CHAPTER 2: ACCOUNTING CONCEPTS AND PRINCIPLES Only the transactions of the business are recorded in the books of

accounts. The personal transactions of the business owner(s) are

Introduction not recorded.
Accounting concepts and principles (assumptions or For example, you started a business. Under the separate
postulates) are a set of logical ideas and procedures that guide the entity concept, you will view your business as a separate person,
accountant in recording and communicating economic information. like a friend maybe. own Facebook account.) (Your business can also
They provide a general frame of reference by which accounting have its own Facebook Account.)
practice can be evaluated and they serve as guide in the
development of new practices and procedures. Therefore, the money you invested to the business is now
owned by the business. It is not your personal money anymore.
Accounting concepts and principles provide reasonable Also, the business owns any money that it earns. If you take money
assurance that information communicated to users is prepared in a from the business for your personal use, it would be recorded in the
proper way. For example, doctors have a proper way of performing books of accounts as a withdrawal of your investment from the
surgery on a patient; engineers have a proper way of constructing a business. Similarly, when you take goods from the business for your
bridge; accountants too have a proper way of recording and personal consumption which you don't intend to pay, this would
communicating economic information. This is to maximize the also be recorded as a withdrawal of your investment.
usefulness of accounting information to the users.
Your personal transactions (i.e., those that do not involve
Basic Accounting Concepts the business) are not recorded in the books of accounts. For
There are numerous concepts and principles used in accounting. example, using your personal money to buy groceries for home
These are sourced from the Standards (PFRSs), the Conceptual consumption is not recorded in the books of accounts.
Framework for Financial Reporting, or general acceptance in the The application of the separate entity concept is necessary
profession due to long-time use. Accounting is constantly changing so that the financial position and financial performance of a
and new concepts are continuously emerging. It is, therefore, not business can be measured properly. By applying the separate entity
practicable to list all the concepts and principles used in accounting. concept, you can objectively know if the business is really earning
Only some of the basic and most common accounting concepts and profits, or if it has the ability to do so.
principles are listed below.
Many businesses have failed because they did not apply the
1. Separate entity concept - Under this concept, the separate entity concept. Take for example an owner of a sari-sari
business is viewed as a separate person, distinct from its owner(s). store who regards the store's cash register as an extension of his
pocket. He takes money from the business for personal use and Thus, income is recognized in the period when it is earned rather
consumes the store's goods without recording them. The business than when it is collected, while expense is recognized in the period
then suffers from lack of working capital. It runs out of goods to sell when it is incurred rather than when it is paid.
without any money to replenish them. Eventually, the business
becomes bankrupt. Unknowingly, this guy has caused his own 6. Prudence (or Conservatism) - Under this concept, the
business to fail. If this guy had applied the separate entity concept, accountant observes some degree of caution when exercising
he would have had better accounting information that could have judgments needed in making accounting estimates under conditions
led him to make better business decisions. of uncertainty. Such that, if the accountant needs to choose
between a potentially unfavorable outcome versus a potentially
2. Historical cost concept (Cost principle) - Under this favorable outcome, the accountant chooses the unfavorable one.
concept, assets are initially recorded at their acquisition cost. This is necessary so that assets or income are not overstated and
liabilities or expenses are not understated.
3. Going concern assumption - Under this concept, the
business is assumed to continue to exist for an indefinite period of 7. Time Period (Periodicity, Accounting period, or Reporting
time. This is necessary for accounting measurements to be period concept) - Under this concept, the life of the business is
meaningful. For example, measuring assets at historical cost divided into series of reporting periods.
