Financial Accounting and Reporting 1

Introduction to Accounting
DEFINITION
Accounting is a process of identifying, recording and communicating economic information that is useful in making
economic decisions.
Essential elements of the definition of accounting
1. Identifying – The accountant analyzes each business transaction and identifies whether the transaction is an
“accountable event” or “non-accountable event.” This is because only “accountable events” are recorded in the
books of accounts. “Non-accountable events” are not recorded in the books of accounts.
2. Recording – The accountant recognizes (i.e., records) the “accountable events” he has identified. This process is
called “journalizing.” After journalizing, the accountant then classifies the effects of the event on the “accounts.”
This process is called “posting.”
3. Communicating – At the end of each accounting period, the accountant summarizes the information processed in
the accounting system in order to produce meaningful reports. Accounting information is communicated to
interested users through accounting reports, the most common form of which is the financial statements.
Nature of accounting
Accounting is a process with the basic purpose of providing information about economic activities intended to be useful in
making economic decisions.
Types of information provided by accounting
 Quantitative information
 Qualitative information
 Financial information
Functions of Accounting in Business
 To provide external users with information that is useful in making investment and credit decisions; and
 To provide internal users with information that is useful in managing the business.
Brief history of accounting
 Accounting can be traced as far back as the prehistoric times, perhaps more than 10,000 years ago.
 Archaeologists have found clay tokens as old as 8500 B.C. in Mesopotamia which were usually cones, disks,
spheres and pellets. These tokens correspond to commodities like sheep, clothing or bread. They were used in the
Middle West in keeping records. After some time, the tokens were replaced by wet clay tablets. During such time,
experts concluded this to be the start of the art of writing. (Source: http://EzineArticles.com/456988)
 Double entry records first came out during 1340 A.D. in Genoa.
 In 1494, the first systematic record keeping dealing with the “double entry recording system” was formulated by
Fra Luca Pacioli, a Franciscan monk and mathematician. The “double entry recording system” was included in
Pacioli’s book titled “Summa di Arithmetica Geometria Proportioni and Proportionista,” published on November
10, 1494 in Venice.
 The concept of “double entry recording” is being used to this day. Thus, Fra Luca Pacioli is considered as the
father of modern accounting.
Common Branches of Accounting
Users of Accounting Information
1. Internal users – those who are directly involved in managing the business.
 Business owners who are directly involved in managing the business
 Board of directors
 Managerial personnel
2. External users – those who are not directly involved in managing the business.
 Existing and potential investors (e.g., stockholders who are not directly involved in managing the business)
 Lenders (e.g., banks) and Creditors (e.g., suppliers)
 Non-managerial employees
 Public
Forms of Business Organizations

