Midterm – Second Semester Week 6: March 1-5, 2021

I. INTRODUCTION

Good Day! Welcome to the 6th week of our Correspondence Learning Modality for the
midterm. This week, you shall be given another lesson to study and another learning task/s to
submit.

Attached to this 6th week module is the weekly Study and Assessment Guide.

DATE TOPIC ACTIVITIES OR TASKS

Read the lessons about accrual accounting.
Read the lessons about the generally accepted
March Accounting Concepts accounting principles.
1-5, 2021 and Principles Analyze and identify the key factors of the different
principles, concepts, and assumptions of accounting.
Accomplish Performance Task #1 and submit output.

For this week, March 1-5, 2021 of this term, the following shall be your guide for the
different lessons and tasks that you need to accomplish. Be patient, read it carefully before
proceeding to the tasks expected of you. GOOD LUCK!

Content VI. Accounting Concepts and Principles

 Accrual Accounting
 Generally Accepted Accounting Principles (GAAP)
 Classification of Accounting Principles

Learning Competencies At the end of the lesson, you should be able to:

 explain the varied accounting concepts and principles;

and
 solve exercises on accounting principles as applied in
various cases.

Activity  Performance Task #1 (Learning Task)

Essential Questions  How can the accrual basis of accounting help external and
internal users?
 Why is the use of estimates necessary in the accounting
process?
 Why should an accountant follow the treatment of a
transaction based on its substance and not its legal form?
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 Value Statement  “Play by the rules, but be ferocious.”
--Phil Knight
 “Effective people lead their lives and manage their
relationships around principles; ineffective people attempt to
manage their time around priorities and their tasks around
goals. Think effectiveness with people; efficiency with things.”
--Stephen R. Covey

References Textbooks:
Florendo, J. 2016, Fundamentals of Accountancy, Business, and
Management 1, Rex Book Store

Paraan, M. et al. 2018, Fundamentals of Accountancy, Business,

and Management 1 For Senior High School, Books Atbp. Publishing
Corp.

Pineda, A. 2018, Fundamentals of Accounting, Business &

Management 1, Principles and Application, Mindshapers Co., Inc.

Books:
Ballada, W. 2017, Fundamentals of Accountancy Business &
Management 1, Made Easy

Aduana, N. 2016, Fundamentals of Accountancy, Business, and

Management 1 for Senior High School, Procedural Approach, C &
E Publishing, Inc.

Manalaysay, B. 2017, Fundamentals of Accountancy, Business,

and Management 1, Anvil Publishing, Inc.

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 II. LEARNING CONTENT

THE RULES OF LIFE

Not a single person in the world lived without following some rules. We are subjected to
rules all our lives. When you were young, your parents probably told you not to sleep late at night,
not to play too much video games, or not to go outside when it is already dark. At school, you
were introduced to new set of rules. No sleeping during class time, no loitering around, do all
your homework, and come to school on time are just some of these rules. After you finished
school, the workplace will once again impose another set of rules. Rules impede our freedom,
but it is for the common good. Can you imagine our society without a law that govern us?
Somebody could steal your phone or hurt you physically, and it is perfectly legal. Without rules,
we would live in chaos.

Rules are not only applicable to our day-to-day lives. In the course of our study, we have
encountered rules, concepts, principles, and assumptions that help us in understanding the
concepts being taught. In economics, we have the ceteris paribus (i.e., all else equal) assumption
whenever we study the effect of a specific factor in the demand and supply. In mathematics, there
are multiple theorems and postulates to guide us in problem solving. These set rules, concepts,
principles, and assumptions are not created just to make students’ lives harder. They are put in
place for students to better understand the concept as well as its limitations.

Just like all other fields of study, accounting also has concepts, principles, and
assumptions. Collectively, these concepts, principles, and assumptions serve as a guide, and
simply, the study of accounting.

In reading the lessons for this week, you shall also take into account the following essential
questions:
 How can the accrual basis of accounting help external and internal users?
 Why is the use of estimates necessary in the accounting process?
 Why should an accountant follow the treatment of a transaction based on its substance
and not its legal form?

INTRODUCTION

Accounting concepts, principles, and assumptions are essential in the practice of accountancy.
Financial statements become more comparable and more useful to users if these concepts,
principles, and assumptions are followed by businesses. We can look at these as a set of rules
that govern the accounting process.