(historical cost concept) is appropriate only when the business is a
going concern. The opposite of going concern is liquidating concern. Anecdote
A grocery store owner from the old country kept his accounts
This is the case if the business intends to end its operations or if it
payable on a spindle, accounts receivable on a note pad, and cash in
has no other choice but to do so, (e.g., the business is bankrupt). a cigar box. His daughter, having just passed the CPA exam, chided
The assets of a liquidating concern are measured at net selling price the father: "I don't understand how you can run your business this
rather than at historical cost. (Going concern - good; Liquidating way. How do you know what your profits are?"
concern - bad). "Well," the father replied, "when I got off the boat forty years ago, I
had nothing but the pants I was wearing. Today your brother is a
4. Matching (or Association of cause and effect) - Under this doctor, your sister is a college professor, and you are a CPA. Your
concept, some costs are initially recognized as assets and charged as mother and I have a nice car, a well-furnished house, and a lake
expenses only when the related revenue is recognized. home. We have a good business, and everything is paid for. So, you
add all that together, subtract the pants, and there's your profit."
5. Accrual Basis of accounting - Under the accrual basis of (Hospitality Financial Accounting by Jerry J. Weygandt, et al, 2005
accounting, economic events are recorded in the period in which John Wiley & Sons, Inc.)
they occur rather than at the point in time when they affect cash.
 A reporting period is usually 12 months, although it can be
longer or shorter. A 12-month accounting period is either a calendar
The business owner may be right. However, it would be impractical year period or a fiscal year period.
to wait so long to determine the financial performance of a
business. Users need timely periodic information to help them make  A calendar year period starts on January 1 and ends on
economic decisions. Managers need periodic information on the December 31 of the same year.
results of operations for them to properly perform their functions.  A fiscal year period also covers 12 months but starts on
a date other than January 1, e.g., July 1, 2019 to June
For example, managers may need to know the following: 30, 2020.
 Which products or services are selling well and which are An accounting period that is shorter than 12 months is called an
not? "interim period." An interim period can be a month, a quarter (3
 Is the business spending too much on expenses? Does the months) or a semiannual period (6 months).
business need to cut down costs?
 Is the business generating enough cash from its operating 8. Stable monetary unit - Under this concept, assets,
activities? liabilities, equity, income and expenses are stated in terms of a
common unit of measure, which is the peso in the Philippines.
External users may need to know the following: Moreover, the purchasing power of the peso is regarded as Stable.
 For creditors: Is the business generating enough cash Therefore, changes in the purchasing power of the peso due to
needed to pay its maturing liabilities? inflation are ignored.
 For investors: Is the business earning enough profits to 9. Materiality concept - This concept guides the accountant
ensure future growth? when applying accounting principles. This is because accounting
 For the government: Is the business paying the right taxes? principles are applicable only to material items.
Thus, instead of waiting until the life of the business ends An item is considered material if its omission or
before profit is determined, the life of the business is divided into misstatement could influence economic decisions. Materiality is a
series of equal short periods called reporting periods (or accounting matter of professional judgment and is based on the size and nature
periods). of an item being judged.

For example, material items are communicated to users in a

more detailed manner as compared to immaterial items.
 Another example is that big companies often round-off disclosure principle, information communicated to users reflect a
amounts in their financial reports. An account with a balance of series of judgmental trade-offs that strive for:
P323,487,679,621.21 may be reported as P323,488 with an
indication of the level of rounding-off as (in '000,000s), meaning "in a. Sufficient detail to disclose matters that make a
millions." Since the company is big (nature), the amount of difference to users, yet
P679,621.21 (size) is considered immaterial. Rounding-off this b. Sufficient condensation to make the information
amount would not affect the decision making of the users. understandable, keeping in mind the costs of preparing and using it.
You may also think of materiality this way. You go to a store 12. Consistency concept - This concept requires a business
to buy some stuff worth P99.90, which you pay using a P100.00 bill. to apply accounting policies consistently, and present information
The cashier tells you that she has no P0.10 to give you as change. consistently, from one period to another. This means that like
Will you get mad? I hope not. Most likely, you will just smile and tell transactions must be accounted for in like manner.
her to keep the change. This is because P0.10 is most likely to be
immaterial to you. Accounting policies used this year shall be the same
accounting policies used last year. This, however, does not mean
It should be noted though that rounding-off of amounts is that a business cannot change its accounting policies. Accounting
acceptable only when preparing financial reports. The accountant policies can be changed if it is required by a standard or the change
does not omit amounts (even centavos) when recording in the would result in more relevant and more reliable information. Any
books of accounts. change in accounting policy must be disclosed.
