PURPOSE AND PHASES OF ACCOUNTING
Accounting is part of a business system that manages finances and provides
information to various departments. It records economic activities (transactions) of
the business, which are essential for planning, control, regulatory compliance, and
decision-making.
To record transactions, accountants measure them in terms of money, which is a
common financial unit. They address three key issues: when the transaction
happened (recognition), how much it's worth (valuation), and how to categorize its
components (classification).
Simply recording transactions isn't enough; the data must be organized.
Classification groups similar transactions, and summarization is done through
financial statements, which show the effects of all transactions in a certain period.
Finally, after summarization, it's crucial to analyze the data to evaluate the
business's liquidity, profitability, and solvency. Accounting provides decision-makers
with information to make informed choices in managing resources for business and
economic activities.
PACIOLI'S DOUBLE-ENTRY BOOKKEEPING AND ITS EVOLUTION
In Fra Luca Pacioli's book "Summa," he emphasizes three essential things for
successful merchants: enough cash or credit, a good bookkeeper, and a system to
oversee business affairs. He introduces the double-entry accounting system, which
has been the foundation of modern bookkeeping since the 15th century.
In "Summa," Pacioli describes three books: the memorandum (records transactions),
the journal (a private record), and the ledger (lists all accounts with balances).
Interestingly, he doesn't discuss financial statements, as they weren't needed at
the time when owners closely controlled businesses. However, he does advocate
annual balancing to assess business success and find errors.
This medieval system has endured because it provides accurate historical records
and helps owners and managers operate effectively by answering key questions:
profit, debts owed, and debts owed to the business.
Modern businesses are more complex, often requiring managers and separation
from owners. Thus, the accounting system evolved into two main specializations:
Financial Accounting (for owners) and Management Accounting (for managers).
However, accountants now provide information to various parties beyond owners
and managers, such as customers, employees, governments, investors, lenders, the
public, and suppliers.
FUNDAMENTAL CONCEPTS
Entity Concept.
➢ An organization is like its own economic world. It's separate from others, and
we should keep its financial transactions separate too. In other words, we
should assess each organization on its own without mixing its finances with
others.
Periodicity Concept.
➢ We don't have to wait until the very end of an organization's life to measure
its profit. We can divide its life into equal time periods, like a year, for
reporting. This way, we can get useful information quickly to make decisions
about the future. Normally, one year is the standard accounting period when
reporting to outsiders.
Stable Monetary Unit Concept.
➢ In the Philippines, we use the peso as a consistent unit of measurement
because its purchasing power stays fairly steady. This means accountants
can treat each peso as having the same value, regardless of inflation, when
doing calculations in accounting records.
Going Concern.
➢ Usually, financial statements are made with the assumption that the
business will keep operating normally in the future. This means it won't
shut down or sell its assets. However, because of the ongoing COVID-19
pandemic, many businesses are facing economic challenges. This uncertainty
might make it unclear if the business can continue operating as usual.
CRITERIA FOR GENERAL ACCEPTANCE OF AN ACCOUNTING PRINCIPLE
Accounting follows certain rules known as GAAP, or generally accepted
accounting principles. These rules define how accounting should be done at a given
time. Unlike natural sciences like physics or chemistry, accounting principles aren't
based on fundamental laws or proven through experiments. They've developed over
time and continue to evolve. Whether an accounting principle is widely accepted
depends on three factors:
1. Relevance: Does it provide useful information about an organization?
2. Objectivity: Is the information reliable, free from personal bias, and verifiable?
3. Feasibility: Can it be applied without being too complex or costly?
These criteria can sometimes conflict with each other. For instance, the most useful
approach might not be the most objective or the easiest to implement.
BASIC PRINCIPLES
In order to generate information that is useful to the users of financial statements,
accountants rely upon the following principles:
Objectivity Principle.
➢ In accounting, we use the most trustworthy information to make records and
statements as accurate and useful as possible. Reliable data can be
checked by independent observers. Ideally, accounting records rely on info
backed by concrete evidence from documented activities. Without this
principle, accounting would be based on personal opinions, leading to
disagreements.
Historical Cost.
➢ States that acquired assets should be recorded at their actual cost and not
at what management thinks they are worth in the reporting period.
Revenue Recognition Principle.
➢ Revenue is to be recognized in the accounting period when goods are
delivered or services are rendered or performed.
Expense Recognition Principle.
➢ Expenses should be recognized in the accounting period in which goods and
services are used up to produce revenue and not when the entity pays for
those goods and services.
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.
Materiality.
➢ Financial reporting focuses on important information that can influence
decisions. What's considered important, or "material," depends on the item's
size and relevance in a specific situation. When deciding if something is
material, we look at both its size and its significance. In some cases, either
the size or the importance can determine whether it's material.
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.
TAXATION OF BUSINESS ORGANIZATIONS (per TRAIN Law and CREATE Act)
• Sole Proprietorship
In the Philippines, individuals who are either Filipino citizens or resident aliens, their
income can fall into three categories: compensation, business, or mixed income.