Accounting concepts, principles, and assumptions serve as the foundation of accounting in order
to avoid misunderstanding and enhance the understanding and usefulness of the financial
statements. (Valix et al. 2013)

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 The financial statements are prepared and presented at least annually and are directed towards
the common information needs of a wide range of users. Some of these users may require, and
have the power to obtain information in addition to that contained in the financial statements.
Many users, however, have to rely on the financial statements as their major source of financial
information and such financial statements should, therefore, be prepared and presented with
their needs in view.

A complete set of financial statements includes the following:

1. Statement of Financial Position
2. Statement of Comprehensive Income
3. Statement of Changes in Equity
4. Statement of Cash Flows
5. Notes, comprising a summary of significant accounting policies and other explanatory
information.
(These topics are to be discussed in the succeeding lessons.)

In this chapter, various accounting concepts, principles, and assumptions will be explained.
Accounting standards that are mentioned in earlier chapters will also be discussed in greater
detail. The topics to be discussed in this chapter are as follows:

1. Accrual Accounting
2. Generally Accepted Accounting Principles (GAAP)
3. Accounting Assumptions
a. Going Concern Assumption
b. Entity Assumption
c. Time Period Assumption
4. Qualitative Characteristics of Financial Statements
a. Fundamental
b. Enhancing
5. Other Generally Accepted Accounting Principles
a. Reliability
b. Use of Judgement and Estimates
c. Prudence
d. Substance Over Form
e. Matching Principle

What is ACCRUAL ACCOUNTING?

In accrual accounting, transactions are recorded whenever they happen, notwithstanding the
inflow or outflow of cash. In other words, under the accrual basis of accounting, business
transactions and events are recognized when they occur, and not as when cash or its equivalent
is received or paid. The business transactions are recorded in the accounting records and reported
in the financial statements in the periods to which they relate.

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 This is the essence of accrual accounting. An accountant does not have to wait for cash to be
received or for cash to be paid before he or she records a business transaction. Because of accrual
accounting, use of accounts such as accounts receivable, accounts payable, prepaid expenses,
accrued expenses, deferred income, and accrued income are possible. You will encounter these
accounts in the latter chapters.

Accrual accounting also results in financial statements that are more accurate and more reliable
in terms of assessing the past performance of the company. Since income is recognized when
earned and expenses are recognized when incurred, financial statements for a particular period
properly reflect the financial transactions pertaining to that period.

Illustrative examples:

a. Suppose Andrew, a budding entrepreneur, established a merchandising business that sells

ready-to-wear clothes to different ukay-ukay stores in the country. The income from Andrew’s
business primarily comes from selling goods to customers. Sales to customers can be for cash
or on credit. If the business was able to sell goods for cash, this will be recorded in the
accounting records of the company. On the other hand, if the goods were sold on credit, the
transaction should still be recorded in the accounting records as accounts receivables.

b. On June 18, 2019, Rolly rendered various electrical services on account to repair the motor
vehicle of Ryven amounting ₱12,000.00. The term on account means that there is no cash
payment made or no cash is involved in the transaction. In other words, Ryven has not yet
paid the services rendered by Rolly.
Query: In the situation, did Rolly realize an income on June 18, 2019? Similarly, did Ryven
incur repair expense on the same day?
Answer: In both queries, the answer is yes. Under the accrual basis, the service provider,
Rolly, has realized an income already although no cash has not been received yet.
On the part of the customer, Ryven, he has already incurred an expense, though
he has not yet paid the service provider.

c. On January 1, 2021, Yvone rented the vacant commercial space owned by Angel with a
monthly rental of ₱15,000.00. On January 31, 2021, Yvone has not yet paid Angel the
equivalent one-month rental.
Query: On January 31, 2021, did Yvone incur rental expenses amounting to ₱15,000.00?
Similarly, on January 31, 2021 did Angel realize a rental income from the lease
made by Yvone?
Answer: The answers to both queries are positive. Under the concept of accrual basis, by
January 31, 2021, Yvone incurred already an expense in the form of rent although
the amount was not yet paid. On the part of Angel, she already earned an income
in the form of rent, but the amount was not yet collected.

The fundamental idea of accrual accounting can be stated as follows:

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 “The effects of business transactions should be recognized in the period in which they occurred.
Income should be recognized in the period when it is earned regardless of when the payment is
received. Expenses should be recognized in the period when it is incurred regardless of when the
expenses are paid.”

