San Jose Community College

San Jose, Malilipot, Albay

First Semester – S.Y. 2022-2023

Module 1:
Financial Analysis and
Reporting

Eva M. Bo, MBA, LPT

Instructor
Chapter 1:
ACCOUNTING: Its Nature and Concepts

Learning Objectives:
At the end of the chapter, the student shall be able to:
 Define Accounting;
 Identify the steps in accounting cycle;
 Discuss the development of accounting in the Philippines;
 Describe the framework for financial statement preparation;
 Enumerate the basic financial statements;
 Identify the various users of the financial statements;
 Discuss the objectives of financial statements;
 Describe the concept of underlying assumption;
 State the qualitative characteristics of the financial statements;
 Identify the accounting constraints;
 Discuss the elements of financial statements
 Describe the measurements procedures of financial elements; and
 Discuss the meaning of concept of capital.

CONCEPT AND NATURE OF ACCOUNTING

The Committee on Accounting Terminology of the American Institute of Certified
Public Accountants (AICPA) defines accounting as follows:
“Accounting is the art of recording, classifying and summarizing in a significant manner
and in terms of money, transactions, events which are in part at least of a financial
character and interpreting the results therefore.”
On the other hand, the Financial Reporting Standard Council (FRSC), which
adopted the standards issued by the International Accounting Standard Board (IASB)
defines accounting as follows:
“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.”
The first definition is widely used in the United States and in other countries that use
the American Standard in their practices and procedures. The second definition is
commonly used by countries that follow the international standards of IASB.

There are common denominators that are highlighted by the two definitions. These
are:
 Accounting is a service activity
 The main objective is to provide quantitative information
 The information is financial in character about the economic entities
 The information is intended in making economic decision

In other words, accounting is a process that ultimately provides information about

the economic activities of a business entity. The usual procedure involve are:
 Identification, measurement and recording of business transactions
 Processing the quantitative information
 Communication and information to interested users.
 Accounting, therefore, is an analytical and constructive process of identifying,
measuring, recording the right financial information to be communicated to interested
users at the right place and at the right time as shown in figure 1.1. The schematic
diagram indicates that data, transactions or events are measured, processed and finally
communicated to the interested users. The final product of measuring and processing
events and transactions is the financial statement.
Also, accounting is considered an important segment in the whole management
information system. The quantitative information provided by accounting is used by
managers in making economic decision.
 Figure 1.1. Analytical and Constructive Process of Accounting

Measuring refers to the process of determining and assigning the monetary value of
business transactions and events. Only business transactions that are quantifiable or
have monetary value should be recorded. For example, the hiring of an employee
cannot be considered a transaction that should be given accounting recognition since
the act of hiring does not have monetary value. This type of transaction then will not be
recorded in the books of accounts.
Processing of information implies two major accounting activities to be undertaken,
a. the grouping of similar transactions, and b. the preparation of financial statements.
Communication refers to the issuance of complete set of financial statements to
various users and interpretation of the data in the financial statements. The financial
statements are considered the final product of accounting.
It is through the financial statements that the business entity can communicate itself
to the outside world and interested users. It is in this line of thought that accounting is
considered as the language of the business.

PROCEDURAL STEPS IN ACCOUNTING CYCLE

The term “process” would imply series of interrelated activities undertaken to
produce the desired result. A delay or error in one of the processes or steps brings
domino effects on the succeeding processes or steps.
The accounting process involves the following steps:
1. Analyzing transactions
2. Journalizing or recording
3. Posting
4. Preparing the Trial Balance
5. Adjusting Entries
6. Preparing Worksheet
7. Preparing financial statement
8. Closing entries
9. Preparing the post closing trial balance
10. Reversing entries’=

ACCOUNTING IN THE PHILIPPINES

The recording and measuring of business transactions, the presentation of the
data, and the preparation of financial statements are based on set of rules, procedures
and standard. These set of accounting procedures, practices and rules are technically
called as the generally accepted accounting principles (GAAP).
The following brief chronological events are related to the development of the
generally accepted accounting principles in the Philippines.
 In Nov. 1981, the Philippine Institute of Certified Public Accountant (PICPA)
formed the Accounting Standard Council (ASC). The main function of the ASC
was to establish the generally accepted accounting principles in the Philippines.
The approved work or statements of the ASC were known as Statement of
Financial Accounting Standards or SFASs. The statements issued by ASC were
predominantly based on American standards and principles.
 In 1996, the Philippine accounting standards were based already on the
approved statements of the International Accounting Standard Committee
(IASC). The (IASC) statements were known as the International International
Accounting Standards (IAS).

