ACCO 001 – FUNDAMENTALS OF ACCOUNTING

Module I

INTRODUCTION TO ACCOUNTING

Overview:

Accounting is one of the key functions for almost any business. It may be handled by a
bookkeeper or an accountant at a small firm, or by sizable finance departments with dozens of
employees at larger companies. A bookkeeper can handle basic accounting needs, but a Certified
Public Accountant (CPA) should be utilized for larger or more advanced accounting tasks.
The reports generated by various streams of accounting, such as cost accounting and
managerial accounting, are invaluable in helping management make informed business
decisions. Regardless of the size of a business, accounting is a necessary function for decision
making, cost planning, and measurement of economic performance measurement.
It is therefore important to know and understand the definition of accounting and its
branches, its history, principles and standards.

Learning Objectives:

1. The learner should be able to know the history of accounting, its origin and the people
who first use the system and how the system evolved into its present condition.
2. The Learners should be able to define Accounting and understand every word used in its
definition and relate these words with the ultimate purpose or purposes of accounting
information system and to identify the primary uses of the financial information.
3. The learner should understand the basic principles in accounting to be able to understand
how the system works and how the information should be recorded and presented in the
financial reports.
4. The learner should be able to understand the different types of business and the different
forms of business organization and should be able to identify each and distinguish it from
the others.
5. The learner should be able to understand the basic accounting equation and all the
elements in it as well as the account titles that would be used in recording the transactions.

History of Accounting

The first name that might come to mind when referencing early accounting history is Fra
Luca Bartolomeo de Pacioli , an Italian mathematician, Franciscan friar, collaborator with
Leonardo da Vinci, who described double-entry bookkeeping in his “Summa de Arithmetica,
Geometria, Proportioni et Proportionalita” in 1494. While that may sound like a long time ago,
accounting may have roots that trace back even earlier. Accounting has been around for
centuries. It’s a critical part of the business, record-keeping, and life in general.

The earliest accounting records were found over 7,000 years ago among the ruins of
Ancient Mesopotamia. At the time, people relied on accounting to keep a record of crop and herd
growth. They used accounting techniques that are still used today to determine if there was a
surplus or shortage after crops were harvested each season. The first record of accounting that
occurred thousands of years ago in Mesopotamia has evolved into the intricate element of
business and life that it is today.

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Accounting History During the Roman Empire

During the reign of the Roman Empire, accounting continued to evolve much further. “The
Deeds of the Divine Augustus” is an account of Emperor Augustus’ financial dealings. It listed
such quantities as distributions to the people, grants of land, building of temples, money to military
veterans, religious offerings, and money spent on theatrical shows and gladiator events. This
discovery hints at the scope of accounting information available to the emperor, which he then
probably used for planning and decision-making purposes. Roman historians also recorded public
revenues, the amount of money in the state treasury, taxes, slaves, freedmen, and more.
Fra. Luca Pacioli’s Contribution to the Accounting Profession

In 1494, Pacioli wrote Summa de Arithmetica, Geometria, Proportioni et Proportionalita,

which included a twenty-seven-page treatise on bookkeeping titled, Particularis de Computis et
Scripturis (Details of Calculation and Recording) on the subjects of record keeping and double-
entry accounting. Pacioli’s book became the reference text and teaching tool on the subjects of
bookkeeping and accounting for the next several hundred years. This was the first time that
symbols for plus and minus appeared in a printed book. This book was the first known published
work on the topic of double-entry bookkeeping.

Accounting During the Middle Ages

During the Middle Ages, bartering was the primary form of money-changing, but when
Europe changed to a monetary economy is the 13th Century, merchants began relying on
bookkeeping to keep a record of multiple transactions. This is when double-entry bookkeeping
got its start, which is when a debit and credit value is entered for each transaction by the
accountant. Merchants at the time used accounting as a new recording system. It provided them
with constant information about their businesses that they could use in decision-making to grow
their business as they saw fit. This laid the foundation of how we use and understand accounting
today.

Accounting Systems in Today’s Generation

Nowadays, there are accounting standards, auditing regulations, and ethical standards for
accountants to follow. Along with this standard is the advancement in technology and accounting
has gone through many changes throughout the ages. Through all the changes, accounting
technology has always played a part in making the accountant’s job just a little easier. As people’s
knowledge of technology increased so has the accountant’s ability to analyze statistical values.
Technology advancements have enhanced the accountant’s ability to interpret data efficiently and
effectively. He/she now has the ability to interpret the language of business with such ease that
the accountant has become a business’ most trusted business advisor.

