Financial Accounting 3 /Chapter 1

New Conceptual Framework

Definition of accounting

“Accounting is the process of identifying, measuring and communicating economic information to permit
informed judgment and decision by users of the information.” – American Accounting Association (AAA)

“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.” – Accounting
Standards Council (ASC), succeeded by Financial Reporting Standards Council (FRSC).

Accounting process

From the definitions above, we can have the following processes and phases of accounting:

1. Identifying – this is the process of recognition or no recognition of business activities as accountable

events.

2. Measuring – this is the process of assigning amounts or value to the accountable economic
transactions and events.

3. Communicating – this is the process of preparing and distributing accounting reports to potential users
of accounting information. This process includes the following phases:

a. Recording – also called journalizing, involves the routine and mechanical process of committing to
writing business transactions and events on the books of accounts in a chronological sequence in
accordance with established accounting rules and procedures.

b. Classifying – this involves sorting or grouping of similar and interrelated transactions and events into
their respective classes. This is performed by posting accounts to ledger.

c. Summarizing – this involves the preparation of financial statements, which includes the balance sheet
(statement of financial position), income statement, statement of equity, statement of cash flows and
accompanying notes to the financial statements.

d. Interpretation – this involves analyzing the liquidity, solvency, stability and profitability of an entity.
Purpose of accounting

The purpose of accounting is to provide financial information to statement users so that they could make
informed judgment and better decision.

Accounting profession

Republic Act No. 9298 or the Philippine Accountancy Act of 2004

Different Fields of Accounting

1. Financial Accounting
2. Management Accounting
3. Cost Accounting
4. External Accounting
5. Tax Accounting
6. Government Accounting
*Accounting (constructive) VS auditing (analytical)

The work of an auditor begins when the work of the accountant ends.

Accounting (Conceptual) concerned with why, reason or justification for any action adopted VS
bookkeeping (procedural) concerns with the how of the accounting

*Accounting (particular field of accounting such as public, private and government accounting)
VS Accountancy (refers to the profession of accounting practice)

* Financial Accounting (focus on general purpose reports known as FS used by internal and
external users) VS Managerial Accounting (preparation of financial report for internal users only)

Generally Accepted Accounting Principles

----refers to a specific set of guidelines that have been established to help publicly-traded companies
create their financial statements.

Users of financial information

Accounting aims to supply financial information to the following users to assist them in making better
decisions.

1. Owners and management (proprietor, partners, stockholders and officers).

2. Investors
3. Employees and labour unions
4. Lenders or creditors
5. Suppliers
6. Customers
7. Government agencies (BIR, SEC, LGU, PSE and other regulatory agencies)
8. The public

4 Basic Accounting Assumptions

Are the basic notion or fundamental premises on which the accounting process is based. It serves as the
foundation of accounting in order to enhance the understanding and usefulness of the financial
statements.

1. Going Concern Assumption

The going concern principle, also known as continuing concern concept or continuity assumption, means
that a business entity will continue to operate indefinitely, or at least for another twelve months.

Financial statements are prepared with the assumption that the entity will continue to exist in the future,
unless otherwise stated.

The going concern assumption is the reason assets are generally presented in the balance sheet at cost
rather that at fair market value. Long-term assets are included in the books until they are fully utilized and
retired.

2. Accounting Entity Concept

The accounting entity concept recognizes a specific business enterprise as one accounting
entity, separate and distinct from the owners, managers, and employees of that business.
In other words, it means that a company has its own identity set apart from its owners or anyone else.
Personal transactions of the owners, managers, and employees must not be mixed with transactions of
the company.

3. Time Period (Periodicity)

The time period assumption, also known as periodicity assumption, means that the indefinite life of an
enterprise is subdivided into time periods (accounting periods) which are usually of equal length for the
purpose of preparing financial reports on financial position, performance and cash flows.

An accounting period is usually a 12-month period – either calendar or fiscal.

A calendar year refers to a 12-month period ending December 31. A fiscal year is a 12-month period
ending in any day throughout the year, for example, April 1 to March 31 of the following year.

The need for timely reports has led to the preparation of more frequent reports, such as
monthly or quarterly statements.

4. Monetary Unit Assumption

The monetary unit assumption has two characteristics – quantifiability and stability of the currency.

Quantifiability means that records should be stated in terms of money, usually in the currency of the
country where the financial statements are prepared.

Stability of the dollar (or euro, pound, peso, etc.), a.k.a. stable dollar concept means that the purchasing
power of the said currency is stable or constant and that any insignificant effect of inflation is ignored.

It is to be noted however that financial statements of a company reporting in the currency of a

hyperinflationary economy (an economy with very high inflation rate) must be restated, in accordance with
applicable accounting standards.

