Financial Accounting and

Reporting
Accounting Intensive Review 2016
Lord Caesar P. Batiancila, CPA

Sacrifice and know your priority.

Financial Accounting 1

The American Accounting Association (AAA) in its statement of Basic Accounting Theory defines
accounting as follows:

Accounting is the process of identifying, measuring and communicating economic information to

permit informed judgment and decision by users of the information.

The definition that has stood the test of time is the definition given by the American Accounting
Association.

Other definition given by:

Accounting Standards Council (ASC)

Accounting Terminology of the American Institute of Certified Public Accountants (AICPA)

Generally Accepted Accounting Principles

GAAP are conventional, meaning, they become generally accepted by agreement often tacit
agreement rather than by formal derivation from a set of postulates and basic concepts. The
principles have developed on the basis of experience, reason, custom, usage and practical
necessity.

Financial Reporting Standards Council

The FRSC is the accounting standard setting body created by the Professional Regulation
Commission upon recommendation of the Board of Accountancy (BOA) in carrying out its powers
and functions provided under R.A. Act No. 9298.

The overall purpose of accounting standards is to identify proper accounting practices for the
preparation and presentation of financial statements.

The accounting standards promulgated by the FRSC constitute the highest hierarchy of GAAP in
the Philippines.

Philippine Interpretation Committee

The Philippine Interpretation Committee (PIC) was formed by the FRSC in August 2006 and has replaced
the Interpretation Committee (IC) by the Accounting Standards Council in May 2000.

The role of the PIC is to prepare interpretations of PFRS for approval by the FRSC and in the context of
the Conceptual Framework, to provide timely guidance on financial reporting issues not specifically
addressed in current PFRS.

International Accounting Standards Committee

The International Accounting Standards Committee or IASC is an independent private sector body, with
the objective of achieving uniformity in the accounting process which are used by the business and other
organizations for financial reporting around the world.

CONCEPTUAL FRAMEWORK

The Conceptual Framework for Financial Reporting is a complete, comprehensive and single document
promulgated by the International Accounting Standards Boards (IASB). It is a summary of the terms and
concepts that underlie the preparation and presentation of financial statements for external users.

IF THERE IS A STANDARD OR AN INTERPRETATION THAT SPECIFICALLY APPLIES TO A TRANSACTION, THE

STANDARD OR INTERPRETATION OVERRIDES THE CONCEPTUAL FRAMEWORK.

However, it is to be stated that the Conceptual Framework is not a PFRS and hence does not define
standard for any particular measurement or disclosure issue.

ASSUMPTIONS AND FINANCIAL REPORTING

Accounting assumptions are the basic notions or fundamental premises on which the accounting
processes is based. ACCOUNTING ASSUMPTIONS ARE ALSO KNOWN AS POSTULATES.

The Conceptual Framework for Financial Reporting mentions only one assumption, namely going
concern. However, implicit in accounting are the basic assumptions of accounting entity, time
period and monetary unit.

Going Concern

The going concern assumption means that in the absence of evidence to the contrary, the
accounting entity is viewed as continuing in operation indefinitely.

Accounting Entity

Under this assumption, the entity is separate from the owners, managers, and employees who
constitute the entity. Accordingly, the transaction 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.

Time Period

This assumption requires that the indefinite life of an entity is subdivided into time periods or
accounting periods which are usually of equal length for the purpose of preparing financial
reports on financial position, performance and cash flows.

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 two aspects, namely quantifiability and stability of the peso.

The quantifiability aspects 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.

The stability of the peso assumption means that the purchasing power of the peso is stable or
constant and that its instability is significant and therefore maybe ignored.

Accrual Accounting

The financial performance of an entity shall be measured in accordance with accrual accounting.

Accrual accounting depicts the effects of transactions and other events and circumstances on an
entitys economic resources and claims in the periods in which those effects occur even if the
resulting cash receipts and payments occur in different period.

Qualitative characteristics

Qualitative characteristics are the qualities or attributes that make financial accounting
information useful to the users.

Under the Conceptual Framework for Financial Reporting, qualitative characteristics are
classified into

fundamental qualitative characteristics

enhancing qualitative characteristics.

