Midterm-1 PDF

CHAPTER 4 CONCEPTUAL FRAMEWORK Financial statements and reporting entity Underlying assumptions GENERAL OBJECTIVE OF FINANCIAL STATEMENTS Financial statement provide information about economic resources of the reporting entity, claims against the entity and changes in the economic resources and cla...

CHAPTER 4 CONCEPTUAL FRAMEWORK Financial statements and reporting entity Underlying assumptions GENERAL OBJECTIVE OF FINANCIAL STATEMENTS Financial statement provide information about economic resources of the reporting entity, claims against the entity and changes in the economic resources and claims. Financial statements provide financial information about an entity's assets, liabilities, equity, income and expenses useful to users of financial statements in: a. Assessing future cash flows to the reporting entity b. Assessing management stewardship of the entity's economic resources. The financial information is provided in the following: 1. Statement of financial position, by recognizing assets liabilities and equity. 2. Statement of financial performance, by recognizing income and expenses. 3. Other statements and notes by presenting and disclosing information about: a. Recognized assets, liabilities, equity, income and expenses b. Unrecognized assets and liabilities c. Cash flows d. Contribution from equity holders and distribution to equity holders e. Method, assumption and judgment in estimating amount presented Types of financial statements The Revised Conceptual Framework recognizes three types of financial statements. 1. Consolidated financial statements - These are the financial statements prepared when the reporting entity comprises both the parent and its subsidiaries. 2. Unconsolidated financial statements - These are the financial statements prepared when the reporting entity is the parent alone. 3. Combined financial statements - These are the financial statements when the reporting entity comprises two or more entities that are not linked by a parent and subsidiary relationship. Consolidated financial statements Consolidated financial statements provide information about the assets, liabilities, equity income and expenses of both the parent and its subsidiaries as a single reporting entity The parent is the entity that exercises control over the subsidiaries. Consolidated information is useful for existing and potential investors, lenders and other creditors of the parent in their assessment of future net cash inflows to the parent. This is because net cash inflows to the parent include distributions to the parent from its subsidiaries. Consolidated financial statements are not designed to provide separate information about the assets, liabilities, equity, income and expenses of a particular subsidiary. A subsidiary's own financial statements are designed to provide such information. Unconsolidated financial statements Unconsolidated financial statements are designed to provide information about the parent's assets, liabilities, income and expenses and not about those of the subsidiaries. Such information can be useful to the existing and potential investors, lenders and other creditors of the parent because a claim against the parent typically does not give the holder of that claim against subsidiaries. Information provided in unconsolidated financial statements is typically not sufficient to meet the requirement needs of primary users. Accordingly, when consolidated financial statements are required, unconsolidated financial statements cannot serve as substitute for consolidated financial statements. Reporting entity A reporting entity is an entity that is required or chooses to prepare financial statement. The reporting entity can be a single entity or a portion of an entity, or can comprise more than one entity. A reporting entity is not necessarily a legal entity. Accordingly, the following can be considered entity: a. Individual corporation, partnership or proprietorship b. The parent alone c. The parent and its subsidiaries as single reporting entity d. Two or more entities without parent and subsidiary relationship as a single reporting entity e. A reportable business segment of an entity Reporting period The reporting period is the period when financial statements are prepared for general purpose financial reporting. Financial statements may be prepared on an interim basis, for example, three months, six months or nine months. Interim financial statements are not required but optional. However, financial statements must be prepared on an annual basis or a period of twelve months. Financial statements are prepared for a specified period of time and provide information about: a. Assets, liabilities and equity at the end of the reporting period. b. Income and expenses during the reporting period. UNDERLYING ASSUMPTIONS Accounting assumptions: are the basic notions or fundamental premises on which the accounting process is based. Accounting assumptions are also known as postulates. Like a building structure that requires a solid foundation to avoid or prevent future collapse and provide room for expansion, and so with accounting. Accounting assumptions serve as the foundation or bedrock of accounting in order to avoid misunderstanding but rather enhance