Chapter I: Purpose and Nature of Accounting PDF

CHAPTER I PURPOSE AND NATURE OF ACCOUNTING At the end of the chapter, learners shall have:  understood the function of accounting in business;  identified businesses as to nature and form;  define...

CHAPTER I PURPOSE AND NATURE OF ACCOUNTING At the end of the chapter, learners shall have:  understood the function of accounting in business;  identified businesses as to nature and form;  defined accounting, identified the important activities in the accounting process and phases of accounting;  understood accounting as the language of business;  differentiated accounting from bookkeeping;  identified the fields of accounting and the specialized accounting services;  distinguished the users of financial information;  understood the basic accounting concepts and principles; and  identified and distinguished the stages of the accounting cycle. Business and Accounting Business is an undertaking where one seeks to make profit by selling goods or rendering services. Some enterprises, however, are organized as non-profit organizations to provide certain benefits to society. In any type of business or organization, a lot of transactions and events happen every day. These transactions should be recorded to have a ready reference for future operations. Keeping records is an important aspect of a business. Without an effective recording or accounting system and procedures, one would find it difficult to determine how the business is fairing, whether it is earning profits or incurring losses. Through accounting, quantitative information can be identified, measured and summarized into financial reports that are to be communicated to the interested parties. These financial reports provide information about the financial condition and results of business operations which are bases for decision-making. The role of accounting in the operation of business entities are essential. As the business operates and transacts to their customers, a record of such will be analyzed and summarized in a financial information arising from business transactions. Accountants relay conclusions acquired from the completed reports for decision-makers. The top management or the decision-makers create and implement well-informed justified decisions. From the strategies and insights derived from the financial information, it is deemed that the business entities will operate with better strategies and methodologies.  Figure 1. The Role of Accounting in the Operation of Business Entities Types of Business Based on the Nature of Operations A business organization can be classified based on the nature of business operation. The purpose for which the business has been established will determine the nature of activities. The following are the classifications: 1. Service business is one which is engaged in the rendering of services to others for a fee. Examples are law firms, accounting firms, auditing firms, medical clinics, barber shops, beauty parlors, stock brokerage firms, recruitment agencies, and the like. 2. Trading business is engaged in the buying and selling of goods or commodities produced by other businesses which are called merchandise, hence, it is also called a merchandising business. It is a link in the physical distribution chain acting as a wholesaler or a retailer firm. Examples are car dealers, grocery stores, supermarkets, cell phone and accessory traders and gift shops. 3. Manufacturing business is engaged in the buying of raw materials, converting them into finished products and selling to traders or final consumers. Examples are car manufacturers, food processors, soft drink bottling companies, drug manufacturers and paper mills. The main difference between a trading and a manufacturing business is that, a trading business buys goods and sells these goods in the same form while a manufacturing business buys raw materials and sells goods that were produced or processed out of the raw materials. 4. Hybrid business is one which is involved in more than one type of business activities (service, merchandising and manufacturing). 2  Figure 2. Types of Businesses based on the Nature of Operations Forms of Business Organization A business operates in a complex environment that affects decision- making. Two of the most important factors making up the firm’s operating environment are the legal form of business organization and taxes. The accounting procedures depend on which form the organization takes. The three forms of business organizations are: 1. Single or Sole Proprietorship. This business organization is owned by an individual who has complete control over business decisions. The owner is called proprietor, who generally is also the manager. The owner is entitled to all the profits, but absorbs all losses. He owns all the firm’s assets and is responsible for all the debts of the business. From a legal point of view, the proprietor is not separable from the business and is personally liable for all debts of the business. However, from an accounting perspective, the business has a separate and distinct personality from that of the owner. The owner is not paid salaries nor wages from the business. Instead, he can withdraw funds or properties from the firm. 2. Partnership. This is a business owned and operated by two (2) or more persons known as partners, who bind themselves to contribute money, property or industry to a common fund, with the intention of dividing the profits between or among themselves. The Articles of Co-Partnership which is to be filed at the Securities and Exchange Commission (SEC) is a written agreement between or among the partners, governing the formation, operation and dissolution of the partnership. 