CHAPTER 3 NOTES TO FINANCIAL STATEMENTS Related parties Events after reporting period TECHNICAL KNOWLEDGE To understand the nature and purpose of notes to financial statements. To identify related parties. To know the requirements for disclosure of related party transactions. To understand the concept of events after the reporting period. To know the types of events after reporting period.NOTES TO FINANCIAL STATEMENTS Notes to financial statements provide narrative description or disaggregation of items presented in the financial statements and information about items that do not qualify for recognition. Notes contain information in addition to that presented in the statement of financial position, income statement, statement of comprehensive income, statement of changes in equity and statement of cash flows. In other words, notes to financial statements are used to report information that does not fit into the body of the statements in order to enhance the understandability of the statements. Notes provide additional information and help clarify the items presented in the financial statements. PAS 1, paragraph 118, provides that an entity shall, as far as practicable, present notes in a systematic manner. Purpose of notes to financial statements The purpose of notes to financial statements is to provide the necessary disclosures required by Philippine Financial Reporting Standards. Specifically, PAS 1, paragraph 112, provides that the notes to financial statements shall: a. Present information about the basis of preparation of the financial statements and the spécific accounting policies. b. Disclose the information required by Philippine Financial Reporting Standards that is not presented in the financial statements. c. Provide additional information which is not presented in the financial statements but is relevant to an understanding of the financial statements.Order of presenting the notes rovides that an entity normal], yllowing order to assist users tatements and to compare them r entities: PFRS PAS 1, paragraph 114, p presents notes in the fo understand the financial s with financial statements of othe Statement of compliance with a. of significant accounting polic jes used b. Summary c. Supporting information or computation for line items presented in the financial statements such contingent liabilities d. Other disclosures, 1 commitments and nonfinancia] unrecognized contractua disclosures. it may be necessary or desirable to vary the order of specific items within the notes. However, the entity must retain the systematic presentation and structure of the notes as far as practicable. In some circumstances, Compliance with PFRS PAS 1, paragraph 16, provides that an entity whose financial statements comply with Philippine Financial Reporting Standards shall make an explicit and unreserved statement of such compliance in the notes. Anentity shall not describe financial statements as complying with PFRS unless they comply with all the requirements of each applicable Philippine Financial Reporting Standard. Accounting policies Accounting policies are defined as the specific principles, methods, practices, rules, bases and conventions adopted by an entity in preparing and ‘presenting financial statements. Accounting standards set out the required recognition and measurement principles that an entity shall follow in preparing its financial statements, and shall often prescribe the accounting policy to be adopted.F Significant accounting policies The summary of significant accounting policies shall disclose the following: a. The measurement basis used b. The accounting policies used Disclosure of measurement basis It is important for an entity to inform users of the measurement basis used in the financial statements because the basis on which the entity prepares the financial statements significantly affects the users’ analysis. Under the Revised Conceptual Framework, the measurement bases are historical cost and currrent value. Current value includes fair value, value in use, fulfillment value and current cost. Disclosure of accounting policies In deciding whether a particular accounting policy should be disclosed, management shall consider whether the disclosure would assist users in understanding how transactions, other events and conditions are reflected in the financial statements. Disclosure of particular accounting policies is especially useful to users when those policies are selected from alternatives allowed in Philippine Financial Reporting Standards. Disclosure of judgment PAS 1, paragraph 122, provides that an entity shall disclose in the summary of significant accounting policies the judgments that management has made in the process of applying accounting policies and that have a significant effect on the amounts recognized in the financial statements. For example, management makes judgment in determining the following: a. Whether financial assets are to be measured at fair value or at amortized cost. b. Whether in substance particular sales of goods are product financing arrangement and therefore do not give rise to revenue. The disclosure of information about judgment is mandatory.Disclosure of estimation uncertainty PAS 1, paragraph 125, provides that an entity shall disclose information about the assumptions it makes about the future, and other major sources of uncertainty at the end of reporting period that have a significant risk of resulting in a materia] adjustment to the carrying amount of assets and Tiabilitieg within the next financial year. With respect to those assets and liabilities, the notes shal] include the nature and carrying amount of the assets and liabilities at the end of reporting period. The disclosure of information about key sources of estimation uncertainty is mandatory. Other disclosures PAS 1, paragraph 138, provides that an entity shall disclose the following: The domicile and legal form of the entity, its country of incorporation and the address of the registered office or principal place of business.’ b. A description of the nature of the entity’s operations and its principal activities. - a. c. The name of the parent and the ultimate parent of the group. Paragraph 137 provides that an entity shall disclose the following: a. The amount of dividends proposed or declared before the financial statements were authorized for issue but not recognized as distribution during the period and the related amount per share. b. The amount of any cumulative preference dividends not recognized. aExamples of notes to financial statements (amounts are assumed) Note 1- Compliance with PFRS The financial statements have been prepared in compliance with the Philippine Financial Reporting Standards and rules and regulations of the Philippine Securities and Exchange Commission The accounting policies adopted in the preparation of financial statements have been applied on a consistent basis Note 2 - Significant accounting policies Measurement basis — The financial statements have been prepared on the basis of historical cost, ‘find except where stated, do not take into account changing prices and current cost of noncurrent assets. Inventories — Inventories are measured at the lower of FIFO cost and net realizable value. Store preopening costs — Such costs are charged to expense in the year incurred. Property, plant and equipment — Property, plant and equipment are recorded at cost. The straight line method is used in recording depreciation on the basis of the estimated useful life of the assets. Capital expenditures —Expenditures incurred subsequent to the acquisition of property, plant and equipment are expensed outright if the amounts are P5,00@ and below. Such expenditures amounted to P100,000 in 2022 and P30,000 in 2024 on the aggregate. Cash equivalents — The entity considers all highly liquid investments with maturities of three months or less when Purchased as cash equivalents.Goodwill represents the differs of an acquired entity ang the ts acquired. e Intangible assets — between the purchase price related fair values of net asse Goodwill is not amortized but tested for impairment annually and other intangible ase, The cost of patents, copyrights ted useful life. The straigh, are amortized over their estima line method is used for amortization. Research and development — All expenditures for research and development are charged to expense 1n the year incurreq Income taxes — Income taxes include deferred income taxes that result from all taxable and deductible temporary differences between carrying amount for financial reporting and tax base for tax reporting of assets and liabilities. Earnings per share — Earnings per share amounts are based on the weighted average number of ordinary shares outstanding after recognition of preference dividends. Potential ordinary shares are not material.} Note 3 - Inventories December 31, 2022 December 31, 2021 Finished goods 3,000,000 2,500,000 Goods in process 2,000,000 1,800,000 Raw materials . 1,500,000 1,200,000 Manufacturing supplies 400,000 300,000 Allowance for inventory , writedown (__700,000) (__ 500,000) 6,200,000 5,300,000 Note 4 - Property, plant and equipment On February 1, 2022, the entity entered into a contract with a contractor for the construction of an office building. The fixed contract price is P8,000,000. The building is expected to be completed in 12 months. December 31,2022 December 31,2021 Land 5,000,000 5,000,000 Buildings 20,000,000 20,000,000 Machinery and equipment 4,000,000 2,000,000 Furniture and fixtures 2,000,000 1,500,000 Patterns, molds, dies and tools _ 1,000,000. 800,000 Total 32,000,000 29,300,000 Accumulated depreciation (14,000,000) (12,300,000) Carrying amount 18,000,000 17,000,000Note 5 - Contingent liability ant in a patent infringement suit seekin, suit is still pending and the that the case will not The entity is a defend: damages of P2,000,000. The entity’s legal counsel firmly believed prosper. Note 6 - Long term debt 5,000,000 mature on December 31, d. ble of P! DE nt cena f 12% on June 30 ang 2026, pay semiannual interest 0 December 31. The bonds require sinking fund deposit of P1,000,000 annually, starting December 31, 2023. Note 7- Shareholders’ equity tal — P100 par value, 100,000 shares Preference share capii at both December 31, authorized, issued and outstanding 2022 and December 31,-2021. The preference share is cumulative and there are no dividends in arrears. Ordinary share capital — P50 par, 1,000,000 shares authorized, and 800,000 shares issued at both December 31, 2022 and December 31, 2021 of which 50,000 shares are held in treasury‘and recorded at cost of P3,000,000. Retained earnings are appropriated to the extent of the cost of the treasury shares. : The balance of retained earnings represents unrestricted amount legally available for dividends. Note 8 - Share options On December 1, 2022, the shareholders of the entity approved : the share option plan which provides for granting of options to ‘purchase 50,000 ordinary shares at 100% of fair value at the date of grant. The options are exercisable immediately”r RELATED PARTIES Related party ~ Parties are considered to be related if one party has: a. The ability to control the other party b. The ability to exercise significant influence over the other party. ¢. Joint control over the entity Control is the power over the investee or the power to govern the financial and operating policies of an entity so as to obtain benefits. Control is ownership directly or indirectly through subsidiaries of more than half of the voting power of an entity. Significant influence is the power to participate in the financial and operating policy decision of an entity, but not control of those policies. Significant influence may be gained by share ownership of 20% or