Chapter 3:

ACCOUNTING CONCEPTS
AND PRINCIPLES

Chapter Outline
1) Accounting Concepts, 8) Basic Financial Statements
Conventions and Principles 1) Elements of Financial Statements
2) Generally accepted Accounting 2) Relationship among Financial
Principles Statements
3) Conceptual Framework 3) Basic Accounting Elements
4) Basic Assumptions 4) Definition, Classification and
In Accounting 5) Definition, Classification and
5) Basic Principles in Accounting Examples of Accounts
6) Accounting Constraints
7) Qualitative Characteristics
Of Accounting Information

Accounting Concepts, Convention and Principles

Users of financial reports should be able to understand financial information in order to draw
sound consistent and profitable economic decisions.

Proper understanding of financial statements is possible only when a user has basic knowledge
of concepts, conventions and principles which serve as guidelines in financing reporting.

Accounting concepts are important ideas which accountants assume is recording business
transactions.

Examples of accounting concepts are separate entity, going concern, time period, accrual and
monetary unit. These serve as the bedrock of accounting and they are also known as postulates
or accounting assumptions

Accounting conventions are accounting practices that practitioners accept because of their long
existence and use. A good example of an accounting convention is the use of debit and credit or
the dual aspect concept. Accountants have long observed this practice based on the idea that in
Every business transaction, a value received has a corresponding value given.

Accounting principles are those that have first importance, which define broadly the actions
that will best accomplish the objectives of accounting. It refers to a doctrine, which is he basis of
all other rules, procedures and methods used in accounting practice.

Accordingly, accounting principles are distinguished from accounting procedures, rules and methods
because the latter comprise the specifics on how transactions and other events should be
recorded, classified, summarized and presented. They are the means of implementing
accounting principles.

Accounting principles are continually evolving and developing to meet changing needs and
conditions. They are influenced by changes in economic conditions and business practices by
the needs of users of financial statements, by practical necessity and by the reasoning and
experience of accountants.

Accounting concepts, conventions, principles, rules, assumptions, doctrines and postulates

these terms are not exactly the same in meaning but over several years, accountants have used
them interchangeably.

The Generally Accepted Accounting Principles

The authoritative body of accountancy formulated standard principles, assumptions and

procedures that are called Generally Accepted Accounting Principles (GAAP). These
principles are used uniformly by accountants in measuring, recording, and reporting financial
activities of an entity. These are developed based on experience, research and careful study.
They become generally accepted by agreement among accounting practitioners.

The main objective of GAAP is expressed in the phrase of the standard auditors report which
states to fairly present the financial statements in conformity with generally accepted
accounting principles

The GAAPs used in the Philippines are the PASs and PFRSs. They are adopted by the FRSC
from the IASs and IFRSs of IASB.

Conceptual Framework for Financial Reporting

A conceptual framework establishes the ideas that bring about financial reporting. It is a
coherent system of concepts that flow from an accounting objective which identifies the purpose
of financial reporting.
Chapter 3: Accounting Concepts and Principles

The accounting conceptual framework establishes a common ground on the following:

1. Identifying the boundaries of financial reporting;

2. Selecting the transactions, other events, and circumstances to be represented;
3. Recognizing and measuring; and
4. Summarizing and reporting transactions and events

The conceptual framework harmonizes varying accounting concepts to achieve a coherent set of
accounting standards that are most useful and consistent.

A soundly developed conceptual framework would lend credibility to financial reports and
would provide clear understanding and confidence in financial reporting. With it, the
accounting profession should be able to quickly solve new emerging practical problems to an
existing framework of the basic accounting theory.

Overview of Conceptual Framework

THIRD LEVEL: how is SECOND LEVEL: what FIRST LEVEL: why is

financial reporting done? does financial reporting financial reporting done?
comprise of?
Recognition, measurement and Disclosure

ASSUMPTIONS QUALITATIVE
CHARACTERISTICS
of accounting
information
OBJECTIVE
Concepts

PRINCIPLES Of
Financial
ELEMENTS
reporting
of
Financial
statements

CONSTRAINTS

The objective of financial reporting ( to provide useful fi nancial i nformation to economic decision-makers) is the
foundation of the Conceptual Framework. Other aspects of the Framework (qualitative characteristics, elements
of fi nancial statements, recognition, measurement a nd disclosure) help to ensure that financial reporting
a chi eves its objective.
Basic Assumptions in Accounting

Accounting assumptions provide a foundation for the rational and systematic formulation of
principles and the development of procedures and methods used to perform accounting
services.

Five basic assumptions stand as foundations of the financial accounting structure, namely: (1)
economic entity, (2) going concern, (3) monetary unit, (4) periodicity and (5) accrual basis.

Economic Entity Assumption

Under economic entity, accountants regard a business enterprise as a separate and distinct entity
from the person or people who own and run it. Consequently, a business must keep its own record
from the point of view of a business and not be merged with the personal transactions of the
owners.

The main purpose of observing the separate entity concept is to properly account the real
transactions of the business in order to report the true and fair picture of the business financial affairs.

The personal transaction(s) of the owner(s) should not be allowed to distort the fina ncial report
of the business. Hence, it should be observed that economic transactions engaged into by
different entities should be separately accounted for.

Other terms to describe this concept are separate entity concept, entity concept, accounting entity or
business entity concept.

