“PFRS financial statements: pitfalls and fortunes [part 2 of 2]” by Dhonabee B. Señeres (February 21, 2011)

SUITS THE C-SUITE By Dhonabee B. Señeres
Business World (02/21/2011)

(Second of two parts)

In last week’s column, we covered certain aspects of the financial statements prepared in compliance with the Philippine Financial Reporting Standards (PFRS). This article continues with a discussion of some of the traps and pitfalls of the other components of the basic financial statements.

Inventories

Inventories vary according to the nature of the business. An inventory item for one entity may be a fixed asset for another. For instance, a real estate company’s inventories consist of land and buildings that are normally classified in other companies’ statement of financial position as property, plant and equipment. The key differentiator is that inventories are goods or services that are sold in the ordinary course of business, while a fixed asset is used to manufacture the inventories or facilitate the rendering of service.

Regardless of the nature of the business, entities have to adjust inventories for obsolescence (for example, wear and tear) to reduce these to their “net realizable value” (NRV). PFRS defines NRV as “…the estimated selling price in the ordinary course of business, less the estimated costs of completion and the estimated costs necessary to make the sale.” Determining NRV is an estimation process and can sometimes be difficult to substantiate because making a sale is always a fundamental business risk.

Accounts receivable

A manufacturing business normally involves the purchase and production of inventory, which may then be sold on account and recognized as accounts receivable in an entity’s statement of financial position. For sales made to customers, once cash is collected, the receivable is de-recognized, the cash received is recorded, and the business cycle begins again.

Converting receivables to cash is also a fundamental credit risk. Accounting standards require that accounts receivable should be recorded net of any estimated uncollectible portion, with the ultimate objective of reporting receivables at the amount expected to be collected in cash.

Valuation of receivables involves both specific and collective impairment assessments. Specific impairment involves identifying specific uncollectible amounts based on the entity’s relationship or experience with a particular customer and the customer’s credit risk. It also involves determining the present value of expected future collections on individually significant accounts. After performing specific impairment testing, collective impairment testing is also done on groups of individually insignificant customer accounts (including significant accounts without impairment provisions) with the same credit exposure and characteristics. Both assessments are complex exercises and require prudence, since effective management of accounts receivable is critical to cash flow. For an efficient assessment, an entity would need a very effective accounting information system that collects and aggregates customer data on credit and collection history.

Property, plant and equipment

Companies spend millions on property, plant and equipment (PPE), since these assets promote business viability, competitiveness and long-term growth. In analyzing PPE, one should first consider whether these assets are carried at historical cost or at revalued amount less accumulated depreciation and impairment loss. At revalued amount, the asset is measured at fair value, which is usually the market value determined by an appraiser.

PPE measured at historical cost are reviewed for possible decline in value (impairment) whenever there is a significant change in asset utility or business operations. If there are indications that asset value has declined, the asset’s recoverable amount must be determined. If it is lower than the recorded amount of the asset, an impairment loss (i.e., write down in asset value) should be recognized.

For assets without a readily available fair market value, the company needs to determine the asset’s value in use (VIU). Determining VIU is a complex and highly judgmental exercise which involves estimating future cash flows expected to be derived from the continued use of the asset over its remaining useful life, and from its ultimate disposal. The company then has to apply an appropriate discount rate to bring those estimated future cash flows to present value.

Another judgmental aspect of accounting is estimating the useful life over which the asset will be depreciated and the residual value, which is essentially salvage or scrap value. The estimation is usually driven by the nature and expected use of the asset and industry practice.

Provisions and contingencies

Unlike trade payables which are invoiced liabilities for goods and services received, and are certain as to timing and amount, provisions are reliably estimable liabilities that are uncertain as to the timing and amount of future expenditures required in settlement. On the other hand, contingent liabilities are not recognized in the financial statements because either settlement is unlikely or the settlement amount cannot be reliably estimated. The challenge is determining at which point a claim against the company would require the recognition of a provision.

Lawsuits are the best example of this. A lawsuit against a company for past transactions does not mean a provision for losses has to be recognized. A provision would be required only if management expects an unfavorable outcome and the amount of loss can be estimated reliably. Evaluating the probability of an unfavorable outcome would require the legal counsel’s opinion of the case’s merits, precedents established by similar cases, and management’s planned response to the claim.

Goodwill

When an entity acquires 100% ownership and control over a business, goodwill is initially recorded as the excess of the purchase price (excluding transaction costs) over the fair values of the assets and liabilities of the acquired entity. These fair values must be carefully established as they directly affect the amount of goodwill to be recognized. Goodwill determination can get complicated if there is a non-controlling interest and if the acquisition is done in stages rather than in one single transaction.

Like other assets, goodwill is subjected to a recoverability test. Since it does not generate cash on its own and cannot be sold separately, it is tested for impairment together with other assets. What is critical here is determining which particular asset or group of assets, referred to in accounting as the “cash generating unit,” the goodwill is identified with and will be used to estimate future cash flows.

While the statement of financial position presents all the assets of a company, it fails to capture one of the company’s most valuable resources — its people. Human assets cannot be tracked or recorded on a balance sheet — it requires wisdom on the part of management to maximize the knowledge, skills and capabilities of the employees. The statement of financial position likewise fails to include internally generated intangible assets such as customer lists and perhaps the relationships that have been built with customers.

As in the case of last week’s article, these are some of the judgments and assumptions involved in the preparation of PFRS-compliant financial statements. While we have tried to describe them in the simplest possible terms, the entire process of preparing and publishing the financial statements remains a multifaceted and complex discipline.

(Dhonabee B. Señeres 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.