BFAR 1st lesson.docx

**ACCOUNTING AND ITS ENVIRONMENT** **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 needs. It can also be a better product or...

**ACCOUNTING AND ITS ENVIRONMENT** **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 needs. It can also be a better product or service. Or, it can be a product or service that offers a better value proposition. A business requires investments to enable it to pay for the infrastructure, equipment and personnel. Only after a skillful combination of these elements can a business generate a revenue stream. Figure 1-1 illustrates 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 then be held in a bank account. 2.  The cash in the business can be: 1. converted into another type of asset that will be used in the business (e.g. equipment) or sold (e.g. inventory); or 1. spent on operating costs such as salaries, rentals and utilities. 3. The combination of business resources provides the basis for producing the products 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\'s an existing debt from banks, the cash inflow from collections will be used to provide the debt providers with interest on their loans to the company. The rest of the cash can be sent back to the cycle by being converted into other assets or spent on operating costs (back to stage 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 can 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 the cash has been spent and how profitable the products or services have been to the business. The availability of this historic information helps management to make judgments on how to improve the performance of business. **TYPES OF BUSINESS** Although the fundamental business model does not vary, there are infinite ways of applying it to provide the range of products and services that make up the business world. However, the range of products and services can be summarized in seven broad categories, they are as follows: +-----------------+-----------------+-----------------+-----------------+ | Types | Activity | Structure | Examples | +=================+=================+=================+=================+ | Service | Selling | Hiring skilled | Software | | | people's time | staff and | development | | | | selling their | | | | | time | Accounting | | | | | | | | | | Legal | +-----------------+-----------------+-----------------+-----------------+ | Trader | Buying and | Buying a range | Wholesaler | | | selling | of raw | | | | products | materials and | Retailer | | | | manufactured | | | | | goods and | | | | | consolidating | | | | | them, making | | | | | them available | | | | | for sale in | | | | | locations near | | | | | to their | | | | | customers or | | | | | online for | | | | | delivery | | +-----------------+-----------------+-----------------+-----------------+ | Manufacture | Designing | Taking raw | Vehicle | | | products, | materials and | Assembly | | | aggregating | using equipment | | | | components and | and staff to | Construction | | | assembling | convert them | | | | finished | into finished | Engineering | | | products | goods | | | | | | Electricity, | | | | | Water Food and | | | | | drink | | | | | | | | | | Chemicals | | | | | | | | | | Media | | | | | | | | | | Pharmaceuticals | +-----------------+-----------------+-----------------+-----------------+ | Raw materials | Growing or | Buying blocks | Farming | | | extracting raw | of land and | | | | materials | using them to | Mining | | | | provide raw | | | | | materials | Oil | +-----------------+-----------------+-----------------+-----------------+ | Infrastructure | Selling the | Buying and | Transport | | | utilization of | operating | (airport | | | infrastructure | assets | operator, | | | | (typically | airlines, | | | | large assets); | trains, | | | | selling | ferries, buses) | | | | occupancy often | | | | | in combination | Hotels | | | | with services | | | | | | Telecoms | | | | | | | | | | Sports | | | | | facilities | | | | | | | | | | Property | | | | | management | +-----------------+-----------------+-----------------+-----------------+ | Financial | Receiving | Accepting cash | Bank | | | deposits, | from depositors | | | | lending and | and paying them | Investment | | | investing money | interest; using | house | | | | the money to | | | | | provide loans | | | | | to borrowers, | | | | | charging them | | | | | fees and a | | | | | higher rate of | | | | | interest than | | | | | the depositors | | | | | receive | | +-----------------+-----------------+-----------------+-----------------+ | Insurance | Pooling | Collecting cash | Insurance | | | premiums of | from many | | | | many to meet | customers; | | | | claims of a few | investing the | | | | | money to pay | | | | | the losses | | | | | experienced by | | | | | a few | | | | | | | | | | customers. By | | | | | understanding | | | | | the risk | | | | | accepted and | | | | | the likelihood | | | | | of a claim, | | | | | more premium | | | | | income can be | | | | | earned than | | | | | claims paid | | +-----------------+-----------------+-----------------+-----------------+ **FORMS OF BUSINESS ORGANIZATIONS** Any of the above types of activities may be performed by a business organization be it a sole proprietorship, a partnership or a corporation. A business generally assumes one of the three forms of organization. The accounting procedures depend on which form the organization takes. **Sole Proprietorship**. This business organization has a single owner called the proprietor who generally is also the manager. Sole proprietorships tend to be small service-type (e.g. physicians, lawyers and accountants) businesses and retail establishments. The owner receives all profits, absorbs all losses and is solely responsible for all debts of the business. From the accounting viewpoint, the sole proprietorship is distinct from its proprietor. Thus, the accounting records of the sole proprietorship do not include the proprietor\'s personal financial records. **Partnership**. A partnership is a business owned and operated by two or more persons who bind themselves to contribute money, property, or industry to a common fund, with the intention of dividing the profits among themselves. Each partner is personally liable for any debt incurred by the partnership. Accounting considers the partnership as a separate organization, distinct from the personal affairs of each partner.  **Corporation**. A corporation is a business owned by its stockholders. It is an artificial being created by operation of law, having the rights of succession and the powers, attributes and properties expressly authorized by law or incident to its existence. The stockholders are not personally liable for the corporation\'s debts. The corporation is a separate legal entity.  **MICRO, SMALL AND MEDIUM ENTERPRISES** Big business may be the country\'s top taxpayers and highest paying employers. Collectively, though, micro, small and medium enterprises (MSMEs) provide employment for 61% of the country\'s labor force. According to the National Statistics Office, MSMES in 2010 accounted for 99.6% of the total business enterprises at 777,687. The 99.6% is broken down as follows: micro enterprises, 91.6% and SMEs, 8%. In terms of economic output, MSMEs account for only 32%. Then, 68% of the economy\'s total output can be attributed to the largest 0.4% of Philippine enterprises, or 3,023 out of a total 777,687 firms counted in 2010. But MSMEs hold. the key to our economic progress, the challenge lies in being able to increase productivity of the MSMEs; also, there\'s a need to further increase their number and in the process help create more jobs. MSMEs in China provide 74% of the jobs and in Japan, 78%; in ASEAN, 68% in Singapore, 77% in Thailand and 97% in Indonesia. Indonesia\'s MSMEs contribute 57% to gross domestic product. On May 23, 2008, Republic Act No. 9501 was signed into law by President Gloria Macapagal-Arroyo. This law seeks to address problems facing MSMEs, particularly the lack of capital and access to credit. Under the law, banks and lending institutions are now required to allocate at least 10% of their total loan portfolio to MSMEs, broken down as follows: 8% to micro and small enterprises, and 2% to medium enterprises. The old law provided only for a total of 8%. The new law also gives the Small Business Corporation, the government financial institution created to assist MSMEs, more financial muscle by increasing its authorized capital stock to P10.0 billion.  The law also updated the definitions of MSMEs by increasing the net assets threshold. Micro enterprises are those with assets, before financing, of P3.0 (before P1.5 million) or less and employ not more than nine workers. Small enterprises are those with assets, before financing, of above P3.0 (before P1.5 million) to P15 million and employ 10 to 99 workers. Medium enterprises have assets, before financing, of above P15 million to P100 million and employ 100 to 199 workers. More than ever, the government should promote and build an entrepreneurial culture and environment to spark an entrepreneurial revolution among the Filipino youth. In the US, 97% of the 28 million firms are small-and medium-scale enterprises (SMEs) with less than US\$1.0 million annual gross sales. This means that even in advanced economies, SMEs make up a big majority in terms of numbers. in China, entrepreneurship has taken 250 million Chinese out of poverty over the last decades. **ACTIVITIES IN BUSINESS ORGANIZATIONS** Many types of decisions are made in business organizations. Accounting provides important information to make these decisions. The three types of organizational activities are as follows: financing, investing, and operating. **Financing Activities** Organizations require financial resources to obtain other resources used to produce goods and services. They compete for these resources in financial markets. Financing activities are the methods an organization uses to obtain financial resources from financial markets and how it manages these resources. Primary sources of financing for most businesses are owners and creditors, such