The opposite of accrual accounting is the cash basis of accounting. Income is recognized
when cash is received and expenses are recognized when cash is paid. Transactions are
recorded based on the date of payment or date of collection. The date of cash inflow or
outflow is the dominating factor in recognizing the transactions.

THE GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP)

The recording of business transactions, the preparation of financial statements, and the practice
of accounting in general are governed by a set of ground rules and procedures to achieve
consistency and comparability of the financial statements. The set of rules, procedures,
assumptions, postulates, and concepts followed in recording business transactions and events,
and in the preparation of general purpose financial statements is called generally accepted
accounting principles.

It is termed generally accepted because this set of principles has been adopted by all business
entities, and mandated by various authorities and accounting organizations worldwide. GAAP are
applicable to al types of business entities regardless of its nature, formation, and level of
capitalization.

Since the GAAP enhance the consistency and comparability of a company’s financial statements,
it will be easier for external users to examine if the company is doing well currently or in relation
to its past performance. Simultaneously, GAAP also help the management in understanding
trends persistent in the company. Management can also compare past and current performance
to check the strong and weak points of the company operations.

All financial institutions, manufacturing companies, merchandising businesses, shipping

companies and airlines, regardless of the amount of capital, management style, or whether
domestically operating or having international coverage, apply the same set of principles with
little modification. In line with these, bookkeepers and accountants cannot apply their own self-
made principles in recording business transactions, and in the preparation of financial
statements. They have to record business transactions and prepare financial statements in
accordance with the requirements of generally accepted accounting principles.

Although the preparation of general purpose financial statements may appear similar from
country to country, there are differences which are probably caused by a variety of social,
economic and legal circumstances, and by different countries having in mind the needs of
different users of financial statements.

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 Accounting
Assumptions

Classification of
Accounting
Principles

Other Qualitative
Accounting Characteristic
Principles s

Figure 6.1 – Classifications of Accounting Principles

ACCOUNTING ASSUMPTIONS

Considered the foundation of generally accepted accounting principles. They serve as the bedrock
of all other accounting principles as illustrated in figure 6.2. The applicability of other accounting
principles has to consider and should be anchored in accordance with accounting assumptions.
Without these accounting assumptions, there can be no uniformity in the practice of accounting
which may result in a distorted and meaningless financial statement.

Accounting Principles

Going Concern Assumption Entity Assumption Time Period Assumption

Figure 6.2 – Accounting Assumptions as Foundation of Accounting Principles

1. Going Concern Assumption

The going concern assumption, otherwise known as continuity principle, states that the
operations of a business will continue to exist indefinitely into the future. This means that the
operations of a business will not stop in the near future and it will not be forced to liquidate its
assets to pay off its liabilities. The going concern assumption allows accountants to defer
recognition of expenses in the future.

However, if there are clear indications that the business cannot continue to operate, then the
going concern assumption is set aside in the preparation of the financial statements. In such case,
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 the assets will then be measured based on their realizable value or selling price. The following
items are evidences that a company is not a going concern:

1. The results of operations consistently show losses.

2. Inability to pay the obligations of the company in time.
3. Loan defaults.
4. Suppliers do not sell on credit to the company.
5. Legal proceedings against the company.

Illustrative examples:

a. Company A rents a building for ₱100,000.00 per month. On January 1, 2021, the company
paid the rent for two (2) years in the amount ₱2,400,000.00. Under the going concern
assumption, the company can recognize the part of the ₱2,400,000.00 that is not yet incurred.
On January 1, 2021, the company has not yet used the building but already paid the rent. In
this case, the accountant can record an asset (i.e., prepaid expense) instead of recognizing an
expense immediately. If the entity is not a going concern, there is no point recognizing the
payment as an asset since the company will not derive all benefits from it. A company that is
not a going concern will halt operations in the future, so the payment of ₱2,400,000.00 will
be recognized wholly as an expense instead of recording an asset.

b. ABC Company is already on the brink of bankruptcy, and there are clear indications that it will
cease to operate. In this case, the going concern assumption is no longer applicable and all
other accounting principles will be anchored on this assumption. The original cost principle
therefore will no longer be applicable in the presentation of the financial statements. Thus, if
the business owns a building with an acquisition cost of ₱5,000,000.00 but it can be sold only
for ₱2,800,000.00, the value to be used in the preparation of financial statement shall be the
realizable value of ₱2,800,000.00. In the notes to the financial statements, this and other
material information should be clearly explained so that users are properly informed.

