INTRODUCTION OF ACCOUNTING

Contents:
1) Definition of Accounting
2) The Accounting Process
3) Nature of Accounting
4) History of Accounting
5) Users of Accounting Information
6) Forms of Business Organizations
7) Types of Business
8) Accounting Concepts and Principles

Definition of Accounting

According to Florendo (2016), accounting is a process that involves identifying the events that
affect a business, recording these events, and communicating the summarized results of all the
events within a particular period to interested parties.

According to the Standards Council (ASC), accounting is a service entity. Its function is to
provide quantitative information, primarily financial in nature, about economic entities that is
intended to be useful in making economic decisions and making reasoned choices among
alternative courses of action.

Accounting is also defined as the art of recording, classifying, and summarizing in a significant
manner and in terms of money, transactions, and events that are at least of financial character and
interpreting the results thereof.

Accounting has been called the Language of Business, because it serves as a communication
link between the business entity and the users of financial information.

In compliance with governmental requirements, all business establishments are obliged to

maintain books of accounts.

Section 232A of the Internal Revenue Code of the Philippines requires all businesses that are
compelled by the law to pay internal revenue taxes to keep books of accountants and records in
accordance with the accounting system.

Section 3 of Revenue Regulation No. V-1 provides that the book of accounts and records shall
consist of a journal and ledger, or their equivalent, and contain all the information necessary for
an accurate determination of the internal revenue taxes due on businesses. This is also done in
compliance with municipal or city ordinances regarding local business taxation.

The Accounting Process

The accounting process is a series of steps that businesses follow to systematically record,
organize, and summarize their financial transactions. These steps help ensure that financial
information is accurate, reliable, and useful for making informed business decisions.
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The key stages of the accounting process are identifying, recording, classifying, and
summarizing.

Identifying: In this stage, businesses identify and collect relevant financial transactions or
events that impact their financial position. Transactions can include sales, purchases,
expenses, investments, loans, and more. It's important to capture all transactions accurately to
ensure that no financial activity goes unnoticed.

Example:

Recording: Once the transactions are identified, they are recorded in the company's accounting
records. It is the process of systematically maintaining a record of all business transactions,
either manually or electronically.

Usually done in chronological order or according to date of occurrence.

This step involves creating journal entries that provide a detailed description of each transaction,
including the accounts involved, the amounts, and the date. These entries serve as the initial
documentation of the financial event.

Example:

Classifying: After recording transactions, they need to be classified into appropriate accounts.
Accounts are categories that track different types of financial activities, such as assets, liabilities,
equity, revenues, and expenses.

Proper classification ensures that financial information is organized and can be easily
analyzed.

Summarizing: Summarizing is the preparation of financial statements, which include the

Statement of Financial Positions (Balance Sheet), Statement of Comprehensive Income,
Statement of Cash Flows, and Statement of Changes in Owner’s Equity.

Keep in mind that these stages are part of an ongoing cycle. Transactions continue to be
identified, recorded, classified, and summarized regularly, ensuring that the company's financial
records remain up-to-date and accurate.

Nature of Accounting
A Process - composed of multiple steps.
An Art - combination of techniques and applied skills, and expertise.
A Means and Not End - tool to achieve specific objectives
Deals with Financial Information and Transactions - deals only with quantifiable financial
transactions
An Information System - recognized and characterized as a storehouse of information.
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History of Accounting

Early people development dated back to ancient Mesopotamia

- people followed a system of writing and counting Money
In ancient Mesopotamia, the Sumerians, around 4,000 BCE, employed clay tablets inscribed with
symbols and numbers to document trade transactions and resources. These early records offer a glimpse
into the origins of economic record-keeping and trade documentation.
Early Development in Ancient Mesopotamia: In ancient Mesopotamia, accounting practices were crucial
for recording economic transactions and managing resources. The Sumerians, who lived in Mesopotamia
around 4,000 BCE, used clay tablets to document various business transactions. These clay tablets
contained impressions of symbols and numerical signs that represented different commodities, quantities,
and transactions. These early records included information about agricultural produce, livestock, and
other goods exchanged in trade.

Reign of Emperor Agustus (63 BC-14 AD)

Res Gestae Divi Augusti (The Deeds of the Divine Augustus).
Emperor Augustus's "Res Gestae Divi Augusti" is a noteworthy inscription that recounted his
accomplishments through bronze tablets across the Roman Empire. Though not a financial statement, it
reflects historical documentation of significant events, showing parallels with communication of financial
information.
Reign of Emperor Augustus (63 BC-14 AD): The "Res Gestae Divi Augusti," also known as "The Deeds
of the Divine Augustus," is a remarkable document that Emperor Augustus ordered to be inscribed in
Latin on bronze tablets and displayed in public places throughout the Roman Empire. It provided a first-
person account of his achievements, including military campaigns, building projects, and other
accomplishments during his rule. While not a financial statement in the modern sense, it serves as an
example of historical documentation of significant events and actions, which shares some similarities
with the communication of financial information.