Fundamental qualitative characteristics

The fundamental qualitative characteristics relate to the content or substance of financial

information. The fundamental qualitative characteristics are:

Relevance

Faithful representation

Information must be both relevant and faithfully represented if it is to be useful.

Relevance

Relevance in its simplest terms is the capacity of the information to influence a decision.
Ingredients of relevance are

predictive value - if it can be used as an input to processes employed by users to predict future outcome
and if it can help users increase the likelihood of correctly or accurately predicting or forecasting
outcome of events.

conformity value - if it provides feedback about previous evaluations.

Materiality

The materiality concept is also known as the doctrine of convenience. Materiality is a

subquality of relevance based on the nature or magnitude or both of the items to which the
information relates.

Faithful representation

Simply stated, faithful representation means that the actual effects of the transactions shall be
properly accounted for and reported in the financial statements. Ingredients of faithful
representation:

Completeness

Neutrality

Free from error

Standard of Adequate disclosure

The standard of adequate disclosure means that all significant and relevant information leading
to the preparation of financial statements shall be clearly reported.

Substance over form

It is necessary that the transactions and events are accounted in accordance with their
substance and reality and not merely their legal form.

Conservatism

There is no discussion of conservatism or prudence in the Conceptual Framework for Financial

Reporting. Under conservatism, when alternatives exist, the alternative which has the least
effect on equity should be chosen. In the simplest words, conservatism means in case of
doubt, record any loss and do not record any gain.

Enhancing qualitative characteristics

The enhancing qualitative characteristics relate to the presentation or form of the financial
information.

The enhancing qualitative characteristics are:

Comparability - the ability to bring together for the purpose of noting points of likeliness and
difference.

Understandability - requires that financial information must be comprehensible or intelligible if it is to

be most useful.

Verifiability - means that different knowledgeable and independent observers could reach consensus,
although not necessarily complete agreement, that a particular depiction is a faithful representation.

Timeliness - means that financial information must be available or communicated early enough when a
decision is to be made.

Consistency

Implicit in the qualitative characteristics of comparability is the principle of consistency.

The principle of consistency requires that the accounting methods and practices should be
applied on a uniform basis from period to period.

Cost constraint on useful information

Cost is a pervasive constraint on the information that can be provided by financial reporting.

The rule is the benefit derived from the information should exceed the cost incurred in
obtaining the information.

Elements of financial statements

Elements directly related to the measurement of statement of financial position:

Asset

Liabilities

Equity

Elements directly related to the measurement of statement of financial performance:

Income

Expense

STATEMENT OF FINANCIAL POSITION

Financial statements are the means by which the information accumulated and processed in
the financial accounting is periodically communicated to the users.

A complete set of financial statements comprises the following components:

Statement of financial position

Statement of financial performance

Statement of comprehensive income

Statement of changes in equity

Statement of cash flows

Notes, comprising a summary of significant accounting policies and other explanatory notes.

Assets

Assets is defined as resource controlled by the entity as a result of past events and from
which future economic benefits are expected to flow to the entity. Assets are classified only
into two, namely current assets and noncurrent assets.

Assets are classified only into two, namely

current assets

noncurrent assets

Liability

Liability is defined as present obligation of an entity arising from past events, the settlement
of which is expected to result in an outflow from the entity of resources embodying economic
benefits.

Liabilities are classified into two, namely

current liabilities

noncurrent liabilities

Equity

The term equity is the residual interest in the assets of the entity after deducting all of its
liabilities. Simply stated, equity means net assets or total assets minus liabilities. The terms
used in reporting the equity of an entity depending on the form of the business organization
are:

Owners equity in a proprietorship

Partners equity in a partnership

Stockholders equity or shareholders equity in a corporation

STATEMENT OF COMPREHENSIVE INCOME

Comprehensive income is the change in equity during a period resulting from transactions and
other events, other than changes resulting from transactions with owners in their capacity as
owners. Accordingly, comprehensive income includes:

Components of profit or loss

Components of other comprehensive income.

The components of OCI include the following:

Unrealized gain or loss on investment in equity instrument measured at fair value through other
comprehensive income

Gain or loss from translation of the financial statements of foreign operation.

Revaluation surplus during the year.

Unrealized gain or loss from derivative contracts designated as cash flow hedge.