more. If an investor holds, directly or indirectly through subsidiaries, 20% or more of the voting power of the investee, it is presumed that the investor has significant influence, unless it can be clearly demonstrated that this is not the case. Beyond the mere 20% threshold of ownership, the existence of significant influence is usually evidenced by the following factors: Representation in the board of dirgetors Participation in policy making process Material transactions between the investor and the investee Interchange of managerial personne Provision of essential technical information Spe op Joint control is the contractually agreed sharing of control over an economic activity.Examples of related parties 1. Affiliates — meaning the parent, the subsidiary and fellow subsidiaries. ywna more than 50% of an investee, 4, as parent and the investee is known e subsidiary is related to the parent a rent are also related to each othe ". If an investor ¢ investor is known the subsidiary. Th fellow subsidiries of one pa 2, Associates — meaning the exercises significant influence: If an investor owns at least 20% of the investee, the iNVeSta— js known as associate. The associate is related to the investor. The term associate includes the subsidiary = subsidiaries of the associate. ir 3. Venturers are related to the joint venture because th,, have joint control of the activities of the joint venture.” However, the fellow venturers are not related to each other, unlike fellow subsidiaries. Other related parties 1. Key management personnel These are the persons with managerial positions, like the president, vice-president, chief executive officer and other officers with responsibility of controlling the activities of entity. Close family members of key management personnel entities over which one Party a. The individual's spouse and children b. Children of the individual's spouse c. Dependents of the individual or the individual's spouse. 3. Individuals or shareholders owning at least 20% of the reporting entity. The close family members of such individuals are also related to the reporting entity. 4. Postemployment benefit plan for the benefit of employees Normally, the retirement ity i nally, plan of an entity is funded by contributions from the entity. : Such contributions constitute the trust fund handled by a trustee. Such trust fund is related to the reporting entity.Related party transaction A related party transaction is a transfer of resources or obligations between related parties, regardless of wheth price is charged. : oe PAS 24, paragraph 20, provides the follc related party transaction: eee ~ NOOR wo Ee Purchase and sale of goods Purchase and sale of property and other asset Rendering or receiving services Leases Transfer of research and development License agreement Finance arrangements, including loans and equity contributions in cash or in kind Guarantee and collateral Settlement of liabilities on behalf of the entity or by the entity on behalf of another party. Related party disclosures PAS 24, paragraph 12, requires disclosure of related party relationships where control exists irrespective of whether there have been transactions between the related parties. In other words, relationships between parents and subsidiaries shall be disclosed regardless of whether there have been transactions between those related parties. An entity shall disclose the name of the entity's parent and if different, the ultimate controlling party. If neither the entity's parent nor the ultimate controlling party produces financial statements available for public use, the name of the next most senior parent that does so shall also be disclosed.Disclosures of related party transaction PAS 24, paragraph 17, provides that if there have been transactions between related parties, an entity shall disclose the nature of the related party relationship as well as information about the transactions and outstanding balances necessary for an understanding of the financial statements. As a minimum, the disclosures of related party transaction shall include: a. The amount of the transaction. The amount of outstanding balance, terms and condition, b. whether secured or unsecured, and nature of consideration, to be provided in settlement. c. The allowance for doubtful accounts related to the outstanding balance. d. The expense recognized during the period in respect of doubtful accounts due from related parties. Disclosures that related party transactions were made on terms equivalent to those that prevail.in arm's length transactions are made only if such terms can be substantiated. Key management personnel compensation PAS 24, paragraph 16, provides that an entity shall disclose key management personnel compensation in total and for each of the following categories: a. Short-term employee benefits b. Postemployment benefits, for example, retirement pensions _ Other long-term benefits d. Termination benefits e. Share based payment transactions, for example, share optionsUnrelated parties Unrelated parties include the following: 1, Two entities simply because they have a director or key ! management personnel in common. g, Providers of finance, trade unions, public utilities and government agencies in the course of their normal dealings with an entity by virtue only of those dealings. 3. Asingle customer, supplier, franchisor or general agent with whom an entity transacts a significant volume of business merely by virtue of the resulting economic dependence. 