Conceptual Framework: Elements of Financial Statements

Elements of the financial statements

 Refer to the “quantitative information reported in the statement of financial position and income statement.
 The “building blocks” from which financial statements are constructed

The elements of financial position describe amounts of resources and claims against resources at the moment in time.

Asset
 Defined as a present economic resource controlled by the entity as a result of past events
 That the potential economic benefits no longer need to be expected to flow to the entity

Economic resource- is a right that has the potential to produce economic benefits

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 a
registered patent

Potential to produce economic benefits

An economic resource could produce economic benefits if an entity is entitled:
 To receive contractual cash flows
 To exchange economic resources with another party on favorable terms
 To produce cash inflows or avoid cash outflows
 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 low 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.

Liability
 As a present obligation of an entity to transfer an economic resource as a result of past events.
 Transfer an economic resource and not the ultimate outflow of economic benefits
 The outflow of economic benefits no longer needs to be expected similar to the definition of an asset

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
 Constructive obligations arise from normal business practice, custom and a desire to maintain good business
relations or actin an equitable manner.
Transfer of an economic resource
 Obligation to pay cash
 Obligation to deliver goods or noncash resources
 Obligation to provide services at some future time
 Obligation to exchange economic resources with another party on unfavorable terms
 Obligation to transfer an economic resource if specified uncertain future event occurs

Equity- It is a residual interest in the assets of the entity after deducting all of the liabilities.

Income
 As increase in assets or decreases in liabilities that result in increases in equity, other than those relating to
contributions from equity holders
 Encompasses both revenue and gain.

Revenue- This arises in the course of 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. It include gain from disposal of noncurrent asset, unrealized gain on trading investment and gain from
expropriation.

Expense
 Decrease in assets or increases in liabilities that result in decreases in equity, other than those relating to
distributions to equity holders
 Encompasses losses as well as those expenses that arise in the course of the ordinary regular activitie

Loses do not arise in the course of the ordinary regular activities and include losses resulting from disasters

Theories
1. A present obligation exists as a result of past event if
a. The entity has already obtained economic benefit
b. The entity must transfer an economic resource
c. The entity has not yet obtained economic benefit but must transfer an economic resource
d. The entity has already obtained economic benefit and must transfer economic resource
2. It is the present ability to direct the use of an economic resource and obtain the benefit that may flow from it
a. Control
b. Legal Right
c. Obligation
d. Ownership

3. Revenue may result from

a. A decrease in an asset from primary operations
b. An increase in an asset from incidental transactions
c. An increase in a liability from incidental transactions
d. A decrease in a liability from primary operations
4. What is the primary distinction between revenue and gain?
a. The materiality of the amount
b. The likelihood that the transaction will recur
c. The nature of the activity that gives rise to the transaction
d. The method of disclosing the transaction
5. The term income
a. Includes revaluation of land
b. Includes adjustment of prior period error
c. Includes gain resulting from the sale of an asset in an arm’s length transaction
d. Is the same as retained earnings
Conceptual Framework: Recognition and Measurement
Recognition- it is the process of capturing for inclusion in the financial statements an tem that meets the definition of an
asset, liability, equity, income and expense
 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

 Basic principle of income recognition is that income shall be recognized when earned.
 With respect to sale of goods in the ordinary course of business, the point of sale is unquestionably the point of
income recognition.
 Legal title to the goods passes to the buyer at the point of sale
 Under certain conditions income may be recognized at the point of production, during production and at the point
of collection.

Expense recognition
 Basic expense recognition means that expense are recognized when incurred
 Application of the matching principle
 There is no gain if there is no pain
 Matching principle has three applications:
o Cause and effect association
o Systematic and rational allocation
o Immediate recognition

Cause and effect association

 The expense is recognized when the revenue is already recognized
 Strict matching concept
 The matching of cost with revenue
 Example: Cost of merchandise inventory, doubtful accounts, warranty expense and sales commissions.

Systematic and rational allocation

 Some costs are expensed by simply allocating them over the periods benefited.
 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
 Example: Depreciation of PPE, Amortization of intangible and allocation of prepaid rent, insurance and other
prepayments.

