. When you have a legally enforceable right to set off the recognized amounts, and
b. When you intend to settle on a net basis, or realize the asset and the liability simultaneously.

NOTE: Both the conditions above must be met before offsetting is permitted.

PAS 12 – INCOME TAXES

Accounting Profit vs. Taxable Profit
Accounting profit is profit or loss for a period before deducting tax expense.
NOTE: PAS 12 defines accounting profit as a before-tax figure (not after tax as we normally do) in order to be
consistent with the definition of a taxable profit.
Taxable profit (tax loss) is the profit (loss) for a period determined in accordance with the rules established by the taxation
authorities upon which income taxes are payable (recoverable).
NOTE: You can clearly see here that these 2 numbers can differ significantly because accounting and tax rules are
not the same. A number of differences can pop out between accounting profit and taxable profit to the point that
you have to make the following adjustments to your accounting profit:
• Add back the expenses recognized but non-deductible for tax purposes
• Add income not recognized but included under tax regulations
• Deduct expenses not recognized but deductible for tax purposes
• Deduct income recognized but not taxable under tax regulations.

Permanent differences vs. Temporary differences

The varying treatments of economic activities between the PFRSs and the tax laws result to the following differences:
a. Permanent differences – arise when income and expenses enter in the computation of either accounting profit or
taxable profit but not both.

NOTE: Permanent differences usually arise from non-taxable and non-deductible expenses and those that have
already been subjected to final taxes. Since they are non-taxable, non-tax-deductible or have already been taxed
under final taxation, they do not have future tax consequences, and hence, do not give rise to deferred tax assets
and liabilities.

b. Temporary differences – differences between the carrying amount of an asset or liability in the statement of
financial position and its tax base.
 NOTE: What is a tax base? Tax base of an asset or liability is the amount attributed to that asset or liability for
tax purposes. Tax base of an asset is the amount that will be deductible for tax purposes against any taxable
economic benefits that will flow to an entity when it recovers the carrying amount of the asset. Tax base of a
liability is its carrying amount, less any amount that will be deductible for tax purposes in respect of that liability
in future periods.

NOTE: When the carrying amount of an asset or a liability is greater than its tax base, then there is a taxable
temporary difference and it gives rise to deferred tax liability. In the opaque situation, when the carrying amount
of an asset or a liability is lower than its tax base, then there is a deductible temporary difference and it gives rise
to deferred tax asset.

NOTE: Temporary differences include timing differences. Timing differences arise when income and expenses are
recognized for financial reporting purposes in one period but are recognized for taxation purposes in another
period (or vice versa). They are temporary differences because their effect reverses in one or more subsequent
periods.

Deferred tax liability vs. Deferred tax asset

Deferred tax liabilities – amounts of income taxes payable in future periods in respect of taxable temporary differences.

Deferred tax assets – amounts of income taxes recoverable in future periods in respect of:
a. Deductible temporary differences;
b. The carryforward of unused tax losses; and
c. The carryforward of unused tax credits.

Income tax expense vs. Current tax expense vs. Deferred tax expense
Income tax expense is the total amount included in the determination of profit or loss for the period. It comprises current
tax expense (current tax income) and deferred tax expense (deferred tax income).

Current tax expense is the amount of income taxes payable (recoverable) in respect of the taxable profit (tax loss) for a
period.

Deferred tax expense (income or benefit) is the sum of the net changes in deferred tax assets and deferred tax liabilities
during the period.

NOTE: If the increase in deferred tax liability exceeds the increase in deferred tax asset, the difference is deferred
tax expense. If the increase in deferred tax asset exceeds the increase in deferred tax liability, the difference is
deferred tax income or benefit.

Recognition
Deferred tax liability is recognized for all taxable temporary differences you discovered, except for the following situations:

• No deferred tax liability shall be recognized from initial recognition of goodwill

• No deferred tax liability shall be recognized from initial recognition of asset or liability in a transaction that is not
a business combination and at the time of the transaction it affects neither accounting nor taxable profit (loss)
• Investments in subsidiaries, branches, and associates, and interests in joint arrangements to the extent that the entity
is able to control the timing of the reversal of the differences and it is probable that the reversal will not occur in
the foreseeable future.

A deferred tax asset shall be recognized for all deductible temporary differences to the extent that it is probable that taxable
profit will be available against which the deductible temporary difference can be utilized. No deferred tax asset shall be
recognized from initial recognition of asset or liability in a transaction that is not a business combination and at the time of
the transaction it affects neither accounting nor taxable profit (loss).

