Chapter I

The Nature of Accounting and Its Business Environment

What is ACCOUNTING?

- is the systematic process of measuring and reporting relevant financial information

about the activities of an economic organization or unit. Its underlying purpose is to
provide financial information. It is capable of being expressed in monetary terms.

According to:

American Institute of Certified Public Accountant (AICPA )

- defines as the art of recording, classifying, and summarizing in a significant manner and in
terms of money, transaction, and events, which are in part at least of a financial character, and
interpreting the result thereof.

Philippines Institute of Certified Public Accountant (PICPA)

- defines as a service activity. Its function is to provide quantitative information, primarily

financial in nature, about economic entities, that is intended to be useful in making economic
decisions.

Nature of ACCOUNTING

 Accounting is a systematic process.

Process is a series of actions that produce something or that lead to a particular result. As
such, the performance of the four aspects of accounting, which are recording, classifying,
summarizing, and interpreting, leads to communicating to its users the relevant financial
information needed by the parties interested.
 Accounting is an art.

Art is a skill acquired by experience, study, or observation. It is also defined as an

occupation requiring knowledge or skill. The four aspects of accounting require both knowledge
and skill through experience, study, or observation as a means to produce the key end product
which are the financial reports.

 Accounting is a service activity.

Service is the occupation or function of serving. Activity is something that is done as work
or for a particular purpose. Combining the meaning of the two words, accounting is a work or
occupation for serving a particular purpose. Hence, since its purpose is to provide financial
information, the data that it will process in terms of the four aspects of accounting should be
expressed in monetary terms. In short, it is interested in activities that can be measured and
expressed in terms of the value of money

FOUR ASPECTS OF ACCOUNTING

• RECORDING

writing down of business transactions chronologically in the books of account as they

transpire

• CLASSIFYING

Sorting similar and related business transactions into the three categories of assets,
liabilities, and owner’s equity

• SUMMARIZING

Preparing the financial statements from the transactions recorded in the books of
account that are designed to meet the information needs of its users
• INTERPRETING

Representing the qualitative and quantitative financial information about the business
transactions in a language comprehensible to the users of financial statements. By
interpreting the data in the financial statements, users are able to determine the
financial standing of the company as well as its stability and growth potential. Users
interpret financial information relating to specific business decisions. This makes
accounting the language of business.

HISTORY OF ACCOUNTING

“It is believed that the very origins of writing itself may have developed out of early
marks used to keep account of goods at ancient warehouses more than 5,300 years ago.
The notion that pre-numerical counting systems pre-dated even written language didn’t
come as a surprise to many historians and archaeologists who have long since
recognized that the history of human civilization is largely indistinguishable from the
history of commerce.”

. Wiley, Carol. “The History of Accounting.” A State by State Accounting Guide. N.p., Apr. 2013. Web. 12 July 2014
http://www.accountingedu.org/history-of-accounting.him>

Ancient Accounting in Egypt, Mesopotamia, Greece, and Rome

The history of accounting dates back to ancient times. The abacus which functioned as a
calculator in the ancient times, was developed by the Sumerians in 5,000 BCE followed
by the papyrus which was developed by ancient Egyptians in 4,000 BCE. The papyrus not
only allowed recording of commercial transactions but also the transcription of religious
text, music, literature, and more. In Egypt, archaeologist Dr. Gunter Dreyer the German
Institute of Archaeology unearthed clay tablets considered to be among the oldest
written tax accounting records. In the tomb of King Scorpion I in Egypt, he discovered
old stone labels were complete with marks representing accounts of oil and linens which
were believed to be paid to the king as taxes.

Mesopotamia had clay tokens and clay tablets to record their loans, herds, crops, and
system of trade. The scribes who performed extensive duties in writing and recording in
the Mesopotamian civilization are the equivalent of present-day accountants. Aside
from writing down commercial transactions, scribes assured that the agreements were
in compliance with the detailed code requirements for commercial transactions.
The greeks also made significant contributions to the development of accounting. In
600B CE, they introduced money on the form of coins. Moreover, they adopted the
Phoenician writing system and invented a Greek alphabet which they used to facilitate
record-keeping. As early as those times, bankers in Greece offered credit and helped
people transfer funds to banks in other cities as evidenced by the bankers ‘book of
accounts. It was the same in Rome where accounting helped establish their finance and
legal system. In fact, the Romans introduce the use of an annual budget which
coordinated estimated revenues and taxes paid by the citizen in relation to the nation’s
expenditures. A cash book was maintained by households for their expenses.