Accountants were pushed towards acquiring new skills due to the advancements that
information technology has made on the accounting industry. Accountants now have to have a
high level of computer and technical skills. These skills have become part of the knowledge, and
abilities of the accounting professionals. In its report the American Institute of Certified Public
Accounts (AICPA) cites that, “The knowledge, skills and abilities necessary for the entry-level
accountant now include the application and integration of information technology into the
accounting process, as well as financial and managerial accounting principles” (Dillon, Kruck,
2004). From this research, not only does an accountant need to have a broad range of accounting
knowledge and a strong ability to apply accounting principles, government regulations and
interpret tax laws; they must also have strong skills in information technology, to be able to merge

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accounting with information systems. These accountants will be in greater demand by the
profession (Dillon, et al, 2004).

Definition of Accounting

What Is Accounting?

Accounting is the process of recording financial transactions pertaining to a business. The

accounting process includes analyzing, recording, summarizing, financial transactions or events
over an accounting period, and reporting these transactions in the form of financial statements
(Income Statement, Balance Sheet, Capital Statement and Statement of Cash Flows) to
government’s regulatory, and tax collecting agencies.

In simple explanation, Accounting is how the business records, organizes, and

understands its financial information. Accounting can be thought of as a big machine where raw
financial information are put into, such as records of all business transactions, taxes, estimates
and allowance, etc., that then spits out an easy to understand reports or statements about the
financial state of the business. These financial statements tell its reader whether the business is
making a profit or not, where the cash came from and where it was put, what the current amount
of the assets and liabilities of the business and how much remained as capital of the business
owner or owners.

Technical definitions of accounting have been published by different accounting bodies.

The American Institute of Certified Public Accountants (AICPA) 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 financial character, and interpreting the
results thereof."

The American Accounting Association on the other hand defines accounting as “the
process of identifying, measuring and communicating economic information to permit informed
judgment and decision by users of the information”.

According to the Accounting Standards Council, “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, in making reasoned choices
among alternative courses of action.”

Branches of Accounting

As a result of economic, industrial, and technological developments, different specialized

fields in accounting have emerged. The most commonly known branches or types of accounting
include: financial accounting, cost accounting, auditing, managerial accounting, AIS ,taxation,
forensic, and fiduciary accounting.

1. Financial Accounting- Financial accounting involves recording and categorizing

transactions for business. This data is generally historical, meaning it’s from the past. It
also involves generating financial statements based on these transactions. All financial
statements, such a balance sheet and income statement, must be prepared according to
the generally accepting accounting principles (GAAP). Financial accounting is performed
to conform to external regulations and requirements.

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2. Cost Accounting - Cost accounting is considered a type of managerial accounting. Cost

accounting is most commonly used in the manufacturing industry, an industry that has a
lot of resources and costs to manage. It is a type of accounting used internally to assess
a company’s operations. Cost accounting concerns itself with recording and analyzing
manufacturing costs. It looks at a company’s fixed (unchanging and constant costs, like
rent) and variable costs (changing costs, like shipping charges) and how they affect a
business and how these costs can be better managed, according to Accounting Tools.

3. Auditing - There are two types of auditing: external and internal auditing. In external
auditing, an independent third party reviews a company’s financial statements to make
sure they are presented correctly and comply with GAAP and IFRS. Internal auditing
involves evaluating how a business divides up accounting duties, who is authorized to do
what accounting task and what procedures and policies are in place. Internal auditing
helps a business to zero in fraud, mismanagement and waste or identify and control any
potential weaknesses in its policies or procedures.

4. Managerial Accounting -Also known as management accounting, this type of accounting

provides data about a company’s operations to managers. The focus of managerial
accounting is to provide data that managers need to make decisions about a business’s
operations, not comply strictly with GAAP. Managerial accounting includes budgeting and
forecasting, cost analysis, financial analysis, reviewing past business decisions and more.
Cost accounting is a type of managerial accounting.

5. 5. Accounting Information Systems - Known as AIS for short, accounting information

systems concerns itself with everything to do with accounting systems and processes and
their construction, installation, application and observation. This can include accounting
software management and the management of bookkeeping and accounting employees.

6. 6. Tax Accounting- Tax accounting involves planning for tax diminution, payment scheme
and the preparation of tax returns. This branch of accounting helps businesses to comply
with regulations of the Philippine Taxing Authorities, more particularly the Local
Government Units for the Mayor’s Permits, BIR for the Internal Taxes and Bureau of
Customs for taxes on importation and exportation. Tax accounting also helps businesses
figure out their income tax and other taxes and how to legally reduce their amount of tax
owing. Tax accounting also analyzes tax-related business decisions and any other issues
related to taxes.

7. Forensic Accounting -This specialized accounting service is trending in accounting and is

becoming increasingly popular. Forensic accounting focuses on legal affairs such as
inquiry into fraud, legal cases and dispute and claims resolution. Forensic accountants
need to reconstruct financial data when the records are incomplete. This could be to
decode fraudulent data or convert a cash accounting system to accrual accounting.
Forensic accountants are usually consultants who work on a project basis.

