ACCOUNTING CONCEPTS AND PRINCIPLES
Accounting system
Comprises the methods used by a business to keep records of its financial activities and to
summarize these accounts in periodic accounting reports.
Transaction
Is a completed action which can be expressed in monetary terms.
GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP)
• These are broad, general statements or "rules" and "procedures" that serve as guides in the
practice of accounting.
• These are standards, assumptions, and concepts with general acceptability.
• These are measurement techniques and standards used in the presentation and preparation of
financial statements.
FUNDAMENTAL CONCEPT
1. Entity Concept regards the business enterprise as separate and distinct from its owners and
from other business enterprises.
Example: Dr. Teng has a skin clinic and a spa. The skin clinic is considered as a separate entity
distinct from the spa and the owner, Dr. Teng. The expenses of the skin clinic should not be mixed
with the expenses of the spa and the personal expenses of Dr. Teng. The two businesses are
considered to be separate economic units, separate and distinct from their owner. As such, they
should be treated as different from each other, although owned and operated by only one person.
Hence, the personal expenses of Dr. Teng should not be mixed with the expenses of any of the
businesses.
2. Periodicity is the concept behind providing financial accounting information about the
economic activities of an enterprise for specified time periods. For reporting purposes, one year
is usually considered as one accounting period.
Example: Separate financial reports are prepared yearly for the skin clinic and the spa of Dr. Teng.
Hence, Dr. Teng can measure the income of the two businesses annually.
An accounting period may be classified as either of the following:
a. Calendar year - a twelve-month period that starts on January 1 and ends on December 31
b. Fiscal year - a twelve-month period that starts on any month of the year other than January
and ends twelve months after the starting period, e.g., a business whose fiscal year starts May 1,
2016 ends its fiscal year on April 30, 2017.
Note: A natural business year is any twelve-month period that ends when business activities are
at their lowest point.
3. Going Concern is a concept which assumes that the business enterprise will continue to operate
indefinitely.
Example: In preparing the financial statements of the skin clinic and the spa, the accountant
assumes that the businesses will not close or shut operations within the next years.
Basic Accounting Principles
1. Objectivity principle states that all business transactions that will be entered in the accounting
records must be duly supported by verifiable evidence.
Example: Payments must be supported by official receipts and bank deposits must be supported
by deposit slips.
2. Historical cost means that all properties and services acquired by the business must be
recorded at their original acquisition cost.
Example: Land bought in 2001 for two million pesos should be recorded at two million pesos even
though its market value in the year 2016 is already three million pesos.
3. Accrual principle states that income should be recognized at the time it is earned such as when
goods are delivered or when services have been rendered. Likewise, expenses should be
recognized at the time they are incurred, such as when goods and services are actually used and
not at the time when the entity pays for those goods and services.
Example: A resort cannot consider as income the advance payment of a customer who paid his
two-week resort accommodation in advance until the customer has checked in. This is because
the resort has not yet rendered the service to the customer. As such, the advance payment by the
customer should be considered as a liability on the part of the resort in the form of services to be
rendered.
4. Adequate disclosure states that all material facts that will significantly affect the financial
statements must be indicated.
Example: Land bought at two million pesos in 2001 should be recorded at historical cost in the
2016 financial statements. However, the current market value of three million pesos in the year
2016 may be indicated in the financial statements for the year 2016 in the form of a footnote or
parenthetical note.
5. Materiality means that financial reporting is only concerned with information significant
enough to affect decisions. This refers to the relative importance of an item or event. An item is
considered significant if knowledge of it would influence prudent users of the financial
statements.
Example: Items of insignificant amount such as paper clips can be charged outright to expenses.
6. Consistency means that approaches used in reporting must be uniformly employed from period
to period to allow comparison of results between time periods. Any changes must be clearly
explained.
Example: If the straight line method of depreciation is being used by the company, then the
method should be uniformly used by the company in computing its annual depreciation.
Assets, Liabilities, Capital, Revenue, and Expenses of the Financial Statements
TYPES OF FINANCIAL STATEMENT
The key product or the end product of the accounting process is a set of documents called the
financial statements comprised of the following:
1. Statement of Financial Position or Balance Sheet - shows the financial condition/ position of a
business as of a given period. It consists of the assets, liabilities, and capital.
2. Income Statement or Statement of Comprehensive Income - shows the result of operations for
a given period. It consists of the revenue, cost, and expenses. The statement of comprehensive
income consists of the revenue, cost, and expenses and also contains components of other
comprehensive income (including reclassification adjustments) as follows: changes in revaluation
surplus, gains and losses on benefit plans, gains and losses from investments in equity
instruments, finance costs, share of associates, and joint ventures under the equity method, tax
expense, gain or loss from discontinued operations, gain or loss on realization of assets from
discontinued operations, gain or loss from foreign operations, and all other operating and
financial events affecting the owner's equity in the business.