as banks and suppliers. Repaying the creditors and paying a return to the owners are also financing activities. **Investing Activities** Managers use capital from financing activities to acquire other resources used in the transformation process-that is, to transform resources from one form to a different form, which is more valuable, to meet the needs of the people. Having the right mix of resources is essential to efficient and effective operations. An **efficient** business is one that provides goods and services at low costs relative to their selling prices. An **effective** business is one that is successful in providing goods and services demanded by the customers. **Investing activities** involve the selection and management including disposal and replacement of long-term resources that will be used to develop, produce, and sell goods and services. Investing activities include buying land, equipment, buildings and other resources that are needed in the operation of the business, and selling these resources when they are no longer needed. **Operating Activities** Operating activities involve the use of resources to design, produce, distribute, and market goods and services. Operating activities include research and development, design and engineering, purchasing, human resources, production, distribution, marketing and selling, and servicing. Organizations compete in supplier and labor markets for resources used in these activities. Also, they compete in product markets to sell the goods and services created by operating activities. **PURPOSE 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 a 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 summarized. Classification reduces the effects of numerous transactions into useful groups or categories. 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. **PACIOLI\'S DOUBLE-ENTRY BOOKKEEPING AND ITS EVOLUTION** In Fra Luca Pacioli\'s book, Summa, there are 36 short chapters on bookkeeping. Luca states that to be successful every merchant needs three essential things: sufficient cash or credit, a good bookkeeper, and an accounting system to view the business affairs at a glance. He discusses three books in the Summa: the memorandum, the journal and the ledger. In Pacioli\'s book, he introduces the double-entry, accounting system-in which for every debet dare (should give) there exists a debet habere (should have or should receive). Modern bookkeeping systems are still based on principles established in the 15th century, although they have had to be adapted to suit modern conditions. In Summa, the **memorandum** is the book where all transactions are recorded, in the currency in which they are conducted, at the time they are conducted. The memorandum, prepared in chronological order, is a narrative description of the business\'s economic events. The memorandum is necessary because there are no documents tó support transactions. The second book, the **journal**, is the merchant\'s private book. The entries made here are in one currency, in chronological order, and in narrative form. The last book, known as the **ledger,** is an alphabetical listing of all the business\'s accounts along with the running balance of each particular account. What is interesting is that Pacioli never discusses financial statements, that, is, statements prepared to communicate the results of business activities to interested users. At that time, financial statements are unnecessary because businesses are still closely controlled by owners who can examine the business\'s records. However, Pacioli does advocate an annual balancing to determine the success or failure of the business and to find errors. Why has a recording system devised in medieval times lasted for so long? There are two main reasons: it provides an accurate record of what has happened to a business over a specified period of time; and information extracted from the system can help the owner or the manager operate the business much more effectively. In essence, the system provides the answers to three basic questions which owners want to know: What profit has the business made? How much does the business owe? How much is owed to it? The medieval system dealt largely with simple agricultural and trading entities. Modern systems have to reflect complex industrial operations and sophisticated financial arrangements. Furthermore, a business may be so big or so complex nowadays that the owners have to employ managers to run it for them. Indeed, the senior managers themselves may largely depend. upon their junior colleagues to tell them what is happening. A traditional bookkeeping system did not have to deal with situations where owners were separated from managers. It was designed largely to supply summarized information only to the owner-managers of a business who knew in detail from their own experience what was going on. The system was not intended to cope with frequent day-to-day reporting remote from production or trading operations. As a result, Pacioli\'s system had to be adapted for modern business practice so that