Fundamentals Of Accounting Chapter 3 PDF

# Chapter 3: Accounting: The Language of Business ## Learning Objectives: After studying this chapter, we should be able to: - understand why accounting is considered the language of business - know the various accounting periods of reporting financial statements - find and what are the information...

# Chapter 3: Accounting: The Language of Business ## Learning Objectives: After studying this chapter, we should be able to: - understand why accounting is considered the language of business - know the various accounting periods of reporting financial statements - find and what are the information needs of various users and the qualitative objective of a financial report - differentiate the various forms of business organization. ## Bridge of Communication The business entity concept in accounting separates the owner from his business and the financial statements prepared by the accountant become the tool used in bridging the communication between them including the various users who are interested about the economic activities. ## When Do Accountants Prepare the Financial Statements? - The business has a continuous life of existence. When it starts, it is assumed that it will continue to operate for an indefinite period of time. This is the continuity or going-concern assumption in accounting. - Considering the length of time involved in its operations, it is very impractical for the owner to wait until the business stops to operate before he would be able to know the results of operations and financial condition of the business. - The life of the business is then divided into equal periods wherein at the end of each period, financial statements are prepared. - These periods are being referred to as "Accounting Periods". This is the periodicity or time period assumption in accounting and the third accounting assumption that we have studied. - This explains why financial statements are prepared and communicated to the owner of the business or various users/decision-makers "periodically". - Speaking of accounting periods, it can be a period of: - 1 Month: where financial statements are prepared at the end of every month. We call this on a "Monthly Basis". This is the shortest accounting period. - 3 Months: where financial statements are prepared at the end of every three months. We call this on a "Quarterly Basis". - 6 Months: where financial statements are prepared at the end of every six months. We call this on a "Semi-Annual Basis". - 12 Months: where financial statements are prepared at the end of every twelve months. We call this on a "Yearly" or "Annual Basis". - The length of accounting period chosen depends on the need of the owner for financial information about his business. Most often, however, the business adopts an accounting period of one year. - The accounting period of less than a year is called "Fiscal Period" and the financial statements prepared are being referred to as "interim financial statements". The Owner ## Qualities That Financial Statements Should Possess The new framework of accounting mentions that the following are the qualities that financial reports should possess to be more useful, to wit: - **Understandability:** this means that financial statements should be prepared and presented in a way that it can be understood by the users. Users are expected to study the financial information with reasonable diligence and assumed to have reasonable knowledge of business, economics and accounting. - **Reliability:** financial information should carry the degree of "confidence" when used by interested parties. To be reliable, it must be "free from material error." that will lead to material misstatement, it must be fairly presented and must be free from bias. - **Faithful Representation:** the information shows what it purports to show. In other words, the financial statements should be adequate. Therefore, accountants should properly report the actual events and their respective amounts in the financial statements as objectively as possible. - **Neutrality:** financial reports should be fairly presented and must be free from bias. It must be directed towards the common interest of the users. It is not good to give favor to one party in detriment to the other. - **Conservatism:** under this doctrine, when alternatives exist, the alternative which has the least effect on owner's equity should be chosen. As between two honestly doubtful alternatives: - understatement of assets and income - overstatement of assets and income, the former is preferred over the latter. - **Completeness:** financial statements is said to be complete if it contains disclosure of significant information necessary in order that the statement would not be misleading. Financial Statements should also contain notes and supplementary schedules and other information. - **Substance Over Form:** financial accounting emphasizes the economic substance of events even though the legal form may differ from the economic substance and suggest different treatment. - **Relevance:** this means that financial statements are prepared intended to help users make informed economic decisions. For example, a balance sheet is relevant in determining "financial condition" just as the income statement is intended for measuring the economic events and effect corrective measures in the future. The following major ingredients describe the relevance of financial statements. ## Types of Accounting Information Just as there are many types of economic decisions, there are also many types of accounting information. The terms Financial Accounting, Auditing, Management Accounting, Tax Accounting, Financial Management, Cost Accounting and Government Accounting are among the types of accounting information that are specialized by a professional accountants most widely used in business community: - **Financial Accounting:** concerns primarily in describing the financial resources, obligations, and activities of an economic entity resulting to the preparation of general-purpose financial reports on financial position and operating results. - **Auditing:** these are classified into two; internal and external auditing. The former sees to it, that the established accounting procedures are being followed throughout the year. It determines strict adherence to management policies and measures the efficiency of operations. These are usually performed by its own employees or staff of the company while the latter is performed by an independent professional accountant, who critically examines the book of accounts and renders an opinion on the fairness of financial statements being examined. - **Management Accounting:** is primarily concern with the designs, installation and improvements of accounting system intended specifically to help management in running the business. - **Tax Accounting:** involves the preparation of income tax returns and the determination of correct amount of taxes due and payable to the government. The most challenging aspect of tax accounting is not the preparation itself, but the tax planning which is anticipating the tax effects of business transactions and structuring these transactions in a manner that will minimize the income tax burden. - **Financial Management:** this is a new type of accounting information wherein its primary concern is to set-up financial planning objectives-including the sources and application of its resources beneficial to the economic entity. - **Cost