5.

Preparing adjusting entries

➢ The accounts are updated as of the reporting date
on an accrual basis by recording accruals,
expiration of deferrals, estimations, and other
events often not signaled by new source
documents.
➢ Adjusting entries are made to update financial
records at the end of a reporting period. This is
done using the accrual method, which means that
transactions are recorded when they happen, not
when money changes hands.
➢ These entries ensure that financial statements
reflect the true financial position at the end of the
Accounting Cycle period.
The accounting cycle represents the steps or procedures 6. Preparing the adjusted trial balance (or worksheet
used to record transactions and prepare financial preparation)
statements. It implements the accounting process of ➢ The equality of debits and credits are rechecked
identifying, recording, and communicating economic after adjustments are made. The adjusted trial
information. balance serves as basis for the preparation of the
1. Transaction or event (Identifying and analyzing business financial statements.
documents or transaction. ➢ The purpose is to ensure that all necessary
➢ The accountant gathers information from source adjustments are reflected and the books are
documents and determines the effect of the balanced before the final reports are prepared.
transactions on accounts. 7. Preparing the financial statements
2. Journalizing ➢ These are the means by which the information
➢ The identified accountable events are recorded in processed is communicated to users.
the journals. 8. Closing the books
3. Posting ➢ This involves journalizing and posting closing
➢ Information from the journal are transferred to the entries and ruling the ledger. Temporary accounts
ledger. (or nominal accounts) are closed and the resulting
4. Unadjusted trial balance profit or loss is transferred to an equity account.
➢ The balances of the general ledger accounts are 9. Preparing the post-closing trial balance
proved as to the quality of debits and credits. It ➢ The equality of debits and credits are again
serves as basis for adjusting entries. rechecked after the closing process.
➢ Adjusting entries are changes made to the 10. Recording of reversing entries
accounts at the end of a reporting period to ensure ➢ Reversing entries are usually made at the
everything is recorded correctly. These beginning of the next accounting period to simplify
adjustments are based on the accrual method of the recording of certain transactions in that
accounting, which means recording things when period.
they happen, even if no money has been
exchanged yet.
Here's how adjusting entries work:
• Accruals: Recording income or expenses that have
been earned or incurred but not yet recorded.
• Expiration of deferrals: Adjusting for payments or
receipts made earlier for future periods (like
prepaid rent), now used up.
• Estimations: Recording guesses for the things that
don’t have exact amount yet (like bad depts).
• Other Events: Things that happen without new
documents, like depreciation of equipment.
•
CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING
Purpose of the conceptual framework The hierarchy guidance above means that in the absence
The Philippine conceptual framework is like a guidebook of a PFRS that specifically applies to a transaction,
for financial reporting in the Philippines. Its main goal are: management shall consider the applicability of the
1. Help the FRSC: It supports the financial standards conceptual framework in developing and applying an
council in creating and updating accounting rules. accounting policy that will result in information that is
2. Support financial statement preparers: It help relevant and reliable.
those who create financial statements understand
and apply these rules, especially for new topics not SCOPE OF THE CONCEPTUAL FRAMEWORK
yet covered. 1. The objective of financial reporting
3. Aid auditors: It assists auditors in checking 2. Qualitative characteristics of useful financial information
whether financial statements meet the 3. financial statements and the reporting entity
established rules. 4. the elements of financial statements
4. Guide users: It helps people who read financial 5. recognition and derecognition
statements understand the information better. 6. measurement
5. Inform interested parties: It provides insights into 7. concepts of capital and capital maintenance
how the FRSC develops its standards for those who
want to know more about the process. THE OBJECTIVE OF FINANCIAL REPORTING
The conceptual framework provides the foundation for the The main goal of general purpose financial reporting is to
development of standards that: give useful financial information about a company to
a. Promote transparency by enhancing the current and potential investors, lenders, and creditors. This
international comparability and quality of financial information helps them decide whether to invest in or lend
information. money to the company.
b. Strengthen accountability by reducing the This objective is the core of the conceptual framework,
information gap between providers of capital and meaning that everything else in the framework is built
the entity’s management. around this idea. All other guidelines and principles
c. Contribute to economic efficiency by helping support this goal of providing valuable information for
investors to identify opportunities and risks decision-making.
around the world, thus improving capital PRIMARY USERS
allocation. The use of a single, trusted accounting The objective of financial reporting refers to the following,
language lowers the cost of capital and reduces so called the primary users:
international reporting costs. 1. Existing and potential investors; and
STATUS OF THE CONCEPTUAL FRAMEWORK 2. Lenders and other creditors
the conceptual framework is not a standard. If there is a General purpose financial reports provide important
conflict between a standard(PFRS) and the conceptual information for investors, lenders, and creditors who can’t
framework, the requirement of the standard will prevail. request specific details directly from companies. These
The authoritative status of the conceptual framework reports aim to meet the common needs of these users,
is depicted in the hierarchy of guidance shown below. though they may not cover all their information needs.
