Handout#2 Accounting Concepts and Principle and Accounting Equation

Learning Outcomes:
After reading this handout the student will be able to:

1. Enumerate and define the accounting concepts and principles.

2. Define conceptual framework
3. Define the fundamental and enhancing qualitative characteristics of accounting.
4. Illustrate and define the accounting equation.

Accounting concepts and principles (assumptions or postulates) are a set of logical ideas and
procedures that guide the accountant in recording and communicating economic information.
They provide a general frame of reference by which accounting practice can be evaluated and
they serve as guide in the development of new practices and procedures.

Basic Accounting Concepts

1. Separate Entity Concept - under this concept, the business is viewed as a separate
person, distinct from its owner(s)
2. Historical Cost Concept (Cost Principle) – at this concept assets are initially recorded at
their acquisition cost.
3. Going Concern Assumption – under this concept, the business is assumed to continue to
exist for an indefinite period of time. Liquidating concern use only when the business
would no longer operate for the coming future.
4. Matching Principle (or association of cause and effect) – under this concept some cost is
initially recognized as assets and charge as expense only when the related revenue is
recognized.
5. Accrual Basis of accounting - under the accrual basis of accounting, economic events
are recorded in the period in which they occur rather than at the point of time when
they affect cash.
6. Prudence (or Conservatism) – under this concept the accountant observes some degree
of caution when exercising judgements needed in making accounting estimates under
conditions of uncertainty.
7. Time Period (Periodicity or Accounting Period Concept) – under this concept, the life of
business is divided into a series of reporting periods.
Calendar Year Period - covers 12 months starting January and ending December.
Fiscal Year – covers 12 months also however starts in different months aside
from January
Interim Period - accounting period shorter than 12 months, it may be monthly,
quarterly or semiannually.
8. Stable Monetary Unit (Monetary Unit Assumption) – under this concept, assets,
liabilities, equity, income and expense are stated in terms of common units of measure.
9. Materiality Concept – This concept guides the accountant when applying accounting
principles. This is because accounting principles are applicable only to material items.
An item is considered material if its omission or misstatement could influence
economic decisions.

Reference: Financial Accounting and Reporting (Fundamentals) by Zeus Vernon B. Millan

Handout#2 Accounting Concepts and Principle and Accounting Equation

10. Cost-benefit (Cost constraint) – under this concept, the cost of processing and
communicating information should not exceed the benefits to be derived from it.
11. Full Disclosure Principle – this concept is related to both the concepts of materiality and
cost-benefit. Under the full disclosure principle, information communicated to users
reflects a series of judgmental trade-offs. The trade-offs strive for:
a. Sufficient detail to disclose matters that make a difference to users, yet
b. Sufficient condensation to make the information understandable, keeping in
mind the costs of preparing and using it.
12. Consistency concept – under this concept, a business shall apply accounting policies
consistently, and present information consistently, from one period to another.

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 (PFRSs).
Traditionally, accounting standards were referred to as the Generally Accepted
Accounting Principle (GAAP).

Financial Reporting Standard Council (FRSC) – adopted the standards and interpretations that
is called Philippine Financial Reporting Standards (PFRS) which consist of the following:
1. Philippine Financial Reporting Standards (PFRSs)
2. Philippine Accounting Standards (PASs); and
3. Interpretations
PFRSs are patterned from the International Financial Reporting Standards (IFRSs)
which
are issued by International Accounting Standards Board (IASB)

“Generally Acceptable”
1. Standard has been established by an authoritative accounting standard setting body; or
2. The principle has gained general acceptance due to practice over time and has been
proven to be most useful.

Relevant regulatory bodies

⮚ Securities and Exchange Commission (SEC)

⮚ Bureau of Internal Revenue (BIR)
⮚ Bangko Sentral ng Pilipinas (BSP)
⮚ Cooperative Development Authority (CDA)

Reference: Financial Accounting and Reporting (Fundamentals) by Zeus Vernon B. Millan

Handout#2 Accounting Concepts and Principle and Accounting Equation

Conceptual Framework is not a standard; rather, the Conceptual Framework serves as a general
frame of reference in the application or development of the standards.

Qualitative characteristics – are the traits that make information useful to users. Without these
characteristics, information may be deemed useless.

