LESSON 1: REVIEW OF BASIC ACCOUNTING (PART 1)

INTRODUCTION
Accounting has evolved, as in the case of medicine and law, in responses to the social
and economic needs of society. As business and society become more complex,
accounting develops new concepts and techniques to meet the ever-increasing needs for
financial information. Without such information, many complex economic developments
and social programs may have never been undertaken.
In a market economy, information helps decision-makers informed choices regarding the
allocation of scarce resources under their control. When decision-makers can make well-
informed decisions, resources are allocated in a way that better meets the needs and
goals of those within the market.
Accounting is relevant in all walks of life, and it is essential in the world of business.
Accounting is the system that measures business activities, processes that information
into reports and communicates the results to decision-makers. Accounting quantifies
business communication. For this reason, accounting is called the language of business.
The task of learning accounting is very similar to the task of learning a new language;
thus, the need for this book which teaches the basics of accounting in a very conceptual
manner.
No business could operate very long without knowing how much it was earning and how
much it was spending. Accounting provides the business with this information and more.
So, accountants can be called the scorekeepers of business. Without accounting, a
business could not function optimally; it wouldn’t know where it stands financially, whether
it’s making a profit or not, and it wouldn’t know its financial situation. Also. A sound
understanding of this language will bring put a better management of the financial aspect
of living. Personal financial planning education expenses, car amortization, business
loans income taxes and investments are based on the information system that we call
accounting.

DEFINITIONS AND NATURE OF ACCOUNTING

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 (Statement of Financial Accounting Standards No. 1, “Basic
Concepts and Accounting Principles Underlying Financial Statements of Business
Enterprises” (Manila: Accounting Standards Council, 1983), par. 1).
Accounting is an information system that measures, processes, and communicates
financial information about an economic entity (Statement of Financial Accounting
Concepts No. 1, “Objectives of Financial Reporting by Business Enterprises” (Norwalk,
Conn.: Financial Accounting Standards Board, 1997), par. 9).
Accounting is the process of identifying, measuring, and communicating economic
information to permit informed judgements and decisions by users of the information
(American Accounting Association, “A statement of Basic Accounting theory” (Evanston,
Ill.: American accounting association, 19960. Par 1; Accounting Principles Board,
Statement No. 4, Basics Concepts and Accounting Principles Underlying Financial
Statements of Business Enterprises” (New York: AICPA, 1970), par. 40).
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 (American Institute of certified Public
Accountants, “Review and Resumes” , Accounting Terminology Bulletin No.1 (New York:
AICPA, 1953), par .9).

FUNCTION AND PHASES OF ACCOUNTING

The accounting function is part of the broader business system and does not operate in
isolation. It handles the financial operations of the business but also provides information
and advice to other departments. Business transactions are the economic activities of the
business. Recording these historical events is a significant function of accounting.
Accounts are produced to aid management in planning, control and decision-making and
to comply with regulations.
Before the effects of transactions can be recorded, they must be measured. In order that
accounting information will be useful, it must be expressed in terms of a common financial
denominator-money. Money serves as both a medium of exchange and a measure of
value.
To measure a business transaction, the accountant must decide when the transaction
occurred (recognition issue), what value to place on the transaction (valuation issue) and
how the components of the transaction should be classified (classification issue).
By simply measuring and recording transactions, the resulting information will be of
limited use. To be useful in making decisions, the recorded data must be classified and
summarize.
Classification reduces the effects of numerous transactions into useful groups or
categorized. Summarization of financial data is achieved through the preparation of
financial statements. These summarize the effects of all business transactions that
occurred during some period.
After going through the preceding phases, it is imperative that the result of the
summarization phase be interpreted or analyzed to evaluate the liquidity, profitability, and
solvency of the business organization. Accounting provides the decision-makers with
information to make reasoned choices among alternative uses of scarce resources in the
conduct of business and economic activities.

OUTPUT OF THE ACCOUNTNG CYLCE

The output, outcome or “big picture” is being presented to pique your interest and
heighten your enthusiasm. An accounting information system is used by a business to
analyze transaction, handle routine bookkeeping tasks and structure information so it can
be used to evaluate the performance and health of the business. This is system generates
output in the form of financial reports which can further be categorized into internal and
external sports
Internal reports are used by those directly involved in the managing and operating the
business or collectively called the “management.” External reports, like the financial
statements, are used by individuals and organization that have an economic interest in
the business but are not part of its management, or the external users.