The feature of the going concern assumption is the underlying reason for recording assets
based on their original cost, and not at their realizable value or selling price. Original cost refers
to the cost involved in acquisition of the assets. Realizable value refers to the amount that can
be collected in the event the asset is sold.

2. Entity Assumption

The term entity in the field of accounting simply means a person. Entity assumption dictates that
the business is treated as a person with personality separate and distinct from the owner(s).

Unlike a human person, a business is a juridical person. It is created by the operation of law.
Accounting is concerned only with the transactions of the business the personal transactions of
the owner are not given accounting recognition; hence, they are not recorded in the books of the

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 business. The personal transactions of the owners should not be merged or combined with the
transaction of the business.

Entity assumption also implies that the name of the business should be different from the name
of the owner. For example, if Juan Cruz opens a small grocery store, he cannot use Juan Cruz as
the name of his business also. But he may register the business with a trade name Juan Sari-Sari
Store, Juan Merchandising, or Juan Cruz Merchandising.

The main purpose of entity assumption is for the fair presentation of the financial statements of
the company. If the personal transactions of owners, managers, and employees are recognized in
the accounting records of the business, the financial statements will not accurately represent the
results of operations of the business.

Illustrative example:

Angel opened a business with a trade name approved by the Department of Trade and Industry
(DTI) as Shining Star Professional Services. In this case, the personality of Angel, as a human
person, is different from the personality of Shining Star Professional Services. The accounting
records of the business will only account various transactions entered into by it. Hence, if Angel
buys a personal computer for her personal use, the equipment will not be included in the
accounting records of the business.

3. Time Period Assumption

The purpose of financial statements is to show the overall results of the operations of a company.
However, the final and comprehensive report of the results of company operations cannot be
produced until the company is at the end of its life (i.e., after liquidation).

Users of the accounting information of a company need periodic reports to enable them to make
economic decisions. An owner or stockholder needs reports consistently to decide if he/she will
still keep ownership interest in the company. A supplier needs reports consistently to decide if it
is still beneficial to transact with the company. This is where the time period assumption comes
into play.

The time period assumption states that the indefinite life of a company can be divided into
periods of equal length for the preparation of financial reports. Normally, the periods span for
one (1) year. Every year, most businesses produce financial reports for the benefit of the users of
accounting information. Still, there are businesses that produce financial reports on periods less
than or in excess of one year. The financial statements prepared in less than one year are known
as interim financial statements. The frequency of financial reporting also depends on the normal
operating cycle of a business.

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 The specific period in the sphere of accounting principles is known as the accounting period or
time-period. The following are the different accounting periods to measure the operating
performance and financial position of a business:

1. Monthly where financial statements are prepared at the end of every month.
2. Quarterly where financial statements are prepared at the end of every three (3) months.
3. Semi-annually where financial statements are prepared at the end of every six (6) months.
4. Annually where financial statements are prepared at the end of every twelve (12) months.

The annual accounting period for periodic reporting may be on a calendar year or a fiscal year
basis. In a calendar year, the accounting period begins on January 1 and ends on December 31 of
the same year. This is the most common annual accounting period adopted by business entities
because of the convenience it offers relative to taxation requirements. In a fiscal year, the
accounting period begins on the first day of any month of the year except January and ends on
the last day of the twelfth month completing a one-year period. For example, a fiscal period that
begins on April 1, 2020 will end on March 31, 2021. Some companies use fiscal year since the
peak of their operations does not occur in December and want to present good results for the
fourth quarter of their operations.

QUALITATIVE CHARACTERISTICS OF FINANCIAL STATEMENTS

The qualitative characteristics refer to the different attributes that make the information provided
in the financial statements useful to users. Financial statements prepared without the different
qualitative characteristics are not meaningful to the users.

Relevance
Fundamentals
Faithful
Representation

Qualitative
Comparability
Characteristics

Understandabil
ity
Enhancing
Verifiability

Timeliness

Figure 6.3 – Qualitative Characteristics of Financial Statements

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 1. Relevance

Accounting information provided on the face of the financial statements has the fundamental
quality of relevance when it influences the economic decisions of users by helping them evacuate
past, present, or future events or confirm, or correct their past evaluations.

