Financial Accounting Fundamentals PDF

Financial Accounting & Reporting (Fundamentals) Accounting – is a process of identifying, recording, and communicating economic information that is useful in making economic decisions. Nature of Accounting – accounting is a process with the basic purpose of providing information about economic acti...

Financial Accounting & Reporting (Fundamentals) Accounting – is a process of identifying, recording, and communicating economic information that is useful in making economic decisions. Nature of Accounting – accounting is a process with the basic purpose of providing information about economic activities intended to be useful in making economic decisions. Essential Elements of the Definition of Accounting 1. Identifying – the accountant analyzes each business transaction and identifies whether the transaction is an “accountable event” or “non-accountable event.” − This is because only “accountable events” are recorded in the books of accounts. − “Non-accountable events” are not recorded in the books of accounts. 2. Recording – 1.) Journalizing – the process where the accountant recognizes (i.e., records) the “accountable events” he has identified. 2.) Posting – the process after journalizing wherein the accountant then classifies the effects of the event on the “accounts.” 3. Communicating – at the end of each accounting period, the accountant summarizes the information processed in the accounting system in order to produce meaningful reports. 1.) Accounting Information – is communicated to interested users through Accounting Reports. 2.) Financial Statements – the most common form. Types of Information Provided by Accounting 1. Quantitative Information 2. Qualitative Information 3. Financial Information Functions of Accounting Business 1. External Users – to provide them with information that is useful in making investment and credit decisions. 2. Internal Users – to provide them with information that is useful in managing the business.  Brief History of Accounting Pre-Historic Times – accounting can be traced far back as the Prehistoric times, perhaps more than 10,000 years ago. Clay Tokens – Archeologists have found clay tokens as old as 8500 B.C. in Mesopotamia which were usually cones, disks, spheres and pellets. − These tokens correspond to commodities like sheep, clothing or bread. − They were used in the Middle West in keeping records. Clay Tablets – after some time, the tokens were replaced by wet clay tablets. − During such time, experts concluded this to be the start of the art of writing. Double Entry Records – first came out during 1340 A.D. in Genoa. 1494 – the first systematic record keeping dealing with the “Double Entry Recording System” was formulated by Fra Luca Pacioli. Double Entry Recording System – was included in Pacioli’s book titled “Summa di Arithmetica Geometria Proportioni and Proportionista,” − It was published on November 10, 1494, in Venice. − The concept is still being used to this day. Fra Luca Pacioli – Father of Modern Accounting − A Franciscan monk and mathematician. Common Branches of Accounting 1. Financial Accounting – general record-keeping, maintenance of journals and ledgers. − Preparation of General-Purpose Financial Statements (FS). − All businesses use financial accounting in their record-keeping. − These records provide information that is also used in the other branches of accounting. − Businesses prepare general purpose FS at least annually for the use of lenders, investors, or government regulatory bodies. 2. Management Accounting – preparation of specifically tailored management reports. − Required by management to aid them in performing their management functions. 3. Government Accounting – general record-keeping and preparation of financial reports for the government and its agencies. − It also includes the preparation of budgets and accountability reports. − Required by the government and its agencies. 4. Auditing – expression of an opinion on the correspondence between management assertions and established criteria. − Businesses with gross quarterly revenues of P150,000 are required to have their financial statements audited by an independent Certified Public Accountant (CPA). Independent Auditors’ Report – the most common form of such opinion which is attached to audited financial statements. 5. Tax Accounting – preparation of tax returns and providing tax advice. − All businesses are required to file tax returns. − Some taxpayers may require the professional advice of a tax practitioner regarding the management of taxes. 6. Cost Accounting – analyzes of costs of products or services. − Businesses use cost accounting to analyze the cost of their products or services and the effects of those costs in, among others, earnings and pricing policies. 7. Accounting Education – teaching of accounting and related subjects. − Required by business students, business owners, accounting practitioners in their Continuing Professional Development (CPD), and other interested parties. 