Unit I (Introduction to Accounting)

Unit IIntroduction

Overview

Background The evolution of accounting is attributed to the social and economic needs of

society. As business and society become more complex, accounting develops new concepts, methods and techniques to meet the ever changing and increasing needs for financial information. Without the necessary information furnished by accounting, many complex social programs and economic development may never have been realized.

Information, in any market economy, assists decision-makers in making wise choices regarding the use of limited resources under their control. When decision-makers are able to make well-informed decisions, resources are allocated in a manner that better meets the needs and goals of companies within the given market.

The Philippines, being a developing country, would need a great deal of reliable and timely information to compete in the global market and accounting will play an important role in this prevailing competitive global structure of the economy. Companies use accounting information to evaluate the business situations around the world. It is therefore necessary that future accountants, businessmen, entrepreneurs and economists must be trained properly on how to generate and interpret this financial information.

Purpose The purpose of Unit I “Introduction to Accounting and Basic Accounting

Principles” is to provide students with brief descriptions of the nature and scope of accounting. This unit also includes simple explanation of the 13 basic accounting concepts.

In this unit This unit contains the following topics:

Topics See PageNature and Scope of Accounting 2 of AHistory of Accounting Thought 5 of AUsers of Financial Statements 6 of AForms of Business Organizations 8 of ABasic Accounting Concepts 9 of AThe Accounting Profession 17 of A

Marivic D. Valenzuela-Manalo Page 1of A

Nature and Scope of Accounting

Overview The two terms accounting and bookkeeping have been used interchangeably

and without distinction. This line of thought finds support based on the condition prevailing during the early times when businesses were not as complex and multifarious as they are nowadays. However, recognition of the importance of accounting in the development of modern business methods, the industrial revolution and the growth of unlimited companies that provided the impetus for the development of accounting as a profession has led to the distinction in the concepts and effects of bookkeeping as against accounting.

Definition The following definitions differentiates bookkeeping from accounting:

Bookkeeping deals primarily with the systematic method of recording and classifying financial transaction of business. It is considered to be the procedural element of accounting as arithmetic is a procedural element of mathematics. Normally, books are set up and prepared in a manner that ensures an orderly recording and classification of business transactions. However, because of the rapid economic growth and technological changes, which necessitate the mechanization of the bookkeeping job, the demand for bookkeepers has been reduced. The bookkeeping process is now basically done through the use of computers and soft wares designed for such purpose.

Accounting as differentiated from bookkeeping has been authoritatively defined by the American Institute of Certified Public Accountants (AICPA), as the art of recording, classifying and summarizing in a significant manner and in terms of money, transactions and events that are, in part at least, of a financial character, and interpreting the results thereof. Accounting is also defined by the Philippine Institute of Certified Public Accountants (PICPA) as a system that measures business activities, processes given information into reports, and communicates those findings to decision-makers.

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Nature and Scope of Accounting, Continued

Definition, con’t

The “art” in AICPA’s definition connotes that accounting is an art of communication. Although the primary function of accounting is to supply of financial information, it also provides non-financial information.

Moreover, accounting is referred to as a science in the sense that is a systematized knowledge. A growing body of accounting theories seeks to place accounting in the context of human knowledge and activity in general.

Hence, an accountant is a bookkeeper and more, for he must not only be well- versed with the recording process but must also be concerned with the functions of interpretation and analysis of financial statements which require the exercise of reason, judgment and intelligence of a higher order. It is these functions that best distinguish accounting from bookkeeping.

Language of Business

Accounting is a special kind of language. It is often described as the “language of business” because it is the medium of communication between a business firm and the various parties interested in its financial activities. It is the tool, which enables firms to communicate to various interested third parties certain quantitative information about the financial activities of a business.

Accounting is often utilized whenever there are business transactions. And business transactions normally involve people. One cannot engage in business without involving and affecting other persons. The activities of a business enterprise involve and affect many parties -- management, owners, short-term and long-term creditors, employees, prospective investors, the government, and even the general public. All these interested parties need to be informed about the financial affairs of a business enterprise. Accounting, therefore, serves this need of providing quantitative information, primarily financial in nature, about economic entities that is useful in making economic decisions.

The principal accounting reports are the financial statements, i.e., the balance sheet, income statement and the cash flow statement. As the major end products of accounting, these statements convey to management and/or interested outsider(s) the messages about the financial activities of the business.



Nature and Scope of Accounting, Continued

Language of Business, con’t.

Information needed by different parties is of three kinds:

The financial condition or position of the business, i.e., the amounts and kinds of its assets and liabilities, and the status of the owners’ interest at a given point in time.

