CHAPTER 1

BASIC CONCEPTS OF ACCOUNTING

Definitions of Accounting

Accounting is a service activity. Its function is to provide quantitative information primarily

financial in nature, about economic entities, that is intended to be useful in making economic decisions.
(Accounting Standards Council in its SFAS no. 1)

Accounting is an art of recording, classifying, summarizing in a significant manner and in terms

of money, transactions and events which are, in part at least of a financial character and interpreting the
results thereof. (American Institute of Certified Public Accountants)

Accounting as the Language of Business

Accounting is the medium of communication between a business firm and the various parties
interested in its financial activities. It transmits financial information by means of periodic reports
principally the financial statements. As the major end-products of accounting, these statements carry to
the management and other interested parties the messages about the financial activities of the business.

Functions of Accounting in Business

The functions of accounting in business can be attributed to the three fundamental objectives of an
information system.

1. To fulfill the stewardship function of the management (or owners);

2. To help increased users come up with informed decisions; and
3. To support daily operations of the business.

BASIC FINANCIAL STATEMENTS

Financial Statements are the means by which the information accumulated and processed in
financial accounting are periodically communicated to the users.

1. Balance Sheet. It shows the financial position or condition of an enterprise as of a particular

date. It has three sections namely the Assets, Liabilities and Owner’s Equity.
2. Income Statement. It shows the performance or the results of the enterprise’s operations for a
given period of time. It consists of revenues and expenses.
3. Statement of Changes in Equity. It summarizes the changes in equity for a given period of time.
The beginning equity of the owner is increased by the additional investment and net income and
is decreased by withdrawal and net loss.
4. Statement of Cash Flows. It provides information about cash inflows and cash outflows of an
entity for a given period of time. Activities are classified into Operating, Inventing and
Financing.
5. Accounting Policies and Notes to Financial Statements. This presents important accounting
policies that affected the financial statements and other disclosures necessary to make the
financial statements more useful.

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The Objectives of Financial Statements

The objective of the financial statements is to provide information about the financial position, financial
performance, and cash flows of the business that is useful to key personalities who are making economic
decisions. To meet this objective, financial statements provide information about the business assets,
liabilities, equity, income and expenses, contributions by and contributions to owners.

USERS OF FINANCIAL STATEMENTS

Internal users are those who make decisions on behalf of the organization, they are:

1. Management. Financial statements information is used in planning, implementing, controlling

and decision making. Analysis of these reports helps the management in determining the
efficiency and effectiveness of its operations.
2. Business Owners. Proprietors rely on financial information to monitor and evaluate the status
and performance of the management. Through these reports the owners determine the returns of
their investments.
3. Employees. Workers are also interested in the financial statements of their company to have the
necessary information in wage negotiations and other terms of employment.

External users are those who makes decisions based on the company’s financial information, they are:

1. Investors. They need information to help them decide whether they should invest or not in the
business.
2. Creditors. Financial statements are used by creditors and suppliers to evaluate the ability of the
company to pay their existing obligations and to determine credit terms.
3. Customers. They assess the financial position of their suppliers which is necessary for them to
maintain a stable source of supply in the long run.
4. Suppliers. They use financial reports of their customers to determine whether the debts owed to
them will be paid when due or whether the customer has enough funds of resources to pay the
goods to be delivered or the services to be rendered.
5. Tax Authorities. They use financial reports to determine the credibility of the tax returns filed on
behalf of the company. They are interested to know if the business paid the taxes correctly.
6. Regulatory Bodies. They want to ensure that the company’s disclosure of accounting
information is in accordance with the rules and regulations set in order to protect the interest of
the stakeholders who rely on such information. Examples of these are Securities and Exchange
Commission (SEC) and the Bangko Central ng Pilipinas (BSP).
7. Public. They use financial information to know how the business affects the economy possible
prospects for employment.

BRANCHES OF ACCOUNTING

Public of Accounting
In public accounting, the accountant performs of offers to perform any activity that will result to
the issuance of an attest report that is in accordance with professional standards. Such activities include
consulting services, personal financial planning services, the preparations of tax returns, and advice on
tax matters for a fee. Usually, a public accountant works in a firm offering its services to various clients.
Certified Public Accountants (CPAs) refer to those who had passed the licensure examination for
accountants.

