Chapter 2.

ACCOUNTING CONCEPTS AND PRINCIPLES

Learning Objectives:

After studying this chapter, you should be able to:

a. Explain the fundamental accounting concept, principles

b. Explain the purpose of a conceptual framework
c. Understand the qualitative characteristics of useful financial information

INTRODUCTION.

An entity is something that can be recognized as having its own separate identity, such as an individual. The
term economic entity usually refers to a business or organizations whose major purpose is to produce a profit for its
owner. Social entities are non-profit organizations, such as cities, public schools and hospitals. The application of
accounting process and it concepts are very crucial to both entities for its survival and continuity as an entity.

FUNDAMENTAL CONCEPTS

Several fundamental concepts underlie the accounting process. In recording business transactions,
accountants should consider the following:

Entity Concept. The most basic concept in accounting is the entity concept.
 An accounting entity is an organization or a section of an organization that stands apart from.
 Other organizations and individuals as a separate economic unit.
 The transactions of different entities should not be accounted for together.
 Each entity should be evaluated separately

Entity Concept– a business enterprise is separate and distinct from its owner or investor.

Examples :

 If the owner has a computer shop, the cash generated from the computer shop should be reported
separately from personal cash.

 The owner had a business meeting with a prospective client. The expenses that come with that
meeting should be part of the company’s expenses. If the owner paid for gas for his personal use, it
should not be included as part of the company’s expenses

Periodicity Concept. An entity's life can be meaningfully subdivided into equal time period’s for reporting purposes.
 Allows the users to obtain timely information to serve as a basis on making decisions about future activities.
 One year is the usual accounting period.
 Financial statements are to be divided into specific time intervals

Calendar Year – starts in January and ends in December.

Fiscal Year – starts in any month and ends after 12 months.
Example :
 Philippine companies are required to report financial statements annually. All income and expenses
from January to December 2022 should only be reported in 2022

Monetary Unit Concept. The Philippine peso is a reasonable unit of measure.

 It allows accountants to add and subtract peso amounts as though each peso has the same purchasing power
as any other peso at any time.
 Amounts are stated into a single monetary

Example :

 Chowking should report financial statements in pesos even if they have a store in the Middle East.
 Shake shack should report financial statements in dollars even if they have a branch here in the
Philippines
THE NEED FOR GENERALLY ACCEPTED ACCOUNTING PRINCIPLES

Sole proprietorship,
 Adherence to proper accounting rules is important even though the owner is usually deeply involved
in the firm's activities and is the person primarily interested in its financial affairs.
 However, creditors, suppliers, and others rely on the financial statements prepared for a sole
proprietorship,

Partnership or a corporation,
 It is even more important that operations be properly accounted for because owners are unlikely to
be intimately involved in the activities of the firm.

Generally accepted accounting principles make financial statement meaningful and useful, regardless of the
type of business organization.

The different needs for accurate and reliable financial information can be satisfied if generally accepted
accounting rules, procedures, and principles are used. Records and reports of entities can be compared for different
periods if accounting principles were applied consistently. Users of financial statements will not be misinformed and
misled.

CRITERIA FOR GENERAL ACCEPT ANCE OF AN ACCOUNTING PRINCIPLE

1. Relevance
A principle has relevance refers to information that is meaningful and useful to those users of that
information.

2. Objectivity.
A principle has objectivity when the resulting information is not influenced by bias or judgment of those
who furnish it. Objectivity connotes reliability and trustworthiness. It also connotes verifiability, meaning
there is a way of finding out whether the information is correct.

3. Feasibility.
A principle has feasibility to the extent that it can be implemented without undue complexity or cost. These
criteria often conflict with one another. In some cases, the most relevant solution may be the least
objective and the least feasible.

BASIC PRINCIPLES

Accounting practices follow certain guidelines. The set of guidelines and procedures that constitute acceptable
accounting practice at a given time is GAAP, which stands for Generally Accepted Accounting Principles

1. Objectivity Principle. Accounting records and statements are based on the most reliable data available so that
they will be as accurate and as useful as possible. Reliable data are verifiable when they can be confirmed by
independent observers.

2. Historical Cost. This principle states that acquired assets should be recorded at their actual cost and not at
what management thinks they are worth as at reporting date.
 Historical cost is often calculated as the cash or cash equivalent cost at the time of purchase.
This includes the purchase price and any additional expenses incurred to get the asset in place
and prepared for use.(Cost of delivery, storage cost.)

3. Revenue Recognition Principle. Revenue is to be recognized in the accounting period when goods are
delivered or services are rendered or performed.