The financial performance or results of operations, i.e., whether the business operating activities during a given period of time resulted in net income or a loss.

The financing and investing activities that are responsible for the changes in the financial resources of the business, i.e., the sources and applications of fund during a given period of time.

This information, furnished through accounting, are utilized by end-users as basis for reaching important decisions affecting themselves, the business enterprise, the government and other parties.


History of Accounting Thought

Overview Accounting has a long history. Some scholars claim that writing arose in

order to record accounting information. Account records date back to the ancient civilizations of China, Babylonia, Greece and Egypt. The rulers of these civilizations used accounting to keep track of the cost of labor and materials used in building structures like the great pyramids.

History Accounting developed as a result of the information needs of merchants in

the city-states of Italy during the 1400s. In that commercial climate a monk, Luca Pacioli, a mathematician and friend of Leonardo da Vinci, published the first known description of double-entry bookkeeping entitled Summa de Arithmetica, Geometria, Proportioni et Proportionalite (Everything about Arithmetic, Geometry, and Proportion), published in Venice in November 1494. This book contained primarily principles of mathematics and incidentally set of accounting procedures. (Horngren, Harison and Robinson,1995).

The pace of accounting development increased during the Industrial Revolution as the economics of developed countries began to mass-produce goods. Until that time, merchandise was priced based on managers’ hunches about cost but increased competition required merchants to adopt more sophisticated accounting system.

In the nineteenth century, the growth of corporations, especially those in the railroad and steel industries, spurred the development of accounting. Corporate owners, were no longer necessarily the managers of their business. Managers had to create accounting systems to report to the owners how well their businesses were doing.

Government played a role in leading more development in the field of accounting when it started using the income tax. Accounting supplied the concept of “income”. Also, government at all levels has assumed expanded roles in health, education, labor and economics planning. To ensure that the information that it uses to make decisions is reliable, the government has required strict accountability in the business community.

At the beginning of the third millenium, there would still be a lot of developments in the field of accounting. The great challenge of globalization and the effects of new technologies (e.g. super computers, robotics, inter and intra-net, etc.) pose a shift in the structure and pattern in this field. More and better information are now being required and therefore, accounting, being the means used in communicating business and financial information must also evolve into a more efficient level.


Users of Financial Statements

Overview Today's accountant focuses on the ultimate needs of decision-makers who use

accounting information, whether decision makers are inside or outside the business. Accounting "is not an end in itself," but is an information system that measures, processes, and communicates financial information about an identifiable economic entity (Needles, Belverd, et al, 1999). It provides a vital service by supplying the information decision-makers needs to make "reasoned choices among alternative uses of scarce resources in the conduct of business and economic activities.”

Internal Users Those who are directly involved in the business enterprise such as:

Owners. The owner provides the money/capital that the business needs to begin operations. Through the financial reports, the owner can properly manage and monitor the business, analyzing whether or not he can expect reasonable return from his investment.

Management. Managers of business use accounting information to set goals for the organization, to evaluate the progress made toward those goals, and to take corrective action if necessary.

External Users Those who are not directly involved in the operation of the business such as:

Potential investors. Investors use financial reports in evaluating what income they can reasonably expect from their investment.

Creditors. Potential lenders or current creditors determine the borrower’s ability to meet scheduled payments.

Taxing authorities. Local and national government levy taxes on individuals and businesses. The amount of the tax is determined using accounting information.



Users of Financial Statements, Continued

External Users, con’t.

Those who are not directly involved in the operation of the business such as:

Government regulation agencies. Most organizations face government regulation. For example, the Securities and Exchange Commission (SEC) requires businesses to disclose certain financial information to the public. The SEC, like many government agencies, bases its regulatory activity in part on the accounting information it receives from firms.

Nonprofit organizations. Nonprofit organizations, e.g., churches, most hospitals, government agencies, and colleges, which operates for purposes other than to earn a profit use accounting information in much the same way that profit-oriented businesses do.

Other users. Employees and labor unions may make wage demands based on the accounting information that shows their employer’s reported income. Consumer groups and the general public may also be interested in the amount of income that the businesses earned.


Forms of Business Organization

Based on Ownership

There are three basic forms of business organization according to ownership. This classification is based on owner/s investing or putting capital on a business being started.

Sole or single proprietorship. When only one person makes the investment.

Partnership. When two or more persons agree to operate the business as co-owners under certain conditions. The persons owning this form of business are called partners.

Corporation. A body formed and authorized by law to act as a single person although constituted by one or more persons and legally endowed with various rights and duties. This is the more popular form of business organization today. Persons who put in capital in a corporation are called stockholders.

