2 - THE ACCOUNTING FRAMEWORK

CONTENT
1. Basic accounting assumptions
2. Functions of accounting
3. The basic financial statements
4. Elements of financial statements

ACCOUNTING CONCEPTS AND PRINCIPLES

Objective of FS – to provide information about the financial position, performance, and cash flows of an
entity that is useful to a wide range of users in making economic decisions.

Accounting Assumptions are basic notions or fundamental premises on which the accounting process is
based.
1. Going Concern Assumption means that the entity is viewed as continuing in operation indefinitely
in the absence of evidence to the contrary statements.
2. Accrual Assumption means that income is recognized when earned regardless of when received
and expense is recognized when incurred regardless of when paid.
3. Accounting Entity Assumption states that the enterprise is separate from the owners, managers,
and employees who constitute the firm. Transactions of the firm must not be merged with
transactions of the owners.
4. Time Period Assumption requires that the indefinite life of an enterprise is subdivided into time
periods of accounting periods which are usually of equal length for the purpose of preparing FS.
5. Monetary Unit Assumption has two aspects:
a. Quantifiability – means that elements of the FS should be stated in terms of a unit of
measure which is the peso in the Philippines
b. Stability of Peso – means that the purchasing power of peso is stable or constant and that
its instability is insignificant and therefore may be ignored. The accounting function is to
account for pesos only and not for changes in its purchasing power.

Identifying Function of Accounting

This is the recognition or non-recognition of accountable events. There are four recognition principles:
1. Asset recognition
2. Liability recognition
3. Recognition of income
4. Recognition of expense

RECOGNITION PRINCIPLES – Recognition as defined by the Conceptual Framework is the process of

capturing for inclusion in the statement of financial position or the statement(s) of financial performance an
item that meets the definition of an asset, a liability, equity, income or expenses.

Basically, whether to recognize an element answers the questions, “Should we record it? Should we make
a journal entry? Should it be included in the financial statements?”

Recognition is appropriate if it results in both relevant information about assets, liabilities, equity, income
and expenses and a faithful representation of those items, because the aim is to provide information that is
useful to investors, lenders and other creditors.

 Asset - A present economic resource controlled by the entity as a result of past events. An
economic resource is a right that has the potential to produce economic benefits.
 A present obligation of the entity to transfer an economic resource as a result of past events. An
obligation is a duty or responsibility that the entity has no practical ability to avoid.
 Income - Increases in assets, or decreases in liabilities, that result in increases in equity, other than
those relating to contributions from holders of equity claims.
  Expenses - Decreases in assets, or increases in liabilities, that result in decreases in equity, other
than those relating to distributions to holders of equity claims.

These terms will be explained further later.

Measuring Function of Accounting

1. Historical Cost – original acquisition cost
2. Current Cost – replacement cost or current purchase price
3. Realizable Value – current selling price
4. Present Value – discounted value of future net cash inflows that the asset is expected to generate
in the normal course of business

Communicating Function of Accounting

Financial statements
1. Statement of financial position
2. Income statement
3. Statement of comprehensive income
4. Statement of changes in equity
5. Statement of cash flows
6. Notes to financial statements

*The statements enumerated above are those required to be presented under Philippine Financial
Reporting Standards. Other reports may still be made by companies for other purposes.
*Numbers 3 & 6 are tackled in higher accounting subjects. The rest are basic financial statements
introduced in basic accounting courses. SOCI is a complete statement that covers items not reported in the
Income Statement, and the Notes to financial statements clarify accounting procedures used by a company,
as well as to divulge information that has occurred during and immediately after the close of the accounting
period.
STATEMENT OF FINANCIAL POSITION
This is a formal statement showing the financial position of an entity as of a particular date. The
balance sheet shows the three elements of financial position, namely:

1. Assets Operating Cycle

These are properties or things of value, tangible or
intangible, controlled by the entity as a result of
past transactions and events and from which future
economic benefits are expected to flow to the
entity.
2. Liabilities
These are present obligations of an entity arising
from past transactions or events, the settlement of
which is expected to result in an outflow of asset
This is the time from the acquisition of asset to the time
this asset is realized into cash or cash equivalents in the
ordinary course of business.
An entity which conducts business on cash basis has a
shorter operating cycle than that of a business which
extends credit to customers.
Cash

from the entity.

