 What are the four recognition principles?

1. Asset recognition principle

2. Liability recognition principle
3. Income recognition principle
4. Expense recognition principle

 Asset recognition principle.

An asset is recognized in the statement of financial position when it is probable that future economic
benefits will flow to the entity and the asset has a cost or value that can be measured reliably. Thus, two
conditions must be present for the recognition of an asset:
a) It is probable that future economic benefits will flow to the entity.
b) The cost or value of the asset can be measured reliably.

 What is the meaning of future economic benefit?

The future economic benefit embodied in an asset is the potential to contribute directly or indirectly to the
flow of cash and cash equivalents to the entity.

The potential may be a productive one that is part of the operating activities of the entity.
It may also take the form of convertibility into cash or cash equivalents or a capability to reduce cash outflows, such
as when an alternative manufacturing process lowers the costs of production.
 What is the cost principle?
Inherent in asset recognition is the cost principle.
This principle requires that assets shall be recorded initially at original acquisition cost.
The initial cost may be carried without change, may be changed by depreciation, amortization or write-off, or
may be shifted to other categories ag in the cage of raw materials being converted into finished goods.
In other words, the financial statements shall be based on historical cost rather than market value.
The reason is that cost is objective and therefore verifiable while market value is subjective.
 How much is cost?
In a cash transaction, cost is equivalent to the cash payment.
Thus if an equipment is acquired for P100,000 cash, the cost of the equipment is P 100,000.
In a noncash or an exchange transaction, the cost is equal to the following in the order of priority:
a) Fair value of asset given
b) Fair value of asset received
c) Carrying amount of asset given

 Explain the liability recognition principle.

A liability is recognized in the Statement of financial position when it is probable that an outflow of resources
embodying economic benefits will be required for the settlement of a present obligation and the amount of the
obligation can be measured reliably.
Thus, two conditions must be present for recognition of a liability:
a) It is probable that an outflow of economic benefits will be required for the settlement of a present
obligation.
b) The amount of obligation can be measured reliably.

 Explain "present obligation" as an essential characteristic for the recognition of a liability.

An essential characteristic of a liability is that the entity has a present obligation which may be legal or
constructive.
Obligations may be legally enforceable as a consequence of a binding contract or statutory requirement.
This is normally the case, for example, with amounts payable for goods and services received.
Constructive obligations arise from normal business practice, custom and a desire to maintain good business
relations or act in an equitable manner.
For example, an entity decides as a matter of policy to rectify faults in the products even when these become
apparent after the warranty period.
 Explain the income recognition principle or realization principle.
The basic principle is that "income shall be recognized when earned".
But the question is when is income considered to be earned?
The Conceptual Framework provides that "income is recognized when it is probable that an increase in future
economic benefits related to an increase in an asset or a decrease in a liability has arisen and that the increase in
economic benefits can be measured reliably."
Thus, two conditions must be present for the recognition of income, namely:
a) It is probable that future economic benefits will flow to the entity as a result of an increase in an asset
or a decrease in a liability.
b) The economic benefits can. be measured reliably.
Undoubtedly, both conditions are present at the point of sale. Accordingly, the point of sale is the point of
revenue recognition.
The reason is that it is at the point of sale that the entity hag transferred to the buyer the significant risks and
rewards of ownership of the goods.
Stated differently, legal title to the goods passes to the buyer at the point of sale.
Incidentally, the point of sale is usually the point of delivery, which may be actual or constructive.
Legally, it is delivery that transfers ownership from the seller to the buyer.
 Distinguish income from revenue and gain.
The definition of income encompasses both revenue and gain.
Revenue arises in the course of the ordinary regular activities and is referred to by a variety of different names
including sales, fees, interest, dividends, royalties and rent.
The essence of revenue is regularity.
Gain represents an item that meets the definition of income and does not arise in the course of ordinary regular
activities.
 What are the conditions for the recognition of revenue from the sale of goods?
PAS 18, paragraph 14, provides the following conditions for the recognition of revenue from sale of goods:
1. The entity has transferred to the buyer the significant risks and rewards of ownership of the goods.
2. The entity retains neither continuing managerial involvement nor effective control over the goods sold.
3. The amount of revenue can be measured reliably.
4. It is probable that economic benefits associated with the transaction will flow to the entity.
5. The costs incurred or to be incurred in respect of! the transaction can be measured reliably.

 What are the situations in which an entity may retain the significant risk and rewards of
ownership?
PAS 18, paragraph 16, provides that an entity may retain the significant risks and rewards of ownership in the
following situations:
1. When the seller retains an obligation for unsatisfactory performance not covered by normal warranty of
provision.
2. When the receipt of revenue from a particular sale is contingent on the derivation of revenue by the
buyer from the sale of goods.
3. When the goods are shipped subject to installation and the installation is a significant part of the contract
which has not yet been completed by the seller.
 4. When the buyer has the right to rescind the purchase for a reason not specified in the sale contract and
the seller is uncertain about the probability of the return.

 What are the conditions for the recognition of revenue from rendering of services?
PAS 18, paragraph 19, provides the following conditions for the recognition of revenue from rendering of
services:
1. The amount of revenue can be measured reliably.
2. It is probable that the economic benefits associated with the transaction will flow to the entity.
3. The stage of completion of the transaction at the end of reporting period can be measured reliably.
4. The costs incurred for the transaction and the costs to complete can be measured reliably.

