CHAPTER 4 CONCEPTUAL FRAMEWORK – FINANCIAL STATEMENTS AND REPORTING

ENTITY UNDERLYING ASSUMPTIONS

General objective of Financial Statements
Financial statements provide information about economic resources of the reporting entity, claims against the
entity and changes in the economic resources and claims. Financial statements provide financial information
about an entity’s assets, liabilities, equity, income and expenses useful to users of financial statements in:
a. Assessing future cash flows to the reporting entity.
b. Assessing management stewardship of the entity’s economic resources.
The financial information is provided in the following:
1. Statement of financial position, by recognizing assets, liabilities and equity.
2. Statement of financial performance, by recognizing income and expenses.
3. Other statements and notes by presenting and disclosing information about:
a) Recognized assets, liabilities, equity, income and expenses
b) Unrecognized assets and liabilities
c) Cash flows
d) Contribution from equity holders and distribution to equity holders
e) Method, assumption and judgment in estimating amount presented

Types of Financial Statements

The Revised Conceptual Framework recognizes three types of financial statements.
1. Consolidated financial statements – These are the financial statements prepared when the reporting
entity comprises both the parent and its subsidiaries.
2. Unconsolidated financial statements – These are the financial statements prepared when the reporting
entity is the parent alone.
3. Combined financial statements – These are the financial statements when the reporting entity
comprises two or more entities that are not linked by a parent and subsidiary relationship.

Consolidated financial statements

Consolidated financial statements provide information about the assets, liabilities, equity, income and
expenses of both the parent and its subsidiaries as a single reporting entity. The parent is the entity that
exercises control over the subsidiaries. Consolidated information is useful for existing and potential investors,
lenders and other creditors of the parent in their assessment of future net cash inflows to the parent. This is
because net cash inflows to the parent include distribution to the parent from its subsidiaries. Consolidated
financial statements are not designed to provide separate information about the assets, liabilities, equity,
income and expenses of a particular subsidiary. A subsidiary’s own financial statements are designed to
provide such information.

Unconsolidated financial statements

Unconsolidated financial statements are designed to provide information about the parent’s assets, liabilities,
income and expenses and not about those of subsidiaries. Such information can be useful to the existing and
potential investors, lenders and other creditors of the parent because a claim against the parent typically does
not give the holder of that claim against subsidiaries. Information provided in unconsolidated financial
statements are required , unconsolidated financial statements cannot serve as substitute for consolidated
financial statements.

Combined financial statement

Combined financial statement provide financial information about the assets, liabilities, equity, income and
expenses of two or more entities not linked with parent and subsidiary relationship.

Reporting entity
A reporting entity is an entity that is required or chooses to prepare financial statements. The reporting entity
can be a single entity or portion of an entity, or can comprise more than one entity. A reporting entity is not
necessarily a legal entity. Accordingly, the following can be considered a reporting entity:
a) Individual corporation, partnership or proprietorship
b) The parent holder
CHAPTER 4 CONCEPTUAL FRAMEWORK – FINANCIAL STATEMENTS AND REPORTING
ENTITY UNDERLYING ASSUMPTIONS
c) The parent and its subsidiaries as single reporting entity
d) Two or more entities without parent and subsidiary relationship as a single reporting entity
e) A reportable business segment of an entity.

Reporting period
The reporting period is the period when financial statements are prepared for general purpose financial
reporting. Financial statements may be prepared on an interim basis, for example, three months, six months or
nine months. Interim financial statements are not required but optional. However, Financial must at least be
prepared on an annual basis or a period of twelve months. Financial statements are prepared for a specified
period of time and provide information about:
a) Assets, liabilities and equity at the end of the reporting period
b) Income and expenses during the reporting period
To help users of financial statements to identify and assess change in trends, financial statements also
provide comparative information for at least one preceeding reporting period
Financial statements may include information about transactions and other events that occurred after the end
of reporting period if the information is necessary to meet the general objective of financial statements.

Underlying Assumptions
Accounting assumptions are the basic notions or fundamental premises on which the accounting process is
based. They are also known as postulates. Like a building structure that requires a solid foundation to avoid
or prevent future collapse and provide room for expansion, and so with accounting Accounting assumptions
serve as the foundation or bedrock of accounting in order to avoid misunderstanding bit rather enhance the
understanding and usefulness of the financial statements. The Conceptual Framework for Financial Reporting
mentions only one assumption, namely going concern. However, implicit in accounting are the basic
assumptions of an accounting entity, time period and monetary unit.

