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MODULE in Accounting 15

Accounting for Government, Non for Profit Entities and Specialized Industries

Objectives:

Learning Guide

The continuing growth in world trade and the significance of foreign operations to Philippine
companies have resulted in increasing attention being paid to international accounting
practices and problems. These problems are generally subdivided into two broad areas:

1. Problems related to transactions which give rise to receivables and payables denominated
In foreign currencies must be measured and recorded in the Philippine currency (Peso).
2. Problems arising from the translation of foreign currency into Philippine currency. This is
Discussed in chapter 20.

The discussion of the nature of these problem areas and the related accounting procedures
focuses in the accounting principles prescribed in International Accounting Standards (IAS)
no. 21 “ Accounting for the effects of changes in foreign exchange rate” and no. 39, “
Financial Instrument: Recognition and Measurement”.

Chapter explanation: Lesson 1

Measured versus Denominated

It is useful to have an understanding of these two terms used in accounting of foreign

currency transactions. Assets and liabilities are denominated in one currency if their amount
is fixed in terms of that currency. However, they must be measured (for financial reporting
purposes) in another currency.

When a transaction is to be settled by the receipt or payment of a specified currency, the

receivables or payable is said to be denominated in that currency. Regardless of the
currency in which a transaction is denominated, the party to the transaction measures and
records the transaction in the currency (local currency) in which the party is located for
example, a Philippine importer purchases goods on credit from a U.S. exporter who is to be in
US dollars. The transaction is denominated in US dollars but measured and recorded by the
Philippine importer Philippine pesos. However the U.S. exporter’s transaction is both
denominated and measured in US dollars.

Conversion and Translation

It is important to know the distinction between the conversion and translation of foreign
currencies. In the case of the example above, the Philippine importer converts Philippine
pesos on the date of payment into US dollars at the prevailing rate of exchange.

On the other hand, the assets, liabilities, and operating items of a foreign branch or subsidiary
are translated into Philippine pesos to consolidate them into the financial statements of the
Philippine home office or parent company. No actual exchange of currencies is involved,
only a translation into a single currency.

Currency Exchange Rate

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The exchange rate is the in which the currencies of two countries are exchanged at a
particular time. The buying and selling of foreign currencies as though they were
commodities result in variation in the exchange rate between the currencies of two countries.
For examples, a daily newspaper might quote exchange rates for the US dollars ($) as follows,
based on the prior day’s transactions in the Philippine stock exchange:

Foreign Currency Pesos in FC

United States of America (US dollar) 56.20 0.01779

The first column indicates that $1 could be exchanged for approximately P56.20 (direct
quotation) the second column indicates that P1 could be exchange for approximately
$0.01779 (indirect quotation). Note that the two exchange rates are reciprocals (1/56.20 =
$0.01779).

The exchange rate illustrated above is the selling spot rate charged by the bank for current
sales of the foreign currency. The bank’s buying spot rate for the currency usually is less than
the selling spot rate; the spread between the selling and buying spot rates, there are forward
exchange rates, which apply to foreign currency transactions to be consummated on a
future date. Forward rates apply to forward exchange contracts, which are derivative
instruments discussed in a subsequent section of this chapter. Factors influencing fluctuations
in the nation’s exchange rates include differing global rates of inflation, money variations,
capital investment levels, and monetary actions of the central banks.

ACCOUNTING FOR FOREIGN CURRENCY TRANSACTIONS

A transaction that requires settlement or payment in a foreign currency is called foreign

currency transaction. A transaction with a foreign company that is to be paid in Philippine
peso is not a foreign currency transaction to a Philippine company, because the amount of
pesos to be received or paid to settle the account is fixed and is not affected by subsequent
changes in the exchange rate. Thus, a transaction of a Philippine company with a foreign
company to be settled in pesos is accounted for in the same manner as if the transaction
had been with a company in the Philippines.

Often, however, the transaction described is negotiated and settled in terms of the foreign
company’s local currency unit. In such cases, the Philippine company must account for the
transaction denominated in foreign currency in terms of Philippine pesos. This accounting,
described as foreign currency translation, is accomplished by applying the appropriate
exchange rate between the foreign currency and the Philippine pesos.

Some of the more common foreign currency transactions are:

1. Importing and exporting goods on credit with the receivable or payable denominated in
Foreign currency.
2. Borrowing or lending denominated in foreign currency.
3. Entering into a forward exchange contract to buy or sell foreign currency.

Importing and Exporting of Goods

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This is the most common form of foreign currency transaction. In each unsettled foreign
currency transaction, there are three (3) issues of concern to the accountant. These issues
and the appropriate exchange rate to be used in translating accounts denominated in units
of foreign currency (except for forward exchange contracts) are as follows.

1. At the date the transaction is first recognized. Each asset, liability, revenue, gain or loss
Arising from the transaction is measured and recorded in Philippine pesos by multiplying
The units of foreign currency by the closing exchange rate that is, the spot rate in effect
On a given date.
2. At each balance sheet date that occurs between the transaction date and the settlement
Date. Recorded balances that are denominated in a foreign currency are adjusted to
reflect the closing exchange rate in effect at the date of the statement of financial position.
Foreign exchange (forex) gain or loss is recognized for the difference in the exchange rate
between the transaction date and the balance sheet date.
3. At the settlement date. In the case of a foreign currency payable, a Philippine company
must convert Philippine pesos into foreign currency units to settle the account, while foreign
currency units received to settle a foreign currency receivable will be converted into pesos.
Although translation is not required, a foreign exchange (forex) gain or loss is recognized if
the amount of pesos paid or received upon conversion does not equal the carrying value of
the related payable receivable.

Importing Transactions- Purchase of merchandise from a Foreign Supplier

Illustration
To illustrate a purchase of merchandise from a foreign supplier, assume that on November
15, 2016, Manila Corporation purchased merchandise from a U.S. firm for US$ 10,000 and
opened a letter of credit with Bank of Philippine Island (BPI) to cover the importation bank
services charge amounted to P1,500. The corporation’s fiscal year ends December 31. The
selling spot rate issued by PBI for US$ at various dates is as follows:

Date of arrival of goods – December 15, 2016 P50.50

Balance sheet date – December 31, 2016 50.80
Date of receipt of importation documents and the required
Payment of the letter of credit to BPI – January 10, 2017 50.90

Assuming that Manila Corporation uses the periodic inventory system, the journal entries to
record the above transactions relating to the importation are as follows:

2016
November 15: Bank charges 1,500
Cash 1,500
To record bank charges
December 15: Purchases 505,000
Acceptance payable 505,000
To record the receipt of goods ($10,000xP50.5)
December 31: Foreign exchange loss 3,000
Acceptance payable 3,000
To adjust acceptance payable and recognize forex loss for the increase
in the exchange rate. $10,000 x (P50.80-P50.50)
2017
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January 10: Acceptance payable 508,000

Foreign exchange loss 1,000
Cash 509,000
To record the payment of letter of credit (LC) to PBI, and recognition of
forex loss. $10,000 x P50.90.

If no payment is made by Manila Corporation to PBI upon receipt of the goods and the
related importation documents, a trust receipts payable account is credited instead of cash
account. Later, when payment is made, trust receipts payable account is debited with a
corresponding credit to cash account.

Marginal Deposit on Letter of Credit (LC). Some banks may require importers to make a
marginal deposit upon opening of LC. As an example, let us assume that PBI required Manila
Corporation to give a 25% marginal deposit on the $10,000 letter of credit. The exchange
rate given by the bank on November 15, 2017 is P50.00 to US$1. The entry to record this
transaction is:
2017
November 15: Marginal deposit on LC 125,000
Cash 125,000
To record marginal deposit on LC 25% x ($10,000 x P50.50)

On the date of settlement of the LC, this marginal deposit is applied as payment.

Two-Transaction Perspective and One-Transaction Perspective

The journal entries above reflect the two-transaction perspective for recording foreign trade
transaction. Under the concept, Manila’s transaction with the US supplier basically were two-
separate transactions. One transaction was the purchase of the merchandise; the second
transaction was the acquisition of the foreign currency required to pay the LC for the
merchandise purchased.

Under the one-transaction perspective, Manila’s total foreign exchange loss of P4,000 on its
purchase from the US supplier should be applied to increase the cost of merchandise
purchased. Under the approach, Manila would not prepare a journal entry on December
31, 2016, but would prepare the following entry on January 10 ,2017:

2017
January 10: Acceptance payable 505,000
Purchases 4,000
Cash 509,000
To record payment of LC for P509,000 ($10,000 xP50.90),
And increase purchases for resulting forex loss

In effect, the one-transaction perspective considers the original amount recorded for the
purchase of foreign merchandise as an estimate, subject to adjustment when the exact cash
outlay required for the purchase is known.

The authors supports the two-transaction perspective for foreign trade transactions and for
loans receivable and payable denominated in foreign currency.

Exporting Transactions – Sale of Merchandise to a Foreign Customer

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Illustration
Assume that on November 3, 2016, Pilipino Company sold merchandise for $10,000 to a US
firm. On November 8, Bank of Philippine Island (BPI) received a confirmation of LC from the
bank of the US firm to support the purchase order. On November 10, Pilipino Company
availed a Packing Credit Line of P100,000 with BPI to fund his exportation against the
confirmed purchase order or letter of credit. The selling spot rates issued by the bank for US
dollars at various dates are as follows:
Date of shipment- November 20, 2016 P50.60
Balance sheet date – December 31, 2016 50.80
Date of settlement – January 25, 2017 50.90

The journal entries of Pilipino Company to record the above transactions relating to
exportation of goods are as follows:
2016
November 10: Cash 100,000
Packing credit line 100,000
To record availment of packing credit line
November 20: Accounts receivable 506,000
Sales 506,000
To record shipment of merchandise ($10,000 x P50.60)
December 31: Accounts receivable 2,000
Foreign exchange gain 2,000
To adjust accounts receivable and recognize
Forex gain for the increase in the exchange rate,
$10,000 (P50.80-P50.60)
2017
January 25: Cash 509,000
Accounts receivable 508,000
Foreign exchange gain 1,000
To record settlement received from BPI for the
LC and recognition of forex gain

Loans Payable Denominated in Foreign Currency

Illustration
If a Philippine Company chooses to borrow foreign currency to pay for the merchandise
purchased from a foreign supplier, the following journal entries will illustrate the procedures
involve (HK$ is the symbol for the Hongkong Dollars).
2016
May 30: Purchases 580,000
Accounts payable 580,000
To record purchase from Hongkong supplier for 100,000 HK$, converted
At selling spot rate of P5.80 to 1 HK$.
June 1: Accounts payable 580,000
Notes payable 580,000
To record borrowing of 100,000 HK$ from a bank on 30-days, 12% loan
To be repaid in Hongkong dollar, and payment of liability to Hongkong supplier.
June 30: Notes payable 580,000
Interest expense 5,880
Foreign exchange loss 8,000
Cash 593,880
To record payment of 101,000 HK$ to pay 100,000 HK$, 30-day, 12% note,
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Together with 1,000 HK$ interest (100,000HK$ x 12% x 30/360) at selling

Spot rate of 1HK$ = P5.88 (101,000 HK$ x P5.88 = P593,880)

Loan Receivable Denominated in Foreign Currency

Illustration
Assume that a Philippine Corporation received a promissory note denominated in foreign
currency from the sales made to a Japanese customer (Y is the symbol for Japanese Yen).
This transactions might be illustrated by the following journal entries:
2016
March 31 Notes receivable 430,000
Sales 430,000
To record sale to a Japanese customer for 60-day, 12% promissory
Note for Y1,000,000 translated at buying spot rate of Y1=P.43.
April 30 Notes receivable 20,000
Interest receivable 4,500
Interest income (Y1,000,000 x 12% x 30/360) x P.45 4,500
Forex gain (Y1,000,000 x (.45-.43)) 20,000
To recognize forex gain for the increase in the spot rate from March 31,
To April 30 and to accrue interest on notes receivable, valued at the buying
Spot rate of Y1= P.45.
May 30 Cash (Y1,020,000 x P0.44) 448,800
Forex loss 10,100
Notes receivable 450,000
Interest receivable 4,500
Interest income(1,000,000 x P0.44) x 12% x 30/360) 4,400
To record receipt and conversion to pesos of Y1,020,000 note including
Interest of Y20,000 (Y1,000,000 x 12% x 60/360), and the recognition of
Forex loss of 10,100 (Y1,000,000+Y10,000) x (P0.45-P0.44)

Foreign exchange (forex) Gains and Losses

From the foregoing illustrations, it shows that increases in the selling spot rate for a foreign
currency required by a Philippine Company to settle a liability denominated in that currency
generate foreign exchange (forex) losses to the company because more Philippine pesos
are required to obtain the foreign currency. Conversely, decreases in the selling spot rate
produce foreign exchange (forex) gains to the company because fewer Philippine pesos are
required to obtain the foreign currency. In contrast, increases in the buying spot rate for a
foreign currency to be received by a Philippine company in settlement of a receivable
denominated in that currency generate foreign exchange (forex) gains to the company;
decreases in the buying spot rate produce foreign exchange (forex) losses. These
relationships are summarized below:

Statement of FP effect on statement

Account affected balance reported of CI effect
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Increase in exchange rate:

Importing transaction payable increase loss
Exporting transaction receivable increase gain

Decrease in exchange rate:

Importing transaction payable decrease gain
Exporting transaction receivable decrease loss

Foreign exchange gains and losses are included in the measurement of net income for the
accounting period in which the exchange rate (spot rate) changes (PAS 21).

