CHAPTER 3 the ability of the entity to meet maturing

commitments.
CONCEPTUAL FRAMEWORK (Qualitative
Characteristics) The net cash provided by operating activities is
valuable in predicting loan payment or default.
QUALITATIVE CHARACTERISTICS
Financial information has confirmatory value if
Qualitative characteristics are the qualities or
it provides feedback about previous evaluations.
attributes that make financial accounting information
useful to the users. In other words, financial information has
confirmatory value when it enables users confirm
In deciding which information to include in financial
or correct earlier expectations.
statements, the objective is to ensure that the
information is useful to the users in making For example, a net income measure has
decisions. confirmatory value if it can help shareholders
confirm or revise their expectation about an
Fundamental qualitative characteristics
entity's ability to generate earnings.
(CONTENT OR SUBSTANCE)
Often, information has both predictive and
A. RELEVANCE
confirmatory value.
In the simplest terms, relevance is the capacity of
The predictive and confirmatory roles of
the information to influence a decision.
information are interrelated.
To be relevant, the financial information must be
An example is an interim income statement
capable of making a difference in the decisions
which provides feedback about income to date
made by users.
and serves as a basis for predicting the annual
In other words, relevance requires that the income.
financial information should be related or
The interim income statement for the first quarter
pertinent to the economic decision.
shows net income of P2,000,000. This
Information that does not bear on an economic information is the confirmatory value.
decision is useless.
If this trend continues for the entire year, it is
To be useful, information must be relevant to the logical to assume that the net income after four
decision-making needs of users. quarters or one year would be P8,000,000. This
information is the predictive value.
For example, broadly, the statement of financial
position is relevant in determining financial Materiality
position, and the income statement is relevant in
Materiality is a practical rule in accounting which
determining performance.
dictates that strict adherence to GAAP is not
More specifically, the earnings per share required when the items are not significant
information is more relevant than book value per enough to affect the evaluation, decision and
share in determining the attractiveness of an fairness of the financial statements.
investment.
The materiality concept is also known as the
Ingredients of relevance doctrine of convenience.
Financial information is capable of making a Materiality is really a quantitative threshold
difference in a decision if it has predictive value linked very closely to the qualitative
and confirmatory value. characteristic of relevance.

Financial information has predictive value if it The relevance of information is affected by its
can be used as an input to processes employed by nature and materiality.
users to predict future outcome.
In other words, materiality is a subquality of
In other words, financial information has relevance based on the nature or magnitude or
predictive value when it can help users increase both of the items to which the information
the likelihood of correctly or accurately relates.
predicting or forecasting outcome of events.
The Conceptual Framework does not specify a
For example, information about financial uniform quantitative threshold for materiality or
position and past performance is frequently used predetermine what could be material in a
in predicting dividend and wage payments and particular situation.
Materiality is a relativity primary users shall be included in the financial
statements.
Materiality of an item depends on relative size
rather than absolute size. What is material for b. Obscuring information
one entity may be immaterial for another.
Obscuring information is a new concept added to
An error of P500,000 in the financial statements the new definition of materiality.
of a multinational entity may not be important but
Information is obscured if presenting or
may be so critical for a small entity.
communicating it would have a similar effect as
When is an item material? omitting or misstating the information.
There is no strict or uniform rule for determining Obscuring information means the presentation of
whether an item is material or not. financial information not readily understood or
not clearly expressed.
Very often, this is dependent on good judgment,
professional expertise and common sense. Obscuring information may be characterized by
deliberate vagueness, ambiguity and
As a general guide, an item is material if
abstruseness.
knowledge of it could reasonably affect or
influence the economic decision of the primary Examples of obscured material information are:
users of the financial statements.
a. The language is vague or unclear.
New definition of materiality b. The information is scattered throughout
the financial statements.
The IASB provided the following new definition
c. Dissimilar items are aggregated
of materiality.
inappropriately.
