What is accounting?

Accounting is the art of recording, classifying and summarizing in a significant manner and in
terms of money, transaction and events which are, in part at least of a financial character, and
interpreting the results thereof.

Classifying – This involves selecting economic events that are relevant to a particular business
transaction. The economic events of an organization are referred to as transactions.
Examples of economic events or transactions – In a bakery business:
• sales of bread and other bakery products
• purchases of flour that will be used for baking
• purchases of trucks needed to deliver the products

RECORDING – This involves keeping a chronological diary of events that

are measured in pesos. The diary referred to in the definition are the journals and
ledgers.

SUMMARIZING – This occurs through the preparation and distribution of

financial and other accounting reports.

The Nature of Accounting

According to Accounting Theory Accounting is a systematic recording of financial transactions and
the presentation of the related information to appropriate persons.

(Accounting Theory n. d.) Based on this definition we can derive the following basic features of
accounting:

•Accounting is a service activity. Accounting provides assistance to decision makers by

providing them financial reports that will guide them in coming up with sound decisions.

•Accounting is a process. A process refers to the method of performing any specific job step by
step according to the objectives or targets. Accounting is identified as a process, as it performs the
specific task of collecting, processing and communicating financial information. In doing so, it
follows some definite steps like the collection, recording, classification, summarization, finalization,
and reporting of financial statements.

•Accounting is both an art and a discipline. Accounting is the art of recording, classifying,
summarizing and finalizing financial data. The word ‘art’ refers to the way something is performed.
It is behavioural knowledge involving a certain creativity and skill to help us attain some specific
objectives. Accounting is a systematic method consisting of definite techniques and its proper
application requires skill and expertise. So by nature, accounting is an art. And because it follows
certain standards and professional ethics, it is also a discipline.

•Accounting deals with financial information and transactions. Accounting records financial
transactions and data, classifies these and finalizes their results given for a specified period of
time, as needed by their users. At every stage, from start to finish, accounting deals with financial
information and financial information only. It does not deal with non-monetary or non-financial
aspects of such information.

•Accounting is an information system: Accounting is recognized and characterized as a

storehouse of information. As a service function, it collects processes and communicates financial
information of any entity. This discipline of knowledge has evolved to meet the need for financial
information as required by various interested groups. Accounting is the means by which business
information is communicated to business owners and stakeholders. The role of accounting in
business is to provide information for managers and owners to use in operating the business. In
addition, accounting information allows business owners to assess the efficiency and effectiveness
of their business operations. Prepared accounting reports can be compared with industry
standards or to a leading competitor to determine how the business is doing. Business owners
may also use historical financial accounting statements to create trends for analysing and
forecasting future sales.

Accounting helps the users of these financial reports to see the true picture of the business
in financial terms. In order for a business to survive, it is important that a business owner or
manager be well-informed.

Example:
Mr. Juan is a retired government employee who is good at baking. One day he decides to put up a
bakery shop in your barangay. He renovates a portion of his house to serve as the area for the
production of bread. He purchases baking equipment and raw materials to produce five different
types of bread. Mr. Juan also hires Jose to help him with the baking and, at the same time, to be
in-charge of sales. Mr. Juan pays Jose on a weekly basis. Every day, Mr. Juan’s wife deposits the
daily cash sales in their bank account at XY Savings Bank. With the help of accounting, what
possible decisions or questions of Mr. Juan can accounting provide an answer to?

Guide questions to come up with possible decisions:

•Is my business earning? (profitability)
•How much daily or monthly sales do I need in order to recover my fixed cost? (break-even)
•Do I need to hire additional workers to help me with my production?
•Can I afford to set up a new store in another place? Where do I get the funds?
•Can I afford to pay a bank loan?

