Chapter 1

INTRODUCTION TO
FINANCIAL ACCOUNTING
 ACCOUNTING
 The art of classifying, recording, summarizing and communicating 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
therefore.

Classifying / Identifying – involves selecting those events that are considered

evidence of economic activity relevant to a particular organization (transactions).

Recording – also known as “journalizing”, is the process of keeping a

chronological diary of measured events in an orderly and systematic manner. In
recording, economic events are also classified and summarized. It is putting in
writing of economic transactions.

Communicating / Interpreting – describing and reporting the recorded data to

interested users. They are communicated through the preparation and
distribution of accounting reports e.g. financial statements.
Brief History of Accounting

 The origins of accounting are generally attributed to the word

of Luca Pacioli, a famous Italian Renaissance mathematician.

 In his text Summa de Arithmetica, Geometria, Proportione et

Proportionalite,Pacioli described a system to ensure that
financial information was recorded efficiently and accurately.

 With the advent of Industrial Age in the 19th century and later,
the emergence of large corporations, a separation of the
owners from the managers of businesses took place. As a
result, the need to report the status of the business enterprise
took an increasing importance , to ensure that managers acted
in accord with owner’s wishes
Users of Accounting Information
 Individuals – managing bank accounts, evaluating job prospects, investments, and
deciding whether to rent or buy a house.

 Businesses- setting goals for the organization, to evaluate their progress, and take
corrective action e.g. which building and equipment to purchase, how much
merchandise inventory to keep on hand, and how much cash to borrow.

 Investors– accounting helps them to evaluate what income they can reasonably
expect on their investment.

 Creditors – lenders determine the borrower’s ability to meet scheduled payments

through accounting information. They are interested in information that enables
them to determine whether amounts owing to them will be paid when due.

 Government Regulatory Agencies- accounting provides financial statements of an

enterprise for statistics, income taxes, etc.

 Nonprofit organizations- they deal with budgets, payrolls, rent payments, and the
like e.g. churches, hospitals, government agencies and colleges
RELEVANT GENERALLY ACCEPTED ACCOUNTING PRINCIPLES
(GAAP’s)

1. CONSERVATISM CONCEPT. You are allowed to provide for all possible losses,
but you should never, never anticipate gains. Also, normally among several possible
alternatives, the alternative with the lowest figure will be chosen.
2. COST CONCEPT. Financial transactions are recorded at acquisition cost rather
than at market value. The accounting records only reflect at what price the properties
were acquired, not what they are presently worth.

3. DUAL ASPECT CONCEPT. Each financial transaction affects at least two

accounts. As such, accounting is often referred to as a double-entry system.

4. ENTITY CONCEPT. Personal transactions should be segregated from business

transactions. Nonbusiness transactions should not be recorded in the books.

5. GOING-CONCERN CONCEPT. An entity is in business to make a profit and does

not envision an immediate liquidation of the business. Current resale values of
properties are not primarily significant to the owners since the intent of the business
is to use the properties rather than to sell them.
RELEVANT GENERALLY ACCEPTED ACCOUNTING PRINCIPLES
(GAAP’s)

6. CONSISTENCY CONCEPT. Once an accounting method has been chosen, it

must be consistently used every accounting period. Changing accounting methods
from time to time would only make comparative analyses difficult and inconclusive,
and also, the government internal revenue does not allow the arbitrary changing of
accounting methods.

7. MONEY-MEASUREMENT CONCEPT. All financial transactions must be capable

of being measured in terms of money. Transactions are recorded in terms of
monetary values and not in terms of economic values or the purchasing power.

8. MATERIALITY CONCEPT. The recording and treatment of events or transactions

are to be dictated by the usefulness of the results. If a financial transaction, when
recorded or omitted, would grossly distort any of the financial statements, then that
transaction is said to be material and should be recorded.

9. MATCHING CONCEPT. All the costs/expenses for the period must be properly
matched with all the revenues for the same period. Any expense or revenue before
or after this period must be excluded.
RELEVANT GENERALLY ACCEPTED ACCOUNTING PRINCIPLES
(GAAP’s)

10. TIME-PERIOD CONCEPT. An accounting period or an accounting cycle can be

a month, a quarter, six months, or one year. Owners of a business usually prefer
regular monthly reports to keep track of their operations; those for outsiders are
usually done intermittently or for one-year period.

11. REALIZATION CONCEPT. Revenues are normally recognized at the time goods
or services are provided to the customers at the price agreed upon, and not upon the
actual collection of the income unless the cash basis of accounting is being used.
Expenses are likewise normally recognized at the time they are incurred, and not
upon the actual payment of the expenses unless the cash basis of accounting is
being used. The actual realization of the cash in or cash out is not necessary for the
transaction to be recorded under the accrual basis of accounting.

12. RELIABILITY CONCEPT. The accounting data must be dependable and legally
defensible. They must reflect an honest basis of measurement and must be properly
documented.
RELEVANT GENERALLY ACCEPTED ACCOUNTING PRINCIPLES
(GAAP’s)

13. COMPARABILITY CONCEPT. Financial data to be comparable must have a

common base. The same or similar businesses may be compared as long as the
accounting method and period are the same. The same accounting practices must
be applied from period to period.

14. DISCLOSURE CONCEPT. The financial statements of a business must be

reliable and reflective of its operations. Full disclosure must be made in the financial
reports, especially those provided to outside parties. Footnotes may also be
included.