the understanding and usefulness of the financial statement. The Conceptual Framework for Financial Reporting mentions only one assumption, namely going concern. However, implicit in accounting are the basic assumptions of accounting entity, time period and monetary unit. Going concern The going concern or continuity assumption means that in the absence of evidence to the contrary, the accounting entity is viewed as continuing in operation indefinitely. In other words, the financial statements are normally prepared on the assumption that the entity will continue in operations for the foreseeable future. The going concern postulate is the very foundation of the cost principle. Thus, assets are normally recorded at cost. As a rule, market values are ignored. However, some new standards require measurement of certain assets at fair value. If there is evidence that the entity would experience large and persistent losses or that the entity's operations are to be terminated, the going concern assumption is abandoned. In this case, the users of the statements will have a great interest in the amount of cash that will be generated from the entity's assets in the short term. Accounting entity ✓ In financial accounting, the accounting entity is the specific business organization, which may be a proprietorship, partnership or corporation. ✓ Under this assumption, the entity is separate from the owners, managers, and employees who constitute the entity. ✓ The reason for the entity assumption is to have a fair presentation of financial statements. ✓ The personal transactions of the owners shall not be allowed to distort the financial statements of the entity. ✓ For example, the cash invested by the proprietor is treated as an asset of the proprietorship. ✓ If an enterprising entrepreneur owns department store. restaurant and bookstore, separate statements shall be prepared for each business in order to determine which business is profitable. ✓ When a major shareholder of a corporation borrows money from a bank on his own personal account, the loan is a liability of the shareholder alone and not of the corporation. ✓ The shareholder is not the corporation and the corporation is not the shareholder. ✓ However, where parent and subsidiary relationship exists, consolidated statements for the affiliates are usually made because for practical and economic purposes, the parent and the subsidiary are a "single economic entity. Time period A completely accurate report on the financial position and performance of an entity cannot be obtained until the entity finally dissolved and liquidated. Only then can the final net income and networth of the entity he determined precisely. However, users of financial information need timely information for making an economic decision. It becomes necessary therefore to prepare periodic reports on financial position, performance and cash flows of an entity. The time period assumption requires that the indefinite life of an entity is subdivided into accounting periods which are usually of equal length for the purpose of preparing financial reports on financial position, performance and cash flows. Time period By convention, the accounting period or fiscal period is one year or a period of twelve months. The "one-year period" is traditionally the accounting period because usually it is after one year that government reports are required. The accounting period may be a calendar year or a natural business year. A calendar year is a twelve -month period that ends on December 31. A natural business year is a twelve-month period that ends on any month when the business is at the lowest or experiencing slack season. Monetary unit The monetary unit assumption has two aspects. Namely quantifiability and stability of the peso. The quantifiability aspect means that the assets, liabilities equity, income and expenses should be stated in terms of unit of measure which is the peso in the Philippines. How awkward to see financial statements without any common unit of measure. Such statements would be largely unintelligible and incomprehensible. The stability of the peso assumption means that the purchasing power of the peso is stable or constant and that its instability is insignificant and therefore may be ignored. The stable peso postulate is actually an amplification of the going concern assumption so much so that adjustments are unnecessary to reflect any changes in purchasing power. The accounting function is to account for nominal pesos only and not for constant pesos or changes in purchasing power. Monetary unit In today's world, the assumption that the peso is a stable measure over time is not necessarily valid. Consider an equipment that was imported 10 years ago from the United States for $100, 000 when the exchange rate was P35 to $1 or an equivalent of P3,500,000. If the same equipment is purchased now and assuming there is no change in the $100,000 purchase price, the replacement cost in terms of pesos would be in the vicinity of P5,400,000, considering a current exchange rate of P54 to $1. Obviously, there is a significant gap between historical cost and current replacement cost. In this regard, an entity may choose the revaluation model as an accounting policy. THANK YOU!