Going Concern Assumption

This concept assumes that the business entity will continue operating indefinitely for period of
time sufficient to carry out its contemplated objectives, plans, contract and commitments unless
the liquidation of the entity is imminent.

In the preparation of financial statement, the accountant assumes that the business has no
intention of stopping; liquidating, or curtailing its operation. Hence, the values of accounting
elements in the financial statements should be based on the accounting conventions of objectivity
and historical cost.

Objectivity stated that accounting measurement must be both definite and verifiable. All
documents used in record keeping must be evidence by a source document that identifies the actual cost
incurred.
Chapter 3: Accounting Concepts and Principles

Historical cost helps to attain objectivity by considering only the purchase price as the value of
an asset. It is called historical cost because, once recorded, it remains unchanged.

If the business has the intention to liquidate, it becomes a liquidating concern. The valuation of
accounting elements in the financial statements is valued at their fair market value which
should be disclosed in the notes to financial statements.

Depreciation and amortization policies are justifiable and appropriate only if the business
enterprise assumes permanency in its existence. If it liquidates, the current or noncurrent
classification of assets and liabilities defeats its significance.

Monetary Unit Assumption

This accounting concept assumes that money is the common denominator in measuring
economic activity.

Accounting generally pays no attention to inflation or deflation (price level changes) and
assumes that the monetary unit remains stable regardless of fluctuation in money value.

Changes in money purchasing power are generally not accounted for. Only if circumstances
change dramatically that inflation accounting is considered.

This assumption supports the going concern assumption of accounting.

Periodicity (or Time Period) Assumption

Time period assumes that the life of the enterprise is divided into several periods (normally at
equal lengths of time). Thus, when a financial report is prepared, it is important to indicate the date
when it was prepared and the time period it covers.

Accountants prepare progress financial reports at the end of an accounting period primarily to
cater he needs of management in evaluating the performance and economic condition of the
business.

The financial reports prepared during a given time period, however, only reflect a portion of its
operating performance during its lifetime.

The periodic evaluation of business performance and economic condition is necessary in

making economic decisions that would lead to appropriate corrective measures, or the
continuance or discontinuance of the business.
A time period is usually called an accounting period, which is classified as either (a) calendar
year, (b) fiscal year, or (c) interim period.

The accounting period may refer to the Financial Reporting Time Line. This concept answers
the question as to when a particular financial statement could be reported and as to what the
scope of the period of reporting is.

Start Accounting Period End

The Statement of Financial Position can be prepared any time within the given period.

Financial statements prepared at the

end of the period covering business transactions
from start to the end:
Statement of Comprehensive Income
Cash Flow Statement Owners Equity Statement

A calendar year is a twelve-month period which starts from January 1 to December 31 of the
accounting period.

For example, if the accounting period starts on January 1, 200A and ends on December 31, 200A,
the sample financial report in a calendar year period would look like this:

SPEED COMPUTER SERVICE

This is a calendar year financial
Statement of Comprehensive Income
statement showing the
For the Year Ended December 31, 200A accumulated balance of
transactions of a twelve-month
Revenue:
Computer rentals P500, 000 period from January 1 to
Computer repairs 400, 000 December 31, 200A.
Total revenue P900, 000
Expenses:
Sa l ary expense P460, 000
El ectri c expense 280, 000
Depreciation expense 100, 000
Tel ephone expense 47, 000
Supplies expense 3, 000
Tota l expenses P890, 000
Net Income: P10, 000

A fiscal year is also composed of twelve months but starts from any month other than January.
Consequently, fiscal year does not end in December of the accounting period.

For example, to get the twelve-month period for a business that starts its fiscal year from
November 1, 200A, the end should be dated October 31, 200B.
Here is a sample financial report within a fiscal year period:

SPEED COMPUTER SERVICE

Statement of Comprehensive Income This is a fiscal year financial
statement showing the
For the Period Ended October 31, 200B accumulated balance of
Revenue: transactions during a twelve-
Computer rentals P500, 000 month period starting from
Computer repairs 400, 000 November 1, 200A o October 31,
Tota l revenue P900, 000
Expenses: 200B.
Sa l ary expense P460, 000
El ectri c expense 280, 000
Depreciation expense 100, 000
Tel ephone expense 47, 000
Supplies expense 3, 000
Tota l expenses P890, 000
Net Income: P10, 000

An interim period is a business period within an accounting period. When financial reports are
prepared at any date even if the twelve-month period is not yet due, the reports are called
interim reports because they are prepared within an interim period (e.g. weekly, monthly,
quarterly, or semi-annual).

To illustrate, below is a sample financial report with a specific interim period:

SPEED COMPUTER SERVICE

Statement of Comprehensive Income This is a quarter interim period.

For the Year Ended December 31, 200A An interim period financial
Revenue:
statement can be prepared in
Computer rentals P130, 000 any period within a year.
Computer repairs 80, 000
Tota l revenue P210, 000
Expenses:
Sa l ary expense P110, 000
El ectri c expense 60, 000
Depreciation expense 22, 000
Tel ephone expense 7, 300
Supplies expense 700
Tota l expenses P200, 000
Net Income: P10, 000

Except for the Statement of Financial Position which is prepared any time (as of a given date),
the statement of comprehensive income, cash flows statement, and the statement of changes in
owners equity are prepared at the end of the given period covering the start of the period to the
end of the period.
 BASIC ACCOUNTING

Accrual-Basis Assumption

Financial statements, except Statement of Cash Flows, are prepared on the accrual basis of
accounting. On this basis, the net profit of a business enterprise is the difference between the
revenues and expenses for an accounting period and not the difference between cash receipts and
cash disbursements.