FORMATIVE QUESTIONS

Homework: Activities

Multiple Choices – Theoretical and Computational

1. Which of the following combination correctly describes the relationship between

foreign currency transactions, exchange rate changes, and foreign exchange gains
and losses?
Type of transactions Foreign currency Forex gain (losses)
a. Export sale Appreciates loss
b. Import purchase Appreciates gain
c. Import purchase Depreciates gain
d. Export sales Depreciates gain
2. Philip Company had a Japanese yen receivable resulting from exports to Japan and
Hongkong dollar payable resulting from imports from Hongkong. Philip recorded
foreign exchange gains related to both its yen receivable and HK$ payable. Did the
foreign currencies increase or decrease in peso value from the date of the transaction
to the settlement date?
Japanese Yen Hongkong Dollar
a. Increase Increase
b. Decrease Decrease
c. Decrease Increase
d. Increase Decrease
3. Foreign exchange gains and losses on accounts receivable and payable that are
denominated in a foreign currency are:
a. Accumulated and reported upon settlement
b. Deferred and treated as transaction price adjustment
c. Reported as equity adjustments from translation
d. Recognized in the period in which exchange rates change
4. On December 1, 2017, Import Computers, Inc. purchased 10 personal computers from
a foreign firm for 200,000 FC. The exchange rate for the FC was P1=2.22 on December
1 and P1= 2.70 on December 31. On its December statement of comprehensive
income Import Computers should report a foreign exchange gain (loss) of:
a. P(96,000)
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b. P 96,000
c. P(16,000)
d. P 16,000
5. On December 1, 2016, the Pinoy Company sells construction materials to a Japanese
importer for 1,500,000 Yen. The relevant exchange rates are:
December 1, 2016 1 Yen = P.45
December 31, 2016 1 Yen = P.47
January 30, 2017 1 Yen = P.40

On the statement of comprehensive income for the year ended December 31, 2016,
Pinoy Company should report a foreign exchange gain (loss) of:
a. P 0
b. P (30,000)
c. P 30,000
d. P 3,000
6. On September 1, 2017, wheels Inc., a calendar year corporation, purchased car tires
from a factory in Hongkong for 200,000 Hongkong dollars. The amount is payable in
60 days. The exchange rate for the Hongkong dollar has varied as follows:
September 1, 2017 1HK$ = P5.61
September 30, 2017 1HK$ = P5.59
December 31, 2017 1HK$ = P5.62
If Wheels Inc. prepare quarterly statement of comprehensive income, the forex gain
Or loss for the quarters ended 9/30 and 12/31, respectively, amounts to:
a. P0 and P2,000 loss
b. P0 and P200 gain
c. P4,000 loss and P6,000 gain
d. P40,000 gain and P6,000 loss
7. Great Corporation, had the following foreign currency transactions during 2017:
• Merchandise was purchased from a foreign supplier on January 10, 2017, for the
Philippine peso equivalent of P600,000. The invoice was paid on April 20, 2017, at
the Philippine peso equivalent of P608,000.
• On September 1, 2017, Great Corporation borrowed the Philippine peso
equivalent of P3,000,000 evidenced by a note that was payable in the lender’s
local currency. On December 31, 2017, the Philippine peso equivalent of the
principal amount and accrued interest were P3,200,000 and P120,000,
respectively. Interest on the note is 10 percent per annum.
In Great’s 2017 statement of comprehensive income, what amount should be
included as a forex loss?
a. P40,000 c. P228,000
b. P200,000 d. P300,000

EVALUATION- QUIZ
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Lesson 2: DERIVATIVES

Derivatives are financial contracts or other contract with all three of the following
characteristics (IAS 39):
1. Whose value changes in response to changes in a specified interest rate, security
price, commodity price, foreign exchange rate, index of prices or rates, a credit rating
or credit index or other variable (sometimes called the “underlying’).
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For example, a call option that gives the holder a right to purchase a share for a fixed
price increases in value when the price of that share increases. In that case, the share
price is an underlying that affects the value of the option.
2. It requires no initial net investment or an initial net investment that is smaller than would
be required for other types of contracts.

For instance, a call option on a share can usually be purchased for an amount much
smaller than what will be required to purchase the share itself.
3. It is settled at a future date.

For instance, a call option on a share is settled on the future date on which the holder
may exercise the call option to purchase the share for a fixed price.

HEDGING

Hedging is a risk management technique that involves using one or more derivatives or other
hedging instruments to offset changes in fair value or cash flows of hedged items. The general
provisions on hedging and hedge accounting are contained in PAS 39. A hedging
relationship has two components namely:

1. Hedged item. A hedge item is an asset, liability , firm commitment, highly probable
forecast transaction, or net investment in a foreign operation. To be designated as a
hedged item, the designated hedged item should expose the entity to risk of changes
in fair value or future cash flows.
2. Hedging instrument. A hedging instrument is a designated derivative or a designated
non-derivative financial asset or non- derivative financial liability whose fair value or
cash flows are expected to offset changes in fair value or cash flows of a designated
hedged item. Examples of hedging instruments are foreign exchange forward
contracts, interest rate swaps and commodity futures contracts.

There are three types of hedging relationships. These are:

a. Fair value hedge. This is a hedge of the exposure to changes in fair value of a
recognized asset or liability or an unrecognized firm commitment that is
attributable to a particular risk, and that could affect profit or loss. Under fair
value accounting changes In the fair value of the hedging instrument and of
the hedged item are recognized in profit or loss at the same time. The result is
that there will be no (net) impact on profit or loss of the hedging instrument and
the hedged item if the hedge is fully effective, because changes in fair value
will offset each other. If the hedge is not 100 percent effective (i.e., the
changes in fair value do not fully offset), such ineffectiveness is automatically
reflected in profit or loss.
b. Cash flow hedge. This is a hedge of the exposure to variability in cash flows
that is attributable to particular risk associated with a recognized asset or
liability or a highly probable forecast transactions and could affect profit or loss.
Under cash flow hedge accounting, changes in the fair value of the hedging
instruments attributable to the hedged risk are deferred (rather than being
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recognized immediately in profit or loss). The accounting for the hedged item
is not adjusted.
c. Foreign currency hedge. This is a hedge of the exposure to foreign currency
exchange gains or losses on an entity’s net investment in a foreign operation
(which is the amount of the entity’s interest in the net asset of that operation).
Hedges of net investments in foreign operations are accounted for like cash
flow hedges.

Hedge Accounting

Hedge accounting recognizes the offsetting effects on profit or loss of changes in the fair
value of the hedging instrument and the hedge item every accounting period. (However,
under BSP Circular 476, banks are required to book the market-to-market valuation for
securities at fair value through profit or loss on a daily basis although they are permitted to do
the booking every end of the month provided it has an adequate mechanism in place to
determine the daily fair values of the securities)

To qualify for hedge accounting, the hedging relationship should meet the following
conditions:
1. There is a formal designation and documentation of the hedging relationship and the
entity’s risk management objective and strategy for undertaking the hedge. Hedge
accounting is permitted only from the date such designation and documentation is in
place.
2. The hedge is expected to be highly effective in achieving offsetting changes in fair
value or cash flows attributable to the hedged risk.
3. The effectiveness of the hedge can be measured reliably.
4. The hedge is assessed on an ongoing basis and determined actually to have been
highly effective throughout the financial reporting periods for which the hedge was
designated.
5. For cash flow hedges, a hedged forecast transaction must be highly probable and
must present an exposure to variations in cash flows that could ultimately affect profit
or loss.

FOREIGN CURRENCY FORWARD CONTRACT

A foreign currency forward contract is an agreement to exchange currencies of different

countries on a specified future date at the specified rate (the forward rate).
The fair value of a foreign currency forward contract is determined by reference to changes
in the forward rate over the life of the contract. The changes in the forward rate may be
discounted to the present value.

Foreign currency forward contracts are usually entered into for the following purposes:
1. A fair value hedge – this includes hedges against a change in the fair value of:
• A recognized foreign currency denominated asset or liability.
• An unrecognized foreign currency firm commitment.
2. A cash flow hedge – this includes hedges against the change in cash flows associated
with
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• A forecasted foreign currency transaction.

• An unrecognized foreign currency firm commitment.

Fair Value Hedge of an Exposed Net Asset or Net Liability Position

A foreign currency exposed net asset position is the excess of assets denominated in foreign
currency over the liabilities denominated in the same foreign currency and translated at the
current rate. A foreign currency exposed net liability position is the excess of liabilities
denominated in a foreign currency over assets denominated in that foreign currency and
translated at the current rate.

Companies enter into forward contracts to limit the amount of gains or losses from the
delayed settlement of foreign- currency – denominated accounts receivable and payables.
A forward contract to hedge an exposed asset or liability position may be used by either
importer to hedge accounts payable, i.e., a company enters into a forward contract to
purchase foreign currency or by exporters to hedge accounts receivable, i.e., a company
enters into a forward contract to sell foreign currency for future delivery.

When the exposed asset or liability position is completely hedged, no net forex gains or losses
is to be recognized. Forex gains and the offsetting losses are to be recognized in the
computation of comprehensive income and of the carrying value of the hedge items.

Normally, banks set the forward rate at an amount different from the spot rate on the contract
date. The difference between these rates represents the cost of avoiding the risk of
exchange rate fluctuations.

Hedging an Exposed Net Liability Position

Illustration

Assume that on October 1, 2016, Manila Corporation purchases goods on account from
Crown Company of Japan for 500,000 yen. No letter of credit is required by Crown Company.
The billing date for the sale is December 1, 2016, and the payment is due in 60 days on
January 30, 2017. In view of the sale, Manila Corporation enters into a forward contract to
buy 500,000 yen from Philippine National Bank (PNB) in 60 days. The relevant exchange rates
are as follows:

Date spot rate forward rate for remaining term of contract

December 1, 2016 1 yen = P0.45 1 yen = P0.50

December 31, 2016 1 yen = P0.48 1 yen = P0.51
January 30, 2017 1 yen = P0.49 1 yen = P0.49

The change in the value of the forward contract is not discounted.

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The journal entries on the books of Manila Corporation to record the purchase (importation),
the forward contract, year-end adjusting entries, and the final settlement are as follows
(perpetual inventory system is used):

Relating to importing transactions Relating to forward contract

December 1, 2016:

Inventory 225,000 Forward contract receivables 250,000

Accounts payable 225,000 Forward contract payable 250,000
Purchase of inventory purchase of forward contract
(500,000 yen x P0.45) (500,000 yen x P0.50)

December 31, 2016:

Forex loss 15,000 Forward contract receivable –FC 5,000
Accounts payable 15,000 Gain on forward contract 5,000
To adjust accounts payable to to record increase in value of the
Year –end spot rate: forward contract:
(500,000 yen x P0.03) (500,000 yen x P0.01)

January 30, 2017:

Accounts payable 240,000 Foreign currency 245,000
Forex loss 5,000 loss on forward contract 10,000
Foreign currency 245,000 Forward contract receivable-FC 255,000
To record settlement of the To record receivable of 500,000 yen according
Accounts payable at P0.49 to the forward contract

Forward contract payable 250,000

Cash 250,000

Alternative entries:

a. An alternative for this entry would be a memo entry to describe the executory
contract. This treatment is acceptable since the forward contract has a fair
value of zero on that date. However, recognizing the forward contract with
entries helps in understanding the relationships in using forward contracts. If no
entry were made at inception, subsequent changes in the value of the forward
contract (hedging instrument) would still be recognized by either debiting or
crediting the forward contract receivable in the case of unrealized gain or loss,
respectively.
b. If a memo entry was initially used to record the forward contract, the
settlement of the contract would be recorded as follows:
Foreign currency 245,000
Forward contract receivable – FC 5,000
Cash 250,000

The following should be noted from the journal entries:

1. On December 1, 2016, the date of forward contract, Manila Company can compute
its total gain or loss on the hedged item and the hedge contract. Subsequent
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fluctuations in exchange rates will not affect the amount of the gain or loss. The net
gain or loss is the difference between the contracted forward rate and the spot rate
on the date the contract is entered into.

Forward rate (500,000 yen x P.50) P250,000

Spot rate (500,000 yen x P.45) 225,000
Net loss P 25,000
=======
The company will lose P25,000 since it has contracted to pay P.05 more than the spot
rate at the time the contract was entered into.
2. On December 31, 2016, the accounts payable from the purchase is adjusted to reflect
the increase in the exchange rate, and a P15,000 forex loss is recorded. On the
forward contract, gain would be recognized equal to the initial forward rate of P.50 x
500,000 yen less the current forward rate of P.51 x 500,000 yen (P250,000- P255,000)
which is P5,000. The gain on forward contract is recognized immediately to profit and
loss.
3. The forex gain or loss on the underlying liability hedged will not be equal to the gain
or loss on the forward contract. This is because the underlying liability is carried at the
spot rate and the forward contract is carried at the forward rate. During the term of
the forward contract, the forward rate will approach the spot rate, exactly equaling
it on the settlement date. The change in the relative value of the spot and forward
rates determines the effect on the net income. In this example, the net change in
relative value is shown below:

Import entries gain (loss) on net gain (loss)

Forex gain (loss) Forward contract

December 31, 2016 P(15,000) P5,000 P(10,000)

January 30, 2017 P( 5,000) P(10,000) (15,000)
Total P(20,000) P(5,000) P(25,000)
======== ======= ========
Note that the net loss of P25,000 is equal to the loss computed on the date of
Forward contract.
4. In the final analysis, Manila Corporation purchases goods in the amount of P225,000.
It takes a P25,000 charge on the transaction in order to avoid the risks of foreign
currency price fluctuations, and pays P250,000 in final settlement of the purchase
transaction. The P25,000 is charged to profit and loss over the term of the forward
contract.

Hedging an Exposed Net Asset Position

Accounting procedures for hedging an exposed asset position are basically comparable to
those illustrated for Manila Corporation except that the purpose is to hedge an asset
denominated in foreign currency, rather than a liability. Usually, the forward rate for selling
foreign currency for future delivery is normally less than the spot rate. For example, a forward
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contract to sell 100,000 Hongkong Dollar for delivery in 60 days may have a forward rate of
P5.50 when the spot rate is P5.70. the forward contract is recorded as follows:
Forward contract receivable 550,000
Forward contract payable 550,000
To record forward contract to deliver 100,000 Hongkong dollar at
Forward rate of P5.50

The contract hedges any effect of changes in the exchange rate so that the net cost over
the life of the contract will be the P20,000 difference between the forward and spot rates.

Result of Hedging. Forward rates are ordinarily set so that a cost is incurred related to the
hedge. Usually, the rates for future contracts result in hedges that increase income.