4, Two venturers simply because they share joint control over a joint venture. Fellow venturers are unrelated to each other. Transactions with government-related entities A reporting entity is exempted from providing the normal disclosures for transactions with: a. A government that has control, joint control or significant influence over the entity. b. Other entities controlled, jointly controlled or significantly influenced by the same government. In applying the exemption, the reporting entity is required to disclose only the following: a. The name of the government and the nature of the relationship with the*reporting entity. b. The information on the nature and amount of each "individually" significant transaction with the government.Related party disclosures not required PAS 24, paragraph 3, requires disclosure of related Part, transactions and outstanding balances in the separate¥inancigg statemenis of a parent, subsidiary, associate or venturer However, Paragraph 4 provides that intragroup related P: transactions and outstanding balances are eliminated in ty, preparation of consolidated financial statements of the zroup Pricing policies Accounting recognition of a transfer of resources is normally based on the price agreed upon between the parties. Between unrelated parties, the price is an arm's length price. Between related parties, there may be a degree of flexibility im the price setting process that is not present between unrelated parties. PAS 24 did not provide for the measurement of related Party transactions. However, a variety of methods is used to price transactions between related parties. 1. Uncontrolled price method — This sets the price by reference to comparable goods sold in an economically comparable market to a buyer unrelated to the seller. 2. Resale price method — This method is often used where goods are transferred between related parties before a sale to an independent party is made. This reduces the resale price by a margin, representing an amount from which the reseller would seek to recover costs and make an appropriate profit. 3. Cost plus method — This method seeks to add an appropriate markup to the supplier's cost. 4. No price method - Literally, no price is charged, as in the case of free provision of management services and the extension of free credit on a debt.EVENTS AFTER REPORTING PERIOD pAS 10, paragraph 3, defines events after the reporting period as those events, whether favorable or unfavorable, that occur between the end of reporting period and the date on which the financial statements are authorized for issue. Types of events after the reporting period Events after the reporting period may require either adjustment or disclosure. y Adjusting events after the reporting period are those that provide evidence of conditions that exist at the end of reporting period. b. Nonadjusting events after reporting period are those that are indicative of conditions that arise after the end of reporting period. Examples of adjusting events 1. Settlement after the reporting period of a court case because it confirms that the entity already had a present obligation at the end of reporting period. 2. Bankruptcy of a customer which occurs after the reporting period. 3. The determination after the reporting period of the cost of assets purchased or the proceeds from assets sold before the end of reporting period. 4. The determination after the reporting period of the profit sharing or bonus payment if the entity has the present obligation at the end of reporting period to make such payment. 5. The discovery of fraud or errors that show the financial statements were incorrect.Examples of nonadjusting events 1. Business combination after the reporting period. 2. Plan to discontinue an operation. Major purchase and disposal of asset or expropriation of major asset by government. 4. Destruction of a major production plant by a fire afte, the reporting period. 5. Major ordinary share transactions and potential Ordinary share transactions after the reporting period. 6. Announcing or commencing the implementation of a major restructuring. Abnormally large changes after the reporting period jy asset prices or foreign exchange rates. st 8. Entering into significant commitments or contingent liabilities, for example, by issuing guarantees. 9. Commencing major litigation arising solely from events that occurred after the reporting period. 10. Change in tax rate enacted or announced after the end of reporting period that has a significant effect on current and deferred tax asset and liability. Financial statements authorized for issue Financial statements are authorized for issue when the board of directors reviews the financial statements and authorizes them issue. : In some cases, an entity is required to submit its financial statements to the shareholders for approval after the financial statements have been issued. In such cases, the financial statements are authorized for issue on the date of issue by the board of directors and not 00 the date when shareholders approve the financial statements. |[Illustration The management of an entity completed draft of the financial statements for the year ended December 31, 2021 on February 1, 2022. On March 1, 2022, the board of directors reviewed the financial statements and authorized them for issue. The entity announced the profit and selected financial information on March 15, 2022. The financial statements were mad ilabl hold on April 1, 2022. le available to shareholders The shareholders approved the financial statements at their annual meeting on April 10, 2022. The approved financial statements were then filed with SEC on April 15, 2022. The financial statements are authorized for issue-on March 1, 2022, the date of the board authorization for issue. Disclosure of date of authorization for issue PAS 10, paragraph 17, provides that an entity shall disclose the date when the financial statements are authorized for issue and who gave the authorization. If the entity's owners or others have the power to amend the financial statements after issue, the entity shall disclose such fact. It is important for users to know when the financial statements are authorized for issue because the financial statements do not reflect events after this date.