CHAPTER 7: Notes – Part 1

Notes
The notes (or notes to the financial statements) provide information in addition to those presented in the other financial
statements. It is an integral part of a complete set of financial statements.
PAS 1 requires an entity to present the notes in a systematic manner. Notes are normally structured as follows:
1. General information on the reporting entity.
2. Statement of compliance with the PFRSS and Basis of preparation of financial statements.
3. Summary of significant accounting policies.
4. Disaggregation (breakdowns) of the line items in the other financial statements and other supporting
information.
5. Other disclosures required by PFRSS, such as (the list is not exhaustive):
a. Contingent liabilities and unrecognized contractual commitments.
b. Non-financial disclosures, e.g., the entity's financial risk management objectives and policies.
c. Events after the reporting date, if material.
d. Changes in accounting policies and accounting estimates and corrections of prior period errors.
e. Related party disclosure.
f. Judgments and estimations.
g. Capital management.
h. Dividends declared after the reporting period but before the financial statements were authorized for issue,
and the related amount per share.
i. The amount of any cumulative preference dividends not recognized.
6. Other disclosures not required by PFRSS but the management deems relevant to the understanding of the
financial statements.

Accounting policies
Accounting policies are "the specific principles, bases, conventions, rules and practices applied by an entity in preparing
and presenting financial statements." (PAS 8.5)

Changes in Accounting Policies

 PAS 8 requires the consistent selection and application of accounting policies.
 PAS 8 permits a change in accounting policy only if the change:
a. is required by a PFRS; or
b. results in reliable and more relevant information
 A change in accounting policy usually results from a change in measurement basis. Examples of changes in
accounting policies:
a. Change from FIFO to the Weighted Average cost formula for inventories.
b. Change from the cost model to the fair value model of measuring investment property.
c. Change from the cost model to the revaluation model of measuring property, plant, and equipment and
intangible assets.
d. Change in business model for classifying financial assets.
 e. Change in the method of recognizing revenue from long-term construction contracts.
f. Change to a new policy resulting from the requirement of a new PFRS.
g. Change in financial reporting framework, such as from PFRS for SMEs to full PFRSS.
 The following are not changes in accounting policies:
a. the application of an accounting policy for transactions, other events or conditions that differ in substance from
those previously occurring
b. the application of a new accounting policy for transactions, other events or conditions that did not occur
previously or were immaterial

Accounting for Changes in Accounting Policies

Changes in accounting policies are accounted for using the following order of priority:
1. Transitional provision in a PFRS, if any.
2. Retrospective application, in the absence of a transitional provision.
3. Prospective application, if retrospective application is impracticable.

Retrospective Application
 Retrospective application means adjusting the opening balance "of each affected component of equity (e.g.,
retained earnings) for the earliest prior period presented and the other comparative amounts disclosed for each
prior period presented as if the new accounting policy had always been applied." (PAS 8.22)
 If retrospective application is impracticable for all periods presented, the entity shall apply the new accounting
policy as at the beginning of the earliest period for which retrospective application is practicable, which may be the
current period. If retrospective application is still impracticable as at the beginning of the current period, the entity
is allowed to apply the new accounting policy prospectively from the earliest date practicable.
 Impracticable means it cannot be done after making every reasonable effort to do so.

Voluntary change in accounting policy

 An entity may adopt a pronouncement of other standard-setting body (e.g., U.S. GAAP issued by the FASB) in the
absence of a PFRS that specifically applies to a transaction. If later on the other standard-setting body amends the
adopted pronouncement and the entity decides to adopt the amended version, such event is called a voluntary
change in accounting policy.
 A voluntary change in accounting policy is accounted for by retrospective application.
 An early application of a PFRS is not a voluntary change in accounting policy.

Change in reporting entity

SFAS No. 154 (US GAAP) issued by the FASB defines a change in reporting entity as "a change that results in financial
statements that, in effect, are those of a different reporting entity. A change in the reporting entity is limited mainly to
(1) presenting consolidated or combined financial statements in place of financial statements of individual entities, (2)
changing specific subsidiaries that make up the group of entities for which consolidated financial statements are
presented, and (3) changing the entities included in combined financial statements."
Changes in Accounting Estimates
Many items in the financial statements cannot be measured with precision but only through estimation because of
uncertainties inherent in business activities. The use of reasonable estimates therefore is necessary in order to provide
relevant information. Estimates are an essential part of financial reporting and do not undermine the reliability of
financial reports. For example, the following necessarily requires estimation:
a. net realizable value of inventories;
b. depreciation;
c. bad debts;
d. fair value of financial assets or financial liabilities; and
e. provisions.
A change in accounting estimate is "an adjustment of the carrying amount of an asset or a liability, or the amount of the
periodic consumption of an asset, that results from the assessment obligations associated with, assets and liabilities.
Changes in the present status of, and expected future benefits and Accounting estimates result from new information or
new developments and, accordingly, are not corrections of errors." (PAS 5.5)

