Principles Of Accounting Lesson 1 PDF

Central Luzon State University College of Business Administration and Accountancy Department of Accountancy...

Central Luzon State University College of Business Administration and Accountancy Department of Accountancy PRINCIPLES OF ACCOUNTING Lesson 1 Fundamental Accounting, Concepts, and Principles I. Objectives After studying this chapter, you should be able to: 1. Define accounting and explain its role in business. 2. Describe the attributes that make it a profession including the scope of its practice. 3. Identify and discuss the career opportunities open to accountants and be familiar in different branches of accounting. 4. Describe the fundamental business model and find how it is applied to the various types of businesses. 5. Distinguish between the different forms and activities of business organizations. 6. Explain the importance and purpose of the accounting process and identify the users of accounting information. 7. Explain the fundamental accounting principles and concepts. 8. Explain the objective of general-purpose financial statements and identify the elements of financial statements. ACCOUNTING DEFINED According to Accounting Standards Council, Accounting is a service activity. Its function is to provide quantitative information primarily financial in nature, about economic entities that are intended to be useful in making economic decisions. American Institute of Certified Public Accountants (AICPA) defines accounting as 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. Simply put, Accounting is the process of recording business transactions which is financial in nature pertaining to an organization. The accounting process includes summarizing, analyzing, and reporting these transactions to users of financial information such as creditors and lenders, investors, and managers. The financial statements used in accounting are a concise summary of financial transactions over an accounting period, summarizing the organization’s operations, financial position, and cash flows in order for users to make sound business decisions. Accounting is one of the key functions of almost any business. It may be handled by a bookkeeper or an accountant at a small firm, or by sizable finance departments with dozens of employees at larger companies. The reports generated by various streams of accounting, such as cost accounting and managerial accounting, are invaluable in helping management make informed business decisions. In a market economy, information helps decision-makers make informed choices regarding the allocation of scarce resources under their control. When decision-makers are able to 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 absolutely 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. For this reason, accounting is called the language of business.  Principles of Accounting Accountants are the scorekeepers of business. Without accounting, a business couldn't function optimally; it wouldn't know whether it's making a profit, and it wouldn't know its financial situation. Also, a sound understanding of this language will bring about better management of the financial aspects 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. CHARACTERISTICS OF THE ACCOUNTANCY PROFESSION Accountancy qualifies as a profession because it possesses the following attributes: All members of the accountancy profession are Certified Public Accountants, which means that they have earned a Bachelor of Science in Accountancy degree and have passed the CPA Licensure Examinations. CPAs have their own body of language. They use terminology peculiar to the profession (e.g. debits and credits). CPAs adhere to a Code of Ethics. This code upholds the CPA’s serve the public with competence and integrity. The public, in return, expresses its confidence in CPAs by relying on the financial statements they audit. Like other professions, CPAs are members of a national organization, the PICPA, whose role is to ensure the continued improvement of the accountancy profession to meet the demands of the times. Scope of Practice The practice of Public Accountancy. Public Practice shall constitute in a person, be it his/her individual capacity, or as a partner or as a staff member in an accounting or auditing firm, holding out himself/herself as one skilled in the knowledge, science and practice of accounting, and as a qualified person to render professional services as a certified public accountant (CPA); or offering or rendering, or both, to more than one client on a fee basis or otherwise, services such as: - the audit or verification of financial transactions and accounting records; or - the preparation, signing, or certification for clients of reports of audit, balance sheet, and other financial, accounting and related schedules, exhibits, statements, or reports which are to be used for publication or for credit purposes, or to be filed with a court or government agency, or to be used for any other purpose; or - the design, installation, and revision of the accounting system; or - the preparation of income tax returns when related to accounting procedures; - when he/she represents clients before government agencies on tax and other matters related to accounting or renders professional assistance in matters relating to accounting procedures and the recording and presentation of financial facts of data. Practice in Commerce and Industry shall constitute a person involved in decision-making requiring professional knowledge in the science of accounting, or when such employment or position requires that the holder thereof must be a certified public accountant. Practice in Education/Academe shall constitute in a person in an educational institution which involves teaching of accounting, auditing, management advisory services, finance, business law, taxation, and other technology related subjects: Practice in Government shall constitute in a person who holds, or is appointed to, a position in an accounting professional group in government or in a government-owned and/or -controlled corporation, including those performing proprietary functions, where decision making requires professional knowledge in the science of accounting, or where a civil service eligibility as a certified public accountant is a prerequisite. 