Chapter

The Environment of
Financial Accounting
and Reporting

Learning Objectives
After studying this chapter, you should be able to:
1. Explain the impact of accounting on the decisions of the various users
of financial information at all levels of the economy.
2. Understand the basic objective of financial statements.
3. Distinguish between external and internal users of accounting
information.
4. Identify the major financial statements and other means of financial
reporting.
5. Explain the development and sources of financial reporting standards.
6. Identify sources of accounting standards and other organizations that
influence PFRS.
7. Familiarize yourself with the Philippine Financial Reporting Standards
(PFRSs) applicable to annual period up until January 1, 2015.
8. Explain the issues related to ethics as well as creative and critical
thinking in accounting.

CHAPTER 1

The Environment of Financial Accounting

and Reporting
Introduction
Accounting is an information system, designed to identify, collect,measure,and
communicate economic information about a business entity (firm) to those having
interest in the financial affairs of the entity.

Accounting is a social science, developed in a world of scarce resources. It is

influenced by, and interacts with economic, social and political environments.
Business is conducted by investor-owned enterprises,managed and controlled by
professional managers, who are held responsible for providing reports to absentee
owners, creditors and other external interested parties. The process of developing
general-purpose financial statements and reporting general-purpose accounting
information to various external users is called financial accounting. In this
environment, financial accounting and reporting communicate information about the
economic effects of accounting transactions and other events on a business entity to
these external user groups.

Accountants are communicators; Accountancy is the art of communicating financial

information about a business entity to users such as shareholders,creditors and
managers. The communication is generally in the form of financial statements that
show in money terms the economic resources under the control of the management.
The art lies in selecting the information that is relevant to the users and is reliable.

Most accounting systems are designed to generate information for both internal and
external reporting. The external information is much more highly summarized than
the information reported internally. Understandably,a company does not want to
disclose every detail of its internal financial dealings to outsiders. For this reason,
external financial reporting is governed by an established body of standards or
principles that are designed to carefully define what information a firm must disclose
to outsiders. Financial accounting standards also establish a uniform method of
presenting
4
Chapter 1
information so that financial reports for different companies can be more easily
compared.

Objective of Financial Statements

The objective of financial statements is to provide information about the
financial position, performance, and changes in financial position of an entity
that is useful to a wide range of users in making economic decisions
(e.g.,whether to sell or hold an investment in the entity). Users include present
and potential investors, employees, lenders, suppliers and other trade
creditors,customers, governments and their agencies, and the public. Because
 investors are providers of risk capital, it is presumed that financial statements
that meet their needs will also meet most of the needs of other users.

Accounting Information Users and Their Needs

The basic role of accountants is to provide useful economic information to

external and internal decision makers (users) as explained below:

a. External decision makers include present and potential

stockholders,investors, creditors, suppliers, customers, legislators, trade
associations and others, who lack direct access to the information generated by
the internal operations of the business and must rely on general-purpose
financial statements to make their investment, credit and public policy
decisions.

1) Investors. The providers of risk capital and their advisers are concerned
with the risk inherent in, and return provided by their investments.
Shareholders require periodic information that the managers are
accounting properly for the resources under their control. This information
helps the shareholders to evaluate the performance of the managers. The
performance measured by the accountant shows the extent to which the
economic resources of the business have grown or diminished during the
year. Shareholders are also interested in information such as the
enterprise's ability to generate cash and the timing and certainly of its
generation. They also need information to help them control the business
and make investment decisions.
2) Employees. Employees and their representative groups are interested in
information about the stability and profitability of their employers.They are also
interested in information which enables them to assess the ability of the enterpise
to provide remuneration, retirement benefits and employment opportunities.
3) Lenders. Lenders are interested in information that enables them to determine
whether their loans, and the interest attaching to them will be paid when due.
4) Suppliers and other trade creditors. Suppliers and other creditors are interested in
information that enables them to determine whether amounts owing to them will
be paid when due. Trade creditors are likely to be interested in an enterprise over a
shorter period than lenders unless they are dependent upon the continuation of the
enterprise as a major customer.
5)Customers. Customers have an interest in information about the continuance of
an enterprise, especially when they have a long-term involvement with, or are
 dependent on, the enterprise.
6)Governments and their agencies. Governments and their agencies are interested
in the allocation of resources and, therefore, the activities of enterprises. They also
require information in order to regulate the activities of enterprises, determine
taxation policies and as the basis for national income and similar statistics.
7)Public. Enterprises affect members of the public in a variety of ways. For
example,enterprises may make a substantial contribution to the local economy in
many ways, including the number of people they employ and their patronage of
local suppliers. Financial statements may assist the public by providing information
about the trends and recent developments in the prosperity of the enterprise and
the range of its activities.
b. Internal decision makers are the managers of a business entity,responsible for
managing efficiently and effectively, and who have the power and authority to obtain
whatever economic information they need.The process of providing accounting
information to internal decision makers is called management accounting.
Financial Statements

Financial statements are the principal means through which a company communicates
its financial information to those outside it. These statements provide a company's
history quantified in money terms.

Some financial information is better provided, or can be provided only,by means

of financial reporting other than formal financial statements.Examples include
the president's letter or supplementary schedules in the corporate annual
report, prospectuses, reports filed with government agencies, news releases,
management's forecasts, and social or environmental impact statements.
Companies may need to provide such information because of authoritative
pronouncements, regulatory rule,or custom. Or they may supply it because
management wishes to disclose it voluntarily.

Although there are other ways to communicate external financial information such as
the prospectus, news releases, the president's letter and other supplementary
schedules, the complete set of financial statements are primary. This includes the
following:
a.The statement of financial position as at a certain point in time. This statement
shows the resources of a company (the assets),the company's obligations (the
liabilities), and the net difference between its assets and liabilities,which
represents the equity of the owners. The statement of financial position
 addresses these fundamental questions: What does a company own? What does
it owe?
b. The statement of profit or loss and other comprehensive income for the
period or for a certain interval. This reflects the net assets generated through
business operations (revenues), the net assets consumed (expenses), and the
difference, which is called net income as well as other comprehensive income.
C.The statement of cash flows reports, for a certain interval,the amount of cash
generated and consumed by a company through the following three types of
activities: operating, investing, and financing. The statement of cash flows is the most
objective of the financial statements because it is somewhat insulated from the
accounting estimates and judgments needed to prepare a statement of financial
position and statement of profit or loss.
The Environment of Financial Accountig and
Reporting 7
d. The statement of changes in equity which summarizes the changes in each
item of equity for a period of time.
e. The notes to the financial statements. The notes contain supplemental
information as well as information about items not included in the financial
statements such as accounting estimates. Each financial statement routinely
carries the following warning printed at the bottom of the statement. “The
notes to the financial statements are an integral part of this statement.”

Auditors, working independently of a company's management and internal

accountants, examine the financial statements and issue an auditor's opinion
about the fairness of the statements and their adherence to proper accounting
principles. The opinion is based on evidence gathered by the auditor from the
detailed records and documents maintained by the company and from a review
of the controls over the accounting system.

In compliance with statutory requirements, financial statements and

accompanying notes presented to external users (particularly corporations as
well as registered partnerships) are audited by an independent certified public
accountant (CPA).

Development and Sources of Financial Reporting Standards

To a large extent, accounting is a product of its environment; that is, it is
shaped by, reflects, and reinforces particular characteristics unique to its
 national environment. Like business in general, corporate accounting and
information disclosure practices are influenced by a variety of economic,social
and even political factors. While there are many differences in national
environments, with corresponding varying effects on accounting systems and
reporting, there are also many similarities.