3. Owner’s Equity Cash sale Inventory

This is the residual interest of the owner or owners
in the assets of the business entity. Also known as
Operating Cycle of a cash-basis business
net assets. The other term for owner’s equity is
capital.
Cash
ASSETS
Characteristics:
1. Acquired from a past event Collection Inventory

2. Value of the assets can be measured reliably

3. Will give future economic benefits to the owner
4. Owner of the assets has complete control over Axxount Credit

them and has the legal capacity to restrict Receivable Sale

others from using these assets

Operating Cycle of a business extending credit

*Note that even if an entity is expecting to receive

any payment or asset (say, someone has promised to give or donate property) if such cannot be
reliably measured, no recognition will be made, although the information may be disclosed in
Notes to Financial Statements.

Classification:
1. Current Assets – include unrestricted cash or cash equivalents and other noncash items
which are expected to be realized, sold, or consumed within the normal operating cycle.
2. Noncurrent Assets – those assets which cannot be classified as current

Examples of Current Assets

1. Cash – literally money, coins and currency that are legal tender or standard medium of
exchange
2. Cash equivalents – highly liquid investments readily available for cash, normally within
3mos.
3. Marketable securities - short term investments that can be realized into cash within a year
4. Accounts receivable – collectibles from customers arising from credit sales in the ordinary
course of business. These are open accounts not covered by promissory notes, otherwise,
they are called Notes receivable.
 5. Merchandise inventory – goods or products acquired to be sold to customers at a profit
6. Prepaid expenses – represent unused portion of an expense that has already been paid
for
Normally, prepaid expenses are determined at the end of the reporting period.
Examples of prepaid expenses:
Prepaid supplies – unused office supplies like pens, coupon bonds, ink, etc.
Unexpired insurance – portion of insurance premium that has not been used yet
Prepaid rent – portion of rent that has not yet expired
7. Interest receivable – represents interest earned on promissory notes issued by customers

Examples of Noncurrent Assets

1. Property, plant and equipment – tangible assets Property, plant, and equipment
held for use in production or supply of goods and
services, for rental to others, or for administrative (PPE), except Land, are shown in the
purposes and are expected to be used during Balance Sheet net of accumulated
more than one period (PAS 16) depreciation.
2. Long-term investments – intended to be held for
more than a year
3. Intangible assets – identifiable nonmonetary asset without physical substance
4. Other noncurrent assets

Examples of PPE
1. Land – the lot the business owns
2. Building – the structure owned and used by the business in its operation
3. Equipment
a. Office equipment like computers, typewriters, fax machines, copiers
b. Delivery equipment like trucks, van, tricycle
c. Transportation equipment like cars, motorcycle used by owner in transacting
business
d. Store equipment like cash register, money counters, detectors
e. Shop equipment like computers and printers in a computer shop; welding and
press machine in a machine shop; or cellphones in a loading station.
4. Furniture and fixtures – appliances, cabinets, show cases, sala sets, audio and video units
5. Tools – like screwdrivers, pliers, etc.

LIABILITIES
Characteristics:
a. Present obligation of the business
b. Arises from a past transaction or event
c. Settlement of the liability requires the transfer of cash and noncash assets or to provide
services at some future date

Classifications of Liabilities
1. Current liabilities – expected to be settled within 12 months after the reporting period or
within the normal operating cycle
2. Noncurrent liabilities – those not classified as current

Examples of Current Liabilities:

1. Accounts payable – obligation or debt to suppliers for purchases of goods or services on
credit in the ordinary course of business not covered by a promissory note
 2. Notes payable – obligation in the ordinary course of business covered by a note
3. SSS premium payable – premium deducted by employer from employees’ salaries to be
remitted to the Social Security System
4. Withholding taxes payable – taxes withheld for employees to be remitted to the BIR
5. Philhealth contributions payable – medical contributions deducted from employees’
salaries to be remitted to PHILHEALTH
6. Accrued expenses – expenses incurred but not yet paid, like rent payable, salaries
payable, utilities payable (bills for water, electricity, telephone, etc.)

