CHAPTER 4

Conceptual
Framework:
Elements of Financial Statements
 Definition
The elements of financial statements refer to the quantitative
information reported in the statement of financial position and
income statement.
The elements of financial statements are the “building blocks” from
which financial statements are constructed.
These elements are the broad classes of events or transactions that
are grouped according to their economic characteristics.
The elements directly related to the measurement of financial position
in the statement of financial position are:
a. Asset
b. Liability
c. Equity
The elements directly related to the measurement of financial
performance in the income statement are:
a. Income
b. Expense
The Conceptual Framework identifies no elements that are unique
to the statement of changes in equity because such statement
comprises items that appear in the statement of financial position
and the income statement.
Equity is the “residual interest in the assets of the entity after
deducting all the liabilities”
 RECOGNITION OF ELEMENTS
Recognition is a term which means the reporting of an asset,
liability, income, or expenses on the face of the financial statements
of an entity.
There are four main recognition principles to be followed in the
preparation and presentation of financial statements, as explicitly
enumerated in the Conceptual Framework, namely:
a. Asset Recognition Principle
b. Liability Recognition Principle
c. Income Recognition Principle
e. Expense Recognition Principle
Asset Recognition Principle
An asset is defined as “a resource controlled by the entity as a
result of past events and from which future economic benefits are
expected to flow to the entity”.
An asset is recognized when it is probable that future economic
benefits will flow to the entity and the asset has a cost or vale that
can be measured reliably.
Thus two conditions must be present for the recognition of an asset:
a. It is probable that future economic benefits will flow to the
entity.
The term “probable” means that the chance of the future
economic benefit arising is more likely rather than less likely.
b. The cost or value of the asset can be measured reliably.
Future Economic Benefit
The Future Economic Benefit embodied in an asset is the potential to
contribute directly or indirectly to the flow of cash and cash equivalents to the
entity
The potential may be a productive one that is part of the operating activities of
the entity.
It may also take the form of convertibility into cash or cash equivalents or a
capability to reduce cash outflows such as when an alternative manufacturing
process lowers the costs of production.
The future economic benefit embodied in an asset may flow to the entity in a
number of ways, for example, by being:
a. Used singly or in combination with other assets in the production of
goods or services to be sold by the entity.
b. Exchange for other assets
c. Used to settle a liability
d. Distributed to the owners of the entity
Cost Principle
Inherent in asset recognition is the cost principle.

The cost principle requires that assets should be recorded initially at original
acquisition cost.

This initial cost may be carried without change, may be change by depreciation,
amortization or write off, or may be shifted to other categories as in the case of
raw materials being converted into finished goods.

But the question is “how much is cost?”

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

In a noncash or an exchange transaction, the cost is equal to the fair market

value of an asset given or fair value of the asset received, whichever is clearly
evident.

In the absence of fair value, the cost is equal to the carrying amount of the asset
given.
Liability Recognition Principle
A liability is defined as “a present obligation arising from past events
that the settlement of which is expected to result in an outflow from the
entity of resources embodying economic benefits”.

A liability is recognized when it is probable that an outflow of resources

embodying economic benefits will be required for the settlement of a
present obligation and the amount of the obligation can be measured
reliably.

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

a. It is probable that an outflow of economic benefits will be required

for the settlement of a present obligation.

b. The amount of obligation can be measure reliably.

Liabilities
An essential characteristics of a liability is that the entity has a
present obligation which may be legal or constructive.
Obligations must be legally enforceable as a consequence of a
binding contact or statutory requirement.
This is normally the case, for example, with accounts payable for
goods and services received.
Constructive obligations arise from normal business practice,
custom and a desire to maintain good business relations or act in
an equitable manner.
For example, an entity decides as a matter of policy to rectify
faults in the products even when these become apparent after the
warranty period.
Settlement of liability
Settlement of a present obligation may occur in a number of ways,
for example, by:
a. Payment of cash
b. Transfer of noncash assets
c. Provision of services
d. Replacement of the obligation with another obligation
e. Conversions of obligation into equity
Definition of Income
Income is “increase in economic benefit during the accounting period
in the form of inflow or increase in asset or decrease in liability that
results in increase in equity, other than contribution from equity
participants”

The definition of income encompasses both revenue and gains.

