CO1_What is Financial Accounting

Accounting

• The art of recording, classifying, and summarizing in a significant manner and in terms of money, transactions and events that are, in part at least, of a financial character, and interpreting the results thereof (AICPA defined)

• Helps an entity, be it for profit or otherwise, to summarize its transactions and communicate them in a way that will be understood by its intended users

As an art and a science is universally accepted as the language of business

Primary users

• Previously called external users

• Uses financial information for investment and lending purposes

• They are the main providers of funds to the entity

Investors

Need accounting data to help them decide whether to buy, hold, or sell their stakes (investments) in the company

Lenders or Creditors

Need to know if the entity will be able to pay off its debt

Government

Through the Bureau of Internal Revenue, needs to know the correct amount of tax that the entity has to pay

Other users

• Also called internal users

• Uses accounting data to help them decide on the particular transactions and directions to be taken by the entity

• These people need financial information to guide them in maintaining the entity’s profitable and stable existence

Management

Which is normally comprised by the board of directors, executive officers, supervisors, and rank and file personnel

Management accounting

• Primarily used by internal users

• A branch of accounting that focuses on the needs of internal users

• Used to make decisions regarding the daily operations of a company

• Based on current and future trends

• It is more flexible in a way that the rules and conventions being used to produce certain information may be added or reduced, changed, or even disregarded to support its needs information-wise

• Sole purpose is to produce reports and provide information to be circulated inside the company

  • These reports usually cover a period of less than one year, and sometimes are produced as needed

Financial accounting

• Primarily used by external users

• Main purpose is to produce general purpose financial statements

• Used to present the financial health of a company to external stakeholders

• These reports are filed on an annual basis

• Differs from management accounting on at least 2 aspects

1. They have different intended users

2. Management accounting is more flexible in a way that the rules and conventions being used to produce certain information may be added or reduced, changed, or even disregarded by the entity to support its needs information-wise

 Internal Accounting Standards Board (IASB)

For the preparation of general purpose financial statements to be used by primary users, financial accounting requires the financial statement preparers to follow the guidelines, conventions, and framework set by the _____

Philippine Financial Reporting Standards (PFRS)

In the PH, the framework used is the __

Philippine Financial Reporting Standards (PFRS)/Philippine Accounting Standards (PAS)

• Are the new set of GAAP issued by the Accounting Standards Council (ASC) to govern the preparation of financial statements

• These standards are patterned after the revised International Financial Reporting Standards (IFRS) and International Accounting Standards (IAS) 

  • issued by the International Accounting Standards Board (IASB)

• It allows the financial statements users to get the information they need from the entity without asking the entity for such information

• Comprised of different standards and interpretations that lay out the guidelines and principles to be followed in the presentation of the items shown in the general purpose financial statements, as well as their disclosures

information asymmetry

1. The standards help minimize, if not totally eliminate, the occurrence of _____. 

• Allowed the financial statement users to get the information they need from the entity without asking the entity for such information. The entities are required to observe full disclosure of necessary accounting information in their financial statements

comparability

If all the existing businesses were to be allowed to present financial information the way they want, it would be very difficult for users to compare companies side by side. Allows these entities to speak the same language in their financial reports

Conceptual Framework for Financial Reporting

• Has been developed so that the financial reporting standards are applicable to a wide range of accounting models including the concepts of capital and capital maintenance

• sets the overarching principles that are seen in the other PFRSs, which in turn lays out the guidelines for the preparation of financial statements of entities.

• Purpose:

1. To assist the Board in the development of future PFRSs and in its review of existing PFRSs;

2. To assist the Board in promoting harmonization of regulations, accounting standards, and procedures relating to the presentation of financial statements by providing a basis for reducing the number of alternative accounting treatments permitted by PFRSs;

3. To assist national standard-setting bodies in developing national standards;

4. To assist preparers of financial statements in applying PFRSs and in dealing with topics that have yet to form the subject of a PFRS;

5. To assist auditors in forming an opinion on whether financial statements comply with the PFRSs;

6. To assist users of financial statements in interpreting the information contained in financial statements prepared in complying with PFRSs; and

7. To provide those who are interested in the work of the IASB with information about its approach to the formulation of PFRSs.