Based on Operations or Activity

Business may also be classified according to business operations or activity after the necessary capital has been received from the owner or owners and the business starts its operations. The purpose for which the business has been formed will determine the nature of its activities.

Service concern. Businesses engage in the rendering of services to others for a fee, like the beauty parlor, law firm, dental clinic, and medical clinic.

Merchandising or trading concern. Businesses that are into the buying and selling of goods or commodities like the grocery store, drug store and department store.

Manufacturing concern. Businesses that are engaged in the processing of products or the conversion of raw materials into finished goods that are then sold like the furniture factory and shoe factory. A trading or merchandising business differs from a manufacturing concern in that the former buys finished goods, which are ready for sale, while the latter produces or manufactured the goods that it sells.


Basic Accounting Concepts

Overview The Generally Accepted Accounting Principles (GAAP), also known, as

the basic accounting concepts are the ground rules that govern how accountants measure, process and communicate financial information. These principles have been developed by the accounting profession over the years to provide a consistent system of financial reporting in a constantly changing business environment (Smith, Keith, et al, 1993).

These concepts assure users of financial statements that the reports are prepared in specific ways so that they are reliable and comparable for the usefulness of these reports rests on their reliability and comparability.

Purpose Generally accepted accounting principles serve three basic purposes:

They help increase the confidence of financial statement users that the financial statements are representationally faithful.

They provide companies and accountants who prepare financial statements with guidance on how to account for and report economic activities.

And they provide independent auditors of financial statements with basis for evaluating the fairness and completeness of those statements (Chasteen, l., Flaherty, R., O'Connor, M., 1998).

Entity Concept For accounting purposes, an entity is the organizational unit for which

accounting records are maintained, e.g., Joseph Labrador Accounting Firm. Under entity concept, the business is regarded as having a separate and distinct personality from that of the owner/s – generating its own revenue, incurring its own expenses, owning its own assets, and owing its own liabilities (Smith, Keith, et al, 1993). This means that the personal transactions of owners must not be combined with transactions of the business.

This concept also requires that an accountant record only those financial activities that occur between the entity being accounted for and other parties. Thus, the accounting entity assumption establishes boundaries or limits as to what information should be included in the financial statements of a given company.



Basic Accounting Concepts, Continued

Entity Concept, con’t

Business Transaction. A business event that can be measured in terms of money that affects the enterprise. This would give rise to an exchange between the business and another party: “value received and value parted with”.

Example: A barber provides services to a customer by trimming the latter's hair: “value parted with” by the barber will be his service and time; and the “value received” is the payment made by the client.

Monetary Concept

Money is a common unit of measure that we can use to record economic transactions and prepare financial statements. Under this concept, money is used as the unit of measure in preparing the various financial reports of the company (example of these would be in terms of Peso ( P ), Dollar ( $ ), etc.).

It is a common belief that everybody understands money—it's universally available, its certainly relevant to financial transactions and its easy to use. But money, the "peso" in our case, as a measure of economic activity does not have a constant value especially in recent years. It is not time in itself that causes the change in the value of money but economic events, e.g., change in government leadership, chaos in the stocks markets, etc. The stable money concept assumes that, monetary unit of measure does not change value overtime, even if in fact it does. The assumption is made in order to ensure objectivity in reporting data on the financial statements.

Time Period Concept or Periodicity

It is also known as periodicity concept. It divides the life of the business into regular intervals (usually one year) at the end of which financial statements are prepared. This means that the economic activities undertaken during the life of an accounting entity are assumed to be divisible into various artificial time periods for financial reporting purposes. For example, it is assumed that a reasonable report of income earned can be made annually or quarterly, even though the revenue generating activities of a business are continuous.




Time Period Concept, con’t.

This is the assumption that implies that it is necessary to measure accounting income for periods of time less than the life of a firm and that measurement will not be precise but will be timely and therefore useful (Smith, Keith, et al, 1993).

In choosing one year, the business has two options:

Calendar Year. A twelve-month period beginning with January 1 and ending December 31.

Fiscal Year. The length of the fiscal period is determined by the nature of the business and the frequency of the need for data regarding the financial condition and progress of the business. A yearly fiscal period does not start with January 1 and end on December 31. (e.g., educational institutions normally follows a fiscal year beginning May 1 and ending April 30).

Revenue Realization Concept

Revenue or income is the inflow of assets that results from producing goods or rendering services. Revenue is not earned all at one point in time. Instead, the earning process extends over a considerable length of time.

The revenue realization concept provides that income is recognized when earned regardless whether cash is received. This means that both of the following conditions are met:

The earning process is essentially complete;

An exchange has taken place (Smith, Keith, et al, 1993).