5. Accrual Basis of Accounting

The accrual method of accounting means that "revenue or income is recognized when earned regardless
of when received and expenses are recognized when incurred regardless of when paid".

The Conceptual Framework of Accounting

-----summary of terms and concepts that underlie the preparation and presentation of financial statement.

Other Principles Derived from the Above Concepts

Some of the other principles followed in accounting include:

Matching Principle – The matching concept means that expenses are recognized in the period the related
income is earned, and income is recognized in the period the related expenses are incurred. In essence,
income is matched with expenses and vice versa.

Through the accrual basis of accounting, better matching of income and expenses is achieved.

Revenue Recognition Principle – In accrual basis accounting, revenue or income is recognized when
earned regardless of when received. It means that income is recorded when the service is fully performed
or when sale occurs, even if the amount is not yet collected.

Expense Recognition Principle – Also under accrual basis accounting, expenses are recognized when
incurred regardless of when they are paid. In other words, expenses are recorded when used (incurred),
even if they are not yet paid.
Historical Cost Principle – Items in the balance sheet are generally presented at historical cost.
Nonetheless, some accounts are measured using other bases such as fair market value, current cost,
and discounted amount. You will learn

QUALITATIVE CHARACTERISTICS are the qualities or attributes that make financial

accounting information useful to the users.

Fundamental qualitative characteristics

1. Relevance
The capacity of the information to influence a decision.

Financial information has PREDICTIVE VALUE if it can be used as an input to processes employed
by users to predict future outcome.

Financial information has CONFIRMATORY VALUE if it provides feedback about previous

evaluations.

MATERIALITY or doctrine of convenience is a practical Rule in accounting which dictates that

strict Adherence to GAAP is not required when the items are not significant enough to affect evaluation,
decision and fairness of the financial statements.

2. Faithful representation
Financial reports represent economic phenomena or transactions in words or numbers

INGREDIENTS OF FAITHFUL REPRESENTATION

A. COMPLETENESS
Requires that relevant information should be presented in a way that facilitates understanding
and avoids erroneous implications.

STANDARD OF ADEQUATE DISCLOSURE

Disclosure of any financial facts significant enough to influence the judgment of
informed users.

NOTES TO FINANCIAL STATEMENTS

Provide narrative description or disaggregation of the items presented in the financial
statements and information about items that do not qualify for recognition.

B. NEUTRALITY or PRINCIPLE OF FAIRNESS

The information contained in the financial statements must be free from bias.

C. FREE FROM ERROR

There are no errors or omissions in the description of the phenomenon or transaction, and the
process used to produce the reported information has been selected and applied with no errors in
the process.
SUBSTANCE OVER FORM
If information is to represent faithfully the transactions and other events it purports to
represent, it is necessary that transactions and events are accounted in accordance with their substance
and reality and not merely their legal form.

CONSERVATISM
In case of doubt, record any loss and do not record any gain.

CONTINGENT LOSS – recognized as a provision if the loss is probable and the amount can be
reliably measured.
CONTINGENT GAIN – not recognized but disclosed only.

PRUDENCE
The desire to exercise care and caution with dealing with the uncertainties in the measurement
process such that assets or income are not overstated and liabilities or expenses are not understated.

ENHANCING QUALITATIVE CHARACTERISTICS

Relate to the presentation and from of financial statements. Intended to increase the usefulness
of the financial information that is relevant and faithfully represented.

a. COMPARABILITY
The ability to bring together for the purpose of noting points of likeness and difference.

COMPARABILITY WITHIN AN ENTITY or HORIZONTAL COMPARABILITY or

INTRACOMPARABILITY

The quality of information that allows comparisons within a single entity through time or from one
accounting period to the next.

COMPARABILITY BETWEEN AND ACROSS ENTITIES or DIMENSIONAL COMPARABILITY or

INTERCOMPARABILITY

The quality of information that allows comparisons between two are more entities engaged in the
same industry.

CONSISTENCY
The accounting methods and practices should be applied on a uniform basis from period to
period.

b. UNDERSTANDABILITY
Financial information must be comprehensible or intelligible if it is to be most useful.

c. VERIFIABILITY
Different knowledgeable and independent observers could reach consensus, although not
necessarily complete agreement, that a particular depiction is a faithful representation.
DIRECT VERIFICATION – verifying an amount or other representation through direct observation.
 INDIRECT VERIFICATION – checking the inputs to a model, formula or other technique and
recalculating the inputs using the same methodology.

d. TIMELINESS
Financial information must be available or communicated early enough when a decision is to be
made.

FINANCIAL STATEMENTS AN INTRODUCTION

FINANCIAL STATEMENT-end product or main output of the financial accounting process.

