Unit 2

Accounting Concepts & Principles

Overview of Basic Financial Statements
Conceptual Framework of Accounting

Conceptual Framework of Accounting sets out the agreed concepts that underlie the
preparation and presentation of financial statements for external users. Emphasizing the
word “framework”, the conceptual framework of accounting serves as a “theoretical
foundation” that assists standard-setting body in developing new and reviewing existing
reporting standards.

Furthermore, the framework aims to harmonize the regulations, accounting standards and
procedures about the preparation of financial statements. In addendum, the framework also
helps users of financial information to interpret financial statements.

Scope of Conceptual Framework

1. Objective of financial reporting
2. Qualitative characteristics of useful financial information
3. Definition, recognition and measurement of the elements from which financial
statements are constructed
4. Concept of capital and capital maintenance

Qualitative Characteristics of Useful Financial Information

a. Fundamental Qualitative Characteristics

➢ Relevance. Financial information is relevant if it is capable of making a
difference to the decisions made by users. This means that information becomes
relevant when it can affect the decisions of the users. Relevant information can
facilitate in predicting future trends and confirming past predictions.

➢ Faithful Representation. Financial information is said to be faithfully

represented when presents what really existed or happened. Accounting
information must be complete, neutral, and free from material error.

b. Enhancing Qualitative Characteristics

➢ Verifiability. Accounting information must be supported by evidence and that
independent individuals can obtain similar results when same measurement
methods are used.

➢ Comparability. Users of information are able to identify similarities and

differences between economic events.

➢ Understandability. Users must be able to perceive the significance of the

information presented. Reasonable knowledge in accounting is required in the
spirit of understandability because a person having no background will
definitely not understand the financial information no matter how well it is
presented.

➢ Timeliness. Information must be available to decision-makers at the time it is

needed.

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Accounting Principles

The Generally Accepted Accounting Principles (GAAP) governs and guides the preparation
of financial statements. These are uniform set of accounting rules, procedures, practices
and standards for the preparation of financial statements. Among the principles are:

➢ Cost Principle

This principle defines “cost” as the amount spent when an item is originally
acquired irrespective of the timing of purchase. Items bought are recorded
based on the actual cash or original cost of acquisition and not based on the
prevailing market price or future value.

So, if you purchased office furniture for ₱35,000, the transaction shall be
recorded at ₱35,000.

➢ Full Disclosure Principle

The word “disclosure” means making something known. In relation to

accounting, full disclosure means that an accountant should include
sufficient information to make way for a sound judgment about financial
conditions and performance of the business. Take note that it’s not just
disclosure but FULL DISCLOSURE, hence we emphasize “SUFFICIENT
information” that are significant based on the needs of the users of
information.

➢ Revenue Recognition Principle

The word REVENUE refers to an income item generated from “normal

business operations”. When we say normal operations, we are talking about
the “usual activities” or the things that are done by the business on a
regular basis.

A good example would be the income of a tutor from teaching students. The
usual activity of a tutor is to teach students about matters that he is an expert
of. So, the income he earns from such an activity is labelled as revenue
because it is derived from his regular activity which is tutoring. If he earns an
income outside of that (not his usual activity), then it is NOT a revenue.

The Revenue Recognition Principle states that revenues are recognized as

soon as the goods have been sold (delivered to the customers) or a service
has been rendered, REGARDLESS of when the money is actually received.

Applying the principle to the preceding example, the tutor can already claim
that he has earned an income if he has already rendered his service to his
students even if the students DID NOT pay him YET. If the students pay him in
advance but he has not yet rendered tutorial services, there is NO REVENUE
YET.

This means that the basis for recognizing revenue is NOT on the time on
which the business receives the payment from customers but it is on the
POINT OF RENDERING THE SERVICE or DELIVERY OF GOODS.

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 ➢ Matching Principle

The things being MATCHED here are the revenues (income) and expenses.
This principle plays around the idea that for revenue recorded, there is a
related expense that also needs to be recorded.