Because business is increasingly conducted across national borders,companies

must be able to use their financial statements to communicate with external
users all over the world. As a result, divergent national accounting practices are
now converging to an overall global standard.
Sources of Accounting Standards

Setting financial reporting standards is a complex process occurring within a political

environment that influences both what reporting is required and when. Businesses, trade
and consumer associations, courts, public accounting firms, individual users, and
government can and do influence reporting practice. The following provides the
authoritative support for these accounting standards:

a. International Accounting Standards Board (IASB) {Formerly International Accounting Standards

Council (IASC)}.

In an attempt to harmonize conflicting standards, the International Accounting

Standards Council was formed in 1973 to develop worldwide accounting standards. The
original IASC was founded by representatives of professional bodies in Australia,
Canada,France,Germany, Japan, Mexico, the Netherlands, the United Kingdom,
Ireland,and the United States. By 2012, out of 196 countries, over 120 countries have
either fully or partially adopted and permitted the use of International Financial
Reporting Standards.

The accounting standards produced by the IASB are referred to as International Financial
Reporting Standards (IFRSs) and International Accounting Standards (IASs). The
difference between these two sets of standards is merely one of timing; the IASB
standards issued before 2001 are called IAS and those issued since 2001 are called IFRS.
In practice, the entire body of IASB standards is referred to simply as IFRS.The
International Financial ReportingInterpretations Committee (IFRIC)which was called the
Standing Interpretations Committee (SIC) before 2002 provides technical assistance and
support to the IASB in the implementation of the standards.

Rationale for the Adoption of International Fimancial Reporting Standards (IFRSs)

In view of the greatly magnified emphasis on international commerce

and capital flows over the past thirty years,the need for global
accounting standards has been increasingly recognized. Multinational
 companies have grown dramatically in both size and importance over
this period, assuming very important and dominant roles in many
market segments and
The Environment of Financial Accounting and Reporting 9
affecting almost every country, every government, and every person.

From a financial reporting perspective, both individual accountants and the

professional bodies that establish accounting and auditing standards, face a
daunting challenge and difficulty because of the complexity of conducting
international business operations across borders each with a different set of
business regulations and often different accounting methods.

Differences in applicable accounting, auditing and tax standards and regulations

may negatively impact the ability of the enterprise to prepare reliable financial
information and for the evaluation of investment opportunities vital to their
further expansion or growth.

Hence, it was envisioned that IFRSs which should be capable of worldwide

acceptance can contribute to a significant improvement in the quantity and
comparability of corporate financial reports. They are the set of standards that
can be used by all companies regardless of where they are based. In fact,IFRSs
may eventually supplement or even replace standards set by national standard
setters.

Standard-Setting Due Process

As part of its due process in developing new or revised Standards, the Board
publishes an Exposure Draft of the proposed Standard for public comment in
order to obtain the views of all interested parties. It also publishes a “Basis for
Conclusions” to its Exposure Drafts and Standards to explain how it reached its
conclusions and to give background information. When one or more Board
members disagree, with a Standard, the Board publishes those dissenting
opinions with the Standard. To obtain advice on major projects, the Board often
forms advisory committees or other specialist groups and may also hold public
hearings and conduct field tests on proposed Standards.
1 Chapter 1
0 b. Financial Reporting Standards Council (FRSC) {Formerly Accounting Standards
Council (ASC)}.

The Professional Regulation Commission (PRC) of the Republic of the Philippines

upon the recommendation of the Board of Accountancy created an accounting
 standard setting body known as the Financial Reporting Standards Council (FRSC) to
assist the Board in carrying out its powers and functions provided for in Article II,
Section 9 (g) of the Philippine Accountancy Act of 2004 (R.A.9298) and Section 9 (a)
of the Implementing Rules and Regulations of the said law.

The FRSC is composed of fifteen (15) members with a Chairman,who had been or
presently a senior accounting practitioner in any of the scope of accounting practice
and fourteen (14) representatives from the following:

(a) Board of Accountancy 1

(b) Securities and Exchange Commission 1
(c) Bangko Sentral ng Pilipinas 1
(d) Bureau of Internal Revenue 1
(e) A major organization composed of preparers and users of financial
statements 1

(f)Commission on Audit 1
(g)Accredited National Professional Organization of CPAs
Public Practice 2
Commerce and Industry 2
Academe/Education 2
Government 2 8

14

The FRSC actively participates in the evaluation and deliberation of

proposed IFRSs forwarded by the IASB to the country's standard setting
body and submits to the Board of Accountancy its recommendation for
the adoption of the proposed IFRS. Once approved, the IFRS is
designated as Philippine Financial Reporting Standard (PFRS).
The Environment of Financial Accounting
and Reporting 11
Other Organizations Influencing Financial and Reporting
Accounting Standards
c. Securities and Exchange Commission (SEC). The Securities and
Exchange Commission has the legal authority to prescribe
accounting principles and practices for usually all companies
issuing publicly traded securities. To date, the SEC has participated
 in the formulation of accounting principles. In addition, the SEC
administers the extensive disclosure requirements of the Securities
Act.

d. Philippine Institute of Certified Public Accountants (PICPA). The

Philippine Institute of Certified Public Accountants, the PRC
accredited professional organization is in the forefront in the
standard setting activities in the country. Representatives from the
four sectors of the organization (public practice, commerce and
industry, education and government) are appointed to FRSC.

e. Other professional associations also influence the development

of accounting standards. The Financial Executives Institute (FINEX)
is composed mainly of high-level financial executives. The Institute
of Management Accountants (IMA) emphasizes managerial and
cost accountancy. Each of these organizations provides input to
the Philippine Financial Reporting Standards (PFRS) through
representation in the FRSC. Technical papers and publications of
accounting educators are also included as sources of accounting
standards.

f. Bureau of Internal Revenue (BIR). The Bureau of Internal

Revenue administers the provisions of the Internal Revenue Code.
These provisions do not always reflect the goals of financial
accounting.However, they do at times influence the choice of
accounting methods and procedures.
Ethics in the Accounting Environment

Ethics is a term that refers to a code or moral system that provides criteria for
evaluating right and wrong. One of the elements that many believe distinguishes a
profession from other occupations is the acceptance by its members ofa
responsibility for the interests of those it serves.

Because of the important role of accounting in society, accountants must maintain

high ethical standards. Facing pressures and influence of numerous groups with
conflicting.interests, the accountant should always be alert about ethical behavior.
The Code of Ethics promulgated by the Board of Accountancy provides guidelines for
 practicing accountants. However, the code does not present a strctured approach to
resolving ethical dilemmas and conflicts.

In general, the accountant should be able to recognize and understand ethical issues
to identify and evaluate the possible consequences of each of the alternative
solutions and to select the best alternative which will ensure relevant,reliable,
comparable and consistent financial information to serve the best of the users'
interests as a whole..

CPAs as well as other accountants are expected to make unswerving commitment to

honorable behavior, even at the sacrifice of personal advantage.

Creative and Critical Thinking in Accounting

The global business environment is continually becoming more complex,with new
products, services, and methods of production, distribution,and communication.
Globalization is occurring, with more and more companies becoming international in
their operating activities by buying, producing and selling products in foreign
countries. Government regulations are increasing,as more concern and attention are
given to such issues as worker safety and pollution control.

