UNIT 1

Introduction and Framework of Accounting

Introduction

The origin of keeping accounts has been traced as far back as 8500 B.C., the date
archaeologists have established for certain clay tokens found in modern Iraq. These tokens
represented commodities and were used in the Middle East to keep records. The tokens were
often sealed in clay balls, called bullae, which were broken on delivery so the shipment could be
checked against the invoice; bullae, in effect, were the first bills of lading. Later, symbols
impressed on wet clay tablets replaced the tokens. Some experts consider this stage of record
keeping the beginning of the art of writing, which spread rapidly along the trade routes and
took throughout the known civilized world. Clay tablets, stones and wood devices were used to
record payment of services in temples in Babylonia as early as 2300 B.C. In 200 B.C.,
government records of Roman Empire classified items under cash receipts as rent and interest
while expenses included wages, entertainment and sacrifices.

Accounting for private business in terms of ventures was an outgrowth of Italian

commerce during the 13th century. Loans to trading firms and investments of money by
partners led to the development of special records and reports which would show their
respective interests. In 1494, an Italian monk named Luca Pacioli included a section on
bookkeeping in a mathematics textbook. This was the first printed description of double entry
bookkeeping.

As the culture, politics and economy of a country changes with time, accounting
methods and techniques had to be developed to meet these changes. Accounting standards
setting bodies have been formed to establish and improve accounting standards in many
countries. In the Philippines, the Accounting Standards Council (ASC) is given this task.

The ASC was created in November 18, 1981 by the Philippine Institute of Certified Public
Accountants. Its main function is to establish and improve accounting standards that will be
generally accepted in the Philippines. The approved statements of the ASC are known as
Statements of Financial Accounting Standards (SFAS). The approved SFAS and the related
interpretations are submitted to the Professional Regulation Commission for final approval so
that it will become effective.

Forms of Business Organizations

Sole Proprietorship. This business organization has a single owner called the proprietor
who generally is also the manager. Sole proprietorships tend to be small service-type
businesses and retail establishments.

Partnership. A partnership is formed by two or more persons who agreed to contribute

money, property or industry to a common fund, with the intention of dividing the profits among
themselves. Each partner acts as an agent of the partnership in the absence of any agreement
to the contrary.

Corporation. A corporation is a business owned by its stockholders. 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 stockholders are
not personally liable for the corporation’s debts. The corporation is a separate legal entity.

Activities Performed by Business Organizations

Service companies perform services for a fee (e.g. law firms, accounting firms, stock
brokerage, barber shops, medical clinics).

Merchandising companies purchase goods that are ready for sale and then sell these to
customers (e.g. grocery stores, department stores, car dealers).

Manufacturing companies buy raw materials, convert them into products and then sell
the products to other companies or to final consumers (e.g. drug manufacturers, steel mills, car
manufacturers).

Definitions of Accounting
1. 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.
2. Accounting is the process of identifying, measuring and communicating economic
information to permit informed judgments and decisions by users of the information.
3. Accounting 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.

Phases of Accounting
1. Recording – is popularly known as journalizing. This involves the routine and
mechanical process of committing to writing business transactions and events on the
books of accounts in a chronological sequence in accordance with established
accounting rules and procedures.
2. Classifying – involves the sorting or grouping of similar items into their respective
kinds. This is done through the process of posting the information from the journal
to the ledger.
3. Summarizing – involves the determination of the balances of each account and the
preparation of financial statements.
4. Interpreting – is considered as the analytical phase of accounting.

Fundamental Concepts
1. Entity. The most basic concept in accounting. The transactions of different entities
should not be accounted for together. Each entity should be evaluated separately.
 2. Periodicity. 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.
3. Stable Monetary Unit. The Philippine peso is a reasonable unit of measure and that
its purchasing power is relatively stable. It allows accountants to add and subtract
peso amounts as though each peso has the same purchasing power as any other
peso at any time. This is the basis for ignoring the effects of inflation in the
accounting records.
Basic Principles
Accounting practices follow certain guidelines. The set of guidelines and procedures that
constitute acceptable accounting practice at a given time is GAAP, which stands for generally
accepted accounting principles.

1. Objectivity Principle. Accounting records are based on information that flows from
activities documented by objective evidence.
2. Historical Cost. 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 date.
3. Revenue Recognition Principle. Revenue is to be recognized in the accounting
period when goods are delivered or services 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 or services.
5. Adequate Disclosure. Requires that all relevant information that would affect the
user’s understanding and assessment of the accounting entity be disclosed in the
financial statements.
6. Materiality. 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.
However, changes are permitted if justifiable and disclosed in the financial
statements.
Scope and Purpose of the Framework
The framework deals with the objective of financial statements; the qualitative
characteristics that determine the usefulness of information in financial statements; the
definition, recognition and measurement of the elements from which financial statements are
constructed; and concepts of capital and capital maintenance.
The framework is concerned with general-purpose financial statements. Such financial
statements are prepared and presented at least annually and are directed toward the common
information needs of a wide range of users. Financial statements form part of the process of
financial reporting.
The framework applies to the financial statements of all commercial, industrial and
business reporting enterprises, whether in the public or the private sectors.
Users and Their Information Needs
1. Investors need information to help them determine whether they should buy, hold or sell.
2. Employees are interested in information about the stability and profitability of the their
employers.
3. Lenders are interested in information that enables them to determine whether their loans
and the related interest will be paid when due.
4. Suppliers and other trade creditors are interested in information that enables them to
determine whether amounts owing to them will be paid when due.
5. Customers have an interest in information about the continuance of an enterprise,
especially when they have a long-term involvement with, or dependent on, the enterprise.
6. Government and their agencies are interested in the allocation of resources and,
therefore, the activities of the enterprise.
7. Public. Enterprises affect members of the public in a variety of ways. Financial statements
may assist the public by providing information about the trends and recent developments in
the prosperity of the enterprise and the range of its activities.