Immediate recognition
 Cost incurred is expense outright
 An expense is recognized immediately:
o When an expenditure produces no future economic benefit
o When cost incurred does not qualify or ceases to qualify for recognition as an asset.
o Example: Officers’ salaries and most administrative expense, advertising and most selling expenses,
amount to settle lawsuit and worthless intangibles, worthless patent

Derecognition defined as the removal of all or part of a recognized asset or liability from the statement of financial
position.

Measurement is defined as quantifying in monetary terms the elements in the financial statements.

Two categories:
1. Historical cost
 Historical of an asset is the cost incurred in acquiring or creating the asset compromising the consideration
paid plus transaction cost
  Historical of an liability is the consideration received to incur the liability minus transaction cost
 Historical cost is the entry price or entry value to acquire an asset or to incur a liability.
2. Current cost
 Fair value
o Asset: price that would be received to sell an asset in an orderly transaction between market
participants at measurement date.
o Liability: price that would be paid to transfer a liability in an orderly transaction between market
participants at measurement date.
o Not adjusted for transaction cost
 Value in use for asset
o Present value of the cash flows that an entity expects to derive from the use of an asset and from
the ultimate disposal of an asset

 Fulfillment value for liability

o Present value of cash that an entity expects to transfer in paying or settling a liability.
 Current cost
o Asset: is the cost of an equivalent asset at the measurement date comprising the consideration paid
and transaction cost
o Liability: is the consideration that would be received less any transaction cost at measurement
date.

Matching
Note: Onlyof fair
costvalue,
with revenue- It isand
value in use thefulfillment
process that involves
value the simultaneous
is an exit or combined
price or exit value while therecognition of is
Current cost revenue and
an entry
expenses that result directly from the same transactions and other events.
price or entry value like historical cost. The IASB did not mandate a single measurement basis because the different
measurement bases could produce useful information under different circumstance.
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 rational allocation.

An expense is recognized immediately when an expenditure produces no future economic benefit and when cost
incurred ceases to quality as an asset.

Measurement- It is the process of determining the monetary amounts at which the elements of the financial statements are
recognized and carried in the financial statements.

Measurement attributes currently used in practice:

 Present value- most relevant
 Net realizable value- amount of cash that could currently be obtained by selling the asset in an orderly disposal.
 Current replacement cost
o Amount of cash or cash equivalent that would have to be paid if the same or an equivalent asset was
acquired currently.
o Assets recorded at the amount that represents the immediate purchase cost of an equivalent asset.

Asset measurements in financial statements reflect several financial attribute.

Current value measure:

 Replacement cost
 Exit value
 Discounted cash flow

Primary measurement basis is the market price at the date the asset was acquired.
Measurement bases is currently used in financial statements:
 Present value
 Settlement value
 Fair value

Generally, revenue from sale of goods shall be recognized at a point when the entity has transferred to the buyer the
significant risks and rewards of ownership of the goods.

Revenue from sale of goods shall be recognized when

 Entity has transferred to the buyer the significant risks and rewards of ownership of the goods.
 The amount of revenue can be measured reliably.
 It is probable that economic benefits will flow to the entity.
 Managerial control over the goods sold has been relinquished.
 Significant risks and rewards of ownership have been transferred from the seller to the buyer.

Recognition of revenue:
 Revenue from rendering of services shall be recognized by reference to the stage of completion of the transaction.
 Royalty revenue shall be recognized on an accrual basis
 Dividend revenue shall be recognized when the shareholder’s right to receive payment is established.
 For transactions involving the rendering of services:
o The amount of revenue and the costs incurred and costs to complete can be measured reliably.
o It is probable that payment for the services shall be received by the entity.
o The stage of completion of the transaction at the end of reporting period can be measured reliably.

Revenue recognition principle

 It is probable that future economic benefit will flow to the entity and the amount can be measured reliably.
 Revenue shall be recognized at a point when an exchange transaction has occurred and the earning process is
essentially complete.
 Generally, revenue is recognized at the point of sale, during production and at the end of production.
 Normally, revenue from sale of goods is recognized when the title to the goods changes.
 Acceptable deviation from recognizing revenue at the point of sale when upon receipt of cash, during production
and end of production.
 Accepted basis of recognition of revenue passage of time, performance of service and completion of percentage of
a project.
 Revenue from an artistic performance is recognized when the event takes place.
 A wholesale bakery would normally recognize revenue when goods are delivered to the customer.