Luca Pacioli in 14th Century

- double-entry bookkeeping system
Luca Pacioli's 14th-century work laid the foundation for modern accounting, introducing the double-entry
bookkeeping system in his book "Summa de Arithmetica, Geometria, Proportioni et Proportionalita." This
system's equal debit and credit entries ensured balanced accounts, and his principles, like the balance
sheet equation, continue to be core to contemporary accounting practices.
Luca Pacioli in the 14th Century: Luca Pacioli's contributions in the 14th century were foundational to
modern accounting practices. His book "Summa de Arithmetica, Geometria, Proportioni et
Proportionalita" included a section titled "Particularis de Computis et Scripturis" (Details of Calculation
INTRODUCTION OF ACCOUNTING
and Recording), where he described the double-entry bookkeeping system. This system ensured that for
every transaction recorded, there was an equal debit and credit entry, maintaining the balance of accounts.
The principles Pacioli introduced, such as the balance sheet equation (Assets = Liabilities + Equity), are
still fundamental to modern accounting.

Queen Victoria in 19th Century

- granted royal charter to the Institute of Accountants.
In the 19th century, Queen Victoria's granting of a royal charter to the Institute of Accountants marked a
crucial moment in the professionalization of accounting, bestowing authority for regulating the field and
setting ethical standards. This recognition elevated the institute's role in shaping accounting as a regulated
and skilled profession.
Queen Victoria and the Institute of Accountants: In the 19th century, accounting was becoming
increasingly important as business transactions and economic activities grew more complex. The granting
of a royal charter to the Institute of Accountants (which later became the ICAEW) by Queen Victoria was
a significant step in recognizing the professional nature of accounting. The charter conferred prestige and
authority upon the organization, allowing it to regulate the profession, establish ethical standards, and
promote the education and training of accountants. This formal recognition marked a turning point in the
professionalization of accounting.

USERS OF ACCOUNTING INFORMATION

"Users of Accounting Information" refers to individuals or groups who rely on financial and
accounting data to make informed decisions about a business or organization. These users can be
categorized as either external or internal users.
External Users: External users are individuals or entities that are not directly involved in the day-
to-day operations of the business but have a vested interest in its financial performance and
position. They use accounting information to assess the company's health, make investment
decisions, and evaluate its compliance with regulations. Some examples of external users are:
Customers: Customers might use financial information to assess a company's stability and ability
to fulfill its commitments, especially if they're entering into long-term relationships.
Creditors: Creditors, such as banks and suppliers, analyze financial statements to determine the
creditworthiness of a company before extending loans or providing goods on credit.
Potential Investors: Investors review financial reports to evaluate the company's profitability and
growth potential before deciding to invest their money.
Government: Government agencies require financial statements for tax assessment, regulatory
compliance, and other legal purposes.
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Academia: Researchers and educators analyze financial data to study trends, teach accounting
principles, and contribute to the advancement of accounting knowledge.
Public: The general public may use financial information to assess the social and economic
impact of a company and its ethical practices.
Internal Users: Internal users are individuals within the organization who use accounting
information to manage and operate the business effectively. They use financial data to plan, make
strategic decisions, and monitor performance. Some examples of internal users are:
Management: Managers at various levels use financial reports to monitor the company's
performance, allocate resources, and make strategic decisions.
Employees: Employees might use accounting information to understand the financial health of
the company they work for and how their efforts contribute to its success.
Owners or Stockholders: Business owners or stockholders use financial statements to assess the
profitability of their investments and to make decisions about the future of the company.

Forms of Business Organizations

Sole Proprietorship:
A sole proprietorship is the simplest form of business ownership where a single individual owns
and operates the business. The owner has full control over decision-making and assumes all
liabilities. While easy to set up, sole proprietorships may have limited access to capital and
resources.
Advantages Disadvantages
Easy and inexpensive to set up. Limited access to capital.
Full control over decision-making. Unlimited personal liability for business
debts.
Direct access to profits. Limited expertise and resources.
Simple tax reporting (personal tax return). Business continuity can be a challenge in case
of owner's absence or death.

Partnership:
A partnership is a business owned and operated by two or more individuals who share the
responsibilities, profits, and losses. Partnerships can be general (where all partners are equally
responsible) or limited (with different levels of liability for partners). Partnerships offer shared
resources and expertise but also require clear agreements to manage potential conflicts.
INTRODUCTION OF ACCOUNTING

Advantages
Shared responsibilities and decision-making.
Combined expertise and resources.
Shared financial burden.
Flexible structure and fewer regulations
compared to corporations.
Disadvantages
Shared profits.
Potential for conflicts between partners.
Unlimited liability for general partners.
Limited life span if outlined in the partnership
agreement.