HIERARCHY OF REPORTING STANDARDS While the reports don’t directly show a company’s value,
1. PFRS accounting standards they help users estimate it. The conceptual framework
2. Judgement guides the estimates and judgements made in preparing
When making the judgement: these reports. Although other groups (like management or
➢ Management shall consider the following: regulators) may find the reports useful, they are not the
a. Requirements in other PFRSs dealing with primary audience.
similar transactions DECISIONS ABOUT PROVIDING RESOURCES TO THE
b. Conceptual framework ENTITY
➢ Management may consider the following: The primary user’s decision about providing resources to
a. Pronouncements issued by other standard- the entity involve decisions on:
setting bodies. a. Buying, selling or holding investments
b. Other accounting literature and industry b. Proving or settling loans and other forms or credit;
practices. c. Exercising voting or similar rights that could
influence management’s actions relating to the
use of the entity’s economic resources.
These decisions depend on the investor/lender/other QUALITATIVE CHARACTERISTIC
creditor’s expected returns (e.g investment income or The qualitative characteristics of useful financial
repayment of loan). Expectation about returns, in turn, information identify the types of information that are likely
depend on assessment of the entity’s (i) prospects for to be most useful to the primary users in making decisions
future net cash inflows and (ii) management stewardship. using an entity’s financial reporting.
To make these assessments, investors, lenders, and other The conceptual frameworks classifies the
creditors need information on. qualitative characteristic into the following:
INFORMATION ON ECONOMIC RESOURCES, CLAIMS, 1. Fundamental qualitative characteristic – these are the
AND CHANGES characteristics that make information useful to users. The
General purpose financial reports provide information on consist of the ff:
a reporting entity’s: a. relevance
a. Financial position – information on economic b. faithful representation
resources (assets) and claims against the reporting
entity (liabilities and equity); and 2. Enhancing qualitative characteristic – these are the
b. Changes in economic resources and claims – characteristics that enhance the usefulness of information.
information on financial performance (income and They consist of the ff:
expenses) and other transactions and events the a. comparability
lead to changes in financial position. b. verifiability
Collectively, these are referred to under the c. timeliness
conceptual framework as the economic phenomena. d. understandability
ECONOMIC RESOURCES AND CLAIMS FUNDAMENTAL QUALITATIVE CHARACTERISTIC
Information about the nature and amounts of an entity’s Relevance
economic resources (assets) and claims (liabilities and Information is relevant if it is capable of making a
equity) can help users to identify the entity’s financial difference in the decisions made by users. Relevant
strength and weaknesses. That information can help users information has the following:
in assessing the entity’s: a. Predictive value- the information can be used to make
A. Liquidity and solvency; predictions.
B. Needs for additional financing and how successful it is b. Confirmatory value (feedback value)- the information
likely to be in obtaining that financing; and can be used in confirming previous predictions.
C. management’s stewardship on the use of economic Predictive value and confirmatory value are connected.
resources. Information with predictive value helps users make
➢ Liquidity refers to an entity’s ability to pay short forecasts about the future, while confirmatory value helps
term obligation, while solvency refers to an users check if past predictions were accurate. For example,
entity’s ability to meet its long long-term a company's current revenue can help predict future
obligations. revenue and also confirm whether past revenue forecasts
All of these contribute to the assessment of the were correct.
entity’s ability to generate future cash flows. For ex:
• Receivables, investments, inventory, and other MATERIALITY
assets show how easily the company can convert Refers to the importance of information in financial
non-cash assets into cash. reports. If leaving out, misstating, or hiding certain
• Obligations give insight int when the company will information could influence the decisions of primary users
need to pay out cash. (like investors or lenders), that information is considered
• Liquidity and solvency reveal the company’s ability material. Materiality is specific to each company and
to secure additional financing. If the company has depends on its unique circumstances, so there isn't a one-
too much debt (overleveraged), it may struggle to size-fits-all rule for what is material. It requires judgment.
obtain more financing. The IFRS Practice Statement 2 provides guidance on how
CHANGES IN ECONOMIC RESOURCES ANF CLAIMS to make these materiality judgments, but it's not
a. Financial performance (income and expenses); mandatory to follow.
b. Other events and transactions The guidance consists of a four-step process called the
“materiality process”:
 STEP 1 – IDENTIFY INFORMATION THAT HAS THE STEP 4 – REVIEW THE DRAFT FINANCIAL STATEMENTS
POTENTIAL TO BE MATERIAL. TO DETERMINE WHETER ALL MATEERIAL INFORMATION
When identifying material information for financial HAS BEEN IDENTIFIED AND MATERIALITY CONSIDERED
reports, the first step is to follow the Standards set by the FORM A WIDE PERSPECTIVE AND AGGREGATE, ON THE
IASB. The IASB considers the needs of a wide range of users BASIS OF THE COMPLETE SET OF FINANCIAL
and balances the benefits of the information with the cost STATEMENTS.
of producing it. However, when making materiality The review process allows the entity to take a "step back"
judgments, cost is not a factor. Companies must also and consider the bigger picture of the financial information
consider the common information needs of their primary provided. Even if a particular item isn't material on its own,
users, beyond what's specified in the standards. This it could become material when viewed together with
ensures that the most important information is included other information in the complete set of financial
for decision-making. statements. This broader perspective ensures that users
get a more comprehensive understanding of the entity’s
SETP 2 – ASSESS WHETER THE INFORMATION financial position.