Examples of Noncurrent Liabilities:

1. Mortgage payable – loans with real property given as collateral
2. Bank loan payable – those payable beyond 1 year from the balance sheet date
3. Notes payable -those payable beyond 1 year from the balance sheet date

OWNER’S EQUITY
Account titles:
1. (Name of owner), capital – used to record investments of the owner
2. (Name of owner), withdrawals – used to record withdrawals of owner from the business
assets

Forms for the STATEMENT OF FINANCIAL POSITION

1. Report form – the three sections: Assets, Liabilities, and Equity are presented following a
downward sequence
2. Account Form – assets are presented on the left side while Liabilities and Equity on the right
side.

An accountant is having a hard time sleeping and goes to see his doctor. “Doctor, I just
can’t get to sleep at night.” “Have you tried counting sheep?” “That’s the problem – I make a
mistake and then spend three hours trying to find it.”
Sample Statement of Financial Position

Report Form

ARIATE LAW OFFICE

STATEMENT OF FINANCIAL POSITION
January 1, 2020

ASSETS
Current Assets
Cash PHP 30,000
Accounts Receivable 45,000
Prepaid Advertising 5,000
Prepaid Insurance 10,000
Office Supplies 500
Total Current Assets PHP 90,500

Noncurrent Assets
Property, plant and equipment 20,000
Less: Accumulated depreciation 5,000
Total Noncurrent Assets 15,000

TOTAL ASSETS PHP 105,500

LIABILITIES AND OWNER'S EQUITY

Current Liabilities
Accounts Payable PHP 30,000
Accrued Expenses 8,000
Unearned Fees 20,000
Loan Payable 30,000
Total Current Liabilities PHP 88,000

Owner's Equity

Ariate, Capital 17,500

TOTAL LIABILITIES AND OWNER'S EQUITY PHP 105,500

INCOME STATEMENT

Forms for the INCOME STATEMENT

1. Functional presentation - also known as Cost of This statement shows the result of
Sales method, expenses are classified according to
operation.
their function as part of Cost of Sales, selling
activities, administrative activities, and others
activities. If income > expenses = net income
2. Natural Presentation – also known as Nature of If income < expenses = net loss
expense method, expenses are aggregated
according to their nature.

Examples of Income accounts:

1. Service fees or service income – used to record income earned for services rendered to
customers in the ordinary course of business
2. Professional fees – used to record services rendered by a doctor, CPA, lawyer,
architect, engineer, and other professionals in the ordinary course of business
3. Commission income – income earned by agents and brokers
4. Rent revenues or rent income – income earned in renting out assets to other entities
5. Interest income – income earned on money lent. Usually, interest is earned on Notes
Receivable
6. Tuition fees – income account used by academic institutions
7. Gain on sale of PPE – income earned on the sale or disposal of PPE when selling price
is more than its book value
8. Sales or Sales Income or Sales revenue – income account for a merchandising business
representing sale of goods in the ordinary course of business

TYPES OF ACCOUNTS
1. Real accounts – balance sheet accounts, and as differentiated from nominal accounts,
are forwarded to the next accounting period
2. Nominal accounts – income statement accounts and are temporary in nature. At the
end of the accounting period, these accounts are closed to Capital.

Examples of Expense and Loss Accounts:

A. For service business
1. Salaries and wages – remuneration for services of employees
2. Taxes and licenses – used for permits, licenses
3. Doubtful Accounts expense – used for bad accounts receivable. The other term is
bad debts expense, or uncollectible accounts expense
4. Communication expense –connected with the use of telephones, cellphones, faxes,
internet, and other modes of communication
5. Utility expenses – expenses for water and electricity usage
6. Supplies expense – for office supplies, shop supplies, store supplies, etc.
7. Rent expense – rent of space
8. Insurance expense
9. Depreciation expense – for value lost on PPE due to usage, obsolescence, wear and
tear, etc.
10. Interest expense
11. Loss on sale of PPE – difference between selling price and book value, where SP <
BV
B. For merchandising business
 1. Cost of sales – cost of merchandise sold
2. Purchases – cost of merchandise bought
3. Purchase returns and allowances – cost of merchandise returned to suppliers. This
is a deduction from purchases.
4. Freight in – cost of transporting merchandise bought
5. Freight out – cost of transporting merchandise sold
6. Sales commissions expense – given to salesmen for sales made

