Accounting Essentials 2018 Edition PDF

No part of this book may be reproduced or distributed in any form or by any means, or stored in a database without the prior written consent of the authors. Accounting Essentials 2018 Edition Published in 2018 by CMU Press Central Mindanao University, University Town 8710 Musuan, Bukidnon, Philippines Illustrations and Layout by the Authors and as cited i ACCOUNTING ESSENTIALS VOLUME 1 2018 Edition Elaine Joy G. Claudel Erwin Dave M. Dahao Raymond S. Pacaldo Mellbourne C. Poliran Sheila Mae L. Poliran ii BRIEF CONTENTS Page I. INTRODUCTION TO ACCOUNTING 1 II. ELEMENTS AND COMPONENTS OF FINANCIAL STATEMENTS 36 III. RECORDING OF TRANSACTIONS OF A SERVICE COMPANY 50 IV. POSTING TO THE LEDGER AND PREPARATION OF TRIAL BALANCE 61 V. MEASURING BUSINESS INCOME 74 VI. COMPLETING THE ACCOUNTING CYCLE 85 iii 1 INTRODUCTION TO ACCOUNTING LEARNING OUTCOMES At the end of the Chapter, students must have: 1. Defined accounting and the basic terms in accounting. 2. Discussed the classical notion of stewardship. 3. Discussed the nature, purpose, functions, scope and objectives of accounting. 4. Narrated the significant events in the history of accounting in the world and in the Philippines. 5. Discussed the uses and users of financial statements. 6. Distinguished the different branches of accounting. 7. Applied the professional values and ethics expected from accountants. 8. Distinguished the forms of business organizations and their activities. 9. Applied accounting concepts and principles. 10. Enumerated the career opportunities available to accountants. 11. Distinguished the different fields of accounting practice. Welcome to your first college accounting class. A common misconception about this course is that it is a mathematics class like algebra, statistics or calculus. Well, it isn’t. More so, don’t tell yourself, “I’m not good at math so I probably won’t be good at accounting.” Though it’s true that this course is heavy in numbers, it is far more than adding, subtracting, and solving for unknown variables. Your analytical skills will be tested though in taking-up business transactions, along with your comprehension skills in understanding the manifold variations of business transactions. WHAT IS ACCOUNTING? Why you should study accounting? You should study accounting because it can help you succeed in business. Businesses use accounting to keep score. Imagine trying to play basketball without knowing how many points a shot is worth. Like sports, business is competitive. If you do not know how to keep score, you are not likely to succeed. With that, how is accounting defined in the business realm? Some people may kiddingly answer, “Accounting is a-one, a-two, a-three, and so on”. That is counting preceded with an ‘a’. Kidding aside, the term accounting has been defined in many ways. Accounting is an information system that reports on the economic activities and financial condition of a business or other organization. It is a system of maintaining records of a company’s operations and communicating that information to decision makers. Accounting information can be used in various ways such as enabling an investor predict business success. Communicating economic information is so important that accounting is frequently called the language of business. Accounting is defined by different accounting organizations as follows: Accounting is a service activity. Its function is to provide quantitative information, 1 primarily financial in nature, about economic entities that is intended to be useful in making economic decisions (Accounting Standards Council). Accounting is an information system that measures, processes and communicates financial information about an economic entity (Financial Accounting Standards Board). Accounting is a process of identifying, measuring and communicating economic information to permit informed judgments and decisions by users of the information (American Accounting Association). 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). Accounting consists of three basic activities – it identifies, records and communicates the economic events relevant to its business. Once the company identifies the economic events, it records those events in order to provide a history of its financial activities. Recording consists of systematic, chronological diary of events, measured in pesos. In recording, the company classifies and summarizes economic events. Finally, if communicates the collected information to interested users by means of accounting reports, called financial statements. Accounting process simplifies the multitude of transactions by aggregating recorded data, thus making the series of events meaningful and easy to understand. Vital element to the communication process is the accountant’s ability to analyze and interpret the reported information through the use of ratios, percentages, graphs and charts to highlight significant financial trends and relationships. Interpretation involves explaining the uses, meaning, and limitations of reported data. People and organizations need useful information in order to make good decisions. This is where accounting plays a key role. The functions of accounting are to measure the activities of the company and communicate those measurements to people. This is illustrated in Figure 1-1. Make Decisions People Companies Accountant Activities Communicate measured information Figure 1-1. Functions of Accounting The product of accounting is referred to as general purpose financial reports. The objective of general purpose financial reporting is to provide financial information about the reporting 2 entity that is useful to existing and potential investors, lenders and other creditors in making decisions relating to providing resources to the entity. Those decisions involve decisions about: a. buying, selling or holding equity and debt instruments; b. providing or settling loans and other forms of credit; or c. exercising rights to vote on, or otherwise influence, management’s actions that affect the use of the entity’s economic resources. Figure 1-2. Objective of Financial Reporting (Adopted from IFRS Conceptual Framework Project Summary, March 2018) BRANCHES OF ACCOUNTING We classify accounting into two broad categories: managerial accounting and financial accounting. Financial accounting produces general purpose accounting information needed by external users. In contrast, the accounting information needed by internal users, such as managers and employees, is provided by managerial accounting. Oftentimes, their information needs overlap and is being provided from a common accounting database of the business entity. Not all entities are established for the purpose of generating profit. There are those organized for civic or humanitarian purpose. These entities are called not-for-profit entities, nonprofit or nonbusiness organizations. Not-for-profit accounting measures the cost of goods and services they provide, the efficiency and effectiveness of their operations, and the ability of the organization to continue to provide goods or services. Other branches of accounting include auditing, bookkeeping, cost accounting, financial management, government accounting and taxation. There are different types of audit, the most common is external auditing. It is the independent examination that ensures the fairness and reliability of the reports that management submit to users. The result of this examination is embodied in the independent auditor’s report. Bookkeeping is a mechanical task involving the collection of basic financial data. The bookkeeper’s task ends where the accountant’s function begins. Cost accounting deals with the collection, allocation and control of the cost of producing specific goods and services. Financial management is a new branch of accounting intended for setting financial objectives, making plans based on those objectives, obtaining the finance needed to achieve that plans, and generally safeguarding all the financial resources of the entity. Management accounting incorporates cost accounting data and adapts them for 3 specific decisions which management may be called upon to make. Government accounting is concerned with the identification of the sources and uses of resources of government agencies. Tax accounting includes the preparation of tax returns and the consideration of the tax consequences of proposed business transactions or alternative courses of action. Accounting Information Financial Accounting Managerial Accounting Nonprofit Accounting Investors Managers Benefactors & Beneficiaries Creditors Employees Legislators Brokers Unions Citizens Figure 1-3. Accounting as Information Provider THE CLASSICAL NOTION OF STEWARDSHIP Micro and small businesses are often managed and run by the owners themselves. Yet, as the business grows, self-managing the business requires more time and expertise from the owner who is expected to be the ultimate decision maker. Out of this demand, arise the need to hire professional managers. The manager is the agent or steward of the owner. Owners have entrusted their business to the managers. Management is therefore accountable to the owner or investors for the custody and safekeeping of the company’s economic resources. The manager is therefore expected to act to serve the interest, goals and objectives of the owner. The corporate form of business organization arises during the Industrial Revolution. Corporate owners, the shareholders, were no longer the managers of their business. Manager had to create accounting systems to report to the owners the results of their stewardship of the business. In stewardship or agency theory, a conflict between the owner and the manager can be inevitable. This situation created a need for an independent report to provide assurance that management’s financial representations are reliable. 4 USERS OF ACCOUNTING INFORMATION The many users of accounting information are commonly called stakeholders. Users of accounting information may be internal or external users. Internal users use financial information to help them carry out their planning, decision-making and control responsibilities in the entity. This user group is mainly composed the entity’s management team in various levels. They use accounting information together with other qualitative information to decide whether to make or buy a component of its product, to hire permanent or casual employees under its administration or through an employment agency, to continue or cease producing a product line, to grant or reject employees’ demands, and the like. Internal Users: 1. Managers decide production and expansion. External Users: 2. Investors decide whether to invest in stock. 3. Employees decide employment opportunities. 4. Creditors decide whether to lend money. 5. Suppliers decide the ability to pay for supplies. 6. Customers decide whether to purchase products. 7. Competitors decide market share and profitability. 8. Regulators decide on social welfare. 9. Tax authorities decide on taxation policies. 