International Accounting Standards 1 defines Total Comprehensive Income as the "change in
equity during a period resulting from transactions and other events, other than those changes
resulting from transactions with owners in their capacity as owners".
For purposes of lessons in single proprietorship, the activities will consist of the usual revenue,
cost, expense, and transactions with owners in their capacity as owners. Hence, the Income
Statement will be used to show the results of operations since there is no activity beyond the
regular profit and loss items.
3. Statement of Changes in Owner's Equity or Statement of Owner's Equity-shows the changes in
the capital or owner's equity as a result of additional investment or withdrawals by the owner,
plus or minus the net income or net loss for the year.
4. Statement of Cash Flows-summarizes the cash receipts and cash disbursements for the
accounting period. It summarizes the cash activities of the business by classifying cash inflows
(receipts) and cash outflows (payments) into operating, investing, and financing activities. It
shows the net increase or decrease of cash in a given period and the cash balance at the end of
the period. This allows management to assess the business' ability to generate cash and project
future cash flows.
Typical Account Titles Used
Balance Sheet
Balance sheet accounts, namely assets, liabilities, and owner's equity, are classified as real or
permanent accounts.
Assets - economic resources owned by the business expected for future gain. They are
property and rights of value owned by the business.
Liabilities - include debts, obligations to pay, and claims of the creditors on the assets of
the business.
Owner's Equity or Capital - includes the interest of the owners on the business; claims of
the owners on the assets of the business; and the investment of the owner plus or minus
the results of operations. Owner's equity or capital comes from two main sources—
investment of owners and earnings of the business.
A. ASSETS
CLASSIFICATION OF CURRENT ASSETS
Improvements to International Accounting Standards 1 (December 2003) classify an asset as
current asset when it is:
1. expected to be realized in, or is intended for sale or consumption in the entity's normal
operating cycle;
2. held primarily for the purpose of being traded;
3. expected to be realized within twelve months of the balance sheet date; or
4. cash or a cash equivalent unless it is restricted from being exchanged or used to settle a liability
for at least twelve months after the balance sheet date.
Examples of current assets are as follows:
1. Cash includes coins, currencies, checks, bank deposits, and other cash items readily available
for use in the operations of the business.
2. Cash equivalents are short-term investments that are readily convertible to known amounts of
cash which are subject to an insignificant risk to changes in value (per SFAS No. 22, revised 2000).
3. Marketable securities are stocks and bonds purchased by the enterprise and are to be held for
only a short span of time or duration. They are usually purchased when a business has excess
cash.
4. Trade and other receivables include the amounts collectible from any of the following
accounts:
a. accounts receivable - amount collectible from the customer to whom sales have been-
made or services have been rendered on account or credit
b. notes receivable - promissory note issued by the client or the customer in exchange for
services or goods received as evidence of his/her obligation to pay
c. interest receivable - amount of interest collectible on promissory notes received from
customers and clients
d. advances to employees - certain amount of money loaned to employees payable in cash
or through salary deductions
e. accrued income - income already earned but not yet received
5. Inventories represent the unsold goods at the end of the accounting period. This is applicable
only to a merchandising business.
6. Prepaid Expenses include supplies bought for use in the business or services and benefits to be
received by the business in the future paid in advance.
7. Contra-Asset Accounts are accounts deducted from the related asset accounts.
a. Allowance for bad debts - losses due to uncollectible accounts. This is deducted from the
accounts receivable account to get the net realizable value. This is in line with the financial
statements' qualitative characteristic of conservatism wherein no profits would be
anticipated but all probable or estimable losses should be provided.
b. Accumulated depreciation - represents the expired cost of property, plant, and equipment
as a result of usage and passage of time. This is deducted from the cost of the related asset
account to get the carrying value or book value of the asset.
CLASSIFICATION OF NON-CURRENT ASSETS
1. Long-term investments are assets held by an enterprise for the accretion of wealth through
capital distribution such as interests, royalties, dividends and rentals, for capital appreciation or
for other benefits to the investing enterprise such as those obtained through trading
relationships. Investments are classified as long-term when they are intended to be held for an
extended period of time (International Accounting Standards No. 25).
2. Property, plant, and equipment are tangible assets that are held by an enterprise for use in the
production or supply of goods or services, or for administrative purposes.