In summary, a forward contract is recorded at the forward rate, while the underlying asset or
liability is recorded at the spot rate (and adjusted to the changes in rates and values at the
financial statement date). Over the life of the contract, the initial difference between the
spot and the forward rate is the cost of hedging the exchange risk, which is sometimes called
premium or discount. Since the gains and losses on both the hedge and the underlying are
recorded in current earnings, the net cost reported in the income statement is the change in
the relative value of the spot and forward rates.

If a company enters a forward contract for foreign currency units in excess of the foreign
currency units recognized in its exposed net asset or net liability position (a speculation in the
currency), the difference ends up either as a gain or loss. This is due to the difference in the
change in the value of the derivative and the change in the value of the underlying item
hedged both being reported in the income statement.

Fair Value Hedge of a Foreign Currency Denominated Commitment

A foreign currency commitment is a contract or agreement to purchase or sell goods to a

foreign entity in the future, to be settled in the foreign currency. The settlement will not be
made until after delivery of the goods; therefore, it is exposed to changes in currency
exchange rates before the transaction date (the date of the delivery of the goods). The
accounting for the forward contract must begin when the forward contract is designated as
a hedge of a foreign currency commitment.

Illustration:

On October 1, 2016 Pilipino Corporation entered into a firm commitment with a Japanese
firm to acquire machine, with delivery, and passage of title on March 31, 2017, at a price of
1,000,000 yen. On the same date, to hedge against unfavorable changes in the exchange
rate of the yen, Pilipino Corporation entered into a 180-day forward contract with Bank of PI
for 1,000,000 yen.

The relevant exchange rates for this example are as follows:

October 1, 2016 December 31, 2016 March 31, 2017
Spot rate P.40 P.41 P.38
Forward rate .425 .41 .38
 16

Filipino Corporation’s journal entries to record the forward contracts transactions and the
purchase of the machine are:
2016
October 1 Forward contract receivable (fc) 425,000
Forward contract payable 425,000
To record forward contract for 1,000,000 yen for delivery
In 180 days at forward rate of P.425
December 31 loss on forward contract 15,000
Forward contract receivable 15,000
To record forex loss for the decrease in the forward rate,
1,000,000 yen x (P.425-P.41)

Firm commitment for machinery 15,000

Gain on firm commitment 15,000
To record the increase in fair value of the purchase commitment
And resultant gain or the decrease in the forward rate. Payment
Of Japanese yen will cost smaller Phil. Pesos.
2017
March 31 Forward contract payable 425,000
Cash 425,000
To record settlement of forward contract.

Cash 380,000
Loss on forward contract 30,000
Forward contract receivable 410,000
To record receipt of 1,000,000 yen from BPI when the exchange
Rate is P.38
Firm commitment for machinery 30,000
Gain on firm commitment 30,000
To record the change in the value of the underlying firm commitment,
1,000,000 yen x (P.41 – P.38).
Machinery 425,000
Firm commitment for machinery 45,000
Cash 380,000
To record purchases of machinery
Key Observations from the above entries
Entry (1) records payment to the bank for the 1,000,000 yen at the contracted forward rate
of P.425. Entry (2) reflects the collection of the 1,000,000 yen from the bank and records an
additional exchange loss on the further decline of the exchange rate from the forward rate
of P.41 at December 31, 2016, to the P.38 spot rate (this is also the forward rate for the date
of settlement) at March 31, 2017. Entry (3) records the gain on the change in the peso cost
of the firm commitment to buy the machinery since December 31, 2016. Entry (4) records
receipt of the machinery from the Japanese firm and records the settlement in Japanese
Yen. It also incorporates the change in the firm commitment in the value of the machinery.

Because Pilipino Corporation had acquired a forward contract for the same amount of the
same currency in which the firm commitment was denominated, the hedge was “perfect”
 17

because it fully covered the risk of unfavorable changes in the exchange rate for the yen.
Also, the cost of the machine purchased from the Japanese firm was equal to the Philippine
peso amount of the forward contract.

The changes in the fair value of the forward contract (changes in forward rate) is not
discounted.

Cash Flow Hedge of a Foreign Currency Forecasted Transaction

It is important to differentiate accounting treatment of a hedge of a forecasted transaction

as a cash flow hedge versus that of an identifiable foreign currency commitment as a fair
value hedge. Unlike a foreign currency commitment, a forecasted transaction is anticipated
but not guaranteed.

Under cash flow hedge the changes in fair value of the hedging instrument is deferred and
recognized as other comprehensive income. This is accumulated and reported as a
separate line in the stockholders’ equity section of the statement of financial position.

Illustration
To illustrate the special accounting for a cash flow hedge of a forecasted transaction, assume
the following:
1. On June 1, a company forecasted the purchase of 5,000 units of inventory from foreign
supplier for 100,000FC. The purchase is forecasted to occur on September 1.
2. On June 1, the company purchased a forward contract to buy 100,000 FC at a
forward rate of 1FC = P5.42 on September 1.
3. The hedge is expected to be fully effective because the critical terms of the hedging
instrument match the terms of the hedged item.
4. Changes in the fair value of the forward contract are to be discounted at a 6% rate.
5. Spot rates, forward rates, and changes in value over time are as follows:

June 1 June 30 July 31 September 1

Number of FC 100,000 100,000 100,000 100,000
Spot rate –FC P5.30 P5.52 P5.70 P5.75
Forward rate for remaining time 1FC P5.42 P5.60 P5.72 P5.75
Initial forward rate P5.42 P5.42 P5.42
Fair value of forward contract
Original forward value P542,000 P542,000 P542,000
Current forward value P560,000 P572,000 P575,000
Change –gain (loss) P 18,000 P 30,000 P 33,000
======== ======== ========
Present value of change:
N=2, I =6% /12 (.990) P17,820
N = I, I=6%/12 (.995) P29.850
N = 0 I = 6%/12 P 33,000
Prior present value 0 17,820 29,850
Change in present value P 17,820 P12,030 P 3,150
======== ======= ========
 18

The journal entries to account for the cash flows hedge of the above forecasted transaction
and the subsequent actual transactions are as follows:

June 1: Forward contract receivables –FC 542,000

Forward contract payable 542,000
To record purchase of forward contract.

June 30: Forward contract receivable – FC 17,820

OCI Unrealized gain 17,820
To record change in value of the forward contract.

July 31: Forward contract receivable –FC 12,030

OCI – Unrealized gain 12,030
To record change in value of the forward contract

Sept. 1: Forward contract receivable –FC 3,150

OCI- Unrealized gain 3,150
To record change in value of the forward contract.

Foreign Currency 575,000

Forward contract payable 542,000
Forward contract receivable –FC 575,000
Cash 542,000

The remaining entries relate to the inventory assuming the purchase was made on September
1 at 100,000 FC and sold on September 15 at P958,000.

Inventory 575,000
Cash 575,000
To record purchase of inventory (100,000 FC x P5.75)

Cash 958,000
Sales 958,000
To record sales

Cost of sales 575,000

Inventory 575,000
To record cost of sales

OCI – Unrealized gain 33,000

Realized gain on cost of sales 33,000
To close the balance of OCI – unrealized gain.

An analysis of the entries in illustration shows that the cash flow hedge was effective in
accomplishing the concern of the Philippine company. The effect of the cash flow hedge
for the forecasted transaction can be summarized as follows:
 19

Without the with the

Forward contract Forward Contract
Sales P958,000 P958,000
Cost of sales 575,000 575,000
Gross profit 383,000 383,000
Realized gain on forward contract 33,000
Net income effect P 383,000 P416,000
======== ========

Speculation – Fair Value Hedge

Illustration
Forward contract for speculation is valued at forward rates throughout the life of the contract.
To illustrate the basic accounting procedures, assume That on November 2, 2016, a Philippine
company enters into a 90 days forward contract with Metro bank to purchase 100,000
Japanese yen when the forward rate for 90-day is P.4400. the spot rate for Japanese yen on
November 2 is P.4440. Exchange rates at December 31, 2016 and January 30, 2017 are as
follows.

December 31, 2016 January 30, 2017

30-day forward rate P.4450 P.4480
Spot rate .4500 .4530

The journal entries on the books of the Philippine company to account for the speculation
are as follows:
2016
Nov. 2 Forward contract receivable (fc) 44,000
Forward contract payable 44,000
To record contract for 100,000 yen at P.4400 exchange rate for 90- day.

Dec. 31 Forward contract receivable (fc) 500

Gain on forward contract 500
To adjust contract receivable from Metro bank and recognized
Forex gain for the increase in the forward rate (.4450-.4400) x 100,000 yen
2017
Jan. 30 Cash (fc) 45,300
Forward contract receivable – (fc) 44,500
Gain on forward contract 800
To record receipt of 100,000 yen converted using
the current spot rate of P.4530.

Forward contract payable 44,000

Cash 44,000
 20

To record payment of contract payable to Metro Bank denominated in peso.

The following should be noted in the journal entries to record the forward contract for
speculation.
1. The entry on November 2 records Philippine company’s right to receive 100,000
Japanese yen from Metro Bank in 90 days. It also records Philippine company’s
liability to pay P44,000 to Metro Bank in 90 days. Both the receivable and payable
are recorded at P44,000, but only the receivable is denominated in Japanese yen
and is subject to exchange rate fluctuations.
2. At December 31, 2016, the forward contract has remaining 30-days until maturity.
The receivable denominated in Japanese yen is adjusted to reflect the increase in
the forward rate of P.0050 for 30 – day futures on December 31, 2016. This is
accompanied by the recognition of gain for the increase in the forward rate of P.0050
which is included in Philippine company’s income for 2016.
3. On January 30, 2017, Philippine company receives 100,000 Japanese yen with a
current value of P45,300. The translated value of the foreign currency is P.0080 more
than the recorded amount of the receivable (P.4480 – P.4400), so additional gain
results. On this date, Philippine company also pays the liability with Metro Bank.

SWAPS
A swap contract is an arrangement whereby two counter parties contractually agree to
swap or exchange one stream of cash flows for another, over a period of time. There are
two major types of swaps, namely, interest rate swaps and cross-currency swaps.

Interest rate (and currency) swaps have become widely used financial arrangements.
Regardless of how the arrangement is to be settled, the three key defining characteristics
are present in all interest rate swaps: namely, that value changes are in response to
changes in an underlying variable (interest rates or an index of rates), that there is little or
no initial net investment, and that settlement will occur at future dates. Thus, swaps are
always derivatives.

Interest-Rate Swap to Hedge Variable-Rate Debt: A Cash Flow Hedge

Illustration
Assume that on June 30, 2016, Family Corporation borrows P5,000,000 of three-year
variable-rate debt with interest payments equal to the six-month inter-bank interest rate
for the prior six months. The company then enters into a three-year interest – rate swap
with Metro Bank to convert the debt’s variable rate to a fixed rate. The swap agreement
specifies that Family will pay interest at a fixed rate of 7.5 percent and receive interest at
a variable rate equal to the six-month inter-bank rate based on the notional amount of
P5,000,000. Both the debt and the swap require interest to be paid semi-annually on June
30 and December 31.

The six-month inter-bank interest rate and the market value for the first-year of the swap
agreement is as follows:
Date six month swap agreement fair value
Inter- bank rate Asset (Liability)
 21

June 30, 2016 6.0% P0

December 31, 2016 7.0% 165,000
June 30, 2017 5.5% (70,000)
Note that the value of the swap agreement to Family is positive if the variable rate will rise
higher than the fixed rate. However, the swap agreement’s value to Family is negative if the
variable rate remains lower than the fixed rate. Note that Family must still pay the variable
interest to the holders of the P5,000,000 debt.

Family’s payment on the variable-rate and the net payments to Metro Bank on the interest-
swap agreement for the initial two semiannual periods are presented below:
Interest payments
December 31, 2016 June 30, 2017
Variable-rate interest payment P150,000 (a) P175,000 (b)
Interest- rate swap net payment 37,500 (c) 12,500
Total cash payment P187,500 P187,500
======== ========

(a) P150,000 = P5,000,000 x .06 x 6/12 months

(b) P175,000 = P5,000,000 x .07 x 6/12 months
(c) P 37,500 = net payment required to Metro for the difference between variable and
Fixed interest rate.
(d) P187,500 = P5,000,000 x .075 fixed rate x 6/12 months

The journal entries to account for the interest swap for the first year are as follows:

2016
June 30: Cash 5,000,000
Debt Payable 5,000,000
To record 3 year variable rate debt

Dec. 31: Interest expense 150,000

Cash 150,000
To record payment of semi-annual interest to debt holders
At a variable rate of 6%

Interest expense 37,500

Cash 37,500
To record payment of semi-annual net settlement of swap agreement

Swap agreement 165,000

Unrealized gain-OCI 165,000
To record change in fair value of swap agreement
2017
June 30 Interest expense 175,000
Cash 175,000
To record payment of semi-annual interest to debt holders at
A variable rate of 7%
 22

Interest expense 12,500

Cash 12,500
To record payment to Metro for semi-annual net settlement of swap
Agreement

Unrealized loss – OCI 235,000

Swap agreement 235,000
To record decrease in fair value of swap agreement
From P165,000 asset to P(70,000) liability.

The bold entries are the relevant entries relating to interest swap. Because the fair value of
the swap agreement will converge to zero by its maturity, the unrealized gain/loss OCI will
also converge to zero by its maturity to the extent the hedge remains in place and is effective.

OPTION CONTRACTS

An option is a financial derivative contract that provides the holder the right to buy or sell an
underlying in the future, for a price set today. The price of the option is separate from the
price of the underlying. The following terms are usually associated on options contracts:

Premium – the option price. This is the sum of money that the option buyer pays the option
seller to obtain the “right being sold in the option. This money is paid when the option
contract is initiated.
Time value of the option – This is the difference between the options market price and the
option price and its intrinsic value. Changes in the time value of the option are taken to
current earnings.
Intrinsic value of the option – This is the difference between the options market price and the
option price of the hedge item. This is also the value of the option if it were exercised today.
Strike price – The price at which the holder has the option to buy or sell the item.
Option to buy “in the money” – This exists when the market price is more than the strike price.
Option to buy “out of the money – This exists when the market price is less than the strike price.
Underlying – The asset, financial instrument or any other basis (e.g., interest rates ) to which
the option is linked, and from where its value is derived. The underlying can be a stock, bond,
interest rate, foreign currency or commodity.

