Fundamentals of Accounting PDF

FUNDAMENTALS OF ACCOUNTING Definitio Accounting is the systematic process of recording, classifying, n of summarizing, and interpreting financial transactions and events to Accounti provide relevant financial information to stakeholders. I...

FUNDAMENTALS OF ACCOUNTING Definitio Accounting is the systematic process of recording, classifying, n of summarizing, and interpreting financial transactions and events to Accounti provide relevant financial information to stakeholders. It involves ng maintaining accurate and comprehensive records of all financial activities of an individual, organization, or business to ensure transparency, accountability, and proper management of resources. Key aspects of the Definition: 1. Systematic Process – Accounting follows a systematic and methodical process that ensures consistency and accuracy. This process includes the identification of financial transactions, their proper recording in the accounting system, and their eventual summarization in financial statements. 2. Recording - This involves capturing every economic event that affects the financial position of the entity. Transactions could include sales, purchases, receipts, and payments. These are recorded in the journal using double-entry bookkeeping, which ensures that every transaction affects at least two accounts (debits and credits) to maintain the accounting equation: Assets = Liabilities + Equity. 3. Classifying - After recording, transactions are classified into categories that reflect the nature of the financial data. Classification involves posting transactions from the journal to the ledger, where they are grouped into accounts, such as cash, inventory, sales, expenses, etc. This classification helps in organizing financial data for easier analysis and reporting. 4. Summarizing - The next step is summarizing the classified information to provide a snapshot of the financial status of the entity. This is done through the preparation of financial statements, including the income statement (which shows profitability), the balance sheet (which shows financial position), and the cash flow statement (which shows cash inflows and outflows). Summarization allows stakeholders to see the overall financial performance and position of the entity. 5. Analyzing - financial information is crucial for understanding the implications of financial data. This involves interpreting the financial statements to assess the entity's financial health, performance trends, liquidity, solvency, and profitability. Analysis provides insights that inform strategic decisions, identify areas for improvement, and guide future planning. 6. Communicating Financial Information - One of the key roles of accounting is to communicate financial information to interested parties. This is done through  financial reports and statements that are presented in a standardized format, making them understandable and comparable across different entities and time periods. Effective communication ensures that all stakeholders, including investors, management, creditors, and regulators, have the information they need to make decisions. Users of 1. Internal Users Accounti Management: Managers use accounting information to ng make strategic decisions, such as budgeting, forecasting, Informat and planning for future ion  growth. They rely on financial data to evaluate the company's performance, control costs, and allocate resources efficiently. Employees: Employees may use accounting information to assess the company’s financial health, which can impact job security, wage negotiations, and benefits. They are also interested in profit-sharing plans and bonuses that are often linked to the company's financial performance. Owners/Shareholders: Owners or shareholders of a business use accounting information to monitor the company’s profitability and financial stability. They need to know how well their investment is performing and whether the company is generating sufficient returns. 2. External Users Investors: Current and potential investors use accounting information to assess the viability of investing in a company. They analyze financial statements to determine the company’s profitability, risk, and growth potential. Creditors: Creditors, including banks and suppliers, use accounting information to evaluate the company’s creditworthiness. They want to ensure that the business can meet its debt obligations before extending credit or loans. Regulatory Agencies: Government and regulatory bodies, such as the Securities and Exchange Commission (SEC) and tax authorities, use accounting information to ensure that companies comply with laws and regulations. They monitor financial statements to enforce standards and collect taxes. Suppliers: Suppliers use accounting information to determine the financial stability of the companies they do business with. They assess whether a company can pay for goods and services supplied on credit. Customers: Customers, particularly large clients or those with long- term contracts, may use accounting information to evaluate the financial health of a company. They want to ensure that the company is capable of fulfilling its obligations and continuing to supply goods or services. Financial Analysts: Analysts use accounting information to provide recommendations to investors and the public. They analyze financial statements to evaluate a company’s performance, stock value, and market position. Competitors: Competitors may use publicly available accounting information to benchmark their own performance against that of the company. This can help them identify strengths, weaknesses, and opportunities within the industry. Tax Authorities: Tax authorities use accounting information to determine the amount of tax that a  company is liable to pay. They rely on accurate financial records to ensure compliance with tax laws and to audit companies when necessary. Branche 1. Financial Accounting - Financial Accounting involves s of the recording, summarizing, and reporting of an entity’s Accounti financial transactions through standardized financial ng statements. Assessing profitability and financial health.  