8. 8. Fiduciary Accounting - This branch of accounting centers around the management of

property for another person or business. The fiduciary accountant manages any account
and activities related to the administration and guardianship of property. Fiduciary
accounting covers estate accounting, trust accounting and receivership (the appointing of
a custodian of a business’s assets during events such as bankruptcy).

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Purposes and Uses of Accounting Information

The purpose of accounting is to accumulate and report on financial information about the
performance, financial position, and cash flows of a business. Accounting provides people
interested in the business or company with various pieces of information regarding business
operations, this information is then used to reach decisions about how to manage the business,
or invest in it, or lend money to it.

Uses of Accounting Information

1. A common use of accounting information is measuring the performance of various

business operations. While financial statements are the classic accounting information
tool used to assess business operations, business owners may conduct a more thorough
analysis of this information when reviewing business operations. Financial ratios use the
accounting information reported on financial statements and break it down into leading
indicators. These indicators can be compared to other companies in the business
environment or an industry standard. This helps business owners understand how well
their companies operate compared to other established businesses.

2. Business owners often use accounting information to create budgets for their companies.
Historical financial accounting information provides business owners with a detailed
analysis of how their companies have spent money on certain business functions.
Business owners often take this accounting information and develop future budgets to
ensure they have a financial road map for their businesses. These budgets can also be
adjusted based on current accounting information to ensure a business owner does not
restrict spending on critical economic resources.

3. Accounting information is commonly used to make business decisions. For financial

management, an income statement and accounting of expenses provides an important
overview of the business. Decisions may include expanding current operations, using
different economic resources, purchasing new equipment or facilities, estimating future
sales or reviewing new business opportunities.

4. Accounting information usually provides business owners information about the cost of
various resources or business operations. These costs can be compared to the potential
income of new opportunities during the financial analysis process. This process helps
business owners understand how current business operations will be affected when
expanding or growing their businesses. Opportunities with low income potential and high
costs are often rejected by business owners.

5. External business stakeholders often use accounting information to make investment

decisions. Banks, lenders, venture capitalists or private investors often review a
company's accounting information to review its financial health and operational
profitability. This provides information about whether or not a small business is a wise
investment decision. Many small businesses need external financing to start up or grow.
The inability to provide outside lenders or investors with accounting information can
severely limit financing opportunities for a small business.

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ACCOUNTING PRINCIPLES

The phrase "generally accepted accounting principles" (or "GAAP") consists of three
important sets of rules: (1) the basic accounting principles and guidelines, (2) the detailed rules
and standards issued by FASB and its predecessor the Accounting Principles Board (APB), and
(3) the generally accepted industry practices.

If a company distributes its financial statements to the public, it is required to follow

generally accepted accounting principles in the preparation of those statements. Further, if a
company's stock is publicly traded, Philippine law requires the company's financial statements be
audited by independent public accountants. Both the company's management and the
independent accountants must certify that the financial statements and the related notes to the
financial statements have been prepared in accordance with GAAP.

Since GAAP is founded on the basic accounting principles and guidelines, we can better
understand GAAP if we understand those accounting principles.

The following is a list of the ten main accounting principles and guidelines with a highly
condensed explanation of each.

1. Economic Entity Assumption

The accountant keeps all of the business transactions of a sole proprietorship separate
from the business owner's personal transactions. For legal purposes, a sole proprietorship and
its owner are considered to be one entity, but for accounting purposes they are considered to be
two separate entities.

2. Monetary Unit Assumption

In the Philippines economic activity is measured in Philippine pesos, and only transactions
that can be expressed in Philippine pesos are recorded.
Because of this basic accounting principle, it is assumed that the peso's purchasing power
has not changed over time. As a result, accountants ignore the effect of inflation on recorded
amounts. For example, pesos from a 1960 transaction are combined (or shown) with pesos from
a 2019 transaction.

3. Time Period Assumption

This accounting principle assumes that it is possible to report the complex and ongoing
activities of a business in relatively short, distinct time intervals such as the five months ended
May 31, 2019, or the 5 weeks ended May 1, 2019. The shorter the time interval, the more likely
the need for the accountant to estimate amounts relevant to that period. For example, the property
tax bill is received on December 15 of each year. On the income statement for the year ended
December 31, 2018, the amount is known; but for the income statement for the three months
ended March 31, 2019, the amount was not known and an estimate had to be used.
It is imperative that the time interval (or period of time) be shown in the heading of each
income statement, statement of owner’s/stockholders' equity, and statement of cash flows.
Labeling one of these financial statements with "December 31" is not good enough–the reader
needs to know if the statement covers the one week ended December 31, 2019 the month ended
December 31, 2019 the three months ended December 31, 2019 or the year ended December
31, 2019

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4. Cost Principle

From an accountant's point of view, the term "cost" refers to the amount spent (cash or
the cash equivalent) when an item was originally obtained, whether that purchase happened last
year or thirty years ago. For this reason, the amounts shown on financial statements are referred
to as historical cost amounts.