Two Basic Types of Options

An option can be either one of the following:
1. Call option – an option granting the right to buy the underlying. Options of this type
may simply be called “calls.
2. Put option – an option granting the right to sell the underlying. Options of this type may
simply be called “put”.

The explanations of the perspectives (position) involved with calls and puts are as follows:

Call Option
 23

For example, Powerplant Corporation shares are currently traded at P65. An option to buy
1,000 shares at P68 per share three months from now is worth P2 per share. If the option is
bought, the call option buyer’s positions are:
1. The option buyer will pay the option seller the premium of P2,000 (1,000 shares x P2).
2. If at the end of 3 months, the stock trade at P75:
a. The option buyer will exercise, and thus pay the option seller P68,000 for the
1,000 shares (1,000 shares x P68 strike price).
b. The buyer may either keep these stocks or sell them:
1. If he holds the stocks, he’ll record the receipt in his books at P75,000.
2. If he sells the stocks, he’ll receive P75,000 (1,000 shares x P75) from the
sale.
Regardless of what the buyer chooses to do with the stocks, he gained P7,000 (P75,000 less
68,000), and netted P5,000 (P7,000-P2,000) initially paid the option) from the option
transaction
3. If at the end of 3 months, the stock traded at P66.
The buyer will not exercise the option. If he does, he’ll pay the option seller P68,000
and receive stocks that he can sell for only P66,000 (1,000 shares x P66). He will lose
P2,000 (68,000-P66,000) plus the option premium of P2,000 for a total loss of P4,000. If
he does not exercise, he will lose the premium only.
4. If at the end of 3 months, the stock traded at P68 (the strike price). The option buyer
will generally not exercise the option, because no gain can be realized.

Put Option

Shoemart Inc. currently trades at P15 per share. An option to sell 1,000 shares for P17
per share three months from now is worth P2.00. If the option is bought, the option
buyer’s positions are:

1. The option buyer will pay the option seller the premium of P2,000 (1,000 x P2.00)
2. If at the end of 3 months, the stock is traded at P11:
a. The option buyer will exercise, and buy 1,000 shares from the market
for P11,000 (1,000 shares x P11), give the stocks to the option seller,
and receive P17,000.
b. The buyer gained P6,000 (P17,000-P11,000), and netted P4,000
(P6,000- P2,000 premium) from the option transaction.
3. If at the end of 3 months, the stock is traded at P20.
The buyer will not exercise the option. If he does exercise, he’ll buy 1,000 shares
from the market for P20,000 and sell the same to the option buyer for only
P17,000. He will lose P3,000 (P20,000-P17,000) plus the option premium of
P2,000, for a total loss of P5,000. If he does not exercise, he will lose only the
premium of P2,000.
4. If at the end of 3 months, the stock is traded at P17 (the strike price). The option
buyer will generally not exercise the option (no gain, from the effort.)

FOREIGN CURRENCY OPTION

 24

A foreign currency option gives the holder of the option the right but not the obligation to
trade foreign currency in the future. A put option is for sale of foreign currency by the holder
of the option; a call option is for the purchase of foreign currency by the holder of the option.
Foreign currency option can be purchased directly from the bank.

FOREIGN CURRENCY OPTION USED TO HEDGE A FOREIGN CURRENCY DENOMINATED ASSETS

Illustration
Assume that a Pilipino Company sold inventory to a foreign customer with collection due in
foreign currency (fc) and that the company acquired a put option to sell FC.

Additional information:

1. On November 1, 2017, the company sold inventory, with a cost of P320,000 to a foreign
customer with payment due on February 1, 2018, in the amount of 100,000 FC.
2. On November 1, 2017, the company purchased an out-of-money put option to sell
100,000 FC on February 1, 2018, at a strike price of 1FC = P51.00 An option premium of
P4,000 was paid.
3. Spot rates, option values, and changes in value over time are as follows:

November 1. December 1. February 1

2017 2017 2017
Strike price 1FC P5.10 P5.10 P5.10
Spot rate 1FC P5.15 P4.98 P4.95
Fair value of options P4,000 P13,000 P15,000
Intrinsic value of option 0 12,000 15,000
Time value of option P4,000 P1,000 P0
====== ====== =======

Because the strike price is less than the spot rate on November 1, the option has no intrinsic
value. The entire fair value is attributable to time value only. On December 1, there is
intrinsic value, because the strike price is more than the spot rate. The time value is the
difference between the fair value and the intrinsic value. On February 1, the date of the
expiration, no time value remains, and the entire amount of fair value is attributable to
intrinsic value.

Option Designated as Fair Value Hedge

Illustration

Assume that the Pilipino Company designates the foreign currency option as a fair value
hedge of a foreign currency denominated asset. In this case, Pilipino Company recognizes
the gain or loss on the option immediately in net income and does not separately recognize
the change in the time value of the option. The company prepares the following journal
entries to account for the foreign currency transactions and the related foreign currency
options:
 25

Related to the sale of Inventory Related to the Put Option

November 1, 2017
Accounts receivable –FC 515,000 investment in put option 4,000
Sales 515,000 cash 4,000
To record purchase of option as an asset
At its fair value P4,000
Cost of sales 320,000
Inventory 320,000
December 31, 2017
Forex loss 17,000 investment in put option 9,000
Accounts receivable fc 17,000 gain on put option 9,000
To adjust the value of the FC receivable to record change in value of the option
To the new spot rate. And record forex Note that the entry includes the entire
Loss for the decrease. Change in the value of the option
Including both the effective (intrinsic
Value) and ineffective (time value)
Portion.
February 1, 2018
Foreign currency 495,000 investment in Put option 2,000
Forex loss 3,000 gain on put option 2,000
Accounts receivable 498,000
To record settlement of the receivable to record change in the value of the
Put option
Cash 510,000
Foreign currency 495,000
To record net settlement of the option
Option designated as Cash Flow Hedge
Illustration

Assume that Pilipino Company designates the foreign currency option as a cash flow hedge.
Pilipino will recognize the change in the option’s time value immediately in net income while
the change in the options intrinsic value is deferred as other comprehensive income (OCI).

The journal entries relating to the changes in the fair value of the put option will be modified
as follows:
November 1, 2017: investment in put option 4,000
Cash 4,000
To record purchase of the put option
December 31, 2017: investment in put option 9,000
Loss on put option (decrease in time value) 3,000
OCI (increase in intrinsic value) 12,000
To record the decrease in the time value of the option immediately
To net income and the increase in intrinsic value as OCI.
February 1, 2018: investment in put option 2,000
Loss on put option (decrease in time value) 1,000
OCI (increase in intrinsic value) 3,000
To record change in value of the option.
 26

Cash 510,000
Foreign currency 495,000
Investment in put option 15,000
To record exercise of the put option

OCI 15,000
Gain on put option or cost of sales 15,000
To close OCI to realized gain

FOREIGN CURRENCY OPTION TO HEDGE A FORECASTED TRANSACTION- A CASH FLOW HEDGE

ILLUSTRATION
To illustrate the special accounting for a cash flow hedge of forecasted transaction with a
call option, assume the same facts presented in illustration above in the case of hedging with
a forward contract except for the following:
1. On June 1, the company purchased an out –of –the –money call option to buy 100,000
FC at a strike price of 1FC = P5.50 due in September. An option premium of P9,000
was paid.
2. Effectiveness of the hedge is measured by comparing changes in the option’s intrinsic
value with changes in the forecasted cash flows based on changes in the spot rates
for FC. Changes in the time value of the option will be excluded from the assessment
of hedge effectiveness and recognized currently in earnings rather than as a
component of other comprehensive income.
3. Spot rates, option values, and changes in value overtime are as follows:
June 1 June 30 July 31 September 1
Strike price-FC P5,50 P5,50 P5.50 P5.50
Spot rate – 1FC P5.50 P5.52 P5.70 P5.76
Fair value of option P9,000 P13,500 P24,000 P26,000
Intrinsic value of option 0 2,000 20,000 26,000
Time value of option P9,000 P11,500 P4,000 P0
====== ======= ====== =======
An analysis of the entries shows that the cash flow hedge was effective in
accomplishing the concerns of the Philippine company. The effect of the cash flow
hedge of the forecasted transaction can be summarized as follows:
Without the with the
Call option call option
Sales price inventory P958,000 P958,000
Cost of sales 575,000 575,000
Gross profit P383,000 P383,000
OCI –unrealized gain on call option 25,000
Adjusted gross profit P408,000
Loss on call option (change in time value) (8,000)
net income effect P383,000 P400,000
======== ========

Home work:
Multiple choice. Theoretical & Computational.
1. A forward exchange contract is a form of:
 27

a. Hedging
b. Translation
c. Black market exchange
d. Preferential exchange
2. When a transaction is to be settled by the receipt or payment of a fixed amount of a
specified currency, the receivable or payable is said to be:
a. Converted in that currency
b. Denominated in that currency
c. Measured in that currency
d. Translated in that currency
3. A future or forward rate of exchange will apply if:
a. Delivery of the exchanged currency is desired at a specified date.
b. Delivery of the exchanged currency is made now but at future rates
c. Future rates are known
d. Future rates can be estimated
4. If the value of a currency sold under a speculative forward exchange contract
changes, the speculator should:
a. Recognize both gains and losses currently
b. Recognize losses currently but defer gains until the date of settlement
c. Recognize losses currently if they are material but defer gains until the date of
settlement
d. Defer both gains and losses to the date of settlement
5. On May 1, 2017, Durian Export Corporation sold a quantity of durian fruit to a foreign
customer for 100,000 foreign currency, payable in 30 days. On May 1, the spot rate
was 1FC = P.85 and the 30 – day forward rate was 1FC = P.8415. On May 30, when the
bill was paid, the spot rate was 1 FC = P856.
The sale of durian fruits should be recorded at:
a. a. P85,000 c. P85,600
b. b. P84,150 d. P117,647
6. On June 30, 2017, Sweet Tooth Company purchased chocolate candies from a
foreign supplier for 50,000 foreign currency, payable in 60 days. On June 30, 1 FC was
worth P.6498; by August 30, the day of settlement, 1FC was worth P.6256. The 60-day
forward rate on June 30 was 1 FC = P.6612. Sweet Tooth should record the cost of the
chocolate candies at:
a. P31,280 c. P32,490
b. P31,885 d. P33,060
7. Tony Tan, a money changer speculate in foreign currency as his business. On October
1, 2017, Tony bought a 180 days forward contract to purchase 5,000 US dollar at a
forward rate of $1 = P56.50 when the spot rate was P56.00. Other exchange rates
were as follows:
Spot rate Forward rate for March 31, 2018
December 31, 2017 P56.30 P56.60
March 31, 2018 56.32
The forex gain (loss) recognized by Tony from this forward contract is:
a. P1,500 c. P 500
b. P( 900) d. P(10,000)
8. Pinoy, Inc. imports machinery from a foreign supplier. On June 1, the company
received delivery of the machinery with a cost of P450,000 FC when the spot rate was
 28

1FC = P1.370. Pinoy paid 50,000 FC, when the spot rate was 1FC = P1.350 at the time
of placing the order, with the balance due in 60 days after delivery. On June 15, Pinoy
purchased an option to buy FC on July 31 at a strike price of 1FC = P1.375. The hedge
was designated as a fair value hedge. At the time of the purchase the out- of –the-
money option has a value of P1,400 and a value of P2,600 at June 30. FC spot rates
are as follows:
June 15 1FC = P1.373
June 30 1FC = P1.381
June 31 1FC = P1.385
On July 31, the option was settled and the foreign currency was remitted to the foreign
supplier.
What is the net forex gain (loss) on the purchase of machinery?
a. P(6,000) c. P(1,600)
b. P6,000 d. P(4,400)

9. What is the net gain (loss) on option?

a. P(1,200) c. P(2,600)
b. P(1,400) d. P2,600
10. What is the cost of the machinery in the statement of financial position on July 31?
a. P615,500 c. P616,500
b. P607,500 d. P548,000

EVALUATION: QUIZ-2

LESSON 3-Translation of Foreign Financial Statements (IAS re21)

ACCOUNTING PROCEDURES

Accountants of the Philippine company usually perform the following steps in the translation
and consolidation of the foreign entity financial statements:

1. Receive foreign entity’s financial statements, which are reported in foreign currency.

2. Translate the statements in foreign currency to Philippine peso. Each foreign entity
account balance must be individually translated into its Philippine peso equivalent, as
follows:
Account in appropriate account in
foreign currency units X exchange rate = Philippine peso
equivalent value
3. Consolidate the translated foreign entity’s accounts, which are now stated in
Philippine Peso, with the Philippine company’s accounts.

DEFINITION OF KEY TERMS (in accordance with IAS 21)

The following terms are usually used in the translation of foreign financial statements.
• Functional currency. The currency of the primary economic environment in which
the entity operates.
 29

• Exchange difference. The difference resulting from translating a given number of

units of one currency into another currency at different exchange rates.
• Foreign operation. A subsidiary, associate, joint venture, or branch whose activities
are based or conducted in a country or currency other than that of the reporting
entity.
• Closing rate. The spot exchange rate at the balance sheet date.
• Spot rate. The exchange rate for immediately delivery.
• Presentation currency. The currency that is used to present the financial
statements.

Functional Currency
The functional currency should be determined by looking at several factors. This
currency should be one in which the entity normally generates and spends cash and in which
transactions are normally denominated. All transactions in currencies other than the
functional currency are treated as transactions in foreign currencies. Five factors can be
considered in making this decision: the currency
1. That mainly influences the price at which goods and services are sold.
2. Of the country whose competitive forces and regulations mainly influence the entity’s
pricing structure.
3. That influences the costs of equity.
4. In which funds are generated.
5. In which receipts from operating activities are retained.
The first three items are generally considered to be the most influential in deciding the
functional currency.