To establish and maintain accounting systems which meet the needs of

users,accountants must be both creative and critical thinkers. Creative thinking
involves the use of imagination and insight to solve problems by finding new
relationships (ideas) among items of information. Terms that are used to describe a
creative thinker include insightful, intuitive, imaginative,sensitive, flexible, original,
adaptable, and tolerant of ambiguity.Critical
 19
The Environment of Financial Accounting and Reporting
thinking involves the logical analysis of issues, using inductive or deductive reasoning to
test new relationships (ideas) to determine their effectiveness. It also involves using
inductive or deductive reasoning to analyze an issue logically. A critical thinker is
described as one who is objective,independent,analytical, logical, rational, consistent,
organized, and able to synthesize.

In financial accounting, accountants tend to be problem solvers. Problem solving

generally involves the following steps:
(1)Recognizing a problem,
(2) Identifying alternative solutions,
(3)Evaluating the alternatives,
(4) Selecting a solution from among the alternatives, and
(5) Implementing the solution.

In problem solving, creative thinking is most important in the identification of alternative

solutions while critical thinking is most important in the evaluation of the alternative
solution.
REVIEW QUESTIONS AND EXERCISES
Questions
Q1-1. What is the function and primary focus of financial accounting?
Q1-2. What is meant by the phrase efficient allocation of resources?
Q1-3. What is the economic and political environment in which standard setting occurs?
Q1-4. What are the two categories of financial statements users?Differentiate their decision-
making needs.
Q1-5. Describe financial reporting and how may a company's financial information be reported?
Q1-6. What is the International Accounting Standards Board and what is its role?
Q1-7. What five items make up the general- purpose financial statements?
Q1-8. Why are differing national accounting standards converging to a common global standards?
Q1-9. List the steps a person should follow to determine whether an action is ethical.
Q1-10. What is critical thinking? How would you describe a creative thinker?
Q1-11. What is creative thinking? How would you describe a creative thinker?
Multiple Choice Questions

MC1-1. Choose the correct statement:

a. Financial accounting is a social science and cannot be influenced by changes
in legal, political, business and social environments.
b. Financial accounting is an information system designed to provide
information primarily to internal users.
C. General-purpose financial statements must be prepared by a certified public
accountant.
d. The preparation of general-purpose financial statements is usually based on
the assumption that the primary users of the information are external decision
makers.

MC1-2. Which of the following statements is false?

a. Financial reporting should provide information which is relevant to
investment, credit and public policy decisions.
b. Generally speaking, Philippine Financial Reporting Standards (PFRSs) are
those standards with substantial authoritative support.
C.(PFRSs) are established to ensure the relevancy of the general-purpose
financial statements to the widespread uses of the information by external
decision makers.
d. Once established, PFRS should never be changed.

MC1-3. Which of the following statements is true?

a. Managers of an entity are considered to be internal decision makers.
b. External decision makers can obtain whatever financial data they need
whenever they need it.
C. Accounting information is prepared for and useful to only outside decision
makers.
d. The members of the Board of Directors are not “external users” of financial
information, but are “internal users” only.
MC1-4. Choose the incorrect statement.
 a. The objective of external financial statements is to communicate the economic effects
of completed transactions and other events on the entity.
b. The practice of accounting requires considerable professional judgment.
C. Security analysts use information from financial statements and other sources to
project future earnings.
d. The assessment of earnings quality has become an exact science.

MC1-5. Which of the following statements is correct?

a. Certified Public Accountants are not independent for the benefit of the users,of
the financial statements, because they are paid by the client.
b. Accounting concepts, principles and standards are just as broad and general today
as they were sixty years ago.
C. Due to the excellent work of the FRSC,there are very few choices among alternative
accounting policies today.
d. Disclosure notes are an integral part of the financial statements.

MC1-6. Choose the incorrect statement.

a.Benefits provided by accounting procedures should exceed their cost.
b. The Securities and Exchange Commission (SEC) exerts influence on the development of
accounting standards.
C. The primary function of the Financial Reporting Standards Council is to develop
and enforce auditing standards.
d. The double-entry system of accounting has been used for centuries.

MC1-7. External decision makers include all of the following except:

a. managers.
b. owners.
C. creditors.
d. financial press.
MC1-8. General-purpose financial statements report financial information

relevant to:
a. investors only.
b.creditors only.
C. government users only.
d. investors, creditors and government users.
MC1-9. Which of the following best states the purpose of general-purpose financial
statements?
a. To disclose the market value of the firm's assets and liabilities.
b. To determine compliance with tax laws.
C.To identify shareholders.
d. To help users make decisions.

MC1-10. Which of the following statements about International Accounting Standards is

true?
a. International standards are enforceable world-wide, in order to allow for
judgments regarding international investments.
b. Legal and psychological hurdles to achieving common reporting standards
have largely been overcome.
C. The International Accounting Standards Board (IASB) was established with the
purpose ofnarrowing the range of divergence in accounting standards used
throughout the world.
d. The IASC is able to enforce its standards by prohibiting the listing of
companies which do not comply on stock exchanges which sell internationally.

MC1-11. Which of the following is an internal user of a company's financial information?

a. company treasurer
b. stockholder in the company
C.bank lending to the company
d. union representative
MC1-12. Which of the following is not a decision that external users of a

company's financial information would make?

a. whether or not to extend credit to the company
b. whether or not to hold the company's stock
c. whether or not the company should add a new product line
d.whether or not to ask for an increase in employees' benefits during union contract
negotiations

MC1-13. Critical thinking is most important in which of the following problem-solving steps?
a. recognizing a problem
b. identifying alternative solutions
 c. evaluating the alternatives
d. selecting a solution from among the alternatives

MC1-14. Which of the following areas within the accounting field has as its main purpose serving
the information needs of parties outside the reporting firm?
a. Financial accounting.
b. Tax accounting.
c. Managerial accounting.
d.Auditing.

MC1-15. External financial statements, according to FRSC Presentation of Financial Statements, should
provide all of the following information except:
a. information that is useful to present and potential investors and creditors and other
users in making rational investment, credit, and other decisions.
b. information that is comprehensible to those who have a reasonable understanding of
business and economic activities and are willing to study the information with reasonable
diligence.
C. information for planning the future of the entity, implementing those plans, and for
controlling daily operations.
d. information to help present and potential investors and creditors and other users in
assessing the amounts, timing and uncertainty of prospective cash receipts.
CHAPTER 2

Conceptual Framework and Theoretical Structure of

Financial Accounting and Reporting

ntroduction
The conceptual framework allows for the systematic adaptation of accounting standards for a
changing business environment. It aids in an organized and consistent development of new
accounting standards and allows one to understand and, perhaps, anticipate future standards. A
strong theoretical foundation is essential ifaccounting practice is to keep pace with a changing
business environment. Accountants are continually faced with new situations, technological
advances, and business innovations that present new accounting and reporting problems. These
 problems must be dealt with in an organized and consistent manner. The conceptual framework
plays a vital role in the development of new standards and in the revision of previously issued
standards. Recognizing the importance of this role, the standards setters (IASB) stated that
fundamental concepts “guide the Board in developing accounting and reporting standards by
providing... a common foundation and basic reasoning on which to consider merits of
alternatives.”In a very real sense, then, the IASB itself is a primary beneficiary of a conceptual
framework. In addition, when accountants are confronted with new developments that are not
covered by IFRS, a conceptual framework provides a reference for analyzing and resolving
emerging issues. Thus,a conceptual framework not only helps in understanding existing practice
but also provides a guide for future practice.

This conceptual framework outlines the objectives of financial reporting and the qualities of
good accounting information, precisely defines commonly used terms such as asset and
revenue, and provides guidance about appropriate recognition, measurement, and
reporting.
The increasing complexity of our business world creates growing pressure on the standard setters to delicately
balance the many constituents of the accounting standard-setting process. The task of IASB and the national
standard setters of the world is made less complex if there exists a set of cohesive objectives and fundamental
concepts on which financial accounting and reporting can be based.