These assets are expected to be used for more than one period (International Accounting
Standards No. 16):
Examples of property, plant, and equipment are the following:
a. land - a piece of lot or real estate owned by the enterprise on which a building can
-be constructed for business purposes
b. building - edifice or structure used to accommodate the office, store, or factory of a
business enterprise in the conduct of its operations
c. equipment - includes typewriter, air-conditioner, calculator, filing cabinet, computer,
electric fan, trucks, and cars used by the business in its office, store, or factory. Specific
account titles may be used such as office equipment, store equipment, delivery
equipment, transportation equipment, and machinery equipment.
d. furniture and fixtures - include tables, chairs, carpets, curtains, lamp and lighting fixtures,
and wall decors. Specific account titles may be used such as office furniture and fixtures,
and store furniture and fixtures
e. intangible assets - identifiable, non-monetary assets without physical substance held for
use in the production or supply of goods or services, for rental to others, or for
administrative purposes. These include goodwill, patents, copyrights, licenses, franchises,
trademarks, brand names, secret processes, subscription lists, and non-competition
agreements (International Accounting Standards No. 38).
B. LIABILITIES
Classification of Current Liabilities
Improvements to International Accounting Standards 1 (December 2003) classify liability as a
current liability when:
1. it is expected to be settled in the entity's normal operating cycle;
2. it is held primarily for the purpose of being traded;
3. it is due to be settled within twelve months after the balance sheet date; or
4. the entity does not have an unconditional right to defer' settlement of the liability for at least
twelve months after the balance sheet date.
Trade and Other Payables - include payables from any of the following accounts:
1. Accounts payable includes debts arising from the purchase of an asset or the acquisition of
services on account.
2. Notes payable includes debts arising from the purchase of an asset or the acquisition of
services on account evidenced by a promissory note.
3. Loan Payable is a liability to pay the bank or other financing institution arising from funds
borrowed by the business from these institutions payable within twelve months or shorter. (Note:
If the loan is payable beyond twelve months, then it is classified under non-current liabilities.)
4. Utilities payable is an obligation to pay utility companies for services received from them.
Examples of this are telephone services to PLDT, electricity to Meralco, and water services to
Maynilad.
5. Unearned revenues represent obligations of the business arising from advance payments
received before goods or services are provided to the customer. This will be settled when certain
goods or services are delivered or rendered.
6. Accrued liabilities include amounts owed to others for expenses already incurred but are not
yet paid. Examples of these are salaries payable, utilities payable, taxes payable, and interest
payable.
Classification of Non-Current Liabilities
Non-current liabilities are long term liabilities or obligations which are payable for a period longer
than one year. Examples of non-current liabilities are as follows:
1. Mortgage payable is a long-term debt of the business with security or collateral in the form of
real properties. In case the business fails to pay the obligation, the creditor can foreclose or cause
the mortgaged asset to be sold and use the proceeds of the sale to settle the obligation.
2. Bonds payable is a certificate of indebtedness, under the seal of a corporation, specifying the
terms of repayment and the rate of interest to be charged.
OWNER'S EQUITY
Capital is an account bearing the name of the owner representing the original and
additional investment of the owner of the business increased by the amount of net income
earned during the year. It is decreased by the cash or other assets withdrawn by the owner
as well as the net loss incurred during the year.
Drawing represents the withdrawals made by the owner of the business in cash or other
assets.
Income Summary is a temporary account used at the end of the accounting period to close
income and expense accounts. The balance of this account shows the net income or net
loss for the period before it is closed to the capital account. This will be taken up in Chapter
6 during the discussion of closing entries.
INCOME STATEMENT
Income statement accounts, namely revenue and expense, are classified as nominal or temporary
accounts.
a. Service income includes revenues earned or generated by the business in performing
services for a customer or client. The following are different examples of income and the
accounting term used to describe the income:
• Laundry services by a laundry shop (Laundry Income)
• Medical services by a doctor (Medical Fees)
• Dental services by a dentist (Dental Fees)
• Legal services by a lawyer (Legal Fees)
• Advisory services by a consultant (Consultancy Fees)
• Accounting or auditing services by a certified public accountant (Audit Fees)
b. Salaries or wages expense include all payments made to employees or workers for
rendering services to a company. Examples are salaries or wages, 13th month pay, cost of
living allowances, and other related benefits given to the employees.
c. Utilities expense is an expense related to the use of electricity, fuel, water, and
telecommunication facilities.
d. Supplies expense covers office supplies used by a business in the conduct of its daily
operations.
e. Insurance expense is the expired portion of premiums paid on insurance coverage such
as premiums paid for health or life insurance, motor vehicles, or other properties.
f. Depreciation expense is the annual portion of the cost of tangible assets such as
buildings, machineries, and equipment charged as expense for the year.
g. Uncollectible accounts expense/ doubtful accounts expense/ bad debts expense means
the amount of receivables charged as expense for the period because they are estimated
to be doubtful of collection.
h. Interest expense is the amount of money charged to the borrower for the use of
borrowed funds.