1. If they earn solely from compensation, they'll be taxed based on a graduated
scale ranging from 20% to 35% (from January 1, 2018, to December 31,
2022, and from 15% to 35% starting January 1, 2023). This tax is
determined by Sec. 24(A) of the Tax Code.
Their taxable income is their total compensation income minus any non-taxable
income or benefits. This includes things like the 13th-month pay (up to a limit of
P90,000), minor benefits, and deductions for contributions to SSS, GSIS, PHIC,
Pag-IBIG, and union dues. You can find more details about this in Chapter 11 of the
book titled "Payroll."
Gross Compensation Income
P xxx
Less: Non-Taxable/Exempt Compensation
xx
Gross Taxable Compensation Income
P xxx
2. Business income comes from being self-employed or practicing a profession.
It does not include income earned as an employee.
If someone earns income solely from self-employment or a profession and their total
earnings (including non-operating income) are less than P3.0 million, they have two
tax options:
a. They can follow the graduated income tax rates as per Sec. 24(A) of the
Tax Code; or
b. They can choose to pay an 8% tax on the portion of their earnings above
P250,000 (GSRONO!) instead of using the graduated income tax rates and
the percentage tax under Sec. 116 of the Tax Code
Gross Sales/Receipts
Less: Cost of Sales
P xxx
xx
Gross Income
xxx
Less: Operating Expenses
xx
Taxable Income (if graduated rates)
xxx
3. Mixed Income Earners. Some people earn money from both a regular job
(compensation) and their own business or profession. They have to pay
taxes in two ways:
• On their salary, they follow the regular graduated tax rates.
• For the money they make from their business or profession, they have two
options:
➢ If their total business income (GSRONOI) is less than the VAT
threshold, they can either follow the graduated tax rates or pay an
8% tax on that income above a certain amount (P250,000), depending
on what they prefer.
➢ If their business income exceeds the VAT threshold, they have to use
the graduated tax rates for that part. The P250,000 mentioned earlier
doesn't apply here because it's already considered in the first tier of
the graduated tax rates for their salary income.
• Partnership
In taxation, there are two types of general partnerships:
1. General Professional Partnership (GPP):
➢ This is formed by people who share a common profession, and they don't
earn any income from business activities. GPPs don't pay income tax, but
they must file an annual income tax return to provide information about their
income, deductions, and partner details. Each partner is individually
responsible for paying income tax.
2. General Co-Partnership (compania colectiva):
➢ This is a general partnership that isn't focused on a common profession like
GPPs. Unlike GPPs, which don't pay income tax, general co-partnerships are
treated as corporations for tax purposes and are taxed accordingly.
For both types of partnerships, if they incur losses, the partners can decide how
to divide them. If there's no agreement on loss division but there's one for profit
sharing, the losses are distributed according to the profit-sharing arrangement.
Each partner reports their share of losses in their individual income tax returns.
Additionally, a GPP can choose to use the optional standard deduction (OSD) once,
either for the whole partnership or for the individual partners within it.
• Corporation
A corporation can be either local (domestic) or from another country (foreign).
➢ A domestic corporation is one created or organized in the Philippines or under
its laws.
- For domestic corporations, there's a general income tax rate of 25% that
applies to their income from all sources, both within and outside the
Philippines, starting from July 1, 2020.
Generally, the pro-forma computation of the normal income tax of domestic and
resident foreign corporations follows:
Gross Income
P xxx
Less: Allowable Deductions
xx
Taxable Net Income
xxx
Multiply by: Tax Rate
Income Tax Due
P xxx
➢ For domestic corporations with net taxable income not exceeding P5.0 million
and with total assets not exceeding P100 million excluding land on which the
particular business entity's office, plant and equipment are situated during
the taxable year, shall be taxed at 20% effective July 1, 2020.
To calculate a corporation's tax, we first figure out the "normal income tax due."
Then, we compare it with something called the "minimum corporate income tax"
(MCIT). If the MCIT is higher than the normal tax due, we use the MCIT amount.
The MCIT is a fixed percentage (2% or 1% from July 1, 2020, to June 30, 2023) of
the corporation's gross income at the end of the taxable year. It's imposed on
taxable corporations starting from the fourth year after they begin their business
operations, but only if the MCIT is greater than the tax calculated using the
normal income tax rate.
Foreign Corporation:
➢ This term refers to a corporation that isn't local (domestic).
Resident Foreign Corporation:
➢ It's used for foreign corporations doing business in the Philippines. They pay
a 25% income tax starting from July 1, 2020, and might also have to deal
with the MCIT (minimum corporate income tax).
Non-Resident Foreign Corporation:
➢ This term is for foreign corporations that aren't doing business in the
Philippines. They have different tax rules.
Generally, the pro-forma computation of the income tax of non-resident foreign
corporations follows:
Gross Income
P xxx
Multiply by: Tax Rate (effective Jan. 1, 2021)
x 25%
Final Income Tax Withheld
xxx