it can satisfy the demand for information from two main sources: 1. from owners, who want to know from time to time how the business is doing; 2. from the managers, who need information in order to help plan and control it. Owners and managers do not necessarily require the same information and so based on this accounting has developed into two main specializations: 1. Financial Accounting, which is concerned with the supply of information to the owners of an entity; and 2. Management Accounting, which is concerned with the supply of information to the managers of an entity. While it is useful to classify accounting into these two broad categories, accountants are now involved in supplying information to a wide range of other interested parties, such as customers, employees, governments and their agencies, investors, lenders, the public and suppliers and other trade creditors. **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 as a separate economic unit. Simply put, the transactions of different entities should not be accounted for 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 profit. This concept allows the users to obtain timely information to serve as a basis on making decisions about future activities. For the purpose of reporting to outsiders, one 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. **Going Concern.** Financial statements are normally prepared on the assumption that the reporting entity is a going concern and will continue in operation for the foreseeable future. Hence, it is assumed that the entity has neither the intention nor the need to enter liquidation or to cease trading. This assumption underlies the depreciation of assets over their useful lives. The COVID19 pandemic continues to cause significant deterioration in economic conditions for many entities worldwide. The economic  uncertainties may cast doubt on the entity\'s ability to continue as a going concern. **CRITERIA FOR GENERAL ACCEPTANCE OF AN ACCOUNTING PRINCIPLE** Accounting practices follow certain guidelines. GAAP, which stands for generally accepted accounting principles, encompasses the conventions, rules and procedures necessary to define accepted accounting practice at a particular time. Accounting principles are established by humans. Unlike the principles of physics, chemistry, and the other natural sciences, accounting principles were not deduced from basic axioms, nor can they be verified by observation and experiment. Instead, they have evolved. This evolutionary process is going on constantly; accounting principles are not eternal truths. The general acceptance of an accounting principle usually depends on how well it meets three criteria: relevance, objectivity and feasibility. 1. A principle has **relevance** to the extent that it results in information that is meaningful and useful to those who need to know something about a certain organization. 2. A principle has **objectivity** to the extent that the resulting information is not influenced by the personal bias or judgment of those who furnish it. Objectivity connotes reliability and trustworthiness. It also connotes verifiability, which means that there is some way of finding out whether the information is correct. 3. A principle has **feasibility** to the extent that it can be implemented without undue complexity or cost. These criteria often conflict with one another. In some cases, the most relevant solution may be the least objective and the least feasible. **BASIC PRINCIPLES** In order to generate information that is useful to the users of financial statements, accountants rely upon the following principles: **Objectivity Principle.** 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 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. **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 is only concerned with information 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 items 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. **TAXATION OF BUSINESS ORGANIZATIONS (per TRAIN Law and CREATE Act)** In a nutshell, the income tax for each of the following taxpayers is derived as follows: **Sole Proprietorship** An individual taxpayer, a Filipino citizen or a resident aliens, can be classified as a compensation, business or mixed income earner. 1. **Individuals earning purely compensation income** shall be taxed based on the graduated income tax rates (from 20% to 35% effective Jan. 1, 2018 to Dec. 31, 2022; from 15% to 35% effective Jan. 1, 2023 onwards) prescribed under Sec. 24(A) of the Tax Code. Taxable income\' for compensation earners is the gross compensation income less non-taxable income/benefits such as but not limited to the 13th month pay and other benefits (subject to limitation of P90,000), de minimis benefits, and employee\'s share in the SSS, GSIS, PHIC, Pag-IBIG contributions and union dues. See Chapter 11 of this book, Payroll. Gross Compensation Income Less: Non-Taxable/Exempt Compensation Gross Taxable Compensation Income 2. **Business Income** arises from self-employment or practice of profession. This shall not include income from performance of services by the taxpayer as an employee. Individuals earning income purely from self-employment and or practice of profession whose gross sales/receipts and other non-operating income (GSRONO!) do not exceed the P3.0 million value-added tax (VAT) threshold, shall have the option to avail of: 1. the graduated rates under Sec. 24(A) of the Tax Code, as amended; or  1. 