Described as a constitution, the conceptual framework is a coherent system of interrelated objectives and
fundamentals that can lead to consistent standards and that prescribe the nature, function, and limits of financial
accounting and reporting. The fundamentals are the underlying concepts of accounting, concepts that guide the
selection of events to be accounted for,the measurement of those events, and the means of summarizing and
communicating them to interested parties.

The conceptual framework issued by the IASB in September 2010superseded the Framework for the Preparation
and Presentation of Financial Statements. The Philippine Regulatory Board of Accountancy approved its adoption
in July 2011 upon the recommendation of the Financial Reporting Standards Council.

Financial statements are prepared to meet the common needs of most users who make economic decisions such
as :
a) to decide when to buy, hold or sell an equity investment;
b) to assess the stewardship or accountability of management;
c) to assess the ability of the entity to pay and provide other benefits to its employees;
d) to assess the security for amounts lent to the entity;
e) to determine taxation policies;
 f) to determine distributable profits and dividends;
g) to prepare and use national income statistics; and
h) to regulate the activities of entities.

The IASB and the FRSC recognize however, that governments adopting the accounting standards, may specify
different or additional requirements for their own nurposes.
Purpose of the Conceptual Framework

This conceptual framework sets out the concepts that underlie the preparation and presentation of
financial statements for external users. The comprehensive purposes of the Conceptual Framework
are:
a) To assist the Board in the development of future IFRSs and in its review of existing IFRSs;
b)To assist the Board in promoting harmonisation of regulations,accounting standards and
procedures relating to the presentation of financial statements by providing a basis for reducing the
number of alternative accounting treatments permitted by IFRSs;
c) To assist national standard-setting bodies in developing national standards;
d) To assist preparers of financial statements in applying IFRSs and in dealing with topics that have
yet to form the subject of an IFRSs;
e)To assist auditors in forming an opinion on whether financial statements comply IFRSs;
f) To assist users of financial statements in interpreting the information contained in financial
statements prepared in compliance with IFRSs;and
g) To provide those who are interested in the work of IASB with information about its approach to
the formulation of IFRSs.

In the Philippines, both the Board of Accountancy and the Securities and Exchange Commission
require the use of the Full Philippine Accounting Standards (PASs), Philippine Financial Reporting
Standards (PFRSs), the counterpart of IASB's International Accounting Standards (IASs) and
International Financial Reporting Standards (IFRSs), respectively to the following public-interest
entities (entities with public accountability):
Publicly-Interest Entities
(a) Entities which have issued a class of securities listed for trading on an Exchange.
Other Public-Interest Entities but Not Listed

(a) Entities which have sold a class of their securities pursuant to a registration under Section 12
of the Securities Regulation Code;
 (b) Entities with assets of at least P50 million and having 200 or more holders each holding at
least 100 shares of a class of its equity securities as of the first day of the issuers' fiscal year;
(c) Entities which are in the process of filing their financial statements for the purpose of issuing
any class of instruments in a public market;
(d) Entities that hold assets in a fiduciary capacity for a broad group of outsiders such as a bank
(all types of banks), an investment house, a finance company, an insurance company, a securities
broker/dealer, a mutual fund and a pre-need company or entities with secondary license;
(e) Public utility entities;and
(f)Entities which are economically significant. These are entities whose total assets exceed P350
million or whose total liabilities exceed P250 million. Total assets and total liabilities are based on
the entity's annual financial statements and on consolidated totals, if the entity presents
consolidated financial statement. An entity that is a subsidiary of a parent that is considered to
have public accountability is similarly considered to have public accountability.

The non-public interest entities enumerated bélow are required to use the PFRS for Small-and Medium-
Sized Entities (SMEs). These entities include:
(a) Entities with total assets of between P3 million and P350 million or total liabilities of between
P3 million and P250 million;
(b) Entities not required to file financial statements under Securities Regulation Code Rule 68.1;
(c) Entities not in the process of filing their financial statements for the purpose of issuing any
class of instruments in a public market;
Conceptual Framework... 31
(d) Entities which are not holders of secondary license issued by a regulatory agency, such as a bank
(all types of banks), an investment house, a finance company, an instrument company,a securities broker /
dealer, a mutual fund and a pre-need company; and
(e) Entities which are not public utility companies.
In some cases, entities falling under this classification may apply for exemption from the use of PFRS for
SMEs. For reportorial compliance with the SEC, other businesses classified as micro-financed entities are
given the option to use as their financial reporting framework either the PFRS for SMEs,income tax basis or
accounting standards in effect as of December 31,2004 provided however, that the financial statements shall
at least consist of the Statement of Management's Responsibility, Auditor's Report, Statement of Financial
Position, Statement of Income, and Notes to Financial Statements, all of which cover the two-year
comparative periods, if applicable. These entities are those that meet all of the following criteria:
(a) Total assets or liabilities are below P3 Million;
(b) Are not required to file financial statements under Part 2 of SRC Rule 68;
 (c) Are not in the process of filing their financial statements for the purpose of issuing any class of
instruments in a public market; and
(d) Are not holders of secondary licenses issued by a regulatory agency.
The coverage and discussion of the standards in this textbook (Volumes I, II and III [Except in the Chapter on
PFRS for SMEs]) are based on Full PFRS.

Scope of the Conceptual Framework

The Conceptual Framework deals with
(a)The objective of financial reporting;
(b) The qualitative characteristics of useful financial information;
(c) The definition,recognition and measurement of the elements from which financial statements are
constructed; and
(d) Concepts of capital and capital maintenance.
Overview of the Conceptual Framework
Figure 2.1 provides an overview of the IASB's conceptual framework.

First Level: Objective

The "why"of
Financial
-purpose of Reporting
accounting

Qualitative Elements
Characteristic of
of Accounting Financial
Information Statements
Second Level: Assets
The Bridge · Liabilities
between Relevance ·Equity
Faithful
Levels 1 and 3 Predictive ·Income
Value Representation ·Expenses
Confirmatory Completeness · Gains
Value Neutrality ·Losses
Free from Errors Comprehensive Income

Third Level:
The“how”-
implementation
 Figure 2.1. Overview of the Conceptual Framework
Conceptual Framework...33
Objective of General Purpose Financial Reporting
The Conceptual Framework for the Financial Reporting spells out the basic objective of general purpose financial reporting as
follows:

The objective of general purpose financial reporting is to provide 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. Those decisions involve buying, selling or holding equity and debt instruments, and
providing or settling loans and other forms of credit. (OB2)

Types of Useful Information

To help external users assess the amounts, timing and any uncertainty about the future net cash inflows of the
company, the following types of information have been identified:

a. Financial Flexibility. Financial flexibility refers to the ability of a company to use its financial resources to adapt to
change. It comes from a quick access to the cash generated from more “liquid” economic resources. But liquidity is
only part of financial flexibility. A company's financial flexibility stems from its ability to generate sufficient net cash
inflows from operations, from additional capital contributed by investors or long-term creditors, or from liquidating
long-term economic resources without disrupting continuing operations.Information about a company's financial
flexibility is important to external users in assessing the uncertainty of the company's future cash flows.

