CHAPTER 1 Concepts and Principles

CHAPTER 1

Concepts

& Principles

DEFINITION OF ACCOUNTING
Accounting is a service activity. Its function is to provide quantitative information primarily financial in nature, about economic entities that is intended to be useful in making economic decisions. (FRSC) Accounting is the art of recording, classifying and summarizing in a significant manner and in terms of money, transactions and events which are, in part at least, of a financial character, and interpreting the results thereof. (AICPA) Accounting is the process of identifying, measuring and communicating economic information to permit informed judgments and decisions by users of the information. Accounting is an information system that measures, processes and communicates financial information about an identifiable economic entity. Accounting is the language of business. It is the medium for reporting financial information about a business entity to many different users of financial statement needed in making economic decisions.

FORMS OF BUSINESS ORGANIZATION

Sole Proprietorship This form of business organization has a sole owner called the proprietor. This is the most common form adopted by business entrepreneurs. Owners usually act as its manager.
Examples: Sari-sari store owned solely by Mr. Soriano Machine shop owned solely by Mrs. Grande Barbershop operated by Ms. Amolo Dental clinic operated by Dra. Umayan

CHAPTER 1 Concepts and Principles

Partnership It is a contract wherein two or more persons bind themselves together to contribute money, property and/or industry into a common fund with the intention of dividing the profits among themselves (Article 1767, Civil Code). It has features different from sole proprietorship and corporation which will be discussed further in the Volume 2 of this book. An owner of the partnership is called a partner.
Examples: SGV and Company accounting firm Tax consultancy firm owned by Mr. Soledad, Mr. Chua and Mr. Del Rosario.

Corporation It is treated as an artificial being created by operation of law, having the right of succession and the powers, attributes and properties expressly authorized by law (Section 2, Corporation Code). Owners of corporations are called stockholders or shareholders. This is type of business organization common to large companies operating in different industries.
Examples: San Miguel Corporation Jollibee Foods Corporation SM Prime Corporation

Although they differ in type of owners, features and domestic laws applied, accounting procedures used in recording transactions and preparing financial statements for these forms are largely the same. These organizations are separate and distinct entities from its owners, whether proprietor, partner or stockholder. Therefore, records of business transaction of the organization should not include owners personal records of transactions. The choice of form of business organization depends on different factors such as nature of the business entity, capital requirement for operation or a requirement set by the laws.

TYPES OF BUSINESS ENTITY

Service Businesses under service activity perform services for fees such as professional fee, consultancy fee, management fee and talent fee.
Examples: Spa salons Auditing and accounting firms Law firms Management firms

CHAPTER 1 Concepts and Principles

Merchandising Merchandising entities purchased finished goods then sold these for profit. These are the companies usually referred as in buy-and-sell business.
Examples: Car dealers Bookstores Sari-sari stores

Manufacturing These companies acquire raw materials to produce goods and then sell these to customers which are usually the entities in merchandising activity.
Examples: Apple Corporation Coca-Cola Company Asia Brewery Sugar manufacturers

USERS OF FINANCIAL STATEMENTS

Bases in making decision were the information provided by financial records and statements of a business entity or an individual. Usually, users of this information need different data in order for them to arrive at timely decision for their business or interest in other entities. These users of financial statements and the information they need were as follows: Present and potential investors They need information to help them determine whether they should buy, hold or sell. They also need information that enables them to determine the investees ability to pay dividends.
Illustrations: XYZ Company plans to sell the shares of Jollibee Food Corporation it holds. The management of XYZ Company collected data about the present fair market value of the shares and its potential earnings needed in arriving for its asking price. XYZ Company wants to acquire shares of Jollibee Food Corporation. The management of XYZ Company gathered data through JFCs comparative financial statement to determine the potential risk or benefits in acquisition of interest and the investees ability to pay dividends to shareholders.

Lenders They need information that enables them to determine whether their loans and its interest earned will be paid when due.
Illustration: Banco San Juan requires clients applying for loans to submit financial statements to assess their ability to pay.

CHAPTER 1 Concepts and Principles

Suppliers and other trade creditors They need information that enables them to determine whether the amounts owing to them will be paid when due.
Illustration: CDM Bookstore collected records of CBA Marketing Cooperative from other suppliers to determine its credit standing.

Customers They have interest in the information about the continuance of an entity, especially when they have a long-term involvement with, or are dependent on the entity
Illustration: Oil consumers, especially those in business activities, gathered data on the financial stability of ONE Gas Company, the sole oil provider in Batanes.