8. Accounting Research – accounting research papers, articles, and similar publications. − Required by business owners, professional organizations, and other interested parties. Users Account of Accounting Information 1. Internal Users – those who are directly involved in managing the business. − Business owners who are directly involved in managing the business − Board of directors − Managerial personnel 2. External Users – those who are not directly involved in managing the business. − Existing and potential investors (e.g., stockholders who are not directly involved in managing the business) − Lenders (e.g., banks) and Creditors (e.g., suppliers) − Non-managerial employees − Public  Forms of Business Organization 1. Sole Proprietor – one individual (sole proprietor). − Registered with the DTI. − Advantages: ✓ You are the boss, and you keep all the profits. ✓ Decision making is simple because you have complete control over the business. ✓ Relatively easier and less costly to form because there are fewer formal business requirements. ✓ Lower extent of government regulation and relatively lower taxes. − Disadvantages: You assume all the risk of loss. You take all responsibility and rely mostly on yourself in making decisions. It is more difficult to raise capital because you rely mostly on your personal assets and loans to initially finance the business. You are personally liable for the debts and obligations of the business. 2. Partnership – more than one (partners). − Formed by contractual agreement. − Registered with the SEC. − Advantages: ✓ Better business decisions can be made because "two heads are better than one." ✓ You share the business risk and the responsibility of running the business with your partners. ✓ Compared to corporations and cooperatives, a partnership is easier to form because only a contractual agreement between the partners is needed. ✓ Greater capital compared to sole proprietorship. ✓ Relatively lower extent of government regulation compared to corporations. − Disadvantages: Making business decisions may give rise to conflict among the partners. You don't keep all the profits because you need to share them with your partners. Limited life, in the sense that a partnership can be easily dissolved by the withdrawal, retirement, death or insanity of one of the partners. Lesser capital compared to a corporation. A partnership (other than a general professional partnership) is taxed like a corporation. Unlimited liability. The partners can be held liable for partnership debts up to their personal assets. 3. Corporation – more than one (stockholders). − Formed by operation of law. − Registered with the SEC.  − Advantages: ✓ A stockholder who is not a member of the corporation's board of directors is relieved from managerial responsibilities. ✓ Only the stockholders that are elected as members of the board of directors and those they hire or appoint are tasked with managerial responsibilities. ✓ This can be an advantage because a regular investor does not need to work for the corporation to earn income. ✓ Limited liability of the owners because stockholders are liable for corporate debts only up to the amount they have invested. ✓ Greater capital and ease in raising additional funds because a corporation can issue shares to a wider extent of investors. ✓ If the corporation is listed, you can easily transfer your shares to other investors by selling them in the stock market. ✓ Stock Trading – many investors earn profit this way - by buying shares at a cheap price, waiting for prices to go up, and then sell them. ✓ Unlimited life, in the sense that the withdrawal, retirement, death or insanity of one of the stockholders does not dissolve the corporation. ✓ Although a corporation has a legal life of 50 years, this can be renewed for an indefinite number of renewals. − Disadvantages: Your "say" on corporate affairs depends on the number of shares you own. Those who own more shares are the bosses and enjoy a larger share of the corporation's profits. A corporation is more difficult and more costly to form because there are more formal business requirements. Greater extent of government regulation and higher taxes. Unlike for a sole proprietorship or a partnership where business profits are easily distributed to the owners), in a corporation, you have to wait for the board of directors to declare dividends before you get your share in the profits of the corporation. 4. Cooperative – more than one (members). − Formed in accordance with the Cooperative Code. − Registered with the CDA. − Advantages: ✓ Unlike in a corporation, your "say" on cooperative affairs is not affected by the number of shares you own. ✓ This is because, in a cooperative, each member is entitled to one vote regardless of his or her shareholdings. ✓ However, members with larger shareholdings are entitled to a larger amount of profit (Net Surplus). ✓ A cooperative is generally exempt from paying taxes. ✓ This is the main advantage of a cooperative and the most common reason why cooperatives are organized. ✓ Moreover, a cooperative may receive assistance from the government.  ✓ Compared to a corporation, a cooperative is easier and less costly to form because there are fewer formal business requirements. ✓ Limited liability - the members are liable for cooperative debts only up to the amount they have invested. ✓ Unlimited life, in the sense that the withdrawal, retirement, death or insanity of one of the members does not dissolve the cooperative. ✓ Although a cooperative has a legal life of 50 years, this can be renewed for an indefinite number of renewals. − Disadvantages: A cooperative is prone to poor management. Cooperatives are, more often than not, managed by members who were elected as board of directors rather than by employed professional managers. Since there is a 'one-member’, one-vote policy in a cooperative, influential members tend to dominate the election process. The result is that those who get elected may not be the ones who are most qualified for the task. A cooperative is susceptible to corruption. Due to its management structure and lack of profit motive, the elected officers may be inclined to act on their personal interests. The Cooperative Code places some restrictions on the distribution of a cooperative's profit to its members. More specifically, the Code requires a cooperative to appropriate a portion of its annual profit to some funds. Only the remaining portion can be distributed to the members. Furthermore, when the cooperative is dissolved, the amount accumulated in a fund called the "reserve fund" shall not be returned to the members but rather donated to another cooperative or to the community. Compared to a corporation, it is more difficult for a cooperative to sustain growth. This is in part because of the lack of profit motive and lack of management expertise. Moreover, a cooperative's success strongly depends on the members' cooperation and members are not always willing to cooperate. The success of a business depends on continuing effort. Sadly, many cooperatives are zealous at the start but fail to sustain continuing effort resulting to the waning down of their activities. This does not mean though that all cooperatives are small businesses. There are many multi-billionaire cooperatives in our country. Some might be located in your community. Unlike in a corporation where the stockholder can freely transfer his shares, in a cooperative, there are restrictions on the transfer of a member's shares. For example, the approval of the board of directors must first be obtained before a member can transfer his or her shares.  Types of Business According to Activities 1. Service Business – − Advantages: ✓ You don't need to worry about inventory costs, warehousing and distribution costs because you don’t have any inventory. ✓ You only have some minimal supplies necessary in providing your services. ✓ You may only need a small capital because what you are selling is your skill set, and you only need yourself to render a service. ✓ If you are a manufacturer, you need to buy raw materials and machinery to produce your product. ✓ You are perceived as an expert in your chosen field. − Disadvantages: You may not have flexible personal time because you need to be directly involved in providing a service to a customer. You can stock inventory but not service. Until your business is big enough to be able to hire other professionals to do the work for you, you will need to render the services yourself. Service businesses normally suffer first from a decline in demand during times of economic difficulty. This is because most services are perceived as luxuries rather than necessities for survival. Your business' success depends on your credibility. Since a service business is founded on good reputation, it is more costly to commit an error in a service business compared to a merchandising business. 2. Merchandising (trading) – − Advantages: ✓ Compared to a manufacturing firm, you may need much lower start-up capital because you don't need to acquire machinery to produce your goods. ✓ You can take advantage of price fluctuations. ✓ For example, when goods are on sale, you can acquire them at a discounted price and resell them at a much higher price. ✓ You can't do this in a service business. ✓ Lower cost of quality. This is because "what you buy is what you sell." ✓ It is much easier to start a merchandising business because you don’t need to have an expertise, or a special skill (service business) and you don't need to have invented a new product or have conceptualized an innovative idea for an existing product (manufacturing business).  − Disadvantages: You need to have a retail store to display your goods, and the store must be in a strategic location for it to attract more customers. Less flexibility in managing costs. This is because the cost of your goods is based primarily on their purchase price, which you do not control. Keeping track of inventory is tedious, most especially when you are selling numerous and varied items with a fast turnover rate. Also, you can incur additional costs due to spoilage, theft, breakages, damages, and obsolescence Self-satisfaction is low because you did not produce the products you sold. 3. Manufacturing – − Advantages: ✓ You have a high growth potential. ✓ You have the opportunity to establish a brand that could last longer than your lifetime. ✓ Self-satisfaction is high. ✓ You may not need to have a strategically