Income recognized using the installment method of accounting generally equals cash collected multiplied by gross profit
percentage.

Under the installment method of accounting, gross profit on an installment sale is recognized in income in proportion to
the cash collection.

Under the cost recovery method of accounting, gross profit on an installment sale is recognized after cash collections
equal to the cost of sales have been received.

An entity is engaged in extensive exploration for water. If upon discovery of water, the entity need not recognize any
revenue from water sales unit the sales exceed the cost of exploration, the basis of revenue recognition being employed is
sunk cost or cost of recovery basis.

There is no reasonable basis for the estimating collectability, the use of the cost recovery method of revenue recognition
to account for installment basis.

The installment method of recognizing revenue should be used when no reasonable basis exists for estimating the
collectability.
Installment sales method appropriate for the recognition of revenue, when for sales where collection is spread over a
reasonable long period of time and significant doubt exists about ultimate collection of installments receivable.

When using the installment method of revenue recognition, total revenue and costs are recognized at the point of sale
but gross profit is deferred in proportion to the cash that is uncollected from the sale.

The cost of recovery method of revenue recognition is used only when circumstances surrounding a sale are so
uncertain that earlier recognition is impossible.

Revenue recognition reflects the greatest degree of uncertainty about future events, when cost recovery method applied to
installment sales

The term “revenue recognition” conventionally refers to the process of identifying transactions to be recorded as
Realization- means
revenue in an the process
accounting of converting noncash resources and rights into cash or claims to cash. Synonymous with
period.
the term “Recorded”
When the ultimate sale of the goods is at an assured sales price, it is proper to recognize revenue prior to the sale of the
Unrealized- gains on assets unsold are identified in a precise sense.
merchandise.
Recorded- synonymous of recognized

Equipment was sold in exchange for a note receivable conforms to the realization concept.
Revenue may result from a decrease in a liability from primary operations.

Installment method of revenue recognition when there is no reasonable basis for estimating collectability.

The installment method of accounting may be used if the ultimate amount collectible is inappropriate.

Costs that can be reasonably associated with specific revenue but not with specific products should be expensed in the
period in which the related revenue is recognized.

Certain costs of doing business capitalized when incurred and then depreciated or amortized over subsequent accounting
periods to match the costs of production with revenue as earned.

Sales commission-example of the expense recognition principle of associating cause and effect.

Theories
1. Recognition of an element is appropriate when information results in
a. Relevance
b. Faithful representation
c. Both relevance and faithful representation
d. Neither relevance nor faithful representation
2. Derecognition normally occurs when
a. An item no longer meets the definition of an asset or a liability
b. The entity loses control of the asset
c. The entity no longer has a present obligation for the liability
d. Under all of these circumstances
3. Generally, revenue is recognized
a. At the point of sale
 b. When cause and effect are associated
c. At the point of cash collection
d. At appropriate points throughout the operating cycle
4. Which of the following is not an accepted basis for recognition of revenue?
a. Passage of time
b. Performance of service
c. Completion of percentage of a project
d. Upon signing of contract