The financial position of an enterprise is affected by the economic resources it controls, its financial structure, its
liquidity and solvency,and its capacity to adapt to changes in the environment in which it operates. Information
about the economic resources controlled by the enterprise and its capacity in the past to modify these resources
is useful in predicting the ability of the enterprise to generate cash and cash equivalents in the future.
Information about financial structure is useful in predicting future borrowing needs and how future profits and
cash flows will be distributed among those with an interest in the enterprise; it is also useful in predicting how
successful the enterprise is likely to be in
34 Chapter 2
raising funds. Information about liquidity and solvency is useful in predicting the ability of the enterprise to
meet its financial commitments as they fall due.

b. Liquidity and Solvency. Liquidity refers to the availability of cash in the near future after taking account of
financial commitments over this period. Solvency refers to the availability of cash over the longer term to meet
financial commitments as they fall due.

Liquidity is the term used to describè how quickly an asset can be converted into cash or a liability paid.
Liquidity reflects an asset's or liability's nearness to cash. For operating assets,liquidity relates to the timing of
cash flows in the normal course of business. For nonoperating assets, liquidity refers to marketability. The
liquidity of a company is an indication of its ability to meet its obligations when they come due.Liquidity is
positively related to financial flexibility but negatively related to both risk and return on investment. A more
 liquid company is likely to have a superior ability to adapt to unexpected needs and opportunities and a lower
risk of failure. On the other hand, liquid assets often offer lower rates of return than nonliquid assets.

c. Operating Capability. Operating capability refers to the ability of a company to maintain a given physical level of
operations. This level of operations may be indicated by the quantity of goods or services (e.g.,inventory) of a
specified quality produced in a given period or by the physical capacity of the fixed assets (e.g., property, plant, and
equipment). Information about operating capability is helpful in understanding a company's past performance and
in predicting future changes in its volume of activities. Operating capability may be affected by changes in methods
of operations, changes in product lines,and the timing of the replacement of the service potential used up in
operations.

Information about the performance of an enterprise, in particular its profitability, is required in order to assess
potential changes in the economic resources that it is likely to control in the future. Information about
variability of performance is important in this respect. Information about performance is useful in predicting
the capacity of the enterprise to generate cash flows from its existing resource base. It is also useful in forming
judgments about the effectiveness with which the enterprise might employ additional resources.
d. Investing, Financing and Operating Activities. Information concerning changes in the financial
position of an enterprise is useful in order to assess its investing, financing and operating
activities during the reporting period. This information is useful in providing the user with a
basis to assess the ability of the enterprise to generate cash and cash equivalents and the
needs of the enterprise to utilize those cash flows. In constructing a statement of changes in
financial position, funds can be defined in various ways, such as all financial resources, working
capital,liquid assets or cash. No attempt is made in this framework to specify a definition of
funds. SFAS 22 (revised 2000) however, encourages the use of “cash and cash equivalent”
concept in the preparation of the funds statement.

Limitations of General Purpose Financial Reporting

General purpose financial reporting however, have some significant limitations. They include,
but are not limited to, the following:
1. They do not and cannot provide all the information that existing and potential investors,
lenders and other creditors need such as general economic conditions and expectations,
political events and political climate and the industry and company outlooks;
2. They are not designed to show the value of a reporting entity but they provide
information to the users to estimate the value of such entity;
3. General purpose reports may not meet the needs of individual primary users because of
the difference and sometimes conflicting information needs and desires of such users; and
 4. To a large extent, financial reports are based on estimates, judgments and models
rather than exact depictions. The conceptual framework however, establishes the
concepts that underlie those estimates,judgments and models for better understanding
acceptance and implementation by the users.
Fundamental Qualitative Characteristics of Financial Information

To be useful, financial information must make a difference in the decision process. The financial statements and their
elements are most informative and useful when they possess specific qualitative characteristics. The fundamental
qualitative characteristics are:
Relevance and
·Faithful Representation

Fundamental Quality: Relevance

Relevant financial information is capable of making a difference in the decisions made by users. Financial
information is capable of making a difference in decisions if it has
Predictive Value
Confirmatory Value
Or both

Predictive Value

Financial information has predictive value if it can be used as an input to processes employed by users to
predict future outcomes.Financial information need not be a prediction or forecast to have predictive value.
Financial information with predictive value is employed by users in making their own predictions. The
information helps usérs to increase the likelihood of correctly forecasting the outcome of past and present
events.
Confirmatory Value

Financial information has confirmatory value if it provides feedback about (confirms or changes) previous
eations. The information helps users to confirm or correct earl'er precons.

Relevant information normally provides both feedback value and predictive value at the same time. Fee on
past events helps confirm or correct earlier expectations. Such information can then be used to help predict
future outcomes. For example,when a company presents comparative income statements, an investor has
information
to compare last year's operating results with this year's. This provides a general basis for evaluating prior
expectations and for estimating what next year's results might be. Users are also able to predict the
firm's ability to take advantage of profitable opportunities and react to adverse situations.

Materiality: Its Relationship to Relevance

 A practical boundary or constraint to achieving desired qualitative characteristics of relevance on the
type of information provided is materiality. In an accounting context for example, if a more costly way of
providing information is not expected to have a material effect on decisions made by those using the
information, the less costly method may be acceptable.

Information is material if omitting it or misstating it could influence decisions that users make on the
basis of financial information about a specific reporting entity. In other words, materiality is an entity
specific aspect of relevance based on the nature or magnitude,or both, of the items to which
information relates in the context of an individual entity's financial report. Consequently, the IASB
cannot specify a uniform quantitative threshold for materiality or predetermine what could be material
in a particular situation.

Fundamental Quality: Faithful Representation

Faithful representation means that the numbers and descriptions match what really existed or happened.

The financial reports must not only represent relevant economic activity but there must also be agreement
between a measurement and the economic activity or item that is being measured.

Faithful representation is a necessity because most users have neither the time nor the expertise to evaluate
the factual content of the information.For example, if Rado Motors (Phils) Inc.'s income statement reports
sales of P60 Million when it had sales of P40 Million, then the statement fails to faithfully represent the
proper sales amount. To be a faithful representation, information must be complete, neutral and free of
material error.
3 Chapter 2
8
Completeness

Completeness means that all information necessary for a user to understand the economic activity,
or a phenomenon must be depicted,including all necessary descriptions and explanations. An
omission can cause information to be false and misleading and thus not be helpful to the users of
the financial report. For example,a complete depiction of a group of assets such as property and
equipment would include, at a minimum, a description of the nature of the assets in the group, a
numerical depiction of all the assets in the group, and a description of what the numerical
depictions represents (for example,original cost, adjusted cost or fair value).

Neutrality

Neutrality means that an enterprise cannot select information to favor one set of interested parties
over another. A neutral depiction is without bias in the selection or presentation of financial
information.It is also not slanted, weighted, emphasized, de-emphasized or otherwise manipulated
to increase the probability that financial information will be received favorably or unfavorably by
users. If financial information is biased (rigged), the public will lose confidence and no longer use it.
 Free from Errors

When an information item is free from error, it will be a more accurate (faithful) representation of a
financial item. Faithful representation, however, does not imply total freedom from error nor
perfectly accurate in all respect. This is because a number of financial reporting measures involve
estimates of various types that incorporate management's judgment. For example, management
must estimate the amount of uncollectible accounts. A representation of that estimate can be
faithful if the amount is described clearly and accurately as being an estimate, the nature and
limitations of the estimating process are explained and no errors have been made in selecting and
applying an appropriate process for developing the estimate.
Applying the Fundamental Qualitative Characteristics

Information must be both relevant and faithfully represented if it is to be useful. The most effective and
efficient process for applying the fundamental qualitative characteristics the following steps would be
followed (subject to the effects of enhancing characteristics and the cost constraint):
1. Identify an economic phenomenon or activity that has the potential to be useful to users of the
reporting entity's financial information;
2. Identify the type of information about the phenomenon that would be most relevant if it is available
and can be faithfully represented; and
3. Determine whether that information is available and can be faithfully represented.