Financial Statement
Pro-forma general purpose financial statements are shown for ASEAN Traders, a
merchandising entity. These statements answer the following questions.
1. What were the operating results for the period?
2. How did equity change over the reporting period?
3. What is the entity’s financial status?
4. What are the cash flows from operating, investing, and financing activities during
the period
In a nutshell, the income statement presents a summary of the revenues and expenses
of an entity or a specific period. The statement of changes in equity presents a summary
of the changes in capital such investments, profit or loss and withdrawals during a specific
period.
The balance sheet (or statement of financial position provides a snapshot by listing all the
assets, liabilities, and equity of an entity as a specific date. The statement of cash flows
reports the amount of cash received and disbursed during the period.
Fundamental Business Model
For a business to be successful, it needs to develop a product or service that customers
will pay for and thus create a revenue stream. It can be a new product or service that
meets specific need. It can also be a better product or a service. Or, it can product or
service that offers a better value proposition. A business requires investment to enable it
to pay for the infrastructure, equipment and personal. Only after a skillful combination of
these element can be a business generate a revenue system.
Figure 1-1 illustrate how a business is structured to provide a customer proposition. The
business model is built on five activities:
1. First, the investors provide the required capital for the business. The cash investment
will be held in a bank account.
2. The cash in the business can be:
• Converted into another type of asset that will be use in the business. (e.g.
equipment) or sold (e.g. inventory); or
• Spent on operating cost such as salaries, rentals, and utilities
3. The combination of business resources provides the basis for the production product
or services.
4. The sale of a product or service generates an asset called a receivable. This asset
once collected will produce a cash inflow for the business.
5. If there is an existing debt from banks, the cash inflow from the collections will be used
to provide the dept providers with interest on their loans to the company. The rest of the
cash can be sent back on the cycle by being converted into other assets or spent on
operating costs (back to state 2). In the normal course of business. This whole process
will earn profits on which tax will have to be paid. Any profit after tax continue to be
reinvested in the cycle or paid out to the owners as a “return” on their investments.
The model illustrates the way money flows around a business and provides the basis of
accounting. To manage a business effectively it is important to know how to the cash has
been spent and how profitable the products or service have been to the business. The
availability of this historic information helps management to make judgments on how to
improve the performance of business.

FUNDAMENTAL CONCEPTS
Several fundamental concepts underlie the accounting process. In recording business
transactions, accountants should consider the following:
Entity concept. The most basic concept in accounting is the entity concept. An accounting
entity is an organization or a section of an organization that stands apart from other
organizations and individuals separate economic unit. Simply put, the transactions of
different entities should not be accounted together. Each entity should be evaluated
separately.
Periodicity Concept. An entity’s life can be meaningfully subdivided into equal time
periods for reporting purposes. It will be aimless to wait for the actual last day of
operations to perfectly measure the entity’s net income. This concept allows the users to
obtain timely information to serve as a basis on making decisions about future activities.
For the purposes of reporting to outsiders, on year is the usual accounting period.
Stable Monetary Unit Concept. 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.
Accrual Basic. Accrual accounting depicts the effects of transactions and other events
and circumstances on a reporting entity’s economic resources and claims in the periods
in which those effects occur, even if the resulting cash receipts and payments occur in a
different period.
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 enterprises has “neither the intention nor the necessity of
liquidation or curtailing materially the scale of its operations”.

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 principle. In order to generate information that is useful to
the users of financial statements, accountants rely upon the following principles:
Objectivity Principles. Accounting records and statements are based on the most reliable
data available so that they will be as accurate and as useful as possible. Reliable data
are verifiable when they can be confirmed by independent observers. Ideally, accounting
records are based on information that flows from activities documented by objective
evidence. Without this principle, accounting records would be based on whims and
opinions and is therefore subject to disputes.
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.
Revenue Recognition Principle. Revenue is to be recognized in the accounting period
when goods are delivered, or services are rendered or performed.
Expenses Recognition Principle. Expenses should be recognized in the accounting period
in which goods and services are used up to produced 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 is only concerned with information that would affect 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. In deciding
whether an item or an aggregate of item is material, the nature and size of the item are
evaluated together. Depending on the circumstances, either the nature or the size of the
item could be the determining factor.
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.
QUALITATIVE CHARACTERISTICS OF USEFUL FINANCIAL INFORMATION
The qualitative characteristics of useful financial reporting identify the types of information
are likely to be most useful to users in making decisions about the reporting entity on the
basis of information in its financial report. The qualitative characteristics apply equally to
financial information in general-purpose financial reports as well as to financial
information provided in other ways. The IFRS Framework identifies two fundamental
qualitative characteristics and four enhancing characteristics as follows:

Financial information is useful when It is relevant and represents faithfully what is purports
to represent. The usefulness of financial information is enhanced if it is comparable,
verifiable, timely, and understandable.

