POLYTECHNIC UNIVERSITY OF THE PHILIPPINES – GRADUATE SCHOOL

MASTER IN PUBLIC ADMINISTRATION

Basic Accounting Principles:

How Accounting Changed the way we approach in
Financial and Transaction Perspective?

Christian Ian P, Lim

MPA 626
Government Accounting and Auditing

Prof. Dr. R.S Catli

July, 2014
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LINEAGE OF ACCOUNTING RECORDS

The principles of rewarding the study of accounting would be grateful to discipline
distributed in old and time honored discipline. History indicates that all developed
societies require certain accounting records. Record-keeping in an accounting sense is
thought to have begun about 4000 BCE. A study of the evolution of accounting
suggests that accounting processes have developed primarily in response to business
needs. Also, economic progress has affected the development of accounting processes.
History shows that the higher the level of civilization, the more elaborates the
accounting methods1.

Accounting originally served a stewardship function, as a result of the separation of

ownership and control of resources. First wealthy landowners, and later company
shareholders, hired managers or ‘stewards’ to run their properties and businesses. The
landowners and shareholders owned the resources, but the stewards and managers
controlled them. As the business owners could not always be on hand to watch their
stewards or managers perform their duties, they required the stewards to make regular
reports on their activities, using accounting to prepare the figures.

The emergence of double-entry bookkeeping was a crucial event in accounting history.

In 1494, a Franciscan monk, Pacioli, described the double-entry Method of Venice
system in his text called “Everything about arithmetic, geometry, and proportion”. Many
consider Pacioli's Summa to be a reworked version of a manuscript that circulated
among teachers and pupils of the Venetian school of commerce and arithmetic 2. Since
Pacioli's days, the roles of accountants and professional accounting organizations have
expanded in business and society. As professionals, accountants have a responsibility
for placing public service above their commitment to personal economic gain.
Complementing their obligation to society, accountants have analytical and evaluative

1
Paragraph 3, P14, Accounting Principles: A Business Perspective Financial Accounting; Hermanson, Edward &
Maher,
2
Summa de Arithmetica, Geometica. Proportion et Proportionate by Luca Paciolli
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skills needed in the solution of ever-growing world problems. The special abilities of
accountants, their independence, and their high ethical standards permit them to make
significant and unique contributions to business and areas of public interest.

INTRODUCTION
In all activities (whether business activities or non-business activities) and in all
organizations (whether business organizations like a manufacturing entity or trading
entity or non-business organizations like schools, colleges, hospitals, libraries, clubs,
temples, political parties) which require money and other economic resources,
accounting is required to account for these resources. In other words, wherever money
is involved, accounting is required to account for it. Accounting is often called the
language of business. The basic function of any language is to serve as a means of
communication. Accounting also serves this function.

Accounting provides information for a wide variety of different users and purposes, and
its practices can only be properly understood and assessed in relation to the economic
and social environment in which they are applied. Therefore there are four aspects to
this subject3:
1. Techniques for recording, calculation, classification and reporting of accounting
information.
2. The legal and institutional background associated with accounting information.
3. The economic and administrative problems which the information is required to solve.
4. The interpretation of reports prepared using 1 in the light of 2 and 3.The accounting
information referred to in 1 need not be financial, although for our purposes in this unit it
will almost always be.

In business activity a lot of “give & take” exist which is known as transaction.
Transaction involves transfer of money or money’s worth. Thus exchange of money,

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goods & services between the parties is known to have resulted in a transaction. It is
necessary to record all these transactions very systematically & scientifically so that the
financial relationship of a business with other persons may be properly understood,
profit & loss and financial position of the business may be worked out at a particular
date. The procedure to record all these transactions is known as “Book-keeping”4.
Accounting is often confused with bookkeeping. Bookkeeping is a mechanical process
that records the routine economic activities of a business. Accounting includes
bookkeeping but goes well beyond it in scope. Accountants analyze and interpret
financial information, prepare financial statements, conduct audits, design accounting
systems, prepare special business and financial studies, prepare forecasts and
budgets, and provide tax services.

Book – Keeping
Book - keeping5 includes recording of journal, posting in ledgers and balancing of
accounts. All the records before the preparation of trail balance is the whole subject
matter of book- keeping. Thus, book- keeping many be defined as the science and art of
recording transactions in money or money’s worth so accurately and systematically, in a
certain set of books, regularly that the true state of businessman’s affairs can be

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Paragraph 1, Page 60, Module 1, Basic Accounting Principles (Business Envronment);
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correctly ascertained. Here it is important to note that only those transactions related to
business are recorded which can be expressed in terms of money.

