Financial Accounting Vol.

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. 1

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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 Accounting is 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 Statements key 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. Identifying analytical component b. Measuring technical component c. Communicating formal component Identifying recognition or nonrecognition of business activities as accountable events. Not all business activities are accountable. Accountable or Quantifiable when 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 activities referred to as transactions which may be classified as external and internal. External transactions or 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 transactions economic events involving the entity only. These are economic activities that take place entirely within the entity. E.g. production and casualty loss 3

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Production the process by which resources are transformed into products Casualty is any sudden and unanticipated loss from fire, flood, earthquake and other event ordinarily termed as an act of God. Measuring is 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 peso unit of measuring accountable economic transactions. Measurement bases: a. Historical cost most common measure. b. Current cost c. Realizable value d. 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 journalizing is the process of systematically maintaining a record of all economic business transactions after they have been identified and measured. Classifying is 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 Ledger is a group of accounts which are systematically categorized into asset accounts, liability accounts, equity accounts, revenue accounts and expense accounts. Summarizing is 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. 4

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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 other words, 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. 9298 is 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. 5

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- usually offer 3 kinds of services: 1) Auditing traditionally 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. BIR requires audited financial statements to accompany the filing of annual income tax return. 2) Taxation Service includes 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 Services has 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 Accounting includes accounting staff, chief accountant, internal auditor, and controller. Controller highest 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, producing the 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 Accounting encompasses 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. 6

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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: Accounting embraces auditing. Auditing one of the areas of accounting specialization Limited Sense: Accounting essentially constructive in nature. Accounting ceases when financial statements are prepared. Auditing is 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. 7

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Technically Speaking: Accountancy refers to the profession of accounting practice. Accounting is 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 Accounting primarily 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 Accounting is 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. Financial Statements shall therefore comply with all applicable accounting standards.

FINANCIAL REPORTING STADARDS COUNCIL (PFRC) - replaces the Accounting Standards Council - is the accounting standard setting body created by the Professional Regulation Commission upon recommendation of the Board of Accountancy to assist the Board of accountancy in carrying out its powers and functions provided under R.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 Securities and Exchange Commission Bangko Sentral ng Pilipinas Bureau of Internal Revenue Commission on Audit Major Organization of preparers and users of financial statements Accredited National Professional Organization of CPAs: Public Practice Commerce and Industry Academe or Education Government Total 1 1 1 1 1 1 2 2 2 2 14

- The Chairman and members of the FRSC shall have a term of 3 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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Interpretations are 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 and other 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. 10

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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 and expense 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, accounts payable, prepaid expenses, deferred income, and accrued income. 2) Going Concern in the absence of evidence to the contrary, the accounting entity is viewed as 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 Entity is 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 Assumption requires 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 period is one year or a period of 12 months. - maybe a calendar year or a natural year: Calendar year 12- month period that ends on December 31. Natural business year 12- month period that ends on any month when the business is at the lowest or experiencing slack season. Monetary Unit Assumption has 2 aspects: 1) Quantifiability the 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 assumption the purchasing power of the peso is stable or constant and that its instability is insignificant and therefore may be ignored. Stable peso postulate 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 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 supplementary disclosures 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 standardsetters, 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) Investors the providers of risk capital and their advisers are concerned with risk inherent in and return 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) Employees interested 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 interest thereon will be paid when due. 4) Suppliers and other trade creditors these users are interested in information which enables them 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 when they have a long-term involvement with or are dependent on the entity. 6) Government and their agencies are interested in the allocation of resources and therefore the activities 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) Public entities affect members of public in a variety of ways. Financial statements may assist the 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 Philippine GAAP. 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. 13

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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 reports e.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 Position comprises 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. Liquidity is the availability of cash in the near future to cover currently maturing obligations. Solvency is 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 Structure is 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 how profits 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 performance comprises 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 and financing activities of the entity during a period. This information is found in the statement of cash flows.

Accounting Concepts 1. Entity theory the accounting objective id geared in toward proper income determination. Proper matching 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 theory the accounting objective id directed toward proper valuation of assets. - emphasizes the importance of the statement of financial position. It is exemplified by the equation: Assets Liabilities = Capital 3. Residual equity theory the accounting objective is also proper valuation of assets. This is applicable where there are two classes of shareholders, ordinary and preference. Assets Liabilities Preference Shareholders Equity = Ordinary Shareholders Equity 15

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4. Fund theory the accounting objective is neither proper income determination nor proper valuation of assets but the custody and administration of funds. - Government accounting and fiduciary accounting are examples of the application of this concept. Fund = Cash inflows Cash outflows Financial Reporting is 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 Reports include not only financial statements but also other information such as financial highlights, summary of important financial figures, analysis of financial statements 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 form predictions 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). Timeliness providing 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 the representation 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 representation the actual effects of the transactions shall be properly accounted 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 form If information is to represent faithfully the transactions and other 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. 17

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c. Neutrality the information contained in the financial statements must be free from bias. 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 is to be fair. d. Conservatism or prudence when alternatives exist, the alternative which has the least 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 gain is 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. Completeness requires that relevant information shall be presented in a way that facilitates 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 by Philippine Financial Reporting Standards. - provide narrative description or disaggregation of the items presented in the financial statements that do not qualify for recognition.

Understandability requires 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 and reliable, it may prove to be useless if it is not understood by the users or decision-makers.

Comparability the 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 entity is 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 entities is the quality of information that allows comparisons between two or more entities in the same industry. 19

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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.

Consistency implicit 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. Timeliness require 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-benefit balance 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. Materiality is 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 Item in 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 Item an 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 Assets resources 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. Liabilities are present obligations of the entity arising from past transactions or events the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. Equity is the residual interest in the assets of the entity after deducting all of its liabilities. Income is 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. Probable the chance of the future economic benefit arising is more likely rather than less likely. 22

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2. The cost or value of the asset of the asset can be measured reliably. Future Economic Benefit embodied 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 reduce cash 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 Principle requires 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 23

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- normally the case. e.g. with amounts payable for goods and services received Constructive obligations arise 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 when these 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 Recognition the basic principle income shall be recognized when earned. When is income considered to be earned? The Framework provides 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 and that 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 Sale is the point of income recognition. - it is at the point of sale that the entity has transferred to the buyer the significant risks and 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. Income encompasses 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. Gains represent 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 Method Revenue 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 Method Revenue 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 Method Revenue 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 Method when 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 Method revenue 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 a government 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 Recognition 1. 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 Framework provides 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. 26

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Expenses encompasses 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. Losses represent 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 Principle the 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. - has 3 applications: 1. Cause and Effect Association the 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 Allocation some costs are expensed by simply allocating over the periods 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. 27

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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 of future 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 Cost is 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 Value is the amount of cash or cash equivalent that could be obtained by selling the asset in an orderly exchange price. d. Present Value is 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: 28

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1. Transaction Approach is the traditional preparation of income statement. 2. Capital Maintenance net income occurs only after the capital used from the beginning of the period is maintained. Net income is the amount an entity can distribute to its owners and be as well off at the end of the year as at the beginning. The Framework considers 2 concepts of Capital Maintenance: 1. Financial Capital is 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 the beginning of the period, after excluding distribution to and contributions by owners during the period. 2. Physical Capital is 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.

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