TRANSLATION OF FINANCIAL STATEMENTS OF FOREIGN OPERATIONS

A foreign operation is an entity that is a subsidiary, associate, joint venture, or a branch of the
reporting entity, the activities of which are based or conducted in a country or currency other
than those of the reporting entity. For a local parent entity, it is not necessary that its foreign
operation must be located in another country. It may own a subsidiary that is incorporated
and located in Singapore, but if that subsidiary conducts its business in a functional currency
(the primary currency of the foreign entity’s operating environment) other than of the parent,
that subsidiary is a foreign operation. Conversely, the local parent may own a subsidiary
located in another country, but if that subsidiary conducts its business in the same functional
currency as that of the parent, that subsidiary, although a foreign operation, is considered to
be an integral part of the parents operation.

With respect to the translation to be used, IAS 21 changes the requirements of the original IAS
21 by not distinguishing between integral foreign operations and foreign entities. Instead, all
overseas subsidiaries, branches, associates and joint ventures are now classified as foreign
operations. As a result of applying the functional currency concept,
a. there is no longer a distinction between integral operation and foreign entities.
Instead, an entity that was previously classified as an integral foreign operation will
have the same functional currency as the reporting entity (the need to translate
to the functional currency will not raise); and
 30

b. only one translation method is prescribed for foreign operations, i.e., the closing or
the current rate method that was applied to foreign entities under the original IAS
21.

The Closing Rate Method

When the closing rate method is used, exchange differences can arise from three
sources, as follows:
1. Translating the opening net assets in the foreign operation at an exchange rate
different from that at which it was previously reported;
2. Translating the income and expense items (net retained earnings for the period) at
the rates at the dates of transactions (or at a rate that approximates the actual rates,
such as the average rate) but assets and liabilities at the closing rate; and
3. Other changes to equity in the foreign entity, such as an asset revaluation.

If the financial statements of the entity are not in the functional currency of a hyperinflationary
economy, then IAS 21 prescribes the following procedures to translate foreign entity’s
statements from its functional currency into the presentation currency.
a. Translate all items of financial position, including the allocated goodwill, at the closing
rate, except for share capital and pre-acquisition surplus which should be translated
at their historical rate. Post – acquisition profits are derived based on the balances in
their year-to-year translations. Exchange surplus are derived as the balancing figure.
b. Translate all items of income and expenses in profit or loss at the average rate or as
the accounting policy required. Translate items of other comprehensive income at
the average rate (e.g. fair value gain of financial assets) or rate ruling at valuation
date e.g. revaluation surplus)
c. Retained earnings brought forward should be based on the prior year’s post
acquisition profits in the presentation currency (e.g. in the local peso). Interim
dividend paid is translated at the actual rate ruling at the date of payment while
dividend payable, if any, is translated at the closing rate.
d. Prepare the consolidated financial statements using the normal consolidation
procedures.
e. Prove the total exchange differences as follows:
i) Net assets and goodwill at acquisition date translated at closing rate minus
net assets and goodwill at acquisition date translated at their historical rate.
ii) Year-to-year increase in net assets (i.e., retained earnings for each year)
translated at closing rate minus their year-to –year reported amounts in
Philippine Peso; and
iii) Any revaluation surplus arising during the year translated at the closing rate
minus the amount translated at the date of the revaluation.

Noted that the above proof is for the total exchange differences. If movements in
exchange surplus (reserves) are required, then the proof should be as follows:
i) Obtain or prove the exchange difference as at end of the prior year (using the
same technique as described above but applying it to the position as at the
end of the prior year);
ii) Retranslate the opening net assets and goodwill of the subsidiary at the current
year’s closing rate;
 31

iii) If the average rate is used to translate the items in the statement of profit and
loss and other comprehensive income, retranslate the retained earnings and
items of other comprehensive income for the year at the closing rate;
iv) If there has been a revaluation of property, plant and equipment during the
year, retranslate the surplus at the closing rate.
v) Allocate the exchange difference between parent and non-controlling
interest and produce the consolidated statement of changes in equity.

Comprehensive illustration of the Practical Application of IAS 21

First year-2016
Assume that a Philippine company has 100% owned subsidiary in Taiwan that began
operation in 2016. The subsidiary conducts operation in the company-owned building. This
building, which cost 50 million NT dollars (NT$), was financed primarily by Taiwan banks,
although the parent invested 20 million NT dollar in the Taiwan operation. All revenues and
cash expenses are received and paid in NT dollar. The subsidiary also maintains its books and
records in NT dollar.

The subsidiary’s statement of financial position at December 31, 2016, and its combined
statement of income and retained earnings for the year ended December 31, 2016 are
presented below.
Taiwan Company
Statement of Financial Position
December 31, 2016
(In thousands of NT$)
Assets
Cash and cash equivalents NT$ 5,000
Accounts receivable 2,000
Land 10,000
Building 50,000
Accumulated depreciation ( 1,000)
Total assets NT$ 66,000
=========
Liabilities and Stockholders’ Equity
Accounts payable NT$ 3,000
Unearned rent 1,000
Mortgage payable 40,000
Common stock 4,000
Additional paid in capital 16,000
Retained earnings 2,000
Total liabilities and Stockholders’ Equity NT$ 66,000
==========

Taiwan Company
Combined Statement of Comprehensive Income and Retained Earnings
For the year ended December 31, 2016
(in thousands of NT$)
Revenues NT$ 20,000
 32

Operating expenses (including depreciation of NT$ 1,000) 17,000

Comprehensive income 3,000
Retained earnings, January 1 -
Dividends paid (1,000)
Retained earnings, December 31 NT$ 2,000
=========

Various assumed exchange rates for 2016 are as follows:

NT$ = P.90 at the beginning of 2016 (when the common stock was issued and the land and
Building were financed through the mortgage)
NT$ = P1.05 weighted average for 2016
NT$ = P1.10 at the date the dividends were declared and the unearned rent was received.
NT$ = P1.20 closing rate (December 31, 2016)

The Taiwan Company’s financial statements must be translated into Philippine pesos in terms
of the provisions of IAS 21. The translation process is illustrated below:

Taiwan Company
Translation of Financial Statements to Philippine Pesos
For the Year Ended December 31, 2016
(In thousands of NT$)
NT$ Exchange rates Philippine Pesos
--------------------------------------------------------------------------------------------------------------------------------------
Combined Statement of Comprehensive
Income and Retained Earnings
Revenue $ 20,000 1.05 P 21,000
Operating expenses 17,000 1.05 17,850
Comprehensive 3,000 3,150
Retained earnings, January 1 - -
Dividends (1,000) 1.10 (1,100)
Retained earnings, December 31 $ 2,000 P 2,050
======= ========
Statement of Financial Position
Cash and cash equivalents $ 5,000 1.20 P 6,000
Accounts receivable 2,000 1.20 2,400
Land 10,000 1.20 12,000
Building (net) 49,000 1.20 58,800
Total assets $66,000 P79,200
======= =======
Liabilities and Stockholders’ Equity
Accounts payable $ 3,000 1.20 P 3,600
Unearned rent 1,000 1.20 1,200
Mortgage payable 40,000 1.20 48,000
Common stock 4,000 .90 3,600
Additional paid in capital 16,000 .90 14,400
Retained earnings 2,000 (see, RE, December 31) 2,050
Translation adjustment –OCI - 6,350
 33

Total liabilities and stockholders $66,000 P79,200

Equity ======= =======

The following features of the translation of the foreign entity’s financial statement in illustration
should be noted
1. All assets and liabilities are translated using the closing rate at the
statement of financial position date. All revenues and expenses are
translated at the average rates for practical consideration.
2. IAS 21 clearly prescribes that assets and liabilities are to be translated
using the closing rate and that stockholders’ equity accounts be
translated using the historical rates. The translated balance of
retained earnings is the result of the weighted-average rate applied
to revenues and expenses and the specific rate in effect when the
dividends are declared.
3. Cumulative exchange differences (translated adjustments) result from
translating all assets and liabilities at the closing rate and stockholders’
equity using historical rates and weighted-average rates.
4. The cumulative exchange differences (translation adjustments) credit
of P6,350 may be computed directly to verify the translation process
as shown below:
NT$ exchange rate Phil. Pesos
Net assets at the beginning $ 20,000 .90 P 18,000
Changes in net assets:
Net income 3,000 1.05 3,150
Dividends (1,000) 1.10 (1,100)
Net assets translated at rates:
During the year 20,050
At the end of year $ 22,000 1.20 26,400
=======
Exchange difference
Translation adjustment - OCI P(6,350)
========
5. The exchange difference (translation adjustment ) that is presented
as other comprehensive income is cumulative in nature, and the
changes in the balance should be disclosed in the financial
statements. In the above computations the balance went from zero
to P6,350 at the end of 2017. The translation adjustments have a credit
balance because the spot exchange rate at the end of the year is
higher than the exchange rate at the beginning of the year or the
average for the period. If the exchange rate had decreased during
the period, the translation adjustment would have a debit balance.

Formative questions: Homework

Solve the following problems.

On January 3, 2017, Pilipino Company acquired a 100 percent interest in the common stock
of Arigato Company, a Japanese firm, when Arigato’s stockholders’ equity was:
 34

Common stock 200,000 yen

Retained earnings 400,000 yen

On December 31, 2017, Arigato’trial balance was:

Debit Credit
Cash and cash equivalents (in yen) 40,000
Accounts receivable 120,000
Inventory 100,000
Plant and equipment 700,000
Accumulated depreciation 240,000 yen
Accounts payable 80,000
Common stock 200,000
Retained earnings 400,000
Sales 600,000
Cost of sales 360,000
Operating expenses 140,000
Depreciation expenses 60,000
------------ -------------
Total Y1,520,000 Y1,520,000
========= =========
Exchange rates were:
January 3, 2017 Yen 1 = P.44
December 31, 2017 1 = .40
2017 average 1 = .425

Revenue and expenses were incurred evenly during 2017.

Required:
a. Prepare a schedule translating the December 31, 2017, trial balance from
Japanese yen to Philippine pesos.
b. Prepare a proof of the accumulated exchange differences on translating
foreign operation (translation adjustment).

EVALUATION: Quiz 3
 35

Lesson 4: Government Accounting System for National Government Agencies

The discussion in this chapter were lifted from the revised Commission on Audit (COA)
Circular no. 2002-002 dated June 18, 2002

Recent development brought about by the Philippine Public Financial Management Reforms
and significant changes in the field of accounting prompted the harmonization of the existing
accounting standards. The Commission on Audit revised the New Government Accounting
System (NGAS) Manual prescribed under COA Circular no. 2002-002 dated June 18, 2002 to
make it responsive to dynamic changes and modern technology.

“The Commission on Audit shall have exclusive authority, subject to the limitations in this
Article, to define the scope of its audit and examination, establish the techniques and
methods required therefore, and promulgate accounting and auditing rules and regulations,
including those for the prevention and disallowance of irregular, unnecessary, excessive,
extravagant, or unconscionable expenditures, or uses of government funds and properties”

This Manual presents the basic accounting policies and principles in accordance with the
Philippine Public Sector Accounting Standards (PPSAS) adopted thru COA resolution no. 2014-
003 dated January 24, 2014 and other pertinent laws, rules and regulations. It includes the
revised chart of account (RCA) prescribed under COA circular no. 2013-002 dated January
30, 2013, as amended; the accounting procedures, books, registries, records, forms, reports,
and financial statements; and illustrative accounting entries. It shall be used by all National
Government Agencies (NGASs) in the:
a. preparations of the general purpose financial statements in accordance with the
PPSAS and other financial reports as may be required by laws, rules, and regulations;
and
b. reporting of budget, revenue and expenditure in accordance with laws, rules and
regulations.

Objective of the Manual. The Manual aims to update the following:

a. standards, policies, guidelines and procedures in accounting for government funds
and property;
b. coding structure and accounts; and
c. accounting books, registries, records, forms, reports and financial statements.

GENERAL PROVISIONS, BASIC STANDARDS AND POLICIES

 36

This covers the general provisions from existing laws, rules and regulations; and the basic
standards/fundamental accounting principles for financial reporting by national government
agencies.
Definition of Terms. For the purpose of the GAM; the terms used as stated below shall be
construed to mean as follows:
a. Accrual basis – a basis of accounting under which transactions and other events are
recognized when they occurs (not only when cash or its equivalent is received or
paid). Therefore, the transactions and events are recognized in the accounting
records as well as in the financial statements of the periods to which they relate. The
elements recognized under accrual accounting are assets, liabilities, net
assets/equity, revenue, and expenses.
b. Assets – are resources controlled by an entity as a result of past events, and from which
future economic benefits or service potential are expected to flow to the entity.
c. Contribution from owners – refers to future economic benefits or service potential that
have been contributed to the entity by parties external to the entity, other than those
that result in liabilities of the entity. A financial interest in the net assets/equity of the
entity is established which:
1. conveys entitlement both to (i) distributions of future economic benefits or
service potential by the entity during its life, such distributions being at the
discretion of the owners or their representatives; and (ii) distributions of any
excess of assets over liabilities in the event of the entity being wound up; and/or
2. can be sold, exchanged, transferred, or redeemed.
d. Distributions to owners – means future economic benefits or service potential
distributed by the entity to all or some of its owners, either as a return on investment or
as a return of investment.
e. Entity – refers to a government agency, department or operating field unit. It may be
referred to in this GAM as an agency.
f. Expenses – are decreases in economic benefits or service potential during the
reporting period in the form of outflows or consumption of assets or incurrence of
liabilities that result in decreases in net assets/equity, other than those relating to
distributions to owners.
g. Government accounting – encompasses the processes of analyzing, recording,
classifying, summarizing and communicating all transactions involving the receipt and
disposition of government funds and property, and interpreting the result thereof.
h. Government budget – is the financial plan of a government for a given period, usually
for a fiscal year, which shows what its resources are, and how they will be generated
and used over the fiscal period. The budget is the government’s key instrument for
promoting its socio-economic objectives. The government budget also refers to the
income, expenditures and resources of borrowing of the National Government (NG)
that are used to achieve national objectives, strategies and programs.
i. Liabilities – are firm 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 or service potential.
j. Net assets/equity – is the residual interest in the assets of the entity after deducting all
its liabilities.
 37

k. Revenue – is the gross inflow of economic benefits or service potential during the
reporting period when those inflows result in an increase in net assets/equity, other
than increases relating to contributions from owners.
l. Revenue funds – comprise all funds derived from the income of any agency of the
government and available for appropriation or expenditure in accordance with law.