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Examples of public accounting services are as follows:

External Auditing
The public accountants examine the financial statements in order to express an opinion
on whether statements have been fairly presented or not. The auditor critically examines the
accounting record of the client to check if the business transactions have been properly recorded.
The auditor then issues an independent audit report of his or her findings.

Tax Preparation and Planning Services

Some CPAs also offer tax services wherein they advise and help their clients in tax
planning and preparing tax returns.

Management Advisory Services

Management consulting is an area in public accounting that involves financial planning
and control, and the development of accounting and computer systems. The accountant advises
management on matters such as the installation of an accounting system, finance, budgeting.
Business processes, introduction of new products, and other business activities.

Private of Accounting
Private accounting involves setting up systems of recording business transactions that are
aggregated into financial statements. It includes the development and interpretation of accounting
information intended to assist management in operating the business. The private accountant is an
employee of the company who will be performing the day-to-day accounting needs.

Examples of private accounting services are as follows:

Financial Accounting
This branch of private accounting provides economic and financial information for
investors, creditors, and other external users. It uses a system of reporting designed to meet the
information needs of external users. Financial accounting is governed by an established body of
standards and principles. If focuses on the recording and classifying of business transactions
while applying generally accepted accounting principles (GAAP).

Cost Accounting
Cost accounting focuses on accumulating manufacturing cost for financial reporting and
decision-making purposes. It covers the reporting of financial information relevant to
manufacturing operations. It provides management with the necessary tools and information for
planning and controlling activities.
The primary role of cost accounting is to determine the inventory cost for financial
reporting purposes.

Budgeting
Budgeting provides a detailed collection and reporting of the expenditures and revenues
involved in a business or company operations. This branch of private accounting tracks the
financial details of the firm, including the money taken in and the money spent by the company
and the staff. It also assists the management in quantifying goals concerning revenue, cost of
sales of services, and operating expenses.

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 Accounting Information System
Accounting information system collects and processes transaction data. It also
disseminates information to interested parties. It involves the designing of both manual and
computerized data processing system.

Tax Accounting
It deals with the preparation of various tax returns and doing tax planning for the
business. This is similar to the tax services done in public accounting.

Internal Auditing
This branch of private accounting reviews the business operations to check if they are
complying to management policies. It also evaluates the efficiency of business operations.
Normally, an internal auditor is hired employee of a company.

Government Accounting
Government accounting is a system used in government offices to record and report financial
transactions. It is the systematic process of collecting, recording, classifying, summarizing, and
interpreting the financial transactions relating to the revenues and expenditures of government offices.
Government accounting reveals how public funds have been generated and utilized. It is
employed in both national and local governments.
CPAs are needed in all levels of government. He or she could be a provincial accountant, a
Commission on Audit (COA) auditor to various government agencies, a BIR examiner to local and
national businesses, a budget officer of the Department of Budget and Management, or a bank examiner
of Bangko Sentral ng Pilipinas.

Accounting Education
This branch of accounting is responsible for training future accountants. It engages in teaching
accounting, financial management, taxation, and other related business course. As per Commission on
Higher Education (CHED) Memorandum Order (CMO) No. 3, series 2007, a CPA in accounting
education should possess the educational qualifications, professional experience, classroom teaching
ability, computer literacy, scholarly research productivity, and other attributes that are essential for the
successful conduct of a professional accounting system.
CPAs are encouraged to be part of the academe and become an integral force in inspiring
learners pursue a career in accounting. Accounting educators could be teachers, administrators, or
researchers. Accounting research, though a separate discipline, usually falls under this branch.
Accounting research is broader is scope and wider in coverage. It encompasses research interests in the
areas of financial accounting, management accounting, auditing and assurance, and taxation, among
others.

CPAs in Specialized Areas

1. Forensic Accounting
Forensic accountants provide the detective work needed to investigate and examine
evidence of white-collar financial crimes such as stealing and fraud. They often act as expert
witnesses in legal proceedings and prepare evidence to be presented in court.
2. Information Technology Services
Businesses often seek individuals who can design and implement customized software
system. CPAs who possess strong skills in information technology can work with e-commerce
ventures and consult with others to determine which decisions are the most financially and
technologically sound for the company.