3  3. Corporation. It is an artificial being created by the operation of law, having the rights of succession and the powers, attributes and properties expressly authorized by law or incident to its existence (Corporation Code Section 2). The incorporation process is initiated by the filing of the Articles of Incorporation with the SEC. The owners are called shareholders or stockholders. These owners are not directly involved in the management of the firm, instead, they select managers designated as the Board of Directors to run the firm for them. The Corporation Law provides that the number of directors be not less than five but not more than 15. 4. Cooperative. It is an autonomous association of persons united voluntarily to meet their common economic, social, and cultural needs and aspirations through a jointly-owned enterprise. The owners are called members. These owners are entitled with one voting right; such is one of their distinctions with the corporation. Cooperatives are being regulated by the Cooperative Development Authority (CDA). Figure 3. Forms of Business Organizations Micro, Small and Medium Enterprises (MSMEs) In 2008, the Magna Carta for Micro, Small and Medium Enterprises, otherwise known as Republic Act 9501, was signed into law. This law seeks to address problems faced by MSMEs particularly the lack of capital and access to credit. It also updated the definition of MSMEs as follows: 4  Assets before financing No. of Employees Micro Enterprise P3 Million and below 9 and below Small Enterprise More than P3 Million to P15 Million 10 to 99 Medium Enterprise More than P15 Million to P100 Million 100 to 199 These MSMEs are registered as any of the legal forms and nature of business. Enterprises with assets and employees above the MSME threshold are considered large enterprises. Brief History of Accounting The origin of keeping accounts has been traced as far back as 8500 B.C., the date archaeologists have established certain clay tokens – cones, disks, spheres and pellets – found in Mesopotamia (modern Iraq). These tokens represented commodities such as sheep, jugs of oil, bread or clothing and were used in the Middle East to keep records. The tokens were often sealed in clay balls, called billae, which were broken on delivery. The shipment could be checked against the invoice. Later, symbols impressed on wet clay replaced the tokens. Some experts consider this stage of record keeping the beginning of the art of writing, which were spread rapidly along the trade routes and took hold throughout the known civilized world. Account records date back to the ancient civilizations of China, Babylonia, Greece and Egypt. People in these civilizations maintained various types of records of business activities. Table 1. Summary of Events TIME PERIOD EVENTS 4 000 B.C.  The income of temples was recorded in lower Mesopotamia. Around 3600 B.C.  In Babylonia, clay tablets recorded payments of wages. 2500 B.C.  Historical accounting records had been found in ancient civilizations like the Egyptian, Roman, and Greek Empires as well as ancient Arabia. During that time, accounting records were kept by rulers for taxing and spending on public works. 1000 B.C.  The Phoenicians created an alphabet with accounting so that they were not cheated through trades with ancient Egyptians. 500 B.C.  Egyptians carried on with accounting records and even invented the first bead and wire abacus. 423 B.C.  The auditing profession was born to double check storehouses as to what came in and out the door. 5  The reports that were taken by these accountants were given orally hence the name “auditor”. 10  Emperor Wang Mang (45 B.C. to 23 of Xin Dynasty) of China instituted the first known income tax at a flat rate of 10% of profits. 1300 to 1943  In 1300, accountants were mentioned in historical records for the first time in the Statute of Westminster indicating they are considered important.  The first requirement for businesses to keep accounting records spread across many of the Italian Republics in the 13th century. These records mainly taken to keep track of the day to day transactions and credit accounts with other businesses.  In 1327, early books from the commune of Genoa displayed an early form of bookkeeping. The oldest double-entry books entitled “Missari (Treasury Officials) Ledgers of the Commune of Genoa” were written in 1340. In today’s accounting system, this is simplified into the T-account and expanded into the ledger.  In Florence, writing debits over credits for its double-entry recording. In today’s accounting system, this is similar to preparing journal entries.  In 1400, the Italian trading period saw sophisticated accounting systems developed within banking houses. Double-entry bookkeeping was discovered.  