The IASC was formed in 1973 through the agreement made by the professional
accounting bodies from Australia, Canada, France, Japan, Mexico, Germany,
United Kingdom and Ireland, United States of America, and the Netherlands to
achieve a uniform accounting principles around the world.

 In 1997, the ASC totally adopted the statements issued by the IASC. However, in
2000 the Philippine Accounting Standards were conformed to International
standards.

 On May 13, 2004, the President approved Republic Act No. 9298, otherwise
known as the Philippine Accountancy Act of 2004. This law repealed Presidential
Decree No. 692, which regulates the practice of Accountancy in the Philippines.

 Under the implementing rules and regulation of the Accountancy Act specifically,
Resolution No. 71, series of 2004, the Board of Accountancy established the
Financial Reporting Standards Council (FRSC) in 2006 to replace the ASC. The
FRSC has full discretion in developing and pursuing the technical agenda for
setting accounting standards in the Philippines.

The FRSC is composed of a Chairman and member of representatives from the

following:
Board of Accountancy 1
Securities and Exchange Commission 1
Bangko Sentral ng Pilipinas 1
Bureau of Internal Revenue 1
Commission on Audit 1
Major Organization of preparers and users of financial statements 1

Accredited National Professional Organization of CPA’s in:

Public Practice 2
Commerce and Industry 2
Education 2
Government 2
 The FRSC monitors the technical activities of the international Accounting Standards
Board (IASB) and issues Invitation to comment on exposure drafts of proposed
International Financial Reporting Standards (IFRS) as these are issued by the IASB.
When finalized, these are issued as Philippine Financial Reporting Standards (PFRSs).
The International Accounting Standards Board (IASB) replaced the International
Accounting Standard Committee (IASC).
 In August 2006, the FRSC formed the Philippine Interpretations Committee (PIC)
to assist the FRSC in establishing and improving the financial reporting
standards in the Philippines. The principal role of the PIC is to issue
Implementation guidance on PFRS. The PIC members were appointed by the
FRSC and include accountants in public practice, the academe and regulatory
bodies and users of financial statements. The PIC replaced the Interpretations
Committee created by the ASC in year 200.

At present, the FRSC issues its Standards in a series of pronouncement called

Philippine Financial Reporting Standards (PFRSs). These consist of:
1. Philippine Financial Reporting Standards (PFRSs) which correspond to the
International Financial Reporting Standards (IFRSs);
2. Philippine Accounting Standards (PASs) which correspond to the International
Accounting Standards (IAS); and
3. Philippine Interpretations (PIs) which correspond to interpretations of the
International Financial Reporting Interpretations Committee (IFRIC) of the IASB).

The chronological events narrated above on the development of accounting practice

signifies that the field of accounting will continue to undergo changes and development
in the future in order to answer the various economic challenges and issues of the
business environment. Accounting is not a dormant field.

FRAMEWORK FOR THE PREPARATION OF FINANCIAL STATEMENTS

The Framework sets out the concepts that underlie the preparation and
presentation of financial statements for external users.

The following concepts will be of help in gaining deeper understanding of the

framework.
1. The Framework serves as a general guideline in the preparation and
presentation of financial statements in the absence of specific standard.
2. The Framework is not a Philippine Financial Reporting Standards.
3. The Framework does not define standards for any particular measurement or
disclosure issue.
4. Nothing in the framework overrides any specific Philippine Financial
Reporting Standards.
5. In case of conflicts between the framework and PFRS, the conditions and
requirements for measurement and disclosure set by PFRS will prevail over
those of the Framework.

PURPPOSE OF THE FRAMEWORK

Generally, the objective of Framework is to facilitate the consistent and logical
formulation of PFRSs. It would also provides a basis for the use of judgement in
resolving accounting issues.
 In specific terms, the Framework aims to:
1. Assist the FRSC in developing future PFRS and reviewing existing Philippine
Accounting standards;
2. Assist preparers of financial statements in applying PFRS and dealing with
topics not yet covered by any PFRS;
3. Assist auditors in forming an opinion as to whether financial statements
conforms with PFRSs;
4. Assist users of financial statements in interpreting the information contained
in financial statements; and
5. Provide those who are interested in the work of FRSC with information about
its approach to the formulation of PFRS.

SCOPE OF THE FRAMEWORK

As shown in Figure 1.2, the Framework deals with the following:
1. Objective of financial statements
2. Qualitative characteristics that determine the usefulness of information in
financial statements;
3. Definition, recognition and measurement of the elements from which financial
statements are constructed; and
4. Concepts of capital and capital maintenance.