Remeasurements of defined benefit plan, including actuarial gain or loss.

Change in fair value attributable to credit risk of a financial liability designated at fair value through
profit or loss.

The line items for amounts of OCI shall be grouped as follows:

OCI that will be reclassified subsequently to profit or loss when specific conditions are met.

OCI that will not be reclassified subsequently to profit or loss.

Components of OCI that will be reclassified subsequently to profit or loss include:

Gain or loss from translating financial statements of a foreign operation.

Unrealized gain or loss on derivative contracts designated as cash flow hedge.

Components of OCI that will not be reclassified subsequently to profit or loss include:

Unrealized gain or loss on investments in equity instruments measured at fair value through OCI.

The Application Guidance of PFRS 9, paragraph b5.7.1, provides that such unrealized gain or loss is
reclassified to retained earnings upon disposal of the investment.

Revaluation surplus during the year.

The realization of the revaluation surplus is through retained earnings.

Remeasurements of defined benefit plan, including actuarial gain or loss.

The remeasurements are not reclassified subsequently but are permanently excluded from profit or
loss. However, the remeasurments may be transferred within equity or retained earnings.

Change in fair value attributable to credit risk of a financial liability designated at fair value through
profit or loss.

Such gain or loss from change in fair value attributable to credit risk of a financial liability may be
transferred within equity or retained earnings.

PAS 1, paragraph 87, specifically mandates that an entity shall not present any items of
income and expenses as extraordinary items, either on the face of the income statement or
other comprehensive income or in the notes.

Forms of income statement

the income statement may be presented in two ways, namely

Functional presentation - This form classifies expenses according to their function as part of cost of
sales, distribution costs, administrative activities and other activities. It is also known as the cost of
sales method. An entity shall also disclose additional information on the nature of expenses.

Natural presentation - Under this form, expenses are aggregated according to their nature and not
allocated among various functions within the entity.

PAS 1 does not prescribe any format. Paragraph 105 simply states that because each method
of presentation has merit for different types of entities, management is required to select the
presentation that is reliable and more relevant.

Statement of retained earnings

This statement shows the changes affecting directly the retained earnings of an entity and
relates the income statement to the statement of financial position.

Statement of changes in equity

This statement is a basic statement that shows the movements in the elements or components
of the shareholders equity. The statement of retained earnings is no longer a required basic
statement but it is a part of the statement of changes in equity.

Statement of cash flows

This statement is a basic component of the financial statements which summarizes the
operating, investing and financing activities of an entity. In simple terms. The statement of
cash flows provides information about the cash receipts and cash payments of an entity during
a period.

CASH AND CASH EQUIVALENTS

Cash

Cash includes checks, bank drafts and money orders because these are acceptable by the bank
for deposit or immediate encashment. But postdated checks received cannot be considered as
cash yet because these checks are unacceptable by the bank for deposit and immediate credit
or outright encashment.

Cash equivalents

PAS 7, paragraph 6, defines cash equivalents as short-term and highly liquid investments that
are readily convertible into cash and so near their maturity that they present insignificant risk
of changes in value because of changes in interest rates.

The standards further states that only highly liquid investments that are acquired three
months before maturity can qualify as cash equivalents. Examples:

Three-month BSP treasury bills

Three-year BSP treasury bill purchased three months before date of maturity

Three-month time deposit

Three-month money market instrument or commercial paper

Measurement of cash

Cash in measured at face value. Cash in foreign is measured at the current exchange rate.

Financial statement presentation

The caption cash and cash equivalents should be shown as the first item among the current
assets. However, the details comprising the cash and cash equivalents should be disclosed in
the notes to financial statements.

Cash fund for a certain purpose

Classification of a cash fund as current or noncurrent should parallel the classification of the
related liability.

Bank overdraft

A bank overdraft is classified as a current liability and should not be offset against other bank
accounts with debit balances.

It is to be stated that generally overdrafts are not permitted in the Philippines.

Compensating balance

If the deposit is not legally restricted as to withdrawal by the borrower because of an informal
compensating balance agreement, the compensating balance is part of cash.

