DEFINITION OF ACCOUNTING Accounting is “the process of identifying, measuring and communicating economic information to permit informed judgments and decisions by users of the information” Three important activities 1. Identifying 2. Measuring 3. Communicating Identifying is the process of analyzing events and transactions to determine whether or not they will be recognized. Only accountable events are recognized. An accountable event is one that affects the assets, liabilities, equity, income or expenses of an entity (journalized). Non-accountable events are not recognized but disclosed only in the notes if they have accounting relevance (memorandum entry). Types of events or transactions: 1. External events (entity and other external party) a. Exchange (reciprocal transfer) b. Non-reciprocal (like donations, gifts, penalty) 2. Internal events (do not ilve external party) a. Production b. Casualty Measuring lves assigning numbers, normally in monetary terms to the economic transactions and events. Basis of measurement Historical cost Fair value Present Value Realizable value Current cost Inflation-adjusted costs o o The financial statements are said to be a mixture of fact and opinion. When measurement is affected by estimates, the items measured are said to be valued by opinion. Estimates of uncollectible amounts of receivables Depreciation and amortization Estimates of liabilities Communicating is the process of transforming economic data into useful accounting information, such as financial statements and other accounting reports, for dissemination to users. It also involves interpreting the significance of the processed information. The communicating process of accounting involves three (3) aspects: 1. Recording – journal entries 2. Classifying – postings in the ledger 3. Summarizing – preparation of FS and other accounting reports Interpreting / financial analysis The basic purpose of accounting is to provide information that is useful in making economic decisions. Types of information provided by accounting 1. Qualitative information – expressed in numbers, units or quantities 2. Quantitative information – expressed in words 3. Financial information – expressed in money Types of accounting information classified as to user’s needs 1. General purpose accounting information – designed to meet the common needs of most statement users. (Philippine Financial Reporting Standards) 2. Special purpose accounting information – designed to meet the specific needs of particular statement users. (Management accounting, tax basis accounting) Information in the financial statements is not obtained exclusively from the entity’s accounting records. Accounting as science and art 1. As social science, accounting is a body of knowledge which has been systematically gathered, classified and organized. 2. As a practical art, accounting requires the use of creative skills and judgment. Accounting is often referred to as a “language of business” because it is fundamental to the communication of financial information. Creative and critical thinking in accounting The practice of accountancy requires the exercise of creative and critical thinking. Creative thinking involves the use of imagination and insight to solve problems. It is most important in identifying alternative solutions Critical thinking involves the logical analysis of issues. It is most important in evaluating alternative solutions Accounting Concepts Accounting concepts refer to the principles upon which the process of accounting is based. The term can be used interchangeably with the following: Accounting assumptions – fundamental concepts and principles that provide the foundation of the accounting process Accounting theory – is a logical reasoning in the form of a set of broad principles that: i. ii. Provide a general frame of reference by which accounting practice can be evaluated Guide the development of new practices and procedures Accounting theory comprises the Conceptual Framework and the Philippine Financial Reporting Standards (PFRS). Some of the concepts are implicit, meaning they are not expressly stated in the framework or PFRS but are generally accepted because of their long-time use in the profession. Examples of Accounting Concepts: 1. Double-entry system – each accountable event is recorded in 2 parts (debit and credit) 2. oncern assumption – entity does not expect to end its operations in the foreseeable future (measurement basis is the mixture of costs and values). 3. Separate entity – the entity is viewed separately from its owners. 4. Monetary unit assumptions – amount is stated in terms of a common unit (Php) 5. Time period – calendar or fiscal 6. Materiality concept – information is material if its omission or misstatement could influence economic decisions 7. Cost-benefit – the cost of processing and communicating information should not exceed the benefits to be derived from it. 8. Accrual basis of accounting – income is recognized when earned rather than when cash is collected and expenses are recognized when incurred rather than when cash is paid. 9. Historical cost concept – the value of an asset is determined on the basis of acquisition cost. This concept is not always maintained as some PFRS require different measurement. a. Inventory measured at net realizable value b. Financial instrument measured at fair value 10. Concept of Articulation – all of the components of a complete set of financial statements are interrelated. FS, notes and cash flows should be interrelated. 