History/Origin of Accounting

The Cradle of Civilization

• Record-keeping was already common from Mesopotamia, China and India to Central and South
America around 3600 B.C.
• Clay Tablet - The oldest evidence of record keeping in Mesopotamia in dealing with commercial
transactions at the time such as listing of accounts receivable and accounts payable

French Revolution (1700s)

• The thorough study of accounting and development of accounting theory began during this
period.
• Social upheavals affecting government, finances, laws, customs and business had greatly
influenced the development of accounting.

The Industrial Revolution (1760-1830)

• Mass production and the great importance of fixed assets were given attention during this period.

19th Century

• Modern Accounting In Europe and America began

• The modern, formal accounting profession emerged in Scotland in 1854 when Queen Victoria
granted a Royal Charter to the Institute of Accountants in Glasgow, creating the profession of the
Chartered Accountant (CA).
• In the late 1800s, chartered accountants from Scotland and Britain came to the U.S. to audit
British investments. Some of these accountants stayed in the U.S., setting up accounting practices
and becoming the origins of several U.S. accounting firms. The first national U.S. accounting
society was set up in 1887. The American
Association of Public Accountants was the forerunner to the current American Institute of Certified
Public Accountants (AICPA).
• Rapid changes in accounting practice and reports were made.
Accounting standards to be observed by accounting professionals were promulgated. Notable
practices such as mergers, acquisitions and growth of multinational corporations were developed.
A merger is when one company takes over all the operations of another business entity resulting in
the dissolution of another business.
• Businesses expanded by acquiring other companies. These types of transactions have
challenged accounting professionals to develop new standards that will address accounting issues
related to these business combinations.

The Present

• The Development of Modern Accounting Standards and Commerce

• The accounting profession in the 20th century developed around state requirements for financial
statement audits.
• Beyond the industry's self-regulation, the government also sets accounting standards, through
laws and agencies such as the Securities and Exchange Commission (SEC).
• As economies worldwide continued to globalize, accounting regulatory bodies required
accounting practitioners to observe International
• Accounting Standards. This is to assure transparency and reliability, and to obtain greater
confidence on accounting information used by global investors.

INTERNAL USERS

Internal Users
Internal users are the primary users of accounting. Primary means they are the people within a
business organization who use accounting information to make decisions that directly affect the
internal operations of the business. They are categorized the following:

OWNERS - is the legal proprietor of a business. An individual or group that owns

the assets of a firm and profits from them.

INTERNAL Why need Information Decisions

USERS Accounting needed supported
Information
Owners 1. Assess how well their Profit or income for Considerations
business is performing. the period, regarding
2. Provide information to resources or additional
owners about the assets of the investment,
profitability of the overall business, liabilities expanding the
business. of the business. business,
3. Interested in knowing borrowing funds
how risky their business is. to support any
4. Assess the level of expansion plans.
stability in
business over the years.
5. Helps owners to decide
if they invest further in
business.
Top level managers: Decisions about the future cash, measures to
includes executive of the company. production cost improve the company
officers such as CEO, ➢ To evaluate results.
CFO, COO, etc. the result of Sufficiency of cash to
They are in charge of their past decisions. pay dividends to
the overall plans and ➢ Used as guide in making stockholders;
policies of the decisions for pricing decisions
organization. the future.

Middle level
managers:
departmental heads,
branch managers,
junior executives.
They are in charge of
executing the plans of
the top management
and oversee the
performance of the
division or department
they are handling.

Lower level managers:

supervisors and
foremen.
They are the first-line
managers who
supervise the day-to-
day operations of the
business and directs
workers and
employees.

Employee is someone who gets paid to work for a person or company.

INTERNAL USERS Why need Information Decisions

Accounting needed supported
Information
Employee/s ➢ Assess whether they are Profit for the Job security,
receiving the right period, salaries Consider staying in
compensation paid to employees the employ of the
➢ To check if they bargain company or look for
for higher remuneration, other employment
retirement benefits and opportunities.
employment
opportunities.
➢ To learn about
the financial health of the
organization.