In England, William the Conqueror took possession of al properties in the name of the
king upon his invasion. In 1086, the Domesday Book contained all the real estate
surveyed by William the Conqueror and the taxes due to them. To date, the Pipe Roll or
the Great Roll of the Exchequer is the most ancient surviving accounting record in the
English language. This contains the yearly accounting of rents, fines, and taxes due to
the King of England, from 1130 to 1830.

14th Century – The Birth of Double Entry Bookkeeping

During the 14th century, Luca Pacioli of Italy, otherwise known as Friar Luca dal Borgo, a
mathematician, friend and contemporary of Leonardo da Vinci, and considered to be
the “Father of Accounting” wrote Summa de Arithmetica, Geometria, Proportioni et
Proportionalita (Everything About Artithmetic, Geometry and Proportion). One section
of this book, De Computis et Scripturis (Of Reckonings and Writings), is composed of 36
short chapters that describe bookkeeping. The accounting cycle, similar to the modern
day accounting cycle is also included in this book. The book also explains the extensively
used balance sheet of today, the method of using memorandums, journals and ledgers,
the use of accounts such as assets, liabilities, owner’s equity, revenue and expenses,
year-end closing entries, and the use of the trial balance to prove a balanced ledger.

Pacioli credited Benedetto Cotrugli, for the original idea of the double-entry
bookkeeping. Cotrugli’s manuscript of Della Mercatura et del Mercante Perfetto (of
Trading and The Perfect Trader), which contains a brief description of the double entry
of bookkeeping, was never printed. Actually, not only Luca Pacioli, but the Italians are
broadly recognized to be the father of accounting for their marked contribution to the
improvement of trade and commerce. The business-minded early capitalistic Venetian
merchants used double-entry system of recording in the late 15 th century to calculate
their earnings and profits.

19th Century – The Dawn of Modern Accounting in Europe and America

Domination of the Theories of accounts (rather than accounting theories) marked not
only the beginning but also the latter part of the nineteenth century. In England, the
Industrial Revolution which replaced hand tools with machine or power tools, otherwise
known as the factory system, transformed accounting into an actual profession.
Businesses continued to expand requiring the expertise of accountants to gain
corporate control of their flourishing businesses.

In Scotland, Queen Victoria granted a royal charter to the Institute of Accountants in

Glasgow on July 6, 1854, thereby creating the profession of chartered accountant (CA).
Thus, accounting became a formal profession. In the latter part of the 19 th century,
because large amounts of British capital were invested in flourishing industries in the
United States, Scottish or British chartered accountants were sent to the United States
to audit British investments. Some of these accountants decided to stay in America and
became provenances of various accounting firms which they set up to practice their
profession. The year 1887 saw the birth of the present American Institute of Certified
Public Accountants (AICPA).

20th Century – The Evolution of Modern Accounting Standards

The American Institute of of Certified Public Accountants (AICPA), the first national
professional association for Certified Public Accountants (CPA), was formed in the young
but prosperous nation of the United States. Because of the economic depression, the
Securities and Exchange Commission (SEC) was formed. Periodic reports vouched by
certified public accountants were filed by all publicly-traded companies who had to
register with the SEC before selling their securities to the public. Thus, the AICPA was
tasked to set the accounting and auditing standards for these reports until the
establishment of the Financial Accounting Standards Board (FASB) in 1973. The FASB is
the result of the demand for more reliable and comparable financial reporting by the
Congress and SEC. Thus, the FASB and the Governmental Accounting Standards Board
(GASB) are currently two of the significant authorities establishing the generally
accepted accounting principle (GAAP) in the US. On the other hand, in response to the
continuing expansion of businesses, large accounting firms offered consultancy services
aside from their auditing function.

The Information Age

The information Age, otherwise known as the Computer Age, or New Media Age, has
brought about a significant change in the workload of accountants. Manual, tedious,
and time-consuming tasks were replaced by faster and more accurate computer
methods. Transactions can be consummated online with the help of the internet.
Various software applications in accounting have been developed to expedite
procedures and accommodate the numerous needs and demands of the different
businesses.