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 3. Environmental Accounting
CPAs involved in environmental accounting determine how companies can be both
profitable and environmentally responsible. They do environmental compliance audits and set
up preventive systems to ensure compliance and avoid future environmental related claims or
disputes.
4. International Accounting
International Accountants are knowledgeable in international trade rules and regulations,
international mergers, government regulations, tax laws, and overseas transactions. CPAs who
work in this area often travel abroad and can understand different languages.

FORMS OF BUSINESS ORGANIZATIONS

Types of Business According to Ownership

A person puts in or invests capital when he starts a business. A business assumes one of the
three forms of organization.

1. Sole Proprietorship – the business is owned by a single person known as the proprietor who
generally is also the manager. This is the simplest form of business organization.
2. Partnership – the business is owned and operated by two or more persons who bind themselves
to contribute money, property, or industry to a common fund, with the intention of dividing the
profits among themselves.
3. Corporation – presently the most popular form of business organization. The business is owned
by its stockholders. Stockholders are persons who put in capital in a corporate business.
Certificate of stocks are issued to them as their evidence of ownership.

Types of Business According to Activities

Any of these types of activities may be performed by a business organization be it a sole

proprietorship, a partnership or a corporation.

1. Service - the business performs services for a fee like the laundry shop, beauty parlor, barber
shop, law firms, dental clinic and medical clinic.
2. Merchandising or Trading – these are businesses engaged in the buying and selling of finished
goods or commodities. Grocery store, textile store, drug store and department store belong to
this group.
3. Manufacturing – engages in the production or manufacturing of goods that it sells. The
business buys raw materials, convert them into products and then sell the products to other
companies or to final consumers. For example, paper mills, steel mills, car manufacturers and
drug manufacturers.

ACCOUNTING CONCEPTS and PRINCIPLES

In recording business transactions, accountants should consider the following concepts in
understanding the records
Accounting is called the language of business. It communicates the financial condition and
performance of a business to interested users for decisions-making purposes. A widely accepted set of
rules, concepts, and principles referred to as the Generally Accepted Accounting Principles (GAAP)
governs the application of accounting procedures.

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Underlying Accounting Assumptions

1. Economic Entity Assumption. In accounting, the business is an organization is separate and

distinct from its owners. Business transactions and the personal transactions of the owner must
be accounted separately.
2. Time-Period Assumption. The life of an entity can be divided into artificial time period for the
purpose of providing periodic reports on the economic activities of the entity. It means that
financial statements are prepared at equal time intervals.
3. Monetary Unit Assumption. The Philippine peso is a reasonable unit of measure and that its
purchasing power is assumed to be relatively stable.
4. Accrual Basis Assumption. It requires that all business transactions and other events are
recognized in the accounting records when they occur, rather than when the cash or equivalent is
received or paid.
5. Going Concern Assumption. In the absence of contrary information, a business entity assumed
to remain in existence for an indeterminate period of time. The current relevance of the
historical cost principle is dependent on the going concern assumption.

Basic Accounting Principles

Accounting practices follow certain guidelines known as the generally accepted accounting
principles. In order to generate information that is useful to the users of financial statements,
accountants rely upon the following principles:

1. Objectivity Principle. Accounting records and statements are based on the most reliable data
available so that they will be accurate and as useful as possible. Ideally, accounting records are
based on information that flows from activities documented by objective evidence.
2. Cost Principles. This principle states that acquired assets should be recorded at the actual cost
and not at what management thinks they are worth as at reporting date.
3. Revenue Recognition Principle. Revenue is to be recognized in the accounting period when
goods are delivered or services are rendered or performed.
4. Matching Principle. This principle requires that expenses be matched with revenues. It means
that in a given accounting period, the revenue recorded should have its corresponding expense
recorded, in order to show the true profits of the business.
5. Full Disclosure Principles. Requires that all relevant information that would affect the user’s
understanding and assessment of the accounting entity be disclosed in the financial statements.
6. Materiality Principle. 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.
7. Conservatism of Prudence Principle. This principle states that given two options in the
valuation of business transactions, the amount recorded should be the lower rather than the
higher value. If a situation arises where there are two acceptable alternatives for reporting an
item, conservatism directs the accountant to choose the alternative that will result in less effect
on net income and/or less amount.