Basic Government Accounting and Budget Reporting Principles. Each entity shall
recognize and present its financial transactions and operations in accordance with the
following.
a. generally accepted government accounting principles in accordance with the
PPSAS and pertinent laws, rules and regulations;
b. accrual basis of accounting in accordance with the PPSAS;
c. budget basis for presentation of budget information in the financial statements
(FSs) in accordance with PPSAS 24;
d. RCA prescribed by COA;
e. Double entry bookkeeping;
f. Financial statements based on accounting and budgetary records; and
g. Fund cluster accounting.

Keeping of the General Accounts. The COA shall keep the general accounts of the
Government and, for such period as may be provided by law, preserve the vouchers and
other supporting papers pertaining thereto.

Financial Reporting System for the National Government. The financial reporting system of
the Philippine government consists of accounting system on accrual basis and budget
reporting system on budget basis under the statutory responsibility of the NGAs, Bureau of the
Treasury (BTr), Department of Budget and Management (DBM), and the COA, as follows:
a. Each entity of the National Government (NG) maintains complete set of
accounting books by fund cluster which is reconciled with the records of cash
transactions maintained by the BTr.
b. The BTr accounts for the cash, public debt and related transactions of the NG.
c. Each entity maintains budget registries which are reconciled with the budget
records maintained by the DBM and the Government Accountancy Sector (GAS),
COA.
d. The COA, through the GAS:
1. maintains budget records showing the overall approved budget of the NG and
its execution/implementation;
2. consolidates the FSs and budget accountability reports of all NGAs and the BTr
with the COA’s records to come up with an Annual Financial Report (AFR) for
the NG as required in Section 4, Article IX-D of the 1987 Philippine Constitution;
and
3. prepares other financial reports required by law for submission to oversight
agencies.
 38

Objectives of General Purpose Financial Statements. The objectives of general purpose

financial statements (GPFSs) are to provide information about the financial position, financial
performance, and cash flows of an entity that is useful to a wide range of users in making and
evaluating decisions about the allocation of resources. Specifically, the objectives general
purpose financial reporting in the public sector are to provide information useful for decision-
making, and to demonstrate the accountability of the entity for the resources entrusted to
them.

Responsibility for Financial Statements. The responsibility for the preparation of the FSs rests
with the following:
a. for individual entity/department FSs- the head of the entity/department central
office(COf) or regional office (RO) or operating unit (OU) or his/her authorized
representative jointly with the head of the finance/accounting division/unit; and
b. for department/ entity FSs as single entity- the head of the entity/ department COf
jointly with the head of the finance unit.
Components of General Purpose Financial Statements. The complete set of GPFSs consist of:
a. Statement of Financial Position.
b. Statement of financial performance
c. Statement of changes in net assets/equity
d. Statement of cash flows
e. Statement of comparison of Budget and Actual amounts; and
f. Notes to the financial statements, comprising a summary of significant accounting
policies and other explanatory notes.

Books of Accounts and Registries. The books of accounts and registries of the NG entities
consist of:
a. Journals
1. General Journal
2. Cash Receipts Journal
3. Cash Disbursement Journal
4. Check Disbursement Journal
b. Ledgers
1. General Ledgers
2. Subsidiary Ledgers
c. Registries
1. Registry of Revenue and Other Receipts.
2. Registry of Appropriations and Allotments.
3. Registries of Allotments, Obligations and Disbursements.
4. Registries of Budget, Utilization and Disbursements.

GENERAL ACCOUNTING PROCEDURES- AGENCY BOOKS (Regular Fund)

1. Estimated Revenue per Approved Budget of the Agency (ERABA)

NGAS are given authority to expend funds through the use of a control device called a
budget. Government budget is the financial plan of a government for a given period, usually
for a fiscal year, which shows what its resources are, and how they will be generated and
 39

used over the fiscal period. The budget is the government’s key instruments for promoting
the socio-economic objectives. The government budget also refers to the income,
expenditures and sources of borrowings of the National Government (NG) that are used to
achieve national objectives, strategies and programs.

Recognizing Revenue/Other Receipts Collected and Deposited

All revenues accruing to an entity by virtue of the provision of existing law, orders and
regulations shall be deposited/remitted to the National Treasury (NT) or to any duly authorized
government depository, and shall accrue to the General Fund (GF) of the National
Government.

Sources of Revenue and Other Receipts

Revenue received by NGAs may arise from exchange and non-exchange transaction.

Revenue from exchange transactions. Revenue received by the NGAs from exchange
transactions are derived from the following:
a. Sale of goods or provisions of services to third parties or to other NGAs.
a. Examples are:
1. Service Income – Permit fees, Registration fees, Registration plates,
Tags and Stickers fee, Clearance and Certification fees, Franchising
fees, Licensing fees, Supervision and Regulation Enforcement fee,
Spectrum usage fees, Legal fees, Inspection fees, Verification and
Authentication fees, Passport and Visa fees, Processing fees, and
other service income and
2. Business Income – School fees, affiliation fees, examination fees,
rent/lease income, communication network fees, transportation
system fees, road network fees, waterworks system fees, power supply
system fees, seaport system fees, landing and parking fees, income
from hotel/dormitories and other like facilities, slaughterhouse
operation, income from printing and publication, sales revenue,
hospital fees, share in the profit of joint venture and other business
income.
b. Use by other entity of assets yielding interest, royalties and dividends or similar
distributions, Examples are:
1. Interest income - charges for the use of cash or cash equivalents or
amounts due to the entity;
2. Royalties – fees paid for the use of entity’s assets such as trademarks,
patents, software and copyrights; and
3. Dividends – share of the National Government from the earnings of
the capital/equity investments in Government –owned or controlled
corporation (GOCCs) and other entities.

Revenue from Non-Exchange Transactions. The cash basis of accounting shall be applied by
all government agencies in the recognition of revenue from non- exchange transaction until
a reliable model of measurement of this revenue is developed. Therefore, asset and the
 40

corresponding revenue or liability that arises from non-exchange transaction shall be

recognized when collected or when these are measurable and legally collectible. This
includes the following:
a. Taxation revenue shall be determined at a gross amount. It shall not be reduced for
expenses paid through the tax system.
b. Gifts and donations, other than services in kind shall be recognized as assets and
revenue when it is probable that the future economic benefits or services potential
will flow to the entity and shall be measured at fair value.
c. Goods in –kind received without conditions shall be recognized as revenue
immediately.
d. Donation in cash or in kind shall be recognized as revenue.

2. Appropriation, Allotment and Obligations

Appropriation – is the authorization made by a legislative body to allocate funds for
purpose specifically by the legislative or similar authority.

Allotment – is an authorization issued by the DBM to NGAs to incur obligations for

specified amounts contained to a legislative appropriation in the form of budget
release documents. It is also referred to as obligation authority.

Obligation – is an act of a duly authorized official which binds the government the
immediate or eventual payment of a sum of money. Obligation may be referred to
as a commitment that encompasses possible future liabilities based on current
contractual agreement.

Procedures in Recording Appropriations and Allotments

Upon receipt of the General Appropriation Act (GAA) and the allotment release documents
from the DBM, the staff concerned of the NGA record the same in the logbook and forwards
these documents to the Budget staff for recording in the RAPAL and RAOD. The budget staff
forwards a copy of the allotment release documents to the account department/ unit for
reference. The amount of the allotment should not exceed the authorized appropriations in
the GAA. If the allotment exceeds the appropriation, appropriate actions should be taken.
No. journal entry is made for appropriations allotment.

Procedures in Recording Obligations Incurred

The incurrence of obligations shall be made through the issuance of obligation request and
status (ORS) by the requesting/origination office supported by valid claim documents such
as purchase order (PO). This is recorded in the logbook maintained for the purpose. No entry
is made for the incurrence of obligations.

3. Disbursements
Disbursements constitute all cash paid out during a given period in currency (cash) or
by checks/advice to debit account (ADA). It may also mean the settlement of government
payable/ obligations by cash or ADA. The disbursements are recorded by means of journal
entries.
 41

Notice of cash allocation. The NCA shall be authority of an agency to pay operating
expenses, purchases of supplies and materials, acquisition of PPE, accounts payable and
other authorized disbursements through the issue of MDS checks, ADA or other modes of
disbursements.

ILLUSTRATIVE ENTRIES – REGULAR AGENCY FUND

AGENCY BOOKS
Trial balance – Beginning Balances (assumed)
Debit Credit
Cash –collecting officer 15,000
Accounts receivable 30,000
Office Equipment 80,000
Buildings 500,000
Due to BIR 4,500
Due to GSIS 1,300
Due to Pag-ibig 900
Due to Phil-health 50
Accounts payable 20,000
Accumulated Surplus (Deficit) 598,250
-------------- ---------------
Total 625,000 625,000
======= ========
A. REVENUE
1. Billing of revenue/income for the following:
Rent/lease income 50,000
Seaport System Fees 65,000
Landing and Parking Fees 95,000
------------
Total P210,000
=======
Entry:
Accounts receivable 210,000
Rent /lease income 50,000
Seaport system fees 65,000
Landing and parking fees 95,000
To record billing of revenue

2. Collection and remittance to BTr:

a. Prior year’s Billed Revenue/income:
1. Collection of permit fees, 30,000.
2. Remittance.
Entries:
1. Cash – collecting officer 30,000
Accounts Receivable 30,000
To record collection of prior year’s billed income

2. Cash – treasury/agency deposit, regular 30,000

Cash collecting officer 30,000
 42

To record remittance to BTr

b. Current year billed revenue/income:

1. Collections:
Rent/lease income 45,000
Seaport system fees 60,000
Landing and parking fees 30,000
Total P135,000
=======
2. Remittance, P120,000
Entries:
1. Cash – collecting officer 135,000
Accounts receivable 135,000
To record collection of billed income.

2. Cash – treasury/agency deposit regular 120,000

Cash – collection officer 120,000
To record remittance

c. Unbilled Tax Revenue

1. Collection thru agency collecting:
Travel tax 40,000
Immigration tax 270,000
Total 310,000
======
2. Remittance, P310,000
3. Direct deposit thru Authorized agent banks:
Travel tax 95,000
Immigration tax 220,000
Total 315,000
======
Entries:
1. Cash –collecting officer 310,000
Travel tax 40,000
Immigration tax 270,000
To record collection of unbilled income

2. Cash –treasury/agency deposit, regular 310,000

Cash – collecting officer 310,000
To record remittance to BTr

3. Cash –treasury/agency deposit. Regular 315,000

Travel tax 95,000
Immigration tax 220,000
To record collection/remittance of income to BTr through AGDBs/GSBs
 43

d. Unbilled service income

1. Collection:
Permit fees 210,000
Registration fees 85,000
Licensing fees 60,000
Legal fees 35,000
Inspection fees 15,000
Passport and Visa fees 20,000
Other service income 12,000
Total 437,000
=======
2. Remittance, P302,000
Entries:
1. Cash –collecting officer 437,000
Permit fees 210,000
Registration fees 85,000
Licensing fees 60,000
Legal fees 35,000
Inspection fees 15,000
Passport and visa fees 20,000
Other service income 12,000
To record collection of unbilled income
2. Cash – treasury/ agency deposit, regular 302,000
Cash – collecting officer 302,000
To record remittance to BTr

e. Unbilled Business Income

1. Collection:
Examination fees 1,400
Seminar/training fees 1,600
Other business income 2,000
Total 5,000
=====
2. Remittance, P5,000
Entries:
1. Cash – collecting officer 5,000
Examination fees 1,400
Seminar/training fees 1,600
Other business income 2,000
To record collection of unbilled income.

2. Cash –treasury/agency deposit, regular 5,000

Cash –collecting officer 5,000
To record remittance to the BTr

B. APPROPRIATION, ALLOTMENT, OBLIGATIONS AND DISBURSEMENTS

 44

3. Receipt of GAA
PS 600,000
MOOE 500,000
CO 900,000
TOTAL 2,000,000
========
NO JOURNAL ENTRY IS MADE. This is posted to the appropriate RAPAL. (Registry of
appropriation and Allotment) (RAPAL)

4. Receipt of allotment from the DBM

PS 580,000
MOOE 470,000
CO 850,000
TOTAL 1,900,000
========
NO JOURNAL ENTRY IS MADE. This is posted to the appropriate RAOD. (Registry of allotment,
obligation and disbursement. (RAOD)

5. Incurrence of Obligation
PS 500,000
MOOE 100,000
CO 850,000
TOTAL 1,450,000
========
NO JOURNAL ENTRY IS MADE. The ORS is posted to the appropriate RAOD.

6. Receipt of Notice of cash allocation (NCA) from DBM (net of tax):

a. For current year’s appropriation 1,300,000
b. For prior year’s accounts payable
and not yet due and demandable 27,000
Entries:
a. Cash –modified disbursement system (MDS), regular 1,300,000
Subsidy from National Government 1,300,000
To record receipt of NCA from the DBM
b. Cash –modified disbursement system (MDS), regular 27,000
Subsidy from National Government 27,000
To record receipt of NCA from the DBM
7. Delivery of office Equipment and Office Supplies to agency use
(assumption, beginning of year balance)
a. Prior year’s obligation
1. Receipt of delivery of office supplies, 4,000.
2. Posting of payable.

Entries:
1. Office supplies inventory 4,000
Accounts payable 4,000
 45

To record delivery of office supplies based on delivery receipt (DR)

And inspection and acceptance report (IAR).