If the deposit is legally restricted because of a formal compensating balance agreement, the
compensating balance is classified separately as cash held as compensating balance under
current assets if the related loan is short-term, if the related loan is long-term, the
compensating balance is classified as noncurrent investment.

Window dressing

Window dressing is a practice of opening the books of accounts beyond the close of the
reporting period for purpose of showing a better financial position and performance.

Such practice are unacceptable and undesirable.

Lapping

Lapping is a practice used for concealing a cash shortage. Lapping consists of misappropriating
a collection from one customer and concealing this defalcation by applying a subsequent
collection made from another customer.

Kitting

Kiting is another device used to conceal a cash shortage. Kitting occurs when a check is drawn
against a first bank and depositing the same check in a second bank to cover the shortage in
the latter bank.

No entry is made for both the drawing and deposit of the check.

Accounting for cash shortage

When the cash count shows cash which is less than the balance per book, there is a cash
shortage to be recorded as follows:

Cash short or over

Cash

xx
xx

The cash short or over account is only a temporary or suspense account. When financial
statements are prepared the same should be adjusted.

Hence, if the cashier or cash custodian is held responsible for the cash shortage, the
adjustment should be:

Due from cashier

Cash short or over

xx

However, if reasonable efforts fail to disclose the cause of the shortage, the adjustment is

Loss from cash shortage

Cash short or over

xx

xx
xx

If the amount of cash shortage is not material, it can be debited to miscellaneous expense.

Imprest system

The imprest system is system of control of cash which requires that all cash receipts should be
deposited intact and all cash disbursement should be made by means of check.

Petty cash fund

The petty cash fund is money set aside to pay small expenses which cannot be paid
conveniently by means of check.

There are two methods of handling the petty cash fund, namely:

Imprest fund system - is the one usually followed in handling petty cash transaction.

Fluctuating fund system - because the checks drawn to replenish the fund do not necessarily equal the
petty cash disbursements. The replenishment checks are simply drawn upon the request of the petty
cashier.

BANK RECONCILIATION

A bank reconciliation is a statement which brings into agreement the cash balance per and cash
balance per bank. It is usually prepared monthly because the bank provides the depositor with
the bank statement at the end of every month. Actually, the bank statement is an exact copy
of the depositors ledger in the records of the bank.

Bank deposit

Demand deposit This is the current account or checking account or commercial deposit where
deposits are covered by deposit slips and where funds are withdrawable on demand by drawing
checks against the bank. Demand deposit is non-interest bearing.

Saving deposit The depositor is given a passbook upon the initial deposit. The passbook is
required when making deposits and withdrawals. A saving deposit is interest bearing.

Time deposit This is similar to saving deposit in the sense that it is interest bearing. A time
deposit is evidenced, however, by a formal agreement in an instrument call certificate of
deposit.

Incidentally, of the three kinds of deposit, a bank reconciliation is necessary only for a demand
deposit or checking account.

Reconciling items

Book reconciling items:

Credit memos - refer to items not representing deposit credited by the bank to the account of the
depositor but not yet recorded by the depositor as cash receipts. The credit memos have the effect of
increasing the bank balance.

Debit memos - refer to items not representing checks paid by bank which are charges or debited by the
bank to the account of the depositor but not yet recorded by the depositor as cash disbursement. The
debit memos have the effect of decreasing the bank balance.

Errors

Bank reconciling items:

Deposit in transit - are collections already recorded by the depositor as cash receipts but not yet
reflected on the bank statement.

Outstanding checks - are already recorded by the depositor as cash disbursements but not yet
reflected on the bank statement.

Errors

Forms of bank reconciliation

Adjusted balance method

Book to bank method

Bank to book method

The first method is preferred over the two.

Computation of book balance

Balance per book- beginning of the month

xx

add: book debits during the month

xx

total

xx

less: book credits during the month

xx

balance per book end of the month

xx

Computation of bank balance

Balance per bank- beginning of the month

xx

add: bank credits during the month

xx

total

xx

less: bank debits during the month

xx

balance per bank end of the month

xx

Computation of deposit in transit

Deposit in transit- beginning of the month

xx

add: cash receipts deposited during the month

xx

total deposits to be acknowledge by the bank

xx

less: deposits acknowledge by the bank during the month

xx

deposits in transit end of the month

xx

Computation of outstanding checks

Outstanding checks- beginning of the month

xx

add: checks drawn by depositor during the month

xx

total checks to be paid by the bank

xx

less: checks paid by the bank during the month

xx

outstanding checks end of the month

xx

Proof of cash

A proof of cash is an expanded reconciliation in that it includes proof of receipts and

disbursements. This approach may be useful in discovering possible discrepancies in handling
cash particularly when cash receipts have been recorded but have not been deposited.

