INTRODUCTION TO FINANCIAL STATEMENTS

CONCEPTUAL FRAMEWORK

Elements of Financial Statements

Definition:

The elements of financial statements refer to the quantitative information reported in the statement of
financial position and income statement.

The elements of financial statements are the “building blocks” from which financial statements are
constructed.

These elements are the broad classes of events or transactions that are grouped according to their
economic characteristics.

The elements directly related to the measurement of financial position in the statement of financial
position are:

a. Asset
b. Liability
c. Equity

The elements directly related to the measurement of financial performance in the income statement
are:

a. Income
b. Expense

The Conceptual Framework identifies no elements that are unique to the statement of changes in equity
because such statement comprises items that appear in the statement of financial position and income
statement.

Equity is the “residual interest” in the assets of the entity after deducting all of the liabilities.

RECOGNITION OF ELEMENTS

Recognition is a term which means reporting of an asset, liability, income or expense on the face of the
financial statements of an entity.

There are four main recognition principles to be followed in the preparation and presentation of
financial statements, as explicitly enumerated in the Conceptual Framework, namely:

a. Asset recognition principle

b. Liability recognition principle
c. Income recognition principle
d. Expense recognition principle

Asset Recognition Principle

An asset is defined as “a resource controlled by the entity as a result of past events and from which
future economic benefits are expected to flow to the entity.”

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.

Thus, two conditions must be present for the recognition of an asset:

a. It is probable that future economic benefits will flow to the entity.

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 The term “probable” means that the chance of the future economic benefits arising is more
likely rather than less likely.

b. The cost or value of the asset can be measured reliably.

Future Economic Benefit

The 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.

The future economic benefit embodied in an asset may flow to the entity in a number of ways, for
example, by being:

a. Used singly or in a 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 a liability.
d. Distributed to the owners of the entity.

Cost Principle

Inherent in asset recognition is the cost principle.

The 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 write-
off, or may be shifted to other categories as in the case of raw materials being converted into finished
goods.

But the question is “how much is cost”?

In a cash transaction, cost is equivalent to the cash payment.

In a noncash or an exchange transaction, the cost is equal to the fair value of the asset given or fair
value of the asset received, whichever is clearly evident.

In the absence of fair value, the cost is equal to the carrying amount of the asset given.

Liability Recognition Principle

A liability is defined as “a present obligation arising from the past events the settlement of which is
expected to result in an outflow from the entity of resources embodying economic benefits”.

A liability is recognized when it is probable that an outflow of resources embodying economic benefits
will be required for the settlement of a present obligation and the amount of the obligation can be
measured reliably.

Thus, two conditions must be present for the recognition of a liability:

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

An essential characteristic of a liability is that the entity has a present obligation which may be legal or
constructive.

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Obligations may be legally enforceable as a consequence of a binding contract or statutory
requirement.

This is normally the case, for example, with accounts payable for goods and services received.

Constructive obligations arise from normal business practice, custom and a desire to maintain good
business relations or act in an equitable manner.

For example, an entity decides as a matter of policy to rectify faults in the products even when these
become apparent after the warranty period.

Settlement of Liability

Settlement of a present obligation may occur in a number of ways, for example, by:

a. Payment of cash
b. Transfer of noncash assets
c. Provision of services
d. Replacement of the obligation with a another obligation
e. Conversion of the obligation into equity

Definition of Income

Income is “increase in economic benefit during the accounting period in the form of inflow or increase in
equity or decrease in liability that results in increase in equity, other than contribution from equity
participants.”

The definition of income encompasses both revenue and gains.

Revenue arises in the course of the ordinary regular activities and is referred to by a variety of different
names including sales, fees, interest, dividends, royalties and rent.

The essence of revenue is regularity.

Gains represent other items that meet the definition of income and do not arise in the course of
ordinary activities.

For example, gains include gain from disposal of noncurrent assets, unrealized gain on trading securities
and gain from expropriation.

Income Recognition Principle

The basic principle is that “income shall be recognized when earned”.

But the question is when is income considered to be earned?

The Conceptual Framework provides that “income is recognized when it is probable that an increase in
future economic benefits 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”.

Thus, two conditions must be present for the recognition of income, namely:

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.

Point of Sale

Undoubtedly, the two conditions for income recognition are present at the point of sale. Accordingly,
the point of sale is the point of income recognition.

The reason is that it is at the point of sale that the entity has transferred to the buyer the significant risks
and rewards of ownership of goods.

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Stated differently, legal title to the goods passes to the buyer at the point of sale.

Incidentally, the point of sale 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.

Revenue from Sale of Goods

In general, the following conditions should be present for the recognition of revenue from sale of goods.

a. The entity has transferred to the buyer the significant risks and rewards of ownership of the
goods.
b. The entity retains neither continuing managerial involvement nor effective control over the
goods sold.
c. The amount of revenue can be measured reliably.
d. It is probable that economic benefits associated with the transaction will flow to the entity.
e. The costs incurred or to be incurred in respect of the transaction can be measured reliably.