2  Principles of Accounting Code of Ethics A professional accountant is required to observe the following fundamental principles: Integrity. A professional accountant should be straightforward and honest in all professional and business relationships, Integrity also implies fair dealing and truthfulness. A professional accountant should not be associated with reports, returns, communications or other information where they believe that the information: Contains a materially false or misleading statement; Contains statements or information furnished recklessly; or Omits or obscures information required to be included where such omission or obscurity would be misleading. Objectivity. A professional accountant should not allow bias, conflict of interest, or undue influence of others to override professional or business judgments. Professional Competence and Due Care. A professional accountant has a continuing duty to maintain professional knowledge and skill at the level required to ensure that a client or employer receives competent professional service based on current developments in practice, legislation, and techniques. A professional accountant should act diligently and in accordance with applicable technical and professional standards when providing professional services. Competent professional service requires the exercise of sound judgment in applying professional knowledge and Skill in the performance of such service. Professional competence may be divided into two separate phases: Attainment of professional competence. The normal pattern of development starts initially with a high standard of general education followed by specific education, training, and examination in professionally relevant subjects, and whether prescribed or not, a period of work experience. Maintenance of professional competence. This requires a continuing awareness and an understanding of relevant technical professional and business developments. Continuing professional development develops and maintains the capabilities that enable a professional accountant to perform competently within professional environments. Confidentiality. A professional accountant should respect the confidentiality of information acquired as a result of professional and business relationships and should not disclose any such information to third parties without proper and specific authority unless there is a legal or professional right or duty to disclose. Confidential information acquired as a result of professional and business relationships should not be used for the personal advantage of the professional accountant or third parties. Professional Behavior. A professional accountant should comply with relevant laws and regulations and should avoid any action that discredits the profession. In marketing and promoting themselves and their work, professional accountants should not bring the profession into dishonor. Professional accountants should be honest and truthful and should not: make exaggerated claims for the services they are able to offer, the qualifications they possess, or experience they have gained; or make disparaging references or unsubstantiated comparisons to the work of others. BRANCHES OF ACCOUNTING Accountancy and Accounting. Accountancy is a profession whose members are engaged in the collection of financial data, the summary of that data, and then the presentation of information in a form that helps recipients take effective decisions. Many writers use 'accountancy' and ‘accounting' as synonymous terms, but in this course, we shall use the term 'accountancy' to describe the profession, and the term 'accounting' to refer to the subject. 3  Principles of Accounting Auditing. Auditing is one of the most important branches of accountancy. Once accounts and financial reports have been prepared, they may have to be checked in order to ensure that they do not present a distorted picture. The checking of accounts and reporting on them is known as auditing. Businesses have their reports audited as a legal requirement. Auditors are usually trained accountants who specialize in checking accounts rather than preparing them. If they are appointed from outside the organization, they are usually referred to as external auditors. Corporate external auditors are appointed by shareholders, and not by the management. The auditor's job is to protect the interests of the shareholders; they answer to them, and not to anyone in the entity. By contrast, internal auditors are employees of the entity. They are appointed by and answer to the entity's management. Internal auditors perform routine tasks and undertake detailed checking of the entity's 'accounting procedures, whereas external auditors are likely to go in for much more selective testing. 