RECEIVABLES
ACCOUNTS RECEIVABLE

Receivables are financial assets that represent a contractual right to receive cash or another
financial asset from another entity.

Trade receivables refer to claims arising from sale of merchandise or services in the ordinary
course of business. It include accounts receivable and notes receivable.

Initial measurement of receivables

PFRS 9, paragraph 5.1.1, provides that a financial asset shall be recognized initially at fair
value plus transaction costs that are directly attributable to the acquisition.

The fair value of a financial asset is usually the transaction price, meaning, the fair value of
the consideration given.

For short-term receivables, the fair value is equal to the face value or original invoice amount.

For long-term receivables

that are noninterest-bearing, the fair value is equal to the face value.

that are interest bearing, the fair value is equal to the present value of all future cash flows
discounted using the prevailing market rate of interest for similar receivables.

Subsequent measurement of receivables

Subsequently the accounts receivable shall be measured at net realizable value, meaning the
amount of cash expected to be collected or the estimated recoverable amount. Accordingly, in
estimating the net realizable value of trade accounts receivable, the following deductions are
made:

Allowance for freight charge

Allowance for sales return

Allowance for sales discount

Allowance for doubtful accounts

Terms related to freight charge

FOB destination means that ownership of the goods purchased is vested in the buyer upon
receipt thereof. The seller shall be responsible for the freight charge up to the point of
destination.

FOB shipping point means that ownership of the goods purchased is vested in the buyer upon
shipment thereof. The buyer shall be responsible for the freight from the point of shipment to
the point of destination.

Freight collect means that freight charge on the goods shipped is not yet paid. Thus, under
this, the freight charge is actually paid by the buyer.

Freight prepaid means that freight charge on the goods is already paid by the seller.

Accounting for bad debts

Two methods are followed in accounting for this bad debt loss, namely:

Allowance method requires recognition of a bad debt loss if the accounts are doubtful of collection.

Direct write-off method requires recognition of a bad debt loss only when the accounts proved to be
worthless or uncollectible.

Methods of estimating doubtful accounts

Doubtful accounts are recognized when loss is probable and the amount can be estimated
reliably. There are three methods of estimating doubtful accounts, namely:

Aging the accounts receivable or statement of financial position approach

Percent of accounts receivable or also statement of financial position approach

Percent of sales or income statement approach

Impairment assessment

PAS 39, paragraph 64, provides the following detailed guideline in assessing whether accounts
receivable should be considered impaired:

Individually significant accounts receivable should be considered for impairment separately and if
impaired, the impairment loss is recognized.

Accounts receivable not individually significant should be collectively assessed for impairment.

Accounts receivable not considered impaired should be included with other accounts receivable
with similar credit-risk characteristics and collectively assessed for impairment.

NOTES RECEIVABLE

Notes receivable are claims supported by formal promises to pay usually in the form of notes.

Initial measurement of notes receivable

Conceptually, notes receivable shall be measured initially at present value.

Short-term notes receivable are measured at face value.

The initial measurement of long-term notes will depend on whether the notes are interestbearing or noninterest-bearing.

Interest bearing long-term notes are measured at face value which is actually the present value upon
issuance.

Noninterest-bearing long-term notes are measured at present value which is the discounted value of
the future cash flows using the effective interest rate.

Subsequent measurement

Subsequent to initial recognition, long-term notes receivable shall be measured at amortized

cost using the effective interest method.

For long-term noninterest-bearing notes receivable, the amortized cost is the present value
plus amortization of the discount, or the face value minus the unamortized unearned interest
income.

LOAN RECEIVABLE

A loan receivable is a financial asset arising from a loan granted by a bank or other financial
institution to a borrower or client.