In other words, the revenue of an enterprise includes not only those cash receipts from revenue
transactions during a financial period, but also the income earned but not yet received (accrued
income).

Expenses, on the other hand, include not only the cash that a business pays out in this period
but also the expenses outstanding (accrued expense).

The accrual concept provides information about past transactions and other future economic
events that are most useful to users in the making of economic decisions.

In contrast to the accrual basis is the cash basis. Under cash-basis accounting, business entity
records revenue or expenses only when cash is received or paid. Cash-basis accounting is not
allowed under IFRS because it violates the revenue and expense recognition principles.

Basic Principles of Accounting

There are four basic principles of accounting that are used to record and report business
transactions, namely: (1) measurement, (2) revenue recognition, (3) expense recognition, and (4)
full disclosure.

Measurement Principles

Measurement principles guide accountants how assets and liabilities are valued. Accounting
uses two measurement principles:

1. Cost Principle (also known as historical cost principle). As required by IRFS, business
entitles should account for and report many assets and liabilities on the basis of
acquisition price.

Many users prefer the cost principle because it adheres to the fundamental qualities of
faithful representation and establishes verifiable benchmark for measuring historical trends.

2. Fair Value Principle. Fair value is defined as the amount for which an asset could be
exchanges, a liability could be settled, or an equity
 instrument granted could be exchanged between knowledgeable and willing parties in
an arms length transaction.

This valuation principle is a market-based and is currently increasing because it

provides more relevant information regarding the expected future cash flow related to
the asset or liability.

IFRS has allowed for the use of fair value measurement in some certain types of assets
and liabilities and in certain types of industries.

Examples when fair value measurement is used are as follows:

Particulars: Valuation
1. Financial instruments, including derivatives Fair Value
2. Financial statements of brokerage and Fair Value
mutual funds companies
3. Long-lived assets with significant decline Fair Value
in value
4. Agricultural industry, biological assets Net realizable value
such as crops and livestock

Net realizable value generally approximates the fair value of assets.

Revenue Recognition Principle

Revenue is synonymous to income. Income is defined as increases in economic benefits during

the accounting period in the form of inflows or enhancements of assets or decreases of liabilities
that result an increases in equity, other than those relating to contributions from equity
participants.

As a rule, income is recognized when earned or has been substantially completed, generally at
the point of sale. It is because the transfer of a title of ownership is made at the point of sale.

Revenue is recognized at the point of sale because the point of sale provides a uniform,
objective, and reasonable test to verify transfer of ownership for a consideration.

Revenues are measured at the fair value of the consideration received or receivable.

Exceptions to the rule to recognize revenue at the point of sale are as follows:

1. Earlier recognition. Revenue can be recognized before the time of the sale. This may be
in two exceptional manners as follows:
 a. At the point of completed production. When products have a ready market, with
established price and with no substantial expenses or effort for their sale, revenue
can be reported at the time of completed production even if there is no actual
exchange that has taken place.

The mining of certain precious metals (such as gold, and diamond) and the harvest
of agricultural products (such as palay, corn and cotton) that are supported by
government price guarantees are examples. Revenue is recognized before sale by
valuing inventory of products on hand at market value.

b. At a certain percentage of completion. This special revenue recognition is applicable

when production or performance of service to complete an advanced contract
extends for more than one year.

Examples of percentage of completion are construction contracts for buildings and

roads, or scientific research contracts.

2. Later recognition. Revenue recognition after the point of sale is applicable when the
collections for the payments of services rendered or goods delivered are doubtful even if
the goods are already delivered or the services have been rendered. Later recognition
thus refers to the point of collection or is determined on a collection basis. The best
example of later revenue recognition is installment sales.

There are three methods generally employed recognizing revenue after the time of sale:

a. Cash or profit recovery method. This method recognizes first the profit upon collection.
Later collections shall be applied to the cost of the product sold.

b. Cost recovery method. In this method, the recognition of revenue is made only when the
related costs o expenses of sale are fully recovered. In other words, revenue is excess
portion of collection over cost incurred.

c. Installment method or Hybrid method. This is usually applied on a cash basis and
installment sales. In installment sales, revenue is to be recognized by multiplying the
total collection by the gross profit rate.

Expense Recognition Principle

Expenses are defined as outflows or other using up of assets or incurring of liabilities (or a
combination of both) during a period as a result of delivering or producing goods and/or
services.
Expense recognition principle is synonymous with the matching principle because as a rule,
expense is recognized when income is earned.

The matching principle states that all costs that were incurred to generate the revenue
appearing on a given periods statement of comprehensive income should appear as an expense
on the same statement.

The expense recognition principle is applied in one of three ways, as follows:

1. Associating Cause and Effect. This is also called direct matching principle because there
is a clear and direct relationship that exists between the expense and the associated
revenue.

Examples are cost of sales and sales commission expense.

2. Systematic and Rational Allocation. Some assets are useful and can provide benefits o
the business over several years. The costs of these assets are expensed over the years
they provided benefits to the business. Examples are depreciation expense of building,
equipment, furniture and fixtures used in the business.

3. Immediate Recognition. These expenses have no discernible future benefit and so they
are expensed immediately as incurred.

Examples are salaries, expense, rent expense, utilities expense, and interest expense.