INDETIFIED IN STEP 1 IS, IN FACT, MATERIAL.
When assessing whether information is material, the
entity considers the following:
1. Impact on Users' Decisions: Whether the
information could affect users' decisions based on
the financial statements as a whole.
2. Nature or Size of the Item: This refers to how
significant the item is, in terms of its importance
(nature) or its amount (size).
3. Quantitative and Qualitative Factors:
o Quantitative Factors: The size of the item,
often measured as a percentage of
another amount like total assets or
revenues. FAITHFUL REPRESENTATION
o Qualitative Factors: Characteristics or Means the information provides a true, correct and
context of the item, including: complete depiction of the economic phenomena that it
▪ Entity-specific factors: Such as purports to represent.
involvement of a related party or When an economic phenomenon’s substance differs form
the uniqueness of the item. its legal form, faithful representation requires the
▪ External factors: Like the entity's depiction of the substance (i.e. substance over form).
industry or the overall state of the Depicting only the legal form would not faithfully
economy. represent the economic phenomenon.
Both the numerical impact and the nature of the item are Faithfully represented information has the following
considered when determining materiality. characteristic:
STEP 3 - ORGANIZE THE INFORMATION WITHIN THE 1. Completeness: All necessary information is
DRAFT FINANCIAL STATEMENTS IN WAY THAT included to help users fully understand the item
COMMUNICATES THE INFORMATION CLEARLY AND being reported. This includes:
CONCISELY TO PRIMARY USERS. a. A description of the item’s nature
The entity must use judgment to present financial b. The numerical value (like the monetary
information in a way that makes it as clear and easy to amount)
understand as possible for the primary users, like investors c. Details about how that value is
and creditors. This involves choosing formats, details, and determined (e.g., historical cost or fair
explanations that enhance the users' ability to interpret value)
the information effectively for decision-making. d. Explanations of significant facts related to
the item
 2. Neutrality: The information is presented without Timeliness
bias. It should not be manipulated to make it look Refers to the availability of information when users need it
better or worse than it is, ensuring users receive so that it can effectively influence their decisions. If
an objective view. information is provided too late, it may lose its relevance
3. Free from Error: While information doesn’t need and usefulness, preventing users from making informed
to be perfectly accurate, it should be free from choices based on that data.
mistakes in its description and the methods used Understandability
to gather and present it. If estimates are involved, Means that information should be presented clearly and
this should be clearly stated, along with an concisely so that users can easily comprehend it. However,
explanation of how the estimates were made. it doesn’t mean that complex information should be left
Together, these characteristics ensure that the information out, as this could lead to incomplete or misleading reports.
is trustworthy and useful for users in making decisions. Financial reports are designed for users who:
1. Have Reasonable Knowledge of Business
ENHANCING QUALITATIVE CHARACTERISTIC Activities: Users should have some background
Comparability understanding of business and finance.
Refers to the ability of information to help users identify 2. Are Willing to Analyze Information Diligently:
similarities and differences between different pieces of Users should be ready to take the time to carefully
information. This can be done by comparing: examine and interpret the information presented.
• Information from the same entity over different This ensures that while the reports contain complex
time periods (called intra-comparability). information, they remain accessible to those who have the
• Information from different entities (called inter- necessary knowledge and willingness to engage with it.
comparability).
Unlike other qualitative characteristics, comparability APPLYING THE QUALITATIVE CHARACTERISTIC
requires at least two items to make a meaningful The fundamental qualitative characteristics of financial
comparison. information are relevance and faithful representation. For
It’s important to note that comparability is not the same as information to be truly useful, it must meet both criteria.
uniformity. Comparability means that similar items should For instance, information that is relevant but contains
be presented similarly, while different items should be errors, or accurate information that isn’t relevant, won’t
shown distinctly. It would be misleading to make dissimilar help users make good decisions.
items appear the same or vice versa. On the other hand, the enhancing qualitative
Additionally, while consistency and comparability are characteristics improve the usefulness of information that
related, they are not the same. Consistency involves using is already relevant and faithfully represented, but they
the same methods for the same items over time, whereas cannot make irrelevant or erroneous information useful.
comparability is the overall goal of ensuring that Therefore, it's important to maximize these enhancing
information can be effectively compared. Consistency is characteristics as much as possible.
one way to achieve comparability. There is no specific order for applying these enhancing
Verifiability characteristics, and sometimes, one may need to be
Means that different users can agree on what the prioritized over another to improve overall quality.
information represents, ensuring it is trustworthy.