Initial measurement of loan receivable

An entity shall measure a loan receivable at fair value plus transaction costs that are directly
attributable to acquisition of the financial asset.

Transaction costs that are directly attributable to the loan receivable include direct origination
costs. Direct origination costs should be included in the initial measurement of the loan
receivable. However, indirect origination costs should be treated as outright expense.

Subsequent measurement of loan receivable

PFRS 9, paragraph 4.1.2, provides that if the business model in managing financial asset is to
collect contractual cash flows on specified dates and the contractual cash flows are solely
payments of principal and interest, the financial asset shall be measured at amortized cost.

Origination fees

The fees charged by the bank against the borrower for the creation of the loan are known as
origination fees.

The origination fees received from borrower are recognized as unearned interest income and
amortized over the term of the loan. The direct origination costs are deferred and also
amortized over the term of the loan.

Accordingly, the origination fees received and the direct origination costs are included in the
measurement of the loan receivable.

RECEIVABLE FINANCING

Receivable financing is the financial flexibility or capability of an entity to raise money out of
its receivables.

The common forms of receivable financing are:

Pledge of accounts receivable

Assignment of accounts receivable

Factoring of accounts receivable

Factoring of accounts receivable

Discounting of notes receivable

Pledge of accounts receivable

When loans are obtained from the bank or any lending institution, the accounts receivable may
be pledged as collateral security for the payment of the loan.

With respect to the pledged accounts, no entry would be necessary. It is sufficient that
disclosure thereof is made in a note to financial statement.

Pledging is GENERAL because ALL ACCOUNTS RECEIVABLE serve as collateral security for the
loan.

Assignment of accounts receivable

In substance, assignment of accounts receivable means that a borrower called the assignor
transfers its rights in some of its accounts receivable to a lender called the assignee in
consideration for a loan.

Actually, assignment is MORE FORMAL TYPE of pledging of accounts receivable.

Assignment is SPECIFIC because SPECIFIC ACCOUNTS RECEIVABLE serve as collateral security

for the loan. The assignor retains ownership of the accounts assigned.

Factoring

Factoring is a sale of accounts receivable on a WITHOUT RECOURSE, NOTIFICATION BASIS. In a

factoring arrangement, an entity sells accounts receivable to a bank of finance entity called a
factor.

Accordingly, a gain or a loss is recognized for the difference between the proceeds received
and the net carrying amount of the receivables factored.

Factoring differs from an assignment in that an entity actually transfers ownership of the
accounts receivable to the factor.

Factoring make take the form of the following:

Casual factoring no accounting problem is encountered in this case. It is an ordinary sale of asset
where the difference between the sakes price and the book value of the asset sold represents gain or
loss.

Factoring as a continuing agreement- where a finance entity purchase all of the accounts receivable of
a certain entity. In this setup, before a merchandise is shipped to a customer, the selling entity request
the factors credit approval

Discounting on note receivable

To discount a note, the payee must indorse it. Thus, legally the payee becomes an endorser
and the bank becomes an endorsee.

Endorsement may be with recourse which means that the endorser shall pay the endorsee if the maker
dishonors the note this is the contingent or secondary liability of the endorser.

Endorsement may be without recourse which means that the endorser avoids future liability even if the
maker refuses to pay the endorsee on the date of maturity.

In the absence of any evidence to the contrary, endorsement is assumed to be with recourse.

Terms related to discounting of note

Net proceeds

Maturity value/ date

Principal

Interest (amount)/ rate

Time

Discount (amount)/ rate/ period

Discounting is treated as a conditional sale

The note receivable discounted account is deducted from the total notes receivable when
preparing the statement of financial position with disclosure of the contingent liability.
Cash

xx

Loss on note receivable

xx

Note receivable discounted

xx

Interest income

xx

Discounting is treated as a secured borrowing

The note receivable is not derecognized nut instead an accounting liability is recorded at an
amount equal to the face amount of the note receivable discounted.
Cash

xx

Interest expense

xx

Liability for note rec. disc.

xx

Interest income

xx

Discounting own note

Where the note discounted is made by the party discounting, a primary liability, not a
contingent liability, exists. In effect, the party discounting is entering into a contract of loan
with the endorsee.
Cash

xx
Discount on note payable

xx

Note payable-bank

xx

INVENOTRIES

PAS 2, paragraph 6, defines inventories as follows:

Inventories are assets which are held for sale in the ordinary course of business, in the process of
production for such sale or in the form of materials or supplies to be consumed in the production
process or in the rendering of services.