During this period, there were two prevailing approaches to reporting. These were the Florentine approach (journal entries) which was introduced by Amatino Manucci and the Venetian approach (ledger postings) which was introduced by Andrea Bargarigo. 1494  Luca Pacioli, the father of modern accounting, wrote his famous paper “Summa de Arithmetica, Geometria, Proportioni et Proportionalita”. The treatise that he wrote. 1500 to 1700  As the time progressed, large and small innovations were added to the double entry 6  records. For example, the East India Company developed invested capital and dividend distribution during the 17h century. This also created the need for a change in financial accounting and managerial accounting. The first for presentation to gain investors and the next was used so that the business could be run as efficiently as possible.  Jacques Savary, in his Commercial Code of France (1973), used historical cost as the basis of valuation. 1700 to 1900  During the Industrial Revolution, accounting really took off as industrial companies sought out to gain financing and maintain efficiency through operations. Several of the double-entry accounting methods was truly developed in this area as there was a focus on business as never before. Shortly after the first accounting organization was developed in New York in the year 1887.  Napoleon Bonaparte, in his Commercial Code (1804) and its supplement Code of Commerce of France (1807), asserted that assets must be carried at their market value and not based on historical cost.  Eugen Schmalenbach utilized price level accounting as the basis of valuation. 1913  The first income tax law in the Philippines was enacted. 1920 to 1940  Accounting in the 1920s became important to reduce the amount of fraud and scandals that were performed in business, particularly in the United States of America (USA).  In 1923, the first Accountancy Law (Republic Act No. 1305) in the Philippines was passed. 1940 to 1970  Globalization of business resulted in diverse accounting practice around the world. Thus, the need for harmonization.  In 1967, the Accountancy Law in the Philippines was revised and passed under the Republic Act No. 5166. This law standardized the accounting 7  education and regulated the practice of accountancy. This law also spelled out the examination process of CPA registration. 1973  The International Accounting Standards Committee (IASC) was created through an agreement made by professional accountancy bodies from Australia, Canada, France, Germany, Japan, Mexico, the Netherlands, the United Kingdom and Ireland, and the USA. Headquartered in London, United Kingdom, the committee is an independent private sector body, with the objective of achieving uniformity in the accounting principles which are used by business and other organizations for financial reporting around the world. The pronouncements were designated as International Accounting Standards (IAS). 1975  In the Philippines, the Accountancy Law was revised and passed under Presidential Decree No. 692. 1981 to 1996  In 1981, the Philippine Institute of Certified Public Accountants (PICPA) created the Accounting Standards Council (ASC) to establish and improve accounting standards generally accepted in the Philippines. 1997  The Philippines started transitioning from applying accounting standards to applying International Accounting Standards (AIS). 2001  The International Accounting Standards Board (IASB) succeeded the IASC. It has still adopted the body of standards issued by the IASC but moving forwards, all standards were designated as International Financial Reporting Standards (IFRS). 2002  The European Union (EU) required all EU listed companied to adopt IFRS starting 2005. 2004  In the Philippines, the Professional Regulation Commission (PRC) created the Financial Reporting Standards Council (FRSC). This replaced the ASC and was created to assist the Board of Accountancy (BOA) to carry out its powers and functions provided under Republic Act No. 9298, the Philippine Accountancy Act of 2004. 8  Complimenting IAS and IFRS were the Philippine Accounting Standards (PAS) and Philippine Financial Reporting Standards (PFRS).  Republic Act No. 9298, an act regulating the practice of Accountancy in the Philippines, repealing for the purpose Presidential Decree No. 692, otherwise known as the Revised Accountancy Law, was also passed and enacted this year. 2005 to present  The Philippines became fully compliant with IFRS. Due to advances in information technology, the manual accounting system is now done with speed, consistency, precision and reliability through the use of computers. Many accounting applications and modules are prepared to suit various needs of businesses. Computer programmers have also come up with computerized accounting systems. The advent of internet through online or E- Commerce has brought about changes in the field of accountancy. As technology advances, so does the practice of accountancy. In addition, the Globalization of Trade and Services (GTS) is bringing about changes in the field of Accountancy. Accountants in the Philippines can practice their profession in foreign countries, in the same manner as foreign accountants can also practice their profession in other countries. Definition of Accounting The following definitions have been given by different authoritative bodies in accounting: Accounting is the