Facilitating investment and lending decisions. Ensuring transparency and accountability to external parties. 2. Managerial Accounting - Managerial Accounting focuses on providing financial information to internal management to aid in decision-making, planning, and control within the organization. Budgeting and financial planning. Cost management and performance evaluation. Strategic decision-making and long-term planning. 3. Cost Accounting - Cost Accounting involves the recording, analysis, and reporting of costs associated with the production of goods or services. Setting product prices based on cost analysis. Monitoring and controlling production costs. Enhancing profitability through cost management. 4. Tax Accounting - Tax Accounting deals with preparing tax returns and ensuring compliance with tax laws and regulations. Preparing and filing tax returns. Advising on tax-efficient business structures. Planning for tax obligations and optimizing tax benefits. 5. Auditing - Auditing involves the independent examination and evaluation of an organization's financial statements and records to ensure accuracy and compliance with accounting standards. Enhancing the credibility of financial statements. Identifying and mitigating financial risks. Ensuring compliance with laws and regulations. 6. Government Accounting - Government Accounting focuses on the recording and management of financial transactions within government entities and public sector organizations. Budget preparation and execution. Financial reporting for government programs and services. Monitoring and controlling public expenditures. Forms of 1. Sole Proprietorship - A sole proprietorship is the Business simplest and most common form of business ownership, Ownership where a single individual owns and operates the business. Advantages: Simple and inexpensive to establish. Complete control by the owner. All profits go directly to the owner. Disadvantages: Unlimited personal liability for business debts. Limited ability to raise capital. Business continuity is dependent on the owner. 2. Partnership - A partnership involves two or more people who agree to share in the profits and losses of a business. There are several types of partnerships. Advantages: Ability to pool resources and expertise. Easier to raise capital than a sole proprietorship. Flexibility in management structure. Disadvantages: Potential for conflicts between partners. Unlimited liability for general partners. Profits must be shared among partners. 3. Corporation - A corporation is a legal entity that is separate from its owners (shareholders). It can own property, enter contracts, and be sued independently of its owners. Advantages: Limited liability for shareholders. Easier to raise capital through the sale of stock. Perpetual existence, independent of owners. Disadvantages: More complex and costly to set up and maintain. Subject to more regulations and government oversight. Double taxation for C Corporations. 4. Cooperative - A cooperative (co-op) is a business owned and operated by a group of individuals for their mutual benefit. Members share profits, decision-making, and responsibilities. Advantages: Democratic decision-making, with each member having a vote.  Profits are distributed among members. Potential tax advantages. Disadvantages: Slower decision-making process due to the need for member consensus. May have difficulty raising capital. Requires strong member participation and commitment. Types of 1. Manufacturing Operations - Manufacturing Business operations involve the production of goods from raw Operations materials or components. These businesses typically have facilities where physical goods are created, assembled, or finished. Examples: Production Lines: Automobiles, electronics, machinery, and consumer goods. Batch Manufacturing: Pharmaceuticals, food products, and beverages. Continuous Manufacturing: Chemicals, oil refining, and paper production. 2. Merchandising Operations - Retail and wholesale operations involve the sale of goods to consumers (retail) or to other businesses (wholesale). Retail businesses sell directly to end customers, while wholesalers sell in bulk to retailers or other businesses.  Examples: Retail: Supermarkets, clothing stores, e-commerce platforms, and specialty shops. Wholesale: Distributors, bulk suppliers, and B2B (business-to- business) marketplaces. 3. Service Operations - Service operations involve providing intangible products or services to customers. Unlike manufacturing, service operations typically do not produce physical goods but focus on delivering expertise, experiences, or activities that meet customer needs. Examples: Professional Services: Legal, accounting, consulting, and financial services. Healthcare Services: Hospitals, clinics, dental practices, and wellness centers. Hospitality Services: Hotels, restaurants, event planning, and travel agencies. Education Services: Schools, universities, training centers, and online education platforms. ACCOUNTING CONCEPTS AND PRINCIPLES Accounting system Comprises the methods used by a business to keep records of its financial activities and to summarize these accounts in periodic accounting reports. Transaction Is a completed action which can be expressed in monetary terms. GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP) These are broad, general statements or "rules" and "procedures" that serve as guides in the practice of