5. Normally, revenue is recognized

a. When the customer order is received
b. When the customer order is accompanied by a check
c. Only if the transaction will create an account receivable
d. When the title to the goods changes
6. Which of the following practices may not be an acceptable deviation from recognizing revenue a the point of sale?
a. Upon receipt of cash
b. During production
c. Upon receipt of order
d. End of production
7. Which of the following represent the least desirable  choice for the recognition of revenue?
a. Recognition of revenue during production
b. Recognition of revenue when a sale occurs
c. Recognition of revenue when cash is collected
d. Recognition of revenue when production is completed
8. Which of the following in the most precise sense means the process of converting noncash resources and rights into
cash or claims to cash?
a. Allocation
b. Collection
c. Recognition
d. Realization
9. Which statement conforms to the realization concept?
a. Depreciation was assigned to product unit cost
b. Equipment was sold in exchange for a note receivable
c. Cash was collected on accounts receivable
d. Product unit costs were assigned to cost of goods sold
10. Which of the following would be matched with current revenue on a basis other than association of cause and
effect?
a. Goodwill
b. Cost of goods sold
c. Sales commission
d. Warranty cost
11. Why are certain costs of doing business capitalized when incurred and then depreciated or amortized over
subsequent accounting periods?
a. To reduce the income tax liability
b. To aid management in the decision-making process
c. To match the cost of production with revenue
d. To adhere to the accounting concept of conservatism
12. Which of the following principle best describes the conceptual rationale for the method of matching depreciation
with revenue?
a. Associating cause and effect
b. Systematic and rational allocation
c. Immediate recognition
d. Partial recognition
13. What is an example of cost that cannot be directly related to particular revenue but incurred to obtain benefits that
are exhausted in the period when the cost is incurred?
a. Sales commissions
b. Sales salaries
 c. Freight in
d. Prepaid insurance

14. The matching principle is best demonstrated by

a. Not recognizing any expense unless some revenue is realized
b. Associating effort with accomplishment
c. Recognizing prepaid rent received as revenue
d. Establishing an appropriation for contingency
15. Bad debt expense is recognized according to which expense recognition principle?
a. Direct matching
b. Immediate recognition
c. Systematic and rational allocation
d. Critical event recognition
16. When should an expenditure be recorded as an asset rather than an expense?
a. In the period when the expenses are paid
b. In the period when the expenses are incurred
c. In the period when the vendor invoice is received
d. In the period when the related revenue is recognized
17. When should an expenditure be recorded as an asset rather than an expense?
a. Never
b. Always
c. If the amount is material
d. When there is a right that has the potential to produce economic benefit
18. Which accounting principle is being observed when an accountant charges to expense a cost that contributed to
revenue during a period?
a. Revenue realization
b. Matching
c. Monetary unit
d. Conservatism
19. Which of the following is not an acceptable basis for the recognition of expense?
a. Systematic and rational allocation
b. Direct matching
c. Immediate recognition
d. Cash disbursement
20. A cause and effect relationship is implicit in the
a. Realization principle
b. Historical cost principle
c. Matching principle
d. Going concern assumption
21. An example of direct matching of an expense with revenue would be
a. Depreciation expense
b. Office salaries expense
c. Direct labor costs incurred to produce inventory sold during a period
d. Advertising expense
22. Which category of expenses is subject to immediate recognition in the income statement?
a. Utilities expense for the production line of a manufacturer
b. Repairs and maintenance expense incurred on production equipment of a manufacturer
c. The salary of the production foreman
d. The salary of the entity president
23. Which principle best describe the rational for matching distribution costs and administrative expenses with revenue
of the current period?
a. Direct matching
b. Systematic and rational allocation
c. Immediate Recognition
d. Partial recognition
 24. It is the amount of cash or cash equivalent that would have to be paid if the same or an equivalent asset was
acquired currently
a. Historical cost
b. Current cost
c. Realizable cost
d. Present value