Owner of goods in transit

FOB destination, ownership of goods purchased is transferred only upon receipt of the goods by
the buyer at the point of destination. Thus, under FOB destination, the goods in transit are still
the property of the seller.

FOB shipping point, ownership is transferred upon shipment of the goods and therefore, the
goods in transit are the property of the buyer.

Freight terms

Freight collect freight charge is actually paid by the buyer.

Freight prepaid freight is actually paid by the seller.

Statement presentation

The inventories shall be presented as one line item in the statement of financial position but
the details of the inventories shall be disclose in the notes to financial statements.

Accounting for inventories

Two systems are offered in accounting for inventories, namely:

periodic system

perpetual system
In an ideal perpetual system, the stock cards are kept to reflect and control both units and costs.

The periodic system calls for the physical counting of goods on hand at the end of the
accounting period to determine quantities.

The perpetual inventory procedure is commonly used where the inventory items treated
individually represent a relatively large peso investment such as jewelry and cars.

Trade discounts and cash discounts

Trade discounts are deductions from the list or catalog price in order to arrive at the invoice
price which is the amount actually charged to the buyer.

Thus, trade discounts are not recorded.

Cash discounts are deductions from the invoice price when payment is made within the
discount period.

Cash discounts are recorded as purchase discount by the buyer and sales discount by the seller.

Cost of inventories

The cost of inventories shall comprise:

Cost of purchase

Cost of conversion

Other cost incurred in bringing the inventories to their present location and condition.

INVENTORY VALUATION

PAS 2, paragraph 9, provides that inventories shall be measured at the lower of cost and net
realizable value. (LCNRV)

Cost formulas

PAS 2, paragraph 25, expressly provides that the cost of inventories shall be determined by
using either:

First in, first out

Weighted average

Net realizable value

Net realizable value or NRV is the estimated selling price in the ordinary course of business less
the estimated cost of completion and the estimated cost of disposal.

If the cost is lower than net realizable value, there is no accounting problem because the
inventory is stated at cost and the increase in value is not recognized.

If the net realizable value is lower than cost, the inventory is measured at net realizable value.
In this case, the problem is the proper treatment of the writedown of the inventory to net
realizable value.

There are two methods of accounting for the inventory writedown, namely:

direct method - The inventory is recorded at the lower of cost or net realizable value. This method is
also known as cost of goods sold method because any loss on inventory writedown is not accounted
for separately but buried in the cost of goods sold.

allowance method - The inventory is recorded at cost and any loss on inventory writedown is
accounted for separately. This method is also known as loss method because a loss account loss on
inventory writedown is debited and a valuation account allowance for inventory writedown is
credited.

Standard costs

Standard costs are predetermined product costs established on the basis of normal levels of
material and supplies, labor, efficiency and capacity utilization.

PAS 2, paragraph 21 states that the standard cost method may be used for convenience if the
results approximate cost.

Relative sales price method

When different commodities are purchased at a lump sum, the single cost is apportioned
among the commodities based on their respective sales price. This is based on the philosophy
that cost is proportionate to selling price.

Purchase commitments

Purchase commitments are obligations of the entity to acquire certain goods sometime in the
future at a fixed price and fixed quantity.

Agricultural, forest and mineral products

PAS 2, paragraph 4, provides that inventories of agricultural, forest and mineral products are
measured at net realizable value at certain stages of production.

Commodities of broker-traders

PAS 2, paragraph 3, provides that commodities of broker-trader are measured at fair value less
cost of disposal.

BIOLOGICAL ASSETS

PAS 41 Agriculture

PAS 41 shall be applied to account for the following when they relate to agricultural activity:

Biological assets

Agricultural produce

Government grant related to a biological asset

Note that PAS 41 is applied to agricultural produce at the point of harvest. Thereafter, PAS 2 on
inventories shall be applied.

Biological assets are living living animals and living plants.

Agricultural produce is the harvested product of an entitys biological assets.