process of identifying, measuring and communicating economic information to permit informed judgements by users of the information (American Accounting Association). Accounting is a service activity. Its function is to provide quantitative information, primarily financial in nature about economic entities that is intended to be useful in making economic decisions (Accounting Standards Council). Accounting is the art of recording, classifying and summarizing in a significant manner and in terms of money, transactions and events which are, in part at least, of a financial character and interpreting the results, thereof (American Institute of Certified Public Accountants). From the definitions given, accounting is a service activity that tries to communicate financial information to interested users. 9 Important Activities in the Accounting Process From the definitions, the three important activities in the accounting process are: 1. Identifying is the recognition or non-recognition of business activities as accountable events. Events are accountable when they affect the assets, liabilities and equity of the business. There are business activities and events which are not accountable because they cannot be quantified, or expressed in terms of a unit of measure, like hiring of employees and entering into a contract. 2. Measuring is the assigning of peso amounts to the accountable economic transactions and events. 3. Communicating is the process of preparing and distributing accounting reports to users of accounting information. Figure 4. Representation of Important Activities in the Accounting Process Phases of Accounting Accounting covers four functions, namely: 1. Recording is the writing down on the books of accounts, the business transactions or events. The technical term for this function is bookkeeping. Bookkeeping is a systematic and chronological recording of business transactions and events. It is systematic because the Generally Accepted Accounting Principles (GAAPs) are applied in the recording of transactions. 2. Classifying is the sorting or grouping of similar and interrelated transactions into their respective classes. For example, in recording the purchase of different goods which are intended for resale, the account “Purchases” should be used for all purchases regardless of the type of goods purchased. This is accomplished by posting to the ledger. The ledger is a group of accounts which are categorized into asset, liability, equity, revenue and expense accounts. 10  3. Summarizing is achieved through the preparation of financial statements or financial reports. The financial statements summarize the effects of all business transactions that occurred during a certain period on the assets, liabilities and equities of the business. 4. Interpreting is being done after the transactions are summarized in the financial statements in order to analyze or evaluate the liquidity, solvency, stability and profitability of the business organization. Liquidity is the ability of the business to pay for its current obligations when they fall due. This is determined by comparing the current assets against current liabilities of the business. Solvency is the ability of the business to operate continuously and smoothly. This is possible only if the assets of the business are sufficient to meet the long-term obligations on the maturity dates and that the owner’s capital is increasing due to profits earned by the business. Profitability is a situation in which an entity is generating a profit. It arises when the aggregate amount of revenue is greater than the aggregate amount of expenses in a reporting period. Figure 5. Phases of Accounting Accounting as the Language of Business Accounting is considered as the language of business, as it is the medium of communication between the business and the parties interested with its financial activities. Through accounting, business transactions are identified, measured and summarized into accounting reports like financial statements. These financial statements provide information about the financial condition and 11 results of operations of the business, which owners, creditors, employees, and government agencies may use to make informed business decisions. Accounting and Bookkeeping Whatever the type of business activity, all enterprises need common basic information about financial operations. The function of providing information and establishing financial records for planning and management of business affairs is what accounting and bookkeeping is all about. Bookkeeping is a procedural element of accounting. It is the process of recording financial transactions and keeping financial records. It is the information processing function of accounting where business data are collected and summarized into financial reports. Accounting, on the other hand, includes many complex activities such as bookkeeping, the design of an information system that meets the user’s needs, the analysis and interpretation of financial statements, preparation of tax and financial reports, budgeting, auditing, planning and forecasting. Accounting cannot exist independently of bookkeeping. An accountant must know the principles and mechanics of bookkeeping. Hence, those who study accounting are taught first the fundamentals of bookkeeping. Today, computers are used for routine bookkeeping operations that used to take weeks or months to complete manually. Basic accounting knowledge however, is needed even though computers can do the routine tasks. Fields of Accounting The professional accountant may pursue a career in any of the following areas of accounting practice: (1) Government Accounting, (2) Private Accounting, (3) Accounting Education, and (4) Public Accounting. The field of public accounting is where the professional accountant offers to the public for a fee accounting services such as general accounting, auditing, design and installation of accounting system, management advisory services, tax planning services, and others. 