10. Local communities decide on environmental issues. Figure 1-4. Users of Financial Statements External users use this information to determine whether their respective concerns are being satisfied. These users normally refer to the general purpose financial statements prepared by the entity. The users of financial statements include present and potential investors, employees, lenders, suppliers and other trade creditors, customers, governments and their agencies, and the public. Their needs include the following: a) Investors. The providers of risk capital and their advisers are concerned with the risk inherent in, and return provided by, their investments. They need information to help them determine whether they should buy, hold or sell. Shareholders are also interested in information which enables them to assess the ability of the entity to pay dividends. b) Employees. Employees and their representative groups are interested in information about the stability and profitability of their employers. They are also interested in information which enables them to assess the ability of the entity to provide remuneration, retirement benefits and employment opportunities. c) Lenders. Lenders are interested in information that enables them to determine whether their loans, and the interest attaching to tem, will be paid when due. 5 d) Suppliers and other trade creditors. Suppliers and other trade creditors are interested in information that enables them to determine whether amounts owing to them will be paid when due. Trade creditors are likely to be interested in an entity over a shorter period than lenders unless they are dependent upon the continuation of the entity as a major customer. e) Customers. Customers have an interest in information about the continuance of an entity, especially when they have a long-term involvement with, or are dependent on, the entity. f) Government and their agencies. Government and their agencies are interested in the allocation of resources and, therefore, the activities of entities. They also require information in order to regulate the activities of entities, determine taxation policies and as the basis of national income and other similar statistics. g) Public. Entities affect members of the public in a variety of ways. For example, entities may make substantial contribution to the local economy in many ways including the number of people they employ and their patronage to the local suppliers. Financial statements may assist the public by providing information about the trends and recent developments in the prosperity of the entity and the range of its activities. HISTORY OF ACCOUNTING The present is better understood when its roots are known. Studying the history of accounting makes it possible to better understand and appreciate the present status of the profession and formulate better projections for the future. Accounting history is the study of the evolution in accounting thought, practices and institutions in response to the changes in the environment and societal needs. It also considers the effect that this evolution has worked on the environment. Accounting records have been found several thousand years ago in various parts of the world. Even before the birth of Christ, evidences show that accounting systems were used in Greece. Romans kept records written in alphabet. Italian merchants borrowed the Arabic numeral system and later arithmetic, which led to the development of the double-entry bookkeeping. Primitive Accounting People have counted and kept records throughout history. Archeologists have established that the origin of keeping accounts in form of certain clay tokens - cones, disks, spheres and pellets – found in Mesopotamia (modern Iraq) were dated as far as 8500 B.C.,. These tokens represented such commodities 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 bullae, which were broken on delivery so the shipment could be checked against the invoice making it the first bills of lading. Tokens were later replaced by symbols impressed on wet clay tablets. Experts consider this stage of record keeping the beginning of the art of writing, which spread rapidly along the trade routes and took hold throughout the known civilized world. Account records date back to the ancient civilizations of Babylonia, Greece, Egypt, and China. People in these civilizations maintained various types of records of business activities. During the 1st dynasty of Babylonia (2286-2242 B.C.), its law which was based on the Code of Hammurabi, requires merchants trading goods to give buyers a sealed memorandum containing the agreed price before it can be considered enforceable. The Scribe, the predecessor of the modern accountant, recorded the agreed-upon transaction on a small mound of clay with the 6 parties affixing “their signatures” on it. This clay was allowed to dry and served as the record of the transaction. For the more important records, clays were kiln-dried. Clay tablets dated around 3600 B.C. in Babylonia were found to contain records on payments of wages. The rulers of these civilizations used accounting to keep track of the cost of labor and materials used in building structures like the great pyramids of the pharaohs of Egypt. Figure 1-5. Primitive Clay Tablets The Accounting Review, October 1966, published an article authored by H.P. Hain entitled “Accounting Control in the Zenon Papyri.” The article described Zenon Papyri discovered in 1905 which reflected information about construction projects, agricultural activities, and business operations of the private estate of Appollonius for a period about thirty years during the 3rd century, B.C. This proved the use of accounting system in Greece before the 5th century, B.C. Accounting is one of our oldest skills. The earliest collections of understandable writing track how many bushels of grain came into the king’s warehouse. Tablets recorded who brought in the grain and how much the king took as his share. Even in the early days, tax collecting is an activity closely linked to accounting. The presence of bookkeeping in the ancient world has been attributed to the following factors: 1. the invention of writing; 2. the introduction of Arabic numerals; 3. the decimal system; 4. the diffusion of knowledge of algebra; 5. the presence of inexpensive writing materials; 6. the rise of literacy; and 7. the existence of a standard medium of exchange. A. C. Littleton in Accounting Evolution to 1990 lists seven preconditions for the emergence of systematic bookkeeping: 1. The Art of Writing since bookkeeping is first of all a record. 2. Arithmetic since the mechanical aspect of bookkeeping consists of a sequence of simple computations. 3. Private Property since bookkeeping is concerned only with recording the facts about property and property rights. 4. Money (i.e. among economy) since bookkeeping is unnecessary except as it reduces all transactions in properties or property rights to this common denominator. 5. Credit (i.e. uncompleted transactions) since there would be little impulse to make any record whatever if all exchanges were completed on spot. 6. Commerce since a merely local trade would never have created enough pressure (volume of business) to stimulate men to coordinate diverse ideas into a system. 7. Capital since without capital commerce would be trivial and credit would be inconceivable. 7 Middle Ages and the Genoese System Northern Italy’s literacy has become widespread as a result of the crusades from the 11th to the 13th centuries. Arabic numerals were used in trades with the Near East allowing columns of numbers to be added and subtracted. A semblance of an international banking system was also functioning as evidenced by the prevalent use of credit. The Inca Empire, which spanned the west coast of South America throughout the 11th to 14th centuries. Quipu, knotted cords of different lengths and colors, were to keep accounting records. Development of more formal account-keeping methods is attributed to the merchants and bankers of Florence, Venice and Genoa during the 13th to 15th centuries. The Genoese system was probably a development of the Ancient roman system. Commercial activity had been flourishing in Genoa for a long time and the Genoese system assumed the concept of business entity. Because it recorded items in terms of money, it was the first to imply that unlike terms could be compared in terms of a common monetary unit. The system also implied some understanding of the distinctions between capital and income that it included both expenses and equity accounts. The oldest double-entry books were the Massari (treasury officials) ledgers of the Commune of Genoa dating from 1340. Double-entry bookkeeping is not a discovery of science but an outcome of continued efforts to meet the changing necessities of trade. German philosopher Oswald Spengler wrote in The Decline of the West (1928) that the invention of double-entry bookkeeping was the decisive event in European economic history. The Florentine Approach to Reporting Renaissance Florentine markets were a fascinating combination, in the form of account books and double-entry bookkeeping, and of informal social networks, constructed out of the surrounding rules of Florentine sociality. To them, doing business and living life were intertwined. Friendship is emotional but was instrumental to doing business. A major achievement in Florence was the development of large associations and compagnie (partnership that pooled capital initially within family groups and then from outside the family groups). Account books were consistent with social exchange and made it easier and formal. The explosion of commercial credit, at that time, required a system of recording. The earliest evidence of business bookkeeping in Florence, France was evidenced by the bank ledger fragments of 1211 (transcribed in 1887 by Pietro Santini) and with the development of accounting in Tuscany, Italy during the 13th century, as evidenced in the account-books or extracts. But, these were in form of “narrative” or “paragraph accounting record (a sezioni sovrapposte), perhaps derived from the “charge and discharge” format used in public accounts. The system was primitive, accounts were not related in any special way (in terms of equality of entries), and balancing of accounts was lacking. The emergence of double-entry itself, was first witnessed in the “ledgers” of Renieri (or Rinieri) Fini & Brothers (1296-1305) and Giovanni Farolfi & Company (1299-1300). Giovanni Farolfi & Company, was a firm of Florentine merchants whose head office was Nimes in Languedoc, in the kingdom of France, as it appear in the “ledger.” The ledger, however, relates exclusively to the branch at Salon, a town in the independent county of Provence. Amatino Manucci was a partner in Giovanni Farolfi & Company, a merchant partnership based in Florence. 