Information is material if omitting, misstating or d. Similar items are disaggregated
obscuring it could reasonably be expected to inappropriately.
influence the economic decisions that primary
users of general purpose financial statements c. Primary users
make on the basis of those statements which
The new definition of materiality narrows the
provide financial information about a specific
definition to primary users who are primarily
reporting entity.
affected by general purpose financial statements
In other words, an information is material if the
The primary users include the existing and
omission, misstatement and obscuring of the
potential investors, lenders and other creditors.
information could reasonably affect the
economic decision of primary users. The new definition specified that only primary
users of financial statements are considered
The revised definition of materiality highlights
because these groups are the users to whom
three important aspects:
general purpose financial statements are
a. Could reasonably be expected to primarily directed.
influence
Such primary users cannot require reporting to
b. Obscuring information
provide information directly to them and
c. Primary users
therefore must rely on general purpose financial
reports for how much financial information is
a. Could reasonably be expected to influence
needed.
The could reasonably be expected to influence
The other users include the employees,
threshold adds an element of reasonability of
customers, government agencies and the public
financial information on which economic
in general.
decision is based.
Factors of materiality
By including the term could reasonably be
expected to influence in the new definition, Materiality depends on the magnitude and nature
material information shall be limited to the of the financial information.
economic decision of primary users rather than to
In the exercise of judgment in determining
all users which is too broad in scope.
materiality, the relative size and nature of an
Moreover, the could reasonably be expected to item are considered.
influence threshold insures that information
capable of influencing economic decision of the
The size of the item in relation to the total of the The purpose of the notes is to provide the
group to which the item belongs is taken into necessary disclosures required by Philippine
account. Financial Reporting Standards.
For example, the amount of advertising in Standard of adequate disclosure
relation to total selling expenses, the amount of
Completeness is the result of the standard of
office salaries to total administrative expenses,
adequate disclosure or principle of full
the amount of prepaid expenses to total current
disclosure.
assets and the amount of leasehold improvements
to total property, plant and equipment. The standard of adequate disclosure means that
all significant and relevant information leading
The nature of the item may be inherently material
to the preparation of financial statements shall be
because by its very nature it affects economic
clearly reported.
decision.
Adequate disclosure however does not mean
For example, the discovery of a P20,000 bribe is
disclosure of just any data.
a material event even for a very large entity.
The accountant shall disclose a material fact
B. FAITHFUL REPRESENTATION
known to him which is not disclosed in the
Faithful representation means that financial financial statements but disclosure of which is
reports represent economic phenomena or necessary in order that the financial statements
transactions in words and numbers. would not be misleading.
Stated differently, the descriptions and figures The standard of adequate disclosure is best
must match what really existed or happened. described by disclosure of any financial facts
significant enough to influence the judgment of
Simply worded, faithful representation means
informed users.
that the actual effects of the transactions shall be
properly accounted for and reported in the b. Neutrality
financial statements.
A neutral depiction is without bias in the
For example, if the entity reports purchases of preparation or presentation of financial
P5,000,000 when the actual amount is information.
P8,000,000, the information would not be
A neutral depiction is not slanted, weighted,
faithfully represented.
emphasized, de-emphasized or otherwise
To record a sale of merchandise as miscellaneous manipulated to increase the probability that
income would not also be a faithful financial information will be received favorably
representation of the sale transaction. or unfavorably by users.
Ingredients of faithful representation In other words, to be neutral, the information
contained in the financial statements must be free
To be a perfectly faithful representation, a
from bias.
depiction should have three characteristics,
namely: The financial information should not favor one
party to the detriment of another party.
a. Completeness
b. Neutrality The information is directed to the common needs
c. Free from error of many users and not to the particular needs of
specific users.
a. Completeness
Neutrality is synonymous with the all-
Completeness requires that relevant information encompassing principle of fairness.
should be presented in a way that facilitates
To be neutral is to be fair.
understanding and avoids erroneous implication.
Prudence
A complete depiction includes all information
necessary for a user to understand the The Revised Conceptual Framework has
phenomenon or transaction being depicted, reintroduced the concept of prudence.
including all necessary description and
explanation. Prudence is the exercise of care and caution
when dealing with the uncertainties in the
To be complete, the financial statements shall be measurement process such that assets or income
accompanied by notes to financial statements.
are not overstated and liabilities or expenses are For example, an estimate of an unobservable
not understated. price or value cannot be determined to be
accurate or inaccurate.