Harvest is the detachment of produce from a biological asset or the cessation of a biological
assets life processes.

Features of agricultural activity

Capability to change living animals and plants are capable of biological transformation.

Management of change the agricultural activity must be managed to facilitate the biological
transformation by enhancing or at least stabilizing conditions necessary for the process to take place.
- Harvesting from unmanaged sources, such as ocean fishing and deforestation, is

not agricultural activity.

Measurement change the change in quality or quantity brought about by biological transformation or
harvest is measured and monitored as a routine management function.

Recognition

An entity shall recognize a biological asset or agricultural produce when:

The entity controls the asset as a result of past events.

It is probable that future economic benefits associated with the asset will flow to the entity.

The fair value or cost of the asset can be measured reliably.

Measurement

A biological asset shall be measured on initial recognition and at the end of each reporting
period at fair value less costs of disposal.

Agricultural produce shall be measured at fair value less costs of disposal at the point of harvest.

Costs of disposal

Costs of disposal are the incremental costs directly attributable to the disposal of an asset.

Under the Basis for Conclusions on PAS 41, costs of disposal exclude transport costs, finance costs
and income taxes.

Financial statement presentation

In the year-end statement of financial position, the biological assets shall be presented as a
separate line item at the fair value less costs of disposal and classified as noncurrent asset.

The income statement for the current year would show gain from change in fair value.

INVENTORY VALUATION

In many cases, it is necessary to know the approximate value of inventory when it is not possible
to take a physical count, or even if the physical count is possible, the same may prove costly,
difficult or inconvenient at the moment.

GROSS PROFIT METHOD

The gross profit method is based on the assumption that the rate of gross profit remains
approximately the same from period to period and therefor the ratio of cost of goods sold to net
sales is relatively constant from period to period.

Sales allowance and sales discount

Sales allowance and sales discount are ignored, that is, not deducted from sales. The reason is
that while these items decrease the amount of sales, they do not affect the physical volume of
goods sold.

Sales allowance and sales discount do not increase the physical inventory of goods, unlike in
sales return where there is an actual addition to goods on hand.

RETAIL INVENTORY METHOD

PAS 2, paragraph 22, provides that this method is often used in the retail industry for measuring
inventory of large number of rapidly changing items with similar margin for which it is
impracticable to use other costing method.
Goods available for sale @retail or selling price

xx

Less: net sales(gross sales less sales return only)

(xx)

Ending inventory @ selling price

xx

Multiply by cost ratio

xx

Ending inventory @ cost

xx

Cost ratio

= goods available for sale @ cost

Goods available for sale @selling price

Treatment of items

Purchase discount deducted from purchase at cost only

Purchase return deducted from purchases at cost and at retail.

Purchase allowance deducted from purchase at cost only.

Freight in addition to purchase at cost only.

Departmental transfer in or debit addition to purchase at cost and retail.

Departmental transfer out or credit deduction from purchases at cost and retail.

Sales discount and sales allowance disregarded, meaning, not deducted from sales.

Sales return deducted from sales.

- If the discount is sales return and allowance, the same should be deducted from sales.

Employee discount added to sales.

- Employee discounts are special discounts usually not recorded because they are directly
deducted from the sales price.
- Only the net sales price is recorded. Consequently, the amount of sales is understated.
Thus, the employee discounts are added back to sales.

Normal shortage, shrinkage, spoilage, breakage this is deducted from goods available for sale at retail.
- Any normal shortage is usually absorbed or included in cost of goods sold.

Abnormal shortage, shrinkage, spoilage, breakage this is deducted from goods available for sale at both
cost and retail so as not to distort the cost ratio.
- Any abnormal amount is reported separately as loss.

Items related to retail method

Initial markup

Original retail

Additional markup

Markup cancellation

Net additional markup or net markup

Markdown

Markdown cancellation

Net markdown

Maintained markup

Approaches in the use of retail method

Conservative or conventional or LCNRV approach includes net markup and excludes net markdown in
determining the cost ratio in order to arrive a conservative cost.

Average cost approach includes both net markup and net markdown in determining cost ratio.

FIFO approach is similar to the average cost approach in that it considers both net markup and net
markdown in arriving at the goods available for sale at retail to serve a basis in computing the cost ratio.