'Nonetheless, they usually work very closely together, although the distinction made between them still remains important. Bookkeeping. Bookkeeping is a mechanical task involving the collection of basic financial data. The data are first entered in special records known as books of account, and then extracted and summarized in the form of a profit and loss account and a balance sheet. This process normally takes place once a year, but it may occur more frequently. A profit and loss account shows whether the business has made a profit or loss during the year. A balance sheet lists what the entity owns (its assets), and what it owes (its liabilities) by the end of the year, The bookkeeping procedures usually end when the basic data have been entered into the books of account and the accuracy of each entry has been tested. At that stage, the accounting function takes over, Accounting tends to be used as a generic term covering almost anything to do with the collection and use of basic financial data. It should, however, be more properly applied to the use to which the data are put once they have been extracted from the books of account. Bookkeeping is a routine operation while accounting requires the ability to examine a problem using both financial and non-financial data. Cost Accounting. Cost accounting makes use of those data once they have been extracted from the cost books in providing information for managerial planning and control. Cost accounting now forms one of the main sub-branches of management accounting. Financial Accounting. Financial accounting is the more specific term applied to the preparation and subsequent publication of highly summarized financial information. The information supplied is usually for the benefit of the owners of an entity, but it can also be used by management for planning and control purposes. It will also be of interest to other parties, e.g. employees and creditors. Financial Management. Financial managers are responsible for setting financial objectives, making plans based on those objectives, obtaining the finance needed to achieve the plans, and generally safeguarding all the financial resources of the entity. Financial managers are much more heavily involved in the management of the entity than is generally the case with either financial or management accountants. It should also be noted that the financial manager draws on a much wider range of disciplines (such as economics and mathematics) and relies more extensively on non-financial data than the more traditional accountant. 4  Principles of Accounting Management Accounting. Management accounting incorporates cost accounting data and adapts them for specific decisions that management may be called upon to make. A management accounting system incorporates all types of financial and non-financial information from a wide range of sources. Taxation. Taxation is a highly complex technical branch of accounting. Accountants involved in tax work are responsible for computing the amount of tax payable by both business entities and individuals. It is not necessary for either companies or individuals to pay more tax than is lawfully due, and so it is quiet in order for them to minimize the amount of tax payable. If tax experts attempt to reduce their clients' tax liabilities strictly in accordance with the law; this is known as 'tax avoidance. Tax avoidance is a perfectly legitimate exercise, but tax evasion (the non-declaration of sources of income on which tax might be due) is a very serious offense. In practice, the borderline between tax avoidance and tax evasion can sometimes be a fairly narrow one. 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 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. The figure below 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: - converted into another type of asset that will be used in the business (e.g. equipment) or sold (e.g. inventory); or - 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 entity. 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. 5  Principles of Accounting FUNDAMENTAL BUSINESS MODEL 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 the business. FORMS OF BUSINESS ORGANIZATIONS AND TYPES OF BUSINESS OPERATIONS 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 into seven broad categories, they are as follows: Type Activity Structure Examples Software development Hiring skilled staff and selling their Services Selling people’s time and skill Accounting time Legal Buying a range of raw materials and manufactured goods and consolidating them, making them Wholesaler Trader Buying and selling products available for sale in locations near Retailer to their customers or online for delivery 6  Principles of Accounting Vehicle Assembly Construction Engineering Electricity Food and Drinks Designing products, aggregating Taking raw materials and using Chemicals Manufacturer components and assembling equipment and manpower to Media finished products convert them into finished goods Pharmaceutical Water Farming Growing or extracting raw Buying large land area and using Raw Materials Mining materials them to provide raw materials Oil Buying and operating assets Transport Selling and utilization of (typically large assets); selling Hotels Infrastructure infrastructure occupancy often in combination Telecoms with services Sports Facilities Accepting cash from depositors and paying them interest; using the Bank Receiving deposits, lending and money to provide loans to Financial Lending companies investing ,money borrowers, charging them fees and Investment house a higher rate of interest than the depositors receive Collecting cash from many customers; investing the money to pay the losses experienced by few Pooling premiums of many people Insurance customers. By understanding the Insurance Companies to meet claims of a few risk accepted and the likelihood of the claim, more premium income can be earned than claims paid FORMS OF BUSINESS ORGANIZATIONS There are three major legal forms of business entity: the sole proprietorship, the partnership, and the corporation. While the accounting process for all three types of business entities is generally the same differences in their structures and in the laws that apply to these structures require some differences in the way certain aspects of their financial affairs are recorded. These specific differences in accounting procedures are presented in detail in advanced accounting subjects. However, for now, you should understand the basic differences between the three types of business entities. 