Verification can happen in two ways: THE COST CONSTRAINT
1. Direct Verification: This involves directly Cost is a significant factor that affects an entity’s ability to
observing the information, such as counting provide useful information. Gathering and presenting
physical cash on hand. information incurs expenses, and these costs must be
2. Indirect Verification: This involves checking the justified by the benefits users will gain from the
information by recalculating it. For example, this information.
could include reviewing the entries in a cash ledger Therefore, it's essential to find an optimum balance
and recalculating the ending balance to ensure between the costs of providing information and the
accuracy. benefits it offers. The goal is to ensure that the costs do not
Both methods help ensure that the information is reliable exceed the benefits, allowing for effective decision-making
and can be confirmed by different users. without unnecessary expenditure.
GOING CONCERN ASSUMPTIONS 2. Right to exchange economic resources with
The going concern assumption in financial reporting another party on favorable terms.
means that it is presumed the entity will continue its 3. Right to benefit from an obligation of another
operations for the foreseeable future and has no intention party to transfer an economic resource if a
or need to cease operations. specified uncertain future event occurs.
If this assumption is not valid—for example, if the entity is b. Rights that do not correspond to an obligation of
facing financial difficulties and may go out of business— another party:
the financial statements must be prepared on a different 1. Right over physical objects (e.g. right to use a
basis. In such cases, the entity might use methods like property or right to sell an inventory)
measuring assets at realizable values instead of using a mix 2. Right to use intellectual property
of historical costs and values. This adjustment ensures that 3.
the financial statements accurately reflect the entity's How Rights Arise:
situation. • Rights come from laws, contracts, or similar
agreements. For example, you have the right to
FINANCIAL STATEMENTS AND THE REPORTNG ENTITY use a property if you own or lease it.
Objective and scope of financial statements • Rights can also arise from something unique you
The objective of general purpose financial statements is to create, like a trade secret.
provide financial information about the reporting entity’s Rights and Economic Benefits:
assets, liabilities, equity, income and expenses that is • When an entity (a business or person) receives
useful in assessing: goods or services that they immediately use (like
a. the entity’s prospects for future net cash flows; and supplies or employee work), their right to gain
b. management’s stewardship over economic resources from these things only lasts as long as they are
REPORTING PERIOD using them.
Financial statements are prepared for a specified period of Not All Rights are Assets:
time and provide information on assets, liabilities, and • To be considered an asset, the right must have the
equity that existed at the end of the reporting period, or potential to provide economic benefits only to the
during the reporting period, and income and expenses for entity and not to everyone else. For example, a
the reporting period. public road is not an asset because everyone can
use it, but a private trade secret could be.
THE ELEMENTS OF FINANCIAL STATEMENTS Rights in the Entity Itself:
1. assets • An entity cannot have rights to gain economic
2. liabilities benefits from itself. For example, treasury shares
3. equity (shares the company owns in itself) are not its
4. income assets.
5. expenses Combining Rights:
• Though each right is technically a separate asset,
ASSET – is “a present economic resource controlled by the related rights are often combined into one asset
entity as a result of past events. An economic resource is a for accounting purposes. For example, owning a
right that has the potential to produce economic benefits” physical object gives multiple rights (like the right
The definition of asset has the following 3 aspects: to use or sell it), but these rights are combined and
a. Right treated as a single asset.
b. Potential to produce economic benefits Lessee Rights:
c. Control • A lessee (someone renting a property) may
recognize an asset for their right to use the
RIGHT property but not for the property itself, as they
Asset is an economic resource, and an economic resource don’t own it.
is a right that has the potential to produce economic Uncertain Rights:
benefits. • Sometimes, whether a right exists can be
Rights that have the potential to produce economic uncertain. For example, if two parties dispute a
benefits include: right, it remains unclear whether it's an asset until
a. right that correspond to an obligation of another party: resolved.
1. Right to receive cash, goods, or services
POTENTIAL TO PRODUCE ECONOMIC BENEFITS Control is typically based on legally enforceable rights, like
The concept of an asset in accounting focuses on a present ownership or legal title, but ownership isn't always
right that has the potential to produce economic benefits, required for control. For example, if Entity A buys a car with
rather than the actual future benefits it might generate. bank financing, even though the bank holds the legal title
What matters is that the right already exists and that it has until the loan is paid off, the car is considered an asset of
the ability, in at least one situation, to produce economic Entity A. This is because Entity A has the exclusive right to
benefits for the entity. The right doesn't have to guarantee use and benefit from the car, showing that control doesn't
benefits or even make them likely; it just needs the always require full ownership.
potential. Similarly, physical possession isn't always necessary to
This means that an asset can still exist even if the chances prove control. For example, if a principal sends goods to an
of it producing benefits are low. However, this low agent to sell on consignment, the goods still belong to the
probability influences how the asset is handled in principal until they are sold. This is because the principal
accounting: whether it should be recognized, how it is retains control over the goods and their potential benefits,
measured, and what information should be disclosed even though the agent has physical possession. The agent,
about it. on the other hand, does not recognize the goods as assets
An economic resource can generate benefits for an entity because they don't control the benefits—they are just
in many different ways. For example, the asset could be: holding the goods on behalf of the principal.