8 Financial records that he kept for the firm’s branch in Salon, Provence, survive from 1299- 1300. Although these records are incomplete, they show enough detail to be identified as double-entry bookkeeping. These details include the use of debits and credits and duality of entries. They are the oldest known existing examples of the double-entry system. Amatino Manucci was the inventor of double-entry bookkeeping. He managed to construct a comprehensive and fully-articulated set of double-entry records, with a regular balancing procedure on closure of the General Ledger. He used five books – general ledger, two merchandise ledgers, expenses ledger, and cash book (with the white ledger as the sixth) – constituted what looks very like a true double-entry system. In addition, there were at least two subsidiary books. He gave importance to the aspect of financial control. The books were logically subdivided, with segregation of cash and goods accounts from the main ledger, a perpetual inventory of each line of agricultural produce and each grade of cloth or yarn dealt in, and full records of debtors and creditors, expenses, profits, interest and partner’s drawings, as well as the state of account with the head office at Nimes, and an estimate (15% per annum) of the expected rate of return on capital employed. The Venetian Approach Luca Pacioli, a Franciscan friar and a celebrated mathematician, is generally associated with the introduction of double-entry bookkeeping. In 1494, he published his book entitled “Summa de Arithmetica, Geometria, Proportioni et Proportionalita” or “Everything about Arithmetic, Geometry, Proportions and Proportionality.” It includes, “Particularis de Computis et Scripturis” or “Details of Calculation and Recording,” describing double-entry bookkeeping. His treatise reflected the practices of Venice at the time, which became known as the Method of Venice of the Italian method. Therefore, he did not invent double-entry bookkeeping, but rather described what were prevalent accounting practices of the day. Although Pacioli made no claim to developing the art of bookkeeping, he has been regarded as the “Father of Double-entry Accounting.” He stated that the purpose of bookkeeping was “to give the trader without delay information as to his assets and liabilities.” Pacioli also advised computation of a periodic profit and the closing of the books. He said, “It is always good to close the books each year, especially if you are in a partnership with others. Frequent accounting makes for long friendship.” The Italian bookkeeping prospered with the development of the commercial republics of Italy and the use of the double-entry method in the fourteenth century. Goethe, the famous German poet and dramatist, referred to double-entry bookkeeping as “one of the finest discoveries of human intellect.” Werner Sombart, an eminent economist- sociologist, believed that “double-entry bookkeeping is born of the same spirit as the system of Galileo and Newton.” Savary and the Napoleonic Commercial Code The earliest systematized form of accounting regulation developed in continental Europe, starting in France in 1673. The government introduced the submission of an annual fair value statement of financial position to protect the economy from bankruptcies. This period saw the personification of accounts, such as the practice of treating accounts as independent, living entities; and the standardization of debits on the left and credits on the right. 9 This legal requirement for businesses to keep accounting records was first introduced in the Ordonnance de Commerce of 1673 which was put through by Jean-Baptiste Colbert during the reign of Louis XIV, and the Napoleonic Commercial Code of 1807, that influenced the bookkeeping provisions of commercial law throughout Continental Europe, Francophone Africa, and beyond. The Napoleonic Code or Code Napoléon is the French civil code, established under Napoléon Bonaparte on March 21, 1804. The Commercial Code was adopted in 1807. Jacques Savary, the elder (1622-1690) in an early accounting text stated, “If this merchandise is starting to deteriorate, or go out of style, or is that which one judges he could find at the factory or wholesalers at 5% or less, it must be reduced to this price.” Although this is the oldest known formulation of the lower-pf-cost-or-market principle, several earlier accounting texts recommended current cost rather than historical cost valuation of inventory in specific examples where the market valuation is lower. Inventory valuation at the lower-of-cost-or- market was required by the Code of Commerce in France in 1673, in Prussia in 1794, and in the German Commercial Code of 1884. As Savary was the principal author, the French Commercial Code of 1673 was also called the Code Savary. In the 17th century, Nicolas Petri was the first person to group similar transactions in a separate record and enter the monthly totals in the journal, rather than recording all transactions seriatim, that is, in a series. In 1769, Benjamin Workman published The American Accountant, the earliest known American accounting textbook. The Industrial Revolution and the Share-Issuing Company Accounting practice dates from antiquity but the formation of an accounting profession was closely tied to the rise of a modern industrial society in Britain during the late 18th century. The need for accounting services emerged slowly, but by the early decades of the 19th century a flurry of textbooks and handbooks on accounting had appeared, reflecting the impact of the Industrial Revolution. This revolution, which occurred in England from the mid-18th to the mid-19th century, changed the method of producing commercial goods from the handicraft method to the factory system. With this change came the problem of costing for a large volume of products. The specialized field of cost accounting emerged to meet this need for the analysis of various costs. The expanded business operations initiated by the Industrial Revolution required increasingly large amount of funds to build factories and purchase machinery. This need resulted to the development of the corporate form of organization. In England, statutory establishments of corporations dated as early as 1845. The growth of corporations spurred the development of accounting standards. Corporate owners, the shareholders, were no longer the managers of their business. Manager had to create accounting systems to report to the owners the results of their stewardship of the business. This situation created a need for an independent report to provide assurance that management’s financial representations are reliable. Those with some experience in bookkeeping or the liking for the subject became accountants. Some of them had gone into “public practice” as early as the mid-17th century. As early as 1799, there were 11 practicing accountants in London. Less than 50 years later, 210 accountants were listed and the numbers in other principal cities had grown commensurately. Accountancy, however, was still an indeterminate calling in Britain as late as the 1830s. Men then engaged in accounting not only made simple accounts but also found it financially 10 necessary to act as auctioneers, appraisers, agents and debt collectors. The profession was shaped by legislation. Accountancy reached the shores of the United States of America as a natural result of the investments being made by British businessmen into the land of opportunities. In 1900, a preliminary report of the Industrial Commission produced in 1898, suggested that an independent public accounting profession should be established to curtail some corporate abuses. During the International Congress of Accountants in 1904, the American Association of Public Accountants was formed as the professional organization of accountants in the United States. Income Taxation and Conflicts with Financial Accounting Xin Dynasty’s Emperor Wang Mang instituted an unprecedented tax – the income tax – at the rate of 10% of profits, for professionals and skilled labor. To pay for weapons and equipment in preparation for the Napoleonic Wars, William Pitt the Younger of Britain levied an income tax in his budget of December 1798. The 1862 Union Government established the Bureau of Internal Revenue to assess personal and income taxes to help finance the Civil War. In 1943, the US Congress passed income tax withholding as the only way to collect on high tax rates to fund World War II. The Philippines’ Bureau of Internal Revenue (BIR) was created through the passage of Reorganization Act No. 1189 dated July 2, 1904. On August 1, 1904, the BIR was formally organized and made operational under the Secretary of Finance. Financial accounting is conservative and it’s about matching efforts and results. Tax accounting, in turn, is about improving the timing of collections. Note that “taxes are the lifeblood of the government and their prompt and certain availability are an imperious need.” This difference in perspective produces conflicts. All returns required to be filed by the Tax Code shall be prepared always in conformity with the provisions of the Tax Code. In case of conflicts with generally accepted accounting principles (GAAP), in the final reckoning, the Tax Code will prevail. Schmalenbach and the Charts of Accounts Eugen Schmalenbach (1873-1955) was a German academician and economist. He was born in Halver, and attended Leipzig College of Commerce starting 1898. Schmalenbach was a professor at the University of Cologne and a contributor to German language journals on the subjects of economics, business management and financial accounting. In the early 1920s, Professor Schmalenbach was frustrated repeatedly with his failure to compare meaningfully the financial data made available by different companies. This led to a research on the problem and the publication of his book, the Model Chart of Accounts. With this book, he laid the foundation for all subsequent developments in uniform accounting in Germany. It also became the basis for corresponding efforts in other European countries. Schmalenbach claimed that important information could be gained from a firm’s accounts. The results of one’s firm should show through-flows more usefully than balances. What he termed “Dynamic Balances” were to be promptly and regularly prepared and presented, so that external changes and internal efficiencies could be gauged, inter-firm comparisons were also to be facilitated. 11 The Rise of the Group of Companies and the Need for Consolidated Accounts Railroads, heavy users of debt financing in the late 1800s, were the first American firms to issue balance sheets to absentee creditors. By 1880, the US railroad system had accumulated $4.6 billion of investments which was roughly equivalent to 40% of the American economy’s annual output. Depreciation was formally considered given that the railroad companies used higher value and longer-lived equipment – locomotives, rail cars and track – than previous established enterprises. With the hauling of freight, the equipment gradually lost productive capacity and needed to be replaced. Due to these, problems arise such as the clarity of the timing of wear and tear and matching of revenues and expenses. The concept of depreciation was introduced when the 1909 US corporate income tax law permitted a deduction for depreciation charges in the calculation of taxable income. At the beginning of the 20th century, some managers began to use depreciation to smooth reported earnings. A 1912 Journal of Accountancy editorial complained that depreciation had become a tool used by management to counter fluctuations in profits. In good years, heavy depreciation charges were made. Bad years saw no provision or an inadequate charge. On March 12, 1903, United States Steel published consolidated financial statements as of December 31, 1902, together with Price Waterhouse & Company’s (PW) assurance that they were audited and found correct. US Steel resulted from the amalgamation of various steel producers at that time. It’s the first billion-dollar corporation which controlled 75% of the US Steel business. There existed complex relationships between US Steel and its many subsidiaries such that PW Managing Partner Arthur Lowes Dickinson believed that the stockholders could be informed adequately of the entity’s relative financial condition only through a consolidation of accounts. Us Steel’s consolidated financial statements rapidly became a landmark in accounting history. The era of modern financial accounting