Figure 1.2 The Scope of the Framework

In applying the Framework relative to the presentation and preparation of

financial statements, the following essential points should be remembered:
1. The Framework is concerned with general purpose financial statements including
consolidated financial statements. Such financial statements are prepared and
presented at least annually and are directed toward the common information
needs of a wide range of users.
The financial statements are understood to be a general-purpose financial
statements that are intended to meet the needs of users who are not in a position
to demand reports tailored to meet their particular information needs.
2. Special purpose financial reports are outside the scope of the framework like
prospectuses and computations prepared for taxation purposes.

3. The Framework applies to the financial statements of all commercial, industrial

and business reporting entities, whether in the public or the private sectors.
 A reporting entity is an entity for which there are users who rely on the financial
statements as their major source of financial information about the entity.

BASIC CONCEPTS OF FINANCIAL STATEMENTS FINANCIAL STATEMENTS

Financial Statements are the final product of the accounting system. They are
structured representation of financial position, financial performance, and cash flow of
an entity.
A complete set of financial statements comprises the following:
1. Statement of Financial Position (Balance Position)
2. Statement of Comprehensive Income (Income Statement)
3. Statement of Changes Equity
4. Statement of Cash Flows (Cash Flow Statement), and
5. Notes, Comprising a summary of significant accounting policies and other
explanatory notes.

The term “structure” means that there are prescribed format followed in the
presentation and preparation of the financial statements. Because of uniformity in
preparation and presentation, the analysis of financial statements is easily
accomplished.
Figure 1.3 presents the complete set of financial statements. The data presented
on the face of the financial statements are interrelated, and analysis cannot be made by
not considering the data from financial statements.
There is no hierarchy of importance among the financial statements. However,
the objective of the user will serve as the prevailing factor that determines which
financial statement is considered important in the analysis.
For example, if the user gives importance to profitability rather than to the
liquidity or solvency of an entity, then the information contained in the statement of
comprehensive income is given heavier weight in the analysis than those in the
statement of financial position.
Though the focus of the analysis is on the statement of comprehensive income in
this case, the items contained statement of financial position and statement of cash
flows before logical decision is made. This process will give a total perspective of the
entity’s operation.

Figure 1.3 Complete Set of Financial Statements

STATEMENT OF FINANCIAL POSITION
The elements directly related to the measurement of financial position are:
1. Assets;
2. Liabilities;
3. Equity.
The Financial Position of a business entity is usually expressed in terms of its
liquidity, solvency, financial structure, and capacity for adaptation.
Liquidity refers to the ability of a business entity to settle its currently maturing
financial obligations. Obligations are currently maturing if they become due within one
year from the date of the statement of financial position notwithstanding the normal
operating cycle of a business.
Solvency is the ability of a business to pay its long-term financial obligations.
Financial obligations are classified long-term if they mature beyond one year from the
date of the statement of financial position.
Financial structure indicates the amount of capital or resources financed by
creditors and the amount provided by owners. The analysis of the financial structure of
the business focuses on the right-side of the accounting equation (Assets= Liabilities +
Capital).
Capacity for adaptation refers to the ability of a business to invest excess available
resources or raise needed funds through borrowings without difficulty in times of needs.
When the business has a very high capacity for adaptation, it can easily find funding
sources when the need arises.

STATEMENT OF COMPREHENSIVE INCOME

The Statement of comprehensive income reflects the operating performance of
the business.
Profit is frequently used as a measure of performance or as a basis for other
measures like determination of return on investment (ROI) or earnings per share (EPS).
The elements directly related to the measurement of profit are:
1. Income, and
2. Expenses
Income and expenses may be presented in the income statement in different
ways in order to provide information relevant for economic decision. For example, it is a
common practice to distinguish between items of income and expenses arising from the
ordinary course of the business of the entity and those that do not.

STATEMENT OF CHANGES IN EQUITY

The movements and changes in the owner’s equity section of the balance sheet
are reflected in the statement of changes in equity.
An entity shall present a statement of changes in equity showing in the
statement.
1. The total comprehensive income for the period, showing separately the amounts
attributable to owners of the parent and minority interest;
2. For each component of equity, the effects of retrospective application or
retrospective restatement recognized;
3. The amounts transactions with owners in their capacity as owners, showing
separately contributions by and distributions to owners; and
 4. For each component of equity, a reconciliation between the carrying amount at
the beginning and the end of the period, separately disclosing each change.