Full-Disclosure Principle

Full-disclosure principle. It requires that financial statements should report all relevant
information bearing on the economic affairs of a business enterprise, including subsequent
events.

Many items, such as minutes of the meeting and contracts, fail to meet the criteria of recognition
but must still be known for relevance and complete reporting. In addition, the report should
reveal a transactions economic substance rather than merely its form.

Financial information should also be accompanied with notes to the financial statements and
supplementary schedules and other information. They may include disclosures about the risks
and uncertainties affecting the enterprise and any resources and obligations not recognized in
the SFP.

Information about geographical and industry segments and the effect on the enterprise of
changing prices may also be provided in the form of supplementary information.
Supplemental information is disclosed in a variety of ways, including:

a. Parenthetical comments or modifying comments placed on the face of the

financial statement.

b. Disclosure notes conveying additional insights about company operations,

accounting principles, contractual agreements, and pending litigation.

c. Supplemental financial statements that report more detailed information than is

shown in the primary financial statements.

In complying with the full-disclosure principle, prepares of financial information should keep
in mind the related costs of preparing and using it.

Accounting Constraints

Accounting practice is generally limited by the following constraints (a) Cost; and (b)
Materiality.

Cost Constraint

Cost constraint suggests that the benefits of accounting for and reporting information should
outweigh the costs.

A reporting entity must consider the cost of information. It should conduct a study of the cost-
benefit analysis before making final their informational requirements.

In order to justify the cost of a particular disclosure or measurement, the benefits derived from
using it should outweigh the costs of obtaining and preparing it.

Materiality Constraint

The materiality constraint concerns an items impact on an entitys overall financial operations.
It involves a relatively significant amount and importance that would change a decision if it has
been omitted or presented.

As provided in the IASB Framework: Information is material if its omission or misstatement

could influence the decisions that users make on the basis of an entitys financial information.

If the item is not material, it does not need to be disclosed because its omission would not make
a difference. Thus, materiality provides a threshold or cut-off point for information to be useful.
It gives way to
Chapter 3: Accounting Concepts and Principles

expediency, especially when dealing with very small amounts or transactions.

Limitations of Accounting Concepts

Although these accounting concepts and principles are very useful in developing the
accounting structure of an organization, they also are subject to the following limita tions:

1. There is no complete set of concepts available.

2. Unlike the double-entry system, these concepts are not universally accepted in the use of
their terms as principles, conventions, postulates, assumptions, etc.

3. Even in the application of these concepts, there is no absolute uniformity.

Qualitative Characteristics of Accounting Information

Accounting adopts some basic ingredients necessary to make accounting reports useful. The
qualitative characteristics of accounting information guide the reporting entity in the following:

1. Decision-usefulness. To choose which among the acceptable accounting methods could

provide the most useful information for decision-making purposes. This serves as the
pervasive criterion in the making of financial reports.

2. Relevant-disclosure. To determine the amount and type of accounting information to

disclose; and

3. Reporting format. To use the appropriate presentation and contents of reporting

consistent to the financial reporting objective.
 BASIC ACCOUNTING

HIERARCHY OF ACCOUNTING QUALITIES

PRIMARY USERS OF ACCOUNTING REPORTS

FINANCIAL INFORMATION

Constraints COST MATERIALITY

DECISION-USEFULNESS
Essential criterion

Fundamental
RELEVANCE FAITHFUL REPRESENTATION
Qualities

Predi cti ve Confi rma tory Compl eteness Neutrality Free from
Ingredients of
va l ue va l ue error
Fundamental
Qualities

Enhancing RELEVANCE RELEVANCE RELEVANCE RELEVANCE

Qualities

Fundamental Qualities of Accounting

The fundamental qualities of accounting are (a) Relevance, and (b) Faithful Representation.

Relevance

To be relevant, accounting information must be capable of influencing or making a difference in

an economic decision. Information that does not bear on the problems for which it is intended is
simply no useful regardless of its other qualities. Accounting information can move decision -
makers when it contains predictive value, confirmatory value, or both.

Predictive value. Accounting information should be helpful to decision-makers when it has

inputs to increase their ability to forecast the outcome of future events. Decision-makers working from
accounting information that has little or no predictive value are merely speculating.

Confirmatory value. Accounting information should be helpful to decision-makers who are

validating, making updates, adjustments, or corrections to past predictions.
Chapter 3: Accounting Concepts and Principles

Faithful Representation

The main objective of faithful presentation is to achieve public trust and confidence in the financial
statements.

Accounting information must contain factual transactions and other events it purports to
represent. Accountants should properly report and match the descriptions of the actual events
and their respective amounts in the financial statements as objectively as possible.

For example, if the inventory of Cacho Enterprises is determined to be at the cost of P100, 000, it
must be reported in the Statement of Financial Position (SFP) with such amount. If the amount
is reported otherwise, it distorts the reliability of the financial reports affecting the assets, net
income, and owners equity.

To be faithfully represented, accounting information must be complete, neutral, and free of

material error.

Completeness. The financial reports must contain all necessary information that would
influence an economic decision. An omission can cause information to be false or misleading
and thus would not be helpful to the users of financial reports to make a sound decision.

Neutrality. Information is neutral when it is fair or free from bias toward a desired result or behavior.
Accordingly, accountants should prepare the financial statements as objectively as possible,
without discrimination or without favouring one party to the detriment of another.