Going concern
The going concern or continuity assumption means that in the absence of evidence to the contrary, the
accounting entity is viewed as continuing in operation indefinitely. In other words, the financial statements are
normally prepared on the assumptions that the entity will continue in operations for the foreseeable future. The
going concern postulate is the very foundation of the cost principle. Thus, assets are normally recorded at cost.
As a rule, market values are ignored. However, some new standards require measurement of certain assets at
fair value.
If there is evidence that the entity would experience large and persistent losses or that the entity’s operations
are to be terminated, the going concern assumption is abandoned. In this case, the users of the statements will
have a great interest in the amount of cash thar will generated from the entity’s assets in the short term.

Accounting entity
In financial accounting, the accounting entity is the specific business organization, which may be a
proprietorship, partnership or corporation. Under this assumption, the entity is separate from the owners,
managers, and employees who constitute the entity. Accordingly, the transactions of the entity shall not be
merged with the transactions of the owners. The reason for the entity assumption is to have a fair presentation
of financial statements. The personal transactions of the owners shall not be allowed to distort the financial
statements.

For example, the cash invested by the proprietorship. If an enterprising entrepreneur owns department store,
restaurant and bookstore, separate statements shall be prepared for each business in order to determine
which business is profitable. Each business is an independent accounting entity. When a major shareholder of
a corporation borrows money from a bank on his own personal account, the loan is liability of the shareholder
alone and not of the corporation. The shareholder is not the corporation and the corporation is not the
shareholder. However, where parent and subsidiary relationship exists, consolidated statements for the
affiliates are usually made because for practical and economics purposes, the parent and the subsidiary are a
“single economic entity”. The consolidation, however, does not eliminate the legal boundary segregating the
CHAPTER 4 CONCEPTUAL FRAMEWORK – FINANCIAL STATEMENTS AND REPORTING
ENTITY UNDERLYING ASSUMPTIONS
affiliated entities. Accounting will continue to be done separately for each entity.

Time period

A completely accurate report on the financial position and performance of an entity cannot be obtained until the
entity is finally dissolved and liquidated. Only then can the final net income and networth of the entity be
determined precisely. However, users of financial information need timely information for making an economic
decision. It becomes necessary therefore to prepare periodic reports on financial position, performance and
cash flows of an entity. The time period assumption requires that the indefinite life of an entity is subdivided
into accounting periods which are usually of equal length for the purpose of preparing financial reports on
financial position, performance and cash flows. By convention, the accounting period or fiscal period is one
year or a period of twelve months. The “one-year period” is traditionally the accounting period because usually
it is after one year that government reports are required. The accounting period may be a calendar year or a
natural business year. A calendar year is a twelve-month period that ends on December 31. A natural
business year is a twelve-month period that ends on any month when the business is at the lowest or
experiencing slack season.

Monetary unit
The monetary unit assumption has wo aspects, namely quantifiability and stability of the peso. The
quantifiability aspect means that the assets, liabilities, equity, income and expenses should be stated in terms
of a unit of measure which is the peso in the Philippines. How awkward to see financial statements without any
common unit of measure. Such statements would be largely unintelligible and incomprehensible. The stability
of the peso assumption means that the purchasing power of the peso is stable or constant and that its
instability is insignificant and therefore may be ignored. The stable peso postulate is actually an amplification of
the going concern assumption so much so that adjustments are unnecessary to reflect any changes in
purchasing power. The accounting function is to account for nominal pesos only and not for constant pesos or
changes in purchasing power.

In today’s world, the assumption that the peso is a stable measure over time is not necessarily valid. Consider
an equipment that was imported 10 years ago from the United States for $100,000 when the exchange rate
was P35 to $1 or an equivalent of P3,500,000.If the same equipment is purchased now and assuming there is
no change in the $100,000 purchase price, the replacement cost in terms of pesos would be in the vicinity of
P5,400,000, considering a current exchange rate of P54 to $1.Obviously, there is a significant gap between
historical cost and current replacement cost. In this regard, an entity may choose the revaluation model as an
accounting policy.