Sample Income Statement

Ariate Law Firm
Income
Statement
For the Month of
December 2019

Revenue
PHP
Fees Earned
60,000

Expenses
PHP
Salary Expense
15,000
Rent Expense 7,000
Advertising
1,000
Expense
Utilities Expense 3,000
Depreciation Expense 5,000
Supplies Expense 2,000
Interest Expense 5,000
Miscellaneous Expense 2,000
PHP
40,000

PHP
NET INCOME
20,000

STATEMENT OF CASH FLOWS

This is a basic statement summarizing the changes in the cash account – cash receipts and cash
disbursements – of the business during a given period of time. It consists of the following:
1. Cash flows from operating activities – derived primarily from principal revenue producing activities
of the entity.
Examples:
a. cash received from sale of services or merchandise (inflow)
b. cash from collection of receivables (inflow)
c. cash payments to suppliers for goods and services (outflow)
 d. cash payments for selling, administrative and other expenses (outflow)
2. Cash flows from investing activities – derived from the acquisition and disposal of noncurrent assets
a. Cash received from sale of noncurrent assets (inflow)
b. Cash payment for acquisition of noncurrent assets (outflow)
3. Cash flows from financing activities – derived from equity and borrowings of the entity
Cash inflows
a. Cash received from short-term or long-term borrowings
b. Cash received from owner
Cash outflows
c. Payments for short-term or long-term borrowings
d. Cash withdrawals by owner

Sample Statement of Cash Flows

De Los Santos Salon
Statement of Cash Flows
For the Period Ended December 31,
2019

Cash flows from operating activities

PHP
Cash received for services rendered
112,074
Collection of accounts receivable 30,824
Payment of
(11,500)
salaries
Payment for utilities (2,500)
Payment for miscellaneous expenses (28,000)
Payment for supplies (3,500)
Payment for communication expenses (3,500)
Cash provided by operation PHP 93,898

Cash flows from investing activities

Payment for equipment (50,000)
Cash used in investing activities (50,000)

Cash flows from financing activities

Payment of
(25,950)
interest
Cash used in financing activities (25,950)

Net increase in
PHP 17,948
cash

STATEMENT OF CHANGES IN EQUITY

This summarizes the changes in a company’s equity for a period of time. This shows the beginning
balance of the equity and the changes that occurred in a given period of time. These changes
often refer to additional investments, withdrawals, and the operation’s income or loss. The
resulting ending balance is presented in the Statement of Financial Position.

De Los Santos Salon

Statement of Changes in Equity
For the Period Ended December
31, 2019

Ariate, Capital, January 1,

2019 ₱20,000.00
Investment in December
2019 ₱10,000.00
Net income for 2019 20,000.00
TOTAL ₱30,000.00
Less: Withdrawals 27,500.00
Decrease in Owner's Equity 2,500.00

Ariate, Capital, December 31, 2019 ₱17,500.00

EXERCISE 2:

1. What are the kinds of financial statements? Discuss each briefly.

2. What are the basic accounting elements? Classify each according to financial statement.

3. Explain the relationship of the different financial statements.

 4. Classify the following accounts in column A and column B:

Financial Statement
ITEMS Accounting Element
Classification
Statement of Financial
1 Cash Current asset
Position
2 Rent income
3 Notes receivable
4 Land
5 Withdrawal
6 Mortgage payable
7 Merchandise inventory
8 Prepaid insurance
9 Depreciation expense – building
10 Bad debts
11 Utilities expense
12 Professional revenue
13 Uncollectible accounts
14 Supplies on hand
15 Plant, property, and equipment