CONCEPTUAL FRAMEWORK
CHAPTER 5: ELEMENTS OF FINANCIAL
STATEMENTS
ELEMENIS 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 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.
The presentation of these elements in the statement of
financial position and the income statement involves a
process of classification and subclassification.
For example, assets and liabilities may be classified by
their nature or function in the business of the entity in
order to display information in a manner most useful to
users for purposes of making economic decisions.
The elements directly related to the measurement of
financial position are:
A. Asset
B. Liability
C. Equity
The elements directly related to the measurement of
financial performance 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 the income statement.
Equity is the residual interest in the assets of the entity
after deducting all of the liabilities.
ASSET
Under the Revised Conceptual Framework, an asset is
defined as a present economic resource controlled by the
entity as a result of past events.
An economic resource is a right that has the potential to
produce economic benefits.
The new definition clarifies that an asset is an economic
resource and that the potential economic benefits no
lonser need to be expected to flow to the entity.
Essential characteristics of asset
a. The asset is a present economic resource.
b. The economic resource is a right that has the
potential to produce economic benefits.
c. The economic resource is controlled by the entity
as a result of past events.
Right
Rights that have the potential to produce economic
benefits may take the following forms:
1. Rights that correspond to an obligation of
another entity
a. Right to receive cash
b. Right to receive goods or services
c. Right to exchange economic resources
with another party on favorable terms
d. Right to benefit from an obligation of
another party if a specified uncertain
future event occurs
2. Rights that do not correspond to an obligation of
another entity.
a. Right over physical objects, such as
property, plant and equipment or
inventories
b. Right to intellectual property
3. Rights established by contract or legislation such
as owning a debt instrument or an equity
instrument or owning registered patent.
Potential to produce economic benefits
An economic resource is a right that has the potential to
produce economic benefits.
For the potential to exist, it does not need to be certain or
even likely that the right will produce economic benefits.
It is only necessary that the right already exists.
A right can meet the definition of an economic resource
even if the probability that it will produce economic
benefit is low.
The economic resource is the present right that contains
the potential and not the future economic benefits that the
right may produce.
An economic resource could produce economic benefits
if an entity is entitled:
a. To receive contractual cash flows
b. To exchange economic resources with another
party on favorable terms
c. To produce cash inflows or avoid cash outflows
d. To receive cash by selling the economic resource
e. To extinguish a liability by transferring an
economic resource
Control of an economic resource
An entity controls an asset if it has the present ability to
direct the use of the asset and obtain the economic
benefits that flow from it.
Control also includes the ability to prevent others from
using such asset and therefore preventing others from
obtaining the economic benefits from the asset.
Control may arise if an entity enforces legal rights.
If there are no legal rights, control can still exist if an
entity has other means of ensuring that no other party can
benefit from an asset.
For example, an entity has access to technical know-how
and has the ability to keep this know-how secret.
LIABILITY
Under the Revised Conceptual Framework, a liability is
defined as present obligation of an entity to transfer an
economic resource as a result of past events.
The new definition clarifies that a liability is the
obligation to transfer an economic resource and not the
ultimate outflow of economic benefits.
The out flow of economic benefits no longer needs to be
expected similar to the definition of an asset.
The new definition of liability to some extent is
inconsistent with the definition of liability under IAS 37.
In case of conflict, the IASB stated that the requirements
of a Standard shall always prevail over the Conceptual
Framework.
Essential characteristics of liability
a. The entity has an obligation.
The entity liable must be identified. However, it
is not necessary that the payee or the entity to
whom the obligation is owed be identified.
b. The obligation is to transfer an economic
resource.
c. The obligation is a present obligation that exists
as a result of past event.
This means that a liability is not recognized until
it is incurred.
Obligation
An obligation is a duty or responsibility that an entity has
no practical ability to avoid. Obligations can either be
legal or constructive.
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
Transfer of an economic resource
Obligations to transfer an economic resource include:
a. Obligation to pay cash
b. Obligation to deliver goods or noncash resources
c. Obligation to provide services at some future
time.
d. Obligation to exchange economic resources with
another party on unfavorable terms.
e. Obligation to transfer an economic resource if
specified uncertain future event occurs
Past event
An obligation exists as a result of past event if both of the
following conditions are satisfied:
a. An entity has already obtained economic
benefits.
b. An entity must transfer an economic resource.
Definition of income
Income is defined as increases in assets or decreases in
liabilities that result in increases in equity, other than
those relating to contributions from equity holders.