Because of this accounting principle asset amounts are not adjusted upward for inflation.
In fact, as a general rule, asset amounts are not adjusted to reflect any type of increase in value.
Hence, an asset amount does not reflect the amount of money a company would receive if it were
to sell the asset at today's market value. (An exception is certain investments in stocks and bonds
that are actively traded on a stock exchange.) If you want to know the current value of a company's
long-term assets, you will not get this information from a company's financial statements–you
need to look elsewhere, perhaps to a third-party appraiser.

5. Full Disclosure Principle

If certain information is important to an investor or lender using the financial statements,

that information should be disclosed within the statement or in the notes to the statement. It is
because of this basic accounting principle that numerous pages of "footnotes" are often attached
to financial statements.

For example, the company is named in a lawsuit that demands a significant amount of
money. When the financial statements are prepared it is not clear whether the company will be
able to defend itself or whether it might lose the case. As a result of these conditions and because
of the full disclosure principle the lawsuit will be described in the notes to the financial statements.

In compliance with this full disclosure principle, a business usually lists its significant
accounting policies as the first note to its financial statements.

6. Going Concern Principle

This accounting principle assumes that a business will continue to exist long enough to
carry out its objectives and commitments and will not liquidate in the foreseeable future. If the
business' financial situation is such that the accountant believes that it will not be able to continue
on, the accountant is required to disclose this assessment.

The going concern principle allows the business to defer some of its prepaid expenses
until future accounting periods.

7. Matching Principle

This accounting principle requires companies to use the accrual basis of accounting. The
matching principle requires that expenses be matched with revenues. For example, sales
commissions expense should be reported in the period when the sales were made (and not
reported in the period when the commissions were paid). Wages to employees are reported as
an expense in the week when the employees worked and not in the week when the employees
are paid. If a company agrees to give its employees 1% of its 2019 revenues as a bonus on
January 15, 2020, the company should report the bonus as an expense in 2019 and the amount
unpaid at December 31, 2019 as a liability. The expense is recorded as the sales or revenue are
recorded.

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8. Revenue Recognition Principle

Under the accrual basis of accounting (as opposed to the cash basis of accounting),
revenues are recognized as soon as a product has been sold or a service has been performed,
regardless of when the money is actually received. Under this basic accounting principle, a
company could earn and report P1,000,000 of revenue in its first month of operation but receive
P0 in actual cash in that month.

For example, if ABC Company completes its service at an agreed price of P50,000, ABC
should recognize P50,000 of revenue as soon as its work is done—it does not matter whether the
client pays the P50,000 immediately or in 30 days. Do not confuse revenue with a cash receipt.

9. Materiality

Because of this basic accounting principle or guideline, an accountant might be allowed

to violate another accounting principle if an amount is insignificant. Professional judgement is
needed to decide whether an amount is insignificant or immaterial.

An example of an obviously immaterial item is the purchase of a 7,500 printer by a highly

profitable multi-million-peso company. Because the printer will be used for five years, the
matching principle directs the accountant to expense the cost over the five-year period. The
materiality guideline allows this company to violate the matching principle and to expense the
entire cost of 7,500 in the year it is purchased. The justification is that no one would consider it
misleading if 7,500 is expensed in the first year instead of 1,500 being expensed in each of the
five years that it is used.

Because of materiality, financial statements usually show amounts rounded to the nearest
hundred, to the nearest thousand, or to the nearest million pesos depending on the size of the
company.

10. Conservatism

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 net income
and/or less asset amount. Conservatism helps the accountant to "break a tie." It does not direct
accountants to be conservative. Accountants are expected to be unbiased and objective.

The basic accounting principle of conservatism leads accountants to anticipate or disclose

losses, but it does not allow a similar action for gains. For example, potential losses from lawsuits
will be reported on the financial statements or in the notes, but potential gains will not be reported.
Also, an accountant may write inventory down to an amount that is lower than the original cost,
but will not write inventory up to an amount higher than the original cost.
Accounting Standards in the World and in the Philippines

Financial statements have incredible importance for both internal and external
stakeholders. They basically are a report card for the company; hence, it is important that they
are regulated and do not report misleading information.

Accounting standards are exceedingly useful because they attempt to standardize and
regulate accounting definitions, assumptions, and methods. Because of generally accepted

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accounting standards we are able to assume that there is consistency from year to year in the
methods used to prepare a company's financial statements. And although variations may exist,
we can make reasonably confident conclusions when comparing one company to another, or
comparing one company's financial statistics to the statistics for its industry. Over the years the
accounting standards have become more complex because financial transactions have become
more complex.

