Download Accounting Principles and Practices: An Introduction and more Summaries Accounting in PDF only on Docsity!
Accounting Principles and
Practices
Introduction to Accounting
Accounting
Accounting is the process of identifying, recording, and communicating economic information that is useful in making economic decisions.
Essential Elements of the Definition of Accounting
a. Identifying : Analyzes each business transaction and identifies whether the transaction is an accountable event or non-accountable. Only accountable events are recorded in the book of accounts. An accountable event is one that affects the assets, liabilities, equity, income, or expenses of a business.
b. Recording : The accountant recognizes the identified accountable events. This process is called journalizing. After the journalizing, it classifies the effects of the event on the "accounts". The process is called posting. An account is the basic storage of information in accounting.
c. Communicating : At the end of each accounting period, the accountant summarizes the information processed in the accounting system in order to produce meaningful reports. Information processed in the accounting system is useless unless it is communicated. The most common form of accounting reports is financial statements.
Nature of Accounting
Accounting is a process with a basic purpose of providing information about economic activities that is intended to be useful in making economic decisions.
Types of Information Provided by Accounting
Quantitative information : Expressed in numbers, quantities, or units. Qualitative information : Expressed in words or descriptive form. It is found in the notes to financial statements and in the face of other components of the financial system. Financial information : Expressed in money. It can also be a quantitative information because monetary amounts are expressed in numbers.
Accounting as Science and Art
Social science : Accounting is a body of knowledge which has been systematically gathered, classified, and organized. Practical art : Accounting requires the use of creative skills and judgment.
Accounting as an Information System
A system is one that consists of an input, process, and output. In the accounting system, the inputs are the identified accountable events; the process are recording, classifying, and summarizing; the output is the accounting report that is communicated to others.
Bookkeeping vs. Accounting
Bookkeeping refers to the process of recording the accounts or transactions of an entity. It does not require interpretation of the significance of the information processed.
Accounting covers the whole process of identifying, recording, and communicating information to interested users.
Functions of Accounting in Business
Accounting is the language of business because it is fundamental to the communication of financial information. The functions of accounting are:
To provide external users with information that is useful in making investment and credit decisions. To provide internal users with information that is useful in managing the business.
Users of Accounting Information
Internal users : Directly involved in managing the business. External users : Not directly involved in managing the business.
Types of Accounting Information
General purpose accounting information : Designed to meet the common needs of most statement users. Provided by financial accounting and prepared primarily for external users. Special purpose accounting information : Designed to meet the specific needs of particular statement users. Provided by management accounting and prepared primarily for external users.
Corporation : A business owned by more than one individual. However, it is created by operations of law. Ownership in a corporation is represented by shares of stocks. A corporation is an artificial being or juridical person, meaning in the eyes of the law, a corporation is like a person, separate from its owners. Therefore, a corporation can transact on its own, have its own properties, incur its own obligations, and sue or be sued. Cooperative : A business owned by more than one individual. It is formed in accordance with the provisions of the Philippine Cooperative Code of 2008. A cooperative is an association of individuals who joined together to contribute capital and cooperate in order to achieve certain goals. Members need to patronize the cooperative's goods or services. If a cooperative earns a profit, a member can recover his costs through patronage funds.
Types of Business According to Activities
Service Business : One that offers services as its main product rather than physical goods. It may offer professional skills, expertise, advice, lending service, and similar services. Merchandising Business (Trading Business) : One that buys and sells goods without changing their physical form. Manufacturing Business : One that buys raw materials and processes them into final products. It changes the physical form of the goods it has purchased in a production process.
Some businesses, called hybrid businesses, engage in more than one type of activity.
Accounting Concepts and Principles
Accounting concepts and principles (assumptions or postulates) are a set of logical ideas and procedures that guide the accountant in recording and communicating economic information. They provide reasonable assurance that information communicated to users is prepared in a proper way.
Basic Accounting Concepts
Separate Entity Concept : The business is viewed as a separate person, distinct from its owners. Only the transactions of the business are recorded in the books of accounts. The application of the separate entity concept is necessary so that the financial position and financial performance of a business can be measured properly.
