Chapter 1

INTRODUCTION TO ACCOUNTING

Intended Learning Outcomes: At the end of this chapter, the students are expected
to:

1. define accounting and differentiate accounting from bookkeeping, and financial

accounting versus managerial accounting;
2. enumerate the chronological phases of accounting;
3. identify users of financial information and their information needs;
4. identify various forms of organization and enumerate characteristics of each type;
5. exhibit understanding of the various rules and concepts in accounting; and
6. discuss the rules on double-entry accounting.
7.

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 1.1 Definition and Scope of Accounting

What is Accounting?
Accounting is a system that measures business activities, processes that information
into reports and communicates the results to decision-makers.
It 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.
It is a process of identifying, measuring and communicating economic information to
permit informed judgments and decisions by users of the information.
It is 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.
It is referred to as the language of business. Like any other language, accounting has
its own terms and rules. To understand how to interpret and use the information accounting
provides, you must first understand this language. Understanding the basic concepts of
accounting is essential to success in business.

Why is study of Accounting Needed?

The purpose of accounting is to provide information that will help you make correct
financial decisions. The accountant’s job is to provide the information needed to run a
business as efficiently as possible while maximizing profits and keeping costs low.

Accounting and Bookkeeping

Accounting is the process of preparing and analyzing financial statements based on
the transactions recorded through the bookkeeping process. Bookkeeping is a very important
part of the accounting process, but it is just the beginning. Accounting goes beyond
bookkeeping and the recording of economic information to include the summarizing and
reporting of this information in a way that is meant to drive decision making within a business.

Phases of Accounting:
1.) Recording – Effects of transactions are recorded and measured or expressed in terms of a
common financial denominator – money.
2.) Classifying – Classification reduces the effects of numerous transactions into useful groups
or categories.
3.) Summarizing – Summarization of financial data is achieved through the preparation of
financial statements or financial reports.
4.) Interpreting – Financial Statements are interpreted or analyzed to evaluate the liquidity,
profitability, financial flexibility and solvency of the business organization.
 Liquidity – refers to the availability of cash in the near future after taking account of
the financial commitments over this period.

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  Profitability – ability to generate profit out of the business operation.
 Financial flexibility – it is the ability to take effective actions to alter the amounts and
timings of cash flows so that it can respond to unexpected needs and opportunities.
 Solvency – refers to the availability of cash over the longer term to meet financial
commitments as they fall due.

Financial Accounting
Financial accounting, is a subset of accounting. Financial accounting involves the
process of preparing financial statements for users external to the business. The area of
accounting known as managerial accounting serves the decision-making needs of internal
users. Financial accounting can also be described as the classification and recording of
monetary transactions of an entity in accordance with established concepts, principles,
accounting standards and legal requirements, and their presentation, by means of various
financial statements, during and at the end of an accounting period.
Two points in particular are worth noting about this description:
1. Financial statements must comply with accounting rules published by the various
advisory and regulatory bodies. The reason for this is that the end product of the financial
accounting process – a set of financial statements – is primarily intended for the use of people
outside the organization. Without access to the more detailed information available to
insiders, these people may be misled unless financial statements are prepared on uniform
principles.
2. Financial accounting is partly concerned with summarizing the transactions of a
period and presenting the summary in a coherent form. This again is because financial
statements are intended for outside consumption. The outsiders who have a need for and a
right to information are entitled to receive it at defined intervals, and not at the whim of
management.

External Users of Financial Statements and their Information Needs:

1.) Investors – need information to help them determine whether they should buy, hold or
sell.
2.) Lenders – interested in information that enables them to determine whether their loans
and the related interest will be paid when due.
3.) Suppliers and other trade creditors – interested in information that enables them to
determine whether amounts owing to them will be paid when due.
4.) Customers – have an interest in information about the continuance of an enterprise,
especially when they have a long-term involvement with, or are dependent on, the enterprise.
5.) Government and their agencies – interested in the allocation of resources and, therefore,
the activities of the enterprises. They also require information to regulate the activities of the
enterprises, determine taxation policies and as the basis for national income and similar
statistics.
6.) Public – enterprises affect members of the public in a variety of ways.