BASIC ELEMENTS OF FINANCIAL STATEMENTS

1. Assets. This refers to economic resources of an enterprise that are recognized and measured in
conformity with generally accepted accounting principles. This includes properties or property
rights owned by the business as at a given date. Examples are cash, receivables, equipments,
furniture and others.

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 2. Liabilities. These are the economic obligations of an enterprise that are recognized and
measured in conformity with generally accepted accounting principles. This includes claims of
creditors against the assets of the company. Examples are accounts payable, notes payable,
accrued expenses, loans payable, SSS premium payable, taxes payable and others.
3. Owner’s Equity. This refers to the interest of the owner in an enterprise which is the excess of
an enterprise’s assets over its liabilities. It includes original investment, additional investment
and withdrawals of the owner, increased or decreased by net income or net loss.
4. Revenues. Are gross increases in assets or gross decreases in liabilities recognized and
measured in conformity with the generally accepted accounting principles that resulted from
those types of profit-directed activities of an enterprise that can change owner’s equity.
Examples are service income, rental income, interest income, fees income and others.
5. Expenses. Gross decreases in assets or gross increases in liabilities recognized and measured in
conformity with the generally accepted accounting principles that resulted from those types of
profit-directed activities of an enterprise that can change owner’s equity. Examples are salaries
and wages, rent expense, office supplies, transportation expenses and others.
6. Net income (net loss). The excess (deficit) of revenue over expenses for an accounting period,
which results to an increase (decrease) in the owner’s equity (assets minus liabilities) of an
enterprise for an accounting period arising from profit-directed activities that is recognized and
measured in conformity with the generally accepted accounting principles.

Account Titles
Current Assets. Cash and other assets that may reasonably be expected to be realized in cash or sold
or consumed usually within a year or less through the normal operations of the business. This
includes the following accounts:
Cash on Hand. This includes currency or cash items on hand (such as items awaiting deposit).
This account is debited or charged for all daily collections. It is credited when the collections are
deposited in the bank.

Cash in Bank. This includes currency deposited in a bank be it in peso or foreign currency,
which is unrestricted and immediately available for use in current operations or which could be
withdrawn any time or upon demand. This account is debited when collections are deposited to
a bank, either saving or current account. It is credited for disbursements.

Petty Cash Fund. This account includes currency or cash items on hand for petty expenses. It is
debited for all amount set up to take care of petty cash disbursements as well as addition thereto.
In no case this account, be debited/credited except when the fund itself has to be
increased/reduced or adjusted/closed.

Notes Receivable. These are open accounts or receivables which are supported by formal
promises to pay in the form of notes. These are debited when a promissory note is received for
the settlement of the account and credited when payment is received or canceled thereof.

Accounts Receivable. These are claims of the business against clients or customers usually
arising from services rendered or from sales of goods.

Allowance for Bad Debts. This is a valuation account which reduces accounts receivable and
where the provision for bad debts is credited. It is debited when an account receivable is written-
off.

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 Accrued interest Receivable. It represents interest due from debtors, like interest on notes
receivable. This account is debited at the end of the accounting period when adjustment is made
and credited upon collection.

Office Supplies on Hand. It refers to unused office supplies. This account is debited upon
acquisition of office supplies under the asset method of recording prepayments and credited upon
adjustment. Shop Supplies on hand is used to record unused shop supplies.

Prepaid Expenses. This refers to payment of expenses made in advance. Some examples of
prepaid expenses that have future benefits are prepaid insurance, prepaid rent, prepaid supplies
and prepaid interest.

Non-current Assets.
Property, Plant and Equipment or Plant Assets or Fixed Assets. Are tangible assets used in the
business that are of a permanent or relatively fixed nature.
Land. Real estate owned by a business and used in operations such as land on which is
constructed an office building is referred to as land.

Building. This includes structures like plants, shops, office and others which are being used in
the normal course of business operations. It is debited for acquisition and constructions of such
structures and credited when sold and retired.

Equipment. This term is used to refer to typewriters, cash registers, calculators, computers,
filing cabinets and etc. If used in the office the appropriate term is Office Equipment, if used in
the shop then Shop equipment is used.

Furniture and Fixtures. This refers to tables, chairs, counters, cabinets, and any other furniture
items. If used in the store, the account Office Furniture and Fixtures is used. If the items are for
the shop, then Shop Furniture and Fixtures is used.