2. The payable is posted to the payable column of section C of the obligation

Request status (ORS)

b. Current year’s purchases and delivery

1. Receipt of delivery
Office equipment 620,000
Office supplies inventory 25,000
Total 645,000
======
2. Posting of payable.
Entries;
1. Office Equipment 620,000
Office supplies inventory 25,000
Accounts payable 645,000
To record delivery of office equipment and supplies based on the delivery
Receipt (DR) and inspection and acceptance report (IAR)
2. The payable is posted in payable column of section C of the ORS.
8. Payment of Personnel Benefits
a. Set up the amount Due to Officer and Employees upon approval of payroll
Salaries and Wages 520,000
PERA 60,000
Gross compensation 580,000
======
Withholding tax 52,000
GSIS 16,500
PAG-IBIG 10,500
Phi-health 550
Total deduction 79,550
-----------
Net payroll 500,450
=======
Entries:
a. Salaries and Wages, regular 520,000
Personnel Economic Relief Allowance 60,000
Due to BIR 52,000
Due to GSIS 16,500
Due to PAG-IBIG 10,500
Due to Phil-health 550
Due to Officers and Employees 500,450
To record liabilities to officers and employees upon approval of payroll.
b. This is posted in payable column of section C of the (ORS)

c. Advances for payroll 500,450

Cash –modified disbursement system (MDS) regular 500,450
d. Posting to the payments column of section C of the (ORS) and
 46

to the disbursements column of the RAOD based on the report of

disbursements
9. Liquidation of Payroll Fund, P500,450.
Entry:
Due to officers and employees 500,450
Advances for Payroll 500,450
To record liquidation of disbursements and supporting documents submitted
By the cashier
10. Payment of MOOE and accounts payable.
a. Payment of expenses
Traveling-local (reimbursement) 5,500
Training 11,100
Water 1,700
Electricity 8,300
Telephone 1,700
Janitorial 1,100
Security 2,800
Rent 22,100
Total 54,300
Less: withholding tax (assumed) 2,200
Net 52,100
======
Entry:
Travel expenses –local 5,500
Training expenses 11,100
Water expenses 1,700
Electricity expenses 8,300
Telephone expenses 1,700
Janitorial services 1,100
Security services 2,800
Rent/ lease expenses 22,100
Due to BIR 2,200
Cash – modified disbursement system (MDS), regular 52,100
To record issuance of MDS checks based on the report of checks issued (RCI)

b. Payment of accounts payable

1. Current year’s account payable for the purchase of :
Office equipment 525,000
Office supplies inventory 11,500
Total 536,500
Less: withholding tax 28,800
Net 507,700
 47

======
Entry:
Accounts payable 536,500
Due to BIR 28,800
Cash –modified disbursement (MDS), regular 507,700
To record payment of accounts payable.
2. Prior year’s accounts payable
MOOE 20,000
Less withholding tax 1,300
Net 18,700
======
Entry:
Accounts payable 20,000
Due to BIR 1,300
Cash-modified disbursement system (MDS), regular 18,700
To record payment accounts payable
3. Prior year’s obligation
MOOE 300
Less: withholding tax 15
Net 285
===
Entry:
Accounts payable 300
Due to BIR 15
Cash –modified disbursement system (MDS), regular 285
To record payment of accounts payable.

c. Grant of cash advance for traveling expenses, P3,000.

Entry:
Advances to officers and employees 3,000
Cash –modified disbursement system (MDS),regular 3,000
To record grant of cash advance for travel.

d. Posting of payments to the payments column of Section C of the (ORS)

and the disbursements to disbursements column of the RAOD based on
the report of disbursement.
e. Liquidation of cash advance for traveling expenses – foreign 2,000.

Entry:
Traveling expenses – foreign 2,000
Advances to officers and employees 2,000
To record liquidation of cash advance for travel.

f. Receipt and deposit of refund of excess cash advance for traveling expenses, 1,000.
Entries:
Cash –collecting officer 1,000
Advances to officers and employees 1,000
 48

To record refund of excess cash advance for travel.

Cash –treasury/agency deposit, regular 1,000

Cash –collecting officer 1,000
To record remittance of the refund of excess cash advance for travel.

g. Posting of adjustments of disbursements to the appropriate ORS and RAOD.

11. Remittance of taxes thru TRA

a. Constructive receipt of NCA for TRA consisting of:
PS 55,500
MOOE 5,315
CO 28,000
TOTAL 88,815
=====
ENTRY:
Cash –tax remittance advice 88,815
Subsidy from National Government 88,815
To record constructive receipt of NCA for withholding tax
b. Remittance of taxes thru TRA
Income tax 60,700
Business tax 28,115
Total 88,815
=====
Entry:
Due to BIR 88,815
Cash –tax remittance advice 88,815
To record remittance of withholding tax thru TRA.

c. Posting of disbursements in the payments column of section C of the ORS

and to the disbursements column of the RAOD.
12. Remittance of the following deductions from payroll:
GSIS 15,000
PAG-IBIG 10,000
Phil-health 500
Total 25,500
======
Entry:
Due to GSIS 15,000
Due to Pag-ibig 10,000
Due to Phil-health 500
Cash – modified disbursement system (MDS), regular 25,500

13. ADJUSTMENTS
a. Issuance of supplies and materials to end users, 12,500
Entry:
Office supplies expense 12,500
Office supplies inventory 12,500
 49

To take up issuance of supplies and materials based on the monthly report of

Supplies and materials issued and supporting document submitted by the
Property officer.
b. Adjustment for unused NCA
NCA received 1,327,000
Payments 1,107,735
Total 219,265
========
Entry:
Subsidy from National Government 219,265
Cash – modified disbursement system (MDS), regular 219,265
c. Depreciation of office equipment (estimated life, 5 years
Entry:
Depreciation –Machinery and Equipment 140,000
Accumulated depreciation 140,000
To record depreciation of office equipment
d. Depreciation of building with an estimated life of 25 years. Yearly depreciation
20,000.
Entry:
Depreciation –buildings and other structure 20,000
Accumulated depreciation 20,000
e. Allowance of impairment of accounts receivable, 150.
Entry:
Impairment loss – loans and receivable 150
Allowance for impairment 150

14. CLOSING ENTRIES.

The following accounts are to be closed at year end.
a. Income accounts to revenue and expense summary account.
b. Expense accounts to revenue and expense summary account.
c. Subsidy from NG and subsidy to NGAs to revenue and expense summary.
d. Balance of revenue and expense summary to accumulated (deficit) account.
e. Cash deposit account to accumulated surplus (deficit) account.

CLOSING ENTRIES:
a. Travel tax 135,000
Immigration tax 490,000
Permit fees 210,000
Registration fees 85,000
Licensing fees 60,000
Legal fees 35,000
Inspection fees 15,000
Passport and visa fees 20,000
Examination fees 1,400
Seminar/training fees 1,600
Other business income 2,000
Other service income 12,000
 50

Rent/lease income 50,000

Seaport system fees 65,000
Landing and parking fees 95,000
Revenue and expense summary 1,277,000
To close all income accounts
b. Revenue and Expense Summary 808,950
Salaries and wages 520,000
Personnel economic relief allowance 60,000
Traveling expense-local 5,500
Traveling expense – foreign 2,000
Training expense 11,000
Office supplies expense 12,500
Water expense 1,700
Electricity expense 8,300
Telephone expense 1,700
Janitorial services 1,100
Security services 2,800
Rent/lease expense 22,100
Depreciation expense – building and other structure 20,000
Depreciation expense – Machinery and Equipment 140,000
Impairment loss – loans receivables 150

c. Subsidy from National Government 1,196,550

Revenue and expense summary 1,196,550

d. Revenue and expense summary 1,664,600

Accumulated surplus (deficit) 1,664,600

e. Accumulated Surplus (deficit) 1,083,000

Cash – treasury/agency deposit regular 1,083,000
To close cash deposit account.

Home Work:
Solve the following problem.
Entity ABC is a national government agency. Some of the major transactions of the agency
for the year 2017 were as follows:
1. The approval legislative appropriation for the year was 1Billion. 5% of this
appropriation was allotted by the Department of Budget and
Management (DBM) to Entity ABC. This allotment is broken down as follows:
Capital outlay (CO) 50%
Maintenance and other operating expenses (MOOE) 40%
Personnel services (PS) 10%
2. Received Notice of Cash Allocation (NCA) from DBM, 20 million (net of tax).
3. Obligations were incurred as follows:
Capital outlay 5 million
Obligation for MOOE 3 million
Personnel services 2 million
 51

4. Delivery of office equipment and office supplies for agency use:

Office equipment 3 million
Office supplies 200,000
5. Payable to officers and Employees upon approval of payroll:
Salaries and wages 1,000,000
PERA 150,000
Gross Payroll 1,150,000
Less: deductions:
Withholding tax 35,000
GSIS 55,000
PAG-IBIG 4,000
Phil-health 3,000 97,000
Net 1,053,000
========
6. Grant of cash advances for payroll, 1,053,000.
7. Liquidation of payroll.
8. Remittance of salary deduction.
9. Payment of the following MOOE:
Electricity 50,000
Telephone 30,000
Janitorial 20,000
100,000
Less: withholding taxes 5,000
Net 95,000
======
10. Payment of accounts payable, 1,500,000 (net of withholding tax of 150,000)
11. Receipt of NCA for TRA, 190,000.
12. Remittance of taxes withheld thru TRA.
13. Billing of revenue/income:
Registration fees 400,000
Permit fees 300,000
Other service income 200,000
14. Collection of revenues, P400,000.
15. Remittance of collection to Bureau of treasury (BTr), 400,000.

Required:
Using the following chart of accounts, prepare the journal entries to record the above
transactions in the books of entity ABC.

Cash –collecting officer

Cash – treasury/agency deposit, regular
Cash – modified disbursement system (MDS), regular
Accounts receivable
Office equipment
Office supplies inventory
Advance for payroll
Accounts payable
Due to BIR
 52

Due to GSIS
Due to PAG_IBIG
Due to Phil-health
Subsidy from National Government
Permit fees
Registration fees
Other service income
Salaries and wages, regular
Personnel economic relief allowance
Electricity expense
Telephone expense
Janitorial expense

EVALUATION: QUIZ 3

LESSON 5. Nonprofit Organizations

This chapter will discuss and illustrate some of the general accounting procedures and
financial statement presentation for non-profit organizations. A non-profit organization is a
non-stock corporation that is organized for the benefit of the public as a whole, rather than
for the benefit of an individual proprietor, or a group of partners or stockholders. Therefore,
the concept of net income is not the primary objective of a nonprofit organization. Instead,
a nonprofit organization generally obtains revenues sufficient to cover its expenses.

Nonprofit organization include civic organizations, colleges, and universities, cultural

institutions, hospital, labor unions, private foundations, professional organizations, religious
organizations, cooperatives, and social country clubs. They do not include governmental
units.

Characteristics of Nonprofit organizations

Some of the characteristics of nonprofit organizations are similar to those of governmental
entities and business enterprises. Among the features of nonprofit organizations that are
similar to governmental entities are the following:
 53

1. Public service. Nonprofit organizations usually render services to society as

a whole. The members of this society may range from a limited number of
citizens. Like governmental entities, the services of nonprofit organizations
are for the benefit to the many rather than the few.
2. No profit motives. The objective of nonprofit organizations is not to earn
profit. Therefore, nonprofit organizations are exempt from income taxes,
but not from business taxes.
3. Finance by the citizenry. Most nonprofit organizations depend on the
voluntary contributions of the citizenry to support their operations, because
revenues derived from their services are not enough to cover their
operating expenses. Exceptions are philanthropic foundations established
by wealthy individuals or families.
4. Stewardship of resources. Since substantial portion of the resources of
nonprofit organization is donated, the organization must account for the
resources on a stewardship basis like the governmental entities. Fund
accounting is appropriate for this requirement.
Among the features of nonprofit organizations that are similar to those of business enterprises
are the following:
1. Governance of board of directors. As with business corporations, nonprofit
corporations (non-stock) are governed by elected or appointed directors.
2. Use of accrual basis of accounting. Non-profit organizations adopt the same accrual
basis of accounting used by business enterprises. Thus, revenues and expenses are
recorded as earned and incurred.

Accounting Standards for Nonprofit Organizations

Up to the writing of this book, the Philippine Institute of Certified Public Accountant (PICPA)
has not yet issued a Philippine Accounting Standard (PAS) applicable to nonprofit
organizations. The accounting standards to be discussed in this chapter are adopted from
the guidelines issued by American Institute of Certified Public Accountant (AICPA) applicable
to all nonprofit organizations.

Fund Accounting by Nonprofit organizations

Generally, like governmental entities, the accounting unit for nonprofit organizations is the
FUND, as defined in governmental accounting. Separate funds are necessary to separate
assets to be used as authorized by the board of directors and assets that are restricted by
donors. Funds usually used by some of the nonprofit organizations to be discussed in this
chapter include the following:
• Unrestricted fund (sometimes called unrestricted current fund or general fund)
• Restricted fund (sometimes called restricted current fund)

Unrestricted Fund
This fund includes all the assets of a nonprofit organization that are available for use as
authorized by the board of directors and not restricted for specific purposes.
 54

Revenues and Gains from Unrestricted Fund

Revenues and gains of unrestricted fund are derived from a number of sources. For example,
a hospital derives unrestricted fund revenues from patient services, unrestricted donations,
and unrestricted fund revenues include student tuition fees; government grants; donations
and private grants; and unrestricted income from endowment fund. Revenues of
unrestricted fund may also include membership dues, interest, dividends, and gains from
investments in debt and equity securities.

Revenues from Services. A nonprofit organization’s total revenues are reported in the period
in which services are rendered, even though part or all of the revenue is to be waived or
reduced. To illustrate, assume that the following nonprofit organizations service records fo
May 2017 include the following data:

Hospital:

Gross patient service (before charity care or contractual adjustments) P200,000

Charity care for poor and indigent patients 10,000
Contractual adjustment allowed to Phil-health patients 30,000
Provision for doubtful accounts 20,000
The following journal entries are recorded in the unrestricted fund of the hospital:

Accounts receivable 190,000

Service revenue –patients 190,000
To record gross patient revenue exclusive of charity care

Contractual adjustments 30,000

Accounts receivable 30,000
To record contractual adjustment allowed to Phil-health.

Doubtful accounts 20,000

Allowance for doubtful accounts. 20,000

College and Universities:

Gross tuition fees P500,000

Tuition wavers provided under fellowship program 50,000
Provision for doubtful accounts (5%) 25,000
The following journal entries are appropriate for the college’s general fund for the month of
May, 2017:
Accounts receivable 500,000
Service revenue – tuition fees 500,000
To record educational and general tuition fees.