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. 7  Principles of Accounting 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. 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. 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. 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, what value to place on the transaction and how the 8  Principles of Accounting components of the transaction should be classified. 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 or financial reports. These usually 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. USERS OF ACCOUNTING INFORMATION Decision-makers need information. The more important the decision is, the greater the need for reliable information. Virtually all businesses and most individuals keep accounting records to aid them in making decisions. The users utilize financial statements in order to satisfy some of their different needs for information. The users of financial statements and their information needs to follow: Investors need the information to help them determine whether they should buy. hold or sell. Employees are interested in information about the stability and profitability of their employers. They are also interested in information that enables them to assess the ability of the enterprise to provide remuneration, retirement benefits, and employment opportunities. Lenders are interested in information that enables them to determine whether their loans and the related interest will be paid when due. Suppliers and other trade creditors are interested in information that enables them to determine whether amounts owing to them will be paid when due. Customers have an interest in information about the continuance of an enterprise, especially when they have a long-term involvement with, or are dependent on, the enterprise. Government and their agencies are interested in the allocation of resources and, therefore, the activities of the enterprises. They also require information in order to regulate the activities of the enterprises, determine taxation policies, and as the basis for national income and similar statistics. 9  Principles of Accounting FUNDAMENTAL CONCEPTS AND GENERALLY ACCEPTED ACCOUNTING PRINCIPLES 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 net income. This concept allows the users to obtain timely information to serve as a basis for making decisions about future activities. For the purpose of reporting to outsiders, one year is the usual accounting period. Stable Monetary Unit Concept. A 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. GENERALLY ACCEPTED ACCOUNTING PRINCIPLES In a sole proprietorship, adherence to proper accounting rules is important even though the owner is usually deeply involved in the firm's activities and is the person primarily interested in its financial affairs. However, creditors, suppliers, and others. Must also be able to rely on the financial statements prepared for a sole proprietorship. When the business is a partnership or a corporation, it is even more important that operations be properly accounted for because owners are unlikely to be intimately involved in the activities of the firm. Generally accepted accounting principles make financial statements meaningful and useful, regardless of the type of business organization. The various needs for reliable financial information can be satisfied only if there are rules, procedures, and principles of accounting that are generally accepted and used. If each entity made up its own rules, there could be no basis for comparing the earnings and financial position of different firms. Even the records and reports of a particular entity could not be compared for different periods unless accounting principles were applied consistently. In addition, users of financial statements would probably be misinformed and misled. Many of today's accounting principles were developed over a period of years in response to the changing needs for business reports. The process has worked very much like this: A particular procedure is devised by an accountant as a solution to a specific problem. Then other accountants find the procedure suitable for their problems and start to use it. Eventually, the procedure may become widely used and may be recognized by professional accountants, accounting writers, and organizations that are responsible for developing generally accepted accounting principles. Businesses and the environment in which they operate are constantly changing. The economy, technology, and laws change. Therefore, financial information and the methods of presenting that information must change to meet the needs of the people who use the information. Generally accepted accounting principles are changed and refined as accountants respond to the changing environment. 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 principles. In order to generate information that is useful to the users of financial statements, accountants rely upon the following principles: 10  Principles of Accounting 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. 