CHAPTER 1 FINANCIAL STATEMENTS TECHNICAL KNOWLEDGE To identify the components of financial statements. To know the objective of financial statements. To know the objective of financial reporting. To understand the primary responsibility for the preparation of financial statements. To identify the general features in the preparation of financial statements.FINANCIAL STATEMENTS Financial statements are the means by which the information accumulated and processed in financial accounting ig periodically communicated to the users. Financial statements are a structured financial representation of the financial position and financial performance of an.entity. General purpose financial statements General purpose financial statements are the statements intended to meet the neede of users who are not in a position to require an entity to prepare reports tailored to their particular information needs. Reports prepared at the request of management and bankers are not general purpose financial statements because such reports are prepared specifically to meet the needs of management and bankers. 7 Components of financial statements A complete set of financial statements comprises the following components; 1. Statement of financial position 2 Income statement: 3. Statement of comprehensive i 4. Statement ofl changes in equity - . Statement of cash flows . Notes, comprising a summary of significant accountil policies and other explanatory iterate 7 Many entities also present reports and statements such a8 environmental reports and value added statements, particularly in industries in which environmental factors are significant and when employees are regarded as ari important user group. - ‘However, such statements and reports are not ts of financial statements. eae Objective of financial statements jective of general purpose financial statements is to Te oe mt OL Aon about the financial position, Anieneioh onltmance and cash flows of an entity that is useful to a pete Tange of users in making economic decisions. Financial statements show the results of the stewardship of management of the resources entrusted to it. ‘To meet this objective, financial etatements provide information about the following: and expenses, including gains and losses + Teor tputions by and distributions to owners in their capacity as owners £. Cash flows Such information, slong with other information in the notes, would assist users of financial statements in predicting the entity's cash flows and in particular their timing and certainty. However, financial statements do not provide all the information that users may need to make economic decisions. ‘The reason is that the financial statements largely portray the financial effects of past events and do not necessarily provide nonfinancial information. a. b. ©. d. e. ‘The financial position comprises the assets, liabilities and equity of an entity at a particular moment in time. Specifically, financial position pertains to the liquidity, solvency, and the need of the entity for additional financing. | The financial performance comprises the revenue, expenses and net income or loss of an entity for a period of ime. Performance is the level of income earned by the entity through the efficient and effective use of its resources. Cash flows are the cash receipts and cash payments arising from the operating, investing and financing activities of the entity.Financial reporting Financial reporting is the provision of financia) ; about an entity to external users that is useful to thes Matin economic decisions and for assessing the effectivenese ing entity's management. ‘88 of the The principal way of providing financial informatio, users is through the annual financial statements. 32°" ncial reporting encompasses not only financial statement, but also other means of communicating information _ tl directly or indirectly to the financial accounting pete eres Financial reports include not only Snancial statements but als other information such as financial highlights, summer's important finanaial figures and analysis of financial stateneyc. Financial reports also include nonfir e inancial information such as description of major products and a listing of corporate officers and directors. Objective of financial reporting Under the Revised Conceptual Framework for Financial Reporting, the objective of financial reporting is to pravide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity. General purpose financial reporting is directed primarily to the exiting and potential investors, lenders and other creditors which compose the primary user group. The reason is that the primary users have the most critical and immediate need for information in financial reports. Specific objectives of financial reporting a. To provide information useful in making investing and credit decisions about providing resources to the entity: b. To provide information useful in assessing the cash flow Prospects of the entity. : ¢. To provide information about entity resources, claims and changes in resources and claims, 4 pe j Limitations of financial reporting General purpose financial reports do not and cannot * provide all of the information that existing and potential investors, lenders and other creditors need. al purpose financial are not designed to y See sales of a reporting entity but these reports provide information to help the primary users estimate the value of the entity. c. General purpose financial reports are intended to provide common information to users and cannot accommodate every epecific request for information. d. To a large extent, financial reports are based on estimate and judgment rather than exact depiction. Responsibility for financial statements - The management of an entity has the primary responsibility for the preparation, and presentation of financial statements. The Board of Directors in discharging its responsibilities reviews and authorizes the financial statements for issue before these are submitted to the shareholders of the entity. Management. is accountable for the safekeeping of the resources and their proper, efficient and profitable use. Shareholders are interested in information that helps them assess how effectively management has fulfilled this role as this is relevant to the decision concerning their investment and the reappointment or replacement of management. General features of financial statements Fair presentation and compliance with PFRS Going concern t seorual basis lateriality and aggregation Offsetting me Frequency of reporting Comparative information Consistency of presentation PAPT REE 5Fair presentation ‘The financial statements shall present fairly the financial} position, financial performance and cash flows of an entity, Virtually, in all circumstances, fair presentation is achieveg if the financial statements are prepared in accordance with the Philippine Financial Reporting Standards which represent the GAAP in the Philippines. ‘The application of Philippine Financial Reporting Standards, with additional disclosure when necessary, is presumed