located retail store to display your products. ✓ You can have a better pricing policy because mass production can decrease your unit cost (often called “Economies of Scale”). ✓ Greater flexibility in managing costs. − Disadvantages: You need a high start-up capital. Conceptualizing a viable manufacturing business is difficult. You need to be continuously innovative and abreast of changes in technology. Warehousing and logistics costs can be high. You rely on raw materials. Managing a manufacturing business can be difficult because production processes are often complicated and there is always some room for improvement. Basic Accounting Concepts 1. Separate Entity Concept – the business is viewed as a separate entity, distinct from its owner(s). − Only the transactions of the business are recorded in the books of accounts. − The personal transactions of the business owner(s) are not recorded. 2. Historical Cost Concept (Cost Principle) – assets are initially recorded at their acquisition cost. 3. Going Concern Assumption – the business is assumed to continue to exist for an indefinite period of time. 4. Matching – some costs are initially recognized as assets and charged as expenses only when the related revenue is recognized. 5. Accrual Basis – 1.) Income – is recorded in the period when it is earned rather than when it is collected. 2.) Expense – is recorded in the period when it is incurred rather than when it is paid. 6. Prudence (Conservatism) – the observance of some degree of caution when exercising judgments under conditions of uncertainty. − Such that, if there is a choice between a potentially unfavorable outcome and a potentially favorable outcome, the unfavorable one is chosen. − This is necessary so that assets or income are not overstated, and liabilities or expenses are not understated. 7. Time or Reporting Period – the life of the business is divided into series of reporting periods. 8. 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. − Moreover, the purchasing power of the peso is regarded as stable. − Therefore, changes in the purchasing power of the peso due to inflation are ignored. 9. Materiality Concept – an item is considered material if its 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 being judged. 10. Cost-Benefit – the costs of processing and communicating information should not exceed the benefits to be derived from the information’s use. 11. Full Disclosure Principle – information communicated to users reflect a balance between detail and conciseness, keeping in mind the cost-benefit principle. 12. Consistency Concept – the nature of data used varies depending on whether short term or long-term financial decisions are being made. Philippine Financial Reporting Standards (PFRs) – are the Standards and Interpretations adopted by the FRSC.  Qualitative Characteristics 1. Fundamental Qualitative Characteristics – are the characteristics that make information useful to users. 1.) Relevance – information is relevant if it can affect the decisions of users. a. Predictive Value – the information can be used in making predictions. b. Confirmatory Value – the information can be used in confirming past predictions. c. Materiality – is an ‘entity-specific’ aspect of relevance. 2.) Faithful Representation – means the information provides a true, correct and complete depiction of what it purports to represent. a. Completeness – all information necessary for users to understand the phenomenon being depicted is provided. b. Neutrality – information is selected or presented without bias. c. Free from Error – there are no errors in the description and in the process by which the information is selected and applied. 2. Enhancing Qualitative Characteristics – are the characteristics that enhance the usefulness of information. 1. Comparability – the information helps users in identifying similarities and differences between different sets of information. 2. Verifiability – different users could reach consensus as to what the information purports to represent. 3. Timeliness – the information is available to users in time to be able to influence their decisions. 4. Understandability – users are expected to have: a. Reasonable knowledge of business activities. b. Willingness to analyze the information diligently.  The Accounting Equation Assets = Liabilities + Equity Assets – are the economic resources you control that have resulted from past events and can provide you with economic benefits. Liabilities – are your present obligations that have resulted from past events and can require you to give up economic resources when settling them. Equity – is assets minus liabilities. The Expanded Accounting Equation Assets = Liabilities + Equity + Income – Expenses Income – is increases in economic benefits during the period in the form of increases in assets, or decreases in liabilities, that result in increases in equity, excluding those relating to investments by the business owner. Expenses – are 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 owner. The difference between income and expenses represents profit or loss. The Net Profit/Loss Equation Net Profit/Loss = Income – Expenses