12  Figure 6. Fields of Accounting Further, in public accounting, the accountant performs or offers to perform any activity that will result to the issuance of an attest report that is in accordance with professional standards. Such activities include consulting services, personal financial planning services, the preparation of tax returns, and advice on tax matters for a fee. Usually, a public accountant works in a firm offering its services to various clients. The professional accountant in commerce and industry is employed in any position requiring knowledge and skills in accounting where adherence to GAAP and procedures are to be observed. This includes job titles as chief accountant, internal auditor, budget officer, cost accountant, controller or Vice President for finance. It involves setting up systems of recording business transactions that are aggregated into financial statements. It includes the development and interpretation of accounting information intended to assist the management in operating the business. In addition, a private accountant is a salaried employee who deals with the company’s day to day accounting needs. He/she is trained in the processing of accounting transactions such as billing and accounts payables. His or her knowledge in accounting may be limited to the areas of accounting for which they are responsible. The professional accountant in government may be employed in areas where it requires the application of knowledge and skills of accounting in accordance with prescribed standards. This includes employment at the Commission on Audit (COA), National Treasury, Bureau of Internal Revenue, Bureau of Customs, Department of Budget and Management, Department of Finance, Bangko Sentral ng Pilipinas, or other governmental units or government owned or controlled corporations (GOCCs). Government Accounting is a system used in government offices to record and report financial transactions. It is the systematic process of collecting, recording, classifying, summarizing and interpreting the financial transactions relating to the revenues and expenditures of government offices. Government 13 accounting reveals how public funds have been generated and utilized. It is employed in both national and local governments. The professional accountant in the field of education is one who helps keep the accounting profession alive, relevant and interesting, undertakes research works in an effort to bridge the gap between theory and practice, seeks the rationale for changes in the profession and communicates current thinking to those within the profession or who are about to enter the profession. Accounting education is responsible for training future accountants. It engages in teaching accounting, financial management, taxation and other related business course. As per CHED Memo. 27 s. 2017, a CPA in accounting education should possess the educational qualifications, professional experiences, classroom teaching ability, computer literacy, scholarly research productivity, and other attributes that are essential for the successful conduct of a professional accounting program. Figure 7. Qualifications of Certified Public Accountant in Education Other fields which the professional accountants would venture into include entrepreneurship, personnel administration, insurance and marketing. They become successful in these areas since they are versatile and have been trained to meet the many problems that confront businesses. Specialized Accounting Services Financial Accounting is focused on the recording of business transactions and the periodic reports on financial position and results of operations. Auditing is the examination of financial statements by an independent auditor in order to express an opinion on the fairness of the presentation of the financial position, results of operation, and cash flows in conformity with generally accepted accounting principles. 