The accounting reports should be general-purpose financial statements serving the common
needs of all interested parties. Usually, neutrality is achieved when the financial statements are
prepared in accordance with the generally accepted principles of accounting.

This characteristic of accounting report is by itself an application of the principle of fairness.

Free from error. Financial information must be free from material error to faithfully embody the
representation contained therein.

Faithful representation, however, does not imply total freedom from error. This is because most
financial reporting measurements involve estimates based on management judgement or
company experiences.

Examples of estimates are the estimated uncollectible amounts of receivables and the estimated
useful lives of plant and equipment.
 BASIC ACCOUNTING

Enhancing Qualities of Accounting

Complementary to the fundamental qualitative characteristics are the enhancing qualitative

characteristics of financial reporting. These characteristics set-apart more-useful information
from less-useful information. Enhancing qualities include the following characteristics of
financial information: understandability, verifiability, timelines, and comparability.

Understandability. To be useful, accounting information must be comprehensible. Accountants

provide understandable financial accounting information by presenting data that can be
understood by users of the information. Accordingly, the financial statements should be
expressed in a form properly classified and with terminologies adapted to the users range of
understanding.

Consequently, the users are expected to study the financial information with reasonable
diligence and are assumed to have a reasonable knowledge of business, economics, and
accounting.

However, information about complex matters which provides relevance to the economic
decision making needs of users should not be excluded from the financial statements merely on
the grounds that it may be difficult for certain users to understand.

Accounting principles do not require business entities to report all potentially useful
information. A balance between benefits and cost must be observed in providing financial
information. Accordingly, accounting information should be provided only when the benefits of the
information exceed the costs of providing and using it.

Verifiability. It occurs when independent measurers, using the same accounting methods,
could arrive with the same results. The information as shown in the financial reports should be
checked and corroborated to prove their faithful representation.

To verify the reliability of financial information, CPAs conduct critical and systematic
examinations of financial statements. This examination is called external auditing.

For instance, to verify the inventory, accountants may conduct the following:

1. Direct verification. This is done when independent auditors conduct actual physical
inspection and count of inventory and confirm the correctness of inventory amount as
presented in the financial reports.
 2. Indirect verification. This is done by simply checking the inputs (quantity and cost) and
recalculating the outputs (ending inventory) using the same accounting methodology.

Timeliness. Accounting information must be available on time when needed if it is to influence

decisions. Lack of timeliness reduces relevance. Information is useless if not available when
needed.

Comparability enables users to identify similarities and differences between two or more sets of
economic circumstances.

Comparisons over time are difficult unless there is consistency in the way accounting principles
are applied across fiscal years. Therefore, the reported financial information should conform to
procedures and methods that remain unchanged from one period to another.

An exception to this concept is when a change would present a better or fairer presentation of
economic activity. When a change occurs, the reason for the change and the impact on the net
income must be disclosed in the financial statements.

Compliance with PAS, including the disclosure of the accounting policies used by the
enterprise, helps to achieve comparability.

Basic Financial Statements

Financial Statements are the formal reports prepared by accountants. These statements show
the financial effects of transactions and other events that are grouped into broad classes
according to their economic characteristics. These broad classes are called elements of financial
statements.

Based on the PAS No. 1, the basic financial statements are the following:

1. Statement of Financial Position (SFP) also known as the balance sheet shows the
financial condition of the business entity at any given time.

This financial statement conveys information about the business entitys liquidity,
solvency, stability, capital structure, and financial flexibility.

The accounting elements of the financial position are Assets, Liabilities, and Equity.

2. Statement of Comprehensive Income is also known as the Income Statement. This

accounting report shows the operating performance of the business entity for a given
period.
 BASIC ACCOUNTING

This financial statement provides information about the business entitys profitability.
The accounting elements of performance are Revenues and Expenses.

3. Statement of Changes in Equity shows the movements in the various elements of the
owners equity or capital for a certain period.

The following are the basic components of this statement:

a. Owners investments to the business;

b. Profit or loss for the period;
c. Owners personal withdrawals; and
d. Prior period adjustments.

4. Cash Flow Statement. This financial report explains the changes of cash and cash
equivalents during an accounting period.

A cash equivalent is a short-term, highly liquid investment that is easily convertible to

cash. (The cash flows statement and cash equivalents are discussed thoroughly in
Intermediate Financial Accounting.)

The components of a cash flow statement are classified into the following activities:

a. Operating the inflows and outflows of cash from the normal operating activities of
the business.

b. Investing the inflows and outflows of cash from the sale or purchase of assets other
than inventory.

c. Financing the inflows and outflows of cash from the owners and creditors of the
enterprise.

The components of the cash flow statement merely explain the sources and uses of cash.
Cash is one of the components of the current assets in the Statement of Financial
Position.

5. Notes to the Financial Statements

The parenthetical disclosures and notes to the financial statements are considered part of
the basic financial statements to achieve proper understanding of the financial reports.
Chapter 3: Accounting Concepts and Principles

Elements of Financial Statements (FS)

The IASB Framework provides five interrelated elements that are used to measuring the
financial position and the operating performance of business enterprise.

The elements directly used to the measurement of financial position are the following:

1. Assets. There are resources owned or controlled by an entity resulting from past events
and from them, future economic benefits are expected to flow to the entity.

2. Liabilities. These are existing obligations of the entity arising from past events; their
settlements are expected to result in an outflow of assets from the entity.