had dawned. Scientific American wrote that it was “the most complete and circumstantial report ever issued by any great American corporation,” noting that the company’s total assets of over $1.5 billion dwarfed the $50 million appropriated by Congress for the Spanish-American war several years earlier. Since the early 1900s, business organizations changed rapidly. The increasing complexity of the world’s acquisitions, and the growth of multinational corporations, fostered new internal and external reporting consolidated accounts and control systems. With widespread ownership of modern corporations came new audit and reporting procedures and new agencies became involved in promulgating accounting standards like stock exchanges, securities regulating commissions, and internal revenue agencies. Information Age and Cloud Computing Dan Brinklin and Bob Frankston wrote Visicalc for the Apple II, the first electronic spreadsheet, the most important business application for the personal computer. Tremendous advances in information technology have further revolutionized accounting in recent years. Tasks that are time-consuming when done manually can now be done with speed, consistency, precision and reliability by computers. There is an abundance of accounting applications causing the way of doing business to change. As they say, information technology is it, you either breathe it or perish. The evolution of technology had exponentially speed up with the introduction of internet. With internet connectivity, business have conquered cross-border markets. The borderless market and business activities posed another challenge to the accountancy profession. To address this, cloud computing software, such as enterprise resource planning (ERP) systems were 12 introduced. Accounting and assurance tasks started to be done online. With databases stored in the cloud, many business transactions and financial information became almost readily available on real-time. Internationalization of Markets and Reporting The dramatic increase in foreign investments and world trade and the formation of regional economic groups such as the European Union and the Association of South-East Asian Nations (ASEAN) posed problems concerning the international activities of business. It became more complex involving reconciling of accounting practices of different nations in which each multinational company operates, as well as dealing with accounting problems specific to international business. The different accounting practices can completely obscure the comparisons and analyses used by foreign investors to assess various investment opportunities. Aside from international mergers and consolidations, securities markets are now crossing boundaries as well. Euronext was created out of the combination of the former Amsterdam, Brussels, Lisbon, and Paris stock exchanges. NASDAQ and London shares can be bought on the stock exchange of Hongkong. AMEX shares are traded in Singapore. Even the Philippines’ “PLDT” traded at the Philippine Stock Exchange (PSE) also trade at NYSE. This calls for the global harmonization of accounting standards. Figure 1.6. International Exchange Statistics Accountancy Profession in the Philippines Bookkeeping was introduced in the Philippines during the Spanish era. A bookkeeper was then called “Tenedor de Libro.” During the American occupation in the country, U.S. practices and procedures were introduced. In 1923, accounting was legally recognized as a profession in the Philippines when the sixth Philippines Legislature approved Act No. 3105 on March 17, 1923. This law created the Board of Accountancy vested with authority to promulgate rules and regulations, to set professional standards for the accounting profession practice and to issue certified public accountant Figure 1-7. BOA Logo certificates to those who have qualified in accordance with the requirements of the law. The Board then was composed of a chairman and two members. The first Board of Accountancy was composed of Chairman W. W. Larkin, and, Domingo Dikit and Felix Tiongson, as members. In this same year, the first licensure examination for public accountants was given. 13 Figure 1-8. Composition of Board of Accountancy Philippine Institute of Certified Public Accountants (PICPA), the accredited professional organization (APO) of accountants in the Philippines, was founded in November 1929 by a group of illustrious pioneers in the accounting profession. They are Enrique Caguiat, Santiago de la Cruz, Francisco Dalupan, Jaime Hernandez, Felipe Ollada, Ramon del Rosario, Antonio Sanchez, Jose Torres, Artemio Tulio, Clemente Uson and Jesus Zulueta. W. W. Larkin, holder of CPA Certificate No. 1, was its first president. The accreditation started on October 2, 1973, when PICPA was awarded Certificate of Accreditation No. 6, by then PRC Chairman Eric Nubla, after having complied with the requirements for accreditation under Presidential Decree No. 223. This distinction, which recognized the Institute as the bonafide professional organization of CPAs, likewise gave PICPA the responsibility of setting into motion a scheme for the integration of all CPAs in the country. Over the years, PICPA has been sustaining its accreditation with PRC and has been awarded twice as PRC most outstanding APO from among other professional organizations. PICPA operated with various committees taking charge of the different services offered to the members. Figure 1-9. PICPA Logo The Committee on Accounting Principles which operated under PICPA was charged the function to study and adopt U.S. accounting principles applicable to the country. In 1981, the Accounting Standards Council (ASC) was formed to formalize the accounting standard-setting function of PICPA. By 1995, 22 Statement of Financial Accounting Standards (SFAS) were approved and published. SFAS, comprising the generally accepted accounting principles (GAAP), focused on the commercial and industrial enterprises except for SFAS 19 which discussed principles for banks and financial institutions. In the same year, the ASC started to adopt the International Accounting Standards (IAS) to address the need to harmonize the standards among Southeast Asian countries and in the world. The applicable standards were revised to apply to Philippine business industries and termed as Philippine Accounting Standards (PAS). All PAS were fully implemented in 2005. The effort to harmonize accounting standards in the world led to the convergence agreement between the U.S. Financial Accounting Standards Board (FASB) and Britain’s International Accounting Standards Board (IASB). As a result of convergence, International Financial Reporting Standards (IFRS) were issued. In the Philippines, the Financial Reporting Standards 14 Council of the Philippines replaced ASC to review and adopt applicable IFRSs. The adopted IFRSs are termed as Philippine Financial Reporting Standards (PFRS). The convergence efforts continues until today. The year 2018 marks the 95th anniversary of the establishment of the accountancy profession in the Philippines and the creation of the Board of Accountancy. From 43 registered accountants in 1923, the number of Certified Public Accountants (CPAs) has grown to over 185,000 by January of 2018. Many of these professionals have distinguished themselves not only in the field of accountancy but in many areas of human endeavor. Among the distinguished luminaries belonging to the roster of CPAs follows:  Jaime Hernandez and Paciano Dizon, the first and second Filipino Auditor Generals of the Commission on Audit,  Manuel Villar, a billionaire businessman, former Senate President and Speaker of the House of Representatives,  Washington Sycip, past president of the International Federation of Accountants, the only Asian who has held the position, and founder of SGV & Co. and the Asian Institute of Management (AIM),  Jose Diokno, former senator of the Philippines and Secretary of Justice,  Wenceslao Lagumbay and Alberto Romulo, former senators,  Ambassador Alfredo Yuchengo and Andres Soriano, founder of the country’s leading conglomerates,  Heide Mendoza, presently the Under-Secretary-General for Internal Oversight Services, Office of the United Nations, and  Dante Gierran, the present National Bureau of Investigation Director More CPAs have been cabinet members, heads of government agencies, chairmen and members of corporations and institutions, leaders in global institutions, heads and professors in the academe, and entrepreneurs. Definitely, the accounting professionals play an integral part of the country’s development. The increasing complexity of professional regulation and developments in the practice of the profession have occasioned the expansion of the Board of Accountancy from a president and two members under Act No. 3105 in 1923, through a chairman and five members under Republic Act No. 5166 (The Accountancy Act of 1967), to seven comprised of a chairman and six members under Presidential Decree No. 692 (The Revised Accountancy Law) in 1975. PD 692 governed the profession for almost three decades until the Republic Act No. 9298 (Philippine Accountancy Act of 2004) was passed. The results of the public consultations on the revisions of the Philippine Accountancy Act of 2004 are now pending in Congress. Accountancy Profession in the Future In 2017, Commission on Higher Education (CHED) issued the following CHED Memorandum Orders (CMOs) to govern the new and revised programs under the Accountancy Education: 1. CMO No. 27 for Bachelor of Science in Accountancy 2. CMO No. 28 for Bachelor of Science in Management Accounting 3. CMO No. 29 for Bachelor of Science in Internal Auditing 4. CMO No. 30 for Bachelor of Science in Accounting Information System The aforementioned CMOs will create a more focused path for the future accounting professionals. The CMOs are anchored to the latest competency framework for professional accountants issued by the International Federation of Accountants (IFAC) through their International Education Standards. 15 Accountancy is a profession that involves providing assurance and audit services for statutory financial reporting, tax-related services, management advisory services partnering in management decision-making, devising planning and performance and control systems, and providing expertise in financial reporting and control to assist various stakeholders in making decisions. Management accounting profession involves partnering in management decision-making, devising planning and performance management systems, and providing expertise in financial reporting and control to assist management in the formulation and implementation of an organization’s strategy. Internal Auditing is a profession that enhances and protects organizational value by providing stakeholders with risk-based, objective and reliable assurance, advice and insight. It is an independent, objective assurance and consulting activity designed to add value and improve an organization’s operations. It helps an organization accomplish its objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control, and governance processes. Accounting Information System is a profession that combines knowledge in business, accounting and computer systems. It involves partnering with management operations and decision-making, by coordinating the information technology activities, providing expertise in choosing the best software or designing and maintaining the overall information system, assessing the integrity of systems, assessing the inefficiencies of a company’s system and recommending improvements to assist management in the formulation and implementation of an organization’s strategy. Figure 1-10. Philippine Accountancy Education Framework (PAEF) The curricular programs for Accounting Education are designed to support aspiring professional accountants to develop the appropriate entry-level technical competence, professional skills, values, ethics and attitudes to successfully complete their studies, pass their professional certification assessment/examination and the practical experience period. The required General Education and major areas required by the profession such as: 1. Accounting, finance and related knowledge 2. Organizational and business knowledge; and 3. Information technology, knowledge and competencies Pending the passage of the proposed amendment to the present Accountancy Law, only the graduates of the BS in Accountancy program shall be eligible to take the CPA Licensure Examination. The proposed revision of the Accountancy Law, however, will require a two-tier examination. 