14  Government Accounting is concerned with the identification of sources and uses of resources consistent with the provisions of city, municipal, provincial or national laws. Management Services is the processing of historical as well as projected data of an entity to assist management in establishing plans for reasonable economic objectives. Tax Accounting encompasses the preparation of tax returns and consideration of tax consequences of proposed business transactions. Financial Management is concerned with the setting of financial objectives, making plans based on those objectives, obtaining the funds needed to achieve the plans, and generally safeguarding all the financial resources of the entity. Management Accounting incorporates cost accounting data and adopts them for specific decisions which 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 resources. Users of Financial Information Financial information is used by different groups for a variety of purpose and reason. These users may be internal or external decision makers. Internal decision makers are the owner(s)/managers responsible for managing the resources of the firm. They have the power and authority to obtain whatever economic information they need in evaluating the efficiency on the use of resources. They are also interested on the result of operations and financial condition as bases in the formulation of plans and policies. External decision makers include those parties interested with the financial information of a business but lack direct access to the information generated in the internal operations. This includes the following: Investors are concerned with the risk inherent in and the return provided by their investments. They need information to help them determine whether to invest, buy, hold or sell shares. Employees are interested in information about the stability and profitability of their employers. They need information which enables them to assess the ability of the enterprise to provide them fair remuneration, retirement benefits and other employment opportunities. Creditors and suppliers are also interested in the financial information for them to determine whether credit should be extended or not. 15  Customers have interests in information about the continuance of business operations, especially when they have long term involvement in the firm or are dependent on the enterprise. Government and their agencies require information in order to regulate the activities of enterprises, determine taxation policies and as basis for national income and similar statistics. The Public need information about the trends and recent developments in the performance of the enterprise and the range of its activities. Fundamental Concepts and Principles Some of the fundamental concepts that underlie the accounting process include: Business 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. Transactions of different entities should be accounted for separately. In like manner, the personality of the owner or owners of a business is separate and distinct from that of the business, thus, transactions of the business should not be combined with the owner’s personal transactions. Periodicity Concept. Accounting periods usually cover one year from January to December (calendar year) or starting from any period and ending in any period to complete 12 months (fiscal year). But, for reporting purposes, the life of a business is subdivided into time periods less than one year. Reports prepared in said periods are called interim financial reports. This concept allows the users to obtain timely information to serve as basis in making decisions for future activities. Stable Monetary Unit Concept. This concept emphasizes the Philippine peso to be used as a unit of measure and that its purchasing power is relatively stable. It also states that only those quantifiable transactions are recorded in the books of accounts and those which can be measured and expressed in monetary terms specifically the Philippine peso. Further, information that cannot be expressed in monetary figure are irrelevant, therefore those are not recognized. Generally Accepted Accounting Principles (GAAP) Generally Accepted Accounting Principles make financial statements meaningful and useful to any type and form of business organization. Financial information can become more useful and reliable because there are practices, procedures, rules and principles of accounting that are generally accepted which were used in generating the financial statements. These GAAP have evolved as they have been widely used and may be recognized by professional bodies and 16 organizations on the basis of experience, reason, custom, usage and practical necessity. GAAP are like laws that must be followed in financial reporting. And since businesses and the environment in which they operate are constantly changing, GAAP keep on changing also. The general acceptance of an accounting principle depends on how well it meets the following criteria: relevance, objectivity and feasibility. A principle has relevance if it results in information that is meaningful and useful to the users. A principle has objectivity if the resulting information is not influenced by the personal bias or judgement of those preparing it. A principle has feasibility if it can be implemented without undue complexity or cost. Basic Principles Accounting practices follow guidelines set forth in the GAAP. In order to generate information that is useful to the users, the following principles can be relied on: Objectivity principle. Financial statements are based on the most reliable data. These data can be verified and confirmed. These are based from the information that flows from the activities documented by objective evidence. Historical cost. Cost is the proper basis for accounting the resources of the business. It is defined as the price paid to acquire an asset. The acquisition cost will remain in the