• The International Financial Reporting Standards (IFRS) Foundation is a not-for-profit

international organization responsible for developing a single set of high-quality, global
accounting standards, known as IFRS Standards. IFRS Standards are set by the IFRS
Foundation’s standard-setting body, the IASB.
• The Monitoring Board is a group of capital market authorities and provides formal link
between the Trustees and public authorities in order to enhance the public accountability
of the IFRS Foundation.
• The International Accounting Standards Board (IASB) is the independent standard-
setting body of IFRS Foundation responsible for the development and publication of IFRS
and for approving Interpretations of IFRS as developed by the IFRS Interpretations
Committee.
• The Trustees of the IFRS Foundation are responsible for the governance and oversight
of the IASB, including the due process for the development of the accounting standards.
• The IFRS Advisory Council provides advice and counsel to the Trustees and the Board,
whilst the Board also consults extensively with a range of other standing advisory bodies
and consultative groups.
• The Accounting Standards Advisory Forum (ASAF) provides an advisory forum in which
members can constructively contribute towards the achievement of the IASB’s goal of
developing globally accepted high-quality accounting standards.
• The IFRS Interpretations Committee is the interpretative body of the International
Accounting Standards Board, which reviews implementation issues.

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The first accounting standards used in the Philippines were the Generally Accepted
Accounting Principles of the US. However, with the convergence of reporting standards, the
Philippine Financial Reporting Standards (PFRS)/Philippine Accounting Standards (PAS) the new
set of accounting standards issued by the Accounting Standards Council (ASC) are adopted to
govern the preparation of financial statements. These standards are patterned after the revised
International Financial Reporting Standards (IFRS) and International Accounting Standards (IAS)
issued by the International Accounting Standards Board (IASB).

The IFRS is a set of accounting standards that are recognized by at least 120 countries
(including the Philippines) and provides a guide on how particular types of transactions and other
events should be reported in financial statements. The rationale for using the IFRS is to ensure
consistency in recording, recognizing and measuring financial transactions, which, if followed
properly, will ensure stability and transparency throughout the financial reporting process of the
company. These standards are not enforceable and compliance is voluntary.

The International Accounting Standards (IAS) were an older set of standards stating how
particular types of transactions and other events should be reflected in financial statements.

The PFRS, the Philippine version of the IFRS with some minor modifications, and the
Philippine Accounting Standards are issued by the PFRS Council (formerly the Accounting
Standards Council [ASC]), under the oversight of the Board of Accountancy (BOA).

The Bangko Sentral ng Pilipinas (BSP) pronounced its adoption of the PFRS/PAS
effective the annual financial statements beginning 1 January 2005 in its Memorandum to All
Banks and Other BSP Supervised Financial Institutions (BSFIs) dated 11 January 2005.

Forms of Business Organization

A business entity is a group of people organized for some profitable or charitable purpose.
The source of capital of the business determines the form of business organization. Business
entities include organizations such as corporations, partnerships, charities, trusts, and other forms
of organization. Business entities, just like individual persons, are subject to taxation and must file
a tax return.

In Philippines the most common forms of businesses are sole proprietorships,

partnerships and corporation.

1. Sole Proprietorship - Sole Proprietorship is a business entity owned by an individual who

has full control/authority of its business and owns all the assets, personally owes answers
to all liabilities or suffers all losses but enjoys all the profits to the exclusion of others. A
sole proprietorship must apply for a business name and be registered with the Department
of Trade and Industry (DTI) - National Capital Region (NCR). In the provinces, application
may be filed with the DTI regional/provincial offices.

2. Partnership - Under the Civil Code of the Philippines, a partnership is treated as juridical
person, having a separate legal personality from that of its members. Partnerships may
either be general partnerships, where the partners have unlimited liability for the debts
and obligation of the partnership, or limited partnerships, where one or more general
partners have unlimited liability and the limited partners have liability only up to the amount
of their capital contributions. It consists of two or more partners. A partnership with more

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than Peso 3,000 capital must register with the Securities and Exchange Commission
(SEC).

3. Corporation - Corporation is composed of juridical persons established under the

Corporation Code and regulated by the SEC with a personality separate and distinct from
that of its stockholders. The liability of the shareholders of a corporation is limited to the
amount of their share capital. It consists of at least five to 15 incorporators, each of whom
must hold at least one share and must be registered with the SEC. Minimum paid up
capital is Peso 5,000. A corporation can either be stock or non-stock company regardless
of nationality. Such company, if 60% Filipino - 40% foreign-owned is considered a Filipino
corporation; if more than 40% foreign-owned, it is considered a domestic foreign-owned
corporation.
a. Stock Corporation- Stock Corporation is a corporation with capital stock divided into
shares and authorized to distribute to the holders of such share’s dividends or allotments
of the surplus profits on the basis of the shares held.
b. One Person Corporation- A One-Person Corporation (OPC) is a corporation with a
single stockholder, who can only be a natural person (who must be of legal age), trust or
estate. As an incorporator, the “trust” does not refer to a trust entity but rather pertains to
the subject being managed by a trustee.
c. Non-Stock Corporation- Non-Stock Corporation is a corporation organized principally
for public purposes such as charitable, educational, cultural, or similar purposes and does
not issue shares of stock to its members.