• Sold, leased, transferred, or exchanged for other In summary, control means having exclusive rights to the
assets. benefits of an asset, even if ownership or physical
• Used on its own or combined with other assets to possession is not involved. The key factor is the ability to
produce goods or services. prevent others from accessing those benefits.
• Used to increase the value of other assets.
• Used to improve efficiency and cut costs. LIABILITY – is “a present obligation of an entity to transfer
• Used to settle liabilities. an economic resource as a result of past events.
The idea of spending money isn't necessary to prove an The definition of liability has the following three aspects:
asset exists. For instance, paying a penalty for breaking the a. obligation
law doesn't create an asset. However, an asset can come b. transfer of an economic resource
from something that was acquired for free, like a donation. c. present obligation as a result of past events
Furthermore, spending money to acquire an asset doesn't OBLIGATION - is “a duty or responsibility that an entity has
have to happen at the same time the asset is recognized. no practical ability to avoid.”
For example, when a company buys inventory on credit, An obligation is either:
the inventory is considered an asset before the payment is a. Legal obligation – an obligation the result from a contact,
made. legislation, or other operation of law.
In summary, an asset is a present right with potential b. Constructive obligation – an obligation that results from
economic benefits, even if those benefits are uncertain or an entity’s actions (e.g. past practice or published policies)
unlikely. This affects how the asset is treated in accounting, that create a valid expectation on other that the entity will
and economic benefits can arise in various ways without accept and discharged certain responsibilities.
always involving direct expenditure.
An obligation in accounting is something that one party
CONTROL owes to another. It is not necessary for the identity of the
The concept of control in accounting refers to an entity's other party to be known. For example, in cases of
exclusive right over the benefits of an asset and its ability environmental damage, the obligation might be owed to
to prevent others from accessing those benefits. If one society as a whole, even though no specific individual or
party controls an asset, no other party can control that group can be identified.
same asset. This doesn't mean the entity can guarantee Typically, an obligation for one party corresponds to a right
the asset will always produce economic benefits, but if for another. For instance, if a buyer owes P100 in accounts
benefits arise, they will belong solely to the entity. payable, the seller has the right to receive P100 in accounts
Control connects an asset to an entity, determining how receivable. However, this symmetry between the
much of the resource the entity should account for. For obligation and the right isn't always perfect because
instance, if the entity controls only part of a resource, it accounting rules sometimes differ between the
only accounts for that part and not the whole resource. If recognition and measurement of liabilities and the
the entity does not control the asset, it is not considered corresponding assets. For example, costs related to
the entity's asset.
originating a loan can lead to different amounts being PRESENT OBLIGATION AS A RESULT OF PAST EVENTS
recorded by the lender (loan receivable) and the borrower The obligation must be a present obligation that exists as a
(loan payable). Similarly, if a seller recognizes a warranty result of past events. A present obligation exists as a result
obligation, the buyer may not record a matching asset for of past events if:
that warranty. a. the entity has already obtained economic benefits or
In some cases, the existence of an obligation can be taken an action; and
uncertain. For example, if a legal dispute arises, it may not b. as a economic consequence, the entity will or may have
be clear whether a liability exists until the matter is to transfer an economic resource that it would not
resolved, such as through a court ruling. Until then, the otherwise have had to transfer.
obligation remains uncertain.
In summary, obligations are owed to others, often EQUITY
corresponding to rights, but the symmetry between them Equity refers to the residual interest in an entity's assets
may not always be reflected equally in accounting. after deducting all of its liabilities. This definition applies
Additionally, the existence of an obligation may sometimes universally to all types of organizations, including sole
be unclear until further resolution. proprietorships, partnerships, cooperatives, corporations,
TRANSFER OF AN ECONOMIC RESOURCE non-profit entities, and government bodies.
A liability is an obligation that may require an entity to While equity is defined as a residual, meaning it is what's
transfer an economic resource to another party. The key left after liabilities are subtracted from assets, it can be
idea is that the liability is the present obligation, not the broken down into different categories in the statement of
future economic benefits that may be transferred because financial position. For instance, in a corporation, the equity
of that obligation. This means that even if the transfer of provided by owners (also known as contributed capital) is
economic benefits is uncertain or dependent on a future presented separately from retained earnings, reserves,
event, the obligation can still be considered a liability as and other equity components.
long as it already exists and could, in at least one Reserves are amounts set aside by an entity to protect
circumstance, result in the transfer of resources. creditors or stakeholders from potential losses. In some
For example, a company might have an obligation that will cases, such as in cooperatives, setting aside reserves is a
only require payment if a specific uncertain event happens legal requirement. When funds are transferred to reserves,
in the future. What matters is that the obligation is already they are considered an appropriation of retained
in place, even if the likelihood of the event (and the earnings, meaning they are taken from profits but are not
subsequent transfer of economic benefits) is low. However, treated as expenses of the entity.
the lower the probability of the transfer, the more this In summary, equity represents what remains of the assets
affects how the liability is treated in accounting—whether once all debts are paid off, and while it can be divided into
it's recognized, how it's measured, and what information different sections like retained earnings and reserves, its
is disclosed about it. overall function is to reflect the owners' stake in the entity
There are various ways an obligation to transfer economic after covering liabilities.
resources might arise, such as: PERFORMANCE - The elements directly related to the
• The obligation to pay cash, deliver goods, or measurement of performance are income and expenses
provide services.