Only information that has material bearing in the decisions to be made by users should be
included in the financial statements, particularly on its notes and disclosure. Information that is
not necessary in making economic decisions should not be included in the disclosure.

Thus, information like economic profile of the business, the background and financial status of
the stockholders, the programs of the government affecting the business, and other similar
information are not considered relevant, and should not be included in the general purpose
financial statements. This type of information will simply obscure information that is of primary
importance to users of financial statements.

2. Faithful Representation

To be reliable, information must represent faithfully the transactions and other events if either
purport to represent or could reasonably be expected to represent. Simply stated, accounting
information that is supposed to be reported should be included in the financial statements. The
management should not withhold any information that will mislead the users of the financial
statements.

The management is highly responsible for the preparation of the financial statements. The users
can put some degree of reliance on the authenticity of the financial statements if the
management itself has signified the reliability of the documents and declared them to be error-
free. This fundamental characteristic seeks to maximize the underlying characteristics of
completeness, neutrality, and freedom from error.

3. Comparability

Financial statements have the characteristics of comparability when it enables the users to
evaluate accounting information based on comparison with similar data from other companies
and industry averages. The growth of the business in terms of profits and assets can be evaluated
more objectively if it is compared with previous years’ operation or with other business entities
within the industry. Different analytical tools to evaluate the financial performance of a business
can easily be applied and the results can easily be interpreted by comparison. The operating
performance of the business may be computed and the results can be compared and evaluated
within the company or with other companies in the same industry.

In other words, the financial statements possess the characteristics of comparability when the
data can be compared with other business entities within the same industry using the same

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 measurement tools. Unlike the other qualitative characteristics, comparability does not relate to
a single item. A comparison requires at least two items.

4. Understandability

The information provided in the financial statements must be readily understandable in order to
be useful to the interested users. This requires that the notes to the financial statements should
be made simple and within the common range of understanding. Pompous words and lofty
phrases should be avoided in explaining some items or transactions.

However, the different users are assumed to have reasonable knowledge of business and
economic activities and accounting. They should have the willingness and desire to study the
information with reasonable diligence. Users of financial statements are assumed to have a fair
degree of knowledge on the technical terms and jargons used in the preparation of financial
statements.

The quality of understandability encompasses the concept of simplicity in the use of words and
explanation but should be comprehensive enough to cover even the most complicated
information so that users are fully informed. Simplicity does not connote exclusion of complicated
information like that of merger and consolidation.

5. Verifiability

Verifiability implies consensus or similarity among the different measures. In other words, the
financial statements are imbued with the quality of verifiability if the different measures arrive at
the same valuation using the same measurement methods. Verifiability implies that transactions
are supported with business documents.

When the different items in the financial statements are valued at historical cost, the valuation is
easy to verify, because the cost can be traced directly from the source documents. However, items
that are valued using the fair value are much more difficult to verify. In most instances, the
element of subjectivity is present, and appraisers may differ in determining the fair value of the
item.

Illustrative example:

The machinery appearing in the statement of financial position valued at ₱3,000,000.00 is highly
verifiable when Hazel, Izzy, and Jenny, the different independent measurers, arrive at the same
valuation using similar measurement methods. The three (3) measurers could check the historical
cost of the machinery by verifying the sales invoice, delivery receipt, vouchers, canvass form, and
other similar business documents, and would arrive at similar values of ₱3,000,000.00.

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 6. Timeliness

If there is undue delay in the reporting of information, it may lose its relevance. Financial
information and other relevant data that are needed by the decision maker now should be made
available now. If the needed information is delayed, then such information may no longer serve
the purpose when available. Financial information, therefore, should be timely.

However, to provide information on a timely basis it may be often necessary to submit needed
report before all aspects of the transactions or other events are known, thus impairing reliability.
Data are not always available on time

Timeliness then acts as a constraint to reliable information. Financial statements that are timely,
that is available when needed, may not be reliable. On the other hand, a reliable financial
statement, on the basis that it includes all the needed information, may not be timely when
needed because it was prepared only after all information were made available.

OTHER GENERALLY ACCEPTED ACCOUNTING PRINCIPLES

1. Reliability

The financial statements can be relied upon by different users to represent faithfully what it
purports to represent, or could reasonably be expected to represent. Reliability is an ingredient
of faithful representation, a fundamental qualitative characteristic.

The financial statement is considered reliable when no material errors are committed in the
preparation, and it includes all information that need to be recorded. The management should
not select only the favorable information about the business, or should not adopt accounting
procedures that will only show a favorable performance and financial position.

