RECOGNITION AND MEASUREMENT Concepts and Principles

RECOGNITION AND MEASUREMENT (Concepts and Principles) of ELEMENTS of Financial Statements

IFRS/PFRS sets out recognition and measurement requirements dealing with transactions and events.

Recognition Concepts

• Definition of Recognition 

Recognition is the process of incorporating in the statement of financial position or income statement an item that meets the definition of an element and satisfies the criteria for recognition.

An item that meets the definition of an element should be recognized if:

a. it is probable that any future economic benefit associated with the item will flow to or from the entity; and 

b. the item has a cost or value that can be measured with reliability.  

• Recognition of Assets  

An asset is recognized in the statement of financial position when:

a. it is probable that any future economic benefits will flow to the entity; and 

b. asset has a cost or value that can be measured reliably.  

• Recognition of Income

Income is recognized in the income statement when an increase in future economic benefits related to an increase in an asset or a decrease of a liability has arisen that can be measured reliably.

This means, in effect, that recognition of income occurs simultaneously with the recognition of increases in assets or decreases in liabilities. For example, the net increase in assets arising on a sale of goods or services or the decrease in liabilities arising from the waiver of a debt payable. 

Realization Principle 

Realization principle is also known as the Revenue Recognition principle. 

Realization principle guides when to recognize the revenue. 

GAAP requires that two criteria must be satisfied in recognizing revenue...read more

• Recognition of Expenses    

Element is recognized in the income statement when a decrease on future economic benefits related to a decrease in an asset or an increase of a liability has arisen that can be measured reliably.  

This means, in effect, that recognition of expenses occurs simultaneously with the recognition of an increases in liabilities or a decrease in assets. For example, accrual of employee entitlements or the depreciation of equipment.

Matching Principle 

Matching principle states that expenses are recognized in the same period as the related revenues are recognized.  Meaning, expenses recognition is driven by a matching process. 

There’s a relationship between the realization principle and matching principle.  When revenue is recognized in a particular period, all the expenses incurred in generating such revenue must also be recognized...read more

Measurement Principles

• Definition of Measurement 

Measurement is the process of determining the monetary amounts at which the elements of the financial statements are to be recognized and carried in the statement of financial position and income statement.

This involves the selection of the particular basis of measurement.  A number of different measurement bases are employed to different degrees and in varying combinations in financial statements. 

Measurement bases are the following: 

• Historical Cost 

Assets are recorded at the amount of cash or cash equivalents paid or the fair value of the consideration given to acquire them at the time of their acquisition.

Liabilities are recorded at the amount of proceeds received in exchange for the obligations, or in some circumstances at the amounts of cash or cash equivalents expected to be paid to satisfy the liability in the normal course of business. 

Historical Cost Principle 

PAS and GAAP recognized that elements of Assets and Liabilities are measured based on their original transaction value.  And, this is their historical cost...read more 

• Current Cost 

Assets are carried at the amount of cash or cash equivalents that would have to be paid if the same or an equivalent asset was acquired currently.

Liabilities are carried at an undiscounted amount of cash or cash equivalents that would be required to settle the obligation currently.   

• Realizable (settlement) Value 

Assets are carried at the amount of cash or cash equivalents that could currently be obtained by selling the asset in an orderly disposal. 

Liabilities are carried at their settlement values; that is, the undiscounted amounts of cash or cash equivalents expected to be paid to satisfy the liabilities in the normal course of business.

• Present Value   

Assets are carried at the present discounted value of the future net cash inflows that the item is expected to generate in the normal course of business. 

Liabilities are carried at their present discounted value of the future net cash outflows that are expected to be required to settle the liabilities in the normal course of business.

Source: IFRS-PFRS

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Relationships among the Financial Statements

Relationships Among the Financial Statements

Naming or identification of account

A bookkeeper must remember that an Account Name or Account Title is the assigned name or title to a group of values in business transactions which have or bears the same / similar nature, function or character pertaining to one item only.

Meaning, a bookkeeper must assign a name or a title to a grouping of values pertaining to one item only.  Say, a coin, a paper money, checks, bank drafts, or money orders are received or paid. These items pertain to one item only and they are described as Cash. So, assign them the account name or title Cash. In other words, identify them as Cash Account. Other practitioners, uses the account name Cash and Cash Equivalents for Cash Account.  Another example, computers, adding machines, calculators, and filing cabinets pertain to one item only and can be represented as Office Equipment.

This process is called identification of accounts.  The moment an account name or title has already been designated or identified or assigned to a grouping of values, such account becomes identical to the items pertaining to the similar items in the grouping of values.  For instance, the account assigned to cash items becomes known or identified as Cash Account or Cash and Cash Equivalents Account.  Similarly, the account for office equipments becomes identified or known as Office Equipment Account.

The skill or ability to recognize or identify the account name or title of values parted with or values received is a very significant factor in the performance of the work of bookkeeping and accounting. Thus, the bookkeeper must familiarize himself with account names or titles.