Accounting principles do not specify a certain amount that Summary: Basic Accounting Concepts
is considered material - this is a matter of professional judgment 1. Separate Entity Concept
and depends on the facts and circumstances surrounding the entity 2. Historical Cost Concept
(e.g., what is material to you might be immaterial to others, and 3. Going Concern Assumption
vice-versa). 4. Matching
5. Accrual Basis
10. Cost-benefit (Cost constraint) - Under this concept, the 6. Prudence (or Conservatism)
costs of processing and communicating information should not 7. Time Period
8. Stable Monetary Unit
exceed the benefits to be derived from the information's use.
9. Materiality Concept
11. Full disclosure principle - This concept is related to both 10. Cost-benefit
11. Full Disclosure Principle
the concepts of materiality and cost-benefit. Under the full
 12. Consistency Concept (Separate entity concept)
At the end of the year, you prepared the financial statements of
your business to determine, among others, whether the business
Application of the Basic Accounting Concepts has earned profit. (Time period)
During the year, you started a business of selling personalized mugs When preparing the financial statements, you discovered that the
and T-shirts. You opened a separate bank account for the business business has $10 (dollars). You will translate this to Philippine peso
and deposited your initial investment of P250,000 to this account, using the current excharige rate. The amount that you will report in
(Separate entity concept) the financial statements is the translated amount. (Stable monetary
The business acquired a printing machine. The regular selling price is unit)
100,000; however, you were able to acquire it at a discounted price Also, you have found out that the regular selling price of a new
of P90,000. You will record the machine at its acquisition cost of printing machine Increased from 100.000 to 120,000. You will
$90,000 rather than at the regular selling price. (Historical cost Ignore this information (Stable monetary unit) and report the
concept) printing machine at its acquisition cost of P90.000 in the financial
The business acquired initial inventory of mugs and T-shirts for a statements (Historical cost). This is because you don't intend or
total cost of P50,000. You will record the cost as an asset (i.e.. expect to close your business in the foreseeable time (Going
inventory) rather than as expense. (Matching concept) Concern).
All the inventory was sold on credit for 300.000 ("sold on credit' During the year, the business bought a trash bin for P80, You expect
means 'pinautang' in Filipino). You will immediately record the to use this over several years. However, because you deemed the
credit sales as accounts receivable rather than waiting for them to cost as immaterial, you will record this as an expense rather than an
be collected ("accounts receivable' means 'listahan ng mga asset. (Materiality)
pinautang in Filipino). (Accrual basis) Moreover, when you prepared the financial statements, you
Also, you will now record the P50,000 cost of the inventory as decided to include the cost of the trash bin in a "Miscellaneous
expense. (Matching concept) You collected P290,000 out of the Expenses" account together with other immaterial expenses. You
300,000 total credit sales. You will deposit the collections to the don't expect users of the financial statements to benefit from
bank account of the business rather than to your personal account reporting the immaterial cost separately. (Cost-benefit)
(Separate entity concept). You will make a brief description of the "Miscellaneous Expenses"
The debtor for the remaining P10,000 is in financial difficulty account in the notes to financial statements, sufficient for users to
("debtor' means 'taong umutang' in Filipino). This has raised doubt understand the nature of this account. (Full disclosure)
on whether he can pay his account. You will immediately recognize You then adopted an accounting policy of expensing outright all
the doubtful account as expense. (Prudence or Conservatism and acquisitions of equipment costing P5,000 and below. You will apply
Accrual basis) this policy consistently in the future periods. (Consistency)
You withdrew cash of P80,000 from the business for your personal
use. You will record this transaction as a withdrawal of your
investment from the business rather than a business expense.