Objective of Financial Statements

The objective of financial statements is to provide information about the financial
 position
 performance and
 changes in financial position of an enterprise that is useful to a wide range of users in
making economic decisions.

Underlying Assumptions

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. Meaning, the effects of transactions
and other events are recognized when they occur and not as cash or its equivalent is
received or paid. They are recorded in the accounting records and reported in the financial
statements of the periods to which they relate.
The timing of cash flows is relatively immaterial for determining when to recognize revenues
and expenses. As when the business performs a service, makes a sale of goods or incurs
an expense, the accountant records the transaction in the books, whether or not cash has
been received or paid.
Generally accepted accounting principles require that a business use the accrual basis. This
means that the accountant records revenues as they are earned and expenses as they are
incurred.
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. Hence, it is
assumed that the enterprise has neither the intention nor the need to liquidate or curtail
materially the scale of its operations.
This assumption underlies the depreciation of assets over their useful lives. If an entity
expects to liquidate in the near future, its assets are valued at their worth at liquidation
rather than original cost.

Qualitative Characteristics of Financial Statements

1. Relevance. Information must be relevant to the decision-making needs of users.
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. The relevance of information is affected by its nature
and materiality. Information is material if its omission or misstatement could influence
the economic decisions of users taken on the basis of financial statements.
Principal ingredients of Relevance:
a) Confirmatory role – financial information has a confirmatory role when it is used
to confirm or correct the decision-maker’s earlier expectations. It is an analysis
of the relationship between predictions and outcomes. The information is used
to assess how well management has performed its function by comparing its
achievements with expectations.
b) Predictive role – financial information has a predictive role when it is used to
make predictions of, for instance, future cash flows or income. As when
historical information can be extrapolated to make predictions about the future.
Information to be relevant, it should assist in either the confirmation of past
predictions or in the making of new predictions.
2. Reliability. Information has the quality of reliability when its 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.
Financial information will be enhanced by the following:
1. Faithful representation. To be reliable, the information must represent faithfully
the transactions and other events it either purports to represent or could
reasonably be expected to represent.
2. 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.
3. Neutrality. Free from bias. Financial statements are not neutral if, by the
selection or presentation of information, they influence the making of a decision
or judgment in order to achieve a predetermined result or outcome.
d) Prudence/Conservatism. It is the inclusion of caution in the exercise of judgment
needed in making the estimates required under conditions of uncertainty, such
 that assets or income are not overstated and liabilities or expenses are not
understated. This attitude is often expressed in the statement “to anticipate no
profits and provide for all probable and estimable losses.”
e) Completeness. Information must be complete within the bounds of materiality
and cost. An omission can cause false or misleading information and thus be
unreliable and deficient.
3. Comparability. Users must be able to compare the financial statements of an
enterprise through 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
changes in financial position.
4. Understandability. An essential quality of the information provided in financial
statements is that it is readily understandable by users. Users are assumed to have a
reasonable knowledge of accounting, business and its economic activities. They should
also have the willingness to study the information with reasonable diligence.

Constraints on Relevant and Reliable Information

1. Timeliness. Accounting information is communicated early enough to be used for the
economic decisions that it might influence. If there is undue delay in the reporting of
information, it may lose its relevance. Management may need to balance the relative merits
of timely reporting and the provisions of reliable information.
2. Balance between Benefit and Cost. The benefits derived from information should
exceed the cost of providing it. The evaluation of benefits and costs is, however,
substantially a judgmental process. Initially, the costs are incurred by the preparers of the
information while the benefits are enjoyed largely by the users.
3. Balance between Qualitative Characteristics. In practice, a balancing or trade-off
between qualitative characteristics is often necessary in order to meet the objective of
financial statements. The relative importance of the characteristics in different cases is a
matter of professional judgment.

Elements of Financial Statements

1. The elements directly related to the measurement of financial condition in the statement
of financial position are:
a) assets
b) liabilities and
c) equity.
2. The elements directly related to the measurement of performance in the statement of
operations are:
a) income and
b) expenses.
3. The statement of changes in financial position usually reflects statement of operations
elements and changes in statement of financial condition elements.

Recognition of the Elements of Financial Statements

Recognition is the process of incorporating in the statement of financial condition or statement
of operations an item that meets the definition of an element and satisfies the criteria for
recognition. An item that meets the definition of an element should be recognized if:
- it is probable that any future economic benefit associated with the item will flow
to or from the enterprise; and
- the item has a cost or value that can be measured with reliability.

Measurement of the Elements of Financial Statements

Measurement is the process of determining the monetary amounts at which the elements of
financial statements are to be recognized and carried in the statement of financial condition and
statement of operations. This involves the selection of the particular basis of measurement.
This includes historical cost, current cost, realizable value and present value. The measurement
basis most commonly adopted by enterprises in preparing financial statements is historical cost.