Introduction to Accounting

Accounting Defined

Accounting is a service activity. Its function is to provide quantitative information which are primarily
financial in nature, about economic entities that is intended to be useful in making economic
decisions, in making reasoned choices among alternative courses of action. (Mr. Kevin Troy M. Chua,
CPA)

The quantitative information are those found in the financial statements namely the statement of
financial condition/position, statement of comprehensive income, cash flow statement.

Accounting is an art of recording, classifying, summarizing in a significant manner and terms of money,
transactions and events which are in part at least of a financial character and interpreting the results
thereof. (American Institute of Certified Public Accountants – AICPA)

Recording refers to the writing down of business transactions in the books of accounts called the journal
and the ledger. Bookkeeping is the technical term for recording. Bookkeeping is the systematic and
chronological recording of business transactions. Chronological recording means that the transaction
should be recorded in accordance with the date of the business transactions from the first day to the
last day of the month. Systematic recording means that accounting concepts, principles, assumptions,
rules should be properly observed.

Classifying is the sorting of business transactions to their specific accounts. The accounts are maintained
for the assets, liabilities, owner’s equity, incomes, expenses of the business.

Summarizing refers to the summing up of the business transactions recorded in the books of accounts in
the trial balance.

Interpreting is the analysis and interpretation made on the financial statements of the business to be
used in the decision-making process.

Money includes cash

Transaction is the exchange of monetary values which come in the form of money, right, properties and
services.

Event is a happening which has an impact on the business and has an effect to the business.

Accounting is the process of identifying, measuring and communicating economic information to

permit informed judgments and decisions by the users of information. (American Accounting
Association – AAA)

The starting point of the accounting process is the identification of economic events relevant to a
business. Examples of relevant events are the sale of Toyota cars, provision of services in a restaurant,
payment to suppliers, purchase of materials for manufacturing laptops. To be identified as a relevant
economic event, there should be a transfer of things with value. After identifying the economic events,
the company records the events which will serve as the history of its financial activities. Systematically
and chronological recording should be done on the so called books of accounts for easier tracking and
interpretation. Finally, after a lapse of a specific period (usually one year), companies summarizes all the
recorded economic events into accounting reports or financial statements.

History of Accounting

Accounting developed early in Mesopotamia where people followed a system of writing and counting
money which we can relate to taxation and trading activities.
The Roman Emperor Augustus ((63BC -14AD) required its Roman government to keep a detailed
financial information regarding the stewardship of the Roman resources.
Luca Pacioli, an Italian monk during the 14th century introduced the double-entry bookkeeping system.
The system is defined as a bookkeeping system that has a debit and credit of each transaction. Pacioli
became the father of accounting and authored a book entitled Summa de Arithmetica, Geometria,
Proportioni et Proportionalita (Review of Arithmetic, Geometry, Ratio and Proportion). The double-
entry bookkeeping system is the accounting system being used to this very day. (Sangster et. al 2007)
In the 19th century, Queen Victoria of Scotland granted a royal charter to the Institute of Accountants in
Glasgow. It began the modern profession of the chartered accountants.
At present, accountants are guided by accounting standards in the conduct of their profession. The
standards include the Philippine Financial Reporting Standards (PFRC) and the Philippine Accounting
Standards (PAS)

Nature of Accounting

1. Accounting is a process. The process includes identifying economic event, recording and
communicating relevant economic event.
2. Accounting is an art. It involves the art of recording, classifying, summarizing and finalizing
financial transactions.
3. Accounting deals with financial information and transaction. It deals with quantifiable financial
transactions.
4. Accounting is a means not an end. It is a tool in achieving specific objectives.
5. Accounting is an information system. It serves as a storehouse of information.

Functions of Accounting

1. Keeps a systematic record of business transactions. The transactions are recorded

systematically for easy understanding of the users of financial information.
2. Protects properties of the business. Accounting records serve as evidence of the existence and
value of business properties.
3. Communicates results to various parties involved in the business. The different interested
parties of the business are given financial information for their decision-making.
4. Meeting legal requirements. Fulfilling the government requirement to provide financial reports
regularly for the information of interested parties of the business for their decision-making.