Historical Cost Concept : Assets are initially recorded at their acquisition cost. The business is assumed to continue to exist for an indefinite period of time. This is necessary for accounting measurements to be meaningful. The opposite of this is the liquidating concern, where the assets of a liquidating concern are measured at net selling price.
Going Concern Concept : The business is assumed to continue to exist for an indefinite period of time. This is necessary for accounting measurements to be meaningful.
Matching (Association of Cause and Effect) : Some costs are initially recognized as assets and charged as expenses only when the related revenue is recognized.
Accrual Basis of Accounting : Economic events are recorded in the period in which they occur rather than at the point in time when they affect cash.
Prudence or Conservatism : The accountant observes some degree of caution when exercising judgments needed in making accounting estimates under conditions of uncertainty.
Time Period (Periodicity, Accounting Period, Reporting Period Concepts) : The life of the business is divided into a series of reporting periods, usually 12 months, which can either be a calendar year period or a fiscal year period. An accounting period that is shorter than 12 months is called an "interim period".
Stable Monetary Unit : Assets, liabilities, equity, income, and expenses are stated in terms of a common unit of measure, which is the peso in the Philippines. The purchasing power of the peso is regarded as stable.
Materiality Concept : This guides the accountant when applying accounting principles. Accounting principles are applicable only to material items, where their omission or misstatement could influence economic decisions. Materiality is a matter of professional judgment and is based on the size and nature of an item.
Cost-Benefit (Cost Constraint) : The costs of processing and communicating information should not exceed the benefits to be derived from the information's use.
Full Disclosure Principle : Related to both the concepts of materiality and cost-benefit. Under this, information communicated to users reflects a series of judgmental trade-offs that strive for sufficient detail to disclose matters that make a difference to users, yet sufficient condensation to make the information understandable, keeping in mind the costs of preparing and using it.
Consistency Concept : This concept requires a business to apply accounting policies consistently, and present information consistently, from one period to another. Accounting policies can be changed if it is required by a standard or if the change would result in more relevant and more reliable information.
Cooperative Development Authority (CDA) - Tasked in regulating cooperatives and influences the selection and application of accounting policies by cooperatives.
The Conceptual Framework for Financial Reporting
The Conceptual Framework for Financial Reporting also prescribes accounting concepts that are relevant to the preparation of financial statements. It is not a standard but serves as a general frame of reference for developing the standards.
Qualitative Characteristics of Useful Financial Information
Qualitative characteristics are traits that determine whether an item of information is useful to others. Without these, information may be deemed useless. These are broadly classified into two:
Fundamental Qualitative Characteristics
Relevance : Can affect the decisions of users. Without this trait, information is deemed useless. It can help users make predictions about future outcomes (predictive value) or confirm their past predictions (confirmatory value). Materiality is an entity-specific aspect of relevance. Faithful Representation : If the information is factual, meaning it represents the actual effects that have taken place, and all information for users to have a complete understanding of the financial statements is provided. It should also be neutral, meaning it is selected without bias and not manipulated, and free from material error.
Enhancing Qualitative Characteristics
Comparability : If it can help users identify similarities and differences between sets of information, and if different users could reach a general agreement as to what the information intends to present. Verifiability : If it is available to users in time to be able to influence their decisions and is presented in a clear and concise manner.
The Accounting Equation
The Basic Accounting Equation
Assets = Liabilities + Equity
Assets
Economic resources you control that have resulted from past events and can provide you with economic benefits.
Control does not necessarily mean ownership, but rather the exclusive right to enjoy the economic benefits and the ability to prevent others from enjoying those. The control over an economic resource must have resulted from a past event or transaction, and the resource must have the potential to provide economic benefits in at least one circumstance.
Liabilities
Present obligations that have resulted from past events and can require you to give up economic resources when settling them. Obligations can either be a result of a contract, legislation, or other operation of law, or a result of your past actions that have created a valid expectation on others that you will accept and discharge certain responsibilities. Settling the obligation necessarily would require you to pay cash, transfer other non-cash assets, or render a service.
Equity
Assets minus Liabilities. Represents the owners' claim against the total assets of the business.
The Expanded Accounting Equation
Assets = Liabilities + Equity + Income - Expenses
Income
Increases in economic benefits during the period in the form of increases in assets or decreases in liabilities that result in increases in equity.