STATEMENT OF CASH FLOW

A statement of cash flows shall report cash flows (cash inflows and outflows)
during the period classified by operating, investing, and financing activities.
A statement of cash flows provides information that enables users to evaluate the
changes in assets of an entity, its financial structure and its ability to affect the amounts
and timing of cash flows.
This financial statement basically answers the two broad queries.
1. What were the sources of the cash during the period?
2. What happened to the cash during the period?

The difference between the cash inflows and outflows is the net cash flows. The net
cash flows is finally added to the beginning amount of cash balance, and the sum
represents the ending cash balance.

NOTES AND DISCLOSURE OF ACCOUNTING POLICIES

The notes, as far as practicable, shall be presented in a systematic manner. Each
item in the financial statements shall be cross-referenced to any related information in
the notes. For example, the item cash and cash equivalent in the statement of financial
position must be explained fully as to measurement and valuation in the notes.
Also, an entity shall disclose in the summary of significant accounting policies:
1. The measurement basis or bases used in preparing the financial statements; and
2. Other accounting policies used that are relevant to the understanding of the
financial statements.

USERS OF FINANCIAL STATEMENTS AND THEIR INFORMATION NEEDS

The users of financial statements include present and potential investors,
employees, lenders, suppliers and other trade creditors, customers, government and
their agencies, and the public. They use financial statements in order to satisfy some of
their different needs for information. The following are users and their information
needs.
1. Investors – Providers of risk capital and their advisers are concerned with he the
risk inherent in, and return provided by, their investment. 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 – Employees and their representative groups are interested in
information about the stability and profitability of their employers. They are also
interested in information which enables them to assess the ability of the entity to
provide remuneration, retirement benefits, and employment opportunities.
3. Lenders – Lenders are interested in information that enables them to determine
whether their loans, and the interest earned, will be paid when due.
4. Suppliers and Other Trade Creditors – Suppliers and other creditors are
interested in information that enables them to determine whether amounts owing
to them will be paid when due. Trade creditors are likely to be interested in an
entity over a shorter period than lenders, unless they are dependent upon the
continuation of the entity as major customer.
 5. Customers - Customers 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 – Government and their agencies are
interested in the allocation or resources and therefore the activities of entities.
They also require information in order to regulate the activities of entities,
determine taxation policies and as the basis for national income and similar
statistics.
7. Public – Entities affect members of the public in a variety of ways. For example,
entities may make a substantial contribution to the local economy in many ways
including the number of people they employ and their patronage of local
suppliers. 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.
8. Management – Management is interested in the information contained in the
financial statements that will help carry out its planning, decision-making, and
control responsibilities,
The different users mentioned above are broadly classified as internal and
external users.
Basically, internal users are those parties that are connected with the business,
and the primary purpose of analyzing the information in the financial statement is to
improve the operating performance of the business.
External users, on the other hand, are not connected with the business and with
diversified purpose based on their vested interest and priorities.

OBJECTIVE OF FINANCIAL STATEMENTS

The objective of financial statements is to provide information about the:
1. Financial position
2. Operating performance, and
3. Changes in financial position
Financial Statement is a medium to communicate or provide the necessary
information to different economic users as shown in Figure 1.4

Figure 1.4 Communication as the Primary Objective of Financial Statements

The Management of an entity has the primary responsibility for the preparation
and presentation of the financial statements.

UNDERLYING ASSUMPTIONS
The Framework mentioned two underlying assumption in order to meet the
objective of accounting, namely, the
1. Accrual assumption
2. Going concern assumption
 Accounting assumption is considered the foundation or the building block of
other accounting practices and procedures. This is the premise where other accounting
concepts and practices are built as depicted in Figure 1.5.

Figure 1.5 Accounting Assumptions as Foundation of Accounting

ACCRUAL ASSUMPTION
Accrual Assumption means that the effects of transactions and other events
are recognized when they occur and not as cash or its equivalent is received or paid.
The accrual assumption underscores the concept that business transactions and
events are recorded in the accounting records and reported in the financial statements
of the period to which they relate.
Financial statements prepared on the accrual basis inform users not only of past
transactions involving the payment and receipt of cash but also of obligations to pay
cash in the future and of resources that represent cash to be received in the future.
What is the significance of accrual assumption in the analysis of financial statements?
It provides early warning to the analyst or user that the items appearing on the
face of the financial statements are recognized and measured using the accrual
concept. For example, the net profit or income appearing on the statement of
comprehensive income is not cash income but rather accrual income.