• The obligation to exchange assets with another INCOME
party under unfavorable terms. Income refers to increases in an entity's economic benefits
• The obligation to transfer assets if a certain during a specific accounting period. This happens through
uncertain future event occurs. inflows or enhancements of assets or through the
• The obligation to issue a financial instrument that reduction of liabilities, both of which lead to an increase
requires the transfer of an economic resource. in the entity's equity. Importantly, income does not
In summary, a liability exists when an obligation is present, include contributions from equity participants, meaning it
even if the transfer of economic resources is uncertain or excludes investments or capital provided by the owners or
unlikely. This influences how the liability is accounted for, shareholders.
but what matters is that the obligation already exists and In simpler terms, income is the gain an entity experiences
could, under certain conditions, result in a transfer of by receiving more resources or reducing its debts, which
resources. leads to an increase in the entity's value or wealth, but it
excludes any direct financial input from owners or
investors.
EXPENSES examples:
Expenses are defined as decreases in an entity's economic Recognition of income Recording a sale increases
benefits during a specific accounting period. This can occur resulting in an increase in both ‘cash’ / ‘receivable’
through outflows of cash or other assets, or through the asset. (asset) and ‘sales’
incurrence of liabilities, which ultimately leads to a (income).
reduction in the entity's equity. Importantly, expenses do Recognition of income Earning an unearned
not include distributions to equity participants, meaning resulting in a decrease in income decreases
they exclude payments or dividends made to owners or liability. ‘unearned income’
shareholders. (liability) and increases
In simpler terms, expenses represent the costs an entity income.
incurs while operating or conducting business, which Recognition of expense Accruing unpaid salaries
diminish its overall wealth or value, but they do not include resulting in an increase in increases both ‘salaries
any direct payouts made to its owners or investors. liability. expense’ and ‘salaries
payable’ (liability)
RECOGNITION AND DERECOGNITION Recognition of expense Payment for supplies
The recognition process resulting in a decrease in expense increases
Recognition is the process of including in the statement of assets. ‘supplies expense’ and
financial position or the statement(s) of financial decreases ‘cash’.
performance an item that meets the definition of one of
the financial statement elements (i.e. asset, liability, Sometimes the recognition of income results in the
equity, income, or expense). This involves recording the simultaneous recognition of a related expense. This
item in words and in monetary amount and including that simultaneous recognition of income and expense is also
amount in the totals of either of those statements. called “matching of costs and income” (matching
“The amount at which an asset, a liability or equity is concept). For example, the sale of goods results in the
recognized in the statement of financial position is referred simultaneously recognition of sales (income) and cost of
to as its ‘carrying amount’”. sales (expense).
Recognition links the elements, the statement of financial
position and the statement(s) of financial performance as RECOGNITION CRITERIA
follows: An item is recognized if:
a. it meets the definition of an asset, liability, equity,
Statement of financial position at beginning of income or expense; and
reporting period. b. recognizing it would provide useful information, i.e.
Asset minus liabilities equal equity relevant and faithful representation information

Statement(s) of financial performance Before an item can be officially recognized in financial

Income minus expense statements, it must meet specific criteria. If an item meets
the definition of a financial statement element (like an
Contributions from holders of equity claims asset or liability) but does not provide useful information,
minus distributions to holders of equity claims. it will not be recognized. Conversely, if an item provides
useful information but does not meet the definition, it also
Statement of financial position at end of won’t be recognized.
reporting period Recognizing and providing information comes with costs.
Assets minus liabilities equal equity For instance, an entity might incur expenses to appraise its
property for accurate measurement, and users of financial
The statement s are linked because the recognition of one statements spend time analyzing this information.
element (or change in its carrying amount) requires the Therefore, organizations need to consider the cost
recognition or derecognition of another element(s). constraint, also known as the cost-benefit principle, when
deciding whether to recognize an item. This principle
suggests that the usefulness of the information should
justify the costs involved in providing it.
However, there isn’t a one-size-fits-all threshold for FAITHFUL REPRESENTATION
balancing costs and benefits; it varies based on the specific The recognition of an item is appropriate if it provides
item and its context. Thus, judgment is crucial when both relevant and faithfully represented information. The
determining whether to recognize an item, and the level of measurement uncertainty and other factors (i.e.
recognition requirements may differ based on individual presentation and disclosure) affect an item’s faithful
circumstances. representation.