These two conditions for most of the companies are met at the time goods are sold or services rendered. To wit:

Two points of income recognition:

Income is considered earned when services are fully rendered.

Income is considered earned when goods or merchandise are fully delivered.




Accrual Concept

This concept requires that income be recorded when earned regardless whether cash is received. And an expense be recognized when incurred (e.g., when services or benefits have already been received) regardless whether payment is made.

To apply the accrual concept, accountants have developed the accrual accounting. The accrual method of accounting attempts to record the financial effects on a company of transactions and other events and circumstances in the periods in which those transactions, events, and circumstances occur rather than only the periods in which cash is received or paid by the firm. This means that accrual accounting consists of all techniques developed by accountants to apply both the accrual and matching concepts (Needlers, Powers, et al, 1999).

Throughout this study guide we illustrate the accrual basis of accounting, which is required under the Generally Accepted Accounting Principles. Essentially, the accrual basis records expenses (i.e., cost of items used or consumed in business operations, e.g., electricity, water, supplies, etc.) when incurred and revenues (i.e., price of goods sold or services rendered, e.g., service income, sales) when earned.

It is also worth mentioning here that other than the accrual basis, we also have what we call the cash basis of accounting, which generally records a journal entry upon exchange of cash, typically does not require many adjusting entries (Dyckman, T., Dukes, Davis, C., 1998).

Matching Concept

This concept states that all expenses incurred to generate revenues must be recorded in the same period that the income are recorded to properly determine net income or net loss of the period. There is a cause-and-effect relationship between revenue and expense recognition implicit in this definition

Revenues are inflows of resources resulting from providing goods or services to customers. For merchandising companies like Shoe Mart, the main source of income is sales revenue derived from selling merchandise. Service firms such as SGV and Company generate revenue by providing services.




Matching Concept, con’t

Expenses on the other hand are outflows of resources incurred in generating revenue. They represent the costs of providing goods and services. The matching principle is a key player in the way we measure expenses. We attempt to establish a causal relationship between revenues and expenses. If causality can be determined, expenses are reported in the same period that the revenue is recognized. If the causal relationship cannot be established, the expense is either related to a particular period. Allocated over several periods, or expensed as incurred (Spiceland, D., Sepe, J., 1998).

Example: Revenues earned in June and collected in June P30,000 Revenues earned in June but collected in July 20,000 Revenues earned in May but collected only in June 10,000 Expenses incurred in June and paid in June 10,000 Expenses incurred in June but payable in July 15,000 Expenses incurred in May but paid in June 7,000

Net Income or Net loss is computed by deducting total expenses of the period to total revenue of the same period. If total revenue is greater than total expenses, the company’s result of business operation is a net income. But if total expense is greater, the result is a net loss.

Net Income for June:

Revenues (30,000 + 20,000) P50,000 Expenses (10,000 + 15,000) 25,000 Net Income P25,000

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Objectivity or Reliability Concept

This principle requires that all transactions must be evidenced by business documents free from personal biases and independent experts (e.g., CPA) can verify reports.

Example: Official receipts, invoices, vouchers, etc.




Cost Concept Assets, i.e., resources acquired by the business, must be recorded at acquisition price (i.e., what you have to give up in exchange for an ownership of an asset) and no adjustments are to be made on this valuation in later periods.

The cost principle assumes that assets are acquired in business transactions conducted at arm's length transactions, i.e., transactions between a buyer and a seller at the fair value prevailing at the time of the transaction. For non cash transactions conducted at arm's length, the cost principle assumes that the market value of the resources given up in the transaction provides reliable evidence for the valuation of the item acquired (Dyckman, T., Dukes, Davis, C., 1998).

The cost principle provides guidance primarily at the initial acquisition date. Once acquired, the original cost basis of some assets is then subjected to depreciation, depletion, amortization, etc. over time to reflect the said assets in the balance sheet in a more realistic valuation.

Going Concern Concept

In the absence of information to the contrary, this concept assumes that the business is to continue its operations indefinitely. This means that the business will stay in operation for a period of time sufficient to carry out contemplated operations, contracts, and commitments. This non liquidation assumption provides a conceptual basis for many of the classifications used in accounting. Assets and liabilities, for example, are classified as either current or long term on the basis of this assumption. If continuity is not assumed, the distinction between current and long term loses its significance; all assets and liabilities become current. Continuity supports the measurement and recording of assets and liabilities at historical costs and not at their liquidation values (i.e., estimated net realizable amounts) (Dyckman, t., Dukes, Davis, C., 1998).