16 Figure 1-11. Accountancy Education based on the Proposed Amendment to the Accountancy Law THE ACCOUNTING PROFESSION: CAREER OPPORTUNITIES One of the greatest benefits of an accounting degree is the wide variety of job opportunities it opens to you. With an accounting degree you can apply for almost any position available to finance majors. However, it doesn’t work the other way: Finance majors often lack the accounting background necessary to apply for accounting positions. An accounting career can take you to the top of the business world. But what specifically accountants do? The field of accounting offers stimulating and challenging work that is constantly evolving. Accountants may choose a career path in any of the four specialized fields of accounting. Commission on Higher Education (CHED) Memorandum Orders (CMOs) 27- 30, s. 2017 provided the following list of job opportunities for graduates. 1. Entry-level jobs a. Public Practice: Junior Analyst, Consulting staff, Junior Internal Audit Staff, Associate Consultant b. Commerce and Industry: Cost Analyst, Investment Analyst, Accountancy Staff, Tax Accounting Staff, Financial Analyst, Budget Analyst, Credit Analyst, Cost Accountant, Internal Auditing Staff, Compliance Officer, Tax Auditor, Financial Auditor, Management Accounting Staff c. Government: State Accounting Examiner, NBI Agent, Treasury Agent, State Accountant, LGU Accountant, Revenue Officer, Audit Examiner, Budget Officer, Financial Services Specialist d. Education: Junior Accounting Instructor 2. Middle-level positions a. Public Practice: Senior Consulting Manager, Financial Advisory Manager, Senior Internal Audit Manager, Managing Consultant, Lead Consultant b. Commerce and Industry: Controller/Comptroller, Senior Information Systems Auditor, Senior Loan Officer, Senior Budget Officer, Senior Internal Auditor, Senior Information Systems Officer, Senior Compliance Officer c. Government: State Accountant V, Director III and Director IV, Government Accountancy and Audit, Financial Services Manager, Audit Service Manager, Senior Auditor d. Education: Senior Faculty, Accounting Department Chair, Program Head 3. Advanced positions a. Public Practice: Partner, Senior Partner, Senior Consultant/Financial Advisor, Partner of Advisory Services 17 b. Commerce and Industry: Finance Director/ Chief Financial Officer, Chief Information Officer, Chief Audit Executive, Chief Risk Officer, Chief Compliance Officer c. Government: National Treasurer, Vice President for Finance/CFO (for GOCCs), Commissioner, Associate Commissioner, Assistant Commissioner, (COA, BIR, BOC) d. Education: Vice President for Academic Affairs, Dean SPECIALIZED ACCOUNTING FIELDS The practice of accountancy include, but not limited to, the following: 1. Practice of Public Accountancy - shall constitute in a person, be it his/her individual capacity, or as a partner or as a staff member in an accounting or auditing firm, holding out himself/herself as one skilled in the knowledge, science and practice of accounting, and as a qualified person to render professional services as a certified public accountant; or offering or rendering, or both, to more than one client on a fee basis or otherwise, services such as the audit or verification of financial transaction and accounting records; or the preparation, signing, or certification for clients of reports of audit, balance sheet, and other financial, accounting and related schedules, exhibits, statements or reports which are to be used for publication or for credit purposes, or to be filed with a court or government agency, or to be used for any other purpose; or the design, installation, and revision of accounting system; or the preparation of income tax returns when related to accounting procedures; or when he/she represents clients before government agencies on tax and other matters related to accounting or renders professional assistance in matters relating to accounting procedures and the recording and presentation of financial facts or data. The most common services offered by public accountants include audit services, tax services and consulting services. Audit services involve examining a company’s accounting records in order to issue an opinion about whether the company’s financial statements conform to generally accepted accounting principles. The auditor’s opinion adds credibility to the statements, which are prepared by the company’s management. Tax services include both determining the amount of tax due and tax planning to help companies minimize tax expense. Consulting services cover a wide range of activities that includes everything from installing sophisticated computerized accounting systems to providing personal financial advice. 2. Practice in Commerce and Industry - shall constitute in a person involved in decision making requiring professional knowledge in the science of accounting, or when such employment or position requires that the holder thereof must be a certified public accountant. Also called in private accounting, accountants in commerce and industry usually work for a specific company or nonprofit organization. They perform wide variety of functions for their employers from classifying and recording transactions, billing customers and collecting amounts due, ordering merchandise, paying suppliers, preparing and analyzing financial statements, developing budgets, measuring costs, assessing performance, and making decisions. 18 Aside from the CPA title, other internationally recognized professional certifications suit for private accountants. For example, the Institute of Certified Management Accountants issues the Certified Management Accounting (CMA) designation. The Institute of Internal Auditors (IIA) issues the Certified Internal Auditor (CIA) designation. These are widely recognized indicators of technical competence and integrity on the holder. All of these certifications require meeting education requirements, passing a technical examination, and obtaining relevant work experience. 3. Practice in Education/Academe - shall constitute in a person in an educational institution which involve teaching of accounting, auditing, management advisory services, finance, business law, taxation, and other technically related subjects: Provided, That members of the Integrated Bar of the Philippines may be allowed to teach business law and taxation subjects. 4. Practice in the Government- shall constitute in a person who holds, or is appointed to, a position in an accounting professional group in government or in a government– owned and/or controlled corporation, including those performing proprietary functions, where decision making requires professional knowledge in the science of accounting, or where a civil service eligibility as a certified public accountant is a prerequisite. DOUBLE ENTRY BOOKKEEPING Fra. Luca Pacioli’s Summa de Arithmetica is comprised of 36 short chapters in bookkeeping. It has three books – the memorandum, the journal and the ledger. According to him, in order to be successful, every merchant needs three essential things: sufficient cash or credit, a good bookkeeper, and an accounting system to view the business affairs at a glance. Pacioli introduces double-entry accounting system in his book – in which for every debet dare (should give) there exists a debet habere (should have or should receive). Modern bookkeeping still have these principles but adapted to suit modern conditions. The first book in Summa, the memorandum is the book where all transactions are recorded, in the currency in which they are conducted, at the time they are conducted. The memorandum prepared in chronological order is a narrative description of the business’s economic events. The memorandum is important because the use of supporting documents to support transactions is not observed. The journal is the merchant’s private book containing entries made in one currency, in chronological order, and in narrative form. The ledge is the alphabetical listing of all accounts along with the running balance of each particular account. Financial statements are not yet prepared during this time but Pacioli recommended annual balancing to determine the success or failure of the business and to find errors. This lasted for so long because it provides an accurate record of what has happened to a business over a specified period of time, and information extracted from the system can help the owner or the manager operate the business much more effectively. BASIC PROFESSIONAL VALUES AND ETHICS A distinguishing mark of the accountancy profession is its acceptance of the responsibility to act in public interest. Therefore, a professional accountant’s responsibility is not exclusively to satisfy the needs of an individual client or employer. In acting in the public interest, a professional accountant shall observe and comply with the Code of Ethics for professional accountants. A professional accountant shall comply with the following fundamental principles: 19 Integrity This means to be straightforward and honest in all professional and business relationships. Integrity also implies fair dealings and truthfulness. Objectivity Objectivity means to not allow bias, conflict of interest or undue influence of others to override professional or business judgments. Professional Competence and Due Care This is to maintain professional knowledge and skill at the level required to ensure that a client or employer receives competent professional service based on current developments in practice, legislation and techniques and act diligently and in accordance with applicable technical and professional standards. Confidentiality Accountants are expected to respect the confidentiality of information acquired as a result of professional and business relationships and, therefore, not disclose any such information to third parties without proper and specific authority, unless there is legal or professional right or duty to disclose, nor use the information for the personal advantage of the professional accountant or third parties. Professional Behavior This means to comply with relevant laws and regulations and avoid any action that discredit the profession. FORMS OF BUSINESS ORGANIZATION Common business forms include sole proprietorships, partnerships, corporations and cooperatives. Sole proprietorship is the simplest form of business organization where capital is owned and provided by one person called “proprietor.” In a partnership, the capital of the business is owned or provided by two or more persons called “partners”. Partners’ agreements are embodied in the “Articles of Co-Partnership.” A corporation is the biggest and most complicated form of business organization. It requires more formality to organize and manage but its economic life may last up to fifty (50) years, subject to renewal. It is organized by at least five but not more than fifteen (5-15) persons called “Incorporators” and the capital, called “share capital” is divided into units called “shares.” Each share has a designated value called “Par value.” A corporation is governed by the Board of Directors. Cooperatives operates similar to a corporation though voting is based on “one-man, one-vote” basis. To decide on a form of business organization, you need to understand their advantages and disadvantages. The major advantage of the corporate form of business is the limited liability of the corporation’s stockholders. Limited liability means the stockholders are not held personally responsible for the financial obligations of the corporation. If the business fails, stockholders can lose no more than the investment they already made by purchasing stock. In other words, stockholders are not obligated to pay the corporation’s remaining debts out of their own pockets. In contrast, if a sole proprietorship or partnership is unable to pay its legal obligations to creditors, the owner(s) may be forced to surrender personal assets, such as homes, cars, computers, and furniture to satisfy those debts. 