Examples:

a. The money received by a cab driver from his passengers would be his
revenue (income) while the amount of money he spends for his gasoline
will be his expense.

b. A fashion designer for haute couture earns revenues from selling his
collections (clothes) to his clients. His expenses would come from the
salaries of his artisans, etc.

c. The owner of an apartment building can have his revenues from the
rental of the tenants and his expenses would come from the maintenance
cost of his property.

➢ Objectivity Principle

Being objective means being able to consider and represent facts without the
influence of biases and prejudices. In relation to accounting, this principle
requires business transactions to have some form of impartial supporting
evidence or documentation.

➢ Cost-Benefit Principle

The benefits that can be derived from providing accounting information

should EXCEED the cost of releasing the same information.

➢ Conservatism or Prudence

The application of this principle leads to accountants to anticipate losses

rather than profits. When talking about income and/or assets, lower
amounts are chosen. This doesn’t mean though that accountants will
deliberately reduce the amount of income and/or assets.

Accounting Assumptions

➢ Going Concern Assumption. Under this assumption, the business is assumed

to remain in existence for an indeterminate period of time in the absence of
any information to the contrary.

In other words, the business is assumed to continue to exist if there is no

clear evidence that it will end.

➢ Economic Entity Assumption. This assumption suggests the separation of

the business transactions from the personal affairs of the owner. Any event
not related to the business must not be mixed with the records of the
company.

➢ Accrual Basis Assumption. This requires that business transactions enter

the accounting records as they occur instead of when the cash or cash
equivalent is received or paid.

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 Revenues are recorded when they are earned, regardless of when payments
are received (recall the Revenue Recognition Principle).

Expenses are recorded when they are incurred, regardless of the time that
cash is given as payment. This simply means that expenses can already exist
even before you pay for them. An example would be your electric bill. As
long as you are already using electricity to run your shop, you are already
incurring an expense even if payment date falls at the end of the month.

➢ Monetary Unit Assumption. The Philippine peso, being the official currency
of the country, is used in measuring and reporting economic activities of a
Philippine entity.

➢ Time-Period Assumption. This requires a business entity to complete the

whole accounting process over a specific operating time period. With this,
the company’s financial statements are prepared at equal time intervals.

Types of Financial Statements

Financial Statements are structured representation of the financial policies of the

business transactions undertaken by a business entity showing the results of the
management’s stewardship of resources invested.

In simple terms, financial statements are reports made by accountants at the end of the
accounting period. It is in these reports where financial information is communicated to
the various users such as the public, government, creditors, employees, prospective
investors, etc.

The basic financial statements are:

a. Statement of Comprehensive Income (Income Statement)

This shows the “results of operations” for a given period of time. When we
speak of results of operations, we are referring to the performance of the
business. Through this, the users of accounting information will be able to know
how well the business is doing—whether it is profitable or not. It may reflect
NET INCOME or NET LOSS. Net income results when total revenues exceed
total expenses and net loss is the result of the opposite case.

b. Statement of Financial Position (Balance Sheet)

This report shows the company’s financial condition. It does so by providing

information about the company’s assets (resources), liabilities (obligations),
and capital (equity). Through this financial statement, users are able to know
if the company has enough resources to pay for its obligations.

c. Statement of Changes in Equity

From the name itself, this statement summarizes the changes in equity or
capital for a given period of time. This reflects the increases and decreases in
the level of capital through investments and profits, and/or withdrawals and
losses.

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 d. Statement of Cash Flows

The contents of this financial statement focus on the movement of CASH—its

inflows and outflows. Through the cash movement, the change in the
beginning and ending balances of cash can be seen in this report.

*There are more than four (4) financial statements but we will only tackle those listed above.

Elements of Financial Statements

The elements of financial statements have already been mentioned in some parts of this
module but here are the details about them:

a. Assets - These are resources controlled by the enterprise as a result of past

transactions and events and from which future economic benefits are
expected to flow to the enterprise.

Note that the benefits are going to flow “TO THE ENTERPRISE” and NOT “FROM
THE ENTERPRISE”. In other words, through assets there will be an INFLOW of
benefits.