Revenue arises in the course of the ordinary regular activities and is

referred to by a variety of different names including sales, fees, interest,
dividends, royalties and rent.

The essence of revenue is regularity.

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

For example gains include gain from disposal of noncurrent assets,

unrealized gain on trading securities and gain from expropriation.
Income Recognition Principle
The basic principle is that “income shall be recognized when earned”.

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

The Conceptual Framework provides that “income is recognized when it is

probable that an increase in future economic benefits related to an
increase in an asset or a decrease in a liability has arisen and that the
increase in economic benefits can be measured reliably”.

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

namely:

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

a result of an increase in an asset or a decrease in a liability.

b. The economic benefits can be measured reliably.

Point of Sale
Undoubtedly, the two conditions for income recognition are
present at the point of sale. Accordingly, the point of sale is the
point of income recognition.
The reason is that the point of sale that the entity has transferred
to the buyer the significant risk and rewards of ownership of the
goods.
Stated differently, legal title to the goods passes to the buyer at the
point of sale.
Incidentally, the point of sale is usually the point of delivery, which
may be actual or constructive.
Legally, it is delivery that transfers ownership from the seller to
the buyer.
Revenue from sale of goods
In general the following conditions should be present for the
recognition of revenue from sale of goods
a. The entity has transferred to the buyer the significant risks
and rewards of ownership of the goods.
b. The entity retains neither continuing managerial
involvement nor effective control over the goods sold.
c. The amount of revenue can be measured reliably.
d. It is probable that economic benefits associated with the
transaction will flow to the entity.
e. The cost incurred or to be incurred in respect of the
transaction can be measured reliably.
Revenue from Rendering of
Services
In general, the following conditions should be presented for the
recognition of revenue from rendering of services:
a. The amount of revenue can be measured reliably.
b. It is probable that the economic benefits associated with the
transaction will flow to the entity.
c. The stage of completion of the transaction at the end of
reporting period can be measured reliably.
d. The cost incurred for the transaction and the costs to
complete can be measured reliably.
Exceptions to the point of sale
1. Installment Method – Revenue is recognized at the point of collection.

The amount of revenue is determined by multiplying the gross profit rate

by the amount of collections.

The reason for the installment method is the uncertainty of collection or

the possibility of cancelation of the installment sales contract.

2. Cost recovery method or sunk cost method – revenue is recognized also

at the point of collection.

However, unlike the installment method, all collections are first applied to
the cost of the merchandise sold.

When the cost of the merchandise sold is fully recovered through

collections, then all subsequent collections are considered revenue.

This method is usually followed when the collection of the installment

sales contract is very uncertain or highly speculative.
3. Cash Method – Revenue is recognized when received regardless of when
earned. In other words, all collections are treated as revenue. There are no
accruals and Deferrals.

Like the cost recovery method, this approach may be used when there is
considerable uncertainty in the ultimate collection of sales price.

4. Percentage of completion method – when the outcome of a

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

5. Production method – Revenue is recognized at the point of production.

The production method is applicable to agricultural, forest and mineral

products.

The production method is allowed when a sale is assured under a

forward contract or a government guarantee, or when a homogenous
market exists and there is a negligible risk of failure to sell.
Other income recognition
Interest Revenue shall be recognized on a time proportion basis that take into
account the effective yield on the asset.

Royalties shall be recognized on an accrual basis in accordance with the

substance of the relevant agreement.

Dividends shall be recognized as revenue when the shareholder’s right to

receive payment is established, meaning when the dividends are declared.

Installation Fees are recognized as revenue over the period of installation by

reference to the stage of completion.

Subscription Revenue should be recognized on a straight line basis over the

subscription period.