Enhancing Qualitative Characteristics

Comparability, verifiability, timeliness and understandability are qualitative characteristics that enhance the
usefulness of information that is relevant and faithfully represented. These characteristics distinguish more-
useful information from less-useful information.

Comparability

Comparability is the qualitative characteristic that enables uses to identify and understand
similarities in and differences among items (such as economic events between companies).
Information that is measured and reported in a similar manner for different companies is
considered comparable.

Consistency, although related to comparability,is not the same as comparability. Consistency refers
to the use of the same methods for the same items, either from period to period within a reporting
entity or in a single period across entities. Comparability is the goal,consistency helps to achieve
that goal.
 Although a single economíc event or phenomenon can be faithfully represented in multiple ways,
permitting alternative accounting methods for the same event or phenomenon diminishes
comparability.
4 Chapter 2
0
Verifiability

Verifiability means that different knowledgeable and independent observers or users could reach
consensus although not necessarily complete agreement that a particular depiction is a faithful
representation. It occurs when independent measurers using the same methods obtain similar results.

Verification can be direct or indirect. Direct verification means verifying an amount or other representation
through direct observation, for example, by counting cash. Indirect verification means checking the inputs
to a model, formula or other technique and recalculating the output using the same methodology. For
example,two independent auditors compute Anscor inventory value at the end of the year using the FIFO
method of inventory valuation.

Verification may occur by checking the inputs (quantity and costs)and recalculating the outputs (ending
inventory value) using the same accounting methodology.

Timeliness

Timeliness means having information available to decision makers in time to be capable of influencing their
decisions. A lack of timeliness can rob information of its usefulness. For example, if Sony waited to report
its interim results until nine months after the period, the information would be much less useful for
decision-making purposes.

Understandability

To be useful, accounting information should be understandable to users who have a reasonable

knowledge of business and economic activities and who are willing to study the information with
reasonable diligence. Understandability serves as a “link” between the decision-makers and the
accounting information. Classifying,characterizing and presenting information clearly and concisely
make in understandable.
The Constraints on Useful Financial Reporting
Economic decision makers must recognize that the information they receive from accountants constitutes only a part
of the information they need to make sound economic decisions. The financial statements also have limitations and
imperfections which the users should keep in mind. Some of the constraints are:

Cost-Benefit Balancing

The costs of providing financial information fall initially on the preparer (the company) and then are passed
on to consumers (external users). These costs include the cost of collecting,processing, auditing, and
 communicating the information as well as those associated with losing a competitive advantage by
disclosing the information. The benefits are enjoyed by a diverse group of investors and creditors, by
customers (because they are assured a steady supply of goods and services), and by the preparer itself (for
use in internal decision making). To be reported, accounting information not only must be relevant and
reliable but it also must satisfy the benefit/cost constraint. That is, the ASC must have reasonable
assurance that the costs of implementing a standard will not exceed the benefits.

Balance between Qualitative Characteritics

In practice, a balancing, or trade-off, between qualitative characteristics is often necessary.

Generally, the aim is to achieve an appropriate balance among the characteristics in order to meet
the objective of financial statements. The relative importance of the characteristics in different
cases is a matter of professional judgment.

True and Fair View Presentation

Financial statements are frequently described as presenting fairly the financial position,
performance and changes in financial position of an enterprise. Although this framework does not
deal directly with such concepts, the application of the principal qualitative characteristics and of
appropriate accounting standards normally results in financial statements that convey what is
generally understood as presenting fairly such information.
Underlying Assumptions
The basic assumptions that have had an important impact upon the development of Financial
Reporting Standards are:

a. Accrual Basis. Under this-basis, the effects of transactions and other events are recognized when
they occur (and not as cash or its equivalent is received or paid) and they are recorded in the
accounting records and reported in the financial statements of the periods to which they
relate.Financial statements prepared on the accrual basis inform users not only of past transactions
involving the payment and receipt of cash but also of obligations to pay cash in the future and of
resources that represent cash to be received in the future. Hence, they provide the type of
information about past transactions and other events that is most useful to users in making economic
decisions.

b. Going Concern. The financial statements are normally prepared on the assumption that an
enterprise is a going concern and will continue in operation for the foreseeable future. Hence, it is
assumed that the enterprise has neither the intention nor the need to liquidate or curtail materially
the scale of its operations; if such an intention or need exists,the financial statements may have to be
prepared on a different basis and,if so, the basis used is disclosed.

Elements of Financial Statements

 Financial statements portray the financial effects of transactions and other events by grouping them
into broad classes according to their economic characteristics. These broad classes are termed the
elements of financial statements. The elements directly related to the measurement of financial
position in the statement of financial position are the assets, liabilities and equity. The elements
directly related to the measurement of performance in the income statement are income and
expenses.

In the presentation of these elements in the statement of financial position and the income
statement, a process of sub-classification is involved in order to display information in the manner
that is most useful to the users who may make economic decisions.
Conceptual Framework... 43
Financial Position

The elements directly related to the measurement of financial position are assets, liabilities and equity.

Assets

Assets are resources controlled by the entity as a result of past events and from which future
economic benefits are expected.to flow to the entity.

To qualify as assets, the resources must:

a) have future economic benefits (be capable of producing profits).
b) be under management's control (can be freely deployed or disposed of).
c)1result from past transactions (be in place now, as opposed to being under contract for
manufacture,creation or delivery).

Liabilities.

Liabilities are present obligations of the entity arising from past events, the settlement of which is
expected to result in an outflow from the entity of resources embodying economic benefits.

To qualify as liabilities, obligations must:

a) require transfer of assets having future economic benefits.
b) specify to whom the assets must be transferred (the terms, parties, and conditicns under
which asset transfers will take place must be specified).
c) result from past transactions (be binding obligations now, as opposed to obligations that will
exist once pending transactions are completed).
Equity
 Equity is the residual interest in theassets of the entity after deducting all its liabilities.

Performance

Profit is frequently used as a measure of performance or as the basis for other measures, such as return on
investment or earnings per share. The elements directly related to the measurement of profit are income and
expenses. The recognition and measurement of income and expenses,and hence profit, depends in part on
the concepts of capital and capital maintenance used by the entity in preparing its financial statements.

Income

Income is increases in economic benefits during the accounting period in the form of inflows or
enhancements of assets or decreases of liabilities that result in increases in equity other than those
relating to contributions from equity participants.

Income encompasses both revenue and gains. Revenue arises in the course of the ordinary activities
of an entity and is referred to by a variety of names including sales, fees, interest, dividends royalties
and rent. Gains represent income items that may or may not arise in the course of the ordinary
activities of the entity.Gains may include those arising from the disposal of non-current assets,
revaluation of marketable securities and those resulting from increases in the carrying amount of
long-term assets.

Expenses

Expenses are decreases in economic benefits during the accounting period in the form of outflows or
depletions of assets or concurrence of liabilities that result in decreases in equity,other than those
relating to distributions to equity participants.

Expenses encompass losses as well those expenses that arise in the course of the ordinary activities
of the entity involving an outflow or depletion of costs. Examples are cost of sales, wages and
depreciation. Losses represent other expenses that may or
may not arise in the course of theordinary activities of the entity.Losses represent decreases in
economic benefits. Examples are losses from fire and flood, loss on the disposal of non-current
assets.

Capital Maintenance Adjustments

The revaluation or restatement of assets and liabilities gives rise to increases or decreases in
equity. While these increases or decreases meet the definition of income and expenses, they are
not included in the income statement under certain concepts of capital maintenance. Instead
these items are included in equity as capital maintenance adjustments or revaluation reserves.