accounting records until the asset is consumed, sold or expired. Revenue Recognition Principle. Revenue is recognized in the accounting period when goods are delivered or services are performed or rendered. Expense Recognition Principle. Expenses are recognized in the accounting period when goods and services are used to produce revenue and not when such are paid. Adequate Disclosure. This principle requires that all relevant information that would affect the user’s understanding and assessment of the accounting entity be disclosed in the financial statement. Materiality. Financial reporting is concerned with information that is significant enough to affect evaluations and decisions. In deciding whether an item or an aggregate of items is material, the nature and size of the item are evaluated together. Consistency Principle. The same accounting method is applied from period to period to achieve comparability over time. However, changes are allowed if justifiable and disclosed in the financial statements. 17 Underlying Assumptions Accrual Basis. Financial statements are prepared on the accrual basis of accounting. The effects of transactions or events are recognized when they occur and not when cash is received or paid. This means that revenues are recorded when earned and expenses are recorded when incurred. Going Concern. Financial statements are normally prepared on the assumption that an enterprise is a going concern and will continue in operation for an indefinite period. This assumption underlies the depreciation of assets over their useful lives. Economic Entity Concept. It assumes that all of the business transactions are separate from the business owner’s personal transaction. A business is considered to be distinct entity from the owner and therefore the two should be treated separately. Monetary Unit Assumption. Only measurable transactions are recorded in a single monetary value specifically the Philippine peso. It does not consider the time value of money and it only assumes that the depreciation of the purchasing power of peso is immaterial or insignificant. Time-period Assumption. The life of an economic period can be divided into artificial time periods for the purpose of providing periodic reports on the economic activities of the entities which means that financial statements are prepared on a periodic basis with the same interval. Philippine Financial Reporting Standards (PFRS) The Philippine Financial Reporting Standards (PFRSs) are currently fully converged with the International Financial Accounting Standards (IFRSs). This means that all the standards stated in the IFRS are similar to that of the PFRS. PFRS is one of the accounting standards which are being used in the Philippines. The birth of PFRS was last 2004 and the Philippines became fully compliant to it by 2005. The Philippines complied to the said standard in order to be comparable with other countries local and abroad. Accounting Cycle The work to be done for each accounting period follows a uniform cycle, which is composed of the following steps: 1. Identifying is the recognition of accountable events generally from the source documents. 2. Journalizing is the recording of transactions in the book of original entry, called the journal. The effects of the transactions on the different 18  accounts are analyzed and they are recorded chronologically in the journal following generally accepted accounting principles. 3. Posting is the process of transferring the entries from the book of original entry to the book of final entry, called the ledger. Each account is assigned a general ledger, and as the accounts are transferred from the journal to the ledger, they are sorted and classified. 4. Preparing the Preliminary Trial Balance in order to provide a listing to verify the equality of debits and credits in the ledger. After the accounts are posted into the general ledger, the balances of the different accounts shall be determined and then presented in the trial balance showing the total debit balances and total credit balances. 5. Preparing the Adjusting Entries and the Worksheet to bring the accounts up-to-date and accurate. Certain adjustments will have to be journalized and posted at the end of the accounting period to record (1) accrued expenses; (2) accrued income; (3) prepaid expenses; (4) deferred or unearned income; (5) depreciation and (6) bad debts or uncollectible accounts. The preparation of a worksheet, however, is optional. It is done to test the effects of the adjusting entries on the accounts before they are formally recorded in the books. This is to also facilitate the preparation of financial statements. 6. Preparing the Financial Statements which consists of the Balance Sheet, Income Statement, Statement of Cash Flow and Statement of Changes in Equity. The balance sheet shows the financial condition of the business, while the income statement shows the results of operation, whether the business made profits or incurred losses. The cash flow statement shows the sources and uses of funds. The statement of changes in equity shows reconciliations between the carrying amounts at the beginning and the end of the period for each component of equity. 