If a change is difficult to distinguish between these two, the change is treated as a change in an accounting estimate.
Examples of changes in accounting estimates:
a. Change in depreciation or amortization method
b. Change in estimated useful life or residual value of a depreciable asset
c. Change in the required balance of allowance for uncollectible accounts or impairment losses
d. Change in estimated warranty obligations and other provisions

Accounting for Changes in Accounting Estimates

Changes in accounting estimates are accounted for by prospective application. Prospective application means
recognizing the effects of the change in profit or loss, either in:
a. the period of change; or
b. the period of change and future periods, if both are affected.
Errors
 Errors include misapplication of accounting policies, misinterpretations of facts, mathematical mistakes, oversights
or and fraud.
 "Financial statements do not comply with PFRSS if they contain either material errors or immaterial errors made
intentionally to achieve a particular presentation of an entity's financial position, financial performance or cash
flows."
 Material errors are those that cause the financial statements to be misstated. Intentional errors are fraud. In the
case of fraud, it does not matter whether the error is material or immaterial. Fraudulent financial reporting does not
comply with PFRSS.
 Errors can be errors of commission or errors of omission. An error of commission is doing something wrong while an
error of omission is not doing something that should have been done.
 The types of errors according to the period of occurrence are as follows:
a. Current period errors - are errors in the current period that were discovered either during the current period or
after the current period but before the financial statements were authorized for issue. These are corrected
simply by correcting entries.
b. Prior period errors - are errors in one or more prior periods that were only discovered either during the current
period or after the current period but before the financial statements were authorized for issue. These are
corrected by retrospective restatement.

Retrospective Restatement
Retrospective restatement means:
a. restating the comparative amounts for the prior period(s) presented in which the error occurred; or
b. if the error occurred before the earliest prior period presented, restating the opening balances of assets, liabilities
and equity for the earliest prior period presented.

 "Books still open" means that closing entries have not yet been made. Accordingly, nominal accounts can still be
used in correcting entries.
 "Books closed" means that closing entries have already been made. Consequently, nominal accounts cannot be used
anymore. Instead, correcting entries are made by use of real accounts only.

Types of errors
It is nearly impossible to make a complete list of the errors made in accounting. Even right now, as you are reading this
book, someone, somewhere, might be committing an entirely new accounting error that no one had ever dared to
imagine.
Nonetheless, we will make a broad classification of accounting errors into the following:
1. Errors in principle - these arise from lack of knowledge of accounting standards or procedures, misuse of available
information, or misinterpretation of accounting standards, whether intentional or unintentional. Intentional errors
are called "fraud." Intentional misstatement of financial statements is called "fraudulent financial reporting."
2. Clerical and similar errors - these include mathematical mistakes, oversights or misinterpretations of facts. Examples:
a. Transplacement error
b. Transposition error
c. Errors of omission
d. Errors of commission
e. Compensating errors
f. Accounting System Error
g. Counterbalancing and Non-counterbalancing errors

Errors affecting both the statement of financial position and the income statement are either:
a. Counterbalancing errors
- Counterbalancing errors are errors which, if remained uncorrected, are automatically corrected or offset in the
next accounting period. Their effect on the financial statements automatically reverses (counterbalance) in the
next accounting period.

Examples of counterbalancing errors include errors relating to the following:

1. Inventory
2. Purchases
3. Sales
4. Prepayments and Unearned items
5. Accruals for income and expenses

b. Non-counterbalancing errors
- Non-counterbalancing errors are errors which, if remained are uncorrected, are not automatically corrected or
offset in the next accounting period.
- Generally, a non-counterbalancing error affects the profit or loss only in the period the error was committed.
The profit or loss in subsequent periods where the error remains uncorrected, are unaffected. On the other
hand, the statement of financial position, remains erroneous until the non-counterbalancing error is discovered
and corrected.
Examples of non-counterbalancing errors:
1. Misstatement in depreciation
2. Erroneous capitalization of cost that should be expensed outright
3. Non-capitalization of capitalizable cost

Relationships between accounts

In a periodic inventory system, the following relationships between accounts can provide guidance in determining the
effects of counterbalancing errors on profit or loss.
Ending inventory: Profit - Direct relationship
Direct relationship means if ending inventory is understated, profit is also understated.