If an item will not result in the inflow of economic benefits, such item is NOT an
asset. Meaning, not everything we spend on can actually give us future benefits;
hence those with no such benefits cannot be considered as assets.

Once an item can no longer provide future economic benefits, then that item is
NO LONGER part of assets. This means that there are items that can be classified
as assets at first but will subsequently be out of the group when they cannot
anymore provide benefits to the business.

Examples:

*If you buy a new machine for your shop, the machine is considered as an asset.
This is so because the machine is expected to be used in the future.

*You pay IN ADVANCE for a 6-month rental of the commercial space you occupy.
The rental you paid for in advance is considered an asset because you are
entitled to occupy that space not just for the current period but also for the next
few months. There is clearly future benefit in this case.

*You deposited your money in the bank. The amount you deposited is
considered to be your asset since you have the right to claim it for future use.

*You rode on a taxi and paid the driver for the fare. The money you paid to the
driver is NOT part of assets because after the ride, you cannot expect to have
future benefits anymore. Your next ride isn’t for free so the money you paid is
only good for that one ride.

b. Liabilities - These represent the claims of the creditors over the enterprise’s assets
or the financial obligations of the business to its creditors.

Contrary to assets, liabilities result in an outflow of benefits from the business.

Not all liabilities are to be settled using money. Some can be paid through services
and other means.

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 Examples:

*You acquired a computer set for business use and issued a promissory note to
the supplier. This gives you a liability because an obligation to pay the supplier
arises.

*You received an advance payment from your clients for your services to be
rendered next month. You have an obligation to render your service to your
client on the following month. So, while you haven’t rendered the service yet,
your liability will continue to exist.

*You own an apartment building that you rent out to tenants. One of the tenants
paid you in ADVANCE for 5 months. From the time you received the advance
payment, your liability arises since the tenant will be entitled to occupy the
apartment for the next 5 months. So, while the 5-month stay is not yet exhausted,
you still have an obligation.

c. Capital/Equity - This represents the residual interest in the assets of the business
after deducting all of its liabilities. Capital is increased through additional
investments of the owner and income of the business. It is reduced by expenses,
losses and withdrawals.

d. Income - Income is an increase in economic benefits during the accounting

period in the form of inflows or enhancements of assets or decreases of
liabilities that result in increases in equity, other than those relating to
contributions from equity participants (IASB Framework). Income is also from the
proceeds of services rendered or proceeds from the sale of merchandise.

Examples:

*You are a professional make-up artist and you have already rendered services
to your clients. In this case, you have already earned an income since you have
already rendered your service/s. (recall the revenue recognition principle)

*You are into merchandising business and you have sold several items to
customers. Since the items have been sold, you have already earned an income.
(recall the revenue recognition principle)

e. Expenses - Expenses represent the cost of operations incurred by the company in

generating income.

Expenses may also represent the cost of an asset used by the company in the
conduct of business. This simply means that when an asset is fully exhausted
and can no longer provide future benefits to the entity, such value is already
treated as expense.

Examples:

*Office supplies were purchased for business use amounting to ₱7,500. At the
time the supplies were bought, they are considered as ASSETS because they can
still be used for several days or weeks (remember the future benefit). However,
when they are already consumed, they become part of EXPENSE. This is a clear
example of an item that is previously recognized as an asset but becomes an
expense at a later period.

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 *In your shop, you have 2 staffs who man the operation. In carrying out the daily
operation, water and electricity are always used. The salary of your staffs, the
electricity and water bills will be part of your expenses. This is so because you
already availed the services of your staffs, the services of the electric
cooperative, and the services of the water concessionaire.

*You hired a repairman to repair some damaged facilities in your shop. The
service fee that the repairman charges is considered as your expense and is
treated as income of the repairman.

References:

https://courses.lumenlearning.com/boundless-accounting/chapter/the-accounting-
concept/

https://www.iasplus.com/en/standards/ias/ias1

HBL Module by Chavez & Malquisto

********** Nothing Follows**********

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