3. Equity. The residual interest in the assets of the entity after deducting all its liabilities.

The elements that are used to measure operating performance consist of the following:

4. Revenues. These are increase in assets or decreases in liabilities arising from business
operation during an accounting period that result to increase owners equity. These
increases in assets are not contributions of owners and creditors.

5. Expenses. These are decreases in assets or increases in liabilities arising from business
operations during an accounting period that result to the decrease in owners equity.
These decreases in assets are not withdrawals of owners or payments of existing
liabilities.

Recognition of the Elements of FS. The word recognition in accounting refers to the process
of recording an item in the books of accounts or reporting the elements of financ ial statements.
It involves the description of an item including its total amounts in the SFP and statement of
comprehensive income.

As a rule, an item should be recognized when the following two criteria are met:

1. Probability of Future Benefit. It is probable that any future economic benefit associated
with the item will flow to or from the entity.

2. Reliability of Measurement. The item has a cost or value that can be measured with
reliability.
For example, an accounts receivable is reported to the financial statement as asset if its
justifiable that it can be collected; otherwise, such receivable shall not be recognized an asset but
as expense because there would be no future benefit from it.

If an item, at a particular time, fails to meet the recognition criteria but is considered to be
relevant, it may be reported as a subsequent event or a disclosure to the financial statements.

Relationships among the Financial Statements

BASIC FINANCIAL STATEMENTS

COMPREHENSIVE STATEMENT OF CASH FLOW

INCOME STATEMENT FINANCIAL POSITION STATEMENT

Revenue Assets Operating

Activities

Less =
Investing Activities
Expenses Liabilities

Equals + Financing
Activities
Net Income (loss) Owners Equity
equals
Cash and cash
equivalents
STATEMENT OF * Owners beginning capital
CHANGES IN EQUITY *Additional investment
*Net Income (loss)
*Prior period adjustments

Notes:

1. The basic financial statements are fundamentally related to each other. The net income (loss) is forwarded as part
of the owner equity. The cash and cash equivalents of the cash flow statements explain the cash and the
cash equivalent item of the current asset in the SFP.

2. The basic equation of accounting is reflected in the elements of SFP.

Comparison of Financial Statements (FS)

Below are the comparative presentation and descriptions of the different financial statements
(all figures assumed).

Statement of Comprehensive Income

The Statement of Comprehensive Income, SCI (Income
ROX RENTAL SERVICE Statement) shows the results of business operations for a
Statement of Comprehensive Income for the Year given period. It usually starts with the heading
Ended December 31, 200x consisting of the following:

Revenues: Name of the business (who?)

Servi ce Income P500, 000 Name of the statement (what?)
Rent Income 50, 000 Date of the statement (when?)
Interest Income 1, 000
P551, 000 This statement can only be prepared after the business
has engaged in its business activities that is, after the
Opera ting Expenses: sales and necessary expenses have been incurred. Hence,
Sa l ary Expense P300, 000 the date indicates year ended or period ended.
Supplies Expense 500
Interest Expense 500 The components of the comprehensive income statement
P301, 000 are the revenues, expenses, and the net income or net
Net Income P250, 000 loss.

Peso sign at the start of each column. Note that the net income is transferred to the statement
of owners equity.
Peso sign under each single line.

Double line at the end of financial report.

The Statement of Owners Equity

The Statement of Owners Equity or Capital Statement
ROX RENTAL SERVICE reveals the movements of the capital account for a
Statement of Comprehensive Income for the Year certain period. It also starts with the heading consisting
Ended December 31, 200x of the following:

Rox, Ca pi tal, Ja nuary 1, 200x P500, 000 Name of the business (who?)
Add: Net Income 250, 000 Name of the statement (what?)
Tota l P750, 000 Date of the statement (when?)
Les s; Rox, Drawing 10, 000
Rox, Ca pi tal, December, 31, 200x P740, 000 The net income from the comprehensive statement of
comprehensive income is added to the beginning capital
account and the owners personal withdrawals from the
business are deducted to arrive at the ending balance of
capital.
Rox ending capital is to be forwarded to
the Statement of Financial Position. Note that the ending balance of capital is transferred to
the SFP.
The Statement of Financial Position
The Statement of Financial Position, SFP (Balance
ROX RENTAL SERVICE
Sheet) shows the financial condition of the business at
Statement of Comprehensive Income for the Year
any given time. It also starts with the heading comprised
Ended December 31, 200x
of the following:

As s ets Name of the business (who?)

Current As s ets: Name of the statement (what?)
Ca s h P565, 500 Date of the statement (when?)
Accounts receiva ble 50, 000
Notes receiva ble 150, 000 Observe that the date of the business starts with the
P765, 500 word as of. This means that the SFP can be prepare
Non-Current Asset: anytime even if the operation of the business has not
Equi pment 60, 000 started yet. As long as the business has assets
Tota l Assets: P826, 500 contributed by owners or creditors, the SFP can be
prepared.
Li a bilities and Owners Equity
Current Li a bilities: The SFP presented on the left side is an example of
Accounts payable P 500 report form. The SFP can also be presented in its account
Notes payable 36, 000 form as shown below:
SSS pa ya ble 20, 000
Wi thholding ta x payable 30, 000
P86, 500
Owners Equity:
Rox, Capital, December, 31, 200x 740, 000
Tota l Liabilities and Owners Equity P826, 500

A SFP report form presents its An account form SFP presents its
elements in vertical order. elements in horizontal order following
the accounting equation, assets =
liabilities = capital.