Neutrality is supported by the exercise of
prudence. However, a representation of that estimate can be
faithful je the amount is described clearly and
Conservatism
accurately as an estimate.
Conservatism is synonymous with prudence.
Moreover, the nature and limitations of the
Conservatism means that when alternatives exist, estimating process are explained, and no errors
the alternative which has the least effect on have been made in selecting and applying an
equity should be chosen. appropriate process for developing the estimate.

In the simplest words, conservatism means "in Measurement uncertainty

case of doubt, record any loss and do not record
Measurement uncertainty arises when monetary
any ”
amounts in financial reports cannot be observed
For example, if there is a choice between two directly and must instead be estimated.
acceptable asset values, the lower figure is
Measurement uncertainty can affect faithful
selected.
representation if the level of uncertainty in
Accordingly, inventories are measured at the providing an estimate is high.
lower of cost and net realizable value.
However, the use of reasonable estimate is an
Contingent loss is recognized as a "provision" if essential part of providing financial information
the loss is probable and the amount can be and does not undermine the usefulness of the
reliably measured. financial information.

Contingent gain is not recognized but disclosed As long as the estimate is clearly and accurately
only. described and explained, even a high level of
measurement uncertainty does not affect the
It is to be emphasized that conservatism is not a usefulness of the financial information.
license to deliberately understate net income and
net assets. Substance over form

For example, if an entity has a cash of P500,000 If information is to represent faithfully the
and reports only P100,000, this is not transactions and other events it purports to
conservatism but fraud or inaccurate reporting. represent, it is necessary that the transactions
and events are accounted in accordance with
Expressions of conservatism their substance and not merely their legal form.
"Anticipate no profit and provide for probable The economic substance of transactions and
and measurable loss.” events are usually emphasized when economic
"In the matter of income recognition, the substance differs from legal form.
accountant takes the position that no matter how Substance over form is not considered a separate
sure the businessman might be in capturing the component of faithful representation because it
bird in the bush, he, the accountant, must see it would be redundant.
in the hand."
Faithful representation inherently represents the
"Don't count your chicks until the eggs hatch". substance of an economic phenomenon or
c. Free from error transaction rather than merely representing the
legal form.
Free from error means there are no errors or
omiasions in the description of the phenomenon Representing a legal form that differs from the
or transaction. economic substance of the underlying economic
phenomenon or transaction could not result in a
Moreover, the process used to produce the faithful representation.
reported information has been selected and
applied with no errors in the process. Example of substance over form

In this context, free from error does not mean An example is when the lessee leased property
perfectly accurate in all respects. from the lessor.
The terms of the lease provide that the lease between two or more entities engaged in the same
transfers ownership of the asset to the lessee by industry.
the end of the lease
Comparability across entities is also known as
term. intercomparability or dimensional
comparability.
In form, the contract is a lease as popularly
understood. For information to be comparable, like things
must look alike and different things must look
But in substance, in reality, if the "transfer of
different.
ownership provision" is to be considered, the real
intent of the parties is an installment purchase of Comparability is not enhanced by making unlike
an asset by the lessee from the lessor. things look alike or making like things look
different.
Accordingly, the lessee shall record an
acquisition of right of use asset and set up a Consistency
liability to the lessor.
Implicit in the qualitative characteristic of
The periodic rental is conceived as an installment comparability is the principle of consistency.
payment representing interest and principal.
Consistency is not the same as comparability.
Enhancing qualitative characteristics
In a broad sense, consistency refers to the use of
The enhancing qualitative characteristics relate the same method for the same item, either from
to the presentation or form of the financial period to period within an entity or in a single
information. period across entities.
The enhancing qualitative characteristics are Comparability is the goal and consistency helps
intended to increase the usefulness of the to achieve that goal.
financial information that is relevant and
In a limited sense, consistency is the uniform
faithfully represented.
application of accounting method from period to
The enhancing qualitative characteristics are period within an entity.
comparability, understandability, verifiability
On the other hand, comparability is the uniform
and timeliness.
application of accounting methods between and
Relevant and faithfully represented financial across entities in the same industry.
information is useful but the information would
An entity cannot use the FIFO method of
be most useful if it is comparable,
inventory valuation in one year, the average
understandable, verifiable and timely.
method in the next year, again the. FIFO method
Comparability in succeeding year and so on.