Corporation:
A corporation is a legal entity separate from its owners (shareholders). It has its own rights and
liabilities, offering limited liability protection for shareholders. Corporations can raise capital by
issuing shares and often have complex organizational structures. They are subject to more
regulations and reporting requirements than other business forms.
Advantages Disadvantages
Limited liability for shareholders. Complex and expensive setup and ongoing
compliance.
Easier access to capital through stock Double taxation (corporate income tax and
issuance. personal income tax on dividends).
Perpetual existence. More regulations and reporting requirements.
Opportunities for tax planning and Potential loss of control for shareholders.
deductions.

Types of Business

Service Business: This business renders services to customers or clients for a fee.

e.g., public transport companies, beauty parlors, security agencies, repair shops, laundry shops,
schools, medical or health clinics, events coordinators, law offices, accounting firms, and
advertising firms.

Merchandising business or trading: This kind of business buys goods or commodities and
sells them at a profit.

e.g., grocery stores, supermarkets, hardware stores, drugstores, care dealers, real estate
dealers, and appliance stores.

Manufacturing Business: This type makes finished goods from raw materials or unassembled
parts.
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e.g., shoe factories, garment factories, car assemblers, and food processing plants.

Accounting Concepts and Principles

International Financial Reporting Standards

- issued by International Accounting Standards

- enhance the comparability of the financial statements of all companies around the world

International Financial Reporting Standards (IFRS) are a set of accounting standards and
guidelines developed by the International Accounting Standards Board (IASB) to provide a
consistent and globally recognized framework for financial reporting. IFRS aims to standardize
the way companies prepare and present their financial statements, making them more
comparable and transparent across different countries and industries.

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.

GAAP (Generally Accepted Principles)

Accounting has evolved over time, changing with the needs of society. As changes occur and
new types of transactions evolve in trade and industry, accountants develop rules and procedures.

GAAP defines what is accepted accounting practice, and these are likely laws that must be
followed in financial reporting.

Generally Accepted Accounting Principles are accounting principles, standards, rules, and
guidelines that companies follow to achieve consistency and comparability in their financial
statements.

Some general accounting principles are:

1. Accrual accounting: also called accrual basis, Income is recognized when earned, and
expenses are incurred regardless of when the payment is made.

For a service company, revenue is considered earned when services have been rendered, even if
no payment has been received from the customer or client.

Example: Atty. Reyes rendered legal services to a client X on January 1st, and he received the
payment of P100,000 on February 5th. When should Atty. Reyes recognize the revenue? In
January or February?
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Answer: Under the accrual basis, the revenue would be recognized in January because the
revenue is earned in January, the date when service is rendered.

2. Matching Principle: expenses are recognized in the same period as the related revenue.

The matching principle is an accounting principle for recording revenues and expenses. It
requires that a business record expenses alongside revenues earned in the same reporting period.
Ideally, they both fall within the same period of time for the clearest tracking.

Example: Imagine a bakery that sells cupcakes. Let's say the bakery makes a batch of cupcakes
in January and sells them all in February. The cost of the ingredients (flour, sugar, etc.) used to
make those cupcakes is $100.

According to the Matching Principle:

- The revenue from selling the cupcakes ($200) should be recognized in February, when
the actual sale occurs.

- The expenses related to making those cupcakes ($100 for ingredients) should also be
recognized in February because they directly relate to the cupcakes sold in that month.

3. Use of judgment and estimates: should be backed up by a reasonable basis.

Accounting recognizes that certain financial transactions and events may involve uncertainties
that require the application of professional judgment and the use of estimates to accurately
reflect them in the financial statements. This principle acknowledges that not all financial
information can be precisely determined, and therefore, informed decisions must be made based
on reasonable assessments. The principle emphasizes that while these judgments and estimates
are necessary, they should be based on a reasonable and justifiable basis.

In other words, the decisions and estimates made should be well grounded in the available
information, historical data, market conditions, and any relevant industry standards. Accountants
should exercise professional skepticism and apply their expertise to ensure that the financial
statements fairly represent the financial position and performance of the entity.

Example: A company that offers warranties on its products. Customers can claim warranty
repairs or replacements within a certain period after purchase. The company needs to estimate
the potential future costs of honoring these warranties.

- The use of judgment involves the company's assessment of historical warranty claims, the
quality of the products, and any changes in customer behavior.
- The use of estimates involves predicting the number of warranty claims that might be
made in the future and the associated costs of repairs or replacements.