Admission Fees are recognized as revenue when the event takes place

Tuition Fees are recognized as revenue over the period in which tuition is
provided
Definition of Expense
Expense is “decrease in economic benefit during the accounting
period in the form of an outflow or decrease in asset or increase in
liability that results to the decrease in equity, other than
distribution to equity participants”.
Expense encompasses 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, for example, cost of sales, wages and depreciation.
Losses do not arise in the course of the ordinary regular activities
and include losses resulting from disasters.
Examples included losses from fire, flood, storm surge,
tsunami, and hurricane, as well as those arising from disposal of
noncurrent assets.
Expense recognition principle
The basic expense recognition principle means that “ expenses are
recognized when incurred”.
But the question is when are expenses incurred?
The Conceptual Framework provides that “expenses are recognized
when it is probable that a decrease in future economic benefits
related to decrease in an asset or an increase in liability has occurred
and that the decrease in economic benefits can be measured reliably”.
Thus two conditions must be present for the recognition of expenses:
a. It is probable that a decrease in future economic benefits has
occurred as a result of a decrease in an asset or an increase in a
liability
b. The decrease in economic benefits can be measured reliably.
Matching Principle
Actually, the expense recognition principle is the application of the
matching principle.
The generation of revenue is not without any cost. There has got to be
some cost in earning a revenue.
“There is no gain, if there is no pain”
The matching principle requires that “ those costs and expenses
incurred in earning a revenue shall be reported in the same period”.
The matching principle has three applications, namely:
a. Cause and Effect Association
b. Systematic and Rational Allocation
c. Immediate Recognition
Cause and Effect Association
Under this principle, the expense is recognized when the revenue is already
recognized.

The reason is the presumed direct association of the expense with specific items
of income. This is actually the “strict matching concept”.

This process, commonly referred to as the matching of cost with revenue, involves
the simultaneous or combined recognition of revenue 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 in on

hand.

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

Other examples include doubtful accounts, warranty expense and sales

commissions.
Systematic and Rational Allocation
Under this principle, some cost 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, expense are recognized on the
basis of systematic and allocation procedures.
Concrete example include depreciation of property, plant and
equipment, amortization of intangibles, and allocation of prepaid
rent, insurance, and other prepayments.
Immediate Recognition
Under this principle, the cost incurred is expensed outright, because of
uncertainty of future economic benefits or difficulty of reliably associating
certain costs with future revenue.

An expense is recognized immediately:

a. When an expenditure produces no future economic benefit.

b. When cost incurred does not qualify or ceases to qualify for

recognition as an asset.

Examples include officers’ salaries and most administrative expenses,

advertising and most selling expenses, amount to settle lawsuit and
worthless intangibles.

Many losses, such as loss from disposal of building, loss from sale of
investments, and casualty loss are immediately recognized because they are
not directly related to specific revenue.
Measure of Elements
Measurement is the process of determining the monetary
amounts at which the elements of the financial statements are to
be recognized and carried in the statement of financial position
and income statement.
There are four measurement bases or financial attributes, namely:
a. Historical Cost
b. Current Cost
c. Realizable Value
d. Present Value
Definition of Terms

a. Historical Cost is the amount of cash or cash equivalent paid

or the fair value of the consideration given to acquire an asset at
the time of acquisition.
This is also known as “Past purchase exchange price”.
Historical Cost is the measurement basis most commonly
adopted in preparing the financial statements.
b. Current Cost is the amount of cash or cash equivalent that
would have to be paid if the same or equivalent asset was acquired
currently.
This is also known as “Current purchase exchange price”.
c. Realizable Value is the amount of cash or cash equivalent that
could currently be obtained by selling the asset in an orderly
disposal.
This is also known as “Current sale exchange price”.
d. Present Value is the discounted value of the future net cash
inflow that the asset is expected to generate in the normal course
of business.
This is also known as “Future exchange price”.
Prepared by:
Group 4
 AMBAY, Marie Eugenie