Comparability means the ability to bring If the FIFO method is adopted in one year, such
together for the purpose of noting points of method is followed from year to year.
likeness and difference. Consistency is desirable and essential to achieve
comparability of financial statements.
Comparability is the enhancing qualitative
characteristic that enables users to identify and However, consistency does not mean that no
understand similarities and dissimilarities among change in accounting method can be made.
items.
If the change would result to more useful and
Comparability may be made within an entity or meaningful information, then such change shall
between and across entities. be made.
Comparability within an entity is the quality of But there shall be full disclosure of the change
information that allows comparisons within a and the peso effect thereof.
single entity through time or from one accounting
It is inappropriate for an entity to leave
period to the next.
accounting policies unchanged when better and
Comparability within an entity is also known as acceptable alternatives exist.
horizontal comparability or intracomparability.
Comparability between and across entities is the
quality of information that allows comparisons
Understandability Accordingly, verifiability helps assure users that
information represents the economic
Understandability requires that financial
phenomenon or transaction it purports to
information must be comprehensible or
represent.
intelligible if it is. to be most useful.
Verifiability is synonymous with objectivity.
Accordingly, the information should be
presented in a form and expressed in terminology Types of verification
that a user understands.
Verification can be direct or indirect.
Classifying, characterizing, and presenting
Direct verification means verifying an amount or
information "clearly and cconcisely" makes it
other representation through direct observation,
understandable.
for example, by counting cash.
An essential quality of the information provided
Indirect verification means checking the inputs to
in financial statements is that it is readily
a model, formula or other technique and
understandable by users.
recalculating the inputs using the same
But the complex economic activities make it methodology.
impossible to reduce the financial information to
An example is verifying the carrying amount of
the simplest terms.
inventory by checking the inputs in quantities
Accordingly, the users shall have an and costs and recalculating the ending inventory
understanding of the complex economic using the same cost flow assumption, such as
activities, the financial accounting process and first-in, first-out.
the terminology in the financial statements.
Timeliness
Financial statements cannot realistically be
Timeliness means that financial information must
understandable to everyone.
be avoidable or communicated early enough
Financial reports are prepared for users who have when a decision is to be made.
a reasonable knowledge of business and
Relevant and faithfully represented financial
economic activities and who review and analyze
information furnished after a decision is made is
the information diligently.
useless of or no value
At times, even well-informed and diligent users
For example, the most important attribute of
may need to seek the aid of an adviser to
quarterly or interim financial information is its
understand information about complex
timeliness.
phenomena or transactions.
Generally, the older the information, the less
Understandability is essential because a
useful.
relevant and faithfully represented information
may prove useless if it is not understood by users. However, some information may continue to be
timely long after the end of reporting period
Verifiability
because some users may need to identify and
Verifiability means that different knowledgeable assess trends.
and independent observers could reach
Timeliness enhances the truism that without
consensus, although not necessarily complete
knowledge of the past, the basis for prediction
agreement, that a particular depiction is a
will usually be lackiong and without interest in
faithful representation.
the future, knowledge of the past is sterile.
In other words, verifiability implies consensus.
What happened in the past would become the
The financial information is verifiable in the basis of what would happen in the future.
sense that it is supported by evidence so that an
Cost constraint on useful information
accountant that would look into the same
evidence would arrive at the same economic Cost is a pervasive constraint of the information
decision or conclusion. that can be provided by financial reporting.
Verifiable financial information provides results Reporting financial information imposes cost and
that would be substantially duplicated by it is important that such cost is justified by the
measurers using the same measurement method. benefit derived from the financial information.
 In other words, the cost constraints is a reporting entity comprises both the parent
consideration of the cost incurred in generating and its subsidiaries.
financial information against the benefit to be 2. Unconsolidated financial statements are the
obtained from having the information financial statements prepared when the
reporting entity is the parent alone.
The benefit derived from the information should
3. Combined financial statements are the
exceed the cost incurred in obtaining the
financial statements when the reporting entity
information.
comprises two or more entities that are not
However, the evaluation of the cost constraint is linked by a parent and subsidiary
substantially a judgmental process. relationship.