to result in financial statements that achieve a fair presentation. Anentity whose financial statements comply with PFRS shall make 'an explicit and unreserved statement of such compliance in the notes. Fair presentation is defined as faithful representation of the effects of transactions and other events in accordance with the definitions and recognition criteria for assets, liabilities, income and expenses laid down in the Conceptual Framework. Fair presentation requires an entity: a. To select‘and apply accounting policies in accordance with b. To Present information, including accounting policies, in a manner that provides relevant and faithfully represented ¢. To provide additional disclosures necessary for the users to understand the entity's financial statements An entity cannot rectify inappropriate accounting policies either by disclosure of the ccoounting policies used explanatory informat Policies or by notes or Departure from standard tremely rare circumstances in which management pases that compliance with a requirement in a standard would be so misleading, the entity shall depart from that requirement provided the relevant regulatory Conceptual ‘Framework requires, or otherwise does not prohibit, such a departure. ‘Thus, an entity is permitted to depart from a standard: a. In extremely rare circumstances. b. When management concludes that compliance with the standard would be misleading. c. When the departure from the standard is necéssary to achieve fair presentation. 4. When the regulatory Conceptual Framework requires or otherwise does not prohibit such a departure. In such circumstances, it ig incumbent upon the entity to disclose the following: 1. The management has concluded that the financial statements present fairly the ial position, financial performance and cash flows of the entity. 2. That the entity has complied with applicable standards except that it has departed from a particular requirement to achieve a fair presentation. 3. The title of the standard from which the entity has departed, the nature of the departure, including the treatment that the standard would require, the reason why that treatment would be eo misleading and the treatment adopted. 4. For each period presented, the financial impact of- the departure on each item in the financial statements that would have been reported in complying with the requirement. autGoing concern Going concern or continuity assumption means that the in the absence of evidence to the contrary. The going concern postulate is the very foundation of the cost principle. In other-words, financial statements are prepared normally on the assumption that the entity shall continue in operation for the foreseeable future. . Thus, assete are normally recorded at original acquisition cost. Asa rule, market values are ignored. However, some standards require measurement of certain assets at-fair value. nancial statements shall.be prepared on a going concern basis ‘unless management intends to liquidate the entity or cease trading or has no realistic option but to do so. If the financial statements are not prepared on a going concfrn basis, such fact shall be dieclosed together with the measurement basis ‘and the reason therefor. Accrual basis -An entity sh~Il prepare the financial statements, using the accrual basis uf accounting except for cash flow information. Under accrual basis, the effects of transactions and other events are recognized when they occur and not as cash or cash equivalent is received or paid, and they are recorded and reported in the financial statements of the periods to which they relate. Accrual basis means that assets are recognized when receivable rather than when received and liabilities are when payable rather than when actually paid. In simple lai , accrual accounting means that income is recognized when earned regardless of when received and expense is recognized when incurred regardless of when paid. The essence of accrual accounting is the recognition of accounts receivable, accounts payable, prepaid expenses, accrued expenses, deferred income, and accrued income. inion nannies ation Materiality and aggres' ‘An entity shall present separately each material class of similar items: separately items of dissimilar nature An entity shall proeethey are immaterial fanest i of Financial statements result from processing ase transactions or other events that are ageregal frenrding to their nature or function. final stage in the process of ion i the presentation of condensed ‘and classified data which form line items in the financial xxample, cash on Fos exh equivalent shall be cash equivalents”. : ; a inished goods, goods in process, raw materials ant vin hesuting supplies are aggregated and presented as one item “inventories”. Materiality dictates that an entity need not provide a specific disclosure required by standard if the information is not material. .d, cash fund, cash in bank AnD resented as one item “cash and When is an item material? ‘There is no strict or uniform rule for determining whether an item is material or not. Very often, this is dependent on good judgment, professional expertise and common sense. Asa general guide, an item is material if knowledge of it would affect the decision of the primary users of the financial statements, For example; small expenditures for tools are often expensed immediately rather than depreciated over the useful life. Another example is the common practice of large entities of rounding amounts to the nearest thousand pesos in their ial statements. S: iti ore ents. Small entities may round off to the a esNew definition of materiality The IASB provided the following new definition of materiality. Information is material if omitting, misstating or obscuring it could reasonably be expected to influence the economic decisions that primary users of general purpose financial statements make on the basis of those statements which provide financial information about a specific reporting entity. In other words, an. information is material if the omission, misstatement and obscuring of the information could reasonably affect the econome decision of primary users. The revised definition of materiality highlights three important aspects: a. Could reasonably be expected to influence b. Obscuring information c. Primary users Could reasonably be expected to influence ‘The could reasonably be expected to influence threshold adds an element of reasonobility of financial information on which economic decision ie based. By including the ‘term could reasonably be expected to influence in the new definition, material information shall be limited to the economic decision of primary users rather than to all users which is too broad in scope. Moreover, the could reasonably be expected to influence threshold insures that information capable of influencing economic decision of the primary users shall be included in the financial statements. 