Accounting
The American Accounting Association (AAA) defines accounting as "the process of
identifying, measuring and communicating economic information to permit informed
judgments and decisions by the users of the information6." Accounting, then, is a
measurement and communication process used to report on the activities of profit-
seeking business organizations and not-for-profit organizations. As a measurement and
communication process for business, accounting supplies information that permits
informed judgments and decisions by users of the data. The accounting process
provides financial data for a broad range of individuals whose objectives in studying the
data vary widely. Bank officials, for example, may study a company's financial
statements to evaluate the company's ability to repay a loan. Prospective investors may
compare accounting data from several companies to decide which company represents
the best investment. Accounting also supplies management with significant financial
data useful for decision making.

American Institute of Certified Public Accountants (AICPA) which defines accounting as

“the art of recording, classifying and 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”.

BRANCHES OF ACCOUNTING
The changing business scenario over the centuries gave rise to specialized branches of
accounting which could cater to the changing requirements. The branches of accounting
are7:

6
American Accounting Association, A Statement of Basic Accounting Theory (Evanston, III., 1966), p. 1.
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Financial Accounting
The accounting system concerned only with the financial state of affairs and financial
results of operations is known as Financial Accounting. It is the original form of
accounting. It is mainly concerned with the preparation of financial statements for the
use of outsiders like creditors, debenture holders, investors and financial institutions.
The financial statements i.e., the profit and loss account and the balance sheet, show
them the manner in which operations of the business have been conducted during a
specified period.

Cost Accounting
It is that branch of accounting which is concerned with the accumulation and
assignment of historical costs to units of product and department, primarily for the
purpose of valuation of stock and measurement of profits. Cost accounting seeks to
ascertain the cost of unit produced and sold or the services rendered by the business
unit with a view to exercising control over these costs to assess profitability and
efficiency of the enterprise. It generally relates to the future and involves an estimation
of future costs to be incurred. The process of cost accounting based on the data
provided by the financial accounting.

Management Accounting
It is an accounting for the management i.e., accounting which provides necessary
information to the management for discharging its functions. According to the Anglo-
American Council on productivity, “Management accounting is the presentation of
accounting information is such a way as to assist management in the creation of policy
and the day-to-day operation of an undertaking.” It covers all arrangements and
combinations or adjustments of the orthodox information to provide the Chief Executive
with the information from which he can control the business. Management accounting is
not only confined to the area of cost accounting but also covers other areas (such as
capital expenditure decisions, capital structure decisions, and dividend decisions) as
well.
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BASES OF ACCOUNTING
There are three bases of accounting in common usage. Any one of the following bases
may be used to finalize accounts8.

Accounting on ‘Cash basis’

Under cash basis accounting, entries are recorded only when cash is received or paid.
No entry is passed when a payment or receipt becomes due. Income under cash basis
of accounting, therefore, represents excess of receipts over payments during an
accounting period. Government system of accounting is mostly on cash basis.

Accrual Basis of Accounting or Mercantile System

Under accrual basis of accounting, accounting entries are made on the basis of
amounts having become due for payment or receipt. Incomes are credited to the period
in which they are earned whether cash is received or not. Similarly, expenses and
losses are detailed to the period in which, they are incurred, whether cash is paid or not.
The profit or loss of any accounting period is the difference between incomes earned
and expenses incurred, irrespective of cash payment or receipt. All outstanding
expenses and prepaid expenses, accrued incomes and incomes received in advance
are adjusted while finalizing the accounts. Under the Companies Act 1956, all
companies are required to maintain the books of accounts according to accrual basis of
accounting.

Mixed or Hybrid Basis of Accounting

When certain items of revenue or expenditure are recorded in the books of account on
cash basis and certain items on mercantile basis, the basis of accounting so employed
is called ‘hybrid basis of accounting’. For example, a company may follow mercantile
system of accounting in respect of its export business. However, government subsidies
and duty drawbacks on exports to be received from government are recorded only when
they are actually received i.e., on cash basis. Such a method could be adopted because

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of uncertainty with respect of quantum, amount and time of receipt of such incentives
and drawbacks. Such a method of accounting followed by the company is called the
hybrid basis of accounting. In practice, the profit or loss shown under this basis will not
be realistic. Conservative people who prefer recognizing income when received but
cautious to provide for all expenses, whether paid or not prefer this system. It is not
widely practiced due to the inconsistency.