The definition of income has changed to reflect the
change in the definition of assets and liability.
Income encompasses both revenue and gains.
Revenue arises in the course of the ordinary regular
activities and is referred to by variety of different names
including sades, 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 the ordinary
regular activities.
Gains include gain from disposal of noncurrent asset,
unrealized gain in trading investment and gain from
expropriation.
Statement of financial performance
The Revised Conceptual Framework introduces the term
statement of financial performance.
The statement of financial performance refers to the
income statement and a statement presenting other
comprehensive income.
The income statement or statement of profit or loss is the
primary source of information about an entity's financial
performance. As a general rule, all income and expenses
are included in profit or loss.
However, in developing accounting standards, there are
some items of income and expenses that are included in
other comprehensive income and not in profit or loss if
such presentation would provide more relevant and
faithfully represented information about financial
performance.
There are instances that an amount in other
comprehensive income in one reporting period may be
recycled to profit or loss in another reporting period.
Such recycling is permitted as long as it would result to
relevant and faithfully represented information about
financial performance.
Definition of expense
Expense is defined as decreases in assets or increases in
liabilities that result in decreases in equity, other than
those relating to distributions to equity holders.
The definition of expense has changed to reflect the
change in the definition of asset and liability.
Expenses encompass losses as well as those expenses that
arise in the course of the ordinary regular activities.
Expenses that arise in the course of ordinary regular
activities include cost of goods sold, wages and
depreciation.
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.
CHAPTER 6: RECOGNITION AND
MEASUREMENT
RECOGNITION
The Revised Conceptual Framework defines recognition
as the process of capturing for inclusion in the financial
statements an item that meets the definition of an asset,
liability, equity, income, or expense.
The amount at which an asset, a liability or equity is
recognized in the statement of financial position is
reported as carrying amount.
Recognition links the elements to the statement of
financial position and statement of financial performance.
The statements are linked because the recognition of an
item in one statement requires the recognition of the same
item in another statement.
For example, the recognition of income happens
simultaneously with the recognition of an increase in asset
or decrease in liability.
The recognition of expense happens simultaneouly with
the recognition of a decrease in asset or increase in
liability.
Recognition criteria
Only items that meet the definition of an asset, a liability
or equity are recognized in the statement of financial
position.
Similarly, only items that meet the definition of income or
expense are recognized in the statement of financial
performance.
In addition to meeting the definition of an element, items
are recognized only when their recognition provides users
of financial statements with information that is both
relevant and faithfully represented.
Recognition does not focus anymore on how probable
economic benefits will flow to or from the entity and that
the cost can be measured reliably.
An asset or liability and any corresponding income or
expense can exist even if the probability of inflow or
outflow of the benefits is low.
Point of sale income recognition
The basic principle of income recognition is that income
shall be recognized when earned.
But the question is when is income considered to be
earned?
With respect to the sale of goods in the ordinary course of
business the point of sale is unquestionably 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 the goods.
Stated differently, legal title to the goods passes to the
buyer at the point of sale.
Moreover, it is at the point of sale that the entity has
transferred control of the goods to the customer.
However, under certain conditions, income may be
recognized at the point of production, during production
and at the point of collection.
Expense recognition
The expense recognition principle means that expenses
are recognized when incurred.
But the question is when are expenses incurred?
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.
There is no gain if there is no pain.
The matching principle requires that those costs and
expenses period 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 the cause and effect association, the expense is
recognized when the revenue is already recognized.
The reason is the presumed direct association of the
expense with specific income. The cause and effect
association principle is actually the strict matching
concept.
This matching process, commonly referred to as the
matching of cost with revenue, involves the simultaneous
or combined recognition of revenue and expenses that
result directly and jointly from the same transactions or
events.
The best example is the cost of merchandise inventory.
Such cost is considered as an asset in the meantime that
the merchandise is on hand.
When the merchandise is sold, the cost is expensed in the
form of cost of goods sold because at such time revenue
can now be recognized.
Other examples include doubtful accounts, warranty
expense and sales commissions.
Systematic and rational allocation
Under systematic and rational allocation, some costs are
expensed by 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
quality 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.
Derecognition
The Revised Conceptual Framework introduced the term
derecognition.
Derecognition is defined as the removal of all or part of a
recognized asset or liability from the statement of
financial position.
Derecognition normally occurs when an itern no longer
meets the definition of an asset or a liability.
Derecognition of an asset occurs when the entity loses
control of all or part of the asset.