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Classification of Accounting Elements

Accounting Elements are classified into the following:

• Real Accounts
• Nominal Accounts

Real Accounts 

They are the accounting elements of  Statement of Financial Position and are reported therein, to wit:

• Assets 

• Liabilities

• Equity

They are permanent accounts and are not closed at the end of accounting period. Thus, they are called open accounts.

Nominal Accounts

They are the accounting elements which comprise the Income Statement and they are the following:

• Revenues 

• Expenses

They are called temporary accounts because they are put to a zero balance or are closed at the end of accounting period.

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OBJECTIVE OF FINANCIAL STATEMENTS

The objective of financial statements is to provide information about the financial position, performance and changes in financial position of an entity that is useful to a wide range of users in making economic decisions.

Introduction to Elements of Financial Statements

Accounting Elements and their definition

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

These broad classes are termed the elements of financial statements.

The following are the basic accounting elements mentioned in PAS No. 1:

The elements which directly related to the measurement of financial statements are as follows (Statement of Financial Position elements):

• Assets  – These are any tangible and intangible property owned by the business organization that has a monetary value.

• Liabilities  – These are amounts owed to outside creditors.

• Equity  – It is the residual claim against the assets of the business after the total liabilities are deducted. 

The elements directly related to the measurement of profit are the following (Income Statement elements):

• Revenues  – These are the gross earnings of the business as a result in selling of goods or rendering of services. 

• Expenses  – These are the costs incurred or consumed in the process of producing revenues. Other items of expenses, costs incurred, and/or losses that are directly related to the principal operations of the business.

Classification of Accounting Elements

Statement of Financial Position elements are classified as Real Accounts

While, Income Statement elements are classified as Nominal Accounts

...read more

Examples of Accounting Elements and their definition

Click each accounting elements to read examples and their definition.

• Asset elements and examples

• Liability elements and examples

• Equity elements and examples

• Revenue elements and examples 

• Expense elements and examples

Naming or identifying which account to be used 

A bookkeeper must remember that an Account Name or Account Title is the assigned name or title to a group of values in business transactions which have or bears the same / similar nature, function or character pertaining to one item only.

Meaning, a bookkeeper must assign a name or a title to a grouping of values pertaining to one item only.

Say, a coin, a paper money, checks, bank drafts, or money orders are received or paid. These items pertain to one item only and they are described as Cash. So, assign them the account name or title Cash. In other words, identify them as Cash Account. Other practitioners use the account name Cash and Cash Equivalents for Cash Account.

Another example, computers, adding machines, calculators, and filing cabinets pertain to one item only and can be represented as Office Equipment.

This naming process is called identification of accounts...read more

Note: Click the subjects/topics to read the discussion 

Career Opportunities in Accounting Profession

Career Opportunities in Accounting Profession

The Basic Financial Statements and their definition

Philippine Accounting Standards (PAS) No. 1 mentions basic financial statements as follows:

• Statement of Financial Position

• Income Statement

• Statement of Changes in Equity

• Cash Flow Statement

• Notes to Financial Statements

• Full-disclosure Principle

IFRS refers the above as a complete set of financial statements.

Statement of Financial Position

Statement of Financial Position (SFP) is formerly known as Balance Sheet. 

SFP shows the financial condition or position of the organization at any given time.  

The elements of Statement Financial Position comprises assets, liabilities and owner’s equity.

Income Statement

Results of operating the business during a given time are reflected in the Income Statement.  

The elements of Income Statement are Revenues and Expenses.

Statement of Changes in Equity

Statement of Changes in Equity shows movements of owner's capital for a particular period. 

The following comprise Statement of Changes in Equity:

• Owner's investments (capital) to the organization    
• Profit or Loss for the period
• Owner's personal withdrawals
• Prior Period Adjustments 

Cash Flow Statement

Cash Flow Statement reflects the financing and investing activities of the business or the sources and applications of funds during the period. 

It also shows the changes of cash and cash equivalents during the period. Note that cash equivalents are those short-term, highly liquid investments which are easily convertible to cash.   

This statement lists all the cash inflows and outflows, and classifies them as cash flows from the following:

• Operating Activities - Cash inflows and outflows from normal operating activities of the entity.

• Investing Activities - Cash inflows and outflows from the sale or purchase of assets other than inventory.

• Financing Activities - Cash inflows and outflows from the owners and creditors of the organization.

Notes to Financial Statements

Notes to Financial Statements are supplied to achieve proper understanding of the financial statements. 

Notes to Financial Statements are placed on the face of the Financial Statements in the form of parenthetical disclosure. Or, as notes to financial statements which are shown in a different accounting report. 

Full Disclosure Principle

The full-disclosure principle means that the financial reports must include any information that could affect the decisions to be made by external users...read more 

The end-products of financial accounting processes are the financial statements.  The preparation of financial statements is the reason why a business organization must maintain bookkeeping or accounting systems.