4. Expense Recognition Principle, Expenses should be recognized in the accounting period in which goods and
services are used up to produce revenue and not when the entity pays for those goods and services.
5. Adequate Disclosure. Requires that all relevant information that would affect the user's understanding and
assessment of the accounting entity be disclosed in the financial statements. All relevant and material
information should be reported.
 6. Materiality. Financial reporting is only concerned with information that is significant enough to affect
evaluations and decisions.
 Materiality depends on the size and nature of the item judged in the particular circumstances of
its omission.
 In deciding whether an item or an aggregate of items is material, the nature and size of the item
are evaluated together.
 In case of assets that are immaterial to make a difference in the financial statements, the company
should instead record it as an expense.

7. Consistency principle. The firms should use the same accounting method from period to period to achieve
comparability over time within a single enterprise. Changes are permitted if justifiable and disclosed in the
financial Statements.

UNDERLYING ASSUMPTIONS

Accrual Basis

Financial Statements are prepared on the accrual on the accrual basis of accounting and not as cash or its
equivalent is received or paid. Under this assumption, the effects of transactions and other events are recognized
when they occur and they are recorded in the accounting records and reported in the financial statements of the
periods to why they relate.
In short, transactions are recognized when:
 “Revenue as they earned, even not yet received and
 Expenses as they incurred, even not yet paid.
Cash Basis
Does not record a transaction until cash is received or paid. Generally, cash receipts are treated as revenues
and cash payments as expenses, that is revenue is recorded when collected and expenses should be recorded when
paid.

Going Concern
Financial statements are normally prepared on the assumption that an enterprise is a going concern and will
continue in operation for a foreseeable future. It is assumed therefore that the enterprise has neither the intention
nor the need to liquidate its operations.

CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING {IFRS FRAMEWORK)

International Financial Reporting Standards (IFRS) are a set of accounting standards that govern how
particular types of transactions and events should be reported in financial statements. They were developed and are
maintained by the International Accounting Standards Board (IASB).

The IASB’s objective is that the standards be applied on a globally consistent basis to provide investors and
other users of financial statements with the ability to compare the financial performance of publicly listed companies
on a like-for-like basis with their international peers. IFRS are now used by more than 100 countries,

Purpose and Scope

The IIFRS Framework describes the basic concepts that underlie the preparation and presentation of financial
statements for external users.

Companies doing business in the Philippines must comply with the Philippine Financial Reporting Standards
(PFRS). The PFRS is a set of Generally Accepted Accounting Principles (GAAP) issued by the Accounting
Standards Council (ASC) to govern the preparation of financial statements

The framework deals with:

a. The objective of financial statements
b. The qualitative characteristics that determine the usefulness of information in financial statements;
c. The reporting entity;
d. The definition, recognition and measurement of the elements from which financial statements are
constructed.
e. Concepts of capital and capital maintenance.
 a. THE OBJECTIVES OF FINANCIAL REPORTING

Provide information about the financial position, performance and changes in financial position of
an entity that is useful to a wide range of users in making economic decisions.
The primary users need information about the resources and claims against it, future net cash
inflows and how effectively and efficiently a company manages its resources.
 Financial statements also show the results of the stewardship of management, that is the
accountability of management for the resources entrusted to it by the owner(s).

b. QUALITATIVE CHARACTERISTICS OF USEFUL FINANCIAL INFORMATION

Financial information is useful when it is relevant and represents faithfully what it purports to
represent. The usefulness of financial information is enhanced if it is comparable, verifiable, timely and
understandable.

Fundamental Qualitative Characteristics

a. Relevance.
Relevant financial information is capable of making a difference if it has predictive value,
confirmatory value, or both. Relevant information influences the economic decisions of users by
helping them evaluate past, present or future events, or confirming, or correcting, their past
evaluations

 Predictive value. Financial information has predictive value if it can be used as input to
processes employed by users to predict future outcomes. For e.g. information about financial
position and past performance is frequently used in predicting wages payments, and the ability
of the entity to meet maturing obligations.

 Confirmatory value (or feedback). Financial information has confirmatory value if it

provides feedback about (confirms or changes) previous evaluation. It is an analysis of the
relationship between predictions and outcomes. The information is used to assess how well
management has performed its function by comparing its achievements with expectations
Information with feedback value enables users to confirm or correct expectations.

b. Faithful Representation
Financial reports represent economic activities in words and numbers. It must represent `
faithfully the financial transactions as it occurred. This fundamental characteristic seeks to maximize
the underlying characteristics of completeness, neutrality and freedom from error.