 What are the exceptions to the "point of sale" realization principle?

a) Installment method — Revenue is recognized at the point of collection. The amount of revenue is
determined by multiplying the gross profit rate by the amount of collections.
The reason for this approach is the uncertainty of collection or the possibility of cancelation of the installment
sales contract.
b) Cost recovery or sunk cost method — Revenge is recognized also at the point of collection. However,
unlike the installment method, all collections are first applied to the cost of the merchandise sold.
When the cost of the merchandise sold is fully recovered through collections, then all subsequent collections are
considered revenue.
c) Cash method — Revenue is recognized when received regardless of when earned. In other words, all
collections are treated as revenue. There are no accruals and deferrals.
d) Percentage of completion method — When the outcome of a construction contract can be estimated
reliably, contract revenue and contract costs associated with the construction contract shall be
recognized as revenue and expenses, respectively, by reference to the stage of completion of the
contract activity.
e) Production method – Revenue is recognized at the point of production. This method is applicable to
agricultural, forest and mineral products.
The production method is allowed when a sale is assured under a forward contract or a government guarantee,
or when a homogeneous market exists and there is a negligible risk of failure to sell.
 Explain the recognition of revenue from interest, royalties, dividends.
PAS 18, paragraph 30, provides the following guidelines:
a) Interest revenue shall be recognized on a time proportion basis that takes into account the effective yield on the
asset.
b) Royalties shall be recognized on an accrual basis in accordance with the substance of the relevant agreement.
c) Dividends shall be recognized as revenue when the shareholder's right to receive payment is established, meaning,
when the dividends are declared.

 Explain briefly the income recognition from installation fees, subscription fees, admission fees and tuition
fees.
1. Installation fees are recognized as revenue over the period of installation by reference to the stage of completion.
2. Subscription fees should be recognized as revenue on a straight line basis over the subscription period.
3. Admission fees are recognized as revenue when the event takes place.
4. Tuition fees are recognized as revenue over the period in which tuition is provided.

 Explain the expense recognition principle.

The Conceptual Framework provides that "expenses are recognized when it is probable that a decrease in future economic
benefits related to a decrease in an asset or an increase in liability has occurred and the decrease in economic benefits can
be measured reliably".
Thus, two conditions must be present for the recognition of expenses:
a) It is probable that a decrease in future economic benefits has occurred.
b) The decrease in economic benefits can be measured reliably.
  Distinguish expenses and losses.
The definition of expense encompasses losses as well as those expenses that arise in the course of the ordinary regular
activities of the entity. Examples, cost of sales, wages and depreciation.
Losses represent other items that meet the definition of expenses and do not arise in the course of the ordinary regular
activities of the entity. Examples include losses resulting from disasters such as fire and flood, as well as those arising
from disposal of noncurrent assets.

 What do you understand by the matching principle?

The expense recognition principle is the application of the matching principle.
The generation of revenue is not without any cost. There has got to be some cost in earning a revenue.
“There is no gain if there is no pain"
Accordingly, the matching principle requires that "those costs and expenses incurred in earning a revenue should be
reported in the same period".

In other words, there should be simultaneous or combined recognition of revenue and expenses that result directly
from the same transactions and events.

The basic expense recognition principle means that “expenses are recognized when incurred”

But the question is when are expenses incurred?

Expenses are incurred in conformity with the three applications of the matching principle, namely:
1. Cause and effect association
2. Systematic and rational allocation
3. Immediate recognition

 Explain the cause and effect association principle.

The cause and effect association principle means that the expense is recognized when the revenue is already recognized on
the basis of a presumed direct association of the expense with specific revenue.
The cause and effect association principle is actually the "strict matching concept".
The best example is the cost of' merchandise inventory. Such cost is considered as an asset in the meantime that the
merchandise is on hand.
When the merchandise is sold, the cost thereof is expensed in the form of "cost of sales" because at such time revenue
may be recognized.
Other examples include doubtful accounts, warranty expense and sales commissions.

 Explain the systematic and rational allocation principle.

Under the systematic and rational allocation principle, some costs are expensed by simply allocating them over the
periods benefited.

The reason for this principle is that the cost incurred will benefit future periods and that there is an absence of a direct or
clear association of the expense with specific revenue.
When economic benefits are expected to arise over several accounting periods and the association with income can only
be broadly or indirectly determined, expenses are recognized on the basis of systematic and allocation procedures.
Concrete examples include depreciation, amortization and allocation of prepayments.

 Explain the immediate recognition principle.

Under immediate recognition principle, the cost incurred is expensed outright because of uncertainty of future economic
benefits or difficulty of reliably associating certain costs with future revenue.
Actually, this principle reflects a conservative or prudent approach which is the accountant's general guide for dealing
with uncertain situations.
An expense is recognized immediately when an expenditure produces no future economic benefits or when future
economic benefits do not qualify, or cease to qualify for recognition in the statement of financial position as an asset.

 Give examples of expenses that are recognized immediately.

Examples include officers' salaries and most administrative expenses, advertising and most distribution costs, amount to
settle lawsuit and worthless intangible assets.
Many losses, such as loss from disposal of building, loss from sale of investments, and casualty loss, are
immediately recognized because these are not directly related to specific revenue
Explain “measurement” of the elements of financial statements.
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.