Revenue from Rendering of Services

In general, the following conditions should be present for the recognition of revenue from rendering of
services:

a. The amount of revenue can be measured reliably.

b. It is probable that the economic benefits associated with the transaction will flow to the entity.
c. The stage of completion of the transaction at the end of reporting period can be measured
reliably.
d. The costs incurred for the transaction and the costs to complete can be measured reliably.

Expectations to the Point of Sale

1. 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 the installment method is the uncertainty of collection or the possibility of
cancellation of the installment sales of contract.

2. Cost Recovery Method or Sunk Cost Method- Revenue is recognized also at the point of
collection.

However, unlike the installment 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.

This method is usually followed when the collection of the installment sales contract is very
uncertain or highly speculative.

3. Cash Method- Revenue is recognized when received regardless of when earned. In other words,
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 ultimate collection of sales price.

4. Percentage of Completion Method- When the outcome of a construction contract can be

estimated reliably, contract revenue and contract costs associated with the construction
contract shall be recognized as revenue and expenses, respectively, by reference to the stage of
completion of the contract activity.

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 5. Production Method- Revenue is recognized at the point of production.

The production method 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.

Other Income Recognition

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 shareholder’s right to receive payment is
established, meaning, when the dividends are declared.

Installation fees are recognized as revenue over the period of installation by reference to the stage of
completion.

Subscription revenue should be recognized on a straight line basis over the subscription period.

Admission fees are recognized as revenue when the event takes place.

Tuition fees are recognized as revenue over the period in which tuition is provided.

Definition of Expense

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.”

Expenses encompass losses as well as those expenses that arise in the course of the ordinary regular
activities.

Losses do not arise in the course of the ordinary regular activities and include losses resulting from
disasters.

Examples include losses from fire, flood, storm, surge, tsunami and hurricane, as well as those arising
from disposal of noncurrent assets.

Expense Recognition Principle

The basic expense recognition principle means that “expenses are recognized when incurred.”

But the question is when are expenses incurred?

The Conceptual Framework provides that “expenses are recognized when it is probable that a decrease
in future economic benefit related to decrease in an asset or an increase in liability has occurred and
that the decrease in economic benefit can be measured reliably.”

Thus, two conditions must be present for the recognition of expenses:

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 a liability.
b. The decrease in economic benefits can be measured reliably.

Matching Principle

Actually, the expense recognition principle is the application of the matching principle.

The generation of revenue is not without any cost. There has got to be some cost in earning a revenue.

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“There is no gain if there is no pain.”

The matching principle requires that “those costs and expenses incurred in earning a revenue shall be
reported in the same period.”

The matching principle has three applications, namely:

a. Cause and Effect Association

b. Systematic and Rational Allocation
c. Immediate Recognition

Cause and Effect Association

Under this principle, 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. This is
actually the “strict matching concept”.

This process, commonly referred to as the matching of cost with revenue, involves the simultaneous or
combined recognition of revenue or expenses that result directly and jointly from the same transactions
or events.

The best example is the cost of merchandise inventory.

When the merchandise is sold, the cost thereof is expensed in the form of “cost of goods sold” because
at such time revenue may be recognized.

Other examples include doubtful accounts, warranty expense and sales commissions.

Systematic and Rational Allocation

Under this principle, some costs are expensed simply allocating them over the periods benefited.

The reason for this principle is 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.

When economic benefits are expected to arise over several accounting periods and the association with
income can only be broadly or indirectly determined, expenses are recognized on the basis of systematic
and allocation procedures.

Concrete examples include depreciation of property, plant and equipment, amortization of intangibles,
and allocation of prepaid rent, insurance and other prepayments.

Immediate Recognition

Under this principle, the cost incurred is expensed outright because of uncertainty of future economic
benefits or difficulty of reliably associating certain costs with future revenue.

An expense is recognized immediately:

a. When an expenditure produces no future economic benefit.

b. When cost incurred does not qualify or ceases to qualify for recognition as an asset.

Examples include officers’ salaries and most administrative expenses, advertising and most selling
expenses, amount to settle lawsuit and worthless intangibles.

Many losses, such as loss from disposal of building, loss from sale of investments, and casualty loss, are
immediately recognized because they are not directly related to specific revenue.

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.

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There are four measurement bases or financial attributes, namely:

a. Historical Cost
b. Current Cost
c. Realizable Value
d. Present Value

Definition of Terms

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.

This is also known as “past purchase exchange price.”

Historical cost is the measurement basis most commonly adopted in preparing the 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 currently.

This is also known as “current purchase exchange price”.

c. Realizable Value- is the amount of cash and cash equivalent that could currently be obtained by
selling the asset in an orderly disposal.

This is also known as the “current sale exchange price.”

d. Present Value- is the discounted value of the future net cash inflows that the asset is expected
to generate in the normal course of business.

This is also known as the “future exchange price.”

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