Fundamental Theories of Financial Reporting

1.      Entity Theory – emphasizes the importance of proper income determination.

Accounting Equation: Assets = Liabilities + Capital

2.      Proprietary Theory – emphasizes the importance of the statement of financial position. It

is exemplified by the equation:

ASSETS – LIABILITIES = CAPITAL

3.      Residual Equity Theory – the objective of this theory is directed toward the valuation of
assets particularly in the equity portion where it is separated into two classes, namely the
Ordinary Shares and Preference Shares. Simply stated, the equation is:

ASSETS – LIABILITIES – PREFERENCE SHAREHOLDERS’ EQUITY = ORDINARY

SHAREHOLDERS’EQUITY

4.      Fund Theory – the objective of this theory is directed toward the cash flows exemplified
by the formula “cash inflows minus cash outflows equals fund.”
Cash Inflows - Cash Outflows = Fund

STATEMENT OF FINANCIAL POSITION

Definition: A statement of financial position is a form of statement showing the three elements
comprising financial position namely ASSETS, LIABILITIES and EQUITY. It is commonly known
as the Balance Sheet.

Investors, creditors and other users of financial statements analyze the statement of financial
position to evaluate such factors as LIQUIDITY, SOLVENCY and the need of the entity for
additional financing.

Liquidity – is the ability of the entity to meet currently maturing obligations.

Solvency – is the availability of cash over the longer term to meet maturing obligations.

Information about liquidity and solvency is useful in predicting the ability of the entity to comply
with its future financial commitments.

Since you already know the definition of the elements of the items in the financial statements
from your Accounting 1 subject, we proceed in discussing the presentation of the elements in
the statement of financial position.

These elements are classified as current and noncurrent.

Ways of Presentation:

1.      Order of Liquidity presentation – Financial institutions present assets and liabilities in

increasing or decreasing liquidity as it provides information that is faithfully represented and
more relevant.

2.      Current and Noncurrent distinction – It highlights assets that are expected to be

realized within the current operating cycle and liabilities that are due for settlement within the
same period.

3.      Report form vs. Account Form

PAS 1, par. 66 provides that an entity shall classify an asset as current when:

Here are the criteria:

a.      The asset is cash or a cash equivalent unless the asset is restricted from being
exchanged or used to settle a liability for at least twelve months after the reporting period.

b.      The entity holds the asset primarily for the purpose of trading.

c.      The entity expects to realize the asset within twelve months after the reporting period.

d.      The entity expects to realize the asset or intends to sell or consume it within the entity’s
normal operating cycle.

PAS 1, par. 51 provides that as a minimum the line items under current assets are:

a.      Cash and Cash Equivalents (cash on hand, petty cash fund, cash in bank, three-month
treasury bill, three-year BSP treasury bill purchased three months before date of maturity, three-
month time deposit, three-month money market instrument)

b.      Financial assets at fair value through profit or loss (trading securities and other
investments in quoted equity instruments)

c.      Trade and other receivables

d.      Inventories

e.      Prepaid expenses 

PAS 1, par. 66 simply states an entity shall classify all other assets not classified as current as
noncurrent assets and the disposal of which is expected to be more than twelve months.

Accordingly, the line items under noncurrent assets are:

a.      Property, plant and equipment

b.      Long-term investments
c.      Intangible assets

d.      Other noncurrent assets 

PAS 1, par. 69 provides that an entity shall classify a liability as current when: 

Here are the criteria:

a.      The entity expects to settle the liability within the entity’s normal operating cycle.

b.      The entity holds the liability primarily for the purpose of trading.

c.      The liability is due to be settled within twelve months after the reporting period.

d.      The entity does not have an unconditional right to defer settlement of the liability for at
least twelve months after the reporting period.

PAS 1, par. 54 provides that as a minimum the line items under current liabilities are:

a.      Trade and other payables

b.      Current provisions

c.      Short-term borrowings

d.      Current portion of long- term debt

e.      Current tax liability 

PAS 1, par. 69 simply states an entity shall classify all liabilities not classified as current are
classified as noncurrent liabilities and the settlement of which is expected to be more than
twelve months.

Accordingly, the line items under noncurrent liabilities are:

a.      Noncurrent portion of long-term debt

b.      Finance lease liability

c.      Deferred tax liability

d.      Long- term obligation to entity officers

e.      Long- term deferred revenue 

The third element comprising the Statement of Financial Position is the equity. Owner’s equity
or shareholders’ equity is the residual interest of owner/s in the net assets of a business of a
single proprietorship or in a corporation measured by the excess of assets over liabilities.   
All items shown in the statement of financial position are classified as permanent accounts. As
the name suggest, these accounts are permanent in a sense that their balances remain intact
from one accounting period to another.

On the other hand, the term contra assets are those accounts that are presented under the
assets portion of the SFP but are reductions to the company’s assets. 

Examples of Contra Assets are:

a.      Allowance for Doubtful Accounts is a contra asset to Accounts Receivable. This

represents the estimated amount that the company may not be able to collect from delinquent
customers.

b.      Accumulated Depreciation is a contra asset to the company’s Property, Plant and

Equipment. This account represents the total amount of depreciation booked against the fixed
assets of the company.

Let us now go to the difference of Report form and Account form.

a.      Report Form – A form of the SFP that shows asset accounts first and then liabilities and
owner’s equity accounts after. It sets forth the three major sections in a downward sequence.

b.      Account Form – A form of the SFP that shows assets on the left side and liabilities and
owner’s equity on the right side just like the debit and credit balances of an account.

The Advantages of Using Account Form are:

a. Emphasize that the two are only formats and will yield the same amount of total assets,
liabilities and equity

b. Emphasize that assets should always be equal to liabilities and equity