accounting. These are standards, assumptions, and concepts with general acceptability. These are measurement techniques and standards used in the presentation and preparation of financial statements. FUNDAMENTAL CONCEPT Entity Concept regards the business enterprise as separate and distinct from its owners and from other business enterprises. Example: Dr. Teng has a skin clinic and a spa. The skin clinic is considered as a separate entity distinct from the spa and the owner, Dr. Teng. The expenses of the skin clinic should not be mixed with the expenses of the spa and the personal expenses of Dr. Teng. The two businesses are considered to be separate economic units, separate and distinct from their owner. As such, they should be treated as different from each other, although owned and operated by only one person. Hence, the personal expenses of Dr. Teng should not be mixed with the expenses of any of the businesses. Periodicity is the concept behind providing financial accounting information about the economic activities of an enterprise for specified time periods. For reporting purposes, one year is usually considered as one accounting period. Example: Separate financial reports are prepared yearly for the skin clinic and the spa of Dr. Teng. Hence, Dr. Teng can measure the income of the two businesses annually. An accounting period may be classified as either of the following: Calendar year - a twelve-month period that starts on January 1 and ends on December 31 Fiscal year - a twelve-month period that starts on any month of the year other than January and ends twelve months after the starting period, e.g., a business whose fiscal year starts May 1, 2016 ends its fiscal year on April 30, 2017. Note: A natural business year is any twelve-month period that ends when business activities are at their lowest point. Going Concern is a concept which assumes that the business enterprise will continue to operate indefinitely. Example: In preparing the financial statements of the skin clinic and the spa, the accountant assumes that the businesses will not close or shut operations within the next years. Basic Accounting Principles Objectivity principle states that all business transactions that will be entered in the accounting records must be duly supported by verifiable evidence. Example: Payments must be supported by official receipts and bank deposits must be supported by deposit slips. Historical cost means that all properties and services acquired by the business must be recorded at their original acquisition cost. Example: Land bought in 2001 for two million pesos should be recorded at two million pesos even though its market value in the year 2016 is already three million pesos. Accrual principle states that income should be recognized at the time it is earned such as when goods are delivered or when services have been rendered. Likewise, expenses should be recognized at the time they are incurred, such as when goods and services are actually used and not at the time when the entity pays for those goods and services. Example: A resort cannot consider as income the advance payment of a customer who paid his two-week resort accommodation in advance until the customer has checked in. This is because the resort has not yet rendered the service to the customer. As such, the advance payment by the customer should be considered as a liability on the part of the resort in the form of services to be rendered. Adequate disclosure states that all material facts that will significantly affect the financial statements must be indicated. Example: Land bought at two million pesos in 2001 should be recorded at historical cost in the 2016 financial statements. However, the current market value of three million pesos in the year 2016 may be indicated in the financial statements for the year 2016 in the form of a footnote or parenthetical note. Materiality means that financial reporting is only concerned with information significant enough to affect decisions. This refers to the relative importance of an item or event. An item is considered significant if knowledge of it would influence prudent users of the financial statements. Example: Items of insignificant amount such as paper clips can be charged outright to expenses. Consistency means that approaches used in reporting must be uniformly employed from period to period to allow comparison of results between time periods. Any changes must be clearly explained. Example: If the straight line method of depreciation is being used by the company, then the method should be uniformly used by the company in computing its annual depreciation. Assets, Liabilities, Capital, Revenue, and Expenses of the Financial Statements TYPES OF FINANCIAL STATEMENT The key product or the end product of the accounting process is a set of documents called the financial statements comprised of the following: Statement of Financial Position or Balance Sheet - shows the financial condition/ position of a business as of a given period. It consists of the assets, liabilities, and capital. Income Statement or Statement of Comprehensive Income - shows the result of operations for a given period. It consists of the revenue, cost, and expenses. The statement of comprehensive income consists of the revenue, cost, and expenses and also contains components of other comprehensive income (including reclassification adjustments) as follows: changes in revaluation surplus, gains and losses on benefit plans, gains and losses from investments in equity instruments, finance costs, share of associates, and joint ventures under the equity method, tax expense, gain or loss from discontinued operations, gain or loss on realization of assets from discontinued operations, gain or loss from foreign operations, and all other operating and financial events affecting