21st Century – Accounting in the Modern Times

The 21st century opened with the replacement of the International Accounting
Standards Committee (IASC) by the International Accounting Standards Board (IASB)
established in January 2001. In the same year, the Enron Scandal, the greatest corporate
fraud case recorded in American history, caused Arthur Andersen, one of the top audit
firms in the United States to close business. In order to protect investors from corporate
misinformation, the Sarbanes-Oxley Act was passed by the US Congress in 2002. This
imposed tougher restrictions on accountants conducting consultancy services.

The year 2008 witnessed tougher times with the economic recession in the United
States. In response to the Great Recession, the Dodd-Frank Act was signed into federal
law on July 21, 2010. This contains sixteen major areas of reform, including Financial
Stability, Orderly Liquidation Authority, Transfer of Powers to the Comptroller, the FDIC
and the Fed. Regulation of Advisers to Hedge Funds and Others Insurance,
Improvements to Regulation, Wall Street Transparency and Accountability, Payment,
Clearing and Settlement Supervision, Bureau of Consumer Financial Protection, Federal
Reserve System Provisions, Improving Access to Mainstream Financial Institutions, Pay It
Back Act, Mortgage Reform, and Anti-Predatory Lending Act.

With constant developments in modern technology and the globalization of businesses,

accountants continue to cope up with the changing trends. Many countries including the
Philippines have adopted the International Accounting Standards (IAS) and International
Financial Reposting Standards (IFRS) in order to support comparability and
understandability of financial statements across the globe. As a result, the accountants
of today face greater and more complicated responsibilities. In addition, technology
today reduces the time, effort, and cost of recordkeeping minimizes errors as well as
processes and summarizes large volumes of data input. As such, accountants must
always be updated with the latest innovations affecting their profession.

THE BUSINESS ENVIRONMENT

The Different Branches of Accounting

1. Financial Accounting

- deals with the theoretical framework covering accounting principles and concepts
relative to measurement and valuation as applied to assets, liabilities, stockholder’s
equity, retained earnings, revenue, and expense accounts in relation to the
preparation and presentation of financial statements. These financial statements
include disclosure requirements as governed by the generally accepted accounting
principles (GAAP).

2. Management Accounting

- the Institute of Management Accountants (IMA) defines management accounting

as a profession that 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.

3. Government Accounting

- refers to the accounting for the government and its instrumentalities, focusing
attention on the custody of public funds, the purpose or purposes to which those
funds are committed, and the responsibility and accountability of the individuals
entrusted with those funds.

4. AUDITING
- involves the inspection of an entity’s financial statements or business processes to
ascertain their correspondence with established criteria.
5. Tax Accounting
- is the preparation of tax returns and rendering of tax advice, such as the
determination of tax consequences of certain proposed business endeavors.

6. Cost Accounting
- is the systematic recording and analysis of the costs of materials, labor, and
overhead incident to the production of goods or rendering of services.

7. Accounting Education
- refers to teaching accounting and accounting-related subjects in an organized
learning environment. It is a process of facilitating the acquisition of knowledge and
skills regarding one or more of the other branches of accounting.

8. Accounting Research
- pertains to the careful analysis of economic events and other variables to
understand their impact on decisions. Accounting research includes a broad range of
topics, which may be related to one or more of the other branches of accounting,
the economy as a whole, or the market environment.

Users of Financial Information

Internal Users
Internal users are the primary users of financial information who are inside the
reporting entity and are directly involved in managing the company’s daily
operations. They are the decision-makers who make the strategic and operational
decisions for the company.

1. Investors/ Owners / Stockholders

- these parties provide the financial resources to keep the business going. They
decide whether to invest or not depending on the estimated amount of income on
the investment. Upon investment, they would want to know the financial position or
results of operation of their business investment.

2. Management
- organizational managers use financial information to set goals for their
companies. Managers evaluate their progress towards these goals and use financial
data as a guide for future management actions.

3. Employee
- although the employees are not directly involved in the decision making of the
company, they are nonetheless interested in the financial information of the
company to determine if they have a future in the company.

External Users
External users are secondary users of financial information who are parties outside
the company. They may not be directly involved in the company’s operations but
their decisions may significantly affect the business entity.

1. Financial Institutions/ Creditors

- before extending the credit, financial institutions use financial information to
determine the capacity of the business organization to pay its obligations and
their interests at the appropriate time.