7. Preparing the Closing Entries at the end of the accounting period to bring the balances of income and expense accounts to zero. This is in preparation for the next accounting period so as to be able to distinguish income earned and losses incurred for one accounting period. These entries are to be recorded in the general journal and posted in the general ledger. 8. Preparing the Post-Closing Trial Balance to test the equality of the accounts after the closing entries. While the preliminary trial balance contains accounts that are presented in the balance sheet (real accounts) and income statement (nominal accounts), the post-closing trial balance presents only the accounts that are to be reflected in the balance sheet in the next accounting period. 19  9. Preparing the Reversing Entries to simplify bookkeeping procedures for certain regular transactions in the next accounting period. This is done by reversing some adjusting entries to maintain the use of similar methods or procedures in recording income and expenses. These entries are to be recorded in the journal and posted in the ledger. Figure 8. The Accounting Cycle Components of Financial Statements 1. Statement of Financial Position or Balance Sheet. It presents financial position of the entity since its establishment. It reflects the resources, obligations and net worth of the entity. Further, only the real or permanent accounts are presented. 2. Statement of Financial Performance or Income Statement. It presents the financial performance of the entity for a given period of time. It shows the income and expenses for the period. Further, elements of accounting information reflected here are classified as temporary or nominal accounts. 3. Statement of Changes in Owner’s Equity. This area reflects the increases and decreases in the owner’s equity. Equity increases by investments and gains whereas it decreases by incurring drawings/withdrawals and losses. 4. Statement of Cash Flows. It provides the data on the cash inflows and outflows of the entity through its operating, financing and investing activities. 5. Notes to the Financial Statements. It embodies all the notes, transactions or accounts not included in the body of the financial statements. 20  SUMMARY This chapter provided a broad overview of the fundamental concept of accounting in businesses. It inculcates the importance of record-keeping in every business organization in order to determine the its profitability and liquidity. To maximize the primary goal of businesses which is to earn profit, proprietors or individuals who man businesses should have a knowledge of the nature of accounting as it contributes to a more efficient and effective management of finances. Businesses can be classified based on the nature of operations i.e. service, trading/merchandising, manufacturing and hybrid. Further, in this book it discusses the different forms of business organizations namely, sole proprietorship, partnership and corporation. A synopsis of the Micro, Small and Medium Enterprises (MSMEs) is also tackled. A brief history of the origin and emergence of accounting is also discussed in order to see the contributors of knowledge to the accounting profession. Moreover, this encompasses the evolution of accounting in different countries all over the world. Fundamental knowledge in accounting specifically the major activities being done are also discussed i.e. identifying, measuring and communicating and these activities are intertwined with the different phases of accounting namely, (1) recording; (2) classifying, (3) summarizing, and (4) interpreting. Accounting is considered as the language of business, hence, in this chapter it also emphasized the distinction between accounting and bookkeeping services. Moreover, the different fields of accounting are also introduced i.e., commerce and industry, government accounting, accounting education and public accounting. Apart from that a brief discussion on the specialized fields of accounting such as: (1) financial accounting; (2) auditing, (3) government accounting (4) management services, (5) tax accounting, (6) financial management, and (7) management accounting, are also covered in this chapter. It is also important to note the different roles of the users of financial information such as the internal and external decision makers. In establishing a business, one of the equally important concepts to know is the business entity concept for it stresses a segregation of personal and business transactions. Further, in order to complete the overview of the fundamental accounting concepts, introduction to the accounting cycle is also discussed. The steps in the accounting cycle are: (1) identifying, (2) journalizing, (3) posting, (4) preparing the preliminary trial balance, (5) preparing the adjusting entries and worksheet, (6) preparing the financial statements, (7) preparing the closing entries, (8) preparing the post-closing trial balance, and (9) preparing the reversing entries. The different components of financial statements are: (1) Statement of Financial Position or Balance Sheet; (2) Income Statement or Statement of Financial Performance; (3) Statement of Changes in Owner’s Equity; (4) Statement of Cash Flows; and (5) Notes to Financial Statements. Further, a detailed discussion of the components of the financial statements will also be discussed in succeeding chapters. 21