15. IMPARTIALITY CONCEPT. The financial reports must not contain personal
bias. They must be objective, not subjective. Personal feeling/opinions must not be
allowed to cloud the real issues.
 Basic Financial Statements and Their Elements
Financial Statements are the formal reports prepared by accountants. These
statements show the financial effects of transactions and other events by grouping
them into broad classes according to their economic characteristics.

* BALANCE SHEET

- also called “statement of financial condition”, is an itemized statement of

the assets, liabilities and proprietorship of the business.
- It is a statement reflecting the financial condition (ability to meet its
obligations as they fall due) of the business, its debts to outsiders, and the
equity of the owner or members.
It answers the questions:
• How much property does the business own?
• How much does the business owe to outsiders?
• How much is the owner or owner’s worth?
Parts of Balance Sheet:

A. Heading – composed of the following:

- Name of the business, if any, or name of the owner, if there is no
business name.
- Name of the form or statement
- Date of the Statement

B. Body – composed of two divisions. One division contains the assets and the
other contains the liability and proprietorship section
Accounting Elements in the Balance Sheet

I. Assets – properties owned by the business or upon which the business has a
vested equitable interest. They are comprise of anything of economic value to
the owner and which is legally free for him to dispose.

Classifications of Assets:
A. Current assets – easily converted to cash within an accounting period

Examples:
Cash and Cash Equivalents
•Currency - Any form of money that is in public circulation . It
includes in both hard money (coins) and soft money (paper money).
•Bank balances - The amount of money in a bank account
•Negotiable money orders - financial instrument, issued by a bank or
other institution, allowing the individual named on the order to receive
a specified amount of cash on demand.
•Checks. Demand draft drawn on a bank against its maker's (drawer's)
funds, to pay the stated amount of money to the bearer or named party
 Accounts receivable
Normally abbreviated as A/R, these are funds that customers currently owe to a
company. They've received the company's products, but haven't yet paid for those goods
or services.
 Notes Receivable
Loans made to others.

Prepaid Insurance
Premiums that are paid in advance.

Office Supplies
Are assets from purchase to use.

Inventories
These are the components and finished products that a company has currently
stockpiled to sell to customers
B. Non-current or fixed assets – are permanent in nature and they are acquired for use
rather than reselling. They are not expected to be consumed or converted into cash any
sooner than at least one year's time.

Examples:
• Land
Land is considered a fixed asset but, unlike other fixed assets, is not
depreciated, because land is considered an asset that never wears out.
• Buildings
Buildings are categorized as fixed assets and are depreciated over time.
Your place of business - garage, plant, store.

• Office equipment
This includes office equipment such as copiers, fax machines, printers, and
computers used in your business.
• Machinery
This figure represents machines and equipment used in your plant to produce
your product. Examples of machinery might include lathes, conveyor belts, or a
printing press.
• Vehicles
This would include any vehicles used in your business.
II. Liabilities – the things owed by the business. They are financial obligations or
debts of the business in favor of persons or parties other than the owner/s.

Classification of Liabilities:
A. Current Liabilities
• Accounts payable
This is comprised of all short-term obligations owed by your business to
creditors, suppliers, and other vendors. Accounts payable can include supplies
and materials acquired on credit.
• Notes payable
This represents money owed on a short-term collection cycle of one year or
less. It may include bank notes, mortgage obligations, or vehicle payments.

• Accrued payroll and withholding

This includes any earned wages or withholdings that are owed to or for
employees but have not yet been paid.
•Unearned Revenue
- You've been paid, but haven't delivered.

• Salaries Payable
- Salaries you owe employees.

• Interest Payable
- Interest you owe.

• Taxes Payable
- Taxes you owe.
B. Non-Current Liabilities:
•Bonds Payable
Bond - is a promise to repay the principal along with interest (coupons) on
a specified date (maturity).

A debt instrument issued for a period of more than one year with the
purpose of raising capital by borrowing.

•Mortgage payable
Mortgage -The long-term financing used to purchase property . The
property itself serves as collateral for the mortgage until it is paid off.

Obligation listed as a long-term liability in a firm's balance sheet, except

the obligation's current portion (due within a year of the balance sheet date)
which is listed as a current liability.

•Long-term notes
III. Capital/ Owner’s Equity - represents the residual interest in the assets of the
enterprise. If there are no debts, business property is the capital. Therefore, at any
time, capital is equal to property less total debts of the business.
- net worth - owners’ equity
- proprietorship - equity
Income Statement - reports the revenues earned by a company during a given
period of time and all the expenses which were incurred in earning those revenues.

a. Revenue - refers to the sales and other income generating activities.

Effect:
- increasing assets or decreasing liabilities

b. Expenses - refers to necessary operating costs such as salaries, expenses and

other operating expenses (material, labor, overhead)
Types of Business Organizations
 Proprietorship – has a single owner
 Partnership- joins two or more individuals together as co-owners
 Corporation - a business owned by stockholders

Types of Business Organizations (as to source of income)

Service Type - those which derive their income from sales of services to clients or
customers
Examples: Car repair shops, hospitals, apartment houses, travel agencies, etc.

Merchandising or Trading Type – businesses which buy goods, and without

changing their form, sell them at a profit.
Examples: Department stores, drug stores, sari-sari stores, rice dealers, etc.

Manufacturing Type – those businesses who buy raw materials, convert them to
finished goods before finally selling them at a profit.
Examples: garment factories, paper mills, bottling companies, etc.