2. Government
- financial information is important for tax purposes and in checking compliance
with Securities and Exchange Commission (SEC) requirements/

3. Potential Investors / Creditors

- before making an investment or extending credit, potential investors or
creditors may not only be interested in the company’s current financial position
and results of operation, but also in the company’s financial history. This should
give them the assurance that their investment will yield a reasonable rate of
return or the credit extended will be paid within a reasonable period of time.

Types of Business Organization

1. Sole / Single Proprietorship is a business owned and managed by only one

person.

Advantages
a. There are minimal costs and requirements in the formation.
b. The owner can withdraw the assets and profits of the business anytime at his
or her own discretion.
c. Decision making is solely in the hands of the owner.
d. The duration of the life of the business solely depends on its owner.

2. Partnership is a business organization owned and managed by two or more

people who agree to contribute money, property, or industry to a common fund
for the purpose of earning profit.

Advantages

a. There are minimal cost requirements in the formation.

b. There are more funds contributed from the investment of the partners.
c. There is infusion of more knowledge, experience, and skills from two or more
partners.
d. There can be division of labor between or among partners.

Disadvantages

a. The partners are liable for the action of each partner as a result of mutual
agency.
b. A general partner has unlimited liability if the other partners are limited
partners or are insolvent.
c. Disagreement between or among partners can lead to the withdrawal of one
or more partners.
d. The death, retirement, withdrawal, or incapacity of a partner results in the
dissolution of the partnership.
e. Admission of a new partner depends upon the approval of the other
partners.

3. Corporation is a form of business organization managed by an elected board of

directors. The investors are called stockholders and the unit of ownership is
called share of stock.

Advantages
a. The stockholders only have limited liability, as their liability extends only up
to the amount of their capital investment.
b. A corporation has continuous existence as its life is indefinite.
c. There is more infusion of funds from the stockholders or investors.
d. Shares of stocks can be transferred without the consent of other
shareholders.
e. Management of the corporation is vested upon its board of directors.

Disadvantages

a. A corporation entails many requirements and is more costly than a

partnership.
b. The government exercises strict control over corporation and imposes high
taxes.
c. Shareholders have little or no participation in the management of the
corporation,
d. Distribution of net income depends upon the declaration of dividends by the
board of directors.
e. In large corporations, there is formal or impersonal relationship between
employees and management due to the big number of employees. Hence,
chances of creating a personal and friendly atmosphere in the corporate
setting are minimal.

4. Cooperatives
Under Section 3 of republic Act 6938, a cooperative is a duly registered
association of person, with a common bond of interest, who have voluntarily
joined together to achieve a lawful common social or economic end, making
equitable contributions to the capital required and accepting a fair share of the
risks and benefits of the undertaking in accordance with universally accepted
cooperative principles.

In short, a cooperative is an association of small producers and consumers who

come together voluntarily to form a business which they own, manage, and
patronize.

Advantages
a. The prices of products offered to consumers are lower due to direct
purchases of cooperative members from producers or manufacturers.
b. Cooperatives are managed by the members themselves; thus, saving on
management costs which leads to lower prices of products inuring to the
benefit of the consumers.

Disadvantages

a. There is limited capital due to underprivileged members.

b. The cooperative is strictly for members only and shares cannot be
transferred to non-members.
c. Lack of efficient management as it is managed only by its members.

Three Types of Business Activities / Operations

1. Service
- is a type of business operation engaged in the rendering of services. A
service type of business earns based on the skill or quality of service it offers.
In order for the business to grow, its people or employees have to be trained.
For example, a well-known hair cutter cannot perform all the hair and make-
up services to his or her customers. He/She must train employees to
replicate the quality of the service he /she renders. Constant monitoring,
evaluating, and updating of knowledge of the staff are necessary. He/She has
to continuously maintain, if not improve, the quality of service offered to
his/her customers
Example: dental clinic, barber shop, laundry service

2. Trading / Merchandising
- is a type of business engaged in the buying and selling of goods.
Merchandising includes the process of managing and marketing the products
sold to its customers. Sales have to be optimized in order to make money.
Customer demands have to be satisfied with the quality of products sold. The
tedious processes of forecasting, purchasing, pricing, and marketing of
products in order to generate sales are essential in the trading or
merchandising business.
Example: grocery, sari-sari store