Expenses
Decreases in economic benefits during the period in the form of decreases in assets or increases in liabilities that result in decreases in equity, excluding those relating to distributions to the business owners.
Types of Major Accounts
The Account
The basic storage of information in accounting. A record of increases and decreases in a specific item of asset, liability, equity, income, or expense. It can be depicted through a "T-account" with three parts: account title, debit side, and credit side. Debit (Dr.) represents value received, while Credit (Cr.) represents value parted with.
Utilities Expense
Utilities expense refers to the cost of utilities earned during the period. This includes the cost of electricity, water, gas, and other utility services consumed by the business.
Supplies Expense
Supplies expense refers to the cost of supplies used up during the period. This includes the cost of office supplies, cleaning supplies, and other consumable items necessary for the business operations.
Bad Debt Expense
Bad debt expense, also known as doubtful accounts expense, refers to the estimated losses from uncollectible accounts receivable. This expense represents the portion of accounts receivable that is not expected to be collected.
Depreciation Expense
Depreciation expense refers to the systematic allocation of the cost of a long-term asset over its useful life. This expense represents the portion of the asset's cost that is consumed during the period.
Advertising Expense
Advertising expense refers to the cost of promotional or marketing activities undertaken by the business. This includes the cost of advertising campaigns, marketing materials, and other promotional efforts.
Insurance Expense
Insurance expense refers to the cost of insurance coverage during the period. This includes the premiums paid for various insurance policies, such as property, liability, and workers' compensation insurance.
Taxes and Licenses
Taxes and licenses refer to the cost of business and local taxes required by the government. For partnerships and corporations, this may include income tax expense.
Transportation Expense
Transportation expense refers to the cost of employees traveling from one workplace to another. This expense is typically reimbursable to the employees.
Travel Expense
Travel expense refers to the cost of business trips, including transportation, accommodation, and other related expenses.
Interest Expense
Interest expense refers to the cost of borrowing money, such as interest paid on loans or other financing arrangements.
Miscellaneous Expense
Miscellaneous expense refers to small expenditures that do not fit into any of the other expense categories.
Losses
Losses refer to expenses that may or may not arise from the ordinary course of the business, such as the sale of assets for less than their carrying amount or a decrease in the value of assets due to destruction or damage.
The Books of Accounts and Double-Entry
System
The Journal
The journal, also known as the "book of original entries," is the accounting record where business transactions are first recorded. The process of recording transactions in the journal is called journalizing.
Special Journals
Special journals are used to record transactions of a similar nature, simplifying the recording process and providing an efficient way of recording and retrieving information. Examples of special journals include: - Sales Journal: used to record sales on account - Purchases Journal: used to record purchases of inventory on account - Cash Receipts Journal: used to record all transactions involving receipts of cash - Cash Disbursements Journal: used to record transactions involving payments of cash
General Journal
If a transaction cannot be recorded in a special journal, it is recorded in the general journal.
The Ledger
The ledger, also known as the "book of secondary entries" or "book of final entries," is where the information from the journal is transferred.
accountable events are recorded in the journals. 3. Posting: The information from the journal is transferred to the ledger. 4. Unadjusted Trial Balance: The balances of the general ledger accounts are proved as to equality of debits and credits, serving as a basis for adjusting entries. 5. Adjusting Entries: The accounts are updated as of the reporting date on an accrual basis by recording accruals, expiration of deferrals, estimations, and other events. 6. Adjusted Trial Balance: The equality of debits and credits is rechecked after adjustments are made, serving as a basis for the preparation of the financial statements. 7. Financial Statements: The information processed is communicated to users. 8. Closing the Books: Temporary accounts are closed, and the resulting profit or loss is transferred to an equity account. 9. Post-Closing Trial Balance: The equality of debits and credits is again rechecked after the closing process. 10. Reversing Entries: Reversing entries are usually made at the beginning of the next accounting period to simplify the recording of certain transactions in that period.
Source Documents
Source documents are the primary evidence of business transactions, including: - Sales Invoices - Official Receipts - Purchase Orders - Delivery Receipts - Bank Deposit Slips - Bank Statements - Checks - Statements of Account
Types of Events
External Events: Transactions that involve the business and another external party. Internal Events: Events that do not involve an external party, only the business itself.