Accounting standards detailed application of concepts. They also prescribe which principle
is most appropriate for specific economic transactions. They also
Accounting concepts and principles are either explicit or implicit. require certain information that should be included in financial
Explicit concepts and principles are those that are specifically reports and how this information is presented.
mentioned in the Conceptual Framework for Financial Reporting
and in the Philippine Financial Reporting Standards (PFRSs). Implicit You may think of the difference between basic concepts and
concepts and principles are those that are not specifically standards this way - a basic concept would be like "you need to
mentioned in the foregoing but are customarily used because of brush your teeth daily." On the other hand, a standard would
their general and longtime acceptance within the accountancy prescribe a proper way of brushing your teeth, how many times
profession. should you brush in a day, and it may even suggest a certain
toothbrush that is best for you.
The terms "concepts," "principles," "standards,"
assumptions" and "postulates" are used interchangeably in Practice. The PFRSs are issued by the Financial Reporting Standards
However, the term "standards" is used to specifically refer to the Council (FRSC), which is the official accounting standard-setting
Philippine Financial Reporting Standards (PFRSs). Traditionally, body in the Philippines.
accounting standards were generally accepted accounting principles
(GAAP). The PFRSs are patterned from the International Financial
Reporting Standards (IFRSs) which are issued by the International
Philippine Financial Reporting Standards (PFRSs) Accounting Standards Board (IASB). This means that the accounting
standards used here in the Philippines are similar to those used in
The Philippine Financial Reporting Standards (PFRSs) are Standards other countries worldwide.
and Interpretations adopted by the Financial Reporting Standards
Council (FRSC). They consist of the following: But why do we need to have uniform accounting standards?
Well, this is because, for financial statements to be useful, they
a. Philippine Financial Reporting Standards (PFRSs); must be prepared using reporting standards that are generally
b. Philippine Accounting Standards (PASS); and acceptable. Otherwise, each business would have to develop its
own standards. If that is the case, every business may just present
c. Interpretations any asset or income it wants and omit any liability of expense it
does not want to present, Financial statements would not be
Just like the basic accounting concepts, the standards serve
comparable, the risk of fraudulent reporting is heightened, and
as guide when recording and communicating accounting
economic decisions based on these financial statements would be
information. The difference is that the standards provide a more
grossly incorrect. For this reason, entities should follow a uniform 2. Bureau of Internal Revenue (BIR) The BIR is tasked in collecting
set of reporting standards when preparing and presenting financial national taxes and administering the provisions of the Tax Code.
statements. Although the provisions of the Tax Code do not always reflect the
goals of financial reporting, they do at times influence the choice of
Imagine a basketball game with no rules - the players would accounting methods and procedures.
be like a bunch of monkeys jumping and running around; or a
society with no laws - everything would be in chaos. 3. Bangko Sentral ng Pilipinas (BSP) - The BSP is tasked in regulating
banks and other entities performing banking functions. The BSP
The term "generally acceptable" means that either: influences the selection and application of accounting policies by
1. The standard has been established by an authoritative accounting these businesses.
standard-setting body; or 4. Cooperative Development Authority (CDA) - the CDA is tasked in
2. The principle has gained general acceptance due to practice over regulating cooperatives. The CDA influences the selection and
time and has been proven to be most useful. application of accounting policies by cooperatives.

The process of establishing accounting standards is a The Conceptual Framework for Financial Reporting
democratic process in that a majority of practicing accountants Just like the Standards, the Conceptual Framework for Financial
worldwide must agree with a standard before it becomes Reporting also prescribes accounting concepts that are relevant to
implemented. the preparation of financial statements. However, the Conceptual
Relevant regulatory bodies Framework is not a standard. Rather, the Conceptual Framework
serves as a general frame of reference in developing or applying the
Other than the Financial Reporting Standards Council (FRSC), the standards.
following also affect the accounting policies used by businesses and
their financial reporting: Qualitative Characteristics of useful financial information

1. Securities and Exchange Commission (SEC) - The SEC is tasked Among the concepts stated in the Conceptual Framework are the
with regulating corporations, including partnerships. The SEC qualitative characteristics of useful financial information.
requires corporations and partnerships to file audited financial Qualitative characteristics are the traits that determine
statements. whether an item of information is useful to users. Without these
characteristics, information may be deemed useless.