Even if an item meets the definition of an asset or liability MEASUREMNT UNCERTAINTY
but is not recognized in the financial statements, there For an asset or liability to be recognized in financial
might still be a need to disclose information about it in the statements, it must first be measured. This measurement
notes. These items are then referred to as unrecognized often involves estimation, which introduces a degree of
assets or unrecognized liabilities. measurement uncertainty. Using reasonable estimates is
In summary, recognition in financial statements requires a crucial aspect of financial reporting and does not
that items not only meet specific definitions but also inherently diminish the usefulness of the information
provide useful information at a justifiable cost. Judgment provided. Even when there is a high level of measurement
plays a key role in these decisions, and unrecognized items uncertainty, an estimate can still be valuable if it is clearly
may still require disclosure. and accurately described and explained.
However, if the measurement uncertainty is exceptionally
RELEVANCE high, it can impact the faithful representation of an asset
The recognition of an item may not provide relevant or liability. This situation may arise when cash-flow-based
information if, for example: measurement techniques are employed under certain
a. it is uncertain whether an asset or liability exist; or challenging circumstances, such as:
b. an asset or liability exists, but the probability of an inflow 1. Wide Range of Possible Outcomes: If there is an
or outflow of economic benefits is low. exceptionally wide range of potential outcomes,
and estimating each outcome proves to be
EXISTING UNCERTAINTY & LOW PROBABILITY OF extremely difficult.
INFLOWS/OUTFLOWS 2. Sensitivity to Changes: If the measurement is
The uncertainty regarding the existence of an asset or highly sensitive to minor changes in the estimates
liability, or the low probability of an inflow or outflow of related to the probability of various outcomes.
economic benefits, does not automatically mean that the 3. Difficult Allocations: If measuring the asset or
asset or liability will not be recognized. Other factors must liability requires particularly challenging or
be considered in the decision-making process. subjective allocations of cash flows that are not
If the uncertainty or low probability leads to non- solely related to the asset or liability being
recognition, there may still be a requirement to disclose measured.
information about the unrecognized asset or liability in the In summary, while measurement and estimation are
financial statement notes. This could include details about essential for recognizing assets and liabilities, excessive
the uncertainty itself or potential inflows or outflows uncertainty in measurement can hinder the accurate
associated with the asset or liability. representation of these items. Careful consideration must
Moreover, even with uncertainty or low probability, an be given to the level of uncertainty and the factors involved
asset or liability can still be recognized if doing so provides to ensure that the reported information remains useful
relevant information. For example, if an asset arises from and reliable.
an exchange transaction at market terms, its cost typically DERECOGNITION
reflects the probability of future economic benefits Derecognition is the process of removing a previously
(inflow) related to that asset or the liabilities (outflow) recognized asset or liability from an entity's statement of
associated with it. Recognizing the asset or liability in this financial position. This occurs when an asset or liability no
case helps avoid misrepresenting the financial results, such longer meets its definition, such as when an entity loses
as incorrectly recognizing income or expenses that do not control over the entire asset or part of it, or when it no
accurately reflect the transaction. longer has a present obligation for all or part of a liability.
In summary, while uncertainty and low probability may Upon derecognition, the entity undertakes the following
suggest non-recognition, they do not automatically actions:
determine it. Recognition can still occur if it provides
relevant information, and any unrecognized items may
need to be disclosed to maintain transparency.
 1. Derecognizing Expired or Transferred Items: The • Changing Units of Account: If an entity transfers
entity removes assets or liabilities that have part of an asset or part of a liability, the unit of
expired, been consumed, collected, fulfilled, or account may change. This means that the
transferred. In this case, any resulting income or transferred component and the retained
expenses from the derecognition are also component become distinct units of account. Each
recognized. This means that if the asset was sold component is then recognized and measured
or the liability settled, the entity would record the separately.
financial impact of that action. TRANSFER
2. Retaining Components: The entity continues to Transfers refer to the movement of assets or liabilities
recognize any assets or liabilities that it retains from one party to another. In the context of derecognition,
after derecognition (referred to as the "retained it’s important to understand that derecognition is not
component"). Typically, no income or expense is appropriate if the entity retains substantial control over a
recognized for this retained component unless transferred asset.
there is a change in its measurement basis. Once Key Points on Transfers and Derecognition:
derecognition occurs, the retained component • Substantial Control Retained: If the entity still has
becomes a separate unit of account, distinct from significant control over the asset after transferring
the transferred component. it, it must continue to recognize the asset in its
In summary, derecognition involves removing assets or financial statements. Any proceeds received from
liabilities from the financial statements when they no this transfer are then recorded as a liability. This
longer qualify as such. It also entails recognizing any means the entity still has obligations related to
related income or expenses and maintaining separate that asset, and it cannot be fully derecognized.