Employees They are interested in the information about the profitability and stability of their employers. They are also interested in employers ability to provide their remuneration, retirement benefits and employment opportunities.
Illustration: Labor union protests after financial information about their employer revealed that it is near insolvency.

Government and its agencies The government and its agencies are interested in the allocation of resources and therefore the activities of entities. They also require information to regulate the activities of entities, determine taxation policies and to use as basis for national income and related statistics.
Illustration: Bureau of Internal Revenues require individuals and entities to submit income tax return to determine the amount or level of tax to be imposed.

Public Financial statements may assist the public by providing information about the trends and recent developments in the prosperity of the entity and the range of its activities.

CHAPTER 1 Concepts and Principles

THE FINANCIAL STATEMENT

Objectives of Financial Statements The objective of the financial statement is to provide information about the financial position, financial performances and changes in financial position of an entity that is useful to a wide range of users in making economic decisions. Financial statements prepared for this purpose meet the common needs of most users. However, financial statements do not provide all the information that users may need to make economic decisions since they largely portray the financial effects of past events and do not provide non-financial information. Financial statements also show the result of the stewardship of management or the accountability of management for the resources entrusted to it. A complete set of financial statement consists: 1. Statement of financial position or balance sheet 2. Income statement 3. Statement of comprehensive income 4. Statement of changes in owners equity 5. Statement of cash flows 6. Notes to the financial statement

FUNDAMENTAL CONCEPTS
Entity Concept This is the most basic concept in accounting. It states that transactions of different entities should be accounted and evaluated for separately. Personal records of transactions of the owners should not be mixed up with the records of the business entity.
Illustration: Mr. Asther Soriano, owner of Tapsi ni Papsi, acquired kitchen equipment for the business entity. It is proper to record the acquisition of the assets in the books of the business entity. Illustration: Mr. Asther Soriano, owner of Tapsi ni Papsi, bought a service vehicle for personal use. The acquisition should be recorded in his personal books rather than the books of business entity.

Periodicity Concept This concept suggests that life of the business entities should be subdivided evenly into time periods usually called accounting periods. This would help the users of financial statement to easily evaluate and compare the financial position and financial performance of an entity from period to another period. This allows the users to obtain timely information for making economic decisions. For the purpose of presentation of financial statements, accounting periods are commonly equivalent to 12 months or one year.

CHAPTER 1 Concepts and Principles

Stable Monetary Unit Concept This concept ignores the effect of inflation in the accounting records. This allows accountants or bookkeepers to easily subtract or add peso amounts from one period to another period assuming the purchasing power of peso remained the same.

GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP) & THE BASIC PRINCIPLES

These refer to the standard framework of guidelines for financial accounting used in any given jurisdiction; generally known as accounting standards. GAAP includes the standards, conventions, and rules accountants follow in recording and summarizing, and in the preparation of financial statements. In order to provide information that is useful in making economic decisions, those responsible in preparation of financial statement should rely to the following basic principle: Objectivity Principle It states that accounting will be recorded on the basis of objective evidence. Objective evidence means that different people looking at the evidence will arrive at the same values for the transaction and based on most reliable data available to keep the financial statement accurate. Historical Cost Principle This principle states that assets should be recorded in their actual cost or historical cost rather than its current value. Revenue Recognition Principle Revenue should be recognized when earned (when goods are delivered or when services are performed) rather than when cash is received from customers for the goods and services.
Illustration: Green Dragons Company received P20,000 for two-month rent from Lions Merchandising on January 1, 2013. The rent will start on February 2013. Full realization of revenue will be after the rental period of the facilities which will be on March 31, 2013.

Expense Recognition Principle Expenses should be recognized when incurred (when goods are consumed, used or expires, or when services are received) rather than when cash is paid to the providers of services or suppliers of goods.
Illustration: Lions Merchandising received an electric bill from Green Dragons Electric Company which it intended to pay next month. Though no cash is paid to Green Dragons, Lions should recognize expense incurred because electricity has already been used or consumed by Lions evidenced by the electric bill.

CHAPTER 1 Concepts and Principles

Adequate Disclosure It is proper to include or disclose all relevant documents or information in the financial statement to help the users that would affect the understanding of the items therein. Consistency Principle Consistency principle maintains financial statement comparable from period to period. It suggests that management should be consistent in the accounting methods and practices it uses in recording transaction and events, and preparation of financial statements. However, changes are permitted if it will result to a more reliable and relevant information and disclosed in the financial statement.