Assessing whether the cost of reporting Consolidated financial statements

outweighs or falls short of the benefit is difficult
Consolidated financial statements provide
to measure and becomes a matter of professional
information about the assets, liabilities, equity,
judgment.
income and expenses of both the parent and its
CHAPTER 4 subsidiaries as a single reporting entity.

FINANCIAL STATEMENTS AND The parent is the entity that exercises control over
REPORTING ENTITY UNDERLYING the subsidiaries.
ASSUMPTIONS
Consolidated information is useful for existing and
GENERAL OBJECTIVE OF FINANCIAL potential investors, lenders and other creditors of the
STATEMENTS parent in their assessment of future net cash inflows
to the parent.
Financial statements provide information about
economic resources of the reporting entity, claims This is because net cash inflows to the parent include
against the entity and changes in the economic distributions to the parent from its subsidiaries.
resources and claims.
Consolidated financial statements are not designed to
Financial statements provide financial information provide separate information about the assets,
about an entity's assets, liabilities, equity, income, liabilities equity, income and expenses of a
and expenses useful to users of financial statements particular subsidiary.
in:
A subsidiary's own financial statements are designed
a. Assessing future cash flows to the reporting to provide such information.
entity.
Unconsolidated financial statements
b. Assessing management stewardship of the
entity's economic resources. Unconsolidated financial statements are designed to
provide information about the parent's assets,
The financial information is provided in the
liabilities, income, and expenses and not about those
following.
of the subsidiaries.
1. Statement of financial position, by
Such information can be useful to the existing and
recognizing assets, liabilities and equity
potential investors, lenders, and other creditors of the
2. Income statement, by recognizing income
parent because a claim against the parent typically
and expenses
does not give the holder of that claim against
3. Statement of cash flows, by recognizing cash
subsidiaries.
flows from operating, investing and
financing activities Information provided in unconsolidated financial
4. Statement of changes in equity, by statements is typically not sufficient to meet the
recognizing contributions from equity requirement needs of primary users.
holders and distributions to equity holders
Accordingly, when consolidated financial statements
5. Notes to financial statements, by recognizing
are required, unconsolidated financial statements
disclosures required by accounting standards
cannot serve as substitute for consolidated financial
Types of financial statements statements.
The Revised Conceptual Framework recognizes Combined financial statements
three types of financial statements.
Combined financial statements provide financial
1. Consolidated financial statements are the information about the assets, liabilities, equity,
financial statements prepared when the
income and expenses of two or more entities not UNDERLYING ASSUMPTIONS
linked with parent and subsidiary.
Accounting assumptions or accounting postulates
Reporting entity are the basic notions or fundamental premises on
which the accounting process is based.
A reporting entity is an entity that is required or
chooses to prepare financial statements. Like a building structure that requires a solid
foundation to avoid or prevent future collapse and
The reporting entity can be a single entity or a portion
provide room for expansion, and so with accounting.
of an entity, or can comprise more than one entity.
Accounting assumptions serve as the foundation or
A reporting entity is not necessarily a legal entity.
bedrock of accounting in order to avoid
Accordingly, the following can be considered a misunderstanding but rather enhance the
reporting entity: understanding and usefulness of the financial
statements.
a. Individual corporation, partnership or
proprietorship The Conceptual Framework for Financial Reporting
b. The parent alone mentions only one assumption, namely going
c. The parent and its subsidiaries as single concern.
reporting entity
However, implicit in accounting are the basic
d. Two or more entities without parent and
assumptions of accounting entity, time period and
subsidiary relationship as a single reporting
monetary unit.
entity
e. A reportable business segment of an entity Going concern
Reporting period The going concern or continuity assumption means
that in the absence of evidence to the contrary, the
The reporting period is the period when financial
accounting entity is viewed as continuing in
statements are prepared for general purpose
operation indefinitely.
financial reporting.
In other words, the financial statements are normally
Financial statements may be prepared on an interim
prepared on the assumption that the entity will
basis, for example, three months, six months or nine
continue in operations for the foreseeable future
months.
The going concern postulate is the very foundation
Interim financial statements are not required but
of the cost principle.
optional.