THE ACCOUNT
The basic summary device if accounting is the account. A separate accountant is
maintained for each element that appears in the balance sheet (assets, liabilities, and
equity) and in the income statement (income and expenses). Thus, an accountant may
be defined as detailed record of the increases, decreases, and balanced of each element
that appears in an entity’s financial statements. The simplest form of the account is known
as the “T” account because of its similarity to the letter “T”. The account has three parts
as shown:
THE ACCOUNTING EQUATION
Financial statements tell us how a business is performing. They are the final products of
the accounting process. But how do we arrive at the items and amounts that make us the
financial statements? The most basic tool of accounting is the accounting equation. This
equation presents the resources controlled by the enterprise, the present obligations of
the enterprise and the residual interest in the assets. It states that assets must always
equal liabilities and owner’s equity.
The basic accounting model is:
Assets = Liabilities + Owner’s Equity
Note that the assets are ion the left side of the equation opposite the liabilities and owner’s
equity. This explains why increases and decreases in assets are recorded in the opposite
manner (“mirror image”) as liabilities and owner’s equity are recorded. The equation also
explains why liabilities and owner’s equity follow the same rules of debit and credit.
The logic of debiting and crediting is related to the accounting equation. Transactions may
require additions to both sides (left and right sides), subtractions from both sides (left and
right sides), or an addition and subtraction on the same side (left or right side), but in all
cases the equality must be maintained.

DEBITS AND CREDITS - THE DOUBLE-ENTRTY SYSTEM

Accounting is based in a double-entry system which means that the dual effects of a
business transactions is recorded. A debit side entry must have a corresponding credit
side entry. For every transaction, there must be one or more accountants debited and
one or more accounts credited. Each transaction affects at least two accounts. The total
debits for a transaction must always equal the total credits.

An account is debited when an amount is entered on the left side of the account and
credited when an amount is entered on the right side. The abbreviations for debit and
credit are Dr. (from the Latin debere) and Cr. (from the Latin credere), respectively.
The account type determines how increases or decreases in it are recorded. Increases in
assets are recorded as debits (on the right side of the account) while decreases in assets
are recorded as credits (on the right side). Conversely, increases in liabilities and owner’s
equity are recorded by credits and decreases are entered as debits.
The rules of debit and credit for income and expense accounts are based on the
relationship of these accounts to owner’s equity. Income are recorded as credits and
decrease as debits. Increases in expenses are recorded as debits and decreases as
credits. These are the rules of debit and credit.
The following summarizes the rules:
Here is another way of summarizing the rules:

NORMAL BALANCE OF AN ACCOUNT

The normal balance of any account refers to the side of the account-debit or credit –
where increases are recorded. Asset, owner’s withdrawal, and expense accounts
normally have debit balances; liability, owner’s equity and income accounts normally have
credit balances. This result occurs because increases in an account are usually greater
than or equal to decreases.

ACCOUNTING CYCLE
The accounting cycle refers to a series of sequential steps or procedures performed to
accomplish the accounting process. The steps in the cycle and their aims follow:
Step 1. Identification of events to be recorded
 Aim: To gather information about transactions or events generally through the
source documents.
Step 2. Transactions are recorded in the journal
Aim: To record the economic impact of transactions on the firm in a journal, which
is a form that facilitates transfer to the accounts
Step 3. Journal Entries are posted to the ledger
Aim: To transfer the information from the journal to the ledger for classification.
Step 4. Preparation of a Trial Balance
Aim: To provide a listing to verify the equality of debits and credits in the ledger.
Step 5. Preparation of the Worksheet including Adjusting Entries
Aim: To aid in preparation of financial statements.
Step 6. Preparation of the Financial Statements
Aim: To provide useful information to decision-makers.
Step 7. Adjusting Journal Entries are Journalized and Posted
Aim: To record the accruals, expiration of deferrals, estimation, and other events
from the worksheet
Step 8. Closing Journal Entries are Journalized and Posted
Aim: To close temporary accounts and transfer profit to owner’s equity.
Step 9. Preparation of a Post-Closing Trial Balance
Aim: To check the equality of debits and credits after the closing entries
Step 10. Reversing Journal Entries are Journalized and Posted
Aim: To simplify the recording of certain regular transactions in the next accounting
period.
This cycle is repeated each accounting period. The first three steps in the accounting
cycle are accomplished during the period. The fourth to the ninth steps generally occur at
the end of the period. The last step is optional and occurs at the beginning of the next
period.
Source:
Ballada, W. (2018). Fundamentals of Accountancy Business & Management 2. DomDane
Publishers.