Branches of Accounting

1. Financial Accounting. It deals with financial transactions for production of financial statements
intended for the external users (creditors, suppliers, government, consumers, employees) of
financial information.
 2. Management Accounting. It focuses on the preparation of reports for the use of internal users
(owners, managers) in their decision-making.
3. Government Accounting . It deals with the accounting of government receipts and
disbursements.
4. Auditing. It is the independent examination and evaluation of financial statements of the
business for credibility and reliability.
5. Tax Accounting. It deals with the laying down of the different treatment of the taxing
authorities regarding financial transactions.
6. Cost Accounting. It deals with cost determination and cost control.
7. Accounting Education. It deals with the promulgation of accounting knowledge to various
interested parties to help them achieve individual goals.
8. Accounting Research. It focuses on the improvement of the accountancy field through research
and studies.

Forms of Business Organizations.

1. Single Proprietorship. It is owned by only one individual.

2. Partnership. It is owned by two or more persons who contribute money, property or services
into a common fund with the intention of dividing the profits among themselves.
3. Corporation. It is an artificial being created by operation of law, having the rights of succession
and the powers, attributes and properties expressly authorized by law or incident to its
existence. The owners are called stockholders or corporators.
4. Cooperative. It is a duly registered association of persons, with a common interest, who
voluntarily joined together to achieve a lawful common social or economic end, making
equitable contributions to the capital required and accepting a fair share of the risks and
benefits of the undertaking in accordance with universally accepted cooperative principles.

Types of Business

A business is an organization that converts inputs or resources such as materials, labor and overhead
inputs which are usually either goods or services.

1. Service Business. Business which provides intangible products or services to customers.

Services include professional skills, advice, expertise and other related products. The primary
source of revenue or income comes from the performance of services referred to as service
revenue or service income. Examples: banks, schools, accounting firms, law offices
medical /dental clinic.

2. Merchandising Business. Tangible goods are sold. The business buys finished goods from their
suppliers and resale the same to customers. Revenues generated from the sale of
goods/merchandise are called Sales Revenue/Sales. Examples: sari-sari store, department
store, hardware, drugstore.

3. Manufacturing Business. The business creates their products. Raw materials are processed
using materials and labor to produce the finished goods. Examples: Procter and Gamble ,
Unilever, Ford, Honda, San Miguel Corp.
Accounting Concepts and Principles

The accounting process is governed by rules known as accounting concepts, principles, and
assumptions. Financial statements are made more useful to the users when accounting concepts,
principles and assumptions are followed. Accounting concepts, principles and assumptions are
considered the foundation of accounting to enhance understanding of the usefulness of the financial
statements.

Generally Accepted Accounting Principles

Generally Accepted Accounting Principles (GAAP) refer to a common set of accounting

Principles, standards, and procedures issued by the Financial Accounting
Standards Board (FASB). (source: Investopia April 2020)

GAAP are applied by business companies to help both the external users and
Management in assessing the current performance as compared to its past. Applying
GAAP results to consistency and comparability of the company’s financial statements.

International Financial Reporting Standards (IFRS)

The International Financial Reporting Standards (IFRS) set common rules so that
financial statements can be consistent, transparent and comparable around the world.
They specify how companies must maintain and report their accounts, defining types
Of transactions and other events with financial impact.
(source: htttps//www.investopia.com)

Philippine Financial Reporting Standards (PFRS)

Philippine Financial Reporting Standards (PFRS) are standards issued by the Philippine
Financial Reporting Standards Council (PFRSC) for use in the Philippines.
(source: Joselito G. Florendo)
Philippine Financial Reporting Standards are the new set of Generally Accepted
Accounting Principles (GAAP) issued by the Accounting Standards Council (ASC)
to govern the preparation of the financial statements. (source: www.bsp.gov.ph)
The following are the accounting concepts, principles and assumptions:

Accrual Accounting

The fundamental idea of accrual accounting can be stated as follows:

“The effects of the business transactions should be recognized in the period when it is
earned regardless of when the payment is received. Expenses should be recognized in the
period when it is incurred regardless of when the expenses are paid.”