Thus, assets are normally recorded at cost. As a rule,
However, financial statements must be prepared on
market values are ignored.
an annual basis or a period of twelve months.
However, some new standards require measurement
Financial statements are prepared for a specified
of certain assets at fair value.
period of time and provide information about:
If there is evidence that the entity would experience
a. Assets, liabilities and equity at the end of the
large and persistent losses or that the entity's
reporting period.
operations are to be terminated, the going concern
b. Income and expenses during the reporting
assumption is abandoned In this case, the users of the
period.
statements will have a great interest in the amount of
To help users of financial statements to identify and cash that will be generated from the entity’s assets in
assess changes in trends, financial statements also the short term.
provide comparative information for at least one
Accounting entity
preceding reporting period.
In financial accounting, the accounting entity is the
Financial statements may include information about
specific business organization, which may be a
transactions and other events that occurred after the
proprietorship, partnership, or corporation.
end of reporting period if the information is
necessary to meet the general objective of financial Under this assumption, the entity is separate from the
statements. owners, managers, and employees who constitute the
entity.
Accordingly, the transactions of the entity shall not
be merged with the transactions of the owners.
The reason for the entity assumption is to have a fair The one-year period is traditionally the accounting
presentation of financial statements. period because usually it is after one year that
government reports are required.
The personal transactions of the owners shall not be
allowed to distort the financial statements of the The accounting period may be a calendar year or a
entity. natural business year.
For example, the cash invested by the proprietor is A calendar year is a twelve-month period that ends
treated as an asset of the proprietorship. on December 31.
If an enterprising entrepreneur owns a department A natural business year is a twelve-month period that
store, restaurant and bookstore, separate statements ends on any month when the business is at the lowest
shall be prepared for each business in order to or experiencing slack season.
determine which business is profitable.
Monetary unit
Each business is an independent accounting entity.
The monetary unit assumption has two aspects,
When a major shareholder of a corporation borrows namely quantifiability and stability of the peso.
money from a bank on his own personal account, the
The quantifiability aspect means that the assets,
loan is the liability of the shareholder alone and not
liabilities, equity, income and expenses should be
of the corporation.
stated in terms of a unit of measure which is the peso
The shareholder is not the corporation, and the in the Philippines.
corporation is not the shareholder.
How awkward to see financial statements without
However, where parent and subsidiary relationships any common unit of measure. Such statements would
exist, consolidated statements for the affiliates are be largely unintelligible and incomprehensible.
usually made because for practical and economic
The stability of the peso assumption means that the
purposes, the parent and the subsidiary are a single
purchasing power of the peso is stable or constant
economic entity.
and that its instability is insignificant and therefore
The consolidation, however, does not eliminate the may be ignored.
legal boundary segregating the affiliated entities.
The stable peso postulate is actually an amplification
Accounting will continue to be done separately for of the going concern assumption so much so that
each entity. adjustments are unnecessary to reflect any changes
in purchasing power.
Time period
The accounting function is to account for nominal
A completely accurate report on the financial
pesos only and not for constant pesos or changes in
position and performance of an entity cannot be
purchasing power.
obtained until the entity is finally dissolved and
liquidated. In today's world, the assumption that the peso is a
stable measure over time is not necessarily valid.
Only then can the final net income and networth of
the entity be determined precisely. Consider an equipment that was imported 10 years
ago from the United States for $100,000 when the
However, users of financial information need timely
exchange rate was P35 to $1 or an equivalent of
information for making an economic decision.
P3,500,000.
It becomes necessary therefore to prepare periodic
If the same equipment is purchased now and
reports on the financial position, performance, and
assuming there is no change in the $100,000
cash flows of an entity.
purchase price, the replacement cost in terms of
The time period assumption requires that the pesos would be in the vicinity of P5,000,000,
indefinite life of an entity is subdivided into considering a current exchange rate of P50 to $1.
accounting periods which are usually of equal length
Obviously, there is a significant gap between
for the purpose of preparing financial reports on
historical cost and current replacement cost.
financial position, performance and cash flows.
In this regard, an entity may choose the revaluation
By convention, the accounting period or fiscal period
model as an accounting policy.
is one year or a period of twelve months.