Accounting:** concerns primarily on cost collection, allocation and control of producing goods and services. - **Government Accounting:** deals primarily on the proper custody of public funds in both national and local government, such as cities, provinces, municipalities and barangays. ## Users of Financial Statements Financial accounting information is used by a variety of groups and diverse purposes. The needs and expectations of users determine the type of information required. The users of financial statements and their information needs follow: - **Investors:** They need information to help them determine whether they should buy, hold or sell. Shareholders are also interested in information which enable them to assess the ability of the enterprise to pay dividends. - **Employees:** Employees are interested in information about the stability and profitability of the enterprise. They are interested in information which enable them to assess the ability of the enterprise, to provide remuneration, retirement, benefits and employment opportunities. - **Lenders:** Lenders are interested in information which enable them to determine whether their loans and interest thereon will be paid when due. - **Suppliers and other trade creditors:** These users are interested in information which enable them to determine whether amounts owing to them will be paid on maturity. - **Customers:** 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:** These users require information to regulate the activities of the enterprise, determine taxation policies and as a basis for national income and similar statistics. - **Public:** Enterprises affect members of the public in a variety of ways. For example, enterprises make substantial contributions to the local economy in many ways including the number of people they employ and their patronage of local suppliers. Financial statements may assist the public by providing information about the trends and recent developments in the prosperity of the enterprise and the range of its activities. ## Nature of Business A business firm may be classified in terms of what they offer, sell or produce. They are as follows: - **Service Concern:** the business derived its income from services rendered to clients, in the case of professional services like that of Accountants, Lawyers, Doctors, Dentists, etc., or to customers, in the case of non-professional services, like that of a Laundry Shop, Car Repair Shop, Janitorial Servicing, etc.. - **Merchandising:** the business is engaged in buying goods or commodities or any form of finished products and sells these at a profit. It might be at a retail or wholesale basis. Grocery stores are typical examples of this nature of business. - **Manufacturing:** the business is engaged in buying of raw materials and supplies to be processed or manufactured, converting them into finished products for sale at a profit, like that of a furniture shop, a manufacturer of cars, and a home appliances and the like. - **Agriculture:** the business is engaged in planting of crops and sells its products either in raw or finished form at a profit. - **Hybrid Companies:** are those involve in more than one type of activity which are manufacturing, merchandise and service. ## Forms of Business Organization And Their Capital Structures - **Single or Sole Proprietorship:** This is the simplest form of business organization where capital is owned and provided by one person called Proprietor, who may manage the business by himself or hire another person to do so. Whatever happens to the business, whether it succeeds and fails, the owner has to bear it all including any unpaid obligations that the business may have incurred. At this point, it is interesting to note that when the business gets bankrupt, the separate entity assumption will cease and the reality prevails; that the owner and the business are one. Aside from this, the owner cannot claim salaries or remuneration from his business. However, he can make withdrawals in cash or in kind from his capital. As there is only one owner in a sole proprietorship business, the capital account is called Owner's Equity. - **Partnership:** The capital of the business is owned or provided by two or more person called Partners who should set forth agreements among themselves which include among others, the investments of each partner, how profit and loss is to be divided and settlement to be made upon death or withdrawal of a partner as embodied in the Articles of Co-Partnership they have executed and registered with Securities and Exchange Commission (SEC). As to management, one of the partners may take charge in the affair of the business or they may hire another person to do so. As there are two or more partners in a partnership business, the capital account is called Partners Equity. - **Corporation:** This is the biggest and most complicated form of business organization. It is formed by any person, partnership, association or corporation, singly or jointly with others but not more than fifteen (15) in number. Their corporate charter is called Articles of Incorporation which is registered with Securities and Exchange Commission (SEC) together with their By-laws. In a corporation, Capital is called "Share Capital" which is divided into units called "Par Value". There are two (2) classes of share capital: Ordinary and Preferred Shares. Owners of the shares of stock are called "Shareholders" and their ownerships are evidenced by "Share Certificate". Share of stock can be transferred to any person without the consent of other stockholders. A Corporation shall have perpetual existence unless its Articles of Incorporation provides otherwise. As there are hundreds if not thousands of shareholders, their equity is called Shareholders' Equity. - **Cooperatives:** They operate similar to a corporation but their charter which is called Articles of Cooperation is registered with Cooperative Development Authority (CDA). It has its board of directors who are elected from among its members. However, while the number of voting share in a corporation is based on the number of shares that a shareholder holds, in a cooperative, it is on a "one-man, one-vote" basis. Moreover, patronage refund is given to cooperative members who patronize their business activities. Annually, cooperatives are also holding members' assembly meeting wherein they are going to elect the new sets of officers and board of directors. It is during this assembly that each member will receive a copy of cooperatives' financial reports and at the same time receive their individual cash dividends representing their shares on cooperatives' profit after deducting statutory requirements which are as follows: - 10% - for General Reserve Fund - 10% - for Cooperative Education and Training Fund - 7% - for Optional Fund - 3% - for Community Development Fund. ## Review Questions: 1. Why is accounting considered the "language of business"? 2. When is an item considered immaterial for financial statements?? 3. What are the qualitative objectives of a financial report? 4. When do accountants prepare the financial statements? 5. What is periodicity concept in accounting? 6. What are the three (3) annual accounting periods?. 7. How many quarters are there for a year? Name them?? 8. Why is there a need to divide the life of the business? 9. Who are the users of financial statements and what are their information needs? 10. What are the legal forms of business organization? Enumerate and explain.