accounting for any retained components. • Partial Transfers: In cases where there is only a
partial transfer of an asset, the entity will
UNIT OF ACCOUNT derecognize only the part of the asset that has
A unit of account refers to the specific right or group of been transferred. The portion that remains under
rights, obligation or group of obligations, or a the entity's control is recognized as a retained
combination of both to which recognition criteria and component. This retained component continues
measurement concepts are applied. This concept is to be accounted for as an asset.
detailed in the Conceptual Framework (4.48). MEASUREMENT
Key Points about Unit of Account: Recognition requires quantifying an item in monetary
• Examples: A unit of account can take various terms, thus necessitating the selection of an appropriate
forms: measurement basis.
o An individual account title (e.g., Cash or The application of the qualitative characteristic, including
Accounts Receivable). the cost constraint, is likely to result in the selection of
o A collection of similar assets (e.g., different measurement bases for different assets,
Property, Plant, and Equipment). liabilities, income, and expenses. Accordingly, the
o A combination of assets and liabilities standards prescribe specific measurement bases for
(e.g., a Cash-Generating Unit). different types of assets, liabilities, income and expenses.
• Selection for Recognition: When determining how MEASUREMENT BASES
to recognize and measure an asset or liability, a The conceptual framework describes the following
specific unit of account is selected. For instance: measurement bases:
o Cash is recognized when it is either 1. Historical cost
physically present or deposited in a bank, 2. Current Value
and it is measured at its face value. a. Fair value
o Accounts Receivable is recognized when a b. Value in use and fulfillment value
sale takes place and is measured at the c. Current cost
transaction price, adjusted for any
amounts that may be uncollectible.
HISTORICAL COST CURRENT COST
The historical cost of an asset is the total amount spent to The current cost of an asset is the amount it would cost to
acquire it, including any extra costs associated with the acquire an equivalent asset at the measurement date. This
purchase, like fees or taxes. includes the price that would be paid for the asset plus any
For a liability, the historical cost is the amount received transaction costs associated with the purchase.
when the liability was created, minus any costs related to For a liability, the current cost is the amount that would be
that transaction. received for an equivalent liability at the measurement
If it’s difficult to determine the cost, such as in transactions date, minus any transaction costs expected to be incurred.
that aren’t based on market prices, the asset or liability is Key Points:
first recorded at its current value. This current value then • Current Cost vs. Historical Cost: Both current cost
serves as the starting cost for future measurements at and historical cost are considered entry values
historical cost. because they represent the prices paid to acquire
CURRENT VALUE an asset or incur a liability. However, current cost
Current value measurement reflect changes in values at is updated to reflect the market conditions at the
the measurement date. Unlike historical cost, current measurement date, while historical cost is based
value is not derived from the price of the transaction or on past transactions.
other event that gave rise to the asset or liability. • Exit Values: In contrast to entry values, fair value,
Current value measurement bases include the following: value in use, and fulfillment value are exit values.
a. fair value These reflect the prices for selling or using an asset
b. value in use of assets and fulfillment value for liabilities or transferring a liability.
c. current cost • Indirect Measurement: Sometimes, current cost
FAIR VALUE cannot be directly measured. In such cases, it can
Fair value is "the price that would be received to sell an be estimated by adjusting the current price of a
asset, or paid to transfer a liability, in an orderly transaction new asset to account for the age and condition of
between market participants at the measurement date." the asset that the entity currently holds.
Fair value reflects the perspective of market participants CONSIDERATIONS WHEN SELECTING A MEASUREMENT
(i.e., participants in a market to which the entity has BASIS
access). Accordingly, it is not an entity-specific When selecting a measurement basis, it is important to
measurement. consider the following:
Fair value can be measured directly by observing prices in a. the nature of information provided by a particular
an active market or indirectly using measurement measurement basis; and
techniques, e.g., cash-flow-based measurement b. the qualitative characteristics, the cost constraint, and
techniques. Fair value is not adjusted for transaction costs. other factors
VALUE IN USE AND FULFILLMENT VALUE ENHANCING QUALITATIVE CHARACTERISTIC AND THE
Value in use is the present value of the cash flows or other COST CONSTARINT
economic benefits that an entity expects to receive from COMPARABILITY
using an asset and from eventually selling it. Consistently using same measurement bases for same
Fulfillment value is the present value of the cash or other items, either from period to period within a single entity
resources that an entity expects to pay when it fulfills a (intra-comparability) or within a single period across
liability. different entities (inter-comparability), makes the financial
Both value in use and fulfillment value are based on statements more comparable.
specific assumptions related to the entity, rather than This does not mean a selected measurement basis should
general market assumptions. never be changed. A change is appropriate if it results in
These values are usually calculated using cash-flow-based more relevant information. Because a change in
techniques, similar to those used for fair value, but they measurement basis can make financial statements less
focus on the entity’s own situation rather than the understandable, explanatory information should be
market’s perspective. disclosed to enable users of financial statements to
Neither value in use nor fulfillment value includes understand the effect of the change.
transaction costs related to acquiring the asset or incurring
the liability. However, they do account for any transaction
costs expected to be incurred when the asset is sold or the
liability is fulfilled.