Objective of Accounting
Objective of accounting may differ from business to business depending upon their
specific requirements. However, the following are the general objectives of accounting9:
 To keeping systematic record: It is very difficult to remember all the business
transactions that take place. Accounting serves this purpose of record keeping by
promptly recording all the business transactions in the books of account.
 To ascertain the results of the operation: For this purpose, a business entity
prepares either a Trading and Profit and Loss account or an Income and
Expenditure account which shows the profit or loss of the business by matching
the items of revenue and expenditure of the same period.
 To ascertain the financial position of the business: This helps the
businessman to know his financial strength. Financial statements are barometers
of health of a business entity.
 To portray the liquidity position: Financial reporting should provide information
about how an enterprise obtains and spends cash, about its borrowing and
repayment of borrowing, about its capital transactions, cash dividends and other
distributions of resources by the enterprise to owners and about other factors that
may affect an enterprise’s liquidity and solvency.
 To protect business properties: Accounting provides up to date information
about the various assets that the firm possesses and the liabilities the firm owes,
so that nobody can claim a payment which is not due to him.

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 To facilitate rational decision – making: Accounting records and financial

statements provide financial information which help the business in making
rational decisions about the steps to be taken in respect of various aspects of
business.
 To satisfy the requirements of law: Entities such as companies, societies,
public trusts are compulsorily required to maintain accounts as per the law
governing their operations
Importance of Accounting
The following are the importance of Accounting that would help everyone why
Accounting has big impact to our financial way of living10:
 Owners: Owners, being businessmen, always keep an eye on the returns from
the investment. Comparing the accounts of various years helps in getting good
pieces of information.
 Management: The management can study the merits and demerits of the
business activity. Thus, the management is interested in financial accounting to
find whether the business carried on is profitable or not.
 Creditors: Creditors are the persons who supply goods on credit, or bankers or
lenders of money. It is usual that these groups are interested to know the
financial soundness before granting credit. Profit and Loss Account and Balance
Sheet are nerve centers to know the soundness of the firm.
 Employees: Payment of bonus depends upon the size of profit earned by the
firm. The more important point is that the workers expect regular income for the
bread. The demand for wage rise, bonus, better working conditions etc. depend
upon the profitability of the firm and in turn depends upon financial position. For
these reasons, this group is interested in accounting.
 Investors: The prospective investors, who want to invest their money in a firm, of
course wish to see the progress and prosperity of the firm, before investing their
amount, by going through the financial statements of the firm.

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 Government: Government keeps a close watch on the firms which yield good
amount of profits. The state and central Governments are interested in the
financial statements to know the earnings for the purpose of taxation. To compile
national accounting is essential.
 Consumers: These groups are interested in getting the goods at reduced price.
Therefore, they wish to know the establishment of a proper accounting control,
which in turn will reduce to cost of production, in turn less price to be paid by the
consumers. Researchers are also interested in accounting for interpretation.
 Research Scholars: To make a study into the financial operations of a particular
firm, the research scholar needs detailed accounting information relating to
purchases, sales, expenses, cost of materials used, current assets, current
liabilities, fixed assets, long-term liabilities and share-holders funds which is
available in the accounting record maintained by the firm.

Accounting Principles
Various accounting systems and techniques are designed to meet the needs of the
management. The information should be recorded and presented in such a way that
management is able to arrive at right conclusions. The ultimate aim of the management
is to increase profitability and losses. In order to achieve the objectives of the concern
as a whole, it is essential to prepare the accounting statements in accordance with the
generally accepted principles and procedures11.

The term principle refers to the rule of action or conduct to be applied in accounting.
Accounting principles may be defined as "those rules of conduct or procedure which are
adopted by the accountants universally, while recording the accounting transactions."
The accounting principles can be classified into two categories:
a. Accounting Concepts
b. Accounting Conventions

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Accounting Concepts
Accounting concepts mean and include necessary assumptions or postulates or ideas
which are used to accounting practice and preparation of financial statements.

Entity Concept: Separate entity concept implies that business unit or a company is a
body corporate and having a separate legal entity distinct from its proprietors. The
proprietors or members are not liable for the acts of the company.