Relevance

• A piece of information is relevant if it is capable of making a difference in the decisions made by the user.

• Basically, information is relevant if it is being used in the decision-making process.

Faithful representation

• requires a piece of information to be complete, neutral, and free from material error.

• In other words, a piece of information is faithfully represented if it depicts what it says it is.

Comparability

• is the qualitative characteristic that enables users to identify and understand similarities in, and differences among, items. 

• Information becomes more useful if it can be compared with similar information about other entities and with similar information about the entity for another period or another date.

Consistency

refers to the use of the same methods for the same items, either from period to period within a reporting entity or in a single period across entities.

Verifiability

• assures users that information faithfully represents the economic phenomena it seeks to represent. 

• It means that different knowledgeable and independent observers could reach a consensus, although not necessarily complete agreement, that a particular information is a faithful representation.

Timeliness

• means having information available to decision makers in time to be capable of influencing their decisions. 

• This is the reason why companies not only produce financial statements once a year but also produce regular partial, or interim, financial statements, throughout a year to supplement their general-purpose financial statements. Interim financial statements are released by entities during the year that spans less than a year; it does not cover an entire year.

Understandability

• financial information is understandable if it is classified, characterized, and presented clearly and concisely. This is one of the reasons why the face of the financial statements is presented separately from their disclosures. 

• However, for financial information to be understandable, the users should have adequate background of the financial statements, the financial information, and of course, financial accounting.

Going concern

• Financial statements are prepared under an assumption that an entity is a going concern and will continue in operation for the foreseeable future.

• In other words, the financial statements are prepared with the assumption that the entity is not going to liquidate, or will be forced to do so, in the foreseeable future.

Liquidating phase

• Should the going concern assumption be not applicable to the entity anymore, it may not follow the guidelines set out in the PFRSs but choose another framework to follow in the preparation of its financial statements.

• In this case, the entity is said to be in a liquidating phase.

Accrual basis

• The going concern assumption allows the entity to use the accrual basis of accounting.

• Accrual basis requires that the effects of transactions and other events are recognized when they occur, and not as cash is received or paid.

• Events therefore are recorded in the accounting records and reported in the financial statements of the periods to which they relate.

• With this assumption, the users would know not only the past transactions from which cash was received or paid but also of future receivables and payables to be received and paid, respectively.

Financial statements

• financial accounting’s main concern

• are a structured representation of the financial position and financial performance of an entity.

• They also show the results of management’s stewardship of the resources entrusted to it. These results are shown in the financial statements that the entity is required to issue at least every year.

Statement of Financial Position

• shows the entity’s assets, liabilities, and equity as of a particular date. Previously called the balance sheet, this financial statement also proves that the assets (entity’s resources) are equal to the sum of the liabilities (claim of outside parties) and equity (claim of owner/s).

Elements of this are Assets, Liabilities, and Owner’s Equity

Statement of profit or loss and other comprehensive income

• presents the entity’s profit or loss, total other comprehensive income, and comprehensive income for the period—being the total of profit or loss and other comprehensive income. This is where we see the entity’s income, expenses, gains, and losses that were recognized during the period. Other comprehensive income comprises items of income and expense that are not presented or recognized on the face of the income statement.

Statement of Changes in Equity

shows the changes in the entity’s net assets during the period. Net assets are the shareholders’ equity for a corporation, partners’ equity for a partnership, and owner’s equity for a sole or single proprietorship. This particular financial report shows the total comprehensive income for the period as well as transactions with the entity’s owners in their capacity as owners, such as issuance and repurchase of shares, and declaration of dividends.