The internal users use accounting information for decision purposes that are illustrated in the
diagram. Without the proper accounting information, these type of decisions would be difficult and
impossible to make.

EXTERNAL USERS

External users are individuals and organizations outside a company who want financial
information about the company. These users are not directly involved in managing and operating
the business. The two most common types of external users are potential investors and creditors.
Potential Investors use accounting information to make decisions to buy shares of a
company . Creditors (such as suppliers and bankers) use accounting information to evaluate the
risks of granting credit or lending money. Also included as external users are government
regulatory agencies such as Securities and Exchange Commission (SEC), Bureau of Internal
Revenue (BIR), Department of Labor and Employment (DOLE), Social Security System (SSS),
and Local Government Units (LGUs).

External users (Secondary Users) of accounting information include the following:

1. Creditors
• for determining the credit worthiness of an organization.
• for setting terms of credit are set by creditors according to the assessment of their customers'
financial health.
• include suppliers as well as lenders of finance such as banks.

2. Tax Authorities (BIR)

• for determining the credibility of the tax returns filed on behalf of a company.

3. Investors
• for analyzing the feasibility of investing in a company.
• want to make sure they can earn a reasonable return on their investment before they commit any
financial resources to a company.

4. Customers
• for assessing the financial position of its suppliers which is necessary for them to maintain a
stable source of supply in the long term.

5. Regulatory Authorities (SEC, DOLE)

• for ensuring that a company's disclosure of accounting information is in accordance with the
rules and regulations set in order to protect the interests of the stakeholders who rely on such
information in forming their decisions.

INTERNAL USERS

Internal users of accounting information are those individuals inside a company who plan,
organize, and run the business. These users are directly involved in managing and operating the
business. These include marketing managers, production supervisors, finance directors, company
officers and owners.

Internal users (Primary Users) of accounting information include the following:

1. Management
a. Information need: income/earnings for the period, sales, available cash, production cost
b. Decisions supported: analyze the organization's performance and position and take appropriate
measures to improve the company results, sufficiency of cash to pay dividends to stockholders;
pricing decisions

2. Employees
a. Information need: profit for the period, salaries paid to employees
b. Decisions supported: job security, consider staying in the employ of the company or look for
other employment opportunities

3. Owners
a. Information need: profit or income for the period, resources or assets of the business, liabilities
of the business
b. Decisions supported : considerations regarding additional investment, expanding the business,
borrowing funds to support any expansion plans.
 Accounting information is presented to internal users usually in the form of management
accounts, budgets, forecasts and financial statements. This information will support whatever
decision of the internal users.

Types of Information needed by each Group of Users

Accounting information includes both financial (quantitative) and non-financial (qualitative)

information used by the decision maker.
*Qualitative analysis-means looking at the intangibles
*Quantitative analysis- means looking at the actual numbers.
*Comprehensive analysis- should include looking at both qualitative and quantitative factors that
would impact decision maker.

The Basic Accounting Concepts and Principles

1. Business entity principle (also known as separate entity and economic entity concept)
states that the transactions related to a business must be recorded separately from those of its
owners and any other business. Accounting is called the language of business. It communicates
the financial condition and performance of a business to interested users for decision-making
purposes. The Generally Accepted Accounting Principles (GAAP) is a widely accepted set of rules,
concepts and principles that governs the application of accounting procedures. The GAAP has
been developed by the accounting professionals to guide preparers of financial statements in
recording and reporting financial information regarding a business enterprise, hence aiding in the
effective execution of the accounting procedure and in communicating the financial condition of
the business.
In other words, while recording transactions in a business, we take into account only those
events that affect that particular business; the events that affect anyone else other than the
business entity are not relevant and are therefore not included in the accounting records of the
business.
Example: ➢ If the owner has a barber shop, the cash of the barber shop should be reported
separately from personal cash.