GOING CONCERN ASSUMPTION

Going concern assumption means the financial statements are prepared on the
assumption that an entity will continue in operation for the foreseeable future. Hence, it
is assumed that the entity has neither the intention nor the need to liquidate or curtail
materially the scale of its operation.
However, if there is an intention to stop business operation or a need exists, the
financial statements may have to be prepared on a different basis and, if so, the basis
used is disclosed in the notes accompanying the financial statements.
Because of the going concern assumption, the values that appear on the face of
the financial statements are usually the fair market value and not the liquidation or
realizable value. This basic premise should always be the working principle in the
analysis of the financial statements.

QUALITATIVE CHARACTERISTICS
 Qualitative characteristics refer to the attributes that make the information
provide in the financial statements useful to users.
The four principal qualitative characteristics are:
1. Understandability,
2. Relevance,
3. Reliability,
4. Comparability.

Understandability
An essential quality of the information provided in financial statements is that it is
readily understandable by users. For this purpose, users are assumed to have
reasonable knowledge of business and economic activities and accounting and
willingness to study the information with reasonable diligence.

Relevance
Information has the quality of relevance when it influences the economic
decisions of users by helping them evaluate past, present or future events or
confirming, or correcting their past evaluations.
The information in the financial statements has predictive and confirming or
correcting their past evaluations.
Information about financial position and past performance is frequently used as
the basis for predicting future financial position and performance and other matters in
which users are directly interested.

Reliability
Information has the quality of reliability when it is free from material error and
bias. Otherwise stated, reliability refers to the level of confidence that users place on
truthfulness of the information.
Information is also reliable when it can be depended upon by users to represent
faithfully that which it purports to represent or could reasonably be expected to
represent.
The Framework mentioned the following elements in order that the information
will be reliable:
1. Faithful representation
2. Substance over form
3. Neutrality
4. Prudence
5. Completeness
Because of these elements, there are nine qualitative characteristics that will
make the financial statements useful to interest users of which the first four attributes
are the principal qualitative elements as reflected in Figure 1.6.
Faithful Representation – To be reliable, information must represent faithfully
the transactions and other events it either purports to represent or could reasonably be
expected or represent. For example, a balance sheet should represent faithfully the
transactions and other events that result in assets, liabilities and equity of the entity and
the reporting date which meet the recognition criteria.
Substance over form – If information is to represent faithfully the transactions
and other events that it purports to represent, it is necessary that they are accounted for
and presented in accordance with their substance and economic reality and not merely
their legal form.
Neutrality – To be reliable, the information contained in the financial statements
must be neutral, that is, free from bias. Financial statements are not neutral if, by the
selection or presentation of information, they influence the making of a decision or
judgement in order to achieve a predetermined result or outcome.
Prudence – Prudence is the inclusion of a degree of caution in the exercise of
the judgements needed in making the estimates required under condition or uncertainty,
such that assets or income are not overstated and liabilities and expenses are not
understated. However, the exercise of prudence does not allow, for example, the
creation of hidden reserves or excessive provision, the deliberate understatement of
assets or income, or the deliberate overstatement of liabilities or expenses, because the
financial statements would not be neutral and, therefore, not have the quality of
reliability.
To become meaningful under the principle of prudence, the financial statements
should not overstate the equity of the owners by overstating the assets or understating
the liabilities.
Completeness – To be reliable, the information in financial statements must be
complete within the bounds of materiality and cost. An omission can cause information
to be false or misleading and thus unreliable and deficient in terms of its relevance.
In the exercise of completeness, the cost factor and the materiality elements
should be considered. Information where the cost involved in gathering it exceeds the
benefit may warrant the non-inclusion of the same in the financial statements.

COMPARABILITY
Information has the quality when users are able to compare the financial
statements of an entity through time in order to identify trends in its financial position
and performance.
The measurement and presentation of the financial effects of like transactions
and other events must be carried out in a consistent way throughout an entity and over
time for that entity and in a consistent way for different entities.

ACCOUNTING CONSTRAINTS
Accounting constraints refers to the elements that affect the qualitative
characteristics of relevance and reliability.
The constraints enumerated in the Framework are:
1. Timeliness,
2. Balance between benefit and cost,
3. Balance between qualitative characteristics,
4. True and fair view/fair presentation.

Timeliness – If there is undue delay in the reporting of information it may lose its
relevance. To provide information on a timely basis, it may often be necessary to report
before all aspects of a transaction or other event are known, thus impairing reliability.
Conversely, if reporting is delayed until all aspects are known, the information
may be highly reliable but of little use to users who have had to make decisions in the
interim.
 Apparently, timeliness serves as hindrance to both relevance and reliability. If
you give importance to relevance, you tend to lose reliability. Similarly, if you consider
reliability as important element, then you tend to loss the value of relevance.