20 The disadvantage of the corporate form of business is the higher tax burden on the owners. Generally, the corporate income tax rate is greater than the individual income tax rate. Moreover, a corporation’s income is taxed twice—first when the company earns it and pays corporate income taxes on it, and then again when stockholders pay personal income taxes on amounts the firm distributes to them as dividends. This is called double taxation. Any income of a sole proprietorship or a partnership is taxed only once, and at the personal income tax rate. CLASSES OF BUSINESS ORGANIZATION AS TO NATURE OF OPERATION As previously indicated, organizations exist in many different forms. Business entities are typically service, merchandising, manufacturing, agriculture or hybrid companies. Service businesses derive its income by providing services to their clients. Most common examples include doctors, lawyers and accountants. Merchandising businesses sell goods to customers that other entities make. The business is therefore engaged in buying goods and commodities or any form of finished products and sells theses for profit. A merchandising entity is either a retail or wholesale company. Manufacturing businesses make the goods that they sell to their customers. They are engaged in buying raw materials and supplies to be processed or manufactured, converting them into finished products for sale at a profit. Examples are car manufacturer, home appliance manufacturer and furniture shop. An agriculture business is engaged in planting of crops and sells its products either in raw or finished form for a profit. Hybrid companies are those involved in more than one type of activity which are manufacturing, merchandising, service and agriculture. The nature of reporting entity affects the form and content of the information reported in an entity’s financial statements. For example, manufacturing companies report cost of goods manufactured which is not present in both merchandising and service entities. A service entity does not report cost of goods sold, which is common in the income statement of both merchandising and manufacturing companies. More diverse reports can be viewed in looking into real-world financial statements. Figure 1-12. Operating Cycle of a OPERATING CYCLE Service Concern Entity An operating cycle is the length of time lapsed from the disbursement of cash until it reverted back to cash. The phases and duration of time to complete an operating cycle varies depending on the nature of the business operation, the products business entities produced, and other external and internal factors affecting each phase. The size of the business also affects the operating cycle. The operating cycle for a “sari-sari” store may be completed in one day or less, while the operating cycle for a wine manufacturer takes more than a year to complete. Figure 1-13. Operating Cycle of a Merchandising Entity 21 Figure 1-14. Operating Cycle of Figure 1-15. Operating Cycle of an a Manufacturing Entity Agriculture Entity BUSINESS ACTIVITIES TO MEASURE The first of financial accounting’s functions is to measure business activities. A business engages in three fundamental activities – financing, investing, and operating. Financing activities are transactions involving external sources of funding. There are two basic sources of this external funding – the owners of the company who invest their own funds in the business, and creditors who lend money to the company. With this financing, the company engages in investing activities. Investing activities include the purchase and sale of (1) long-term resources such as land, buildings, equipment, and machinery and (2) any resources not directly related to a company’s normal operations. Once these investments are in place, the company has the resources needed to run the business and can perform operating activities. Operating activities include transactions that relate to the primary operations of the company, such as providing products and services to customers and the associated costs of doing so, like utilities, taxes, advertising, wages, rent, and maintenance. In summary, financing activities include transactions with creditors and owners. Investing activities generally include the purchase or disposal of productive assets. Operating activities relate to earning revenues and incurring expenses. ACCOUNTING CONCEPTS AND PRINCIPLES Underlying Assumptions Accrual Basis In order to meet their objectives, financial statements are prepared on the accrual basis of accounting. Under this basis, the effects of transactions and other events are recognized when they occur (and not as cash or its equivalent is received or paid) and they are recorded in the accounting records and reported in the financial statements of the periods to which they relate. Financial statements prepared on the accrual basis inform users not only of past transactions involving the payment and receipt of cash but also of obligations to pay cash in the future and of resources that represent cash to be received in the future. Hence, they provide the type of information about past transactions and other events that is most useful to users in making economic decisions. Going Concern The financial statements are normally prepared on the assumption that an entity is a going concern and will continue in operation for the foreseeable future. Hence, it is assumed that the entity has neither the intention nor the need to liquidate or curtail materially the scale of its 22 operations. Hence, in the absence of information to the contrary, a business entity will be presented to continue to operate indefinitely. This assumption is critical to many broad and specific accounting principles. It provides justification for measuring many assets based on their original costs (a practice known as the historical cost principle). If we knew an enterprise was going to cease operations in the near future, we would measure assets and liabilities not at their original costs but at their current liquidation values which should be appropriately disclosed. Economic Entity Assumption The economic entity assumption states that we can identify all economic events with a particular economic entity. In other words, only business transactions involving the entity should be reported as part of that entity’s financial accounting information. Another key aspect of this assumption is the distinction between the economic activities of owners and those of the company. Monetary Unit Assumption Information would be difficult to use if, for example, we listed assets as “three machines, two trucks, and a building.” According to the monetary unit assumption, in order to measure financial statement elements, we need a unit or scale of measurement. A monetary unit like the Philippine peso is the most appropriate common denominator to express information about financial statement elements and changes in those elements. The common denominator in Europe is the euro while dollar in the U.S. If an entity has operations throughout the world, it must translate all its financial information to common monetary unit often that of the parent company, under the monetary unit assumption. Periodicity Assumption The periodicity assumption relates to the qualitative characteristic of timeliness. External users need periodic information to make decisions. The periodicity assumption divides the economic life of an enterprise (presumed to be indefinite) into artificial time periods for periodic financial reporting. QUALITATIVE CHARACTERISTICS OF FINANCIAL STATEMENTS The qualitative characteristics of useful financial information identify the types of information that are likely to be most useful to the existing and potential investors, lenders and other creditors for making decisions about the reporting entity on the basis of information in its financial report (financial information). Financial reports provide information about the reporting entity’s economic resources, claims against the reporting entity and the effects of transactions and other events and conditions that change those resources and claims. Some financial reports also include explanatory material about management’s expectations and strategies for the reporting entity, and other types of forward-looking information. The qualitative characteristics of useful financial information apply to financial information provided in financial statements, as well as to financial information provided in other ways. Cost, which is a pervasive constraint on the reporting entity’s ability to provide useful financial information, applies similarly. However, the considerations in applying the qualitative characteristics and the cost constraint may be different for different types of information. For example, applying them to forward-looking information may be different from applying them to information about existing economic resources and claims and to changes in those resources and claims. 