Types of Business Activity

A business entity is an organization that uses economic resources to provide goods or

services to customers in exchange for money or other goods and services.

There are three major types of businesses:

1. Service Business - A service type of business provides intangible products (products with
no physical form). Service type firms offer professional skills, expertise, advice, and other
similar products. Examples of service businesses are: salons, repair shops, schools,
banks, accounting firms, and law firms.

2. Merchandising Business - This type of business buys products at wholesale price and
sells the same at retail price. They are known as "buy and sell" businesses. They make
profit by selling the products at prices higher than their purchase costs. A merchandising
business sells a product without changing its form. Examples are: grocery stores,
convenience stores, distributors, and other resellers.

3. Manufacturing Business - Unlike a merchandising business, a manufacturing business

buys products with the intention of using them as materials in making a new product. Thus,
there is a transformation of the products purchased. A manufacturing business combines
raw materials, labor, and overhead costs in its production process. The manufactured
goods will then be sold to customers.

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Reports or Financial Statements Generated from the Accounting System

Financial statements are written reports prepared by business’ management to present its
financial affairs in a given period (monthly, quarterly, six monthly or yearly). These statements
include Balance Sheet, Income Statement, Cash Flows and Statement of Owner/s’ Equity (for
sole proprietorship and partnership) or Shareholders’ Equity (in case of corporation).
Balance Sheet.

A balance sheet is a financial statement that reports a company's assets, liabilities and
shareholders' equity at a specific point in time, and provides a basis for computing rates of return
and evaluating its capital structure. It is a financial statement that provides a snapshot of what a
company owns and owes, as well as the amount invested by owner/s’ or shareholders. The
equation that you need to remember when you prepare a balance sheet is this –

Assets = Liabilities + Shareholders Equity.

Assets. The International Financial Reporting Standards (IFRS) framework defines an asset as
follows: “An asset is a resource controlled by the enterprise as a result of past events and from
which future economic benefits are expected to flow to the enterprise.”
Properties of an Asset
There are three key properties of an asset:
• Ownership: Assets represent ownership that can be eventually turned into cash and cash
equivalents
• Economic Value: Assets have economic value and can be exchanged or sold
• Resource: Assets are resources that can be used to generate future economic benefits

Classification of Assets

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Importance of Asset Classification

Classifying assets is important to a business. For example, understanding which assets
are current assets and which are fixed assets is important in understanding the net working capital
of a company. In the scenario of a company in a high-risk industry, understanding which assets
are tangible and intangible helps to assess its solvency and risk. Determining which assets are
operating assets and which assets are non-operating assets is important to understanding the
contribution of revenue from each asset, as well as in determining what percentage of a
company’s revenues comes from its core business activities.
Assets are generally classified in three ways:
1. Convertibility: Classifying assets based on how easy it is to convert them into cash.
2. Physical Existence: Classifying assets based on their physical existence (in other words,
tangible vs. intangible assets).
3. Usage: Classifying assets based on their business operation usage/purpose.

1. Classification of asset as to Convertibility - If assets are classified based on their

convertibility into cash, assets are classified as either current assets or fixed assets. An
alternative expression of this concept is short-term vs. long-term assets.

a. Current Assets - Current assets are assets that can be easily converted into cash and
cash equivalents (typically within a year). Current assets are also termed liquid assets and
examples of such are:
o Cash
o Cash equivalents
o Short-term deposits
o Stock
o Marketable securities
o Office supplies

b. Non-Current Assets or Fixed Assets - Non-current assets are assets that cannot be easily
and readily converted into cash and cash equivalents. Non-current assets are also termed
fixed assets, long-term assets, or hard assets. Examples of non-current or fixed assets
include:
o Land
o Building
o Machinery
o Equipment
o Patents
o Trademarks

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2. Classification of asset as to Physical Existence - If assets are classified based on their

physical existence, assets are classified as either tangible assets or intangible assets.

a. Tangible Assets - Tangible assets are assets that have a physical existence (we can
touch, feel, and see them). Examples of tangible assets include:
o Land
o Building
o Machinery
o Equipment
o Cash
o Office supplies
o Stock
o Marketable securities

b. Intangible Assets - Intangible assets are assets that do not have a physical existence.
Examples of intangible assets include:
o Goodwill
o Patents
o Brand
o Copyrights
o Trademarks
o Trade secrets
o Permits
o Corporate intellectual property

3. Classification of assets as to Usage - If assets are classified based on their usage or

purpose, assets are classified as either operating assets or non-operating assets.