Expenditures for student aid 50,000

Accounts receivable 50,000
 55

To record tuition waivers

Doubtful accounts 25,000

Allowance for doubtful accounts 25,000
To record provision for doubtful accounts.

The contractual adjustments. Recorded illustrate the unique feature of nonprofit hospitals.
Usually, for hospitals, accounts receivable are collectible from a third party payor, rather than
from the patient. Among the third-party payors are the Philippine health insurance, and
private medical insurance companies. For colleges and universities, the comparable tuition
adjustment is debited to Expenditures-student aid account.

In the statement of activities, the balances of the contractual adjustments account (for
hospital) and the expenditures –student aid account (for colleges and universities) are to be
deducted from the total service revenues to compute the net service revenue for the month.
The balance of allowance for doubtful accounts account is treated in the usual manner, that
is, as a deduction from the accounts receivable in the balance sheet. Write offs of accounts
receivable if any, are also recorded in the customary manner.

Contributed Materials, Services and Facilities. Aside from cash contributions, nonprofit
organizations, often receive contributions of materials, services, and facilities. For example,
a hospital may receive free drugs, or a university may receive supplies. The contributed
material is recorded in the inventories account at its current fair value, with a corresponding
credit to a revenue account in an unrestricted fund, as shown in the following proforma entry:

Inventories xx
Contribution revenue xx
To record contributed materials at current fair value

Contributed services and facilities are debited to an unrestricted fund as salary expense for
contributed services and rent expense for contributed facilities, with corresponding credit to
contribution revenue account.

Other Operating Revenues. These represent income derived from other related activities,
other than service revenues of nonprofit organizations, examples are proceeds from gifts
shops, cafeterias, snack bars, newsstands, and parking lots. They are all recorded as other
operating revenues. These are recorded to unrestricted fund by the following entry:
Cash (or accounts receivable xx
Other operating revenue xx
To record other operating revenue
Pledges. A pledge promise to give is a commitment by a prospective donor to contribute a
specific amount of cash or property to a nonprofit organization on a future date or in
installments. Under the accrual basis of accounting, unconditional pledges are recorded as
receivables and revenues in the unrestricted fund, with appropriate provision for doubtful
pledges. Pledges due in future accounting periods or having restrictions as to their use are
accounted for in a restricted fund.
 56

To illustrate the accounting for pledges, assume that a nonprofit organization, received
unconditional pledges totaling P500,000 in a fund-raising drive 10% of the pledges are
considered to be doubtful of collection. The required journal entries are shown below.
Pledge receivable 500,000
Contribution revenue 500,000
To record receivable from pledges

Doubtful pledges expenses 50,000

Allowance for doubtful pledges 50,000
To record 10% provision for doubtful pledges

Contributions revenue and other operating revenues are presented in the statement of
activities, as well as doubtful accounts. Accounts receivable are presented in the balance
sheet net of the allowance for doubtful accounts.

Expenses of Unrestricted Fund

A non-profit organization usually recognizes all expenses in its unrestricted fund. Expenses are
classified as program services and supporting services and are reported on a functional basis
under their classifications. Program services are the organization’s activities that result in the
distribution of goods and services to fulfill the purposes of the organization. Supporting
services are all activities of the organization other than program services, such as
administrative expenses and fund-raising costs. These expenses are recorded by a debit to
expense account classified according to function and a credit to cash or accounts payable
account.
Depreciation expense. Depreciation is required on all the property and equipment’s of
nonprofit organizations, except for individual works of art or historical treasures having
extraordinary long economic lives.

Assets and Liabilities of Unrestricted Fund

Most of the assets and liabilities of nonprofit organization’s unrestricted fund are similar to the
current assets and liabilities of a business enterprise. Cash, investments, accounts receivable,
inventories, and prepaid expenses are typical assets of an unrestricted fund. Nonprofit
organizations that use fund accounting generally account for fixed assets in a property and
equipment fund.

The liabilities of an unrestricted fund include payables, accrued expenses, and deferred
revenues similar to those of a business enterprise.

Restricted Fund
Nonprofit organization establish restricted fund to account for assets received from donors.
These assets are available for current use but expendable only as authorized by the donor of
the assets.

The assets of restricted funds are not derived from the operations of the nonprofit
organization. Instead, the assets are obtained from (1) restricted gift or grants from individuals
or governmental entities, (2) revenues from restricted fund investments, (3) realized and
 57

unrealized gains or investments of the restricted funds, and (4) restricted income from
endowment funds.

Restricted funds are classified into temporarily restricted and permanently restricted.
Temporary restricted funds are (1) specific-purpose funds (2) time restricted funds, and (3)
plant replacement and expansion funds. Permanently restricted funds are assets that are to
be held for an indefinite period of time and generally are included in an endowment fund.

To illustrate, assume that a nonprofit organization received the following donations on June
1, 2017:

Cash, restricted for the acquisition of equipment for special project P 50,000
Securities, at market value for permanent endowment of a special project
(any Income earned on the securities is restricted to use for the special project) 100,000
On July 1, 2017, the nonprofit organization paid P20,000 for the equipment and received
dividend income from the securities amounting to P4,500. These transactions and events are
recorded by the nonprofit organization as shown on next page:

Restricted Fund:
2017
June 1 Cash 50,000
Contribution revenue –temporary restricted 50,000
To record donation received for the acquisition of equipment

Securities 100,000
Contribution revenue –permanently restricted 100,000
To record receipt of securities permanently restricted
July 1 Net assets released from restrictions 20,000
Cash 20,000
To record funds released from temporary restriction.
Cash 4,500
Investment income 4,500
To record dividend income restricted for special project.

Unrestricted Fund
July 1 Property and equipment 20,000
Cash 20,000
To record purchase of equipment.
Cash 20,000
Net assets released from restrictions 20,000
To record transfer of temporarily restricted fund.

Other Funds of Nonprofit Organizations

Endowment Fund
A permanent endowment fund is one in which the principal must be maintained indefinitely
in revenue –producing investments. Only the revenues from a permanent endowment fund’s
investment may be expended by the nonprofit organization. On the other hand, the principal
 58

of the endowment fund may be expended after the passage of time or the occurrence of
an event specified by the donor of the endowment principal.

The revenue derived from the endowment funds are accounted for in accordance with the
instructions of the donor or the board of directors. If there are no restrictions on the use of the
endowment fund income, it is transferred to the unrestricted fund. Otherwise, the revenues
are transferred to an appropriated restricted fund.

Agency Fund
Agency fund is used to account for assets held by a non-profit organization as a custodian.
The assets are disbursed only as instructed by their owner. For example, a nonprofit college
or university may act as custodian of cash for students. Faculty members and for their
organizations. The nonprofit organization disburses the cash as directed by the officers of the
student or faculty organization. The unexpended cash is reported as a liability of the
university’s agency fund, rather than as a fund balance, because the university has no equity
in the fund. Transactions of agency fund only affect asset and liability accounts and not result
in revenues and expenditures.

Plant Fund
The components of the plant funds vary among nonprofit organizations. Normally, plant fund
is composed of (1) unexpended funds to be used in the acquisition of physical properties, (2)
renewal and replacement funds, (3) retirement of indebtedness funds and (4) funds
previously expended to acquire properties. In addition to plant assets plant funds may
include cash and investments earmarked for additions to plant assets and mortgage notes
payable and other liabilities collateralized by the plant assets.

Financial Statements of Nonprofit Organizations

Financial statements of nonprofit organizations vary in forms and contents. For uniformity in
financial reporting, the Financial accounting Standard Board of the AICPA issued FASB
statement no. 117, “Financial Statement of Not-for- Profit Organizations”.
Among its provisions are the following:
1. Financial statements of nonprofit organizations shall be statement of
financial position, a statement of activities, a statement of cash flows, and
notes to the financial statement.
2. The statement of financial position shall report the following:
a. Amounts of the organization’s total assets, total liabilities, and total net
assets.
b. Amounts for each of the three classes of the organization’s net assets:
permanently restricted, temporarily restricted, and unrestricted.
3. The statement of activities shall report the following:
a. Amount of the change in the organization‘s net assets for the period
with a caption such as changes in net assets or change in equity.
b. Amount of the changes in each of the three classes of the
organization’s net assets: permanently restricted, temporarily restricted,
and unrestricted.
c. Gross amounts of revenue may be reported net of expenses and gains
or losses on disposal of plant assets.
 59

d. Expenses by functional classifications such as program services and

supporting services.
4. The statement of cash flows shall be similar in format –direct method or
indirect method – to one that is used by business enterprises.
The financial statements presented below, illustrate a format that complies with the above
standards:

Nonprofit Organization
Statement of Activities
For the year ended December 31, 2017
(Amounts in thousands)

Changes in unrestricted net assets:

Revenue and gains:
Contributions P 4,500
Fees 3,000
Investment income 3,500
Net realized and unrealized gains on investment 4,000
Others 500
Total unrestricted revenues, and gains 15,500
Net assets released from restrictions 6,000
Total unrestricted revenues, gains and other support 21,500
Expenses:
Programs 14,000
Operating 1,500
Fund raising 1,000
Total expenses 16,500

Increase in unrestricted net assets 5,000

Changes in temporarily restricted net assets:

Contributions 4,500
Investment income 1,500
Net realized and unrealized gains on investments 1,500
Net assets released from restrictions (6,000)
Increase in temporarily restricted net assets 1,500

Changes in permanently restricted net assets:

Contributions 1,000
Investment income 5,000
Net realized and unrealized gains on investment 3,000
Increase in permanently restricted net assets 9,000

Increase in net assets 15,500

Net assets, beginning of year 126,100
Net assets, end of year P141,600
=======
 60

The following should be noted from the above Statement of Activities.

1. Contributions, investment income, and gains or losses are
commonly subjected to changes in all three categories of net
assets (unrestricted, temporarily restricted and permanently
restricted).
2. Fees and other operating revenues and expenses are
associated with changes in unrestricted net assets only.

Nonprofit Organization
Statement of financial position
December 31, 2017
(amounts in thousands)

Assets
Cash and cash equivalent P50
Short –term investments in securities, at market value 750
Accounts and interest receivable 1,150
Pledges receivable 1,500
Inventories 200
Prepaid expenses 150
Long-term investment in securities, at market value 110,000
Cash and investment in securities, restricted to acquisition of equipment 2,650
Property and equipment (net) 31,000
Total assets P147,450
=======
Liabilities and Net Assets
Liabilities:
Accounts payable P 2,000
Long-term debt 3,850
Total liabilities 5,850
Net assets:
Unrestricted 46,000
Temporarily restricted 25,000
Permanently restricted 70,600
Total net assets 141,600
Total liabilities and net assets P147,450
=======

The features of the statement of financial position may be noted as follows:

1. Restricted cash and investments are presented separately.
2. All security investments: short term, long-term, and restricted are
valued at their current fair market values.

Nonprofit Organization
Statement of Cash Flows (indirect method)
For year ended December 31, 2017.
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(amounts in thousands)

Cash flows from operating activities

Increase in net assets P 15,500
Adjustment to reconcile increase in net assets to
Net cash provided by operating activities:
Depreciation 3,500
Increase in accounts and interest receivable (500)
Increase in pledges receivable (500)
Decrease in inventories 600
Decrease in prepaid expenses 400
Decrease in accounts payable (1,000)
Net realized and unrealized gains on investments in securities (8,500)
Net cash provided by operating activities P9,500
Cash flows from investing activities:
Acquisitions of investment in securities P(14,500)
Acquisition of property and equipment (1,000)
Disposal of property and equipment 6,300
Net cash used in investing activities (9,200)
Cash flows from financing activities:
Contribution received P 2,000
Payment of long-term debt (2,500)
Net cash used in financing activities (500)
Net decrease in cash and cash equivalents P(200)
Cash and cash equivalents, beginning of year 250
Cash and cash equivalents, end of year P 50
=====

In the statement of cash flows (indirect method), the P8,500 of net realized and unrealized
gains on investments is the total of the following in the statement of activities:

Net realized and unrealized gains on investments from:

Unrestricted net assets P4,000
Temporary restricted net assets 1,500
Permanent restricted net assets 3,000
Total P8,500
======

For nonprofit organizations that use fund accounting, unrestricted net assets usually are those
in the unrestricted (or general) fund. Temporary restricted net assets generally are those in
restricted funds, loan funds, and plant funds. The source of permanently restricted net assets
is permanent endowment funds.

Home Work:
Multiple choice: Encircle the best answer.
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1. Which of the following should be used in accounting for nonprofit

organization?
a. fund accounting and accrual accounting
b. fund accounting but not accrual accounting
c. accrual accounting but not fund accounting
d. neither accrual accounting nor fund accounting
2. One characteristics of nonprofit organizations that is comparable with
characteristics of governmental entities is:
a. Stewardship of resources
b. Government by board of directors
c. Measurement of cost expirations
d. None of the foregoing
3. A nonprofit organization’s restricted fund resembles a governmental entity’s
a. Agency fund
b. Endowment fund
c. Special fund
d. Assessment fund
4. A gift to nonprofit organization that is not restricted by the donor is credited in
the unrestricted (general) fund to:
a. Fund balance
b. Deferred revenues
c. Contributions revenue
d. Non-operating revenues
5. The current fair value of contributed material is recognized in a nonprofit
organization’s unrestricted fund with a debit to inventories and a credit to:
a. Undesignated fund balance
b. Payable to Restricted fund
c. Designated fund Balance – Merchandise
d. Contributions revenue
6. AB university’s (a nonprofit organization) unrestricted funds comprised the
following:
Assets P500,000
Liabilities (including deferred revenues of P10,000) 300,000

The fund balance of AB University’s unrestricted funds was:

a. P190,000 c. P210,000
b. P200,000 d. P500,000
7. The records of TMT hospital, a nonprofit organization, had the following
amounts on June 30, 2017:
Charity care P 80,000
Contractual adjustments 160,000
Patient service revenues (gross) 1,240,000
Provision for doubtful accounts 140,000
Net patient service revenues for TMT hospital for the year ended June 30, 2017
Amounts to
a. P1,640,000 c. P1,000,000
b. P1,100,000 d. P1,080,000
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EVALUATION: Quiz 4

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