23 For information to be useful it must both be relevant and provide a faithful representation of what it purports to represent. Relevance and faithful representation are the fundamental qualitative characteristics of useful financial information, and the guiding concepts that apply throughout the revised Conceptual Framework. The usefulness of financial information is enhanced if it is comparable, verifiable, timely and understandable. Figure 1-16. Qualitative Characteristics of Useful Financial Information Fundamental Qualitative Characteristics Relevance An information is relevant if it is capable of making a difference to the decisions made by users. Information may be capable of making a difference in a decision even if some users choose not to take advantage of it or are already aware of it from other sources. Financial information is capable of making a difference in decisions if it has predictive value or confirmatory value. Financial information has predictive value if it can be used as an input to processes employed by users to predict future outcomes. Financial information need not be a prediction or forecast to have predictive value. Financial information with predictive value is employed by users in making their own predictions. Financial information has confirmatory value if it provides feedback about (confirms or changes) previous evaluations. The predictive value and confirmatory value of financial information are interrelated. Information that has predictive value often also has confirmatory value. For example, revenue information for the current year, which can be used as the basis for predicting revenues in future years, can also be compared with revenue predictions for the current year that were made in past years. The results of those comparisons can help a user to correct and improve the processes that were used to make those previous predictions. Materiality. Information is material if omitting it or misstating it could influence decisions that the primary users of general purpose financial reports make on the basis of those reports, which provide financial information about a specific reporting entity. In other words, materiality is an entity-specific aspect of relevance based on the nature or magnitude, or both, of the items to which the information relates in the context of an individual entity’s financial report. 24 Consequently, a uniform quantitative threshold for materiality or predetermined quantity on what could be material in a particular situation cannot be specified. Faithful Representation Information must faithfully represent the substance of what it purports to represent. A faithful representation is, to the maximum extent possible, complete, neutral and free from error. A faithful representation is affected by level of measurement uncertainty. Substance over Form. Financial reports represent economic phenomena in words and numbers. To be useful, financial information must not only represent relevant phenomena, but it must also faithfully represent the substance of the phenomena that it purports to represent. In many circumstances, the substance of an economic phenomenon and its legal form are the same. If they are not the same, providing information only about the legal form would not faithfully represent the economic phenomenon. To be a perfectly faithful representation, a depiction would have three characteristics. It would be complete, neutral and free from error. Of course, perfection is seldom, if ever, achievable. The objective is to maximise those qualities to the extent possible. Completeness. A complete depiction includes all information necessary for a user to understand the phenomenon being depicted, including all necessary descriptions and explanations. For example, a complete depiction of a group of assets would include, at a minimum, a description of the nature of the assets in the group, a numerical depiction of all of the assets in the group, and a description of what the numerical depiction represents (for example, historical cost or fair value). For some items, a complete depiction may also entail explanations of significant facts about the quality and nature of the items, factors and circumstances that might affect their quality and nature, and the process used to determine the numerical depiction. Neutrality. A neutral depiction is without bias in the selection or presentation of financial information. A neutral depiction is not slanted, weighted, emphasised, de-emphasised or otherwise manipulated to increase the probability that financial information will be received favourably or unfavourably by users. Neutral information does not mean information with no purpose or no influence on behaviour. On the contrary, relevant financial information is, by definition, capable of making a difference in users’ decisions. Prudence. Neutrality is supported by the exercise of prudence. Prudence is the exercise of caution when making judgements under conditions of uncertainty. The exercise of prudence means that assets and income are not overstated and liabilities and expenses are not understated. Equally, the exercise of prudence does not allow for the understatement of assets or income or the overstatement of liabilities or expenses. Such misstatements can lead to the overstatement or understatement of income or expenses in future periods. The exercise of prudence does not imply a need for asymmetry, for example, a systematic need for more persuasive evidence to support the recognition of assets or income than the recognition of liabilities or expenses. Such asymmetry is not a qualitative characteristic of useful financial information. Nevertheless, particular Standards may contain asymmetric requirements if this is a consequence of decisions intended to select the most relevant information that faithfully represents what it purports to represent. Free from Error. Faithful representation does not mean accurate in all respects. Free from error means there are no errors or omissions in the description of the phenomenon, and the process used to produce the reported information has been selected and applied with no errors in the process. In this context, free from error does not mean perfectly accurate in all respects. 25 For example, an estimate of an unobservable price or value cannot be determined to be accurate or inaccurate. However, a representation of that estimate can be faithful if the amount is described clearly and accurately as being an estimate, the nature and limitations of the estimating process are explained, and no errors have been made in selecting and applying an appropriate process for developing the estimate. When monetary amounts in financial reports cannot be observed directly and must instead be estimated, measurement uncertainty arises. The use of reasonable estimates is an essential part of the preparation of financial information and does not undermine the usefulness of the information if the estimates are clearly and accurately described and explained. Even a high level of measurement uncertainty does not necessarily prevent such an estimate from providing useful information Applying the Fundamental Qualitative Characteristics Information must both be relevant and provide a faithful representation of what it purports to represent if it is to be useful. Neither a faithful representation of an irrelevant phenomenon nor an unfaithful representation of a relevant phenomenon helps users make good decisions. The most efficient and effective process for applying the fundamental qualitative characteristics would usually be as follows: 1. Identify an economic phenomenon, information about which is capable of being useful to users of the reporting entity’s financial information. 2. Identify the type of information about that phenomenon that would be most relevant. 3. Determine whether that information is available and whether it can provide a faithful representation of the economic phenomenon. If so, the process of satisfying the fundamental qualitative characteristics ends at that point. If not, the process is repeated with the next most relevant type of information. The foregoing is subject to the effects of enhancing characteristics and the cost constraint. In some cases, a trade-off between the fundamental qualitative characteristics may need to be made in order to meet the objective of financial reporting, which is to provide useful information about economic phenomena. For example, the most relevant information about a phenomenon may be a highly uncertain estimate. In some cases, the level of measurement uncertainty involved in making that estimate may be so high that it may be questionable whether the estimate would provide a sufficiently faithful representation of that phenomenon. In some such cases, the most useful information may be the highly uncertain estimate, accompanied by a description of the estimate and an explanation of the uncertainties that affect it. In other such cases, if that information would not provide a sufficiently faithful representation of that phenomenon, the most useful information may include an estimate of another type that is slightly less relevant but is subject to lower measurement uncertainty. In limited circumstances, there may be no estimate that provides useful information. In those limited circumstances, it may be necessary to provide information that does not rely on an estimate. Enhancing Qualitative Characteristics Comparability, verifiability, timeliness and understandability are qualitative characteristics that enhance the usefulness of information that both is relevant and provides a faithful representation of what it purports to represent. The enhancing qualitative characteristics may also help determine which of two ways should be used to depict a phenomenon if both are considered to provide equally relevant information and an equally faithful representation of that phenomenon. 26 Comparability Users’ decisions involve choosing between alternatives, for example, selling or holding an investment, or investing in one reporting entity or another. Consequently, information about a reporting entity is more useful if it can be compared with similar information about other entities and with similar information about the same entity for another period or another date. Comparability is the qualitative characteristic that enables users to identify and understand similarities in, and differences among, items. Unlike the other qualitative characteristics, comparability does not relate to a single item. A comparison requires at least two items. Consistency is related to comparability but not the same. Consistency refers to the use of the same methods for the same items, either from period to period within a reporting entity or in a single period across entities. Comparability is the goal; consistency helps to achieve that goal. Uniformity. Comparability is not uniformity. For information to be comparable, like things must look alike and different things must look different. Comparability of financial information is not enhanced by making unlike things look alike any more than it is enhanced by making like things look different. Some degree of comparability is likely to be attained by satisfying the fundamental qualitative characteristics. A faithful representation of a relevant economic phenomenon should naturally possess some degree of comparability with a faithful representation of a similar relevant economic phenomenon by another reporting entity. Although a single economic phenomenon can be faithfully represented in multiple ways, permitting alternative accounting methods for the same economic phenomenon diminishes comparability. Verifiability Verifiability helps assure users that information faithfully represents the economic phenomena it purports to represent. Verifiability means that different knowledgeable and independent observers could reach consensus, although not necessarily complete agreement, that a particular depiction is a faithful representation. Quantified information need not be a single point estimate to be verifiable. A range of possible amounts and the related probabilities can also be verified. Verification can be direct or indirect. Direct verification means verifying an amount or other representation through direct observation, for example, by counting cash. Indirect verification means checking the inputs to a model, formula or other technique and recalculating the outputs using the same methodology. An example is verifying the carrying amount of inventory by checking the inputs (quantities and costs) and recalculating the ending inventory using the same cost flow assumption (for example, using the first-in, first-out method). It may not be possible to verify some explanations and forward-looking financial information until a future period, if at all. To help users decide whether they want to use that information, it would normally be necessary to disclose the underlying assumptions, the methods of compiling the information and other factors and circumstances that support the information. Timeliness Timeliness means having information available to decision-makers in time to be capable of influencing their decisions. Generally, the older the information is the less useful it is. However, some information may continue to be timely long after the end of a reporting period because, for example, some users may need to identify and assess trends. 