a. Operating Assets - Operating assets are assets that are required in the daily operation of
a business. In other words, operating assets are used to generate revenue from a
company’s core business activities. Examples of operating assets include:
o Cash
o Stock
o Building
o Machinery
o Equipment
o Patents
o Copyrights
o Goodwill

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b. Non-Operating Assets - Non-operating assets are assets that are not required for daily
business operations but can still generate revenue. Examples of non-operating assets
include:
o Short-term investments
o Marketable securities
o Vacant land
o Interest income from a fixed or time deposit

Liabilities -Defined by the International Financial Reporting Standards (IFRS) Framework: “A liability is a
present obligation of the enterprise arising from past events, the settlement of which is expected to result
in an outflow from the enterprise of resources embodying economic benefits.”

Classification of Liabilities
These are the three main classifications of liabilities:
1. Current liabilities (short-term liabilities) are liabilities that are due and payable within one year.
2. Non-current liabilities (long-term liabilities) are liabilities that are due after a year or more.
3. Contingent liabilities are liabilities that may or may not arise, depending on a certain event.

1. Current Liabilities also known as short-term liabilities, are debts or obligations that need to be
paid within a year. Current liabilities should be closely watched by management to make sure that
the company possesses enough liquidity from current assets to guarantee that the debts or
obligations can be met.
Examples of current liabilities:
Accounts payable
Interest payable
Income taxes payable
Bills payable
Bank account overdrafts
Accrued expenses
Short-term loans

Current liabilities are used as a key component in several short-term liquidity measures. Below
are examples of metrics that management teams and investors look at when performing financial
analysis of a company.

Examples of key ratios that use current liabilities are:

❖ The current ratio: Current assets divided by current liabilities
❖ The quick ratio: Current assets, minus inventory, divided by current liabilities
❖ The cash ratio: Cash and cash equivalents divided by current liabilities

2. Non-current liabilities, also known as long-term liabilities, are debts or obligations that are due in
over a year’s time. Long-term liabilities are an important part of a company’s long-term financing.
Companies take on long-term debt to acquire immediate capital to fund the purchase of capital
assets or invest in new capital projects.

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Long-term liabilities are crucial in determining a company’s long-term solvency. If companies are
unable to repay their long-term liabilities as they become due, then the company will face a
solvency crisis.
List of non-current liabilities:
Bonds payable
Long-term notes payable
Deferred tax liabilities
Mortgage payable
Capital leases

3. Contingent Liabilities are liabilities that may occur, depending on the outcome of a future event.
Therefore, contingent liabilities are potential liabilities. For example, when a company is facing a
lawsuit of P100,000, the company will incur a liability if the lawsuit proves successful. However, if
the lawsuit is not successful, then no liability would arise.

In accounting standards, a contingent liability is only recorded if the liability is probable (defined
as more than 50% likely to happen) and the amount of the resulting liability can be reasonably
estimated.
Examples of contingent liabilities:
Lawsuits
Product warranties

Capital also known as net assets or equity; capital refers to what is left to the owners after all liabilities
are settled. Simply stated, capital is equal to total assets minus total liabilities. Capital is affected by the
following:
1. Initial and additional contributions of owner/s (investments),
2. Withdrawals made by owner/s (dividends for corporations),
3. Income, and
4. Expenses.

Owner contributions and income increase capital. Withdrawals and expenses decrease it. The terms
used to refer to a company's capital portion varies according to the form of ownership. In a sole
proprietorship business, the capital is called Owner's Equity or Owner's Capital; in partnerships, it is
called Partners' Equity or Partners' Capital; and in corporations, Stockholders' Equity.

In addition to the three elements mentioned above, Assets, Liabilities and Capital, there are two items
that are also considered as key elements in accounting equation. They are income and expenses; these
items are ultimately included as part of capital.

Income refers to an increase in economic benefit during the accounting period in the form of an
increase in asset or a decrease in liability that results in increase in equity, other than contribution from
owners. Income encompasses revenues and gains.

Revenues refer to the amounts earned from the company’s ordinary course of business such
as professional fees or service revenue for service companies and sales for merchandising and
manufacturing concerns.

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Gains come from other activities, such as gain on sale of equipment, gain on sale of short-term
investments, and other gains.

Income is measured every period and is ultimately included in the capital account. Examples of income
accounts are: Service Revenue, Professional Fees, Rent Income, Commission Income, Interest Income,
Royalty Income, and Sales.

Expenses are decreases in economic benefit during the accounting period in the form of a decrease in
asset or an increase in liability that result in decrease in equity, other than distribution to owners.
Expenses include ordinary expenses such as Cost of Sales, Advertising Expense, Rent Expense, Salaries
Expense, Income Tax, Repairs Expense, etc.; and losses such as Loss from Fire, Typhoon Loss, and Loss
from Theft. Like income, expenses are also measured every period and then closed as part of capital.
Net income refers to all income minus all expenses.