4. Prudence: income, assets, liabilities, and expenses are not overstated.

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The prudence concept principle says that whenever you have a situation where you have some
future income, you should not recognize or include that in your books of accounts. This principle
is not to overstate your income unless and until you have possession of that income.

The principle of "prudence," also known as the "conservatism principle," in accounting guides
accountants to exercise caution and avoid overstating or inflating the financial position and
performance of a business. It encourages a more cautious approach to financial reporting by
recognizing potential losses and risks sooner rather than later.

"Overstate" means to exaggerate, inflate, or present something as being larger, more valuable, or
more significant than it actually is. In the context of accounting, overstating refers to the act of
reporting financial information, such as income, assets, liabilities, or expenses, at values that are
higher than their true or accurate amounts.

Overstating financial information can misrepresent a company's financial position and

performance, leading to a misleading impression of its health and profitability.

in case of doubt, record expenses and DO NOT RECORD INCOME.

5. Substance over Form: look at the substance of every financial transaction rather than its legal
form.

Substance over form is the concept that the financial statements and accompanying disclosures
of a business should reflect the underlying realities of accounting transactions. Conversely, the
information appearing in the financial statements should not merely comply with the legal form
in which it appears. In short, the recording of a transaction should not hide its true intent, which
would mislead the readers of a company's financial statements.

Scenario (Renting a car): You rent a car for a weekend getaway. The rental agreement states that
you're responsible for any damages to the car during the rental period.

Substance over Form: While the legal form is a car rental, the substance of the transaction is that
you're essentially paying for the use of the car as well as taking on the risks associated with it.
From an economic standpoint, it's similar to temporarily leasing a car. This concept
acknowledges that you're not just paying for the rental service but also for the temporary benefits
and responsibilities of car ownership.

Scenario (Lease vs. Purchase Decision): A company decides to lease (rent) a piece of equipment
rather than purchase it outright (fully).

Substance Over Form: Even though the legal arrangement is a lease, if the lease agreement
effectively transfers the risks and benefits of ownership to the company (e.g., if it's a long-term
lease with a bargain purchase option), the company might need to treat it as a purchase in its
financial statements. This accurately reflects the economic reality that the company has
essentially acquired the asset.
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6. Going Concern Assumption: Operations of the business will continue indefinitely (forever)
into the future. This assumes that unless there is evidence to the contrary, the business will
continue to operate for an indefinite period.

Means that by default, it's believed the business will keep running without any set end date,
unless there's clear proof or information showing that it won't continue indefinitely.

7. Accounting Entity Assumption: also known as "Business Entity Concept," states that the
business is separate from the owner.

This principle ensures that the financial activities and transactions of the business are recorded
and reported separately from the personal financial activities of its owners.

For example, if you own a small business, your personal expenses, such as mortgage payments
or groceries, are not mixed with the business expenses, like purchasing inventory or paying rent.
This clear distinction allows for accurate tracking of business performance, financial health,
and compliance with accounting standards.

- The personal transactions of the owner should not be merged with those of the business
he owns.
- Likewise, if the proprietor owns several businesses, there must be a separate accounting
for each business because each is an independent entity.

8. Time Period Assumption: The indefinite life of a company can be divided into periods of
equal length for the preparation of financial reports.

Financial reports covering an accounting period have to be prepared because users of financial
information need timely reports to make economic decisions.

Financial statements may be prepared on:

a) a monthly basis (the shortest accounting period)

b) at the end of every three months (quarterly basis)
c) every six months (semi-annual basis)
d) or once a year (annually).

The annual accounting period of a company may be a calendar year, fiscal year, or natural
business year.

a) The calendar year begins on January 1 and ends on December 31 of the same year.
b) The fiscal year begins on any month (except January) and ends on the twelfth month of the
following year.
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Example: If the business started on July 1, 2009, the end of its accounting period covering
one year of operation would be on June 30, 2010.

c) A natural business year is a twelve-month period that ends on any month when the business
is at its lowest point or experiencing slack season.

Resources:

Baguino, A., et al. (2014). Principles of Accounting (pp. 1-12). Philippines: Allen Adrian Books Inc.

Bragg, S. (2023). Substance over form definition. AccountingTools.

https://www.accountingtools.com/articles/what-is-substance-over-form.html#:~:text=Substance
%20over%20form%20is%20the,form%20in%20which%20they%20appear.

IFRS: International Financial Reporting Standards. (n.d.). CFA Institute.

https://www.cfainstitute.org/en/advocacy/issues/international-finance-reporting-stds#sort=
%40pubbrowsedate%20descending

Team, C. (2023). Fiscal Year (FY). Corporate Finance Institute.

https://corporatefinanceinstitute.com/resources/accounting/fy-fiscal-year/