3. Manufacturing
- is engaged in the production of items to be sold. It involves the purchasing
and converting of raw materials to finished goods. This type of business
incurs overhead costs aside from the wages and materials used in the
production of goods. A rise in price in one of these costs causes an increase
in the price of goods produced. Aside from this, there are certain expenses
incurred even during periods of non-manufacturing such as rent, insurance,
worker benefits, and machine depreciation. Hence, careful planning is
involved in manufacturing.
Example: shoe factory, food processing

ACCOUNTING CONCEPTS ANF PRINCIPLES

Generally Accepted Accounting Principle (GAAP)

 These are broad, general statements or ‘’rules’’ and “procedures”

that serve as guides in the practice accounting.
 These are standards, assumption, and concepts with general
acceptability.
 These are measurement techniques and standards used in the
presentation and preparation of financial statements.

 Accounting System comprises the methods used by a business to keep records

of its financial activities and to summarize these accounts in periodic accounting
reports.
 Transaction is a completed action which can be expressed in monetary terms.

Fundamental Concepts

1. Entity Concept
- regards the business enterprise as separate and distinct from its owners and
from other business enterprises

Example: Dr. Teng has a skin clinic and a spa. The skin clinic is considered as a
separate entity distinct from the spa and the owner, Dr. Teng. The expenses of
the skin clinic should not be mixed with the expenses of the spa and the personal
expenses of Dr. Teng. The two businesses are considered to be separate
economic units, separate and distinct from their owner. As such, they should be
treated as different from each other, although owned and operated by only one
person. Hence, the personal expenses of Dr. Teng should not be mixed with the
expenses of any of the businesses.

2. Periodicity
- is the concept behind providing financial accounting information about the
economic activities of an enterprise for specified time periods. For reporting
purposes, one year is usually considered as one accounting period.

Example: Separate financial reports are prepared yearly for the skin clinic and
the spa of DR. Teng. Hence, Dr. Teng can measure the income of the two
businesses annually.

An accounting period may be classified as either of the following:

a. Calendar year
- a twelve-month period that starts on January 1 and ends on December 31

b. Fiscal year
- a twelve-month period that starts on any month of the year other than
January and ends twelve months after the starting period e.g., a business
whose fiscal year starts May 1, 2016 ends it fiscal year on April 30, 2017.

Note: A natural business year is any twelve-months period that ends when
business activities are at their lowest point.

3. Going Concern
- is a concept which assumes that the business enterprise will continue to
operate indefinitely.

Example: In preparing the financial statements of the skin clinic and the spa, the
accountant assumes that the businesses will not close or shut operations within
the next years.

Basic Accounting Principles

1. Objectivity Principle
- states that all business transactions that will be entered in the accounting
records must be duly supported by verifiable evidence.
Example: Payments must be supported by official receipts and bank deposits
must be supported by deposit slips.

2. Historical Cost
- means that all properties and services acquired by the business must be
recorded at their original acquisition cost.

Example: Land bought in 2001 for two million pesos should be recorded at
two million pesos even though its market value in the year 2016 is already
three million pesos.

3. Accrual Principle
- states that income should be recognized at the time it is earned such as
when goods are delivered or when services have been rendered. Likewise,
expenses should be recognized at the time they are incurred, such as when
goods and services are actually used and not at the time when the entity
pays for those goods and services.

Example: A resort cannot consider as income the advance payment of a

customer who paid his two-week resort accommodation in advance until the
customer has checked in. This is because the resort has not yet rendered the
service to the customer. As such, the advance payment by the customer
should be considered as a liability on the part of the resort in the form of
services to be rendered.

4. Adequate Disclosure
- states that all materials facts that will significantly affect the financial
statements must be indicated.

Example: Land bought at two million pesos in 2001, should be recorded at

historical cost in the 2016 financial statements. However, the current market
value of three million pesos in the year 2016 may be indicated in the financial
statements for the year 2016 in the form of a footnote or parenthetical note.

5. Materiality
- means that financial reporting is only concerned with information
significant enough to affect decisions. This refers to the relative importance
of an item or event. An item is considered significant if knowledge of it would
influence prudent users of the financial statements.

Example: Items of insignificant amount such as paper clips can be charged

outright to expenses.

6. Consistency
- means that the approaches used in reporting must be uniformly employed
from period to period to allow comparison of results between time periods.
Any changes must be clearly explained.

Example: if the straight line method of depreciation is being used by the

company, then the method should be uniformly used by the company in
computing its annual depreciation.