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Financial Statements
Accountants supply information to people both inside and outside the firm by issuing
formal reports that are called financial statements. The financial statements are usually issued
at least once a year. In many cases they are issued quarterly or more often where necessary.
A set of rules, called Generally Accepted Accounting Principles (GAAP), govern the
preparation of the financial statements.
Generally Accepted Accounting Principles has been defined as a set of objectives,
conventions, and principles to govern the preparation and presentation of financial
statements. These rules can be found in volumes of documents issued by the International
Accounting Standards Board (IASB), the Securities and Exchange Commission (SEC), and other
regulatory bodies.
The basic financial statements include the Statement of Financial Position or Balance
Sheet, the Statement of Comprehensive Income or Income Statement, the Statement of Cash
Flows, and the Statement of Changes in Equity. (Note: A detailed discussion of the financial statemen ts
is presented in Chapter 4.)
Financial statements vary in form depending upon the type of business in which they
are used. In general there are three forms of business operation: proprietorships ,
partnerships, and corporations.
1.) Sole Proprietorship – This business organization has a single owner called the proprietor
who generally is the manager. The owner receives all profits, abs orbs all loses and is solely
responsible for all debts of the business.
2.) Partnership – A partnership is a business owned and operated by two or more persons
called partners who bind themselves to contribute money, property, or industry to a common
fund, with the intention of dividing the profits among themselves. Each partner is personally
liable for any debt incurred by the partnership.
3.) Corporation – It is an artificial being created by operation of law, having the rights of
succession and the powers, attributes and properties expressly authorized by law or incident
to its existence. The owners of a corporation are called stockholders. The stockholders are not
personally liable for the corporation’s debts.

Nature of Operation/Activities Performed by Business Organizations:

1.) Service – business perform services for a fee (e.g. law firms, accounting & audit firms,
beauty salons, recruitment agencies, etc.)
2.) Merchandising – business purchase goods which are ready for sale and then sell these to
customers (e.g. car dealers, clothing stores, supermarkets, etc.)
3.) Manufacturing – business buy raw materials, convert them into products and then sell the
products to other companies or to final consumers (e.g. paper mills, steel mills,
pharmaceutical companies, etc.)

The goal of accounting is to ensure information provided to decision makers is useful.

To be useful, information must be relevant and faithfully represent a business’s economic
activities. This requires ethics, beliefs that help us differentiate right from wrong, in the
application of underlying accounting concepts or principles.

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 GAAP are undergirded by qualitative characteristics and principles that inform how
and when financial information is presented. Financial information should possess qualitative
characteristics relating to content and relating to presentation.
Primary Qualitative Characteristics Relating to Content
1. Relevance – Information has the quality of relevance when it influences the economic
decisions of users by helping them evaluate past, present or future events, or confirming, or
correcting, their past evaluations.
Principal ingredients of relevance:
a.) confirmatory role – used to confirm or correct the decision-maker’s earlier
expectations.
b.) predictive role – used to make predictions.
2. Reliability – Information has the quality of reliability when it is free from material error
and bias and can be depended upon by users to represent faithfully that which it either
purports to represent or could reasonably be expected to represent.
Factors of reliability:
a.) faithful representation – to be reliable, the information must present faithfully
the transactions and other events it either purports to represent or could reasonably
be expected to represent.
b.) substance over form – it is necessary that transactions and other events are
accounted for and presented in accordance with their substance and economic
reality, and not merely their legal form.
c.) neutrality – free from bias
d.) prudence/conservatism – it is the inclusion of a degree of caution in the exercise
of judgments needed in making estimates required under conditions of uncertainty,
such that assets or income are not overstated and liabilities or expenses are not
understated.
e.) completeness – information must be complete within the bounds of materiality
and cost.
Primary Qualitative Characteristics Relating to Presentation
1. Comparability – Users must be able to compare the financial statements of an enterprise
over time in order to identify trends in its financial position and performance. Users must
also be able to compare the financial statements of different enterprises in order to
evaluate their relative financial position, performance and financial adaptability.
2. Understandability – An essential quality of the information provided in financial
statements is that it is readily understandable by users.

Constraints on Relevant and Reliable Information:

1.) Timeliness – management may need to balance the relative merits of timely reporting and
the provision of reliable information.
2.) Balance between benefit and cost – the benefits derived from information should exceed
the cost of providing it.
3.) Balance between qualitative characteristics

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 1.2 Fundamental Concepts and Principles of Accounting

Fundamental Concepts in Accounting:

1.) Entity Concept – In accounting for business, it is assumed that the business is separate
from its owners or other businesses. Revenue and expenses should be kept separate from
personal expenses.
An accounting entity is an organization or a section of an organization that stands apart from
other organizations and individuals as a separate economic unit. The transactions of different
entities should not be accounted for together.
2.) Periodicity Concept – An entity’s life can be meaningfully subdivided into equal time
periods for reporting purposes. This concept allows the users to obtain timely information to
serve as a basis on making decisions about future activities. For the purpose of reporting to
outsiders, one year is the usual accounting period.
“Books should be closed each year, especially in a partnership, because frequent accounting
makes for long friendship.”
 Fra Luca Pacioli, 1949 (Note: Fra Luca Pacioli is the recognized Father of Accouting)
3.) Stable Monetary Unit Concept – The Philippine peso is a reasonable unit of measure and
that its purchasing power is relatively stable. This is the basis for ignoring the effects of
inflation in the accounting records.