Derecognition of a liability occurs when the entity no
longer has a present obligation for all or part of the
liability.
MEASUREMENT
Measurement is defined as quantifying in monetary terms
the elements in the financial statements.
The Revised Conceptual Framework mentions two
categories:
a. Historical cost
b. Current value
HISTORICAL COST
The historical cost or original acquisition cost of an asset
is the cost incurred in acquiring or creating the asset
comprising the consideration paid plus transaction cost.
The historical cost of a liability is the consideration
received to incur the liability minus transaction cost.
Simply stated, historical cost is the entry price or entry
value to acquire an asset or to incur a liability.
An application of the historical cost measurement is to
measure financial asset and financial liability at amortized
cost.
The amortized cost reflects the estimate of future cash
flows discounted at a rate determined at initial
recognition.
Historical cost updated
1. Historical cost of an asset is updated because of:
a. Depreciation and amortization
b. Payment received as a result of disposing
part or all of the asset
c. Impairment
d. Accrual of interest to reflect any
financing component of the asset
e. Amortized cost measurement of financial
asset
2. Historical cost of a liability is updated because of.
a. Payment made or satisfying an obligation
to deliver goods
b. Increase in value of the obligation to
transfer economic resources such that the
liability becomes onerous
c. Accrual of interest to reflect any
financing component of the liability
d. Amortized cost measurement of financial
liability
CURRENT VALUE
Current value includes:
a. Fair value
b. Value in use for asset
c. Fulfillment value for liability
d. Current cost
Fair value
Fair value of an asset is the price that would be received
to sell an asset in an orderly transaction between market
participants at measurement date.
Fair value of liability is the price that would paid to
transfer a liability in an orderly transaction between
market participants at the measurement date.
Fair value is an exit price or exit value.
Fair value can be observed directly using market price of
the asset or liability in an active market.
In cases where fair value cannot be directly measured, an
entity can use present value of cash flows.
Fair value is not adjusted for transaction cost. The reason
is that such cost is a characteristic of the transaction and
not of the asset or liability.
Value in use
Value in use is the present value of the cash flows that an
entity expects to derive from the use of an asset and from
the ultimate disposal.
Value in use does not include transaction cost on acquiring
the asset but includes transaction cost on the disposal of
the asset.
Value in use is an exit price or exit value.
Fulfillment value
Fulfillment value is the present value of cash that an entity
expects to transfer in paying or settling a liability.
Fulfillment value does not include transaction cost on
incurring a liability but includes transaction cost on
fulfillment of a liability.
Fulfillment value is an exit price or exit value.
Current cost
Current cost of an asset is the cost of an equivalent asset
at the measurement date comprising the consideration
paid and transaction cost.
Current cost of a liability is the consideration that would
be received less any transaction cost at measurement date.
Similar to historical cost, current cost is also based on the
entry price or entry value but reflects market conditions
on measurement date.
Selecting a measurement basis
In selecting a measurement basis for an asset or a liability
and for the related income and expense, it is necessary to
consider the nature of the information that the
measurement basis will produce.
In most cases, no single factor will determine which
measurement basis should be selected.
The relative importance of each factor will depend on
facts and circumstances.
The information produced by the measurement basis must
be useful to the users of financial statements.
To achieve this, the information must be both relevant and
faithfully represented.
Historical cost is the measurement basis most commonly
adopted in preparing financial statements.
In many situations, it is simpler and less costly to measure
historical cost than it is to measure a current value.
In addition, historical cost is generally well understood
and verifiable.
The IASB did not mandate a single measurement basis
because the different measurement bases could produce
useful information under different circumstances.
CHAPTER 7: PRESENTATION AND DISCLOSURE
CONCEPTS OF CAPITAL
PRESENTATION AND DISCLOSURE
The presentation and disclosure can be an effective
communication tool about the information in financial
statements.
A reporting entity communicates information about its
assets, liabilities, equity, income and expenses by
presenting and disclosing information in the financial
statements.
Effective communication of information in financial
statements makes the information more relevant and
contributes to a faithful representation of an entity's assets
liabilities, income and expenses.
Effective communicator. of information in financial
statements also enhances the understandability and
comparability of information in the financial statements.
Effective communication in financial statements is
supported by not duplicating information in different
parts of the financial statements.
Duplication is usually unnecessary and can make
financial statements less understandable.
Classification
Classification is the sorting of assets, liabilities, equity,
income and expenses on the basis of shared or similar
characteristics.