Statement of Cash Flows

provides users of financial statements with a basis to assess the ability of the entity to generate cash and cash equivalents and the needs of the entity to utilize those cash flows. The statement of cash flows also shows how the entity was able to handle one of its most important and delicate resources, cash.

Notes to Financial Statements

• according to Philippine Accounting Standard No. 1 (PAS 1) Presentation of Financial Statements, contain information in addition to that presented on the other financial statements.

• They provide narrative descriptions or disaggregations of items presented on the statements and information about items that do not qualify for recognition on those statements.

• give supplementary information to the financial statements users regarding the entity itself, and the amounts on the face of the financial statements.

• fully disclose significant information that could not be presented on the face of the financial statements for practical purposes. Thus, they usually comprise many pages of any complete set of financial statements should a user decide to download and print the same.

Financial statements of big corporations, such as banks and other multinational companies, normally exceed 100 pages and most of the pages comprise the entity’s notes.

Financial statements

• present the financial effects of transactions and other events by grouping them into broad classes according to their economic characteristics.

Financial position

• The three broad elements of financial position are assets, liabilities, and equity.

  • Assets = Liabilities + Equity.

Liabilities & Equity

• claims to such resources

• Sources of the entity’s resources

Assets

• resources of an entity

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

• 2 criterias for an entity to be recognized as an asset:

1. it is probable that future economic benefits will flow to the entity.

2. the cost can be measured reliably.

• Some assets are recognized on the entity’s financial statements even though the entity does not have the legal title or ownership to such.

Ex. When a lessee recognizes the right-of-use asset on its financial statements for long-term leases.

Whether or not there is a transfer of ownership at the end of the lease, the lessee should still recognize the asset on its financial statements.

Intangible assets

• It is not a requirement that assets should have a physical form

• Ex. copyrights, patents, and trademarks

Ownership

• no longer a necessary criterion for an asset to be recognized on the entity’s statement of financial position; 

control is enough.

Liability

• present obligation 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.

• is something that has to be settled in the future because of a past transaction that gave rise to it.

• may be legally enforceable or not.

• may be incurred and recognized from normal practice, custom, or a desire to maintain good business relations.

  • This gives rise to liabilities that are not legally enforceable.

  • Ex. entended warranty period

• may not always be settled in cash.

  • may be settled by a transfer of assets as in the case of settling an advance payment of a customer for products not yet produced, or provision of services as in the case of an advance payment from a client for services to be rendered in the future.

• do not always have an exact amount nor specific name of the payee.

  • A present obligation may still exist, even though the entity is not certain as to how much will be paid or to whom the amount is to be paid upon settlement.

Ex. warranties payable, premiums payable, and provision for payments in an ongoing court case.

Account payable

An example of a legally enforceable liability which represents the amount the entity has to pay its suppliers in the near future

Equity

• the residual interest in the entity’s assets after deducting its liabilities.

• this is the other component of the right side of the accounting equation representing claim of the owners on the assets of the entity.

Financial Performance

• Elements that measure performance or profitability of the entity are broadly classified into two: income & expenses

  • are mainly extensions or sub-elements of equity.

Income

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

• Contributions from equity participants refer to investments by owners in a sole proprietorship and partnership and sale of shares of stock by a corporation.

• makes the entity and its owner(s) better off.

• encompasses both revenues and gains.

Revenues

arise in the course of the ordinary activities of an entity such as sales, fees, interest, dividends, royalties, and rent.

Gains

• represent other items that do not arise in the ordinary course of business.

Ex. gain arising from the disposal of an item of property, plant equipment

Expenses (costs)

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

• Distributions to equity participants refer to withdrawals by owners and declaration of dividends by a corporation.

• Expenses encompass losses as well as those expenses that arise in the course of ordinary activities of the entity.

Ex. cost of goods sold, salaries, wages, and depreciation.

Losses

may arise from disposal of property, plant, and equipment, or early retirement of bonds payable.