Suppose Andrew, a budding entrepreneur, established a merchandising business that sells

ready-to-wear clothes to different ukay-ukay stores in the country. The income from
Andrew’s business primarily comes from selling goods to customers. Sales to customers can
be for cash or on credit. If the business was able to sell goods for cash, this will be recorded
in the accounting records of the company. On the other hand, if the goods were sold on
credit, the transaction should still be recorded in the accounting records as accounts
receivable. This is the essence of accrual accounting. An accountant does not have to wait
for cash to be received or for cash to be paid before he or she records a business
transaction. Because of accrual accounting, use of accounts as such as accounts receivable,
accounts payable, prepaid expenses, accrued expenses, deferred income and accrued
income are possible. Accrual accounting also results in financial statements that are more
accurate and reliable in terms of assessing the past performance of the company. Since
income is recognized when earned and expenses are recognized when incurred, financial
statements for a particular period properly reflect the financial transactions pertaining to
that period.

The opposite of accrual accounting is cash basis of accounting. Under the cash basis of
accounting, income is recognized when cash is received, expenses are recognized when cash
is paid. As the name implies, under the cash basis of accounting, the receipt and/or
payment of cash is a requisite before transactions are recorded in the accounting records of
the company. (source: Joselito G. Florendo)

Matching Principle

The matching principles is closely related to accrual accounting. Under the matching
principle, expenses are recognized in the same period as the related revenue. Revenues
of a business always comes with expense. No business can generate revenues, without
incurring expenses. The matching principles states that related revenues and expenses
should always go together. In other words, if the revenues are recorded in period 1, the
related expenses should be recorded in period 1.
For examples, Rudy, a car salesman who works for Honda, has a monthly salary of
P30,000. Aside from that, he receives a commission of 5% for all the sales he made for
the month. During the month of December, he was able to sell 10 cars for a total of
12M. The 12M is recorded as sales of the company. By selling 10 cars for the month,
Rudy is entitled to receive P630,000 (i.e., P30,000 monthly salary plus commission). The
monthly salary of Rudy plus his commission are expenses of the company. By the end of
the month, the salary of Rudy and his commission are expenses of the company. By the
end of the month, the salary of Rudy and his commission are still not paid. Under the
 matching principle, the P630,000 will be recorded as an expense in December even
though it is not yet paid since it is related to the 12 M in revenues. Without the
matching principle the P630,000 may be recorded as an expense in January when the
payment to Rudy is made.

Remember that under the matching principle, expenses follow the related revenues.
Like accrual accounting, the matching principles also provides more accurate and
reliable information in the financial statements. It prevents understatement of
expenses in one period while overstating expenses in the next period.

Moreover, under the matching principle, there is a cause and effect relationship
between revenues and expenses. If this relationship does not exist between revenues
and expenses, the expenses should be recognized immediately in the accounting
records of the company. Advertising and marketing expenses are the most common
examples of this kind of expense. Since the related benefit that is expected to be
derived from advertising and marketing expenses cannot be measured reliably, these
expenses are recognized immediately. (source: Joselito G. Florendo)

Use of Judgment and Estimates

Accounting estimates are approximations made by the accountant or the management

in the preparation of financial statements. The use of reasonable estimates is an
essential part of the preparation of financial statements and does not
Undermine their reliability. (source: International accounting Standards 8). So items in
a company’s accounting records such as cash, property, plant and equipment (PPE), and
accounts payable can be measured precisely. For these items that can be measured with
precision, the use of the estimates is not required.

Warranty expense is an item in the accounting records that requires the use of
Estimates. A warranty is a guarantee made by the seller to the buyer promising to
Repair or replace the thing sold if necessary within a specified period of time. When a
seller sells goods, there are revenues generated that are recorded in the company’s
accounting records. According to the matching principle, all related expenses should
also be recorded in the same period the revenues are recognized. Warranty expense
is related to the revenues generated from the sale of goods. The problem is what
amount of warranty the company should recognize in the accounting records.

A company is not entirely sure when warranties will be performed by the company. It
can be in the same period as the related revenues, one year after the date of sale, or
even further into the future. Because of this, the warranty expense in the company’s
accounting records is usually estimated based on historical data.