Financial Statements cannot be done without the groundworks of bookkeeping because the financial data starts with analyzing, classifying and recording of business transactions.

Financial Statements particularly audited ones are the basis of Government Agencies and Bureaus when examining the financial records of the company.

Periodically, Government Agencies and Bureaus require businesses to submit, pay and file taxes and dues on or before the set deadlines. The basis of the figures to be filed are the financial statements prepared monthly.

Small and Medium Entity (SME) Criterion

The Philippine Securities and Exchange Commission (SEC), in its En Banc Resolution dated August 13, 2009, adopted a definition of "small and medium entities" that includes a size criterion.

An entity is an SME if:
a.  The entity has total assets of between P3 Million and P350 Million or total liabilities of between P3Million and P250 Million;
b.  It is not required to file financial statements under SRC Rule 68.1;
c.  It is not in the process of filing its financial statements for the purpose of issuing any class of instruments in a public market;
d.  It is not a holder of a secondary license issued by a regulatory agency, such as bank (all types of banks), an investment house, a finance company, an insurance company, a securities broker/dealer, a mutual fund and a pre-need company; and
e.  It is not a public utility.



Source:  Guide to PFRS for SMEs 2010 Edition

Full-disclosure Principle

The full-disclosure principle means that the financial reports must include any information that could affect the decisions to be made by external users.

Supplemental information is disclosed as follows:

1.Parenthetical comments or modifying comments
   - these comments are placed on the face of the financial statements.

2.Disclosure notes
   - convey additional undertakings regarding company operations.

3.Supplemental financial statements
   - report more information than is shown in the primary financial statements.


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Matching Principle

Matching principle gives guidance as to when expenses are recognized.

Matching principle states that expenses are recognized in the same period as the related revenues are recognized.  Meaning, expenses recognition is driven by a matching process.

There’s a relationship between the realization principle and matching principle.  When revenue is recognized in a particular period, all the expenses incurred in generating such revenue must also be recognized.

Note that not all expenses are directly caused by generating revenues. There are expenses which are incurred but indirectly associated to generate revenue.

Approaches in recognizing expenses are as follows:

1. Some expenses are recognized based on the exact cause-and-effect between revenue and expense event. 

There is a cause-and-effect relationship or direct relationship between revenues and expenses.
Such expenses pertain to the cost to sell or cost to produce goods and services. 

These are the cost of service or cost of goods sold or cost of sales. 

Another example for this approach is the sales commission paid for obtaining revenues.

2.  By associating the expenses with the revenues recognized in a particular period. 

There are expenses which are not directly cause by a revenue event.  However, some expenses can be related to the time period during which the revenue is earned.

For example, the monthly salary paid to employees is not directly associated to any revenue event. Employees render services during the month and indirectly relate to the recognized revenue in that period.

3.  By systematic and rational allocations to specific time periods. 

Some expenses are recognized or allocated to a specific time period.  There are costs which are incurred to acquire assets that benefit more than one reporting period.  Such costs are systematically and rationally allocated periodically. 

Examples are the systematic and rational allocations of some prepaid expenses, depreciation and amortization expenses.

4.  In the period incurred, without regard to related revenues.  

This approach is called for in situations when costs are incurred but it is not possible to determine in which time periods to recognize.   

Example is the marketing and advertising expenses.  It is difficult to determine how much is expended in generating incremental revenues.  Because of this, such marketing and advertising expenditures are recognized at the period they are incurred.

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Realization Principle

Realization principle is also known as the Revenue Recognition principle.

Realization principle guides when to recognize the revenue.

GAAP requires that two criteria must be satisfied in recognizing revenue:

1.The earnings process is judged to be completed or virtually complete.
2.There is reasonable certainty as to the collectability of the asset (usually cash) to be received.

In short, Revenue must be recognized the earnings process is virtually complete and collection is reasonably assured.

The primary earning activity which triggers revenue recognition is known as the critical event.  The critical event for many organizations occurs at the point of sale.  This usually happened when the goods are delivered or title and ownership is transferred to the buyer, or the services is already rendered or performed.

The timing of revenue recognition is a key element in the measurement of earnings.  In preparation of financial statements, the income must be reported at the proper time period otherwise, this may result to overstatement or understatement of revenue and net income. Hence, the revenue recognition criteria helps ensure that proper recording is made.

Note that the revenue recognition allows the implementation of the accrual accounting model, where revenue must be reported in the period when it is earned, not necessarily when the cash is actually received.

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Historical Cost Principle

Historical Cost Principle

PAS and GAAP recognized that elements of Assets and Liabilities are measured based on their original transaction value.  And, this is their historical cost.

For asset, this is the exchange or transaction value given for the asset at the point of acquisition.

For liabilities, it is the current cash equivalent received at the time when assuming the liability.

In other words, historical cost principle states that the measurement of asset or liability must be based on the amount given or received in the exchange transaction.

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