Income Statement
The income statement is the next financial statement everyone should look at. It looks quite
different than the balance sheet. In the income statement, it’s about the revenue and the expenses.
It starts with the gross sales or revenue. Then we deduct any sales return or sales discount from the gross
sales to get the net sales. From net sales, we deduct the costs of goods sold, and we get the gross profit.
From gross profit, we deduct the operating expenses like the expenses required for daily administrative
and selling expenses. By deducting the operating expenses, we get the operating income.

From the operating income we add, if there is any, interest and other non-operating income
received during the period and deduct the interest charges paid and other non-operating losses sustained
during the period, by this we get the EBT, meaning Earnings Before Taxes. From EBT, we deduct the
income taxes for the period, and we get the Net Income or Net Profit, meaning profit after tax.

Cash Flow Statement

Cash Flow Statement is the third most important statement every investor should look at. There are three
separate segments of a cash flow statement. These are cash flow from the operating activities, cash flow
from investing activities, and cash flow from finance activities.
1. Cash Flow from Operations is the cash generated from the core operations of the business.
2. Cash Flow from Investing Activities relates to the cash inflows and outflows related to investment
in the company like buying of property, plant, and equipment or other investments.
3. Cash Flow from Financing Activities relates to the cash inflows or outflows related to debt or
equity of the company. It includes raising of equity or capital, debt, loan repayments, buyback of
shares, and similar financing activities.

Statement of Owner/Partners’ Equity (for sole proprietorship and partnership) or Statement of

Changes in Shareholders’ Equity (for corporation)
Statement of Owner/Partners’ Equity or Statement of Changes in Shareholders’ Equity is
a financial statement that provides a summary of changes in the owner/partners’ or shareholders’
equity in a given period.

Illustration of Income Statement for the Different Forms of Business Organization:

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Sole Proprietorship’s Income Statement

Terimacor Bicycle Rental Services
Statement of Owner's Equity
For the year ended December 31, 2019

Teresa Corrales, capital Jan. 1, 2019 90,000

Add: additional capital by Teresa Corrales
net income from Jan.1-Dec. 31, 2019
Total
Less: withdrawals or drawings from Jan. 1-92,000
Dec. 31, 2019
Teresa Corrales, capital Dec. 31, 2019 182,000

Partnership’s Income Statement

Terimacor Bicycle Rental Services Ltd.
Statement of Partner's Equity
For the year ended December 31, 2019
Teresa Anita Total
Balances Jan. 1, 2019 90,000 160,000 250,000
Add: additional capital by partners 82,000 10,000 92,000
net income from Jan.1-Dec. 31, 201928,000 28,000 56,000
Total 200,000 198,000 398,000
Less: withdrawals or drawings from Jan. 1- 18,000
Dec. 31, 2019
24,000 42,000
Capital balances Dec. 31, 2019 182,000 174,000 356,000
Elements of Statement of Changes in Owner/Partners’ Equity/Capital
Capital or investment- A capital or investment is a sum of cash acquired by a business to pursue
its objectives, such as continuing or growing operations. It also can refer to permanent fixed
assets such as property, plant, & equipment which ownership has been transferred to the
business.
Net income - For a business, net income equals is the amount remaining after subtracting all
costs and expenses from revenue. If the costs and expenses exceed revenue, it is called net loss
and this is subtracted from the capital or investment.
Drawings or withdrawals- represent an amount of cash or non-cash items removed by the owner
or partners from the business for personal use or expenditure.

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Corporation’s Income Statement

Terimacor Bicycle Rental Services Co.
Statement of Stockholders' Equity
For the year ended December 31, 2019
Additional
Common paid-in Retained
Stock capital earnings
Balance Jan. 1, 2019 80,000 160,000 130,000
Issuance of Stock 20,000 65,000
Net income 69,000
Cash dvidends -21,000
Stock dividend- 8% 8,000 26,000 -34,000
Purchase of treasury stock
Sale of treasury stock 13,000
Balance Dec. 31, 2019 108,000 264,000 144,000

Elements of Statement of Changes in Stockholders’ Equity

Common Stock is the first and most important component of shareholders’ equity. Common
stockholders are the owners of the company, however there are corporations which issue
preference shares which holders are also owners of the company but with limited rights.
Additional Paid in Capital means when the company receives a premium on the shares. Premium
results when the shares of stock are issued above par value.
Retained earnings or losses are accumulated from the previous period. In simple terms, retained
earnings are the amount the company keeps after paying the dividend from net income.
Treasury shares are the sum total of all the common shares that have been purchased back by
the company.
Dividend is the distribution of some of a company's earnings to a class of its shareholders, as
determined by the company's board of directors.

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