Balance Between Benefit and Cost – The balance between benefit and cost is
a pervasive constraint rather than a qualitative characteristic.
The benefit derived from information should exceed the cost of providing it. The
evaluation of benefits and costs is, however, substantially a judgmental process.

Balance Between Qualitative Characteristics – In practice a balancing, or

trade-off, between qualitative characteristics is often necessary. Generally, the aim is to
achieve an appropriate balance among the characteristics in order to meet the objective
of financial statements.
The relative importance of the characteristics in different cases is a matter of
professional judgment.
In achieving a balance between relevance and reliability, the overriding
consideration is how best to satisfy the economic decision-making needs of users.

True and Fair View/Fair Presentation

Financial statements are frequently described as showing a true and fair view of,
or as presenting fairly, the financial position, performance and changes in financial
position of an entity.
True presentation of information will definitely disregard the concept of materiality
and the concept of balance between cost and benefit. On the other, fair presentation
considers the materiality of the item, and the degree of influence it will provide to
interested users of the financial statements.

Figure 1.7 Accounting Constraints

In Figure 1.7, the accounting constraints act as stumbling block to relevance and
reliability of information to interested users.

ELEMENTS OF FINANCIAL STATEMENTS

Financial statements portray the financial effects of transactions and other events
by grouping them into broad classes according to their economic characteristics. These
broad classes are termed the elements of financial statements.
 The three elements directly related to the measurement of financial position in
the statement of financial position are assets, liabilities, and equity as depicted in
Figure 1.8
Assets are resources controlled by the entity as a result of past events and from
which future income benefits are expected to flow to the entity.
Liabilities are present obligations of the entity arising from past 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 its
liabilities.

Figure 1.9 Accounting Elements of Statements of Financial Position

The elements directly related to the measurement of performance in the

statement of comprehensive income are income and expense.
Income is increase in economic benefits during the accounting period in the form
of inflows or enhancements of assets or decreases of liabilities that result in increases
in equity, other than those relating to contributions from equity participants.
Expenses are decreases in economic benefits during the accounting period in
the form of outflows or depletions of assets or incurrence of liabilities that result in
decreases in equity, other than those relating to equity participants.
The statement of changes in financial position usually reflects income statement
elements and changes in balance sheet elements.

RECOGNITION OF ELEMENTS OF FINANCIAL STATEMENTS

Recognition is the process of incorporating in the statement of financial position
or statement of comprehensive income an item that meets the definition of an element
and satisfies the criteria for recognition.

The process of incorporating an event in the financial statements starts during

the recording phase where it involves the depiction of the item in words and by a
monetary amount and the inclusion of that amount in the statement of financial position
or statement of comprehensive income totals.
There are two criteria in order that an item shall be given accounting recognition.
An item shall be recognized if:
 a. It is probable that any future economic benefit associated with the item will
flow to or from the entity; and
b. The item has a cost or value that can be measured with reliability.

THE PROBABILITY OF FUTURE ECONOMIC BENEFIT

The first criterion for an item to be given accounting recognition is the probability
of future economic benefits associated with the element.
The concept of probability is used in the recognition criteria to refer to the degree
of uncertainty that the future economic benefits associated with the item will flow to or
from the equity.
Assessments of the degree of uncertainty attached to the flow of future economic
benefits are made on the basis of evidence available when the financial statements are
prepared.
For example, when it is probable that a receivable owed to an entity will be paid,
it is then justifiable, in the absence of any evidence to the contrary, to recognize the
receivable as an asset.
In the same manner, if the evidence dictates that the debtor failed to pay its
financial obligations on maturity date, then it would be justifiable to recognize losses as
a result of the impairment of the receivable. There is a reasonable degree of probability
in this case, hence, it warrants recognition of the event in the financial statements.
The criterion of the probability of future economic that will flow to or from the
business is based on the following:
1. Evidence associated with the event
2. Professional expertise and judgment of the preparer

RELIABILITY OF MEASUREMENT
The second criterion for the recognition of an item is that it processes a cost or
value that can be measured with reliability.
This criterion requires that an event or transactions should have monetary value
in order to be recognized in the financial statements, and the amount can be measures
with reliability. Reliability implies that the amount or value is based on evidence or
supporting documents.
In many cases, cost or value must be estimated. The use of reasonable
estimates is an essential part of the preparation of financial statements and does not
undermine their reliability.
For example, the expected proceeds from a lawsuit may meet the definition of
both an asset and income as well as the probability criterion for recognition. However, if
it not possible for the claim to be measured reliably, it should not be recognized as an
asset or a s income. The existence of the claim would be disclosed in the notes,
explanatory material or supplementary schedules.
Disclosure is appropriate when knowledge of the item is considered to be
relevant to the evaluation of the financial position, performance and changes in financial
position of an entity by the users of financial statements.
RECOGNITION PRINCIPLES
The Framework enumerates four recognition principles to be observed in the
preparation and presentation of the financial statements as follows:
1. Asset recognition
2. Liability recognition principle
 3. Income recognition principle
4. Expense recognition principle