✔ Fundamental qualitative characteristics – these refer to the essential characteristics

that information must have before it can be included in the financial statements.
a. Relevance – information is considered relevant if it has the ability to affect the
decision making of the users.
Elements:
o Predictive Value – information has a predictive value if users can
use it as an input in making predictions or forecasts of outcomes
of events.
o Confirmatory Value (Feedback Value) – information has
confirmatory value if users can use it to confirm their past
transaction.
Materiality – information is material if omitting or misstating it could
influence the decision making of the users.

b. Faithful representation – information is faithfully represented if it is factual,

meaning it represents the actual effect of events that have taken place.
Elements:
o Completeness – information must be presented with sufficient
detail necessary for the users to understand them. Important
information must not be omitted.
o Neutrality – information is selected or presented without bias.
Information must not be manipulated to increase the probability
that it will be received favorably or unfavorably by the users.
o Free from error – means information presented in the financial
statements must not be materially misstated.

✔ Enhancing qualitative characteristics – these characteristics support the fundamental

characteristics. They enhance the usefulness of information. As such, they must be
maximized.
a. Comparability – information has its characteristics if it enables users to make
comparisons to identify and understand the similarities in and the differences
among, items.
b. Verifiability – information is verifiable if it enables different and independent
users to reach a general agreement about what the information intends to
depict.
c. Timeliness – information must be provided to users on time to be capable of
influencing their decisions.

Reference: Financial Accounting and Reporting (Fundamentals) by Zeus Vernon B. Millan

Handout#2 Accounting Concepts and Principle and Accounting Equation

d. Understandability – information must be presented clearly and concisely in order

for users to understand them.

The Accounting Equation

Basic Accounting Equation [ Assets = Liabilities + Equity ]

ASSETS – are the resources that reporting entity control that have resulted from past events and
can provide the entity with future economic benefits.

LIABILITIES – are the entities present obligations that have resulted from past events and can
require you to give up resources when settling them.
Essential elements in the definition of liability
a. Present obligation – means that right now, you have a responsibility to pay someone
because of an obligating event that has already transpired.
An obligating event is an event that creates either (a) a legal obligation or (b) a
constructive obligation.

⮚ A legal obligation arises from:

a. A contract;
b. A Law: or
c. Other operations of law.

⮚ A constructive obligation arises from the entity's past business practices or published
policies that have created a valid expectation on the part of others that you will pay
them.

Equity – is simply assets minus liabilities. Other terms for equity are “capital,” “net assets,” and
“net worth”

Illustration:

Mr. Mando Rogas decided to put up a pawnshop and estimated that he will be needing
Php 800,000 as start-up capital.
He went to Pig-E Bank and withdrew his personal savings there amounting Php 550,000
to be used in the pawnshop business. Then, he bought a small business establishment where his
pawnshop will be operating.

● Right now Mr. Mando Rogas has the following

ASSET = LIABILITIES + EQUITY

550,000 0 550,000

Reference: Financial Accounting and Reporting (Fundamentals) by Zeus Vernon B. Millan

Handout#2 Accounting Concepts and Principle and Accounting Equation

Since he needed Php 250,000 for his pawnshop business to start to operate, He went so
his Chinese bestie Ms. Pau Tang. Because Mr. Mando Rogas was an honest and trustworthy
bestie of Ms. Pau Tang, she lent Mr. Mando Rogas Php 250,000 for his business.

● After Ms. Pau Tang lend the said amount Mr. Mando Rogas has now:

ASSET = LIABILITIES + EQUITY

800,000 250,000 550,000

Basic Accounting Equation [ Assets = Liabilities + Equity + Income - Expense]

INCOME – is increases in economic benefits during the accounting period in the form of inflows
or enhancements of assets or decreases of liabilities that result in increases in equity, other
than those relating to contributions from equity participants

EXPENSES – are decreases in economic benefits during the accounting period in the form of
outflows or depletions of assets or incurrences of liabilities that result in decreases in equity,
other than those relating to distributions to equity participants.

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: (Continuation)

After the operations period Mr. Mando Rogas, earned income amounting of
Php 100,000 and incurred only Php 20,000 for his expenses in the business.

In this case, the total assets of Mr. Mando Rogas in his business would increase by
Php 80,000.

❖ The expanded accounting equation would be

ASSETS = LIABILITIES + EQUITY + INCOME - EXPENSE

880,000 250,000 550,000 100,000 20,000

Reference: Financial Accounting and Reporting (Fundamentals) by Zeus Vernon B. Millan