2. Going concern principle implies that the business entity will continue its operations in the
future and will not liquidate or be forced to discontinue operations due to any reason. A company is
a going concern if no evidence is available to believe that it will or will have to cease its operations
in foreseeable future.
In other words, the going concern concept assumes that businesses will have a long life
and not close or be sold in the immediate future.
Example: ➢ When preparing financial statements, you should assume that the entity will
continue indefinitely.

3. Time period principle (also known as periodicity assumption and accounting time period
concept) states that the life of a business can be divided into equal time periods. These time
periods are known as accounting periods for which companies prepare their financial statements
to be used by various internal and external parties. The length of accounting period to be used for
the preparation of financial statements depends on the nature and requirement of each business
as well as the need of the users of financial statements. Normally, an accounting period consists of
a quarter, six months or a year.
Example: ➢ The salary expenses from January to December 2015 should only be
reported in 2015.

4. Monetary unit principle (also known as money measurement concept) states that only those
events and transactions are recorded in books of accounts of the business which can be
measured and expressed in monetary terms. Amounts should only be stated into a single
monetary unit. Therefore, an information that cannot be expressed in terms of money is useless
for financial accounting purpose and is therefore not recorded.
Example: ➢ Jollibee should report financial statements in pesos even if they have a store
in the United States.

5. Objectivity principle states that accounting information and financial reporting should be
independent and supported with unbiased evidence. This means that financial statements must be
presented with supporting evidence. The objectivity principle is aimed at making financial
statements more relevant and reliable.
Example: ➢ When the customer paid Jollibee for their order, Jollibee should have a copy of
the receipt to represent as evidence.

6. Cost principle is an accounting principle that records assets at their respective cash amounts
at the time the asset was purchased or acquired. Assets that are recorded can include short-term
and long-term assets, liabilities and any equity, and these assets are always recorded at their
original cost.
Example: ➢ When Jollibee buys a cash register, it should record the cash register at its
price when they bought it.

7. Accrual Accounting Principle is an accounting method where revenue or expenses are

recorded when a transaction occurs rather than when payment is received or made. The method
follows the matching principle, which says that revenues and expenses should be recognized in
the same period. Cash accounting is the other accounting method, which recognizes transactions
only when payment is exchanged. However, cash basis is not the generally accepted principle
today.
Example: ➢ When a barber finishes performing his services he should record it as revenue.
When the barber shop receives an electricity bill, he should record it as an expense even if it is
unpaid.

8. Matching principle is a principle that requires a company to match expenses with related
revenues in order to report a company's profitability during a specified time interval. Therefore,
cost should be matched with the revenue generated. Example: ➢ When you provide tutorial
services to a customer and there is a transportation cost incurred related to the tutorial services, it
should be recorded as an expense for that period.

Incurred means expense has occurred and needs to be recognized even though no payment
was made.

9. Disclosure principle is a concept that requires a business to report all necessary information
about their financial statements and other relevant information to any persons who are
accustomed to reading this information. In other words, all relevant and material information
should be reported.
Example: ➢ The company should report all relevant information.

10. Conservatism principle- is the general concept of recognizing expenses and liabilities as
soon as possible when there is uncertainty about the outcome, but to only recognize revenues and
assets when they are assured of being received. In case of doubt, assets and income should not
be overstated while liabilities and expenses should not be understated.
Example: ➢ In case of doubt, expenses should be recorded at a higher amount. Revenue
should be recorded at a lower amount.

11. Materiality principle states that financial reports only need to include information that will be
significant or material to their users. In case of assets that are immaterial to make a difference in
the financial statements, the company should instead record it as an expense.
Example: ➢ A school purchased an eraser with an estimated useful life of three years.
Since an eraser is immaterial relative to assets, it should be recorded as an expense
 The importance of these concepts and principles lies in the fact that they are related to the
entire financial accounting process while they affect directly the way the financial reports are
prepared. Accountants need to apply professional judgments while preparing financial reports,
these concepts and principles help them to ensure that they are not being misled and that
providing a true and fair view of financial statements is being accomplished.
Also, it’s worthwhile to note that the accounting concepts and principles is of great help and
assistance to the professional accountants to consider and apply what is best in the interests of
the users of financial information in case an accounting concept or principle leads to create
conflict with that of another. In addition, after you acquire a good knowledge of accounting
principles, most accounting topics will make more sense to help you perform the related activities
in a more professional manner. Thus, the accounting concepts and principles are important for
accountants, as they need to abide by them every time they involve in analyzing, recording,
summarizing, reporting and interpreting financial transactions of a business.