UNDERLYING ASSUMPTION
Going Concern Financial statements should be presented with the assumption that the entity being reported will continue its business operation indefinitely, otherwise explicitly stated by the management or owners.

FUNDAMENTAL QUALITATIVE CHARACTERISTICS

Qualitative characteristics are the attributes that makes the information provided in the financial statements useful to users. The two fundamental qualitative characteristics are relevance and faithful representation. Relevance Relevant financial information is capable of making a difference in the decisions made by users. Financial information is capable of making a difference in decisions if it has predictive value, confirmatory value, or both. The predictive value and confirmatory value of financial information are interrelated. Materiality as an Aspect of Relevance It is an entity-specific aspect of relevance based on the nature or magnitude (or both) of the items to which the information relates in the context of an individual entity's financial report. Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements. Materiality depends on the size of the item or error judged in the particular circumstances of its omission or misstatement. Thus, materiality provides a threshold or cut-off point rather than being a primary qualitative characteristic which information must have if it is to be useful.

CHAPTER 1 Concepts and Principles

Faithful Representation General purpose financial reports represent economic phenomena in words and numbers. To be useful, financial information must not only be relevant, it must also represent faithfully the phenomena it purports to represent. This fundamental characteristic seeks to maximize the underlying characteristics of completeness, neutrality and freedom from error. Faithful representation means that the effects in peso amount of a certain business transaction should be accounted for and be reflected in the financial statement.
Illustrations: DEF Company acquired a parcel of land for P2,500,000. The land was then recorded at P5,000,000 in the books of the entity.

To make its income statement looks good, the bookkeeper of GHI Company purposefully omitted P200,000 worth of expenses to increase its profit.

The illustrations above shows information not represented faithfully, thus, making the financial information not reliable for making economic decisions.

ENHANCING QUALITATIVE CHARACTERISTICS

Substance Over Form It is necessary that information are accounted for and presented in accordance with their substance and economic reality and not merely their legal form.
Illustration: Legal title on a car purchased in installment basis remained on the seller but the economic benefit was passed on to the buyer. The car should be recorded in the books of the buyer

Neutrality Information contained in the financial statements should be free from bias.
Illustration: The owner of the KLM Services reported only the profitable months of operation and omitted the months the entity incurred losses.

Prudence It is the inclusion of a degree of caution in the exercise of the judgments needed in making the estimates required under conditions of uncertainty, such that assets or income are not overstated and liabilities and expenses are not understated. It is well known as the principle of conservatism.
Illustration: Inventories are measured at lower of cost and net realizable value.

CHAPTER 1 Concepts and Principles

Comparability Information about a reporting entity is more useful if it can be compared with similar information about other entities and with similar information about the same entity for another period or another date. Comparability enables users to identify and understand similarities in, and differences among, items. This also allows users evaluate their financial position, performance and financial adaptability. Consistency in presentation, use of standards and reporting are required to maintain comparability. The need for comparability should not be confused with mere uniformity and should not be allowed to become an impediment to the introduction of improved accounting standards. It is also inappropriate for an entity to leave its accounting policies unchanged when more relevant and reliable alternative exist. Verifiability Verifiability helps to assure users that information represents faithfully the economic phenomena it purports to represent. Verifiability means that different knowledgeable and independent observers could reach consensus, although not necessarily complete agreement, that a particular depiction is a faithful representation. Understandability An essential quality of information provided in financial statements is that it is readily understandable by users. Classifying, characterising and presenting information clearly and concisely makes it understandable. While some phenomena are inherently complex and cannot be made easy to understand, to exclude such information would make financial reports incomplete and potentially misleading. Financial reports are prepared for users who have a reasonable knowledge of business and economic activities and who review and analyse the information with diligence.

CONSTRAINTS ON RELEVANT AND RELIABLE INFORMATION

Timeliness Timeliness means that information is available to decision-makers in time to be capable of influencing their decisions. Even if information is reliable, it will lose its relevance if there is undue delay in reporting the information. The balance between the timely reporting and the provision of reliable information should be observed by the management.
Illustration: NOP Corporation would like to expand its business by 2015 due to increasing opportunities and demand for the products and services it offers to public. The feasibility study on the project prepared by the managers was finished before 2014.

Balance Between Benefits and Cost The balance between benefit and cost is a pervasive constraint rather than a qualitative characteristic. The benefits derived from information should exceed the cost of providing it.