Asset Recognition Principle

The asset recognition principle dictates that asset is recognized in the statement
of financial position when it is probable that the future economic benefit will flow to the
entity and the asset has a cost or value that can be measured reliably.
Expenditure made where there is improbability of inflow of economic benefits to
the entity beyond the current accounting period will not be recognized in the statement
of financial position. This type of transaction, however, will be given accounting
recognition in the statement of comprehensive income or expense.

Liability Recognition Principle

Liability is recognized in the statement of financial position when it is probable
that an outflow of resources embodying economic benefits will result from the
settlement of a present obligation and the amount can be measured reliably.
Obligation under contracts that are equally proportionately unperformed are not
recognized in the statement of financial position as liabilities. For example, inventory
ordered from supplier but not yet received will not be considered liability.

Income Recognition Principle

Income is recognized in the statement of comprehensive income when an
increase in future economic benefits related to an increase in an asset or a decrease of
a liability has arisen that can be measured reliably.
Recognition of income occurs simultaneously with the recognition of increases in
asset or decreases in liabilities. For example, income is recognized when there is an
increase in asset arising from sale of goods or services. Similarly, an income is
recognized when there is a decrease in liability from a waiver in debt payable.
The normal procedure of recognizing income occurs when the revenue has been
earned already.

Expense Recognition Principle

Expenses are recognized in the statement of comprehensive income when a
decrease in future economic benefits related to a decrease in an asset or an increase of
a liability has arisen that can be measured reliably.
Recognition of expense also occurs simultaneously with the recognition of an
increase in liabilities or decrease in assets.
Apparently, expenses are incurred because of expected revenues in the future. It
is just proper to recognize expenses by matching them against the expected revenues.
The Framework mentioned four methods or procedures of recognizing expense
in the statement of comprehensive income, namely:

1. Matching of cost with revenues

2. Systematic and rational allocation
3. Immediate recognition
4. Non-matching principle
Matching of Cost with Revenue
This process of recognizing expense involves the simultaneous recognition of
revenues and expenses that result directly and jointly from the same transactions and
events. In other words, expenses will not be recognized in the statement of
comprehensive income unless revenues are recognized.
Because there is an actual cause-and-effect relationship existing between
revenues and expenses, this method is sometime termed as “cause and effect
association principle.”

Systematic and Rational Allocation

This method of recognizing expense is used when the economic benefits
expected from the assets will benefit more than one accounting period.
Oftentimes, this method applies to the expenses of using property, plant and
equipment by simply allocating the costs on systematic and rational basis. Hence,
expenses are recognized in the accounting period in which the economic benefits
associated with the assets are consumed or expire.
The recognition of depreciation on property, plant and equipment, the
amortization of intangible assets, the allocation of prepaid items are concrete examples
of the application of systematic and rational allocation.
There is no cause-and-effect relationships that exists between revenues and
expenses in systematic and rational allocation.

Immediate Recognition
Under this expense recognition principle, expenses are recognized immediately
in the statement of comprehensive income under the following instances:
a. When expenditures produce no future economic benefits,
b. When expenditures do not qualify for recognition in the statement of financial
position.
The relationship that exists between revenues and expenses in the immediate
recognition principle is considered indirect.
Thee amount of salaries of the administrative personnel is concrete examples
under this method of recognizing expenses. This type of expense does not provide
future economic benefits to the entity, hence, it is recognized outright in the period
incurred.

Non-Matching Principle
The last method of recognizing expense in the statement of comprehensive
income mentioned in the Framework occurs in those cases when a liability is incurred
without the recognition of an asset.

MEASUREMENT OF THE ELEMENTS

Measurement is the process of determining the monetary amount at which the
elements of the financial statements are to be recognized and carried in the statement
of financial position and statement of comprehensive income. This involves the
selection of the particular basis of measurement.
 A number of different measurement bases are employed to different degrees and
in varying combinations in financial statements. They include the following:
1. Historical Cost – Assets are recorded at the amount of cash or cash
equivalents paid or the fair value of the consideration given to acquire them at
the time of their acquisition.
Liabilities are recorded at the amount of proceeds received in
exchange for the obligation, or in some circumstances, at the amounts of
cash or cash equivalents expected to be paid to satisfy the liability in the
normal course of business.