COMPONENTS OF FINANCIAL STATEMENT

1. Statement of Financial Position

2. Statement of Financial Performance
3. Statement of Comprehensive Income
4. Statement of Changes in Equity
5. Statement of Cash Flow
6. Notes to Financial Statement

OBJECTIVE OF FINANCIAL STATEMENT

-provide information about financial reports of an entity that is useful to a wide range of users in making
economic decisions.

-shows the result of the management stewardship of the resources entrusted to it.

a. Asset b. Liabilities c. Equity d. Income and Expenses e. Contributions by and distribution to owner’s f.
Cash Flow

Frequency of Reporting---at least annually

1. Statement of Financial Position--- Presentation of Current Asset

shows Assets, Liability, Equity (evaluate solvency, 1. Cash and Cash Equivalent
financial structure and capacity for adaptation) 2. Financial Asset eg. Trading Securities,
Available for Sale Securities, Other
Marketable Asset
Assets- Characteristic of Assets Current 3. Trade and Other Receivables
4. Inventories
Asset 5. Prepaid Expenses
1. Is controlled by entities.
2. Is the result of past transaction or
event Non 1. Property Plant and Equipment
3. Provides future economic benefits Current 2. Long Term Investment
4. Can be measured reliably Asset 3. Intangible Asset
4. Other Non Current Asset
Liabilities -Characteristic of Liabilities Current Presentation of Current Liabilities
Liabilities 1. Trade and Other Receivables
1. Present obligation of a particular entity
2. Short Term Borrowing
2. Arises fr. Past Trans. Or event 3. Current Provisions
3.INCOME
Settlement requires an outflow of EXPENSE
4. Current Portion of Long Term Debt
resources embodying economic benefits 5. Current tax Liability
Sources of Income Components of Expense

1. Sale of merchandise to customers 1. Cost of Sales or Cost of Goods Sold

2. Rendering of Services 2. Distribution cost or selling expenses
3. Use of entity resources 3. Administrative expenses
4. Disposal of Other Resources other than 4. Other Expenses
Note: No moreproducts
extraordinary Item on Income Statement or OCI 5. Incomem Tax Expense
 2. Statement of Financial Performance---shows the financial performance of
an entity for a given period of time.
-results of operation

Which Form of Income Statement?

Line Items in Statement of Financial Performance Forms of Income Statement

1. Revenue
2. Gain or loss from derecognition of financial
asset (amortized cost)
3. Finance Cost
4. Share in income or loss (Investment in
Associates/Joint Venture)
5. Income Tax Expense
6. Amount of Discontinued Operations
7. Profit or loss for the period
8. Total Comprehensive Income
9. Comprehensive Income for the period.
1. Functional Presentation (Cost of Sales
Method)
-classifies expenses according to their
function.
2. Natural Presentation (Nature of Expense
Method)
-expenses are aggregated according to
their nature.

3. Statement of Comprehensive Income-starts with the profit or loss as

shown in the income statement plus or minus the components of total Comprehensive
Income.

Comprehensive Income-change in equity during a period resulting from transactions and other
events, other than changes resulting from transactions with owners in their capacity as owners

Components of Other Comprehensive Income

1. Unrealized gain or loss on available for sale securities

2. Gain and losses on effective portion of cash flow hedge.
3. Gain s and losses from foreign currency translation
4. Actuarial gains and losses on defined benefit pension plan.

EXAMPLAR COMPANY
Statement of Comprehensive Income
Year Ended December 31, 2012

Net Income 1,500,000.00

Other Comprehensive Income to be reclassified to profit or loss:
Foreign currency translation gain 150,000.00
Unrealized loss on derivative
contract (100,000.00)
designated as cash flow hedge 50,000.00
Comprehensive Income 1,550,000.00
EQUITY
Residual interest in the assets of the entity after deducting all of its liabilities.

PAS 1 paragraph 7
The holders of instruments classified as equity are OWNERS.

SHAREHOLDER’S EQUITY
Is the residual interest of owners in the net assets of a corporation measured by the
PHILIPPINE TERM IAS TERM
Capital Stock Share Capital
Subscribed Capital Stock Subscribed Share Capital
Preferred Stock Preference Share Capital
Common Stock Ordinary Share Capital
Additional Paid In Capital Share Premium
Retained Earnings (deficit) Accumulated Profits (Losses)

Retained Earnings Appropriated Appropriated Reserve

Revaluation Surplus Revaluation Reserve

Treasury Stock Treasury Share

5. Statement of Cash Flow

-summarizes the operating, investing and financial activities of the entity.
Operating activities. These constitute the revenue-generating
activities of a business.
Investing activities. These constitute payments made to acquire long-
term assets, as well as cash received from their sale.
Financing activities. These constitute activities that will alter the
equity or borrowings of a business.

6. Notes to Financial Statement

-Also referred to as footnotes. These provide additional information
pertaining to a company's operations and financial position and are
considered to be an integral part of the financial statements. The notes
are required by the full disclosure principle.