Transportation Equipment. This includes trucks, cars, jeeps, motorcycles, and any other vehicle
used for transportation purposes by the business.

Accumulated Depreciation. All property, plant and equipment are subject to depreciation except
land. The amount of depreciation provided over a period of time is referred to as accumulated
depreciation.

Current Liabilities. Liabilities that will be due within a short time, usually one year or less, and that
are to be paid out of current assets.

Accounts Payable. A liability representing an amount owed to a creditor, usually arising from
the purchase of merchandise or materials and supplies.

Notes Payable. A liability evidenced by a promissory note.

Interest Payable. The amount additional due on a promissory note as interest.

Accrued Expenses. Amount owed to others for unpaid expenses. This account includes salaries
payable, utilities payable, interest payable and taxes payable.

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 Unearned Revenues. When the business entity receives payment before providing its customers
with goods or services, the amounts received are recorded in the unearned revenue account
(liability method). When the goods or services are provided to the customer, the unearned
revenue is reduced and income is recognized.

Noncurrent Liabilities. Liabilities other than current liabilities.

Long-term Notes Payable. Notes payable that are due after one year.

Mortgage Payable. Obligations which are evidenced by a mortgage of real estate and are
usually long-term.

Owner’s Equity. The excess of assets over the liabilities of the business represents owner’s equity.
The two principal elements comprising the owner’s equity are the proprietor’s investment and the
earnings of the business.

Owner’s/Proprietor’s Capital. The term capital is used to refer to the investment of the
proprietor in the business.

Owner’s Drawing or withdrawal. This refers to the withdrawals by the proprietor in the
business.

Service Income. This is the general term used to refer to any kind of income from services
rendered. This represents an inflow of cash or other non-cash assets such as accounts or notes
receivable which arises from services rendered. Other account names that may be used to refer
to income from services describe the specific nature or type of services rendered.

Professional Fees. This term refers to income received from rendering professional services to a
client for a fee but does not specify the particular type of professional service rendered. Other terms
that are descriptive of the nature of services rendered are medical fees, legal fees, dental fees,
accounting fees, and management fees.

Other Income. Income earned from sources other than from the principal line of service rendered is
referred to as “Other Income”. Some examples are rent income, commissions income and interest
income.

Operating Expenses. Operating expenses are the cost of goods or services that are used or
consumed in the operations of a business. Some common operating expenses include the following:

Salary Expense. This refers to the cost of service rendered by the employees of the business.

Rent Expense. This refers to the cost of renting office space used by a business in its operations.

Office Supplies Expense. This refers to the cost of office stationery, envelopes, bond paper,
clips and other office supplies that are normally used in operations.

Utilities Expense. This refers to the cost of light and water consumed as well as telephone
service used in business operations.

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 Taxes and Licenses Expense. This refers to all payments required by the local municipal
treasurer’s office for privilege taxes, mayor’s permit, municipal taxes and licenses, business
taxes, garbage fees, and other similar payments.

Transportation Expenses. This refers to the cost incurred by officers and employees for
transportation in the conduct of operation, such for client or customer calls. Business trips for
out-of-town assignments are referred to as “traveling” expenses. Sometimes, this account may be
called transportation and traveling expenses.

Gas and oil Expenses. This refers to the cost of gas and oil consumed whenever transportation
vehicles are used in official business functions.

Representation Expense. This refers to the cost incurred while entertaining clients or customers.
Also included are the costs incurred when officers and employees represent the company in some
official business functions.

Depreciation Expense. This refers to the portion of the cost of a property item that is charged
against current year’s operations.

Doubtful Accounts Expense. This refers to the receivables that is estimated to be uncollectible
and is charged against current year’s operations.

Insurance Expense. This refers to the premium chargeable to current year’s operation on fire
insurance coverage, motor vehicles comprehensive insurance coverage or surety bonds acquired.

Miscellaneous Expenses. Any other normal costs of conducting business that are not significant
enough to be reported separately may be grouped together in an account called “miscellaneous”
expenses.

Normal Balances

The rules of debit and credit, and the normal balances of the various types of accounts are
summarized below.

Type of Account Increase Decrease Normal Balance

Asset Debit Credit Debit

Liability Credit Debit Credit
Capital Credit Debit Credit
Drawing Debit Credit Debit
Revenue Credit Debit Credit
Expense Debit Credit Debit

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