The following are given situations related to accounting concepts and principles. Let us now apply
these principles in analyzing business transactions.

SITUATION 1: The accountant return to the employees the receipts of the personal transaction
they made during working hours.
In this scenario, we can say that this relates to the Business Entity Principle which
states that the transactions related to a business must be recorded separately from those of its
owners and any other business.

SITUATION 2: The accountant compute the depreciation on the basis of expected economic life
of fixed assets rather than their current market value.
In this scenario, companies assume that their business will continue for an indefinite period
of time and the assets will be used in the business until fully depreciated. Therefore, this applies
to the Going-Concern Principle.

SITUATION 3: The accountant finishes the financial statement for the year after the 12- month
fiscal period and begins with the new fiscal year.
In this scenario, Time-Period Principle applies wherein companies should prepare their
financial statements to be used by various internal and external parties in a time period. These
time periods are known as accounting periods that can either be of a quarter, six months or a
year.

SITUATION 4: The accountant recorded all monetary transactions in pesos.

In this scenario, the Monetary Unit Principle is applied. All transactions are recorded in
books of accounts of the business which can be measured and expressed in monetary terms and
amounts should only be stated into a single monetary unit which in this case is in pesos.

SITUATION 5: The accountant gathers all the official receipts, vouchers, and invoices for a
particular period and records them objectively.
In this scenario, this simply applies to Objectivity Principle which states that all
accounting information and financial reporting should be independent and supported with
unbiased evidence.

SITUATION 6: The accountant records the value of the acquired computer units at its prevailing
price.
In this scenario, assets should be recorded at their respective cash amounts at the time it
was purchased or acquired. This applies to the Cost Principle.

SITUATION 7: The accountant records income as soon as the sales people report the delivery of
goods to the clients.
 In this scenario, revenue is recorded when a transaction occurs rather than when payment
is received or made. This process follows the Accrual Accounting Principle.

SITUATION 8: The accountant receives the utility billing statements for June and includes them in
the financial statement for the same month.
In this scenario, the company match their expenses with related revenues in order to report
a company's profitability during a specific time interval. Therefore, in the Matching Principle cost
should be matched with the revenue generated.

SITUATION 9: Company X purchased a piece of property, and are now the current owners. A
passing pedestrian had a terrible fall on the property and got badly injured. This pedestrian is now
suing Company X for a significant amount of money for negligence. The pedestrian is likely to win
the lawsuit in the following year.
Under the Disclosure Principle, Company X should disclose the anticipated losses from
the lawsuit in the footnotes of their financial statement, even though the loss has not been
confirmed or finalized yet. Thus, this principle requires a business to report all necessary
information about their financial statements and other relevant information to any persons who are
accustomed to reading this information.

SITUATION 10: The accountant records contingent liability that the company might incur in a
legal battle with its employees to indicate that the company might have to pay out employees.
In this scenario, the Conservatism Principle is applied. It recognizes expenses and
liabilities as soon as possible when there is uncertainty about the outcome. The idea of
conservatism suggests that a business should anticipate and record future losses rather than
future gains.

SITUATION 11: A school purchased an eraser with an estimated useful life of three years. Since
an eraser is immaterial relative to assets, it was recorded as an expense.
In this scenario, Materiality Principle is applied. Financial reports only need to include
information that will be significant or material to their users. In this case, the eraser is immaterial to
make a difference in the financial statements, thus it was recorded as an expense.