10 Pico eS Obscuring information ing i ion i ded to the new Obscuririg information is a new concept a definition of materiality. j : ; Aare! tion is obscured if presenting or communicating Informeiave @ similar effect as omitting or misatating the ing information means the presentation of financial eee or readily understood or not clearly expressed. ing i is ized by deliberate Obscuring information may be characteri vagueness, ambiguity and abstruseness. Examples of obscured material information are: . The | age is vague or unclear. ‘ b The information is scattered throughout the financial statements. : 7 c. Diesimilar items are aggregated inappropriately. d. Similar items are disaggregated inappropirately. Primary users The new definition of materiality narrows the definition to primary users who are primarily affected by general purpose financial statements. ' The primary users include the existing and potential investors, lenders and other creditors. The other users include the employees, customers, government agencies and the public in general. The new definition specified that only primary users of financial statements are considered because these groups are the users to whom general purpose financial statements are primarily directed. Such primary users cannot require reporting entities to provide information directly to them and therefore must rely on general purpose financial reports for how much financial information is needed. 1 pas ee Se aeMateriality j, a relativity Materiality of an item depends on relative size rathor the absolute size. What i i i then im ial for iota material for one entity may be An error of Pi00,000 in the. financial state multinational entity may-not be important but mee cf & critical for a small entity, 4 re Ps Factors of materiality In the exercise of judgment in determining materiali following factors may be considered: materiality, the a. Relative size of the item in relation to the total of to which the item belongs. eset the romp For example, the amount of advertising'in relation to distribution costs and the amount of prepaid expenses tz total current assets. b. Nature of the item — An item may be inherently material because by its very nature it affects economic decision, For example, the discovery of a P20,000 bribe is a material event even for a very large entity. Offsetting Assets and liabilities, and income and expenses, when material, shall not be offset against each other. Offsetting may be done when it is required or permitted by another PERS. Gains and losses on disposal of noncurrent assets are’ reported by deducting from the proceeds the carrying amount of the assets and the related selling ‘expenses. The expenditure related to a provision and any reimbursement froin a third party can be offeet, and only the net expenditure is presented as expense. : Foreign exchange gains and losses or gains and losses arising from trading securities are netted against the other. The measurement of assets net of valuation allowance is permitted because technically this is not offsetting. Thus, accounts receivable may be shown net of allowance for doubtful accounts. 12 Frequency of reporting tity shall present a complete set of financial statements pasts annually, When an entity changes the end of the reporting period and presents financial statements for a period longer or shorter than one year, the eritity shall disclose: . The period cavered by the financial statements. b. The reason for using a longer or shorter period. 3 c. The fact that amounts presented in the financial statements are not entirely comparable. Comparable information Except when permitted or required otherwise by standard, an entity shall disclose comparative it ation in respect of the prevjous period for all amounts reported in the current period's financial statements. In other words, the financial statements of the current period shall be presented with comparative figures of the financial statements of the immediately preceding year. Comparative information shall be included for narrative and descriptive information when it is relevant to an understanding of the current period's financial statements. For example, details of a legal dispute, the outcome of which was uncertain at the end of the preceding reporting period and is yet to be resolved, are disclosed in the current period. Third statement of financial position A third statement of financial position is required when an entity: a. Applies an accounting policy retrospectively. b. Makes retrospective restatement of items in the financial statements. c. Reclassifies items in the financial statements. Under these circumstances, an entity shall present three statements of financial position aa at: 1. The end of the current period 2. The. end of the previous period. 3. The beginning of the earliest comparative period 18Consistency of presentation Implicit in the presentation of information j principle of ooiaistency: comparable rmation is the The principle of consistency requires that the accounti iti methods and practices shall be applied on a uniform bask from period to period. Haste The presentation.and classification of financial statement items shall be uniform from one accounting period to the next. ‘An entity cannot use the FIFO method of inventory valuation in one year, the average method in the next year, another method in succeeding year and 0 on. If the FIFO method is adopted in one year, such method is followed from year to year. Consistency is desirable and essential to achieve comparability of financial statements. However, consistency does not mean that no change in accounting method can be made. If the change will result to information that is faithfully represented and more relevant to the ueers of financial statements, then such change should be made. But there should be full disclosure of the change and the peso effect of the change. ‘A change in the presentation and classification of items in the financial statements is allowed: a. When it is required by another Standard. b. When a significant change in the nature.of the operationé ofthe entity will demonstrate a more appropriate revised presentation and classification. It is igappropriate for an entity to leave accquriting policies unchanged when better and acceptable alternatives exist.. 14 Identification of financial statements Financial statements shail be clearly identified and Uistinguiahed from other information in the same published document. Each component of the financial statements shall be cleatly identified. In addition, the following information shall be prominently displayed: ‘a. The name of the reporting entity. b. Whether the financial statements cover the individual ‘entity or a group of entities. c. The end of the reporting period or the period covered by the financial statements or notes. d. The presentation currency. e. The level of rounding used in the amounts in the financial statements. Financial statements are often made more understandable by presenting information in thousands or millions of unite of the presentation currency. This is acceptable as long as the level of rounding in presentation is disclosed and relevant and material information is not lost or omitted. 15