Simple and Compound Journal Entries
Simple Journal Entry: Contains a single debit and a single credit. Compound Journal Entry: Contains two or more debits or credits.
Posting
Posting is the process of transferring data from the journal to the appropriate accounts in the ledger.
Trial Balance
The trial balance is a list of general ledger accounts and their balances, which checks the equality of total debits and credits in the ledger. There are three types of trial balances: 1. Unadjusted Trial Balance: Prepared before adjusting entries are made. 2. Adjusted Trial Balance: Prepared after adjusting entries but before the financial statements are prepared. 3. Post- Closing Trial Balance: Prepared after the closing process.
Errors Revealed by a Trial Balance
The trial balance can reveal errors that cause the total debits and total credits to be unequal, such as: 1. Journalizing or posting one-half of an entry.
- Recording one part of an entry for a different amount than the other part.
- Transplacement error on one side of an entry. 4. Transposition error on one side of an entry.
Errors Not Revealed by a Trial Balance
The trial balance cannot reveal errors that do not cause the debits and credits to be unequal, such as: 1. Omitting entirely the entry for a transaction. 2. Journalizing or posting an entry twice. 3. Using the wrong account with the same normal balance as the correct amount. 4. Wrong computation with the same erroneous amount posted to both debit and credit sides.
Heading of the Trial Balance
The heading of the trial balance should include: 1. Name of the business 2. Title of the report 3. Date of the report
Order of Account Titles in the Unadjusted Trial Balance
The account titles in the unadjusted trial balance should be presented in the following order: Assets, Liabilities, Equity, Income, Expenses.
Accounting for Prepayments and Deferrals
Unadjusted Prepayments and Deferrals
Prepayments (prepaid assets) and deferrals (unearned income) have both expired and unexpired components. The expired portion is the nominal account component, while the unexpired portion is the real account component. These are separated because the nominal account should be in the income statement, while the real account is in the balance sheet.
Methods of Initial Recording of Income and Expenses
Income
Liability Method : Advanced collections of income are initially credited to a liability account. At the end of the period, the "earned portion" is recognized as income, while the "unearned" portion remains as a liability. Income Method : Advanced collections of income are initially credited to an income account. At the end of the period, the "unearned portion" is recognized as a liability, while the "earned" portion remains as income.
Rules of Debits and Credits
Debit and Credit or vice versa: Subtract Cross-footing: Adding or subtracting amounts horizontally in accounting reports Footing: Adding or subtracting amounts vertically in accounting reports Double Rule: Two lines underneath an amount, used to connote a total or the end of a computation
Financial Statements
The financial statements are the end products of the accounting process and the means by which information is summarized and communicated to users. They include:
Statement of Financial Position (Balance Sheet): Shows the assets, liabilities, and equity of a business. Statement of Profit or Loss (Income Statement): Shows the income and expenses, and consequently, the profit or loss of a business.
Profit or Loss
Profit: Debits exceed credits Loss: Credits exceed debits Profit or Loss for the period is the balancing figure in the Income Statement and Balance Sheet.
Closing Entries
Closing entries are prepared at the end of the accounting period to "zero out" all nominal accounts in the ledger. The Income Summary is a clearing account used in this process.
Post-Closing Trial Balance
The post-closing trial balance is prepared to check the equality of the debits and credits in the general ledger after the closing entries are made. It contains only real accounts.
Reserving Entries
Reserving entries are usually made on the first day of the next accounting period to reverse certain adjusting entries in the immediately preceding period. These may include:
Accruals for income or expense Prepayments (expense method) Advance collections (income method)
Accounting Cycle of a Merchandising
Business
Merchandising Business
A merchandising business buys and sells goods without changing their physical form, in contrast to a service business.
Inventory Systems
Perpetual Inventory System : The Inventory account is updated each time a purchase or sale is made, maintaining a continuing or running balance of the goods on hand. Periodic Inventory System : The Inventory account is updated only when a physical count of inventory is performed.
Accounts Used in a Merchandising Business
Purchases : Records the purchase of inventory under the periodic system. Freight-In (Transportation-In) : Records the shipping costs incurred on purchases of inventory under the periodic system. Purchase Returns : Records returns of purchased goods to the supplier. Purchase Discounts : Records cash discounts availed of on the purchased goods. Sales : Includes both cash sales and credit sales. Sales Returns : Records goods returned by customers. Sales Discounts : Records cash discounts given to customers.