 Completeness. A complete depiction includes all information necessary for a user

to understand the event or information being presented, including all necessary
descriptions and explanations.

 Neutrality. A neutral presentation is one without bias .Financial statements are

not neutral if, by the selection or presentation of information, they influence the
making of a decision or judgment in order to achieve a predetermined result or
outcome,

 Freedom from error. Means there are no errors or omissions in the description of
the transactions, and the process used to produce the reported information has
been selected and applied with no errors in the process.

. Enhancing Qualitative characteristics

Comparability, verifiability, timeliness and understandability are qualitative characteristics

that enhance the usefulness of information that is relevant and faithfully represented

a. Comparability. It enables the users to identify and understand similarities in, and differences
among, items. A comparison requires at least two items.
 Consistency, although related to comparability, is not the same. . Consistency refers to the use of
the same methods for the same items, either from period to period within a reporting entity or in
a single period across entities. “Comparability is the goal; consistency helps to achieve that goal.”

b. Verifiability. Means that different knowledgeable and independent observers could reach
consensus, although not necessarily complete agreement, that a particular depiction is a faithful
representation.

c. Timeliness. Means having information available to decision-makers in time to be capable of

influencing their decisions.

d. Understandability. Classifying, characterizing, and presenting information clearly and concisely,

makes a financial statement understandable.

THE ELEMENTS OF FINANCIAL STATEMENTS

The financial statements portray the financial effects of transactions and other events by
grouping them into broad classes according to their economic characteristics. These termed the
elements of financial statements.

Elements directly related to measurement of financial position (represented by the Balance sheet) are:
 Assets - Economic resources of an enterprise that are recognized and measured in conformity
with generally accepted accounting principles..
 Liabilities –Economic obligations of an enterprise that recognized and measured in conformity
with general accepted accounting principles.
 Owner ‘Equity- The interest of owners in an enterprise which is the excess of an enterprise’s
assets over its liabilities.
Elements directly related to measurement of performance or results of operations (represented by the Income
statement) are:
 Revenue – gross increases in assets or gross decreases in liabilities recognized and measured in
conformity with general accepted accounting principles that result from those types of profit-
directed activities of an enterprise that can change the owner’s equity.
o Revenue result only from those types of profit-directed activities that can change the
owner’s equity under the general accepted accounting principles
 Expense – gross decrease in assets or gross increases in liabilities recognized and measured in
conformity with general accepted accounting principles that result from those types of profit-
directed activities of an enterprise that can change the owner’s equity.
o Expenses like revenues, result only from those types of profit-directed activities that can
change the owner’s equity under the general accepted accounting principles

RECOGNITION OF THE ELEMENTS OF FINANCIAL STATEMENTS

Recognition is the process of incorporating in the balance sheet or income statement an item that
meets the definition of an element and satisfies the criteria for recognition. An item that meets the
definition of an element should be recognized if:
 It is probable that any future economic benefit associated with the item will flow to or from the
enterprise; and
 The item has a cost or value that can be measured with reliability.

MEASUREMENT OF THE ELEMENTS OF FINANCIAL STATEMENTS

Measurement is the process of determining the monetary amounts at which the elements
of financial statements are to be recognized and carried in the balance sheet and income statement.
 This involves the selection of a particular basis of measurement. A number of these are used to
different degrees and in varying combinations in financial statements. They include the following:

HISTORICAL COST. Assets are recorded at the amount of cash or cash equivalents paid or the fair
value of the consideration given to acquire them at the time their acquisition.

CURRENT COST. Assets are carried at the amount of cash or cash equivalents that would have to be
paid if the same or an equivalent asset was acquired currently.

“Liabilities are carried at the discounted amount of cash and cash equivalents that would be required
to settle the obligation currently.”

RELIAZABLE (SETTLEMENT) VALUE

Reliazable value. Assets are carried at the amount of cash or cash equivalents that could
currently be obtained by selling an asset in an orderly disposal.

Settlement value. Liabilities are carried at the undiscounted amounts of cash or cash
equivalents expected to be paid to satisfy the liabilities in the normal course of business.

Present Value. Assets/liabilities are carried at present discounted value of the future net cash
inflows/outflows that the item is expected to generate/settle in the normal course of
business.
.

***End of Chapter 2***

References:
Ballada, Win & Susan Ballada. Accounting Fundamentals Made Easy 15th Edition. DomDane Publishers. 2019
Ballada, Win. Basic Financial Accounting and Reporting, 22nd Edition. DomDane Publishers. 2019.