2. Current Cost – Assets are carried at the amount of cash or cash equivalents
that would have to be paid if the same or an equivalent asset was acquired
currently.
Liabilities are carried at undiscounted amount of cash or cash
equivalents that would be required to settle the obligation currently.
3. Realizable Cost – Assets are carried at the amount of cash or cash
equivalents that could currently be obtained by selling the assets in an orderly
disposal.
Liabilities are carried at their settlement values, that is, the undiscounted
amounts of cash or cash equivalents expected to be paid to satisfy the
liabilities in the normal course of business.

4. Present Value – Assets are carried at present discounted value of the future
net cash flows that the item is expected to generate in the normal course of
the business.
Liabilities are carried at the present discounted value of the future net
cash outflows that are expected to be required to settle the liabilities in the
normal course of business.
The measurement basis most commonly adopted by entities in preparing their
financial statements is historical cost

CONCEPT OF CAPITAL
Another area covered by the Framework is the concept of Capital. This concept
relates to the measurement of the items that affect the capital of the owners.
Profit is frequently used as a measure of performance or as the basis for other
measures, such as return on investment or earnings per share. The elements directly
related to the measurement of profit are income and expenses.
The recognition and measurement of income, expenses and profit depends in
part on the concept of capital and capital maintenance used by the entity in preparing its
financial statements.
In measuring the financial performance, an entity may use the following
approaches:
1. Transaction approach, or
2. Capital maintenance approach

Transaction Approach – computes profit by deducting expenses incurred from

realized. If the income is more than expenses, the difference is known as profit;
otherwise, the difference is termed net loss.
In formula, the profit or loss is computed as follows:
 Revenue xxxxx
Less: Expenses xxxxx
Net income (loss) xxxxx

Capital Maintenance Approach calculates profit by determining the excess amount

after maintaining the value of the beginning capital.
There are two variations in the Framework to determine profit or loss using the
capital maintenance approach. These are the:
1. Financial capital
2. Physical capital

Financial Capital
Under this concept, a profit is earned only if the financial amount of the net
assets at the end of the period exceeds the financial amount of net assets at the
beginning of the period, after excluding any distributions to, and contributions from,
owners during the period. However, if the amount of net assets at the end of the period
is less that the net assets at the beginning of the period, there arises net loss.
The term “net assets” refers to the excess of total assets over the total liabilities
of the business.
The profit or loss is computed as follows:
Net assets, ending xxxxx
Less: Net assets, beginning xxxxx
Net Profit (Loss) xxxxx

Financial Capital Maintenance can be measured in either nominal monetary units

or units of constant purchasing power.
A financial concept is adopted by most entities in preparing their financial
statements.

PHYSICAL CAPITAL
The other variation of capital maintenance approach in determining income or
loss is the physical capital.
Under this concept, profit is earned only if the physical productive capacity or
operating capacity of the entity at the end of the period exceeds the physical productive
capacity at the beginning of the period after excluding any distributions to and
contributions from, owners during the period.
The concept of physical capital defines capital in terms of the physical productive
and profit represents the increase in the capital over the period.
An example of productive capacity of an entity may be units of outputs per day.
The physical capital concept requires the adoption of the current cost as the
basis of measurement.
SELECTION OF METHODS
The selection of the appropriate concept of capital by an entity should be based
on the needs of the users of its financial statements.
 A financial concept of capital should be adopted if the users of financial
statements are primarily concerned with the maintenance of nominal invested capital or
the purchasing power of invested capital.
However, if the main concerns of the users is with the operating capacity of the
entity, a physical concept of capital should be used.
The concept chosen indicates the goal to be attained in determining profit, even
though there may be some measurement difficulties in making the concept operational.
The selection of the measurement bases and concept of capital maintenance will
determine the accounting model used in the preparation of the financial statements.
Different accounting models exhibit different degrees of relevance and reliability.
However, as of this writing, the two concepts of capital maintenance mentioned
in the Framework in determining the Financial performance of the entity are not
commonly applied.
At present, the most common and popular method adopted in determining the
financial performance of the entities is the transaction approach.
The transaction approach is widely covered in the introductory accounting
subject.

CHAPTER QUIZ
Answer the following questions for 5 points each. Please use a separate sheet. For next
week’s submission.

1. In your own understanding, define Accounting.

2. Describe Accounting in the Philippines.
3. What is the significance of Accounting in an entity?
4. Explain briefly the steps in Accounting cycle.
5. Discuss the objective of financial statements
6. Describe statement of financial position.
7. What is the ultimate goal of an entity? Explain.