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 of 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. GENERAL PURPOSE FINANCIAL REPORTING Financial Reporting is directed primarily to the existing and potential investors, lenders, and other creditors which compose of the primary user group. The reason is that existing and potential investors, lenders, and other creditors have the most critical and immediate need of information in the financial reports. Specific objectives of financial reporting are to: - To provide information useful in making decisions about providing resources to the entity. - To provide information useful in assessing the cash flow prospects of the entity. - To provide information about the entity resources, claims, and changes in resources and claims Information about the nature and amounts of a reporting entity's economic resources and claims assists users to assess that entity's financial strengths and weaknesses; to assess liquidity and solvency, and its need and ability to obtain financing. Information about the claims and payment requirements assists users to predict how future cash flows will be distributed among those with a claim on the reporting entity. A reporting entity's economic resources and claims are reported in the statement of financial position. Information about a reporting entity's financial performance during a period, representing changes in economic resources and claims other than those obtained directly from investors and creditors, is useful in assessing the entity's past and future ability to generate net cash inflows. Such information may also indicate the extent to which general economic events have changed the entity's ability to generate future cash inflows. The changes in an entity's economic resources and claims are presented in the statement of comprehensive income. 11  Principles of Accounting Information about changes in an entity's economic resources and claims resulting from events and transactions other than financial performance, such as the issue of equity instruments or distributions of cash or other assets to shareholders is necessary to complete the picture of the total change in the entity's economic resources and claims. The changes in an entity's economic resources and claims not resulting from financial performance is presented in the statement of changes in equity. General purpose financial reports cannot provide all the information that users may need to make economic decisions. They will need to consider pertinent information from other sources, for example, general economic conditions and expectations, political events and political climate, and industry and company outlooks. ELEMENTS OF FINANCIAL STATEMENTS Financial Position At regular intervals, the business will review the status of the firm's assets, liabilities, and owner's equity in a formal report called a balance sheet, which is prepared to show the firm's financial position on a given date. An asset is a present economic resource controlled by the entity as a result of past events. An economic resource is a right that has the potential to produce economic benefits (per March 2018 Conceptual Framework for Financial Reporting). There are three aspects to these definitions: "right"; "potential to produce economic benefits" and "control". Liability is a present obligation of the entity to transfer an economic resource as a result of past events. For liability to exist, three criteria must all be satisfied: (a) the entity has an obligation (b) the obligation is to transfer an economic resource; and (c) the obligation is a present obligation that exists as a result of past events Equity is the residual interest in the assets of the enterprise after deducting all its liabilities. In other words, they are claims against the entity that do not meet the definition of a liability. Equity may pertain to any of the following depending on the form of business organization: - In a sole proprietorship, there is only one owner's equity account because there is only one owner. - In a partnership, an owner's equity account exists for each partner. - In a corporation, owners' equity or stockholders' equity consists of share capital, retained earnings and reserves representing appropriations of retained earnings among others. Financial Performance If there is an excess of income over expenses, the excess represents a profit. Making a profit is the reason that people risk their money by investing it in a business. A firm's accounting records show not only increases and decreases in assets, liabilities, and owner's equity but the detailed results of all transactions involving income and expenses. 12  Principles of Accounting Income is increases in assets, or decreases in liabilities, that result in increases in equity. other than those relating to contributions from holders of equity claims. Expenses are decreases in assets, or increases in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity claims. It follows from these definitions of income and expenses that contributions from holders of equity claims are not income, and distributions to holders of equity claims are not expenses. Income and expenses are the elements of financial statements that relate to an entity s financial performance. Users of financial statements need information about both an entity's financial position and its financial performance. Hence, although income and expenses are defined in terms of changes in assets and liabilities, information about income and expenses is just as important as information about assets and liabilities. From the books: Ballada, W., Ballada, S.,(2019), Accounting Fundamentals “Made Easy” (5th Edition) Dome Dane Publishers, Sampaloc, Manila Valix, C., Peralta, J., Valix, CA., (2019) Conceptual Framework and Accounting Standards, GIC Enterprises, Claro M. Recto, Manila San Juan, D., Fundamentals of Accounting (Basic Accounting Principles Simplified for Accounting Students), AuthorHouse, Bloomington, Indiana, retrieved in https://books.google.com.ph/books?id=60Kc6jMpSfIC&printsec=frontcover&source=gbs_ge_summary_r&cad=0#v=onepage&q&f=false Next Lesson: Qualitative Characteristics of Accounting Information 13