Dual Aspect Concept: Every business transaction involves two aspects, namely, for
every receiving of benefit and. there is a corresponding giving of benefit. The dual
aspect concept is the basis of the double entry book keeping. Accordingly for every
debit there is an equal and corresponding credit. The accounting equation of the dual
aspect concept is:

Capital + Liabilities = Assets

Or
Assets = Equities (Capital)

Accounting Period Concept: Income or loss of a business can be analyzed and

determined on the basis of suitable accounting period instead of wait for a long period
until it is liquidated. Being a business in continuous affairs for an indefinite period of
time, the proprietors, the shareholders and outsiders want to know the financial position
of the concern, periodically. Thus, the accounting period is normally adopted for one
year. This concept is simply intended for a periodical ascertainment and reporting the
true and fair financial position of the concern as a whole.

Going Concern Concept or Continue of Activity Concept: This concept assumes

that business concern will continue for a long period to exit. In other words, under this
assumption, the enterprise is normally viewed as a going concern and it is not likely to
be liquidated in the near future. This assumption implies that while valuing the assets of
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the business on the basis of productivity and not on the basis of their realizable value or
the present market value, at cost less depreciation till date for the purpose of balance
sheet. It is useful in valuation of assets and liabilities, depreciation of fixed assets and
treatment of prepaid expenses.

Cost Concept: This concept is based on "Going Concern Concept." Cost Concept
implies that assets acquired are recorded in the accounting books at the cost or price
paid to acquire it. And this cost is the basis for subsequent accounting for the asset. For
accounting purpose the market value of assets are not taken into account either for
valuation or charging depreciation of such assets.

Money Measurement Concept: According to this concept, accounting transactions are

measured, expressed and recorded in terms of money. This concept excludes those
transactions or events which cannot be expressed in terms of money. For example,
factors such as the skill of the supervisor, product policies, planning, employer-
employee relationship cannot be recorded in accounts in spite of their importance to the
business. This makes the financial statements incomplete.

Matching Concept: Matching Concept is closely related to accounting period concept.

The chief aim of the business concern is to ascertain the profit periodically. To measure
the profit for a particular period it is essential to match accurately the costs associated
with the revenue. Thus, matching of costs and revenues related to a particular period is
called as Matching Concept.

Realization Concept or Revenue Recognition Concept: Revenue is the gross inflow

of cash, receivables or other considerations arising in the course of an enterprise from
the sale of goods or rendering of services from the holding of assets. If no sale takes
place, no revenue is considered. However, there are certain exceptions to this concept.
(Hire Purchase/Sale, Contract Accounts etc.)
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Accrual Concept: Accrual Concept is closely related to Matching Concept. According

to this concept, revenue recognition depends on its realization and not accrual receipt.
Likewise cost is recognized when they are incurred and not when paid. The accrual
concept ensures that the profit or loss shown is on the basis of full fact relating to all
expenses and incomes.

Accounting Conventions
Accounting Convention implies that those customs, methods and practices to be
followed as a guideline for preparation of accounting statements. The accounting
conventions can be classified as follows12:

Convention of Disclosure: The disclosure of all material information is one of the

important accounting conventions. According to this convention all accounting
statements should be honestly prepared and all facts and figures must be disclosed
therein. The disclosure of financial information is required for different parties who are
interested in the welfare of that enterprise. The Companies Act lays down the forms of
Profit and Loss Account and Balance Sheet. Thus convention of disclosure is required
to be kept as per the requirement of the Companies Act and Income Tax Act.

Convention of Conservatism: This convention is closely related to the policy of

playing safe. This principle is" often described as "anticipate no profit, and provide for all
possible losses." Thus, this convention emphasis that uncertainties and risks inherent in
business transactions should be given proper consideration. For example, under this
convention inventory is valued at cost price or market price whichever is lower.

Convention of Consistency: The Convention of Consistency implies that accounting

policies, procedures and methods should remain unchanged for preparation of financial
statements from one period to another. Under this convention alternative improved
accounting policies are also equally acceptable. In order to measure the operational

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efficiency of a concern, this convention allows a meaningful comparison in the

performance of different period.

Convention of Materiality: According to Kohler's Dictionary of Accountants Materiality

may be defined as "the characteristic attaching to a statement fact, or item whereby its
disclosure or method of giving it expression would be likely to influence the judgment of
a reasonable person." According to this convention consideration is given to all material
events, insignificant details are ignored while preparing the profit and loss account and
balance sheet. The evaluation and decision of material or immaterial depends upon the
circumstances and lies at the discretion of the Accountant.