ROX RENTAL SERVICE

Statement of Comprehensive Income for the Year Ended December 31, 200x

As s ets Li a bi l i ti es a nd Owners Equi ty

Current As s ets: Current Li a bilities:
Ca s h P565, 500 Accounts payable P 500
Accounts receiva ble 50, 000 Notes payable 36, 000
Notes receiva ble 150, 000 SSS pa ya ble 20, 000
P765, 500 Wi thholding ta x payable 30, 000
Non-Current Asset: P86, 500
Equi pment 60, 000 Owners Equity:
Tota l As s ets : P826, 500 Rox, Ca pi tal, December, 31, 200x 740, 000
Tota l Li a bi l i ti es a nd Owners Equi ty P826, 500
Managements Role in FS Preparation

The management (or owner of business) is primarily responsible and interested for the
information contained in the financial statement. Hence. He must ensure that financial
statements are good for general-purpose reporting.

Management must review and approve any adjustments are included in the financial
statements. He must make sure that before the release of the financial statements the
related disclosures are adequate according to the financial reporting standards and that all
the disclosure elements are truthful to protect other decision-makers.

Limitations of Financial Statements

Although the general-purpose of financial statements are useful for economic decision
purposes; they possess some limitations as described below.

1. Use of estimates. Some accounting data contained in the financial statements are
based on estimates. For example, estimated doubtful account, warranty liabilities,
depreciation expenses. Financial users may give some reservation regarding the estimates
made by the management.

2. Use of historical costs. Actual costs signifies faithful presentation, but it does not
show the current value of assets, liabilities, and equity. In fact, historical costs fail to
show the time value of money of the entitys resources.

3. Non-inclusion of developed tangible assets. When a business entity self-develops its

tangible assets, such as developing good will due to good name, or having skilled
workers or secret trade, accounting principles do not permit their reporting as part of
assets because their cost cannot be objectively determine.

Financial users should also understand that general-purpose financial statements are not
absolutely free from errors as explained by materiality and cost-benefit restraints.

Definitions, Classifications and Examples if Accounts

Accounting uses several account titles to describe economic transactions and events.

Real accounts

The real accounts are Assets, Liabilities, and Owners Equity. Real accounts are reported
in the SFP. They are not closed at the end of accounting period.
The Assets Account

Assets are resources or things of value owned by an enterprise. Some of them have
physical form (such as cash or inventory), but bothers have no physical form (such as
patents and copyrights). For as long as future economic benefits are expected from them
to flow to entity and if they are controlled by entity, they are assets.

Generally, they are recorded in books of accounts with normal debit balance. The assets
are classified into current and noncurrent assets.

Current Assets. An asset should be classified as current when any of the following
criteria are met:

1. It is cash or cash equivalent which is not restricted for current use.

2. It is expected to be realized or is held for sale or consumption in the normal course of
the enterprisers operating cycle.
3. It is held primarily for trading purposes or for the short-term, and it is expected to be
realized within twelve months of the SFP date.

If an asset does not meet any of the criteria above, then it shall be classified as noncurrent
asset.

The operating cycle of an enterprise is the time between acquisition of materials entering
into process and its realization in cash or an instrument that is readily convertible into
cash.
The following are some of the current assets that are commonly used:

Cash any item on hand with monetary value that a bank will accept for deposit and
all amounts currently on deposit with the bank in the name of the business. This
includes coins and currencies, personal check, money orders, travelers check made
payable to the business and bank drafts. Also included are any funds that are currently
on deposit at the bank and readily available as checking and savings account.
Account Receivable the amounts collectible on open accounts of the customer.
These represents debtors oral promise to pay a certain amount to the business and
right of the business to collect certain amount in peso. Examples are receivable goods
from sales of goods or services.
Notes Receivable a promissory note received by the business form its debtors
and/or customers. A promissory note is a written promise to pay a certain amount on
specified or determinable date.
Accrued Interest Receivable the interest earned on note receivable but not yet
received in cash
Inventories assets that held for sale in the normal operation of the business, in the
process of production for sale, or in the form of materials or supplies to be consumed
in the production process or in the rendering of services. Examples are merchandise
inventory, work-in-process inventory, and raw materials inventory.
Prepaid Supplies these are various materials which remains unused at the end of
the accounting period. Examples are unused coupon bond, inks, ballpen, janitorial
supplies.

Noncurrent Assets. These are assets that do not meet the criteria of a current asset.
Generally, they include tangible, operating, and financial assets of a long-term nature.

Land the site owned by the business on which the business building is constructed.
This plant asset is not subject to depreciation. All other plant assets are subject to
depreciation.
Building the structure owned by the business used in the operation of the business
building.
Furniture and Fixture long-lived items used by the business including store
furnishings such as showcases, counters, containers, display rack, as well as furniture
used for office purposes such as desks, chairs, and cabinets.
 Equipment consists of what generally might be called the machinery used in
business such as computers, delivery equipment of any sort, or machinery used in
conveying, packing, sorting or altering the commodities handled.

Contra-Valuation Accounts:

Allowance for Doubtful Accounts refers to amount estimated uncollectible on

receivable in compliance with the principle of conservatism. It is credited to serve as
a contra account for related receivable. Other terms used to describe this account are
allowance for uncollectible accounts and allowance for bad debts.
Accumulated Depreciation the aggregate periodic costs of using a depreciable
plant asset. In accordance with the systemic cost allocation principle, the acquisition
cost, of predictable plant asset should be allocated as expense over its full useful life.
Examples are accumulated depreciation of building accumulated depreciation of
equipment, etc.