the owner's equity in the business. International Accounting Standards 1 defines Total Comprehensive Income as the "change in equity during a period resulting from transactions and other events, other than those changes resulting from transactions with owners in their capacity as owners". For purposes of lessons in single proprietorship, the activities will consist of the usual revenue, cost, expense, and transactions with owners in their capacity as owners. Hence, the Income Statement will be used to show the results of operations since there is no activity beyond the regular profit and loss items. Statement of Changes in Owner's Equity or Statement of Owner's Equity-shows the changes in the capital or owner's equity as a result of additional investment or withdrawals by the owner, plus or minus the net income or net loss for the year. Statement of Cash Flows-summarizes the cash receipts and cash disbursements for the accounting period. It summarizes the cash activities of the business by classifying cash inflows (receipts) and cash outflows (payments) into operating, investing, and financing activities. It shows the net increase or decrease of cash in a given period and the cash balance at the end of the period. This allows management to assess the business' ability to generate cash and project future cash flows. Typical Account Titles Used Balance Sheet Balance sheet accounts, namely assets, liabilities, and owner's equity, are classified as real or permanent accounts. Assets - economic resources owned by the business expected for future gain. They are property and rights of value owned by the business. Liabilities - include debts, obligations to pay, and claims of the creditors on the assets of the business. Owner's Equity or Capital - includes the interest of the owners on the business; claims of the owners on the assets of the business; and the investment of the owner plus or minus the results of operations. Owner's equity or capital comes from two main sources— investment of owners and earnings of the business. ASSETS CLASSIFICATION OF CURRENT ASSETS Improvements to International Accounting Standards 1 (December 2003) classify an asset as current asset when it is: expected to be realized in, or is intended for sale or consumption in the entity's normal operating cycle; held primarily for the purpose of being traded; expected to be realized within twelve months of the balance sheet date; or cash or a cash equivalent unless it is restricted from being exchanged or used to settle a liability for at least twelve months after the balance sheet date. Examples of current assets are as follows: Cash includes coins, currencies, checks, bank deposits, and other cash items readily available for use in the operations of the business. Cash equivalents are short-term investments that are readily convertible to known amounts of cash which are subject to an insignificant risk to changes in value (per SFAS No. 22, revised 2000). Marketable securities are stocks and bonds purchased by the enterprise and are to be held for only a short span of time or duration. They are usually purchased when a business has excess cash. Trade and other receivables include the amounts collectible from any of the following accounts: accounts receivable - amount collectible from the customer to whom sales have been- made or services have been rendered on account or credit notes receivable - promissory note issued by the client or the customer in exchange for services or goods received as evidence of his/her obligation to pay interest receivable - amount of interest collectible on promissory notes received from customers and clients advances to employees - certain amount of money loaned to employees payable in cash or through salary deductions accrued income - income already earned but not yet received Inventories represent the unsold goods at the end of the accounting period. This is applicable only to a merchandising business. Prepaid Expenses include supplies bought for use in the business or services and benefits to be received by the business in the future paid in advance. Contra-Asset Accounts are accounts deducted from the related asset accounts. Allowance for bad debts - losses due to uncollectible accounts. This is deducted from the accounts receivable account to get the net realizable value. This is in line with the financial statements' qualitative characteristic of conservatism wherein no profits would be anticipated but all probable or estimable losses should be provided. Accumulated depreciation - represents the expired cost of property, plant, and equipment as a result of usage and passage of time. This is deducted from the cost of the related asset account to get the carrying value or book value of the asset. CLASSIFICATION OF NON-CURRENT ASSETS Long-term investments are assets held by an enterprise for the accretion of wealth through capital distribution such as interests, royalties, dividends and rentals, for capital appreciation or for other benefits to the investing enterprise such as those obtained through trading relationships. Investments are classified as long-term when they are intended to be held for an extended period of time (International Accounting Standards No. 25). Property, plant, and equipment are tangible assets that are held by an enterprise for use in the production or supply of goods or services, or for administrative purposes. These assets are expected to be used for more than one period (International Accounting Standards No. 16): Examples of property, plant, and equipment are the following: land - a piece of lot or real estate owned by the enterprise on which a building can -be constructed for business purposes building - edifice or structure used to accommodate the office, store, or factory of a business enterprise in the