27 Understandability Classifying, characterising and presenting information clearly and concisely makes it understandable. Some phenomena are inherently complex and cannot be made easy to understand. Excluding information about those phenomena from financial reports might make the information in those financial reports easier to understand. However, those reports would be incomplete and therefore possibly misleading. Financial reports are prepared for users who have a reasonable knowledge of business and economic activities and who review and analyse the information diligently. At times, even well- informed and diligent users may need to seek the aid of an adviser to understand information about complex economic phenomena. Applying the Enhancing Qualitative Characteristics Enhancing qualitative characteristics should be maximised to the extent possible. However, the enhancing qualitative characteristics, either individually or as a group, cannot make information useful if that information is irrelevant or does not provide a faithful representation of what it purports to represent. Applying the enhancing qualitative characteristics is an iterative process that does not follow a prescribed order. Sometimes, one enhancing qualitative characteristic may have to be diminished to maximise another qualitative characteristic. For example, a temporary reduction in comparability as a result of prospectively applying a new Standard may be worthwhile to improve relevance or faithful representation in the longer term. Appropriate disclosures may partially compensate for non-comparability. Cost Constraint Cost is a pervasive constraint on the information that can be provided by financial reporting. Reporting financial information imposes costs, and it is important that those costs are justified by the benefits of reporting that information. There are several types of costs and benefits to consider. Providers of financial information expend most of the effort involved in collecting, processing, verifying and disseminating financial information, but users ultimately bear those costs in the form of reduced returns. Users of financial information also incur costs of analysing and interpreting the information provided. If needed information is not provided, users incur additional costs to obtain that information elsewhere or to estimate it. Reporting financial information that is relevant and faithfully represented helps users to make decisions with more confidence. This results in more efficient functioning of capital markets and a lower cost of capital for the economy as a whole. An individual investor, lender or other creditor also receives benefits by making more informed decisions. However, it is not possible for general purpose financial reports to provide all the information that every user finds relevant. Applying the cost constraint necessitates assessment whether the benefits of reporting particular information are likely to justify the costs incurred to provide and use that information. In most situations, assessments are based on a combination of quantitative and qualitative information. Because of the inherent subjectivity, different individuals’ assessments of the costs and benefits of reporting particular items of financial information will vary. 28 Measurement uncertainty Measurement uncertainty does not prevent information from being useful. However, in some cases the most relevant information may have such a high level of measurement uncertainty that the most useful information is information that is slightly less relevant but is subject to lower measurement uncertainty. 29 DISCUSSION QUESTIONS 1. Why is accounting called the “language of business”? 2. How is accounting defined by different accounting organizations? 3. What are the three basic activities in accounting? 4. What is the objective of financial reporting? 5. What is the basic difference between financial accounting and managerial accounting? 6. Distinguish the branches of accounting. 7. What is meant by stewardship or agency theory? 8. Identify some of the people interested in making decisions about a company. 9. Describe how ancient people keep track of their business transactions. 10. What are the seven preconditions for the emergence of systematic bookkeeping? 11. Distinguish the Genoese System from Florentine Approach to reporting. 12. What is the contribution of Luca Pacioli to the accounting profession? 13. Describe the early regulations giving rise to the mandatory demand for accounting services. 14. Describe the accounting issues that emerge due to industrial revolution. What branch of accounting was born to address these concerns? 15. What caused the conflicts between taxation and financial accounting? 16. How was the use of Chart of Accounts developed? 17. Why is there a need for consolidated accounts and financial reports? 18. Discuss the impact of technology and internet to the accountancy profession. 19. How internationalization affects the accounting practices? 20. Discuss the evolution of the accountancy profession in the Philippines. 21. Distinguish the four programs under the accountancy education. 22. What are some of the benefits to obtaining a degree in accounting? 23. What are the specialized fields of accounting? Describe each. 24. What are the opportunities available to accountants? 25. What new areas are accountants expanding into? 26. Discuss double-entry bookkeeping. 27. What are the fundamental principles required from professional accountants? Describe each. 28. What are the three major legal forms of business organizations? Which one is chosen by most of the largest companies in the Philippines? 29. What are the major advantages and disadvantages of each of the legal forms of business organizations? 30. What are the classes of business organizations according to nature of its operation? Define each. 31. Differentiate the accounting cycle classes of business organizations. 32. What are the three basic business activities that financial accounting seeks to measure and communicate to external parties? Define each. 33. What are a few of the typical financing activities of large conglomerates like Ayala Corporation? 34. What are a few of the typical investing activities for a company like Smart Communications, one of the leading internet provider in the country? 35. What are a few of the typical operating activities for a company like Hewlett-Packard, one of the world’s leading supplier of electronic devices like computers and laptops? 36. Discuss the underlying assumptions in financial reporting. 37. What are the fundamental qualitative characteristics of financial statements? Discuss each. 38. What are the two components of relevance? 39. What are the three components of faithful representation? 40. What are the enhancing qualitative characteristics of financial statements? Discuss each. 41. Why cost is considered a pervasive constraint on the information that can be provided by financial reporting? 30 THEORETICAL QUESTIONS 1. Who invented double-entry bookkeeping? a. Eugen Schmalenbach b. Amatino Manucci c. Giovanni Farolfi d. Luca Pacioli 2. Financing activities of a company include which of the following? a. Using cash to purchase long-term assets such as machinery. b. Selling products or services to customers. c. Borrowing money from the bank. d. Paying salaries to employees. 3. Investing activities of a company include which of the following? a. Using cash to purchase long-term assets such as equipment. b. Issuing common stock to investors. c. Borrowing money from the bank. d. Paying salaries to workers. 4. Why does financial accounting have a positive impact on our society? a. It allows investors and creditors to redirect their resources to successful companies and away from unsuccessful companies. b. It entails a detailed transaction record necessary for filing taxes with the Bureau of Internal Revenue (BIR). c. It provides a system of useful internal reports for management decision making. d. It prevents competitors from being able to steal the company’s customers. 5. What are the two primary qualitative characteristics identified by the International Accounting Standards Board’s (IASB) conceptual framework? a. Relevance and faithful representation. b. Comparability and consistency. c. Materiality and efficiency. d. Costs and benefits. 31 EXERCISE 1 True or False. Indicate whether the definition of accounting provided is true or false. _______ 1. The language of business. _______ 2. Counting preceded with an ‘a’. _______ 3. A service activity which function to provide qualitative information mostly financial in nature, about economic entities that is intended to be useful in making socio-economic decisions. _______ 4. An information system that measures, processes and communicates financial information about an economic entity. _______ 5. Identifying, recording and communicating the economic events relevant to the business. EXERCISE 2 Identification. Identify the terms described in the statements provided. _________________ 1. Its function is to measure the activities of the company and communicate those measurements to people. _________________ 2. It is a mechanical task involving the collection of basic financial data. _________________ 3. It describes the conflict between the owner of economic resources and the manager who is entrusted with these economic resources. _________________ 4. Use financial reports to decide whether to invest in stocks or withdraw his investment. _________________ 5. Tokens often sealed in clay balls used by primitive people and considered as the first bill of lading. _________________ 6. A celebrated mathematician known as the Father of Modern Accounting. _________________ 7. Designed by Schmalenbach that paved the way to comparability of financial reports. _________________ 8. The prevailing law governing the Accountancy profession in the Philippines. _________________ 9. This means being straight forward and honest in all professional and business relationships. _________________ 10. The most complicated form of business organization. _________________ 11. The length of time lapsed from the disbursement of cash until it reverted back to cash. _________________ 12. Involves transactions intended to draw funds from external sources. _________________ 13. It distinguishes business transactions from that of the personal economic trans

Accounting Essentials 2018 Edition PDF

Document Details

Tags

Related

Summary

Full Transcript

Upgrade to continue