The Liability Accounts

Liabilities are present obligations to pay cash or cash equivalent by an entity. In other
words, they represent claims against the assets of the business. Liability accounts have
normal credit balance. They are classified into current and noncurrent liabilities.

Current liability is one that meets the following criteria:

1. It is expected to be settled in the normal course of the enterprises operating cycle.

2. It is due to be settled within twelve months of the Statement of Financial Position
date.

Below are examples of current liabilities:

Accounts Payable an obligation or debt to creditors for any money borrowed or

merchandise and other assets bought on credit. Examples are obligations arising from
purchases on account.
Notes Payable a promissory note issued by the business to its creditors for money
borrowed or merchandise and other assets bought on credit.
Accrued Interest Payable the interest incurred in the current period but not yet
paid.
SSS Premium Payable representative of the amount the employee and employer
contribution to SSS which are not yet remitted to SSS.
 Withholding Tax Payable the amount of income tax withheld from the salary of
the employee in behalf of BIR that the employer has to remit to BIR on the specified
due date.

All other liabilities should be classified as noncurrent liabilities.

Noncurrent Liability is one that does not meet the criteria of a current liability. Generally,
it compromises the portion payable beyond one year of the long-term liability.

The Owners Equity Accounts

Owners Equity the residual amount after deducing the liabilities form assets. It
compromises the capital contribution and withdrawals by the owner. It is increased by the
capital contribution of the owner and the net income of the business, and decreased by the
owners withdrawals and net losses of the business.

Owners equity is described as owners capital (sole proprietorship), partners capital

(partnership) and shareholders equity (corporation). These accounts have normal credit
balances.

Drawing is a temporary account used to record initially the amount taken by the
owner from the business. This is closed to the capital account of the owner at the end
of the accounting period.

Nominal Accounts

Nominal Accounts are those that comprise the elements of the Statement of
Comprehensive Income the revenue and expenses accounts. These accounts are called
temporary because they are closed or put to zero balance at the end of the accounting
period.

The Revenue Accounts

Revenue represents the earnings of the business from sales of goods or service rendered.
Revenue accounts have normal credit balance. Below are some common revenue
accounts.

Sales an account used to summarize sale of goods of a trade or merchandising

business. This includes cash sales and sales on account.
Service Income the earning derived from service rendered by a servicing business
to its customers. This includes cash and on account service.
 Professional Fees the earning derived from services rendered by a professional or
professional servicing firm which could be in cash or in collectibles to its clients.
Interest Income the earning representing the time value of money derived from
promissory notes received by the business, whether in cash or collectibles in future.
Rent Income the income earned from allowing others to use property or facility of
the business.
Gain on Sales of other Assets the income derived from the sales of assets used in
the business operation. There is a gain on sale if the proceeds exceed the book value
or cost of disposed asset. Examples are gain on equipment, gain on sale investments,
gain on sale of land, etc.

The Expenses Account

Expenses are cost incurred in conducting the business activities. Expense accounts have
normal debit balances. Some common expense accounts are as follows:

Cost of Sales the value of merchandise sold

Supplies Expense the amount of supplies consumed or used by the business during
the period. Examples: used in papers, inks, ballpoint pens, etc.
Salaries and Wages Expenses the amount paid to service rendered by the
employees in the operation of the business
Insurance Expense the amount of insurance policy incurred during the current
period. Examples: premiums on building insurance, life insurance, plant insurance,
etc.
Taxes and Licenses Expenses the cost of local as well as national taxes that are
incurred and required to be paid in connect with the conduct of business. Examples:
cost to acquire mayors permit, registration cost of the building, percentage tax on
sales, etc.

Estimated Expense

Doubtful Account Expenses the estimated amount of losses the uncollectible

accounts arising from credit sales of the current period. This is also called the debt
expense or uncollectible account expense.
Depreciation Expense represents the current periodic cost for using depreciable
plant assets. In accordance with the systemic cost of depreciable asset should be
allocated as expense over its useful life.
BASIC ACCOUNTING

Chapter 3 REVIEW QUESTIONS

Chapter Discussion

1. Differentiate the following accounting terms:

a. Accounting concepts
b. Accounting conventions
c. Accounting principles
2. What is GAAP?
3. Illustrate the levels of conceptual frameworks.
4. Enumerate and explain five (5) basic assumptions in accounting.
5. Discuss the period covered by the following accounting reports:
a. Calendar year financial statement
b. Fiscal year financial statement
c. Interim year financial statement
6. Enumerate and explain the four basic principles of accounting.
7. What are accounting constraints?
8. What do qualitative characteristics of accounting information achieve?
9. Explain relevance and faithful representation fundamental qualities of accounting
information.
10. Enumerate and explain the enhancing qualities of accounting information.
11. Describe the components of basic financial statements.
12. What are the five elements of basic financial statements? Explain each.
13. Discuss the similarities and dissimilarities of the three basic financial statements.
14. What is the managements role in FS preparation?
15. What are the limitations of business statement?
16. Differentiate real account from nominal account.
17. Define the following (a) assets, (b) liabilities, and (c) owners entity.
18. Explain the operating cycle of an enterprise.