Partnership Formation
Characteristics of a Partnership
a. Ease of formation b. Separate legal personality c. Mutual agency d. Co- ownership of property e. Co-ownership of profits f. Limited life g. Transfer of ownership h. Unlimited liability
Types of Partnerships
General Partnership : All partners are individually liable. Limited Partnership : Includes at least one general partner with unlimited liability and limited partners who may limit their liability up to the extent of their contributions. Limited Liability Partnership (LLP) : Usually has "LLP" in its name.
Salaries
Normally, an industrial partner receives a salary in addition to their share in the partnership's profits as compensation for their services to the partnership.
Bonuses
The managing partner may be entitled to a bonus for excellent management performance. Unlike salaries, a partner is entitled to a bonus only if the partnership earns a profit. The partner is not entitled to any bonus if the partnership incurs a loss.
The partnership agreement may also stipulate that capitalist partners are entitled to an annual interest on their capital contributions.
The items above are normally provided first to the respective partners, and any remaining amount of the profit or loss is shared among the partners based on their stipulated profit or loss ratio.
Partnership Dissolution
Dissolution
One of the characteristics of a partnership is that it has a "limited life," in the sense that the partnership agreement can be easily dissolved. Dissolution is the change in the relation of the partners caused by any partner being disassociated from the business. Dissolution is different from liquidation, which is the termination of business operations or the winding up of affairs. Partnership dissolution does not necessarily terminate the business, as the business may continue until the remaining partners decide to liquidate it. If the business is continued after dissolution, new articles of partnership should be drawn up.
The major considerations in the accounting for partnership dissolutions are:
Admission of a Partner
The admission of a new partner or the withdrawal, retirement, or death of an existing partner dissolves the original partnership agreement because it creates a change in the relation of the partners (e.g., a change in the number of the partners in a partnership). It should be noted that the admission of a new partner requires the consent of all existing partners.
Admission of a Partner: Purchase of Interest
A new partner may be admitted when they purchase part or all of the interest of one or more of the existing partners. This transaction is a personal transaction between and among the partners, and any consideration paid or received is not recorded in the partnership books. The only entry to be made in the partnership books is a transfer within equity. A
new capital account is established for the new partner, and a corresponding decrease is made on the capital account(s) of the selling partner(s). No gain or loss is recognized in the partnership books.
Admission of a Partner: Investment in the Partnership
Instead of purchasing interest from the existing partners, a new partner may be admitted by investing directly in the business. This transaction is a transaction between the new partner and the partnership, and any consideration paid by the incoming partner is recorded in the partnership books. However, because this is a transaction with an owner, no gain or loss is recognized.
When a new partner invests in a partnership, two things may happen:
The new partner's capital account is credited at an amount equal to the fair value of their investment. The new partner's capital account is credited at an amount greater than or less than the fair value of their investment. This scenario is accounted for under the "bonus method," where any increase (or decrease) in the capital of the new partner is a reduction (or addition) to the capital of the existing partners.
Withdrawal, Retirement, or Death of a Partner
When a partner withdraws, retires, or dies, their interest may be purchased by (a) one or all of the remaining partners or (b) the partnership. In the case of death, the deceased partner's estate is entitled to the value of the partner's interest at the date of their death.
The interest of the withdrawing, retiring, or deceased partner is adjusted for their share of any profit or loss during the period up to the date of their withdrawal, retirement, or death, and their share of any revaluation gains or losses as at the date of their withdrawal, retirement, or death.
Withdrawal, Retirement, or Death of a Partner: Purchase
by Remaining Partners
One or all of the remaining partners may purchase the interest of the retiring, withdrawing, or deceased partner. This is a transaction between and among the partners (or deceased partner's estate), and the settlement amount is not recorded in the partnership books. The only entry to be made is a transfer within equity, after recording any necessary adjustments.
Withdrawal, Retirement, or Death of a Partner: Purchase
by the Partnership
The partnership may purchase the interest of the retiring, withdrawing, or deceased partner. This is a transaction between the retiring or withdrawing partner (or deceased partner's estate) and the partnership, and the