11. Full disclosure principle – sufficient detail to disclose matters that make a difference to users 12. Consistency concept – basis of accounting principles are applied consistently from one period to the next. Changes in accounting policy should be made when required by PFRS and additional disclosure. 13. Matching – costs are recognized as expenses when related revenue is recognized 14. Entity Theory – assets = liabilities + capital 15. Proprietary theory – assets – liabilities = capital 16. Residual equity theory assets – liabilities – preferred shares = common shares (book value determination) 17. Fund theory – cash inflow minus cash outflow equals fund 18. Realization – the process of converting non-cash assets into cash or claims for cash 19. Prudence (conservatism) – caution in making estimates wherein assets or income are not overstated and liabilities or expenses are not understated. Financial accounting is governed by the Philippine Financial Reporting Standards (PFRS) Common Branches of Accounting 1. Financial Accounting – structured representation of an entity’s financial position and results of operations. A complete set of financial statements consists of the following: a) b) c) d) e) f) Statement of Financial Positions Statement of Profit or Loss and Other Comprehensive Income Statement of Changes in Equity Statement of Cash Flows Notes Additional Statement of Financial Position (required only when certain circumstances occur) 2. Management Accounting (Management Advisory Services) – refers to the accumulation and communication of information for use by the internal users or management. 3. Cost Accounting – systematic recording and analysis of the costs of materials, labor and overhead incident to production 4. Auditing – is the process of evaluating the correspondence of certain assertions with established criteria and expressing an opinion thereon. 5. Tax Accounting – the preparation of tax returns and rendering of tax advice. 6. Government accounting – accounting for government and its instrumentalities placing emphasis on the custody of public funds, the purpose for which those funds are committed and the responsibility and accountability of the individuals entrusted with those funds 7. Fiduciary accounting – refers to handling of accounts managed by a person entrusted with the custody and management of property for the benefit of another 8. Estate accounting – accounting for the properties of deceased person 9. Social accounting – the process of communicating the social and environment effects of an entity’s economic actions to the society. 10. Institutional accounting – accounting for non-profit entities other than government accounting 11. Accounting systems – installation of accounting procedure for the accumulation of financial data and designing of accounting forms to be used in data gathering. 12. Accounting research – pertains to the careful analysis of economic events and other variables to understand their impact on decisions. Bookkeeping Process of recording of accounts or transactions of an entity Normally ends with the preparation of trial balance Does not require the interpretation of the significance of the processed information Accountancy – refers to the profession or practice of accounting Four sectors in the practice of accountancy 1. Practice of Public Accountancy – involves rendering of audit or accounting related services to more than one client on a fee basis 2. Practice in Commerce and Industry – refers to employment in the private sector in a position which involves decision making requiring professional knowledge in the science of accounting and such position requires that the holder thereof must be a certified public accountants. 3. Practice in Education/Academe – employment in an educational institution which involves teaching of accounting, auditing, management advisory services, finance, business law, taxation and other technically related subjects 4. Practice in the Government – employment or appointment to a position in an accounting professional group in the government. Accounting Standards The Philippine Financial Reporting Standards (PFRSs) represent the generally accepted accounting principles (GAAP) in the Philippines The term “generally accepted” means that either: 1. The standard has been established by an authoritative accounting rule-making body ex: PFRS 2. The principle has gained general acceptance due to practice over time and has been proven to be the most usefule ex: double-entry recording and other implicit concepts Hierarchy of Reporting Standards When selecting its accounting policies, an entity considers the following in descending order: 1. Philippine Financial Reporting Standards (PFRS) 2. In the absence of a PFRS that specifically applies to a transaction or event, management shall use its judgment in developing and applying an accounting policy that results in information that is relevant and reliable. PFRS > Conceptual Framework > Pronouncements of other standard-setting bodies > accounting literature and accepted industry practices Selection of appropriate accounting policies is the responsibility of the entity’s management, the proper application of accounting principles is most dependent upon the professional judgment of the accountant. Accounting standard setting bodies and other relevant organizations 1. Financial Reporting Standards Council (FRSC) – official accounting standard setting body in the Philippines created under the Philippine Accountancy Act of 2004. 