Recognition and Measurement Concepts

 Now that the various elements of financial statements have been identified,we discuss when they
should be recognized (recorded) and how they should be measured.

Recognition of the Elements of Financial Statements

Paragraph 4.37 of the Framework states that recognition is the process of incorporating in the
statement of financial position or income statement an item that meets the definition of an element
and satisfies the criteria for recognition set out below. It involves the depiction of the item in words
and by a monetary amount and the inclusion of that amount in the statement of financial position or
income statement totals. Items that satisfy the recognition criteria should be recognized in the
statement of financial position or income statement. The failure to recognize such items is not
rectified by disclosure of the accounting policies used or by notes or explanatory material.

An item should be recognized in the basic financial statements when it meets the following criteria,
subject to a cost effectiveness constraint and materiality threshold:
a) It is probable that any future economic benefit associated with the item will flow to or from
the enterprise; and
4 Chapter 2
6
b) The item has a cost or value that can be measured with reliability.Information is reliable when it is complete,
neutral and free from errors.

1) Recognition of Assets. An asset is recognized in the statement of financial position when it is probable that the
future economic benefits will flow to the enterprise and the asset has a cost or value that can be measured reliably.

2) Recognition of Liabilities. A liability is recognized in the statement of financial position when it is probable that an
outflow of resources embodying economic benefits will result from the settlement of a present obligation and the
amount at which the settlement will take place can be measured reliably.

3) Recognition of Income. Income is recognized in the income statement when an increase in future economic
benefits related to an increase in an asset or a decrease of a liability has arisen that can be measured reliably.

4)-Recognition of Expenses. Expenses are recognized in the income statement when a decrease in future economic
benefits related to a decrease in an asset or an increase of a liability has arisen that can be measured reliably. This
means, in effect, that recognition of expenses occurs simultaneously with the recognition of an increase in liabilities
or a decrease in assets (for example, the accrual of employee benefits or the depreciation of equipment).

Measurement of the Elements of Financial Statements

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. This
involves the selection of the particular basis of measurement.
 Bases of Measurement. A number of different measurement bases.are employed to different degrees in varying
combinations in financial statements. They include the following:

1) Historical cost. Assets are recorded at the amount of cash or cash equivalents paid or the fair value of the
consideration given to acquire them at the time of their acquisition. Liabilities are recorded
at the amount of proceeds received in exchange for the obligation, or in some circumstances (for example,
income taxes), at theamounts of cash or cash equivalents expected to be paid to satisfy the liability in the
normal course of business. This is the most common basis adopted by enterprises.

2) Current cost. Assets are carried at the amount of cash or cash equivalents that would have to be paid if the
same or an equivalent asset was acquired currently. Liabilities are carried at the undiscounted amount of cash
or cash equivalents that would be required to settle the obligation currently.

3) Realizable (settlement) value. Assets are carried at the amount of cash or cash equivalents that could
currently be obtained by selling the asset in an orderly disposal. Liabilities are carried at their settlement values;
that is, the undiscounted amounts of cash or cash equivalents expected to be paid to satisfy the liabilities in the
normal course of business.

4) Present value. Assets are carried at the present discounted value of the future net cash inflows that the item
is expected to generate in the normal course of business. Liabilities are carried at the present discounted value
of future net cash outflows that are expected to be required to settle the liabilities in the normal course
ofbusiness.

Concepts of Capital and Capital Maintenance

Financial statements are most commonly prepared in accordance with the nominal financial capital
maintenance concept. Other concepts may be more appropriate in order to meet the objective of providing
information that is useful for making economic decisions although there is presently no consensus for
change. This Framework has been developed so that it is applicable to a range of concepts of capital and
capital maintenance.

Concepts of Capital

a. Financial concept. A financial concept of capital is adopted by most enterprises in preparing their financial
statements. Under a financial concept of capital, such as invested money or invested purchasing
power,capital is synonymous with the net assets or equity of the enterprise. A financial concept of capital
should be adopted if the users of financial
statements are primarily concerned with the maintenance of nominal
invested capital or the purchasing power of invested capital.

b. Physical concept. Under a physical concept of capital, such as operating capability, capital is regarded as the
productive capacity of the enterprise based on, for example, units of output per day. If the main concern of users
is with the operating capability of the enterprise, a physical concept of capital should be used.
Concepts of Capital Maintenance

a. Financial capital maintenance. Under this concept, a profit is earned only if the financial (or money) amount of
the net assets at the end of the period exceeds the financial (or money) amount of net assets at the beginning of
the period, after excluding any distributions to,and contributions from, owners during theperiod. Financial capital
maintenance can be measured in either nominal monetary units or units of constant purchasing power.

Under the concept of financial capital maintenance where capital is defined in terms of nominal monetary
units, profit represents the increase in nominal money capital over the period. Thus, increases in the prices
of assets held over the period, conventionally referred to as holding gains, are, conceptually, profits. They
may not be recognized as such,however, until the assets are disposed of in an exchange transaction.

b. Physical capital maintenance. Under this concept, a profit is earned only if the physical productive capacity (or
operating capability) of the enterprise (or the resources or funds needed to achieve that capacity) at the end of
the period exceeds the physical productive capacity at the beginning of the period, after excluding any
distributions to, and contributions from, owners during the period.

Under the concept of physical capital maintenance where capital is defined in terms of the physical
productive capacity, profit represents the increase in that capital over the period. All price changes affecting
the assets and liabilities of the enterprise are viewed as changes in the measurement of the physical
productive capacity of the enterprise;hence,they are treated as capital maintenance adjustments that are
part of equity and not as profit.
Exercises

E2-1.
In the blanks provided to the left of the following eight statements,enter the letter
of the 'concept most closely associated with the statement.

Concepts

A. Reliability
B. Relevance
C. Comparability (includes consistency)
D. Some other concept

Statements

Improves comparisons of financial statements of successive reporting periods.

Financial statements are audited by an independent CPA.
A quality requiring that data should be comparable among entities and time.
 The Acquisition cost is the proper starting point for asset valuation.
capacity of A quality that states that accounting information should possess
information representational faithfulness, verifiability and neutrality.
to make a The primary stock exchanges, such as the Philippine Stock Exchange, will not
difference in list (i:e., market) the shares of stock of a corporation that does not provide
decisions by independently audited financial statements, or that has major exceptions specified
helping in the opinion of the independent auditor.
users make A company cannot change to and from alternatively acceptable
reasonable accounting methods (such as FIFO, Weighted Average, etc.) each reporting
predictions period.
about the
future.
E2-2. Listed below are several terms and phrases associated with the IASB's conceptual framework. Pair
each item from List A (by letter)with the item from list B that is most appropriately associated wit
it.

List A List B
1.Predictive value a. Decrease in equity resulting transfers to owners.
b. Requires considerations of the costs and value of
2. Relevance information.
3. Timeliness - c. Important for making inter firm comparisons. "
d. Applying the same accounting practices overtime.
4.Distribution to owners e.Along with relevance, a primary decision-specific
quality
5. Confirmatory valuer f. Agreement between a measure and the phenomenon
it purports to represent.
6.Reliability
g. Information is available prior to the decision.
7.Gain-
8.Faithfulness h. Pertinent to the decision at hand.
Representation 14.Consistency
9. Comprehensive income
15.Cost effectiveness
10.Materiality
16. Verifiability
11.Comparability

12.Neutrality

13. Recognition-
 m. Accounting information should not favor a
i. Implies consensus. among different measures. particular group.
j. Information confirms expectations.
k. The change in equity from nonowner n. Results if an asset is sold for more than its book
transactions. value.
l.The process of admitting information into o. Information is useful in predicting the future.
financial statements. p.Concerns the relative size of an item and its effect on
decisions.
E2-3
Match the phrases with the accounting terms by entering the letter of a
phrase to the left of each accounting term.