Inverse relationship means if an account (e.g., ending inventory) is understated, the related account (e.g., cost of goods
sold) is overstated.
The relationships shown above are applicable only under the periodic inventory system because under this system cost
of goods sold is a residual amount after deducting "ending inventory" (determined through physical count) from "total
goods available for sale." The above-mentioned relationships are not applicable under the perpetual inventory system
because under this system cost of goods sold is determined independently of the physical count of ending inventory.
Relationships can also be derived for prepayments unearned items, and accrual for income and expenses.
Asset-related account: Profit - Direct relationship
Asset-related account" pertains to prepayments (eg, prepaid insurance prepaid rent, etc.) and accrual for income (eg
accrued come interest receivable, etc.).

 If current assets are understated, working capital is also understated (direct relationship).
 If current liabilities are understated, working capital is also overstated (direct relationship).
 Counterbalancing errors affecting current assets and current liabilities affect working capital only in the year the
error were committed. Working capital in subsequent years is not affected because the errors have already
counterbalanced or offset.

Events after the Reporting Period

 Events after the reporting period are "those events, favorable and unfavorable, that occur between the end of the
reporting period and the date when the financial statements are authorized for issue." (PAS 10.3)
 For example, Entity A's reporting period ends on December 31, 20x1 and its financial statements are authorized for
issue on March 31, 20x2. Events after the reporting period are those events that occur within January 1, 20x2 to
March 31, 20x2.
 The date of authorization of the financial statements is the date when management authorizes the
financial statements for issue regardless of whether such authorization is final or subject to further approval.

Two types of events after the reporting period

1. Adjusting events after the reporting period – are events that provide evidence of conditions that existed at the end
of the reporting period.
2. Non-adjusting events after the reporting period – are events that are indicative of conditions that arose after the
reporting period.

Adjusting events after the reporting period

Adjusting events, as the name suggests, require adjustments of amounts in the financial statements. Examples of
adjusting events:
a. The settlement after the reporting period of a court case that, confirms that the entity has a present obligation at
the end of reporting period.
b. The receipt of information after the reporting period indicating that an asset was impaired at the end of reporting
period. For example:
i. The bankruptcy of a customer that occurs after the reporting period may indicate that the carrying amount of a
trade receivable at the end of reporting period is impaired.
ii. The sale of inventories after the reporting period may give evidence to their net realizable value at the end of
reporting period.
c. The determination after the reporting period of the cost of asset purchased, or the proceeds from asset sold, before
the end of reporting period.
d. The determination after the reporting period of the amount of profit-sharing or bonus payments, if the entity had a
present legal or constructive obligation at the end of reporting period to make such payments.
e. The discovery of fraud or errors that indicate that the financial statements are incorrect.

Non-adjusting events after the reporting period

Non-adjusting events do not require adjustments of amounts in the financial statements. However, they are disclosed if
they are material. Examples of non-adjusting events:
a. Changes in fair values, foreign exchange rates, interest rates or market prices after the reporting period.
b. Casualty losses (e.g., fire, storm, or earthquake) occurring after the reporting period but before the financial
statements were authorized for issue.
c. Litigation arising solely from events occurring after the reporting period.
d. Significant commitments or contingent liabilities entered after the reporting period, e.g., significant guarantees.
e. Major ordinary share transactions and potential ordinary share transactions after the reporting period.
f. Major business combination after the reporting period.
g. Announcing, or commencing the implementation of, a major restructuring after the reporting period.
h. Announcing a plan to discontinue an operation after the reporting period.
i. Change in tax rate enacted after the reporting period. j. Declaration of dividends after the reporting period

Dividends
Dividends declared after the reporting period are not recognized as liability at the end of reporting period because no
present obligation exists at the end of reporting period.

Going Concern
PAS 10 prohibits the preparation of financial statements on a going concern basis if management determines after the
reporting period either that it intends to liquidate the entity or to cease trading, or that it has no realistic alternative but
to do so.

Notes:
Adjusting events are those that provide evidence of conditions that existed at the end of the reporting period. Non-
adjusting events are those that are indicative of conditions that arose after the reporting period.

Disclosure
The following are disclosed in the notes:
a. Date of authorization for issue and who gave the authorization.
b. An update on the disclosures to include the effects of adjusting events.
c. Non-adjusting events that are material, including:
i. the nature of the event; and
ii. an estimate of its financial effect, or a statement that such an estimate cannot be made.