Conservatism Concept

This concept has a powerful influence in valuing assets and measuring net income. When faced which uncertainties, the accountant traditionally leans towards the direction of caution, choosing the method that would give the business a less favorable financial condition and lowers net income.

The reasoning behind this assumption is that investors prefer information that does not unnecessary raise expectations. For example:

In recognizing assets, preferably the lower of two alternative valuations would be recorded.

In recognizing liabilities, preferably the higher of two alternative amounts would be recorded.

In recording revenues, expenses, gains, and losses where there is reasonable doubt as to the appropriateness of alternative amounts, the one having the least favorable effect on net income should be preferred.

Conservatism assumes that when uncertainty exists, the users of financial statements are better served by understatement than by overstatement of net income and assets (Dyckman, t., Dukes, Davis, C., 1998).

Consistency Concept

This concept states that once a method is adopted, it must not be changed from year to year to allow comparability of financial statements between years and between businesses.

For example if the First In First Out (FIFO) method was used by the firm in valuing their inventories, the firm should not change the method into Last In First Out (LIFO) in the following year and then go back again to FIFO on the next year.

Consistency in this case means that the reported information conforms with procedures that remain unchanged from period to period. Comparison overtime are difficult unless there is consistency in the way accounting principles are applied across accounting year.




Materiality concept

This concept refers to relative importance of an item or event. An item/event is considered material if knowledge of it would influence the decision of prudent users of financial statements.

To illustrate an instance where strict conformity with GAAP is not necessary because an item is immaterial, consider a low-cost asset, such as a P150 waste can. This item can be recorded as an expense in full when purchased rather than an asset subject to depreciation. The peso amount involved is simply too small for external users of financial reports to worry about.

Disclosure concept

All relevant and material events affecting the financial condition/position of a business and the results of its operations must be communicated to users of financial statements.

We must remember that the purpose of accounting is to provide information that is useful to decision-makers. So, naturally, if there is accounting information not included in the primary financial statements that would benefit users, that information should be provided to.

Supplemental information is disclosed in a variety of ways including:

Parenthetical comments or modifying comments placed on the face of the financial statements.

Disclosure notes conveying additional insights about company operations, accounting principles, contractual agreements, and pending litigation.

Supplemental financial statements that report more detailed information than is shown in the primary financial statements. (Spiceland, D., Sepe, J., 1998)


The Accounting Profession

Overview The success of the accountant in the accounting profession depends on how

well he understands the accounting procedures and principles, and on how clearly and accurately he can communicate financial information to the users of the statements.

Classification The nature of these works though relies on the position, which the accountant

holds in his field. The positions in the field of accounting are generally classified into two, namely, public accounting and private accounting.

Public Accountants are those who serve the general public and collect professional fees for their work such as doctors and lawyers do. Their work include auditing, income tax planning and preparation and management consulting. Those public accountants who have certain professional requirements are designated as Certified Public Accountants (CPAs).

Private Accountants work for a single business, e.g. PLDT, Meralco, Jollibee, etc. Charitable organizations, educational institutions and government employ private accountants. Some accountants would also pursue a career in education and research

Certified Public Accountant

A Certified Public Accountant (CPA) is a professional accountant who earns his title through a combination of education, qualifying experience, and an acceptance score in the written national examination given by the Board of Accountancy.

The Board of Accountancy prepares, grades and gives the results of the examination to the Professional Regulation Commission (PRC) who then issues licenses that allow qualifying examinees to practice accounting as CPAs.

CPAs must also be of good moral character and must carry on their professional practices according to a code of professional conduct.



The Accounting Profession, Continued

Organizations The Philippine Institute of Certified Public Accountants (PICPA) is the national professional organization of CPAs in the country.

In order to formalize the accounting standard-setting function in the Philippines, the Philippine Institute of Certified Public Accountants (PICPA) established the Accounting Standards Council (ASC).

The Accounting Standards Council's main function is to establish and improve accounting standards that will be generally accepted in the Philippines (Preface to Statements of Financial Accounting Standards of ASC, 1999).

The Accounting Standards Council (ASC) is the same body that formulates the Generally Accepted Accounting Principles (GAAP). These principles are the most important accounting guidelines that provide the general framework determining what information is included in financial statements and how this information is to be presented.

The ASC has approved in November 2004 the adoption of International Accounting Standards (IAS) 1, Presentation of Financial Statements, issued by the International Accounting Standards Boars (IASB), as the Philippine Financial Reporting Standards (Preface to Philippine Accounting Standard (PAS) 1 of ASC, 2005).


Documents

Unit I (Introduction to Accounting)