Basic Principles in Accounting:

1.) Objectivity Principle
 Accounting records and statements are based on the most reliable data available so
that they will be as accurate and as useful as possible. Ideally, accounting records are
based on information that flows from activities documented by objective evidence.
2.) Historical Cost Principle
 This principle states that acquired assets should be recorded at their actual cost and
not at what management thinks they are worth as at reporting period.
3.) Revenue Recognition Principle
 Revenue is to be recognized in the accounting period when goods are delivered or
services are rendered or performed.
4.) Expense Recognition Principle
 Expenses should be recognized in the accounting period in which goods and services
are used up to produce revenue and not when the entity pays for those goods and
services.
5.) Adequate Disclosure
 This principle requires that all relevant information that would affect the user’s
understanding and assessment of the accounting entity be disclosed in the financial
statements.

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6.) Materiality Principle
 Financial reporting is only concerned with information that is significant enough to
affect evaluations and decisions. Materiality depends on the size and nature of the
item judged in the particular circumstances of its omission.
7.) Consistency Principle
 The firms should use the same accounting method from period to period to achieve
comparability over time within a single enterprise.

Underlying Assumptions in Preparing Financial Statements:

1.) Accrual Basis
 The financial statements, except for the cash flow statement, are prepared on the
accrual basis of accounting in order to meet their objectives. Under the accrual basis,
the effects of transactions and other events are recognized when they occur and not
as cash or its equivalent is received or paid.
2.) Going Concern
 The financial statements are normally prepared on the assumption that an enterprise
is a going concern and will continue in operation for the foreseeable future.

Ethics in Financial Reporting

Financial reporting depends heavily on some ethical behavior. Ethics is the standards
of conduct that judges ones actions as right or wrong, honest or dishonest and fair or unfair.
The following illustration shows the necessary steps applied when analyzing various ethics
cases and also in personal experiences.
1. Recognize an 2. Identify and analyze 3. Identify the
unethical situation the principle alternatives and
and the involved elements in the weigh the impact of
ethical issues. This situation. This each to the involved
involves using your involves identifying stakeholders.
personal ethics to individuals or Consider all the
identify unethical participants that can consequences and
situations and be harmed or then select the most
issues. Some benefited by the ethical alternative. It
business situation and then involves a thorough
organizations utilize identify their evaluation of the
a written code of responsibilities and alternatives because
ethics to guide them obligations. in some cases there
in some business is one right solution
situations. while in other cases
there is more than
one solution.

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1.3 Double-Entry Accounting System of Recording Business Transactions

Debits and Credits – the Double-entry System

 Accounting is based on a double-entry system which means that the dual effects of a
business transaction is recorded. A debit side entry must have a corresponding credit
side entry. For every transaction, there must be one or more accounts debited and
one or more accounts credited. Each transaction affects at least two accounts. The
total debits for a transaction must always equal the total credits.
 An account is debited when an amount is entered on the left side of the account and
credited when an amount is entered on the right side.
 The account type determines how increases or decreases in it are recorded. Increases
in assets are recorded as debits while decreases in assets are recorded as credits.
Conversely, increases in liabilities and owner’s equity are recorded by credits and
decreases are entered as debits.
 The rules of debit and credit for income and expense accounts are based on the
relationship of these accounts to owner’s equity. Income increases owner’s equity and
expense decreases owner’s equity. Hence, increases in income are recorded as credits
and decreases as debits. Increases in expenses are recorded as debits and decreases as
credits. These are the rules of debit and credit.

Accounting Event – is an economic occurrence that causes changes in an enterprise’s assets,

liabilities, and/or equity.
Transaction – a particular kind of event that involves the transfer of something of value
between two entities.

1.4 Time Period Assumption and Use of Adjusting Entries

The process in which accounting data are recorded and summarized in financial
statements is a period process. Data are recorded, and the income statement, retained
earnings statement, and statement of cash flows are prepared for a period of time such as a
month or a year. The balance sheet is then prepared as of the end of the period. After the
accounting process is completed for one period, a new period begins and the accounting
process is repeated for the new period. This process is based on the accounting period
concept. Some expenses of the business covers more than one accounting period, hence
there is a need for adjustment to account for expenses that are due only for the current
period.

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