2. Philippine Interpretations Committee (PIC) – predecessor of FRSC with the role of reviewing the interpretations of the International Financial Reporting Interpretations Committee (IFRIC) 3. Board of Accountancy – professional regulatory board to supervise the registration, licensure and practice of accountancy in the Philippines. 4. Securities and Exchange Commission (SEC) – is the government agency tasked in regulating corporations and partnerships, capital and investment market and the investing public. 5. Bureau of Internal Revenue – administers the provisions of the National Internal Revenue Code. These provisions do not always reflect the goals of financial reporting. However, they do at times influence the choice of accounting methods. 6. Bangko Sentral ng Pilipinas (BSP) – influences the selection and application of accounting policies by banks and other entities performing banking functions 7. Cooperative Development Authority (CDA) – influences the selection and application of accounting policies by cooperatives. US GAAP (Statement of Financial Reporting Standards) – Federal Accounting Standards Board 2005 full adoption of IFRS o Primarily brought about by increasing acceptance of IFRSs world-wide and increasing internationalization of businesses thereby increasing the need for a common financial reporting standards that minimize inconsistencies of financial reporting among nations. International Accounting Standards Board (IASB) is the standard-setting body of the IFRS Foundation with the main objectives of developing and promoting global accounting standards. The accounting standards used in the Philippines are the PFRS, which are based on the IFRSs. The PFRSs are comprised of the following: 1. PFRSs 2. PASs 3. Interpretations Financial reporting standards continuously change primarily in response to users’ needs. Conceptual Framework Sets out the concepts that underlie the preparation and presentation of financial statements for external users. The Conceptual Framework is not a PFRS and therefore does not prescribe any measurement or disclosure requirement. If there is a conflict between a PFRS and the Conceptual Framework, the requirements of the PFRS will prevail. Hierarchy of reporting standards a. PFRSs b. Judgment When making the judgment: Management shall consider the following: o Requirements in other PFRSs dealing with similar transactions o Conceptual Framework Management may consider the following: o Pronouncements issued by other standard-setting bodies o Other accounting literature and industry practice SCOPE The Conceptual Framework deals with the following: a. b. c. d. Objective of financial reporting Qualitative characteristics of useful information Definition, recognition and measurement of financial statement elements Concepts of capital and capital maintenance Objective of financial reporting “The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity.” Foundation of Conceptual Framework Primary Users of Financial Reporting 1. Existing and Potential Investors 2. Lenders and Other Creditors These users cannot demand information directly from reporting entities and must rely on general purpose financial reports for their financial information needs. Lenders > extend loans; Creditors > other forms of credit The concern of primary users is the entity’s prospects for future net cash inflows. General purpose financial reports provide information on a reporting entity’s: a. Financial position – information on economic resources (assets) and claims against the reporting entity (liabilities and equity). b. Changes in economic resources and claims – information on financial performance and other transactions and events that lead to changes in financial position. Economic resources and Claims Information on economic resources and claims help users assess the entity’s: a. Financial strengths and weaknesses b. Liquidity and solvency c. Needs for additional financing and how successful it is likely to be in obtaining that financing Liquidity > ability to pay short-term; solvency > ability to meet long term obligations Current ratio; asset-liability matching Economic resources and claims Helps users assess the entity’s ability to produce return from its economic resources. o Return provides an indication on how well management has efficiently and effectively used the entity’s resources. Variability of the return helps users in assessing the uncertainty of future cash flows. o For example, significant fluctuations in reported profits may indicate financial instability and uncertainty on the entity’s ability to generate cash flows from its operations. Qualitative Characteristics The qualitative characteristics of useful financial information identify the types of information that are likely to