8% tax of GSRONOl in excess of P250,000\* in lieu of the graduated income tax rates under Sec. 24(A) and the percentage tax under Sec. 116 under the Tax Code, as amended. Gross Sales/Receipts Less: Cost of Sales Gross Income Less: Operating Expenses Taxable Income (if graduated rates) 3. **Mixed Income Earners.** There are individuals who earn income both from compensation and from self-employment (business or practice of profession): They shall be subject to the following taxes: - On compensation income - at graduated rates; plus - On income from business or practice of profession shall be subject to, the following: 1. If GSRONOI do not exceed the VAT threshold - - either at graduated rates or - 8% of GSRONOI in lieu of graduated rates and percentage tax, at the option of the taxpayer. ii. If GSRONOI exceed the VAT threshold - at graduated rates - The P250,000 mentioned is not applicable to mixed income earners since it is already incorporated in the first tier of the graduated income tax rates applicable to compensation income. **Partnership** There are two classifications of general partnerships in taxation: 1. **General Professional Partnership (GPP).** One formed by persons for the sole purpose of exercising their common profession, no part of the income of which is derived from engaging in any trade or business. A general professional partnership (GPP) shall not be subject to the income tax but is required to file annual income tax return/annual information return for the purpose of furnishing information as to the items of gross income, deductions, and the names, tax identification numbers (TINs), addresses and share of each of the partners. Partners in a general professional partnership shall be liable for income tax in their separate and individual capacities. Where the result of partnership operation is a loss, the loss will be divided as agreed upon by the partners. If there is no agreement as to division of losses but there is as to profits, the losses shall be distributed according to the profit-sharing ratio. Such share in the losses may be taken up by the individual partners in their respective income tax returns. A GPP may avail of the optional standard deduction (OSD) only once, either by the GPP or the partners comprising the partnership. 2. **General Co-Partnership** (compania colectiva). A general partnership which is not a general professional partnership. Partnerships (other than GPPs), whether registered or not, are considered as corporations and are therefore taxed as corporations. **Corporation** A corporation is either a domestic or a foreign corporation. 1. **Domestic Corporation** is one that is created or organized in the Philippines or under its laws. For domestic corporations, in general, an income tax rate of 25% effective July 1, 2020, is hereby imposed upon the taxable income derived during each taxable year from all sources within and without the Philippines. Generally, the pro-forma computation of the normal income tax of domestic and resident foreign corporations follows: Gross Income Less: Allowable Deductions Taxable Net Income Multiply by: Tax Rate Income Tax Due 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. The above computed \"normal income tax due\" will be compared with the \"minimum corporate income tax\" (MCIT). When MCIT is higher than the normal tax due, then the MCIT amount will be the basis. A MCIT of 2% of the gross income as of the end of the taxable year is imposed on any taxable corporation beginning on the fourth (4th) taxable year immediately following the year in which such corporation commenced its business operations, when the MCIT is greater than the tax computed using the normal income tax rate provided that effective July 1, 2020 until June 30, 2023, the rate shall be 1%. 2. **Foreign Corporation.** When applied to a corporation, means a corporation which is not domestic. 1. **Resident Foreign Corporation.** Applies to a foreign corporation engaged in trade or business within the Philippines. The applicable income tax is 25% effective July 1, 2020 with MCIT. 1. **Non-Resident Foreign Corporation.** Applies to a foreign corporation not engaged in trade or business within the Philippines. Generally, the pro-forma computation of the income tax of non-resident foreign corporations follows: Gross Income Multiply by: Tax Rate (effective Jan. 1, 2021) Final Income Tax Withheld At initial glance, the above discussion on taxation may be overwhelming but do not worry as you gain more knowledge, you will find them very manageable. They will be tackled in detail in another book, Income Taxation Made Easy 2022 Edition by Prof. Win Ballada and Susan Ballada.