conduct of its operations equipment - includes typewriter, air-conditioner, calculator, filing cabinet, computer, electric fan, trucks, and cars used by the business in its office, store, or factory. Specific account titles may be used such as office equipment, store equipment, delivery equipment, transportation equipment, and machinery equipment. furniture and fixtures - include tables, chairs, carpets, curtains, lamp and lighting fixtures, and wall decors. Specific account titles may be used such as office furniture and fixtures, and store furniture and fixtures intangible assets - identifiable, non-monetary assets without physical substance held for use in the production or supply of goods or services, for rental to others, or for administrative purposes. These include goodwill, patents, copyrights, licenses, franchises, trademarks, brand names, secret processes, subscription lists, and non-competition agreements (International Accounting Standards No. 38). LIABILITIES Classification of Current Liabilities Improvements to International Accounting Standards 1 (December 2003) classify liability as a current liability when: it is expected to be settled in the entity's normal operating cycle; it is held primarily for the purpose of being traded; it is due to be settled within twelve months after the balance sheet date; or the entity does not have an unconditional right to defer' settlement of the liability for at least twelve months after the balance sheet date. Trade and Other Payables - include payables from any of the following accounts: Accounts payable includes debts arising from the purchase of an asset or the acquisition of services on account. Notes payable includes debts arising from the purchase of an asset or the acquisition of services on account evidenced by a promissory note. Loan Payable is a liability to pay the bank or other financing institution arising from funds borrowed by the business from these institutions payable within twelve months or shorter. (Note: If the loan is payable beyond twelve months, then it is classified under non-current liabilities.) Utilities payable is an obligation to pay utility companies for services received from them. Examples of this are telephone services to PLDT, electricity to Meralco, and water services to Maynilad. Unearned revenues represent obligations of the business arising from advance payments received before goods or services are provided to the customer. This will be settled when certain goods or services are delivered or rendered. Accrued liabilities include amounts owed to others for expenses already incurred but are not yet paid. Examples of these are salaries payable, utilities payable, taxes payable, and interest payable. Classification of Non-Current Liabilities Non-current liabilities are long term liabilities or obligations which are payable for a period longer than one year. Examples of non-current liabilities are as follows: Mortgage payable is a long-term debt of the business with security or collateral in the form of real properties. In case the business fails to pay the obligation, the creditor can foreclose or cause the mortgaged asset to be sold and use the proceeds of the sale to settle the obligation. Bonds payable is a certificate of indebtedness, under the seal of a corporation, specifying the terms of repayment and the rate of interest to be charged. OWNER'S EQUITY Capital is an account bearing the name of the owner representing the original and additional investment of the owner of the business increased by the amount of net income earned during the year. It is decreased by the cash or other assets withdrawn by the owner as well as the net loss incurred during the year. Drawing represents the withdrawals made by the owner of the business in cash or other assets. Income Summary is a temporary account used at the end of the accounting period to close income and expense accounts. The balance of this account shows the net income or net loss for the period before it is closed to the capital account. This will be taken up in Chapter 6 during the discussion of closing entries. INCOME STATEMENT Income statement accounts, namely revenue and expense, are classified as nominal or temporary accounts. Service income includes revenues earned or generated by the business in performing services for a customer or client. The following are different examples of income and the accounting term used to describe the income: Laundry services by a laundry shop (Laundry Income) Medical services by a doctor (Medical Fees) Dental services by a dentist (Dental Fees) Legal services by a lawyer (Legal Fees) Advisory services by a consultant (Consultancy Fees) Accounting or auditing services by a certified public accountant (Audit Fees) Salaries or wages expense include all payments made to employees or workers for rendering services to a company. Examples are salaries or wages, 13th month pay, cost of living allowances, and other related benefits given to the employees. Utilities expense is an expense related to the use of electricity, fuel, water, and telecommunication facilities. Supplies expense covers office supplies used by a business in the conduct of its daily operations. Insurance expense is the expired portion of premiums paid on insurance coverage such as premiums paid for health or life insurance, motor vehicles, or other properties. Depreciation expense is the annual portion of the cost of tangible assets such as buildings, machineries, and equipment charged as expense for the year. Uncollectible accounts expense/ doubtful accounts expense/ bad debts expense means the amount of receivables charged as expense for the period because they are estimated to be doubtful of collection. Interest expense is the amount of money charged to the borrower for the use of borrowed funds.