Terminologies and Definitions

It is necessary to understand some basic accounting terms which are daily in business
world. These terms are called accounting terminology13:

Transaction: An event the recognition of which gives rise to an entry in accounting

records. It is an event which results in change in the balance sheet equation. In a simple
statement, transaction means the exchange of money or money’s worth from one
account to another account. Cash transaction is one where cash receipt or payment is
involved in the exchange.

Debtor: A person who owes money to the firm mostly on account of credit sales of
goods is called a debtor. For example, when goods are sold to a person on credit that
person pays the price in future, he is called a debtor because he owes the amount to
the firm.

Creditor: A person to whom money owes by the firm. For example, Madan is a creditor
of the firm when goods are purchased on credit from him.

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Capital: It means the amount (in terms of money or assets having money value) which
the proprietor has invested in the firm or can claim from the firm. Owner’s equity means
owner’s claim against the assets. It will always be equal to assets less liabilities, say:
Capital = Assets - Liabilities.

Liability: It means the amount which the firm owes to outsiders that is, excepting the
proprietors. In the words of Finny and Miller, “Liabilities are debts; they are amounts
owed to creditors; thus the claims of those who ate not owners are called liabilities”. In
simple terms, debts repayable to outsiders by the business are known as liabilities.

Asset: Any physical thing or right owned that has money value is an asset. In other
words, an asset is that expenditure which results in acquiring of some property or
benefits of a lasting nature.

Goods: It is a general term used for the articles in which the business deals; that is,
only those articles which are bought for resale for profit are known as Goods.

Revenue: It means the amount which, as a result of operations, is added to the capital.
It is defined as the inflow of assets which result in an increase in the owner’s equity. It
includes all incomes like sales receipts, interest, commission, and brokerage. However,
receipts of capital nature like additional capital, sale of assets, are not a pant of
revenue.

Expense: The terms ‘expense’ refers to the amount incurred in the process of earning
revenue. If the benefit of an expenditure is limited to one year, it is treated as an
expense (also know is as revenue expenditure) such as payment of salaries and rent.

Expenditure: Expenditure takes place when an asset or service is acquired. The

purchase of goods is expenditure, where as cost of goods sold is an expense. Similarly,
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if an asset is acquired during the year, it is expenditure, if it is consumed during the

same year; it is also an expense of the year.

Purchases: Buying of goods by the trader for selling them to his customers is known as
purchases. Purchases can be of two types. viz, cash purchases and credit purchases. If
cash is paid immediately for the purchase, it is cash purchases, if the payment is
postponed, it is credit purchases.

Sales: When the goods purchased are sold out, it is known as sales. Here, the
possession and the ownership right over the goods are transferred to the buyer. It is
known as. 'Business Turnover’ or sales proceeds. It can be of two types, viz.,, cash
sales and credit sales. If the sale is for immediate cash payment, it is cash sales. If
payment for sales is postponed, it is credit sales.

Stock: The goods purchased are for selling, if the goods are not sold out fully, a part of
the total goods purchased is kept with the trader unlit it is sold out, it is said to be a
stock. This closing stock at the year end will be the opening stock for the subsequent
year.

Drawings: It is the amount of money or the value of goods which the proprietor takes
for his domestic or personal use. It is usually subtracted from capital.

Losses: Loss really means something against which the firm receives no benefit. It
represents money given up without any return. It may be noted that expense leads to
revenue but losses do not. (e.g.) loss due to fire, theft and damages payable to others,

Account: It is a statement of the various dealings which occur between a customer and
the firm. It can also be expressed as a clear and concise record of the transaction
relating to a person or a firm or a property (or assets) or a liability or an expense or an
income.
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Invoice: While making a sale, the seller prepares a statement giving the particulars
such as the quantity, price per unit, the total amount payable, any deductions made and
shows the net amount payable by the buyer. Such a statement is called an invoice.

Voucher: A voucher is a written document in support of a transaction. It is a proof that a

particular transaction has taken place for the value stated in the voucher. Voucher is
necessary to audit the accounts.

Proprietor: The person who makes the investment and bears all the risks connected
with the business is known as proprietor.

Discount: When customers are allowed any type of deduction in the prices of goods by
the businessman that is called discount.

Solvent: A person who has assets with realizable values which exceeds his liabilities.

Insolvent: A person whose liabilities are more than the realizable values of his assets.