Classifying dissimilar assets, liabilities, equity, income
and expenses can obscure relevant information, reduce
understandability and comparability and may not provide
a faithful representation of financial information.
For example, it could be appropriate to classify an asset
or a liability into current and noncurrent.
It may be necessary to classify components of equity
separately if such components are subject to legal,
regulatory and other requirements.
Thus, ordinary share capital, preference share capital,
share premium and retained earnings should be disclosed
separately.
Classification of income and expenses Return of capital is an erosion of the capital invested in
the entity.
Income and expenses are classified as components of
profit lass and components of other comprehensive The Conceptual Framework considered two concepts of
income. capital maintenance or well-offness, namely financial
capital and physical capital.
The Revised Conceptual Framework has introduced the
term statement of financial performance to refer to the Financial capital
income statement together with the statement presenting
Under a financial capital concept, such as invested money
other comprehensive income.
or invested purchasing power, capital is synonymous with
The income statement or statement of profit or loss is the net assets or equity of the entity.
primary source of information about an entity's financial
Financial capital is the monetary amount of the net assets
performance for the reporting period.
contributed by shareholders and the amount of the
All income and expenses should be appropriately increase in net assets resulting from earnings retained by
classified and included in the income statement. the entity.
However, there are certain items of income and expenses Financial capital is the traditional concept based on
that are presented outside of profit or loss but included in historical cost and adopted by most entities.
other comprehensive income.
Net income under financial capital
The components of other comprehensive income are
Under the financial capital concept, net income occurs
subsequently recycled or reclassified either to profit or
when the nominal amount of the net assets at the end of
loss or retained earnings.
the year exceeds the nominal amount of the net assets at
Aggregation the beginning of the period, after excluding distributions
to and contributions by owners during the period.
Aggregation is the adding together of assets, liabilities,
equity, income and expenses that have similar or shared Illustration
characteristics and are included in the same
The following assets, liabilities and other financial data
classification.
pertain to the current vear:
Aggregation makes information more useful by
summarizing a large volume of detail. However, January 1 December 31
Total assets 1,500,000 2,500,000
aggregation may conceal some of the detail.
Total liabilities 1,000,000 1,200,000
Hence, a balance should be made so that relevant Additional investments 400,000
during the year
information is not obscured either by a large amount of Dividends paid during 300,000
insignificant detail or by excessive aggregation. the year

Typically, the statement of financial position and the

statement of financial performance provide summarized Computation of net income
or condensed information.
Net Assets – December 31 1,300,000
More detailed information is provided in the notes to Add: Dividends paid 300,000
financial statements. Total 1,600,000
Less: Net Assets – January 1 500,000
CAPITAL MAINTENANCE Additional investments 400,000 900,000
The financial performance of an entity is determined Net Income 700,000
using two approaches, namely transaction approach and
capital maintenance approach. The amount of net assets is the excess of total assets over
The transaction approach is the traditional preparation of the total liabilities.
an income statement. This is the reason this approach is also known as the net
The capital maintenance approach means that net income assets approach.
occurs only after the capital used from the beginning of Physical capital
the period is maintained.
Physical capital is her quantitative measure of the
In other words, net income is the amount an entity can physical productive capacity to produce goods and
distribute to its owners and be as "well-off” at the end of services.
the year as at the beginning.
The physical productive capacity may be based on, for
The distinction between return of capital and return on example, units of output per day or physical capacity of
capital is important to the understanding of net income. productive assets to produce goods and services.
Shareholders invest in entity to earn a return on capital or This concept requires that productive assets be measured
an amount in excess of their original investment. at current cost, rather than historical cost
Productive assets include inventories and property, plant
and equipment.
The current costs for these productive assets must be
maintained in order that physical capital is also
maintained.
Accordingly, physical capital is equal to the net assets of
the entity expressed in terms of current cost.
The physical concept of capital should be adopted if the
main concern of users is the operating capability of the
entity, meaning, the resource or fund needed to achieve
that operating capability or capacity.
Under physical capital concept, net income occurs when
the physical productive capital of the entity at the end of
the year exceeds the physical productive capital at the
beginning of the period, also after excluding,
distributions to and contributions from owners during the
period.
Illustration
Assume in the previously given illustration, the net assets
Of P500,000 on January 1 had a current cost of PS00,000
by reason of inflationary condition.

Net Assets – December 31 1,300,000

Add: Dividends paid 300,000
Total 1,600,000
Less: Net Assets at current 800,000
cost – January 1
Additional investments 400,000 1,200,000
Net Income 400,000