However, the use of accounting estimates cannot be abused by an entity by purposely

overestimating expenses. Some companies overestimate expenses to decrease net
income and decrease the taxes payable. Judgment in making accounting estimates
should be backed up by a reasonable basis. It is more desirable to use judgment in the
accounting process because the use of judgment leads to more subjective financial
statements. (source: Joselito G. Florendo)
Prudence

Prudence is otherwise termed as conservatism. There are financial transactions which

are uncertain like the warranty expense. These kinds of transactions are subject to the
concept of prudence and will be reported if they pertain to a specific period. In applying
the concept of prudence, the accountant makes sure that income and assets are not
overstated and liabilities and expenses are not understated. According to Valix et al
(2013). “In the simplest word, conservatism means in case of doubt, record any loss and
do not record any gain.” For example, when an accountant is unsure whether or not to
recognize an expense, the concept of prudence states that he or she should recognize it
in the accounting records. On the other hand, if an accountant is unsure whether or not
to recognize income, prudence states that he or she should not recognize it. (source:
Joselito G. Florendo)

If there are two alternatives in a situation, choose the alternative that will result in
lesser income or resource.

Substance Over Form

Financial statements should present truthful financial condition and financial

performance of a company. Thus, accountants should look at the substance of every
financial transaction rather than its legal form.

An example of a transaction where the substance differs from the legal form is a lease.
In a lease, the lessor allows the lessee to use the former’s property in exchange of a
specific fee.
However, when ownership of the property transfers to the lessee at the end of the
lease, the substance differs from the legal form. In this case, the transaction is really a
sale of property with installment payments instead of a lease. The lessee will record an
asset and a liability is his or her accounting records instead of recognizing an expense.
When the substance differs from the legal form, follow the substance of the transaction.
In the example given, the substance is a sale of property in installment payments while
the legal form is a lease. The transaction should be treated as a sale of property in
installments since substance prevails over legal form. (source: Joselito
G. Florendo)

Going Concern Assumption

The going concern assumption states that the operations of a business will continue
indefinitely in the future. This means that the operations of the business will not stop in
the near future and it will not be forced to liquidate its assets to pay off its liabilities.
The going concern allows the accountants to defer recognition of expenses in the
future.
For example, Company A rents a building for P100,000 per month. On January 1, 2016,
the company paid the rent for two years in the amount of P2,400,000. Under the going
concern assumption, the company can recognize the part of the P2,400,000 that is not
 yet incurred. On January1, 2016, the company has not yet used the building but already
paid the rent. In this case, the accountant can record as asset
(i.e. prepaid expense) instead of recognizing an expense immediately. If the entity is not
a going concern, there is no point recognizing the payment as an asset since the
company will not derive all benefits from it. A company that is not a going concern will
halt its operations in the near future, so the payment of P2,400,000 will be recognized
wholly as an expense instead of recording as asset. (source: Joselito G.
Florendo)

Accounting Entity Assumption

The accounting entity assumption states that the business is separate from the owners,
managers and employees operating the business. Each business has to keep its own
accounting records. Personal transactions of the owner should not affect the financial
statements of the business. For example, the amount of food purchased by the owner
for his family should not be reflected in the financial statements of his business. The
purpose of the accounting entity assumption is to reflect the fair presentation of the
company’s financial position and operating results in its financial statements.

Time Period Assumption

According to the time period assumption, the life of the business can be divided into
periods of equal length for the preparation of financial statements. Accounting periods
can be a calendar year or a fiscal year. A calendar year is a 12 month period starting
from January and ending in December. A fiscal year is a 12 month period that ends on
any month of the year. Financial statements are prepared after an accounting period.

Full Disclosure

In preparation of the financial statements, the accountant should include enough

information to permit the stakeholders to make informed judgment about the financial
condition of the company.

Cost Principle/ Historical Cost

Historical Cost refers to the amount when an item was originally obtained whether that
purchase happened last year or ten years ago amounts are not adjusted upward for
inflation. Example: A vehicle bought on December 2020 costing P300,000 with a current
value of P200,000 should be recorded at P300,000.

Monetary Unit

It assumes that only transactions can be expressed in terms of money are recorded.
Transactions are expressed in monetary unit.
Example: Land bought at P2M should be recorded at P2M.

Objectivity
 It requires business transactions that have some form of impartial supporting evidence or
documentation. Example: The purchase of goods to be sold by the business should be
supported with an invoice to support the purchase.

Materiality

In accounting, materiality refers to the relative size of an amount. Determining

materiality requires sound and professional judgment. Omitted items/amounts must
have an effect on a decision. Example: P20,000 cash is immaterial for a business whose
net income is P1M, but a business earning P40,000, P 20,000 is material.

Revenue recognition

Income is recorded when service is rendered or goods are sold regardless of cash
received. Example: Goods sold on credit worth P500 will be recorded as income even
when there is no cash received.