Identification
1. An entity charges the cost of new office equipment to expense in the year of purchase although the equipment is
expected to help produce revenue for many years. Systematic and Rational Allocation
2. An entity records sales after inventory has been produced but before it is sold. Income Recognition Principle
3. An entity having 150 accounts payable list each account among the liabilities in the statement of financial position.
Materiality
4. An entity does not report the major details about the shareholders' equity. Completeness / Standard Adequate
Disclosure
5. An entity follows a policy of recording an item as an asset when the entity is in doubt whether the item is an asset
or expense of the current period. Prudence
6. The accountant of the entity keeps a detailed depreciation record on every asset no matter how small its value.
Materiality
7. A construction firm signed a three-year contract to build a skyway connecting Alabang and Tagaytay City. The
firm immediately records the full contract price as revenue. Income Recognition Principle
8. Competition has taken away much of the business of an airline. The airline is unwilling to report its plans to sell
half of its fleet of aircraft. Standard Adequate Disclosure
9. A department store changes accounting method every year in order to report a higher net income possible under
accounting standards. Comparability
10. The damaged inventory of a department store is being written down. The manager bases the writedown on
subjective opinion in order to minimize income tax. Faithful Representation
11. An entity records a new machine at the cash equivalent price paid. Historical Cost
12. A large entity decides that whenever an asset has a cost of less than P10,000, the cost will be charged to expense
even though the asset may benefit several accounting periods. Materiality
13. The entity allocates the cost of a patent to the accounting periods in which it helps to produce the revenue.
Matching Principle / Expense Recognition Principle
14. The entity estimates and records interest expense on a 5-year noninterest-bearing note payable. Substance over
form
15. Subscriptions received in advance by a magazine publishing entity are treated as deferred revenue until the
magazines are published. Income Recognition Principle
16. Users have trouble making interperiod comparisons when an entity changes accounting principles from one year to
the next. Comparability / Consistency
17. Many users of financial statements prefer accounting principles such as accelerated depreciation that tend to state
income on the "low side". Conservatism
18. The entity should always report the important details about share capital, for example, the number of shares
authorized, shares issued, shares in treasury, subscribed shares and par value. Completeness / Standard Adequate
Disclosure
19. An allowance for doubtful accounts is established. Matching Principle
20. The lower of cost and net realizable value is used to measure inventory. Conservatism

Conceptual Framework: Presentation and Disclosure; Concept of Capital

Classification is the sorting of assets, liabilities, equity, income and expenses on the basis of shared or similar
characteristics.

Aggregation is the adding together of assets, liabilities, equity, income and expenses that have similar or shared
characteristics and are included in the same classification.
 Two approaches:
 Transaction approach- is the traditional preparation of an income statement
 Capital approach- means that net income occurs only after the capital used from the beginning of the
period is maintained.

Distinction between return of capital and return on capital

1. Shareholders invest in entity to earn a return on capital of an amount in excess of their original
investment.
2. Return of capital is an erosion of the capital invested in the entity.

Two concepts of Capital maintenance or well offness:

 Financial Capital
o Monetary amount of the net assets contributed by shareholders and the amount of the increase in
net assets resulting from earnings retained by the entity.
o Traditional concept based on historical cost and adopted by most entities.
o Under the financial capital concept, net income occurs “when the nominal amount of the net
assets at the end of the year exceeds the nominal amount of the net assets at the beginning of the
period, after excluding distributions to and contributions by owners during the period.”
o Known as the net asset approach

 Physical Capital
o Quantitative measure of the physical productive capacity to produce goods and services
o Requires that productive assets be measured at current cost, rather than historical cost.

Under this 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.”

Theories
1. The presentation and disclosure requirement achieves all of the following
a. An effective communication tool
b. More relevant and faithfully represented financial information
c. Understandability and comparability of information
d. Financial position, financial performance, and cash flows
2. All of the following can considered appropriate classification, except
a. Current and noncurrent asset
b. Current and noncurrent liability
c. Ordinary share capital and preference share capital
d. Offsetting asset and liability
3. Financial capital is defined as
a. Net assets in monetary terms
 b. Net assets in terms of physical productive capacity
c. Legal capital
d. Share capital issued and outstanding
4. The physical capital maintenance concept requires the adoption of which measurement basis
a. Historical cost
b. Current cost
c. Fair value
d. Present value
5. Which concept is applied to net income and other comprehensive income?
a. Financial capital
b. Physical capital
c. Legal capital
d. Borrowed capital
6. Which statement regarding the term profit is true?
a. Profit is any amount over and above that required to maintain the capital at the beginning of the period
b. Profit is equal to income minus expenses
c. Profit is the equivalent of net income under IFRS
d. All of these statements are true about the term profit
7. Under the financial capital concept, net income occurs when
a. The nominal amount of net assets at year-end increased
b. The physical productive capital at year-end increased after excluding any distributions to and contributions
from owners
c. The nominal amount of net assets at year-end increased after excluding distributions to and
contributions from owners
d. The physical productive capital at year-end increased.