Measurement
In measuring deferred tax assets / liabilities you need to apply the tax rates that are expected to apply to the period when
the asset is realized or the liability is settled.

However, these expected rates need to be based on tax rates or tax laws that have been enacted or substantively enacted by
the end of the reporting period.

Presentation
Deferred tax assets and deferred tax liabilities are presented separately as noncurrent assets and noncurrent liabilities,
respectively, in the statement of financial position. PAS 12 permits offsetting of deferred tax assets and deferred tax
liabilities only if:
1. You have a legally enforceable right to set off the current income tax assets against current income tax liabilities
(see above when it happens); and
2. The deferred tax assets and the deferred tax liabilities relate to income taxed levied by the same taxation authority

Accounting for Current Taxes

An entity uses relevant tax laws in computing for its current taxes. Unpaid current taxes are recognized as current tax
liability. Excess tax payments over the current tax due are recognized as current tax asset. PAS 12 permits offsetting of
current tax assets and current tax liabilities only if:
1. You have a legally enforceable right to set off the recognized amounts; and
2. You intend either to settle on a net basis or to realize the asset and settle the liability simultaneously.

PAS 33 – EARNINGS PER SHARE

Earnings per share – a computation made for ordinary shares. It is a form of profitability ratio which provides a measure
of how much profit (loss) each ordinary share has earned (incurred) during the period.

Types of Earnings per share

1. Basic earnings per share
2. Diluted earnings per share

Basic earnings per share (calculated simply as the):

• Net profit or loss for the period attributable to ordinary shareholders, divided by
• Weighted average number of ordinary shares outstanding during the period.
 NOTE: Earnings basically include all items of income and expense including tax and non-controlling
interests LESS the net profit attributable to preference shareholders, including preference dividends.

NOTE: When ordinary shares are issued without a corresponding change in resources (assets), the basic and
diluted EPS and the weighted average number of ordinary shares outstanding during the period and for all periods
presented are adjusted retrospectively.

NOTE: When stock rights are issued, the weighted average shares before the issue is multiplied by the following
adjustment factor: (FV of stocks right-on ÷ FV of stocks ex-right). FV of stocks ex-right = FV of stocks right-on
less Value of 1 right

Diluted earnings per share

An entity with dilutive potential ordinary shares presents diluted EPS in addition to basic EPS. An entity with no dilutive
potential ordinary shares presents basic EPS only.

Before you start calculating the diluted EPS, you need to determine whether the potential

ordinary share is dilutive or not. Some potential ordinary shares can have dilutive effect (your EPS would go down) and
some can have antidilutive impact (your EPS would go up).

The formula:

Profit (Loss) 𝒑𝒍𝒖𝒔 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒

𝐷𝑖𝑙𝑢𝑡𝑒𝑑 𝐸𝑃𝑆 = 𝑜𝑛 𝑐𝑜𝑛𝑣𝑒𝑟𝑡𝑖𝑏𝑙𝑒 𝑏𝑜𝑛𝑑𝑠
Weighted average number of outstanding
𝑜𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑠ℎ𝑎𝑟𝑒𝑠 𝒑𝒍𝒖𝒔 𝐼𝑛𝑐𝑟𝑒𝑚𝑒𝑛𝑡𝑎𝑙 𝑠ℎ𝑎𝑟𝑒𝑠 𝑎𝑟𝑖𝑠𝑖𝑛𝑔
𝑓𝑟𝑜𝑚 𝑡ℎ𝑒 𝑎𝑠𝑠𝑢𝑚𝑒𝑑 𝑐𝑜𝑛𝑣𝑒𝑟𝑠𝑖𝑜𝑛 𝑜𝑟 𝑒𝑥𝑒𝑟𝑐𝑖𝑠𝑒 𝑜𝑓 𝑑𝑖𝑙𝑢𝑡𝑖𝑣𝑒
𝑝𝑜𝑡𝑒𝑛𝑡𝑖𝑎𝑙 𝑜𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑠ℎ𝑎𝑟𝑒𝑠

Multiple potential ordinary shares

When there are two or more potential ordinary shares, they need to be ranked according to their dilutive effect on basic EPS.
The most dilutive potential ordinary share is ranked first; the least dilutive is ranked last. The most dilutive potential ordinary
share is the one with the least incremental EPS.
When computing for the diluted EPS, the potential ordinary shares are considered step-by-step according to their rankings.
If any time the diluted EPS exceeds the basic EPS,

the entity discontinues considering further any potential ordinary share and the lowest amount computed is the amount
presented as diluted EPS.