“PFRS financial statements: pitfalls and fortunes [part 1 of 2]” by Armin Darel F. Tulio (February 14, 2011)

Suits the C-Suite By Armin Darel F. Tulio
Business World (02/14/2011)

(First of two parts)
Philippine Accounting Standards (PAS) No. 1, Presentation of Financial Statements, describes financial statements as “structured representations that 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 economic decisions.”

They are further described as “the results of management’s stewardship of the resources entrusted to it.”

Philippine Financial Reporting Standards (PFRS) govern the preparation of financial statements which must meet the information needs of stakeholders with a basic grasp of finance and economics.

Financial statements should be understandable, relevant, reliable and comparable. Such statements must be “relevant,” in that they must help users in decision-making; “reliable,” because information must be free from material error and bias; and “comparable,” since users must be able to distinguish accounting policies used for similar transactions by the same enterprise from period to period.

However, with business transactions becoming more complex, the application of accounting rules has become decidedly complicated. As such, judgments, assumptions and estimations in preparing the financial statements are likewise challenged.

Moreover, because of regulatory requirements and the evolution of accounting standards, the number of required disclosures has multiplied, overwhelming readers with information found in the financial statements. This article attempts to help readers understand certain aspects of the PFRS financial statements.

The basic PFRS financial statements consist of the statement of financial position, statement of comprehensive income, statement of cash flows, statement of changes in equity and explanatory notes.

Statement of financial position

This is a snapshot of the financial condition of an entity at a specific point in time.

It provides an overall view of the entity’s financial decisions — obtaining financing, capital spending and the cumulative effect of these decisions. It begins with the classic balanced accounting equation “assets minus liabilities equals equity.”

Statement of comprehensive income

In lieu of the statement of income, a statement of comprehensive income is introduced.

“Income and expenses” do not only consist of classical accounting terms such as revenue, cost of goods sold and operating expenses. Income and expenses recognized in the statement of comprehensive income now include certain unrealized fair value changes in net assets that affect the entity’s overall performance in its broadest sense.

These changes in net assets may directly be recognized in equity, such as fair value gains and losses on re-measuring available-for-sale financial assets and certain hedging transactions.

Statement of cash flows

Even if the statement of comprehensive income paints a rosy picture of an entity’s operations, the statement of cash flows may indicate otherwise.

After all, a net income position does not necessarily translate to liquidity.

As the name implies, the statement of cash flows shows cash movements into and out of the entity, with such movements being categorized as operating, investing and financing. This statement reveals if the entity is able to generate or source sufficient cash flows to fund both its current operations and long-term growth.

Statement of changes in equity

This statement summarizes the various components of equity and how these components have changed.

It also shows retained earnings, or the entity’s cumulative profit or loss, which may be distributed to stockholders as dividends.

It also covers activities such as issuances of new shares to raise fresh capital and redemption of the entity’s own stocks reflected as treasury shares.

Notes to financial statements

To fully understand the statements of financial position, comprehensive income, cash flows and equity, users must be aware of the underlying details provided in the explanatory notes.

Reading the notes increases one’s appreciation of the information and transaction details in the financial statements, as companies may use different methods to account for similar transactions.

A word of caution

All assets and liabilities in a statement of financial position are subject to some assumptions, judgments and estimates.

Readers should bear in mind that the amounts presented as assets are not entirely precise.

Following are some possible common misconceptions.

One common misconception is that valuation of cash is straightforward — that cash is cash.

However, we often come across the term “cash equivalents.” How are cash investments different from cash equivalents?

For a cash investment to qualify as cash equivalent, it must be readily convertible to a known amount of cash and with an insignificant risk of change in value.

However, the standard does not provide a quantitative threshold for “insignificant risk of change in value.”

Normally, only an investment with short maturity, e.g. three months or less from the date of acquisition, qualifies under the definition of a cash equivalent.

However, even a short-term cash investment may not qualify as cash equivalent if its fair value is subject to significant uncertainty, like investments in traded shares.

The general principles provided by PFRS in determining cash equivalents render this asset susceptible to judgment.

Another trap is the measurement of cash denominated in a foreign currency.

Foreign currency-denominated cash and cash equivalents are converted to their peso equivalent at the closing exchange rate as of reporting end (e.g., closing rate as of Dec. 31 for a calendar yearend company).

However, it does not mean that these foreign currency-denominated cash and cash equivalents could have been or can be converted at the stated rate, especially since financial statements are released weeks or months after the reporting period ends. By that time, a significant currency appreciation or devaluation may have occurred.

There are still a number of judgments and assumptions involved in the financial statements preparation.
The second part of this article will further explore and explain these accounting conventions.

(Armin Darel F. Tulio is a Senior Director of SGV & Co.)

This article was originally published in the BusinessWorld newspaper. It is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.