Phrases
A. Inflows of assets or settlements of liabilities during a period from
delivering goods or services related to ongoing, central operations.
B. Outflows or consumption of assets or in currences of liabilities from
delivering goods or services related to ongoing, central operations.
C. Decreases in equity from peripheral or incidental transactions.
D. Increases in equity from peripheral or incidental transactions.
E. Probable future sacrifices of economic benefits arising from present
obligations.
F. Probable future economic benefits obtained as a result of past
transactions or events.
G. Residual interest in assets belonging to owners.
H. All changes in equity during a period except those resulting from
investments by owners and distributions to owners.

Accounting Terms
1. Assets
2. Comprehensive income
3. Equity
4. Expense
5. Gains
 6.
Liabilities
7.
Losses
8.
Revenues
E2-5. Match the qualitative characteristics below with the following statements.

1.Relevance 5.Comparability
2.Faithful representation 6.Completeness
3. Predictive value 7.Neutrality
4.Confirmatory value 8.Timeliness

(a) Quality of information that permits users to identify similarities in and

differences between two sets of economic phenomena.

(b)Having information available to users before it losses its capacity to influence

decisions.

(c)Information about an economic phenomenon that has value as an input to the

processes used by capital providers to form their own expectations about the
future.

(d)Information that is capable of making a difference in the decisions of users in

their capacity as capital providers.

(e) Absence of bias intended to attain a predetermined result or to induce a

particular behavior.
54 Chapter 2
E2-6. Match the qualitative characteristics below with the following statements.

1. Timeliness 5.Faithful representation

2.Completeness 6.Relevance
3.Free from error 7.Neutrality
4.Understandability 8. Confirmatory value

(a) Quality of information that assures users that information represents

the economic phenomena that it purports to represent.

(b) Information about an economic phenomenon that changes past or

present expectations based on previous evaluation.

(c) The extent to which information is accurate in representing the

economic substance of a transaction.

(d) Includes all the information that is necessary for a faithful

representation of the economic phenomena that it purports to represent.

(e) Quality of information that allows users to comprehend its meaning.

E2-7. Fill in the blanks related to the following statements.

1. Financial reporting imposes ; the benefits of financial reporting should

justify those

2. The information provided by focuses on the needs of all capital

providers, not just the needs of a particular group.

3. A depiction of economic phenomena is if it includes all the information

that is necessary fro faithful representation of the economic phenomena
that it purports to represent.

4. is the quality of information that allows users to comprehend its

meaning.

5. is the quality of information that permits users to identify similarities in

and differences between two sets of economic phenomena.

6. Information about economic phenomena has_if it changes past or

present expectation based on previous evaluation.
 Conceptual
Framework...55
Multiple Choice Questions

MC2-1. Choose the statement that is correct.

a. External decision makers can obtain whatever financial data they need
whenever they need it.
b. Accounting information is prepared for and useful to only outside decision
makers.
C. The members of the Board of Directors are not "external users” of financial
information, but are “internal users” only.
d. Managers of an entity are considered to be internal decision makers.

MC2-2. Choose the incorrect statement.

a. The objective of external financial statements is to communicate the
economic effects of completed transactions and other events in the entity.
b. General purpose financial statements were developed primarily because all
outside users have the same information needs.
C. The double-entry system of accounting has been used for centuries.
d. The practice of accounting requires considerable professional judgment.

MC2-3. Choose the incorrect statement.

a. Disclosure notes facilitate the evaluation of enterprise position and
performance because they include information which helps to explain the
quality of earnings.
b. Disclosure notes are an integral part of the financial statements.
C. Companies often look for opportunities to smooth earnings.
d. Accounting concepts, principles and standards are just as broad and
general today as they were sixty years ago.

MC2-4. A primary objective of financial reporting is to:

a. assist investors in analyzing the economy.
b. assist suppliers in determining an appropriate discount to offer a particular
company.
c. 'assist investors in predicting prospective cash flows.
d. assist banks to determine an appropriate interest rate for their commercial
loans.
MC2-5. Which of the following is the incorrect statement?
 a. Theory can be defined as a coherent set of
hypothetical,conceptual, and pragmatic principles forming a
general frame of reference for a field of inquiry.
b. Accounting theory has developed primarily in response to
government regulations.
C. Concepts are components of theory.
d. Accounting concepts are human-made.

MC2-6. Accounting concepts are not derived from:

a. inductive reasoning.
b. experience.
c. pragmatism.
d. laws of nature.

MC2-7. The primary qualitative characteristics of accounting information

include which of the following:
a. comparability.(including consistency).
b. understandability.
c. relevance.
d.materiality.

MC2-8. If accounting information is timely and has predictive and feedback

value, then it can be characterized as:
a.verifiable.
b. relevant.
c. reliable.
d. qualitative.

MC2-9. Comparability is sometimes sacrificed for:

a. reliability.
b. conservatism.
c. objectivity.
d.relevance.
MC2-10.What is the authoritative status of the framework?
 a. It has the highest level of authority. In case of a conflict between the
Framework and a Standard or Interpretation, the framework overrides the
Standard or Interpretation.
b. If there is a Standard or Interpretation that specifically applies to a
transaction, it overrides the Framework. In the absence of a Standard or an
Interpretation that specifically applies, the framework should be followed.
C. If there is a Standard or Interpretation that specifically applies to a
transaction, it overrides the Framework. In the absence of a Standard
or an Interpretation that specifically applies to a transaction,
management should consider the applicability of the Framework in
developing and applying an accounting policy that results in
information that relevant and reliable.
d. The Framework applies only when IASB develops new or revised
Standards. An entity is never required to consider the framework

MC2-11.What is the objective of financial statements according to the framework?

a. To provide information about the financial position, performance,and
changes in financial position of an entity that is useful to a wide range of
users in' making economic decisions.
b. To prepare and present a Statement of Financial Position, an income
statement, a cash flow statement, and a statement of changes in equity.
C. To prepare and present comparable, relevant, reliable, and
understandable information to investors and creditors.
d. To prepare financial statements in accordance with all applicable
Standards and interpretations.

MC2-12. Which of the following are underlying assumptions of financial statements?

a. Relevance and Reliability.
b. Financial capital maintenance and physical and physical capital
maintenance.
C. Accrual basis and going concern.
d.Prudence and conservatism.
MC2-13. What are qualitative characteristics of financial statements
according to the Framework?
 a. Qualitative characteristics are the attributes that make
the information provided in financial statements useful to
users.
b. Qualitative characteristics are broad classes of financial
effects of transactions and other events.
C. Qualitative characteristics are nonquantitative aspects of
an entity's position and performance and changes in financial
position.
d. Qualitative characteristics measure the extent to which an
entity has complied with all relevant Standards and
Interpretations

MC2-14. Which of the following is not a qualitative characteristic of

financial statements according to the Framework?
a. Materiality.
b. Understandability.
C. Comparability.
d. Relevance.

MC2-15. When should an item that meets the definition of an

element be recognized,according to the Framework?
a. When it is probable that any future economic
benefit associated with the item will flow to or from
the entity.
b. When the element has a cost or value that can be
measured with reliability.
C. When the entity obtains control of the rights or
obligations associated with the item.
d. When it is probable that any future economic
benefit associated with the item will flow to or from
the entity and the item has a cost or value that can be
measured with reliability.