 For example, you need new shoes so you go to a store to Fundamental qualitative characteristics
buy a pair. If you get to the store, you don't just buy the first pair
you see. You look around and try some until you find the pair that Relevance
you prefer. Your preference is affected by the qualitative Information is relevant if it can affect the decisions of users.
characteristics of the shoes, e.g., how well it fits on your foot, its Without this trait, information is deemed irrelevant. Relevant
design, its durability, its suitableness for your intended purpose etc. information has the following aspects:
These qualities make the shoes useful to you. If the shoes don't fit
you well, then they are useless. If you buy low-quality shoes that get a. Predictive value - Information has a predictive value if it can help
destroyed within a month of use, then they are again useless. users to make predictions about future outcomes.
Similarly with accounting information, the information must have
b. Confirmatory value (or Feedback value) - This concept is related
certain qualitative characteristics so that it can be deemed useful to
to the predictive value. Information has a confirmatory value if it
users.
can help users confirm their past predictions.
The qualitative characteristics are broadly classified into
c. Materiality - is an entity-specific aspect of relevance, meaning it
two, namely:
depends on the facts and circumstances surrounding a specific
1. Fundamental qualitative characteristics - these are the entity. For example, an item may be considered by one business as
characteristics that make information useful to users. They consist material but is considered by another as immaterial. Information is
of the following: a. Relevance b. Faithful representation material if omitting it or misstating it could influence the decisions
of users.
2. Enhancing qualitative characteristics - these characteristics
support the fundamental characteristics. They enhance the Faithful representation
usefulness of information. As such, they must be maximized. The
Information is faithfully represented if it is factual, meaning it
enhancing qualitative characteristics consist of the following:
represents the actual effects of events that have taken place. For
a. Comparability example, if a business makes total sales of PIM, it should report that
amount in its financial statements - no more, no less!
b. Verifiability
Faithfully represented information has the following
c. Timeliness aspects:
d. Understandability
A. Completeness - All information necessary for users to have Timeliness
a complete understanding of the financial statements is
provided. Information is timely if it is available to users in time to be able
B. Neutrality - Information is selected or presented without to influence their decisions. This is like the saying "Aanhin pa
bias Information is not manipulated to increase its ang damo kung patay na ang kabayo" or "Too late the hero."
favorability or decrease its unfavorability. Understandability
C. Free from error - Free from error means the information is
not materially misstated. This does not mean, however, that Information is understandable if it is presented in a clear and
accounting information must be perfectly accurate in all concise manner. On the other hand, users are expected to have
respects because some accounting information necessarily a reasonable knowledge of business activities and a willingness
needs to be estimated. Free from error means there are no to analyze the information diligently.
errors in the description and in the process by which the
Summary: Qualitative Characteristics
information is selected and applied.
I. Fundamental Qualitative Characteristics
Enhancing qualitative characteristics
a. Relevance
Comparability i. Predictive Value
ii. Confirmatory Value
Information is comparable if it can help users identify iii. Materiality ('entity-specific' aspect of relevance).
similarities and differences between different sets of b. Faithful Representation
i. Completeness
information. Unlike the other qualitative characteristics,
ii. Neutrality
comparability does not relate to only one item because a iii. Free from error
comparison requires at least two items. II. Enhancing Qualitative Characteristics
i. Comparability
Verifiability ii. Verifiability
iii. Timeliness
Information is verifiable if different users could reach a general iv. Understandability
agreement as to what the information intends to represent. For
example, "I say red; you say green" - not verifiable. "I say red;
you say red" - verifiable.