be most useful to the primary users in making decisions using an entity’s financial report. The Conceptual Framework classifies the qualitative characteristics into the following: 1. Fundamental qualitative characteristics – these are the characteristics that make information useful to users. They are consist of the following: a. Relevance i. Materiality concept b. Faithful Representation i. Completeness ii. Neutrality iii. Free from error 2. Enhancing qualitative characteristics – these are the characteristics that enhance the usefulness of information. They consist of the following: a. Comparability b. Verifiability c. Timeliness d. Understandability Relevance Information is relevant if it is capable of making difference in the decisions made by the users. Materiality Information is material if omitting, misstating or obscuring it could reasonably be expected to influence decisions that the primary users of a specific reporting entity’s general purpose financial statements make on the basis of those financial statements. The Conceptual Framework states that materiality is an ‘entity-specific’ aspect of relevance, meaning materiality depends on the facts and circumstances surrounding a specific entity. Accordingly, the Conceptual Framework and the Standards do not specify a uniform quantitative threshold for materiality. Materiality is a matter of judgment. Faithful Representation The information provides a true, correct and complete depiction of what it purports to represent. Faithfully represented information has the following characteristics: a. Completeness – all information necessary for users to understand the phenomenon being depicted are provided. These include: o Description of the nature of the item o Numerical depiction (monetary amount) o Description of the numerical depiction (historical cost or fair value) o Explanations of significant facts surrounding the item b. Neutrality – information is selected or presented without bias c. Free from error – this does not mean that the information is perfectly accurate in all aspects. It means there are no errors in the description and in the process by which the information is selected and applied. o If the information is an estimate, that fact should be described clearly, including an explanation of the process used in making that estimate. Comparability Information is comparable if it helps users identify similarities and differences between one information and another information that is either provided by the same entity but in another period (intracomparability) or by other entities (inter-comparability). Although related, consistency and comparability are not the same. Consistency refers to the use of the same methods for the same items. Comparability is the goal while consistency is the means of achieving that goal. Verifiability Information is verifiable if different users could reach an agreement as to what the information purports to represent. Direct verification - involves direct observation (counting of cash, inventory of supplies) Indirect verification – recalculating using the same formula (checking the inputs in the cash ledger and recalculating the ending balance) Timeliness Information is timely if it is available to users in time to be able to influence their decisions. Understandability Information is understandable if it is presented in a clear and concise manner. Understandability does not mean that complex matters should be excluded because this would make information incomplete and potentially misleading. Accordingly, financial reports are intended for users: o Who have reasonable knowledge of business activities and o Who are willing to analyze the information diligently Underlying Assumption The underlying assumption in financial reporting is going concern. It is assumed that the entity has neither the intention nor the need to end its operations in the foreseeable future. The Elements of Financial Statements Financial statement portray the effects of transactions and events by grouping them into broad classes. Financial Position the elements directly related to the measurement of financial position are assets, liabilities and equity Asset “An asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity”. Essential Elements in the definition of asset a. Control – means the entity has the exclusive right over the benefits of an asset or the ability to prevent others from accessing those benefits o Substance over form concept i. Ownership or possession is not always necessary for control to exist (ex. Asset acquire through bank financing) ii. Physical form is not necessary for an asset to exist. (ex. Receivables and intangibles) iii. The presence or absence of expenditure is not necessary in determining the existence of an asset. (ex. Donations) b. Past Events o Resources for which control is yet to be obtained in the future do not qualify as assets in the past event. (ex. Mere intention to acquire vehicles) c. Future Economic Benefits o ‘Future” means the resource is expected to provide economic benefit over more than one accounting period. Expense for current period only. o “Economic benefits” means the potential of the resource to provide the entity, directly, indirectly with cash and cash equivalents. Liability “A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits” Essential Elements in the definition of liability a. Present obligation arising from past events – means that at the reporting date, the entity has the responsibility to perform some act because of an obligating event that has already transcribed. i. Legal obligation – an obligation that results from a contract, legislation or other operation of law ii. Constructive obligation – an obligation that results from an entity’s actions that create a valid expectation from others that the entity will accept and discharge certain responsibilities. o Intention to purchase inventory (no obligation) o Irrevocable contract to purchase an inventory (creates liability) o Assumed acceptable of repairs in the future (constructive) b. Outflow of economic benefits – settling an obligation normally requires the entity to: o Pay cash o Transfer non-cash assets o Render a service o Replace the obligation with another obligation o Convert the obligation to equity The Conceptual Framework’s definition of a liability encompasses a broad approach to identifying the existence of a liability, such that a liability may exist: o Even if the obligee (payee) is not specifically known o Even if the amount of the liability is not definite (ex. Provisions) Equity “Equity is the residual interest in the assets of the entity after deducting all its liabilities” Performance The elements directly related to the measurement of performance are income and expenses. Income “Income is increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants”. Income includes both revenue and gains. a. “Revenue arises in the course of the ordinary activities of an entity and is referred to by a variety of different names including sales, fees, interest, dividends, royalties and rent” b. “Gains represent other items that meet the definition of income and may, or may not, arise in the course of the ordinary activities of an entity”. Revenues and gains are normally presented separately in the financial statements as knowledge of them is useful in making economic decisions. Expenses “Expenses are decrease in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decrease in equity, other than those relating to distributions to equity participants”. Capitalizable costs – recognized as assets Period costs or revenue expenditures – expensed immediately in the period they are incurred Expense recognition principle The following principles are applied when recognizing expenses: 1. Matching concept (direct association of cost and revenues) Costs that are directly related to the earning of revenue are recognized as expenses in the same period the related revenue is recognized. (ex. Commissions) 2. Systematic and rational allocation – costs that are not directly related to the earning of revenue are initially recognized as assets and recognized as expenses over the periods their economic benefits are consumed, using some method of allocation. (ex. Depreciation, prepayments). 3. Immediate recognition – costs that do not provide or cease to provide future economic benefits are expensed immediately (ex. Obsolete properties, impaired receivables) Measurement “Measurement is the process of determining the monetary amounts at which the elements of the financial statements are to be recognized and carried in the balance sheet and income statement”. Basis of measurements Historical Cost Current Cost Realizable value (settlement value) Present value For Assets This is the amount of cash paid or the fair value of the consideration given to acquire them at the time of their acquisition This is the amount of cash that would have to be paid if the same asset was acquired currently This is the amount of cash that could currently be obtained by selling the asset in an orderly disposal. This is the discounted value of the future net cash inflows expected to be derived from the asset For Liabilities This is the amount of proceeds received in exchange for the obligation or the amount of cash expected to be paid to settle the liability This is undiscounted amount of cash that would be required to settle the obligation currently. This is the settlement value or the undiscounted amount of cash expected to be paid to satisfy the liabilities in the normal course of business This is the discounted value of the future net cash outflows expected to be paid to settle the liability Concepts of Capital and Capital Maintenance Two Concepts of Capital a. Financial Concept of Capital – capital is regarded as the invested money or invested purchasing power. Capital is synonymous with equity or net assets. b. Physical concept of capital – capital is regarded as the entity’s productive capacity ex. Units of output per day. The choice of an appropriate concept is based on the user’s needs. The concept chosen affects the determination of profit. o Financial capital maintenance – profit is earned if the net assets at the end of the period exceeds the net assets at the beginning of the period, after excluding any distributions to and contributions from owners o Physical capital maintenance –profit is earned only if the entity’s productive capacity at the end of the period after excluding any distributions to and contributions from owners during the period.