Information is likewise considered favorable when it is supported by reliable documents either

derived from within the entity or from outside source. Accounting information is reliable when it
shows:

a. Completeness

The information in the financial statements must be complete within the bounds of
materiality and cost. The objective of completeness is to provide users with the information
they need to make intelligent, informed decisions. Financial statements are said to be
complete when they present all the information that needs to be presented and adequately
disclosed in the notes. The principle of completeness dictates that the accounting policy, the
measurement, and the composition of the terms must be clearly outlined and explained in
the notes.

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 b. Neutrality

The information contained in the financial statements must be neutral, that is, free from bias.
There should be no attempt to influence the decisions of the users to predetermine the
outcome or result. The financial statements do not favor any interested user. A neutral
depiction is not slanted, weighted, emphasized, de-emphasized or otherwise manipulated to
increase the probability that financial information will be received favorably or unfavorably
by users.

The concept of neutrality suggests that the financial statements are not tailored to meet the
needs of a specific user. The principle of neutrality mandates that the financial statements
should be prepared to meet the needs of all interested users. It should be based on reliable
documents and free from biases.

c. Free from Error

The concept of being free from error does not necessarily mean that the financial statements
are absolutely correct in all aspects. It implies, rather, that there are no material errors
committed in the preparation of the financial statements that will significantly change the
decision of the users.

The underlying premise is that there should be no deliberate intention on the part of the
management to distort the information contained in the financial statements. The financial
statements fairly present, not in absolute or perfect fashion, that all the information it
purports to represent are considered free from error.

2. Use of judgment and Estimates

Accounting estimates are approximations made by accountants or the management in the

preparation of financial statements. The use of reasonable estimates is an essential part of the
preparation of financial statements and does not undermine their reliability. (International
Accounting Standards 8) Some items in a company’s accounting records such as cash; property,
plant, and equipment (PPE); and accounts payable can be measured precisely. For these items
that can be measured with precision, the use of estimates is not required. As you study higher
levels of accounting, you will encounter items in a company’s accounting records that cannot be
exactly measured. Thus, these items require the use of accounting estimates.

Warranty expense is an item in the accounting records that requires the use of estimates. A
warranty is a guarantee made by the seller to the buyer promising to repair or replace the thing
sold if necessary within a specified period of time. When a seller sells goods, there are revenues
generated that are recorded in the company’s accounting records. Warranty expense is related
to the revenues generated from the sale of goods. The problem is what amount of warranty the
company should recognize in the accounting records.

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 A company is not entirely sure when warranties will be performed by the company. It can be in
the same period as related revenues, one year after the date of sale, or even further into the
future. Because of this, the warranty expense in a company’s accounting records is usually
estimated based on historical data.

However, the use of accounting estimates cannot be abused by an entity to purposely

overestimating expenses. Some companies overestimate expenses to decrease net income and
decrease the taxes payable. Judgment use in making accounting estimates should be backed up
by a reasonable basis. It is more desirable to use less judgment in the accounting process because
the use of judgment leads to more subjective financial statements.

3. Prudence

Prudence in the accounting sense is also called conservatism. Some financial transactions are
sometimes uncertain when they occur. Nevertheless, we still need to report these transactions if
they pertain to a specific period. When applying the concept of prudence, an accountant makes
sure that income and assets are not overstated and liabilities and expenses are not overstated.

Prudence is the inclusion of a degree of caution in the exercise of the judgments needed in making
estimates required under conditions of uncertainty. Not all data contained in the financial
statements are real amounts. Some are results of conservative estimates. Thus, the data
presented in the financial statements is a mixture of real amounts and estimates.

For example, the flood destroyed part of the goods intended for sale. The amount of losses on
inventory is estimated to be ₱300,000.00 but on ₱200,000.00 was reported. This estimate
overstated the asset by ₱100,000.00 or understated the losses by the same amount. The effect
of this unconservative estimate overstated the capital by the same amount.

Sound accounting principle dictates that in making estimates, the result should give the least
favorable effect to the capital of the owner. In the above example, the loss of ₱300,000.00 has
the least favorable effect to the capital of the business. Furthermore, the principle of
conservatism suggests that in the preparation of financial statements profits should not be
anticipated, but all probable losses should be provided. Prudence, therefore, is exercised by the
use of professional judgment.

4. Substance over Form

Information presented in the financial statements of a company should be truthfully and faithfully
represent the financial condition and financial performance of the company. For this to be
possible, an accountant should look at the substance of every financial transaction rather than its
legal form.

In a transaction where the economic substance differs from legal forms, the former is given
preference over the latter. The term legal form means that the recording process should be in
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 accordance with the requirements of the law. The term economic substance means that
transactions should be recorded in accordance with monetary implications.

Illustrative example:

Jocelyn bought a motorcycle from a dealer for ₱60,000.00 to be used in her trading business. She
made a downpayment of ₱5,000.00 and the balance, together with the interest based on the
prevailing market rate, is payable in equal monthly payments for three (3) years. After the
completion of all sale requirements, the dealer released the motorcycle to Jocelyn. The conflicting
issue to settle in this case is: Immediately after the purchase, who is the owner of the motorcycle?

From the legal point of view, the owner is the dealer since he has all the legal rights to the
motorcycle in view of the fact that it is not yet fully paid. On the other hand, from the economic
point of view, the owner of the motorcycle is Jocelyn because she is the one using it already. In
other words, there are conflicting views as to the ownership of the motorcycle.

The accounting principle, however, dictates that in case of conflict between the economic
substance and the legal form, the former shall prevail. Thus, in the example given, the buyer is
the owner of the motorcycle. Being an owner, Jocelyn then will include the motorcycle in her
financial statement as an asset. The dealer, on the other hand, shall exclude the motorcycle from
his inventory or goods intended for sale.

5. Matching Principle

The matching principle is closely related to accrual accounting. Under the matching principle,
expenses are recognized in the same period as the related revenue. Revenue of a business always
come with expenses. No business can generate revenues without incurring expenses. The
matching principle states that related revenues and expenses should always go together. In other
words, if the revenues are recorded in period 1, the related expenses should also be recorded in
period 1.

Remember that under the matching principle, expenses follow the related revenues. Like accrual
accounting, the matching principle also provides more accurate and more reliable information in
the financial statements. It prevents understatement of expenses in one period while overstating
expenses in the next period.

Moreover, under the matching principle, there is a cause-and-effect relationship between the
revenues and expenses. If the relationship does not exist between revenues and expenses, the
expenses should be recognized immediately in the accounting records of the company.
Advertising and marketing expenses are the most common examples of this kind of expense.
Since the related benefit that is expected to be derived from advertising and marketing cannot
be measured reliably, these expenses are recognized immediately.

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 Illustrative example:

Rudy, a car salesman who works for Honda, has a monthly salary of ₱30,000.00. Aside from that,
he receives a commission of 5% for all the sales he made for the month. During the month of
December, he was able to sell ten (10) cars for a total amount of ₱12,000,000.00. The
₱12,000,000.00 is recorded as sales of the company. By selling 10 cars for the month, Rudy is
entitled to receive ₱630,000.00 (i.e., ₱30,000.00 monthly salary plus ₱600,000.00 commission).
The monthly salary of Rudy plus his commission are expenses of the company. By the end of the
month, the salary of Rudy and his commissions are still not yet paid. Under the matching
principle, the ₱630,000.00 will be recorded as an expense in December even though it is not yet
paid since it is related to the ₱12,000,000.00 in revenues. Without the matching principle, the
₱630,000.00 may be recorded as an expense in January when the payment to Rudy is made.

GENERALIZATION

In this chapter, various accounting concepts, principles, and assumptions was be explained.
Remember in accrual accounting, income is recognized when earned and expenses are
recognized when incurred irrespective of the timing of cash receipt or payment and it results in
more accurate financial statements. However, cash basis of accounting recognizes income when
cash is received and recognizes expenses when cash is paid. Meanwhile, the generally accepted
accounting principles refer to a set of accounting principles, concepts, rules, and guidelines that
companies follow to enhance the consistency and comparability of their financial statements.
GAAP includes three classifications of accounting principles: accounting assumptions as the
foundation of accounting principles include the going concern assumption, entity assumption,
and time period assumption; the qualitative characteristics of financial statements which
categorized into the fundamental qualities and enhancing qualities; and, other generally accepted
accounting principles which focused on the reliability, use of judgement and estimates, prudence,
substance over form, and matching principle. These set of rules, concepts, principles, and
assumptions serve as guide in studying and practicing accounting.

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