Advantages and Disadvantages of Forms of Business

Types of Business According to Activities
1. Service business
2. Merchandising (Trading)
3. Manufacturing
 Accounting Concepts and Principles
DEFINITION
 Accounting concepts and postulates are a set of logical ideas and procedures that guide the accountant in
recording and communicating economic information.
 It provide reasonable assurance that information communicated to users is prepared in a proper way.
ACCOUNTING ASSUMPTIONS
 Accounting assumptions are basic notions or fundamental premises on which the accounting process is based.
 It serve as the foundation or bedrock of accounting in order to avoid misunderstanding but rather enhance the
understanding and usefulness of financial statements.
BASIC ACCOUNTING CONCEPTS
1. Separate entity concept
2. Historical cost concept
3. Going concern assumption
4. Matching
5. Accrual Basis
6. Prudence (or Conservatism)
7. Time Period
8. Stable monetary unit
9. Materiality concept
10. Cost-benefit
11. Full Disclosure principle
12. Consistency concept
 Separate entity concept – The business is viewed as a separate entity, distinct from its owner(s). Only the
transactions of the business are recorded in the books of accounts. The personal transactions of the business
owner(s) are not recorded.
 Historical cost concept (Cost principle) – assets are initially recorded at their acquisition cost.
 Going concern assumption – The business is assumed to continue to exist for an indefinite period of time.
 Matching – Some costs are initially recognized as assets and charged as expenses only when the related revenue
is recognized.
 Accrual Basis of accounting – income is recorded in the period when it is earned rather than when it is collected,
while expense is recorded in the period when it is incurred rather than when it is paid.
 Prudence – The observance of some degree of caution when exercising judgments under conditions of
 uncertainty. Such that, if there is a choice between a potentially unfavorable outcome and a potentially favorable
outcome, the unfavorable one is chosen. This is necessary so that assets or income are not overstated and
liabilities or expenses are not understated.
 Reporting Period – The life of the business is divided into series of reporting periods.
 Stable monetary unit – Assets, liabilities, equity, income and expenses are stated in terms of a common unit of
measure, which is the peso in the Philippines. Moreover, the purchasing power of the peso is regarded as stable.
Therefore, changes in the purchasing power of the peso due to inflation are ignored.
 Materiality concept – An item is considered material if its omission or misstatement could influence economic
decisions. Materiality is a matter of professional judgment and is based on the size and nature of an item being
judged.
 Cost-benefit – The costs of processing and communicating information should not exceed the benefits to be
derived from the information’s use.
 Full disclosure principle – Information communicated to users reflect a balance between detail and conciseness,
keeping in mind the cost-benefit principle.
 Consistency concept – Like transactions are accounted for in like manner from period to period.
ACCOUNTING STANDARDS
 Accounting concepts and principles are either explicit or implicit. Explicit concepts and principles are those that
are specifically mentioned in the Conceptual Framework for Financial Reporting and in the Philippine Financial
Reporting Standards (PFRS). Implicit concepts and and principles are those that are not specifically mentioned in
the foregoing but are customarily used because of their general and longtime acceptance within the accountancy
profession.
PHILIPPINE FINANCIAL REPORTING STANDARDS (PFRSs)
 The PFRSs are Standards and Interpretations adopted by the FRSC. They consist of the following:
 Philippine Financial Reporting Standards (PFRSs);
 Philippine Accounting Standards (PASs); and
 Interpretations
RELEVANT REGULATORY BODIES
 Other than the Financial Reporting Standards Council (FRSC), the following also affect the accounting policies
used by businesses and their financial reporting:
 Securities and Exchange Commission (SEC);
 Bureau of Internal Revenue (BIR);
 Bangko Sentral ng Pilipinas (BSP); and
 Cooperative Development Authority (CDA).
QUALITATIVE CHARACTERISTICS OF USEFUL FINANCIAL INFORMATION
 Qualitative characteristics are the traits that determine whether an item of information is useful to users. Without
this characteristics, information may be deemed useless.
The qualitative characteristics are broadly classified into two, namely:
1. Fundamental qualitative characteristics - these are the characteristics that make information useful to others. They
consist of the following:
- Relevance
- Faithful representation
2. Enhancing qualitative characteristics - these characteristics support the fundamental characteristics. They enhance
the usefulness of information. As such, they must be maximized. The enhancing qualitative characteristics consist
of the following:
- Comparability
- Verifiability
- Timeliness
- Understandability
RELEVANCE
Information is relevant if it can affect the decisions of users. Relevant information has the following:
 Predictive value – the information can be used in making predictions
 Confirmatory value – the information can be used in confirming past predictions
 Materiality – is an ‘entity-specific’ aspect of relevance
FAITHFUL REPRESENTATION
Faithful representation means the information provides a true, correct and complete depiction of what it purports to
represent. Faithfully represented information has the following:
  Completeness – all information necessary for users to understand the phenomenon being depicted is provided.
 Neutrality – information is selected or presented without bias.
 Free from error – there are no errors in the description and in the process by which the information is selected and
applied.
COMPARABILITY
The information helps users in identifying similarities and differences between different sets of information.
VERIFIABILITY
Different users could reach consensus as to what the information purports to represent.
TIMELINESS
The information is available to users in time to be able to influence their decisions.
UNDERSTANDANBILITY
Users are expected to have:
- reasonable knowledge of business activities; and
- willingness to analyze the information diligently.
The Accounting Equation
THE ACCOUNTING EQUATION
Assets = Liabilities + Equity
DEFINITION
ASSETS – are the economic resources you control that have resulted from past events and can provide you with
economic benefits.
Control
You don't necessarily need to own the economic resource for it to be considered your asset. What is important is that you
control the right over the economic benefits that the resource may produce. "Control" means you have the exclusive right
to enjoy those benefits and the ability to prevent others from enjoying those benefits.
Example 1: Resource owned but not considered an asset
You own a building. However, you do not have the right to use, sell, lease, or transfer (or other similar rights over) the
building- another party does.
Analysis: The building is not your asset because you do not control the right over the economic benefits from it, even if
you are the legal owner/
Example 2: Resource not owned but considered an asset
You acquired a cellphone from a telecommunications Company on a 2-year installment plan. The agreement states that if
you miss an installment payment, the telecommunications company can get the cellphone back.
Analysis: Upon taking possession, the cellphone becomes your asset even if you do not actually own it yet until you have
fully paid the installment price.This is because you control the right over the economic benefits of the cellphone through
exclusive use.
Past events
The control over an economic resource have resulted from a past event or transaction. Therefore, resources for which
control is yet to be obtained in the future do not quality as assets in the present.
For example, you have an intention of purchasing a cellphone next year. Right now, the cellphone is not yet your asset.
The cellphone becomes your asset only after you have purchased it and have taken possession over it.
Physical possession, however, is not always necessary for Control to exist. For example, the money that you have
deposited to a bank remains your asset despite the transfer of physical possession. This is because you still control the
right over the money by withdrawing it or spending it through electronic means.
Economic benefits
To be an asset, the economic resource must have the potential to provide you with economic benefits in at least one
circumstance.
For example, the economic resource can be:
1. Sold, leased, transferred or exchanged tor other assets;
2. Used singly or in combination with other assets produce goods or provide services;
3. Used to enhance the value of other assets,
4. Used to promote efficiency and cost saving; or
5. Used to settle a liability
LIABILITIES – are your present obligations that have resulted from past events and can require you to give up economic
resources when settling them.
Obligation
Obligation means a duty or responsibility. An obligation is either
  Legal obligation -an obligation that results from a contract, legislation, or other operation of law; or
 Constructive obligation - an obligation that results from your past actions (e.g. past practice or published policies)
that have created a valid expectation on others that you will accept and discharge certain responsibilities.
Giving up of economic resources
Settling the obligation necessarily would require you to pay cash, to transfer other non-cash assets, or to render a service.
Present obligation as a result of past events
A present obligation exists as a result of past events if:
1. you have already obtained economic benefits or taken an action; and
2. as a consequence, you are required to transfer an economic resource.
Examples:
You have an intention to purchase a cellphone in the future.
Analysis:
You have no present obligation, and hence no liability, because you have not yet purchased and received the cellphone,
and therefore, you are not required to pay for the purchase price.
You purchased a cellphone on credit. You took possession over the cellphone but have not yet paid the purchase
price.
Analysis:
You have a present obligation, and hence a liability, because:
1. you have already purchased and received the cellphone; and
2. as a consequence, you are required to pay tor the purchase price.
Your obligation is a legal obligation because it arises from acontract.
You earned taxable income during the period but have not yet paid the tax due to the government.
Analysis:
You have a present obligation because:
1. you earned taxable income; and
2. as a consequence, you are required to pay the corresponding tax due.
Your obligation is alegal obligation because it arises from legislation (i.e., tax law).
Although not stated in the sales contract you have a publicly-known policy of providing free repair services tor the
goods your business sells. You have consistently honored this implied policy in the past.
Analysis:
You have a present obligation to provide free repair services for the goods you have already sold because:
1. you nave already taken an action by creating valid expectation on your customers that you will provide
free repair services; and
2. as a consequence, you will have to provide those free services.
Your obligation is a constructive obligation.
EQUITY – is simply assets minus liabilities. Other terms for equity are “capital”, “net assets”, and “net worth”.
Illustration 1:
You decided to put up a barbeque stand and have estimated that you will be needing P2,000 as start-up capital.
You then went to your closet and broke Mr. Piggy Bank which you have been saving for quite some time now. Alas! You
only have P800. You went to your Mama and asked her to give you P1,200 but she told you that she has been feeding you
for far too long. But don't give up hope yet, Mr. Bombay is just around the corner.
As of this point, your accounting equation is as follows:

Assets
Notes:
Your total assets are P800 - the amount of economic resources that you control.
You don't have any liability yet because you are still negotiating with Mr. Bombay.
Your equity is also (800 assets-0 liabilities = 800 equity)
After a lengthy negotiation, Mr. Bombay agreed to lend you 1,200.
As of this point, your accounting equation is as follows:

Notes:
  Your total assets are now 2,000 - the total amount of economic resources that you control (P800 from Mr. Piggy plus
P1,200 from Mr. Bombay).
 Of your total assets of P2,000:
P1,200 represents your liability, the amount you are obligated to pay Mr. Bombay in the future.
b. P800 represents your equity (i.e., P2,000 assets -P1,200 liabilities).
 Liabilities represent the Creditors' claim, while equity represents the owner's claim, against the total assets of the
business.
Notice that from Piggy to Bombay, the accounting equation remains balanced. The equality of the accounting equation
must be maintained in all the accounting processes of recording, classifying and summarizing. If the accounting
equation doesn't balance, there is something wrong.
THE EXPANDED ACCOUNTING EQUATION
We can expand the basic accounting equation by including two more elements -income and expenses, The expanded
accounting equation shows all the financial statement elements. The expanded accounting equation is as follows:
Assets = Liabilities + Equity + Income - Expenses
Notice that income is added while expenses are deducted in the equation. These are because income increases equity
while expenses decrease equity.
INCOME - is increases in economic benefits during the period in the form of increases in assets, or decreases in
liabilities, that result in increases in equity, excluding those relating to investments by the business owner.
EXPENSES - are decreases in economic benefits during the period in the form of decreases in assets, or increases in
liabilities, that result in decreases in equity, excluding those relating to distributions to the business owner.
The difference between income and expenses represents profit or loss.
 If income is greater than expenses, the difference is profit.
 If income is less than expenses, the difference is loss.
Illustration 2: (Continuation of Illustration 1)
During the period, you earned income of P10,000 and incurred expenses of P6,200. At  the end of the period, your total
assets increased from P2,000 to P5,000 and your total liabilities decreased from P1,200 to P400.
Your expanded accounting equation is as follows:

Your profit for the period is P3,800 (P10,000 income minus P6,200 expenses). There is profit because income is greater
than expenses.
A variation of the expanded accounting equation is shown below

Income and expenses (or profit or loss) are closed to equity at the end of each accounting period. Thus, the
adjusted balance to equity is computed as follows:
Equity, beginning        800
Add: Income           10,000
Less: Expenses      (6,200)
Equity, Ending       4,600
Your basic accounting equation at the end of the accounting period is as follows: